NYT and Press: Get Your Facts Straight About Municipal Swaps

"Knit Cap Creates Huge Hangover" is Not a Good Headline  

I know the "Complicated Stuff You Don't Understand Is Secretly Destroying You" theme is an eminently reliable one that reporters have used since time immemorial.  Couple it with the now wildly popular "Wall Street Fat Cats are Stealing Your Money" theme and you've got a ready-made recipe for some uber-potent journalistic catnip.  Reporters from WSJ,Bloomberg News (covering this for years and still looking for that Pulitzer...), and most recently the NYTimes have gotten wild highs off of combining these two stories into some variant of, "Wall Street Robs a Town Near You with Interest Rate Swaps."  The facts in these stories, if discernible beyond the often fuzzy innuendo, are usually distorted at best or flat out wrong.  So let's get the story straight.  Much of it ain't that sinister or complex and the talented public finance professionals who work to save tax and rate payer money deserve it. 

No different than the homeowner who must decide on either a fixed or adjustable rate mortgage, public finance officials must make tough decisions about interest rates.  Most of the time they employ traditional fixed rate bonds, or as I call them, Boring Old Bonds (BOBs).  However, history has shown us that over substantial periods variable rate bonds have offered a lower cost of capital than BOBs. Yes, this is obviously not a rule and far from a prediction about the future.  However, it was not unreasonable or uncommon for an issuer to decide to have a certain portion of its debt exposed to the short end of the yield curve.  If the issuer had working capital or short duration assets on the balance sheet, this was in fact the prudent risk management decision.  The rating agencies even had a rule of thumb: no more than 20-25% debt in a variable mode, unless it came with a compelling story.  

Public finance borrowers used auction rate securities (ARS) and traditional variable rate demand bonds (VRDBs) with bank liquidity support as floating rate instruments.  Now enter the subprime meltdown and subsequent credit/liquidity black hole from the last 18 months.  In retrospect, ARS were sold in an extremely thin and fragile market which evaporated during the crisis; ARS rates went to a failure rate, which was often, though not always, very high.  VRDBs performed well if the issuer was lucky enough to have a strong bank name behind them.  Others suffered and had rates go to the moon.  Where are the interest rate swaps in all this?  NOWHERE!  And that's the point. 

Interest rateswaps were used to hedge the interest rate risk inherent in the ARS or VRDBs.  Over the last year, the difference between 67% of LIBOR and SIFMA was 0.14%.  For the record, historically that's an extremely narrow spread.  These swaps were never designed to hedge MBIA falling off a cliff, the ARS market vanishing, or Dexia's credit rating.  And therein lies the absurd (and I suppose predictable) conflation mistake reporters make on these stories.  It's the interest rate swaps fault for not hedging all the credit events that occurred with the issuer's bonds.  Blaming the interest rate swap for these problems is a bit like having a fearsome headache after a late night and blaming the pain you have on the hat you're wearing in the morning.  Here's the headline, "Knit Cap Causes Enormous Hangover."  The cap is there to keep your head warm, not fix your hangover. And it certainly didn't create your headache in the first place.

Don't get me wrong. I'm hardly naïve.  I realize that having used interest rate swaps to hedge the interest rate risk in ARS and VRDBs has often made the situation more difficult to workout or refinance into fixed rate bonds.  Collateral calls if applicable have further pinched liquidity at just the wrong time and the negative mark-to-market value of the swaps can be large with rates this low.  If refinancing with BOBs, at least the MTM is partially offset by the issuer selling BOBs into a lower fixed rate market than the one in which the swap was executed.  I realize that's all just financial reality and shouldn't get in the way of a good ol' beat up the Street story, particularly not these days.  And that's where the real meat of this story is - whether these contracts are enforceable given the clear verdict in the court of public opinion. Are our legal institutions powerful enough to withstand our political ones?  I'll save that for another post but it was actually covered recently by the press...and relatively well; you can read it here.   

In the meantime, if you're a reporter and you want to do a balanced, factually accurate article about municipal swaps, I'm available.  We're installing new lines to handle call volume...  

