Stock Jockey reviews a NY Times article Risk Mismanagement, discussing Value at Risk (VaR). 
History Of VaR (JP Morgan Strikes Again)
Courtesy of StockJockey at 1440 Wall Street
The quants from JP Morgan have (inadvertently?) done more to ruin Wall Street than anyone, perhaps, more than Bernie Madoff. But JP Morgan was not a lone gunman.
The recent autopsy performed on AIG revealed that for all the sophisticated modeling, the jokers running the company’s Financial Products division did not take into account the ramifications of losing AIG’s AAA credit rating – a downgrade would require them to post more collateral on CDS contracts they had written, and the end was brutal, and swift.
I have often seen smart people do dumb things on the Street, and the over-reliance on Value at Risk models was certainly one of them. A little common sense on Wall Street can go a long way; too bad it is underappreciated.
I have been largely underwhelmed with Joe Nocera’s work but he earns a gold star for his historical account in the New York Times of VaR models – another debacle in many ways similar to the CDS nightmare.
VaR isn’t one model but rather a group of related models that share a mathematical framework. In its most common form, it measures the boundaries of risk in a portfolio over short durations, assuming a “normal” market. For instance, if you have $50 million of weekly VaR, that means that over the course of the next week, there is a 99 percent chance that your portfolio won’t lose more than $50 million. That portfolio could consist of equities, bonds, derivatives or all of the above; one reason VaR became so popular is that it is the only commonly used risk measure that can be applied to just about any asset class. And it takes into account a head-spinning variety of variables, including diversification, leverage and volatility, that make up the kind of market risk that traders and firms face every day. NYT
Yes, like credit default swaps it is all good, in theory, but the models ultimately failed many who relied on them. Goldman Sachs used common sense in working with VaR models, but was well aware of their limitations. It was enough to make them smarter than the rest of the street, but hardly geniuses, as Nocera details in his account.
The article is interesting for a portrait of Nassim Taleb. I enjoyed his recent appearance of Charlie Rose, and he certainly got much right of late but comes across a big jerk.
Black Swans might be relatively rare, but Taleb’s ego seems about par for the course that is the broken Street of dreams.
Risk Mismanagement
JOE NOCERA, New York Times
Excerpt:
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…
Continue here.
