[R-G] [BillTottenWeblog] Fighting Demons

[Bill Totten]

Addressing the Perils of Financial Innovation

Congressional Testimony of Richard Bookstaber

Multinational Monitor (July/August 2008)



Editor's Note: Richard Bookstaber has worked at a variety of Wall Street
firms and hedge funds, with a close-up participant's view of many of the
financial crashes of the last two decades. In 2007, he wrote A Demon of
Our Own Design: Markets, Hedge Funds, and the Perils of Financial
Innovation (Wiley). This book was published before the current financial
crisis, but anticipates many developments that have subsequently
unfolded. Bookstaber emphasizes the inherent, systemic problems in
creating new financial instruments, and hedge funds' heavy reliance on
leverage (borrowed money). Because Bookstaber is currently employed by a
hedge fund and not authorized to comment on the issues in his book, he
has declined interview requests from Multinational Monitor. He did,
however, provide testimony to the US House of Representatives Financial
Services Committee in October 2007, which follows.

The threats to the financial system stem largely from two increasingly
dominant market characteristics. The first is the complexity of the
markets. The second is the tendency for the markets to move rapidly into
a crisis mode with little time or opportunity to intervene. Borrowing
from engineering nomenclature, I refer to this second characteristic as
tight coupling. The challenges in supervising the financial system, and
particularly in safeguarding against market crises and systemic risk,
are centered in dealing with these two characteristics.

Market Complexity as a Source of Crisis

Complexity means that an event can propagate in nonlinear and
unanticipated ways. An example of a complex system from the realm of
engineering is the operation of a nuclear power plant, where a minor
event like a clogged pressure-release valve (as occurred at Three Mile
Island) or a shift in the combination of steam production and fuel
temperature (as at Chernobyl) can cascade into a meltdown.

For financial markets, complexity comes through derivatives and other
innovative products. Many derivatives have nonlinear payoffs, so that a
small move in the market might lead to a small move in the price of the
derivative in one instance and to a much larger move in the price in
another. Many derivatives also lead to unexpected and sometimes
unnatural linkages between instruments and markets.

We observed this in the subprime market meltdown. Subprimes were
included in various Collateralized Debt Obligations (CDOs) along with
other types of mortgages and corporate bonds. Like a kid who brings his
cold to a birthday party, the sickly subprime mortgages mingled with
these other instruments. The result was contagion between markets.
Investors that have to reduce their derivatives exposure or hedge their
exposure by taking positions in the underlying bonds will look at them
as part of a CDO. It doesn't matter if one of the underlying bonds is
issued by an AA-rated energy company and another by a BB financial; the
bonds in a given package will move in lockstep. And although subprime
happens to be the culprit this time around, any one of the markets
involved in the CDO packaging could have started things off.

Tight Coupling and Market Shocks

Tight coupling is a term I have borrowed from systems engineering. A
tightly coupled process progresses from one stage to the next with no
opportunity to intervene. If things are moving out of control, you can't
pull an emergency lever and stop the process while a committee convenes
to analyze the situation. Examples of tightly coupled processes include
a space shuttle launch, a nuclear power plant moving toward criticality
and even something as prosaic as the process of baking bread.

In financial markets, tight coupling comes from the feedback between
mechanistic trading, price changes and subsequent trading based on the
price changes. The mechanistic trading can result from a computer-driven
program, like what we saw with portfolio insurance during the 1987
crash. Or, more commonly, it can result from the effects of leverage.
When things start to go badly for a highly leveraged fund, its
collateral can drop to the point that its lenders force it to start
selling assets. This selling can lead to a drop in prices leading the
collateral to decline further, forcing yet more sales. The resulting
downward cycle is exactly what we saw with the demise of LTCM.

And it gets worse. Just like complexity, the tight coupling born of
leverage can lead to surprising linkages between markets. High leverage
in one market can end up devastating another unrelated and perfectly
healthy market. This happens when a market under stress becomes illiquid
and fund managers must look to other markets: If you can't sell what you
want to sell, you sell what you can. This puts pressure on markets that
have nothing to do with the original problem, other than that they
happened to be home to securities held by a fund in trouble. Now other
highly leveraged funds with similar exposure in these markets are forced
to sell, and the cycle continues. Looking back again at LTCM, the
trigger for LTCM's failure was a default in the Russian debt market, a
market where LTCM had little if any exposure. The point is that
ultimately most financial crises have to do with who owns what, who is
under pressure and what else they own.

