Tuesday, August 07, 2007

Risk Week: When Is A Market Not A Market?

As I devote this week's posts to the topics of risk, and risk management, I want to discuss the question,

"When is a market not a market?"

There are two fundamental assumptions which, when they fail, effectively turn a market into something that is not a market- and does not function like a market. Those two assumptions are: that buyers and sellers always exist for each other, and that pricing is continuous.

These failed in 1987, according to a then-friend of mine who was a very successful asset manager at a major firm. They failed three times in early 1987, on the way up, when the market was peaking, and fills took place at prices higher than those thought to be the execution price. As he wryly noted, nobody complained at that time.

Then, in October of that year, they failed again, this time on the way down. Way down.

People traded, not knowing for days what the actual price at which they sold was. And prices didn't move in small increments, as specialists deserted their functions.

Prices skipped downward, discontinuously.

Further, in panics, markets fail in terms of liquidity. There are not buyers and sellers present to 'make' the market. Again, specialists in equities step back. And in debt markets, bids simply vanish.

The whiz kids of today don't recall LTCM in 1998, much less the crash of 1987. They do not realize that, in a crisis, a panic, the "market," as we conceive of it, vanishes.

Bids fail to materialize. Prices do not move continuously, especially for esoteric, non-listed instruments.

This is, in my opinion, key. So much of the trouble invariably begins with thinly-traded instruments and/or derivatives thereof. One-off CMOs, CDOs, their derivatives, derivatives based upon some proprietary index.

It seems that many trading desks, risk managers, and hedge fund managers either were unaware of, or forgot these phenomena. When markets stop being markets, and become something else, all hell has effectively broken loose in the OTC market where so many esoterics trade, as well as in the more thinly traded listed instruments.

Happy to book profits on originating, distributing and/or trading these esoterics, Wall Street firms suddenly realize how risky they can be at times of lessened liquidity.

In my opinion, this is where a number of interacting phenomena combine to cause major problems.

Few traders remain traders into their forties. Thus, most on a desk at any given time may have no more than ten years' experience. Risk managers are likely similar. Promotions for both tend to lead them off the floor, into senior management, or into other firms, perhaps at hedge funds.

Thus, with each new crisis, the frontline troops are largely untested, and the experienced managers are slower to see the new problem unfold, and are often unfamiliar with the details of the source of the latest debacle. Thus, when all is well on the way 'up,' managers don't think to ask or check that a desk trading mortgage CDOs is in a position to be passively hedged, in the event of a meltdown, so that losses are minimized without the need to trade through non-market periods in which bids vanish or skip around.

Besides, hedging limits profits. Who wants that? It puts a lid on bonuses, doesn't it?


And there you have your new financial instrument crisis. The new whiz kid traders, risk and fund managers think they have it all controlled via quantitative programs. But they fail to account for the inability to even trade a portfolio during the time when asset values are plummeting, if there is a recent market value at all.

And this is, in my opinion, how and why we repeat these types of instrument-based financial market failures every decade. It simply doesn't pay for the adults to bother building in safeguards because, as the Wall Street Journal noted in an article lately, bonuses are short term, but the risks held in portfolio are longer term.

When individuals are paid upwards of $3-4MM annually, the loss of net worth due to the decline of their firm's stock's value is a lot less painful than most people realize. Coming atop a cushion of tens of millions of past compensation, it simply isn't a sufficient incentive to curb current excesses- ever.

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