Felix Salmon

Matt Taibbi is quite right about the $2 billion of rogue-trading losses at UBS. Basically, investment banks hire for risk-takers; they shouldn’t be surprised when this kind of thing happens.

The brains of investment bankers by nature are not wired for “client-based” thinking. This is the reason why the Glass-Steagall Act, which kept investment banks and commercial banks separate, was originally passed back in 1933: it just defies common sense to have professional gamblers in charge of stewarding commercial bank accounts.

Investment bankers do not see it as their jobs to tend to the dreary business of making sure Ma and Pa Main Street get their $8.03 in savings account interest every month. Nothing about traditional commercial banking – historically, the dullest of businesses, taking customer deposits and making conservative investments with them in search of a percentage point of profit here and there – turns them on.

In fact, investment bankers by nature have huge appetites for risk, and most of them take pride in being able to sleep at night even when their bets are going the wrong way.

Taibbi is receiving some blogospheric pushback, because the term “investment banker” means two very different things depending on the context. On the one hand, there’s investment banking as in M&A advice and old-fashioned merchant banking. A typical sentence would be “traders have replaced bankers in the executive suite at Goldman Sachs”. And then there’s Taibbi’s meaning: investment bankers as opposed to commercial bankers, or people who work at investment banks rather than at commercial banks. These are the people that the Vickers report is scared of.

The fact is that old-fashioned advisory bankers are pretty irrelevant here: the big money in finance has always been where the balance sheet is. And balance sheet is used on the trading floor and in commercial banking. So let’s put the fee-based bankers to one side: it’s absolutely true that investment bankers tend to love risk, even as commercial bankers have historically shunned it.

I’m reading The Devil’s Derivatives right now, Nick Dunbar’s fantastic book about credit derivatives traders. (I’ll have much more on the book when I’m done with it.) In the introduction, he makes this distinction really well, introducing the hotshot traders he dubs “the men who love to win”:

This rare, often admirable, but ultimately dangerous breed of financier isn’t wired like the rest of us. Normal people are constitutionally, genetically, down-to-their-bones risk averse: they hate to lose money. The pain of dropping $10 at the casino craps table far outweighs the pleasure of winning $10 on a throw of the dice. Give these people responsibility for decisions at small banks or insurance companies, and their risk-averse nature carries over quite naturally to their professional judgment. For most of its history, our financial system was built on the stolid, cautious decisions of bankers, the men who hate to lose. This cautious investment mind-set drove the creation of socially useful financial institutions over the last few hundred years. The anger of losing dominated their thinking. Such people are attached to the idea of certainty and stability. It took some convincing to persuade them to give that up in favor of an uncertain bet. People like that did not drive the kind of astronomical growth seen in the last two decades.

Now imagine somebody who, when confronted with uncertainty, sees not danger but opportunity. This sort of person cannot be chained to predictable, safe outcomes. This sort of person cannot be a traditional banker. For them, any uncertain bet is a chance to become unbelievably happy, and the misery of losing barely merits a moment’s consid- eration. Such people have a very high tolerance for risk. To be more precise, they crave it. Most of us accept that risk-seeking people have an economic role to play. We need entrepreneurs and inventors. But what we don’t need is for that mentality to infect the once boring and cautious job of lending and investing money.

When you’re hiring people for the UBS trading floor, you’re hiring men who love to win, congenital risk-takers. And then you surround them with risk-management protocols designed to keep them under some semblance of control. There’s a natural tension there. And if you take the hundreds of thousands of risk-takers working on trading floors in London and Hong Kong and New York and Paris, it’s a statistical inevitability that one or two of them will go rogue every year or so.

Risk-managment protocols are important, but they can never be foolproof, because they’re run by humans. So we really shouldn’t let investment bankers — by which I mean risk-hungry traders with access to billions of dollars of balance sheet — anywhere near the systemically-important balance sheets of our largest commercial banks. Losses like the $2 billion at UBS are manageable. But they’re small beer compared to the entirely legitimate losses made by the likes of Morgan Stanley’s Howie Hubler during the financial crisis. He managed to lose $9 billion, and get paid millions for doing so.

