Category / Worst case scenarios

Training with stress July 23, 2012 at 8:48 am

Bloomberg draws some lessons from the report on the crash of Air France 447 for US pilot training. 447 failed due to a high altitude stall.

Pilots of small planes practice diagnosing and recovering from stalls using actual aircraft, but it’s too risky and expensive for the major airlines to do this in their planes, which can cost as much as a few hundred million dollars apiece. Thus, high-altitude conditions need to be programmed into scenarios on the flight simulators that airline pilots use to train.

Second, the report found that pilots aren’t thoroughly trained to deal with sudden developments. Flight 447’s pilots were confounded when they lost airspeed readings because of a malfunctioning part; one of the pilots inadvertently put the plane into the stall that doomed it. French investigators wrote that training scenarios are too familiar to pilots and don’t sufficiently surprise them or test them with harrowing situations. In light of this observation, American aviation officials would do well to scrutinize the simulations used by U.S. airlines to make sure they’re challenging and ever- changing.

Reading this, it struck me how useful it would be to develop stress scenario training for central bankers. It would not be easy to design a simulator flexible enough to cope with a wide range of policy reactions, but it would be a great tool once you had it. You could have historical scenarios from the panic of 1825 through the Great Depression to Swedish and LTCM crises and imaginary ones like Euro breakup or the failure of a triparty repo clearer.

Understatement of the week award July 20, 2012 at 6:05 am

From the FSOC annual report:

Currently, triparty repo trades unwind every day, meaning that the clearing bank returns cash to the lender’s account and returns collateral to the borrower’s account. Trades are not settled until several hours later. For several hours each afternoon, dealers require funding of their entire triparty repo book that lenders do not provide. This $1.7 trillion funding need is provided by two clearing banks.

This is a potentially unstable situation.

(Emphasis mine.)

Planes not bridges December 10, 2011 at 7:30 am

If I had to pick an unconventional member for the financial stability board, I would seriously consider an aircraft safety expert. Let me explain.

Civil engineers know about one kind of safety; the safety of bridges and such like. The crucial thing about a bridge for our purposes is that the elements of it don’t change their nature when you change the design. They might change their role – whether then are in compression or tension say – but their physical properties are constant.

Two planes that kept us safe

Aircraft safety adds an element that civil engineers don’t have to worry about (much) – people. People react to the situation they find themselves in. They learn. Importantly, they form theories about how the world works and act upon them. Thus aircraft accidents are often as much about aircrew misunderstanding what the plane is telling them as about mechanical failure. The system being studied reacts to ‘safety’ enhancements because the system includes people, and hence those enhancements may introduce new, hard to spot error modes.

The report into the Air France 447 crash is an interesting example of this. See the (terrifying) account in Popular Mechanics here. As they say in their introduction to the AF447 Black Box recordings:

AF447 passed into clouds associated with a large system of thunderstorms, its speed sensors became iced over, and the autopilot disengaged. In the ensuing confusion, the pilots lost control of the airplane because they reacted incorrectly to the loss of instrumentation and then seemed unable to comprehend the nature of the problems they had caused. Neither weather nor malfunction doomed AF447, nor a complex chain of error, but a simple but persistent mistake on the part of one of the pilots

AF447 was, by the way, an Airbus 330, a plane packed to the ailerons with sophisticated safety systems. Not only didn’t they work, the plane crashed partly because of the way to pilots reacted to their presence.

Aircraft risk experts understand this kind of reflexive failure whereby what went wrong wasn’t the plane or the pilot but rather a damaging series of behaviors caused by the pilot’s incomplete understanding of what the plane was and wasn’t doing. This is often exactly the type of behaviour that leads to financial disasters. Think for instance of Corzine’s incomplete understanding of the risk of the MF Global repo position.

Another thing aircraft safety can teach us is the importance of an open, honest post mortem. Despite the embarrassment caused, black box recordings are widely available, at least for civil air disasters. (The military is less forthcoming, although things often leak out eventually – see for instance here for a fascinating account of the Vincennes disaster.) In contrast, we still don’t have FSA’s report on RBS, let alone a good account of what happened at, to pick a distressed bank more or less at random, Dexia. UBS is a beacon of clarity in an otherwise murky world.

