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Risk Mismanagement (Part of how Wall Street was too smart by half.)
NY Times Magazine ^ | January 4, 2009 | JOE NOCERA

Posted on 01/03/2009 7:44:06 PM PST by neverdem

‘The story that I have to tell is marked all the way through by a persistent tension between those who assert that the best decisions are based on quantification and numbers, determined by the patterns of the past, and those who base their decisions on more subjective degrees of belief about the uncertain future. This is a controversy that has never been resolved.’


THERE AREN’T MANY widely told anecdotes about the current financial crisis, at least not yet, but there’s one that made the rounds in 2007, back when the big investment banks were first starting to write down billions of dollars in mortgage-backed derivatives and other so-called toxic securities. This was well before Bear Stearns collapsed, before Fannie Mae and Freddie Mac were taken over by the federal government, before Lehman fell and Merrill Lynch was sold and A.I.G. saved, before the $700 billion bailout bill was rushed into law. Before, that is, it became obvious that the risks taken by the largest banks and investment firms in the United States — and, indeed, in much of the Western world — were so excessive and foolhardy that they threatened to bring down the financial system itself. On the contrary: this was back when the major investment firms were still assuring investors that all was well, these little speed bumps notwithstanding — assurances based, in part, on their fantastically complex mathematical models for measuring the risk in their various portfolios.

There are many such models, but by far the most widely used is called VaR — Value at Risk. Built around statistical ideas and probability theories that have been around for centuries, VaR was developed and popularized in the early 1990s...

(Excerpt) Read more at ...

TOPICS: Business/Economy; Crime/Corruption; Editorial; News/Current Events
KEYWORDS: creditcrunch; financialcrisis; quants; var; wallstreet
Nothing about the politics behind it, but it was long enough already.
1 posted on 01/03/2009 7:44:06 PM PST by neverdem
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To: neverdem
Nothing about the politics behind it, but it was long enough already.

The only politics behind it was buying enough votes and getting the necessary laws changed are made by the republicans, common knowledge.

2 posted on 01/03/2009 7:49:49 PM PST by org.whodat (Conservatives don't vote for Bailouts for Super-Rich Bankers! Republicans do!)
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To: org.whodat

Hades Confirms: Hank Paulson Works for the Devil (March 31, 2008) ...... Chas. Hugh Smith

I was preparing to write a nuanced, subtle analysis of the U.S. financial system’s regulatory failures and the inadequacy of Treasury Secretary Henry Paulson’s proposals to “fix” the system (double entendre intended) when I came across a document which proves beyond a shadow of doubt that Hank Paulson is working directly for the Devil.
I know this is a shocking revelation, and unfortunately I can’t scan the incriminating document, as it was written in goat’s blood and only becomes visible for extremely short periods when sluiced with a secret Dark Arts formula (eye of a newt, etc.)

Despite the difficulties, I was able to transcribe the text, which is reprinted below just as it was written.

To provide the proper context for understanding the fiendish cleverness of Paulson’s “reform” proposals, let’s turn to a cogent quote from Gullivers Travels by that incomparable satirist Jonathan Swift, courtesy of frequent contributor U. Doran:

“They look upon fraud as a greater crime than theft, and therefore seldom fail to punish it with death; for they allege, that care and vigilance, with a very common understanding, may preserve a mans goods from thieves, but honesty has no defence against superior cunning; and, since it is necessary that there should be a perpetual intercourse of buying and selling, and dealing upon credit, where fraud is permitted and connived at, or has no law to punish it, the honest dealer is always undone, and the knave gets the advantage.”

Here’s the letter from the Devil to Paulson:


“Prince of Lies and proud of it”

Dear Hank:

You have outdone yourself once again, my loyal servant, with these fraudulent, deliciously deceptive proposals to reform the utterly corrupt financial system you exploited so profitably as head of Goldman Sachs.

My plans for the destruction of the United States of America have been going along rather swimmingly until we rushed things a bit with Bear Stearns—ah, the wondrous power of pure, unmitigated greed! It remains my favorite tool—and calls for reform were suddenly everywhere.

