Shared by JohnH

Wow! Great article… One of the key developers of VaR now works for the SEC and is in charge of investigating the recent ‘Flash Crash’.

Dr. Taleb goes on to chronicle in Appendix 1 of his testimony just how long he has been sounding the warning.  His prior statements are as follows:

“1996-97:VaR is charlatanism because it tries to estimate something that is scientifically impossible to estimate, namely the risk of rare events. It gives people a misleading sense of precision… 2003: Fannie Mae’s models (for calibrating to the risks of rare events) are pseudoscience.  2007: Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deems these events “unlikely.” [Fannie Mae is now a ward of the state.]… Banks are now more vulnerable to the Black Swan [high impact, rare event] than ever before with “scientists” among their staff taking care of exposures. The giant firm J. P. Morgan put the entire world at risk by introducing in the nineties RiskMetrics, a phony method aiming at managing people’s risks…”

One certainly does have to wonder why, if the RiskMetrics risk model was so accurate and valuable for trading, JPMorgan effectively gave it away to the street by publishing the methodology publicly in 1994.  Having read reams of lawsuits filed in Federal Court where Wall Street firms pound the table to keep their proprietary trading secrets under seal, this whole episode does raise a few eyebrows.  To add to the curiosity, RiskMetrics, the firm created inside an incubator at JPMorgan was acquired on June 1 of this year by MSCI, a firm created inside an incubator at Morgan Stanley.  In other words, two of the largest investment banks whose primary job is to allocate capital fairly to the marketplace frequently create their own finance-related firms, then proliferate the “science” masterminded by these firms by spinning them off to the marketplace. 

Within a few weeks, the SEC will be releasing its investigative report of the May 6, 2010 Flash Crash.  Gregg Berman, a key executive of RiskMetrics just one year ago, whose clients at that time are the same firms engaged in the questionable events of May 6, will serve up the results of that investigation to the American people.  In the book “How I Became a Quant: Insights from 25 of Wall Street’s Elite,” Dr. Berman shares this with us:  “…I learned that once the billion-dollar spacecraft I had worked on finally reached Mars, it exploded.”  Dr. Berman is now two for two.  Is he the right man for unraveling the events of May 6?