It is hard to learn from mistakes if you don’t know many of the bad things that happened and what the people who did them believed at the time. Finance, like air safety, is epistemic: to understand it, you have to know something about what people believe to be true, as that will give some insight into how they will behave in a crisis.

The more I think about this, the more I think risk managers in other disciplines have to teach us financial risk folks.

The 5 Step Plan September 15, 2008 at 2:35 pm

Turning JapaneseWe may be turning Japanese I really think so.

FT alphaville has a salutory post on Japanification. The post suggest five steps in crisis management:

1. In order to head off the debt/deflation vicious spiral, monetary policy needs to be extraordinarily stimulative. The risk of runaway inflation is minimal.

Agreed, but even more important is that liquidity policy needs to be very loose. I should be able to repo my dry cleaning receipts at the central bank, at least for a while. The FED’s steps to not so much open the window as knock out the whole back wall out with a JCB are absolutely right here.

2. Fiscal policy has a job to do when the money multiplier collapses. Forget about crowding out – bullish bond markets will absorb all the supply they can get.

Agreed again. It is time for some good old fashioned Keynesian stimulus. Could we please fix the railways as part of that? And how about some other green measures too? Spend on infrastructure for the future.

3.”Strong hands” ( investors with risk-taking capacity) are like gold-dust. The sovereign wealth funds of emerging economies are now in the position to play the role that hedge funds and vulture funds did in Japan and Asia in the 1990s. They should be welcomed, not shafted, criticised, or over-regulated.

Ummm, to some extent. Politically it may be better to pass on more costs to future generations than to pass ownership of the financial system East. Just as energy security is a concern, so should the ownership of the financial system. So yes, welcome capital, but not without some care.

4. Forget about moral hazard. Somebody has to take the credit risk. Future generations are the best candidate because they’re going to have a better life than us, with all kinds of cool gizmos and hobbies. They won’t notice, really.

With the proviso that the equity holders of failed or failing institutions need to be thoroughly caned, yes. The state can and should take a boat load of asset price risk in order to bail out the financial system. The price will be future regulation.

5. No schadenfreude. Never ask for whom the bell tolls. It tolls for thy portfolio.

Awww, c’mon. Merrill was (mostly) a great firm. To see it as part of BofA is a great shame and I certainly have no wish to chortle about that. But no little laughs about Jimmy Cayne? Now you really are asking too much.

What is not expected June 12, 2008 at 1:07 pm

There has been some talk recently (perhaps inevitably) about the next crisis to hit. Suggestions include:

  • A wave of U.S. Bank failures. According to Reuters: Future U.S. bank failures linked to the downturn in the real estate market may include “institutions of greater size” than in the recent past, Federal Deposit Insurance Corp Chairman Sheila Bair said on Thursday.
  • Monoline downgrade related issues. Well regarded doomster Meredith Whitney says that Citi, Merrill, UBS Face Monoline Losses.
  • The forthcoming option ARM crisis. Hundreds of thousands of option ARMs will reset in the next year. The new rates will be unaffordable, leading to a wave of foreclosures. As Business Week reports:

According to Credit Suisse (CS), monthly option recasts are expected to accelerate starting in April, 2009, from $5 billion to a peak of about $10 billion in January, 2010. Today, outstanding option ARM loans in the U.S. total about $500 billion, about 60% of which were sold to California homeowners, according to Credit Suisse. Option ARMs were especially popular in the state, where they were heavily marketed during the boom by such companies as Countrywide Financial, Washington Mutual, and Wachovia.

But will these issues really cause further problems? After all, they are well-known. The FDIC has been talking about bank failures since the winter. Few people other than MBIA and Ambac have believed that MBIA and Ambac are AAA for years. And the Credit Suisse chart on volumes of ARM resets is in general circulation. Isn’t it surprising bad news that spooks the market rather than merely expected bad news?

