Tavakoli Structured Finance LLC

The Financial Report

By Janet Tavakoli

Volcker Blames Models, Dimon Blames Policymakers

Updated February 18, 2014

Paul Volcker, former U.S. Federal Reserve Board chairman and member of President Obama’s economic advisory team, gave a speech in Toronto on February 11, 2009, at the Grano Salon Speakers Series on the U.S. economic crisis. He made the mistake of blaming mathematical models instead of malfeasance as the key source of the financial meltdown:

“They thought financial markets obeyed mathematical laws. They have found out differently now. You know, they all said these events happen once every hundred years. But we have ‘once every hundred years’ events happening every year or two, which tells me something is the matter with the analysis.”

Volcker was only partly right. The models would have failed to capture unexpected “hundred year events,” the outliers Mr. Volcker referred to in his speech, but that was not the cause of the U.S. financial meltdown. There were no outliers; there were outright liars. The models crunched misleading data fed to them by Wall Street’s financiers. The events that keep happening every year or two are the effects of massive unchecked malfeasance.

Malicious Mischief

The global meltdown was not caused by an unfortunate mistake; it was caused by malicious mischief. Every problem related to the financial meltdown was discoverable in the course of competent work. Our financial malaise was caused by bad behavior deliberately hidden behind the opaque veil of models and hard to pronounce financial products like collateralized debt obligations and credit derivatives. There is no innocent explanation, and the problem was massive.

Wall Street knew about predatory lending, easy money, risky loans, over-leveraged homeowners, misleading loan documents, failed business models, overleveraged hedge fund clients, shoddy ratings on Wall Street deals, and more. Any finance professional worth their salt knew the data being fed the models in no way represented the risk.

We have a different problem than bad models. This is a classic case of garbage in/ garbage out, and Wall Street pros selling the garbage out knew what they were doing. As hundreds of mortgage lenders failed, Wall Street sped up—instead of halted—its sales of overrated deals. It rushed garbage out the door and into investment funds all over the globe. That would be bad enough, but investment banks lent money against this garbage, and—just as Archimedes told us it would—leverage (borrowed money) moved the world. But not in a good way.

WIRED blames a model called the Gaussian copula saying it could not capture extreme “black swan” events or “grey swan” events that happen more frequently than the model predicted. It is true that Wall Street’s models are flawed, but even if the models had been changed, we would still have had our financial meltdown. All models are flawed, and the suggested replacement models would not have captured the problem, either. I have been a decades-long critic of the limitations of Wall Street’s models, but to blame models for our current debacle dodges the real issue: malfeasance.

I am quoted in the WIRED article:

“’Correlation trading has spread through the psyche of the financial markets like a highly infectious thought virus,’ wrote derivatives guru Janet Tavakoli in 2006.”

I am a trenchant critic of correlation models, as I wrote to the SEC when I suggested the rating agencies’ NRSRO designation should be revoked in February 2007, but I disagree with WIRED’s premise that models were responsible for Wall Street’s crash. Moreover, models weren’t the problem with JPMorgan’s recent London Whale debacle, its commodity debacles, or allegations of currency manipulation. (More on that later.)

Take a Tip from Richard Feynman, the “Black Swan” Excuse Is For the Birds

Perhaps Volcker and WIRED offered an explanation that is strictly for the birds, because they cannot interpret what they are seeing. At a loss for a reasonable explanation, they claim this was an unexpected “black swan.” Richard Feynman, the Nobel Prize winning physicist who worked on the Manhattan Project, would not have been a fan of Volcker or WIRED, because he believed in understanding his birds:

“You can know the name of a bird in all the languages of the world, but when you’re finished, you’ll know absolutely nothing whatever about the bird…So let’s look at the bird and see what it’s doing—that’s what counts. I learned very early the difference between knowing the name of something and knowing something.”

If you looked at what people were doing, it was easy to see there were no black swans or swans of any color involved. Wall Street’s bankers behaved like Black Bart, the 19th-century California gentleman stage coach robber who galloped off with Wells Fargo’s loot without ever firing a shot. Washington-based financial regulators and Congressional overseers behaved like ostriches. It seems they only raised their heads when it was time to reverse legislation that protected the mortgage lending market, approve an Ambassadorship to the former CEO of a predatory mortgage lender, have dinner with financiers, or collect generous campaign contributions.

The massive creation of phony securitizations from risky (and sometimes predatory) loans combined with leverage to form a toxic brew in Wall Street’s financial meth labs. Debt such as this is initially sold at full price. It has no upside, but it has a lot of downside. If you lend (or borrow) money against an asset that will plummet in price, you are in trouble from the start. As the prices of these toxic products inevitably fell, hedge funds and other over-leveraged borrowers were forced to sell in what is called “the great unwind.” Borrowed money and toxic products caused a vicious cycle of selling that fed on itself.

Wall Street has created such a tangled web of risk for itself that financiers often do not trust each others’ prices and often do not trust their own prices. Wall Street would be delighted, however, if U.S. taxpayers would suspend their disbelief long enough to allow the U.S. Treasury to take this mess off of their hands. We were told we would make money. How is that working out so far? We have lost hundreds of billions of dollars in market value and the oversight panels have lost track of our money.

Dimon Asks “Where Were [Policymakers]?”

At the 2009 Davos conference, Jamie Dimon, Chairman, President, and CEO of JPMorgan Chase, remarked:

“Some really stupid things were done by American banks and American investment banks. To policymakers, I say: Where were they?”

Dimon might ask the regulators where they were when JPMorgan was piling on risk and breaking the law in the London Whale incident and taking over-sized positions and manipulating markets in JPMorgan’s commodity trading debacles. Policymakers may have been preoccupied in a cozy huddle with Dimon’s lobbyists. Investigations are ongoing.

Policymakers allowed bailouts without indictments. It is alarming that Paul Volcker perpetrated the myth of mistaken models instead of identifying the missteps of imprudent and pernicious financial practices.

There shouldn’t be an ill-suited model at the end of this whodunnit, rather there should be a long list of Wall Street bankers and perhaps a few Congressmen and regulators.

Endnote: Problems with bad data and manipulation of assumptions for credit derivatives and collateralized debt obligations was known for over decade, as you can easily see if you peruse the “Finance Articles” section of my web site. Problems were also publicized in main stream financial media, albeit later. Here’s an example from the Financial Times: “Market Faith goes out the window as the ‘model monkeys’ lose track of reality,” by Gillian Tett and Peter Larson, May 20, 2005:

The profit from structuring these vehicles has hitherto more than compensated for the risk. Nevertheless, this business has meant that most banks with large structured credit desks have been left with a net long position on the riskiest portion of CDOs.

“Bank books have [in this area] become like invisible hedge funds,” said Janet Tavakoli, a CDO consultant.

However, although the banks’ pricing models have become central to this business, they have never been entirely based on science. For while banks have generally used the same basic statistical technique in their modelling systems, they have employed different assumptions about corporate default, recovery or correlation rates.

See also: “Goldman’s Undisclosed Role in AIG’s Distress” – TSF – November 10, 2009

Read more finance articles by Janet Tavakoli

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