Aamer Ghaffar's Blog

I have recently been involved in a number of debates about the efficiency/usefulness of VaR (Value at Risk). Much like Macs, you either love it or hate it. In this post I have examined both the usefulness and the effectiveness of the VaR calculation by looking at the pros and cons of its use as a risk management tool.

In financial math VaR is a popular measure used to gauge the risk of loss on a specific portfolio. The VaR itself is a single number that represents the minimum loss that a portfolio can suffer in a period of time, for a pre-calculated percentage of worst cases with the caveat that the absolute weights of the portfolio are not changed during that period.

Proponents of VaR believe that the process behind the calculation is as important as the result because it forces organizations to confront their exposure to risk and set up proper risk management functions to attempt to mitigate the revealed risk. They acknowledge that the benefit of VaR is not in the single number but in everything that goes into calculating the threshold.

A second advantage would be that VaR calculates the minimum loss that will occur one day in a hundred (assuming 99th percentile) enabling the risk manager to allow the company to take all the risk it wants within the VaR limit, as statistically the firm will remain safe. However, outside the limits indicated, nothing can be accounted for and the risk manger is on his own. Proponents of VaR believe that that though it cannot account for everything, the fact that VaR provides the decisive line between what is acceptable risk and what is not proves it to be a useful tool for risk management.

The problem with VaR begins with its definition, which fails to account for the fact that the actual loss could be far deeper than the minimum. Since these losses are buried deep within the ‘tail’ of the portfolio they go largely unobserved.

Another problem with VaR is that it seems to factor in correlations between risk factors that come up during the time the data is gathered (normally VaR takes into account data from the past few years). However, these correlations tend to breakdown in times of turbulent markets. Furthermore, banks are only required to reveal a number but not the method with which it was calculated. A bank can say its VaR is down twenty percent but that does not necessarily mean that the risk is down twenty percent, as the decrease could just be a result of assumptions made by the analyst. The problem once again is that companies and governments both stress too much on the number that VaR shows but do not scrutinize the assumptions driving that number, resulting in the public getting a false sense of security.

The biggest complaint with using VaR has to be the argument for using normal distributions to create scenarios. The normal distribution is a symmetric bell shaped curve that is focused on the center and decreases on each side, and hence has less of a tendency to produce extreme values. Working with the assumption of a normal distribution (in regard to the real life market) seems to be the most unrealistic choice. Simply put, normal distribution fails to capture what is going on in the lower tails of the distribution. Even if we were to accept the assumption that actual portfolio returns would be normally distributed, the market would not be representative of this due two major factors: Firstly, VaR leads to a bunching of risk that contradicts the diversification principle. Secondly, VaR does not take into account the increased complexity that is added by aggressive trading and the use of derivative instruments.

In conclusion, although VaR does have some benefits, it cannot be solely relied on as a measure of risk as it is not designed to deal with extreme shocks or “black swan” events. Rather, by using volatility and correlations calculated from past market movements, VaR estimates a singular risk number that in no way utilizes or takes into account market expectations or movements. As a result I believe that VaR is ineffective as single risk management tool (especially) in the turbulent markets we are faced with today.

Note: General Motors has filed for bankruptcy protection, Chrysler is on its way out of bankruptcy after filing less than two weeks ago…

Finance

The VIX is no where as high as it was towards the end of last year and the markets have been doing significantly better since then as well. However, that does not mean that the market and public are still not afraid of an over involved government. In these trying times everyone is tuning into the news and following every word coming out of Tim Geithner’s mouth. With such high scrutiny on every word uttered, I was astounded to hear about Tim Geithner’s simpleminded and pointless decison to regulate both Venture Capital and hedge funds. What surprised me more is the tepid response this issue has received both from the press and public. Secretary Geithner went onto justify his statement by mentioning the high risk and instability caused by these firms due to the high levels of leverage that they take on. Though I understand his concern regarding Hedge funds, Venture Capital (VC) by their very nature do not take on high amounts of leverage.

There is a significant difference between venture investment funds (what Berni Madoff ran) and venture capital (the kind of investing that started Amazon.com, Google, Microsoft and Apple to mention a few).

