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Market Crises



Copyright 2004, Association for Investment Management and Research. Reproduced and republished from the Financial Analysts Journal with permission from the Association for Investment Management and Research. All rights reserved.

 


Copyright 2009, CFA Institute. Reproduced and republished from Financial Analysts Journal with permission from CFA Institute. All rights reserved.

Risk Avoidance and Market Fragility
by Bruce I. Jacobs, Financial Analysts Journal, January/February 2004

 

Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis
by Bruce I. Jacobs, Financial Analysts Journal, March/April 2009

The credit crisis of 2007-2009 and ensuing economic malaise sprang from the collapse of a tower of structured finance products based on subprime mortgage loans. The relatively high returns on structured products created demand for them, which helped fuel mortgage lending, facilitating more purchases of homes and, in turn, putting upward pressure on prices. This dynamic was abetted by the seeming safety of the products, which encouraged leverage in lender and investor balance sheets. 

As lenders exhausted the pool of possible homebuyers, however, housing prices began to decline in many parts of the U.S. The downside risk of housing-market prices became manifest as the systematic risk of housing-price losses was shifted to lenders and investors. The solvency of some of the institutions that had built the tower of structured products came into question. The real risk of subprime mortgage investing blew up financial firms and, in turn, economies worldwide. Bruce Jacobs describes this process in “Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis.” 

Products designed to reduce risk for mortgage lenders and investors in mortgage-related products ended up creating huge risks for the system as a whole. The past quarter century has witnessed multiple versions of this same story, played out by various financial actors. In the 1980s, a strategy known as portfolio insurance, based on then-new theories of option pricing, purported to reduce the downside risks of equity investing while preserving upside potential. In essence, portfolio insurance aimed to create an option-like put on equity holdings via a trading strategy that called for selling stock as stock prices declined and buying stock as stock prices rose. This mechanistic trading contributed to the crash of October 19, 1987, as Jacobs outlines in “Option Theory and Its Unintended Consequences.” 

In his book Capital Ideas and Market Realities, Jacobs details the role played by portfolio insurance in the 1987 crash and goes on to discuss subsequent crises caused or exacerbated by similar or related strategies. These include actual options, when popular demand for puts forces option dealers to engage in the same type of mechanistic trading required by portfolio insurance, and, less intuitively, the type of arbitrage trades made by hedge funds such as Long-Term Capital Management. LTCM’s trades were theoretically so low risk that leverage of 20 to 30 times capital was required to get the fund’s risk levels up to the desired equity market level. Yet these highly leveraged, supposedly low-risk, and globally diversified strategies all fell apart at the same time when turmoil set off by Russia’s de facto default stampeded investors toward safety and liquidity. Then, the need to unwind arbitrage positions created the same trading patterns as portfolio insurance—selling into down markets and buying into rising markets. Jacobs focuses on this phenomenon in “When Seemingly Infallible Arbitrage Strategies Fail” and “A Tale of Two Hedge Funds.”  

Capital Ideas and Market Realities, “A Tale of Two Hedge Funds,” and “Tumbling Tower of Babel” also discuss how leverage helped to ignite and then spread the fires in the LTCM and 2007-2009 crises. The risks of leverage are too often ignored. Modern Portfolio Theory, for example, focuses on volatility risk but has little to say about the risks of leverage, other than its contribution to volatility. Reliance on conventional optimization techniques can thus give rise to portfolios that are highly leveraged. The articles in the section “Optimization, Short Sales, and Leverage Aversion” describe the unique risks of leverage and offer a possible solution in the form of a mean-variance-leverage optimization model that incorporates investor leverage aversion. 

Another common thread of these crises is the seemingly general lack of appreciation for the difference between risk sharing and risk shifting. Jacobs’s “Risk Avoidance and Market Fragility” discusses these differences. Risk-sharing can reduce risk, as diversification of the specific risks within a portfolio reduces overall portfolio risk. But risk-shifting merely moves risk from one party to another. Risk shifting tends to reduce investors’ perceptions of the risks they are incurring, thereby encouraging more risk-taking. Overall risk in the system, however, remains, and increases as investors take on more risk. Eventually, markets become fragile and susceptible to even small exogenous shocks.



