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The Perils of Simplifying Risk To a Single Number 286

Posted by kdawson
from the black-swan-rising dept.
A few weeks back we discussed the perspective that the economic meltdown could be viewed as a global computer crash. In the NYTimes magazine, Joe Nocera writes in much more depth about one aspect of the over-reliance on computer models in the ongoing unpleasantness: the use of a single number to assess risk. Reader theodp writes: "Relying on Value at Risk (VaR) and other mathematical models to manage risk was a no-brainer for the Wall Street crowd, at least until it became obvious that the risks taken by the largest banks and investment firms were so excessive and foolhardy that they threatened to bring down the financial system itself. Nocera explores the age-old debate between those who assert that the best decisions are based on quantification and numbers, and those who base their decisions on more subjective degrees of belief about the uncertain future. Reliance on models created a 'false sense of security among senior managers and watchdogs,' argues Nassim Nicholas Taleb, who likens VaR to 'an air bag that works all the time, except when you have a car accident.'"
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The Perils of Simplifying Risk To a Single Number

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  • by gambit3 (463693) on Monday January 05, 2009 @08:09AM (#26328839) Homepage Journal

    For an EXCELLENT article about this, read Malcolm Gladwell's "Blowing up", which you can find online for free:

    http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm [gladwell.com]

    • Re: (Score:2, Informative)

      by Paul Rose (771894)
      Highly recommend book "When Genius Failed"
      About the "rise and fall" of Long Term Capital Management -- based on the massive 1998 failure of a hedge fund based on mathematical risk models and included a Nobel prize winner among its directors.
      ISBN-10: 0375758259
      ISBN-13: 978-0375758256
      Amazon link: http://www.amazon.com/When-Genius-Failed-Long-Term-Management/dp/0375758259/ref=sr_1_1?ie=UTF8&s=books&qid=1231168194&sr=1-1 [amazon.com]
      Also see wikipedia writeup: http://en.wikipedia.org/wiki/LTCM [wikipedia.org]
    • Re: (Score:3, Funny)

      by Chris Burke (6130)

      Personally I think the most surprising thing is that the risk factor for simplifying risk to a single number is 70%.

  • Math? (Score:4, Insightful)

    by EdIII (1114411) * on Monday January 05, 2009 @08:21AM (#26328899)

    Nocera explores the age-old debate between those who assert that the best decisions are based on quantification and numbers, and those who base their decisions on more subjective degrees of belief about the uncertain future.

    Hmmmm. Math or "subjective degrees of belief about the uncertain future".

    I've always operated on the principle that they were all lying, thieving, immoral, unethical, and greedy fucking bastards that were ready to bend you over for a nickel. Seems my supposition is being proven correct more and more each day.

    Until recently, it was the smaller guys in the stock market that were getting screwed and the whole system kept the thievery down to a manageable level. Now from the largest, to smallest, they all seem to be getting destroyed, American in ruins, and the previously rich and powerful with outstretched hands at the Feds.

    Of course maybe that is too cynical, but I always saw the stock market as rigged from the beginning. What do I know though? :)

    • Re:Math? (Score:5, Insightful)

      by Chapter80 (926879) on Monday January 05, 2009 @08:43AM (#26329077)

      You're looking at it all wrong! I mean, you may be right (that they are all lying, thieving, immoral, unethical, and greedy f'ing bastards), but there's opportunity in that!

      Had you BET on that, you'd be rich right now. You can invest in the potential downfall of many securities. Which, by the way, was what many of the financial companies and hedge funds did.

      And I really don't think this is a "if you can't beat them, join them" situation. It's recognition of human nature, and investing with that recognition in mind. You aren't necessarily doing anything illegal or immoral by betting on the downfall of companies. You are wisely investing.

      Looking at it that way, many moral, ethical Wall-streeters may have made lots of money on the downside fluctuations in the market, and so your premise that they are *all* thieves must be incorrect.

      • Re: (Score:3, Interesting)

        by Znork (31774)

        Ah, see, that doesn't work either. When the market moves against the wrong players they'll use their political influence and get the rules changed. Many hedge funds and others who were 'correct' eventually lost out anyways, as the Fed simply prints money to fill the holes for the right people.

