German M.
Project Management & Risk Management and Basel II international experienced professional - Kondor +
Credit & Risk Management ... go Simple ?
What do you think …?
Rocket Science formulas, derivatives valuation, complex hedging based on option and swaps. Off-balance sheet and Balance “Picasso’s” … tax cuts, soft regulation…AND
Money for everybody
Or just…back to simple way:
Strong regulation based on simple things IE reduce Banks debt to capital ratio, limit and reduce off-balance sheet (meaning those “Picasso’s”), to have registered derivatives products as they are, because MANY times Futures / Swaps supposed to be a Hedging position actually give a open risk position, Then Banks have lend money very conservatively. After that you can apply much complex analysis over Credit and Market positions based on a true balance sheet.
German
Answers (12)
German - Quotation from a recent White Paper may help answer;-
"One of the primary causes of the Credit Crunch (CC) was the failure to comprehensively compute risk capital in structured instruments. It is clear however that these products cannot be abandoned entirely since that would send the banking industry and the wider economy back to a prehistoric wilderness.
We are systemically dependent upon innovations in financial technology now. Computation of risk capital in an holistic and comprehensive manner is the key to recovery from this crisis episode."
Referential Tags are Associated!
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Ajay W.
Project and Business advisory services.
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I am in favor of the simple way ... the quants have made things so complex as to be incomprehensible to the average person. Clean, transparent reporting with a large piece of common sense will make for far more efficient risk management and reduce the risk that financial institutions are exposed to.
All models have limitations and this should be understood by the users, who should not place blind reliance on the numbers, instead use them as one of the tools available for a proper appreciation of the risk that the organization is exposed to.
The rule of thumb should be "If you can't price it, you can't trade it". Vanilla options, swaps and credit default swaps are simple enough to lend themselves to a simple explanation and relatively transparent treatment. Exotic derivatives should be treated with utmost care as they tend to blow up unexpectedly. Rocket science is only as good as the data you put in.
I am also in favor of the simple way. However, to have it work we need to look again at accounting standards and their role in this crisis. Clearly they allowed sale treatment and off-balance sheet reporting for instruments with a lot of tail risk. I'm thinking of the subprime mortgage industry, which touched this whole crisis off. There was far too much repurchase risk to allow sale and revenue recognition in hindsight. Without sale treatment the balance sheet would have reflected a more accurate picture of the risk and thus more capital would have been necessary, or originations would have been forced to slow down for the same capital levels. Without a clearer picture of the debt and capital levels as is truly inherent in the business, a ratio is not worth much. If I were the ruler of the world, I would force a rethinking of accounting and reporting standards.
Lynn W.
virtualization since Jan68, online at home since Mar70
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How Wall Street Lied to Its Computers
http://bits.blogs.nytimes.com/2008/09/18/how-wall-streets-quants-lied-to-their-computers/
Subprime = Triple-A ratings? or 'How to Lie with Statistics'
http://www.bloggingstocks.com/2007/07/25/subprime-triple-a-ratings-or-how-to-lie-with-statistics/
And even with SOX ... it doesn't seem to have reduced such activity ... pbs program discussing some of the deregulation, enron, worldcom, repeal of Glass-Steagall, etc
http://www.pbs.org/wgbh/pages/frontline/shows/wallstreet/
GAO numbers seemed to show activity is increasing (in spite of SOX)
http://www.gao.gov/special.pubs/gao-06-1079sp/index.html
from above:
The database consists of two files: (1) a file that lists 1,390 restatement announcements that we identified as having been made because of financial reporting fraud and/or accounting errors between July 1, 2002, and September 30, 2005, and (2) a file that lists 396 restatement announcements that we identified as having been made because of financial reporting fraud and/or accounting errors between October 1, 2005, and June 30, 2006.
... snip ...
The crash of 2008: A mathematician's view
http://www.eurekalert.org/pub_releases/2008-12/w-tco120808.php
from above:
Markets need regulation to stay stable. We have had thirty years of financial deregulation. Now we are seeing chickens coming home to roost. This is the key argument of Professor Nick Bingham, a mathematician at Imperial College London, in an article published today in Significance, the magazine of the Royal Statistical Society.
... snip ..
Corporate Fraud and Misconduct Risks Driven by Pressure to do 'Whatever It Takes'; Fewer episodes reported by companies with ethics and compliance programs
http://www.financetech.com/news/showArticle.jhtml?articleID=212501185
from above:
Of more than 5,000 U.S. workers polled this summer, 74 percent said they had personally observed misconduct within their organizations during the prior 12 months, unchanged from the level reported by KPMG survey respondents in 2005. Roughly half (46 percent) of respondents reported that what they observed "could cause a significant loss of public trust if discovered," a figure that rises to 60 percent among employees working in the banking and finance industry.