Multiply that by an entire company, and you get Lehman Brothers, or Merrill Lynch. One of the great good fortunes of the financial crisis was that neither of them was attached to a commercial bank at the time; one of the great bad fortunes of the financial crisis is that the sins of Merrill Lynch weigh down BofA’s balance sheet to this day, and are in large part responsible for the fact that, still, no one really knows whether the bank is solvent or not.

Tom Laskawy, of Beyond Green, writes asking for a bit more detail about this bit of my locavorism article:

If you only grow one crop, the downside of losing it all to an outbreak is catastrophe. In rural Iowa it might mean financial ruin; in Niger, it could mean starvation.

Big agriculture companies like DuPont and Archer Daniels Midland (ADM), of course, have an answer to this problem: genetically engineered crops that are resistant to disease. But that answer is the agricultural equivalent of creating triple-A-rated mortgage bonds, fabricated precisely to prevent the problem of credit risk. It doesn’t make the problem go away: It just makes the problem rarer and much more dangerous when it does occur because no one is — or even can be — prepared for such a high-impact, low-probability event.

The point here is that a disease-resistant crop is a lot like a triple-A-rated structured bond: they’re both artificially engineered to be as safe as possible. That would be a wonderfully good thing if no one knew that they were so safe. But if you’re aware of a safety improvement, that often just has the effect of increasing the amount of risk you take: people drive faster when they’re wearing seatbelts, and they take on a lot more leverage when they’re buying AAA-rated bonds.

The agricultural equivalent is the move to industrial-scale monoculture, “safe” in the knowledge that lots of clever engineers in the US have made the crop into the agribusiness version of a bankruptcy-remote special-purpose entity.

But the problem is that bankruptcy-remote doesn’t mean that bankruptcy is impossible: just ask the people running Citigroup’s AAA-rated SIVs. If and when the unlikely event eventually happens, the amount of devastation caused is directly proportional to the degree to which people thought they were protected. When something like that goes wrong, it goes very wrong indeed: artificial safety improvements have the effect of turning outcomes binary.

Essentially, you’re trading a large number of small problems for a small probability that at some point you’re going to have an absolutely enormous problem.

And on a long enough time line, even a small probability is bound to happen sooner or later. Which is something that the likes of Bob Rubin would do well to remember.

Peter Conti-Brown has a new paper proposing the creation of what he calls a Fat Tail Risk Metric, or FTRM. The paper itself is flawed, and the details of how it’s constructed would need to be reworked from scratch. But conceptually, the FTRM I think is a good idea. Here’s Conti-Brown’s abstract:

The paper proposes a legal solution that will create a more robust metric: require mandatory disclosure of a firm’s exposure to contingent liabilities, such as guarantees for the debts of off-balance sheet entities, and all varieties of OTC derivatives contracts. Such disclosures—akin to publicly traded corporations’ filing of 10-Ks with the SEC—will allow regulators and researchers to approximate an apocalyptic, black-out, no-bankruptcy-protection and no-bailout scenario of a firm’s implosion; force firm’s to maintain daily record-keeping on such obligations, a task which has proved difficult in the past; and, most importantly, will open up a crucial subset of data that has, until now, been opaque or completely invisible.

Conti-Brown’s method for coming up with the FTRM involves adding up a firm’s total netted derivatives exposure; the size of its off-balance-sheet vehicles; and its liabilities. That gives a total-risk measure; the FTRM itself is the log of that figure.

There are lots of problems here. For one thing, netting derivatives exposure effectively eliminates an enormous amount of counterparty risk. For another thing, it’s impossible to calculate: if I write a call option on a stock, there’s no limit to how much my contingent liability might be, because there’s no limit to how far that stock can rise. And off-balance-sheet vehicles are just one of a potentially infinite line of entities which remove a company’s legal liability, but where the firm can still end up paying out a lot of money in practice. Think, for instance, the money which Bear Stearns threw at its failed hedge funds, or the money which banks used to make whole the people who invested in auction-rate securities. Those things don’t look like bank liabilities, or even contingent liabilities, until it’s far too late.

