So what prompted the composer of “The Black Swan” to button his shirt all the way up on that fall date? He had been invited to a very solemn venue by very distinguished hosts. And that was an invitation that Taleb had every intention of accepting. In fact, he had been waiting and expecting it for more than a decade. The raison d’etre of the event for which his company was now being required had been close to Taleb´s heart for most of his professional and intellectual life. It represented a central theme in his actions and ideas, close to an obsession. He had through the years incessantly warned as to the havoc that might be wreaked should others massively act in a manner counter to his convictions. Such concerns typically went unheeded (to the detriment, it turned out, of society), but now he was being offered a pulpit that seemed irresistible. This time, the world would have no option but to listen attentively.
As Taleb entered the Rayburn Building of the U.S. House of Representatives on Capitol Hill that September morning, he must have felt vindication. As he approached the sober room where several men and women awaited the start of the House Committee on Science and Technology´s hearing on the responsibility of mathematical model Value at Risk (VaR) for the terrible economic and financial crisis that had caused so much misery, Taleb probably reflected proudly on all those times when, indefatigably and in the face of harsh opposition, he alerted us of the lethal threat to the system posed by the widespread use of VaR in finance. Now that the damage wrought by VaR seemed so inescapably obvious that lawmakers had been motivated into investigating the device, Taleb no longer seemed like a lone wolf howling at the moon.
What is so wrong about VaR, and why was Taleb so concerned about its impact? More importantly, why should VaR be held responsible for the crisis? VaR is a number that purports to estimate future losses derived from a portfolio of financial assets, and presents two major problems: 1) it is doomed to being a very wrong estimate, because of its analytical foundations and the realities of real-life markets; 2) in spite of such (well-known) deficiencies, it has for the past two decades become an ubiquitously influential force in the financial world, capable of directing decision-making inside the most important banks. In other words, by letting trading activity be guided by VaR, we have essentially exposed our economic fate to a deeply flawed mechanism. Such flawedness, as was the case not only in this crisis but also before, can yield untold malaise.
One dimension in a 3D world
VaR is an untrustworthy measure of future market risk for one main reason: it is calculated by looking at the past. The upcoming risk of a trading asset (a stock, bond or derivative) is essentially assumed to mirror its behavior over the historical time period arbitrarily selected for the calculation (one year, five years, etc). If such past happened to be placid (no big setbacks, no undue turbulence) then VaR would conclude that we should rest easy, safe in the statistical knowledge that no nasty surprises await. For instance, in the months prior to the kick-start of the crisis in mid-2007, the VaR of the big Wall Street firms was relatively quite low, reflecting the fact that the immediate past had been dominated by uninterrupted good times and negligible volatility, particularly when it came to the convoluted, eventually lethal, mortgage-related securities that investment banks had been enthusiastically accumulating on their balance sheets. A one-day 95% VaR of $50 million was typical, and typically modest in its estimation of losses: at that level, a firm would be expected to lose no more than $50 million from its trading positions 95% of the time (in other words, it would be expected to lose more than $50 million only 12 days out of a year´s 250 trading days). Once we keep in mind that those Wall Street entities owned trading assets worth several hundred billion dollars and that the eventual setbacks amounted to several dozen billion dollars, we can appreciate that VaR´s predictions were excruciatingly off-base. The soulless data rearview mirror may have detected no risk, but that certainly did not mean that the system was not flooded with the worst kind of risk, ready to explode at any time. In finance, the past is simply not prologue, but someone forgot to tell VaR that.
Beware of the fat tails
The fact that the mathematical engineering behind VaR tends to assume that markets follow a normal probability distribution (thus assuming extreme moves to have negligible chance of happening, something obviously quite contrary to empirical evidence) can also contribute to the model churning unrealistically low numbers as big losses are ruled out, as can VaR´s reliance on the statistical concept of correlation, which calculates the future expected co-movement of different asset classes, based on how such co-dependence worked out in the past. If several assets in the portfolio happened to be uncorrelated or, better yet, “negatively correlated” in the past, VaR will take for granted that those exposures should cancel each other out, yielding lower overall portfolio risk estimates. However, as any seasoned trader would tell you, just because several assets were negatively correlated last year, we can´t imply that they won´t move in tandem (positively correlated, implying that chances are that they can all tumble concurrently, thus painting a much worse overall risk picture) next month. Market history is flooded with cases when assets that were supposed to move independent of each other all tanked at the same time. Correlation in finance simply can´t be captured mathematically.
