Customer Reviews

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation

5 star:		(33)
4 star:		(21)
3 star:		(10)
2 star:		(3)
1 star:		(1)

 

 

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.

Exquisitely adapted

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.

This is an entertaining account of 25 years of financial disasters by a smart insider who is also a keen observer and witty storyteller. Some authors take simple ideas and cloud them with hairsplitting definitions and complex equations, real mathematicians like Bookstaber effortlessly work in deep concepts like sufficient statistics and state variables without any equations or formal mathematics.

The best part of this book is the context. If you read books on individual disasters the situations come across as complex and the people as tragic geniuses. If you read the one paragraph versions favored by the business press, the underlying trades seem impossibly simple, and the protagonists seem to be morons. This book shows the euphoria of winning trades when money flows in like magic, and the confusion and shock that result from unanticipated losses. There are many reactions to these losses: cut them quickly, ride out the storm, even double up the bets. Each of these sometimes works and sometimes makes the situation worse. Only after reading all the permutations and outcomes can you understand the stark choices posed as the disasters unfold. The players are neither idiots nor geniuses, they are smart but ordinary people, facing understandable human dilemmas.

This context is precisely what is missing in the chapter on engineering disasters. If you look only at disasters, when by definition all the safety precautions failed, it's no surprise that you'll conclude safety precautions are worthless. If you only look at the most dramatic disasters, it's no surprise you'll conclude that the most ambitious, advanced, complex and tightly-coupled systems are the most prone to catastrophe. Bookstaber relies on writers I call the dismal engineers. I think optimists like Duke civil engineering professor Henry Petroski have more to say to financial risk managers. Petroski wrote "no one wants to learn from mistakes, but we can't learn enough from successes to advance the state of the art."

The chapters on biological, mathematical and quantum mechanical limits on rationality are interesting speculations. Bookstaber appears to know, or perhaps to care, more about these fields than about engineering. However even in these cases his thesis is not entirely convincing within the realm of discussion, nor is the analogy he wants to draw to finance compelling. There's another good book (or three) in these ideas, this book gives only a taste of the arguments.

Despite being a very smart guy with a quarter century of experience in cutting-edge trading, Bookstaber cannot overcome the disadvantages of being trained as an economist, especially an MIT economist. In the final analysis, he believes risk is bad. Trading is defended as socially useful when it provides liquidity, when traders exploit pricing discrepancies caused by short-term supply and demand forces. These traders stabilize the market. But at least half of trading is trend-following, which exacerbates pricing discrepancies and sucks up liquidity, destabilizing the market. To a University of Chicago finance guy, these are symmetrical market forces, both good. Bookstaber correctly points out how financially-supplied liquidity ushered in the Industrial Revolution by converting frozen wealth to dynamic capital. But he doesn't mention the momentum traders who forced prices quickly to their eventual equilibrium, sweeping aside those who try to stand in the way of progress. This is the creative destruction of capitalism. Economists are comfortable with the markets facilitating real economic decisions, spreading the inherent risk among willing investors. They are less comfortable with the market forcing real economic decisions, creating virtual risk and imposing it upon unwilling actors.

This anti-risk bias shows in the account of Tulipmania and the reflexive comparison of financial disaster to engineering disasters. No one died at Long-Term Capital Management. It's true that some financial crises, like the 1997 Asian Crisis, impose human costs, but financial crises are virtual, and therefore less harmful than the same degree of failure with physical economic experimentation, and far, far less harmful than the retarded progress if experimentation is slowed. Bookstaber celebrates the liquidity provided by a shrewd swimsuit retailer who anticipates fashion and supplies her customers' demand without excessive price increases. Nowhere does he mention the businesses that create fads, including swimsuit fashions, and thereby the need for liquidity providers. Economists like businesses that respond to exogenous consumer preferences, they have trouble with businesses that manipulate consumer preferences. But both are needed for successful dynamic economies.

None of this takes away from the fact that this is an entertaining and insightful book, essential reading for people interested in financial risk. I disagree with Bookstaber's conclusions calling for slowing market innovation and trading, but I think these are preconceptions from his early training rather than the result of his experiences since.

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.

Just a warning - if you don't know what LTCM stands for or have never heard of a "swap spread", you may want to read some other books first - Peter Bernstein's book on risk, or "When Genius Failed". The title is somewhat of a misnomer - this is more a collection of Wall Street war stories than an explanation of modern financial instruments and innovation. If you have the background to follow it, though, it is entertaining and scary.

