Wednesday, 3 October 2007

In Times of Stress ...

Alongside mathematical methods, a key risk-management discipline is to conduct Stress Tests. Statistics alone don't capture what can happen in extreme events, which occur more frequently than simple probability-distributions would suggest. A stress-test scenario doesn't come with a probability: that's the point. But thinking it through carefully can be very illuminating.

One problem is paucity of imagination: the worst we can envisage is what has happened before. When oil was last at $10 (1998!), very few companies were stress-testing for $80: (who is testing at $ 500 now?). When Enron was the pre-eminent market-maker for every wholesale energy player, few were considering its sudden melt-down: (who is modeling the collapse of a really big bank now?).

As an experiment - which might even be of benefit to readers in their personal financial planning - we are running a short series on this topic. To get the ball rolling, here are a few: vote in the Poll (in the sidebar) for which one you find most illuminating (or frightening!).

Then give us your own ideas ! Remember: s**t happens !


Notes on the Poll questions:

1. Food: Price of food trebles
2. Cybercrime: Gets so bad that banks stop authomatically refunding victims

3. House prices: Crash by 50% in one year
4. Inflation: Hits 10% during sharp economic downturn
5. Terror(1): successful attack on City / Parliament
6. Terror(2): 5 more years of Gordon Brown


Old BE said...

HSBC are a bunch of cowboys apparently despite their trad-con image.

CityUnslicker said...

I disagree Ed, they did their wrtie down on sub prime last year; the others are all playing catch-up now...

As for the test, my vote went for food prices trebling.

Anonymous said...

Is anyone stress testing for everyone gets bitten by a midge which gives them a kind of virus which makes them die and come back to life as a zombie??

CityUnslicker said...

that has been done to death by hollywood already Mutt.

However, I think you should do some stress testing on theose radioactive howler monkeys in your parts to see what they think of the value of money.

Newmania said...

CU I keep a bucket full to the brim with sand exactly so I don`t have to think of the awful "scenarios" you open up.

My general rule is that the thing that is going to screw you is the thing you didn`t think of and it has stood me well in a lifetime of DOH!!

I think everyone is wondering what might happen were some thing more substantial than the sub Prime squall to hit the system. I `m not a great doom monger about personal debt but added to high taxes and soon it must create fragility

In Insurance what goes wrong is that people do think of one event but forget that when that one event happens then a lot more are likely to happen at the same time.
Also that parcelled and notionally seperate exposures are actually all the same one .

Now I`m scared now what was the point of that. Nasty man

Newmania said...

Juts caught up with the rest iof your blog CU . I like the article on Tory taxes.

I thuink you are probably taking them too literally . If you look at what Thathcer said and then did and Blair as well positions now are no more thna a a statenment of intent .
What worries me is that Brown is silent on tax rises

Nick Drew said...

And not just insurance, Mr Mania - the 'fat tails' phenomenon is widely encountered. Ordinarily, there are whole categories of events that are essentially independent. But in extreme circumstances, one event actually causes others and the usual principles and benefits of diversification no longer apply in quite the same way.

Mark Wadsworth said...

House prices ARE going to crash (as a multiple of average earnings), just like in the 1950s, 1970s and 1990s. So to mask this, they'll make sure that the nominal fall in prices is much lower, by allowing for much higher inflation (like in the 1970s, the 1990s, dunno about the 1950s).

That's not stress testing, that's going to happen so you may as well start planning now.

If The Goblin King really wanted to win a snap election he could just announce that there'll be a referendum on EU treaty on the same day. But Nulab have learned the lesson of Jim Callaghan. The know now that what they SHOULD have done is call an election in 1978 and LOSE narrowly.

But who gives a shit? Tories and Nulab are pretty much indisinguishable nowadays anyway.

Nick Drew said...

Mark - points taken (1st 2 paras) but our scenario, 50% in 12 months, wouldn't allow any time for an inflationary 'solution'

Long before that would ameliorate nominal prices, it seems to me the early consequencea are: a concommitant collapse in consumer confidence & spending ...

with banks being forced to write down a heap of negative equity ...

and then ... ?

