It was early in March 2007 that I realised that two of the world’s markets held each other in a tight and deadly embrace.
A week earlier, global stock markets had suffered the “Shanghai Surprise”, when a 9 per cent fall on the Shanghai stock exchange led to a day of global turmoil. That afternoon on Wall Street, the Dow Jones Industrial Average dropped by 2 per cent in a matter of seconds. A long era of unnatural calm for markets was over.
Watching from the FT’s New York newsroom, I tried to make sense of it. Stocks were rising again, but people were jittery. Currency markets were in upheaval. In what was becoming a nervous tic, I checked the Bloomberg terminal. One screen showed minute-by-minute action in the S&P 500, the main index of the US stock market. Then I called up a minute-by-minute chart of the exchange rate of the Japanese yen against the US dollar. At first I thought I had mistyped. The chart was identical to the S&P.
Had it not been so sinister, it might have been funny. As the day wore on and turned into the next, we in the newsroom watched the two charts snaking across the screen. Every time the S&P rose, the dollar rose against the yen, and vice versa. What on earth was going on?
Correlations like this are unnatural. In the years leading up to the Shanghai Surprise, the yen and the S&P had moved completely independently. They are two of the most liquid markets on earth, traded historically by completely different people, and there are many unconnected reasons why people would exchange in and out of the yen (for trade or tourism), or buy or sell a US stock (thanks to the latest news from corporate America). But since the Shanghai Surprise, statisticians have shown that any move in the S&P is sufficient to explain 40 per cent of moves in the yen, and vice versa. Does this matter? Perhaps more than you might think. These two measures should have nothing in common, which implies that neither market was being priced efficiently. Instead, these entangled markets were driven by the same investors, using the same flood of speculative money.
The Shanghai Surprise, we now know, marked the start of the worst global financial crisis for at least 80 years, and plunged the global economy into freefall in 2009 – the most truly global economic crash on record. Inefficiently priced markets drove this dreadful process. If currencies are buoyed or depressed by speculation, they skew the terms of global trade. Governments’ control over their own economies is compromised if exchange rates render their goods too cheap or too expensive. An excessive oil price can drive the world into recession. Extreme food prices mean starvation for millions. Money pouring into emerging markets stokes inflation and destabilises the economies on which the world now relies for its growth. If credit becomes too cheap and then too expensive for borrowers, then an unsustainable boom is followed by a bust.
And for investors, risk management becomes impossible when all markets move in unison. With nowhere to hide, everyone’s pension plan takes a hit if markets crash together. In one week of October 2008, the value of global retirement assets took a hit of about 20 per cent.
Such a cataclysm should have purged the speculation from the system for a generation. But by the end of 2009, when I began thinking about writing this book, risky assets were well into a strong resurgence and markets were even more tightly linked than they were in early 2007. Once again it was impossible to tell the difference between charts of the dollar and of the US stock market. Links with the prices of commodities and credit remained perversely tight. Since then some of that fearful symmetry has dwindled, but that is largely thanks to the Greek crisis – which points to other glaring weaknesses.
The financial disaster of 2007 to 2009, then, has not cured any of the underlying factors that led markets to become intertwined and overinflated and to endanger the world economy. This does not mean that another synchronised bubble followed by a crash is inevitable, but it does mean that such an event remains a distinct possibility.
Like many other financial commentators, I had the unnerving experience of trying to disentangle what had happened and explain it in real time, facing a camera each day to try to give a two-minute potted “short view” for FT.com’s video viewers. Having to venture an opinion so publicly and so regularly at least has the advantage that you soon learn when you have got something wrong (FT.com viewers are not backward at coming forward). In the feedback, as many others in the markets tried to nail what was wrong, a few recurring themes began to stand out from the noise. Not all were part of the political dialogue at the time. So I tentatively tried mapping out a book that would give a “short view” of the causes that led our markets to malfunction so badly.
Investment bubbles are rooted in human psychology, so it is inevitable that they should occur from time to time. Markets are driven by the interplay of greed and fear. When greed swamps fear, as it tends to do at least once in every generation, an irrational bubble will result. When the pendulum snaps back to fear, the bubble bursts, causing a crash.
History provides examples from at least as far back as the 17th century “Tulip Mania,” when Dutch merchants paid life savings for a single tulip bulb. Then came the South Sea Bubble in England and the related Mississippi Bubble in France, as investors fell over themselves to finance prospecting in the New World. Later there were bubbles in canals. The Victorian era saw a bubble in US railroad stocks; the 1920s saw a bubble in US stocks, led by the exciting new technology of the motor car.