The rules which would have undone us were simple indeed, as you know all too well:

1. complete transparency of risk and leverage in all financial documents and financial instruments
2. the marking to market of all financial instruments and assets at the close of the trading day, as is currently done with commodities futures and stock options
3. the banning of “off balance sheet” accounting
4. the banning of offshore accounts and holding companies
5. the uniform enforcement of these regulations across all financial classes, assets, firms, brokers and banks

As you know, Hank, transparency, mark-to-market and strictly enforced regulations of all banks, broker-dealers and financial institutions would deal a death blow to my plans to destroy the U.S. via destruction of its financial system. Having sold your soul to me for the glory and riches you received at Goldman Sachs, you had to comply with my orders to destroy any such useful regulations with cunning “fixes” of your own.

Though I counted on your native feral survival instincts, I did not expect a plan of such evil genius. Imagine how foolish and naive humans must be to accept your “fix”! My mind boggles at the ease with which you have conned the gullible gallery of idiots in Congress and the mainstream media:

1. you diminish the powers of the Federal agencies and favor the “shadow government” Federal Reserve, which is not even a government agency but a private institution
2. Instead of proposing transparency, you are adding another layer of secrecy in what the Fed can investigate and do to “fix” future problems
3. Enable more “self-regulation” (hahahaha, I can’t stop laughing at this one! You really are a comedian!)

I am still amused that the American populace hasn’t noticed that you, Master of the Dark Arts at Goldman Sachs, have been duly appointed as the wolf assigned to guard the sheep. Now you have suggested opening the rusty wire fencing and lighting the opening so your brethren can more easily slip in and slaughter as many sheep as they wish—and the American sheep sit there mesmerized by my other crowning achievement, the TV, blithely accepted that the most voracious, cleverest wolf is now their “guardian.” Never in my wildest imaginations did I hope for such gross stupidity, ignorance and naivite.

Keep up the fine work—

Your Lord and Master,


3 posted on 01/03/2009 7:55:28 PM PST by Attention Surplus Disorder (Our government is an edifice of artifice.)
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To: Attention Surplus Disorder
Thanks I had not seen that, printing it out!!!!
4 posted on 01/03/2009 8:33:17 PM PST by org.whodat (Conservatives don't vote for Bailouts for Super-Rich Bankers! Republicans do!)
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To: Attention Surplus Disorder

not just unfunny, not just devoid of understanding, but 30 X leveraged tin-foil material.

5 posted on 01/03/2009 8:57:04 PM PST by the invisib1e hand (revolution is in the air.)
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To: wardaddy; Joe Brower; Cannoneer No. 4; Criminal Number 18F; Dan from Michigan; Eaker; Jeff Head; ...
Look Who's Buying IndyMac (George Soros among others)

Is Religion Necessary?

Mr. Gore: Apology Accepted Huffington Post has been successfully infiltrated by an informed, articulate denier!

Some noteworthy articles about politics, foreign and military affairs, IMHO, FReepmail me if you want on or off my list.

6 posted on 01/03/2009 9:02:40 PM PST by neverdem (Xin loi minh oi)
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To: neverdem

There is plenty of blame to go around.

If the NY Times and Salzberger wanted to do an investigative journalism piece that was fair and accurate, they can find legitimate cases for their argument that free markets and greed were 20-40% at fault .

They are not interested. Journalism is DEAD. This is agenda driven.

7 posted on 01/03/2009 9:21:32 PM PST by Eric Blair 2084 (Alcohol, Tobacco and Firearms shouldn't be a federal should be a convenience store.)
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To: neverdem

Statement by the Press Secretary on Irresponsible Reporting by New York Times

White House News
Setting the Record Straight: The Three Most Egregious Claims In The New York Times Article On The Housing Crisis
In Focus: Economy
Most people can accept that a news story recounting recent events will be reliant on ‘20-20 hindsight’. Today’s front-page New York Times story relies on hindsight with blinders on and one eye closed.

