A Demon of Our Own Design E-Book

Richard Bookstaber

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 560

Veröffentlichungsjahr: 2011

Beschreibung

Inside markets, innovation, and risk Why do markets keep crashing and why are financial crises greater than ever before? As the risk manager to some of the leading firms on Wall Street-from Morgan Stanley to Salomon and Citigroup-and a member of some of the world's largest hedge funds, from Moore Capital to Ziff Brothers and FrontPoint Partners, Rick Bookstaber has seen the ghost inside the machine and vividly shows us a world that is even riskier than we think. The very things done to make markets safer, have, in fact, created a world that is far more dangerous. From the 1987 crash to Citigroup closing the Salomon Arb unit, from staggering losses at UBS to the demise of Long-Term Capital Management, Bookstaber gives readers a front row seat to the management decisions made by some of the most powerful financial figures in the world that led to catastrophe, and describes the impact of his own activities on markets and market crashes. Much of the innovation of the last 30 years has wreaked havoc on the markets and cost trillions of dollars. A Demon of Our Own Design tells the story of man's attempt to manage market risk and what it has wrought. In the process of showing what we have done, Bookstaber shines a light on what the future holds for a world where capital and power have moved from Wall Street institutions to elite and highly leveraged hedge funds.

Leseprobe

CONTENTS

Preface

Acknowledgments

About the Author

Chapter 1: Introduction: The Paradox of Market Risk

Chapter 2: The Demons of ’87

Crunch Time at Morgan Stanley

The Formula

My Life as an Insurance Salesman

Running for the Lifeboat

Read the Fine Print

Risk Arbitrage: The Snowball at the Mountaintop

Ignoring the Cassandras

A Long Weekend

The Avalanche Buries the Buyers

Collateral Damage

Bad Gamma

The Physics of the Meltdown

We can see the Future of Markets, And it’s Ugly

Chapter 3: A New Sheriff in Town

Searching for Land Mines with their Feet

The APL Cult

Out of the Loop

Chapter 4: How Salomon Rolled the Dice and Lost

The Roof Caves in on Mortgages

Thirty Million Over Tokyo

Shotgun Marriage

A Lesson in Self-Delusion

Jack Jumps in

The Problem with Stocks

Into the Arms of Travelers

Chapter 5: They Bought Salomon, then They Killed it

The Arbs Lose Face

Good-Bye to Quant Heaven

Circling Vultures

The July Fourth Massacre

Rothschild and Waterloo

Fooling Just About Nobody

Leverage and the Roots of Crises

How to Prevent a Liquidity Crisis

Chapter 6: Long-Term Capital Management Rides the Leverage Cycle to Hell

Risky Business

The Deceptive Charms of Relative Value

Haghani Steps off the Cliff

The Competition Sticks the Knife in

What were they Thinking?

Mirror, Mirror, on the Fall

Lousy with Leverage

The Japanese take UBS to the Cleaners

Ramy Goldstein takes UBS to the Cleaners

LTCM takes UBS to the Cleaners

Salomon Smith Barney Loses its Nerve

Chapter 7: Colossus

Sandy Steps in it with Both Feet

Standing Tall

Kindergarten Confidential

The Consequences of Colossus

The Numbers are the Issue

Pacioli Runs the Numbers

Da Vinci’s Accountant is Still Keeping Our Books

My Departure from Citigroup

Chapter 8: Complexity, Tight Coupling, and Normal Accidents

The Ties that Bind

The Regulation Trap

Accidents Waiting to Happen: Interactive Complexity and Tight Coupling

Tight Coupling and Interactive Complexity: An X-Rated Behavior

Normal Accidents and Organizations

You can’t Play it Safe

Chapter 9: The Brave New World of Hedge Funds

Fun with Data

Bubble Baths

Why Tulip Mania wasn’t Crazy

Futures Shock, 1635

“This Crap is Going to be Worth Zero”

Pairing Off: The Emergence of Statistical Arbitrage

Arrivederci Tartaglia

Long-Term Capital Management’s Scandalous Birth

The March of the Long/Short Hedge Funds

Chapter 10: Cockroaches and Hedge Funds

Imperfections in the Perfect Paradigm

It’s the Liquidity, Stupid

Liquidity in Three Easy Lessons

Too much Information

Primal Risk and the Limits of Knowledge

Cockroaches and the Benefits of Coarse Behavior

Fate Finishes the Furu

Primal Risk and the Case for Coarse Humans

Our Not-so-Efficient Reality

The Danger to the System is the System

Chapter 11: Hedge Fund Existential

Can We Regulate Hedge Funds?

