Institutional Investors are Finding a New Sensitivity to Risk
Written by Michael Stocker and Monami Chakrabarti
In a campaign season that has focused intensely on proposals to spur the economy, there has been a surprising silence on what may be the most important impediment to growth: investor sensitivity to risk.
The nation’s sluggish recovery has inspired no end of measures aimed at coaxing capital back into the markets, ranging from laws reducing regulatory burdens on newly public companies to measures permitting start-up ventures to solicit funding directly from retail investors. However, these efforts, which have focused almost exclusively on easing corporate burdens in raising capital, may be stymied by something legislators and regulators have largely failed to consider – that investors’ fear of hidden risk might make them reluctant to part with their money. To address this problem, corporations will have to take a pro-active approach to turn the tide.
Signs of pervasive investor anxiety about market risk are easy to identify. In spite of periodic share price surges, 2012 has been shadowed by persistent fears about the strength and stability of equity markets, as reflected in an unprecedented flight of investors from U.S. mutual funds. According to the Wall Street Journal, as of August 2012, investors pulled out roughly $68 billion from U.S. stock mutual funds.
Increased volatility in the equity markets is also symptomatic of investor unease. Although computerized high frequency trading has probably played a role in amplifying this year’s roller-coaster share price movements markets, more than high speed trading is to blame. There is a growing consensus that fear-based investor behaviors are acting as a trigger for market turbulence. For instance, a May 2012 commentary by Bernie Schaeffer of Schaeffer’s Investment Research indicates that these conclusions are consistent with spikes this year in the two major volatility indices, the CBOE Market Volatility Index (VIX) and the iPath S&P 500 VIX Short-Term Futures ETN (VXX).
Retail investor anxiety has also taken its toll on this year’s big-ticket IPOs. The first ten months of 2012 have seen a string of IPO debacles, including Facebook, Groupon, Zynga and Angie’s List, reflecting a drastic weakening in investor appetite for purchases on IPOs, something once considered a sure-fire way for investors to turn short-term profits. Although these companies’ business models vary significantly, the takeaway is simple: many of these IPOs grossly overestimated investor enthusiasm and appetite for new offerings.
The roots of this creeping investor anxiety lie not only in current market phenomena like Euro-zone instability and uncertain earnings, but in the financial crisis of 2007 and 2008, which was, above all other things, a crisis of confidence. The events of those two years sorely undermined investors’ confidence in their own understanding and assessment of risk, especially because of the shocking failures of many basic tools which investors depend upon to gauge risk. The crisis cast doubt on the accuracy of metrics including credit ratings, Value at Risk (VaR) figures, and commercial corporate governance indexes that purport to assess the quality of management.
While failures of all three metrics took a heavy toll on investors, nothing has been as devastating to confidence as the failure of many credit rating agencies to act as effective arbiters of risk. In fact, the day that the incipient financial crisis transformed into a full fledged cataclysm was probably July 10, 2007, when credit rating agencies downgraded hundreds of CDOs from AAA to junk status. Many hundreds more would be downgraded a few days later, and again in October of that year.
The sheer terror that these downgrades inspired in investors cannot be emphasized enough. AAA ratings are supposed to be reserved for the safest investments with the least chance of default. Although investments holding AAA ratings have traditionally had a less than 1% probability of incurring defaults, analysts have determined that, by 2010, over 90% of subprime RMBS securities issued in 2006 and 2007 and originally rated AAA had been downgraded to junk status by Moody’s and S&P.
These actions caused deep anxiety about the reliability of a tremendous number of financial instruments: between 2000 and 2007 Moody’s alone rated 45,000 mortgage related securities as triple A.
The collapse in ratings left many investors baffled. How could the agencies have gotten their ratings so wrong? How does an investment go from extremely safe to junk in months? At the heart of the problem is the so-called “issuer-pays” model used by most credit rating agencies. Under this system, the firm interested issuing an RMBS or CDO security pays the rating agency for the credit rating needed to sell the security. The result is a system that creates strong incentives for the rating agencies to inflate their ratings to attract business. If an issuer doesn’t like the rating it is going to get for a CDO or RMBS, it can simply shop for another rating agency that might be more accommodating.
The notion that these conflicts gravely compromised ratings for asset-backed securities is not speculation: investigations by the U.S. Congress has turned up both documents and testimony linking the issuer-pays system with ratings inflation. Emails show that agencies simply weakened ratings criteria if business from issuers was slackening. Ratings analysts faced intense pressure from company management to inflate ratings, and that analysts who were too conservative were simply fired.
The impact of flawed credit ratings were exacerbated by Value at Risk models, more commonly known as VaR, that dramatically understated the scale of potential corporate investment losses.
Put most simply, VaR models are used to predict the loss of securities, portfolios, divisions and entire firms under changing market conditions. Although the preparation of VaR figures is mathematically complex, and is tied to the reliability of a multitude of key data inputs, banks typically present VaR as a single number: for example, if a bank states that its daily VaR is $2 million, this supposedly means that the bank is very confident that it would not lose more than $2 million on any given trading day.
