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Risk Management

04:59 PM
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Nothing Has Changed, Paul Wilmott Says

Risk models are OK, says famous researcher and quant who predicted the subprime crisis, but they need to be paired with common sense rather than a sheep-like mentality.

It would be foolish to paraphrase Paul Wilmott, a researcher, consultant and lecturer in quantitative finance who has strong opinions about Wall Street's risk management practices, a sharp wit and a way with words. So here's a lightly edited version of our recent interview with him about how to fix risk problems on the Street.

WS&T: How are you?

Wilmott: Tired. I've got a crazy Dutch film crew following me around, everything's a bit manic and I'm exhausted.

WS&T: Concerns about risk management have been growing on Wall Street post-crisis and pre-regulation. How might Wall Street firms change the way they do risk management, are there new metrics, models or methods that will be or should be considered? For instance, some say Value at Risk is no longer relevant as a measurement of risk.

Wilmott: There are plenty of good models out there, it's just that nobody's incented to use them. If you used the wrong model to design airplanes, you'd kill passengers and end up in prison. But do the people using financial risk models care what happens? Of course they don't.

WS&T: So there should be a direct link between the risk modelers and...

Wilmott: Prison, I agree. There's people who think we should go after these people. There should certainly be more lawsuits going around. Someone I know moved to a new bank recently. He was doing a risk management procedure and the traders came up to him to say, 'You're telling me the risk is too big, can you just fudge the figures and make it smaller?' Nothing has changed. I don't know why anybody thinks it has.

That's why no one with half a brain has ever liked VaR, because it can be used to hide risk. I've been talking for years about how people hide risk rather than hedge, because that allows them to trade bigger and bigger and if they're lucky, they get a big bonus. If they're not lucky, nothing happens to them. The more sophisticated your tool, the greater potential for pretending there's no risk.

WS&T: Do you think Value at Risk should be thrown away?

Wilmott: No. VaR is fine for for day-to-day activities, but there are lots of other things people should be doing. For example, worst-case scenarios. I don't believe in trying to refine the probability of crashes happening. People are surprised that crashes are happening every few years that according to theory are only supposed to happen once every 10,000 years. Who cares whether it's once every few years, once every six years or once every 7.3 years? What matters is taking steps that will protect you when there's a crash, because there will be one.

Did you expect anything was going to change because of the subprime crisis? People say that's the end of everything, quantitative analytics is dead, CDOs are dead. I say it will be business as usual and faster than you think. Nothing's changing. People deserve everything they're going to get in the next crisis because they're not complaining enough. But there are really good models out there.

WS&T: Such as?

Wilmott: The trick is to not have models that are too sophisticated. Don't get too caught up in the details of the mathematics. One of the main culprits in all this has been the Masters in Financial Engineering courses. They're sold by universities to 22 year olds who have no experience in life and banking. Professors who never worked a day in their life in the real world are teaching all of these poor, unsuspecting fools who are paying $80,000 a year for the degree, because they know they can get a job in a bank and they'll be making millions. They're happy to pay $80,000. I'm not happy because I know the education they're getting is substandard, to say the least. It may be fantastically mathematical, but it's got nothing to do with finance in the real world. So there are swarms of these people out there, many tens of thousands of people have come out of these degree programs and are put in charge of derivatives, valuation and risk management and they've never seen the real world. This is where I plug the Certificate in Quantitative Finance. CQF is the only financial engineering course in the world that hasn't had to rewrite any lecture notes because of the recent crisis. We've been warning about these things since we started in 2003.

WS&T: Have the graduates of your course performed better than the average quant?

Wilmott: Sadly, we haven't reached the critical mass where my CQF alumni could save the planet. Had we started the CQF five years earlier, then we would have saved the world, but we haven't. Maybe we'll stop the next crisis.

WS&T: Do you try to introduce common-sense thinking into your courses?

Wilmott: Everything we do is real world. Everything is practical, based on data, common sense. When did common sense disappear from the planet? We try to knock some common sense back into these people. We try to instill confidence that they can do their own modeling and think for themselves. Another one of my pet peeves is how sheep-like people who work in banks are. They copy each other so much. We teach skeptical thinking, to question assumptions, to figure out if the model is wrong.

WS&T: What about the data itself? One of the problems with the subprime mortgage mess was that for many years prior, housing prices hadn't dropped and U.S. homeowners had a history of paying their mortgages and being unwilling to foreclose. So if someone was analyzing the past four years of historical data, they wouldn't have any indicator of trouble.

Wilmott: Why are they using the last four years worth of data?

WS&T: How far back to they need to go? No historical information really tells you what's going to happen in the future.

Wilmott: I've owned some properties, I bought my first house when I was 25 and in my experience, there's a one in three chance of losing money from property. You do have to go back a few years, but not a long time, to see falling house prices. When you go through bubble after bubble after bubble in every single walk of life, what a lack of imagination a person has to have to think house prices never fall. I have to hit myself in the head with a hammer to get into that frame of mind.

WS&T: But I've heard models like that are used in financial firms.

Wilmott: 2010 I hope will be the year in which people finally start taking moral hazard seriously. People have an incentive to say house prices will keep on rising if it means they can do the trade. But you're also right that there are people who believe in all of these models and the idea that house prices don't go down. I'm incredibly blessed or cursed by always questioning everything. You have to do constant rethinking.

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