Where as venture investment funds, invest your money in the market and generate returns using their savvy investing skills (or Ponzy schemes). Venture capital invests money in small business without using much leverage (debt). Start ups traditionally don’t take on debt because they don’t have steady or at all predictable cash flows, they also make it clear from the outset that you may loose 100% of your investment if things don’t go as planned. Thus, it is not the average Joe that invests his life savings but wealthy institutions and investors that are looking to make high returns by ‘gambling’/investing a few hundred thousand.

Mr. James Freeman the author of the Op-Ed peace, makes a compelling case and there is little I can add to what he wrote.What I will try to do in this piece is try and understand what Secretary Geithner was trying to accomplish by making such statements.

I will give the treasury secretary the benefit of the doubt and assume that his intention behind the policy recommendation was not to regulate venture capital per se but to try and make it harder for hedge funds to pose as venture capital funds to avoid the vast umbrella of SEC regulation. We saw an example of such shenanigans at work with TARP 1.0, when insurance companies started to buy small and mid size banks in order to be eligible for TARP funds. However, what I don’t understand is why Mr. Geithner would explicitly go after VC funds, instead he could have made more caveats regarding hedge funds rather then explicitly talking about VC funds. The fact of the matter is that the NASDAQ has by far been the best functioning exchange this year. Small and medium sized industries suffered already due to the high expense incurred due to compliance with Sarbanes Oxley. Regulating VC funds is going to create more road blocks for start ups and make it harder for these companies to come up. By trying to mollycoddle the investor the administration is not encouraging risk (something the treasury secretary insisted he wanted to see more of) but instead is scaring people away from the mere thought of taking risk. This Results in the suffocation of yet another growth artery of the currently (growth) anemic economy.

I hate to quote fictional charecters such as Spider man’s grandad but the guy had a point when he told his grandson Peter Parker, “with great power comes great responsibility’. Think about it Timmy G!

Politics, The Economy

Re-Cap
Monday the 23rd of March was the best day for the market since October 2008 and consequently the best day of 2009. The S&P was up 7% (12% in March) making March 2009 the best month since March of 2000. While the Dow was up 6.8%  (10% for March) it has managed to be the best monthly percentage gain since October 2002. Technology continued to lead the charge with the NASDAQ up 6.76% (it has only been down 1% the entire year, and March has been the best month for the index since November ‘02)

Unlike the rallies of the past six months that were hard to explain, the reason for this rally can be primarily attributed to an Op-ED that Tim Geithner wrote (a couple of weeks ago) along with some other news that we will discuss further in this post. In short, Mr. Geithner stated that the treasury will vow to use $100 billion in funds from TARP (through its toxic asset plan) to buy distressed debt and pool these assets together. In return, the treasury secretary wants both individuals and banks to take more risk.

In spite of the S&P going south 3.5% on the news of the administration cracking down on the auto industry and FASB ditching mark to market accounting in favor of mark to model, I could not be happier. I think someone in the administration finally read my blog.

In regards to the auto industry I am ecstatic that the government has started taking some initiative and given Chrysler thirty days to make a deal with FIAT or else resort to bankruptcy. In principle I do not support a large amount of government intervention, nor can I be happy when someone loses his or her job. However, I whole-heartedly support the president’s decision to ask the GM CEO to step down. The fact of the matter is that unless the companies change their business plans drastically they do not deserve any money as they will continue to be non-competitive and be a recurring expense on the government’s already over leveraged balance sheet. The pressure on the auto manufacturers is not unpatriotic by any means. All it is doing is requiring that auto manufacturers take some serious initiative to try and right many years of inefficacy. To illustrate my point, the Ford Model T was more fuel efficient than a Ford Taurus.

In reference to the accounting standards, changing to mark to model will by no means solve the financial crisis. Mark to model accounting rates assets valued purely by mathematical models. This should be able to help value assets that do not have a market available. Contrary to popular belief this will not increase the big banks’ stock prices either because the market will ‘price in’ the fact that mark to market accounting is not being used. What mark to model accounting will do is boost the banks’ capital ratios (the ratio gives an idea of a company’s financial structure and some insight into the companies financial strength). In essence, the higher the capital the ratio, the less money will be required by the banks. It is important to note that this will not be retroactive (for past years) and will only be valid starting the first quarter.

