Tales from the Meltdown 8: The Fall of VaR

When the markets fell, the common wisdom was that no one saw it coming. Somebody did. In fact, a lot of somebodies did. So why didn't everyone? Joe Nocera at the New York Times Magazine goes hunting the Value at Risk model, which gives a confidence interval around downside losses for a security or total portfolio. Unfortunately, the VaR number may also be based on inaccurate assumptions, and may therefore lead to worse decision making than would be the case if no measure were used at all.

How then do we account for that story that made the rounds in the summer of 2007? It concerns Goldman Sachs, the one Wall Street firm that was not, at that time, taking a hit for billions of dollars of suddenly devalued mortgage-backed securities. Reporters wanted to understand how Goldman had somehow sidestepped the disaster that had befallen everyone else. What they discovered was that in December 2006, Goldman’s various indicators, including VaR and other risk models, began suggesting that something was wrong. Not hugely wrong, mind you, but wrong enough to warrant a closer look.

“We look at the P.& L. of our businesses every day,” said Goldman Sachs’ chief financial officer, David Viniar, when I went to see him recently to hear the story for myself. (P.& L. stands for profit and loss.) “We have lots of models here that are important, but none are more important than the P.& L., and we check every day to make sure our P.& L. is consistent with where our risk models say it should be. In December our mortgage business lost money for 10 days in a row. It wasn’t a lot of money, but by the 10th day we thought that we should sit down and talk about it.”

So Goldman called a meeting of about 15 people, including several risk managers and the senior people on the various trading desks. They examined a thick report that included every trading position the firm held. For the next three hours, they pored over everything. They examined their VaR numbers and their other risk models. They talked about how the mortgage-backed securities market “felt.” “Our guys said that it felt like it was going to get worse before it got better,” Viniar recalled. “So we made a decision: let’s get closer to home.”...

“The question is: how extreme is extreme?” Viniar said. “Things that we would have thought were so extreme have happened. We used to say, What will happen if every equity market in the world goes down by 30 percent at the same time? We used to think of that as an extreme event — except that now it has happened. Nothing ever happens until it happens for the first time.”

Which didn’t mean you couldn’t use risk models to sniff out risks. You just had to know that there were risks they didn’t sniff out — and be ever vigilant for the dragons. When Wall Street stopped looking for dragons, nothing was going to save it. Not even VaR.