... snip ...
If the overall avg. is 46percent and the financial industry is 60 percent, then the non-financial avg may be as low as 30percent ... making the financial industry twice as bad as other industries.
The congressional hearings last fall highlighted that both the rating agencies and the toxic CDO issuers/sellers knew that the toxic CDOs weren't worth triple-A ratings ... but the toxic CDO issuers/sellers were paying for the triple-A ratings. This significantly increased the institutions that would deal in the toxic CDOs and correspondingly significantly increased the amount of money available for lending. In the hearings they noted that in the early 70s, the rating agencies switched from buyers paying for the rating to the sellers/issuers ... resulting in misaligned business process and opening the way for conflict of interest.
A combination of deregulation and not enforcing regulations resulted in numerous greed/corruption hot-spots to combine together into an economic firestorm.
Many of the institutions buying the toxic CDOs were playing long/short mismatch ... which has been known for centuries to take down institutions. The comment was that Bear-Stearns and Lehman had marginal chance of surviving playing long/short mismatch (independent of the heavy leveraging and whether or not the toxic CDOs were worth triple-A rating) ...
http://www.forbes.com/entrepreneursfinance/2007/11/13/citigroup-suntrust-siv-ent-fin-cx_bh_1113hamiltonmatch.html
and decade old article from the fed
http://www.frbsf.org/econrsrch/wklyltr/2000/el2000-26.html
Clarification added January 31, 2009:
A couple recent posts mentioning IDC buying "pricing services" division from one of the rating agencies in 1972 ... and there was TV business news show earlier this month mentioning that IDC was helping price the toxic assets that gov. was looking at buying:
http://www.garlic.com/~lynn/2009.html#21
http://www.garlic.com/~lynn/2009.html#31
http://www.garlic.com/~lynn/2009.html#32
'72 was in the period that the congressional hearings mentioned that the rating agencies' business process became misaligned (switching from the buyers paying for ratings to the sellers/issuers paying for the ratings, and increasing the potential for conflict of interest).
disclaimer: i interviewed with IDC in '69 ... but didn't join the organization ... although I continued to have contact with several of the people.
The Man Who Beat The Shorts
http://www.forbes.com/personalfinance/global/2008/1124/042.htm
from above:
Watsa's only sin was in being a little too early with his prediction that the era of credit expansion would end badly. This is what he said in Fairfax's 2003 annual report: "It seems to us that securitization eliminates the incentive for the originator of [a] loan to be credit sensitive. Prior to securitization, the dealer would be very concerned about who was given credit to buy an automobile. With securitization, the dealer (almost) does not care."
... snip ...
Not so much debt itself ... but securitization (along with the rating agencies giving triple-A ratings to toxic CDOs) resulted in huge amount of money being pumped into the lending market ... with nobody caring how it was being used (people lending the money could immediately unload as a toxic CDO ... so regardless of what happened later, every loan made was profit).
No documentation, no-down-payment, 1% introductory rate ARMs with
interest-only payments, became extremely attractive for speculators
since the carrying cost was significantly less than the home appreciation in numerous markets (planning on flipping before the rate reset). the large amount of speculation, in turn, significantly increased the inflation in the market. eventually the bubble bursts but while it lasted ... lots of people were raking in the money (in some sense, the 1% funds were allowing speculators to treat the home market like the 1920s unregulated stock market)
Clarification added January 31, 2009:
Last spring there was business school article about the effects of securitization (this was before the congressional hearings about rating agencies knew that the toxic CDOs weren't worth triple-A ratings) and estimated that possibly 1000 executives are responsible for 80% of the current mess (and it would go a long way to fixing the situation if the gov. could figure out how they could loose their jobs)
http://knowledge.wharton.upenn.edu/article.cfm?articleid=1933
and decade old, long winded post discussing some of the current issues
http://www.garlic.com/~lynn/aepay3.htm#riskm
Clarification added February 1, 2009:
Also, with regard to the triple-A ratings on toxic CDOs, supposedly SOX required SEC to do something with respect to the rating agencies ... but there doesn't seem to have been anything besides a Jan2003 report.
Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets; As Required by Section 702(b) of the Sarbanes-Oxley Act of 2002
http://www.sec.gov/news/studies/credratingreport0103.pdf
In Dec, CSPAN had a panel from the mortgage industry. They appeared to be somewhat torn between claiming the problems are because the people in the mortgage industry are ignorant and totally incompetent vis-a-vis they just ignored all prudent business processes. They also mentioned that only about 10% of the subprime, no-documentation, no-down, 1% interest only ARM loans could be considered falling into the CRA category (large percentage picked up by speculators that could treat home market like the unregulated 1920s stock market).