But put all that to one side: one thing which doesn’t currently exist, and which would be very useful indeed, is some kind of measure of the total amount of risk in the financial system. A lot of people had a conception, pre-crisis, of some kind of law of the conservation of risk: that tools like mortgage-backed securities simply moved risk from banks’ balance sheets to investment accounts, and therefore, at the margin, actually dispersed risk and made the system safer. What was missed, however, was the fact that total risk was increasing fast, especially as house prices rose and the equity in those houses was converted into financial assets through the magic of second mortgages, cash-out refinancings, and home-equity lines of credit.

Some types of risk are more dangerous than others, of course: if there’s a stock-market bubble, then it’s easy to see that the total value of the stock market, which is the total amount that can be lost in the stock market, has risen a lot. But stock-market investments are a little bit like houses without mortgages: where there’s very little leverage, there’s also relatively little in the way of systemic risk. It’s rare to suffer great harm from the value of your house falling if you don’t have a mortgage.

Still, stock-market bubbles can cause harm, and it’s worth including equities as part of the total risk in the system, along with bonds and loans. That’s one metric which macroprudential regulators should certainly keep an eye on; Conti-Brown’s idea is then basically to try to disaggregate that risk on a firm-by-firm basis, to see which companies have the most risk and to see how concentrated the risk is in a small number of large institutions.

It won’t be easy to do that — indeed, it will be impossible to do it with much accuracy. But even an inaccurate measurement will be helpful, especially if it becomes a time series and people can see how it’s been changing over time. It’s good to know how much risk is out there — and it’s better to know that financial institutions themselves are keeping an eye on that number, and trying to measure it as part of their responsibilities to their regulator.

The most ridiculous sentence I’ve read today comes from Goldman Sachs, protesting against proposals that money-market funds should be marked to market. But first let’s remember what Goldman CEO Lloyd Blankfein has to say about marking to market:

For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in positions that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions. We mark-to-market, not because we are required to, but because we wouldn’t know how to assess or manage risk if market prices were not reflected on our books.

Now read this, from his employee James McNamara:

We do not believe that disclosing shadow prices or market-based prices of portfolio securities would be informative to investors… Investors who perceive a NAV differential between two money market funds may wrongly assume that the fund with the lower market NAV is experiencing a material credit or liquidity problem. This may result in destabilizing — and unnecessary — levels of redemption activity in that fund, which could infect other funds managed by the same adviser or other funds as well. The Commission should be mindful of this type of unintended consequence before adopting regulations mandating the disclosure of market-based NAV’s and market-based pricing of portfolio securities.

When Goldman Sachs reduces its positions as a result of declining market prices, then, that’s a necessary, if difficult and sometimes painful, discipline. When investors in money-market funds do the same thing, however, that’s destabilizing and unnecessary. Alles klar?

David Reilly makes short shrift of such hypocrisy in his column today, and adds something important:

The industry’s case against floating values is that investors would pull cash out of money-market funds because they want investments with a stable value. That, the argument goes, would deprive American companies of a vital source of funding, since money-market funds are big buyers of short-term commercial paper issued by companies.

That is a well-worn ploy from the financial-services industry to counter any change that cuts into business. Banks used this tactic effectively in 2003 and 2004, for instance, to pressure the Financial Accounting Standards Board to water down rules that would have limited banks’ ability to use off-balance- sheet vehicles.

The result was out-of-control securitization and under- capitalized banks, both of which played huge roles in crashing the financial system.

The fact is that higher short-term funding costs for large corporations are a feature, not a bug, in terms of moving money-market funds to floating NAVs. Goldman might like to bellyache about “the diminished supply of short-term credit to corporations” that might result, but short-term credit is always the most systemically-dangerous form of credit, since it can dry up with no warning and cause a major liquidity crisis.

