A guest post by Pablo Triana:
The punditry and the world at large have been hard at work trying to find ex-ante predictors for the malaise that has engulfed our markets, our economies, and our societies. Desperate efforts to find those who “called it” have been relentlessly launched. We all seem to want to know who among us really saw the mayhem coming. It was unavoidable that such agitated process would deliver a sizable dose of less-than-reliable prophets and less-than-robust explanations. The breathless quest for prospective explainers, the unquenchable thirst for totemic ex-ante seers has resulted in the crowning of individuals who, notwithstanding their many qualities, did not get it exactly right before the troubles initiated. Yes, many of those vaticinators did warn as to the unsustainability of the housing bubble, as to the insalubrious practices taking place in the subprime mortgage business, and (much less often) as to the toxic nature of certain new-flanged securities. But only one person among the appointed oracles truly pointed fingers prospectively at the true culprit behind the current devastation. And he did so not in 2005 or 2006, but as far back (at least) as 1997.
This is what Nassim Taleb, the famed author and iconoclast, said more than a decade ago that qualifies him, in my eyes, as the true and only visionary: “I believe that Value at Risk is the alibi bankers will give shareholders and the bailing-out taxpayer to show documented due diligence, and will express that their blow-up came from truly unforeseeable circumstances and events with low probability, not from taking large risks they did not understand…I maintain that the due diligence VaR tool encouraged untrained people to take misdirected risk with shareholders´, and ultimately the taxpayers´, money”. In the midst of the credit nightmare, such pearls could not appear any more prescient.
For VaR did ultimately cause the crisis (and the Taleb-predicted bail-out), precisely by providing reckless bankers with an iron-clad, scientifically-smelling, regulatory-sanctioned alibi to monstrously leverage their balance sheets with the most toxic and illiquid of financial wares. Plainly stated, without the aid from VaR (a mathematical model which for the past years has been the tool charged with dictating the capital requirements for banks’ trading activities, and which, because of the way it is calculated, consistently delivered very economical price tags for speculation activities thus enabling untold leverage) banks would not have been able to gorge on Subprime CDOs for amounts way larger than their entire equity base. Since those gigantic toxic positions are what truly sank Wall Street, and since the sinkage of the latter is what truly unleashed what is known as the credit crisis, it follows that without VaR the pain would have been much more diluted.
VaR is supposed to measure expected losses from a trading portfolio at a given statistical confidence level. It is calculated by looking at past data and then inferring future market behavior. If markets have been trotting along calmly, as was certainly the case prior to the summer of 2007, VaR will say that there´s no risk ahead. The VaR figure will be small, resulting in small capital charges, allowing banks to have to pay just a little upfront (maybe as little as less than 1%) in order to devour monstrous amounts of those “non-risky” assets. This is valid both for liquid and illiquid stuff since VaR, incredibly, does not discriminate between, say, a Treasury Bond and a CDO; all that matters is what past data says, potentially resulting in the obscene conclusion that a T-Bond may incur a higher capital charge than a CDO. That is, VaR can make it easier (cheaper) for you to gorge on deleteriously lethal stuff than on staid safe alternatives.
Many bankers love to have VaR setting capital charges, because they can use it as the perfect excuse to achieve their golden dream: building up hugely geared bets on hugely junky assets. Since the junk would deliver tasty yields (at least until it inevitably blows up) you would be able to claim extraordinary returns on capital. Headline-grabbing profits, enhanced share prices, and mouthwatering bonuses would surely follow. Traders know that VaR can be made to be negligible (just find the right combination of asset type and time series that would render a placid past period), permissively opening the gates of leverage paradise.
This crisis was not really a “housing crisis”, but a “trading crisis”. Mortgage defaults on their own would have never created this kind of tremors. The melting into oblivion of complex securities based on those mortgages is what did unleash hell. VaR unseemly allowed banks to afford the complexity feast, and that´s why I declare it guilty numero uno. Only Taleb saw this coming, more than ten years ago. If only we had listened to him more attentively.
Pablo Triana is the author of Lecturing Birds On Flying: Can Mathematical Theories Destroy The Financial Markets? (Wiley, 2009)