Math, leverage and risk
How modern finance and government intervention crashed the financial system
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Mathematics, Leverage and Risk
by Martin Hutchinson
Monday, 18 June 2012 13:46
The $2 billion (or maybe $5 billion) loss by JP Morgan Chase went unnoticed for several months, because JP Morgan Chase was relying on the Value-at-Risk risk management metric, which as we pointed out in “Alchemists of Loss” is hopelessly flawed. However there is a cultural question here: large conservative banks thirty years ago would never have relied on a flawed mathematical algorithm to determine their risk position, and would in any case have been far less leveraged. The combination of Bernankean monetary policy, modern ideas about leverage and flawed mathematical concepts seems uniquely toxic. Is the financial system to be bedeviled by it from here on forward?
It did not take the 2008 crisis to show Kevin Dowd and me that Value-at-Risk, invented in the early 1990s, was utterly unsound. Indeed its flaws were well known for several years before the crash – the great mathematician Benoit Mandelbrot, in his 2004 “The Misbehavior of Markets,” had pointed them out with mathematical elegance we could not hope to match (Mandelbrot had pointed out flaws in the emerging underlying theory as early as 1962). Both Kevin and I had also written on the subject, with my own first essay in the area being published in “Derivatives Quarterly” in early 1998, before the Long-Term Capital Management debacle had first demonstrated the fallibility of Wall Street’s models to all who were willing to examine its denouement impartially.
Naively, we assumed if nothing else came out of the 2008 debacle, it would at least lead to banks ceasing to use such an obviously flawed methodology, and moving to something more satisfactory. However, when details came out of JP Morgan Chase’s losses, it became clear this had not happened. Indeed, so engrained is VaR that the new Basel III regulatory system still contemplates its use, although to be fair regulators have now issued a discussion paper suggesting that alternatives might be sought.
The problem is not one of inadequate mathematicians. The Mandelbrot book is highly readable, and generally mathematically accessible. Furthermore, the problem with VaR, its inadequate recognition of “fat tails” and “long tails,” is obvious to anyone observing its behavior in a crisis. When David Viniar, the CFO of Goldman Sachs, said in 2007 he was seeing “25-standard-deviation moves, several days in a row,” he would have needed only a minute or so with Microsoft Excel to see that the existence of such moves wholly invalidated the VaR methodology.
The problem was the incentives on Wall Street. Mathematicians were brought into the major investment banks only in the mid 1980s. Seduced by the remuneration available, far in excess of what they could conceivably get in academia, they became slaves to the more strong-willed traders and management of the banks. Told that their jobs depended on managing risk in such a way as to allow the traders free rein, they devised mathematical models that appeared legitimate, and could be presented to inquisitive top management and regulators, but in reality were fatally flawed.
The traders also responded to incentives. Told that their bonus required them to maximize profit while remaining within the risk management parameters produced by the mathematicians, they found ways of designing products that satisfied the fallible models, but nevertheless allowed them to take larger risks than top management contemplated. Credit default swaps, the loss on which could be 100 times the premium paid for them, had “tails” far longer than the VaR models contemplated, and hence risks far greater than the models predicted. Collateralized debt obligations, especially the multi-layered “CDO-squared” and CDOs on subprime credits, turned out to be far more internally correlated than the VaR models predicted. In other words, while the “tail” losses on CDOs were of the same order as VaR predicted, the “tails” were much fatter—the probability of those losses occurring was far higher.
Because of the pathological nature of their risk profiles, CDOs and CDS were extremely attractive to traders, who found they could generate far more profit from these very risky instruments than was possible from conventional instruments, the “spreads” on which were arbitraged away by fierce competition.
The poison of misguided incentives also extended to the top executive suite, by the malign effect of leverage. Traditionally, leverage in banking had been moderate. While long-term interest rates were generally higher than short-term rates, occasional credit crises kept bankers honest, convincing them that it was foolish to leverage up on long-term paper and borrow in the short-term market. The 1980 bankruptcy of First Pennsylvania Bank, which found its capital wiped out by price declines in government bonds, showed the folly of relying too heavily on the positive “spread” between short-term and long-term rates. Generally, while leverage enhanced the returns bankers made, it did not turn an otherwise unprofitable business into a bonanza, because borrowing was expensive and reserves needed to be kept to face credit crises.
