Thursday, January 08, 2009

VaR: The Story of How the Best Wall-Street Minds Imploded the World’s Economy

VaR stands for Value at Risk. It’s a single number that can be calculated for any investment bank, trading desk, or individual trader using statistical methods worked out by physicists and mathematicians over a period of years (so the math is good). This number represents the maximum value that could be lost in a specified number of trading days – accurate 99% of the time irrespective of asset class – assuming “normal” market conditions inferred from performance in the recent past. As trading in derivatives exploded in the late 1990’s, the SEC allowed the use VaR calculations to disclose firm’s market risks, and soon thereafter an international rule-making board permitted banks to use their own internal VaR calculations to determine how much capital to set aside to cover their risks. Thus, industry-wide capitalization of their loans shrank ever smaller during the years when the still-inflating real estate bubble was interpreted as “normal.” In this time interval, firms took on ever more risk in their headlong race to increase their trading profits. To facilitate this insanity, they began to manipulate their VaRs by loading up with products that generate small gains but were (insanely) deemed unlikely to lead to losses. Foremost among these products were the credit default swaps (CDSs), a kind of insurance against losses due to defaults of their risky loans. The total CDSs issued summed to $45 trillion (roughly twice the size of the entire U.S. stock market) and subsequently rose to about $500 trillion in the course of totally unregulated trading (about 10 times the total value of the world’s stock and bond markets!). Like the story of “The Emperor’s New Clothes,” greedy bankers deluded themselves into believing they had bought themselves fool proof protection, whereas in fact they had left themselves completely naked to bankruptcy. Unfortunately for us ordinary taxpayers, however, the greedy perps usually seem to hold on to their ill-gotten riches, leaving us to pay the tab.

In a recent New York Times essay, Joe Nocera does an outstanding job of relating the story of VaR in layman’s terms, yet allowing physicists to understand how their fine math was misused to bring about the presently unfolding financial meltdown. He doesn’t say much about the CDSs though, so you might also want to check here.

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