Crash of 2008/Tutorials

Risk-management errors

(for definitions of the terms shown in italics on this page see the glossary on the Related Articles subpage [[1]]

Tail risk

An explanation for risk-management errors that has been put forward by Andrew Haldane (Head of the Bank of England's Systemic Risk Assessment Department) suggests that they arose from investors' and rating agencies' use of linear models based upon the CAPM (Capital Asset Pricing Model) . Such models assume that risks can be represented by the symmetrical bell-shaped normal distribution, and can give inaccurate results if the true distribution has a "fat tail", as a result of which there is a significant additional tail risk. Earlier work by Raghuram Rajan (Director of Research at the International Monetary Fund) suggested that securitised assets may be expected to involve significant tail risks. . Since the events involving such risks are by definition rare, they cannot be expected to be picked up by models based upon a five or six years' run of data.

Credit rating errors

According to Frank Raiter (former Managing Director and Head of Residential Mortgage-backed Securities Rating at Standard and Poor's) his company was assessing default probabilities using a model based upon the analysis of 900,000 mortgages that had been implemented in 1996, and which did not, therefore, capture the changes in performance brought about by the subsequent increase in the numbers of subprime mortgages . Later - improved and updated - models had been developed, but were not implemented because of budgetary constraints.