How Risk Models Failed Wall Street
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Interesting article -
A Mountain, Overlooked; How Risk Models Failed Wall St. and Washington
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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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Interesting article -
A Mountain, Overlooked; How Risk Models Failed Wall St. and Washington
.
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.........
.
......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).......
.
......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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Comments
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.
According to your logic there is actually a way to avoid these economic disasters; immortality.
Hmmm... That would help, but not solve the problem entirely. I think the issue is that you need a certain percentage of the population that has PERSONALLY experienced an economic catastrophe. If the population kept growing infinitely, and everyone was immortal, you would still inevitably reach a point where only a small fraction of the population remembered the last depression.
Actually, even those "immortals" with personal memories of previous hard times would likely even be fooled into believing that depressions were a thing of the past since the periodicity of the cycle would increase SO much due to immortality that they would be fooled into thinking the cycle had vanished. Instead of just 70 or 90 years for the cycle to play out, we might be talking about 500 to 700 years.
What might actually be a solution to this cycle is some sort of memory transference technology, that allows people who lived through past depressions to pass on the COMPLETE experience, with fear, full senses, and all, to every person of the newer generations. If everyone had a full understanding of what it really was like to live through a depression, and of what led up to it (i.e. all the hubris), then we might never experience such a thing again. Unfortunately, books, documentaries, and movies are a poor substitute for the "real" experience, and will never really impart a full comprehension of the event.
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.
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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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?
While this may well be correct, my contention is that investment bankers didn't want to look outside the window. They just wanted an excuse for excessive risk-taking, and the flawed risk models were one of the justifications they used for doing so. Let's put it another way: no one WANTED to have accurate risk models. It was in their (percieved) interests to have the risk models proclaim that everything was kosher.
I have read articles about Wall Street executives who lost their jobs because they questioned the rosy assumptions, and data, used to build risk models at their firms.
My point is that the core problem wasn't the use or innacuracies of risk models, per-se, but the fact that ANY risk management system will be abused when society is rife with bullish optimism. Discussing the specifics of how any particular risk management or regulatory system failed perpetuates the belief that it is actually possible to construct one that really does work in the midst of a mania. I would contend that no matter what the regulations or risk analyses methodologies are, that they will all be abused and contorted when society is rabidly bullish.
This is the theory, but the reality is that the regulators are simply a product of the society they live in. Given enough years of prosperity, politicians will be elected who vow to viserate the regulations (i.e. cutting red tape), and appoint toothless enforcers. If a president, and congress, are elected who don't believe regulation is necessary anymore, then they can repeal and castrate any regulations or regulatry agencies they please.
Unfortunately, I believe it is INEVITABLE that politicians will eventually be elected who dismantle the regulatory infrastructure. 70 years from now it will be hard to argue that regulations enacted during the depression of 2010-2014 are still necessary.
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.
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.
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.
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.
http://www.perrspectives.com/blog/archives/000705.htm
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.
Unfortunately, this "break-down" in regulatory enforcement is INEVITABLE in the midst of a financial mania. A bullish society will elect leaders who don't believe in regulation, and evicerate enforcement. When society is bearish (which it is starting to become) it elects leaders who believe in regulation and will have strict enforcement. This is why I keep saying that 80 or 90 years from now, the cycle will just repeat itself again, with a new crop of leaders getting elected to the White House and Capitol Hill who don't believe in regulation.
Regulators merely represent the broader values and beliefs of the societies they live in.
By the way, when society is bearish, regulation isn't needed that much since the appetite for risk is so low. Maddof's can only exist in bullish times, when people are just looking for reasons to dispell critical thinking. Conversely, when regulation would really help, the regulatory regime will inevitably have been rendered toothless.
Stock Holders were only too happy to believe in the paper profits of Consumer Credit, Auto Financing, Equipment Leasing, and all the other Financing schemes. Everybody paid while times were good and everything looked good on paper.
Was a regulator really supposed to say that the end was near? Was a regulator supposed to question whether a house hold income of $50K can have ten credit cards with $7K limits, on top of a mortgage, and car loan? No. Those decisions were made by the investors and they were good decisions for the investor.
Now if you are trying to say the regulators are supposed to look out for the little guy, good luck. His car loans are with GMAC, his consumer credit is with Chase, Citi, BoA, GE Money, and his mortgage is with WaMu by way of Long Beach Mortgage. Each entity has Financial Centers in various states. Federal regulators are also by region.
