Aaron BrownTrader Interview: Aaron Brown on the '07 Financial Crisis. Photo: eraider.com

Pod Chats: Aaron Brown on Predicting a Financial Crisis

Trend Following Radio Episode 666: Aaron Brown. Click above to listen to the full episode.

Aaron Brown is the former Chief Risk Manager at AQR Capital Management and one of the original developers of VAR (value at risk).

An expert on risk management and gambling, he is also the author of Red-Blooded Risk, The Poker Face of Wall Street, and co-author of A World of Chance.

In episode 666 of Trend Following Radio, host Michael Covel talks to Aaron about his start in gambling and poker, when he realised the real money was to be made on Wall Street, and his thoughts on the 2007 financial crisis...

Read below for some extracts from the interview, or listen to the full episode here...

My personal definition of a Quant is someone who makes calculations and bets on them. And a lot of people want to make calculations but don’t want to bet on them.Aaron Brown

On his strengths...

I’ll tell you something about what Paul Wilmott said about me, I think he might have meant as an insult, I’m not sure, but he said “Aaron Brown can solve any problem for which a solution is known to exist". And I haven’t quite figured out why he said that specifically but that is my talent.

I don’t tackle problems where I’m not sure a solution exists, where people are going to argue about what the solution should be. I like things where when you find a solution, you know it is and know that there has to be a solution. That’s why I like applied math rather than pure math and that turns out to be valuable in the financial world.

My personal definition of a Quant is someone who makes calculations and bets on them. And a lot of people want to make calculations but don’t want to bet on them.

On his focus on odds, uncertainty and risk...

I may have been born with that. But if I wasn’t, it probably came about from reading Beat the Dealer back when I was 8 or 9 years old. I had always thought that way. There are two great revelations…the first was when I was 14 when I realised I could walk into a commercial poker game, I could sit down, I could win. I knew I could win, that was never an issue. And people would let me walk out with their money….that was very important to me, for various reasons.

I’m 61 years old, so we’re talking 1970, and Seattle had been hit by the recession a couple years before the rest of the country, things felt very insecure, getting a job seemed very insecure and it seemed like money was real important and that you couldn’t count on any of the traditional things, inflation was out of control and unpredictable…it seemed to be a very complicated world and very scary.

Poker was pretty simple, you walk in and bet your money, got you money and walked out. And that was why I was attracted to it, I was also attracted to horse racing and sports betting and so on, but those were more difficult for me to access at that age…so it was really important to me and I realised when I walked out, ok I don’t know what’s going to happen in life, but I know I can always get enough money to eat today, to get a place to stay for the night because there is always poker anywhere in the world, all you have to do is find a game and if you’re a good player and don’t have any money, someone will lend you a stake. You’ve got guaranteed income for life.

And that bit of security has always been important to me…the ability to make money in a self-organised way without external rules, without counting on some government or company or set rules, other than the poker player network. So that’s when I decided, ok, I can make a living exploiting chance and exploiting bets.

On moving to Wall Street...

I go off to college and pay my way through with poker and also doing some sports betting, some blackjack stuff. Let’s say late 70’s, in my early 20’s, it hits me that there's a lot more money to be made and the gambling is a lot easier on Wall Street than Las Vegas. That was a daring thought at the time. I mean there weren’t mathematicians on Wall Street, if you wanted to get a Wall Street job and you happened to take some math courses, you left them off your resume. Wall Street was all about sales. But I started looking, I read Beat the Market by Ed Thorp and read a lot of other stuff and thought ok, the edges are a lot bigger in Wall Street and the amount you can bet and get paid are a lot larger. Gambling for a living, if you don’t join with a group, it’s hard to make more than, say, 500k/600k a year. You know that’s great, you can live pretty well…Wall Street was orders of magnitude more opportunity, more profit.

I would say it’s 1982 when I realise this stuff really works, it’s not just theory. When quants first came to Wall Street, late 70’s early 80’s, I was three to four years after the first people who did this, we were regarded as just one more group to help the sales. If you come to Wall Street and want to make money with astrology, or by asking my dog what stocks to buy, they love you. Because as far as they’re concerned your job is to go and raise money from investors and pay fees on trades, they don’t care if your trades work or don’t work, it makes no difference, your job is to gather assets and generate commissions. It took them until mid to late 80’s [to see] that the quants were different, because the quants actually made money.

