How Risk Models Failed Wall Street

[TJ_98370]

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Interesting article -


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Crooked mortgage brokers, greedy investment bankers, oblivious rating agencies and gullible investors have all been faulted in the financial crisis, and there is bipartisan agreement that regulators were asleep at the switch. It's all well and good to call for substantial new oversight. But if regulators were oblivious to the danger, the question is why.........
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......The problem is that Wall Street and regulators relied on complex mathematical models that told financial institutions how much risk they were taking at any given time. Since the 1990s, risk management on Wall Street has been dominated by a model called "value at risk" (VaR).......
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......Lurking behind the models, however, was a colossal conceptual error: the belief that risk is randomly distributed and that each event has no bearing on the next event in a sequence.......
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[sniglet]

Yes, the VaR (value at risk) models used by Wall Street were flawed, but that misses the bigger point. The generally bullish societal attitudes that had been building for 50+ years were only looking for excuses to justify excessive risk-taking. The VaR risk models were a convenient justification for imprudent risk taking, but if they hadn't had rosy VaR projections then something else would have been used.

When EVERYONE is feeling bullish then there is absolutely nothing that can stop the inevitable bubble. Not regulation, not ratings agencies, nothing.

I come back to my broken record of chalking up the bubble to nothing more than the generational economic cycle (similar to what Kondratieff postulated). The greater the distance from the last economic catastrophe, the more emboldened society becomes, undertaking ever greater financial risks until the whole thing winds up in a massive bubble and then crashes. There is nothing that can be done to stop this cycle. No matter what amount of regulations, or lessons, are learned after each major crash/depression, people will forget them and talk themselves into believing a "new era" has arrived some 70 to 90 years later.

We just have to accept this growing depression as part of the normal human cycle of life.

[buyStocks]

sniglet,
According to your logic there is actually a way to avoid these economic disasters; immortality.

[sniglet]

[davidlosh@davidlosh.com]

I started thinking today that the risk models worked perfectly.

My contention five years ago was that lenders, investors, and banks went on a shopping spree. They were buying property more than lending on it. My over all theory is long and involved, but it seems to be working today.

For all the sky is falling doom and gloom there is a huge pile of cash reserves in the global market today. Just because paper profits are contracting I don't see what that does to drain cash.

Let's say every one stops paying debt today. That would stop interest income. Let's say people walk away from homes, Those homes become rentals. In the end international corporations end up owning huge segments of the United States.

The reality is most people will keep on paying into debt. More and more people are creating more debt by refinancing homes, suplementing declining incomes with credit card purchases, and consolidating debt to keep a FICO score.

I see how people are hurt, but corproations seem to be getting tax breaks, tax dollars, cutting staff and maintaining income while retaining assets. Corporations seem to be doing extremely well.

[TJ_98370]

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Sniglet, I do not necessarily disagree with all that you are saying. I do agree that during good times people become less financially risk adverse.
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What I find interesting about this article is that it brings out the fact that modeling has the problem of the unknown / unexpected reality. The more complex the system, the more the possibility exists of having unknown / unexpected variables that can influence events. Investment bankers got into trouble because they relied too heavily on their proprietary models without sticking their heads outside the window occasionally to see which way the wind was really blowing.
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At a much more mundane level, I deal with modeling on a regular basis. My work involves production. We are a couple of decades into developing a system that monitors / controls production thru computer modeling of production processes. Generally, everything works great until something occurs that perturbs the expected. If there is a deviation from the modeled process, the system breaks down.
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There is no substitute for monitoring reality.
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[davidlosh@davidlosh.com]

In the financial markets the unexpected was having the World Trade Center attacked and ulitamtely destroyed by a group on Muslim extremists.

The financial markets trade paper. They have very little exposure to the world outside of the numbers. It must be hard to explain why World Trade would be the target of so much hate, or that the financial markets are playing the villian in today's economic collapse. It's unexpected.

This is why I have been contending that the credit and financial markets have invested so heavily in hard tangible assets such as Real Estate. Large Investment Trusts don't care if the price of Real Estate goes down. They control the asset while the stock holders take the losses.

Governments around the world are only to eager to cover those losses. Why?