But the past few decades have seen more and more bubbles. Gold formed a bubble that burst in 1980; Mexican and other Latin American debt suffered the same fate in 1982 and again in 1994; Japanese stocks peaked and collapsed in 1990, followed soon after by Scandinavian banking stocks; stocks of the Asian “Tiger” economies came back to earth in 1997; and the internet bubble burst with the dotcom meltdown of 2000.
Some said this was understandable. From 1950 to 2000, after all, the world saw the renaissance of Germany and Japan, the peaceful end of the cold war, and the rise of the emerging markets – all events that had seemed almost impossible in 1950 – while young and growing populations poured money into stocks. Maybe the bubbles at the end of the century were nothing more than froth after an unrepeatable Golden Age. But since then, the process has gone into overdrive. Bubbles in US house prices and in US mortgage-backed bonds, which started to burst in 2006, gave way to a bubble in Chinese stocks that burst in 2007. The year 2008 saw the bursting of bubbles in oil; industrial metals; foodstuffs; Latin American stocks; Russian stocks; Indian stocks; and even in currencies as varied as sterling, the Brazilian real and the Australian dollar.
And then, 2009 brought one of the fastest rallies in history.
News from the “real world” cannot possibly explain this. Why were markets so much more prone to bubbles? It is fashionable to blame greed. But this makes little sense; it implies that, worldwide, people have suddenly become greedier than they used to be. Greed, surely, is a constant of human nature. Rather, it is more accurate to say that in the past half century, fear has been stripped from investors’ decisions. With greed no longer moderated by fear, investors are left overconfident.
How did this happen? I suggest it is down to what might be called the fearful rise of markets. Over the decades, the institutionalisation of investment and the spread of markets to cover more of the global economy have inflated and synchronised bubbles. This rise of markets has brought several trends in its wake, all of which seemed to have contributed to the eventual disaster of 2008.
Other people’s money. In the 1950s, investment was a game for amateurs, with less than 10 per cent of the stocks on the New York Stock Exchange held by institutions; now institutions drive each day’s trading. In the past, lending was for professionals, with banks controlling virtually all decisions. Now that role has been taken by the capital markets, which businesses can tap for funding. As economists put it, in both investing and lending, the “principals” have been split from the “agents”. When people make decisions about someone else’s money, they lose their fear and tend to take riskier decisions than they would with their own money.
Herding. The pressures on investors from the investment industry, and from their own clients, are new to this generation, and they magnify the human propensity to crowd together in herds. Professional investors have strong incentives to crowd into investments that others have already made. When the weight of institutions’ money goes to the same place at the same time, bubbles inflate.
Safety in numbers. Not long ago, market indices were compiled weekly by teams of actuaries using slide rules. Stocks, without guaranteed dividends, were regarded as riskier than bonds. Now computerised mathematical models measure risk with precision, and show how to trade it for return. When academics produced these theories, they were nuanced with many caveats. Their psychological impact on investors was cruder. They created the impression that markets could be controlled, and that led to overconfidence. They also promoted the idea that there was safety in diversification – investing in different assets. Diversification per se is almost impossible to argue against, but this notion ended up encouraging risk-taking and led investors into markets they did not understand. This in turn tightened the links between markets.
Moral hazard. As memories of the bank failures of the 1930s grew fainter, governments eventually dismantled the limits imposed on banks in that era. Banks grew much bigger. Government bank rescues made money cheaper while fostering the impression among bankers that there would always be a rescue if they got into trouble. That created moral hazard – the belief that there would be no penalty for taking undue risks. Similarly, big bonuses for short-term performance, with no penalty for longer-term losses, encouraged hedge fund managers and investment bankers to take big short-term risks and further boosted overconfidence.
The rise of markets and the fall of banks. Financial breakthroughs turned assets that were once available only to specialists into tradeable assets that investors anywhere in the world could buy or sell – at a second’s notice. Emerging market stocks, currencies, credit, and commodities once operated in their separate walled gardens and followed their own rules. Now they are all interchangeable financial assets, and when their markets expanded with the influx of money, many risky assets shot upward simultaneously, forming synchronised bubbles. Meanwhile, banks saw their roles usurped by markets. Rather than disappear, they sought new things to do – and were increasingly lured into speculative excesses.
