By Richard Bookstaber
Special to TheStreet.com
4/5/2007
SourceWhile I didn't cause the two great financial crises of the late 20th century -- the 1987 stock market crash and the Long Term Capital Management hedge fund debacle 11 years later -- let's just say I was in the vicinity. My actions, which seemed insignificant at the time and their consequences unintended, did help get the ball rolling.
And that's why I wrote
A Demon of Our Own Design. Not so much to recount those disasters -- although that is part of the story -- but to raise a red flag: Those stunning financial disasters are not isolated incidents. More are on their way.
In fact, they're inevitable.
As I explain in
A Demon of Our Own Design, today's financial markets are so complex and the speed of transactions so fast that apparently isolated actions and even minor events can cascade to have unexpected and even catastrophic consequences.
Indeed, my role in those two outsized 20th-century debacles came about more or less by happenstance. Shortly after I completed my doctorate in economics at MIT and settled into the academic world, my area of interest -- option theory -- became the center of a Wall Street revolution. I was persuaded to join what would turn out to be an unending stream of nerdy academics who headed to New York City to quench the thirst for quantitative talent. On Wall Street, I got my nose out of the data and started developing derivatives and other new financial products. Later, I managed firm-wide 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.
What I learned along the way is that nearly all market mishaps over the past few decades have their roots in the structure of the financial market itself. This structural risk is a surprising result of our attempts to improve the state of the financial markets. Its origins are found in what we would generally chalk up as progress -- the ability to trade quickly, the integration of the financial markets into a global whole, ubiquitous and timely market information and the array of options and other derivative instruments developed to meet investors' needs.
These innovations are making our investments more risky by making the market more complex. And when more regulation is poured on top of these increasingly intricate markets, it may do little more than compound the risk.
And there is a troublesome fact about our modern market crises: They keep getting worse.
Two of the great market bubbles of the past century occurred in the last two decades. First, the Japanese stock market bubble, in which the Nikkei Index tripled in value over a three-year period and then halved in less than a year. The second, our own Internet bubble that witnessed the Nasdaq rise fourfold in just over a year and then decline by a similar amount over the course of the following year. These were followed by the spectacular failures of Enron, WorldCom, and Tyco after the dot-com collapse. And did anyone even notice the convertible bond collapse in 2005 or the $6 billion of losses by Amaranth in September 2006? It's only money.
When blowups happen in the future I can almost guarantee that the focus will be directed improperly -- not at the issues of market design but at hedge funds. Hedge funds will more than likely be implicated for the simple reason that they are engulfing more and more of the risk-taking landscape. But blaming hedge funds is a little bit like the reaction after a meteorite hits Springfield in an episode of The Simpsons: "Let's burn down the observatory so this never happens again!" True, they are the institutions that have the appetite for the risk; but there is nothing inherent in hedge funds that make them the cause of anything.
The question posed by my book is simple: Why can't the financial markets get their act together? Why, in spite of reduced risk in the underlying economy, in spite of the march of innovation and financial engineering, do we not enjoy reductions in financial risk that we find in other areas of our lives? Why are markets actually becoming more crisis-prone? It would seem there is a demon unleashed, haunting the market and casting our efforts awry -- a demon of our own design.