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The global credit market has plummeted and the collapse of various hedge funds has raised fears that the credit market conflagration could become a true economic crisis.

Richard Bookstaber, a former academic, who went on to head risk management for Morgan Stanley, and now runs a large hedge fund at FrontPoint Partners, argues in his book A Demon of Our Own Design that financial markets are too complex for their own good and that creates the risk of a financial disaster.

Mr Bookstaber claims that a crude strategy (like being guided by a few benchmarks, or sticking to stocks, bonds and cash), is more likely to survive a change in the environment - even if today’s far more complex strategies might work better in this current environment. He rules out extra regulation and suggests that hedge funds be left alone.

Why do markets keep crashing and how much of that is caused by the complexity of financial instruments? Mr Bookstaber answers your questions below.

How much can we say we really understand simpler financial instruments such as shares, if we are still unable to say with certainty what has led to various market crashes in the past? Financial disaster happened in 1929 without derivatives. What tells us that a similar crash could occur again either without derivatives, or because of them?
Ludovico Zaraga, London

Richard Bookstaber: I don’t think derivatives are necessary to have a market crisis, but I do think they increase the likelihood of one because they make the markets more complex, and it becomes more difficult to understand how an event may evolve or propogate. Derivatives also are a source of leverage, and I think leverage is a key component of many market crises.

Going back to 1929, or even (as I do in my book) to the tulip mania of the 1630s, we find leverage in some guise. It might be the use of forward contracts in buying tulip bulbs that essentially allowed infinite leverage, or the use of margin accounts by investors in 1929.

Why do you suggest that, even as the economy becomes more stable, markets become more prone to a crash?
Helen Nichol, California, US

Richard Bookstaber: It seems paradoxical, but it can be the case that when markets appear very stable (for example, when volatility is very low) the risk of a crisis is actually higher. The day-to-day volatility and liquidity of the market does not provide much guidance as to how deep the market is (in other words, how big a flow of selling will occur if there is an unexpected shock, or how well the market can manage such a sudden flood of selling).

The example I like to use for this (and I discuss in my book) is the market in the summer of 1998 before the Russian default and the subsequent problems with Long-Term Capital Management. During that summer, swap markets were extremely quiet. But this hid a reticence on the part of most of the large players to be active in any size. Many of them wanted to wait on the sidelines when Salomon closed its US proprietary trading unit (which dealt in US fixed-income arbitrage), since no one wanted to be the first to take on what might be billions of dollars coming into the market as that group liquidated.

There is another point. During periods of stability and low volatility, many investors will be willing to take on more leverage and higher risk. The higher leverage means more liquidity; buyers and sellers will find the other side of their trades more quickly, with less price disruption; but, of course, if an adverse event does occur, the higher risk posture will lead to a higher probability of things moving into a crisis.

What do you believe is the best way of attempting to manage market risk?
Emily Cook, Sussex, UK

Richard Bookstaber: Risk management requires that you know all of the positions in your portfolio, have a means of pricing them and have a means of establishing their volatility, correlation and sensitivity to important market factors. You then can use standard methods to determine the value at risk for the portfolio, and do stress analysis to look at how a larger market move will affect the portfolio and how changes in the market factors will affect the portfolio.

I think most people in risk management do these sorts of tasks, and indeed they can find any number of vendors that will assist in them in doing so.

The next step, which is more difficult and cannot be left purely to an analytic solution is to try to understand what the flows are in various markets, what markets are more highly levered or in the hands of ‘hot money’, and what other markets might move with these ‘hotter’ markets in the event of a market break. This is a task that is not much different from what any number of portfolio managers do in making their trading decisions, but for the risk manager, the question is not the likely direction of prices, but of the unlikely shifts in the volatility of the markets.

My question pertains to winners and losers in the subprime lending debacle. Clearly, most financial firms exposed to structured products would experience a sell-off that may well be driven by panic. Given that the problem arose from excess liquidity in some pockets, where is this likely to be diverted with the onset of a full-blown lending crisis?
Chandra Krishnamurti, Melbourne

Richard Bookstaber: I think you hit the nail on the head when you attributed the problem to excess liquidity; and that is coming from leverage, both at the point of the investors, such as the hedge funds, and, perhaps even more significantly for the mortgage market, at the point of the homeowners who are borrowing to the hilt to finance their home purchases.

The problems with liquidity and leverage actually may be reduced if the subprime mortgage problems propagate out to the broader mortgage market, and possibly to other credit-related markets (as seems to be occurring). If we see continued hedge fund failures due to the declines in these markets, credit spreads will widen and financing will dry up. The result will be that leverage will become more costly, and the market itself will push leverage down.

