Financial Crisis

THE REAL CAUSES OF THE

FINANCIAL CRISIS A Max Capital presentation

DEM OCR D RATS S

CDO’s D short S sellers ’s s THE FED

R UBLIC REPU CANS S

MANY CAUSES HAVE BEEN NAMED:

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 t wantt to some milk.

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

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

Bad incentives were everywhere…

EXECUTIVES

MORTGAGE BROKERS

RATING AGENCIES

HOME BUYERS

AC CTIO ONS S

IMME EDIA ATE

and

There was no l-i-n-k between

FUTURE

CONSEQUENCES

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

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

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

companies didn d d ’tt 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, your investments y 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

st 1

We’re not very good at judging extremely rare risks

st 1

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

st 1

But the odds of an earthquake will be much less accurate

st 1

Withoutt the ability Witho abilit to judge these rare risks, the VaR models aren’t very useful

nd 2

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

nd 2

Garbage in, in garbage out. o t

nd 2

Garbage in, in garbage out. o t

rd 3

VaR ignores the worstworst case scenario So losses could be:

rd 3

rd 3

And this loss could wipe p the company out

COMPLEXITY

is one off the biggest gg problems of the market

Some ENGINEERING concepts can help explain p the issue

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...

BREAD OR MAKING 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. Any problem can cause a

C-H-A-I-N REACTION

DESTROYS the system and POISONS that

the surrounding area.

SOUND FAMILIAR

FINANCIAL MARKETS are another perfect example. example

FINANCIAL MARKETS WILL NEVER BE SIMPLE

HOWEVER, HOWEVER LESS

COMPLEXITY

WILL MAKE A AND

CRISIS EASIER

MORE RARE TO SOLVE

So, as long as these

PROBLEMS

aren’t solved: l d

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

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

CREDITS Slide 40: Slid 40 Charlie Ch li Chaplin Ch li (www.doctormacro1.info) ( d 1i f ) Slide 44: UCLA (knifetricks.blogspot.com) Slide 45: Harvard p ) (outdoors.webshots.com/photo/1180073619050918329ZHUCAf 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. Design Hoboken: John Wiley & Sons, Sons 2007.