Pinning colours to the mast

I've been thinking about starting a blog for a while but Goldman Sach's obscene second quarter results have finally got me off my backside. A year or so ago, a rather bizarre image entered my head that has, stubbornly, stayed with me. It was of Chuck Prince, former Chief Executive of Citigroup, dancing cheek-to-cheek with David Viniar, current CFO of Goldman Sachs. In July 2007, Mr Prince, talking about securitisation, told the FT, "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing."

I, like many, thought this remark was pretty dumb. But, hey, if he wants to dance, wherever he's hiding, let's find him a dance partner! Who better than Goldman's CFO David Viniar, who trumped Prince with his own dumb remark a month later? Viniar's remark was made in a call to investors in two of Goldman's model-driven quant funds. The funds' poor performance, he explained, was attributable to them having experienced "25 standard deviation events, several days in a row". It is utterly absurd to even think about explaining how unlikely such an occurrence is (though an alternative explanation is that the funds' models might, just might, be flawed). So, instead, I'll just let him and Chuck dance the night away. A heavenly merger.

Anyway, back to Goldman's results. That the bank making a profit of US$3.4 billion thanks to direct and indirect support from taxpayers, many of whom have lost their jobs in recent months as a result of the financial crisis, is obscene is without question. What is unclear is what the backlash will look like. As George Bernard Shaw noted, "A government that robs Peter to pay Paul can always depend on the support of Paul." If Obama does not act to ensure that it is Paul, not Peter, who benefits from Goldman's windfall, Paul may be compelled to take the law into his own hands.

Dangerous risk, also known as fat tail risk, relates to events that have not been contemplated, so is unlike the common-or-garden variety that the financial industry naval-gazes over. If we had seriously contemplated two planes being flown into the World Trade Center, not only would the probability of 9/11 happening have been much lower, as Saudis inquiring about commercial jet simulator lessons, among other things, would have raised red flags as well as eyebrows, but our response to the event would also have been different. By being able contemplate an event, we can act to reduce both the probability of it occurring as well as our exposure to it, physically or emotionally. In fact it is this combination of (objective) probability and (subjective) exposure that is what is known as risk (an event may be likely to happen, but it poses no risk to us if we would not be impacted by it.)

Dangerous risk, therefore, relates to "unknown unknowns", as Donald Rumsfeld might have put it, whose probabilities, of course, cannot be known (outcomes of the throw of a die, like day-to-day stock price movements, are "known unknowns"). However, for the investment world's risk models to have an output, probabilities (the input) must be known. The models are spitting out something, but it's not a measure of risk, that's for sure (naval variations, perhaps?) David Einhorn, President of Greenlight Capital, likened Value-at-Risk, the flagship of the financial risk management world, to “an airbag that works all the time, except when you have a car accident.”

We assume that fewer tremors in stock markets, economies, societies etc. to mean that risk has fallen. In fact, like volcanoes, it normally means the opposite, as pressure, hidden from view, builds and builds, eventually to be released in violent fashion. Paul has been patient, but the blatant robbing of lower income groups by government and its bankster paymasters seems, to me, an eruption waiting to happen.