More generally, it’s both silly and far too easy for banks to cry “more expensive credit!” every time that anybody proposes tightening regulations on anything from credit cards to prop trading. Yes, it is true that decades of financial-sector deregulation led to cheaper credit, in the financial industry, in the housing market, in the private-equity world, and elsewhere. This was not a good thing. $1 NAVs obscure the risks inherent in money-market funds, and a sensible regulatory overhaul would put an end to them.

The World Economic Forum has released its annual Global Risks report, which kicks off with this chart:

There’s a key explaining what all these numbers are, ranging from 1 (food price volatility) to 36 (data fraud/loss). But the really scary thing, for me, is the pretty clear positive correlation between severity and likelihood: the trillion-dollar risks all have a significant probability of happening, with the most severe risk of all — a global asset price collapse — being associated with a probability of well over 20%.

That collapse in asset prices is #6; #7 (developed-country retrenchment from globalization) is just as severe, if not as likely. #2 is a spike in the oil price, #5 is fiscal crises, #31 is chronic diseases, and #4 is a slowing Chinese economy.

The report is being published in the run-up to the WEF’s annual meeting, in Davos, where the great and the good will try to convince themselves that they’re part of the solution rather than being part of the problem. But frankly there’s really nothing they can do about the biggest risk of all, that asset-price collapse. In fact, given how rich they are, they’re likely to bear the brunt of it themselves.

Malcom Gladwell is no particular expert on financial markets. But he has said, according to Moe Tkacik, that of all the people he has interviewed, he most identifies with Nassim Nicholas Taleb — in a 7,800-word profile which explains just how hard it is to invest in markets when your strategy involves losing money every day and waiting for a tail event.

With a few notable exceptions, like the few days when the market reopened after September 11th — Empirica has done nothing but lose money since last April. “We cannot blow up, we can only bleed to death,” Taleb says, and bleeding to death, absorbing the pain of steady losses, is precisely what human beings are hardwired to avoid. “Say you’ve got a guy who is long on Russian bonds,” Savery says. “He’s making money every day. One day, lightning strikes and he loses five times what he made. Still, on three hundred and sixty-four out of three hundred and sixty-five days he was very happily making money. It’s much harder to be the other guy, the guy losing money three hundred and sixty-four days out of three hundred and sixty-five, because you start questioning yourself. Am I ever going to make it back? Am I really right? What if it takes ten years? Will I even be sane ten years from now?” What the normal trader gets from his daily winnings is feedback, the pleasing illusion of progress. At Empirica, there is no feedback. “It’s like you’re playing the piano for ten years and you still can’t play chopsticks,” Spitznagel say, “and the only thing you have to keep you going is the belief that one day you’ll wake up and play like Rachmaninoff.”

So I was very puzzled to pick up this week’s New Yorker to find Gladwell write about John Paulson in very different terms. (The story is behind a firewall; it’s not particularly worth paying for, although the magazine as a whole is a fantastic value.)

Gladwell in this essay characterizes Paulson as “The most successful entrepreneur on Wall Street — certainly of the past decade and perhaps even of the postwar era”. I think this involves a very narrow criterion of what makes successful entrepreneur. Later in the essay Gladwell talks about how “people who work for themselves are far happier than the rest of us”, and in my experience hedge-fund managers — who do after all work primarily for their clients — are not in fact particularly happy people. They might not have a single boss telling them what to do, but the pressures of managing other people’s money are immense.

What’s more, any hedge fund manager playing a version of the negative-carry trade has it much worse than most of his peers. Warren Buffett says that the first rule of running other people’s money is don’t lose it; the second rule is “don’t forget the first rule”. One of the reasons Taleb gave for giving up running money day-to-day was precisely the incredible toll it takes when you’re losing money almost every day. Andrew Lahde, another huge winner from the subprime crisis, also quit the business, citing the way in which the stress of the job destroyed his health. Gladwell himself talks about how successful entrepreneurs will deliberately harm their own reputation if it means improving their risk-adjusted returns. That’s not a route to happiness.

