Friday, February 8, 2008


"Value at risk, the measure banks use to calculate the maximum their trades can lose each day, failed to detect the scope of the U.S. subprime mortgage market's collapse as it triggered more than $130 billion of losses since June for the biggest securities firms led by Citigroup Inc., Merrill, Morgan Stanley and UBS AG. The past six months have exposed the flaws of a financial measure based on historical prices that securities firms use idiosyncratically and that doesn't anticipate every potential disaster, such as the mistaken credit ratings on defaulted subprime debt. 'Finance is an area that's dominated by rare events,' said Nassin Taleb, a research professor at London Business School and former options trader. 'The tools we have in quantitative finance do not work in what I call the "Black Swan" domain.' ... Executives at Merrill, Morgan Stanley and UBS took steps in the past six weeks to overhaul their risk-mangement groups after internal models failed to foresee the first annual decline in house prices since the Great Depression. ... Hiring risk managers and giving them more power won't alter the mistake that led to last year's slump and that was Wall Street's dependence upon statistics to quantify risks, Taleb said. 'We have had dismal failures in quantitative finance in measuring those risks, yet people hire quants and hire risk managers simply to back up the desire to take these risks,' he said. 'There are some probabilities that you cannot compute.' ... 'If you compare what peoples' [VaR] are versus what their losses were in the third quarter or fourth quarter, the numbers are astounding,' said David Einhorn, president and co-founder of hedge fund Greenlight Capital LLC in New York. ... All of the risk-meaurement tools failed to prepare Merrill for the unforeseen declines on triple-A rated securities backed by subprime mortgages. ... 'In a market stress event, some individual sectors that previously appeared unrelated do move together, and as a result, the organization could take losses on both of them or even on positions that were previously deemed to be a hedge,' said Ed Hilda, the partner who runs the risk strategy and analytics services group at Deloitte & Touche LLP in New York . ... 'Stress tests are only as good or as predictive as the scenarios used and in many cases the scenarios that played out were much more severe than people anticipated,' Hilda said", Christine Harper at, 28 January 2008.

Yves Smith has a fine post about this at on 28 January 2008. He says it all. I previously discussed those models, unflatteringly, on 23 August, 8 November and 1 December 2007.

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