Greenspan: No Perfect Model of Risk

Teresa, March 17, 2008 @ 2:54AM ET | Link | RSS | Read via Email | 3 Comments  

Former FOMC Chairman Greenspan wrote a lengthy article in today’s Financial Times:

greenie.jpgCredit market systems and their degree of leverage and liquidity are rooted in trust in the solvency of counterparties. That trust was badly shaken on August 9 2007 when BNP Paribas revealed large unanticipated losses on US subprime securities. Risk management systems - and the models at their core - were supposed to guard against outsized losses. How did we go so wrong?

The essential problem is that our models - both risk models and econometric models - as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality. A model, of necessity, is an abstraction from the full detail of the real world. In line with the time-honoured observation that diversification lowers risk, computers crunched reams of historical data in quest of negative correlations between prices of tradeable assets; correlations that could help insulate investment portfolios from the broad swings in an economy. When such asset prices, rather than offsetting each other’s movements, fell in unison on and following August 9 last year, huge losses across virtually all riskasset classes ensued.

The most credible explanation of why risk management based on state-of-the-art statistical models can perform so poorly is that the underlying data used to estimate a model’s structure are drawn generally from both periods of euphoria and periods of fear, that is, from regimes with importantly different dynamics.

Also by Greenspan: The Roots of the Mortgage Crisis

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  1. Damian on March 17th, 2008 8:36 AM

    A bit of a joke, no? This was the guy that:

    - Opposed any regulation on mortgages.
    - Suggested that Americans should take advantage of the great ARMs out there.
    - Kept interest rates too low for too long, thus creating the real estate bubble to replace the Nasdaq bubble.

    Seems to me he’s talking about the failure of risk models while he should be talking about asymmetric risk structures and just plain o’ greed.

    Now do I think the models are too simple? Yes, absolutely - it is very difficult to model for long tail events. But it doesn’t take a model to tell you that being 32x leveraged is a bad idea.

  2. Teresa on March 17th, 2008 10:05 AM

    As a Libertarian, I imagine that he doesn’t want to legislate stupdity and has confidence that over the long haul, markets are best left as free as possible; the irrational and greedy pay the price for their actions.

    30X leverage is indeed stupid, and that is what happens when people (hints: quants and FOREX traders) use a strategy that, to paraphrase Myron Scholes, makes only nickels. The only way to transform a 5 cents into a dollar is by levering it up 20X. Then lose their ass in the end.

  3. Damian on March 17th, 2008 11:06 AM

    Like most people on Wall Street, he’s all for market dynamics as long as it doesn’t hurt his friends. Wall Street is always shouting about someone being a communist but is the first to step up for a handout, with no consequences for anyone involved.

    Now, that being said, do I think that Bennie had a choice? Not really - but I do loath the bailout of numb-nuts who made every bad decision and now need $30b of our tax dollars to even make a deal happen.