What if I told you that the true culprit behind the credit crisis was a mathematical device known as Value at Risk (or just VaR)? And what if I told you that said tool has been promoted, embraced, and enforced by financial regulators for more than a decade? That such enthusiastic backing by the policymakers was not abated one iota by VaR's well-known structural flaws and capacity for havoc-wreaking? Wouldn't you feel cheated by those who are supposed to watch for our safety? Are regulators really supposed to condemn us to economic hell via the adoption of knowingly misguided and lethal theoretical concoctions? Shouldn't things be changed? Shouldn't senior politicians intervene?
Let me tell you why VaR caused the crisis: as the regulatory-sanctioned mechanism for determining the capital charges that banks have to incur for their trading activities (ie, how much they have to put upfront in order to play the market game), VaR allowed Wall Street to gorge on the kind of poisonous toxic securities which eventual tumble unleashed the chaos. Because VaR numbers were (unrealistically so) very very low in the build-up to the troubles that started in mid-2007, Wall Street was required to part with but a tiny amount of capital in order to accumulate all those billions of Subprime Collateralized Debt Obligations. The tool said that if you wanted to devour lots of illiquid (high-yielding) stuff you just had to deposit a little bit of collateral, and investment banks obliged in earnest. It has been estimated that in the case of several banks the (VaR-dependent) market-related regulatory capital charges amounted to just 1% (and even less) of their entire trading positions. Now that's a lot of leverage. If pundits have been making a fuss about the 30-to-1 overall leverage levels displayed by Wall Street in recent years, how about the 100-to-1 and even 500-to-1 leverage that the regulatory rules permitted for speculative trading activities?
Keep in mind that what truly killed us was the impossibly leveraged accumulation of impossibly toxic speculative bets by Wall Street. That combination of leverage and junk is what devastated Lehman Brothers, Bear Stearns, Merrill Lynch and the rest, giving birth to the worst financial malaise since the Great Depression. And what sanctioned such deadly, unseemly combo? VaR. By churning out minion figures for capital requirements (ie, by making the speculative binge affordably economical), the tool did it.
Why does VaR produce such low numbers? Because of the way it is calculated. VaR is supposed to measure the worst outcomes (losses) deriving from a portfolio of trading assets, with a given degree of statistical confidence. The problem is that in order to arrive at those "predictive" loss numbers, VaR focuses exclusively on the rear mirror, essentially assuming that the future will be like the past. But in the markets, the past is certainly not prologue, and there's no guarantee that historical data will ever be able to capture the future nasty surprises unavoidably lurking in the dark alleys of financeland; especially if, as VaR tends to do, you believe that markets follow a Normal probability distribution, one that rules out the possibility of extreme events. If the recent past, as was certainly the case in the run-up to the crisis, has been calm and placid VaR will say that the future will also be calm and placid, thus no need for prohibitive capital charges. "There's no risk!", VaR loudly proclaimed all those years prior to mid-2007, "Freely gorge on that Subprime stuff!". Thus the 500-to-1 lethal leverage. In essence, those low VaR numbers allowed Wall Street to take more and more risk, more and more recklessly.
Before VaR (which was enshrined into law by international banking regulators around 1996), the capital charges on toxic trading fare would have been way less economical for traders (charges might have reached 100%, rather than 1%), effectively making it impossible for firms to bet the farm on such daring punts. By adopting VaR, regulators signed our death sentences.
Somebody should loudly tell politicians that this can't happen again. How can you allow the determination of trading-related capital charges, an irremediably impacting element of the economic sphere, to be based on a tool that consistently underestimates risk, especially when it matters the most? How could the Securities and Exchange Commission, fatalistically fatefully, have allowed Wall Street broker-dealers in 2004 to use VaR to determine the cost of their trading adventures? That single action, dubbed by some as "Bear Stearns Future Insolvency Act", killed us as much as anything else.
It's time for political bigwigs to release the "stop VaR" sign and order their financial mandarins to relinquish the deleterious machination once and for all. It's fine to spend time approving rescue packages that can help salvage the economy, but you can't leave the root evil of this malaise unaddressed. President Obama, please say no to VaR and help us avoid a future similar meltdown.