The Half-Life of Hedge Funds

Will Hedge Funds take Over the Investment World?

Do You Believe?

Conclusion

Index

More Praise forA Demon of Our Own Design

“Every so often [a book] pops out of the pile with something original to say, or an original way of saying it. Richard Bookstaber, in A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, accomplishes both of these rare feats.”

—Fortune

“Like many pessimistic observers, Richard Bookstaber thinks financial derivatives, Wall Street innovation, and hedge funds will lead to a financial meltdown. What sets Mr. Bookstaber apart is that he has spent his career designing derivatives, working on Wall Street, and running a hedge fund.”

—Wall Street Journal

“Bookstaber is a former academic who went on to head risk management for Morgan Stanley and now runs a large hedge fund. He knows the subject and has written a lucid and readable book. To his aid he calls mathematics (from Bertrand Russell to Gödel’s theorem); physics (particularly Heisenberg’s uncertainty principle); and even—meteorology.”

—Financial Times

“Mr. Bookstaber is one of Wall Street’s ‘rocket scientists’—mathematicians lured from academia to help create both complex financial instruments and new computer models for making investing decisions. In the book, he makes a simple point: The turmoil in the financial markets today comes less from changes in the economy—economic growth, for example, is half as volatile as it was 50 years ago—and more from some of the financial instruments (derivatives) that were designed to control risk.”

—New York Times

“With spectacular timing, a Wall Streeter named Rick Bookstaber published a book on financial engineering . . . His argument was that a new breed of “quants”. . . had created a system too complex to be manageable . . . Bookstaber was reporting from inside the laboratory, and he was yelling that something was about to blow. It seemed crazy not to listen.”

—Washington Post

“A risk-management maven who’s been on Wall Street for decades . . . Bookstaber’s book shows us some complex strategies that very smart people followed to seemingly reduce risk—but that led to huge losses.”

—Newsweek

“. . . smart book . . . Part memoir, part market forensics, the book gives an insider’s view . . .”

—Bloomberg News

“Bookstaber is not the first to warn about risks of financial innovation. But he may be the person most deeply embedded in the belly of the beast.”

—Salon.com

Copyright © 2007 by Richard Bookstaber. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Bookstaber, Richard M., 1950–

A demon of our own design : markets, hedge funds, and the perils of financial innovation / Richard Bookstaber.

p. cm.

Includes bibliographical references and index.

ISBN 978-0-471-22727-4 (cloth)

ISBN 978-0-470-39375-8 (paper)

1. Hedge funds. 2. Risk management. I. Title.

HG4530.B66 2007

332.64'524—dc22

2006034368

In memory of my son, Joseph Israel Bookstaber

PREFACE

What a mess. In the year since A Demon of Our Own Design was published, we seem to have moved from a world where mortgage brokers, bankers, and traders had everything figured out into one of a bottomless crisis—a crisis that could serve as a case study for the risks I set forth in my book. Many profess surprise that Lehman Brothers and Bear Stearns, once Wall Street titans, were wiped out; that Merrill Lynch traded its independence for survival; that many banks have failed while yet others teeter on the abyss. Those caught in the trap set off by the subprime mortgage debacle often speak of the crisis by describing 20 standard deviation moves and 100-year floods, usually in a tone of: “Who could have known? It was a 100-year flood. We can’t be held accountable for such an unforeseeable, rare event.”

Oh yes you can. No one should have been surprised to see this crisis engulf us, because it wasn’t anything we haven’t seen before. Look at the speculation leading up to the collapse of hedge fund Long-Term Capital Management in 1998, or the junk bond defaults earlier that decade. Nor is there anything unusual about the current crisis spreading from CDO issuers and investors to money-center banks or bridging the barrier between Wall Street and Main Street. Look back to the Savings and Loan crisis or the Latin American debt crisis before that. Or look beyond the United States to the Asian meltdown in 1997 or Japan’s “lost decade.” All the talk about 100-year flood events is either naiveté about market reality or—even worse—neglect. More charitably, we can label it a reflection of poor understanding of how the markets work and why crises occur.

