Risk Mismanagement and VaR

This article in the NYT is a fascinating, although a long, read if you want to understand how the financial experts got it so wrong despite all the tools they had and were unable to protect even themselves.

Money managers use a concept called VaR (Value at Risk). This formula helps determine if there is any 'value' i.e. amount at risk in a portfolio of holdings, be it a bank's total portfolio, mutual fund holding portfolio or any other bundle of investments and how much is the 'value' at risk.

Most top notch investment banks use this concept and claim that 99% of the times they are able to predict the VaR and this helps them manage risks. but the uncertainty and unpredictability of the 1% is what breaks the back especially because these events have never occurred before and more importantly, have not been planned for. Therefore, such highly improbable events cause the greatest damage including the current financial crisis. Such events are earthquakes, depression due to bank failures, depression due to housing prices (current crisis) and are usually catastrophic.

Excerpt:
“VaR is a useful tool,” he said as our interview was nearing its end. “The more liquid the asset, the better the tool. The more history, the better the tool. The less of both, the worse it is. It helps you understand what you should expect to happen on a daily basis in an environment that is roughly the same. We had a trade last week in the mortgage universe where the VaR was $1 million. The same trade a week later had a VaR of $6 million. If you tell me my risk hasn’t changed — I say yes it has!” Two years ago, VaR worked for Goldman Sachs the way it once worked for Dennis Weatherstone — it gave the firm a signal that allowed it to make a judgment about risk. It wasn’t the only signal, but it helped. It wasn’t just the math that helped Goldman sidestep the early decline of mortgage-backed instruments. But it wasn’t just judgment either. It was both.

Why Goldman Sachs avoided the brunt of the crisis unlike other major investment banks:
"So Goldman called a meeting of about 15 people, including several risk managers and the senior people on the various trading desks. They examined a thick report that included every trading position the firm held. For the next three hours, they pored over everything. They examined their VaR numbers and their other risk models. They talked about how the mortgage-backed securities market “felt.” “Our guys said that it felt like it was going to get worse before it got better,” Viniar recalled. “So we made a decision: let’s get closer to home.”

Alan Greenspan said last year during a Congress testimony: “The whole intellectual edifice, however, collapsed in the summer of last year because the data input into the risk-management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.”

However, the writer of the book "The Black Swan" and "Fooled by Randomness", Nicholas Taleb who is a Professor and an author of widely read and followed books claims that the concept of VaR is pretty useless.

Taleb: Yet even faulty historical data isn’t Taleb’s primary concern. What he cares about, with standard VaR, is not the number that falls within the 99 percent probability. He cares about what happens in the other 1 percent, at the extreme edge of the curve. The fact that you are not likely to lose more than a certain amount 99 percent of the time tells you absolutely nothing about what could happen the other 1 percent of the time. You could lose $51 million instead of $50 million — no big deal. That happens two or three times a year, and no one blinks an eye. You could also lose billions and go out of business. VaR has no way of measuring which it will be.

VaR is a guide to at least some future trend forecasts. It may not be the best tool but it is the best that experts have come out with thus far over the course of history to get a future trend line on what to expect. Of course, it must be used with intelligent inputs from other mediums as well, as the article explains.

Excerpt:
One risk-model critic, Richard Bookstaber, a hedge-fund risk manager and author of “A Demon of Our Own Design,” ranted about VaR for a half-hour over dinner one night. Then he finally said, “If you put a gun to my head and asked me what my firm’s risk was, I would use VaR.” VaR may have been a flawed number, but it was the best number anyone had come up with.

Risk Mismanagement

By JOE NOCERA
Published: January 2, 2009