DON'T IT MAKE YOUR BLACK SWAN WHITE (via Bruno Behrend):

Risk Mismanagement (JOE NOCERA, 1/04/09, NY Times Magazine)

VaR DIDN’T GET EVERYTHING right even in what it purported to measure. All the triple-A-rated mortgage-backed securities churned out by Wall Street firms and that turned out to be little more than junk? VaR didn’t see the risk because it generally relied on a two-year data history. Although it took into account the increased risk brought on by leverage, it failed to distinguish between leverage that came from long-term, fixed-rate debt — bonds and such that come due at a set date — and loans that can be called in at any time and can, as Brown put it “blow you up in two minutes.” That is, the kind of leverage that disappeared the minute something bad arose.

“The old adage, ‘garbage in, garbage out’ certainly applies,” Groz said. “When you realize that VaR is using tame historical data to model a wildly different environment, the total losses of Bear Stearns’ hedge funds become easier to understand. It’s like the historic data only has rainstorms and then a tornado hits.”

Guldimann, the great VaR proselytizer, sounded almost mournful when he talked about what he saw as another of VaR’s shortcomings. To him, the big problem was that it turned out that VaR could be gamed. That is what happened when banks began reporting their VaRs. To motivate managers, the banks began to compensate them not just for making big profits but also for making profits with low risks. That sounds good in principle, but managers began to manipulate the VaR by loading up on what Guldimann calls “asymmetric risk positions.” These are products or contracts that, in general, generate small gains and very rarely have losses. But when they do have losses, they are huge. These positions made a manager’s VaR look good because VaR ignored the slim likelihood of giant losses, which could only come about in the event of a true catastrophe. A good example was a credit-default swap, which is essentially insurance that a company won’t default. The gains made from selling credit-default swaps are small and steady — and the chance of ever having to pay off that insurance was assumed to be minuscule. It was outside the 99 percent probability, so it didn’t show up in the VaR number. People didn’t see the size of those hidden positions lurking in that 1 percent that VaR didn’t measure.

EVEN MORE CRITICAL, it did not properly account for leverage that was employed through the use of options. For example, said Groz, if an asset manager borrows money to buy shares of a company, the VaR would usually increase. But say he instead enters into a contract that gives someone the right to sell him those shares at a lower price at a later time — a put option. In that case, the VaR might remain unchanged. From the outside, he would look as if he were taking no risk, but in fact, he is. If the share price of the company falls steeply, he will have lost a great deal of money. Groz called this practice “stuffing risk into the tails.”

And yet, instead of dismissing VaR as worthless, most of the experts I talked to defended it. The issue, it seemed to me, was less what VaR did and did not do, but how you thought about it. Taleb says that because VaR didn’t measure the 1 percent, it was worse than useless — it was downright harmful. But most of the risk experts said there was a great deal to be said for being able to manage risk 99 percent of the time, however imperfectly, even though it meant you couldn’t account for the last 1 percent.

“If you say that all risk is unknowable,” Gregg Berman said, “you don’t have the basis of any sort of a bet or a trade. You cannot buy and sell anything unless you have some idea of the expectation of how it will move.” In other words, if you spend all your time thinking about black swans, you’ll be so risk averse you’ll never do a trade. Brown put it this way: “NT” — that is how he refers to Nassim Nicholas Taleb — “says that 1 percent will dominate your outcomes. I think the other 99 percent does matter. There are things you can do to control your risk. To not use VaR is to say that I won’t care about the 99 percent, in which case you won’t have a business. That is true even though you know the fate of the firm is going to be determined by some huge event. When you think about disasters, all you can rely on is the disasters of the past. And yet you know that it will be different in the future. How do you plan for that?”

One risk-model critic, Richard Bookstaber, a hedge-fund risk manager and author of “A Demon of Our Own Design,” ranted about VaR for a half-hour over dinner one night. Then he finally said, “If you put a gun to my head and asked me what my firm’s risk was, I would use VaR.” VaR may have been a flawed number, but it was the best number anyone had come up with.

Of course, the experts I was speaking to were, well, experts. They had a deep understanding of risk modeling and all its inherent limitations. They thought about it all the time. Brown even thought VaR was good when the numbers seemed “off,” or when it started to “miss” on a regular basis — it either meant that there was something wrong with the way VaR was being calculated, or it meant the market was no longer acting “normally.” Either way, he said, it told you something useful.

