WE INTERRUPT “What Is To Be Done?”

TO BRING YOU THIS NEWS BULLETIN ---

Crock Spokesmen Strain The Nation’s Incredulity

I have decided not to use this space to initiate a discussion of all the inanities that were uttered yesterday before the House of Commons Treasury Select Committee by the Northern Rock Board Chairman, Dr. Matt Ridley; the CEO, Adam Applegarth and the “independent” Board Member, Sir Derek Wanless. (Blessedly, the other independent member, Sir Ian Gibson, kept to platitudes and words of commiseration for employees and depositors.)

This decision is partially in keeping with my desire to continue on the positive track of my “What Is To Be Done?” series. It is also because even I, in my most cynical and satirical frame of mind, could not replicate the farce that was played out in the committee room at Portcullis House.

Instead, I wish to make reference to only one point put most eloquently by Dr. Ridley and repeated ad nauseum by Mr. Applegarth and Sir Derek Wanless that “We were hit by an unexpected and unpredictable concatenation* of events.” As lyrical and melodic as the phrase may be and, as brilliant a zoologist as Dr. Ridley is, he and his colleagues were speaking, I regret to say, balderdash, claptrap, drivel, hogwash, idiocy, lunacy, poppycock, rot, rubbish, tosh, twaddle; i.e., all around nonsense. Let us take the quote one claim at a time:

First, it was not “unexpected.”
Many commentators and market watchers were positing, even as early as the fourth quarter of 2006, the potential for a severe and long-lasting disruption in the credit markets. The very committee that had called the Northern Rock management to testify had discussed the possibilities in open session in the spring of this year. The housing market in the US (something one would expect mortgage bankers in the UK to follow rather carefully) had been exhibiting difficulty since autumn 2006 and went into a free-fall in spring 2007. Whilst no one was placing a date and time on when and by whom the shot would be fired, we all knew that the gun was loaded and that it had a hair trigger.

Second, it was not “unpredictable.”
The FSA had warned Northern Rock in April that its stress testing regimen, built for the regulatory reforms of Basel II, was not thorough enough. Indeed, Mr. Applegarth admitted today that the bank hadn't run tests to see how it would cope with a "rapid, long-lasting closure of the financial markets."

When asked by Committee Chairman, John McFall, why such a scenario had not been run,the head of Northern Rock’s Risk Committee, Sir Derek Wanless, failed to follow the party-line (enunciated just minutes before by Mr. Applegarth) saying, “Our stress tests at the time were sufficient.” An incredulous Chairman McFall parried by asking, “Why are you here alone, out of all banks? Why are you an orphan in the banking sector?" Sir Derek, threw all caution, as well as logic, to the wind and responded, “The position is not that at all. We were stress testing plausible scenarios.” When I read this quote, I must admit words failed me. Fortunately, they did not fail MP McFall who, shaking his head, hit back with, “This is unreal! This is unreal!...You don't know how you got here? You as head of the risk committee didn't do your job."

Third, “concatenation of events” are anything but rare.
A review of the most severe market disruptions/dysfunctions (which were accompanied by rapid rises in interest rates and/or inflation) over the last three plus decades include the following events:

The Russian collapse/LTCM failure starting August/September 1998
The East Asian Financial crisis starting in July, 1997
The Market Crash of October 19,1987 – Black Monday
The US Recession of 1980-1983
The Second Oil Shock of 1978
The First Oil Shock of 1973

Add to these:
The Enron/Worldcom/Quest/Adelphia, etc. collapses of 2002 - 2004,
The Dot.Com bubble burst of 2000-2001,
The UK Housing Market collapse of 1991 -1993
The US Housing Market collapse of 1989 -1992,
The Junk Bond (LBO) market collapse of 1989 -1990
(including the liquidation of Drexel Burnham Lambert)

and you can see that concatenation is not a “remote” event. Rather, it is something that we have experienced repeatedly in the markets over our lifetime. For the principal players at Northern Rock not to have known of these past events and the probability of a future catastrophic event occurring that could cause massive market disruption is not only highly implausible, it borders on the impossible.