And in any event, although success is often measured in dollars on Wall Street, even Wall Streeters don’t end the analysis there. Is Paulson really a more successful entrepreneur than, say, Charles Schwab, just because he arguably has more money? For that matter, Mike Bloomberg has not only founded a hugely successful company which can run very well without his presence; has also made more money than Paulson. Even if Paulson does count as an entrepreneur, it’s not at all obvious how he counts as being more successful than Bloomberg.

But I digress. The point is that Paulson, like Taleb, is a negative-carry kind of guy. Positive-carry investing can take you a very long way, and indeed it’s the foundation of the entire global banking industry, but it’s negative-carry trades which have the ability to score enormous home runs like Paulson’s. Many big hedge-fund managers avoid negative-carry trades, because they feel too much like a gambling habit: you pay out money every day in the hope of scoring a huge jackpot. That’s not the kind of strategy most investors in hedge funds particularly like, and indeed the likes of Taleb take great care to sell their funds as hedging devices — a place to put a small amount of your net worth for insurance purposes — much more than as absolute-return vehicles.

Paulson is no Taleb: his clients are pretty typical hedge-fund investors, including rich individuals who really hate losing money. Which means that his negative-carry trade — buying credit default swaps which obligated him to pay out millions of dollars in annual premiums, with no income attached at all — was extremely risky, from a business point of view. Gladwell quotes Greg Zuckerman explaining that “the most an investor could lose would be 8 percent a year”, while the upside (as we saw) turned out to be astronomical. But it doesn’t take many years of 8% losses — or any losses at all, for that matter — for clients to pull all their money out of your hedge fund.

Paulson was not actively trying to burst the bubble, in the way that George Soros pushed the pound out of the European exchange-rate mechanism with his legendary 1992 negative-carry trade. Instead, he was just the biggest of a long line of investors who saw that there was a housing bubble and tried to find a way to go short. Those who were right but too early disappeared into the footnotes of finance — if they were lucky to get even that. They learned the hard way that “the market can stay irrational longer than you can stay solvent”. Paulson was like them: he felt certain that the bubble was going to burst, but he didn’t — couldn’t — know when, and he simply had to pray that it would happen before his investors deserted him.

What’s more, there was no guarantee that even if the housing bubble did burst, that Paulson was going to make lots of money. To be sure, he had a lovely model, put together by his colleague Paolo Pellegrini, showing that if house prices stopped rising, subprime mortgages were going to suffer enormous losses. But on the other hand, all the banks and credit-rating agencies also had models, showing that the bonds that Paulson was betting against had almost no chance of defaulting. When your model shows one thing, and everybody else’s models show something else entirely, there’s a very good chance that your model is flawed.

Gladwell’s thesis, in this essay, is that Paulson is actually very risk-averse, rather than being a big risk-taker. “Would we so revere risk-taking,” he asks right before introducing Paulson as Exhibit A, “if we realized that the people who are supposedly taking bold risks in the cause of entrepreneurship are actually doing no such thing?”

The fact is that Paulson did take bold risks, on factors which were entirely out of his control: When would the bubble burst? How long could he hold out before his investors deserted him? Indeed, Paulson’s strategy had a Ponzi aspect to it, where he would try to make up losses with new investments: “He bought CDS contracts by the truckload,” Gladwell writes, “and, when he ran out of money, he found new investors, raising billions of new dollars so he could buy even more.”

Warren Buffett has described his most recent mega-acquisition, that of Burlington Northern, as a huge bet on the long-term health of the US economy. That kind of bet has made him more billions than even Paulson can dream of, and it’s a bet made in the positive-sum game of the equity markets. Stocks can and do rise over time, and a well diversified stock-market investor has been able to reasonably expect to see some kind of profit over the long term.

Paulson, by contrast, was playing in the zero-sum derivatives markets. In order for him to make any money at all, somebody else had to lose. If I bought a random basket of derivatives contracts and held them over the long term, my expectation would be that I would end up with less money than when I started.

