Friday, 24 October 2008


Bank Street
Take a walk down Bank Street and follow the fortunes of some of the world’s largest banks as they navigate the global financial crisis

Government interventions
Governments across the world have stepped up their interventions to stem the worst financial crisis in decades. This graphic examines the rescue measures in detail.

Economista Graham Turner - Segunda-feira, 17/11/2008
Graham Turner, autor do recém-lançado livro The Credit Crunch”, faz um diagnóstico da crise em diferentes continentes. As idéias de Turner são mais uma contribuição para a discussão sobre a crise (Programa Milênio - BloboNews)

From Sky News, 23rd September

Graham argued two weeks ago that big cuts in interest rates are necessary to restore confidence. This was certainly the route taken to stabilise the japanese banking crisis some years ago.

Discussion of the current crisis needs to recognise that there are two interconnected issues:
i) a short term liquidity crisis, with paralysis of the wholesale money marketsii) an underlying threat of recession and even depression
Together these are impacting on the stock markets to cause panic selling, and the market hasn’t bottomed out yet.
Arguments from the left need to be calibrated to address both parts of the problem, to appreciate that they are to a degree seperable; although of course we also need to recognise that they are interconnected - especially through worries about bank insolvency.
Solving the short term liquidity crisis is a pre-condition for mitigating the effect of a recession, and the softer landing we can achieve the better context we will have for arguing for left wing alternatives to the economics of neo-liberalism that got us into this mess.
There simply is a short term liquidity crisis, that is threatening to burst the housing bubble. It is not in anyone’s interest that this happpens, and the left should demand government action to prevent banking collapse.
The Darling rescue package was a bold one, and far better than the response of the US government, because Darling is insisting that the banks recapitalise, and can borrow money from the governments to do so, thus seeking to address the fundamental doubt about their insolvency. the government itsellf is borrowing the money to do so, and can expect this money repaid at a profit.
But it was not bold enough, the funds committed were sufficient to take the entire UK banking sector into public ownership. this is now what needs to be demanded by the trade unions. Public ownership will mean complete transparency. There is a traditional Trotsykist demand for companies to “open the Books”: this idea didn’t come from no-where, it is what the American President Franklin D Rooselvelt actually did to the US banks in 1932 - he closed all the banks in the country for two weeks, while forcing them to open the books to government inspectors.
Public ownership of the banks would also allow recovery of assets that have been squirrelled away offshore to avoid UK tax.
What is more, the doubts about the banks are causing their share prices to be extremely volaitile: so nationalisation would have the added benefit of removing the banks from the FTSE which would give a confidence building gain to the whole stock market.
Gordon Brown and Alistair Darling have shown that they are prepared to act boldly and decisively, and they have taken the lead in the international stage in taking the strongest action to solve the current crisis. The trade unions need to demand that this bold action is not confined to saving the banking sector, but extends to defending the People’s economy - defending jobs in manufacturing, distribution and retail, as well as the public sector. The pre-condition for that succeeding is to solve the short term crisis of the wholesale money markets, and prevent the entire credit system collapsing - this also means propping up the housing market, and we have already seen coordinated action to reduce interest rates.
The current financial crisis is an important test for the left, we need to position ourselves at the heart of the debate within the mainstream labour movement, and the trade unions, demanding firm government action to protect and promote the interests of working people. This means recognising that we have a stake in preventing the economy collapsing.
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There is only one alternative to the dollar
By David Hale
January 5 2009 19:01 Last updated: January 5 2009 19:01
The great challenge confronting the foreign exchange market at the start of 2009 is finding a good alternative to the US dollar. One of the ironies of market events during 2008 was that the US financial crisis produced a flight to safety in the dollar. The dollar emerged triumphant from a financial debacle that centred on $1,300bn (€960bn, £890bn) of subprime US mortgage loans. The fallout has triggered a $32,000bn decline in global stock market capitalisation and driven all the Group of Seven leading industrialised countries into recession.
The dollar slumped against the euro during the final weeks of 2008 but fears about the financial system still drove US Treasury yields down to zero on three-month paper and less than 2.1 per cent on 10-year notes. This fear factor is likely to sustain demand for the dollar during the early months of 2009.
There is not now a clear alternative to the dollar because all big economies have slid into recession. Real gross domestic product could contract by 1.5 per cent in both the US and Europe during 2009 and by as much as 2.5 per cent in Japan. The decline in world trade and commodity prices will also reduce significantly the growth rates of the emerging market economies. South Korea and Taiwan are already in severe slumps. The growth rate of China could halve.
The US economy could be the first to emerge from recession this year because it appears to be headed for a far more aggressive macroeconomic stimulus programme than any other country. Barack Obama’s administration will announce a $700bn-$800bn multi-year fiscal package focusing on cuts in payroll taxes, aid to state and local governments and infrastructure investment. The Federal Reserve is also engaging in a programme of unprecedented monetary stimulus. It has slashed its core lending rate to zero and tripled the size of its balance sheet since August. Ben Bernanke, the Fed chairman, has also stated his willingness to engage in further large liquidity injections to buy mortgages, consumer loans and government securities. Mortgage rates have recently eased to 5.1 per cent after remaining above 6 per cent during the past year.
The European response to the recession has been far less aggressive. The European Central Bank is still under the influence of the Bundesbank and will ease monetary policy far more gradually than the Fed. Some Bundesbankers are opposed to cutting interest rates at this month’s meeting. The ECB policy could produce political tensions because interest rate spreads on Greek and Spanish bonds have risen sharply compared with German bonds. Japan’s government has been announcing modest fiscal policy changes but it cannot act decisively since it no longer controls the upper house of the Diet. And an election, before September, could produce a change of government.
The Kevin Rudd government in Australia announced a fiscal stimulus programme in October and Canada will announce a big fiscal package at the end of this month. But both currencies are dominated by market perceptions of the outlook for Chinese industrial production and commodity prices, not domestic economic policy.
If the US stimulus policy revives the economy by spring or summer, the dollar could rally further. The risk posed by US policy comes from potential market concerns about monetary policy becoming inflationary. The current growth rate of the Fed’s balance sheet is totally unprecedented. As a result of the Obama fiscal policy and the troubled asset relief programme, the Federal government’s borrowing requirement could rise to $1,500bn-$1,700bn this year. Government bond yields have collapsed because of investor fears about the safety of the financial system but they could rebound when conditions normalise. The current level of yields is the lowest since the period of official interest rate controls during the second world war. Mr Bernanke has indicated that he would be prepared to return to the wartime policy of restraining yields. What remains unclear is whether such a policy of accommodation would provoke fears about inflation and encourage dollar selling, which could in turn drive up bond yields.
Foreign central banks could play an important role in the US government bond market because they already own about half of the existing debt stock. China recently displaced Japan to become the largest holder of US government securities because of its long-standing policy of intervening to manage its exchange rate against the US dollar policy. As a result of the downturn in its economy, China has recently begun to lose foreign exchange reserves and may not need to intervene in the market again to restrain the renminbi. Japan, by contrast, has been experiencing significant upward pressure against the yen despite the severe downturn in its exports and output growth. Japan has not intervened since 2003 but, if the yen rallies another 5 per cent, the country could be forced to spend large sums restraining its currency. If it does, Japan could provide $200bn-$300bn of funding for the US deficit during 2009 while Chinese demand for US securities fades.
As a result of the global scope of the recession, there is no country that wants its exchange rate to appreciate. The clear alternative to the dollar in 2009 is not other currencies but that ancient form of money: gold. Precious metals could emerge as a hedge for investors suspicious of central banks and fearful that inflation will be the simplest solution to the challenge of global deleveraging.
The writer is chairman of David Hale Global Economics
Copyright The Financial Times Limited 2009