I think it was deliberate. Deregulation sounds good, but I think that the sharpest minds in the world figured this out. The end result has been huge international corporations with a finger in everything. They are cash rich in a very down market. That is a good position to be in.
RCC, I hope your scenario is the more accurate because what singlet and mukoh are suggesting implies rampant corruption IMO.
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In my little world, the computer modeling guy is a certified genius. I deal with him very occasionally and every time I talk to him it's like, " What did he just say? I know he is speaking English because I recognize the words, but what the hell did he just say!?! Does anybody else understand what he just said?" Management tends to leave him alone and give him what he wants. They are happy if he and his group provide results that look good when they have to make a Power Point presentation to their supervision. Management does not understand what he is doing and they know they never will. I've listened / watched him and his ilk explain "fuzzy logic" and solve differential equations on the whiteboard during presentations. You can just see the upper management types eyes glaze over.
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An interesting side story about our computer modeling guy is that his brother was the lead singer for the band Survivor. Their most well known song is Eye of the Tiger. It is his brother who is singing lead in the original version of that song. I am absolutely not making this up. Talent must run deep in that family. His brother was also the singing voice in the recent Bud Light Real Men of Genius commercials.
Survivor
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I can't speak for Mukoh, but I am not really suggesting "corruption" at all. I am simply saying that after the good times have gone on for long enough society starts to think regulations, and cautious investing, are passe. It's not so much that a regulator is corrupt, per-se, but rather that they might genuinely believe that businesses should be given a lot of latitude. There is a LOT of grey area when it come to prosecuting, and enforcing, the law. But even if the regulators really were zealous, it is inevitable that governments will start cutting agency budgets and gutting the laws eventually. Just look at how few protests there were with the dismantling of the the depression era regulations in the last 20 years? Even democrats (like Clinton) based in the glow of the reformer, doing away with silly old rules like Glass-Steagall.
Think of it another way: when a city on the Gulf of Mexico hasn't seen a hurricane in over a 100 years, people begin to feel invulnerable and start to build in areas prone to flooding. It's not corruption, it's just that people have short memories and want to believe all the bad things have disappeared.
Claiming legislation from 1933 had a bearing today in the technology age is a feel good response to what has become the main problem in banking.
Banks, in particular, have to answer to stock holders. They are the face we see day to day. Do you remember WaMu, the friend of the family, introducing Murphy Favre into bank branches? They were an investment arm of the company. I was surprised in my little research to find: Murphy Favre Housing Managers, Inc.
Murphy Favre Properties, Inc.
I'll check further but it seems these are Real Estate Holding Companies. It makes sense from the dealings I had with the Loss Mitigation Department about two years ago. The negotiator told me that it was WaMu policy to add foreclosed properties to the Property Management portfolio.
Stock Holders are demanding profits. The stock holders have made money, or should I say made money, by stock price appreciation. You can tie it to mortgages, but ultimately those mortgages at least have an asset. Consumer Credit is unsecured.
So when companies began selling secured debt it looked great on paper because the alternative was thin air. Regulators did their job by over seeing the transfer of unsecured debt into HELOCs and Mortgages. They were in fact working in the best interest of the Stock Holders.
Our government passed laws to allow 29% interest plus late fees on Consumer Credit. That's all profit. It's legal and looks very good on paper. That paper was transferred into secured mortgages, again legal, and good for investors.
The regulators did their jobs. There are more than enough laws on the books that we as tax payers have encouraged. Glass-Steagall had to go. Stock holder demanded it. The stock market was inflated to 14000 by the tech stock revolution. Pension Plans, IRAs, 401Ks were tied to it. The federal government had to sustain the "markets." It was and is still a mandate.
We all have an opportunity today to stop the stock market from acting foolishly. It's called Consumer Confidence, but I look at it as Consumer Spending. Rather than spend we can pay down debt. It's an individual choice not tied to what the government does.
The stock market has been a gamble since 1987. In the 1980s Mergers and Acquisitions gutted any and all viable companies. It's a long story, but technology took over. Microsoft, as a monopoly, by the way, made America Great once again.
In 1999 when the monopoly was broken it should have been a warning. Stock Holders ignored the warning and moved ahead based on Consumer Spending of new found wealth. In a way the stock market perpetuated itself.
It's all legal and demanded by the Stock Holders. Claiming the government was some how at fault is misleading. it has all worked perfectly. We are exactly were we wanted to be.
I think you misunderstand what falls into the regulators purvey. Investors should be allowed to invest in essentially anything they want (houses, dotcoms, beanie babies...?). But regulators should be monitoring the situation for rampant corruption. If investors want CDOs, great; just make sure their bond ratings are believable. If they want to hedge a position, cool; just make sure the insurer of the hedge can actually meet their obligations.
