Risky Business

In peacetime, you think about other people’s intentions. In wartime, only their capabilities matter. VaR is a peacetime statistic.

In financial risk management, Value at Risk (VaR) is a widely used measure of the risk of loss on a specific portfolio of financial assets.

If a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 5% probability that the portfolio will fall in value by more than $1 million over a one day period, assuming markets are normal and there is no trading. Informally, a loss of $1 million or more on this portfolio is expected on 1 day in 20.

With the current economic downturn, the role, relevance, success and dangers of VaR are being hotly debated and – at least for now – Honestly Lay Bare is not going to dirty its keyboard to enter such a discussion.

What Honestly Lay Bare has found of interest in researching this entry is the history of VaR and how it came to be.

In less than a decade it appeared that we had mastered the quantification of risk!

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The late 1980s and the early 1990s were a time when many firms were trying to devise more sophisticated risk models because the world was changing around them.

Banks, whose primary risk had long been credit risk — the risk that a loan might not be paid back — were starting to meld with investment banks, which traded stocks and bonds.

Derivatives and securitizations — those pools of mortgages or credit-card loans that were bundled by investment firms and sold to investors — were becoming an increasingly important component of Wall Street.

But they were complicated to value.

For one thing, many of the more arcane instruments didn’t trade very often, so you had to try to value them by finding a comparable security that did trade. And they were sliced into different tranches each of which had a different risk component. In addition every trading desk had its own way of measuring risk that was largely incompatible with every other desk.

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JPMorgan’s chairman at the time VaR took off was a man named Dennis Weatherstone.

Weatherstone, who died in 2008 at the age of 77, was a working-class Englishman who acquired the bearing of a patrician during his long career at the bank. He was soft-spoken, polite, self-effacing.

At the point at which he took over JPMorgan, it had moved from being purely a commercial bank into one of these new hybrids.

Within the bank, Weatherstone had long been known as an expert on risk, especially when he was running the foreign-exchange trading desk. But as chairman, he quickly realized that he understood far less about the firm’s overall risk than he needed to.

Did the risk in JPMorgan’s stock portfolio cancel out the risk being taken by its bond portfolio — or did it heighten those risks? How could you compare different kinds of derivative risks? What happened to the portfolio when volatility increased or interest rates rose? How did currency fluctuations affect the fixed-income instruments?

Weatherstone had no idea what the answers were. He needed a way to compare the risks of those various assets and to understand what his companywide risk was.

The answer the bank came up with was Value at Risk.

To phrase it that way is to make it sound as if a handful of math whizzes locked themselves in a room one day, cranked out some formulas, and — presto! — they had a risk-management system.

In fact, it took around seven years, according to Till Guldimann, a former JPMorgan banker who ran the team that devised VaR and who is now vice chairman of SunGard Data Systems.

“VaR is not just one invention,” he said. “You solved one problem and another cropped up. At first it seemed unmanageable. But as we refined it, the methodologies got better.”

Early on, the group decided that it wanted to come up with a number it could use to gauge the possibility that any kind of portfolio could lose a certain amount of money over the next 24 hours, within a 95 percent probability.

That became the core concept. When the portfolio changed, as traders bought and sold securities the next day, the VaR was then recalculated, allowing everyone to see whether the new trades had added to, or lessened, the firm’s risk.

“There was a lot of suspicion internally,” recalls Guldimann, because traders and executives — nonquants — didn’t believe that such a thing could be quantified mathematically. But they were wrong. Over time, as VaR was proved more correct than not day after day, quarter after quarter, the top executives came not only to believe in it but also to rely on it.

For instance, during his early years as a risk manager, pre-VaR, Guldimann often confronted the problem of what to do when a trader had reached his trading limit but believed he should be given more capital to play out his hand.

“How would I know if he should get the increase?” Guldimann says. “All I could do is ask around. Is he a good guy? Does he know what he’s doing? It was ridiculous. Once we converted all the limits to VaR limits, we could compare. You could look at the profits the guy made and compare it to his VaR. If the guy who asked for a higher limit was making more money with lower VaR” — that is, with less risk — “it was a good basis to give him the money.”

By the early 1990s, VaR had become such a fixture at JPMorgan that Weatherstone instituted what became known as the 415 report because it was handed out every day at 4:15, just after the market closed.

It allowed him to see what every desk’s estimated profit and loss was, as compared to its risk, and how it all added up for the entire firm.

Weatherstone had been a trader himself; he understood both the limits and the value of VaR. It told him things he hadn’t known before. He could use it to help him make judgments about whether the firm should take on additional risk or pull back. And that’s what he did.

What caused VaR to catapult above the risk systems being developed by JPMorgan competitors was what the firm did next: it gave VaR away.

In 1993, Guldimann made risk the theme of the firm’s annual client conference.

Many of the clients were so impressed with the JPMorgan approach that they asked if they could purchase the underlying system. JPMorgan decided it didn’t want to get into that business, but proceeded instead to form a small group, RiskMetrics, that would teach the concept to anyone who wanted to learn it, while also posting it on the Internet so that other risk experts could make suggestions to improve it.

As Guldimann wrote years later, “Many wondered what the bank was trying to accomplish by giving away ‘proprietary’ methodologies and lots of data, but not selling any products or services.” He continued, “It popularized a methodology and made it a market standard, and it enhanced the image of JPMorgan.”

In the late 1990s, as the use of derivatives was exploding, the Securities and Exchange Commission ruled that firms had to include a quantitative disclosure of market risks in their financial statements for the convenience of investors, and VaR became the main tool for doing so.

Around the same time, the Basel Committee on Banking Supervision, went even further to validate VaR by saying that firms and banks could rely on their own internal VaR calculations to set their capital requirements.

JPMorgan later spun RiskMetrics off into its own consulting company.

By then, VaR had become so popular that it was considered the risk-model gold standard.

The month RiskMetrics went out on its own, September 1998, was also when Long-Term Capital Management “blew up.”

L.T.C.M. was a fantastically successful hedge fund famous for its quantitative trading approach and its belief, supposedly borne out by its risk models, that it was taking minimal risk.

It had been an early and high profile adopter of VaR.

Post based on Risk Mismanagement by Joe Nocera New York Times January 4, 2009