Journal Issue

CHAPTER 4 The Private Sector

Luc Leruth, and Pierre Nicolas
Published Date:
November 2010
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The world of finance has witnessed the most flagrant abuses, and therefore we will use it to illustrate our argument. It is clear that the private sector has suffered greatly from “denial of reality,” for example with the explosive expansion of mergers and acquisitions, whose rationale was based implicitly on long-term continuation of abnormally low interest rates and on exaggeratedly optimistic assumptions about economies of scale and additional profits linked to synergies. In perhaps more spectacular fashion, we all witnessed the arrival of CEOs in Washington in private jets, to beg public money, and the televised presentations by Mr. Wagoner,10 who would have made a very fitting Miss Emily if Mr. Madoff hadn’t beaten him to it by a nose.11 In this section, we are going to take on two principal themes: the exaggerated confidence of various actors in validating certain mathematical models (a common point therefore between the private sector and academics, itself so rare a fact that it should be emphasized), in particular value-at-risk (VaR), which played a key role in the unfolding of the current crisis; second, we will return to the decidedly curious case of Mr. Madoff in the role of Emily.

Let us start, then, with the exaggerated confidence placed in the validity of certain mathematical models, and in particular, VaR.12

The VaR of a portfolio provides a quantified value (in euros, for instance) representing its risk of maximum loss within a well-defined time frame (typically 1 day, 30 days, 60 days) and with a given confidence interval (95 percent or 99 percent). For a financial instrument, the VaR is based largely on past volatility calculated over a relatively short time frame. The VaR assumes, however, that returns will follow a normal distribution (a further example of an assumption often made but less often verified). For a portfolio, evaluation of the VaR incorporates correlations between the various component instruments, once again in the relatively short term. As Montier (2007) points out, in periods of turbulence, historic volatility and past correlations are very poor indicators of future changes in these variables. They are all the worse if the sample is limited to the most recent data, which are necessarily a reflection of the present state of affairs. More generally speaking, the principal weakness in VaR-type models is that they consider risk as an exogenous variable. But in cases of violent movements in which all the actors race to act before it is too late, and thereby pursue identical strategies, risk becomes endogenous to the system and the assumption of normal returns is no longer realized.

In the present crisis, VaR was granted unwarranted confidence and proved a paltry risk indicator, providing no danger signal at precisely the moment when it was most needed. Worse still, since most of the financial sector actors were tolerating a maximum VaR relatively independent of the context, the substantial decrease in volatility that almost always precedes a major correction13 led them to take more risk. By contrast, once the correction began, the VaR had to be maintained below a certain value, despite the violent spike in volatility, which naturally set in motion a chain reaction of forced sales.

By trusting too blindly in VaR—and again, this is just one example—the financial sector showed that it was the victim of a serious illusion, namely that it was controlling the risks.

The optimistic use of models is not limited to VaRs. For instance, the rating agencies continue to attribute the same rating scale to assets of very different kinds, whether paper issued by a given business or the slicing up into tranches of portfolios composed of paper issued by a number of businesses.14 By proceeding in this fashion, the rating agencies contributed to fostering still another illusion that affects investors: the illusion of secure investments. Several reasons explain this effect, including the intrinsic difficulty (rarely acknowledged and emphasized by the rating agencies) of awarding an objective rating to a bond portfolio or commercial paper issued by different companies, especially during a period of liquidity crisis, when risks of default are amplified, including by domino effects. The illusion of secure investments was also strengthened by the frequently repeated saying that the “originate and distribute” model enabled spreading risk more widely, thereby diminishing it. The idea is sound (at least from a theoretical point of view, that is, insisting on a point already made, if the initial assumptions prove to be valid), but financial institutions generalized the idea and in fact increased risks rather than diminishing them, thereby contributing to the crisis. Once it becomes difficult to determine exactly who owns what, the distribution of risk cannot be equated with its reduction. No doubt, the agencies should have reacted, but they did not. In fact, they minimized risks prior to the crisis and even during the crisis, just as most of the other players in the financial sector did. On this last point, the analogy with Miss Emily is apposite: it is sufficient to spread a little lime and the nauseating smell will vanish; if it doesn’t vanish, we look for an obvious suspect, hedge funds, for example, the root of all evils for vaguely specified reasons, in exactly the way Emily’s town blamed the servant for leaving a dead rat somewhere (since no one could accept the notion that the very respectable Miss Emily might be associated with the smell).15

To conclude this section with another aspect of “denial of reality,” we recall that Miss Emily makes categorical denials and does not appear surprised that her absence of argument is accepted by the town citizenry (or rather by their representatives). Was this very different in the case of Madoff? In a 2007 interview that became a hit on YouTube, Madoff describes his business in a way that seems delusional to us, now that the facts have been revealed (at least in part).16 Among the most striking points, Madoff is quick to:

  • Explain that mathematicians are needed in order to remove the human element from transactions, but that the mathematicians from MIT lost too much time thinking. As replacements for these professionals, Madoff preferred people like his colleague, present at the interview, and whose CV remains a puzzle despite the questions from the journalist.17

  • Declare very authoritatively that it is impossible to fool the regulators (he would be very surprised if a cheater could be successful for a significant length of time).

  • Underscore that the programs are precise and honest, adding with a smile that it would doubtless be possible to design programs that cheated, but that no one had done so as yet.

  • Reassure investors nervous about the volatility of prices with revealing words: “trust me” and “you can take my word for it,” the star replies, he who—it has recently been revealed—didn’t even take the trouble to engage in trading with his clients’ money (The Economist, August 15, 2009).

Participants in the interview, very impressed to be in the presence of such a financial authority, such a “glamorous” personality with a spotless reputation, lose all their critical acumen, just like the citizens of Jefferson.

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