Complexity killing the market: Risk expert

Innovation in today’s investment products is causing more harm than good, according to well-known author and risk management expert Richard Bookstaber.

Bookstaber, who works at Connecticut-based investment management company Bridgewater Associates, was the keynote speaker at an event hosted by the Alternative Investment Management Association of Canada in Toronto on Monday. His talk centred on his latest book, A Demon of Our Own Design.

The book draws on his experience as head of risk management for some of the world’s largest investment banks and hedge funds such as Salomon Brothers and Moore Capital Management, where he observed first-hand how market innovation was at the heart of some of the biggest financial crises of the past 25 years. These include the market crash of October 1987 and the collapse of hedge fund Long Term Capital Management (LTCM).

He told the audience the market has effectively reduced external risk from outside factors like the economy but has increased internal risk by adding layers of complexity to how it runs itself and the types of financial products it now produces. This has created in the market many cases of “tight coupling,” an engineering term that refers to complex systems of interdependence where if a crisis arises in one area, the steps required to correct the problem lead to a crisis in another area.

According to Bookstaber, incidences of the risk of tight coupling are increasing with the increased use of leverage by investment firms, which creates what he calls a liquidity crisis cycle. He says manageable leverage can spiral out of control if a lender makes a margin call at an inopportune time.

He suggests that the first major incident of this was LTCM, which found itself in a vicious cycle of having to liquidate assets to cover the margins on its leverage. When an institutional firm of that size starts selling certain types of assets, it creates a perception of devaluation of those assets in the market; a market sell-off begins, which in turn forces the banks to make more margin calls, and the cycle continues.

“Your very attempt to prevent problems occurring adds to the problems occurring,” he says.

Bookstaber added that a similar liquidity crisis was starting with the failed Bear Stearns hedge funds, which had invested in large positions of sub-prime debt. But the banks that provided loans to the hedge funds reversed their normal logic of selling the hedge funds’ collateral to cover the loans and decided instead to sit on them.

These problems are also exacerbated by complex financial instruments like collateralized-debt obligations (CDOs), composed of hundreds of different grades and tranches of debt obligations, which can sometimes be difficult to value without actually floating them on the market. There is a substantial risk of devaluation if they are floated and there are no buyers.

Rather than trying to make things more transparent, he says, the market tried to solve these problems by adding new fail-safe features, which further complicated the system and tightened the coupling.

“Currently we take a laissez-faire approach to the markets. The markets do whatever they want, and whenever there is a problem, we will try to fix it somehow,” he said. “We let the complexity grow, and we are going to add a layer on top of that. If the analogy from engineering systems is correct, this is not going to work. All you’re doing is making the market more complex.”

His proposed solution? Simplify and focus on building a market geared toward long-term survival rather than being perfect right now. He says hedge funds and banking institutions place too much emphasis on trying to innovate in order to capitalize on current market conditions. For example, he says selling sub-prime mortgages was a great innovation in a low-interest rate environment but is obviously problematic now.

Bookstaber believes a cockroach is a great analogy of how simpler markets can be better for long-term prospects. The cockroach has not evolved much over hundreds of millions of years, but it has managed to survive in almost every environment it finds itself in with a simple survival mechanism of running in the opposite direction of stimuli.

“Cockroaches don’t see, hear or smell. All they do is when there is a gust of wind, they run the opposite direction,” he said. “There might be some insect in the jungle that has this mandible that is just right for crushing a particular seed — present, it thrives. As soon as that jungle changes, it’s gone. The cockroach is not optimal, but it is still there.”

He believes there is a need to create a simpler market with fewer instruments that are understood better.

“If you want to reduce the degree of crisis in the markets, then you have to do two things: you have to reduce the degree of complexity, and you have to reduce the amount of leverage,” he said. “The place a lot of people think about doing it is with hedge funds because they are the risk takers. The hedge funds tend to morph and change a lot.”

But instead of focusing on hedge funds, Bookstaber said, simplification should be directed at the large banking institutions, which are the central hubs of activity in the markets.

“The natural focal point should be with the banks and the investment banks because they are used to regulation; they have a good structure for it,” he said. “There is not that many of them, so we can keep track of them, and they are the ones that have the most incentive to pump out innovative securities because they make a huge spread on them.

“They are the ones that have the incentive to promote leverage because they make money on the financing.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(01/10/08)