The amount of sheer hubris involved in Paulson’s trade, then, is enormous. He had to have an unshakeable faith in the infallibility of his own models, in a world where no model is infallible. He had to have entirely irrational confidence that the bubble would burst before he ran out of cash. And he had to do all of this with other people’s money: while he was already personally set for life when he entered into the bet, he couldn’t say the same thing about all of his clients, who didn’t necessarily share his shoot-for-the-moon risk profile.

After all, Paulson’s clients had invested their money with a manager whose returns, Gladwell quotes Zuckerman as saying, were solid, careful, and decidedly unspectacular. Did Paulson decide to put them into a risky derivatives trade with a negative carry just because he’d already made lots of money and was now aiming for posterity? I’m sure all those clients are very happy with Paulson today. But if you’d told them about his strategy while the bubble was still inflating, they might have had a very different opinion indeed.

Update: Zuckerman responds, in the comments.

What’s the correlation between wealth and risk appetite? I suspect that it’s somewhat bell-shaped: when you’re very poor you can’t afford to take any risks, while if you’re entering the middle classes you often feel that you have to take risks, especially with your retirement assets, if you’re going to have a chance of maintaining your standard of living once you stop working. If you already have more money than you’ll ever spend, however, then you don’t need to take those kind of risks any more, and you start becoming much more conservative again — see for instance the way in which Suze Orman is invested only in wrapped munis.

This big picture can be blurred by the fact that many of the riskiest investments, like venture-capital funds or leveraged hedge funds, are invested in only by the wealthy. But look a bit closer and you’ll invariably find that the investors in those funds are careful to make sure they’re set for life before taking a small percentage of their wealth and investing it in high-risk assets.

But thanks to a new law, we can now see how senior executives invest their money. And it turns out that even diversified stock-market investments are too risky for them:

Top executives at Bank of New York Mellon Corp. could invest their savings in a fixed-income fund that had a 6.6% return in 2008; thanks to electing this fund, Steven Elliott, senior vice chairman, had earnings of $1.3 million on his account, according to filings.

Executives at Cummins Inc. could choose among three options: the return on the S&P 500, “the Lehman Bond Index, or 10 year Treasury Bill + 2%,” according to filings. The executives at the engine maker had a total of $1.4 million in gains on their accounts, suggesting that none of them elected the stock index.

Executives at Illinois Tool Works Inc., a maker of fasteners and adhesives, received returns of 6.1% to 8.4% in 2008, while investments in the employees’ 401(k) lost 25%. A spokeswoman says that so far this year, the average return of employees’ 401(k) plans has been 23%, while the interest credited to the executives’ deferred-compensation plan is just 5.6%.

The WSJ implies, and Ryan Chittum makes explicit, the concept that any executives seeing gains in their retirement accounts were somehow getting special treatment, compared to ordinary employees whose 401(k)s got destroyed. But the bigger point here is that the rich executives are simply availing themselves of the luxury of being able to afford very low risk, modest-return investments. (As ever, Comcast is the outlying villain, guaranteeing senior executives a 12% return on their savings. Yuck.)

I’d also be interested in finding out how much company-specific credit risk is involved in these schemes. A giveaway is the word “notional”:

These deferred-compensation plans generally provide notional investment elections that mirror the returns on mutual funds available in the employee 401(k) plan.

In other words, we’re not talking about actual returns on actual money, here, we’re talking about notional returns on notional money which is really just an unsecured liability of the company to the executive. If the company goes bust, the money disappears — and even if it doesn’t, the money might not ever arrive. Just ask Fred Goodwin and Dick Grasso whether promised retirement funds are certain to become real cash.

There’s something to like about the fact that senior executives have an enormous amount of their retirement assets tied up in unsecured obligations of their employer: it gives them a strong incentive to avoid the kind of fat-tailed risks which could really wipe them out. So I’m not as shocked by the WSJ story as Chittum is. Except for that Comcast factoid, of course.

Comment of the day comes from Chris:

The person most willing to take on risk is the one unaware he is doing so. He charges no risk premium…

The resulting market equilibrium is that the guy who is unaware of the risk ends up loaded with it. Then the music stops.