The Big BAD Mistake about BABs

"Prediction is very difficult, especially if it's about the future." 

- Niels Bohr (long before Yogi Berra) 

Lots of people seem to be making a big mistake analyzing Build America Bonds (BABs).  The popular and straightforward analysis is to compare yields on traditional fixed rate bonds (or "BOBs" as I call them - Boring Old Bonds) to the after-subsidy yield on BABs.  Here's an example:

 

The (overly) simple analysis says that BOBs are the cheaper cost of capital through about year 12 and then BABs are the way to go thereafter.

The heroic simplifying assumption of course that works so nicely in spreadsheets and standard software packages is that this line-item Federal subsidy duck will stay staticand not shot down over the entire life of the bonds.  Is this a good assumption?   Let's look at some facts:

-     The BABs legislation explicitly states that the subsidy is not permanent and can be changed at any time

-     The BABs subsidy is qualitatively very different than the one inherent in BOBs.  As anyone dealing with a government budget knows, there's a fundamental practical and political difference between revenue lost in the opportunity sense (BOBs) vs the Treasury needing to cut a check for a subsidy as with BABs  

-     The US debt and fiscal imbalance are ugly. Some argue worse than they've been excluding WWII

With these facts, is it prudent to be overly optimistic about this US subsidy staying static over 20-30 years, through changing administrations, congressional seats and political winds?  I don't think so.  In fact, the analysis of this risk is not unlike the oft-discussed "tax risk" that people cogitated about when evaluating synthetic fixed-rate borrowing strategies using LIBOR swaps.

Putting a finer point on it, when an issuer sells BOBs the following risks are shifted to the investor:

1)   Interest rate - rates go through the moon, the investor suffers the MTM loss. The nominal cost of capital for the issuer is locked in.

2)   Credit - should the issuer's credit deteriorate, again the investor suffers

3)   Tax law - should the US become less reliant on income taxes and more on consumption taxes or VAT or shifts to a flat tax, the preference for tax-exempt income would fall and investors would suffer losses.     

For BABs, the third item no longer applies.  The investor gets a taxable coupon.  Has the third risk gone away entirely?  I think it's been transformed.  That third "tax law" risk is now replaced with US Fiscal Policy Risk (FP Risk^TM) which I would argue is significantly non-zero and different qualitatively then we've seen before in the tax-exempt markets.   

So if we're NOT to assume that this subsidy will stay static, and now the issuer has this new FP Risk to manage, how can this risk be incorporated into decision-metrics in a non-trivial way?  After all, what gets measured gets managed.  Stay tuned, but in the meantime, what do youthink?           

Green shoot economy…infested with parasites?

Ye can lead a man up to the university, but you can't make him think.

- Finley Peter Dunne

Whenever the people are well-informed, they can be trusted with their own government.

- Thomas Jefferson

History is a race between education and catastrophe.

- H.G. Wells

The other day I found myself waiting for a flight at O'Hare and at the time I couldn't avoid listening to the CNN morning show on the airport monitor. They were showing a segment on expected changes in an average $50,000 salary for 2010. The forecast was for a $1,600 increase. Now you might anticipate me railing on about the fact that they provided no measure of deviation around the expectation, but I'll save that for another post. I found what happened next far more disturbing. The reporter then said something along these lines, "Let me see if I can give you that in percentage terms." After a few time-buying other comments she returned to the percentage issue with, "Well, we'll come back to you later with that percentage so you can get a feeling for how things might change at your particular salary level."

Now I had a 6am flight so this was pretty early. Perhaps the reporter wasn't a morning person; maybe she hadn't had her cup of coffee yet; or perhaps the producer was yapping in her ear at the time. But to me, it looked a whole heckuva lot like she couldn't multiply the salary change by 2 and put the decimal point in the right spot to come up with the percentage. For anyone who's satisfied the arithmetic requirements of a fourth grader, I'm expecting that that information is readily calculable, and right quick.