Let's be clear, failed regulations did not cause this bubble. But, it could not possibly have grown so large if properly regulated. We might be looking at nationwide price drops of 5%-10% instead of 20% and counting. That's a huge difference.
It made sense that banks could offer a wide variety of lending products to generate profit. Taken as a whole the entire bank potfolio was taking in cash. It invested cash in instruments tied to lending. As lending grew, they then included insurance products, it was all income.
We're just talking about banks because you see them. We have the idea they take in deposits then lend the money in say home loans, like in "It's a Wonderful Life."
The reality is that banks are now parts of larger and larger corporate entities. They buy mortgage generating branchs like Long Beach Mortgage. Other corporations may invest in those mortgages because they have a vested interest.
Unsecured debt holders are fair game for refi and second position loan solicitation. Citi Group could, I'm not saying they did, have given Long Beach Mortgage a list of usecured debtors and inticed them into refinancing to pay unsecured debt.
Citi Group could have been the investor that backed the refi or second position loans. I'm not saying that happened, but it is possible and legal. On paper it looks as though Citi Group is on the hook for the loan. They are the ones at risk. It's legal, regulated, looks great on paper and everybody should be happy.
Once the loan is in place Citi Group could solicit the home owner with more lending products like credit cards and the cycle begins again.
Unlike Amazon or Google these corporations and banks are making real profits. The stocks and securities are sold on the basis of real profits that are in many cases now backed by mortgages.
It's all legal, regulated and looks very good on paper. Real Estate prices appreciated across the board, it was national and global. On paper it looks very solid.
Ok, even with a crash as we are calling it these corporations still end up with tangible assets. These banks end up with rentable properties. maybe the rental market softens and they rent for less, but it is still income. They own the properties free and clear and it is all income paying down a principle balance.
In the mean time banks, and corporations are still selling consumer credit which more and more people need more and more. It's perfect, legal, and regulated.
The kicker is that every stock purchaser, 401k, IRA, and Pension Plan wanted this. It is a mandated to have an "expanding economy." So if I understand regulations concerning stocks it's to work for the stock holders.
Yes, exactly. All those bankers are going to happily trade their six-figure salaries for $40k a year managing rentals. If you think banks are glad to be stuck with a bag of continually less valuable homes, you're nuts. That's the last thing they want. Let's put it another way, name one super-wealthy-elite person who made it on slums.
Trump makes his on real estate, but not on individual condos and mobile homes in trailer parks. Shoot, go back through all the history you can find. Did anyone make the kind of profit these banks depend on by renting out thousands of homes spread throughout the nation? It just doesn't work that way. In fact, I challenge you to even point out a single press release where a big banker explains to his banks shareholders that they don't really need to worry about all the billions of write-downs because his bank will make up for it over the coming years by renting out foreclosed properties. Just one article.
Instead, banks are paying to get these homes off their books in Michigan.
I completely agree that the recent era of big Wall Street money, and slight of hand, is over, just like it was "over" in 1929. However, in 2090 or so I suspect all those evils will have returned as society forgets the lessons it is so painfully learning today. 80 years from now the people will be electing politicians to office who run on platforms of dismantling regulations, and appointing regulators who will maintain a hands-off approach. Investors (and individuals) will feel bullish once again, jumping at a new age of bubble investments certain with the belief they are in a NEW era.
Number one the lenders are not writing down the value of properties they own outright. On the books the value of the asset is as they say. They bundle the properties into land trusts.
Murphy Favre Housing Managers, Inc.
Murphy Favre Properties, Inc.
You can do wonders with mobile homes in a leverage situation. Yes, if you own a few hundred rentals it adds up to very little, a few thousand units or a million start to make money. They are not the prize.
Then take the second part of the equation of the performing loans and consumer credit. That's where the repeal of the Glass-Steagall Act come in. Provisions that prohibit a bank holding company from owning other financial companies were repealed on November 12, 1999,
Banks can do anything today and certainly do no wrong as far as the stock holders are concerned.
No those single wide mobiles will be leveraged into larger parcels, built on, and resold. Maybe with some accounting creativity they will buy the Trump Tower if they don't own them already.
Yes this has always been true even in very good times for the Real Estate market. You used to be able to buy homes, apartment buildings, and commercial buildings for $1 now it's $10. The cost of rehab is higher than the property is worth.
It's dollars in, dollars out.