February 2000 Newsletter
Issue Two, Volume One

A BRAVE NEW WORLD

By Mike Gasior

Welcome to issue two of the AFS Seminars newsletter. I would like to take this early opportunity to thank all of you who sent words of thanks or encouragement after receiving issue one. Your thoughts were touching and appreciated. It is quite humbling that this issue is going out to over 127,000 financial, accounting and systems professionals worldwide. For those of you who think you know me pretty well, I don’t want to hear any cracks about the "humble" comment. It really is true, I do have some humility. One should not confuse my somewhat big mouth as an egomaniacal trait. All I ever want to do is tell my audience the straightforward truth whenever I possibly can. I always think of Harry Truman’s quote when someone told him "Give ‘em hell Harry". His response was that he "always tells the truth, they just think it’s hell". This admission is a wonderful preface for the topic of this month’s newsletter: Risk. There will no doubt be a few readers who won’t appreciate some of my comments, and will send me nasty notes letting me know how wrong I am, and that I’m oversimplifying things. Needless to say, much of this newsletter has to do with Derivatives. Other parts of it will not. If the audiences in my seminars know anything about me, they know one thing for sure: I LOVE Derivatives. It has always been people I have the problems with. More on that to come.

If you would like to see last month’s issue on the move to T+1 and Straight Through Processing; or in the future any previous month’s issue; please visit http://www.afs-seminars.com. This way you don’t need to store it in your e-mail box. You can also visit the website if you’d like to print a pretty HTML version of any month’s copy or to subscribe in order to receive this newsletter personally. Feel free to forward this to anyone you think may enjoy or benefit from reading it. You have my explicit permission.

A BRAVE NEW WORLD

I don’t want to re-write last month’s newsletter, but let me remind you of some important facts. Trading volume continues to explode. The time in which trades must be processed and settled is shortening and will keep getting shorter. The investment vehicles handled in these transactions become more complex by the day. And all of this is being handled by increasingly smaller groups of humans. The question becomes whether or not all of this is a recipe for more disaster. I’m thinking that it might be.

Please don’t make me recite this damn list one more time. Barings. Orange County. Proctor & Gamble. Dell Computer. Gibson Greeting Cards. The State of Wisconsin. Of course there could be dozens of other substantial disasters I could re-visit; I’m not seeking to single out the poor organizations just listed. Quite frankly, I’m pretty sick of telling the groups in my seminars what happened in these situations. There is a very simple word that sews them all together: Control. There was not enough control by the respective managements over the people responsible for the trading and that was the cause of the disaster. If I have to read one more headline proclaiming "Derivatives Bring Down So-and-So Company" I am just going to have to puke. The headline never reads "Corvette Crashes into Guardrails on Highway". Instead it tells of the pimply face 16-year-old kid doing doughnuts in the rain that crashed. The poor Corvette was actually an innocent bystander to this whole thing. The 16-year-old could have also crashed the family wagon. Admittedly the Corvette made it easier but it was not culpable in the crash. Here is the headline, as I would have written it: "Idiot Human Buys Derivatives….Loses Big".

This is what actually happened. It would have been my Mom who would have asked the profound question: "How did those Derivatives get into that portfolio? Did a little Derivative fairy sneak in at night and put those Derivatives in there?"

In summary, my opinion can be seen clearly when I alter a National Rifle Association slogan to suit my own needs. "Derivatives don’t lose money. People lose money." People have been losing money since the beginning of time in everything from tulip bulbs, to stocks, to real estate and more. Derivatives were just the latest, greatest and perhaps fastest way to lose.

THE INESCAPABLE FACT

Some stuff I don’t negotiate. This is one of those times and it is actually pretty simple. Here are the facts about Derivatives.

You can use them for hedging.

You can use them for speculating.

There is no gray area when it comes to Derivative usage, and from time to time someone in my seminar will tell me about some Derivative or strategy which their organization is employing. Since I’m an admitted idiot I must always ask; "Why are they doing that?" Then the answer will come out something like "we’re kinda hedging" or "we’re sorta hedging" to which I always have to stop them cold and tell them that is an unacceptable answer. You are either hedging, or you’re not. There is no woulda, coulda, kinda hedging. The minute you’re not hedging you’re speculating. Period. Paragraph. Remember that there are some questions in life that have to be answered directly; "Are you pregnant, yes or no?" You’re never a little pregnant and you’re never sorta hedging. So if you ever get an answer like I just described, understand that it’s complete crap and that someone is not being straight with you. Tell them I said so.

PREPARING FOR THE BRAVE NEW WORLD

So finally we have to talk about what needs to be done if an organization is going to be ready for the momentous changes coming in the next 900 days.

To lay down a solid foundation I would like to share with you some of the findings of the Risk Standards Working Group. The copy of their report I am quoting from is dated 1996 and I am unaware of a newer version. Not that it really matters for our sake. The guidelines laid out by them still hold true and only small details need be changed to fine tune any control issues of today. All of us know too clearly that in the financial markets four years is like an eternity. Here are the important facts and responsibilities the Working Group outlined in the paper titled "Risk Standards for Institutional Investment Managers and Institutional Investors". We will reference back to this list later in the newsletter.

