The current economic recovery looks long and difficult, and makes providing for an ageing population an even greater challenge. Will economies rebound to provide for the health care needs of retirees? At a conference organised in November 2008 by the Sim Kee Boon Institute’s Centre for Silver Security at the Singapore Management University, Todd Groome, adviser in the monetary and capital markets department of the International Monetary Fund (IMF), spoke on how the ongoing financial crisis could shape retirement risk .

According to Groome, the current economic crisis has brought home a number of lessons. One is that new products can hold unknown risks. Another is that risk management may not have been up to the task since many of the standard quantitative models and users of these models underestimated the systematic nature of risks. 

Among lessons learned are to “nip it in the bud”. Early detection and cure will reduce spill-over effects. Also, diversify to avoid counter-party risk. Everyone using the same risk management techniques amplifies systematic risk.

Recent Analysis on Financial Crisis

There has been a substantial amount of analysis of the recent economic crisis. Some examples of recent work include: Enhancing market and institutional resilience (Financial Stability Forum); Credit risk transfer (Working Group on Risk Assessment and Capital); Observations on risk management practices during the recent market turbulence (Senior Supervisors Group); Supervisory lessons from the sub-prime mortgage crisis (Basel Committee on Bank Supervision); Study of market best practices (International Institute of Finance), and; Risk management practices including the identification of risk management challenges and failures, lessons learned and policy considerations (International Monetary Financial Committee (IMFC).

From this work have come a number of broad findings. “The epicentre of the market crisis was sub-prime mortgages and structured credit products,” stated Groome.  With them came innovative financing, such as asset backed security CDOs (collateralised deposit obligations). From these arose more potent variations such as CDO-squares (baskets of CDOs), and synthetic CDOs (CDOs combined with credit default swaps). 

Second, risks were often under-estimated due in part to product complexity and over-reliance on quantitative analysis, including by rating agencies. Investors learned too late that many risk evaluations were wrong. Data shows that CDOs were indeed different. Default rates on Moody’s Baa bonds have been 2.2% since 1983. Default rates (since 1993) on Moody’s Baa CDOs have been 24%.

Third, mark-to-market accounting amplified price gapping and volatility among these typically illiquid securities including, in some cases, market losses which might not ultimately materialise as credit losses.  As Groome pointed out, “Taking write-downs in illiquid markets will amplify the loss.” To some extent, this may have been avoided in Asian markets which permit write-downs directly against owners’ equity rather than income if management (and auditors) feel the loss is not permanent. Even then, however, it is still a heavy weight hanging over earnings. 

Fourth, there has also been a substantial wealth effect with the decline in home prices followed by the sagging stock market. The mechanism by which wealth links to consumer spending is uncertain but the direction is known: It is negative.

Fifth, it wasn’t true in every case that poor risk management was to blame. In many cases, banks and other companies did their best based on available data within sample periods. Often, however, economies experienced an out-of-sample event when the economy moved into uncharted territory. “It makes the risk manager’s job very difficult,” observed Groome.

Sixth, bad risk management played a role. According to Groome, “There may have been over-reliance on models and, in many cases, too similar risk management and mitigation strategies.”  While the models may have been accurate, the fact that everyone used them meant all users came to the same conclusion at the same time, thereby increasing systematic risk. It is similar to technical market analysis. If everyone agrees that three ‘up’ days conveys a buy signal, all will rush to purchase at the same time, creating a self-fulfilling prophecy. 

Risk Management Failures

According to Groome, “One failure was properly recognising counter-party risk. An example is the monoline insurers.” He noted that, “The likelihood of a systematic credit event -- or more likely the volatility of the exposure being insured -- overwhelming the resources of the monoline insurers was not anticipated.”

Second, many investors may have misunderstood the unique nature of CDO ratings and how they differ from ratings of other debt. This may have caused them to underestimate CDO risks. Some, but not all, of the fault lies with the rating agencies. After all, S&P, Moody’s and Fitch did not issue a warning, for example, that their CDO ratings were not comparable to identical ratings for other bonds.  

