History Of VaR (JP Morgan Strikes Again)
The quants from JP Morgan have (inadvertently?) done more to ruin Wall Street than anyone, perhaps, than Bernie Madoff. But they were not the long gunmen.
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 model ultimately failed many who relied on them. Goldman Sachs used common sense in working with VaR models, but were 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
New York Times
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