Chapter 1
Introduction: The Paradox of Market Risk
While it is not strictly true that I caused the two great financial crises of the late twentieth century — the 1987 stock market crash and the Long-Term Capital Management (LTCM) hedge fund debacle 11 years later — let's just say I was in the vicinity. If Wall Street is the economy's powerhouse, I was definitely one of the guys fiddling with the controls. My actions seemed insignificant at the time, and certainly the consequences were unintended. You don't deliberately obliterate hundreds of billions of dollars of investor money. And that is at the heart of this book — it is going to happen again. The financial markets that we have constructed are now so complex, and the speed of transactions so fast, that apparently isolated actions and even minor events can have catastrophic consequences.
My path to these disasters was more or less happenstance. Shortly after I completed my doctorate in economics at the Massachusetts Institute of Technology and quietly nestled into the academic world, my area of interest — option theory — became the center of a Wall Street revolution. The Street became enamored of quants, people who can build financial products and trading models by combining brainiac-level mathematics with massive computing power. In 1984 I was persuaded to join what would turn out to be an unending stream of academics who headed to New York City to quench the thirst for quantitative talent. On Wall Street, too, my initial focus was research, but with the emergence of derivatives, a financial construct of infinite variations, I got my nose out of the data and started developing and trading these new products, which are designed to offset risk. Later, I managed firmwide risk at Morgan Stanley and then at Salomon Brothers. It was at Morgan that I participated in knocking the legs out from under the market in October 1987 and at Solly that I helped to start things rolling in the LTCM crisis in 1998.
The first of these crises, the 1987 crash, drove the Dow Jones Industrial Average down more that 20 percent, destroying more market wealth in one day than was generated by the world economies in the previous two years. The repercussions of the LTCM hedge fund default sent the swap and credit markets, the backbone of the world's financial system, reeling. In the process it nearly laid waste to some of the world's largest financial institutions. Stunning as such crises are, we tend to see them as inevitable. The markets are risky, after all, and we enter at our own peril. We take comfort in ascribing the potential for fantastic losses to the forces of nature and unavoidable economic uncertainty.
But that is not the case. More often than not, crises aren't the result of sudden economic downturns or natural disasters. Virtually all mishaps over the past decades had their roots in the complex structure of the financial markets themselves.
Just look at the environment that has precipitated these major meltdowns. For the crash of 1987, it was hard to see anything out of the ordinary. There were a few negative statements coming out of Washington and some difficulties with merger arbitrage transactions — traders who play the market by guessing about future corporate takeovers. What else is new? The trigger for the LTCM crisis was something as remote as a Russian default, a default we all saw coming at that.
One of the curious aspects of worsening market crises and financial instability is that these events do not mirror the underlying real economy. In fact, while risk has increased for the capital markets, the real economy, the one we live in, has experienced the opposite. In recent decades the world has progressively become a less risky place, at least when it comes to economics. In the United States, the variability in gross domestic product (GDP) has dropped steadily. Year by year, GDP varies half as much as it did 50 years ago. The same holds for disposable personal income.
The fact that the total risk of the financial markets has grown in spite of a marked decline in exogenous economic risk to the country is a key symptom of the design flaws within the system. Risk should be diminishing, but it isn't.
This is not the way it is supposed to work. Consider the progress of other products and services over the past century. From the structural design of buildings and bridges, to the operation of oil refineries or power plants, to the safety of automobiles and airplanes, we learned our lessons. In contrast, financial markets have seen a tremendous amount of engineering in the past 30 years but the result has been more frequent and severe breakdowns.
These breakdowns come about not in spite of our efforts at improving market design, but because of them. The structural risk in the financial markets is a direct result of our attempts to improve the state of the financial markets; its origins are in what we would generally chalk up as progress. The steps that we have taken to make the markets more attuned to our investment desires — the ability to trade quickly, the integration of the financial markets into a global whole, ubiquitous and timely market information, the array of options and other derivative instruments — have exaggerated the pace of activity and the complexity of financial instruments that makes crises inevitable. Complexity cloaks catastrophe.
My purpose here is to explain why we seem to be doing the right things but the results go in the other direction. The markets continue to develop new products to meet investors' needs. Regulation and oversight seek to ensure that these advances land on a level playing field, with broad and simultaneous dissemination of information and price transparency. But the innovations are somehow making our investments more risky. And more regulation, ironically, may be compounding that risk. It would seem there is a demon unleashed, haunting the market and casting our efforts awry: a demon of our own design.
Excerpted with permission of the publisher John Wiley & Sons, Inc. from A Demon of Our Own Design. Copyright (c) 2007 by Richard Bookstaber. This book is available at all bookstores, online booksellers and from the Wiley web site at www.wiley.com, or call 1-800-225-5945.
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