The real causes of the financial crisis: incentives, risk management, and complexity.

1. THE REAL CAUSES OF THE
FINANCIAL
CRISIS
A Max Capital presentation

2. MANY CAUSES HAVE BEEN NAMED:
CDO’s
R UBLIC S
REPU CANS
DEM RATS
D OCR S
D short
S sellers
’s THE FED
s
GREEDY EXECUTIVES
REAL ESTATE SPECULATORS

3. But there are
SYSTEMIC
reasons for the crisis:

4. 1.INCENTIVES

5. 1.INCENTIVES
2.RISK
2 RISK
MANAGEMENT

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

7. misaligned
INCENTIVES
were pervasive

8. If you give
i
a mouse a
cookie…

9. If you give
i
a mouse a
cookie…
he’s going
to
t wantt
some milk.

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

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

12. Bad incentives were everywhere…
MORTGAGE
EXECUTIVES
BROKERS
RATING
HOME BUYERS
AGENCIES

13. There was
IMME ATE
no l-i-n-k
EDIA
AC ONS
CTIO S
between
FUTURE
and
CONSEQUENCES

14. Giving a manager
part of the
profits may not
sound b d
d bad…

15. But when they aren’t punished
for t ki
f taking long-term risks…
l t ik

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

17. companies d d ’t
didn t
MANAGE RISK
correctly
tl

18. One example is
Value at Risk

19. The VaR analysis
y
tries to give the
firm a look at how
much risk it’s
taking.

20. It starts with the
analysis of historical
data & statistics

21. The data is then run
through a bunch of
advanced models

22. The final result is a $
amount for a certain
percentile & time

23. This means that
98% of the time
time,
y
your investments
won’t lose over
$20 million in a
one-month
p
period

24. There are 3
reasons why
VaR causes
problems:
bl

25. Keep in mind that
ALMOST ALL
financial firms use
VaR to manage risk

26. 1 st
We’re not very good at
judging extremely rare
risks

27. 1 st
For example, we can guess
the odds of rain tomorrow
fairly well

28. 1 st
But the odds of an
earthquake will be much
less accurate

29. 1 st
Without
Witho t the ability to
abilit
judge these rare risks,
the VaR models aren’t
very useful

30. 2 nd
Historical data
Hi t i l d t
doesn’t necessarily
predict future returns

31. 2 nd
Garbage in, garbage out.
in ot

32. 2 nd
Garbage in, garbage out.
in ot

33. 3 rd
VaR ignores the worst-
worst
case scenario
So losses
could be:

34. 3 rd

35. 3 rd
And this loss
could wipe the
p
company out

36. COMPLEXITY
is one of the biggest
f gg
problems of the market

37. Some ENGINEERING
concepts can help
explain the issue
p

38. TIGHT COUPLING:
Every component is tightly linked

39. When something is
TIGHTLY COUPLED,
it provides no slack
if there is a problem,
problem
AND NO OPPORTUNITY
TO INTERVENE.

40. LIKE AN ASSEMBLY LINE...

41. OR MAKING BREAD.
BREAD
(once the yeast is added)

42. INTERACTIVE
COMPLEXITY:

43. INTERACTIVE
COMPLEXITY:
A complex system with
components that interact
in unexpected ways

44. A university
is complex, but
not tightly coupled

45. There are many components that
interact, but not a lot of problems.
There is plenty of slack and time to
fix any issues.

46. THE PROBLEM IS WHEN
SOMETHING IS BOTH
INTERACTIVELY
COMPLEX
AND
TIGHTLY
COUPLED

49. A NUCLEAR REACTOR IS
ANOTHER GOOD EXAMPLE
EXAMPLE.

50. It’s
EXTREMELY COMPLEX.
C-H-A-I-N
Any problem
REACTION
can cause a
DESTROYS
that
and POISONS
the system
the surrounding area.

51. SOUND
FAMILIAR

52. FINANCIAL MARKETS
are another perfect
example.
example

53. FINANCIAL MARKETS
WILL NEVER BE SIMPLE

54. HOWEVER,
HOWEVER
COMPLEXITY
LESS
WILL
CRISISMORE
RARE
MAKE A
EASIER TO
AND
SOLVE

55. So, as long as these
PROBLEMS
aren’t solved:
ld

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

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

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