VaR and the Black Swan

VaR AND THE BLACK SWAN....Joe Nocera has a good piece in the New York Times Magazine today about VaR, the risk model that established a virtual hegemony on Wall Street before the great financial implosion of 2007-08. Nassim Nicholas Taleb, author of The Black Swan, argues that the fundamental problem with VaR lies not in its technical guts, but in the fact that it's specifically designed to exclude potential catastrophes:

In its most common form, [VaR] measures the boundaries of risk in a portfolio over short durations, assuming a "normal" market. For instance, if you have $50 million of weekly VaR, that means that over the course of the next week, there is a 99 percent chance that your portfolio won't lose more than $50 million.

....VaR is often measured daily and rarely extends beyond a few weeks, and because it is a very short-term measure, it assumes that tomorrow will be more or less like today. Even what's called "historical VaR" — a variation of standard VaR that measures potential portfolio risk a year or two out, only uses the previous few years as its benchmark.

....Yet even faulty historical data isn't Taleb's primary concern. What he cares about, with standard VaR, is not the number that falls within the 99 percent probability. He cares about what happens in the other 1 percent, at the extreme edge of the curve....A good example was a credit-default swap, which is essentially insurance that a company won't default. The gains made from selling credit-default swaps are small and steady — and the chance of ever having to pay off that insurance was assumed to be minuscule. It was outside the 99 percent probability, so it didn't show up in the VaR number. People didn't see the size of those hidden positions lurking in that 1 percent that VaR didn't measure.

Taleb has been making this argument for quite a while, and obviously events have proven him prescient. But I've always had a couple of problems with his critique. First, our current economic crisis isn't really a black swan, is it? Things like this have happened fairly regularly during the past century (and before), on the order of once a decade at least, and maybe more often than that. Pretending that this was a wildly improbable event strikes me as nothing more than a sophisticated version of "nobody could have predicted." After all, if the crash of 2008 really was a one-in-a-hundred (or one-in-a-thousand) event, then it really is true that even reasonable people couldn't have been expected to foresee it.

Second, I've never seen Taleb explain what we should do about this. What's his advice? Here's Nocera: "Taleb likes to say that, as a trader, he has made money only three times in his life — in the crash of 1987, during the dot-com bust more than a decade later and now. But all three times he has made a killing." Fine. He's made money three times in the past two decades. But he knows perfectly well that this doesn't work on a broad scale. Ordinary trading desks have to make daily trades based on evaluation of ordinary risks. That's how global finance gets done. So the question is: given the fact that we need ordinary global finance, and not everyone can just sit around waiting to make a killing on black swans, what should all these ordinary trading desks be doing to protect themselves against possible meteor strikes?

Taleb doesn't seem to say (though maybe he has and I just haven't seen it), but this is what I'd like to hear more about, especially since he seems to have a lot of interesting and perceptive ideas about the behavioral basis of finance and financial crashes. In the meantime, Nocera's article is a good read, even if it doesn't really provide any answers.

UPDATE: Yves Smith pans Nocera's article here. I'm a little puzzled by a lot of what she says, since it strikes me that Nocera wrote at length about topics that she says he ignored, and in no way wound up "defending a failed orthodoxy." But maybe I'm missing something.

Frost/Nixon

FROST/NIXON....Becks went to see Frost/Nixon and wasn't impressed:

The movie is even worse than the play. I felt that it was total bullshit. I don't want to get too spoileriffic, but my main problem was that the movie cultivates an air of a faux documentary, trying to convince the readers that it's well-researched and based on actual events, and then completely invents a pivotal scene that is supposed to explain both Frost and Nixon's motivations. I was pissed enough that this went unmentioned in the movie (my recollection was that it's admitted in the play) but really turned against it upon learning of even more insidious manipulation of events from my fellow moviegoers after the show.

I haven't seen the film either, partly for this reason, and I'm beginning to wonder if Ron Howard is planning to make a habit of this. As I recall, he was praised for the accuracy of Apollo 13, but then he went and made A Beautiful Mind, which bore practically no resemblance to the book at all. Like all of us, I'm pretty used to movies taking dramatic liberties with the truth, but aside from the fact that it depicts a famous mathematician who later became mentally ill, the movie version of A Beautiful Mind might as well have been made on another planet from the one where the book was published. I've been suspicious of everything Howard has made since then, and it sounds like Frost/Nixon is more along the same lines.

Anybody else seen it? What did you think?

The Ownership Society

THE OWNERSHIP SOCIETY....The Washington Post reports that the Bush administration plans to sign an eleventh hour agreement allowing a timber company in Montana to pave roads passing through Forest Service land. Why? Apparently because we're suffering from a housing shortage:

The shift is technical but with large implications....As Plum Creek has moved into the real estate business, paving those roads became a necessary prelude to opening vast tracts of the company's 8 million acres to the vacation homes that are transforming landscapes across the West.

Scenic western Montana, where Plum Creek owns 1.2 million acres, would be most affected, placing fresh burdens on county governments to provide services, and undoing efforts to cluster housing near towns.

Impeccable timing as always from the Bush administration. What better time than now to provide a free gift to the homebuilding industry?

