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On Jodaism - A Reply To Aaron Brown

Posted At : February 2, 2010 8:35 PM | Posted By : Pablo Triana
Related Categories: Books
First of all, let me say that I am honored that someone of the stature of Aaron Brown decided to review my Lecturing Birds on Flying. Having clarified that, I wish he had chosen a more regular venue for said exercise; Amazon.com is more than fine, but whatever happened to GARP Risk Review, Wilmott Mag, or the WSJ? Given Brown´s excellent writing skills I for one would have loved a lengthier, more formal take on my humble tome.

But a shortish, informal review on Amazon is all we´ve got, so let´s face reality and delve into the analysis. The review is a mix of positive and negative assessments. Such apparently unenthusiastic response may throw some authors back, but not me. I am too busy glowing in the fact that Brown finds good stuff buried within all those bothersome inverted pluperfect subjunctives (he says I remind him of Joda, of Star Wars fame). I can proclaim that I wrote a book that Aaron Brown found (somewhat) useful. That´s a very good thing. For not only is Brown a very prominent risk professional, or a very gifted and thoughtful "financial intellectual". He is also a renowned defender of the quanty stuff. So when someone like that is willing to compliment a book that goes heavily at the quanty stuff, you know that at least something has been done right (of course, I personally believe that a lot in the book is right).

Let´s stop basking in short-lived, modestly-served glory, and turn our attention now to Brown´s criticisms. He claims that I lose out to BSM, VaR, and other theoretical "straw men", that my views are deeply misinformed. I beg to differ. I think here I have the advantage of not being a quanty type and thus of having taken the approach of looking at the historical record and the opinion of other, much better informed, experts when analyzing the validity and wholesomeness of the best-known models, rather than try to engage them on mathematical grounds (though, naturally, I do attempt to dissect the essential technical deficiencies). So when I declare VaR a failure, I do so based on its behaviour during the credit crisis or during the Asian-LTCM meltdowns. I do it based on the monstrous shortcomings of the tool during crunch time out there in the real world. I think my book is the first ever to actually collect and display the actual data: what figures VaR registered, the number of exceptions incurred, how actual trading losses deviated from VaR. All that data comes straight from banks´ regulatory filings, a pretty solid source. I wouldn´t exactly call that misinformedness.

Same with BSM. My analysis of its role in the 1987 crash comes from official reports and other well-informed sources. My interpretation of what the volatility smile means in terms of the model´s reliability has been espoused by many through the years. And my summary of the Taleb&Haug paper is exactly that, a summary of a pretty trustworthy reference. So the foundations on which my lambasting of BSM rests also have the smell of solidity. I detect little misinformedness here too.

Brown says that risk management is not about predicting, but rather about preventing disasters. Fine, but then why use VaR? VaR is a predictor, with a degree of confidence. And VaR can´t, almost by definition, capture disasters. Many VaR lovers have, serendipitously, ceased to endow VaR with the predictor label following the (VaR-fueled, VaR-exposing) credit crisis. Upon seeing all those exceptions (80 real versus 5 theoretical in the case of UBS for 2007-2008, I seem to recall) it is only natural that they would want to deviate out attention from hitherto familiar arguments a la "99% VaR will not be exceeded more than twice a year". But that does not mean that I am wrong when, upon studying the hard evidence, I dare to proclaim that VaR failed monstrously.

Finally, Brown asserts that institutions with bad risk management fail only once. By that definition, VaR is clearly bad risk management. Anybody remembers Bear Stearns, Lehman Brothers, or Merrill Lynch? They used VaR for risk guidance and capital-charge setting. They had never failed in their entire combined history (three centuries?). All it took for such holly tradition to be broken was the concurrent abidance by a statistical tool that encouraged, allowed, and afforded the vast accumulation of the most toxic positions ever witnessed on Wall Street. VaR made sure that those legendary, erstwhile indestructible institutions would not fail a second time. When VaR kills you, it kills you for good.

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Quantitative Madoffs?

