|A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation
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Inside markets, innovation, and risk
Why do markets keep crashing and why are financial crises greater than ever before? As the risk manager to some of the leading firms on Wall Street¨Cfrom Morgan Stanley to Salomon and Citigroup¨Cand a member of some of the world¡¯s largest hedge funds, from Moore Capital to Ziff Brothers and FrontPoint Partners, Rick Bookstaber has seen the ghost inside the machine and vividly shows us a world that is even riskier than we think. The very things done to make markets safer, have, in fact, created a world that is far more dangerous. From the 1987 crash to Citigroup closing the Salomon Arb unit, from staggering losses at UBS to the demise of Long-Term Capital Management, Bookstaber gives readers a front row seat to the management decisions made by some of the most powerful financial figures in the world that led to catastrophe, and describes the impact of his own activities on markets and market crashes. Much of the innovation of the last 30 years has wreaked havoc on the markets and cost trillions of dollars. A Demon of Our Own Design tells the story of man¡¯s attempt to manage market risk and what it has wrought. In the process of showing what we have done, Bookstaber shines a light on what the future holds for a world where capital and power have moved from Wall Street institutions to elite and highly leveraged hedge funds.
- Unsatisfying Mix of "Liar's Poker" and "Remarkable History of Risk"
Mr. Bookstaber appears to have set out to write a memoir to rival "Liar's Poker" (from a more famous Salomon Brothers alumnus Michael Lewis), and the book starts out well. But after the first third of the book, the narrative loses steam and then meanders listlessly, and then finishes with barely a whimper. You'd be much better off reading "Liar's Poker" and "Remarkable History of Risk" for entertainment and educational value....more info
- Rare insider's view
The author's point of view is surprisingly neutral. He has nothing to sell except his belief that the changes in the markets over the last twenty years have increased susceptibility to huge price drops. This is due to the need to sell into a falling market, a common feature of hedging strategies based on derivatives such as market indexes. He exposes so many sophisticated schemes used by professionals that amateurs ought to be afraid to ever trade again. However, he says nothing about the credit bubble that undoubtedly existed at the time the book was written, and whose bursting showed that risk reduction strategies above work only when not widely used....more info
- Nails it on the head
This book nails it for the sort of market problems that ended up being behind the sub prime crisis, and sets the stage to understand the problems at Citigroup to boot. It points the finger at all the complexity in the market that is coming from derivatives and structured products, and the "tight coupling" that is arising from leverage.
I read a borrowed copy and ended up liking it enough that I decided to buy copies for two of my friends who are in finance. I am not in the investment world, but I found it interesting and easy to read, and sometimes even funny. And it looks like it has made its mark -- I see positive reviews from the New York Times, Wall Street Journal, the Economist and a number of other business publications....more info
- Thought-provoking reflection on Wall Street risk today
This book is part memoir, part reflection on risk, part tell-all, part recapitulation of recent financial crises and part polemic. If you fret that all these parts might blur author Richard Bookstaber's objectives and message, you are right, but, if you have the patience, keep reading. Enjoy the somewhat diffuse anecdotes and observations in the first few chapters until you reach the author's straightforward presentation of his case that the U.S. financial system is at risk from complexity and tight coupling. The book would have benefited from a slightly fresher take on the financial crises of the last three decades. However, given the author's years as a risk manager on Wall Street (Morgan Stanley, Salomon Brothers, Citigroup) and as a hedge fund expert (Moore Capital, Ziff Brothers, FrontPoint), his personal experience during fiscal crises and his close view of dramatic turns in the market, getAbstract finds that his diagnosis of systemic problems conveys several important stories and that his analysis deserves your attention....more info
- Pretty complex, but interesting
There were a lot of interesting side stories. In fact I liked them better than the financial stuff. Great context for blow ups in markets. A little too much technical detail for me in the long run....more info
If your interest is first person experiences told by "I this" and "we that" relating to events that are stale and bear little relation to the title of the book, then this text is for you.
