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A DEMON of OUR OWN DESIGN ~~ Markets, Hedge Funds, and the Perils of Financial Innovation

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A DEMON of OUR OWN DESIGN ~~ Markets, Hedge Funds, and the Perils of Financial Innovation ffirs.qxd 10/21/08 11:55 AM Page A ffirs.qxd 10/21/08 11:55 AM Page A More Praise for A 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 de- rivatives, 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 sub- ject and has written a lucid and readable book. To his aid he calls mathe- matics (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 pub- lished 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 ffirs.qxd 10/21/08 11:55 AM Page B “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 ffirs.qxd 10/21/08 11:55 AM Page i A DEMON OF OUR OWN DESIGN ffirs.qxd 10/21/08 11:55 AM Page ii ffirs.qxd 10/21/08 11:55 AM Page iii A DEMON OF OUR OWN DESIGN ~~ Markets, Hedge Funds, and the Perils of Financial Innovation RICHARD BOOKSTABER John Wiley & Sons, Inc. ffirs.qxd 10/21/08 11:55 AM Page iv Copyright © 2007 by Richard Bookstaber. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our Web site at www.wiley.com. 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 Printed in the United States of America. 10987654321 ffirs.qxd 10/21/08 11:55 AM Page v In memory of my son, Joseph Israel Bookstaber ffirs.qxd 10/21/08 11:55 AM Page vi ftoc.qxd 10/17/08 6:01 PM Page vii CONTENTS Preface ix Acknowledgments xvii About the Author xix CHAPTER 1~ Introduction: The Paradox of Market Risk 1 CHAPTER 2~ The Demons of ’87 7 CHAPTER 3~ A New Sheriff in Town 33 CHAPTER 4~ How Salomon Rolled the Dice and Lost 51 CHAPTER 5~ They Bought Salomon, Then They Killed It 77 CHAPTER 6~ Long-Term Capital Management Rides the Leverage Cycle to Hell 97 CHAPTER 7~ Colossus 125 CHAPTER 8~ Complexity, Tight Coupling, and Normal Accidents 143 CHAPTER 9~ The Brave New World of Hedge Funds 165 CHAPTER 10 ~ Cockroaches and Hedge Funds 207 CHAPTER 11 ~ Hedge Fund Existential 243 Conclusion: Built to Crash? 255 Notes 261 Index 273 vii ftoc.qxd 10/17/08 6:01 PM Page viii fpref.qxd 10/17/08 8:34 PM Page ix PREFACE hat a mess. In the year since A Demon of Our Own Design was published, we seem to have moved from a world where mort- Wgage 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 spread- ing 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. ix fpref.qxd 10/17/08 8:34 PM Page x P REFACE 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 com- plex 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 summa- rize key points of this testimony here: Establish a liquidity provider of last resort. In my book I discuss the down- ward cycle of the leverage-induced crisis.
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