Do Regulators Have the Tools They Need?

The starting point for grappling with systemic risk, and in particular
with dealing with the threats that come from innovative products on the
one hand and from high leverage on the other, is getting the right data.
And we do not have much of the data we need.

For example, can we lay out the intricate web of counterparty risk for
swaps and derivatives - who owes what to whom? Can we monitor the amount
of leverage being employed by various types of hedge funds? Can we tell,
even after that fact, the nature of the positions or strategies that are
concentrated in specific types of market participants? At this point, we
cannot. And so we cannot map out how a failure in one segment of the
financial market might propagate out to affect other segments. Nor can
we learn from past market crises, because we cannot recreate what occurred.

It is as if the National Transportation Safety Board were not given
flight recorders or allowed to investigate the crash site, or the
Nuclear Regulatory Commission were not allowed access to nuclear power
facilities. For example, in a few days in early August 2007, many
quantitative long/short equity hedge funds suffered large losses, in
some cases of over thirty percent. We do not know what set off the wave
of these losses or why the losses affected so many of these funds. We
suspect high leverage was a culprit and the triggering event was somehow
related to the subprime and credit stresses, but we do not know because
we do not have the relevant data.

I suggest three steps to improve the tools for meeting the regulatory
challenges.

The first step is to create a committee to review the types of data that
would be necessary to evaluate market dislocations and to monitor system
risk at the broad market level. I have mentioned a few of the areas of
critical data above.

The second step is to determine the necessary powers to allow the
regulatory bodies to access these data. The most glaring area where such
powers are absent is in the realm of the hedge funds. There are
arguments made against providing position transparency to regulators
because of the sensitivity of this information. The issues are real, but
that said, many hedge funds already provide their positions to third
party risk management providers, and thus it seems hard to argue against
also providing them to a government regulator. In any case, much
critical information does not require drilling down to the position
level details. We should also consider how to extend regulatory powers
to compel banks and investment banks to provide counterparty and
inventory data. On a technical note, with the use of modern extensible
mark-up languages there is little difficulty in establishing protocols
for data to be provided efficiently.

The third step is to create a regulatory body, a government-level risk
manager, with a role perhaps modeled after that of industry-level risk
managers, that can use these data to monitor potential systemic threats
and to investigate and learn from market failures.

What Changes Should Be Contemplated?

In speaking to the question of regulation, let me start by confirming
the premise: The markets require regulation. There are clear profit
incentives for the banks and investment banks to facilitate, even to
encourage, leverage, just as there are strong profit incentives for them
to design and market innovative products. And there are competitive
pressures for hedge funds and others to avail themselves of these. But
on the margin, each decision to increase leverage and to create an
innovative product adds to the potential for market crises and systemic
risk by increasing the tight coupling and complexity of the market. The
business decisions do not take this into account. In other words, there
is an unpriced negative externality to the actions of market
participants. And unpriced negative externalities require intervention.

Reducing leverage and market complexity: Insofar as complexity and
leverage are critical components of market crises, regulation needs to
address these two factors. If we allow leverage to mount and allow new
derivatives and swaps to grow unfettered, and then try to impose
regulation above that, we will fail. Indeed, if the potential for
systemic risk stems from market complexity, adding layers of regulation
might actually make matters worse by increasing the overall complexity
of the financial system. This may seem to be an abstract argument, but a
number of crises in other industries - including ValuJet, Chernobyl and
Three Mile Island - occurred due to complications that arose from
mandated safety measures.

Often a hedge fund manager is faced with the choice of either increasing
leverage to try to meet target returns or see his business diminish.
There are thus strong incentives to push leverage to the edge. This is
especially the case because few hedge funds face an accounting of their
use of leverage; few provide any data on the level of leverage in their
portfolios. Since high leverage is the most common source of market
cascades, where forced selling leads to price drops which leads to more
forced selling, the first step in addressing tight coupling is to
control the leverage employed by hedge funds and others.