[sniglet]

[TJ_98370]

Sniglet - I understand what you are saying, but aren't regulators supposed to be immune to the influences that affect bank CEO's, investors, etc? If they are doing their job, aren't regulators supposed be independent, neutral evaluators? Apparently, they accepted the VaR models as being accurate.

[sniglet]

[mukoh]

TJ, its not that the regulators lacked oversight, or ability to understand it. The system is what it has been since the beginning of time and will continue to be.
An oversight official brings a question to an X billion dollar investment firm/bank. I have a concern about this.
Wink wink nod nod the regulators concerns are solved as he is later hired by a "different" firm as its consultant, or his daughter/son get a job right out of college for six+ figures.
Thats the simple way. There are a myriad more other ways that this is done.

[rose-colored-coolaid]

I think what really happened was people were pulled in by the trust-the-expert mode of thought. When things become too complicated for someone to understand, they tend to go find someone who does understand it, they listen politely as the smart-dude(t) explains it, and then they confidently go off and tell anyone who is interested what the "correct" answer is.

Remember in college during calculus class. If you worked in a group, one person did half the solving, told everyone to do X because of theorem Y, and those people just did it. If asked why, they would mumble something about how so-and-so says it's the right thing to do.

I believe this is what happened to regulators. They were confronted with figuring out what was going on at Wall Street. They poked their heads in, looked around, and got confused. So the next thing they did was ask the guys running the companies. Those guys didn't understand the system either, it was too complex. So the CEOs went to their experts (and especially computer model creators) and asked how it worked. They got some kind of answer, and after adding a little hand-wavium they passed the answer that their really smart model guys had worked it out onto the regulators. Content that some really smart guys had figured out the system so well, the regulators slept peacefully.

OK, maybe that's not the exact story, but I suspect it's actually surprisingly close to what really happened. I predict we won't really hear it though, because it makes too many people sound completely incompetent.

[Charles Dean]

That's a pretty amazing assessment Rose. This rings especially true with CDS'.

[davidlosh@davidlosh.com]

Let's take credit. Consumer credit is allowed to charge 29% interest plus fees, and late fees. Over in mortgages you have fist position and second position. One at a lower rate, one at a higher rate. Then there is equipment leasing, small business lending, and car loans. Then you have insurance, car, health, and life, all collecting money to invest. They all have regulations, they all have government over sight, they are all in different departments and different parts of the country or the world.

The London Times in 2006 questioned wether Citi Group knew what what department was doing what, when, or where. It turned out to be very true that every one claimed deniability, but I don't buy it.

It' seems very convenient for the entire Financial Community to say "they didn't know" while reaping huge amounts of cash. When you look at the Madoff scandal you see that people made money, Madoff made tons of money. He goes to jail, but he is one guy out of hundreds or thousands that made staggering profits. The article yesterday where some of his investors felt guilty for making a profit was very telling.

Investors who were at the tail end of the scheme "lost" money. Madoff knows where the money is, where it went, and who got paid. He was trading dollars because he never did anything but trade dollars. If he were to have ended up owning companies, Real Estate, or equipment there would be something to attach. Money you can hide in a coffee can to dig up later.

It's all working perfectly. The stock market is over priced and has been since 1995. It's paper profits that generate cash. That cash now owns houses, office buildings, corporations equipment, and the stock holders are paying for it.

In the Real Estate business it's called leveraging. There is a point where you stop buying and pay down.

[plymster]

I think that if there were any conscientious regulators or employees on Wall Street, they either STFU, or got walked out. There was a story on NOW on PBS recently about one such fellow at Standard and Poors, Frank Raiter, who was a managing director for 10 years until he said "we can't support this valuation". Then he was quickly, quietly walked out. Here's the video:

This is the nature of our culture. There was a story the other day about Thomas Tamm, the former Justice Department official that leaked the illegal wiretapping story, is being prosecuted by the DoJ. Still no prosecutions against the people that actually violated FISA.


More and more, whistleblowers are getting castigated, while the crooks go free. This is a cultural problem. Until this is solved we will not have anything approaching justice.

In my opinion, the complete breakdown of our law enforcement system is the most impactful difference between now and the Great Depression. It is the ultimate cause of our economic downfall, and until it is solved, the US will never be a meaningful power in the world again.