As the alert reader may have by now noticed, the main problem with VaR is not so much that its forecasts won´t be accurate, but that it can be quite easy to get a VaR that´s very low. You just need a portfolio of assets that happened to have recently enjoyed benevolent calm and/or little correlation with each other. If you manage to compose such grouping, the model will yell to the world that you run a sound, riskless operation. That´s exactly what was taking place on Wall Street all those years prior to late 2007. According to VaR, the situation could not have been rosier and less worrisome, risk-wise.
Such misplaced generosity would not be a big concern if VaR did not play a relevant role in the markets. But, rather unfortunately, the tool could not have played a more decisive part. Simply put, VaR may have been the single most influential metric in the history of finance. No other single number ever impacted, shaped and disturbed market (and thus economic) activity as profoundly as it did. VaR´s perilously inexact estimations of risk mattered because the model mattered so much.
Invented by Wall Street in the late 1980s, VaR quickly became the accepted de rigour market risk measurement tool inside dealing floors around the globe. Trading decisions and traders’ compensation began to depend on what VaR said; if the number churned by the model was deemed unacceptably large, a trader would be asked to cut down his positions, if the number was deemed comfortably tame the trader would be assigned more capital. If he made good money while enjoying a low VaR, he would be considered a hero by his bosses, someone capable of bringing in big bucks in a (purportedly) risk-lite manner. Clearly, traders had every incentive to own portfolios endowed with low VaRs, and thus began a long-honored tradition to try and game the system into delivering subdued mathematical risk estimates. The pernicious effects of such gaming may have come fully home to roost during the credit crisis, two decades after the quantitative prodigal son was first allowed to infiltrate us.
VaR´s reputation as a risk measurement tool certainly has taken a big hit during the recent malaise. During the nightmarish days that saw the eruption of the worst financial meltdown in eight decades, the device insultingly misbehaved as a warning signal when it came to the fallen financial giants. The real losses witnessed were way above the predicted theoretical losses, and VaR numbers were breached far more abundantly than what the model would dictate.
Take Swiss giant UBS, a very prominent victim of the crash. It reported 50 VaR exceptions for 2008 and 29 for 2007. At the 99% confidence level chosen by UBS, there should have only been about 2.5 exceptions (trading days when actual losses exceeded VaR´s predictions) per year. Or take local rival Credit Suisse. The Zurich powerhouse experienced 25 and nine VaR exceptions in 2008 and 2007, respectively; also at 99% confidence, this implies above six times more real losses than theoretically forewarned. It seems unnecessary to state that VaR did not properly warn the Helvetians during the unfolding of the bloodbath.
And you didn´t need to be based in a neutral country with magnificent ski slopes and exquisite private bankers in order to experience your own dose of VaR disillusionment. Perhaps it shouldn´t be exceedingly surprising that Lehman Brothers and Bear Stearns witnessed less-than-glorious VaR behavior, particularly in the latter case (in excess of 20 exceptions during its last three quarters as a living independent entity, more than twice the predicted number for the adopted 95% confidence level, which allows for only twelve yearly exceptions); but they were not alone by any means, with Morgan Stanley, JP Morgan and Bank of America (BoA), for example, similarly witnessing the breakdown of the theoretical dogma (BoA had 14 violations in 2007 at 99%, JP Morgan had eight in 2007 at 99% and Morgan Stanley had 18 violations in 2008 at 95%). And other Europeans can boast plenty of misguiding too. Mighty Deutsche Bank, for one, was surprised to observe 35 VaR violations in 2008 and 12 the year before, in all around ten times higher than theory would dictate.