This is possibly a very beautiful and elegant explanation for the extreme profitability of investment banks. They charge their clients a lot of money to take risk off their hands, and then they transformed that risk, using sophisticated financial engineering, into instruments which didn’t, on their face, look risky at all, and which could easily be sold to risk-averse investors. Bingo, massive profits.

Financial complexity and innovation, on this view, are essentially tools of obfuscation. And it’s easy to hide risks when risk-averse investors want debt-like products which retain their face value: such instruments tend to have very low volatility, and so look and feel as though they’re low-risk, even if they’re full to bursting with enormous amounts of tail risk. The answer, as I’ve said many times in the past, is for risk-averse investors to be willing to take a small amount of explicit market risk, and to move towards safe equities (utilities and the like) and away from debt. Because if they go to an investment bank asking for safety, they’re likely to just get hidden risk in return.

Eleanor Laise has the encouraging news this morning that Deutsche Bank is planning to launch a money-market fund whose shares fluctuate in value, rather than being artificially pegged at $1.

On the face of it, this is a very good idea. Money-market funds are low-risk instruments, but that one phrase hides many different possible meanings, which get unhelpfully elided in the minds of investors. Moving to what’s known as a “floating NAV” (the net asset value goes up and down over the course of each trading day) helps to make some of those distinctions explicit.

Most people intuitively think that “low-risk” means “you can’t lose much money”. In finance, however, “low risk” can also mean “there’s a very low probability that you’ll lose any money at all”. And the problem with $1 money-market funds is that if they “break the buck”, then all hell breaks loose, and investors can end up waiting months to get their money back. It’s classic tail risk.

Wall Street is good at massaging risk in this way: taking risk and shoving it off into the tails. Most triple-A-rated structured products were like that: part of the reason that they offered a big yield pickup was by effectively maximizing the loss given default in the (perceived unlikely) event that a default did occur. Of course, another huge problem with tail risk is that measuring it, ex ante, is pretty much impossible.

So I’m all in favor of a product which has small fluctuations in value every day, thereby helping to reduce the tail risk associated with putting a floor on the fund value.

There are good reasons not to go down this road, however, and if you look at section 8.1 of this report, you’ll find a lot of them. What’s more, there are bad reasons to go down this road, specifically the idea that it’s just nimble-footed regulatory arbitrage:

In a letter to the SEC this week, Deutsche Bank suggested that floating NAV funds have a starting price of $10 a share and that they don’t need to be subject to tighter money-fund rules recently proposed by the SEC.

Rolfe Winkler adds another wrinkle to all this, which is the whole idea of money-market funds being “cash equivalents”. I’m with FASB on this front, in believing that the whole concept of a “cash equivalent” is dangerous and unhelpful. There’s really no such thing as “cash”, beyond folding banknotes — and those literally come with a cost of carry. All other forms of cash carry some kind of counterparty, credit, or interest-rate risk. We should move to a world where those kind of small risks are embraced and understood, rather than being ignored by being lumped into the category of “cash equivalents”.

Whenever I write about banks’ rising Value-at-Risk, a bunch of commenters tells me that duh of course VaR is rising, because VaR is a function of volatility, and volatility has gone up. So here’s my question: can someone come up with a baseline VaR chart, for a hypothetical bank which had, say, a fixed $1 million investment in the S&P 500. What would its quarterly Value-at-Risk have looked like over the past couple of years?

Would the decrease in volatility this year have shown up as decreased VaR in say the second quarter? Or do the volatility calculations go back so far that only now are we losing the Great Moderation datapoints and using volatility numbers only from the era of increased volatility?

Armed with that kind of baseline chart, we’ll be able to tell much more easily, for any given bank, whether it’s actually increasing the size of its bets, or whether increased VaR is simply a statistical necessity given the recent history of volatility. Does such a chart exist?

