Financial Crisis

THE REAL CAUSES OF THE FINANCIAL CRISIS A Max Capital presentation

MANY CAUSES HAVE BEEN NAMED: CDO’s R UBLIC S REPU CANS DEM RATS D OCR S D short S sellers ’s THE FED s GREEDY EXECUTIVES REAL ESTATE SPECULATORS

But there are SYSTEMIC reasons for the crisis:

1.INCENTIVES

1.INCENTIVES 2.RISK 2 RISK MANAGEMENT

1.INCENTIVES 2.RISK 2 RISK MANAGEMENT 3.COMPLEXITY

misaligned INCENTIVES were pervasive

If you give i a mouse a cookie…

If you give i a mouse a cookie… he’s going to t wantt some milk.

(i.e.) When you give someone something, g,

(i.e.) it will drive and shape their behavior.

Bad incentives were everywhere… MORTGAGE EXECUTIVES BROKERS RATING HOME BUYERS AGENCIES

There was IMME ATE no l-i-n-k EDIA AC ONS CTIO S between FUTURE and CONSEQUENCES

Giving a manager part of the profits may not sound b d d bad…

But when they aren’t punished for t ki f taking long-term risks… l t ik

then that’s what they’ll do. And the th company will pay the price. ill th i

companies d d ’t didn t MANAGE RISK correctly tl

One example is Value at Risk

The VaR analysis y tries to give the firm a look at how much risk it’s taking.

It starts with the analysis of historical data & statistics

The data is then run through a bunch of advanced models

The final result is a $ amount for a certain percentile & time

This means that 98% of the time time, y your investments won’t lose over $20 million in a one-month p period

There are 3 reasons why VaR causes problems: bl

Keep in mind that ALMOST ALL financial firms use VaR to manage risk

1 st We’re not very good at judging extremely rare risks

1 st For example, we can guess the odds of rain tomorrow fairly well

1 st But the odds of an earthquake will be much less accurate

1 st Without Witho t the ability to abilit judge these rare risks, the VaR models aren’t very useful

2 nd Historical data Hi t i l d t doesn’t necessarily predict future returns

2 nd Garbage in, garbage out. in ot

3 rd VaR ignores the worst- worst case scenario So losses could be:

3 rd And this loss could wipe the p company out

COMPLEXITY is one of the biggest f gg problems of the market

Some ENGINEERING concepts can help explain the issue p

TIGHT COUPLING: Every component is tightly linked

When something is TIGHTLY COUPLED, it provides no slack if there is a problem, problem AND NO OPPORTUNITY TO INTERVENE.

LIKE AN ASSEMBLY LINE...

OR MAKING BREAD. BREAD (once the yeast is added)

INTERACTIVE COMPLEXITY:

INTERACTIVE COMPLEXITY: A complex system with components that interact in unexpected ways

A university is complex, but not tightly coupled

There are many components that interact, but not a lot of problems. There is plenty of slack and time to fix any issues.

THE PROBLEM IS WHEN SOMETHING IS BOTH INTERACTIVELY COMPLEX AND TIGHTLY COUPLED

A NUCLEAR REACTOR IS ANOTHER GOOD EXAMPLE EXAMPLE.

It’s EXTREMELY COMPLEX. C-H-A-I-N Any problem REACTION can cause a DESTROYS that and POISONS the system the surrounding area.

SOUND FAMILIAR

FINANCIAL MARKETS are another perfect example. example

FINANCIAL MARKETS WILL NEVER BE SIMPLE

HOWEVER, HOWEVER COMPLEXITY LESS WILL CRISISMORE RARE MAKE A EASIER TO AND SOLVE

So, as long as these PROBLEMS aren’t solved: ld

1.INCENTIVES 2.RISK 2 RISK MANAGEMENT 3.COMPLEXITY

THERE WILL BE MORE MELTDOWNS O OW S IN THE FUTURE (They might look different, but the t th outcome will be similar) ill b i il )

CREDITS Slide 40 Charlie Chaplin ( Slid 40: Ch li Ch li (www.doctormacro1.info) d 1i f ) Slide 44: UCLA (knifetricks.blogspot.com) Slide 45: Harvard (outdoors.webshots.com/photo/1180073619050918329ZHUCAf ) p Slide 47: Courtesy of Boeing Slide 52: NYSE (www.cnn.com/CNN/Programs/anderson.cooper.360/blog/archives/2008_ 01_01_ac360_archive.html) 01 01 ac360 archive html) CONCEPT RESOURCES Rebonato, Riccardo. Plight of the Fortune Tellers. Princeton: Princeton University Press, 2007. Bookstaber, Richard. Bookstaber Richard A Demon of Our Own Design. Hoboken: John Wiley & Sons, Design Sons 2007.

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Financial Crisis

by Max Olson on Jan 28, 2009

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