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Black Swan Events and the Pursuit of Fake Alpha: Critical Factors in

the Risk Management of Financial Firms

The Financial Executives Networking Group Webinar

April 22, 2010

Presenter: Bernard S. Sharfman

5613 Jordan Rd.Bethesda, Maryland 20816

301-320-0834bernardsharfman@gmail.com

Copyright 2010 Bernard S. Sharfman

Discuss critical factors of risk management that all financial executives should be aware of;

Create an understanding of black swan events and the pursuit of fake alpha;

Explain why I believe they will continue to persist as risk factors; and

Provide recommendations for mitigating their risks.

2Copyright 2010 Bernard S.

Sharfman

Financial Crisis of 2008.

Preceded by sluggish economic growth and deteriorating financial conditions.

Actually, the whole decade pretty mediocre.

Banks and Wall Street firms, publicly traded companies, shelling out huge cash bonuses in 2006 and 2007, dip in 2008, back up in 2009.

2009 cash bonuses restrained by political pressure, could have been much more .

What was and is going on?

3Copyright 2010 Bernard S.

Sharfman

Wall Street’s Corporate Governance Crisis, Corp. Gov. Advisor, Jan. 2009.

Enhancing the Efficiency of Board Decision Making: Lessons Learned from the Financial Crisis of 2008, Del. J. of Corp. Law (Nov. 2009).

How the Weak Bargaining Power of Shareholders can Explain the Baffling Behavior of Wall Street's Public Firms , (Va. Law & Bus. Rev.) (forthcoming, fall 2010).

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Copyright 2010 Bernard S. Sharfman

Black swan events are unpredictable, large impact events, both good and bad. (Taleb, Common Errors in Interpreting the Ideas of The Black Swan and Associated Papers, 2009).

We may be pretty good at predicting that certain events will occur, such as the emergence of the Internet, general housing price declines after 50 years of increases, WWI or a terrorist attack, but we are very bad at gauging their impact. (Id.)

Why?: The less frequent the event, the more we are going to error in estimating its impact. We simply have little information to make a good prediction. (Id.)

5Copyright 2010 Bernard S.

Sharfman

Black swan events reside in the tail of a statistical distribution. But the tail is fat, not thin as commonly assumed in the standard prediction and valuation models.

That is, they occur more often than is commonly assumed.

Our inability to predict or properly value black swans leads to the strong possibility that we may be significantly underestimating the business risks of highly leveraged entities such as financial institutions.

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Fake alpha: Appearing to create excess returns but in fact taking on hidden tail risks, which produces a steady positive return most of the time as compensation for a rare, very negative, return. (Professor Rajan)

The event creating the rare, very negative return can be referred to as a disaster, such as a vicious black swan event. For example, the collapse of housing prices which led to the seizing up of the credit markets and general economic turmoil.

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Sharfman

Pursuing Fake Alpha by:

Borrowing short and lending long.

Savings banks, thrifts and savings and loans.

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Sharfman

The pursuit of fake alpha is all about unintentionally or intentionally ignoring the potential for the tail risk to be realized.

Unintentional: it is a strategy that is susceptible to vicious black swan events.

Intentional: the pursuit of fake alpha is a scam if the tail risk is not taken into account.

9Copyright 2010 Bernard S.

Sharfman

Traders, investment bankers and asset managers allegedly in hot pursuit of fake alpha.

Why? Compensation policies encourage employees to pursue business strategies that ignore the potential for negative black swan events.

The pursuit of fake alpha is all about showing good results now, before a disaster strikes. Have a good year, get a great bonus. String several good years together and you are a big winner.

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Sharfman

• Credit Default Swaps

• Corporate bonds, then MBS

• Large annual bonuses while the going was good

• How did they do it?

• Use of “Lo strategies”

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Sharfman

• Created misleading appearance of enhanced profitability and underestimated risk of operations.

• Created false impression (misinformation) regarding value creating abilities of Wall Street employees.

• Resulted in massive amounts of capital outflows.

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Sharfman

• Aggravated financial stress at financial firms and the financial system in general.

• Perhaps some or most of the pursuers were unaware?

• Boards (independent and disinterested) presumably unaware.

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• Bonus culture derived from Wall Street partnership days.

• Strong resistance to change:

– traders, investment bankers and asset managers are in strong negotiating positions versus shareholders; and

– act as free agents/independent contractors.

• Competitive pressures may discourage looking too closely for the potential occurrence of black swan events.

• Also, it may be hard to distinguish between fake alpha and real alpha except in hindsight.

14Copyright 2010 Bernard S.

Sharfman

Black Swan Events:

The difficulty of incorporating black swan events into prediction and valuation models means that those who manage financial institutions may continue to underestimate the business risk of their firms.

Competitive pressures may discourage looking too closely for the potential of black swan events.

For the financial sector, this most likely means trying to reduce financial leverage, the interdependency of our financial system and reducing the incentives to pursue fake alpha through gov’t action.

15Copyright 2010 Bernard S.

Sharfman

Fake Alpha: Bonuses in the form of restricted stock probably

won’t work.

Clawbacks may work.

Focus on board composition could be helpful. Dysfunctiona Deference and Board Composition:

Lessons from Enron, Northwestern U. L. Rev. Colloquy (2008).

A Team Production Approach to Corporate Law and Board Composition, Northwestern U. L. Rev. Colloquy (2009).

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Have you observed the pursuit of fake alpha in your own experience?

How would you go about minimizing the pursuit of fake alpha if you were the CFO of a major securities firm?

Would you be able to recognize fake alpha during its pursuit? Or, is it possible only in hindsight?

17Copyright 2010 Bernard S.

Sharfman