Uncertainty and strategy May 27, 2008 at 11:11 am

A key issue in strategy is uncertainty in the outcome. Unlike financial return distributions, where we at least have some data to go on, and some models (albeit ones which struggle with autocorrelation, fat tails, and regime changes) there isn’t much data on corporate strategy because each situation is different. I can’t try the same acquisition a hundred times over to get a sense of the distribution of returns or, as Keynes said:

Our knowledge of the factors which govern the yield of an investment some years hence is usually very slight and often negligible

Usually people don’t let that worry them too much not least because the downside is bounded at zero: often you cannot lose more than you put in. But there is one area where is glaringly obvious that a consideration of uncertainty is important because the returns are so volatile and possibly highly negative – nuclear power. Today we heard, entirely predictably, that:

[The] cost of cleaning up the UK’s ageing nuclear facilities, including some described as “dangerous”, looks set to rise above £73bn

In fact we have no reason to believe that nuclear fission has net positive value. The costs of building it, running it and cleaning it up may well exceed, perhaps by an order of magnitude, the value of the power generated. As France’s nuclear safety watchdog has ordered EDF to halt work temporarily at its flagship new generation nuclear power station and half a million people were hit by unscheduled power cuts after seven power stations, including Sizewell B in Suffolk, unexpectedly stopped working within hours of each other perhaps the policy makers might like to reconsider their push for a new generation of nuclear power stations.

Update. WTF? Gordon Brown has said the UK needs to increase its nuclear power capacity – raising the prospect of plants being built in new locations. As Sting didn’t write, every little thing he does is hurried, ill-advised, and foolish.

On Tragedy May 13, 2008 at 12:26 pm

Theatre of TragedyA frequent correspondent who I respect highly has just given me two new pieces of vocabulary: anagnorisis and hamartia. Wikipedia’s entries can be summarised thus:

  • Anagnorisis (ἀναγνώρισις), also known as discovery, originally meant recognition in its Greek context, not only of a person but also of what that person stood for, what he or she represented; it was the hero’s suddenly becoming aware of a real situation and therefore the realisation of things as they stood; and finally it was a perception that resulted in an insight the hero had into his relationship with often antagonistic characters.

  • Hamartia (ἁμαρτία) can be seen as a character’s flaw or error. The word is rooted in the notion of missing the mark and covers a broad spectrum that includes accident and mistake, wrongdoing, error, or sin. In Aristotle’s Nicomachean Ethics (didn’t you always want to write that clause in your blog?) hamartia is described as one of the three kinds of injuries that a person can commit against another person. Hamartia is an injury committed in ignorance (when the person affected or the results are not what the agent supposed they were).

The credit crunch is a tragedy. A tragedy for those that have lost their jobs while blameless (I’m not thinking of Jimmy Cayne here); a tragedy for those that were conned into a mortgage they cannot afford; perhaps even a tragedy for investors who lost a fortune because they believed ratings agency due diligence. There’s lots of Hamartia: a belief in the robustness of risk transfer via securitisation and conduits; a belief that you know what the CDRs will be on mortgage pools; various kind of mis-selling and representations that were either knowingly or unknowingly false.

Then we had a series of moments of Anagnorisis: the initial falls in the prices of mezz then AAA ABS; the wave of announcements of write-downs; the distress of the monolines and the implications of that for the muni markets; conduit and SIV failures; Libor spikes and central bank interventions; rising delinquencies.

Let us take a moment then to mourn a tragedy,-for that is not too extravagant a word,-to hope that at least lessons can be learnt, lives mended, a better equilibrium attained.

When is safety a good idea? March 11, 2008 at 12:24 pm

Faced with that title, the experienced reader will immediately say ‘it depends what you mean by safety’. Let’s start with a seemingly innocuous proposition: ‘if you can make something safer at no or little cost, you should’. One potential counterexample here is bicycle helmets. While the evidence is by no means definitive, it does suggest that making people wear helmets makes cycling less safe. What seems to happen is that people feel safer when wearing a helmet and hence take more risks. They are not that much safer, so the extra risks they take introduce more risk than the helmets remove. It may well be the case that helmets make bike accidents involving banging the head safer, but they make accidents in general more likely, it seems. In short requiring their use involves risk transformation rather than risk reduction.

