Bookstaber’s pre-boarding call for the “flight to simplicity”

It was 8 years in coming.  An idea that began as a set of notes back in 1999 slowly and methodically grew over the years to eventually become a manifesto of modern risk management.  According to author Richard Bookstaber, “A Demon of Our Own Design” began as a labor of love.  It seems that the result represents a sort of catharsis – therapy for a hedge fund insider who has been a first-responder at the scene of some of history’s most calamitous financial crashes.

The labor of love now has 55,000 copies in print and has received accolades from The Economist, Business Week, Forbes, and (most prestigious of all) AllAboutAlpha.com.   Bookstaber was in Toronto earlier this week addressing a sold-out event organized by AIMA (The Alternative Investment Management Association).  I had the chance to join him for dinner before his speech and found him to be a casual and disarming kind of guy who is equally comfortable discussing championship dog breeding as he is dispensing sapient advice on the global financial system.

He gives credit to others – particularly an editor at The Economist – who have recently advocated a “flight to simplicity” for adroitly summarizing the main idea behind his book.  Bookstaber basically says that one can’t fight complexity with more complexity.  Adding ever more complicated financial regulations can (and will) have unknown and unintended consequences for the functioning of capital markets.

But this “flight to simplicity” seems to be at odds with the natural evolution of financial instruments toward ever more targeted securities allowing bets on ever more specific risks.  I asked Bookstaber, a former academic, if he had turned his back on one of the most cherished concepts in modern finance: market completion.  He replied that he had not, but that the derivative instruments envisioned by the concept of market completion had evolved into tools for outright bets, not tools for hedging as initially envisioned by the theory.

This phenomenon may explain a paradox that has obviously galvanized his thinking for several years.  He puts that paradox in the form of a rhetorical question: “Why have economic cycles become less extreme while financial cycles have become more extreme?”.  After all, he continues, “Isn’t the financial market supposed to reflect economic fundamentals?”.

For the answer, he returns to a familiar theme in his book – liquidity.  He says that liquidity is the primary determinant of price, particularly in the short term.  August’s mayhem provides a perfect illustration.  He says that mortgages with entirely different risk profiles quickly became correlated with each other simply because they were packaged together – not because they shared economic fundamentals.  It was the demand for liquidity that determined their short-term price movements.  The result is what he has called a “surprising correlation” – something that can hurt even more than volatility itself.  Said Bookstaber in a September 23 posting on his blog:

“No market veteran should be surprised to see periods when securities prices move violently. The recent rise in credit spreads is nothing compared to what happened in 1998 leading up to and following the collapse of hedge fund Long-Term Capital Management or, for that matter, during the junk bond crisis earlier that decade, when spreads quadrupled.

“What catches many investors off guard and leads them to make the 100 year sort of comment is not the behavior of individual markets, but the concurrent big and unexpected moves among markets. It’s the surprising linkages that suddenly appear between markets that should not have much to do with one other and the failed linkages between those that should march in tandem. That is, investors are not as dumbfounded when volatility skyrockets as when correlations go awry. This may be because investors depend on correlation for hedging and diversifying. And nothing hurts more than to think you are well hedged and then to discover you are not hedged at all.”

He uses this idea to answer our favorite question: Is the world was running out of alpha? These short term liquidity events are evidence, says Bookstaber, that alpha may not be finite after all.  In other words, as long as liquidity events like August continue to occur, there will always be alpha-generating opportunities.  He provides the example of hedge fund Citadel, which recently (and profitably) provided liquidity by buying the assets of failed hedge funds Amaranth and Sowood.

Admitting to a somewhat pessimistic streak, Bookstaber also used this argument to explain his views on the housing market.  He points to the highly inelastic demand for housing during the 1970s and 1980s as baby boomers reached home buying age.  But today, he says “you can run that tape in reverse”.  As a result of the growing liquidity in the housing market, he suggests, we could be in for a “fairly long term dampening” of housing prices.  If that weren’t bad enough though, disappointed retiring homeowners who had banked on a certain home price could be forced to liquidate some of their equities to make up for a shortfall.

While the markets and timeframes are very different, this phenomenon bears a striking similarity to August’s quant fund drawdown.  In both cases, one asset class catches a contagion from an adjacent one.  (See Bookstaber’s comment on a related posting for more about contagion mechanisms.)

Which brings us full circle back to the paradox of dampening economic cycles and increasingly volatile financial ones.  He credits central banks for “getting smarter” about managing the economy.  But he also warns that they may not have the right tools at their disposal to address today’s challenges.

And thus it appears that foggy economic conditions may have grounded central banks for now.  Is another crash inevitable or will we board the flight to simplicity just in time?  Who knows?  But if history is to repeat itself, then let’s all hope Richard Bookstaber is at the controls.

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2 Comments

  1. Andrew Herdman
    January 11, 2008 at 8:49 pm

    For an earlier use of the phrase “flight to simplicity”, see this article from the Financial Times 21 October 2007
    http://www.ft.com/cms/s/0/956c69d2-7ff0-11dc-b075-0000779fd2ac.html
    The phrase is attributed to the head of fixed income from an unnamed US investment bank.


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