In A Demon of Our Own Design I stated that a crisis and its related threat to the financial system are born of the twin demons of market complexity and leverage-induced tight coupling. This was somewhat of a heretical notion at the time; few considered the explosion of complex innovative products as a key ingredient in the formula for disaster. And as I pointed out in the book’s conclusion, regulators need to address this complexity and leverage head on. Yes, we need regulation. Not more regulation, more effective regulation. If we allow leverage to mount and allow new derivatives and swaps to grow unfettered, and then try to impose regulation over them, we will fail. Indeed, adding layers of regulation might actually make matters worse by increasing the overall complexity of the financial system.

With that said, I then closed my book without delving into specific recommendations. But over this past year, with the current crisis as a backdrop, I have been called to testify both to the House and the Senate, where I have provided more detailed recommendations. I will summarize key points of this testimony here:

Establish a liquidity provider of last resort. In my book I discuss the downward cycle of the leverage-induced crisis. When a highly leveraged firm has a sizable position in a market that is under stress, the firm may face losses that force it to liquidate in order to meet margin calls, to meet the demands of its creditors. This selling will lead the market to drop further, which causes the collateral of the firm to decline still further, forcing yet more sales.

Any firm under stress needs liquidity. It needs to find a buyer for its positions. But its actions have the opposite effect. As prices continue to decline, those who might be ready buyers in a normal environment are either under stress themselves or are heading for the sidelines. But the cycle can be broken if someone steps up to the plate with sufficient capital, appetite for risk, and a willingness to hold the positions until the crisis abates.

In Congressional testimony I proposed that the government take on this role, that “the government maintain a pool of capital at the ready to be the liquidity provider of last resort, to buy up assets of firms that are failing.”1 The Federal Reserve’s action with respect to Bear Stearns in March 2008 is along the lines of this proposal. The reason for the government to act as a liquidity provider of last resort is that by taking rapid and decisive action to infuse liquidity, regulators may break the cascade of an emerging crisis and curb a systemic threat.

The concept of a liquidity provider of last resort has already been employed successfully by the private sector. The large hedge fund Citadel has used its capital to buy the assets of distressed hedge funds, in the failure of Amaranth and again with Sowood. Citadel did not bail out these firms; they still went out of business. But its actions forestalled positions being thrown into a jittery, uncertain market and thereby prevented the failure of a single firm from creating a domino effect. If the government considers formalizing a role as last-gasp liquidity provider, it will not be stepping into the game of bailouts, or encouraging more risk. Firms must be allowed to go belly up, which reduces the moral hazard problem. But the collateral damage will be contained. The market will not go into crisis. The dominoes will not fall. And just as Citadel profited from providing liquidity, the odds are the taxpayer would also pocket some profits. Think of it as vulture investing for the greater good.

Revise mark-to-market accounting. Is there anything as boring as reading through accounting rules? Hardly, but sometimes I am forced to do so, because these rules can end up being really important. In the case of the subprime crisis, one rule stands out: FASB 159, which requires institutions to mark less liquid positions to market.

Marking positions to market is intended to price them according to what they would be worth if they had to be sold that day. Yet the mark-to-market concept loses its meaning when applied to large positions during periods of crisis. Indeed, it might even be destabilizing. In a crisis the market is drained of liquidity—there are no buyers. If there are no buyers, a mark-to-market price is next to meaningless. The price of the most recent sale in the market, which might have occurred through a trade of a few million dollars, will bear no resemblance to the price at which an institution could unwind positions that might amount to tens of billions of dollars. And the financial institution might have no intention of selling, in which case a crisis-induced fire sale price bears no relationship to what the positions will be worth if held longer term.

Pricing inventory on a mark-to-market basis can be destabilizing. In the case of the subprime crisis, it forced yet more assets into the market because the institution risked falling below a regulatory capital limit or needed to satisfy covenants of its creditors. It’s nonsensical that an accounting rule can erode the market’s confidence in the viability of the institution. The mark-to-market accounting (and its cousin, mark-to-model) caused the crisis to become more severe.

Applying mark-to-market accounting during a crisis guarantees that prices will be determined by liquidity issues and not by value. The value players have been, by and large, scared away. It is only after the damage has been done and the highly leveraged players are done bailing—or dead—that mark-to-market valuation regains its meaning.2

Overhaul regulation pertaining to risk management. We have a patchwork of regulators tripping over one another to try to oversee risk-taking institutions. Many have oversight over banks, a few over investment banks, and fewer still over hedge funds. There is no central responsibility, nor do the regulators have the power to delve into the guts of the risk-taking activities, or the expertise to monitor these activities in the context of systemic risks.

