Wall Street Follies

Lloyd Blankfein writing in the FT on the lessons of the crisis:

The first is that risk management should not be entirely predicated on historical data. In the past several months, we have heard the phrase “multiple standard deviation events” more than a few times. If events that were calculated to occur once in 20 years in fact occurred much more regularly, it does not take a mathematician to figure out that risk management assumptions did not reflect the distribution of the actual outcomes. Our industry must do more to enhance and improve scenario analysis and stress testing.

Absolutely right. Ever since we went off the gold standard, financial crises occur once a decade. But Wall Street’s risk models, despite all their complexity, appear to be blind to this simple fact. As Blankfein says, it doesn’t take a mathematician to understand that. It takes common sense.

Andrew Lahde, a young hedge fund manager, had a great deal of common sense. He made one of the most successful hedge fund bets of all time in 2007, delivering a near 870% return by shorting subprime.

He famously walked away last year after writing this scathing letter in which he advocates hemp and blasts the “idiots whose parents paid for prep school, Yale, and then the Harvard MBA.” The kind of people, in other words, who work for Lloyd Blankfein.

Before he left, Lahde wrote in 2008 that he was shorting commercial real estate even though prices remained high. As he explained in this letter to shareholders, Lahde realized that the commercial real estate market was doomed even as the risk models were telling everyone else to stay the course.

The losses will materialize. Admittedly I don’t have a clue how severe the losses will be. I don’t have a model that can correctly predict all the variables. Luckily no one else on the planet has such a model either. I gave up on the ability of models to correctly predict the value of securitizations a few years ago. I do know one thing though. It is safe to assume a market is dead when deal volume falls to zero, as was the case with CMBS issuance during January 2008. (emphasis added)

Blankfein at least has the good sense to admit he misjudged it all. After ticking off the numerous failures of risk management by Goldman Sachs and others, Blankfein argues against a regulation of risk that protects us from the 100-year storm. “Taking risk completely out of the system,” he says, “will be at the cost of economic growth.

Is he serious? We are entering a deflationary spiral today because of a failure of risk management that is simply breathtaking. And this is at least the second “100-year storm” to hit the United States in the past 100 years.

If Wall Street can’t design a financial system that can weather such storms, the government must.

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