I. MANAGEMENT

1. Acknowledgement of fiduciary responsibility.
2. Approved written policies, definitions, guidelines and investment documentation.
3. Independent risk oversight, checks and balances, written procedures and controls.
4. Clearly defined organizational structure and key roles.
5. Constant application of risk policies.
6. Adequate education, systems and resources, back up and recovery plans.
7. Identification and understanding of key risks.
8. Setting risk limits.
9. Routine reporting, exception reporting and escalation procedures.

II. MEASUREMENT

10. Valuation procedures.
11. Valuation reconciliation, bid/offer adjustments and overrides.
12. Risk measurement and risk/return attribution analysis.
13. Risk-adjusted return measures.
14. Stress testing.
15. Back testing.
16. Assessing model risk.

III. OVERSIGHT

17. Due diligence, policy compliance and guideline monitoring.
18. Comparison of Manager strategies to compensation and investment activity.
19. Independent review of methodology, models and systems.
20. Review process for new activities.

If you would like to receive a copy of the complete Risk Standards Working Group paper just send me an e-mail requesting a copy. I will send you a copy of the document in its entirety as a Microsoft Word document free of charge. It is something every organization which manages risk needs to read.

Needless to say, in a single newsletter I cannot outline all the steps which must be taken to help my client organizations control their risks. All I can help with here is to begin the dialogue out of which changes can be made. Any reasonable person would agree that if all of the previous 20 steps were taken by an Institutional Investor their risk would be highly reduced. Even if all 20 were taken into consideration by management I venture to say that most of the disasters with which we are all familiar might have been avoided. When I teach my two-day Derivatives program, it almost makes you sick to your stomach to hear Nick Leeson’s words that "the first time I asked London for funding, massive alarm bells should have been ringing." He’s not exaggerating. Some of these financial disasters were frightening because of the lack of control over the personnel in charge of the trading. I tell my audiences every day; "if you don’t understand the products I’m using, or the strategies that I’m employing, THAT’S how we’ll wind up on 60 Minutes some evening."

So what can each area do to better understand and control the trading and risk management process? Just like last month, let’s go group by group.

WHAT EACH AREA CAN CONTRIBUTE TO RISK MANAGEMENT

*Securities Settlement and Operations*

This area must serve as the human element which polices the trading process. With so much of the securities and Derivatives market moving over-the-counter we have to be diligent about the affirmation/confirmation process. Because a lot of these products are outside the exchange and DTC system you have to be sure that a formal confirmation protocol is in place. Something as pedestrian as Mortgage Backed TBA’s can be a danger if left unwatched. Think of the possibilities. You might authorize me as your Mortgage Backed Securities trader and allow me trade in certain dollar amounts with various brokers. One afternoon after you’ve ticked me off I call my 5 largest brokers and take down $100 million of GNMA TBA’s for settlement in three months. I then decide to shred the tickets and hand in my resignation. If you don’t have at least a telephone confirmation agreement with said brokers you won’t know I’ve created a half a billion dollar exposure to the Mortgage Backed market until two business days before settlement three months from now. By then the brokers are sending over the trade detail and asking for their money. Golly. You better hope prices have risen or I guess I’ll be seeing you on 60 Minutes. Go back and re-read numbers 2, 3, 5, 6, 9 and 17.

Also, with the move to T+1 in a little over two years, you must be prepared to handle this process as more of an observer rather than a "hands on" participant. With the coming move to Straight Through Processing all of these compliance activities are going to be occurring in real time in the midst of the settlement process. It’s my guess that you’ll be expected to be watching every kettle on the stove here.

*Securities Accounting*

No doubt you will be the area responsible for the day to day monitoring and reporting of your organization’s overall risk profile. Do the words "Value at Risk" mean anything to you? Well you’d better pick up the learning curve on it, pronto. I had never even heard the term 4 years ago and now I have to include a discussion about it in every Derivatives seminar I teach. When I was getting my futures and options licenses I had never heard the word Derivative either. But of course, the Dow Jones was 820 back then. Oh well…

What will be most difficult to get used to is the speed at which your life will be moving. Besides all the usual monthly, quarterly and year-end reporting, you will be the group calculating our "at risk" position daily. That’s if you aren’t already doing it. If you are asking yourself why the portfolio area isn’t doing this themselves, they are. But remember that we don’t let the foxes watch the henhouse. It’s your job to police their numbers.

*IT and Systems Departments*

Why do I get the feeling that probably every month I will have to break the news to you that it’s your area getting screwed in this deal? Well guess what? You guys will be getting screwed in this deal too. Consider all the flawless systems that will need to be in place in the next two years. Plus they’ll have to be dependable, invisible and they’ll need to communicate with one another at the speed of light. And oh yeah, you’ll have to do it with a few less personnel and maybe a smaller budget too. Does it seem like I sit in the cube next to you or what?