Colorado Governor Bill Ritter's choice of Michael Bennet to replace departing Senator Ken Salazar (Salazar is leaving Congress' esteemed higher body to become Obama's Secretary of the Interior) is already drawing criticism. Bennet, the reform-oriented head of the Denver school system, has never run for office in his life and has never held a statewide position. There is little evidence that suggests he can hold onto the seat when challenged by a Republican in 2010.

A few weeks ago, when Bennet was generating buzz as a possible Secretary of Education, I spoke to a friend who is a charter school teacher in Denver. She was skeptical. Naturally, I asked her for her thoughts on Bennet's latest move. They are below.

A Capitol Hill-type who got his start interning for Blagojevich responds to a blog post from yesterday that raised the possibility that Blago appointed Burris because Burris helped Blago win the 2002 governor's race. Blago, who had no standing in the black community at the time, won the Democratic primary only because Burris stole some of the black vote away from a man named Paul Vallas who had assiduously courted the black community.

Sorry, no. Blago's not the kind of guy who returns favors, and Burris (a man who has built a lavish monument to himself listing his accomplishments) is not the kind of guy that would do a massive favor like this and then wait around 6 years for a Senate appointment that no one could have predicted in 2002. Burris ran because he thought he could get the nomination by having Vallas and Blago split the white/downstate vote, leaving Burris with the nomination in a year with a remarkably weak Republican party and candidate.
Why has Blagojevich picked Burris now? Because he needs 19 votes from State Senators to survive impeachment. 9 State Senators are black. I think Blago's hoping they're all getting calls from community leaders asking them to stand by him since he stood by them.

Can Paving America be Eco-Friendly?

Given that Obama's economic stimulus package is likely to include billions of dollars in road projects, how will he counteract the environmental toll? One idea, supported by the steel industry, is to funnel more of that money into rail, such as the $45-billion high-speed train between Los Angeles and San Francisco that was approved by the state's voters in November.

Another idea is to build those roads greener. Two new cement companies, one in Great Britain, another in Silicon Valley, claim to have discovered a new way to produce cement that not only emits no carbon dioxide, but also sucks much of it from the atmosphere.

This is no small feat. Cement production accounts for 5 percent of the world's CO2 emissions--more than the entire aviation industry. And a recent report by the French Bank Credit Agricole estimated that demand for cement will increase 50 percent by 2020.

The Silicon Valley company, Calera Corp, was founded by Stanford professor Brent Constanz, who in 1986 invented a medical cement that revolutionized the way hospitals repaired broken bones. Unlike conventional cement, which is made by heating up limestone or clay to around 1500 degrees C, his medical cement combined carbon dioxide and magnesium to mimic the way coral reefs are formed. His new eco-cement works much the same way, except the carbon dioxide comes from power plants that would otherwise spew it into the atmosphere. The British company, Novacem, uses a similar process.

Both companies claim their products are strong enough to work in roads, buildings, and bridges and are cost-competitive with conventional cement. The hard part will be to convince customers that the cements will endure the test of time when there's no real track record. Of course, using conventional cement will also be a gamble--in the form of some 450 million tons of yearly carbon emissions.

2009: Predictions For the Year In Music

mojo-photo-2009glasses2.jpg2008 is dead and gone, and the universal opinion seems to be, from the economy to our government to music: "good riddance." As Slant put it, "the cliché that oppressive Republican administrations foster the most compelling music was disproved over nearly each of the last 52 weeks." Music seemed splintered and aimless, and year-end best-of lists seemed to reflect the confusion, with the same 50 records showing up a lot, but in completely different orders. Some of the year's most successful and compelling music was actually made months, or even years, before the start of 2008. So, 2009, will you be any better? Here's a quick (and admittedly somewhat fanciful) look ahead at the year ahead's most anticipated releases.

Friday Cat Blogging - 2 January 2009

FRIDAY CATBLOGGING....Here's Inkblot in the pod again. For some reason, he seems to be going through weird phases of being frightened by the pod, followed by phases of adoring the pod. Yesterday he was in one of his adoration phases. Today he's sleeping on the bed, but making sure to keep his distance. I'm really not sure what's going on.

Domino, meanwhile, is obviously annoyed that Marian is explaining something to Professor Marc, who was visiting last night, instead of keeping immobile and providing her with a proper cat bed. Truly, the life of a cat is a hard one.

*Long-Form Journalism

LONG-FORM JOURNALISM....David Brooks today:

Everything becomes a shorter version of itself. Essays become op-eds. Op-eds become blog posts. Blog posts become Twitter tweets. The Sidney Awards stand athwart technology, yelling stop. They are awarded every year to some of the best examples of long-form journalism and thought.

Of the four pieces Brooks chooses to honor, the Lewis and Judis pieces I had already read, and both were good. The Professor X piece I had also already read. I didn't reread it, but I remember thinking at the time that it was more routine gripe than insightful observation. The Caldwell piece was new to me, and it was pretty engaging. Overall, a pretty good bunch of selections.

Maybe Blagojevich Does Owe Burris Something

The media has been looking for evidence that Roland Burris' appointment to the United States Senate is payback for something Burris once did for Governor Rod Blagojevich. Ben Joravsky, publishing over at TNR, may have put his finger on it. Without Burris, Balgo would have never made it out of the Democratic primary in the 2002 race for Illinois governor: