Tuesday, January 13, 2009

Black Swans And Dead Ducks?

Below is the response of a friend that I went to school with (7th grade thur college) that lives on the west coast and whose company is closely involved in writing software for the investment bankers on Wall Street and around the world. My original e-mail to him dealt with Value at Risk (VaR). The reason I am including his response in this post is because of what he has to say about systemic risk in the market because of the lack of regulation and transparency. Those that read MONEYTHOUGHTS know that I have been beating the drum about the need for more regulation, oversight, transparency and enforcement in the securities markets. Below is another man’s opinion who has been very successful in his business career and has been involved in creating models that deal with risk.

Hi Fred,

Just finished the Nocera article on risk management. Thanks for the heads-up
on the article.

It all makes sense -- the black swans are there (I was told the origin of
the term comes from medieval Europeans who couldn't conceive of the idea of
a black swan because they don't exist in Europe - but they do exist in
Australia). But it’s a real problem as the article says, if you believe in
black swans you'll never do a trade. It doesn't matter how many spinners
there are in your stress-testing model.

So you try and hedge with counterparties -- even against the black swan. But
it doesn’t work because the real source of risk is not the day-to-day
fluctuations in market values -- it's the more systemic problem of a
counterparty defaulting on its hedging contract with you. Then the whole
skein of contracts, like the credit default swaps, just unravels. As long as
there is no clearing house so that you can know your counterparty's
exposures, there's no way to know the value of your own net positions. In my
humble opinion we need more regulation and disclosure requirements.

And of course, the CEO's are going to hyper-leverage and go for broke. They
get huge real bonuses (even if their profits are just accounting figments)
and they get to keep them even after their firm's implode and they are
fired. Heads they win and tails their shareholders and creditors loose).

Thanks for reading my rant!

I love it when someone has something to say and says it. My old friend on the west coast is no exception when it comes to telling it like it is.

The battle lines have been drawn with regards to the issue of more comprehensive regulation, oversight, transparency and enforcement. Wall Street CEOs will fight against more regulation all the way. The politicians will do as little as they can get away with because Wall Street is a source of campaign contributions.

There are even those that say the Securities & Exchange Commission should be scraped and a new more comprehensive organization put together. Whether a two or three peak plan is adopted is only important if the plan has teeth and is backed with sufficient funds and personnel to do the job right.

That still leaves my favorite whipping boy, the rating agencies. Finally, someone besides myself has called them what they are, a failed state. The rating of debt paper must be picked up by some organization and my opinion is that the Federal Government is the best choice to do this necessary job right. The securitization of mortgages, car loans and credit card debt is not the problem. The problem arises when the ratings on this debt does not reflect the risk that they carry. If the mortgages are done right and are not a travesty, mortgage-backed bonds and other asset-backed paper has a place in the fixed-income section of a large and well diversified portfolio.

Bringing back our economy and in turn helping the rest of the world’s economies get moving again will take more than low interest rates on U.S. Treasuries. The Federal Reserve Bank has already shot that arrow. It is time to realize that low interest rates are not the only problem in the capital markets system.

If my old friend on the west coast knows this and others are writing about this, how long will it take before those in Washington, D. C. open up their eyes?

Stay tuned.

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