Filled with cliche and innuendo Bookstaber does little to address the issues of hedge funds today. There are powerful lessons to be learned from the past yet the author draws no conclusions from investing in the 1980s and 1990s to the proliferation of hedge funds today.
The one steady commentary running through the book is liquidity and its importance to functioning markets. If you have a reasonable knowledge of markets you will learn little from this book. In story after story after story there are no conclusions reached that could help the hedge fund or private investor today.
And who, by the way, edited the text. There were numerous textural errors where sentences had been restructured but words and text left dangling. Wiley should go back and fix the errors and re-issue another edition.
In short, a true disappointment. Judging by the length of some of the other reviews it is clear Bookstaber enlisted some of his academic friends to write ridiculously detailed reviews to juice the ratings. After all, the ratings system is an inefficient mechanism to drive book sales (the market) and one would expect him exploiting this defect....more info
- Only a Matter of Time
The premise of this book is definitely interesting: the financial products introduced into the market in the past few decades have become too complicated for our own good. But the book seemed more of a history lesson in finance in the past twenty years than a warning that we are setting up our own economic demise. Yet, it's a worthwhile history lesson, especially upon the tail of what we have seen the subprime and collapsing MBS market do to the markets. The book highlights the ups and downs of the financial markets since the 1987 crash, as told by one who witnessed it all occur firsthand. Bookstaber assumes that the reader has a certain level of understanding of finance and complex financial products and provides excellent examples of how increased regulation and safety procedures actually led to more problems and human error once the emergency that was sought to be prevented by the safety measures occurred. The bottom line: we are not better off if we can squeeze every last dollar out of some financial product. The markets and financial engineers should focus on what they know works, is understandable and simple. Otherwise, a crash bigger than one we have ever experienced before is bound to happen....more info
- Crash of 1987
Portfolio insurance created a new form of investment strategy opportunity. Portfolio insurance is design to protect a portfolio from dropping below a prespecified floor value. The strategy works by hedge - selling S&P 500 futures. If the portfolio increases in value and moves above the desired minimum floor value, the hedge is reduced, allowing the portfolio to enjoy a greater fraction of the market gain; the hedger purchase an undervalued stock with good prospects of profit (innovation, market interest, or breakthrough technology) and combines a short sell of a related security, in the case the market goes down. The short sell allows short term gain, offsetting some of the losses. The risk occurs for a catastrophic downturn when the complete market is experience a tidal wave of selling and buyers are reluctant to enter fearing "unknown" news may be known by the other buyers.
The trader hedges the risk by short selling (number of shares x price). "If the trader were able to short sell an asset whose price had a mathematically defined relation, a call option, the trade might be essentially risk less and be called arbitrage." Suppose two stock share a correlation X and Y.
A trader can borrow a security and sell it, a short seller. A short seller is used when the trader believes the stock will decline. A long seller is used if the trader believes the stock will rise in value. The trader owes the broker the monies for the security, who is hold his shares long; the broker seldom actually purchases the share to lend to the short seller. If the trader borrow 1000 shares of X for $10, he assumes a $10,000 loan, if the price of the shares drop to $8. The short seller would buy the 1,000 shares back for $8,000 and return the shares to the original owner, profiting $2,000. If the share price climbed to $12, a $2,000 loss would be realized.
Short 1,000 shares of X at $10
And Long 500 shares of Y at $20
Arbitrage insures the investor funds. The risk occurs if no market exists to hedge, a selling frenzy.
Oct 19, 1987, a severe imbalance of buyers and seller occurred where sellers of futures outpaced the seller of stock on the S&P 500. The price decline which usually would have been like a dinner bell for buyers, but the velocity of the price drop signaled for buyers to stay on the sidelines and await more information. At the end of the day, the S&P had dropped 22 percent and the futures market declined 29 percent.
