New York: The risk-taking model that emboldened Wall Street to trade with impunity is broken and everyone from Merrill Lynch & Co chief executive officer John Thain to Morgan Stanley chief financial officer Colm Kelleher is coming to the realisation that no algorithm or triple-A rating can substitute for old-fashioned due diligence.

Value at risk, the measure banks use to calculate the maximum their trades can lose each day, failed to detect the scope of the US subprime mortgage market’s collapse as it triggered more than $130 billion of losses since June for the biggest securities firms led by Citigroup Inc, Merrill, Morgan Stanley and UBS AG.

The past six months have exposed the flaws of a financial measure based on historical prices that securities firms use idiosyncratically and that doesn’t anticipate every potential disaster, such as the mistaken credit ratings on defaulted subprime debt.

“Finance is an area that’s dominated by rare events,” said Nassim Taleb, a research professor at London Business School and former options trader.“The tools we have in quantitative finance do not work in what I call the `Black Swan’ domain.”

Taleb’s book, The Black Swan, published last year by Random House, describes how people underestimate the impact of infrequent occurrences.

Just as it was assumed that all swans were white until the first black species was spotted in Australia during the 17th century, historical analysis is an inadequate way to judge risk, he said.

Executives at Merrill, Morgan Stanley and UBS took steps in the past six weeks to overhaul their risk-management groups after internal models failed to foresee the first annual decline in house prices since the Great Depression that eroded five years of trading gains.

Goldman Sachs Group Inc, the firm with the highest nominal VaR, was the sole investment bank to report record earnings in the fourth quarter, while New York-based Merrill, which had the second-lowest nominal VaR of the five biggest US securities firms, posted a $9.8 billion loss for the last three months of 2007, the biggest in its 94-year history.

Thain, who replaced the ousted Stan O’Neal last month at Merrill, said on January 17 that the largest US brokerage should stop making trades that have the potential to wipe out profits.

He revamped the unit overseeing trading positions and hired former Goldman executive Noel Donohoe as co-chief risk officer.

Banks and securities firms increased the size of their trades during the past decade on interest rates, stocks, commodities and credit.

Trading revenue for the five largest securities firms — Goldman, Morgan Stanley, Merrill, Lehman Brothers Holdings Inc and Bear Stearns Cos — climbed to a combined $71.1 billion by 2006 from $29.1 billion in 2002.

The higher profits added to the firms’ capital, enabling even bigger trading bets.

“You can scale your value at risk relative to your book value,” said Wallace. “It was a self-reinforcing part of the cycle.”

Goldman’s average daily VaR more than tripled to $151 million in the fourth quarter from $46 million five years earlier, according to company reports. Goldman’s VaR was almost twice as high as Merrill’s in the third quarter.

Merrill said third-quarter daily average VaR was $76 million, compared with Goldman’s $139 million, Morgan Stanley’s $87 million, Lehman’s $96 million and Bear Stearns’s $32 million.

All the New York-based firms base their calculations at a confidence level of 95%, meaning they don’t expect one-day drops to exceed the reported amount more than 5% of the time.

The amounts differ in part because every firm uses its own methodology and data. For instance, Lehman uses four years of historical data to calculate VaR, with a higher weighting given to more recent time periods, while Morgan Stanley provides VaR calculations using both four years and one year of market data.

“If you compare what peoples’ values at risk are versus what their losses were in the third quarter or fourth quarter, the numbers are astounding,” said David Einhorn, president and co-founder of hedge fund Greenlight Capital LLC in New York.

“There are a lot of things that probably the value-at-risk model said would have trivial losses 95% of the time or 99% of the time but are now having a huge loss.”

"The other risk tool commonly used by securities firms, known as stress testing or scenario analysis, also failed to prepare the industry for the plummeting value of AAA-rated securities that had previously been deemed the most creditworthy," he said.

Stress tests are only as good or as predictive as the scenarios used and in many cases the scenarios that played out were much more severe than people anticipated, said Ed Hida, the partner who runs the risk strategy and analytics services group at Deloitte & Touche LLP in New York.

“One lesson learned is that these stress tests should be broader, should consider more scenarios.”
Kelleher, who became Morgan Stanley’s CFO in October, explained the flaw in the firm’s stress testing in a December 19 interview, the day the company reported its first unprofitable quarter.

“Our assumptions included what at the time was deemed to be a worst-case scenario,’’ he said. “History has proven that the worst-case scenario was not the worst case.”

Investment banks will continue to take unsafe risks as long as traders are rewarded for making profits, leaving shareholders, bondholders and sometimes taxpayers to shoulder the consequences, Taleb said.

Wall Street traders “make an annual bonus and get an annual review based on risks that don’t show up on an annual basis,” Taleb said.
“You have all the incentive in the world to take these risks.”

Source : Dna