Third, there was also some misunderstanding about the nature of credit ratings. Groome explained that, “While a security may be AAA-rated, it does not imply anything about the stability of its market pricing or liquidity. The failure to understand this resulted in medium-term illiquid assets being funded, in some cases, with short-term debt such as Asset-Backed Commercial Paper and Medium Term Notes.”

Fourth, risk models are only as good as their inputs and assumptions, and a model’s output is rarely “the answer”. Unfortunately, underlying assumptions usually went unchallenged. Sometimes, the extent to which the model depended on crucial assumptions was not fully thought through. Similarly, regulators or supervisors did not adequately challenge assumptions. Few asked hard-hitting, informative questions. Those who did were seen as “worrying about things that would probably never happen”, and were too easily refuted.

Lessons Learnt and Relearnt...So Far

As Groome observed, “The financial crisis offers lessons about how to avoid contagion -- second and third round effects.” Among the lessons he mentioned was that, “High credit ratings do not translate into stable liquidity. Also, concentrated positions, such as with a single insurer, should be a concern.”

Funding should also reflect basic banking and funding principles such as better matching of asset and liability term structures, particularly illiquid positions. In a downturn, problems arise when reasonably long-term and illiquid assets are funded with short-term debt which must be refinanced.

Looking forward, the loss in stock and real estate values caused a large decline in the value of many pension funds. About half of the losses in pension funds were in household plans. “In the future, the greatest challenge may be longevity risk,” said Groome. All populations are growing older, and many national pension plans are under-funded.

Several solutions may be pursued, he said, including drawing down pensions at a later age or indexing pensions to longevity, saving more and/or working longer. Investing in higher risk/return assets is a debatable alternative since there is no assurance that, at retirement, the market will be at the ‘up’ and not the ‘down’ part of the cycle.

Health care is probably the biggest risk management challenge since it has the greatest volatility of outcomes and cost estimates. For many countries, the solution has been to transfer the risk to government which picks up much of the health care bill. “These costs are rising with ageing populations, increased longevity and technology improvements in the field of medical care, “Groome stressed. “They are unlikely to be sustainable.”

The central question, as articulated by Federal Reserve Chairman Ben Bernanke in a speech at Jackson Hole in August 2008, is “How to strengthen our financial system … to reduce the frequency and severity of bouts of financial instability in the future.” Bernanke gave an interesting overview and possible roadmap to the “regulatory response” and the roles of the central bank going forward.

Key Questions Remain

Groome highlighted several key questions and issues still pending. 

With regard to Central Banks: They are a liquidity provider of last resort, but liquidity for whom? It used to be for banks only, but has permanently expanded to other financial institutions such as broker-dealers or insurance companies. This may be further expanded to include automobile companies and other manufacturers. 

With regard to regulatory responses: Will the world build a new infrastructure with a greater ability for firms to fail without contagion? This may be the contribution of a central clearing house for OTC derivatives. 

With regard to regulation vs market discipline: Will the future include more rules, or more disclosure and transparency to support better market discipline? 

With regard to the influence of non-banks: It is increasing. It includes insurance companies, pension funds, hedge funds, private equity and sovereign wealth funds.

With regard to retirement savings: It has been a trend to push more of the responsibility away from corporations and government and toward individuals. The problem of government fiscal and financial stability is seen in a study compiled by S&P in 2006. It shows sovereign ratings could decline sharply due to ageing populations.

According to the S&P study, by 2030, sovereign ratings could drop to non-investment grade for France, Italy, Japan, Korea and the US. For others ratings do not fall as far, but still drop. For the US, sovereign ratings could drop from AAA in 2005 to BBB in 2020, and non-investment grade by 2030. By 2040, the sovereign ratings of all countries, except Canada, drop to non-investment grade. (For Canada, it drops only to AA from AAA.)

It dramatically shows the potential seriousness of the problem. There does not yet appear to be action directed at an obvious solution.