Leverage through technology to blame for credit mess
And like any market externality û something that harms society while benefiting only a few û it requires regulation, argues think-tank exec Woody Brock.
To paraphrase Bill Clinton, itÆs the leverage, stupid. That was the message delivered earlier this week to an audience of fund-management and custody executives in Hong Kong by Woody Brock, president of New York-based think tank Strategic Economic Decisions.
Brock, a multi-degreed Harvard and Princeton PhD, advises institutional investors and money managers in the United States, including Fidelity and IBM Pension Fund, on interest rates and the economy.
Current conventional wisdom says the credit crunch is the fault of greedy bankers and stupid risk assessors, and therefore needs transparency, a little more regulation of investment banks, and improvements to the value-at-risk models.
Hogwash, says Brock. The risk-management models used by virtually everyone on the Street are based on fundamentally misguided ideas. The real story is not greed, which remains a human constant, but the advances in technology that have enabled the excessive use of leverage.
To explain this, Brock goes back through a bit of financial academic theory. In 1950, there was no theory of finance or way to explain the existence of securities markets, beyond Adam SmithÆs ôinvisible handö. This changed with John Von Neumann, a Hungarian-born American polymath whose work confirmed SmithÆs insight that the price mechanism allows for the efficient allocation of capital û while adding his observation that such allocation takes place in an environment of uncertainty.
This uncertainty principle led to the realisation that capitalism works only if participants can hedge against uncertainty. From there he explained that markets exist to optimise the reallocation of risk, and that risk was just another commodity, like wheat or pork bellies.
From this promising theoretical start, however, came what Brock calls a ôdisasterö: the advent of the Chicago School of thought, a statistics-heavy philosophy of monetarism and rational expectations. Proponents assumed everyone knows the correct probability of default rates, or the outcome of unknowns, based on crunching historical data; the implication was that hedges are correct and therefore markets canÆt suffer meltdowns.
New instruments such as credit default swaps and securitisation were created on the assumption that participants know the risks they face and can hedge appropriately û and because we know so much, why not leverage to the hilt? Advances in information technology that allowed for lots of data-crunching and back-testing at the blink of an eye made extravagant leverage possible, at a time when governments under Ronald Reagan and Margaret Thatcher eased regulation, believing investment banks were best suited to price, slice and dice risk without any supervision.
This continued even after Black Monday in 1987, when notions such as portfolio insurance combined with program trading caused exactly the kind of market crash that wasnÆt supposed to happen. More recently, by ignoring the correlation of forecast errors and actual uncertainty in pricing models, the flood of structured products using subprime mortgages as underlying securities ran into a simple problem: ôWhatÆs this crap worth?ö, as Brock put it.
Even today, no one knows. And uncertainty has been amplified by leverage.
ôThe fundamental conceit of modern finance has collapsed,ö Brock says, not because of a lack of transparency in structured products, but because of excessive leverage.
Adam Smith wrote that capital is efficiently allocated when the government does not interfere û except when it leads to market externalities. The textbook example of an externality is pollution: a company left to its own devices will pour waste into a river to save costs, but this hurts society at large, mainly people who had nothing to do with the company and never entered into a voluntary contract with it.
ôLeverage is pollution,ö Brock argues, adding investment banksÆ ôpollutingö activities have benefited a handful of financiers while doing grave damage to world economic growth as a whole.
Therefore regulation in the US (and by implication, the world) must be extended to off-balance sheet special-purpose vehicles, hedge funds, private-equity funds and any other financial actor that currently lies outside of federal government oversight. Second, quantitative models need an overhaul, recognising that value-at-risk models are worthless. ôWe need to introduce humility into our beliefs so we donÆt use leverage.ö
But this necessity faces a major hurdle: the regulators have been co-opted by bankers, the very people benefiting from the abuse of leverage. Many US Treasury officials, for example, come from Wall Street backgrounds, notes Brock.
Brock, a multi-degreed Harvard and Princeton PhD, advises institutional investors and money managers in the United States, including Fidelity and IBM Pension Fund, on interest rates and the economy.
Current conventional wisdom says the credit crunch is the fault of greedy bankers and stupid risk assessors, and therefore needs transparency, a little more regulation of investment banks, and improvements to the value-at-risk models.
Hogwash, says Brock. The risk-management models used by virtually everyone on the Street are based on fundamentally misguided ideas. The real story is not greed, which remains a human constant, but the advances in technology that have enabled the excessive use of leverage.
To explain this, Brock goes back through a bit of financial academic theory. In 1950, there was no theory of finance or way to explain the existence of securities markets, beyond Adam SmithÆs ôinvisible handö. This changed with John Von Neumann, a Hungarian-born American polymath whose work confirmed SmithÆs insight that the price mechanism allows for the efficient allocation of capital û while adding his observation that such allocation takes place in an environment of uncertainty.
This uncertainty principle led to the realisation that capitalism works only if participants can hedge against uncertainty. From there he explained that markets exist to optimise the reallocation of risk, and that risk was just another commodity, like wheat or pork bellies.
From this promising theoretical start, however, came what Brock calls a ôdisasterö: the advent of the Chicago School of thought, a statistics-heavy philosophy of monetarism and rational expectations. Proponents assumed everyone knows the correct probability of default rates, or the outcome of unknowns, based on crunching historical data; the implication was that hedges are correct and therefore markets canÆt suffer meltdowns.
New instruments such as credit default swaps and securitisation were created on the assumption that participants know the risks they face and can hedge appropriately û and because we know so much, why not leverage to the hilt? Advances in information technology that allowed for lots of data-crunching and back-testing at the blink of an eye made extravagant leverage possible, at a time when governments under Ronald Reagan and Margaret Thatcher eased regulation, believing investment banks were best suited to price, slice and dice risk without any supervision.
This continued even after Black Monday in 1987, when notions such as portfolio insurance combined with program trading caused exactly the kind of market crash that wasnÆt supposed to happen. More recently, by ignoring the correlation of forecast errors and actual uncertainty in pricing models, the flood of structured products using subprime mortgages as underlying securities ran into a simple problem: ôWhatÆs this crap worth?ö, as Brock put it.
Even today, no one knows. And uncertainty has been amplified by leverage.
ôThe fundamental conceit of modern finance has collapsed,ö Brock says, not because of a lack of transparency in structured products, but because of excessive leverage.
Adam Smith wrote that capital is efficiently allocated when the government does not interfere û except when it leads to market externalities. The textbook example of an externality is pollution: a company left to its own devices will pour waste into a river to save costs, but this hurts society at large, mainly people who had nothing to do with the company and never entered into a voluntary contract with it.
ôLeverage is pollution,ö Brock argues, adding investment banksÆ ôpollutingö activities have benefited a handful of financiers while doing grave damage to world economic growth as a whole.
Therefore regulation in the US (and by implication, the world) must be extended to off-balance sheet special-purpose vehicles, hedge funds, private-equity funds and any other financial actor that currently lies outside of federal government oversight. Second, quantitative models need an overhaul, recognising that value-at-risk models are worthless. ôWe need to introduce humility into our beliefs so we donÆt use leverage.ö
But this necessity faces a major hurdle: the regulators have been co-opted by bankers, the very people benefiting from the abuse of leverage. Many US Treasury officials, for example, come from Wall Street backgrounds, notes Brock.
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