The Times’ ‘reporting’ in this story amounted to finding selected quotes to support a story the reporters fully intended to write from the onset, while disregarding anything that didn’t fit their point of view. To prove the point, when they filed their story, NYT reporters were completely unfamiliar with the President’s prime time address to the nation where he laid out in detail all of the causes of the housing and financial crises. For example, the President highlighted a factor that economists agree on: that the most significant factor leading to the housing crisis was cheap money flowing into the U.S. from the rest of the world, so that there was no natural restraint on flush lenders to push loans on Americans in risky ways. This flow of funds into the U.S. was unprecedented. And because it was unprecedented, the conditions it created presented unprecedented questions for policymakers.

In his address the President also explained in detail the failure of financial institutions to perform normal and necessary due diligence in creating, buying and selling new financial products — a problem that almost no one saw as it was happening.

That the NYT ignored such an important economic speech to the American people and the complex causes of the crises is gross negligence.

The Times story frequently repeats a charge by the Administration’s critics: a ‘laissez faire’ attitude toward regulation. We make no apology for understanding the concept of regulatory balance. That is, regulation should be stringent enough to protect the greater public good and safety but not overly strong so that it unnecessarily inhibits innovation, creativity and productivity gains that are the sole source of increasing Americans’ standards of living. But while repeating this charge, the reporters gave glancing attention to the fact that it was this Administration that pushed for strengthened regulation and oversight, greater transparency, and housing reform.

The story also gives kid glove treatment to Congress. While the Administration was pushing for more transparent lending rules and strengthening oversight and supervision of Fannie and Freddie, Congress for years blocked attempts at stronger regulation and blocked reform of the Federal Housing Administration. Democratic leaders brazenly encouraged Fannie and Freddie to loosen lending standards and instead encouraged the housing GSEs to play a larger and larger role in the housing market — even while explicitly acknowledging the rising risks. And while the story notes the political contributions of some banks to Republicans, it neglects that political contributions from Fannie Mae and Freddie Mac overwhelmingly supported Democratic officials — in particular the chairmen of the banking committees. In fact, even in the midst of what by then was a housing crisis, it took Congress nearly a full year to pass specific legislation called for by the President in the summer of 2007, especially legislation to reform oversight of Fannie Mae and Freddie Mac.

There are many more reporting failures in this story — failure to consider the impact of monetary policy; ignoring the regional nature of housing markets; and ignoring the Bush Administration’s historic proposal to overhaul the nation’s regulatory system, for example. But then a review of these issues would wave complicated the reporters’ myopic point of view that only Bush Administration policies could possibly be responsible for the housing and finance crises.

8 posted on 01/03/2009 9:24:45 PM PST by Eric Blair 2084 (Alcohol, Tobacco and Firearms shouldn't be a federal should be a convenience store.)
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To: neverdem
I disagree: EVERYTHING about the collapse was politically driven, beginning with Pelosi’s extreme global warming hysteria that “required” no drilling, all MidEast oil; then the tripling of oilprioces as the democrats also increased tensions and disruptions in the Israeli- Arab wars.

Once oil was high enough, so gasoline got above 4.00/gallon, then the rest fell “naturally” - and it was THAT failure to anticipate the impact of 4.00 gasoline that Wall Street failed to plan for.

Gas too high? Hurts all markets, lower employment and lower economy (food, manufacturing, construction, etc.) , more layoffs and budget cutting (including ending the housing boom) which led to a “flattening” of the economy through summer, then the people who can't pay bad mortgages corrupted the finance markets, bringing down bad insurance and bad investments that couldn't keep up.

9 posted on 01/03/2009 9:25:14 PM PST by Robert A Cook PE (I can only donate monthly, but socialists' ABBCNNBCBS continue to lie every day!)
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To: neverdem

Thanks for the ping!