The Program for International Student Assessment (PISA) tests 15 year olds in math and science every three years from the 30 member countries of the Organization for Economic and Co-Operation and Development (OECD). The last test was administered in 2006 with the 2007 published results as follows:

	2006 Science Results			2006 Math Results
	Country	Avg Score		Country	Avg Score
1	Finland	548	1	Finland	563
2	Korea, Republic of	547	2	Canada	534
3	Netherlands	531	3	Japan	531
4	Switzerland	530	4	New Zealand	530
5	Canada	527	5	Australia	527
6	Japan	523	6	Netherlands	525
7	New Zealand	522	7	Korea, Republic of	522
8	Belgium	520	8	Germany	516
9	Australia	520	9	United Kingdom	515
10	Denmark	513	10	Czech Republic	513
11	Czech Republic	510	11	Switzerland	512
12	Iceland	506	12	Austria	511
13	Austria	505	13	Belgium	510
14	Germany	504	14	Ireland	508
15	Sweden	502	15	Hungary	504
16	Ireland	501	16	Sweden	503
17	France	496	17	Poland	498
18	United Kingdom	495	18	Denmark	496
19	Poland	495	19	France	495
20	Slovak Republic	492	20	Iceland	491
21	Hungary	491	21	United States	489
22	Luxembourg	490	22	Slovak Republic	488
23	Norway	490	23	Spain	488
24	Spain	480	24	Norway	487
25	United States	474	25	Luxembourg	486
26	Portugal	466	26	Italy	475
27	Italy	462	27	Portugal	474
28	Greece	459	28	Greece	473
29	Turkey	424	29	Turkey	424
30	Mexico	406	30	Mexico	410

 

Out of these thirty countries you can see the US scored 25th and 21st in science and math respectively. The most recent test was administered last year with results due to be released in December, 2010. I'm crossing my fingers…

Joining my airport story with the stats above and forgive this Friedman-esque critique, but I'll bet that if I were watching CNN Japan, CNN Korea, or CNN China (if it existed), that reporter would've been able to multiply the $1,600 expected raise by 2 and come up with the percentage on the fly. Of course, looking at Korea and Japan's test scores above, it's likely that the majority of viewers in those countries wouldn't need that simple numerical translation done for them in the first place.

I don't want to start off the decade with a negative tone, so let me just say that I'm hopeful that we, with fervent new decade resolve, double down on the importance of educating our kids in math and science. And math in particular, a field without which I never would've been able to start this company, must be emphasized as an essential topic even more today due to the competitive world in which we find ourselves. And frankly, my firm belief is that if the US is to continue to sprout its oft-discussed green shoots, than parasites like weak math and science skills will need to be diligently weeded out.

Are munis over-hedged with swaps? Pt3

"It is better to understand a little, than to misunderstand a lot."

- Unknown

The prior two posts came to one simple conclusion: most tax-exempt issuers who have used LIBOR based swaps to hedge variable bonds are over-hedged (see prior posts for details why). This conclusion has two primary ramifications:

1. If you hedged with, for example, 15% more swap than necessary than the issuer paid 15% more to the swap dealer than necessary. Across an estimated $1.5 billion+ in compensation to swap dealers over the last several years on these, its real dough
2. In high rate environments, the overall cost of funding will be lower than expected and in low rate environments higher

Let's look at a simple example. AnyCity, USA uses a 3.50% $100 million 68% 1M LIBOR to hedge $100 million in tax-exempt variable rate demand bonds (VRDBs). This 68% number was determined using an historic average and an implicit assumption of zero correlation between 1M LIBOR and SIFMA/1M LIBOR ratios. If one had assumed correlation of -.35, which is more consistent with what we've seen and might reasonably expect, then the right hedging index would be 58% LIBOR plus 0.52%. Both of these swaps carry a fixed rate of 3.5%.