Key Articles:

· “Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis,” by Bruce I. Jacobs, Financial Analysts Journal, March/April 2009. Abstracted in CFA Digest, August 2009, and in Pensions & Investments commentary, “Mortgage Market Needs Tougher Standards,” August 10, 2009. Updated version in Laurence B. Siegel, Ed., foreword by Rodney N. Sullivan. Insights into the Global Financial Crisis. The Research Foundation of CFA Institute, Charlottesville, VA, December 2009. Executive summary in Robert W. Kolb, Ed. Lessons from the Financial Crisis: Causes, Consequences, and our Economic Future. John Wiley & Sons, Hoboken, NJ, 2010. Reprinted in Walter V. “Bud” Haslett Jr., Ed. Risk Management: Foundations For a Changing Financial World. John Wiley & Sons, Hoboken, NJ, 2010. (1) article
The growth and collapse of the U.S. housing bubble was enabled by the growth of the subprime loan market, a tower of securitized products known by their various acronyms as RMBS, CDO, SIV, and CDS. These products were used to shift risk from one party to another, lender to financial intermediary, financial intermediary to investor. Each party felt its individual risk was reduced, to the point that many lost sight of the real risks of the underlying loans. This sense of safety in turn encouraged more lending, more securitized products, and more leverage. But the systematic risk of the loans remained. When house price appreciation slowed in many areas of the country, and then reversed, a large number of borrowers, especially subprime borrowers, began to default on their mortgages. The tower of securitized products, meant to reduce risk for individual entities, collapsed. Rather than reducing risk, securitized products ended up creating systemic risk.

· “Risk Avoidance and Market Fragility,” by Bruce I. Jacobs, Financial Analysts Journal, January/February 2004. article
Investors who buy "insurance" against a decline in stocks, bonds, or other financial markets are shifting that risk onto the financial institutions providing such "insurance." These insurance providers frequently control their exposure to this risk by purchasing options or by replicating options via dynamic hedging. As more and more investors demand insurance, however, there is more trend-following trading, more market volatility, and more demand for insurance. At some point, the selling required to replicate an option on the market can create a liquidity crisis. In such an event, "insurance" products can fail, along with the firms offering them, giving rise to systemic risk and leaving the Fed the insurance provider of last resort.

Other Articles:

· “Momentum Trading: The New Alchemy,” by Bruce I. Jacobs, The Journal of Investing, Winter 2000. article
Investors who buy "insurance" against a decline in stocks, bonds, or other financial markets are shifting that risk onto the financial institutions providing such "insurance." These insurance providers frequently control their exposure to this risk by purchasing options or by replicating options via dynamic hedging. As more and more investors demand insurance, however, there is more trend-following trading, more market volatility, and more demand for insurance. At some point, the selling required to replicate an option on the market can create a liquidity crisis. In such an event, "insurance" products can fail, along with the firms offering them, giving rise to systemic risk.

· “When Seemingly Infallible Arbitrage Strategies Fail,” by Bruce I. Jacobs, The Journal of Investing, Spring 1999. article
Seemingly infallible arbitrage strategies can fail. When they do, they can take the markets down with them. The near collapse of Long-Term Capital Management bears some eerie parallels to the collapse of portfolio insurance, and the market, in October 1987.

· “Option Pricing Theory and its Unintended Consequences,” by Bruce I. Jacobs, The Journal of Investing, Spring 1998. (2) article
Like any revolution, the options revolution that began with the publication of the Black-Scholes-Merton option pricing formula has had some unintended side effects. Of concern to all investors should be the potentially dangerous increase in market instability created by the trading strategies option sellers use to hedge their market exposures. Dynamic hedging rules that call for buying as market prices rise and selling as they fall have wreaked havoc with markets in the past and are likely to do so again in the future.

Book:

   Copyright © 1999

· Capital Ideas and Market Realities: Option Replication, Investor Behavior, and Stock Market Crashes, by Bruce I. Jacobs, Blackwell Publishers, Malden, MA, 1999.
The summer and fall of 1998 witnessed some of the most turbulent financial markets the world has ever seen. The implosion of the Russian financial markets and investors' ensuing flight to quality propelled the giant hedge fund, Long-Term Capital Management, to the brink of collapse and left the investment portfolios of many of Wall Street's major banks and brokerage houses teetering on the brink. The U.S. equity market dropped precipitously at the end of August and continued over the next month to experience levels of volatility not seen since the major crash of October 1987. Yet, within months of the August sell-off, U.S. stocks had bounced back to new highs. How can markets fall so fast and recover so quickly?