I had the chance to read Richard Bookstaber's new book "A Demon of Our Own Design" recently. Bookstaber touches on some rarefied territory with his Market memoir. Bookstaber is very open about his roles in designing and pricing derivatives. He believes that some of these derivatives facilitated the Crash of '87, and the collapse of LTCM in '98. Most of his commentary reveals examples where liquidity, the blood of trading, simply disappeared during a financial crisis. Given that the entire treatise is written historically, we are left wondering, who is holding the bag in today's Markets? Is it hedge funds themselves for taking on excess, undefined risks? That question is open. Bookstaber asks questions about Markets today- is risk alive more than ever? The general Market opinion seems to be that the Fed will always bail out these types of financial entities. At least we can have confidence in Bookstaber's assessment and risk in todays markets, as he continues to run a firm called FrontPoint Partners, bought last year by Morgan Stanley. For a more thorough review of Bookstaber, read "A Street Pioneer Fears a Blowup" in the Friday, May 18th Wall Street Journal.

In this book, Richard Bookstaber argues that complexity in the financial markets is an unfortunate evil, a consequence of ever more customized investment and hedging solutions. Unlike in other areas, innovation in finance does not make things safer, but instead more complex and hence more dangerous. Complexity by itself is not always bad, but combined with what Bookstaber calls "tight coupling," which means that all steps of a process are interlinked and dependent on each other with no slack, it makes for "normal accidents." Normal accidents are events that we believe to be incredibly rare - yet they occur much more frequently than expected.

How do we battle this problem? Bookstaber argues that more regulation and more transparency are both poor solutions. Regulation only increases complexity, further escalating the problem, and transparency leads to other various problems that stem from limitations of knowledge. Unfortunately, Bookstaber does not provide a clear solution. He believes we need to slow innovation in finance to reduce complexity and reduce leverage in order to give more slack to the system and hence help alleviate tight coupling. However, I don't see these as practical courses of action. Reducing complexity means being less responsive to clients' needs - something firms will never do in this industry. Reducing leverage means smaller returns, again something that the investment community overall is unlikely to agree on. Perhaps some regulation on leverage may be helpful, but hedge funds fall outside of common regulatory rules - and they have become a force to be reckoned with.

The book follows mostly a chronological format, from Bookstaber's early days at Morgan Stanley and Salomon Brothers to Ziff Brothers and Moore Capital. At Morgan Stanley, Bookstaber was involved with portfolio insurance, which was one of the major causes of the October 19, 1987 market crash, creating a downward spiral of selling due to dynamic hedging. At Salomon Brothers, Bookstaber encountered a culture totally different from that described by Michael Lewis in Liar's Poker - things have changed to a much more strict and controlled environment, one much less willing to take risks. Bookstaber describes several failures in risk management at various firms (Leeson at Barings, Jett at Kidder Peabody), and moves on to discussing merger arbitrage at Salomon, touching a bit on Jack Grubman and finally the purchase of Salomon by Sandy Weill and Citigroup.

Bookstaber spends some time describing LTCM and how it got into trouble (see When Genius Failed), and moves on to speaking about hedge funds in general. He defines hedge funds as the universe of all possible investment strategies minus the tiny slice of traditional investments. He discusses the efficient market hypothesis and explains why it doesn't fit with reality - due to liquidity constraints and the tendency of humans to have various risk preferences. He loves the concept of a cockroach, which ignores most of it senses and listens to a very simple fight-or-flight instict. Bookstaber believes this has allowed the cockroach to survive for so many millions of years. I am a bit skeptical of the argument, as it dismisses many biological issues, but it is entertaining none the less. Bookstaber thinks that we can adapt the cockroach approach to the financial markets and listen to our most basic instincts more often.

Being the risk management guru, Bookstaber also discusses how he feels risk management should be changed. He thinks it needs to be less complex and less overburdened by company politics and organization (as it was horribly so at Citigroup). Additionally, he believes that risk managers need to spend less time on known risks and invest more time looking towards unseen risk. This is somewhat paradoxical, since the whole concept of unseen risk is that... it can't be seen/predicted, but I do get the point. At the end, however, Bookstaber says that risk management is what it is - and we just have to learn to live with it, which is somewhat disappointing after his earlier ideas.

In conclusion, I really enjoyed the book. It is well written, easy to read, and provides a ton of excellent examples and history. At times, I felt it was a bit too philosophical for its own good. For example, Bookstaber spends a long time discussing the limits of knowledge (Godel vs Russell, Heisenberg vs Laplace, Lorenz's butterfly effect vs all future-prediction attempts), and it feels very Taleb-like, although much less annoying. Overall, however, the book provides a fresh way to look at risk management and some of the major recent crises. Bookstaber spends a long time discussing hedge funds and what they mean to the markets, and I particularly liked his brief ranting session on the obsolescence of modern accounting methods (including mark-to-market accounting).

