Must-read book helps explain the current turmoil

With the name Pressman, it’s not infrequently that I get the joke “good name for a reporter.” Richard Bookstaber, whose new book, A Demon of Our Own Design, has become a must-read amidst the current market chaos, probably elicits the opposite reaction. But ignore the name and get a copy of Bookstaber’s book. Sure, he was the director of risk management for two hedge funds and at Salomon Brothers. Sure, he helped start the quantitative trading unit at Morgan Stanley and has a Phd in economics from MIT. But none of those credentials are nearly as compelling as what Bookstaber actually experienced in his Wall Street career, as he recounts in the 260-page tome.

Back in 1987, Bookstaber was in charge of executing Morgan Stanley’s portfolio insurance, the hedging technique that’s blamed for accelerating or even instigating the Black Monday crash that year. It was Bookstaber deciding just how many sell orders for S&P 500 futures to enter on the morning of October 19. That’s right—he didn’t just have a front row seat to Black Monday, he was in the ring.

In 1998, he helped oversee the dismantling of Salomon Brothers’ risk arbitrage unit. The unit had many of the same trades and positions as soon-to-be-doomed hedge fund Long Term Capital Management, or Salomon North as it was known. Fear over the liquidation of Solly’s risk arb unit helped freeze markets for obscure securities over the summer of ’98, positioning Long Term Capital for its horrendous fall. You can read reporters’ accounts of these two great financial conflagrations but Bookstaber was in the middle of both, knows where the bodies are buried and reveals all.

Most relevant for today’s situation, he was also in on Morgan Stanley’s “analytical proprietary trading” group in the early 90’s when many of the techniques used by today’s quant hedge funds first got off the ground. Arriving after former Columbia professor David Shaw had left Morgan’s APT unit to start his own now super famous quant hedge fund, Bookstaber describes firsthand how such investment techniques work and why they sometimes don’t.

And all of these experiences have given Bookstaber a uniquely insightful understanding of the current market problems. In times of fear and turmoil, Bookstaber warns, the usual relationships between securities and markets break down. Finely-tuned models become irrelevant, especially if an investor has borrowed money to enhance returns. Leverage works as long as the trades work, but when losses start then lenders come calling for more collateral. That forces the investors to sell some of their positions, typically the ones that are easiest to trade. And those sorts of forced liquidations destroy previously established relationships between markets and securities, just like we saw over the past few weeks.

Is there a solution? While most economists involved in finance have used models from the world of physics to explain how markets work, Bookstaber looked to biology and uses analogies drawn from evolution. Species that are finely tuned and adapted to thrive in one ecosystem can do well for a while but when conditions change, they’re usually wiped out. Cruder species, like the cockroach are rarely at the top of the pile but can survive even when conditions change radically. It’s a message today’s computer-driven risk managers may be loath to hear. Bookstaber recommends curbing the complexity of trading instruments and using less leverage.

“Just because you can turn some cash flow into a tradable asset doesn’t mean you should; just because you can create a swap or forward contract to trade on some state variable doesn’t mean it makes sense to do so…Each innovation adds layers of increasing complexity and tight coupling. And these cannot be easily disarmed through oversight or regulation. If anything, attempts at regulating a complex system just make matters worse…Rather than adding complexity and then trying to manage its consequences with regulation, we should rein in the sources of complexity at the outset.”

He concludes:

“Simpler financial instruments and less leverage make up a painfully obvious prescription for fixing the design of our markets. These modifications will lead to a financial marketplace that will be apparently less finely tuned and less responsive to investor needs. But, like the coarse response mechanism of the cockroach, when faced with the inevitable march of events that we cannot even contemplate, simpler financial instruments and less leverage will create a market that is more robust and survivable.”

For more, you can also check out Bookstaber’s own blog.

Before it's here, it's on the Bloomberg Terminal.