There is one big problem when it comes to fixing these underlying factors – most of them are good ideas. Most of us need a professional institution to run our money for us; money market funds, or securitised mortgages, are popular because they help people raise money swiftly and cheaply. Further, the propensity to inflate bubbles is in the very fabric of world markets, so any reforms need to be systemic. While the absurdly complicated instruments that created the subprime bubble, such as the synthetic collateralised debt obligations that landed Goldman Sachs into trouble with the Securities and Exchange Commission, should go, the roots of the problem lie far deeper. Finding fixes will involve hard choices.
Making this harder still, any solution must be filtered through human nature. Our tendency to suffer swings of emotion, to move in herds and to expect others to rescue us from the consequences of our actions, are never going to go away. So while I felt quite good about the diagnosis of the problem, I should be much more humble when proposing a solution. But in outline, I do have some ideas how markets can be made more fearful, and maybe more efficient.
Moral hazard. Previous financial crises reined in moral hazard by inflicting grievous losses on key investors. The latest crisis was different – it showed that the US, the UK and other governments would spend trillions of dollars to sustain the biggest financial groups. Now, the belief that risk takers will be rescued is stronger than ever. So air must be taken out of markets that are currently betting that the government dare not let them fail. It is still too soon to do that. But at some point, either by raising interest rates or by allowing a big bank to go down, government must make clear it will not be there to bail out the reckless.
A safe place to start would be the megabanks like Bank of America, which are even bigger as a result of shotgun mergers which were arranged during the crisis. They cannot be allowed to fail; instead, they must be regulated so tightly that they simply are not allowed to gamble, or they must be made smaller. Governments could raise reserve requirements, which in practice would force banks to sell off assets; this need not involve imposing a break-up.
The decline of banks and the rise of markets. The rise of money markets created a new class of bank-like institutions that do not need to buy insurance to protect depositors. This shadow banking system, including money market funds (mutual funds that invest in the money markets), must now be regulated as if they were banks. Reforms to solidify the so-called repo market (in which banks borrow from each other over very short periods, putting up bonds as collateral) are vital. When this market seized up, banks were unable to get short-term funding.
Regulators also need to overhaul the rules that inadvertently spurred banks to pile into mortgage-backed securities and outsource to rating agencies their central function as lenders – figuring out who can pay back a loan and who cannot.
Like unemployed teenage boys, these banks have shown a terrible knack for getting into trouble when left to their own devices. Once money markets are subject to the same regulation as banks, their advantages may evaporate, enabling banks to regain their old businesses of lending. If not, the economy can possibly do without banks in their traditional form. Hedge funds drove many trends to destruction by 2007, but the much-feared disorderly collapse of a big hedge fund did not occur. Instead, it was the inherent instability of banks that brought the roof down. And so for banks, the status quo is not an option.
Other people’s money. Banking system reforms must also address the conflicts between principals and agents that arise whenever those who take on a risk are able to sell that risk to other parties. In securitisation, where some principal-agent split is inevitable, loan originators must be required to hold a significant proportion of their loan portfolio – in other words to “eat their own cooking”. Investment banks that are now public might return to the partnership model. Then the money on the line would be that of the partners themselves, not shareholders. Again, this might not require government intervention. Existing investment banks could go private. Or hedge funds, which increasingly already carry out investment banking functions, could evolve further.
All of these areas have been amply discussed in the political dialogue, and rightly so. But they all broadly entail what people in the industry call the “sell-side” – the bankers involved in one way or another in selling securities. In fact, the trickiest principal-agent split affects the “buy-side”: investment managers. Asset bubbles on the scale we have recently seen do not happen unless something is going systematically wrong with the way in which our money is invested. It is hard to see how regulation can fix the problem.
The fundamental problem is herding. The herd mentality of the current generation of investment managers is driven by the way they are paid and ranked. Rank them against their peers and an index, and pay them by how much money they manage, and experience shows that they will hug ever closer to each other and to key benchmarks such as the S&P 500. This inflates bubbles. “We see it time and time again, especially in tough times,” said Jim Melcher, a New York hedge fund manager. “Major investors act like a flock of sheep with wolves circling them. They band closer and closer together. You want to be somewhere in the middle of that flock.”
What does he mean by this? Faced with widely published league tables comparing their recent performance to their peers, it does not pay a fund manager to attempt to do much better than everyone else. If they fail, investors will pull their money out. Crowd together with everyone else and there is safety in numbers. And if the market goes up, then so will the fund manager’s portfolio and their percentage management fee – even if they have done nothing more than passively benefit from the overall rise in the market. The way they are paid encourages them to behave like wildebeest on the Serengeti. Somehow, therefore, we must change the way we pay fund managers.