BELLUZZO - Papel do Banco Central não é agir como governo paralelo.
"Banco Central é um banco. Devia prover o crédito; não agir como governo paralelo"
Para o economista Luiz Gonzaga Belluzzo, professor do Instituto de Economia da Unicamp, recusa do Banco Central em baixar os juros é a "reafirmação algo infantilizada de um princípio de independência que não hesita em colocar suas supostas prerrogativas à frente das prioridades da economia nacional num momento grave como esse". O BC, acrescenta, deveria ter uma ação enérgica para prover o crédito e impedir a passagem da crise financeira para uma crise da economia real.

CARNEIRO - Governo pode antecipar o reajuste do salário mínimo.
No contexto atual, só o sistema público pode expandir o crédito
Há várias batalhas a serem travadas para minimizar os efeitos da crise e redirecionar a economia brasileira para um novo padrão de crescimento. Das questões imediatas, o crédito, a taxa de câmbio e o gasto público assumem importância crucial. A análise é do economista Ricardo Carneiro.
Ricardo Carneiro

CARDIM - Liberdade para capitais tem que ser revista no Brasil.
Crise ataca país de forma inesperada: mas saída de capitais era previsível
Realmente drástica é a reversão no fluxo dos chamados investimentos em carteira, capital para especulação na bolsa de valores ou para aproveitamento dos juros mantidos excepcionalmente altos pelo Banco Central. Neste caso, saímos de um superávit US$ 41 bilhões, de janeiro a outubro de 2007, para um déficit de US$ 7,5 bilhões no mesmo período de 2008. A análise é de Fernando J. Cardim de Carvalho.

