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The Number That Killed Us

A Story of Modern Banking, Flawed Mathematics, and a Big Financial Crisis

Pablo Triana

WILEY

A critical look at the risk measurement tool that has repeatedly hurt the financial world. An analysis of the true key factor behind the 2007-08 crisis. The Number That Killed Us finally tells the "greatest story never told": how a mysterious financial risk measurement model has ruled the world for the past two decades and how it has repeatedly, and severely, caused market, economic, and social turmoil. This model was the key factor behind the unleashing of the cataclysmic credit crisis that erupted in 2007 and which effects are still being felt around the world. The Number That Killed Us is the first and only book to thoroughly explain this hithertouncovered phenomenon, making it the key reference for truly understanding why the malaise took place. The very number financial institutions and regulators use to measure risk (Value at Risk/VaR) has masked it, allowing firms to leverage up their speculative bets to unimaginable levels. VaR sanctioned and allowed the monstrously geared toxic punts that sank Wall Street, and the world, during the latest crisis. We can confidently say that VaR was the culprit. In The Number That Killed Us, derivatives expert Pablo Triana takes you through the development of VaR and shows how its inevitable structural flaws allowed banks to take on even greater risks. The precise role of VaR in igniting the latest crisis is thoroughly covered, including indepth analysis of how and why regulators, by falling in love with the tool, condemned us to chaos. Uncritically embraced worldwide for way too long, VaR is, in the face of such destruction, just starting to be examined as problematic, and in this book Triana (long an open critic of the tools role in encouraging mayhem) uncovers exactly why it makes our financial world a more dangerous place. If we care for our safety, we should let VaR go. Contains controversial analysis of the hotly debated risk metric Value at Risk (VaR) and its central role in the credit crisis Denounces the role of regulators and academics in forcing the presence of the inevitably malfunctioning model in financeland Describes how bonushungry traders can use VaR as an alibi to take on the most reckless of bets Reveals how the most recent financial crisis will simply repeat itself if the problems behind VaR are not unmasked Pablo Triana is also the author of Lecturing Birds on Flying

The very risk measurement tool that was intended to contain risk allowed financial firms to blindly take on more. The model that was supposed to save us condemned us to misery. The Number That Killed Us reveals how this has happened and what needs to be done to correct the situation.

The devastating financial crisis that began in the summer of 2007 and that led to life-threatening losses for the banking industry, to a global economic recession, and to an implosion in government finances was caused by two main factors: toxic assets and leverage. If Merrill Lynch, UBS, Citigroup, Goldman Sachs, Lehman Brothers and so many others had not accumulated so many high-stakes positions in such an undercapitalized way, the mayhem would not have been nearly as pronounced. When the housing market collapsed in the US and complex securities linked to subprime mortgages took a dive, banks suffered billionaire setbacks and their tiny capital bases were quickly depleted, requiring massive public bail-outs. Markets worldwide tumbled. Unemployment skyrocketed. The destructive toxic leverage was taken on by Wall Street and the City of London because a very powerful mathematical model known as Value at Risk (VaR) sanctioned it. The model very unrealistically said that those assets had no risk and thus could be accumulated worry-free. And banks dutifully obliged, intoxicated by the profits to be derived in the short-term. VaR allowed banks to take on positions and leverage that would otherwise not have been allowed. Those positions and that leverage killed us all in the end. VaR has for the past two decades been one of the most influential forces in finance. As the risk radar that guides decision-making inside banks trading floors and the formula that rules over global bank regulation, the VaR number effectively shapes the economic and social wellbeing of millions. VaR can determine whether a banking crisis takes place or not. Unfortunately, VaR has an in-bred tendency to sanction dangerous and reckless behavior. VaR can create chaos out of nothing. Why have bankers and policymakers so enthusiastically promoted and backed the model for so long? Many traders loved VaR because it could make them very rich very fast. Mandarins were blinded by the apparent technical sophistication and by an over-generous desire to accommodate bankers. Following the latest crisis, this infatuation with a flawed and lethal concoction must end, for all our sakes. The Number That Killed Us tells the crucial story that no one had yet dared tell. The really key reasons behind this and other past market cataclysms are unveiled. This lively narrative walks us through the life of VaR, an existence dominated by mathematical wizardry, financial drama, and intriguing characters. This book shows people how their lives have been, and continue to be, dominated by a mysterious analytical machination born to inundate the system with risk.

VaR let Wall Street and the City of London leverage themselves up 1000-to-1 on portfolios loaded with toxic securities (subprime CDOs and the like). It was a death sentence for the banking industry. Why was this allowed to happen?

Contents Introduction: When a Tie Is More Than Just a Tie April 28, 2004: Steve Benardete Gets His Wish; The World Suffers Chapter 1- The Greatest Story Never Told Chapter 2 - Origins Chapter 3 - They Tried To Save Us Chapter 4 - Regulatory Embracement Chapter 5 - Abetting the CDO Party Chapter 6 - VaR Goes To Washington Chapter 7 - The Common Sense That Should Rule the World Finale: The Perils of Making the Simple Too Complex Guest Contributions Why Was VaR Embraced? Q&A with Nassim Taleb A Pioneer Wall Street Rocket Scientists View Essay by Aaron Brown

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