Portfolio insurance program complicated the matter the downtick rule, which proscibes short-selling a falling stock. "The arbitrageurs wanted to buy the futures and sell the stocks short against them. If the market is in free fall...many short seller are trying to squeeze in their execution. It can take time to execute the trade. In the meantime, the long futures position is being held unhedged. If the market drops, the trader loses."
"When the S&P futures contracts sell for less than the price of the basket of individual stocks in the S&P; then the cash-future arbitrageurs buy the S&P and send in orders to sell the stock. If the price difference is greater than the transaction cost profit is guaranteed."
The arbitraguers caused large and long range effects that crashed the market. "The potential liquidity suppliers and investment buyers were being scared off by the higher volatility and wider spreads" With each drop the portfolio software trigger more selling, and portfolio managers threw more sell orders into the futures market" "By the time equity investors could have reacted to the prices and dones some bargain hunting the specialist had moved prices so precipitously that these potential liquidity suppliers were scared away."
- Want to understand the current financial crisis?
Bookstaber has written a cogent, understandable and witty guide to the structural and human underpinnings of the current financial crisis. While this book requires thoughtful reading, it does not assume that the reader is technically savvy about markets or the plethora of financial instruments that have come to have such a dramatic impact on U.S. and world economies. I unhesitatingly recommend this book to anyone wishing a deeper understanding of the problems that can and have been created by financial markets and instruments.
- Lightweight, a conversational biography, good
This is not a heavy theoretical work, contrary to some of the reviews here. This book is more of an autobiography along the lines of Barton Bigg's "Hedgehoging" (also pretty good) or something by Andy Kessler or Michael Lewis (excellent writers) but not as funny or good. But it gets interesting if you read it carefully: basically the author makes the somewhat implausible and incredible claim that the financial institutions that come up with exotic finanical products don't really understand these products themselves, or, equally incredibly, that they market simplistic versions of these products (that can fit on an Excel spreadsheet--however the author was talking about the late 1980s, so perhaps it's possible), or, more credibly, that even when these exotic financial products are used successfully, their profit potential only lasts a few years since they become widely imitated. The author closes with some interesting but speculative parallels between biology and financial markets, arguing that more looseness and 'slop' be allowed in a financial system, because if it is too "tightly coupled" and precise, too many things can go wrong. The analogy between the success of a cockroach, which filters information and is actually pretty simplistic, and a robust financial system is interesting. Interesting tidbits of history are thrown in, for example how primogeneture from the medieval ages prevented liquidity and thereby wealth creation (Peruvian economist Hernando De Soto would agree).
Also some good scuttlebutt is disclosed about various famous Wall Street personalities, and the clash of cultures between Citibank and Salomon Brothers, as well as the characters like Paul Mozer and John Merriwether [who seems to take disaster with him whereever he goes, as he ended up leaving Salomon for the ill-fated LTCM] that got Salomon into trouble in bond trading. For example, I did not realize that Salomon chief John Gutfreund lost a good part of his fortune as a result of the bond trading scandal.
Contrary to the subtitle, except at the very end of the book hedge funds are not really discussed much; this is more of a quant/ financial engineering book.
Insofar as writing style goes, it is easy to read first person passive voice.
All in all a good book you can finish in a few days, and it captures your interest....more info
I found this book very interesting and full of information I haven't seen elsewhere. A Wall Street "quant" insider's perspective, focused on what can and does go wrong. The author also ties his analysis of famous Wall Street tailspins to other notable failures, including Chernobyl and the Challenger, and finds common themes. ...more info
- Pretty complex, but interesting
There were a lot of interesting side stories. In fact I liked them better than the financial stuff. Great context for blow ups in markets. A little too much technical detail for me in the long run....more info
- A MUST READ for all financial markets professionals
This is an excellent book. I cannot say enough good things about it. Unquestionably one of the best books on financial markets of the hundreds that I have read. This book provides a ringside view of how the major banks and hedge funds work and why financial risks have become more magnified than before.
