Some Notable Events in 2007
New Century: 4/2/07 (REIT with market cap of $1.75 billion on 1/1/07, delisted 3/13, filed for bankruptcy 4/2)
S&P/Moody’s significant downgrades beginning in June 2007 Bear Stearns suspends redemptions: 6/7/07
Bear Stearns liquidates funds: 7/31/07
BNP Paribas funds: 8/9/07
The ABX-HE (or just “ABX”), is an index of credit default swaps (CDS) written on subprime mortgage securitizations. The price of the ABX index is essentially a measure of perceived value of subprime securities with various ratings; the return (or spread) on the ABX is essentially a risk premium for subprime.
The index was created by the firm Markit, and first released in January 2006 covering the 20 largest subprime securitizations that closed in the last six months of 2005. These indices were denoted as ABX-HE 2006-1. Subsequent releases were denoted 2006-2, 2007- 1, and 2007-2 before subprime activity became too small for index construction.
The launch of ABX in 2006 was a notable event, as it allowed everyone to see, speculate, and hedge – for the first time – market expectations about subprime.
How Could We Be So Wrong?
“… given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” – Chairman Bernanke in a speech on May 17, 2007
The bad news in subprime was well-known by the time of Chairman Bernanke’s speech. Indeed, the news events in the spring of 2007 seem uncorrelated with the movements in the ABX.
Instead, the problem became the uncertainty about the location of subprime risk. Which securitized bonds were exposed to subprime? Which financial institutions would need to support their investment vehicles?
The financial system is not equipped to analyze “safe” investments. The resources for deep analysis of information are not there.
Consider what you would do if you had uninsured deposits at a bank, and you became nervous about the bank’s solvency. Is it rational to analyze the bank’s balance sheet, or to just take your money out?
The London Interbank Offered Rate (LIBOR) is a measure of the interest rates that banks charge each other for unsecured dollar funding over various time periods (overnight, one-month, threemonth etc.)
The Overnight Index Swap (OIS) is a fixed-floating interest-rate swap for various time periods. Because the amounts owed daily are small and counterparties must continuously post collateral for expected payments, the fixed leg of this swap is considered to be a good proxy for risk-free interest rates.
The LIBOR-OIS spread is thus a good measure for the riskiness of banks’ unsecured borrowing. Historically, this spread was very small (around ten basis points).
Asset-Backed Commercial Paper
Asset-backed commercial paper (ABCP) is primarily a method of maturity transformation – funding a pool of long-term assets with short-term liabilities.
ABCP is designed to meet specific needs of investors (often money-market mutual funds), and includes credit enhancement and liquidity support to achieve this goal.
ABCP vs. Securitization
ABCP may appear similar to securitization, but there are many differences:
- Investments can be revolving and fluctuate in size
- Conduits may invest in various asset types
- Typically engage in maturity transformation, with backup liquidity support
- No scheduled amortization of assets and liabilities
ABCP programs grew rapidly in the 1990s, and then again in the crucial 2003-2007 period.
As of 2007, ABCP programs took many forms, and were not dominated by any particular type of sponsor.
Covitz, Liang and Suarez define an ABCP “run” as a week when the program does not issue new CP despite having at least 10% of outstanding CP mature.
Runs became endemic in August 2007, and once a program experienced a run it was unlikely to ever leave that state. By December 2007 more than 40% of programs were in a run state.
The problems in subprime were clear to all market participants in early 2007.
These problems were not expected to infect the whole financial system, but uncertainty about the location of risks led to a spread of anxiety beginning in the middle of 2007.
The anxiety is driven by a financial system ill-equipped to analyze risks in seemingly “safe” assets. This sets the stage for a good oldfashioned bank run, but now taking place in the shadow banking markets.
Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)
A risk management process is vital to the family office structure in order to formalize the approach to risk relating to the family wealth.
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Risk management systems
Risk, return and liquidity are among the foremost issues to be considered in any investment decision and asset allocation process. These prerequisites will be the basis for the risk management system, which in itself will cover risk mitigation and cost reduction and may lead to value creation. Factors include:
- Identify and address key risk areas that matter.
- Effectively assess risks across the family office, driving accountability and ownership.
- Manage and mitigate mission-critical risks.
- Establish comprehensive risk frameworks.
- Cost efficiencies are a critical part of setting up a family office.
- Implement an automated risk management process to materially improve the cost structure.
- Reduce cost of control spend through the improved use of automated controls.
- Streamline or eliminate duplicative risk activities.
- Improve process efficiency through continuous monitoring.
- Achieve superior returns from risk investments.
- Improve control of key processes.
- Combine risk and control management to improve performance.
- Use analytics to optimize the risk portfolio and improve decision-making.