Another good example is safety glass. Some forms of safety glass (as I have recently found out) don’t shatter: a sheet is in fact composed of two pieces of glass bonded either side of a transparent but tough plastic film, so even if the individual glass sheets break, they remain bonded to the plastic. That’s all very well if you want to avoid glass shards flying all over the place in the event of a breakage. But it does mean when you want to remove the glass you can’t just cover the area with some material to pick up the shards then smash it: you actually have to cut the sheet out of the frame. This is a much more dangerous job than removing ordinary glass as a number of small cuts on my fingers testify. Very minor injuries aside, though, what is interesting is that something that was created as a safety feature actually turns out to increase risk in certain situations. A good question therefore in designing any kind of safety mechanism – in mechanisms, electronics, software, finance or regulation – is:

When might the behaviour we think is unsafe actually be useful? And what will happen then if the safety mechanism prevents it?

One might even argue that collateral is functioning that way at the moment. Clearly in ordinary conditions, calling collateral reduces risk. But if the failure to post collateral actually pushes your counterparty into default, as happened to Carlyle Capital Corp, it might not be such a good idea after all. And, as JPMorganChase recently pointed out, the banking system is currently facing a systemic margin call. Hmmm….

Warren has form… February 14, 2008 at 7:06 am

The offer from Berkshire Hathaway to take the monolines’ stable profitable business – muni wraps – and leave the unstable loss-making part – structured finance – reminds me of LTCM. It is a little discussed part of the LTCM saga that Buffett made an offer to acquire the assets (but not of course the liabilities) of LTCM just before the 11 bank FED-sponsored bail out that eventually rescued the fund. (More details of the LTCM farrago are here and here while Naked Capitalism has more on Warren’s offer to the monolines here.) Then as now the question is why on earth anyone would accept the Buffett proposal.

For the monolines it does not seem as if Dinallo can force them to, and provided they can carry on paying claims, they can operate at least in semi run off for some years. Who knows, the CDO market might even have recovered by then. Even after a downgrade I do not see what would persuade the monolines to do a cash negative deal such as Buffett is offering: they would just bleed to death faster. Which does rather beg the question as to why he proposed something that they are palpably so far from being able to accept.

Private Wisdom, General Ignorance January 12, 2008 at 8:47 am

Equity Private is posting again. That is the cause for some celebration. Her creativity have obviously been refreshed by an absence from the blogosphere (what an ugly word) and she has some acerbic gems at the moment. My favourites:


My own disposition is towards limited market efficiency–prices reflect all sufficiently scrutinized information, subject to sufficiently saturating capital. This implies two major sources of pricing error:

1. Insufficient distribution of material information.
2. Insufficient capital applied by those in possession of material information.

This seems so obviously true that I wouldn’t remark on it but for the sheer prevalence of the opposing view – unlimited market efficiency, aka not long enough out of business school disease. As we move further into the crunch, 2. is becoming an important driver of investment opportunities, so one might hope that the wisdom of the doctrine of limited efficiency will become more readily apparent.


Ms. Private then goes on to discuss those strategies (such as buying AAA yielding Libor + 40) that appear to generate alpha, i.e. return without risk.


The correct response to investment strategies that appear to generate abnormal returns but are of such complexity to defy understand is not to invest. Or, to emphasize the commenter of earlier fame [Alea]:

If you couldn’t determine the conditions under which the transaction would lose money, you didn’t execute.

Follow that? If you don’t understand what you are buying, don’t buy. Quite simple. Or so you would think.

Cheap debt does not cause losses. Being on the wrong side of information asymmetry does. When structures are complex, falling back to a careful look at incentives often is the best (and only) behavioral prediction mechanism.

So true. But, just as with ’86 Lafite vs. the ’85, just because something is obviously worse doesn’t mean that some people won’t buy it.

