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Liquidity Crisis

This New York Times article by Joe Nocera article provides an interesting overview of the financial crisis with a focus on “value at risk,” or VaR, more or less the amount of money that a firm could expect to lose with a certain probability and over a specified time interval. And, even better, there is an Eph connection!

“VaR WAS INEVITABLE,” Gregg Berman of RiskMetrics said when I went to see him a few days later. He didn’t sound like an intellectual charlatan. His explanation of the utility of VaR — and its limitations — made a certain undeniable sense. He did, however, sound like somebody who was completely taken aback by the amount of blame placed on risk modeling since the financial crisis began.

“Obviously, we are big proponents of risk models,” he said. “But a computer does not do risk modeling. People do it. And people got overzealous and they stopped being careful. They took on too much leverage. And whether they had models that missed that, or they weren’t paying enough attention, I don’t know. But I do think that this was much more a failure of management than of risk management. I think blaming models for this would be very unfortunate because you are placing blame on a mathematical equation. You can’t blame math,” he added with some exasperation.

Indeed, Ethan Berman, the chief executive of RiskMetrics (and no relation to Gregg Berman), told me that one of VaR’s flaws, which only became obvious in this crisis, is that it didn’t measure liquidity risk — and of course a liquidity crisis is exactly what we’re in the middle of right now. One reason nobody seems to know how to deal with this kind of crisis is because nobody envisioned it.

In a crisis, Brown, the risk manager at AQR, said, “you want to know who can kill you and whether or not they will and who you can kill if necessary. You need to have an emergency backup plan that assumes everyone is out to get you. In peacetime, you think about other people’s intentions. In wartime, only their capabilities matter. VaR is a peacetime statistic.”

MAYBE IT WOULD HAVE been different if the people in charge had a better understanding of risk. Maybe it would have helped if Wall Street hadn’t turned VaR into something it was never meant to be. “If we stick with the Dennis Weatherstone example,” Ethan Berman says, “he recognized that he didn’t have the transparency into risk that he needed to make a judgment. VaR gave him that, and he and his managers could make judgments. To me, that is how it should work. The role of VaR is as one input into that process. It is healthy for the head of the firm to have that kind of information. But people need to have incentives to give him that information.”

Ethan Berman ’83 drew praise in an EphBlog post three years ago. Although it was fair to describe the crisis as one of liquidity last October, at this stage the issue is solvency. Citigroup, with help from the Fed, is plenty liquid. But is it bankrupt?

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Egalitarian Eph

What is the most complimentary article about an Eph to appear in the New York Times in 2005? I think this one.

Blizzards swept through Wall Street last week — bonus blizzards, that is. Henry M. Paulson Jr., chief executive of Goldman Sachs, received $37 million in shares and options. Richard S. Fuld Jr. of Lehman Brothers got $15 million in restricted stock, while John Mack, Morgan Stanley’s new chief executive, pocketed an $11.5 million stock grant for six months’ work.

But one Wall Street executive atop a fast-growing firm is saying no to the piles of pay that make corporate America’s world spin so splendidly. In a remarkable two-page letter to the chairman of his company’s compensation committee, this executive requested that he receive no increase in salary, zero stock options, a smaller bonus than last year and a piece of the company’s profit-sharing pie equal to that received by all employees. This, in a year when his company’s revenue grew by more than 40 percent.

Who is this magnanimous executive? Ethan Berman, founder and chief executive of RiskMetrics, a private company that was formed at J. P. Morgan Chase and spun out to private investors in 1998. RiskMetrics, based in Manhattan, helps institutions and corporations assess risk in their investments; it is owned by its employees and three private equity firms. It will generate revenue of $100 million this year.

Haven’t heard of Mr. Berman? That is not surprising: his company is small and he is no self-promoter. Unlike other executives uttering the bromide about how the team contributes to a company’s success, Mr. Berman not only says it, he also acts on it.

While Mr. Berman’s may not be a household name, his egalitarian executive pay philosophy is worthy of the spotlight. His letter to the board, outlining this philosophy, should be read by anyone who serves on a compensation committee. It should also be memorized by institutional investors, who too often let managers siphon wealth from their pockets.

Ethan Berman is Williams College, class of 1983. There is a lot of interesting material in the article (more excerpts below) as well as in Berman’s letter. Arthur Levitt ’53 also makes an appearence. Yet, I can’t resist using this hook an another excuse to mention my simple solution to the problems of excessive executive pay. More on that some other time.

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