Dangerous limitations
Twenty years after it was first brought into the fold of finance, should VaR still be used as risk radar following such a disappointing track record? So far, the thing continues to be employed by banks, hedge funds and other firms. It´s true that it´s not the only risk reference consulted, typically complemented with additional analysis such as stress testing. And yet, it appears hard to understanding why a device that can malfunction so gravely (especially at crunch time) should be given so much credence and respectability. When a bank reports its market exposures to investors, journalists, regulators and other outsiders through its quarterly filings, it continues to do so through the VaR lens. To this day, VaR continues to be openly equated with market risk. It´s almost as if the crisis had not happened at all.
Even more important than becoming the in-house method for calculating and managing risk and for informing the rest of the world as to a firm´s riskiness, VaR was adopted by policymakers as the tool to be used for the crucial purpose of determining the mandatory capital charges that financial institutions should face for their trading activities. Trading, you see, is not free. A while back, international regulators decided to impose a capital levy on market punting: for every trading position that a bank took on, a certain amount of capital had to be set aside so as to act as protective cushion for possible future setbacks. Naturally, the size of said capital requirement can play a huge role in the amount (and type) of trading assets that a bank would hold. If the charges are too exacting, accumulating tons of assets will be excruciatingly capital-intensive (i.e., excruciatingly expensive). Expressed differently, the size of the requirements will determine how much trading-related leverage a bank can enjoy. If the capital charge is modest, then traders need only to put up a small upfront deposit to own a whole lot of assets, being allowed to finance their portfolio mostly via borrowing. That is, by crowning VaR as the king of capital requirements, regulators essentially left the determination of banks leverage in the hands of a mathematical construct of dubious reliability. As the recent meltdown clearly shows, few things can be as impacting as the amount of gearing undertaken by financial institutions.
And, as we said earlier, because VaR can tend to be (or can be made to be) quite small, it follows that the reign of VaR is likely to deliver dangerously substantial leverage. Not only that, VaR also can deliver the worst kind of leverage. Because VaR only focuses on past market data, it does not fundamentally discriminate between different types of asset families, treating, say, Treasury bonds the same as, say, subprime CDOs when it comes to measuring their future risk. All that matters is the recent behavior of the given asset, not its obvious intrinsic characteristics. The fact that Treasuries are per definition less adventuresome and more robust than CDOs would not matter one iota to VaR. It doesn´t know that Treasuries are issued and backed by the U.S. government while complex mortgage derivatives are stuffed with toxic NINJA loans. VaR doesn´t read the newspapers, or watch television. It doesn´t know that the U.S. government is, by its very nature, a less risky debtor than an unemployed mortgage borrower. To VaR, Treasuries and CDOs are the same thing: just blips of historical data on a screen. If the CDO data for the last two years happens to be less volatile than the Treasuries data, the model will say with a straight face that CDOs are less risky than Treasuries.
This is not theory, this can actually happen. Even the most lethal of asset families can spend a relatively long period setback-free, showing nothing but continuous gains in value as a bubble is built and sustained. That´s exactly what happened with subprime CDOs all the way to mid-2007, and that is why, according to VaR, those Wall Street firms holding those assets were not facing much trouble and thus should not be demanded to post too much protective capital. Anybody with half a brain who chooses to use it understands that subprime CDOs are far from risk-lite, let alone safer than Treasuries-like securities. Unluckily for us, VaR was not endowed with a brain, notwithstanding the braininess of those who invented it and calculate it daily. The result: VaR permitted investment banks to accumulate untold amounts of very illiquid, very lethal assets in an extremely highly leveraged fashion (i.e. on the cheap, capital-wise). Just before the crisis, the typical VaR-dictated trading-related leverage around Wall Street was 100-to-1 (even 1,000-to-1). That is, banks were forced to post only $1 in capital for every $100 (or $1,000) of assets that they wanted to own. That´s a lot of leverage. The most insignificant drop in value of your portfolio can wipe you out, fast. Given that the portfolio that was being financed with so little equity and so much debt was (thanks to VaR´s blindness as to the true nature of an asset) inundated with poisonous stuff, it is easy to understand why the meltdown, when it inevitably came, was so shocking and so sudden.
