Allen Levinson, W’77, WG’78
You have heard that the whole is worth more than the sum of its parts. You’ve even said it. Now, you’ll be able to explain why! Allen Levinson, W’77, WG’78, recent principal of Credit Risk Advisors, and board member of the Wharton Club of New York, shares in his professorial style, how to use financial risk management tools without hurting yourself or the economy.
What does the word “risk” mean in the context of business?
Risk occurs when you make a conscious decision, to place economic resources onto a probability distribution of alternative outcomes, where you believe the expected returns are attractive enough, that you can live with the possibility of a negative outcome. Uncertainty is the unpredictability of future outcomes. If an investor puts resources into a venture where the outcome is uncertain — say, investing in a startup company — then she will make some assessment of the probability of success or failure, but she is uncertain about how much risk she’s taking. Risk is when, in a fully informed manner, you choose to invest resources in a set of future outcomes, based on a probability distribution that you think you have assessed well.
How does risk work within financial institutions?
Banks and other financial institutions work hard to get the opportunity to take into their credit portfolios exposure to major borrowers, who need funds to, for example, finance a takeover, expand their businesses or refinance existing debt obligations. The bank has a credit officer who assesses the creditworthiness of the borrower. She assesses the riskiness of that one transaction, by developing a probability distribution of outcomes, to calculate an expected return on this investment. Outcomes could include ─ the borrower pays every dollar back; defaults and pays nothing back; or struggles, and the loan needs to be restructured.
Let’s assume that the bank knows at the transaction level what the riskiness is — and how certain it is about that. It now has these various credits in its portfolio. As each of those assets has a probability of default, what is the probability of two of these credits defaulting at the same time? Are they independent, or are they correlated? Let’s say the credit officer is prudent. She does not want her bank to fall apart by losing too much money all at once. She doesn’t want to lend to everyone in the same industry who has the same credit risk profile. However, she has a lot of capital and needs to make enough loans to ensure sufficient returns for her shareholders. Dealing with correlations is important, and it is an area where, due to insufficient analysis and historically little amounts of data, people often erroneously assume independence. “Illusory diversification” of this sort often leads to severe financial losses.
How do banks assume independence and/or miss correlations?
In 2008, we saw that one way sophisticated financial institutions become unprofitable was by illusory diversification. I learned this back in the 1990s, when I was looking at portfolios of commercial real estate that were exceptionally well-diversified by size of borrower, by type of loan and by historical track record of the operator. It turned out that the assets were exceptionally correlated: The loans were all collateralized with commercial real estate. When the dominoes began to fall, it was one after another.
Financial institutions assume a variety of types of risk against their capital: interest rate risk, credit risk, currency risk, commodity risk and equity risk. One risk that financial institutions often miss is exposure to liquidity. If I own something and have to sell it at that moment, but can’t find a buyer, it is worthless. Unanticipated liquidity risk hit us all in 2008, because major financial institutions assumed that all their risks were independent.
If you go back to your basic Wharton financial textbooks, every asset has a market value. If you produce a portfolio of them and add up their market value, is this amount the value of that portfolio? For this to be true, the portfolio must be well-diversified. It must also be totally liquid.
How you can make a portfolio more liquid?
Liquidity requires easy access to sellers when you build the portfolio and easy access to buyers when you decide to sell. Learning the current bid and offer prices of selected assets, and the prices at which transactions were recently completed (that is, “price transparency”), also helps greatly. For many types of securities — notably, commodity futures, stocks and options — exchanges have been established to promote liquidity. For other asset classes, such as bank loans, robust over-the-counter markets have evolved. In each case, the evolution of exchanges and other organized markets is enhancing liquidity for the associated asset classes. This evolution is continuing. As associated assets become more liquid, carefully crafted portfolios from these asset classes show improved liquidity as well.
In a 2009 Knowledge@Wharton interview with you and Professor Richard Herring — Unfreezing Securitization: Restoring the Market’s Confidence in Itself — you described what happened to the securitization market, and a way forward.
During the 2008 to 2009 period, many securitization structures performed unexpectedly poorly. Loans used as collateral defaulted at an unexpected pace; the portfolios of collateral proved to be undiversified in this difficult market; and the value of the associated bonds plummeted. This story was so common that investment losses at many institutions led to severe credit problems for the institutions themselves. Many of the institutions holding such bonds were banks, often the underwriters of the deals. As these institutions saw their own creditworthiness deteriorate, their willingness to lend to their peers decreased substantially, and the credit markets froze. Like any sharp tool, securitization, which through the process of liquification and diversification drove economic growth since the 1980s, turned around and severely hurt those who had relied on it. Many institutions, regulators and financial pundits blamed the securitization process for the current crisis in the credit markets.