BRAGA - Lula tem trunfos para negociar um acordo com o mercado.
Lula tem trunfos para negociar um acordo com o mercado: menos juros, mais crescimento"
“Ou o governo mexe no Banco Central e derruba fortemente as taxas de juros ou o antídoto não funciona e seguimos para baixo”, diz, em entrevista à Carta Maior, o economista José Carlos de Souza Braga, professor da Unicamp. Para ele, o argumento conservador em defesa dos juros é "terrorismo puro e simples".

January 1, 2009, 10:20 pm
Ignoring the Oracles: You Are With the Free Markets, or Against Them
It’s hard to tell what’s more striking about Raghuram Rajan’s 2005 presentation at the Kansas City Fed’s Jackson Hole symposium — the way many of the dangers he laid out came to pass, or the way he was attacked, and then discounted. (Read the full story.).
Mr. Rajan came to the conference, dedicated to soon-to-retire Fed Chairman Alan Greenspan, with strong bona fides as a pro market advocate. He and University Chicago colleague Luigi Zingales wrote a 2003 book, “Saving Capitalism from the Capitalists,” that argued at length that free-market capitalism is the best way to organize an economy, and that free financial markets – through their ability to direct funds to where the economy needs them most – are crucial to the system’s success. But when he suggested at Jackson Hole that markets could get it badly wrong sometimes, and that central banks should consider responding to that, he was lambasted as nostalgic for the old days of highly regulated banking.
Fed Governor Donald Kohn – who for years has played the role of providing intellectual ballast to the central bank’s decisions and now serves as its Vice Chairman – said that for central bankers to enact policy’s aimed at stemming risk-taking would “be at odds with the tradition of policy excellence of the person whose era we are examining at this conference.” Former Treasury Secretary Lawrence Summers said the premise of Mr. Rajan’s paper was “misguided.”
“This is a common feature of people when they come across dissent – they want to put you in a box and label you and dismiss you,” says Mr. Zingales. “He is definitely not anti-market. That’s the most mistaken characterization of Raghu.”
The episode suggests one reason that the crisis went unchecked: A dangerous all-or-nothing orthodoxy had come to dominate the policy debate, where one was either for free markets or against them.
Another reason that many policymakers may have missed the risks is that macroeconomists didn’t have a good understanding of the changes that were occurring within financial markets and the banking system.
There has long been a marked distinction between economists who study finance and economists who study the broader economy, with limited communication between the groups. As a young Harvard University economist, Mr. Summers argued this was a dangerous shortcoming in a now famous screed, where he unfavorably compared finance specialists to “ketchup economists” who are too narrowly focused on their field of study, while also complaining about general economists tendency to continually rediscover conclusions that the finance specialists had come to long ago.
Finally, many academic economists privately worried that a housing bubble was building, and that it’s bursting would cause severe problems, but didn’t publicize their concerns. An exception is New York University’s Nouriel Roubini, who in 2006 said that the U.S. was almost certainly heading into a recession. Mr. Roubini is often characterized as a grand stander, but Mr. Rajan says that he deserves credit for acting on his convictions.
“Most academics are really reluctant to take part in the public dialog, because the public dialog requires you to have an opinion about things you can’t really be sure about,” says Mr. Rajan. “They fear talking about things where everything is not neatly nailed in a model. They stay away and let the charlatans occupy the high ground.” – Justin Lahart