10 posted on 01/03/2009 9:28:16 PM PST by Alamo-Girl
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To: neverdem

Since Nocera is a liberal arts major, he obviously doesn’t understand the underlying issues with the mathematics here, so he makes up in sheer volume of output for his lack of understanding of statistics. By “statistics,” I mean the sort of stats that is taught to hard science and engineering folks, not the stuff taught in business and social science classes.

Here’s the nut of the problem with VaR and other models of market price excursion that use the Gaussian distribution:

The Central Limit Theorem (informally called the “law of large numbers) says that any population of events that are independent from each other in large enough numbers can be modeled with a Gaussian distribution.

The big assumption here that is being made (and violated) is that the price of a stock (or bond, or commodity) in the next minute has NOTHING to do with the price of the thing this minute. Or (more absurdly) that the price of instrument A has nothing to do with the price of instrument B.

Both of these assumptions are false when the crap starts hitting the fan.

The first assumption is false because at some point, the irrationality of crowds and mobs will make manias and panics happen. At some point the price of some instrument will go up high enough to attract enough attention that tomorrow’s price is purely predicated on today’s price movement. They’re not only not independent, tomorrow’s price movement starts becoming strongly correlated and caused by today’s price movement. Machine trading now makes this a certainty.

Then we get into the case of liquidity crunches. Why would the price of commodities go down at the same time that stocks are going down? Typical market behavior is that as commodity prices go up, stocks go down, and when commodities come down, input prices for manufacturing go down and profits go up, which results in profits going up, and therefore stock prices go up.

Likewise, why would bonds, stocks and commodities all be sold at the same time, with prices plummeting all in concert? Typical market behavior says that at least one of the three should be going up.

In a liquidity crisis, where funds and people want to be in cash right the hell now, everything is sold at the same time. Whatever is liquid and can be sold with the minimum price penalty for being illiquid gets sold first. The price movements become correlated and even show causation as funds figure out that “the other guy” is bailing out of commodities, so our fund better get out of commodities ASAP and stocks too before the other guy realizes that he can’t cover his margin call with just his commodity positions.

VaR, because of the under-prediction of 2+sigma price excursions in panic or mania situations, has fallen down. It was bound to do so sooner or later, and Taleb has a indisputable point when he pounds tables in an interview wanting to abolish VaR in an attempt to make people think really hard about the situation.

I would NB that Taleb’s mentor, Benoit Mandelbrot (the Mandelbrot of fractal mathematics fame) did work on price movements of cotton futures years ago. He found that, indeed, price movements do not follow a Gaussian distribution - not even close. The Gaussian distribution vastly under-estimates the likelihoods of radical movements to 2+ standard deviations, especially on the downside. The real world distributions have much “fatter tails” than does a Gaussian distribution function.

Lastly, what Nocera doesn’t explore (and quite frankly, no one is exploring properly) is our over-reliance upon computer modeling. I don’t care which field we’re talking about, there is this obsession now with computer models based on reams of statistics and data.

We have VaR models. We have models for predicting weather and now climate change, both of which are wrong. Models for predicting how many hurricanes will form in the Atlantic this year - also usually wrong. Models that will model how long you should live based on what naughty things you have done - and therefore, what you should pay for life and health insurance. Also wrong.

Models for tax revenue, models for economic growth, models for city planning, urban transport, you name it, we have a computer model for it and a bunch of adherents who worship these models like slaves.

Most all of these models are being used as a way to defer or deflect responsibility and prevent critical decision making upon sound criteria and reasoned judgment of the facts at hand for THIS particular situation, not a amalgamation of all previous situations that were “something like” what we face today.

11 posted on 01/03/2009 9:53:02 PM PST by NVDave
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To: neverdem

Thanks for the ping.

12 posted on 01/04/2009 8:10:22 AM PST by GOPJ (GM's market value is a third of Bed, Bath and Beyond. Why is GM "too big to fail"? Steyn)
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thanks neverdem.

