January 13, 2009

Self-Deception and the Financial Meltdown

Posted in finance tagged , , , , , , at 6:18 pm by mj

This NYTimes article on Value-at-Risk (VaR) and the systematic masking of investment risk (use bugmenot for registration) provides the most coherent explanation I’ve yet read.

Essentially, it tells the story of the rise of Value-at-Risk (VaR), a metric that purports to ascertain how much money you’re likely to lose in the short-term.

Don’t miss how all the financial institutions exploited its known, even deliberate shortcomings to their advantage–by essentially structuring their investments so that any risk could be shoved off into the “1% probability” that VaR was specifically designed to ignore.

Or how VaR didn’t gain widespread acceptance until 1997, when the SEC gave VaR its “seal of approval.” Not just by saying “it’s OK,” but by forcing financial institutions to disclose a quantitative measure (and since there were no such competing measures around, VaR was the path of least resistance). And then, told those same financial institutions that it’s perfectly acceptable to rely on their own internal calculations, and not disclose the input.

Score one for good ol’ Uncle Sam and his Golden Regulators.

It’s a most excellent read, both for the explanation of how financial risk has been widely (mis-)measured in the past decade, and for the stunning example of how self-deception is such an integral part of the human condition.