Who is Raghuram Rajan?
Posted by Edward Harrison on 5 January 2009
Published in economy
Raghuram Rajan is a bloody good economist - one of the best of his generation. Rajan, who succeeded Kenneth Rogoff at the International Monetary Fund as Chief Economist, is also a prescient voice of reason on any number of different subjects. Recently, Nobel-winning economist Paul Krugman used his New York Times column to highlight Rajan’s work. I wanted to use this post to also familiarize you with him and his work because his name should be heard much more going forward as one of the few economists to recognize the unsustainability of the global credit bubble.
In a post entitled “Economists behaving badly,” Krugman lamented the poor record of economists, who as regulators are damagingly subject to “cognitive regulatory capture.” He mentions Rajan by name as one to not follow the herd.
Two things are really striking here. First is the obsequiousness toward Alan Greenspan. To be fair, the 2005 Jackson Hole event was a sort of Greenspan celebration; still, it does come across as excessive — dangerously close to saying that if the Great Greenspan says something, it must be so. Second is the extreme condescension toward Rajan — a pretty serious guy — for having the temerity to suggest that maybe markets don’t always work to our advantage. Larry Summers, I’m sorry to say, comes off particularly badly. Only my colleague Alan Blinder, defending Rajan “against the unremitting attack he is getting here for not being a sufficiently good Chicago economist”, emerges with honor.
So, who is Rajan, and what has he said that is so at odds with the conventional wisdom. Below is what Wikipedia says about Rajan:
Raghuram Govind Rajan (Bhopal, India, February 3, 1963) was the “Economic Counselor and Director of Research” (Chief Economist) at the International Monetary Fund from September 2003 until January 2007. He replaced Ken Rogoff at the IMF in September 2003. He was the youngest individual to hold the position (beginning at the age of 40).
In 2003, he was also the inaugural winner of the Fischer Black Prize awarded by the American Finance Association for outstanding original research in finance.
In early 2007 Rajan returned to the Booth School of Business at the University of Chicago where he is the Eric J. Gleacher Distinguished Service Professor of Finance. With these credentials, at a young age, he is arguably the most prominent economist of Indian origin of his generation.
He obviously has some stellar credentials then. But, let’s get right to what he has said beginning with the paper he wrote in 2005 that Krugman alludes to. His paper says, in a nutshell, so-called disintermediation we have witnessed post-Bretton Woods (after the 1960s) has led to all manner of positive benefits. However, many are underestimating the negative implications of the new financial system.
Rajan points the finger at the transaction-oriented securitization model as one of the new forms of disintermediaton with many hidden risks.
Consider an example. A fixed rate bank loan to a large corporate client has a number of embedded risks, such as the risk that interest rates will rise, reducing the present value of future repayments and the risk that the client firm will default. There is no reason the bank should hold on to interest rate risk. Why not offload it to an insurance company or a pension fund that is looking for fixed income flows? Increasingly, default risk is also being transferred. However, the bank may, want to hold on to some of the default risk, both to signal the quality of the risk to potential buyers, and to signal it will continue monitoring the firm, coaxing it to reduce default risk. The lower the credit quality of the firm, the stronger the role of the bank in monitoring and controlling default risk, as also the greater the need to signal to buyers. Hence, the size of the first-loss position the bank retains is likely to increase as the credit quality of the loan falls.
Thus, risk transfer, through loan and default risk sales, does not completely eliminate risk from bank balance sheets. In fact, bank earnings variability in the United States has not fallen, and average bank distance to default in a number of countries has not increased. It is apparent that banks have not become safer despite the development of financial markets and despite being better capitalized than in the past. In fact, they may have well become riskier in some countries. Finally, if we think bank earnings are likely to grow at the rate at which market earnings will grow over the foreseeable future, the declining price-earnings ratio of banks in the United States relative to the market suggest that the market is discounting bank earnings with an increasing risk premium. This again suggests bank earnings have not become less risky.
Instead of reducing bank risk, risk transfer allows the bank to concentrate on risks so that it has a comparative advantage in managing, making optimal use of its capital while hiving off the rest to those who have a natural appetite for it or to those with balance sheets large enough or transparent enough to absorb those risks passively. It also implies that the risk held on the balance sheet is only the tip of an iceberg of risk that is being created.
Translation: you think banks are offloading risk when they securitize loans. In fact, they are holding A LOT more risk than you think.
We know what happened then. Two years later the subprime crisis showed that this was exactly the case - banks were loaded to the nines with mortgage exposure we thought they had sloughed off onto the marketplace. The paper is a brilliant piece of analysis that explains other risks like hidden tail risk, herding, incentives from low interest rates, and illiquidity. All of these problems have been very much manifest over the past two years as the credit crisis has taken form.
Financial sector compensation schemes
This is another difficult issue which Professor Rajan takes on. In an FT Op-Ed about one year ago, he had this to say.
Banks have recently been acknowledging enormous losses, yet those losses are barely reflected in employee compensation. For example, Morgan Stanley announced a $9.4bn charge-off in the fourth quarter and at the same time increased its bonus pool by 18 per cent. The justification was that many employees had a banner year and their compensation should not be held hostage to mistakes that were made in the subprime market. The chief executive, John Mack, however, assumed some responsibility and agreed to take no bonus for 2007 – although he got a $40m payout for 2006.
Even so, most readers would suspect something is not right here. Indeed, compensation practices in the financial sector are deeply flawed and probably contributed to the ongoing crisis….
The managers who blew a big hole in Morgan Stanley’s balance sheet probably earned enormous bonuses in the past – Mr Mack certainly did. If Morgan Stanley managed its compensation correctly those bonuses should be clawed back and should be enough to pay those who did well this year without increasing the bonus pool. At the very least, shareholders deserve better explanations. More generally, unless we fix incentives in the financial system we will get more risk than we bargain for. Unless bankers offer these better explanations, their enormous pay, which has been thought of as just reward for performance, will deservedly come under scrutiny.