Posted At : January 16, 2010 11:32 PM | Posted By : Pablo Triana
Related Categories: Miscellaneous
Let´s think about disgraced “financier” Bernard Madoff for a second. Why is he the uttermost epitome of inappropriate conduct? Why is he the poster child of fraudulent behavior? Why is he unremittingly fingerpointed as the exemplar of badness? Well, if we had to boil it down to a very quick rationale, it would be the following: Mr Madoff knowingly and vastly lied in matters related to financial activities, and such sizeable untruths caused untold despair and economic setbacks to others. That, in a nutshell, is his legacy to future explicators of financial happenstances. He will always be known as someone who produced deceitful fabrications that enriched him while impoverishing the many who got conned into believing.

My question is, shouldn´t we judge the rest of participants in the financial game by the “Madoff standard”? That is, shouldn´t those who, a la Bernie, contribute to monetary pain by purposely and deliberately duping the world also be loudly accused of fraud, relentlessly disgraced as scammers? I need to ask this, because it is not immediately obvious that those who share Madoff´s affinity for financial hoodwinking and capacity for social havoc-wreaking get called to task.

Take the promoters of quantitative finance. The complex mathematical concoctions that have been increasingly used in the markets for the past three decades have contributed to non-negligible chaos. In fact, it wouldn´t be far-fetched or insultingly irrational to argue that the employment of analytical models was behind the worst three market crisis since 1929. While an army of deniers remains hidden behind academic walls, it is by now pretty much conventional wisdom among many practitioners, analysts, and regulators that things like the Black-Scholes-Merton option pricing formula, the Value at Risk capital charge-setting radar, and the Gaussian Copula CDOs-rating model decisively aided and abetted the unleash of the malaises of October 1987 (one-day 25% drop on Wall Street, threatening the system), September 1998 (LTCM blow up, threatening the system), and 2007-2009 (credit crisis, destroying the system).

But even those who do admit to the failings of the quanty concoctions have typically shied away from being too harsh on the concocters and their intentions. When analyzing the excusing that has typically followed the (chaos-igniting) malfunctioning of the math, it is impossible not to distill the main message: the modelers were acting in good faith, honestly trying to model the market as accurately and truthfully as possible; unfortunately, things went awry once the analytics hit the street, but such outcome (aka as “the perfect 1000-year storm” among financial theoreticians) could not have been predicted by anyone. In other words, the argument would go, there was no equations-driven deceit. The math that was peddled would have been peddled in good faith, the models would have been prospectively assumed to be sound and trustworthy, to the best of the modelers’ abilities. Lots of folks may have lost tons of money as a result of imbuing the math into finance, but not, the excusers would point, as a result of the mathematicians cheating anyone.

Or did they? Bluntly put, the assumptions of many of the most widely used financial models are so egregiously unworldly, so alarmingly unrealistic, so impossibly unseemly that it is very very hard not to contend that many peddlers of the quantitative snakeoil must have been perfectly aware all along of the meaninglessness of some of the solutions. Possibly even of the danger that they pose. But the incentives not to share such beliefs and to instead defend the model´s robustness may have been irresistibly tasty. As long as the math is assumed to be reliable and sound, the mathematicians can enjoy the glamour and paycheques of finance. And the math can be a wonderful alibi for banks to engage in the kind of trades that they love most. By conveniently (and widely unrealistically) projecting very little risk ahead, VaR and the Gaussian Copula, for instance, decisively allowed Wall Street and the City to play the Subprime CDOs game that eventually killed us all. If you are a modeller, are you really going to out the models as useless and dangerous or are you going to continue to trot along and profitably rate garbage as if it were gold?

Naturally, by choosing the latter approach you would be incurring in intellectual fraud. People endowed with prestigious doctorates, and who might have previously dreamed of academic glory and yearned for the pure discovery of knowledge, would be corrupting sacred scientific methodologies. They would have contributed to transforming advanced mathematics and statistics into misleading sales pitches in search of a quick buck. They would be (knowingly) contributing to a lie that clouds understanding and that puts the world at large in undue danger. Is that a lesser crime than the one committed by Bernard Madoff?

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