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How to Use ‘What If’ Scenario Planning as Risk Management

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What if the Federal Reserve raises rates faster or lower than expected?

What if China’s growth slows more than expected?

What if Venezuela defaults?

What if Russia and U.S. relations weaken further — or strengthen?

What if the ISIS crisis worsens?

What if there is another terrorist attack on U.S soil?

Luis Maizel, co-founder and senior managing director at LM Capital Group, is a “what if” scenario planning expert who utilizes proprietary, in-depth research to analyze the outcome of numerous potential scenarios — like the questions above.

Scenario planning — in addition to LM Capital’s quantitative risk tools — acts as a comprehensive risk management platform and allows for proactive response to unforeseen events.

“When I started LM [Capital], I said, ‘It makes a lot of sense to be proactive instead of reactive,’” Maizel told ThinkAdvisor. “If you can plan on a situation ahead of time, you can look at alternatives, you can look at possible reactions by the markets, and you can take a stance that as soon as the event happens you react to it and you don’t wait to see what happens but you are part of the action.”

Maizel, who is also a Mexican-born, Harvard-educated economics professor, founded LM Capital in 1989 to provide active fixed income management to institutional investors using a global macroeconomic approach. Today, LM Capital, which is headquartered in San Diego, has about $5 billion in firmwide assets under management.

Maizel said he and his team always have 40 or 50 life scenarios planned.

“Being a smaller shop, anybody listens to something on the radio will come into the office and say ‘do we have this as a scenario, or how would we react to it?’” he said.

Maizel gave ThinkAdvisor several examples — some current and some past — of scenarios that his firm has planned responses for.

“We have today’s scenarios for another 9/11 … we have scenarios for one of the big-money banks going under,” he said. “It’s mostly bad situations.”

In 1996, LM Capital was looking at a very different scenario. Boris Yeltsin, then the president of Russia, was having heart surgery in 1996, and they thought he would not make it.

“We stayed throughout the night waiting for results of the surgery. And you say, ‘what’s the impact of Yeltsin being on the operating table in Russia, with your money management in the U.S.?’” Maizel said. “We said, if he dies there are three options: a hawk, a dove or a centrist. And the U.S. would have to react differently depending on who became the new president of Russia.”

If the hawk came in, the U.S. would have to spend much more on the military because it would have revived the Cold War, Maizel explained.

“Then there would have been a lot of pressure on interest rates,” he added. “Bonds would have gone up because of the competition of the government for the available money.”

If the dove came in, it was the opposite. The U.S. could spend much less on the military and would not need to raise so much money so there would be less pressure on interest rates, Maizel explained.

In 2008, LM Capital had a scenario and response planned for the question: “What’s going to happen with the U.S auto industry?”

“It was binary; either the government saves them or not. If [the government] saves them, they need to have a financing arm. Americans don’t buy cars for cash, they finance them,” Maizel explained.

The only firm that had an independent financing arm was GM. Their separate company financing General Motors cars was formerly called GMAC (an acronym for General Motors Acceptance Corp.).

“So we said, if the government bails out GM, the industrial company, they will bail out the financing company,” Maizel explained. “So we were ready.” LM Capital did not have any GMAC bonds then, but the day the government announced they were saving GM, it bought $44 million worth of GMAC bonds in the high 60s and low 70s, Maizel said.

“So we made a ton of money fortunately just looking at that alternative: If A happened, B had to happen,” Maizel said.

Scenario planning like this does not always result in such positive results, Maizel admitted.

“The scenario planning really brings out a lot of analysis to cause and effect,” he said. “Sometimes you make the right analysis and it doesn’t pan out.”

He gave the example of the 1995 Quebec referendum, which was a vote on Quebec separating from the rest of Canada.

“We put in a hedge in our Canadian dollar position because we thought that possibly it was very high that Quebec would win and that would hurt the dollar,” Maizel explained. “Well they won, in the end it didn’t happen, but they did win and the dollar did not move. They knew more than anyone else that if they did win it would not happen.”

One scenario that LM Capital has now is for whether Janet Yellen is reappointed as Federal Reserve chair.

“There are three options: One of them is a hawk, one of them is very much like her, and the other one is very soft like Stanley Fisher was,” Maizel explained. “So depending on that is what interest rates will do in the next couple of years in the U.S. … The moment the president announces whether she’s reappointed or who is going to be the next one, we’re going to probably change the duration of our portfolio.”

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