When rates are low, the floating leg of the swap at 68% of 1M LIBOR is less than the 58% of LIBOR plus 52bps. On our $100 million swap for AnyCity, the graph of LIBOR rate level versus annual benefit to having the 58%+52 basis point leg looks like this:

Now obviously as rates go higher the benefit becomes a loss, but that's the point: this is no longer a hedged position as there's an inherent interest rate view within the structure. The overall synthetic fixed-rate structure (variable rate bonds swapped to fixed) performs worse than expected in low rate environments but better than expected in high rate environments. This is due to the fact that we expect SIFMA/LIBOR ratios to be somewhat higher on average in low rate environments and vice versa (the negative correlation between rates and ratios). What does this all mean? Well, few issuers are entering into new synthetic fixed rate deals so it matters more for those that are doing restructuring. What is the optimal portfolio-wide level of LIBOR based swaps for hedging tax-exempt variable rates? Probably less than one might think. What's an issuer to do? Well, if you have more swaps than you need than you could unwind some swaps now though in this rate environment they're likely underwater. You could wait for rates to rise and unwind when the swaps are closer to a zero mark or even an asset. Have to be careful though...that'd be speculating. J

Are munis over-hedged with swaps? pt2

"Our lives improve only when we take chances - and the first and most difficult risk we can take is to be honest with ourselves."

- Walter Anderson

Although it may not look related out of the gate, this post is a continuation of the prior post on LIBOR swaps over-hedging tax-exempt variable rate bonds. I want to start by looking at how one might build a reasonable interest rate model that would facilitate calculating this % LIBOR correctly, so that we expect to minimize the volatility of our synthetic fixed rate structure. Let's say your job is to build an interest rate model that captures the uncertainty inherent in SIFMA and LIBOR. This would be an unusual task for "quants" in public finance whose primary responsibility is coming up with accurate and often elaborate variations of present value ideas. The "model" used most frequently among front-line in investment bankers/advisors in this sector and in part due to an overreliance on spreadsheets looks something like this:

Some historic average over a selected time-period is used to create a static, flat, deterministic assumption for short rates over the time horizon of the analysis. This IS a type of interest rate model no doubt though one whose strength is not in capturing uncertainty/variability.

If an analyst were trying to create a SIFMA and LIBOR market model using two risk factors, perhaps un-intuitively s/he would not want to use "SIFMA" and "LIBOR" as the risk factors themselves. A detailed reason why is beyond the scope of this post (though you can find an outstanding thorough treatment here), but to put it simply, too much of the variability in SIFMA is also present in LIBOR. Let's face it, as US$ denominated short term interest rates, both SIFMA and LIBOR will be driven largely by changes in US monetary policy.

The better choice for a 2 factor model is LIBOR and SIFMA/LIBOR ratios. SIFMA/LIBOR ratios better reflect the unique component of risk in SIFMA itself i.e. the taxable/tax-exempt relationship. But how does this relate to the correlation impact on swap structure mentioned in the first post? It turns out that historically and on average, as LIBOR falls SIFMA/LIBOR ratios tend to go up and vice versa. In the industry vernacular bankers call this "yield compression" and it has a number of reasonable economic and technical explanations.

How do we capture this in a two-factor interest rate model that doesn't take a PhD to understand? For details on that you can read this and/or get a spreadsheet example. Suffice it to say, it really isn't so bad. To ultimately answer the original question, does this inverse relationship between rates (LIBOR) and ratios (SIFMA/LIBOR) impact the *right* percentage of LIBOR to use when hedging tax-exempt variable rate bonds? Absolutely. The graph below shows the LIBOR swap % that minimizes debt service volatility at different levels of expected correlation between LIBOR and SIFMA/LIBOR ratios.

The bottom line is that using simple averages for this LIBOR swap hedge calculation does 2 things: a) ignores the fact that these structures are not equivalent to fixed rate bonds, a fact that's been sometimes painfully understood over the last 18 months and b) implicitly assumes a correlation of zero between rates and ratios which leads to a hedge ratio that is too high, and ultimately more LIBOR swap than is necessary. What are the cash flow and mark to market ramifications of this over-hedging? Stay tuned for the 3rd and final installment on this topic. In the meantime and if you're involved in the biz, how do YOU do this calculation?

Are munis over-hedged with swaps? pt1

"Opportunity is missed by most people because it is dressed in overalls and looks like work."

