Wednesday, December 5, 2007

About Taking Risks

The Eidgenoessische Technische Hochschule (ETH) in Zurich, Switzerland, is an astounding institution of higher learning. Literally, the name translates into English as “Federal Technical High School”. "Federal", because the Swiss federal government supports the institution. "Confederal" would be more appropriate, because the Swiss define their nation as the Confederation of the Swiss. The acronym on their trunk stickers reads CH for confederatio helvetiae, which means Confederation of the Swiss in Latin. Latin was the language of the learned when the Swiss founded their Confederation more than 700 years ago with an oath sworn to help each other. “Eidgenossenschaft”, the German term for the Confederation, means comradeship by oath. The ETH is not a High School. That would be a “Gymnasium” in the Teutonic Languages. It is an engineering school. I use statistical analyses frequently. The ETH helps to develop R, which is one of the most powerful and versatile statistics packages available in open source computing.

In the year 2000, the ETH launched a research initiative in risk assessment. When I heard of this idea, I thought: ”Typically Swiss! They always worry about insurance.” When I checked, most projects aimed at assessing risks in civil engineering and catastrophic damage. But, I bet the principles guiding the software find ready application in the assessment of other types of risk. Just a few weeks ago CEO Charles Prince resigned, because his bank had incurred tantamount losses while dabbling in high-risk investments in sub-prime lending (Dan Wilchins and Jonathan Stempel's post on Reuters dated Nov. 2, 2007, with the title "Citigroup CEO Prince to resign: reports"). What did he blame? Faulty software that was making bad predictions on risk! In his testimony before the Committee on Oversight and Government Reform,  Mar. 7, 2008, he blames the models the industry was using. Perhaps, he should have consulted with the ETH, before he decided to go down that road.


  • In hindsight, the bank managers heavily relied on these tools in their decisions. However, even at UBS they did not comprehend them well enough to interpret the data correctly (08/01/2008).
  • At yesterday's congressional hearing, Citigroup's former CEO Charles Prince apologized to Americans hurt by the financial crisis that Citigroup helped precipitate in no small part. He believes that risk reporting within the institution at the time was not at fault and followed good practices. Rather, faulty risk assessment caused the bank's enormous losses. He had come to this conclusion already three years ago (see above). However, now responsibility is shifted to the originators of the bad loans. Prince seems to believe that Citigroup was misled by the original lenders' overoptimistic judgment of the customers' ability to service subprime mortgages. As a result, the risk attached to the securitized bundles containing these loans was understimated and the price at which they were sold to investors was overrated. Listen closely (04/09/10)!
  • Contrary to the former CEOs of Lehman Brothers, Citigroup and Washington Mutual, some in the industry understood the risk attached to subprime lending extremely well.

    On Apr. 22, 2010, Carrick Mollenkamp, Mark Whitehouse and Anton Troianovski published an informative chronicle in The Wall Street Journal entitled "The Busted Homes Behind a Big Bet" of the events surrounding a collateralized debt obligation, or CDO for short, named Abacus that achieved notoriety lately as an example for the catastrophic failure of securitized mortgage bundles that precipitated this country's greatest economic crisis since the Great Depression while providing its creators with extraordinary returns.

    In 2007, Paulson & Co., a hedge-fund management company, helped create Abacus 2007-AC1 for institutional investors in collaboration with Goldman Sachs and the portfolio selection-agent ACA Management, LLC. Within the next six months, Abacus would lose 83 percent of its value.

    Paulson & Co. had painstakingly analyzed the mortgages bundled in Abacus and correctly predicted that great losses were inevitable and soon to come. A senior employee of the firm, Paolo Pellegrini, was deeply involved in structuring Abacus. According the Wall Street Journal article, " Mr. Pellegrini and a colleague had purchased an enormous database capable of tracking the characteristics of more than six million mortgages in various parts of the country. They spent long hours scouring it all, according to people familiar with the matter." Paulson and Co. took out insurance against the CDO's demise, cashing out a billion dollars at its end.

    Apparently, correct models for risk assessment and data bases with the necessary information were available to those who wished to come to the right conclusions (04/25/10).
  • This Reuters video report by Bobbi Rebell with the title "Camping out for a change" published today portrays a new political movement that attempts to harness people's feared risk of being set adrift by those with a seemingly insatiable appetite for it. Within the past decade, risk assessment has become the overarching theme of our time (10/10/2011).
    (Thumbnail photo by Lucy Nicholson, Reuters)


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