        Fundamentally large parts of the market should be liquidated and shut down; overcapacity is rampant and consumers do not want the products in question at the prices they can be produced, the demand that seemed to be th

    • Re:Math? (Score:5, Interesting)

      by El Torico (732160) on Monday January 05, 2009 @08:54AM (#26329163)

      After seeing the rampant fraud committed by the global financial elite, I'm very inclined to agree with you. What we need isn't just a number that quantifies risk, but also a number that quantifies trust.

      I would pay for a service that tracks every person involved in business that was ever convicted, under indictment, or subject of a complaint. It should also track which firms employed them and where they are working now. It should also cover which "civil servants" were "on watch" at the time.

      • by Tanktalus (794810)

        Aha. What you want is for everyone to join /. so we can hand out appropriate karma. ;-)

      • > After seeing the rampant fraud committed by the global financial elite, I'm very inclined to agree with you. What we need isn't just a number that quantifies risk, but also a number that quantifies trust.

        Won't they just game that number, too? Once you fix the rules for any system, people will start to attack them. And, based on what I've seen in online games, they'll find a way to break them. Especially when there's real money at stake, not just virtual gold and items (though even those can be conve

    • Re: (Score:2, Insightful)

      >>>I've always operated on the principle that they were all lying, thieving, immoral, unethical, and greedy fucking bastards that were ready to bend you over for a nickel.
      >>>

      We're discussing corporations and businessmen, not governments and politicians. Oh wait; they are the same thing. (shrug). Too bad there's still so many gullible citizens out there who believe corporations or governments are trustworthy. If only there was a way to make people more skeptical about the lies spillin

      • by russotto (537200)

        My Congressman on the other hand - he rifles through my wallet as if it was his own personal treasury - grabbing whatever he desires to take. So that makes corporations the lesser of two evils (imho).

        Short term. But in the medium and long terms (which have already arrived), the corporations just use the hand of government to reach into your pocket.

      • It has to do with accountability, and stated ideals and responsibilities.

        When the government screws the people, you can at least point at them and say "That's not right, you're not supposed to do that, and we're going to hold you to higher standards. We have that right."

        When a corporation screws the people, they're just doing what "they're supposed to do". They have no higher standards to be held to.

        That's the freedom we brought to the USSR. The people still get screwed, but the leadership is free of the

        • When the government screws the people, you can at least point at them and say "That's not right, you're not supposed to do that, and we're going to hold you to higher standards. We have that right."

          And then you can enjoy the sweet, sweet sound of their derisive laughter.

          When a corporation screws the people, they're just doing what "they're supposed to do". They have no higher standards to be held to.

          And then you can decide not to give them any more of your money. That's not an option with a government.

      • Re: (Score:3, Insightful)

        If you flee to the Democrats, they hate corporations but love government. No good. If you flee to the Republicans, they hate government but love corporations. That's no good either. If only there were a party that hated both, since both corporations And governments are untrustworthy institutions. That's a party I could stand behind.

        So what you're saying is that you want a political party that is essentially libertarian but also recognizes that rule by the current Libertarian Party would result in a tragedy [wikipedia.org]

    • I think one of the underlying problems was simple greed. For decades, how companies were viewed by Wall Street was their profitability. Over time, it became about growth. The problem with this slight change is growth in mature markets is hard, especially during downturns.

      Take for example, Apple. Apple has made gads of money on the iPod. At some point everyone in the world will have one. Now they either have to find another market or Wall Street will punish them. It won't matter if they still make mon

  • Self-referential? (Score:5, Insightful)

    by aeinome (672135) on Monday January 05, 2009 @08:23AM (#26328915) Journal
    So what's the VaR of using VaR? :)
    • Re: (Score:3, Insightful)

      by mysticgoat (582871)

      So what's the VaR of using VaR? :)

      I think that quote gets closer to the issue than what I've read so far in NYT Risk Mismanagement article. Or seen printed anywhere else, as yet.

      What I don't hear anyone talking about as yet is that VaR and the other fancy new risk management tools failed to account for the way that their deployment would of itself change the underlying dynamics of the economies they were attempting to measure. WRT the housing bubble, for example, VaR measures gave banks the confidence to go with mortgages that they would

    • by wanax (46819)

      The problem with VAR is not the measure itself, which is assuredly useful if one understands the limitations.

