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The Real Causes of The: Financial Financial Crisis Crisis

This document discusses the systemic causes of the financial crisis. It identifies three main causes: 1) Misaligned incentives that encouraged risky behavior, 2) Poor risk management practices like the flawed Value at Risk model, and 3) Complexity in the financial system that made it tightly coupled and interactively complex, preventing intervention when problems arose. The document argues that as long as these problems are not addressed, more meltdowns will occur in the future, though they may look different.

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287 views58 pages

The Real Causes of The: Financial Financial Crisis Crisis

This document discusses the systemic causes of the financial crisis. It identifies three main causes: 1) Misaligned incentives that encouraged risky behavior, 2) Poor risk management practices like the flawed Value at Risk model, and 3) Complexity in the financial system that made it tightly coupled and interactively complex, preventing intervention when problems arose. The document argues that as long as these problems are not addressed, more meltdowns will occur in the future, though they may look different.

Uploaded by

Fall Out Boyz
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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THE REAL CAUSES OF THE

FINANCIAL
CRISIS
A Max Capital presentation
MANY CAUSES HAVE BEEN NAMED:

CDO’s

CANS
S
DEM OCR
D
D short

R UBLIC
S sellers
RATS

REPU
’s
s THE FED
S

GREEDY EXECUTIVES
REAL ESTATE SPECULATORS
But there are
SYSTEMIC
reasons for the crisis:
1.INCENTIVES
1.INCENTIVES
2 RISK
2.RISK
MANAGEMENT
1.INCENTIVES
2 RISK
2.RISK
MANAGEMENT
3.COMPLEXITY
misaligned
INCENTIVES
were pervasive
If you give
i
a mouse a
cookie…
If you give
i
a mouse a
cookie…

he’s going
t wantt
to
some milk.
(i.e.)
When you give
someone something,
g,
(i.e.)
it will drive and shape
their behavior.
Bad incentives were everywhere…

MORTGAGE
EXECUTIVES
BROKERS

RATING
AGENCIES HOME BUYERS
ATE There was
no l-i-n-k
EDIA
ONS
S
between
CTIO
IMME
AC

and FUTURE
CONSEQUENCES
Giving a manager
part of the
profits may not
sounddb bad…
d
But when they aren’t punished
f taking
for t ki long-term
l t risks…
i k
then that’s what they’ll do. And
th company will
the ill pay the
th price.
i
companies didn
d d ’tt
MANAGE RISK
correctly
tl
One example is

Value at Risk
The VaR analysis
y
tries to give the
firm a look at how
much risk it’s
taking.
It starts with the
analysis of historical
data & statistics
The data is then run
through a bunch of
advanced models
The final result is a $
amount for a certain
percentile & time
This means that
98% of the time
time,
your investments
y
won’t lose over
$20 million in a
one-month
p
period
There are 3
reasons why
VaR causes
problems:
bl
Keep in mind that
ALMOST ALL
financial firms use
VaR to manage risk
1 st

We’re not very good at


judging extremely rare
risks
1 st

For example, we can guess


the odds of rain tomorrow
fairly well
1 st

But the odds of an


earthquake will be much
less accurate
1 st

Withoutt the ability


Witho abilit to
judge these rare risks,
the VaR models aren’t
very useful
2 nd

Hi t i l data
Historical d t
doesn’t necessarily
predict future returns
2 nd

Garbage in,
in garbage out.
o t
2 nd

Garbage in,
in garbage out.
o t
3 rd

VaR ignores the worst-


worst
case scenario

So losses
could be:
3 rd
3 rd

And this loss


could wipe
p the
company out
COMPLEXITY
is one off the biggest
gg
problems of the market
Some ENGINEERING
concepts can help
explain
p the issue
TIGHT COUPLING:

Every component is tightly linked


When something is
TIGHTLY COUPLED,
it provides no slack
if there is a problem,
problem
AND NO OPPORTUNITY
TO INTERVENE.
LIKE AN ASSEMBLY LINE...
BREAD
OR MAKING BREAD.
(once the yeast is added)
INTERACTIVE
COMPLEXITY:
INTERACTIVE
COMPLEXITY:

A complex system with


components that interact
in unexpected ways
A university
is complex, but
not tightly coupled
There are many components that
interact, but not a lot of problems.
There is plenty of slack and time to
fix any issues.
THE PROBLEM IS WHEN
SOMETHING IS BOTH

INTERACTIVELY
COMPLEX
AND
TIGHTLY
COUPLED
A NUCLEAR REACTOR IS
ANOTHER GOOD EXAMPLE
EXAMPLE.
It’s
EXTREMELY COMPLEX.
Any problem C-H-A-I-N
can cause a REACTION
that
DESTROYS
and POISONS
the system

the surrounding area.


SOUND
FAMILIAR
FINANCIAL MARKETS
are another perfect
example.
example
FINANCIAL MARKETS
WILL NEVER BE SIMPLE
HOWEVER,
HOWEVER
LESS
COMPLEXITY
WILL
MAKE A CRISISMORE
RARE
AND
EASIER TO
SOLVE
So, as long as these
PROBLEMS
aren’t solved:
l d
1.INCENTIVES
2 RISK
2.RISK
MANAGEMENT
3.COMPLEXITY
THERE WILL BE
MORE
O MELTDOWNS
OW S
IN THE FUTURE

(They might look different, but


th outcome
the t will
ill be
b similar)
i il )
CREDITS
Slide 40:
Slid 40 Charlie
Ch li Chaplin
Ch li (www.doctormacro1.info)
( d 1i f )
Slide 44: UCLA (knifetricks.blogspot.com)
Slide 45: Harvard
p
(outdoors.webshots.com/photo/1180073619050918329ZHUCAf )
Slide 47: Courtesy of Boeing
Slide 52: NYSE
(www.cnn.com/CNN/Programs/anderson.cooper.360/blog/archives/2008_
01 01 ac360 archive html)
01_01_ac360_archive.html)

CONCEPT RESOURCES
Rebonato, Riccardo. Plight of the Fortune Tellers. Princeton: Princeton University
Press, 2007.
Bookstaber Richard.
Bookstaber, Richard A Demon of Our Own Design.
Design Hoboken: John Wiley & Sons,Sons
2007.

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