Family office CEOs, CFOs or CIOs increasingly perceive enterprise risk management as adding value to the family office operation. According to the EFO Survey, family offices worry most about investment risks, family reputation, banking/custody risks and political/ country risks. After the financial crisis, risk management has developed further toward a risk-return based optimization model.
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Maintaining family wealth across generations is extremely complex. The recent global economic difficulties were unprecedented, and many families with significant business assets or private wealth are now looking to stabilize their wealth against this background. For wealthy families in Europe, the uncertainty and volatility resulting from legal, fiscal and political difficulties, coupled with the weakness of the Euro, have added to their problems. Many have been concerned with risks such as permanent loss of capital, counterparty and credit risk, and lack of liquidity. Consequently, with the aim of securing their family legacy over generations they have changed their perception of risk and the definition of risk itself.
The financial crisis of 2008-09, and the fallout from it, has led families to reconsider their approach and behavior towards risk. In broad terms, there has been a shift from too much risktaking before the crisis to too little afterwards. Such subjective perceptions of risk can only be avoided through a stringent and structured risk management process focusing on long-term goals. Furthermore, there is a greater requirement today for additional due diligence procedures for large investments, as well as a desire for more transparency during the investment process.
Against this background, family offices need to complement their existing standard risk measures with additional techniques, such as using additional portfolio analysis tools combined with scenario analyses for different asset classes. The risk management function within the family office is increasingly moving away from a mere controlling role to a time-critical, strategic advisory role. This trend also has a significant impact on make-or-buy decisions in the family offices.
This new demand for risk transparency has led to the desire to invest more in direct investment opportunities and in real assets, rather than in complex financial capital market products. The ease of understanding investment products, proximity to the investments, and the possibility of having a real influence on the investment are more important now than ever. Long-term investments with lower volatility and a moderate expected return are more often combined with short- to mid-term investments with a significantly higher risk profile to achieve outperformance. As part of this process, the further professionalization of family office services is taking place in processes such as manager selection and due diligence of direct investments, and more stringent controlling of portfolio managers.
Risk management and investment reporting and controlling have thus gained in importance following the financial crisis. Market participants typically say that an optimal diversification or asset allocation strategy, combined with active and highly flexible portfolio-management, are the cornerstones of a solid risk management process.
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Typically, financial planning services, asset aalocation, risk management, manager selection, and financial accounting and reporting services tend to be provided in-house. Global custody, alternative investments and private equity, and tax and legal services are often outsourced.
However, families should be aware that the greater the level of outsourcing, the less irect influence the family will have over the decision-making process within the family office, and the less exclusive the products and services will be. Below we provided an overview of selected family office services, which can be categorized as in-house or outsourced based on market analysis.
|Type of services||Service Category||In-house||Outsourced|
|Investment Management and Asset Allocation||Financial Planning||Basic financial planning and aaset allocation decision should be provided in-house||The more complex, specialized and diverse assets make outsourcing a practical option|
|Tax and Legal Advisory||Advisory||Selectively done in-house||Often outsourced to a trusted adviser to ensure state-of-the-art quality services|
|Reporting and Record Keeping||Governance||Record keeping and documentation demand confidentiality and so this should idealy bbe done in-house||Basic reporting tools and software may be provided externally|
|Philanthropic Management||Financial Planning||In-house expertise should serve to assist with philanthropic activities||Setting up a foundation and related activities is often outsourced to a consultancy|
|Compliance and Regulatory Assistance||Advisory||A large family office might require full-time legal and accountancy expeertise||In general, full-time legal staff will be an unnecessary and costly addition to family offices that are not large enough to require them. Such staff can be outsourced when needed.|
|Risk Management and Insurance Services||Advisory||Some risk management skills should be provided in-house, in order to ensure ultimate peace of mind.||Can be outsourced as external risk and insurance professionals can offer trusted expert advise|
|Life Management and Budgeting||Financial Planning||Should be done in-house if information confidentiality is a primary criterion.||Only specialized services would tend to be brought in-house; less specialized services can be outsourced.|
|Training and Education||Strategic Aspects||Can be done in-house, as identifying suitable options for education is by its nature an internal process||Can be outsourced if expert opinion on higher education is required for training and development|
|Business Advisory||Strategic Aspects||Often the general counsel or the finance director of the family busness is involved in the setup of the family office||The service of an external expert can offer a competitive edge|
|Estate and Wealth Transfer||Strategic Aspects||In-house expertise is required as data confidentiality is vital||The family can consult external legal advisers on procedural and legal issues|
|Administrative Services||Governance||Administrative services require daily monitoring and so can be done in-house. Here, outsourcing could lead to greater costs|
If you have any questions don´t hesitate to contact us directly.