VaR figures have not only served as indicators of the scope of banks’ potential trading losses; they have also played a direct role in setting banks’ capital reserves so that financial institutions can cover their losses and avoid liquidity crises. In fact, as regulatory bodies have come to accept VaR as the gold standard of risk assessment, banks increased their autonomy in the way they performed their calculations, and started to use their own internal VaR calculations to set the level of their capital reserves – with little oversight.
Not surprisingly, this created catastrophic problems during the financial crisis. One of the most troubling issues with VaR modeling was that, in assessing market risk, many banks turned a blind eye to the possibility of a severe downturn in the housing market. Lehman Brothers is a case in point. According to the Examiner’s Report in the Chapter 11 proceedings of Lehman Brothers Holdings Inc., Lehman restricted its VaR methodology to incorporate strictly historical scenarios, such as the Avian Flu pandemic, the 1994 Russian debt crisis and the 1987 stock market crash – while paying scant attention to a mounting housing crisis. Shortcomings in Lehman’s risk model have also been extensively detailed by legal commentators, including a John F. Rosato in a Spring 2011 law review article in the Connecticut Insurance Law Review article.
Even for those financial institutions that did appreciate the possibility of a potential housing crash, academics and market observers point out that banks’ VaR models frequently underestimated the probability of such dire events – relegating them to the deep recesses of the bell curve.
Investors who turned to commercial indexes of good governance as a stop-gap measure to assess the riskiness of companies were also in for a rude awakening during the financial crisis. Commercially available corporate governance indexes have long been sold to investors as a means for evaluating corporate governance practices, and are ostensibly predictive of equity returns, accounting restatements and shareholder suits. However, a December 2010 study by Robert Daines and David F. Larcker of Stanford University and Ian D. Gow of Harvard University of these claims indicate that, at least historically, many have little value as a gauge of good management. Indeed, as noted in a February 2011 article by Joan Susie in the bankdirector.com, one of these shareholder advisory firms awarded Lehman Brothers a generous B+, or 86.7% corporate governance rating – just two weeks before Lehman went bankrupt. The same firm awarded AIG an A+ rating – meaning it deemed AIG to be better than 97% of S&P 500 companies and better than 99% of insurance companies – only days before AIG secured an emergency loan to sustain itself.
In an effort to restore confidence in the markets and lessen structural risk, in 2010 Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. The legislation instituted a range of reforms intended to address the causes of the financial crisis, including the regulation of over-the-counter derivatives, the prohibition of proprietary trading by banks and bank holding companies, and increasing shareholder voice and disclosure requirements related to executive compensation.
Although the Dodd-Frank legislation has improved investor protections in many respects, it did little to address some of the fundamental problems that undermine investor visibility into risk exposure. For instance, the Dodd-Frank legislation did not tackle the conflict of interest inherent in the issuer-pay model of credit rating agencies. While the SEC’s proposed credit rating rules promulgated under the statute focus on important issues such as the rating agencies’ inadequate internal control structures and the training and testing of analysts, they do not address the issuer-pay model. The failure of regulators to address such a fundamental problem which played such a key role in the financial crisis has kept investor fears alive.
Yet another fundamental problem that has persisted in the aftermath of the financial crisis is the financial institutions’ continued reliance on VaR. Indeed, the problems with VaR continue to haunt investors today. In May of this year, JP Morgan reported that it had suffered a $2 billion mark-to-market loss in one single day. However, this gigantic market risk was apparently not reflected in the bank’s reported VaR figures – which may have prompted the company to quickly announce a revision to its VaR modeling.
Although it is not clear why banks have failed to adopt alternative risk assessment frameworks, one plausible explanation is inertia. VaR is a common, long-standing practice that is easy to explain, justify and also manipulate. Another explanation is that regulatory bodies and international supervisory entities have not reached a consensus regarding alternative (and better) risk assessment metrics. Earlier this year, the Basel Committee on Banking Supervision proposed scrapping VaR with another quantitative risk metric called expected shortfall. However, in a February 2012 article in centralbanking.com, industry commentator, Laurie Carver noted that the new proposed tool may not be much better than VaR and lacks back-testing.
Commercial corporate governance indices have received a makeover in the aftermath of the financial crisis – but generally have not changed in any meaningful way. In 2010, the RiskMetrics Group, one of the leading proxy research services to institutional investors, abandoned its corporate governance quotient scoring system for a revamped, four-part governance risk indicator system. The new methodology separately rates four distinct governance categories: “Board,” “Audit,” “Compensation,” and “Shareholder Rights,” instead of awarding companies a global governance score. However, that same year, Margaret E. Tahyar of Davis Polk & Wardwell LLP noted on the Harvard Law School Forum on Corporate Governance and Financial Regulation that this new system does not represent a fundamental overhaul in the rating methodology – but is rather merely a change in “packaging and presentation.”
