VaR: For a Crappy Tool, It's Really Important at Goldman Sachs

Dec.17.07 | About: Goldman Sachs (GS)

In Kate Kelly's narrative of Goldman Sachs's (NYSE:GS) mortgage-trading gains, thrice the traders want to keep their bearish bets but are forced to unwind their positions by higher-ups. What fascinates me is the way in which value-at-risk, a very quick-and-dirty risk measure, seems to have been of paramount importance within the highly sophisticated investment bank:

Like other Wall Street firms, Goldman weighs its financial risk by calculating its average daily "value at risk," or VaR. It's meant to be a measure of how much money the firm could lose under adverse market conditions. Because the ABX had become so volatile, the VaR connected to the trades was soaring...
Goldman's top executives understood the group's strategy, say people with knowledge of the matter, but were uncompromising about the VaR. They demanded that risk be cut by as much as 50%, these people say...
"This is the wrong price" to close out the positions, Mr. Birnbaum snapped at a colleague assigned to help reduce risk, slamming down his phone receiver, these people say. He was overruled...
By late July, the Bear Stearns (NYSE:BSC) funds had collapsed and rumors were circulating of multibillion-dollar CDO losses at Merrill (MER). Goldman was raking in profits.
But once again, concern was growing about VaR, the all-important measure of risk. At one point in July, senior executives called another meeting to demand the mortgage traders pull back, according to people familiar with the matter...
Around Labor Day, Mr. Birnbaum was asked to ratchet back one of his short positions by $250 million, according to Hayman Capital managing partner Kyle Bass, a client who had similar positions at the time. Mr. Bass says he made $100 million by relieving Goldman of that particular short bet. "It appeared to me that [the traders] constantly fought a VaR battle with the firm once the market started to break," says Mr. Bass.

Back in October, I asked what the point of VaR was. Here are some of the responses I got: "It doesn’t accurately gage value at risk". "I presume that MS, like other investment banks, has other, more sophisticated, risk controls." "In being so quick and taking only historical and very little information into consideration, it is pretty poor." "VaR’s right now are of especially little use." "It is pretty useful for giving a gross snapshot of risk taken to the guys in the boardroom, or at the SEC or in Basel...That's about it." "VaR seems at best mislabeled, and at worst completely useless for managing risk." "It is not the end-all metric, many think it has fatal flaws."

Yet according to Kelly, this rather crappy measure is so important that, on at least three separate occasions, the mortgage-trading desk was forced to unwind its highly-profitable positions just in order to reduce its VaR. Weird.