Pros:
+ easy to read and understand, very well written
+ contains an excellent preface that addresses the current market crisis with concrete solutions
+ fresh views on accounting being antiquated and on the market NOT needing more transparency and regulation
+ fantastic examples, stories, and case studies
+ good discussion on complexity and tight coupling
+ interesting insights on hedge funds and their future
+ a tremendous amount of history to learn from

Cons:
- sometimes a bit too philosophical for its own good
- a lot of repetition scattered between chapters
- some of the suggestions seem too general and impractical

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.

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.

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.

As the title of my review suggests, this book has great stories from a great insider. I am only in my 30s but already have 12 career years on the sell side of Wall Street. If I were captain of a Wall Street team, I would choose Bookstaber first. After reading this book my insight of the inner annals of opportunistic proprietary, arbitrage and hedge fund trading is drastically realized. Nevertheless, I found the pre-tense hype of the book leading to an unrealized end. Let's talk about the book:

Before reading the book, I thought the modern day global coupling of highly leveraged derivative strategies would be identified with respective consequences. It took me to almost the last chapter to realize this wasn't going to happen. The book was ripe with timeless stories of innovation & disaster. Bookstabers stories and recollections were an important piece of a puzzle put together by countless other books and reports. Richard's career is fascinating and he belongs in the Hall of Fame of Wall Street maybe for reasons other than why Soros or Buffet would be there. I could almost hear Richard's voice in his first person authorship and appreciated his consistent tone. I only wish the book followed the stories with modern day references, respective leveraged strategies and how Richard thinks they can blow up. I guess you can say he laid out foundations which we could apply to modern day wind-up bombs but this isn't enough.

The stories stop midway through the book where the biggest beef can be found. "The interplay of complexity and tight coupling that comes from combining liquidity with its derivative and leverage offspring is a formula for disaster." Alright! Let's start talking about carry trades, relative value in a razor thin risk premium environment and a synthetically low yield curve due to foreign reserve buying! It doesn't happen. The book goes mostly academic, albeit for lehmans, by laying out several caricatures, analogies and non-financial historical events which all masterfully lead to his arguments of what is bad and why it can go wrong. Bookstaber truly does a great job doing this at the expense of providing modern day meat.

Accepting the book for what it is, and putting it on the "great read" bookshelf, my closing thoughts were somewhat open ended. Having bought into Bookstaber's arguments and premise, I wanted to know what his personal long term investments are. Bookstaber's Wall Street career was purely focused on generating returns from everything that is not Fundamental and Long Term. His career was to capitalize on the inefficiencies and phenomena of our trading institutions, with either his firm's or other peoples capital, while the average Joe was using the same market to buy General Electric based on the American Dream. Bookstaber did not execute (or oversee) trillions of dollars over his career with the same long term objectives and beliefs his retail counterparts were piping to their clients. Bookstaber calls the players involved in this high-stakes corporate game "Liquidity Providers" rather than what they are, "Greedy." How can you claim that a proprietary trader is providing liquidity when these same individuals caused the '87 crash? How can you say a Liquidity Provider can be the cause of billions of dollars of losses because their game caused a downward spiral in our markets? I was a little disturbed when Bookstaber quoted Karl Marx in context of his innovation argument (which his argument aside of the Marx reference was right on the mark). I think Karl Marx's quote is better applied to why greater populations will lead more people to buy more tooth brushes; Hence why the stock market over the course of Dow charted history has gone up. Before I drift to far away on my soap box, I want to know more about the first person Author. If he believes a Liquidity Provider is good for capatilism, then what does he think is a good long term investment strategy for his family. I think this is only fair if we are going to judge his argument that high stakes speculative trading, hence liquidity providers, are a good thing.

Bookstaber is the best steward of Hedge Funds I have ever seen and unfortunately the book in the closing chapters became the coke bottle in the Tom Cruise movie. I found great value and belief in Richard's outlook for hedge funds as well his structure of how to categorize them. I just don't believe in the reality of his argument that a hedge fund manager will do better then his equal investment fund manager because of their greater flexibility to engage in unlimited risk transactions (i/e short). This argument mirrors the faulty assumption that greater risk equals greater return. In reality, risk is defined as losing money. I guess Murphy's law of, "What can happen will," is my premise here. I don't think Bookstaber is prepared to defend that a greater return will always prevail as a result of having greater risk flexibility versus the potential of greater loss resulting from greater risk taking. After all Wall Street loves to mask the geometric relationship of losses (To get back to par, you need a 100% return to cover a 50% loss). The restrictions of a common mutual fund manager might be the saving grace for an unsuspecting investor.

I am friends with a couple authors and know their addiction to "Amazon Rankings" and book reviews. If in fact Richard reads this review, I am humbled and only wish I could invite him to dinner. I will forever be a Richard Bookstaber fan and buyer of every book he publishes. I am sure his sons know how lucky they are.