Category Archives: Financial

New York Times on Risk Mismanagement


Should very much enjoy a story in today’s New York Times magazine entitled Risk Mismanagement by Joe Nocera.

The story discusses risk management and introduces the concept of value at risk (VaR), an easy-to-understand measure of the risk of a portfolio of assets, pioneered by JP Morgan. The story touches on two key questions:

  • Did sophisticated risk models help avoid or rather help enable the financial meltdown?
  • To what extent should people worry about the probable 99% or the improbable 1% in assessing risk?

A few quick thoughts:

  • I found the backward-looking nature of historical standard deviation to measure the risk of a portfolio of stocks so counter-intuitive that I didn’t actually understand it in b-school until about the 3rd time it was explained to me. That is, innately, I’ve always understood that risk is about the future and standard deviation is about the past (and, in particular, the past period you are using to calculate it.) So the ideas in the story easily resonate with me.
  • The question is not whether “the math works.” The math always works. It’s about whether people understand that 1% of the time … happens, well … about 1% of the time. To me, the issue is never whether the math works, it’s about what probabilities are built into the models and what boundary conditions cause the models to become invalid. In my (semi-educated) opinion, these are always the sources of the “math problems” in finance.
  • Finally, I’ve always believed that people problems dominate the math problems. For example, in the failure of Long Term Capital Management, the root problem was that other traders started copying the arbitrage strategies they were using, effectively picking the low-hanging fruit from the risk tree. That, plus increasing hubris on the part of the firm’s principals, caused them to take bigger and bigger risks, increasingly deviating from their original strategy, and eventually leading to the collapse of the firm.


Which brings me back to David Viniar and Goldman Sachs. “VaR is a useful tool,” he said as our interview was nearing its end. “The more liquid the asset, the better the tool. The more history, the better the tool. The less of both, the worse it is. It helps you understand what you should expect to happen on a daily basis in an environment that is roughly the same. We had a trade last week in the mortgage universe where the VaR was $1 million. The same trade a week later had a VaR of $6 million. If you tell me my risk hasn’t changed — I say yes it has!” Two years ago, VaR worked for Goldman Sachs the way it once worked for Dennis Weatherstone — it gave the firm a signal that allowed it to make a judgment about risk. It wasn’t the only signal, but it helped. It wasn’t just the math that helped Goldman sidestep the early decline of mortgage-backed instruments. But it wasn’t just judgment either. It was both. The problem on Wall Street at the end of the housing bubble is that all judgment was cast aside. The math alone was never going to be enough.

The full 7500-word story is here. Enjoy!

[Addendum: a critique of the article is here on the naked capitalism blog.]

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Michael Lewis Portfolio Article: The End

A friend recently posted a link to this superb article in Portfolio by Michael Lewis (author of Liar’s Poker and Moneyball) entitled simply: The End.

The article is about the end of an era on Wall Street, an era that lasted about 20 years longer than Lewis thought it would when he quit his job at Salomon Brothers in 1988. The article is long (nearly 10,000 words, i.e., 20 pages) so I’d recommend printing the article and reading it when you have some quiet time.

I’ve read two of Lewis’s books and seen him speak once. He’s a delightful writer and a dynamic speaker, high on energy and low on ego. I highly recommend Moneyball, particularly for those in the BI community, focused on business metrics.

For those who follow Wall Street, The End is a must read. Rather than writing a review, I’ll just try to hook you with this excerpt, the first two paragraphs of the article:

To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital—to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue.

I’d never taken an accounting course, never run a business, never even had savings of my own to manage. I stumbled into a job at Salomon Brothers in 1985 and stumbled out much richer three years later, and even though I wrote a book about the experience, the whole thing still strikes me as preposterous—which is one of the reasons the money was so easy to walk away from. I figured the situation was unsustainable. Sooner rather than later, someone was going to identify me, along with a lot of people more or less like me, as a fraud. Sooner rather than later, there would come a Great Reckoning when Wall Street would wake up and hundreds if not thousands of young people like me, who had no business making huge bets with other people’s money, would be expelled from finance.