Derivatives, trading and hedge funds are here to stay. They perform a valuable service to the financial markets, though Warren Buffet will disagree with me. Nevertheless, it is the mis-use of derivatives and the excessive use of leverage that leads to financial disasters. This book provides an excellent insight into why we witness financial turmoil in some of the most liquid markets.
I strongly recommend it to all MBA finance students as well as to financial markets professionals at hedge funds, prop trading desks, risk managers, quants, bankers, pension fund managers....more info
- excellent overview of risk management
I really liked this book. It is easy reading and offers the best coverage I have seen of sources of financial risk. I bought the book mostly looking for insight into the current financial crisis, but I found much more that I can use well beyond the latest fiasco....more info
- A must-read
Bookstaber's "A Demon of our own Design" shouldn't be missed by anyone interested in what is going on in the financial markets today. His many years leading the risk management areas at top financial firms gave him a vantage point that he openly shares with his readers. His main topic is centered around understanding the volatility of an increasingly complex, tightly coupled global financial system as there is in place today.
I only wish I had read this book before the big market unwound earlier this year. He called the risk of the 2008 financial markets meltdown at least a year before events occurred. He was very close to the action during all financial crisis of the past 25 years, including 1987, LTCM and 2001/3. The lessons learned and the trend identified between these crisis leads to a coherent proposition on understanding risk that is both innovative and useful for the average investor.
A final comment on style: the book is very readable, even entertaining. This is no small feat when you cover dry and tedious topics such as risk management. He pulls no punches; is articulate and accessible even to the non-financially savvy reader.
Hope you enjoy and learn from it as much as I did....more info
- Fascinating book...well worth the read
I found Rick's book fascinating. For a Ph.D from MIT, I thought he did a great job communicating issues less sophisticated readers could understand. He walks you through his career from Salomon Brothers to the Hedge Fund World, he shares his mistakes as well as his colleagues, and he invites you to learn from his foresight of financial modeling products; then his hindsight of financial engineering on Wall Street and its ramifications in the world. Well worth the read. ...more info
- A book for my Son
This was a Christmas present for my son. It arrived in a timely manner and was in terrific shape. Two thumbs up!!!...more info
- A Warning about market risk.
This book is mostly devoted to the author's career in risk management of hedge funds and the like. The author warns against the present complexity of our financial system because of leverage, hedge funds and derivatives. He states that the current complexity and increasing complexity makes it a more dangerous place to invest. Unfortunately he provides very few answers for the investor to protect himself ....more info
- Eye Opener on how our Present Markets Work
As a stockbroker for the last 25 years, it has become ever more clear that our markets (both equity and fixed income) are increasingly driven by the activities of the big traders (hedge funds and investment banks). But what is driving their trades? What are their systems? What are they thinking? Bookstaber's book answered many of my questions, illuminating the world of hedge funds. This book sheds light on the market crises of the last two decades (the 1987 crash and Long Term Credit) and essentially predicts and explains the present subprime loan fiasco and private equity crisis. This is the best, most useful book I've read about our current markets. It's quite readable to boot (though the language is not simple). Bookstaber has the unusual gift of making the complex understandable if not simple. So, at the end of the book I understood "statistical arbitrage", portfolio insurance's mode of operation, and the central importance of liquidity in today's markets, and even, by way of bonus, Heisenberg's uncertainty principle....more info
- Treatise + autobiography + payback of former colleagues
Extremely well-written and thought-provoking. The author has a wide range of interests and knowledge, from yield curve behavior to cockroach survival traits, and explains them all lucidly, simply and in an entertaining and practical manner. He has a deep understanding of the workings of the financial markets, and shares several unique perspectives in this book which I have not read elsewhere, and it is extremely valuable for that reason alone. He is one of those rare geniuses who can keep his autobiographical urge to an interesting, useful and entertaining minimum, only mentioning his personal experiences when they provide insights into larger themes (cf. Black Swans). The author does occasionally use the book as a platform for payback to former colleagues who have done him wrong, but this is done with a stiletto, not a blunderbuss, and is fun to watch. Always well-written, occasionally entertaining. Very highest recommendation....more info
- A well written -- and, it turns out , prescient -- look at the markets
This book has become a must-read for people I know in investments, so I decided to read it. And I thought it was great.
