Economics

The Beautiful Machine(beautifulmachine)

notes&quotes

• "By maintaining market, accounting and transaction details in one place, Sosin and his people could track the constantly changing value of a trade's components in a way no other firm could...Put more simply, they could see opportunities in the marketplace for taking on risk that others couldn't, squeeze out profits where no one had before and protect themselves in the process."
• "Competitors hustled to keep pace. Sosin pressed to find niches where others weren't playing and provide cost-saving solutions for clients. Standard interest-rate swaps were no longer enough. The firm moved into more exotic deals, involving stocks, currency and municipal bonds."
• "A new unit, called the Transaction Development Group, did its part by taking advantage of gaps between securities regulation and tax laws in the United States as well as in other countries. Financial Products associates noticed, for instance, they could make money by exploiting differences between the U.S. and British definitions of stocks and bonds. A security that met the definition of stock in Britain could pay tax-free dividends to shareholders. The same security in the United States was regarded as a bond that provided tax-deductible payments. A Financial Products client would get both tax breaks. The firm used the capital raised from that line of business, in part, to finance other operations."
• "For a group of financial wizards, the coal business seemed an odd turn. But it was a logical extension of what the firm had been doing all along: discovering gaps in regulations and markets.
  
  A 1980 law, generated by the Carter administration, offered tax credits to companies as incentives to design and use synthetic fuel systems. The aim was to reduce U.S. dependence on foreign oil.
  
  Associates at the Transaction Development Group had discovered that many energy companies were not making enough money to benefit from the tax breaks. But Financial Products' profitable parent, AIG, could use those credits to reduce its tax bill."
• "documents appeared to show that Greenberg had arranged bogus transactions with Gen Re that made it look as if AIG had $500 million more in insurance revenue than it had actually earned."
• Heading to Downgrade and Downfall:"How could a single unit of AIG cause the giant company's near-ruin and become a fulcrum of the global financial crisis? By straying from its own rules for managing risk and then failing to anticipate the consequences."

Risk Mismanagement(nocera)

defs

VaR

value at risk, the (typically)1% possibility of loss of the dollar amt represented by VaR value over some period of time. VaR didn't measure liquidity risk.

credit risk

risk that a loan might not be paid back

derivative and securtitizations

bundled pools of mortgages and credit card loans

notes&quotes

• Long Term Capital Management blew up in 1998 due to the Asian and Russian crises.
• the S&L crisis thought thing were OK due to "portfolio insurance".
• the SEC's mandate for self-reporting was that derivatives should be factored into each companies internal VaR numbers. "Oh, that's all we need to do", was the reaction.
• "Guldimann... To him, the big problem was that it turned out that VaR could be gamed. That is what happened when banks began reporting their VaRs. To motivate managers, the banks began to compensate them not just for making big profits but also for making profits with low risks. That sounds good in principle, but managers began to manipulate the VaR by loading up on what Guldimann calls “asymmetric risk positions.” These are products or contracts that, in general, generate small gains and very rarely have losses. But when they do have losses, they are huge. These positions made a manager’s VaR look good because VaR ignored the slim likelihood of giant losses, which could only come about in the event of a true catastrophe. A good example was a credit-default swap, which is essentially insurance that a company won’t default. The gains made from selling credit-default swaps are small and steady — and the chance of ever having to pay off that insurance was assumed to be minuscule. It was outside the 99 percent probability, so it didn’t show up in the VaR number. People didn’t see the size of those hidden positions lurking in that 1 percent that VaR didn’t measure."
• Charles Prince: “As long as the music is playing, you’ve got to get up and dance.”
• John Maynard Keynes: a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.”
• David Viniar od Goldman Sachs: “VaR is a useful tool,” he said as our interview was nearing its end. “The more liquid the asset, the better the tool. The more history, the better the tool. The less of both, the worse it is. It helps you understand what you should expect to happen on a daily basis in an environment that is roughly the same."

take-home

"At most firms, risk managers are not viewed as “profit centers,” so they lack the clout of the moneymakers on the trading desks. That was especially true at the tail end of the bubble, when firms were grabbing for every last penny of profit.

At the height of the bubble, there was so much money to be made that any firm that pulled back because it was nervous about risk would forsake huge short-term gains and lose out to less cautious rivals. The fact that VaR didn’t measure the possibility of an extreme event was a blessing to the executives. It made black swans all the easier to ignore. All the incentives — profits, compensation, glory, even job security — went in the direction of taking on more and more risk, even if you half suspected it would end badly. After all, it would end badly for everyone else too."

my take

Most everyone else, however, hadn't been the beneficiaries of the system drawing obscene salaries and bonuses. This was a machine designed to suck value out of society. It succeeded. It continues to succeed. Nobody is really questioning the value to society of allowing sucking in the first place. Why should the financial sector get all the marbles? How many jobs do they create? How many stable communities or opportunities for every citizen?

biblio

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