Today's Reading List
By Arnold Kling
All from Mark Thoma.
The shortest read is from Robert Waldmann.
A sudden decline in the liquidity of assets can create problems as firms can’t unwind leveraged positions without extreme market disruption. If the assets had always been illiquid, those leveraged positions would never exist. I think that would be a good thing.
The term Austro-Keynesian comes to mind. Read the whole post.
The most frustrating read is from Bethany McLean. I think she is right in her description of the feud between Fannie and policymakers. I think she is wrong in making it sound like the decision to put Fannie and Freddie into conservatorship was arbitrary. They had lost the confidence of investors, and that is the one risk that they could not possibly overcome. I knew they were dead back in July.
Finally, the read that has everything is from Joe Nocera. It has a major suits-vs.-geeks theme. He features Nassim Taleb. He talks about LTCM. One quote:
There was everyone, really, who, over time, forgot that the VaR number was only meant to describe what happened 99 percent of the time. That $50 million wasn’t just the most you could lose 99 percent of the time. It was the least you could lose 1 percent of the time.
This is a really good point. Value at Risk in some sense measures the boundary of the 99 percent confidence interval for your portfolio. Other things equal, it’s better to have a low VaR than a high one. But it is conceptually wrong to think of it as anything like “the most you can lose.” When I was at Freddie Mac, I preferred stress-test methodologies to VAR. A stress test shows how much you lose in a specific scenario. See The Risk Disclosure Problem.
Another good quote:
Guldimann, the great VaR proselytizer, sounded almost mournful when he talked about what he saw as another of VaR’s shortcomings. To him, the big problem was that it turned out that VaR could be gamed. That is what happened when banks began reporting their VaRs. To motivate managers, the banks began to compensate them not just for making big profits but also for making profits with low risks. That sounds good in principle, but managers began to manipulate the VaR by loading up on what Guldimann calls “asymmetric risk positions.” These are products or contracts that, in general, generate small gains and very rarely have losses. But when they do have losses, they are huge. These positions made a manager’s VaR look good because VaR ignored the slim likelihood of giant losses, which could only come about in the event of a true catastrophe. A good example was a credit-default swap
Not surprisingly, I really like the Nocera piece.
UPDATE: TIll Guldimann elaborates on his views of the financial crisis.
In the past banks were the principal intermediaries of money and the national regulators supervised them. Their sources of funds (liabilities) were local customer deposits, their uses (assets) loans. Regulators controlled the financial system by a) allowing only banks to accept deposits, b) specifying the minimum required capital banks must hold and c) influencing interest rates by injecting or removing funds from the banking system. This simple system has changed dramatically
The changes include disintermediation, derivatives, market value accounting, and asymmetric compensation.