In my House testimony I suggested the need for “a regulatory body, a government-level risk manager with a role perhaps modeled after that of industry-level risk managers.”3 The Treasury has since made a similar recommendation in its Blueprint for a Modernized Financial Regulatory Structure. Treasury is calling for a market stability regulator.4 Such a regulatory body would monitor systemic risk and would have the ability, either directly or in cooperation with other regulators, to put checks on the risk-taking activities of the institutions under its purview.

The starting point for such a regulator to grapple with systemic risk, and in particular to deal with the threats that come from innovative products on one hand and high leverage on the other, is to get the right data. Regulators are ill equipped to monitor risk because they lack the data. This is particularly true when we look at crises. For example, we cannot lay out the intricate web of counterparty risk for swaps and derivatives—who owes what to whom. We cannot monitor the amount of leverage being employed by various hedge funds. We cannot tell, even after that fact, the nature of the positions or strategies that are concentrated in specific types of market participants. And so we cannot map out how a failure in one segment might propagate out to affect other market segments.

We are not even in a position to learn from past disasters, because we cannot review the firm-level details of what occurred. It is as if the National Transportation Safety Board was not given flight recorders or allowed to investigate a crash site, or the Nuclear Regulatory Commission was 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 losses of more than 30 percent. We do not know what set off this wave of losses or why the losses affected so many of these funds. We suspect too much 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. As the saying goes, you can’t manage what you can’t measure.

That’s why we need data at the hedge-fund level, not just from big banks and investment banks. You can already hear the screaming about government interference, so regulators need to keep in mind that attempts to gather more information about financial institutions cannot be so burdensome as to push them offshore or disturb the functioning of markets. For example, it is important to create safeguards to treat data as proprietary, because knowledge of any firm’s leverage and positions is competitive information. Firms rightly fear that rivals will trade against them if their own positions are known. That would have an adverse effect on the market, reducing the willingness of investors to take on liquidity in times of crisis.

Strengthen institutions’ risk management. For all their talk of building strong risk-management teams, in the subprime crisis the banks and investment banks got it wrong.

One reason they failed is that the risk systems they have designed do not measure the risks we care the most about: those related to market crises. During a crisis, markets link in unexpected ways. When a downward cycle reduces liquidity in one market, a fund manager who is forced to reduce his positions must look to sell positions he holds in others. This selling drops prices in these other markets, and other highly leveraged funds with exposure in these markets are then forced to sell. And thus the cycle propagates. The result is that the stresses in the first market end up devastating another unrelated and perfectly healthy market, creating surprising and powerful linkages across markets. As a simple example of this dynamic, consider the silver collapse in 1980. The decline in the silver market brought the cattle market down with it. The improbable linkage between silver and cattle occurred because the Hunt brothers needed to raise capital to post margin as their silver positions declined. They happened to have sizeable positions in cattle, so they aggressively sold out of them. The end result was that silver and cattle, which have nothing to do with each other, dropped in unison.

The point is that when it comes to risk management during market crises, the usual economic linkages and historical market relationships do not matter. Rather, what matters is who owns what, and who is under pressure to liquidate. These dynamics are not part of institutions’ risk management models. So at the very time risk measurement is most critical, the models fail to deliver.

That said, whatever the limitations of the risk models, they were not the only culprits in the case of the multibillion dollar writedowns during the subprime crisis. Large positions in CDOs and CMOs were patently visible; no models or detective work were needed. Furthermore, it was clear that the inventory of positions was not liquid and that its market value was uncertain. Indeed, what occurred leaves me scratching my head; it is hard to understand how this elephant in the room was missed. How can a risk manager at a place like Citigroup see inventory grow from a few billion dollars to ten billion dollars and then to thirty or forty billion dollars and not react by forcing that inventory to be brought down?

Sheer stupidity is one unsettling possibility; collective management failure is more likely: The risk managers did not have the courage of their conviction to insist on the reduction of this inventory, or the senior management was not willing to heed their demands. This might occur because the incentive structure for senior management encourages taking risk more than it does safeguarding the shareholders. Even a risk manager who got it right might not have been able to carry the day against the traders. The traders have a self interest in maintaining high risk and can claim better market knowledge than the risk manager can ever hope to have. In an us-versus-them debate between traders and risk managers, the traders would win handily. This means that in such discussions, the risk manager needs a handicap, his views should be weighted differently from those of the trading desk.

