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

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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 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 sub- ject 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 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

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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.

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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 summa- rize 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.

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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 fore- stalled 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 inten- tion 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.

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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

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P REFACE

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 Commis- sion 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 safe- guards 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

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P REFACE

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 size- able 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. Further- more, 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 encour- ages 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

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P REFACE

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.

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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

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ACKNOWLEDGMENTS

early a decade ago I made a presentation to the Institute for Quantitative Research in Finance on the origins of market crisis. NOne 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, for- merly 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.

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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 Quanti- tative 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 Manage- ment. 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.

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A DEMON OF OUR OWN DESIGN flast.qxd 10/21/08 11:57 AM Page xxii c01.qxd 10/17/08 5:41 PM Page 1

CHAPTER 1

INTRODUCTION: THE PARADOX OF MARKET RISK

hile it is not strictly true that I caused the two great financial crises of the late twentieth century—the 1987 stock market Wcrash 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.

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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. The first of these crises, the 1987 crash, drove the Dow Jones Indus- trial Average down more that 20 percent, destroying more market wealth in one day than was generated by the world economies in the previous two years. The repercussions of the LTCM hedge fund default sent the swap and credit markets, the backbone of the world’s financial system, reeling. In the process it nearly laid waste to some of the world’s largest financial institutions. Stunning as such crises are, we tend to see them as inevitable. The markets are risky, after all, and we enter at our own peril. We take comfort in ascribing the potential for fantastic losses to the forces of nature and unavoidable economic uncertainty. But that is not the case. More often than not, crises aren’t the result of sudden economic downturns or natural disasters. Virtually all mishaps over the past decades had their roots in the complex structure of the financial markets themselves. Just look at the environment that has precipitated these major melt- downs. For the crash of 1987, it was hard to see anything out of the ordi- nary. There were a few negative statements coming out of Washington and some difficulties with merger arbitrage transactions—traders who play the market by guessing about future corporate takeovers. What else is new? The trigger for the LTCM crisis was something as remote as a Russian default, a default we all saw coming at that. Compare these with the market

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I NTRODUCTION: THE PARADOX OF M ARKET R ISK

reaction to events that shook the nation. After 9/11, the stock market closed for a week and reopened to a drop of about 10 percent. This was a sizable decline, but three weeks later the Dow had retraced its steps to the pre-9/11 level. Or go back to the assassination of President John F. Kennedy in 1963 or the bombing of Pearl Harbor in 1941. Given the scope of the tumult, the market reactions to each event amounted to little more than a hiccup. There is another troublesome facet to 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 from 1986 through early 1990 and then nearly halved in value during the next nine months. The second was our own Internet bubble that witnessed the NASDAQ rise fourfold in a little more than a year and then decline by a similar amount the following year, ultimately cascading some 75 percent. This same period was peppered with three major currency disasters: the European Monetary System currency crisis in 1992; the Mexican peso crisis that engulfed Latin America in 1994; and the Asia crisis, which spread from Thailand and Indonesia to Korea in 1997, and then broke out of the region to strike Russia and Brazil. The Asia crisis triggered losses that wiped out the majority of the market value that the Asian “Tiger” economies had amassed in the prior decade of booming growth. LTCM seemed just as cataclysmic at the time, but it centered on a single $3 billion hedge fund in 1998, albeit one that had more than $100 billion at risk. As a debacle, it was later overshadowed by the spectacular failures of Enron, WorldCom, and Tyco after the dot-com collapse. Yet, did anyone even notice the convertible bond collapse that erupted for no apparent reason in 2005 or the $6 billion of losses by Amaranth in September 2006? It’s only money. One of the curious aspects of worsening market crises and ﬁnancial instability is that these events do not mirror the underlying real economy.1 In fact, while risk has increased for the capital markets, the real economy, the one we live in, has experienced the opposite. In recent decades the world has progressively become a less risky place, at least when it comes to economics. In the United States, the variability in gross domestic product (GDP) has dropped steadily. Year by year, GDP varies half as much as it did 50 years ago. The same holds for disposable personal income. With greater stability in economic productivity and earnings, and with greater

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and broader access to borrowing—think of your home equity line of credit—the variability of consumption year by year is less than a third of what it was in the middle of the twentieth century. And while recessions still occur, they have become shallower. This same pattern is true in Eu- rope, where both GDP and consumption have become more stable over the course of the past 50 years. There is ample reason for the increased economic stability. In the United States, the federal government provides unemployment insurance and Social Security, most corporations support 401(k) accounts, and many provide pensions. Governments worldwide stabilize commodity and farm prices with massive subsidies. Monetary and fiscal policy has improved with experience and study, and it benefits from improving coordination and real-time access to data. The workforce is more diversified, with a much greater proportion employed in noncyclical sectors such as technology and services than in the past. The economic sectors themselves are also far more diversified. In the early twentieth century, there were no technology, telecommunica- tions, media, or health care sectors. The industrial economy revolved around a few highly integrated, large-scale industries. A coal miners’ or steelworkers’ strike would cripple the country, shutting factory floors and shipping yards. Even as late as the 1970s, the industrialized nations were so energy dependent that an oil shock precipitated a global recession. Today, high gasoline prices cause lots of grumbling, but little real pain. Similarly, as progress and refinement reduce risk, so should they also level the playing field for market participants. There should be less of a gap between your investment returns and those of Wall Street pros. Do you think that’s happening? Sure, the trappings are there: Informa- tion is released more quickly and to a broader constituency of investors, and limitations are imposed on insider trading and nonpublic disclo- sure. Trading costs are a tenth of what they were 30 years ago. Ample liquidity and innovative financial products—all manner of swaps and options, weather futures, exchange-traded funds, Bowie bonds—accom- modate trading in more areas. With all these improvements we are mov- ing ever closer to the notion of perfect markets—and perfect markets should not offer unusual profit opportunities for a subgroup of investors and traders.