And when you actually make money, that whole sales model of taking commissions from both sides and nobody actually making any money, doesn’t work. It’s very similar to what casinos figured out, casinos really didn’t like the game of poker. Because most casino games, any money the player loses the casino wins. It’s very upsetting to casinos that someone in the building is making money and it’s not coming from them, somebody is losing money and they aren’t getting it. Wall Street was just as unprepared as casinos weren’t prepared for poker. There were people out there making money, consistently winning. So that’s when the quant era really began, that’s when people started to take it seriously and people started to make up the name quant.

On predicting a financial crisis...

2007/08 was the most statistically predictable, by the book, financial crisis we’ve ever had. 1987 was the weirdest, it violated all the rules we knew. Most financial crisis’ they follow certain patterns, from people standing 25,000 foot away they all look the same, people got greedy, over leveraged, it fell apart and then there was a crisis. But when you actually live through these things and you’re responsible for lots of money and have to make decisions on what to do, you get a very different view and different feel for crisis.

This one was very predictable, I don’t mean I could predict it, I want to be very clear, I’m not saying that, I’m just saying that it was very much a random walk crisis. If you look, you saw volatility going up and then you saw up and down movements that you would expect given that volatility…the only thing about it that was unpredictable, out of left field, and surprised a lot of people including me, was the government reaction, the government reacted not the way I would have expected and that messed things up a lot.

On the narrative of 2007...

People have a tendency to tell a story about something and the order things happened, the first shoe that dropped in this crisis was sub-prime, so people called it the sub-prime crisis…but when you look back and ask what was really going on, sub-prime wasn’t big enough, we had five previous sub-prime crisis’ and none of them made the front page of the WSJ, they were just contained within the sub-prime field.

These sub-prime pools, you expected a 5% loss rate and it got to about a 20% loss rate. That’s not bad news, you’re sorry you bought it, but you expected a 5% loss rate, you built in an extra 10% interest kicker so you would make money even with a 5% loss rate. So you look to make 5% on these things but you end up losing 10%. That’s just not a disastrous occurrence, that’s not something that makes institutions fail, that’s not a gigantic surprise. Prime mortgages, they were a much bigger surprise. There were pools that should have had a .03% default rate that actually had a 1-2% default rate, that’s actually a much much bigger surprise.

But even that wasn’t enough. I think what you really have you think about it, if you look at 2007 to 2012, the five-year period. The really big event in there, the sovereign debt crisis kind of hit in 2010 and kind of spread and people figured out governments didn’t really have enough money to pay the promises that they had made. We kind of already knew that but it was always say in 25 years when the social security trust fund runs out, you project things out….when you actually have things start failing, like Greece actually fails, Iceland actually fails, Spain and Italy nearly fail, that’s a problem today, you have to deal with it today.

And I think that change in mindset was the ultimate cause of what happened, and the reason it showed up was, so ok, sub-prime has problems, banks have problems, so hedge funds have problems. Hedge fund problems spreads to Bear Sterns, Bear Sterns problems spread to the US government. That’s when people started doing the maths and saying wait a minute, the governments can’t bail out the banks. If the banks lose money that is not that statistically an unpredictable amount of money, it’s not something that someone said wasn’t possible, you would have expected it if you were looking at the value of risk these banks were publishing…a bad event but 10 standard deviation event, a 2.5 standard deviation bad event for the banks.

On the government and Bitcoin...

The governments are helpless, and if the governments are helpless then we don’t know what’s going to happen with the value of our money, that was the reason why Bitcoin was invented at the time…the ultimate issue here is government credit, the value of money, that was not resolved until about 2012, that’s when it went away. So the stock market drops 50%, goes up 100%, goes back up another 100% and all that’s where all the attention is focused, the banks go out of business, new government entities are formed, new laws are passed.

But the real issue was, people believe that governments, primarily developed country governments, can surmount the short-term problem of everything falling apart, and we’re not going to run out of money in the next 5-10 years, we’re back to that problem of 25 years down the road where there’s a lot of ways you can hope that things will get better. And to me that was the nature of the crisis, sovereign credit was the key, which we didn’t know, nobody knew until 2010 or so.

Want to listen to Aaron Brown's full interview with Trend Following Radio? Listen here to Episode 666