Risk Management Decoded

By LIZ PEEK

"Risk management" has a nice ring to it. Not only does it suggest that a hedge fund team, for instance, has pretty much thought of all the things that could go wrong — it has also, bless its heart, managed those nasty surprises.

Leslie Rahl, founder and president of Capital Market Risk Advisors and a board member of Fannie Mae, has an excellent perch from which to view the unfolding of this latest debacle. According to her Web site, her company is "the preeminent financial advisory firm specializing in risk management, hedge funds, financial forensics, and risk governance."

Ms. Rahl graduated both from the Massachusetts Institute of Technology and its Sloan School of Management and was formerly head of Citibank's derivatives group. She actually understands all those complex formulas that are supposed to identify risk. Numbers are to Ms. Rahl as Cheerios are to the rest of us: uncomplicated and easily consumed.

Her take? "Risk management is all about thinking about two or three standard deviations from the mean. No one ever expects events to fall beyond that. Once in a lifetime events that fall outside that parameter have exponential, not arithmetic, consequences. Risk management is built around models, and models are built around assumptions. The models will work if things behave the way you model them to — but they never actually do. These events are somewhat expected, but we keep forgetting. You can't expect a computer model to anticipate changes. This is the big flaw — I keep reminding clients of this — that their assumptions are not the worst case."

"By definition, most risk people are young quants," Ms. Rahl said. Most, she said, do not carry their modeling back far enough to include similar events, such as the 1994 bankruptcy of Orange County, which she views as somewhat analogous to today's situation.

"In 1994, the money funds broke the buck," Ms. Rahl said, referring to the unthinkable: a money market fund that experiences such credit issues with its portfolio that it no longer trades at a dollar. A similar deterioration in shortterm instruments occurred over the past two months, as a few money market funds got into trouble. The credit problems in the early 1990s stemmed from holdings of "inverse floaters" and the "kitchen sinks" — the names given to the leftovers of collateralized mortgage obligations after they had been sliced and diced and the higher-grade parts of the securities had been bought by savvier investors.

At the end of the day, we are reminded of the peril of investing in instruments so complicated that few could really understand them. "Even for me, who loves complex things, it's very complicated," Ms. Rahl said. That's all we had to know.

September 13, 2007