No one who reads Red-Blooded Risk: The Secret History of Wall Street will ever again regard risk management as a necessary but unproductive appendage of the financial industry. Other authors have chronicled how quantitative finance influenced investment management, but Aaron Brown has made a compelling case for a far more profound economic impact.
As a college freshman, Aaron Brown worked on a U.S. government standby gasoline-rationing plan. One of his tasks consisted of determining the amount of fuel that would be needed to harvest crops. To find out whether tractors consumed diesel fuel or gasoline, the city-bred researcher called a Department of Agriculture employee, who told him that 25 percent of tractors ran on diesel. But a Ford Motor Company economist said that 25 percent ran on gasoline. Confronted with this disparity, the two experts hotly—but inaccurately—impugned each other’s methodology. Brown then consulted farmers, mechanics, fuel suppliers, and refineries and discovered that the demand for agricultural fuel was an extraordinarily complex matter. “The more I learned about the issue,” he writes, “the more I realized that no rationing plan had a hope of working.”
If Red-Blooded Risk: The Secret History of Wall Street dealt with nothing more than the inadequacy of models used in highly important activities, it would represent a valuable contribution to financial economics. (Along the way, the author presents even more-disturbing examples of fatally flawed data that render many analyses useless or worse, assuming the data are fed into valid models.) Brown’s book, however, covers a great deal more than econometric malpractice.
A primary focus is risk management, which Brown heads at AQR Capital Management. Probably no other book offers as much insight into the process with so little resort to mathematical notation. Especially valuable are Brown’s discussions of middle-office risk management and value at risk, comparatively recent innovations that are essential to understanding modern financial institutions.
As its subtitle hints, the book undertakes the still more ambitious project of arguing that quantitative analysts have transformed the entire financial industry and even the structure of the U.S. economy. Brown was one of a new breed of financial operators, born in the 1950s, who believed academic theories were untrustworthy unless their proponents were willing to stake money on them. Many of these “rocket scientists” 1 spent part of their careers as professional gamblers; Brown became one of the world’s leading poker players. These unconventional thinkers eventually gravitated to Wall Street, where, Brown maintains, they were responsible for the vast expansion of the financial sector. Thanks to their efforts, he claims, hedge funds gained the potential to make their owners billionaires, not mere multimillionaires. The magic ingredient, Brown says, was the ability to expand investment capital through derivatives and securitization.
Aware that these instruments are not universally viewed as blessings, Brown is candid about their role in the financial disasters of the past two decades. He argues that their contribution to economic growth more than offset the damage inflicted by volatile markets, which were also common in the period preceding modern financial engineering. To diminish nasty fallout in the future, he proposes breaking up systemically important financial institutions that conduct inherently conflicted businesses. Brown would house deposit taking and small-business credit provision in smaller, safer banks.
Readers of Red-Blooded Risk should be prepared to have many of their assumptions challenged. Brown contends that taking too little risk represents a serious and underrated threat to financial health. He considers it necessary that some financial institutions fail, provided they do so quickly, and deems it highly inadvisable for risk managers to target a zero probability of bankruptcy. Hard-money advocates will find Brown an unabashed fan of fiat currency, although he foresees paper money being replaced by derivatives.
Brown denies that the social utility of finance is making markets more efficient. He rejects the popular belief that the securitization disaster of 2007–2009 resulted from faulty models, blaming instead the failure to sell deals in full in bona fide arm’s-length transactions. In addition, he debunks the notion that dual-class share arbitrage 2 represents an anomaly in the form of riskless profits.
Not even Wall Street’s conventional terminology and etymology are safe from Brown’s iconoclasm. Every description of securitization, he says, uses the phrase “sliced and diced,” drawn from 1960s infomercials for the Veg-O-Matic. That kitchen appliance did not actually dice, says Brown, and the metaphor does not really fit securitization. “Bathed and lathed,” “hewed and glued,” or “plied and dried” would be more apt, in his view. Brown also disputes the traditional derivation of “derivative”: the characteristic of being derived from the value of an underlying asset. In reality, he states, the term was coined in the early 1970s to reflect the fact that the value of an option can be derived, at least in theory, from mathematical reasoning.
Brown does embrace one questionable piece of conventional wisdom. Henry Ford’s key innovation, he writes, “was to pay his workers enough that they could afford to buy the cars they made, increasing production scale, so the price fell enough to be affordable by the workers of his suppliers, as well as the general population.” This was indeed the story I heard growing up in Detroit, where Ford’s introduction of the five-dollar-a-day wage in 1914 was remembered fondly. More important to increasing the affordability of Fords, however, was the introduction of the assembly line in 1913, which quickly reduced the number of man-hours required to assemble a car by 80 percent. 3 Even before that innovation, Ford’s efficiency enhancements enabled him to cut the price of a Model T by about one-third between 1908 and 1912. Although boosting wages did expand the market for cars somewhat, that was not Ford’s motive. Rather, he sought to combat the high employee turnover that resulted, in part, from the tedium of assembly line work.
Notwithstanding this quibble, Red-Blooded Risk is one of the most original and thought-provoking books reviewed in these pages in the past 20 years. No one who reads it will ever again regard risk management as a necessary but unproductive appendage of the financial industry. Other authors have chronicled how quantitative finance influenced investment management, but Aaron Brown has made a compelling case for a far more profound economic impact.