      The problem is that once any risk measure (that is say, 95%+ 'reliable') becomes institutionalized as the gold standard, catastrophic failure of the financial system is inevitable (at least according to the general black swan theory).

      Why? Because any firm that doesn't optimize profit against the risk criteria is going to have a lower P/R, and will lose capital to firms who are more 'efficient' at inv

  • by Chrisq (894406) on Monday January 05, 2009 @08:30AM (#26328971)
    I don't think that the problem is a single number it is connectivity. You might think that if you have three investments with a 10% risk of losing £1,000,000 the chances of all three of them losing £1,000,000 is 0.1*0.1*0.1 = 0.001 or 0.1%. The thing is if one loses that much then the markets may lose confidence meaning the others go down too - they are not independent probabilities.
    • Re: I don't think (Score:5, Interesting)

      by Hemogoblin (982564) on Monday January 05, 2009 @10:24AM (#26330091)

      You might think that if you have three investments with a 10% risk of losing £1,000,000 the chances of all three of them losing £1,000,000 is 0.1*0.1*0.1 = 0.001 or 0.1%.

      No, no-one who actually calculates and uses VaR thinks that. Anyone who has done any statistics, like all finance quants, will correctly take into account covariances. The actual problem is the interpretation of the "correct" VaR, and relying on it too heavily.

      I'll give you the actual definition of VaR. If you calculate the VaR(10 day, 5%) to be $100,000, this means that there is a 5% chance that the loss on your portfolio over a 10 day period will be larger than $100,000, or that your profit will be larger than $100,000 assuming a symmetric distribution. It's when people think "Oh that's great, we can ONLY lose $100,000" when you have a problem. The actual loss could be ANY value larger than $100,000.

      It's hardly a perfect statistic, since there are still many assumptions involved. However, it's still a decent estimator and it's better than making a wild guess based on gut feelings. Despite what most people currently believe, a lot of brainpower has gone into developing financial theories and some stuff is pretty damn good. The financial industry deserves some bashing, but it frustrates me when people spread incorrect information; at least complain about the right things.

      • Re: (Score:3, Interesting)

        by SoVeryTired (967875)

        Disclaimer: IAAMFPHDS (I am a mathematical finance PhD student).

        While quants could accurately gauge the historical covariance of different assets in a portfolio, what they failed to take into account is that there is correlation in the tails of the distribution.

        An example of this is that, back in the good old days, there was a degree of correlation between the Dow and the FTSE 100. If the FTSE 100 went up, it was a decent indicator that the Dow would also be up, but by no means a sure thing. However, during

  • by petes_PoV (912422) on Monday January 05, 2009 @08:32AM (#26328985)
    Money is all about numbers, so quantifying "risk" in numerical terms is not only valid, but to be encouraged. You wouldn't bet on a horse if the odds were quoted as "almost impossible", "very unlikely" etc. You'd want to know what possible return you'd get for your bet and roughly what would be the chances of winning.

    The problem in the financial world is one of thinking there's a single factor called "risk". In fact there are many, interlinked factors: The risk the business will go bust is one - however from that sprout a whole range of subsidiary risks: from losing all your investment to getting back 95% of it.

    Similarly with mortgage risk and any other type of investment. What the financial markets need is a better understanding of the causal links between risks and to price the returns on investments accordingly.

    That will be a *big* job, and one that will take years or decades to iron the bugs out of.

  • We discussed (Score:5, Insightful)

    by Hognoxious (631665) on Monday January 05, 2009 @08:32AM (#26328989) Homepage Journal

    we discussed the perspective that the economic meltdown could be viewed as a global computer crash.

    Indeed we did. And I think we came to the consensus that it was a load of bollocks.

  • by radtea (464814) on Monday January 05, 2009 @08:38AM (#26329031)

    Nocera explores the age-old debate between those who assert that the best decisions are based on quantification and numbers, and those who base their decisions on more subjective degrees of belief about the uncertain future.

    Why is anyone still making this distinction, as we now know that the only self-consistent numerical representation of risk follows directly from our subjective degrees of belief about the uncertain future? Furthermore, we have known this for over a generation... isn't it about time that the knowledge start filtering into the popular discourse?