This means that longer term, it might be better to have the subprime crisis propagate into other markets (just not too severely!) rather than have it blow over quickly. If the latter occurs, many investors will be all the more emboldened.

On this point, and the Bear Stearns hedge fund problems in particular, you can refer to an entry I made in July called ‘Dodging Bullets’, on an occasional blog I do at rick.bookstaber.com.

Do you agree with the assumption that the current risk management and credit modelling approaches have to be advanced with the purpose to improve the volatility forecast in capital markets?
Viktor O. Ledenyov, Ukraine

Richard Bookstaber: In a way, the foundation of risk management is forecasting market volatility - or, more precisely, markets volatility, since we need to look at each market based on its own factors. So I would agree that risk management will improve as volatility forecasting improves.

One of the key points in my book is that it is critical to take market dynamics - especially liquidity risk - into account to improve those forecasts. I believe this because market crises and their associated volatility are based more on liquidity events than on the day-to-day information that we typically are measuring when we use historical volatility measures. And this is difficult to do, because the key information that is required to do so is not readily available.

How accurate is the pricing of derivatives, including CDOs by Wall Street firms? Do you agree with Warren Buffett who says this is a significant problem that could contribute to a crisis?
Bob Klein

Richard Bookstaber: Credit derivatives often are marked to model or marked to ratings.

The mark to model methodology has been used for other derivatives for years, although it has led to problems on occasion when a model turned out to be incorrect. The problem with using mark to model for credit derivatives is that the models are not as well tested. Also, the distributional issues are more difficult to estimate, since a key component of credit instruments is default, and default events are few and far between

Mark to rating is a new approach that I find even more problematic than mark to model, because rating agencies tend to use long-term historical analysis in setting ratings, and doing so will miss many of the changes in market dynamics that have occurred with the advent of credit derivatives.

Many products sold to private investors who are nervous about the markets, particularly the equity markets, are now based on derivatives. Do you think, in the event of a global financial crisis, emanating from say the current malaise in the credit markets, investors could find the products, which they had bought as protection, actually fail. In other words, just as it seems that packaged debt instruments may have been given credit ratings that didn’t accurately reflect the real risks, what is the probability that investors might one day find that the packaged protection products they have bought turn out to be part of the problem rather than the safeguard they thought they had bought.?
David G Wallace, Scotland

Richard Bookstaber: I think the point you are getting at in this question is counterparty risk. If the counterparty in a derivatives contract or swap fails, then the protection afforded will no longer be in force. The counterparties typically are highly rated institutions -- banks and investment banks -- but can be other investment firms as well.

Counterparty risk is a bedrock concern. One approach to reduce this risk is to have payments between the parties occur frequently. This is similar to what happens with futures contracts, where variation margin is passed between the parties through the exchange on a daily basis.

But if a crisis moved to the point that the primary counterparties could not deliver on their obligations, we would have system issues that are beyond those we have experienced in any crisis to date.

I am really interested in your thoughts about the activities and the complexity of the financial markets. However, how exactly do you see the role of the hedge funds (in light of the problems with Bear Stearns funds)? Don’t you think that this industry should be more regulated than it is in its present state? Further, what is your personal view on the present conditions (the US subprime market and the weak US currency), and where are the big investment banks and brokerage firms positioned in your views?
Elena, London

Richard Bookstaber: I think hedge funds are a source of market risk, for the simple reason that hedge funds are where much of the risk-taking occurs; and hedge funds tend to be the most concentrated repository of both leverage and innovative instruments, both of which I think are at the core of market crises.

I think the best approach to regulation, however, is not to try to regulate the hedge funds directly, because they are so disparate in their strategies and domicile. Instead, I would attack the problem at the source, by trying to contain the use of leverage and trying to reduce the complexity of the markets through restricting what seems to be an arms race of new derivative instruments.

This sort of regulation would be directed at the banks and investment banks that provide the leverage and that design and market the derivatives. Also, these institutions are well set up for regulation, and are not as much of a moving target as hedge funds are.

Read an extract from A Demon of Our Own Design

Book review: A Demon of Our Own Design

Richard Bookstaber, runs a hedge fund at FrontPoint Partners and is the founder of Scribe Reports, LLC. Prior to this, he was director of risk management at Moore Capital Management and also Ziff Brothers Investments. He served as Managing Director in charge of firm-wide risk management at Salomon Brothers and also served on that firms Risk Management Committee. Mr. Bookstaber spent 10 years at Morgan Stanley in quantitative research and as a proprietary trader, concluding his time there as Morgan Stanleys first market risk manager. He is the author of three books and scores of articles on finance topics ranging from options theory to risk management. Bookstaber received a PhD in economics from MIT.

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