One of the great ironies of the 2008 financial crisis is that it was sparked by a product created from a historically safe investment asset: residential mortgages. In the past quarter century, delinquency rates of single-family home mortgages hovered below 3% for the most part except for the time around the Great Recession, according to the Federal Reserve Bank of St. Louis. Then Wall Street bundled mortgages of various qualities into complex, opaque securities to be bought and sold, often using debt to turbo-charge the investment. When defaults began on Main Street, the tremors reached all the way around the world.
Today, the financial crisis seems like a footnote in history. But like other crises, it has sparked a period of soul-searching. What signs that a crisis was brewing did experts and regulators miss? Why didn’t regulatory reforms in the past prevent it? How could regulators stop another crisis from happening? What are the lessons from this and other meltdowns? These and other questions were the focus of a panel at the “Financial Markets, Volatility, and Crises: A Decade Later” conference held recently in New York by Wharton’s Jacobs Levy Equity Management Center for Quantitative Financial Research.
While this year is generally acknowledged to be the 10th anniversary of the crisis, in actuality there is “no real consensus about when it all began,” said Wharton finance professor Richard Herring, who moderated the panel. Some point to 2006 as the start, when home prices peaked, while others think it began with the 2007 collapse of two Bear Stearns hedge funds that bet heavily on subprime mortgages. Perhaps it was when BNP Paribas froze withdrawals from $2.2 billion worth of funds in the same year. Still others have argued that “it was manageable until the Lehman … orderly liquidation,” Herring said. That was the start.
Whenever the crisis actually began, panelists said that it bore similarities to other Wall Street meltdowns of the past, such as the 1987 market crash and the 1998 collapse of the hedge fund Long-Term Capital Management. Time and again, the chase for a higher investment return, the creation of new, complex securities, the relative inexperience of young traders, the popularity of a new theory to make money and lagging regulations have brought the financial system to the brink.
Free Lunches and the Illusion of Safety
Bruce Jacobs, principal and co-founder of Jacobs Levy Equity Management, said that while the 1987 crash, Long-Term Capital Management and the 2008 credit crisis were different events, they had similarities. “The common theme is that the strategies promised to make investing safe,” he said. “There is an expectation of protection and safety and at the same time they were sold on the basis of higher returns. They become irresistible.” But these “free lunch strategies” later backfired.
In the 1980s, belief in a trading strategy called portfolio insurance was supposed to take out risk. The strategy called for hedging against market downturns by short-selling stock index futures. Jacobs quoted Nobel laureate Robert Merton — who co-created the famed Black-Scholes-Merton calculation to determine fair pricing for options — as saying that if one literally traded continuously, all the risk would disappear because it is being shifted to someone else all the time. But practically speaking, Jacobs said, one can’t trade continuously in practice.
Portfolio insurance also can fail. “We all know what happened in 1987 — there was a major [stock market] crash, the largest one-day decline in the history of the U.S. markets, greater than the decline in 1929,” Jacobs said. It’s fine to shift risk to someone else, providing there are “counterparties on the other side willing to buy,” he said. But as many investors tried to shift risk at the same time, they could not find enough folks to take it off their hands. “The buyers were not there,” he said. “The markets became fragile. And the decline was over 20%.”
“Here, you have a high reward … and the expectation of lower risk. That is very hard to resist. This promise of low risk I will refer to as the illusion of safety.”–Bruce Jacobs
Long-Term Capital Management, a hedge fund led by Nobel laureates, began operations on the premise that it would make money taking “very low risk [arbitrage] positions,” Jacobs said. For example, it would take advantage of securities that are not correctly priced relative to each other. But since the hedge fund only made a small return on its arbitrage positions, it piled on debt so it could bet bigger. In 1997, its debt was 30 times greater than its capital, according to the Federal Reserve. When its bets went south in 1998, 14 banks and brokerage firms pumped $3.6 billion in an arrangement orchestrated by the Fed to prevent a fire sale and harm other markets. The fund was later liquidated.
In the 2008 crisis, the culprit was residential mortgage-backed securities and collateralized debt obligations (CDOs). They were “triple A rated securities, very low risk presumably,” Jacobs said. “There was the promise of safety and yet the promise of higher returns.” But that belief flies in the face of “finance 101,” which is that if investors want a higher return, they have to take more risk, he said. “Here, you have a high reward … and the expectation of lower risk. That is very hard to resist. This promise of low risk I will refer to as the illusion of safety.”
Financial Innovation as Panacea
Another cause of financial crises is financial innovation. “I think most of the financial crises actually start with some new product or new approach to investing, and it’s always sold as a panacea” with reduced risk and higher returns, said Richard Lindsey, co-head of liquid alternatives at Windham Capital Management. “They’re marketed very heavily. They grow rapidly.” That happened with portfolio insurance. “The idea had been around for a couple of years, but once it started, it went very quickly.” Likewise in the 2008 crisis. “If you think about the mortgage-backed market, the growth of that was also spectacular in a relatively short period of time.”
“I think most of the financial crises actually start with some new product or new approach to investing, and it’s always sold as a panacea.”–Richard Lindsey
These new securities also tend to be very complex and sometimes opaque. “Most senior management [of the firm that sells the security] generally don’t understand the product,” Lindsey said. “Investors [also] don’t understand the product they’re investing in. When you exacerbate that with a lot of quant analysis or quant-speak, sometimes it just makes the situation worse. They don’t really know what they’re investing in. They don’t really know what can or could happen to it.”
Risk management vulnerabilities have also characterized crises. For example, in the 2008 crisis, the trading desk might not have seen a risk in mortgages and pointed out that “there’s never been a problem of defaults,” Lindsey said. Meanwhile, risk managers would perhaps have felt that the firm was taking on a lot of risk but “didn’t have a basis for argument other than their perception,” he said. In a match-up between the trader and risk manager, the trader wins because he or she is seen as a “money maker” while the risk manager is part of the firm’s cost center.
Moreover, many traders tend to be younger and haven’t been through financial crises. “They’re new and they say, ‘This is different. This can’t have the risk that anything else has had previously.… I understand [the risk] and I know how to control it.’” Lindsey noted. “Generally, that tends not be true.” For instance, markets tend not to be as liquid as perceived, he said. Everything is working well until there comes “some type of precipitating event” like a currency crisis in Asia. “All of a sudden, it reveals all of the weaknesses in the system.” In the 1980s with portfolio insurance, after the market sold off, one could not trade. “The whole system kind of froze up.”
Vineer Bhansali, founder and CIO of investment advisory services firm LongTail Alpha, said he has survived five financial crises, and “you see the same cyclical, endogenous behavior, and the signs are almost always the same.” The catalyst tends to be “a great theorem that goes bad because it’s abused and it’s levered up,” he said. “It’s also accompanied by a very flat yield curve” that could indicate a coming economic downturn. Once the crisis is over, confidence returns, investors chase returns again and the cycle renews. “People get emboldened because it recovers very rapidly and then you have [another] big crisis.”