The myth of the riskometer

Jon Danielsson, in VoxEU.org (excerpted for length):

There is a widely held belief that financial risk is easily measured – that we can stick some sort of riskometer deep into the bowels of the financial system and get an accurate measurement of the risk of complex financial instruments. Such misguided belief in this riskometer played a key role in getting the financial system into the mess it is in.

Unfortunately, the lessons have not been learned. Risk sensitivity is expected to play a key role both in the future regulatory system and new areas such as executive compensation.

We can create the most sophisticated financial models, but immediately when they are put to use, the financial system changes. Outcomes in the financial system aggregate intelligent human behaviour. Therefore attempting to forecast prices or risk using past observations is generally impossible.

The inaccuracy of risk modelling does not prevent us from trying to measure risk, and when we have such a measurement, we can create the most amazing structures – CDOs, SIVs, CDSs, and the entire alphabet soup of instruments limited only by our mathematical ability and imagination. Unfortunately, if the underlying foundation is based on sand, the whole structure becomes unstable. What the quants missed was that the underlying assumptions were false.

When complicated models are used to create financial products, the designer looks at historical prices for guidance. If in history prices are generally increasing and risk is apparently low, that will become the prediction for the future. Thus a bubble is created. Increasing prices feed into the models, inflating valuations, inflating prices more. This is how most models work, and this is why models are often so wrong.

In the same way it is so hard to measure risk, it is also easy to manipulate risk measurements. It is a straightforward exercise to manipulate risk measurements to give vastly different outcomes in an entirely plausible and justifiable manner, without affecting the real underlying risk. A financial institution can easily report low risk levels whilst deliberately or otherwise assuming much higher risk. This of course means that risk calculations used for the calculation of capital are inevitably suspect.

The myth of the riskometer is alive and kicking. In spite of a large body of empirical evidence identifying the difficulties in measuring financial risk, policymakers and financial institutions alike continue to promote risk sensitivity.

The reasons may have to do with the fact that risk sensitivity is intuitively attractive, and the counter arguments complex. The crisis, however, shows us the folly of the riskometer. Let us hope that decision makers will rely on other methods.

(no subject)

Steven M. Davidoff, in the NYTimes DealBook blog (again, cut for length):

The government bailout of GMAC is a complicated affair, probably the most intricate government bailout to date — at least until the inevitable future workouts of General Motors and Chrysler.

The rescue of GMAC, which is G.M.’s financing arm, involves a debt exchange and cash offer, the reorganization of GMAC’s ownership structure, the partial severing of the exclusive G.M.-GMAC relationship, a government investment of up to $6 billion, and a redesignation of GMAC as a bank holding company, allowing it to tap into the aforementioned federal bailout funds via the Treasury’s Troubled Asset Relief Program (or more particularly, the freshly minted Automotive Industry Financing Program).

Like the bailout itself, this deal was never going to be pretty, but there are a number of things that taxpayers may find particularly irksome about this latest government action.

1. Easy Terms. Unlike other Treasury investments under the TARP, Treasury is not receiving warrants convertible into common equity of GMAC and so will receive no upside. Instead, the best Treasury can do on this deal is be paid back its investment plus interest.

The end result is that GMAC and its owners — Cerberus Capital Management, Cerberus’s limited partners and G.M. — will be able to receive the full benefit of any subsequent turnaround, with the government and taxpayer bearing the significant risk.

2. Ford’s Penalty. The day after the completion of the infusion, General Motors announced “Significant New Loan Financing as Low as 0% APR” and GMAC lowered its credit score for financing to 621, which is one point above what is generally considered a subprime loan. Both entities asserted that these new offers were made possible by the government bailout. Of course, the sales that G.M. reaps on the government’s financing subsidy will come at the expense of Ford and the transplant automakers. Notably, Ford has refused government funds so far and is now being penalized at taxpayer expense. How about them apples?

3. The SUV Sale. The list of cars for which G.M. is offering this special financing can be accessed here. Note that the best deals at 0 percent financing are for the 2008 Chevrolet TrailBlazer; GMC Envoy; and Saab 9-3, 9-5, 9-7X. The Trailblazer and GMC Envoy are SUVs, and Saabs are made abroad in Sweden.