His logic is clear. He suggests that investment managers are rewarded in good times for seeking alpha (investment manager-specific good picks) but actually delivering their investors beta (systemic risk). When the downturn comes, what once seemed to be a good thing is now seen for the systemic risk it was. But as investment managers are not compensated over the entirety of the business cycle and receive huge payouts, they get to keep their bonuses and walk away without consequences. This type of hidden systemic risk is endemic to the compensation systems in finance today. It means it pays to seek risk because of an asymmetric risk reward from outsized pay and from a mismatch between actual performance over an investments lifetime and annual compensation schemes.
Liquidity versus solvency
Then, in another FT Op-Ed he takes on the thorny issue of solvency and liquidity. This is a very big problem because most companies fail due to liquidity problems that have insolvency at their heart. However, when credit crises occur, many solvent companies suffer with the insolvent such that it is difficult to distinguish who is solvent from who is insolvent.
Therefore, it is crucial to understand what the root of the problem is temporary (liquidity) or more structural and permanent (insolvency). In my view, Northern Rock and Lehman Brothers were both insolvent, Bear Stearns is harder to tell. But what happens, when the central banks steps in and provides liquidity to bankrupt institutions? That is the problem we all want to avoid and Rajan explains why quite well.
Central banks have always drawn a line between illiquidity and insolvency. Illiquidity is often viewed as something temporary, an aberration where central bank intervention is permissible. Insolvency, on the other hand, is viewed as something fundamental and abominable and thus to be discouraged. Central bank intervention to restore liquidity to an illiquid market would simply bring prices back to fundamentals. Intervening to bail out insolvent firms would, however, encourage irresponsible behaviour and should be resisted. At least, so the catechism goes.
Central bankers know, though, that the line between illiquidity and insolvency is an extremely fuzzy one, made more so with developments in financial markets. Take, for instance, a mortgage loan made against a house. If the housing market is liquid, loans are easier to come by. The reason is obvious. One of the biggest costs to a lender is that if the borrower defaults, the house has to be repossessed and resold with substantial costs. If, however, houses are selling like hot cakes, then the cost of repossession and resale is likely to be small. Housing loans will appear low risk, the risk premium lenders will charge will be small and housing credit will be plentiful. In turn, this will increase the volume of house sales, increasing liquidity in housing markets. Liquidity thus tends to be self-fulfilling.
But this leads to a problem in assessing whether lenders have been irresponsible or not. A mortgage loan might be perfectly sensible and appropriately priced taking the continued liquidity of the housing market as given. And the same loan may be viewed as reckless, driving a mortgage lender into insolvency, if liquidity in the housing market dries up. Could the mortgage lender not legitimately run to the central bank for help, pleading that illiquidity rather than fundamental insolvency drove him over the brink? What level of liquidity is it appropriate to assure market participants of? And in what markets?
Such a question is not relevant only to housing credit. Expectations of future liquidity conditions are central to the price and availability of many financial transactions. A bank selling complex customised derivatives to clients should price them taking into account its own ability dynamically to trade and hedge its exposure in financial markets. If markets are likely to become illiquid, the bank should recognise that trading will be difficult in those times and incorporate that possibility into the price. Otherwise, too many derivatives will be sold, overwhelming the capacity of sellers to hedge them when markets turn illiquid and eventually creating worse financial market turmoil.
The point is that liquidity is not a free good; it has a price, much as any cash flow would.
An unanticipated shortfall in liquidity increases risks, as does a shortfall in cash flow, and both should have similar consequences. Over the past few years, financial firms have made enormous sums of money as the potential illiquidity they charged for up front in the contracts they wrote failed to materialise. Now that that illiquidity has finally materialised, should the government bail out those who out of greed, complacency or incompetence underpriced it?
These examples also highlight the central bank’s dilemma in assuring markets of liquidity. Because of the self-fulfilling nature of liquidity, small interventions can sometimes revive moribund markets, seemingly at low cost. However, there are indeed costs, perhaps significant ones. First, by providing liquidity freely, the central bank alters the price of liquidity, thus rewarding the reckless and harming the cautious – much as a government-funded recapitalisation hurts the taxpayer. Second, if the central bank induces expectations of continued liquidity, market participants will adopt strategies that rely excessively on it. As such strategies build on each other they will eventually overwhelm the abilities of even the most deep-pocketed interventionist central bank. Thus, even from the perspective of moral hazard, the distinction between liquidity infusions and recapitalisations is fuzzy indeed.
So what should a central bank do in a time of market turmoil? It should clearly lend freely against unimpeachable securities and also maintain a liquid market in such securities. Anything more is problematic. To intervene by making a market in illiquid securities as some have suggested, or in illiquid assets such as housing, may be to imbue those securities or assets with a liquidity they never should have had and thus distort their value. And cutting rates dramatically, as Alan Greenspan’s US Federal Reserve did after the technology bubble burst in 2000, would be an enormous tax on savers the world over. Better let the market weed out the reckless, unless there is a risk of total market collapse.
But knowing that the political pressure to intervene is asymmetric, asserted far more strongly when markets turn illiquid and asset prices fall than when markets are excessively liquid and asset prices booming, central banks ought also to avoid bringing such situations upon themselves. Better to “lean against the wind” with prudential norms, tightening them as liquidity exceeds historical levels, than to ignore the boom and be faced with the messy political reality of forcibly picking up the pieces after the bust.
Translation: Greenspan was wrong.
These are but a few of the things Dr. Rajan has written. It is comforting to know that an institution like The IMF can turn out two very independent thinkers in Ken Rogoff and Raghuram Rajan.
SourcesHas Financial Development Made The World Riskier? - Kansas City FedRaghuram Rajan - WikipediaBankers’ pay is deeply flawed - FTCentral banks face a liquidity trap - FT
Related Reading:
The New Bankruptcy: Will It Work for You? (2nd edition)
Standard and Poor's Guide to Money and Investing (Standard & Poor)
How to File for Chapter 7 Bankruptcy
Securities Regulation: Cases and Analysis Second Edition (University Casebook)
Rich Dad's Advisors: Guide to Investing In Gold and Silver: Protect Your Financial Future