Nassim Taleb was in a good position to understand from the get go that VaR could result in destructive toxic risk-taking if allowed to be influential. As a seasoned and successful options trader who had experienced several market rollercoasters that had been prospectively assumed (by the same theoretical notions underpinning VaR) not to be possible, Taleb quickly realized that it is useless to try to measure that which does not lend itself to be measured. Market activity is simply too untamable, too wild, too undecipherable. In an environment where everything is possible and where the next unprecedented crash may be around the corner, it is hopeless to try to infer much from the historical record. As a quantitatively educated individual, Taleb knew only too well that the rotten math behind VaR (the assumption of normality, the faith in statistical correlation) only makes things worse. For Taleb, there was no doubt: rather than helping understand, control and reduce risk, VaR will result in higher and worse risks. Bothered by such possibility, he decided to embark in the mid-1990s on a loud anti-VaR campaign. At the time, going at VaR was truly heretical. The acceptance of the tool within academic, theoretical and regulatory circles was unassailably unquestionable, religiously so. VaR proponents wasted no time in ruthlessly lambasting Taleb, dismissing him as a ranting worry-monger incapable of appreciating the magic that the mathematical risk technology could deliver. Financial risk, VaR fans declared, had been finally conquered, subjugated into a neat number by the unalterable precision of the precious analytics. How could anyone dare criticize such gloriousness? Had that Lebanese fellow gone mad?
Taleb´s first vindication came in 1997 and 1998. As markets everywhere succumbed to the chaos ignited by the Asian crisis, first, and the disaster of mega hedge fund LTCM afterwards, VaR was openly revealed as a gravely malfunctioning guide. As real trading losses climbed way above those predicted by VaR, the hitherto rock-solid reputation of the model began to suffer. Worse, VaR itself had a large hand in accelerating those losses by prompting banks to engage in sudden and massive liquidations of positions, fueling a devastating falling debacle. In a rehearsal of what would take place a decade later, VaR not only failed to warn of the upcoming danger, but essentially contributed to the realization of such danger.
Despite the temporary tarnishing of its name, VaR was not discarded or abandoned in financeland following those nasty episodes (which, particularly in the case of LTCM, threatened the system´s viability). Quite the opposite occurred, actually. Not only did those regulators who had originally embraced the tool continue to do so, avoiding in the process a much-needed rethink of VaR´s true value, but another, rather significant, one decided to join the party. In 2004, the Washington DC-based U.S. Securities and Exchange Commission (SEC) established a rule that allowed large Wall Street broker-dealers (the likes of Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns and Lehman Brothers) to use their own risk management practices for capital requirements purposes, recognizing outright that charges were destined to be lower under the new approach. VaR was predictably sanctioned as the main method of calculation, and as we know this implied that illiquid securities (“no ready market securities” in the jargon), which previously would have been subjected to something like 100% deduction for capital purposes (about 1-to-1 leverage, making it unaffordably expensive to buy billions and billions of dollars in those securities), were now afforded the same VaR treatment as more conservative and conventional alternatives. If the mathematically-driven number happened to be low, the required capital charge would be low.
That is, engaging in unapologetically risky activities instantly became much more cheap and convenient for U.S. investment banking powerhouses. In this sense, perhaps we shouldn´t be surprised by the fact that those financial institutions gorged on less-than-perfectly-liquid, über-complex (and thus high-yielding, for a while at least) stuff. The VaR-transmitted regulatory encouragement was probably too tempting to resist, as a high return measured against a tiny equity base makes for very tasty quarterly reports. The end result, of course, was a highly levered, undercapitalized financial industry whose fate was exposed to the soundness of subprime securities. Or, in slightly different wording, a ticking time bomb which duly exploded not long after.
By jumping onto the VaR bandwagon in 2004, the SEC allowed Taleb to enjoy a second, much stronger, vindication three years later. Had the SEC not adopted that policy, which some have salaciously termed “The Bear Stearns Future Insolvency Act,” it is quite probable that the crisis would not have happened (as the lethal securities would either not have been accumulated, or would have been backed by a lot more cushiony capital) and that Nassim Taleb would not have had to don that bothersome tie that September morning.
Pablo Triana is the author of "Lecturing Birds On Flying: Can Mathematical Theories Destroy The Financial Markets?" (Wiley 2009).
