Zero Hedge has long contended that risk models based on VaR "predictions" are flawed and only add to systemic instability due to the ever increasing correlations across all asset classes. We now read a first hand mea culpa from Morgan Stanley's Jim Caron, in which the head of the firm's rates strategy highlights precisely this problem: the complete collapse of predictive models when multiple sigma events like the May Flash Crash and the accelerating sovereign collapse of the past several months occurs: "April and May were difficult months for us and others, judging by fund data on market performance. We did not properly discount the risks associated with peripheral Europe. As a result, we had a larger risk exposure than we should have. We measure the return potential for our positions on a per-unit-of-risk basis, similar to a Sharpe Ratio. That unit of risk turned out to be much higher than we anticipated. This will force us, and many others, to right-size our risks." We wish we could agree with the last statement. Alas, each and every risk management group at comparable prop trading desks (to that of Morgan Stanley), will undoubtedly chalk off recent events to chance, and as these "will never recur", business we will promptly return back to normal, until we see another record crash in the Dow, only this time not 1,000 but multiples thereof.
As for those few remaining sane individuals who do learn from past mistakes, here is what Jim Caron suggests are the key implications of consistent underappreciation of risk:
Liquidation of risk exposure: Portfolio positions turned out to be much more correlated than we had initially anticipated. Traders seek to reduce correlation by liquidating many positions, leaving behind perhaps only a few core positions. We saw these liquidations in May and early June
Sit, wait and re-assess: Traders will now have to evaluate the new risk relationships. Since there is great uncertainty, traders might start by making small and short-term tactical bets to get a feel for the risks. Again, only a few core positions may still be left on.
Right-size risk: As the new market environment becomes somewhat better understood – albeit still marked by great uncertainty and higher realized volatility – traders could now start to make an assessment on the proper risk they should have relative to the increased level of expected volatility of returns. For example, if the market is twice as volatile today as it was before, then one should run positions with half the size of risk.
For better or for worse – the introduction of a new tail risk: Given the losses taken and positions liquidated in the past few months, the new tail risk is for risky assets to reverse sharply higher and for yields to rise. This could cause traders to chase performance, so as not to be left behind relative to their peers. Similarly, if markets turn against them, then they will be quick to exit. This introduces two-way risk: traders may start to react equally to both good and bad news. Previously, the tail risk traders were mostly focused on a worsening of risky assets. Now they have to be concerned about both tails, for better or for worse, which will add to market volatility.
Incidentally we agree with virtually all of Caron's observations. And we suggest that before the travesty of a FinReg piece of toilet paper is signed by the president, that someone with half a brain at least pretend to recommend some provisions to haircuts in bank risk exposure. On the other hand, if indeed the Volcker Rule in its full form is set to pass, and the only risk banks are taking on is that compensated by a commission, once prop trading groups are finally split off, a development we have been urging since May of last year, all this is moot, as no longer will banks have to worry about old tail risk, new tail risk, or any risk: they will be merely hedged books, operating in a liquid (thank you HFTs now in equity and soon in cash and CDS) market, where 6, or 666 sigma events will have no bearing on the banks' requirement to be bailed out be taxpayers imminently.