    While Bayesian methods are not always all that useful for practical problems (I use them on occasion in my work) the conceptual foundations and deeper understanding of the nature of plausible reasoning and its relation to probability theory needs to be more widely understood.

    One of the big take-home messages from the Bayesian revolution is that probability theory is nothing but quantification of what we do subjectively, insofar as our subjective impressions are self-consistent, so the only people who are still debating quantitative vs subjective approaches as such are people who do not understand the question.

    • by Hoplite3 (671379) on Monday January 05, 2009 @09:00AM (#26329199)

      Beyond the style of model, the trouble in finance is the feedback nature. If a big impressive model is developed to price an asset and all of the big boys buy in and use the model, then the model DOES describe the assets price. Because everyone is making decisions based on the model.

      That's all great until reality intervenes. Then you have a bubble.

      That sort of model feedback has always made finance seem "iffy" to me.

    • Re: (Score:3, Interesting)

      by mysticgoat (582871)

      How the hell can you apply any kind of probability measure to a self-aware environment like a marketplace?

      Bayesian methods or any other are not going to get around the way the very measure of the risk is going to alter the market itself. You can't use physics and math to predict biologic and cultural processes, not when the processes have the same order of complexity as entire ecosystems and a capacity to learn and change that we haven't yet even begun to understand.

      Introduce a risk management tool into

  • An air bag that works all the time, except when you have a car accident.

    A question for the powerful minds of /.

    How is the risk of driving with that airbag in your car compared to a normal one?

    - Greater.
    - Smaller.
    - Exactly identical.
    - Unknown until you open the box.

    • We know from random statistics of crashes involving cars which are supposedly equipped with airbags capable of deploying during an accident that a high percentage of all "untested airbag readiness" (UAR from here on) cars actually do have airbags. The risk of these not deploying is low.

      Meanwhile, however magically, we know that car X's airbag will _not_ work in an accident. The risk in driving that car is high.

      If X is also a UAR car, the risk is identical.
      If X is known to be defective, the risk is greater.
      I

  • Minmaxing ftw! (Score:5, Insightful)

    by Opportunist (166417) on Monday January 05, 2009 @08:45AM (#26329091)

    Is here any roleplayer that does NOT know how using an artificial value to describe "real" problems automatically leads to some people "playing the system" instead of playing the game?

    Nobody here ever had a munchkin in his troupe? A powergamer? A minmaxer? Someone who learned the rules and immediately started to look for loopholes, how to play by the rules without actually taking them serious?

    Now why did anyone think this would be different when real money is involved, and thus the incentive to abuse the rules way higher?

    • Re: (Score:3, Insightful)

      by Aladrin (926209)

      I've started to play D&D a few times, but the groups I was in didn't seem to care about the rules at all and viewed my interest in the rules as bad... We never got past making a character, and I tried a few times.

      So I'm serious when I ask: Why is that kind of person bad? Aren't they having fun within the rules? Don't the make the adventure more exciting instead of less? They take a system that is pretty predictable and stretch it to the limits.

      As for 'rules lawyers', which you didn't mention, aren'

      • Well, bad. It ain't bad if everyone's doing it and everyone's having fun. It is bad if some people actually want to play by the rules, for various reason (because they think the rules help making things fun for everyone, for example, or because they know the game falls apart if rules are simply ignored, unless people don't give a rat's behind about the game at all and just wanna "gank shit") or if they're not being told that the rules are out the window. Because it's kinda frustrating to try to play by the

      • by hibiki_r (649814)

        If you don't like a game built around a lot of rules to be min-maxed, you play one of many other RPGs that stay far away from the D&D family, and are light on rules precisely to avoid this very issue.

        In D&Ds case, the reason min-maxers are bad is because they turn a cooperative game into a competitive game: If your character is not tuned and theirs is, yours actions become less relevant, and eventually you don't feel like you are playing.

        In the stock market today, a big problem is that many people a

      • Re: (Score:3, Insightful)

        by khallow (566160)

        As for 'playing the system' of the stock market... I'm surprised nobody thought it could happen.

