A simple view of black swan event blowing up Wallstreet
Posted by Frugal on October 14th, 2008
Never say never. It’s always hard to say that the probability of an event is absolute zero. So let’s say you’ve got the following probabilities:
98% of the chance to earn 3% annualized return, and
2% of the chance to lose 5%.
Now comes the “smart” and most greedy Wallstreet bankers and say that I’ve got some great idea. I will leverage 10X to 30X, and then earn a great return from that 3%. So the return becomes 30% to 90% annualized. That is just great!
Okay, so every day or every month, a dice is thrown, and 98% of the time, it will come out winning. And then it’s winning and winning and winning, and it’s great terrific return all the way, until….
Well, everyone knows that 2% chance is NOT an impossible event. So as time goes on, there is going to be one day that this 2% event happens. In fact, given a long enough time period, it is simply a certainty that such event WILL happen. Well, I don’t know why these people don’t think about such certainty of demise, but apparently they are just too greedy.
Anyway, when the 2% event comes, losing 5% in a leverage of 10X to 30X becomes 50% loss to 150% losses. As soon as you cross 100% loss, you are bankrupt and game over in one single shot.
Unfortunately from the very beginning, the leveraged players have already planned their demise.
And WHY does our capitalistic system allows such greedy players to take away millions if not billions of bonus, jumping ahead of everyone else by leverages when things go well, and leaving up a big mess for everyone to clean up when it blows up?
My proposed solution is that there should not be more investing leverages anymore for anyone. Just play fair. If you’ve got one dollar, you bet one dollar. If you’ve got one thousand dollar, you can bet one thousand dollars. No more messing around for Wallstreet. Don’t take everyone else down just because you don’t have those 30X money that you borrowed in the first place.
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October 14th, 2008 at 12:14 pm
I believe the leveraged betting is related to Greenspan Put / moral hazard going back to LTCM, or even the original Savings & Loan bailout. Once the betters see that big government might bail them out, they take on even more leverage. Heads I win, tails you lose. Privatize profits, socialize risk, etc.
October 14th, 2008 at 1:54 pm
The Amero will be here sooner than expected. This has been planned for years.
October 15th, 2008 at 4:25 am
At the very least, keep the leverage to a point where a series of catastrophic events cannot completely wipe out a major financial intermediary.
Sadly, your simple explantion of VaR modelling was lost on the “experts” who became so impressed with the sophistication of their models that they forgot about what happens in a more than 99% event.
That the banks take these risks is due to the fact that, as you say, there is big money to make on all the other days. Any since pay is driven by annual performance, and since performance is measured in comparison with peers over the same period, there is a major penalty for not taking risks that others took successfully. That is, the relative performance risk is extremely high for the individual banker. Besides, most individual bankers/traders do not expect to make a 30 year career of the business. The objective is to make a pile quickly and find some other line of work – ideally managing your assets from your boat. So, if a “Black Swan” occurs every 10 years or so and your time horizon is 1 year, most of the time you are going to be up. Furthermore, when you lose, you get to keep the profits (i.e. bonuses) you earned in previous years. Clearly a heads I win, tails you lose proposition.
Of course, this doesn’t explain the stupidity of bank CEOs who had massive amounts of their personal fortunes at risk in the stock of the bank they managed. Unlike many of the rank and file, they did not have an option that paid off if they were right and simply left them with zero if they lost (which encourages risk taking). They had real prospect of loss. It goes to show that armed with massive incentives for “outperformance” are not a way out of the agency problem.
October 15th, 2008 at 12:31 pm
Question: “And WHY does our capitalistic system allows such greedy players to take away millions if not billions of bonus, jumping ahead of everyone else by leverages when things go well, and leaving up a big mess for everyone to clean up when it blows up?”
Short Answer: Due to the ‘winner take all’ mentality. You see this on game shows, the lottery, court battles, Wall Street.
October 25th, 2008 at 8:21 am
Um, guys, the crisis wasn’t caused by greed. Believe it or not, companies don’t like going bankrupt. Like. Seriously.
The crisis was caused by government policies. Just go check out the Wikipedia article — stop listening to the blasted media. The NYTimes reported that the crisis was coming …. in 1999, because the government literally forced lenders to give loans to people who –couldn’t– afford them. You can’t get around this.