Though I will be the first to admit that I am excited about the progress being made, I caution you not to ignore the past and to ensure that you put the recent gains of the market in perspective. Though things are looking much improved, the gains may be misleading as the market has taken such a beating the past six to eight months that 100 point days may lead you to believe the recession is long gone… Unfortunately, the truth is we still have a long road ahead.

The Economy

Don’t worry, I am not asking you to remember the day, date and location of your first date with your significant other…

Recap:
On March 5th the Dow closed below 6600, the S&P closed at its lowest since Dec 1996 and Citi managed to drop below a dollar. If this news was not depressing enough, an economics professor at Harvard says there is a 20% chance of a depression (and further elaborated that the 1/5 estimation is on the optimistic side.)

Back to the stress test:

The government stress test is expected to be carried out later this month. The goal of the stress test is to see how much capital the banks need to remain solvent and how much money the government will need to invest in order to absorb losses and ensure that the banks are able to sustain lending. Though the final details of the stress test have not been released (or decided), three major scenarios are being looked into during the initial discussions. Will the banks be able to remain solvent if:
i) Unemployment hits a whopping 8.9% in ’09 and 10.3% in 2010.
ii) The Case-Shiller (housing) index declines 22% in ’09 and 7% in 2010.
iii) The GDP contracts 3.3% in ’09 and 0.5% in 2010.
It is important to note that the stress test guidelines are a good indicator of how the government is expecting 2009 and 2010 to pan out. The stress test is set to give banks an idea of what they did right in the past, where they are currently weak and what they should expect in the future (keeping in mind current geo-political stresses and trends).

Now that I have explained what the government is hoping to achieve by using a stress test, I will now show you why this is all a huge waste of time. First, crises don’t occur at the drop of a hat. Unemployment will not instantly hit 10.3% and cause havoc. Most serious problems occur as a series of events. For example, sub-prime loans were only 14% of the US financial market. The problems arose when banks started to package and tank up on AAA rated mortgages as if they were AAA utilities. It is only then that sub-prime became an issue. In short, one ”bad” piece of news will not cause the economy to go down in a tail spin.

Second, can the test be objective? Scenario one: the same test is administered to all banks. The problem with this is that all banks are not the same. For instance Citi Bank and Goldman Sachs are in very different positions. Thus, giving all banks the same test inadequately models the situation and will fail to generate useful information. Scenario two: each bank gets a customized stress test. The problem with this strategy is that there is a chance that the test givers bias (how’s that for a technical term?) may come into play. However, I will be magnanimous for a moment and assume that the test will be extremely fair. In this case, how will the banks be compared on a level playing field if they are been given different tests?

Third, all banks were forced to take TARP 1.0 because the government did not want to single out the banks that needed the money. What is going to happen when a bank fails the stress test and needs more capital? Is it OK for the market to punish the stock now?

Furthermore, there is no guidance on whether the government is going to use tier one capital (common stock, preferred stock and hybrid debt and equity) or tangible equity capital (focus on shareholders equity) to gauge the health of the banks.

How do further capital injections in the absence of altering business models solve anything? AIG just required another $30 billion, after all the money they have already received. Much to GM’s chagrin, their auditors and accountants have said that the company can not function in its current state and will need to file chapter 11 and restructure to remain viable (a fact that GM continues to vehemently deny). Nationalization (or pre-privatization) could be a temporary solution. However, the issue of Moral Hazzard still remains.

The Economy

We have two items of good news. First, the administration has finally addressed what I consider one of the most important issues regarding the economic meltdown… Housing! I am happy that the issue is being addressed, but not how it is being addressed because of the possibility of a moral hazard – individuals that will be insulated from risk may behave differently after receiving the stimulus than they would if they were fully exposed to the risk.  Second, irrespective of where you stand on the issue politically or socially, I feel that it was a good move to lift the ban on stem cell research as it will further strengthen the (thus far) ‘recession proof’ bio tech industry.