For hedge funds, it is up to investors to refuse to pay fees on the skewed basis that at present encourages them to gear up to “go for broke” each year. Fixed annual fees, and basing any performance fees on periods much longer than one year, makes more sense. In mutual funds, it is far too easy for mediocrities to make money in an upward market. Their fees go up merely for taking in more funds. The practice of closet indexing – investing most of your assets in the companies on one index, but demanding the fees of a more active investor – must be actively discouraged, possibly by requiring “active” funds to publish their “active share” (the amount that their portfolio deviates from the index). Closet indexing might also be rendered less harmful if mainstream index funds moved toward fundamental indexing, weighting their portfolios according to fundamentals such as profits rather than their market price. This would force them to sell stocks as they become overvalued.
Paying managers a fixed fee would no longer reward them merely for accumulating assets, and so funds would be less likely to grow too big. Rewards above a fixed fee should be reserved for genuinely excellent performance only.
But this brings up the greatest problem: how to determine that performance? Benchmarking portfolio managers against their peers, or against a market index, just encourages herding. The solution may lie in the growing effort to understand and measure investing skill. It rests in mental discipline and the ability to resist the temptations of greed, panic and mental shortcuts. By looking at how fund managers perform day by day and trade by trade, psychologists are beginning to identify the truly talented. This effort should continue.
The greatest power rests with those who make big asset allocation decisions – primarily brokers and pension fund consultants. They should follow what is known in the trade as a “barbell” – either their investments are passive, with minimal costs, or they are given to active managers on the basis of their skill, who are paid according to that skill. There is no room for anything in between.
Another needed reform would change the design of investment products so as to deliver everyone from temptation. Rather than give savers a range of choices, give them a well-tailored default option, covering a sensible distribution across the main asset classes, with both passive and active management. To maintain investors’ confidence, it may make sense to declare guaranteed gains along the way, much as the old Victorian model of paternalistic pensions did. All of this would avoid the disaster of the 1990s as many investment managers had no choice but to keep pouring money into internet stocks, thanks to the “irrational exuberance” of their end clients.
The default option would not be compulsory – you can choose something else if you wish. The key is that the default should be a good one and not overloaded by fees. The industry is already moving in this direction. This should restore investors’ confidence, avert the risk that “irrational exuberance” might again drive markets, and limit the worries for all managers about their success in accumulating assets. They would merely have to worry about performing skilfully enough to earn a bonus. But note that many of these changes are subtle, and it is hard for politicians to legislate to introduce them.
Will these reforms deliver us efficient markets? Theories must change, not just practice. The old theory of diversification prompted overconfidence and created the rush into “uncorrelated” assets that then became linked. Other core assumptions, such as stable correlations over time, random returns and emphasis on allocation by asset classes, have failed. We need a new theory.
Academics are already on the case. Paul Woolley of the London School of Economics believes efficient markets might be salvaged if we can find a way to model the distorting effects of institutions on incentives. Andrew Lo, of the Massachusetts Institute of Technology, suggests markets are complex adaptive systems that can be modelled using Darwinian biology – which implies we are living in an era when a meteor has just hit the earth and we await the successors to the dinosaurs.
But any new model, I now believe, must not aspire to the same precision as the old; finance and economics are contingent on human decision-making and not the laws of nature. Abandon the attempt to predict markets with precision, and we might avert a return to the overconfidence such models created in the past.
As for diversification, it was the search for new “uncorrelated” asset classes that helped lead to disaster. Those who allocate assets must look at the risks those assets bear and leave a margin for error – meaning more in “conservative” assets, and less potential “upside,” than they would like.
Again, thankfully, such ideas are already bubbling through the investment industry. All of these ideas involve putting limits on the wealth that markets can create. That would be akin to the trade-off the world made after the Depression. With the capitalist world ageing, the growth rate we can expect in the next few decades may well be significantly lower than in the second half of the 20th century. But even taking into account that consideration, many people would be happy to make that trade-off again. Such ideas might defer the next asset price bubble for a generation. And after three hectic years attempting each day on video to explain markets that had fundamentally deviated from common sense, it is a trade-off I too would make.
John Authers became head of the FT’s Lex column in April. This is an edited extract from his book ‘The Fearful Rise of Markets’, published next week by the FT Press (price £20). To purchase a copy call the FT book ordering service on 0870 429 5884 or go to www.ft.com/bookshop. John Authers’ last piece for the magazine was a look at the landmark $1.25bn payment by Swiss banks to Holocaust survivors – 10 years on. Read it at www.ft.com/restitution