- Thomas Edison

Over the last decade, many tax-exempt issuers have executed interest rate swaps based upon a percentage of the 1M or 3M London Interbank Bank Offered Rate in order to hedge the interest rate risk inherent in tax-exempt variable rate, or (perhaps unfortunately) auction rate securities. Whether or not these "synthetic fixed-rate" structures are appropriate for all or any tax-exempt issuers is a hot topic these days in light of expected regulatory changes, and one I'm not touching here. What I am going to discuss is something more fundamental to implementation: how does one arrive at the *best* structure to minimize overall debt service volatility, have historical practices led to chronic over-hedging and if so, what are the ramifications.

The usual methodology employed to determine the "right" percentage of LIBOR for the floating leg of the swap is usually calculated based upon some historic average of the ratio of the SIFMA swap index, a weekly tax-exempt floating index, to 1month or 3 month LIBOR. Ignoring tax and accounting issues for the moment, if the goal is to minimize the expected variability of overall net debt service payments this simple averaging method is incorrect in all cases save one: the expected correlation between SIFMA and LIBOR is precisely 1. My personal assessment is that most issuer/advisor/banker participants in this particular market are not accustomed to thinking explicitly about correlation as it relates to their risk management decisions. However, they're making implicit assessments of correlation quite often, sometimes with regrettable consequences.

Let me explain. Any recently test-taking CFA candidate (congratulations by the way) will tell you that the variance minimizing hedge ratio is calculated using the following simple formula:

Volhedged item / Volhedging item * Correlationbetween the 2

This formula has intuitive appeal. If the volatility of my hedging item is far greater than the item hedged, my hedge ratio should fall, which you can see it does. As it relates to correlation and in the canonical edge case, if I have a 0 expected correlation between the item I'm hedging and the item I'm hedging with, we'd expect our hedge ratio to be zero as well; you can't hedge something with something else if you expect no co-movement between the two items.

But is it our best judgment that (changes in) SIFMA and LIBOR will be perfectly correlated going forward? What does history tell us? If we look at the levels themselves, it's clear their correlation isn't perfect. Below are 5 year rolling correlations of one month averaged SIFMA and 1M LIBOR.

What does all this mean? If we expect that SIFMA LIBOR ratios will be 68% going forward (a common and frequently used historically calculated average ratio), then the right hedge ratio would scale this by our expected correlation which likely does not equal 1. A reasonable expected correlation between 85-90% would yield an optimal hedge ratio of between 57.8 and 61.2%. Some banks have gotten to numbers like this by performing regression calculations, which of course are just alternative ways of determining correlation.

So what and who cares? Well, let's compare an issuer with a 70% LIBOR swap paying a 3.5% fixed rate versus one with a 60% LIBOR swap with a 3% fixed rate. The latter has used roughly 14% less swap to do its hedging, which means the 60% LIBOR swap's value is less sensitive to changes in interest rates. This will have important ramifications for mark to markets and collateral posting. For more detail on that and how to capture these effects within a market model, stay tuned for Part2.

Forecasting in the “Fog”

"…companies are finding their standard budgeting and forecasting of little use. The usual trick of plugging figures from operating units into spreadsheets appeals to number-crunchers, but can often generate misleading targets, especially when conditions change fast."

"Managing in the fog" Economist, February 28, 2009

Even when markets change "slow", to me the point is that they're going to change! And many (perhaps most!) critical capital/corporate planning decisions are based on the spreadsheet building prowess of one or more relatively junior professionals in treasury or the CFOs office. Is this really the way we should operate, particularly after what's happened to markets in the last 18 months? I sure hope not, it seems the Economist does too…

"…more companies should be using 'scenario planning' alongside their financial models, which do not produce a large enough spread of possible outcomes to capture the flavour of today's uncertainties."

"Managing in the fog" Economist, February 28, 2009

Sounds good to me. But what are you YOU doing to help improve your financial decision making?