Worse, the new Jumpstart Our Businesses and Startups Act (“JOBS Act”), passed on March 27 of this year, may have deeply undermined investors’ enthusiasm for investing in new companies.
The premise of the JOBS Act was simple: by reducing investor protection regulations, we can ease capital formation, and hopefully encourage the formation of new companies. There were two main innovations in the legislation: an “IPO onramp” aimed at encouraging IPOs by relaxing audit and disclosure regulations, and a “crowd-funding” measure that would permit companies to sell equity in start-ups directly to unsophisticated retail investors. Both may have the effect of significantly heightening investor anxiety.
Under the onramp provisions, a new class of “emerging growth companies” or ECGs, which may have revenues of up to $1 billion a year, are permitted to delay complying with accounting and auditing rules introduced by the Sarbanes Oxley Act of 2002 or “SOX.” SOX, part of an effort to prevent the kinds of accounting fraud and abuses seen in Enron and Worldcom, required among other things that independent auditors give their blessing to company financials – a valuable safeguard to the accuracy and reliability of financial reporting. Under the JOBS Act, ECGs are not required to obtain such audits for up to five years from the time the ECG goes public.
The increase in investor risk that has resulted from the JOBS Act is reflected in registration statements filed this year by most companies taking advantage of the JOBS Act’s weakened disclosure regime. For example, LegalZoom.com, a company that reported that it intended to take advantage of new JOBS Act exemptions, felt compelled to add a risk disclosure to its IPO registration statement warning that it “cannot predict if investors will find our common stock less attractive” because it may rely on the statute’s exemptions.
The JOBS Act’s crowd funding provisions may also ultimately take a toll on retail investor confidence. Traditionally, private start-ups, considered to be the riskiest kinds of investments, were only permitted to solicit funds from accredited investors, who have greater financial sophistication and financial reserves than non-accredited retail investors. However, under the new crowd funding provisions, start-ups are permitted to raise cash from non-accredited investors via online portals—creating a potentially dangerous mismatch between investors and highly speculative companies. The risks for investors are compounded by the fact that there is no secondary market for equity purchased via crowd funding – so investors will not be able to unload their shares if they have a change of heart.
Because legislative and regulatory reform efforts since the financial crisis have largely abandoned the issue of risk transparency, corporations anxious to restore investor confidence will have to work to address these issues on their own initiative.
As noted by Grant Kirkpatrick of the OECD Steering Group on Corporate Governance, the most important lesson from the financial crisis is that companies must incorporate stronger corporate governance safeguards to prevent excessive risk-taking and increase transparency regarding risk. Corporate culture at many US companies has fostered a too-permissive attitude towards risk management. During the financial crisis, the banks with the highest concentration of mortgage-backed securities on their books did not even have functioning risk committees and lacked internal controls to check the excessive assumptions of risk. For instance, Kirkpatrick noted that Lehman Brothers’ risk committee met only twice in both 2006 and 2007 before it imploded. This crucial risk oversight function plays just as important a role in companies outside of the financial sector. As Kirkpatrick described, a joint report by the U.S. Coast Guard and Bureau of Ocean Energy Management, Regulation and Enforcement found that BP’s risk management shortcomings played a key role in precipitating its disastrous oil spill in 2010.
To foster investor confidence in corporate risk management, companies can and should take tangible steps to address risk management weaknesses. In a December 2010 survey by Deloitte of risk-related proxy disclosures by S&P 500 companies, it was revealed that only 4% of companies noted the presence of a board-level risk committee and only 11% of disclosures noted the board’s involvement in determining corporate risk appetites.
To reassure investors that risk is being managed effectively, companies should create separate risk committees on corporate boards to analyze and set limits regarding companies’ risk appetites. Companies should also enhance the role of risk managers and provide clear channels through which employees can report red flags to senior management. In addition, companies should adopt appropriate executive compensation policies that safeguard against excessive risk-taking at all levels. If executive compensation is tied to performance over a long-term horizon, there will be less incentive to make high-stakes short-term gambles that can wreck a company’s financial future.
There are also several steps that companies can take to increase transparency about risk to the investing public. Companies planning on going public should carefully weigh the short term benefits that ECG status provides over potentially punishing investor reaction to the news that financial statements will be reviewed by independent auditors. Similarly, as described in an October 2012 article by Clifford Rossi in theAmericanBanker.com, financial institutions can provide investors with more detailed disclosures regarding risk models such as VaR and can provide clarity regarding the inputs, assumptions and scenarios they utilize in addressing risk assessment.
While measures to control risk and improve transparency have strong appeal to shareholders, their benefits to corporations themselves should be just as obvious. To get our economy back on its feet, it is as important to support investor confidence as it is to ensure that corporations can efficiently raise capital.
