Financial Crisis

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

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Financial Crisis

  1. THE REAL CAUSES OF THE FINANCIAL CRISIS A Max Capital presentation
  2. 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
  3. But there are SYSTEMIC reasons for the crisis:
  4. 1.INCENTIVES
  5. 1.INCENTIVES 2.RISK 2 RISK MANAGEMENT
  6. 1.INCENTIVES 2.RISK 2 RISK MANAGEMENT 3.COMPLEXITY
  7. misaligned INCENTIVES were pervasive
  8. If you give i a mouse a cookie…
  9. If you give i a mouse a cookie… he’s going to t wantt some milk.
  10. (i.e.) When you give someone something, g,
  11. (i.e.) it will drive and shape their behavior.
  12. Bad incentives were everywhere… MORTGAGE EXECUTIVES BROKERS RATING HOME BUYERS AGENCIES
  13. There was IMME ATE no l-i-n-k EDIA AC ONS CTIO S between FUTURE and CONSEQUENCES
  14. Giving a manager part of the profits may not sound b d d bad…
  15. But when they aren’t punished for t ki f taking long-term risks… l t ik
  16. then that’s what they’ll do. And the th company will pay the price. ill th i
  17. companies d d ’t didn t MANAGE RISK correctly tl
  18. One example is Value at Risk
  19. The VaR analysis y tries to give the firm a look at how much risk it’s taking.
  20. It starts with the analysis of historical data & statistics
  21. The data is then run through a bunch of advanced models
  22. The final result is a $ amount for a certain percentile & time
  23. This means that 98% of the time time, y your investments won’t lose over $20 million in a one-month p period
  24. There are 3 reasons why VaR causes problems: bl
  25. Keep in mind that ALMOST ALL financial firms use VaR to manage risk
  26. 1 st We’re not very good at judging extremely rare risks
  27. 1 st For example, we can guess the odds of rain tomorrow fairly well
  28. 1 st But the odds of an earthquake will be much less accurate
  29. 1 st Without Witho t the ability to abilit judge these rare risks, the VaR models aren’t very useful
  30. 2 nd Historical data Hi t i l d t doesn’t necessarily predict future returns
  31. 2 nd Garbage in, garbage out. in ot
  32. 2 nd Garbage in, garbage out. in ot
  33. 3 rd VaR ignores the worst- worst case scenario So losses could be:
  34. 3 rd
  35. 3 rd And this loss could wipe the p company out
  36. COMPLEXITY is one of the biggest f gg problems of the market
  37. Some ENGINEERING concepts can help explain the issue p
  38. TIGHT COUPLING: Every component is tightly linked
  39. When something is TIGHTLY COUPLED, it provides no slack if there is a problem, problem AND NO OPPORTUNITY TO INTERVENE.
  40. LIKE AN ASSEMBLY LINE...
  41. OR MAKING BREAD. BREAD (once the yeast is added)
  42. INTERACTIVE COMPLEXITY:
  43. INTERACTIVE COMPLEXITY: A complex system with components that interact in unexpected ways
  44. A university is complex, but not tightly coupled
  45. There are many components that interact, but not a lot of problems. There is plenty of slack and time to fix any issues.
  46. THE PROBLEM IS WHEN SOMETHING IS BOTH INTERACTIVELY COMPLEX AND TIGHTLY COUPLED
  47. A NUCLEAR REACTOR IS ANOTHER GOOD EXAMPLE EXAMPLE.
  48. It’s EXTREMELY COMPLEX. C-H-A-I-N Any problem REACTION can cause a DESTROYS that and POISONS the system the surrounding area.
  49. SOUND FAMILIAR
  50. FINANCIAL MARKETS are another perfect example. example
  51. FINANCIAL MARKETS WILL NEVER BE SIMPLE
  52. HOWEVER, HOWEVER COMPLEXITY LESS WILL CRISISMORE RARE MAKE A EASIER TO AND SOLVE
  53. So, as long as these PROBLEMS aren’t solved: ld
  54. 1.INCENTIVES 2.RISK 2 RISK MANAGEMENT 3.COMPLEXITY
  55. 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 )
  56. 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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