Red-Blooded Risk by Aaron Brown
Red-Blooded Risk by Aaron Brown
Brown needs an editor. At points, this feels like Neal Stephenson's Snow Crash, where he's pushing all the cool semi-related ideas he's had since high school into a book. Elsewhere, he just chooses a sub-optimal way to translate notions (granted, he may have felt some paraphrase / obfuscation was warranted for professional reasons). Were one to consider only its failings, this book is a copy of Kent Osband's IcebergRisk with the math removed, the dialogues replaced with cartoons, and a slew of Brown's rants and pet theories added. It's better than that, though.
At the heart of this book is large-scale coordination and loose centralization of capital that free markets, telecommunications, and IT opened in the latter part of the 20th century. As markets opened and exchanges grew, the resulting capital aggregation exceeded the tools with which we had to manage that capital cost-effectively. Thus was born the modern risk manager.
The following anecdote parallels and summarizes his argument exceptionally well:
... the summer I spent working on the US government standby gas-rationing plan. One of my jobs was to figure out how much fuel would be needed to harvest crops and get food to market. I'm a city boy, so I needed to ask whether tractors run on diesel fuel or gasoline. I called the Department of Agriculture and got passed around until I found the right guy. He was out. So I called the Ford Motor Company, and found an economst who had just finished modeling the US tractor market. He told me 75 percent of the tractors ran on diesel and gave me a lot of supporting detail.
The agriculture guy called me back later. I already had the answer, but I figured I'd listen to him anyway to be polite. He had also just finished a model, and told me that 25 percent of the tractors ran on diesel. I said, "You mean 25 percent run on gasoline." No, he insisted that it was 25 percent diesel. I told him what the Ford guy had said and he snorted that Ford was only talking about new sales, not the existing stock. That wasn't true; I had all the supporting numbers from Ford. We discussed them at some length and he had answers to all the points I made, giving me his own supporting detail. I checked those with Ford. That guy said Agriculture was counting old tractors rusting in barns or that had been sold to Mexico in the 1950s (not true).
So I started calling farmers, and garage mechanics in agricultural areas, and fuel suppliers and refineries. The more I learned about the issue, the more I realized that no rationing plan had a hope of working. The amount and types of fuel needed and the times at which they wered needed varied dramatically from place to place, crop to crop, and season to season. Moreover, people needed to know about supplies well in advance. If you really wanted to deliver the fuel necessary to service agriculture in the United States, you would need a nationwide organization with a large degree of local autonomy and massive databases, and you would have to partner with thousands of businesses. Otherwise, it would be a complete disaster.
Of course, nothing like this was contemplated. The idea was that farmers would be issued ration coupons, and the government would direct supplies so that each local area would have right amount of fuel necessary to fulfill all the coupons. And it wasn't just farmers, who might have been barely possible to do right if the right people were in charge and the entire resources of the government were devoted to that one problem. Everyone was going to get ration coupons for everything deemed essential. And the whole plan was based on wild oversimplifications and terrible data....
If the other people working on the standby gas-rationing plan had disagreed with me, I could have taken that. I'm wrong a lot; maybe I was wrong about this one. But they didn't disagree. It just never occurred to them that the plan might actually be implemented. It was all some theoretical exercise that existed on a totally different level than decisions they made for their own lives. If any one of them bought a car, he would look it over carefully and shop for the best price. But that same person was willing to take money to write a plan on which every American's food supply depended -- and all the rest of the US economy that is essential for survival -- without checking any data or doing any experiments at all. No one even was interested in reading about the experiences of agricultural planners in communist countries.
(Granted), I didn't meet everyone on the project...I came to believe that ... even the people running the projects, writing the models, or collecting the data wouldn't bet their own money on the results, and would be insulted if you proposed that they do so.
His pet theory on Tulipmania is fantastic: Strains of tulips can see demand spike, however production is limited (can't copy, have to wait for them to bud). People would flog strains to the glitterati, which would help drive demand. The stories we have from that non-literary period are crystallized advertisements for a particular strain. E.g. the "Black" tulip story has 3 strangers dressed in black visiting a dark tavern to buy a black bulb; the tavern keeper names an outlandish price, which the three promptly pay; they then drop the bulb on the floor and stamp on it, saying "Fool! We would have paid 10 times as much. Now we possess the only Black Tulip!"
Additionally, this book forces me to concede the point that I am not doing nearly enough review of actions and output in my life.
The third principle of modern quantitative risk management was an antisurprise, which we called 'risk ignition'. This is an idea that traces back to John Kelly... He discovered that if you take an optimal amount of risk -- not more and not less -- you can be certain of exponentially growing success, which will always leave you better of than any other strategy.
I see some form of money creation, or attempted money creation, in all bubbles. In Chapter 16 we'll see the power of stock option currency in the Internet bubble. In the housing bubble that popped in 2007 all kinds of new currencies were created, as we'll see in Chapter 10.
Some naive people imagine this kind of leverage when they hear banks were levered up 40 or 50 to 1. No bank borrowed $49 to add to its $1 and bought $50 of stock. Any such institution would go bankrupt very quickly. What banks did for th most part was to use leverage to ffset risk. If the bank found itself holding a billion dollar's worth of US Treasuries, for example, it might enter into a futures contract to offset the risk. That means it now has 2 to 1 gross notional leverage, since it has a billion dollars' worth of Treasuries plus a billion-dollar notional short futures position. But it clearly has far less risk than when it was unlevered, before it entered into the futures contract. Its only risks now are that there might be some problem with the futures clearinghouse or some mismatch between the Treasuries it holds and the Treasuries deliverable under the futures contracts. Otherwise, it does not care if Treasury prices go up or down, or even if the US government defaults.
We always knew there were some risks to this kind of leverage, but they seemed much smaller than the risks you eliminated by hedging.