So here’s your list of things to do:

--A Straight Through Processing system. This will take the order from your trader, in a ticketless environment, seamlessly from his or her fingertips and ultimately to the settlement of the trade without ever being touched by a human hand again.

--Within that system an active compliance system will need to be integrated. One that knows what I’m allowed to trade, who I’m allowed to trade with and what my dollar limits are. In this environment we can’t let an unauthorized trade even leave our shop; It will need to get caught before it ever goes.

--Residing within the system there will need to be a Value at Risk calculation to monitor our overall risk profile in real time.

--All of this will need to flow seamlessly into the accounting system.

Suffice it to say that the IT/Systems group has their work cut out for them. The numbers in the above working paper that apply to you will most likely be 3, 6, 9, 10, 11, 12, 13, 14, 15, 16 and 17. Your list may not be as long as Audit and Compliance but they only have to clearly understand these things. YOU will be the ones building the systems which report this info to them. Good luck men and women of the Systems Department.

*Audit and Compliance*

You are the guys who hold the end of the rope during a tug-of-war. You have to keep us from getting yanked over that proverbial line and onto the 60 Minutes segment. And Because you are the eyes of last resort you better have damn good vision.

Don’t think you can ask me about the ratings on my portfolio and feel at ease because I tell you AAA. I could blow our ass so far out of the water by the weekend with that report, you have no idea. Please remember that Orange County managed to lose over a billion and a half dollars in nothing BUT triple A rated securities. Do you know an IO from an IOU? Can you explain to me what FLUX scoring measures? If the answer to those two things is no, you better grab a book and start reading or sign up for a seminar. Education is your only defense now. What you don’t know WILL hurt you. Go back up and see numbers 2, 3, 5, 6, 7, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19 and 20. Now didn’t I tell you your job was big-time important?

*Traders and Investment Managers*

As always you are probably the most well equipped and ready for this environment. As much as you might get ticked at me when you read some of the stuff in this newsletter, trust me that I’m a better friend to you than you think. Sometimes you might think that if all these other areas were to know more, it would make your life more difficult. Not true. The more they understand, the easier it will be to explain things to them. If anything, the usage of some of these more sophisticated products might mushroom if senior managers felt more comfortable with them. That is only going to happen if they understand them better.

All of the numbers in the Risk Standards Working Group paper apply to you. Or better said, will be applied to you.

*Senior Management*

Your responsibility is straightforward enough. First of all you must be able to read that list from number one to twenty and at least understand what each of them means. You must understand which areas and departments have responsibility for each item and how they will all need to work together. You have to make sure that everyone has the resources necessary to perform their respective role. And you can’t cut any corners here. This is the serious stuff. Hiding your head in the sand about the issue of risk management won’t work here. I spoke in last month’s newsletter about my opinion of FAS 133 and my fear that some management might decide it’s not worth the possible bad PR with regard to marking their Derivatives to market. So the decision might come down that they will stop using Derivatives. Or in the same vein, we could easily eliminate our need to manage risk, if we chose not to use these sorts of products. The downside to that sort of thinking is that there will be other organizations that aren’t afraid. They’ll keep using these products with more and more alacrity and for increased profit as the market becomes less crowded and less efficient. That sound you’re beginning to hear? That’s the express train out of business. All aboard?

Never mind the fact that if something happens to go "boom in the night" with regard to your financial situation, it’s going to be YOU that Mike Wallace will be chasing through the parking lot while you cover your head with your raincoat. Enough said.

RESOURCES

Last month I listed a few web addresses that I thought my readers might find helpful. Thanks to those of you who wrote to tell me that one of the addresses was for a very lovely religious group and not the National Securities Clearing Corporation. Oops. It should have been http://www.nscc.com

I’ve decided that rather than put a list of links in every newsletter I would rather maintain a list of ALL the websites that I think might be helpful at http://www.afs-seminars.com. I’ve grouped them by category, and I hope they will prove to be a valuable resource for all of you going forward. I figure that it will perhaps save you a few steps when you’re searching for something of value on the Web. It has been my experience that you need to visit 25 crappy sites to locate just one that might be of some help. I’ve just tried to eliminate the other 25 for you. You’re welcome.

What I have also added to the website is an investment glossary where most securities and financial terms are explained in a brief format. Since most of the confusion tends to stem from terminology, again I am hoping to make your lives a little easier.

NEXT MONTH

Well, this month’s issue was supposed to have covered the move to decimalization and extended trading hours, but I couldn’t help notice so much discussion of risk in the trade magazines. Thus, the change. So unless there is some breaking news, which I cannot foresee, it will be decimalization and extended trading next month.

If you would like to add anyone to the distribution list, or change the e-mail address where you receive this newsletter, you can accomplish this by visiting our website at http://www.afs-seminars.com

Copyright 2000, Michael Gasior. All Rights Reserved.

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