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Author of ‘The Number That Killed Us’ Explains what Really Caused the Great Recession

GUEST AUTHOR BLOG by Pablo Triana author of "The Number That Killed Us: A Story of Modern Banking, Flawed Mathematics, and a Big Financial Crisis."

What if I told you that the true culprit behind the 2007-2008 credit crisis and, indirectly, the current Euro crisis was a mathematical model known as Value at Risk? And what if I told you that VaR, present in the markets for more than two decades, had caused trouble before and that its obvious structural deficiencies were amply known? And that none of those things stopped bankers and regulators from continuing to embrace the model?

The Number That Killed Us - by Pablo Triana
The Number That Killed Us - by Pablo Triana

No one would blame you for being surprised.

Very few have spoken about the decisive role that VaR played in unleashing the mayhem. When it comes to this particularly important topic, the silence has been deafening. This may be, in fact, the greatest story never told.

Let me tell you why VaR caused the crisis: as the mechanism embraced by financial regulators for determining the mandatory capital charges that banks have to incur for their trading activities, VaR allowed Wall Street and the City of London to build hugely leveraged positions on the kind of poisonous securities (Subprime CDOs and the like) which eventually tumbled and unleashed the chaos.

Because VaR numbers were very low in the build-up to the troubles that started in mid-2007, banks were required to post just a tiny amount of upfront capital in order to accumulate all those billions of speculative punts, being allowed to finance almost all their trading activities with debt rather than equity.

The model said that those positions did not entail much risk, thus no need to reserve too much protective capital. It has been estimated that the trading-related capital charges (calculated as VaR times a multiplication factor) amounted in many cases to just 1%, and even as low as 0,1%, of banks’ entire trading positions. That would be 100-to-1 and even 1000-to-1 leverage. Now that´s a lot of leverage. The slightest decline in value of the portfolio would make a bank insolvent.

That combination of leverage and junk made possible by VaR is what devastated Lehman Brothers, Bear Stearns, Merrill Lynch, Citigroup and the rest. At many firms, assets linked to bad mortgages (that were place under VaR´s tutelage in banks´ trading books) were accumulated for amounts greater than the entire equity base. As soon as the housing market tanked a bit, the huge losses on the toxic assets ate the tiny capital foundations. There was simply too much toxicity for so little capital cushion.

"The math had its chance, and it failed miserably. It´s time to go back to basing the most relevant financial decisions on experience-honed, intuition-fueled common sense."" -Author, "The Number That Killed Us", Pablo Triana

Why does VaR produce such low numbers? VaR is supposed to measure future setbacks deriving from a portfolio of trading assets, with a given degree of statistical confidence. For instance, a $50 million 95% VaR “predicts” that you will only lose more than $50 million twelve days a year.

In order to arrive at those numbers, VaR focuses on the rearview mirror, essentially assuming that the future will be like the past. But in the markets, the past is not prologue especially if, as VaR tends to do, you rule out the possibility of extreme events. If the recent past, as was certainly the case in the run-up to the credit crisis, has been calm and placid VaR will say that the future will also be calm and placid, thus no need for prohibitive capital charges (notwithstanding the obvious fundamental riskiness of a portfolio). “There's no risk!”, VaR loudly proclaimed all those years prior to mid-2007, “Freely gorge on that Subprime stuff!”.

Before VaR, which was enshrined into law by international banking regulators around 1996 and finally adopted by the SEC in 2004, the capital charges on toxic trading stuff would have been way less economical for traders, effectively making it unaffordable for banks to bet the entire farm on such dangerous punts. Without VaR, monstrous leverage on balance sheets inundated with high-stakes punts would not have been possible. Many job losses would have been avoided.

The adoption of VaR was a mistake. Policymakers and many bankers placed too much trust on a concoction born to underestimate risk and to enable reckless behavior. The math had its chance, and it failed miserably. It´s time to go back to basing the most relevant financial decisions on experience-honed, intuition-fueled common sense.

Pablo Triana is a professor at ESADE Business School and the author of "The Number That Killed Us: A Story of Modern Banking, Flawed Mathematics, and a Big Financial Crisis" (Wiley, December 2011).

Email me at bullishonbooks@cnbc.comAnd follow me on Twitter @BullishonBooks