Bruce Jacobs sifts through the history of modern finance, from the efficient market hypothesis to behavioral psychology and chaos theory, to determine the cause of recent market crashes. He finds that some investment strategies, especially those based on theories that ignore the human element, can self-destruct, taking markets down with them. Ironically, some strategies that purport to reduce the risk of investing can pose the greatest danger.

Of particular concern is a trading strategy that grew out of the option pricing model developed by the late Fischer Black and Nobel laureates Myron Scholes and Robert Merton. Used by market professionals, this strategy, known as option replication, requires mechanistic selling as stock prices decline and buying as stock prices rise. When a large enough number of investors engage in this type of trend-following "dynamic hedging," their trading demands can sweep markets along with them, elevating stock prices at some times and causing dramatic price drops at others.

Capital Ideas and Market Realities revisits the crash of October 19, 1987 to examine an option replication strategy known as portfolio insurance. Marketed as a free lunch, offering excess returns at low or no risk, portfolio insurance grew into a $100 billion industry by the fall of 1987. The book documents portfolio insurance's contribution to the crash, examining and dismissing multiple alternative theories along the way. It goes on to look at the so-called "sons of portfolio insurance"—instruments and strategies that have emerged since the 1987 crash, offering similar promises of no-risk returns. These include hundreds of billions of dollars in over-the-counter options and swaps, as well as various "guaranteed" equity products. Their advent has been associated with a number of market disruptions.

An investigation of Long-Term Capital Management and the summer of 1998 reveals how derivatives-dependent hedge fund strategies can have effects similar to those of option replication. In effect, when Long-Term Capital Management's supposedly low-risk strategies reached their liquidity limits, the firm was forced to sell, mechanistically, into declining markets. As with the selling related to portfolio insurance in 1987, the result was precipitous drops in wealth for most investors.


Book Chapters:

· “Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis,” by Bruce I. Jacobs, reprinted in Walter V. “Bud” Haslett Jr., Ed. Risk Management: Foundations For a Changing Financial World. John Wiley & Sons, Hoboken, NJ, 2010.

· “Executive Summary of Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis,” by Bruce I. Jacobs, in Robert W. Kolb, Ed. Lessons from the Financial Crisis: Causes, Consequences, and our Economic Future. John Wiley & Sons, Hoboken, NJ, 2010.

· “Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis” (updated), by Bruce I. Jacobs, in Laurence B. Siegel, Ed., foreword by Rodney N. Sullivan. Insights into the Global Financial Crisis. Research Foundation of CFA Institute, Charlottesville, VA, December 2009.

· “A Tale of Two Hedge Funds,” by Bruce I. Jacobs and Kenneth N. Levy, in Jacobs and Levy, Eds. Market Neutral Strategies. John Wiley & Sons, Hoboken, NJ, 2005.
The blow-ups of two notorious hedge funds hold some lessons for investors considering market neutral strategies. Askin Capital Management's supposedly market neutral posture in mortgage instruments was anything but market neutral. In fact, the firm was extremely susceptible to rising interest rates, and succumbed as the Fed raised rates in 1994. Long-Term Capital Management's sophisticated risk aggregator was supposed to ensure the neutrality of the firm's complicated arbitrage trades. Yet it failed to account for how extreme price movements would affect correlations between different asset classes and the willingness of other arbitragers to take on positions as arbitrage spreads widened. The Russian debt crisis in the summer of 1998 brought the firm to its knees, and the resulting selling pressure roiled financial markets.


Other Research Categories:

Security Selection

Plan Architecture and Portfolio Engineering

Long-Short Investing

Portfolio Optimization, Short Sales, and Leverage Aversion

Market Simulation

___________________________________________
(1)2009 Financial Analysts Journal Graham & Dodd Readers’ Choice Award winner.
(2)Journal of Investing Outstanding Paper Award


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