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A new generation of postfeminist sexologists is trying to discover what ignites female desire.

Magazine Preview - The Big Fix - By David Leonhardt, Jan 27, 2009

Risk Mismanagement

By JOE NOCERA - Published: January 2, 2009

The story that I have to tell is marked all the way through by a persistent tension between those who assert that the best decisions are based on quantification and numbers, determined by the patterns of the past, and those who base their decisions on more subjective degrees of belief about the uncertain future. This is a controversy that has never been resolved.’
THERE AREN’T MANY widely told anecdotes ... ... .... 10 pags....

January 04, 2009
Risk Management
I probably should have done more to highlight the article on risk management by Joe Nocera that appeared in the NY Times Magazine this weekend. Fortunately, James Kwak and others have it covered:
Risk Management for Beginners, by James Kwak: Joe Nocera has an article ... about Value at Risk (VaR), a risk management technique used by financial institutions to measure the risk of individual trading desks or aggregate portfolios. ...
VaR is a way of measuring the likelihood that a portfolio will suffer a large loss in some period of time, or the maximum amount that you are likely to lose with some probability (say, 99%). It does this by: (1) looking at historical data about asset price changes and correlations; (2) using that data to estimate the probability distributions of those asset prices and correlations; and (3) using those estimated distributions to calculate the maximum amount you will lose 99% of the time. At a high level, Nocera’s conclusion is that VaR is a useful tool even though it doesn’t tell you what happens the other 1% of the time.
naked capitalism already has one withering critique of the article out. There, Yves Smith focuses on the assumption, mentioned but not explored by Nocera, that the ... changes in asset prices ... are normally distributed. To summarize, for decades people have known that financial events are not normally distributed.... Yet ... VaR modelers continue to assume normal distributions..., which leads to results that are simply incorrect. It’s a good article, and you’ll probably learn something.
While Smith focuses on the problem of using the wrong mathematical tools, and Nocera mentions the problem of not using enough historical data - “...VaR didn’t see the risk because it generally relied on a two-year data history” - I want to focus on another weakness of VaR: the fact that the real world changes.
» Continue reading "Risk Management"


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