At that time, Dick (Professor Herring) and I were each pondering how to best unfreeze the credit markets and restart the powerful economic driver of securitization. We discarded the idea that securitization was primarily a dangerous process and that regulatory authority should be used to inhibit its use. We believed that investors could develop a new market-driven function, which would establish a rigorous process to ensure that key service providers (that is, accountants, lawyers, originating and underwriting banks, and rating agencies) would be diligent in disclosing relevant deal-specific data that was accurate and not misleading. If these service providers were monitored to ensure that the data provided to institutional investors was reliable, then investors could more accurately evaluate the risk and return associated with each prospective investment, and the market could perform substantially more efficiently, going forward.
This concept, with a lot more meat on the bones, created, at least in Dick’s and my opinion, a solution to this industry dilemma that did not require a substantial amount of new regulations. In a sense, we suggested that institutional investors, with their market clout, take on a regulatory role to ensure that investments in this area performed as advertised. The perceived risk inherent in each deal would more closely equal that which had been assessed.
What role did interest rates play?
Part of what drove securitization into the ground was a period of wishful thinking on the part of institutional investors. Many institutions — most notably, pension funds and charitable endowments — felt pressure to earn sufficient returns that would allow them to fulfill their financial obligations without needing to tap deeply into their principal accounts. As market rates declined, this need put growing pressure on investment managers. To hit their necessary return targets, managers felt the need to buy relatively high yielding assets at a time when interest rates in general were dropping significantly. To do so, they bought record amounts of bonds from securitizations. Their comfort that these bonds were not very risky came, at least in part, from wishful thinking.
As we discussed above, service providers, through their reported data, left plenty of room for the investment manager to assess the risk level of the associated investment as relatively low when compared against the promised return. As interest rates fell, fuel was added to this fire.
What is rewarding about your work?
The financial markets have benefited greatly as risk management capabilities have improved. Through efficient risk management, an institutional investor can buy assets that are attractive, and build them into a portfolio where they can make one plus one to equal three, earning attractive returns. The key is proper measurement and management of the risk that is inherent in such a portfolio. In the current environment, it is exciting to be safely building such portfolios, and in doing so, helping to achieve what financial institutions are about — intermediating capital. Personally, I have found that, over the course of my career, playing the role of risk manager in these processes has been very fulfilling.
What role can Wharton play in educating financial managers?
Wharton already plays an important role in a variety of areas. Many accounting classes emphasize the importance of financial controls. Without controls, investors cannot rely on third-party data to behave as advertised, and sophisticated investment products can fail. Finance classes need to focus on valuation of complex portfolios, using both quantitative and subjective forms of analysis. Sophisticated models can help greatly. Failure to subjectively study the assumptions used in the development of particular models can lead to unexpected consequences. Finance classes need to help provide insight here. Macroeconomic insights help financial professionals of all sorts put their current activities into a longer-term perspective. All of the above helps foster greater expertise in financial managers and greater efficiency in financial markets. I know that Wharton’s Financial Institutions Center and other areas of the school have contributed greatly in these areas. Other business schools should be working to catch up.
What was your path from Wharton?
Upon getting my MBA in 1978, I joined Bankers Trust as a salesman and eventually became a trader of government securities. Interest rate risk was my first area of education. I went on to a variety of jobs in sales, trading and management. By 1990 or so, I became the bank’s loan portfolio manager, and helped develop the markets for loan securitizations and credit derivatives, and finally became chief of staff for corporate finance. In 1995, I moved on to Goldman Sachs, where I managed transactional risk management services. After this time, I became a partner in KMV Corp., an entrepreneurial financial technology company that provided corporate credit risk models to financial institutions globally. After we sold KMV to Moody’s, I partnered with two former clients to form a hedge fund called Credit Risk Advisors, which successfully managed a portfolio of corporate bonds and credit derivatives. Over my career, I’ve held an exceptionally large number of jobs, and I enjoyed every one of them. All in all, I learned a lot, and I had fun; and I still don’t know what I want to do when I grow up.