These were subprime in another sense. With securitization, they could make loans with 1% interest rates ... totally decoupled from the FED PRIME rate. In the past, loans were by regulated financial institutions using deposits. With securitization, unregulated institutions could get into the loan business.
Do a graph of avg. home prices as well as ratio of avg. home prices to avg. salary ... plotted since 1970. The graph is reasonably well behaved until a couple yrs ago when huge pimple/boil starts to spike (speculators taking advantage of 1% interest only ARMs, basically home market acting like the unregulated 1920s stock market) ... which still hasn't completely deflated (totally outside the traditional CRA market of first-time, low-income home buyers)
The spike in home market somewhat corresponds with:
The Fed's Too Easy on Wall Street
http://www.businessweek.com/investor/content/mar2008/pi20080318_697440.htm?chan=top+news_top+news+index_businessweek+exclusives
from above:
Here's a staggering figure to contemplate: New York City securities industry firms paid out a total of $137 billion in employee bonuses from 2002 to 2007, according to figures compiled by the New York State Office of the Comptroller. Let's break that down: Wall Street honchos earned a bonus of $9.8 billion in 2002, $15.8 billion in 2003, $18.6 billion in 2004, $25.7 billion in 2005, $33.9 billion in 2006, and $33.2 billion in 2007.
... snip ...
and some part of the $700B wallstreet bailout possibly goes to replenish the $137B sucked out of the infrastructure (as reward for their part in creating the current situation).
... from a couple weeks ago
Bailed-Out Banks Dole Out Bonuses; Goldman Sachs, CitiGroup, Others Mum on How They Are Using TARP Cash
http://abcnews.go.com/WN/Business/story?id=6498680&page=1
from above:
Goldman Sachs, which accepted $10 billion in government money, and lost $2.1 billion last quarter, announced Tuesday that it handed out $10.93 billion in benefits, bonuses, and compensation for the year.
... snip ...
and more recent ...
Obama Calls Bonuses 'Shameful' as Dodd Vows to Reclaim Money
http://www.bloomberg.com/apps/news?pid=20601087&sid=anzJooSeABDM
Obama: Big Wall Street Bonuses 'Shameful'
http://voices.washingtonpost.com/economy-watch/2009/01/obama_big_wall_street_bonuses.html
Dimitri V.
EM quant Вулис ווּליס Վուլիս Ⴅულის ﻭﻠﻴﺺ ヴリシ वूलीस् 울잇
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I agree with German! If something doesn't pass the smell test, then it shouldn't be traded, no matter what an esoteric model says. All that smoke and mirrors have caused too much real misery.
Alan C.
International Business Development Sales Director - Salesforce Certified Admin: ICT Software Services B2B Specialist
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A 1% tax or leavy on "contracts for differance"
Watch the meet Terry video on www.processmaster.com to see what i mean
Links:
Bernard G.
Programme, Project & Change expert
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Nice idea, but utterly impractical. Banks and banking are global - if one country adopted your idea then it would give massive benefit to banks elsewhere who weren't so restricted, so the local banks and economy would decline and ultimately collapse.
James C B.
JCB Capital Performance - Personal Wealth Management, Asset Manager, Financial Planner, Wealth Adviser
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Hi German,
See:
http://en.wikipedia.org/wiki/Basel_III
http://www.bis.org/bcbs/basel3.htm
JC Brandon
Links:
Adeel T. suggests this expert on this topic:
John C.
Quantitative Analyst - Credit Risk
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I'm afraid that I've a bit of a conflict here: I agree with both the positions!
As a quant, it's important that we can measure risk - not only for commercial purposes but also for academic interest.
If, on the other hand, the risk isn't easy to understand or - better - easy to articulate to a lay person then it's too complex.
I would have to say bit of both.
a) Why did it turn all complex? - A majority of my thoughts are pointing towards greed and being impatient. Bankers earlier had a very simple way of doing banking, but offlate the madness to make money out of even a dollar is catching up as a trend named "value for money".
b) When I can hedge then why suffer? - When it was simple, the concept of financial inclusion was a dream. Rich would continue to be rich and poor remain to be poor. With increasing knowledge to investors, bankers are pushed to a corner to develop ways and means to offer value added services of investments. There is a huge competition in the return on investment market - My yield is better than yours.
c) Increasing frauds/ill practises - Organizations are today compelled to develop their systems, processes & control procedures to beat any possible fraud. Obviously this added numerous layers & functions in the system keeping in mind added security to prevent siphoning off of funds.
d) Market expectations - As an investor you are looking at making more money without having to work for it. Your bankers are betting on behalf of your surplus funds to invest and give you greater return. They see you as a cash cow. Keeping your expectations and continuing to beat it positively has become a mandatory requirement to stay afloat.
But I really wish, it was like golden olden days.