Politics, The Economy

What was the goal of TARP 1.0? Some say it was a failure because the goal was to generate credit (which it failed to do). Thus, these people feel that the second installment will also be a failure. The opposing school of thought is that the program was successful  because the goal was to stabilize the financial sector and build confidence (which it did do to an extent). Thus, the second installment will aim to alleviate credit (build capital). Just to play devils advocate, it can be assumed that TARP 2.0 is either a failure or will be able to alleviate credit. However, wasn’t the high availability of credit the main instigator of the economic crisis as it gave rise to problems such as easy loans to unqualified customers in the first place?

If the banks collapse they face the same question as the auto makers: where does the TARP money stand relative to other debt? In case a ‘big bank’ is forced to file for bankruptcy, where does the government money rank (in terms of seniority). Though they initially bought preferred stock where will the second round of financing stand relative to other debt? Is the government looking for all-out nationalization? Will the government continue to manage the banks’ exposure to leverage, bonuses etc? These are some important questions that need to be addressed when the treasury comes out with its ‘detailed plan’ in a few weeks.

The problem is that this seems to be a recurring theme with the government. Though they are doing what they can to make the economy better, the lack of both details and clarity are making the situation a lot harder to understand and thus a lot harder to deal with. Help me out here, Timmy-G!

Politics, The Economy

The UAW has announced that they have made a tentative agreement to renegotiate their national contracts with the Big Three in order to make the domestic giants more competitive with their international rivals. As it stands today the difference between hourly wages of domestic and international manufacturer’s is between $4 – $7 an hour (not counting retirement and other benefits). The renegotiation of the contracts is expected to level the playing field and make for a more competitive economic landscape. Just as a reminder GM expects to repay the loan by 2012 and to be profitable by 2017. GM also envisions industry wide U.S. sales of 11 million units in 2009. This estimate is the latest revision from the initial projection of 12.5 to 13 million units that was released in December 2008. Of course, none of this will be possible without more of the tax payer’s money: on Tuesday, GM asked for a further $16.6 billion, while Chrysler asked for $5 billion dollars (a combined total of $21.6 billion)!

Just a thought: what happens if GM does not make its numbers due to the condition of the global economy?

In case you do not know what I am talking about, let me give you a recap of the events that took place on Tuesday, February the 17^th 2009. The Japanese index (Nikkei) closed extremely close to its 26 year low. Russia had to close its market (again), the Euro was at a 3 month low, the Dow neared its low from five and a half years ago (29 of the 30 stocks going south) and the S&P was down 4%. It is no surprise that with so much uncertainty surrounding the economy people are turning to safer havens such as Gold and Treasury bills. The increase in demand for Gold has caused it to hit a 7 month high (flirting with $1000) up 9% in 0’9. Furthermore, investors continued to seek safe investments by investing in extremely low yielding T-bills (in some cases investors are losing money with the brokerage fees but taking solace in the fact that the money they invest will still be there in the next few months.) In short, car buying is not really high up on the average Americans ‘to do’ list. If that was not enough to convince you of the condition of the global economy, Adi Ignatius (editor in chief of HBR) gives a wonderful synopsis of the sentiment surrounding the recently concluded World Economic Forum, discussing how the experts feel about the condition of the global economy.

Now that we have gotten that out of the way you can see why I feel that the auto makers will not be able to meet their sales targets. I now come to more pressing issues. Where does the government money that has already been granted go if one or all of the Big Three file for bankruptcy? Seeing how the companies are continuing to ask for more money and repeatedly revising projections, why is the government throwing  more money at the problem? What happens if the Big Three cannot achieve their projected sales? Will the tax payer get any money back?

Politics, The Economy

I was quite excited when I saw the Dow crossing 9000 on Jan 1st 2009. However, I was also cognisant of the fact that very thin volume was responsible for why the market was looking so promising: the first Monday of January (the 5th) was considered to be the real start to the New Year as traders had taken the last few weeks of December and the first few days of January off (coincidentally so had the gloom in the market). Since then things have looked anything but promising. The reason why I am summarizing the events of this month is that it is a harbinger of what lies ahead. The ‘January effect’ states that the first 30 days of January dictate the general trend of the market 90.4% of the time. As the markets closed on Friday, we recorded the worst January to date. Here is to hoping that this year falls into the 9.6% where the theory is off.

