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 A Demon of Our Own Design

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gastaoss



Number of posts : 440
Registration date : 2007-07-01

PostSubject: A Demon of Our Own Design   Tue Sep 04, 2007 11:29 pm

12:08 PM (11 hours ago)
A Demon of Our Own Design

from The Big Picture by ritholtz
I previously mentioned A Demon of Our Own Design in a linkfest a few weeks ago. I enjoyed the book a great deal, and just about finished it over the long weekend.

The opening paragraph just reached out and grabbed me:

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


Terrific stuff.

Indeed, I enjoyed the rest of the book. Bookstaber was on the scene
in the early days of many of derivatives now contributing to market
turmoil. He rather deftly makes complex issues readily understandable,
regardless of how much advanced mathematics you may have under your
belt.

And, he names names. LOTS of names. All the usual suspects come
under scrutiny, as well as a lot of folks who probably assumed they
were not int he public eye. There will be a lot of people not very
happy with his blunt, insider descriptions of the analytical errors
made by major players -- many of whom are still around today and in
positions of authority and power.

He also accepts a lot of responsibility for many costly errors he himself made.


Overall, a fun, very informative read.

I was intrigued enough by the book that I contacted Bookstaber (the
author) and Wiley (the publisher), and asked for their permission to
reproduce the first chapter. They graciously sent me a pdf and text
version, which you will find after the jump: All of chapter one, in both text form and PDF. I also included some mainstream media reviews after the chapter.



I have pretty good relationships with many of the publishing houses
-- they all want to get a book or two out of me. Anyway, if it turns
out you guys like this idea, perhaps we can offer up a book or two that
I am reading every month in this same format. Maybe we can have an
online reading group club -- it could be a good place to have a full
discussion. Share your thoughts.

Enjoy chapter one.




~~~
>
Disclosure:
No, I don't accept money for this -- it was my idea, and I approached
the publisher and author about this -- not vice versa. Please don't
start bombarding me with offers to promote books I am not already
reading. They will be unceremoniously deleted without response.

As noted in our disclosure section, we don't do payola here (if you click thru and buy it on Amazon, I do see some scratch).

>
>

A Demon of Our Own Design

>

Here is the required and official legal notice:

<blockquote>"Excerpted with permission
of the publisher John Wiley & Sons, Inc. from A Demon of Our Own Design. Copyright (c) 2007 by Richard Bookstaber.
This book is available at all bookstores, online booksellers and
from the Wiley web site at www.wiley.com, or call 1-800-225-5945.


</blockquote>

>

You can download and print out chapter in PDF form -- Download Demon Chapter_1.pdf

Or, you can read it here:<blockquote>CHAPTER 1

INTRODUCTION: THE PARADOX OF MARKET RISK



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

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
Industrial 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.

</blockquote>
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gastaoss



Number of posts : 440
Registration date : 2007-07-01

PostSubject: Re: A Demon of Our Own Design   Tue Sep 04, 2007 11:29 pm

Just
look at the environment that has precipitated these major meltdowns.
For the crash of 1987, it was hard to see anything out of the ordinary.
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 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. 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 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 Europe, 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, telecommunications, 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: Information is released more quickly and
to a broader constituency of investors, and limitations are imposed on
insider trading and nonpublic disclosure. 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—accommodate trading in more areas.
With all these improvements we are moving ever closer to the notion of
perfect markets—and perfect markets should not offer unusual profit
opportunities for a subgroup of investors and traders.

That
does not seem to be happening. The market remains volatile and the
returns widely uneven. In spite of 40 years of progress and a drop in
real economic risk by 50 percent or more, the average annual standard
deviation in the S&P 500 index was higher during the past 20 years
than it was 50 years earlier. The fact that the total risk of the
financial markets has grown in spite of a marked decline in exogenous
economic risk to the country is a key symptom of the design flaws
within the system. Risk should be diminishing, but it isn’t.

Meanwhile,
there is a proliferation of hedge funds that continue to capture
differentially higher returns. Over the past five years, the assets
under management by hedge funds have grown over sixfold from $300
billion to more than $2 trillion. And this does not include the
operation of the quasi-hedge fund proprietary trading desks at firms
like Goldman Sachs or Deutsche Bank. It’s a zero-sum game, though, so
if hedge funds are able to extract differentially higher returns,
someone else is paying for them with comparably subpar returns. Maybe
it’s you.

This is not the way it is supposed to work. Consider
the progress of other products and services over the past century. From
the structural design of buildings and bridges, to the operation of oil
refineries or power plants, to the safety of automobiles and airplanes,
we learned our lessons. In contrast, financial markets have seen a
tremendous amount of engineering in the past 30 years but the result
has been more frequent and severe breakdowns.

These breakdowns
come about not in spite of our efforts at improving market design, but
because of them. The structural risk in the financial markets is a
direct result of our attempts to improve the state of the financial
markets; its origins are in what we would generally chalk up as
progress. The steps that we have taken to make the markets more attuned
to our investment desires—the ability to trade quickly, the integration
of the financial markets into a global whole, ubiquitous and timely
market information, the array of options and other derivative
instruments—have exaggerated the pace of activity and the complexity of
financial instruments that makes crises inevitable. Complexity cloaks
catastrophe.

My purpose here is to explain why we seem to be
doing the right things but the results go in the other direction. The
markets continue to develop new products to meet investors’ needs.
Regulation and oversight seek to ensure that these advances land on a
level playing field, with broad and simultaneous dissemination of
information and price transparency. But the innovations are somehow
making our investments more risky. And more regulation, ironically, may
be compounding that risk. It would seem there is a demon unleashed,
haunting the market and casting our efforts awry: a demon of our own
design.

>

~~~~~~

>

MSM Reviews:<blockquote>"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)



"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." (The New York Times)



"Bright sparks like Mr Bookstaber ushered in a revolution that fuelled
the boom in financial derivatives and Byzantine 'structured products.'
The problem, he argues, is that this wizardry has made markets more
crisis-prone, not less so. It has done this in two ways: by increasing
complexity, and by forging tighter links between various markets and
securities, making them dangerously interdependent." (The Economist)



"He understands the inner workings of financial markets...A liberal
sparkling of juicy stories from the trading floor..." (The Economist)



"…smart book…Part memoir, part market forensics, the book gives an insider's view…" (Bloomberg News)



"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." (The Wall Street Journal)



"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



"a must-read amidst the current market chaos"--BusinessWeek.com

</blockquote>Amazon: A Demon of Our Own Design




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