Currency Wars_ The Making of the Next Global Crisis - James Rickards [101]
The role of VaR in causing the Panic of 2008 is immense but has never been thoroughly explored. The Financial Crisis Inquiry Commission barely considered trading risk models. The highly conflicted and fraudulent roles of mortgage brokers, investment bankers and ratings agencies have been extensively examined. Yet the role of VaR has remained hidden. In many ways, VaR was the invisible thread that ran through all the excesses that led to the collapse. What was it that allowed the banks, ratings agencies and investors to assume that their positions were safe? What was it that gave the Federal Reserve and the SEC comfort that the banks and brokers had adequate capital? Why did bank risk managers continually assure their CEOs and boards of directors that everything was under control? The answers revolve around value at risk and its related models. The VaR models gave the all clear to higher leverage and massive off–balance sheet exposures.
Since the regulators did not know as much about VaR as the banks, they were in no position to question the risk assessments. Regulators allowed the banks to self-regulate when it came to risk and leverage. It was as if the U.S. Nuclear Regulatory Commission allowed the builders of nuclear power plants to set their own safety specifications with no independent review.
Many scholars and practitioners had been aware of the flaws and limitations in VaR. The truth is that the flaws were well known and widely discussed for over a decade both in academia and on Wall Street. The banks continued to use VaR not because it worked but because it permitted a pretense of safety that allowed them to use excessive leverage and make larger profits while being backstopped by the taxpayers when things went wrong. Using VaR to manage risk is like driving a car at a hundred miles per hour while the speedometer has been rigged to stay at fifty miles per hour. Regulators in the backseat of the car glance at the speedometer and see 50, then go back to sleep. Meanwhile the car careens wildly, like something from a scene in Mad Max.
The destructive legacy of financial economics, with its false assumptions about randomness, efficiency and normal risk distributions, is hard to quantify, but $60 trillion in destroyed wealth in the months following the Panic of 2008 is a good estimate. Derivatives contracts did not shift risk to strong hands; instead derivatives concentrated risk in the hands of those too big to fail. VaR did not measure risk; it buried it behind a wall of equations that intimidated regulators who should have known better. Human nature and all its quirks were studiously ignored by the banks and regulators. When the financial economy was wrecked and its ability to aid commerce was well and truly destroyed, the growth engine went into low gear and has remained there ever since.
Washington and Wall Street—the Twin Towers of Deception
By the start of the new currency war in 2010, central banking was based not on principles of sound money but on the ability of central bankers to use communication to mislead citizens about their true intentions. Monetarism was based on unstable relationships between velocity and money that made it ineffective as a policy tool. Keynesianism was applied recklessly based on a mythical multiplier that was presumed to create income but actually destroyed it. Financial economics was a skyscraper erected on the quicksand of efficient markets and normal risk distributions that bore no relation to real behavior in capital markets. The entire system of fiscal policy, monetary policy, banking and risk management was intellectually corrupt and dishonest, and the flaws persist to this day.
Recently new and better economic paradigms have emerged. However, Washington and Wall Street both have a vested interest in the flawed models from the past. For Washington, Keynesianism is an excuse to expand spending and monetarism is an excuse to concentrate power at the Fed. For Wall