If you are as frustrated as the I am with the current situation the  the Guardian offers some catharsis by pointing fingers at a few of the major players “responsible for” the financial crisis. Though, I do not entirely agree with some views proffered, it does make for some interesting reading.

The Economy

I pity the fool who thinks the nationalization will be the answer to all our problems. With Britain buying a majority stake in the Royal bank of Scotland and speculation that Lloyd’s and Barclays may follow, the pundits feel that nationalization is the answer to alleviating the troubles of banks today. I beg to differ!

The fact that the government will be running banks is a thought scarier than a slumber party at the Neverland ranch. There are around 8000 banks in the United States today. It will be close to impossible for one body (in this case the government) to run such a large-scale operation. One does not have to look any further than the DMV or the US postal service to see the “efficiency” with which the government runs its large operations.

All things aside, on a fundamental basis the nationalization of Wall Street seems like a huge mistake. What makes Wall Street so amazing is the collection of brilliant minds that can make magic happen (using the free market as a catalyst). Good or bad, what the investment banker can do is truly amazing. (Before you start rolling your eyes and muttering about people being overpaid, please take a look at a GM assembly line employee who gets paid $90,000 for relatively simple work (with full benefits of course). I digress. What makes Wall Street special is its competitive landscape and innovative thinking. Currently the government has already tied the banks’ hands behind their backs by: moderating bonuses, having the last say on the major capital (expenditure) decisions, controlling dividends and regulating the amount of leverage a bank can take on. Nationalization will be the final blow that will take the wind out of Wall Street’s sails.

You may think that it is not a big deal as financials are no longer as important as they once were. A few years ago financial stocks accounted for over twenty percent of the market cap of the S & P 500. Now they have dwindled down to roughly ten percent.  Though the size of the market cap may have diminished the effect on the market, if anything it has grown. In short, financials are without a doubt the trendsetter for the market. (Simply put, the market more or less moves up or down depending on how financials perform on that day.) I will be the first to admit that the condition of the economy is a worrying and that the government has a lot on its plate. However, a bigger role by the government (with little or no technical expertise in the field) is absolutely not the answer to these problems.

Update, Jan 26th: The New York Times has published an insightful article discussing both the pros and cons of nationalization.

Politics, The Economy

(The title seemed appropriate with the current state of affairs and the new B.I.G movie being released)

The government has offered to bail out Bank of America for a second time (helping them to be true to their name and really becoming America’s bank – using the tax payer’s money of course). The reason is simple: they did not expect Merrill to be this hard to digest. (Question, what do you expect with 48 hours of due diligence?)

Citibank is set to split up to form Citicorp and Citi holdings. To put it in simple terms, the former is the ‘good bank’ that will handle the traditional banking work, while the latter will take the role of the ‘bad bank’ and manage the firms riskiest assets. Citi is also selling one of its most profitable divisions, (its brokerage unit Smith Barney) to Morgan Stanley (I like the name Citi–Morg for the company). Furthermore, CitiGroup is planning to eventually cut down to be half or even one third of its current size. Food for thought: will Citi still be considered too big to fail and get continuous support from the US tax payer (as BOA has managed thus far)?

Seeing the conditions of banks one cannot help but agree with Mohamed El Eriam (co-head of PIMCO) that banks are just as good (or bad) as utility stocks.
If you have 15 minutes to spend, I highly recommend playing ‘ the bailout game’

Highlights for this week:

America swears in its 44th president. Though I am excited to see history being made, I am especially excited to see if treasury secretary Geitner will actually go through with his suggestion to let banks move from mark to market accounting to mark to model accounting. This should help banks improve their balance sheets as they will be able to put a reasonable value on assets that do not have a market.

Tech companies will be revealing earnings this week. I have to say I am more excited about the conference calls that will follow. I want to see what Apple has to say after their dismal handling of affairs regarding Steve Jobs health. What will their future guidance be with him on extended leave? Will Microsoft shed light on pursuing Yahoo, now that a new CEO is in place and finally will Google continue to show its resilience as a top firm.

Note: The Maddof scandal, bailouts and depressed condition of the economy makes us all feel like there are a lot of things wrong with the world. However, the spirit of the New Yorkers in aiding the US airways rescue mission and the courage of the pilot reassures you that there is still some good in the world.

Politics, The Economy