|(Image via CNBC.com)|
He mentioned how risk management is "really just advanced contingency planning," or measuring the possibility of low probability events occurring in the future. He essentially explained how strong directional market sentiment and reflexivity makes it easier for low probability events to occur because everyone believes they can't and won't happen (the trend will never end), which ultimately creates a speculative bubble that bursts and a negative feedback loop. Here's what Lloyd Blankfein said, emphasis mine:
"It's not a matter of guessing the future better than others; I think most risk management is really just advanced contingency planning and thinking of possibilities and disciplining yourself to realize that, given enough time, very low probability events not only can happen, they absolutely will happen. The definition of infinity is that you wait long enough, everything happens. People were conducting models and basing their lives and their fortunes and the structure on the fact that since housing has never gone down by 20% ever, and when they did go down by that much it was never everywhere, that it couldn't. Not only should you think that things could happen, you have to think that everything will happen."
"(It is) A lot of contingency planning and scenario planning, not risk analysis where you build in the probabilities of something happening. You have to do that, but I think you have to suspend critical faculty about how improbable things are because improbable events happen, and also you're wrong about the probabilities. Because once you think that something is improbable and everyone thinks it, people modify their behavior in a way that makes it more probable. Like in the real estate. Because everybody thought that it was so improbable that so many people would default on real estate, it absolutely created a higher probability that people would because more capital flowed in that sector."
Of course, it was much easier for Goldman Sachs and the other too-big-to-fail or failed Wall Street banks to predict the likelihood of these improbable scenarios playing out because they controlled the over-the-counter credit and credit default swap markets off public exchanges. Not only were banks and hedge funds knowingly and legally engineering the mispricing of credit risk in the market and creating systemic risk, bank credit/credit default swap trading desks were using this information to profit off their own destruction in their own proprietary funds. I don't want to get too deep into this again, so I linked to a bunch of articles below which explain exactly what happened. The banking system needs to be more transparent and less complex to protect the markets, economy and public from hidden misunderstood risks and (legal) institutional fraud.
But, since we're on the topic of improbable scenarios, I wonder if Goldman Sachs ever discusses the possibility of Dow 5,000 playing out at their contingency planning meetings.
Sorry for the TBTF buzzkill below, but all of this was related to the rampant mispricing of risk in the system, and why the highly improbable possibility of the financial system collapsing turned into a reality. Also, charging a mid-level Goldman employee in his late 20s with securities fraud (misleading professional institutional investors when making markets in mortgage-backed securities, credit default swaps, and synthetic CDOs) doesn't really address the overall problem, imo.
• Goldman Sachs Congressional Hearing Video 1 [Tourre, Birnbaum, Sparks, Swenson]
• Goldman Sachs Congressional Hearing Video 2 [CFO David Viniar, CRO Craig Broderick]
• Goldman Sachs Congressional Hearing Video 3 [Lloyd Blankfein CEO]
• Abacus 2007 CDO Pitch Book Referenced Securities One Notch Above Junk Four Months Before Two Bear Stearns Credit Funds Blew Up (also available here or here).
• Goldman Sachs FCIC Hearing [COO Gary Cohn, CRO Craig Broderick]
• Former Goldman Sachs VP Greg Smith on 60 Minutes
• JP Morgan Sold Investors MBS Covered By "SACK OF SH*T" Loans... Then Shorted All Those With Exposure: A Goldman-AIG Redux
• Sen. Levin Grills Goldman Sachs Exec On "Sh*tty Deal" E-mail (go to the first link for the whole hearing)
• (interesting) Tom Montag, the guy who wrote that Goldman "sh*tty deal" memo, now at Bank of America
• The Magnetar Trade: How One Hedge Fund Helped Keep the Bubble Going
• SEC Investigating Deal Between JPMorgan and Hedge Fund Magnetar
• Yet Another Bank Fined for a Magnetar Deal, With Yet More Revealing Emails
• The ‘Subsidy’: How a Handful of Merrill Lynch Bankers Helped Blow Up Their Own Firm
• Janet Tavakoli on Bank "Control Fraud", Credit Default Swaps, MF Global's Total Return Swap-to-Maturity Trade (and Missing Money)
• Prof. Bill Black: Our System is So Flawed That Fraud is Mathematically Guaranteed! (Part 1)
• The Untouchables - FRONTLINE Documentary