This Thursday September the 10th marks a historic development for both Washington and the financial markets. The US Congress' Committee on Science and Technology will hold a hearing on the responsibility of mathematical model Value at Risk for the credit crisis. As HuffPost readers know full well, I have long blamed VaR for the mayhem (remember: VaR allowed banks to build the toxic leverage that sunk them and the world). To my knowledge this is the first time that a financial theory is put on the spot like that, the inevitable consequence of having endured a theory-caused meltdown of biblical proportions.
My friend Nassim Taleb has been invited as expert witness by the Committee. That's a wise choice. Taleb has not only been a real derivatives trader for decades, but crucially has been warning about VaR's potential for destruction for at least 15 years. As I told HuffPost readers not long ago, he alone predicted what has just happened, including the term "bail out". Frankly, it was only a matter of time before VaR killed us.
While I don't doubt that Taleb will kick ass in the nation's capital, I would like to contribute to the crusade (hey, the Committee also contacted me and apparently began to wonder about VaR's role in the crisis after reading my stuff) by making some suggestions to the author of The Black Swan. Nassim, if I may, here are some things that I would like you to ask at the hearing:
- Why did regulators embrace and enforce a tool that is built on obviously flawed foundations? Didn't they understand that a broken tool should not be given the power to set capital charges for trading activities? Didn't they understand that VaR would tend to generate lethal leverage and to hide risk given its tendency to be unrealistically low?
- Why did they continue to peddle VaR even after it had failed dramatically during the Asian and LTCM crises of 1997-98? Don't regulators care that their models fail?
- Why did the SEC finally succumb to the VaR siren songs emanating from Wall Street and in 2004 allow broker-dealers to use the model to set their capital requirements?
- Why did they find it acceptable that some banks would, courtesy of VaR, run 100-to-1 and even 1000-to-1 leverage on their trading positions, as they did in the run-up to the crisis, especially when a lot of that trading stuff was super nasty?
- Why don't regulators just abandon VaR altogether rather than try to hastily fix what is not fixable?
- Why not use the crisis as an opportunity to erase demonstrably flawed mathematical models from financeland once and for all? Finance theory has been responsible for the worst market meltdowns since 1929, isn't it time we protect ourselves from the delterious math and its quantitative promoters?
It's great that the "beware of models" debate has moved to Washington. Let's not waste the chance. We can't allow a repeat of the latest malaise. I am not sure how close the hearing's venue is to the White House, but if Barack Obama is available and not busy with other things he could do worse than stop by. Perhaps unbeknownst to him and the rest of the political class, the theme under discussion on that Thursday is as relevant to our economic welfare and social stability as almost any other thing. I'm sure that should he eventually stop by, the new leader of the free world would be seduced by Taleb's argumentation and, if that's not too much to hope, prompted to take remedial action. As I also said in a past HuffPost rumination, it is time for President Obama to help us kill the tool that killed us.