Risk management for structured credit portfolios is also very challenging. We've seen two types of risk management today. We haven't gone to either one in any real detail for time reasons, but they're certainly both very important. The first is scenario analysis, where what we did was, we stressed the important risk factors for a portfolio, we move these risk factors to different levels, we re-evaluated the portfolio in the stress scenarios, computed the profit and loss that would therefore arise, and figured out or evaluated the overall risk of a portfolio based on the PNLs in these scenarios. So if we wanted to do scenario analysis with the synthetic CDO portfolio, we'd have to figure out, first of all, what are the main risk factors. Well, that's a very difficult question to answer. There are so many moving parts here, it'll be hard to figure out what are the risk factors. Of course, overall credit spreads are important, because credit spreads drive the individual default probabilities, and certainly the riskiness of these CDO tranches increases as individual default probabilities is increased. Certainly, the overall level of credit spreads is important. But what about the individual credit spreads? Some CDS spreads may increase, some CDS spreads may decrease, and depending on what happens, you will get very different outcomes for a given CDO changes. Correlation, of course, is a hugely important factor. In fact, the trading of synthetic CDO tranches is often called correlation trading because correlation as we saw, drives the value in particular of equity tranches, also super-senior tranches, and so it's very important to be able to stress correlation appropriately. But in fact, measuring correlation, even understanding correlation, what correlation is, what is correlation of default times actually means. There are difficult questions to answer, and it is very difficult to determine what correlation risk factors are there, and how you should stress them. Moreover, you need to determine what are reasonable stress levels; how far should you stress a given factor, what's reasonable, what's not reasonable, what's likely to happen, what's very unlikely to happen, what's almost impossible to happen. You have to be able to answer all these questions in order to do a scenario analysis. Finally, suppose you could figure out what appropriate risk factors are, and you could figure out what reasonable stress levels for these factors are. Well, then how are you going to re-evaluate the portfolio, your synthetic CDO portfolio, in a given scenario where you've stressed these factors. To do that, you need some sort of model. As I've mentioned before, it is very difficult to find a good model. In fact, I think it's fair to say that there isn't a satisfactory model for pricing CDOs out there in the marketplace. The Gaussian copula model has been the standard model, but it is certainly a flawed model, and has many, many weaknesses. So scenario analysis is certainly very difficult. What about the Greeks? Well, we saw the Greeks when we discussed equity derivatives. We saw Delta, Gamma, Vega, Theta, and so on. Well, you can also come up with Greeks' first synthetic CDO portfolios. You can figure out how much the value of a CDO tranche will increase if an individual credit spread, or default probability increases or decreases and so on. So you can certainly come up with Greeks, but there are many, many Greeks. You could argue you've got a separate Greek for every individual default probability, you've got Greeks to correlation and so on, but you've basically got too many of them. You've got too many moving parts here, the Greeks are modeled dependent, and it would be very difficult really to risk manage a portfolio based on the concept of the Greeks. In fact, there's an interesting article that you can read here. It's from the Wall Street Journal back in 2005 which discusses some of the fallout from the downgrading of Ford and General Motors in May 2005. Certain investors in some of these synthetic CDOs found out that they're hedging. Using the Greeks didn't work nearly as well as they anticipated when Ford and General Motors were downgraded. Just as an aside, Ford and General Motors were members in the reference portfolio for very commonly-traded indices at that time, and so they were inside the reference portfolio for CDO tranches, and so certainly some market people lost a lot of money when they thought they were actually hedged when Ford and General Motors were downgraded. I should mention that, in fact, the Wall Street Journal is behind the paywall and so you may not be able to read this article, but it depends on one or two occasions. I've been able to read it when I just Google it, other times I can't, so maybe you'll be able to see it. That said, don't believe everything you read in this article. In my experience, some of these articles which talk about fairly arcane and complicated details in finance. Don't always get all the facts right, but the overall picture is pretty accurate, and it's certainly an interesting read. Liquidity risk and market endogeneity are also key risks that must be considered, and that should have been considered in the trading of CDOs and the risk management of CDOs. I've mentioned market endogeneity before. It basically refers to the idea, for example, that if everybody is holding the same position, that's a much riskier situation to be in, than if only a few people hold a position. That's because if everybody needs to exit that position at the same time. Or in other words, if everyone wants to run for the exits at the same time, then everybody wants to sell the security at the same time, there's no demand for it, and the price will collapse. That's an example of this concept of market endogeneity. You've got a trade that's too crowded, too many people on holding a position, too many people wanting to get out of it at the same time, prices collapse. This certainly happened during the financial crisis. Other problems that arose in the whole structured credit area during the financial crisis were the massive over-reliance and ratings agencies to rate some of the structures, and over-reliance on models that really weren't worthy, or that were at best a poor approximation to reality. You had issues related to just the behavior of organizations, the incentives of individuals making big decisions in these organizations. All of these obviously played a very important role in the financial crisis.
