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26-nov-2020
It was boxer Mike Tyson’s first defeat in his 38th professional fight1. He’d successfully defended his heavyweight title nine times. For nearly five years, Tyson had ruled heavyweight boxing with knockout after knockout and was widely regarded as being indestructible, even invincible. All of that changed on the night of 11 February 1990 in Tokyo when Tyson, and his mythical image, came crashing down. Challenger James “Buster” Douglas knocked Tyson down and out in the 10th round – capturing Tyson’s championship belt and boxing history.
Just as no one saw Tyson’s knockout coming, neither did Wall Street when Lehman Brothers, the venerable brokerage firm, filed for bankruptcy on 15 September 2008 . It was a collapse so unthinkable even the U.S. Federal Reserve didn’t foresee it. In February 20082, Ben Bernanke, the Chair of the Federal Reserve, gave his semi-annual testimony before the U.S. Senate Banking Committee and noted that while there may be failures among smaller banks in the wake of the 2008 financial crisis, he “[didn’t] anticipate any serious problems of that sort among the large internationally active banks …”3
Are tested assumptions, based on past performance, a safe way to quantify risk?
Nevertheless, only a few months prior, Lehman’s annual report for the 2007 financial year had offered 28 pages of elaboration on their risk management and business and geographical diversification, the “mother” of all risk reduction strategies. Their report noted “quantifiable risks using methodologies and models based on tested assumptions” and goes on to “measure the diversification benefit within our portfolio by historically simulating how the positions … would have behaved …”.4
Tested assumptions and potential outcomes seemed a safe way to quantify risk for Lehman Brothers and as a bet on Tyson based on his glorious track record. However, both assumed that past performance was a good guide for the future. It simply wasn’t – and isn’t. Both wagers carried high levels of implicit risk. The global financial crisis became worse than the worst case scenario at that time. Tyson appeared invincible, until he wasn’t. This is the paradox of risk management in financial markets.
The ultimate litmus test for any portfolio risk management is a crisis. If these risk tools fail, what’s left? Is it even possible for a portfolio manager to get a grip on risk?
1
Smyth, Julie. 30 years after Mike Tyson fight, Buster Douglas is ‘feeling good’, The Chicago Tribune, 2-Feb-2020.
2
Sorkin, Andrew Ross, Lehman Files for Bankruptcy; Merrill Is Sold, The New York Times, 14-Sept-2008.
3
Banks should seek more capital: Bernanke, Reuters, 28-Feb-2008.
4
Lehman Brothers Holdings Inc., Form 10-K: Annual Report for the fiscal year ended 30 Nov 2007, SEC Archives, pgs. 69 – 70.