“When I teach it,” Christopher Donohue, the managing director of the research group at the Global Association of Risk Professionals, said, “I immediately go into the shortcomings. You can’t calculate a VaR number and think you know everything you need. On a day-to-day basis I don’t care so much that the VaR is 42. I care about where it was yesterday and where it is going tomorrow. What direction is the risk going?” Then he added, “That is probably another danger: because we put a dollar number to it, they attach a meaning to it.”

By “they,” Donohue meant everyone who wasn’t a risk manager or a risk expert. There were the investors who saw the VaR numbers in the annual reports but didn’t pay them the least bit of attention. There were the regulators who slept soundly in the knowledge that, thanks to VaR, they had the whole risk thing under control. There were the boards who heard a VaR number once or twice a year and thought it sounded good. There were chief executives like O’Neal and Prince. There was everyone, really, who, over time, forgot that the VaR number was only meant to describe what happened 99 percent of the time. That $50 million wasn’t just the most you could lose 99 percent of the time. It was the least you could lose 1 percent of the time. In the bubble, with easy profits being made and risk having been transformed into mathematical conceit, the real meaning of risk had been forgotten. Instead of scrutinizing VaR for signs of impending trouble, they took comfort in a number and doubled down, putting more money at risk in the expectation of bigger gains. “It has to do with the human condition,” said one former risk manager. “People like to have one number they can believe in.”

Brown told me: “You absolutely could see it coming. You could see the risks rising. However, in the two years before the crisis hit, instead of preparing for it, the opposite took place to an extreme degree. The real trouble we got into today is because of things that took place in the two years before, when the risk measures were saying that things were getting bad.”

Contra Taleb, the problem, one again, wasn't some unforseen or unforseeable eventuality, but the exact same one that has recurred repeatedly over the last twenty years: the devices became so complex that they misstated the actual risk investors were assuming--often intentionally so. When the tool you're using to minimize risk is creating it instead the breakdown is always coming.

But the even more telling thing is that when the "black swan" returns, as they generally do, since they aren't unusual, the tendency is to react to them as if they were sui generis anyway, Does Obama Have a Plan B? (Adam S. Posen, 3/29/09, Daily Beast)

[I]t is with some irony if not humility that we should approach Treasury Secretary Geithner’s Public Private Investment Plan presented on March 23. A number of major American banks have lost huge amounts of money, and clearly have insufficient capital if they are not literally insolvent. Why else would they be pushing so hard to change the accounting rules to avoid showing what they really have on their books instead of raising private capital? Why else is the US government taking so long to perform “stress tests” and trying to get expectations of overpayment for some of the bad assets on the banks’ books before the test results are out? In short, the US government is looking to shovel capital into the banks without sufficient conditions, hiding rather than confronting the actual situation.

That is just like the Japanese government in their lost decade, or the US officials during the 1980s before they really tackled the savings-and-loan crisis. In those cases the delay simply made the problem worse over time and in the end the government had to put more money into the troubled banks directly, taking over or shutting down the weakest of them. Whatever the political culture, it would seem we have not learned from experience. Or perhaps we cannot act on our learning. The universal barrier would appear to be the political difficulty of recapitalizing banks. That seems obvious, but the constraint it puts on good policy is enormous.

That is why the Geithner plan is so complex and jury-rigged, to avoid the need for public requests for more money for banks. Unfortunately, it is unlikely to succeed absent additional public money and more intrusive government action. The plan will buy some time and certainly some appreciation in bank share prices. Current shareholders will be getting a new lease on life with subsidies from taxpayers. For that reason alone, the plan certainly will cost the taxpayer more in the end than a more direct recapitalization with public control would have.

A year or two down the road we will know for certain whether it worked. By then the banks will either return to normal pre-crisis lending or they will be both too distrusted and too distrustful even to borrow from each other again. As we have seen over the last eighteen months, the latter is what near- insolvent banks do.

It just doesn't much matter that we know exactly how we should respond to this current perfectly typical credit crunch, we still have trouble doing it.

Posted by Orrin Judd at March 29, 2009 8:02 PM