In terms of controlling innovative products, just because someone can
design a new type of derivative or structured product doesn't mean they
should. It is true that in the academic economist's view of the world
they should, because each new product increases the set of contingencies
that can be addressed by the market. But this ignores the implications
these instruments have on the complexity of the market. On the margin
they increase complexity of the markets and through that they increase
the likelihood of crises.

I suggest the regulatory system actively engage in controlling leverage
and in limiting the arms race of innovative products. This is a markedly
different approach to regulation than is taken now. It is more invasive
to the market and might face political hurdles that would make it
impractical to execute. However, I believe the most effective regulation
will address these key sources of market crisis head on.

Using circuit-breakers to stop a tightly coupled crisis: Regulators may
be able to curb a systemic threat if they can break the tight coupling
during an emerging crisis. We have had a number of successes in stemming
the threats though this route. In the Crash of 1987, the seemingly
inexorable downward cycle caused by the computer-driven selling of
portfolio insurance programs was stemmed by the use of the so-called
circuit breakers. The LTCM failure saw its systemic effects forestalled
by the Federal Reserve's actions in bringing together a bank consortium
and having them stop the demand for sales to meet collateral. In both of
these cases, a mechanism broke the tight coupling. Circuit breakers can
provide breathing room so that those under pressure have time to
negotiate with their creditors, seek sources of liquidity and capital,
and strategize with their investors.

I suggest any regulatory solution include the ability for the regulator
to invoke circuit breakers, by whatever guise, during periods of market
crisis.

A "for-profit" approach to bailouts: There is an approach that we have
seen executed with success in the private sector which suggests a new
regulatory role. The large hedge fund Citadel has used its capital to
buy up the assets of distressed firms, once with the failure of Amaranth
and again with the failure of Sowood. Citadel's action was a bailout of
the markets - by providing liquidity when many others in the market were
unwilling to do so they helped stem a problem from getting worse, from
propagating out further to affect other firms. It was not, however, a
bailout of the troubled funds. Sowood and Amaranth are still out of
business.

The point is that there are two types of bailouts. There are bailouts
that keep the offending fund on its feet and in business. Arguably these
sorts of bailouts create a moral hazard problem. But there is another
sort of bailout that does not stand in the way of failure, but that
still reduces the collateral damage. Citadel's were bailouts of the
latter type.

I suggest the government consider a role for financial bailouts in these
terms. To be specific, I suggest the government maintain a pool of
capital on the ready to be the liquidity provider of last resort, to buy
up assets of firms that are failing much as Citadel did for Amaranth and
Sowood. (Of course, if a private entity is willing to step up to the
plate, all the better). There would need to be a body with substantial
market expertise to determine when this capital can be effectively
applied. In this approach, there would be no moral hazard problems,
since the firm would still fail. But the collateral damage would be
contained; the market would be kept from going into crisis, the dominos
would be kept from falling. And just as Citadel did in these cases, the
taxpayer would have good odds of pocketing some profits.

Lessons of the Cockroach

In most fields, the hand of engineering leads to lower risk. We learn
from our failures and year by year end up with safer bridges and
buildings and cars and airplanes. But this does not seem to be the case
for engineering in the financial markets. The results of financial
engineering - the increasing sophistication of the markets, the
complexity and the speed with which market events unfold and propagate -
seem to be taking us in the wrong direction.

The lowly cockroach can teach us a few things about how to structure and
regulate markets in order to better avoid systemic risk. The cockroach
has existed over hundreds of millions of years, surviving as jungles
have given way to deserts and deserts have been turned into cities. And
it has survived with a simple, coarse defense mechanism. The cockroach
does not make its escape by seeing, hearing or smelling. All it does is
move in the opposite direction of any gust of wind hitting its legs. In
any particular environment it would never win the "best designed insect"
award. But it always seems to be good enough to survive. Other insects
might have been more fine-tuned for foraging or with camouflage
perfectly suited to a particular environment, but few are as robust and
capable of surviving in the face of inevitable changes.

We need to keep the cockroach in mind when we think of how to address
systemic risk. We must rethink efforts that engineer and fine tune the
markets in an attempt to seek out every advantage in the world as we see
it today. When faced with the inevitable march of events that we cannot
even anticipate, simpler financial instruments and less leverage will
create a market that is more robust and survivable.

http://www.multinationalmonitor.org/mm2008/072008/bookstaber.html


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