No Value

No Value

There is an excellent editorial in today’s Wall Street Journal discussing the Value at Risk model and how it failed the markets during the current economic crisis. It is nice to see someone else besides myself criticize the blind reliance on models.

For years I have written of the dangers of the fire and forget method of investing. Value at Risk models are only as good as their input data. One can plug in historical data and a formula (being based on logic) can spit out a result. What a formula can never account for is the human element which is the basis of markets and the economy as a whole. The economy is not like the orbiting of the Space Shuttle or a communications satellite. Engineers can use mathematical formulas to make a satellite remain in a specified orbit. Since there is no human interaction with the direction or speed of the satellite, once in orbit, it will perform as planned by a formula. We can predict the arrival of Halley’s Comet. However, markets and economies are all about human interaction. It is why they exist. The reducing of markets and economies into mathematical formulas will always be problematic because formulas cannot predict the human mind. This is, apparently, surprising to some. It is mainly surprising to the scientists who created the formulas. My advise is to learn the markets and human nature before creating a formula.

Where did the formulas fail us? As the Journal article stated, they did not take into account the politically-motivated decisions regarding Freddie and Fannie and their social lending to people who could not afford a home or the home which they wished to purchase. The so-called Value at Risk models did not (could not) take into account that many mortgages this time around were issued with little or no documentation. Models cannot factor in home flippers who purchased multiple homes with no money down and, because they never paid down payments, have no impetus to try to make mortgage payments. Remember, these were not the roofs over their heads, but investment speculations. Even primary homeowners who put little or no money down have little incentive to pay their mortgages. Buying a home with no money down is similar to renting in that the only capital expended was to make monthly payments. If one cannot afford the monthly payments, one can simply move to a rental property with nothing lost, except for the monthly payment which would have been made anyway be it rent or mortgage payments.

Formulas should be used as guides and re-engineered to account for new market and economic developments. However, this defeats the purpose of formulas. Investment banks and hedge funds use formulas to manage large pools of money most efficiently. Constant human attention makes it less efficient to do so. Some also believe that adding more human interaction creates more volatility and unpredictability. Too bad, the markets are complex and, often, dangerous places. I would rather have a sharp and savvy trader than a reborn physicist creating formulas based on old data and having little if any market experience. This is akin to the age-old criticism of the military. Military strategies are often criticized for planning to fight the last war. History has demonstrated that the strategy which recognizes and reacts to new realities prevails.