Taking a Look Back
To illustrate what went wrong, in part, at Northern Rock, I went in search of two articles I had read many years ago regarding another financial institution (let us call it "XYZ Company" ) and fortunately, for once, found them quickly. The first is from the financial writer, Joe Kolman, in 1999:

Like most players in the market, “XYZ Company” used a variety of risk management techniques, including value-at-risk, stress testing and scenario analysis. VAR analysis estimates the maximum loss that can be suffered at a certain level of confidence, often 95 percent or 99 percent. VAR numbers are estimated using historical information about volatility and correlation. The assumption is that the future will be approximately like the past.

“XYZ's” firm-wide VAR analysis analyzed the thousands of positions it held and generated predictions about the daily profit-and-loss volatility it was likely to face. ... (At the beginning of what would be its last year in business) “XYZ” managers say they carefully geared their portfolios so that the daily firm-wide P&L volatility remained at about $45 million.

Risk managers were comforted by other statistics. According to “XYZ’s” models discussed in the road-show, a 10 percent loss in its portfolio was judged to be a three-standard-deviation event—an event that would occur once in a thousand or so trading periods. A loss of 50 percent of its portfolio was unthinkably high. According to one of its estimates, the firm would have had to wait 10-to-the-30th days—several billion times the life of the universe—to experience that kind of loss. By massaging the data, and applying other, more conservative econometric techniques, it would have had to wait 10-to-the-ninth days (1 billion days or approximately 2.7 million years).

“XYZ” used industry-standard risk management methodologies, but put undue reliance on value-at-risk numbers at the expense of stress testing. ”XYZ’s” executives also admit the firm badly misjudged market dynamics and liquidity issues, and failed to reduce the firm’s risk in the wake of losses."

The second quote comes from an article written in 1998 by Bonnie Loopesko, a former senior staffer at the Federal Reserve Bank of New York:

“People focus a lot on whether volatility should be scaled up to two, three or five standard deviations. But stressing correlation assumptions is as important as stressing the size of shocks in volatility assumptions. In some cases, recent correlations between markets have turned out to be dramatically different from anything we’ve seen before.

One of the most difficult things in stress testing is getting people to suspend incredulity. If you come up with a scenario that’s relatively extreme, senior managers can say: “We can run that scenario but it won’t happen.” As a result, you attach such a low probability to it that you discount it & don’t take any action. So it becomes a meaningless exercise. You don’t reduce positions, you don’t hedge; you just run this scenario because somebody told you to.

You can believe that spreads will converge over a longer time frame, but if that’s outside the time frame of market patience, it doesn’t do you any good. “XYZ” thought it had taken care of that because it had locked in its investors. But it couldn’t lock in its creditors. One could argue that even Drexel Burnham was a viable concern when it went under. If creditors aren’t going to be patient, the liquidity issue bites with a vengeance.”

In case you are still wondering, for “XYZ Company” read Long-Term Capital Management.

So what lesson can we draw from these two seemingly disparate, yet astoundingly similar, failures? Simply, while market upheavals cannot be timed, we know that they are out there waiting for us. Prudence dictates not just that we use models and stress tests, but that we use our experience of past events to prepare for future events, which will undoubtedly not play out as they had in the past. It is imperative that we use our brains, not just computer programmes. Why? To quote Benoit Mandelbrot because, "Clouds are not spheres; mountains are not cones; coastlines are not circles; bark is not smooth; nor does lightning travel in a straight line. Being a language, mathematics may be used not only to inform but also, among other things, to seduce.”

To summarise:
The central question which the Treasury Select Committee asked yesterday, “Could Northern Rock’s Board and Management have foreseen the events that transpired in the markets and, having foreseen them, could they have forestalled the damage to themselves, their debtors, depositors, staff and the British taxpayer?” has only one honest answer, “Yes.”

The leaders of Northern Rock chose to bury their heads in the sand. They low-balled their stress tests by removing what they thought were improbable, but what we know to have been very possible, scenarios. Today, they tried to "pass the buck” to the BBC, the Bank of England, the FSA, to the US, to everyone and anyone, save themselves. They could not admit that they had fallen victim to their own hyperbole, to their own narrow view of the greater world, and worst of all, to their own hubristic belief that their business strategy was foolproof. It turned out instead to be a proof for fools.


Cassandra

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* Concatenation is the linking of things together or the state of being interconnected and/or interdependent.