(because, as you say, it's a real prospect)

Mark Wadsworth said...

And then ... I take all the money (assuming the banks haven't all collapsed as well) I made in the last boom and buy myself a few investment properties again.

James Higham said...

How does one stress test for the central banks divesting themselves of up to half their reserves of gold and when the instability of a liquidity crisis arises, the domestic banks are baled out, creating debt to the CB and paving the way for recession after a largely cashless society has been achieved and everyone's playing with numbers in a ledger, which inevitably must crash?

Just wondering.

Anonymous said...

"50% in 12 months, wouldn't allow any time for an inflationary 'solution'"

It wouldn't, but it would also be almost physically impossible for this to happen. You would have to consider why people would be motivated to sell when their property prices were falling so rapidly. Psychology of the market would suggest that people would rather not trade in a market that is so severely adverse, so to sell at such a drop in value would imply something rather more severe had happened in the economy to cause such a thing - mass unemployment due to massive civil disorder perhaps, or war. In otherwise normal times house prices could easily fall by 50%, even 80% before hitting a floor, but not that rapidly.

"Long before that would ameliorate nominal prices, it seems to me the early consequencea are: a concommitant collapse in consumer confidence & spending ..."

House price crashes are normally caused by a loss of consumer confidence, rather than the other way around.

"with banks being forced to write down a heap of negative equity ..."

Firstly, if house prices fell by 50% most people would still be in positive equity. The banks could also claim that the market was illiquid and could not be adequately priced but as long as interest payments werre being made the market was still solvent. What is more important is the risk to the interest payment, not the collateral.

Nick Drew said...

Mark - glad to hear you are so well-positioned ! Noticed your proviso ...

Anon - thanks for a string of excellent points, triggering a couple of further thoughts:

- chicken-and-egg is certainly a problem: it gets back to Mr Mania's point that in some circumstances (especially extremes), many things becomes correlated that were independent of each other in normal times

- prices are set by marginal activity, which can be susceptible to violent reactions. As you say, many people would stay firmly put in such circumstances (and they are not obliged to mark their assets to market!). I can point to price movements of 50% in less than 12 months in some major commodity markets, though - and while banks are very good at finding excuses for not writing down assets (e.g. the debt on UK power stations during the electricity market price collapse of 2002) there comes a point ...

- the general point about what is and isn't 'physically possible': I am old enough to have lived through several market movements that were strongly believed a priori to be impossible ! I'm not saying you are wrong, just that assumptions need testing.

Nick Drew said...

Trains of thought like your Lordship's frequently lead to people emigrating / stockpiling physical necessities / going into krugerrands / preparing for a barter economy

(When the Hitch is back up and running again he will no doubt add guns to that list)

What indeed do we do when banking lets us down ? Given that it is only a privileged minority in the world who have been more or less immune to this, it ain't so hypothetical

tory boys never grow up said...

I'm afraid stress testing is just another example of voodoo dressed up as rocket science by a load of charlatans who want to justify their current risky activities/bonuses. Oh this position if fine - its within the VAR limits and its been stress tested so it must be ok! It is very easy to chose scenarios that bankrupt everyone - but of course they never do.

There is no alternative to having a proper understanding of the economics and then having proper systems and controls to make sure that positions are capable of liquidation when dicatated by the economic analysis.

Nick Drew said...

TB - can't disagree with proper systems and controls to make sure that positions are capable of liquidation; but equally, reliance on proper understanding of the economics ... dictated by the economic analysis has its dangers too.

Speculative positions are generally justified by someone's take on 'economics', 'fundamentals' etc. You must have seen positions with 'sound economic rationale' driven into a brick wall many times yourself.

They need to be managed with a range of techniques. VaR has its place, along with stress testing, economics, stop-loss limits, common sense, .... etc etc

(& don't forget to think about what you'll do when the intended liquidation can't be executed !)

CityUnslicker said...

Tory what is this proper understanding of modern economics?

Das Kapital, by any chance?

Anyway, we need more uncertainty becuase all my gold stocks have come off a bit this week...

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