Or perhaps the risk manager was too busy in the day-to-day corporate battles—building and defending his organization, worrying about having adequate face time with senior management, elbowing into the right meetings—to actually focus on the task at hand. With reams of risk reports to run through and meetings all day long, the risk manager can end up appearing to be really, really busy while not actually doing his job. On this score, I have suggested to a number of banks that the risk manager should not be managing people or generating reports. He should be able to have the time and space to question and think outside the box. In this respect, his role would not look much different than any number of successful portfolio managers.

In most fields, the evolution of engineering reduces risk. We learn from our successes and failures and year by year end up with safer bridges and buildings and cars and airplanes. 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.

In A Demon of Our Own Design, I propose that 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 for 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 has always been good enough to survive. Other insects might have been more fine-tuned for foraging or camouflage in a particular environment, but few are as robust in the face of inevitable changes.

We need to keep the cockroach in mind when we think of how to address systemic risk. I’m not suggesting a flight from risk at the first hint of market trouble. I am suggesting that we must rethink efforts that engineer the markets in an attempt to seek out every advantage in the world as we see it today. We will often be faced with events that we have failed to anticipate, events that we could simply let pass with the “100-year flood” refrains. What we need to meet these events constructively is a flight to simplicity—simpler financial instruments and less leverage.

Richard Bookstaber

New York, New York

October 2008

NOTES

1. Testimony of Richard Bookstaber, submitted to the Congress of the United States, House Financial Services Committee, for the Hearing on Systemic Risk: Examining Regulators Ability to Respond to Threats to the Financial System, October 2, 2007, page 5.

2. Testimony of Richard Bookstaber, submitted to the Senate of the United States, Senate Banking, Housing and Urban Affairs Subcommittee on Securities, Insurance and Investment, for the Hearing on Risk Management and Its Implications for Systematic Risk, June 19, 2008, page 7.

3. Richard Bookstaber, House testimony, October 2, 2007, page 3.

4. The Department of the Treasury Blueprint for a Modernized Financial Regulatory Structure, March 2008, page 146.

ACKNOWLEDGMENTS

Nearly a decade ago I made a presentation to the Institute for Quantitative Research in Finance on the origins of market crisis. One of those in attendance was the economist and author Peter Bernstein, who encouraged me to pursue the topic as the basis for a book and provided me with initial guidance for the process, including an introduction to the editors at John Wiley & Sons.

The road from that point to completion was far longer than I, Wiley, or just about anyone I knew would have anticipated. The editorial staff at Wiley has been patient in waiting out the manuscript as it moved forward in fits and starts. The book only reached its final form with the editorial guidance of Bill Saporito, business editor of Time magazine, who corralled the mesh of my academic prose, historical vignettes, and biographical events into a cohesive and readable result. My wife, Janice Horowitz, formerly a journalist with Time, supported me throughout the writing of the book and contributed her expertise in editing the final product.

The book has benefited from, and indeed to a large extent has as its topic, those who have enriched my professional life. Many are mentioned in the book so I will not list them here. But I wish to close with a nod of appreciation to those who introduced me to many facets of the exciting and challenging field of finance and who have worked as my colleagues with intensity and integrity through periods of exuberance and crisis.

ABOUT THE AUTHOR

Richard Bookstaber ran a market neutral equity hedge fund at Front-Point Partners. Before that he was the managing director at Ziff Brothers Investments, with responsibility for risk management and for the Quantitative Strategy Group. In the latter capacity he developed and managed the firm’s quantitative long/short equity portfolio. Before joining Ziff in 2002 he was responsible for risk management at Moore Capital Management. Prior to joining Moore, Dr. Bookstaber was the managing director in charge of firmwide risk management at Salomon Brothers, and served on that firm’s Risk Management Committee. He remained in these positions at Salomon Smith Barney after the firm’s purchase by Travelers in 1997 and the merger that formed Citigroup.

Before joining Salomon in 1994, Dr. Bookstaber spent 10 years at Morgan Stanley in quantitative research and as a proprietary trader. He also managed portfolio hedging programs as a fiduciary at Morgan Stanley Asset Management. With the creation of Morgan Stanley’s risk management division, he was appointed as the firm’s first director of market risk management.

Richard Bookstaber also is the principal of Scribe Reports, a firm that provides analytics for skill assessment of long/short equity portfolio managers. He is the author of a number of books and articles on finance topics ranging from option theory to risk management, and has received various awards for his research, including the Graham and Dodd Scroll from the Financial Analysts Federation and the Roger F. Murray Award from the Institute of Quantitative Research in Finance. He received a Ph.D. in economics from MIT.

Richard Bookstaber currently works at a Connecticut-based hedge fund.

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.