Tuesday, January 29, 2008

The Redefinition of Risk

Summer 2005 – Wall Street
“All swans are white” shouted the leader of the investment banking crowd.
“and what if a black one shows up,” countered the risk manager.
“Do you know how much money we are making on these CDOs? How can there be any risk. Risk is a thing of the past. This is the new generation of banking, risk is distributed," cried the room in chorus.
“The black swam is stalking you, and it is just a matter of time till it makes its appearance,” shouted the risk manager over the din.
“The quants have modeled this stuff over the last ten years. They assure me there is no risk and we are going to make a ton of money in fees. Don’t rock our rice bowl,” stated the lead derivative banker as the crowd rose to leave the room, “Let’s go make some bonus money!”
The risk manager sadly shook his head while staring directly at the black swan that was obviously sitting on the table.

The risk manager resigned the following week and was quickly replaced by one more pliable to the demands of the derivative structure crowd. The figurine of the three monkeys on the new risk manager’s desk was an evident sign of the impending future.

The combination of greed, poor modeling, and deliberate disregard of proper diligence practices has come home to roost in one of the largest catastrophes ever experienced by Wall Street. The events of the last six months are an outline of a history lesson that will be taught in business school classrooms a hundred years from today. The trail of wreckage is widespread and unprecedented. Adding liquidity from the Fed was not able to unwind the credit crisis, and the industry was not able to bail itself out. Many major financial institutions had to turn to foreign sovereign funds to provide cash to avoid being effectively left insolvent from a capital ratio perspective.

Value at risk is dead, a new model is needed that properly accounts for derivative risk on Wall Street. The new representation needs to take into account the expectation of six-sigma events and disregard the pressure from bankers focused on greed over common sense. The concept that firms can solely account for risk by defining the dollar amount at risk on any given day with 95% confidence is a failed relic of the past. The quantitative models from Wall Street wizards that cherry-pick ten year nonvolatile timeframes as evidence that no significant losses can ever occur for derivatives has been debunked. The fantasy in the brave new world of banking that risk can be distributed in the derivatives market and nobody will ever be left holding the bag has obviously crumbled into dust.

A recent article (Death of VaR Evoked as Risk-Taking Vim Meets Taleb's Black Swan) outlines these concerns with this opening:

"The risk-taking model that emboldened Wall Street to trade with impunity is broken and everyone from Merrill Lynch & Co. Chief Executive Officer John Thain to Morgan Stanley Chief Financial Officer Colm Kelleher is coming to the realization that no algorithm or triple-A rating can substitute for old-fashioned due diligence.

Value at risk, the measure banks use to calculate the maximum their trades can lose each day, failed to detect the scope of the U.S. subprime mortgage market's collapse as it triggered more than $130 billion of losses since June for the biggest securities firms led by Citigroup Inc., Merrill, Morgan Stanley and UBS AG."

A number of earlier articles at HingeFire talk about the Wall Street derivatives debacle:

Does the Securitization Model actually work?

The Derivative House of Cards: The “Shadow Banking” System falters

Will Someone tell the Financial Whiz Kids that their House is Built of Cards