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| Thought Leaders: Finance |
Precarious Progress
Richard Bookstaber
06/01/2007
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Wall Street is becoming riskier
and riskier. Crises and catastrophic losses seem commonplace. This is odd,
considering investors are more sophisticated now, enabled by an increasing array
of financial products and protected by more government oversight than ever
before.
The risk we see in the financial markets is not a reflection of
growing economic uncertainty. By most measures, the economy is far less risky
today than it was a generation ago. GDP, for example, is less variable and
recessions are shorter and shallower. Today’s rising market risk comes from the
design of the market itself.
 At the forefront are Wall Street innovations such as
derivatives and swaps, as well as Main Street instruments like interest-only mortgages. Many such innovations are designed to control risk, but in aggregate
they tell another story. More financial innovation results in greater market
complexity, unexpected outcomes from market shocks and a mechanism for investors
to skate on the edge with ever-higher leverage.
The relationship between innovative instruments and market
crises is not new. In fact, the poster child of all market bubbles, the Holland
tulip mania in the 1630s, came about due to a financial innovation. The
explanation for the mania usually centers on the irrationality of the market,
but this misses the point. Horticulture was an avocation for many wealthy
Europeans in the 17th century. Rare bulbs fetched huge sums even before the
mania, and continued to do so decades afterward. Clearly, the price of bulbs did
not fuel the speculative fervor. Instead, the development of a forward market
for tulips in 1635 set the stage for disaster.
In that forward market, the physical commodity did not change
hands. Instead, speculators traded ownership certificates. Individuals purchased
the bulbs and then sold them for future delivery. Money changed hands only after
the seller delivered the bulbs. Speculators had no intention of holding onto
their contract for delivery. They planned to close out their commitments before
they came due, so they could buy the bulbs without the capital to make a
physical purchase, then sell bulbs they did not own. The forward contracts
allowed speculators to operate with infinite leverage. Then as now, with
infinite leverage can come infinite demand.
Crises and catastrophic losses seem commonplace. |
Our more advanced innovations continue to propagate the same
flaw: They facilitate financial leverage, and with that leverage comes the
capacity to spawn crises. The leverage facilitated through swaps and the
collateralized financing of investment banks were at the core of one of the
great collapses of the latter part of the 20th century, the demise of the hedge
fund Long Term Capital Management.
Present-day innovations have added another design flaw to
financial markets—and make them far more complex. Options, caps, floors and
other derivatives have nonlinear payoffs. In some cases, a 1 percent drop in
price might mean a 1 percent loss for a derivative instrument, while a 10
percent drop in price might mean a 50 percent loss. If an investor misses some
facet of this nonlinearity, those one-in-a-hundred instances of major market
dislocations become magnified into once-in-a-lifetime surprises. This
complexity, manifest through an optionlike innovation called portfolio
insurance, was at the center of one of the other momentous crises of the recent
past: the crash of 1987.
On their own, higher leverage and complexity each contribute
risk to the market, but the bigger problem arises when the two merge. When this
happens, the complexity leads to unexpected losses, and the leverage magnifies
the result and limits the time available to recover.
We can begin to conquer these risks by thinking twice before
throwing the next new financial instrument into the market. Just because we can
turn some cash flow into a tradable asset, doesn’t mean we should. Just because
we can create a new type of forward contract to trade, doesn’t mean it makes
sense to do so. Granted, if you are the one marketing the instrument, these
innovations make sense because you can find profit margin in them. But looking
beyond the bottom line of the issuer, trying to design a market to allow
limitless trading possibilities will cause more harm than good because each
innovation adds layers of increasing complexity and further opportunities for
leverage.
Illustration by Matt Mahurin.
Richard Bookstaber, the former director of risk management at
Moore Capital Management, runs an equity hedge fund in Greenwich, Conn., and
is author of the new book A Demon
of Our Own Design: Markets, Hedge Funds and the Risks of Financial
Innovation.
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