February 3rd, 2009
23 Oct 2008 – Quote from Greenspan Calls Financial Crisis A Credit Tsunami:
“It was the failure to properly price such risky assets that precipitated the crisis”
When systemic effects are amplifying correlations and limit violations arise day after day over weeks and weeks, losses tend to spread across financial institutions, and practitioners lost faith in the valuation models as well.
But how can we know what to buy or sell without explicit information about the co-dependence of risk. I have spent many years building mathematical, statistical, and financial models, and it is now clear to me that two problems are at the heart of the crisis: (1) valuation models were so limited in scope that they couldn’t link market prices to the value of securities with mortgages as underlying collateral; (2) an institutionalized lack of disclosure that prevented practitioners from achieving the necessary standard of accuracy.
A wise man once said: “in modeling you make a toy-like version of how the market behaves, or how a particular product in the market behaves. You have to be as precise as possible because someone is going to buy or sell something on the basis of the model”.
One important common feature of the financial algorithms I have shared is the neglect or any implicit consideration of contagion effects.
Click here for the Financial Algorithms
As you verify the pricing algorithms you will notice that the complexity could be severe and even the most careful person could put a wide bid-offered spread on any of these types of transaction’s model. Measuring value accurately is at the very heart of successful investing and risk management. The ultimate result would be an end to Gaussian models that don’t explicitly capture such risk spillovers. We could expect new valuation models based on loss aversion and extreme value.
A Must Read: Recipe for Disaster: The Formula That Killed Wall Street
Tags: CoVaR, tail risk
Posted in
Research |
1 Comment »
November 22nd, 2008
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
Former Citigroup CEO Charles Prince, July 2007
The Carnoustie effect is defined as the degree of mental and psychic shock experienced on collision with reality by those whose expectations are founded on false assumptions. This also sounds familiar with the lax interest policy that ignores bubbles, demonstrating a classic reality check for Citigroup.
Citigroup had been acquiring more short-term funding and rolling over short-term liquidity daily. Imagine you have to refinance 20% of your mortgage every day. “But when the music stops, in terms of liquidity, things are complicated”, especially if bursting of bubble affects banking sector triggering a credit crunch.
This week the margins eroded the capital base of Citigroup and equity shrank, and if they cannot get a capital infusion they will be forced to sell assets at fire sale prices. This loss spiral will eventually drive Citigroup hanging on to others, and taking positions that may drag others down. It is important to understand that the capital and leverage ratios do not capture the aspect of overnight borrowing.
Making matters worse, Citigroup announced that it would reclassify $80 billion in assets into categories that are not marked to market. The evident hitch here is that it gives the impression that the board is trying to mask how dire the books are, playing the role of Leonardo Di Caprio in the movie “Catch Me if You Can”.
Unfortunately, any other financial institution will be cautious about making a deal with Citigroup until it can be assured that the bank’s books are done exploding, focusing on maturity mismatch and market liquidity of assets. That ultimately means providing clarity to those Level 2 and Level 3 assets. Until it does so, Citigroup just looks like a ticking time bomb that has a detonating mechanism that can be set to go off any time soon.
Tags: CoVaR, Credit Crisis, tail risk
Posted in
Research |
1 Comment »