Update: Phorgy comes through. All banks calculate VaR differently, but this is a really useful resource. Basically Var increased enormously in 2008, and after that slowed down sharply in 2009, possibly even dropping significantly. Which means, I think, that any significant increases in VaR in 2009 can’t be blamed on increased volatility.

Goldman Sachs bankers are generally smooth, urbane, and on-message. But these days they’re clearly flustered. Why else would Goldman president Gary Cohn say something as arrogant and tone-deaf as this to the NYT’s Jenny Anderson?

“Our risk appetite continues to grow year on year, quarter on quarter, as our balance sheet and liquidity continue to grow,” Mr. Cohn said.

This perfectly fits the Michael Kinsley definition of a gaffe — when a politician accidentally tells the truth. What Cohn should have said is exemplified by his colleague, CFO David Viniar, five paragraphs later:

“There are a few business units that are taking a little more risk. Most are taking less,” Mr. Viniar said.

But the cat’s out of the bag at this point — and even if Cohn hadn’t said it in as many words, Goldman’s soaring profits and VaR tell the story.

Goldman is a bank holding company now; it shouldn’t be able to thumb its nose at its new regulators in this manner. But it will clearly continue to do so unless and until one of those regulators takes a deep breath and cracks down on all this risk-taking and increased leverage. So, who wants to be the regulator who went up against Goldman?

Paul Wilmott has words of wisdom for anybody in the financial-services industry who’s putting a model together:

At every stage of valuation and model development you must be asking questions about risk and robustness. It is dangerous to come up with some fancy model and only afterwards start asking questions about model error. Anyone who has ever calibrated a model knows that the methods used to mitigate model risk almost come as an afterthought, and are totally inconsistent with the original model. This need not be the case.

The problem is that developing a model is the sort of thing which (a) quants are trained to do, and (b) can, eventually, make money. While mitigating model risk is a very recondite field which very few people have any expertise with; what’s more, it doesn’t really make money in and of itself. Where will all the model-risk modellers come from?

Algonaut asks whether the Financial Services Oversight Council will have a direct line to banks’ chief risk officers; I’m sure the answer is yes. But I also think that won’t be enough. What I’d love to see — and this could be put in place directly by the major banks, without the need for any legislation at all — would be a regular formal meeting of all the big banks’ chief risk officers, where they can talk about all the systemic risks they’re worried about which require coordinated response. Does anything like that exist? Is there some way in which the FSOC or the Fed could use its moral suasion to make it happen?

Update: It turns out that the IIF has a Markets Monitoring Group, chaired by Jacques de Larosière, which meets 2-3 times a year with the aim of “bringing together observations and assessments of various developments to build a systemic picture of current risks and their potential negative impacts and seeking to mitigate those risks by encouraging member firms to take the Group’s findings into account in their risk management and collaborating closely with the official sector”. (From page 108 of this document.) Chances of it doing any good at all? Very slim, I’d say, but then again I’m biased against the IIF so I’ll admit I’m not an impartial observer.

The first sukuk (Islamic bond) defaults have arrived, and no one has a clue how they’re going to shake out. Which might actually be a feature rather than a bug, going forwards.

Bondholders often have a large amount of complacency derived from the fact that an enormous amount of equity needs to be wiped out before they take any hit at all. And that complacency does the system no favors in the long term. If capital structures get muddied a little, and debt takes on more equity-like uncertainty — as seems to be the case in the sukuk market — then maybe investors will be more assiduous about examining underlying risks, rather than relying on capital structures to protect them.

Gillian Tett was just in the office to talk about her new book; I interviewed her for Reuters TV, and the results should be up soon. But we got to chatting afterwards, and she made a great point which we didn’t cover in the more formal interview and which she says she would have liked to have put in her book. But since it’s not there, I can at least put it on YouTube. She talks about the Bistro deal (see Jesse for background on that), and how it can be seen as a metaphor for the financial system more generally:

The point is similar to the one I made in my speech to the regional bond dealers: we were far too worried about risk, and not nearly worried enough about safety. And really it was the insatiable demand for safety in general, and triple-A risk in particular, which caused this financial crisis.