According to Yahoo’s auto Web site, the mile-per-gallon EPA rating for the Envoy SLE-1 4WD is 15 in the city, 21 on the highway. The rest of the list is loaded up with similar brands including the Hummer 2 & 3. This financing appears to be going to support sales of less-efficient gas vehicles and cars made outside the United States. I suppose that is fine, as this will clear out G.M.’s inventory in sales to relatively risky borrowers, but it can’t make the Democrats particularly happy — nor does it appear in line with the environmentalist credo G.M. was spouting at the second round of Congressional hearings.

4. Bank Holding Company Status. Under the Bank Holding Company Act, to be a bank holding company, a company must be “well capitalized” — this generally means that its Tier 1 risk-based capital ratio must exceed 6 percent — and be “well managed.” GMAC was allowed to assume this status on an emergency, expedited basis. Make your own judgments on this one.

5. The Merkin Factor. By all public accounts, J. Ezra Merkin is still a member and chairman of the GMAC board. Mr. Merkin, as you may know, headed up Ascot Partners, a feeder fund to Bernie Madoff’s fund. Mr. Merkin was also supposedly responsible for Yeshiva University’s investment with Mr. Madoff and subsequent loss of $14.5 million ($110 million if you include the lost profits, but apparently, some inexplicably don’t.) Mr. Merkin at least has resigned from the board of Yeshiva University. Here, there was no word.

6. Equity. In connection with the transaction, G.M. is investing up to another $1 billion in equity in GMAC. The money for this is coming from Treasury in the form of a loan at 3 percent over the greater of three-month LIBOR or 2 percent. This loan is securitized by G.M.’s interest in GMAC and nothing more. More risk for the government on this deal.

Moreover, the auto industry bailout reflects the political nature of the TARP program. Initially, Treasury Secretary Henry Paulson Jr. submitted a three-page bill that allowed him to purchase mortgage-related assets. Some members of Congress threw a hissy fit, describing this as a power grab, and then proceeded to give Mr. Paulson more power than he asked for. The final bill provided Treasury the power to purchase securities in any institution established and regulated under the laws of the United States or any state.

At the time, I predicted that this large grant of discretion would result in bailout creep. And sure enough, here we are.

With this ad hoc approach to the automakers, the government risks losing its objective for meaningful reform of these institutions. The interests involved (management, labor, dealers, suppliers) know full well that the government is increasingly all-in on an auto bailout. This will make gaining concessions from them more difficult and result in only partial reform at best. After all, why sacrifice when the government has said it will back you anyway?

Remember how they predicted that the Madoff scandal was only the beginning?

Here's another.

From http://ftalphaville.ft.com/blog/2009/01/07/50849/from-the-desk-of-b-ramalinga-raju/:

The chairman of Satyam Computer Services, which ranks as India’s fourth-largest software operation, has fessed up to years of book-cooking. Shares in the company crashed 80 per cent on Wednesday, taking the wider Indian stock market down 7 per cent.

From his confession to the board of directors of Satyam:

It is with deep regret, and tremendous burden that I am carrying on my conscience, that I would like to bring the following facts to your notice...

The gap in the balance sheet has arisen purely on account of inflated profits over a period of last several years (limited only to Satyam standalone, books of subsidiaries reflecting true performance). What started as a marginal gap between actual operating profit and the one reflected in the books of accounts continued to grow over the years. It has attained unmanageable proportions as the size of company operations grew significantly (annualised revenue run rate of Rs 11,276 crore in the September quarter, 2008 and official reserves of Rs 8,392 crore).

The differential in the real profits and the one reflected in the books was further accentuated by the fact that the company had to carry additional resources and assets to justify higher level of operations - thereby significantly increasing the costs.

Every attempt made to eliminate the gap failed. As the promoters held a small percentage of equity, the concern was that poor performance would result in take-over, thereby exposing the gap. It was like riding a tiger, not knowing how to get off without being eaten.

Under the circumstances, I am tendering my resignation as the chairman of Satyam and shall continue in this position only till such time the current board is expanded. My continuance is just to ensure enhancement of the board over the next several days or as early as possible. I am now prepared to subject myself to the laws of the land and face consequences thereof.