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Author: Wotdabny Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 454761  
Subject: Risk Mismanagement Date: 1/5/2009 1:12 AM
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The story of VaR, in which a mathematical model that is perfectly useful in assessing risk becomes a substitute for sound judgement over time, and is even gamed to increase the appearance of better, safer returns:

To motivate managers, the banks began to compensate them . . . for making profits with low risks. . . . managers began to manipulate the VaR by loading up on . . . “asymmetric risk positions.” These are products or contracts that, in general, generate small gains and very rarely have losses. But when they do have losses, they are huge. These positions made a manager’s VaR look good because VaR ignored the slim likelihood of giant losses . . . . A good example was a credit-default swap . . . . The gains made from selling credit-default swaps are small and steady — and the chance of ever having to pay off that insurance was assumed to be minuscule. It was outside the 99 percent probability, so it didn’t show up in the VaR number. People didn’t see the size of those hidden positions lurking in that 1 percent that VaR didn’t measure.

EVEN MORE CRITICAL, it did not properly account for leverage that was employed through the use of options. . . . if an asset manager borrows money to buy shares of a company, the VaR would usually increase. But say he instead enters into a contract that gives someone the right to sell him those shares at a lower price at a later time — a put option. In that case, the VaR might remain unchanged. From the outside, he would look as if he were taking no risk, but in fact, he is. If the share price of the company falls steeply, he will have lost a great deal of money. . . . “stuffing risk into the tails.”

. . . everyone who wasn’t a risk manager or a risk expert
[including many who patently should have been] forgot that the VaR number was only meant to describe what happened 99 percent of the time. [The dollar value at risk] wasn’t just the most you could lose 99 percent of the time. It was the least you could lose 1 percent of the time. In the bubble, with easy profits being made and risk having been transformed into mathematical conceit, the real meaning of risk had been forgotten. Instead of scrutinizing VaR for signs of impending trouble, they took comfort in a number and doubled down, putting more money at risk in the expectation of bigger gains. “It has to do with the human condition,” said one former risk manager. “People like to have one number they can believe in.”

. . . “You absolutely could see it coming. You could see the risks rising. However, in the two years before the crisis hit, instead of preparing for it, the opposite took place to an extreme degree. The real trouble we got into today is because of things that took place in the two years before, when the risk measures were saying that things were getting bad.”

At most firms, risk managers are not viewed as “profit centers,” so they lack the clout of the moneymakers on the trading desks. That was especially true at the tail end of the bubble, when firms were grabbing for every last penny of profit.


http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?pag...
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