I recall in my past life as a trader working for financial institutions that some desks, mostly bank units, did not want to deal with the volatility of the marks-to-market on a daily or monthly basis and ran “accrual” books. An accrual book is gradually marked throughout its life –so the trader knew pretty much, baring a “black Swan”, what his P/L was going to be. Some also tried to escape the marks-to-market when they engaged in some arbitrages that should “converge” at expiration. They claimed to know what the value of the trade would be at expiration time T, so there was no need to mark immediately and deal with the vagaries of the marketplace. In their mind letting the market value these trades did not reflect the economic value of their books. The argument offered was “I will only unwind at expiration, not before”. They were certain about it. They were as certain about it as people tying the know are certain that they are united forever.
I am writing this note because one day, in 2005, at a panel discussion, a board member of FNMA and an advocate of “modern finance” got emotional about the bad press related to some accounting irregularities that was supposed to have taken place at that firm. The panel discussion had nothing directly to do with FNMA or with accounting policies. It was about risk management. I thought of the argument proposed and realized that by not marking to market every single item in one’s book one fell prey to model risk. It was the same type of epistemic arrogance that was behind the central planner: you set an equality between A and B by fiat. [It is not just some unpleasant member of the board of FNMA that falls prey to epistemic arrogance. Merton Miller took similar arguments when he defended the Metalgesselschaft traders who went bust trading short term futures against long term forwards. His argument was that “long term” things should be OK and that we should not have paid attention to the “short term” differences in market values].
Why Model Risk? The simplest of securities embeds model risks: the way the contract is described in your system may be missing a minor component. Minor, except… Say that I have the simplest of trades deemed fungible on my books: I am long a forward with Bank A and short the exact same one with Bank B. I may be hedged, but I have at least a credit risk there. Sometimes the smallest variations in the contracts can be significant. No two contracts will ever be exactly fungible unless they are legally offsetting.
Now the market knows that these contracts are not as identical as they are thought to be. Markets discover things faster than some slow-thinking regulator or overmathematized risk manager. When Russian options traded at 5 implied when supplied by a Russian bank and at 11 with a nonRussian institution, you had a marks-to-market risk not accounted for by models. The market knew it, not the banks.
Another sucker’s problem is the classical forward-future “mispricing”. The forward IS NOT a future, be it only because a future has cash-flow elements throughout its life, something the models miss severely. Many blew up on this.
A Safer System Many corporations do the following arbitrage. They buy plenty of companies, say n units. Say half the companies do well, the other half do poorly. All of them will be marked at cost on your books. You have a bad quarter: no problem. Just sell those that fetch a price higher than acquisition (i.e. books) and you will show a profit. GE does that routinely (Jack Welsh admits it in his memoirs).
The same with traders. When you let them “accrue” you end up having the books doing worse than market. If the trader has a profit, he takes it. A loss becomes accrued. It is like traders becoming “long term investors” when their positions are under water.
A system without opacity will be like Japanese institutions: seemingly less volatile, but exposed to large losses. (I compare this in The Black Swan to a dictatorship that shows political stability but incurs the risk of revolution compared to a country like Italy with a smaller risk of reolution but more fluctuations. Fluctuat nec mergitur.)
One good thing about hedge funds: unlike FNMA they mark to market. They have such bad press that they are forced to do so. Unlike banks and corporations they cannot play nasty games and fool their shareholders. Recall what Enron did with its “contracts”. They may have other problems, but, at least, they are transparent.
Reduction and Platonicity
This problem resembles the more general one of the creation of categories and mental representations that simplify and reduce –it is necessary to simplify. Except that we forget that they aqre just simplifications.