Bookstaber ran Morgan Stanley's portfolio insurance, the market "innovation" that ushered in the Crash of '87, oversaw risk at Salomon when "Salomon North" (aka LTCM) failed, and up until recently ran a quantitative hedge fund. It looks like he's seen it all and has been in the middle of most of it. He has taken that experience to create an argument for why we see the sorts of market crises that we are embroiled in now. And what to do about it.
To top it off, it is readable by a non-professional and entertaining with a peppering of personal experiences. ...more info
- The Wisdom of the Cockroach
In recounting his time as risk manager at a number of prominent houses (Morgan Stanley, Salomon Brothers, Citigroup etc.), Bookstaber completes the i-banking trifecta. First there was the Michael Lewis classic, Liar's Poker, detailing the juvenile bravado and macho antics of the trading floor. Then Jonathan Knee gave an intimate portrait of the i-banker deal making culture with The Accidental Investment Banker.
And now, in A Demon of Our Own Design, we get a glimpse at the risk management side of things... a sort of master plumber's walking tour through the bowels of the system, with technical descriptions of exactly what happens when pipes burst and boilers explode. (Some will find Bookstabers' level of detail intolerably dull; others will find it quite fascinating. I was in the fascinated camp.)
Nature of the beast
In describing the finer points of risk arbitrage, Bookstaber explains why it's normal -- expected even -- for trading desks to take a good whack every so often. The nature of the beast is to make relatively steady profits, month in and month out, and then give back a chunk of those profits when something goes haywire. (That's how you move huge sums on an arb desk; grind out small bets that are almost guaranteed to work, juice up the returns with leverage, and try not to be in the vicinity when the rare position goes kablooey.)
In light of this general modus operandi, perhaps it isn't surprising that the "quant" funds recently took a major hit (as of September 2007). They had been minting money for an extraordinarily long period, had the leverage to show for it, and now, after the recent "oops," seem to be generally back in business.
In fact it appears natural for much of Wall Street to work in this "make a little, lose a lot" fashion... the key idea being that all the little updrafts make up for the once-in-a-blue-moon downdrafts. (Such calculus works better for the fee collectors than the fee payers, but that's a different kettle of fish.)
Bookstaber's detail-rich description of the various trades that investment houses put on, many of them lasting years, is also enlightening. The details seem to confirm that, by and large, Wall Street is a gigantic, slow moving, conventional-returns type machine. (And what else could it be, really, with such an ocean of capital to allocate and so many jobs to fill? There is only so much creativity and contrarianism to go round.)
A dangerous combination
Risk manager war stories aside, Bookstaber's goal is to hammer home a key philosophical point regarding risk. He wants readers to understand that financial markets are inherently unstable, and this reality places limits on how far we (or anyone) should go in pursuit of outsized returns.
To make his point, Bookstaber uses various analogies to describe how the market is a highly complex, tightly coupled system... and to explain why the combination of high complexity and tight coupling is particularly dangerous.
The counterexample Bookstaber gives of a highly complex, loosely coupled system is the US Postal Service. The USPS has countless potential points of failure and myriad moving parts, but there are no catastrophic linkages involved. A lost package does not set off a disastrous daisy chain of events in which millions of packages are lost.
In contrast, the classic example of a highly complex, tightly coupled system is a nuclear reactor. The reactor is tightly coupled because any point of failure can lead to a knock-on chain reaction; one small thing going wrong can set the entire mechanism on a path to disaster. Being a highly complex, tightly coupled system, the market is less like the postal service and more like the nuclear reactor, in that the combination of aggressive leverage, complex methodologies and heavily interlocking parts leads to significant potential for catastrophe.