The REAL Challenge for Investment Banks, Part II…

"Finally, the business model of the investment banks is almost certainly going to change. Over the last 20 years, investment banking went from primarily an advisory business to being mostly a business where firms traded their own accounts – so-called proprietary trading."

- It's Not the Bonus Money. It's the Principle. New York Times, January 30, 2009

In Part 1 I described how investment banks in the current day are no longer organized to adequately address the needs of their clients. This will take a great deal of soul searching to correct. If this weren't challenge enough, the longer term secular trend is a more fundamental problem resulting from the information age and how it affects the traditional IB business model. In fact, I spoke to a comptroller of a state agency just last week on this very topic. His situation embodied the challenge (details below).

The Rise of Navigators

We live in an age of practically boundless information; we can consciously process far less than the 20 Mb/s rate I have at this computer. This information deluge, unorganized, paralyzes and renders us fearful of making suboptimal or just plain bad decisions. What has naturally emerged to help us cope with all this data is the information aggregator, or "navigator", which at this point we all find pretty valuable. There are many types of navigators, from Consumer Reports to Orbitz to the parent most qualified to give advice about raising the kid(s). In this day, the canonical ones are those with the big market caps: search engines like Google, Yahoo, YouTube, etc. Now we even have social navigators to organize our professional and personal relationships i.e. LinkedIn, Spoke, and Facebook. The feature that navigators share is that they aim to be (largely) unaffiliated with any particular buyer or seller. In fact, information businesses everywhere must understand that affiliation is now a very real and powerful axis of competition.

So what does any of this have to do with investment banks? Don't they sit at the top of the economic food chain above all of this stuff? Not remotely. This leads me back to my story about the comptroller. This particular state finance official was wrapping up an advisor request-for-proposal process and was curious about our capabilities. In response to why he was going through this process now, he told me that for the decade plus that he'd worked there, their investment bank (whom they only changed once) had run all of the numbers. But now, they're planning on a financial advisor running the numbers because, "We want to make sure the advice we're getting is solely in our interest."

What Information?

Obviously, one instance does not make a rule. But the increasing awareness and commensurate skepticism associated with the sources of our information is surely not an isolated trend. Investment banking clients want either unaffiliated information or better yet, information that they feel is purely and unfailingly affiliated with them. Investment bankers always walk through the door with their bank's name on their business card. In the back of the client's mind is that name. Rightly or wrongly, along with it is an ongoing question of whether the information coming from that banker isn't perhaps a bit influenced by the interest of her/his employer.

Bankers are hardly defenseless; they can do a great deal to fight the good fight. I personally haven't seen it yet, but that's a topic for another post…

ps Many thanks to Professor Orr for the penny image above.

The REAL Challenge for Investment Banks: Part 1

"Number 10: Never give up on an idea simply because it is bad and doesn't work. Cling to it even when it is hopeless. Anyone can cut and run, but it takes a very special person to stay with something that is truly stupid and harmful…"

- George Carlin, Fifteen Rules to Live By

It's popular these days to jump onto the "Wall Street versus Main Street" bandwagon and say all investment banks are inhabited by dark lords of money, all blood relatives of Gordon Gecko, though more greedy and substantially less charming. I'll go out on a limb here and say that I generally don't agree. I've known plenty of investment bankers – many of them extremely dedicated, hard working, and bright, and in my experience kind (unless you're a starting analyst, but that's another story…). Yes, they're commercially minded but that's the nature of the business. And though I admit that the ego/ability ratio by which I occasionally assess a finance professional can be skewed towards the numerator (sometimes grotesquely) all in all these are usually talented, driven professionals.

That said, whatever new financial regulatory system comes down the pike, investment bankers will still exist and will still serve a critical function as capital raisers for companies that need it. However, they've got two big problems that need to be addressed: one is a functional and organizational misalignment with clients (discussed below); the other is a more fundamental conflict between the information age and the traditional IB business model.

