Market Crises Could Be Avoided Through Simplicity, Better Data

Rick Bookstaber, author of the book A Demon of Our Own Design and a former managing director in charge of firm-wide risk management at Salomon Brothers and a designer of derivatives, proprietary trader and market risk manager at Morgan Stanley, first designing and marketing derivative instruments, then as a proprietary trader, made provocative statements about the state of the markets at the SIFMA show yesterday afternoon.

As he says in his book, Bookstaber believes the two main culprits of the market crisis are leverage and complexity. "Leverage is at the core of crises," he said. He noted that quants have a taken a lot of grief in this crisis. "I've read so many articles that say that PhDs missed the point that fat tails occur." But the real issue, he said, is that "risk management based on historical data doesn't account for tomorrow not being like yesterday."

As for complexity, Bookstaber recently testified before Congress. "I told them, derivatives are the weapon of choice for people who want to game the system." When derivatives first started, he said, they were pure and allowed firms to better mold returns to specific investment goals. Then firms started using them for other purposes, such as to lever where they shouldn't, to take exposure in markets they weren't supposed to be in, and to avoid taxes. He noted that the creation of CDOs made up of bonds of different types changes the correlations of the underlying products - in fact, it creates correlations that previously didn't exist. For instance, "having subprime in a CDO with good real estate investments is like inviting a kid with a cold to a birthday party," he said.

If the problems are leverage and complexity, Bookstaber continued, the only type of regulation that will work is one that lowers both of those. "An alphabet soup of regulators could add to the problem," he said. It could add risk and increase the opportunities for gaming the system. "To deal with market crises on a systemic level, you need to leverage the the data of major financial institutions and hedge funds, XBRL tag every position, and give that to the regulators," he said. Later, an audience member noted that individual firms can't aggregate their own data, so regulators are being given a job they can't do. Bookstaber noted that the majority of trading is conducted by a relatively small number of firms. The government could predict crises if it go the right leverage information - the top 20 firms together could solve this."

Five to ten years from now, institutions will start to lever up again and people will think, this time it's different, Bookstaber predicted.