Another serious problem is Wall Street's deeply ingrained tendency to push the envelope. (Richard Lowenstein put it exceptionally well in his book Origins of the Crash: "Finance has its own Peter Principle, by which a successful model will be adapted to progressively riskier causes until it fails.")
In this habit of fighting for every inch of profit, Wall Street is like a self-evolving animal overquick to embrace the particulars of its immediate environment. The more precisely an animal is attuned to a particular "fitness landscape," the better that animal can thrive... in the short term at least, as long as everything stays just so. To be exquisitely adapted (as opposed to robustly adapted) is to be vulnerable to the slightest change.
Thus when the fitness landscape DOES change -- as it inevitably will -- the heavily specialized competitors tend to get crushed (if not go extinct). If a strategy-gone-sour broadsides a large enough group of market participants, the entire financial ecosystem can be thrown into turmoil. When the turmoil from this upheaval spills into the broader economy, wreaking havoc in its wake, the "demon" spoken of in the book's title is unleashed. (As this reviewer interprets it anyway.)
Wisdom of the cockroach
So the problem, in sum, is Wall Street's tendency to `overadapt' to every appealing landscape it encounters, building up complexity and leverage to dangerous levels in doing so.
Bookstaber's suggestion is to heed the wisdom of the cockroach.
The cockroach has survived a longer time span, and a wider variety of harsh environments, than humans could ever match. It is one of the creatures man cannot wipe out no matter how hard he tries. And yet, the cockroach's key risk management strategy is embarrassingly simple... simpler, even, than putting in a stop loss. The deeper point is that simple equals robust; by refusing to get fancy, and sticking with the tried-and-true, the cockroach ensures its reign as champion survivor.
Bookstaber uses the cockroach (and other examples from nature) to argue that we, too, should consider cutting back on our excessively specialized ways. The cost of a rough-edged strategy is forgoing excess profits in accomodative environments... but the benefit is increased likelihood of survival in a much wider range of environments, including the truly harsh ones. (As Jim Grant likes to joke, if so many of these credit-driven vehicles can barely handle prosperity, how are they supposed to fare when adversity hits?)
Harrumphs all round
Bookstaber's finger-wagging solution (be less fancy; take less risk) has the ring of common sense to it, especially in the way it frustrates all those market participants determined to have their cake and eat it too.
For those who seek to wring every last nickel out of the market (as LTCM used to brag of doing), Bookstaber argues persuasively that flying too close to the sun will always be perilous. The commitment to leveraging every edge on a broad scale inevitably leads to disaster-prone configurations, no matter how smart the players.
For those who think the answer is greater regulation of markets, i.e. more rules, Bookstaber shows how extra layers of bureaucracy can actually bring about the exact opposite of the intended affect. Perversely, layers of red tape can (and often do) make a situation more risky, by increasing confusion and complacency simultaneously.
Nor is greater information disclosure the answer. If the market's traditional liquidity providers (traders, market makers, speculators etc.) are forced to disclose their positions to the world in real time, they will react in the manner of poker players forced to play their hands face-up. To the extent that disclosure resolves uncertainty, it also drives market participants from the game. And because "liquidity is a coward" as the old saying goes, always running away when you need it most, strict disclosure rules would likely make bad market conditions worse at the least opportune times.
Some left smiling
Two groups in particular may be left smiling at the end of this book -- value investors and trend followers. In both the theory and practice of their normal operations, value investors and trend followers intuitively embraced Bookstaber's message a long long time ago, favoring longevity and robusticity over the temptations of adjusting to the moment.
It is perhaps not surprising, then, that value investors and trend followers are arguably the most profitable market participants by far on an absolute-dollar basis, hauling in hundreds of billions in profit over the course of many decades. They are champion survivors too... with a touch more class than the cockroach.