        Guess you haven't been paying attention then. A lot of the rules of the market (for example, insider trading, mark to market accounting, bank reserves, etc) exist because of these well known impulses. When things go bad, the self-serving routinely express bewilderment, employing the "nobody thought it could happen" defense. Almost never is this statement true.

      • Re: (Score:2, Interesting)

        by Tekfactory (937086)

        The problem is that your MinMaxers typically look for odd corner cases where multiple rules add up to more than average results. They also exploit Grey Areas where rules are under defined. This gives a decided edge to the MinMaxer over the other players, now while you're all working together a Win for one person should be a Win for the Team, it is not in fact a Win.

        The MinMaxer succeeds more often, does more, enjoys more (maybe) at the expense of other players fun.

        To take D&D for an example, I have a ch

    • Re: (Score:2, Funny)

      by sugarman (33437)

      Now why did anyone think this would be different when real money is involved, and thus the incentive to abuse the rules way higher?

      Perhaps because those in the "roleplayer" and "policy wonk" sets have almost no-overlap?

      While I'm all for using simulations in systems work, thinking the econ crisis is similar to the time your party killed an Ancient Red Dragon and then bought Greyhawk with the loot probably isn't too helpful.

    • Your comment is strangely relevant and I wish I had mod points.

  • by joss (1346) on Monday January 05, 2009 @08:49AM (#26329127) Homepage

    Risk models are largely irrelevant because the only risk anyone in the financial sector is really interested in minimizing is the risk that they will get fired. The way to do that is to do almost exactly the same thing as everybody else, no matter how mind blowing stupid it is. Plenty of people realized that banks etc were not nearly as sound as commonly believed years ago. Those that tried to act on this were fired long ago since they weren't making as high a ROI as those willing to invest in dodgy hedgefunds etc. Rational market my ass.

    • by u38cg (607297) <calum@callingthetune.co.uk> on Monday January 05, 2009 @08:58AM (#26329185) Homepage
      Mmm. Herd instincts for the lose. But the few financial instituitions that stood against the headwinds are now reaping the rewards. For example, in the UK LTSB is taking over HBOS, despite the fact that HBOS was nearly twice LTSB's size at the height of the boom. The rational players are doing just fine.
      • Re: (Score:3, Insightful)

        by sshir (623215)

        The rational players are doing just fine.

        I smell a common mistake here: "rational players" and "lucky players" are indistinguishable at this point.

        That's the problem with markets.
        Hell, even with Buffet it is hard to be all one hundred percent sure that he's indeed a genius and not just one really-really lucky dude.

      • Re: (Score:3, Insightful)

        by Aceticon (140883)

        Too late and little comfort for those individuals in the "non-rational" companies who were fired (and possibly saw their careers go down the drain) because they were "too cautious".

        For most traders, as an individual the "rational" thing to do was "do the same that all around you are doing and keep your concerns to yourself".

        The ones that rode the ride all the way to the crash are the ones that still have millions in the bank from the last 5 years' bonuses.

        In a couple of year time when the next boom comes, a

    • Re: (Score:3, Insightful)

      by WaZiX (766733)

      Well, it's not so much that they wanted to minimize their risk of being fired as they wanted to maximize their bonuses... But your argument stands nonetheless...

    • by vlm (69642) on Monday January 05, 2009 @09:30AM (#26329429)

      The way to do that is to do almost exactly the same thing as everybody else, no matter how mind blowing stupid it is. Plenty of people realized that banks etc were not nearly as sound as commonly believed years ago. Those that tried to act on this were fired long ago since they weren't making as high a ROI as those willing to invest in dodgy hedgefunds etc.

      The key is not so much making a high ROI, as it was the separation of risk from transaction fees. My local bank would loan to anyone, as they immediately sold the loan and pocketed a transaction fee. They couldn't care less if any payments were made. Very few people realize how "investment"-type companies like banks turned into little more than a commissioned salesforce. And commissioned salespeople only make money on transaction volume, not long term return on investment.

    • Re: (Score:2, Insightful)

      by scamper_22 (1073470)

      Not quite. Risk models are important. However, at some point comes a very subjective view of how much is at stake with that risk. Let us call this resiliancy.