How bad could it get? November 4, 2007 at 8:19 am

Short of green men landing in the City and eating everything within a mile of Bank station, how serious could the credit crunch get, given what we know? The following is not a prediction, more of an exercise in generating plausible worst case scenarios.
Firstly the possibility of the failure of a systemically important institution cannot be ignored. The rumours surrounding further write-downs are too pervasive for that. Undoubtedly a rescue would be organised, but confidence would be very severely shaken and massive injections of liquidity would be necessary to stabilise the markets.

In this context we could expect a series of hedge fund failures too, and a widespread deleverage and flight to quality across the system. Significant falls in equity markets, moves in low yielding currencies vs. the dollar (as carry trades are unwound) and spikes in implied volatility are also to be expected. The securitisation markets would remain shut for an extended period of time, ABCP would be very difficult or impossible to roll, and the swap spread would go out significantly.

Another possibility is the failure of a monoline (such as MBIA, Ambac, FGIC, FSA or Radian) or a large insurance company involved in the credit markets such as Ace or XL. This is more problematic in that the parties who would be involved in a rescue are less clear and the majority of the systemic risk related to such a failure would be confined to the wholesale market. On balance though in the circumstances I think a rescue would be more likely than not. We have not seen a failure like this before so the consequences are harder to predict, but certainly the impact on the muni and structured credit markets would be considerable.

We can reasonably assume that the largest firms have the resources to attempt to mark their books. For smaller banks or fund managers that may not be the case, so there could well be medium sized institutions that are sitting on losses that are significant given their capital base without knowing it. This won’t be as bad as a big player going down, but on the other hand a struggling tiddler might actually be allowed to fail, depending on the country. That would cause further spread widening and deleverage across the industry.

Just as Sarbannes Oxley was a (-n over) reaction to Enron, so we can expect to see revisions to Basel 2 and to the accounting framework for conduits and SIVs. These will be a slow burn rather than sudden changes, in all likelihood, but depending on how far they go, they have the potential to reduce the intermediation of risk and decrease bank profitability, at least until the industry figures out how to arb the new rules.
Meanwhile we can expect the U.S. housing market to trend down for an extended period, until mid 2009 at the earliest, and contagion into other bubbly markets such as the UK and Spain is entirely possible. Specialist mortgage lenders, REITs, builders, and the holders of 2006 and 2007 vintage MBS paper are likely to suffer most. The impact on the economies concerned will be considerable, and full blown consumer-lead recessions are entirely possible in the U.S. and the UK.

The equity markets seem particularly vulnerable at the moment: perhaps we are seeing the start of an inevitable repricing of risk, but with many established equity markets close to their all-time highs, large falls from here are possible. Bank debt must also be vulnerable: while spreads have blown out, they are still rather tight compared with the potential downside in some of the scenarios I have outlined. This will have a knock-on effect in credit markets generally as risk capital is withdrawn and investors become much more risk averse.

None of this is inevitable, or even — so far at least — likely. But looking at what the future might bring is always a useful exercise, particularly in the heat of a crisis. Look on my stress tests, ye Mighty, and despair:

  • Failure of your largest (by notional or PFCE) bank counterparty.
  • One day equity market fall of 25%, followed by a further 40% over six months. Private equity cannot be sold.
  • Short rates go to 2%, long rates to 6%, and the swap spread is 100 bps.
  • Interbank borrowing is impossible for three months. Securitisation is impossible for ever.
  • One day dollar fall of 5% followed by a further 20% over six months.
  • All asset-backed securities except RMBS become completely illiquid and halve in value. (Remember this has an effect on collateral from clients and on SIVs and conduits too.)
  • Default rates on prime retail mortgages are the worst ever experienced historically plus 10%. Subprime assets are worthless.
  • AA- or better credit spreads for financials go out 100 bps. 150 bps for A to BBB. 300 bps below that. Corporate spreads go out by half those amounts, as do emerging market spreads. (Or if you want a riff on this, BRICS spreads tighten.)
  • All monoline or credit insurer protection is worthless. Monoline spreads are 500 bps.
  • All hedge funds concentrating in ABS default. Default probabilities triple for the rest.

