...including those that have won Nobel Pizes.
I know this, and, apparently, Nassim Taleb and Pablo Triana do also.
They write in FT:
A crime has been committed. Yes, we insist, a crime. There is a victim (the helpless retirees, taxpayers funding losses, perhaps even capitalism and free
society). ... And there was a robbery (overcompensated bankers who got fat bonuses hiding risks; overpaid quantitative risk managers selling patently bogus methods). ...
Almost everyone in risk management knew that quantitative methods –like those used to measure and forecast exposures, value complex derivatives and assign credit ratings – did not work... Almost everyone would accept that the failure in 1998 of Long Term Capital Management discredited the quantitative methods of the Nobel economists involved with it (Robert Merton and Myron Scholes) and their school of thought called “modern finance”. LTCM was just one in hundreds of such episodes.
Yet a method heavily grounded on those same quantitative and theoretical principles, called Value at Risk, continued to be widely used. It was this that was to blame for the crisis. ... Indeed, the same Nobel economists who helped blow up the system at least once, Professors Scholes and Merton, could be seen lecturing us on risk management, to the ire of one of the authors of this article. Most poignantly, the ... regulators were using the same arguments. They, too, were responsible.
So how can we displace a fraud? Not by preaching nor by rational argument (believe us, we tried). Not by evidence. Risk methods that failed dramatically in the real world continue to be taught to students in business schools... As we are writing these lines, close to 100,000 MBAs are still learning portfolio theory... The fraud can be displaced only by shaming people, by boycotting the orthodox financial economics establishment and the institutions that allowed this to happen. ...
So when you see a quantitative “expert”, shout for help, call for his disgrace, make him accountable. Do not let him hide be-hind the diffusion of responsibility. Ask for the drastic overhaul of business schools (and stop giving funding). Ask for the Nobel prize in economics to be withdrawn from the authors of these theories, as the Nobel’s credibility can be extremely harmful. Boycott professional associations that give certificates in financial analysis that promoted these methods. Remove Value-at-Risk books from the shelves – quickly. Do not be afraid for your reputation. Please act now. Do not just walk by. Remember the scriptures: “Thou shalt not follow a multitude to do evil.”
Their risk management failed because they were not based on accurate information. How can you manage debt risk accurately when you don’t know accurate information about the debt. For example if you are doing risk management on debt that was based on South Florida real estate then you need to be knowledgeable on that debt, but instead the people doing this risk management relied on information from the RE industry. The RE industry gave out inflated RE values and inflated income for the buyers, the bankers gave out inflated bond values based on the inflated information and the rating agencies gave out inflated bond ratings, that is because they were all trying to sell and salesmen are not the best place to get accurate information on the product being sold.
ReplyDeleteIt does not matter what kind of risk management you do if you don’t insure that the information you are using is good, if you don’t, you end up with garbage in garbage out. How many of these risk managers visited such places as South Florida and looked at the high RE prices and the low incomes of the buyers, how many looked at the huge amount of speculation and flipping, how many looked at the huge volume of new RE coming on line to flood the market. Instead of looking at reality they looked at computer programs some of which were so badly written that they only had RE prices going up forever.
So I am betting that the worse part of these quantitative risk systems is that they blind people to the need to look at fundamentals and reality and instead rely on a system which will magically eliminate risk.
DJ