      This is really what most of the western world is missing. Resiliancy.
      Resiliancy is an attitude more than just a number. This is really what Taleb talks about with the black swan.
      Before, they only knew of white swans. So if someone came up to you and made you a bet that there were only white swans, you would take it. Almost as if someone made a b

    • ... is that it's OK to bet the farm - in reality, someone else's farm - because no matter how badly the bet goes, you'll still come out of it OK (in the long term - you might lose your job, buy hey when things pick up, you'll get another. No biggie). However, the person who does suffer is the ex. farm-owner, or vagrant as they're now known.

      What we need is for the upside/downside/inside risks that all the banks are exposed to, to be made public. That way customers can decide for themselves which bunch of c

  • by Doofus (43075) on Monday January 05, 2009 @08:52AM (#26329147)
    Far down in the depths of the article, the author points out that JPMorgan open-sourced their risk modeling methodology, which popularized the VaR (Value at Risk) approach used by most of the big financial firms:

    What caused VaR to catapult above the risk systems being developed by JPMorgan competitors was what the firm did next: it gave VaR away. In 1993, Guldimann made risk the theme of the firm's annual client conference. Many of the clients were so impressed with the JPMorgan approach that they asked if they could purchase the underlying system. JPMorgan decided it didn't want to get into that business, but proceeded instead to form a small group, RiskMetrics, that would teach the concept to anyone who wanted to learn it, while also posting it on the Internet so that other risk experts could make suggestions to improve it. As Guldimann wrote years later, "Many wondered what the bank was trying to accomplish by giving away 'proprietary' methodologies and lots of data, but not selling any products or services." He continued, "It popularized a methodology and made it a market standard, and it enhanced the image of JPMorgan."

  • by tomhath (637240) on Monday January 05, 2009 @09:17AM (#26329319)
    Objective or subjective models don't mean anything to people who only care about short-term performance. Whether the investment is good or bad in the long term doesn't matter to an investment manager who stands to get a seven figure bonus based on the current year's numbers. So what if the company fails next year? Not his problem.
    • That certainly had something to do with it, but there were a great deal of contributing factors, particularly depending on which effects of the credit meltdown you are concentrating on (bank insolvency, the decline in value of subprime mortgage assets, the decline in value of residential real estate, etc). For example (and this plays into your point) when primary lenders were distributing mortgage-backed securities to secondary lenders (other banks who would buy mortgages packaged together), they were able

  • If it works for Dick Clark, it works for me.

    "I give Bank of America a 77, because of their assets and because I can really dance to it. "

  • by tbannist (230135) on Monday January 05, 2009 @09:54AM (#26329697)

    The problem with using a single number is simple: It is easily gamed and there's lots of incentive to do so.

    So people will sell you worthless junk that technically has a high number rating because if you're relying on the number you'll pay them for their worthless junk.

    • by giafly (926567) on Monday January 05, 2009 @10:07AM (#26329879)

      The problem with using a single number is simple: It is easily gamed and there's lots of incentive to do so

      Exactly. And one easy way to game the system is to bet that the authorities will always act to keep markets stable, which you can do by taking risks that would otherwise be stupid. In other words, traders are incentivized to leech off the taxpayer. I'm surprised the crash took so long.

  • by Kupfernigk (1190345) on Monday January 05, 2009 @10:08AM (#26329897)
    Taleb is very arrogant. But he still cannot see beyond his limited perspective as a quant. He is right in arguing that the fundamental error in the model was to assume that the binomial distribution works for everything, but there also seems to have been a "conservation" error - assuming that risk scaled linearly with the axes. Any statistician with experience knows that reliance can only be placed on the outliers of a distribution when there is enough data around those outliers.

    As an example, suppose that the distribution suggests the chance of losing 50 million dollars is +3 sigma for some measure. The problem is that there is a subtle effect - say panic, herd effect or some interaction of derivative models - which only becomes significant around the 3 sigma mark. The result could be that the exposure at a 4 sigma event is billions of dollars. A proper risk model would need to take this into account

    My conclusion based on what I have read so far is that the physicists (in particular) involved in developing quantitative models would have benefited from a lot more exposure to real world experiment. They would then have had more of a clue about the unreliability of data away from the mean, scatter, and the importance of the fact that in physics subtle errors turn out to be signs that the model is wrong - e.g. relativistic effects only become important at a significant fraction of c.