Should We Rename the 401K the 201K?

This quip popped into my mind the other day and, hoping to coin a phrase, I decided to blog on it. Sadly however, a few others seem to have beaten me to the punch. (Nothing like a bit of gallows humor to cheers us up.)

Quote of the Week

“The only thing that goes up in bear markets is the correlation between asset classes.”
— Richard Davis, Needham & Co

I’m sure it’s a bona fide “ism” in the finance industry, but I’d not heard it before. And boy does it seem true. Consider this headline: “Stocks, Oil, Gold Tank on Growing Recession Fears.

Isn’t gold supposed to inversely correlated to stocks? Aren’t commodities only partially correlated? And, worst of all, aren’t hedge funds supposed to be uncorrelated or inversely correlated?

If you believe the “ism,” it’s a great argument to suggest that a diversified portfolio is a fair weather friend, an illusion that appears to work in smooth seas but that sinks in rough ones. Is real diversification possible — i.e., diversification where the correlation doesn’t head to 1 in rough times? I’m not so sure.

Best Notes on the Financial Crisis: Nobody Knows

I’ve read a lot of notes and articles about the current financial crisis. This one, forwarded to me by First Republic, is among the best I’ve read. Entitled simply, Nobody Knows, it’s written by Howard Marks of Oaktree Capital. A few excerpts:

On forecasting:

This is a great time for my favorite quote from John Kenneth Galbraith: “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”

On the causes of the crisis:

  • Excess liquidity, which had to find a home.
  • Interest rates that had been reduced to stimulate the economy.
  • Dissatisfaction with the resulting prospective returns on low-risk investments.
  • Inadequate risk aversion, and thus a willingness to step out on the risk curve in search of higher returns.
  • A broad-scale willingness to try new things, such as structured products and derivatives, and to employ massive leverage.
  • A desire on the part of financial institutions to supplement operating income with profits from proprietary risk taking – that is, to be “more like Goldman.”
  • A system of disintermediation, selling onward, and slicing and dicing that caused many participants to overlook risk in the belief that it had been engineered away.
  • Excessive reliance on rating agencies which were far from competent to cope with the new instruments, and on black-box financial models that extrapolated recent history.
  • Unquestioning acceptance of financial platitudes without wondering whether altered circumstances and elevated asset prices had rendered them irrelevant: (1) houses and condos are good investments and can be counted on to appreciate, (2) mortgages rarely go into default, (3) there can never be a nation-wide decline in home prices, (4) it’s okay to grossly lever a balance sheet if you’ve hedged enough through derivatives, and (5) it’s safe to borrow and invest funds equal to a huge multiple of your equity capital if the probabilistic expected value is positive, because “disasters rarely happen.”
  • Individuals such as mortgage brokers and mortgage borrowers who were given incentives to do the wrong thing.
  • Newly minted financial “masters of the universe” encouraged to maximize returns for themselves and their employers without concern for whether they were adding value to the financial system or endangering it.

On what to do:

My answer is simple: we have no choice but to assume that this isn’t the end, but just another cycle to take advantage of. I must admit it: I say that primarily because it is the only viable position. Here are my reasons:

  • It’s impossible to assign a high enough probability to the meltdown scenario to justify acting on it.
  • Even if you did, there isn’t much you could do about it.*
  • The things you might do if convinced of a meltdown would turn out to be disastrous if the meltdown didn’t occur.

On cycles:

Then I went on to create the converse of the above, the three stages of a bear market:

  • the first, when just a few prudent investors recognize that, despite the prevailing bullishness, things won’t always be rosy,
  • the second, when most investors recognize things are deteriorating, and
  • the third, when everyone’s convinced things can only get worse.

In the final stage, you can buy assets at prices that reflect little or no optimism. There can be no doubt that we are in the third stage with regard to many financial institutions. Not necessarily at the bottom, but in a serious period of unremitting pessimism.