The Art of Counterparty Risk Management

The kerfuffle last fall around the fortunes of Deutsche Bank resurrected the question among hedge funds about how to react to increased insolvency risk at one of their counterparties. Call it Lehman Brothers redux. The potential $14B mortgage settlement with the DOJ created panic among the bank’s clients (the flames being ably fanned by the media coverage). The Deutsche Bank situation forced their hedge fund clients consider whether to reduce exposure and by how much. One would think with what hedge funds learned in 2008 that they would move decisively in this type of situation. I would suggest that in 2017, more than eight years after the fall of Lehman, that this is still a difficult decision. Counterparty risk management remains both science and art.

The science is the analysis of the crisis that leads to the analysis of possible scenarios, each with their own probability. The art is the decision to act. Should we pull back? How much should we reduce exposure? When should we pull the trigger. The science, if it is compelling enough, can make the art (decision) easier. If you can’t stomach the worst-case scenario it is time to go. Unfortunately in the real world the science tends not to be so black and white so we must then make the call. This is the art of counterparty risk management.

This was the difficult thing with Lehman Brothers in 2008. I would suggest that the decision to act was complicated by an almost complete lack of science. There was for example, a general lack of understanding by hedge funds about where their assets were and the legal jurisdictions that had claim over those assets. Having never gone into the abyss of a broker dealer failure on this scale there was a tendency to wait things out. Everyone is much farther up the curve in 2017. So when a situation like the one with Deutsche Bank occurs, we are better able to analyze the situation.

The art is more complicated. The decision to move assets and reduce exposure involves taking a stand with multiple constituencies about your read of the situation. This includes investors, other senior managers at the fund and the banks involved. The COO (Treasurer or Risk Manager) has to deal simultaneously with these various parties who are demanding to know what you are doing about the situation. “Are you pulling out or just reducing exposure and if not, why not? “ Timing is also an issue. Too early and it’s easy to get out but you may be jumping the gun. If you wait until it becomes obvious that you need to move (to you and everyone else) it will be much more difficult to get your assets out. If you were waiting until Monday, September 15, 2008 to move out of Lehman well… we know how that turned out.

Reducing exposure and moving assets will have ramifications on your relationships at your provider and the services they provide. You have to realize that once you make a move to reduce exposure you may damage those relationships. This can make it harder to rebuild those relationships should the crisis be short-lived. What other services beside prime brokerage do you use and value at the counterparty? Can you reasonably give up those services; can you get them at another provider? Again this is the art of counterparty management.

In the end there are many moving parts involved in the decision to reduce exposure at an embattled counterparty. What you can do is prepare and maintain a detailed crisis plan. A well thought out crisis plan will allow you to move quickly to analyze the situation (the science) and be prepared to move your assets. Then comes the hard part.

The decision process was also influenced by the resolution of the Bear Stearns situation the previous spring i.e., the thinking that the government would come to the rescue, which almost happened.

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