The Organizational Challenge – Misalignment with the Client

Investment banks are not organized in a way to efficiently provide services that the client wants. To a large degree, investment banks today remain silos of product knowledge organized through a traditional command and control hierarchy with managers and staffs. Each business manager and her/his team tries to achieve certain budgetary goals and targets set at the beginning of each fiscal cycle. Within investment banks these groups tend to line up with the various services and products that the bank provides. Many are divided along market lines: interest rate, currency, energy, commodity, etc. This structure has been exacerbated in recent years as IBs have moved more and more away from their traditional roles as consultants and deal-makers for raising capital, to levered risk takers managing the IBs balance sheet aggressively through prop-trading. To add to the problem, every two or three years the IB alternates between organizing across market lines and geographic lines. In both cases, IB management seems to either ignore or misunderstand the functional needs of their clients.

Investment banking clients by contrast are concerned with some combination of risks due to the nature of their current or anticipated balance sheets. However, concepts behind risk across multiple asset classes are subtle and often counterintuitive. Standard deviation or "volatility", the most frequently used proxy for a risk measure is not a simply additive term. In volatility terms, one plus one can equal anything between zero and two, and is usually somewhere in between. This truth currently manifests itself in the frequently misunderstood topic of "asset/liability management".

In short, clients face multiple market risks at once and are managing them in a portfolio. A bank is a conglomeration of products that buy/sell each of the risks the client faces but have little cross-product interaction or understanding. And the incentive structure internally at an investment bank amplifies the silo problem. An investment bank is not functionally aligned to understand its clients perspective, and therefore, to really address their needs. Investment banks are set up to sell products; IB clients want to receive high quality analysis of those products in aggregate as it relates to their specific situation, as a service. Do banks want to provide this service and if so, what does it look like? How does the bank get paid for it? Why should the client believe in the analysis? Does the banker's affiliation with her/his employer result in an increasingly skeptical client perspective? I'll leave some answers to that for part II….

VaR and the Meltdown

If you didn't catch it, the NYT magazine this weekend had a cover story on risk which posed the question, was management or specifically risk management more responsible for the current financial mess in which we now sit? Not unexpectedly, Mr. Black Swan himself got a good dose of coverage railing against the utter folly of VaR and seemingly anyone who attempts to quantify anything about risk in finance. The other corner is represented by the leadership at RiskMetrics, Sunguard, etc weighing in with the "calculating risk has benefits" position, given it (VaR) provides relevant and useful information the majority of the time. Taleb's point is the "majority of the time" doesn't matter much after insolvency.

Given the topic, the article provides predictable variations of common platitudes: "Guns (quantifying risk) don't kill people, people (dumb risk management) kill people," and "Those who ignore the lessons of history are bound to repeat it (particularly if you only use 2 years of data as a basis for your VaR calc)."

I couldn't help but notice how much the article echoes the debate about the degree of risk versus uncertainty present in financial management, and what to do about it. In fact, one way to look at the position of people like Taleb/Mandelbrot is that the uncertainty about which Dr. Knight wrote in his 1916 dissertation is really the driving force behind socio-economic variable movement and as such, if you're going to do any modeling, fractals are your best only choice. They argue fractals and power laws are the only things that give you a prayer of appreciating the potential magnitude out in the tails of the uncertainty.

I think the article properly highlighted one VaR shortcoming that has been reasonably well-known but under-addressed, "[VaR] failed to distinguish between leverage that came from long-term, fixed-rate debt…and loans that can be called at any time and…blow you up in 2 minutes." Coincidentally this is highly germane to my disagreement with Dr. Black, and perhaps even the mindset behind a lot of quant training.

I wish there was a bit on behavioral finance. The author hints at that quoting a risk manager, "It has to do with the human condition. People like to have one number they can believe in." It might've been nice if he touched on concepts like availability bias, overconfidence, and herding as additional contributors to the problem. What ramifications this all has for future policy is anyone's guess. In the end, we are still doing this democratic/capitalist experiment and it doesn't appear we're in any danger of getting it *right* anytime soon.

Of course, I'm sure some risk managers out there reveled in one of the author's concluding and resigned ruminations, "Maybe it would have been better if the people in charge had a better understanding of risk." I suppose that would've been nice.