There has been much discussion about the failure of brokerage/hedge operations to predict the potential disaster in the sub-prime market. The VaR (value at risk) models , it is pointed out, failed to protect positions from 'the event' and as such a new methodology is needed.
It is further explained that the credit agencies themselves did not evaluate correctly the implications of these financial instruments.
While all of the above seems to fit into the obvious explanation for the mortgage meltdown, there is a simpler explanation. When designing risk models, nothing will be more important to the management of actual positions than an exit strategy which takes into account the size of the position on the books. The ramping of single strategies by every trading operation in sight is going to effect the ability to maneuver the position when it is time to get out. The sub-prime disaster was created by the mania to compete for debt transaction fees while ignoring the implications of heavily ramped risk models. A great trading strategy consists of a risk design that can actually be executed. Markets are not liquid just because the trade volume is large. In fact, every experience trader knows the larger the position, the less liquid the exit price. That is trading 101. The fact is, these trading operations are not a bright as they would like you to think. They are just risking more per unit to make less in volume.