HuffPo: Gore Should Apologize for Spreading Climate Hysteria
News Busters | January 03, 2009 | Noel Sheppard
Posted on 01/03/2009 4:01:18 PM PST by RobinMasters

13 posted on 01/04/2009 8:20:34 AM PST by SunkenCiv ( finally updated Saturday, December 6, 2008 !!!)
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To: neverdem
As the risk consultant Marc Groz puts it, “The years 2005-2006,” which were the culmination of the housing bubble, “aren’t a very good universe for predicting what happened in 2007-2008.”

This was one of Alan Greenspan’s primary excuses when he made his mea culpa for the financial crisis before Congress a few months ago. After pointing out that a Nobel Prize had been awarded for work that led to some of the theories behind derivative pricing and risk management, he said: “The whole intellectual edifice, however, collapsed in the summer of last year because the data input into the risk-management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.” Well, yes. That was also the point Taleb was making in his lecture when he referred to what he called future-blindness. People tend not to be able to anticipate a future they have never personally experienced.

Short term thinking and an inability to program institutional memory?

14 posted on 01/04/2009 8:21:15 AM PST by GOPJ (GM's market value is a third of Bed, Bath and Beyond. Why is GM "too big to fail"? Steyn)
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To: NVDave

“I would NB that Taleb’s mentor, Benoit Mandelbrot (the Mandelbrot of fractal mathematics fame) did work on price movements of cotton futures years ago. He found that, indeed, price movements do not follow a Gaussian distribution - not even close. The Gaussian distribution vastly under-estimates the likelihoods of radical movements to 2+ standard deviations, especially on the downside. The real world distributions have much “fatter tails” than does a Gaussian distribution function.”

Surely then the models need to just account for that historical fact and use a different distribution?

Likewise, your point about correlation - these are in VaR models, are they not?

Taleb’s real point is that historical data cant predict future action, especially at the ‘fat tails’ of rare events, which are not in the historical data to begin with.

15 posted on 01/04/2009 12:07:36 PM PST by WOSG (Obama - a born in the USA socialist)
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To: neverdem
People wrongly assume that intelligent people are above mania and hysteria. Wall street executives, like executives in other businesses are shackled by group think and the quarterly report.
If you follow the pack or "conventional wisdom" (ie something that is always temporary convention and never wise) you rusk little. If you break from the pack any small error is magnified and can destroy your career. If you are right, all you have done is piss everyone off. Instead of shaking assumptions, all you do is become a bigger target. However, once the pack breaks with historical knowledge, the person who brings it up is worse than the innovator. We have a stupid cultural assumption that change is progress, and foolishly believe that just because technology changes, the past is irrelevant. Hence you get stupid statements like the assumptions of the past are wrong because of new technology or global trade. They forget that human nature remains the same, and that these arguments have been used before. (In fact, if you want a hedge, whenever you hear the "experts" use this line, get out of that industry or market. It is a bubble.)

Hedge funds and commodities were supposed to provide security. But they are run under the same assumptions and using the same derivatives and models as everyone else. Worse, in the real world, most hedges are poor choices as they are dependent on the same market conditions as everything else.

The quarterly report, if not the daily cycle, has become the measure of performance. Speaking of long term (5 year) trends or historical pictures are laughed at. Business school re-enforce this by not focusing on economic history. They are mere trade schools, creating a culture of dependence on tools, rather than critical thinking. Trade journals and shows re-enforce group think.

16 posted on 01/04/2009 1:39:48 PM PST by rmlew (The loyal opposition to a regime dedicated to overthrowing the Constitution are accomplices.)
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Using a different probability distribution function makes some of the math involving the PDF quite difficult. One of the reasons why so many academics like to use Gaussian (aka “normal”) distributions is that the higher-level math in probability and stats just “falls out” when you use a Gaussian PDF - and if you don’t use a Gaussian PDF, things can and do get very complicated in some models and types of probabilistic math.

The point about correlation/causation — if it were accounted for in the models, they could not use the Gaussian distribution at all, because admitting that the probability of the next price movement is caused & correlated to the previous price movement violates the assumption of the Central Limit Theorem that all events in the underlying PDF are independent.

17 posted on 01/04/2009 6:06:55 PM PST by NVDave
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