First of all models are guides and frameworks with limitations. Its a guide and not a decision-tree.

Second you follow lending principles and resultant loan book looks like Gaussian Distribution. You cannot aim for Gaussian distribution – for that process in itself creates a skew.

Thirdly, the incentives are all misaligned – agree with Yves here.

Fourth – banking is not telecom where you go for 100% coverage – banking by definition excludes a certain portion of population by defining them as unbankable. One needs to cross a threshold to be able to bank. And this threshold cannot go lower indefinitely.

Combine all – and you have Subprime!

Rahul

1/ As mentioned by some the problem is not really that the models asume a Gaussian distribution. Risk management in most firms proceeds by looking at V.A.R. numbers and risk scenario numbers. The risk scenarios calculate what happens (how much the firm earns or loses) when a tail event occurs.

The problem is that it is difficult to calibrate what extreme events are viable and need to be considered. If the stock market went down 95% is a day, every IB would collapse. If the housing and commercial real estate markets went down 40% in a day, pretty much every bank would collapse. These, however, are not considered viable extreme events, and no one considers them.

I have no expertise in housing or derivatives based on housing, but I imagine the banks are being faced with a market much like the one where housing goes down 40% in a day. It’s not doing that, of course, – it’s going down (say) 40% or so over the course of 5 or so years, but it’s *like* 40% in a day because the market for housing products has turned illiquid and no one is able to offload their products. Think of it in terms of stocks. Banks don’t collapse when the market goes down 5% because they suppose that when it does go down 5%, they can at least sell their shares and get out, thereby limiting their losses. But if stocks were to go down 5% every day for a while, *and* at the same time stocks became illiquid so that no one could sell their shares, then most IBs would indeed eventually collapse, because the cumulative effect would (eventually) be -95%.

So I imagine what caught the risk managers of housing products, is that the risk scenario which would have captured the market that we have fallen into (-40% or so on housing overnight, equivalent to a lengthy, more spread-out downturn of -40% *with* illiquidity of the products) was considered too extreme and just not a viable possibility. “Housing never falls 40% in a day! It goes down slowly!” The illiquidity may seem an obvious oversight, but then things are always more obvious post hoc.

2/ You can’t argue with success. This is by and large true, and does not hold just for financial firms. Greenspan was hailed as a maestro for a long time because the economy seemed to be doing so well. The counter-argument that some (including myself, and I imagine Yves) were making that things were doing well *now* but it would all end in tears, carries absolutely no traction until it actually does end in tears. American auto companies were doing very well with SUVs, invested massively, and now look ready to collapse. In financial firms there were (and always will be) people, including risk managers, who argue that the money being made today would be offset by losses down the road. But the certainty that money is being made now simply cannot be offset by the possibility of money, however much, might be lost in the future, because it only remains a possibility and is thus intangible.

Today their bank is doing fine. They are not publicly traded.

http://ethix.org/article.php3?id=396

Managers will always go with the answer they want, rather than the one that might be true.

Your comment gets at one of my pet peeves: the wreckage that has been created by letting investment banks go public. When partners were playing with their own money, they were vastly more cautious (although firms still managed to get themselves in trouble, witness First Boston, which was eventually taken over by Credit Suisse, or Lehman Brothers, which did itself a tremendous amount of damage due to infighting when the driving force of the fractious firm, Bobbie Lehman, died unexpectedly, or John Gutrfreund’s failure to call the Fed immediately when he learned a senior trader had been gaming Treasury auctions). However, comp was also kept within reasonable bounds, for the most part, because making partner was the big reward. Thus top talent had a reason to stay in place and build the firm. Incentives were vastly better aligned.

In commercial banks historically, there was much less turnover and promotions were based significantly on seniority. That had the effect of not encouraging risky behavior (and traditionally, banks were conservative and stodgy). If you did something risky and it paid off, you wouldn’t get paid more or promoted faster; indeed, you were likely to get a black mark for flouting the rules. But commercial banks decided they wanted to become investment banks and started changing their practices accordingly.

Management can make money on their options if the price goes up, walk away or even get repriced options if the stock goes down. For a manager to care about 10-year credit losses assumes that the manager is still going to be working at the same place in ten years, which is dubious.

it is not as Black-and-white.
Even Jamie Dimon had to concede that JPM has some problems with brokered loans and that they raised loan standards 6 times in 2007.
PLease read his excellent management letter in the AR for 2007.
I am not so sure that JPM is in great shape. Maybe relative to Citicorp – but that does not mean much.

What to conclude? Even super-smart guys like Dimon cannot move totally away from a bubble-way of doing business. Competitive pressures are too big; you have to maintain some market share; so you share some of the stupidities, even if you avoid many.