Tuesday, March 13, 2007

The Wizards of VaR and "pilot error"

The company has also been honored for the way it does business, receiving the Ethics in America award from the Passkeys Foundation and Chapman University in 2004. “Over the years, we believe we have earned the reputation with our customers and our investors for delivering results without compromising our values; this is the cornerstone of our corporate culture,” notes Bob. “To articulate that culture, in 2005 we adopted a new brand identity, ‘A New Shade of Blue Chip,’ and created a strategy to help us live up to that brand. We are proud of our results, but just as proud of how those results are achieved.” New Century Financial Company History

NYSE's move [ to delist NEW ] came as New Century disclosed in an SEC filing today that the U.S. Attorney had initiated a criminal investigation into both the company's securities trading and accounting errors involving the company's allowance for losses from the repurchase of bad loans. New Century said it had received a grand jury subpoena and would cooperate. O.C. Register

According to Wikipedia, Pilot error is a term used to describe the cause of a crash of an airworthy aircraft where the pilot is considered to be principally or partially responsible. Pilot error can be defined as a mistake, oversight, lapse in judgement, or failure to exercise due diligence by an aircraft operator during the performance of his/her duties. In other words, the plane was working fine, us humans screwed up.

Despite fears of mechanization run amok, the financial world still relies on its pilots. Despite changes in tools (abacus, computer) and methods (cash, VaR) of calculation, people still have to input the records, ensure their accuracy and plan for the future. The most hi-tech tools and sophisticated methods (pun intended) will not mitigate the simple pilot error of being unprepared for eventualities.

I wonder how many at New Century Financial asked the question, once the Fed began raising interest rates in 2004, "How are we going to deal with the eventual slowdown in mortgage lending?"

I wonder how many times that question inspired a response to the effect that it wouldn't be a problem, that things were under control, and that all eventualities had been foreseen. In the event, as is all too often the case when money, lives and fortunes are involved, the real response was lie, deny, justify. Pilot error, sure, but show me a financial company without pilots.

And thus the ever efficient financial markets give another classic "crash and burn" picture. Like Enron, they did all they could to convince the external world that all was well, and, while buying some time, the eventual effect was to make the decline more spectacular and certain. Few things guarantee defeat more certainly than denying the possible.

Those who fear the mess to come from the VaR (Value at Risk) masked derivatives monster are in a similar position to those in New Century who worried about the eventual slowdown in mortgage lending. We are worried about eventualities, in New Century's case, interest rate hike inspire slowdowns in mortgage creation and in our case, unhedgeable (or mismanaged) price changes that lead first to individual bankruptcy and then, via ever more tightly woven financial links, a more general credit market breakdown.

While the Wizards of VaR, who turn The Wizard of Oz's trick on its head, using smoke and mirrors to make the awe-inspiring and terrible appear ordinary and manageable, (pay no attention to the trillions of $ of derivatives behind the curtain) would have you
believe that by the magic of risk summation, millions of individual contracts between parties can be distilled into simple, hedgeable "deltas," I'd rather focus on those two words, pilot error.

Corporations, be they governmental, religious or commercial come and go. They are run by men and men err. Pilot error is here to stay and, as noted above, one obvious form of pilot error is to deny eventualities. So take your reassurances from the Wizards of VaR that there is far less risk than there seems to be with a grain of salt. If Toto, in the form of New Century Financial, fails to tear down the curtain there will be, I fear, more to come.


The brass tacks crowd is likely wondering IS THIS IT? The problem is, I don't think anybody knows. How many other financial institutions are as unprepared for a housing recession,
or any other untoward shift, as New Century, and as un-forthcoming?

My best guess is that, barring drastic changes, the world of finance can continue duct-taping the markets together for the time being. The myth, or so I see it, of safety in bonds and risk of real assets like precious metals, remains firmly entrenched judging by price action in Treasuries. When Bond prices begin to follow equity indices lower, which will likely coincide with a break in the recent correlation between precious metals and equity indicies, watch out.


STS said...

Pilot error indeed. Pure play companies like New Century could reasonably be expected to be more deeply in denial about the risks of their trade. More diversified players (eg GS) have "co-pilots" (higher levels of mgmt) who are less incented to see a particular sector as "coming up roses".

With your "good gamma gone bad" example in the previous post, the key issue is contagion. Does the next domino fall, or not? The good folks at JPM who told our journalist friend (daan) "our risk analysis is very good" need to look to the risk of multiple counterparty failures (a spike in default correlation) as much or more than the risk inherent in a given name.

The next few weeks or months should be instructive in measuring the "rate of infection" from subprime to other areas.