From the March 2008 issue of Investment Advisor • Subscribe!

Getting a Handle on Risk

It's one surprise after another in financial services these days

As participants in financial markets struggle to absorb giant losses and other negative surprises from some of the largest investment banks and broker/dealers on the planet, word comes of startling misjudgments by bond insurers that they, too, are in danger of going bust because they forgot about their longstanding business of insuring municipal bonds, and started insuring structured products--adding fees to their coffers but ultimately shooting themselves in the foot by insuring much more, ultimately, than they have the capital to pay off. Sure, they could have stuck with the business of insuring good old plain vanilla munis, but what's the fun in that? And then, the icing on the cake, the cherry on the sundae: the January 24 announcement by Soci?(C)t?(C) G?(C)n?(C)ral, founded in 1864 under a decree by France's Emperor Napoleon III, that a trader had allegedly made unauthorized trades that resulted in the loss of $7.2 billion.

By and large, most independent broker/dealers don't take on the kinds of capital-at-risk business models that the large investment banks do, so the risk of a rogue trader may not be quite so high for the independents, but what about the risk of a rogue representative? What other risks do executives of independent B/Ds worry about? In a slowing market, perhaps not one so volatile as the current scenario, "the biggest risk is that your income doesn't match your expenses," says Arthur Grant, president of Syracuse, New York-based Cadaret, Grant & Co., Inc. "It would seem rather obvious, but you know if business falls off, it's necessary to contain the expenses."

"The biggest risk," which for many independent B/Ds is that of a broker gone bad, "is solved by having good quality brokers and good quality compliance," Grant asserts. "We're going into a period where business can be very slow, obviously. The other side of that, though, is it's a great time to gather clients," he notes. "There are clients whose advisors were giving them aggressive advice that turned out to be not so great, so for a good conservative advisor this is the time to gather more clients.

"There's a perverse aspect to slow economies," Grant continues. "People get laid off, or take early retirement, and take packages, and so forth, and that's always a source of business for us...while people may be reluctant to invest, they still need advice."

He believes that the biggest risk going forward is reaching for yield in this environment. "We have a lot of clients who are middle- to late-middle age or are retired. Those people need income, and it's getting harder and harder to find income; interest rates have come down, and [many] REITs look risky," Grant reveals. "When people look around and say: 'I'm only getting 2% or 3% from my money market fund, so what else can I do to get better yields?' that's when they reach for things that they probably shouldn't be reaching for. When money market funds have their lowest yield, that's probably the best time to be in them."

Assessing Counterparty Risk

There's another type of risk that has become a greater concern to independent B/D executives lately: "We're seeing more counterparty risk," says Richard Closs, a director with the credit risk management department of Pershing, LLC in New York. "People are worrying about whether there's adequate capital," according to Closs. "Firms are putting together Focus Reports," due the week of January 28, and "year end financials reports, due the first week of March, and I think [B/Ds] are going to be examining those reports [of their counterparties] but also, some firms are cutting back in overall exposure until they can figure out the financial positions of firms," they do business with. There are, potentially, some firms B/Ds just won't do business with, or, Closs notes, they may cut back the counterparty's line of credit for trading purposes "by 50%." Firms which clear through Pershing may be "more comfortable" doing business with outfits like Merrill Lynch, which have announced capital infusions, but in the case of counterparties where capital infusions have not yet been announced, "that's where I think that the independent firms may be looking at other firms to deal with."

"We have systems in place where we see what our independent broker/dealers' trading portfolios are, so we see on a day-to-day basis any change in trading position, mark to market, etc., so I'm very comfortable that we have the right guidelines in place." If B/Ds are trading with "global counterparties," Closs argues, "we see those transactions--and we look at that closely, and if I saw that there was one counterparty that I had a particular concern with I would probably call that broker/dealer and we'd have a discussion to maybe mitigate their risk, and maybe they should look to gain flexibility, but we wouldn't tell them what to do." Closs acknowledges that he is seeing more questions from correspondent B/Ds asking what Pershing thinks about specific counterparties.

All this brings us to the question of what more can B/Ds do to reduce counterparty risks. Closs advises that B/Ds get a counterparty's history of financials, its regulatory history, and ratings from annual SRO audits. Look at "trading patterns and what type of products is that counterparty going to trade in," and check out the counterparty's principals "to make sure they are up to snuff--that they' don't have any regulatory discipline actions against them."--Kathleen M. McBride


E-mail Senior Editor Kathleen M. McBride at kmcbride@investmentadvisor.com.

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