Salomon Brothers and other trading houses showed in the 1980s that leverage could be used to produce outsize returns. It is thus significant that the first major bankruptcy of the modern era, Long-Term Capital Management, was engineered by former Salomon traders who had juiced up apparently ordinary returns (and risks) by the use of unprecedented levels of leverage. The bailout of LTCM provided all the wrong lessons to the market. Just at the time when the market needed a salutary lesson of greed given its just deserts of bankruptcy, ideally accompanied by a term in debtors’ prison, it got the opposite lesson, an entity of exceptional foolishness and greed being bailed out because it was deemed “too big to fail.”
Continental Illinois Bank in 1984 had likewise been deemed too big to fail because of its lunatic oil patch lending, but Continental Illinois was a major bank, seventh largest in the United States, with tens of thousands of employees. LTCM was a bunch of spivs in a Connecticut office park; if it could be rescued, then any big institution could expect the same favor, provided its financial connectivity was great enough.
Needless to say, the monetary policies of Messrs Greenspan and Bernanke played a major role in the degradation of finance. From 1995, first Greenspan and then Bernanke expanded money supply at record rates, then after 2008 Bernanke kept interest rates far below the rate of inflation. Naturally, in this environment, excessive leverage was encouraged. So also was bad behavior. Long periods of easy money make the warnings of the prudent seem old-fashioned, and the risks taken by the Gordon Gekko-like “BSDs” on the trading floor seem justified by the outsize profits they produce for the institution and the bonuses they receive.
If the 2008 crash had been treated with the traditional Walter Bagehot remedy of lending amply, but on good security and at high rates, behavior patterns would have been modified, as caution was once again seen to have its virtues. As it was, the combination of a bailout that was almost cost-free to the banks concerned and an intensification of the easy-money policies that had caused the problem produced the inevitable behavior of yet more leverage, yet larger trading risks, all suitably hidden by the spurious VaR system.
One might well ask where the regulators were while all this was going on. The abolition of Glass-Steagall restrictions in 1999, while sensible in principle, in practice allowed the biggest banks to take massive advantage of easy money conditions, gambling with the proceeds of FDIC-insured deposits, in the knowledge that on the Continental Illinois and LTCM precedents, they would be bailed out if necessary. The abolition in 2004 of leverage restrictions on brokerage houses worsened the problem.
However the worst regulatory dereliction of duty came from the Basel regulators tasked with setting leverage and risk principles for the banking industry. Instead of using a common-sense definition of leverage based on balance sheet totals, they allowed banks to “weight” their assets, with government debt having a zero risk weighting – thus allowing infinite leverage in that sector. Instead of applying the strictest supervision to the mushrooming trading desks, by which such risks were being incurred, they allowed the banks to devise a spurious risk management metric that hid the most serious risks, then permitted the banks using this metric to describe themselves as “sophisticated” thereby allowing them to escape much of the regulation imposed on lesser mortals.
Not only were the Basel regulators “captured” by the industry, they have suffered a “Stockholm syndrome” by which they have adopted the attitudes and practices of their captors. (This syndrome also seems to have affected the SEC, which is currently trying to use the tools of the Dodd-Frank legislation, supposed to rein in the banking industry, to put out of business the money market funds, useful bank-hated consumer-friendly entities that were entirely blameless in the 2008 debacle.) No serious attempt has been made, nearly four years after the 2008 collapse, to replace the discredited VaR system with something that works properly. What’s more, while the Basel regulators have now included a “common sense” un-weighted leverage limit as well as the spurious weighted limits, their required capital is a pathetic 3%, allowing leverage of 33 to 1, higher than that which led Bear Stearns and Lehman Brothers to their doom.
Comfort yourselves: if something cannot go on for ever, it will end. The current rickety edifice of international finance, with reckless monetary policies, excessive leverage, spurious risk management and Stockholm Syndrome regulators, will cause a series of crashes, each one more expensive than the last. One had hoped a serious crisis such as that of 2008 would have brought reform as well as recession. It now appears that we will need half a dozen such global financial crises, each doubtless nastier than the previous one, before common sense returns. But return it will!
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Interesting article worth reading
Look, folks
Greenspan, Bernanke, Rubin, Summers .. and and and .. all from the tribe .. point not they all knew what was going on and game played .. point, they were ARCHITECT of those ruinous economic tools & policy given to their tribal friends on Wall Street to genuflect America .. many experts warned them, but, they steam rolled all
decent
and ? ?
Joe was fucked for generations
and
money disappeared (you know where
) so
there is 2 question
either they were all idiots
or
what happened were intentional
skip that durian part
question remains , if intentional , why so ? ?
well
that another story for another time
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