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Financial Crisis

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The real causes of the financial crisis: incentives, risk management, and complexity.

The real causes of the financial crisis: incentives, risk management, and complexity.

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  • This website can be a useful resource to find out what started the financial crisis http://www.financialcrisis2009.org
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    Financial Crisis Financial Crisis Presentation Transcript

    • 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
    • 2 nd Garbage in, garbage out. in ot
    • 3 rd VaR ignores the worst- worst case scenario So losses could be:
    • 3 rd
    • 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.