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Disclosure: In a previous life I examined 330,000 residential mortgages and 220,000 CMBS assets, and was surprised to find substantial unusable data in these assets.

I read Pandit memo: Citi profitable in 2009, and it got me thinking about my own work and findings in loss modeling. I have no doubt that Citi would be profitable some day, given the amount of bailout funds it has received.

What concerns me is that the stress test was completed in a matter of weeks. This suggest that Citi and other banks are using the same risk models and stress testing that got them into this mess to redo their stressing.

That the assumption these banks are making is that their models are still correct but they need to increase the severity of their stress factors. For example if you originally expected an average default rate of 1.96% you now use say 2x or 3.92%. Maybe some additional combinations such as also increasing average loss severity from 35% to 55%.

Sorry this does not fly with me. My work with CMBS loss models shows:

1. That the more popular loss models are significantly biased. The problem with statistical bias is that stressing them more does not give a better understanding of future losses.

2. Some of the model factors don’t even work or don’t work correctly.

3. Nassim Nicholas Taleb’s Black Swan hypothesis suggests that the CMBS Black Swan’s are on the order of 20% to 80%.

4. To do real stress testing you have to know 3 numbers, VaR, CVaR and Black Swan.

5. It takes at least a year to develop new stress models, not days or weeks.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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