Does a steeper skew presage a crash? October 19, 2007 at 6:38 pm


The S&P skew has steepened significantly of late. Does that mean anything, other than more buyers of downside options? In particular is there any evidence that a steeper smile is associated with large moves down? In the other direction it works – if there is a big fall then vols rise and the skew steepens. But I know of no studies that suggest skew steepening is a useful predictor of falls. It would be interesting to know though… after all, we are close to the anniversary. Certainly it seems likely that with all the press coverage, the big 2 0 is spooking investors. But of course that doesn’t mean we won’t have a crash.

Liquidity Dynamics August 31, 2007 at 8:24 am

Three pieces of recent news seem interlinked. Barclays used the Bank of England window to buy in liquidity at a penal rate. The president of Moody’s thinks that what we’re experiencing is an extreme lack of confidence and lack of liquidity. I have never seen this before. And the CP market is still shrinking.

This highlights the importance of liquidity and suggests that it would be interesting to incorporate liquidity dynamics into models of market returns. A model that just accounts for asset returns is not that useful in many cases if the implicit assumption is that prices can fall but you can still sell. The reality in many securities at the moment is that the holders strongly suspect that prices have fallen but they have no real idea because there is no liquidity.

Extreme value theory might account for the tail of the return distribution well for liquid assets like the S&P 500 future, but it isn’t much use by itself if it tells you your ABS can fall by 50%. For many securities a large fall in value implies extreme illiquidity and hence a large measure of uncertainty as to the right mark to market. So the possibility of a 50% fall is not a useful quantification. Instead it would be useful to have a theory that says ‘today your ABS is worth 98 +/-1 and you can sell it in a day. In a year at 99% confidence it might be worth 50 +/- 25 and if it has fallen that far, you can sell it in three months’.

Finally, some real liquidity, from the Wild Coast of South Africa.

What does safe mean? May 25, 2007 at 9:43 pm

It is an interesting question. Nothing is safe, 100% robust under any set of circumstances. If a two hundred foot high sea monster climbs out of the Thames and starts munching on Canary Wharf a few disaster recovery plans would doubtless be found wanting.

There are at least two issues. The first is to encourage people to be skeptical about the performance of any construction, mechanical, electronic or intellectual: there are some events that will screw up any design.

But then we come to the problem of how to estimate how unlikely these testing circumstances are. Typical operational risk events involve a concatenation of errors, of individually improbable circumstances. Sadly it seems that sometimes these events are not independent so that the joint probability of a screw up is much bigger than one might think. For that matter, the equity, credit, FX and interest rate markets often have low return correlations: but they can all move together in a crisis, as LTCM found out. It isn’t that a plausible worst case is bad — we knew that — it is that the worst case can be much more likely than it appears.

Believing the worst May 17, 2007 at 8:33 pm

Shamelessly stolen from Overcoming Bias:


In 1983, NASA was planning to bring back Martian soil samples to Earth. Contaminating the Earth with alien organisms was an issue, but engineers at Jet Propulsion Laboratories had devised a “safe” capsule re-entry system to avoid that risk. However, Carl Sagan was opposed to the idea and explained to JPL engineers that if they were so certain […] then why not put living Anthrax germs inside it, launch it into space, then [crash the capsule back to earth] exactly like the Mars Sample Return capsule would.

The engineers helpfully responded by labeling Sagan an alarmist and extremist. But why were they so unwilling to do the test, if they were so sure of their system? The answer is probably they feared that if the test failed, their careers would be over and they would have caused a catastrophe. But an out of control Martian virus, no matter how unlikely, would have been equally a catastrophe. However, that vague threat didn’t concentrate their minds like the specific example of anthrax.

Imagine for a moment that those engineers had been forced to do Sagan’s test. Fear of specific disaster would have erased their overconfidence, and they would have moved from ‘being sure that things will go right’ to ‘imagining all the ways things could go wrong’ – and preventing them. The more dangerous the test, the more the engineers would have worked to overcome every contingency.