  • by EdwinFreed (1084059) on Monday January 05, 2009 @10:20AM (#26330041)
    A friend of mine is a risk assessment quant who was working at Lehman right up to the point where they declared bankruptcy. I asked him about this article the other day. He said that their models started telling them something was very wrong back in 2007. The problem was that Fuld (the CEO) refused to believe what the models were saying.

    The most accurate model in the world won't help if you don't pay atention to the results it produces.

    There's also apparently an issue with the classical VaR models depending on transparent pricing, which these real estate instruments lack. So some of the most troublesome assets apparently weren't in the model.
    • Re: (Score:3, Informative)

      by Atario (673917)

      It's even worse than that. A coworker of mine used to work for a company that made models for mortgage banks. Some of the banks started balking that the models were showing something bad was happening, so they demanded the models be changed. Instead of saying no, the company responded by giving the banks "knobs" to tweak. This shut them up, but also let them lie to themselves till it was too late.

  • I'd say that if you use a single number, the peril would be 52.994.
  • Models (Score:3, Interesting)

    by fwarren (579763) on Monday January 05, 2009 @10:49AM (#26330399) Homepage

    Reality's an untamed beast
    That's difficult to master,
    But models are quite docile
    And give you answer faster.

    From a pome I saw in a computer book from the 70's, can be found online here http://www.langston.com/Fun_People/1993/1993AFE.html [langston.com]

  • The Perils of Simplifying Risk To a Single Number

    Even if it's a complex number? Or would that make it too imaginary?

  • by redelm (54142) on Monday January 05, 2009 @11:40AM (#26331111) Homepage
    It bothers me because I've done both. Simply put, finance is seeking out risk. Upside risk with lesser downside. Engineering is building machines (of all kinds) to operate with minimal risk. No matter how much math you do, you can't convert one into the other (except by erroneously dividing by zero)!

    Furthermore, engineered systems have two separate control systems: normal operating controls and independant safety controls. Never the twain shall meet, for often the normal controls exacerbate the situation and must be pre-empted by the safety controls. The more advanced the normal controls (optimization), the more advanced the safeties have to be.

    None of this is present in finance. VaR may be all well and good as a normal operating measure, but does nothing in the tail which will blowup. I do not see anything as a tail safety measure institutionalized. What measures are taken are done on "gut feel".

  • VaR = GIGO (Score:4, Informative)

    by phlegmofdiscontent (459470) on Monday January 05, 2009 @12:08PM (#26331519)

    Risk, in financial terms, is a measure of the variability of returns, i.e. the standard deviation of the returns. A well-diversified portfolio generally reduces the variability due to the individual risks of investments being uncorrelated. Harry Markowitz, the father of portfolio theory, pointed out that these quants all assumed that a basket of mortgages is highly uncorrelated and thus well diversified. However, in a broad real estate downturn, they all become very highly correlated. Therefore, if your standard deviation WAS 10%, it suddenly becomes 50% or more, which rapidly changes your VaR from a handful of millions to several billion overnight. VaR, being an oversimplification, didn't take that into account and all the big investment firms suddenly had billions of dollars at risk and billions of dollars of losses without realizing it. It's simply a matter of garbage-in, garbage-out, something my Portfolio Analysis prof drilled into our head and hopefully gets drilled into the heads of Wall Street CEOs.

  • Systemic risk (Score:3, Insightful)

    by TheSync (5291) on Monday January 05, 2009 @01:02PM (#26332311) Journal

    The biggest problem with those creating financial instruments from home loans is that no one tested their models with systemic housing price decreases.

    Economist Arnold Kling said that many years ago, Freddie Mac actually did "stress testing" of their portfolios under a 20% systemic real estate market downturn, but during the early 2000's they abandoned this technique.

    CDOs did a good job of reducing the risk of early repayment and "random" defaults on mortgages. However it ended up concentrating the risk for a systemic market downturn.

    Unfortunately, I am sure that some time in the future there will be another huge systemic risk that both government and the private sector will miss and we'll get hit again. The only thing we can do is keep economic freedom high in the period in-between to allow the economy to restructure (less jobs in building, more in health care, for example) in order to return to growth.

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