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URL:  http://boards.fool.com/in-essence-the-var-calculations-became-an-30304966.aspx

Subject:  Re: Countdown to the next financial bomb Date:  10/7/2012  6:42 AM
Author:  AdvocatusDiaboli Number:  405465 of 457799

In essence, the VAR calculations became an extremely complex, precise work of fiction that had virtually no basis in reality and had negligable impact in convincing management to apply the brakes.

There's always the problem with what I like to call "systemic feedback" in economics. You develop a model on the basis of historical data. The conclusion that are drawn from the model influence your behavior (and eventually the behavior of a lot of other people) which changes reality, so your model no longer applies and your conclusions become invalid.

A good example is securitization. The models for developing securitization where originally created on the basis of mortgage data where no or only relatively few mortgages were originated to be securitized.
Of course once you get into mass securitization, mortgages are going to behave a lot differently, as:

1. the originator no longer holds the mortgage to maturity and thus has far less incentive to make sure it's repaid, and

2. securitization enabled a large increase in the volume of credit granted, which drove real estate prices into a bubble.

As a result, mortgages defaulted at a far higher rate and with far lower recovery rates than had historically been the case.
And so the application of conclusions drawn from the historical data altered reality in a way which rendered those same conclusions invalid.

There seems to be very little awareness of this phenomenon as a general problem in the financial markets (Soros is aware of it, he calls it "reflexivitiy".
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