From 1982 until 1987, the US stock market enjoyed a strong bull run. Against this positive background, seminal papers on how to set the price of an option – written in 1973 by academics Fischer Black, Myron S. Scholes and Robert C. Merton – became more influential.
“As scientists are beginning to discover, perfect storms are the result not only of God and nature, but of man. The same holds true for financial storms.”
An option in finance is a contract in which an investor pays for the right to buy or sell a stock at a specific date in the future for a specific price. Obviously, the party who gains or loses from this option relies on what happens to the actual price of the stock during the intervening period. Options themselves are an old idea, with a genuine value to certain nonfinancial businesses who use them to hedge against extreme price changes.
“A number of ‘flash crashes’ – sudden, sharp and seemingly inexplicable price movements – have been blamed on market manipulation, investor error and computer trading algorithms.”
The option-valuing models that Fisher, Scholes and Merton developed are important because they contributed to the thinking behind – and gave credibility to – a novel approach to stock market investing known as portfolio insurance (PI). In attempting to replicate the risk-reducing qualities of an option, this investment strategy worked by dynamically changing the proportions of assets within a portfolio or fund between those invested in equities and those invested in cash or “safe” assets.
“All these strategies and products seemed to offer a free lunch – the potential to reduce risk while increasing return.”
The theory was that investors could gain from rising share prices, but if the stock market were to fall, they could limit their downside risk by selling their equity investments and taking on a higher proportion of safe assets.
By the mid-1980s, the prospect of a heavily advertised chance to “lock in” the gains already made in a booming stock market, plus the opportunity for continued growth, was extremely attractive to investors, giving a further boost to the bull market. In 1987, most large financial firms offered portfolio insurance, and it had grown into a $100 billion business, equaling 3% of the total market value of US equities.
Portfolio Insurance Made the Boom and Bust Worse
In October 1987, the US Dow Jones Industrial Average started to wobble in reaction to rising base interest rates and other negative statistics on the US economy. This caused the PI funds to sell some equities and increase their holdings of cash or near-cash assets, as dictated by their option-replicating formulas. Due to the strategies’ design, a 10% drop in share prices would trigger the average PI fund to sell 20% of its stocks. The signs of a potential downturn spooked the markets, overwhelmed them with sell orders. Buyers were not able to distinguish between programmatic selling and the possibility that other investors had perceived a change in fundamental values.
“Many investors, concerned with elevated stock price levels and anxious to preserve the investment gains already under their belts, turned to portfolio insurance as a safety net.”
The “cascade scenario” caused by continuing rounds of selling and price drops in equities and futures revealed PI to be essentially a type of “momentum trading,” which exaggerates the booms and then the busts of the stock market. Advocates of PI strategies at the time cynically suggested that greater than anticipated volatility caused the crash of October 19, 1987, without acknowledging that their “free-lunch” strategies played a central role in that volatility.
- An Impressive Figure On the Hedge Fund Scene
Long Term Capital Management (LTCM) was an audacious and ambitious hedge fund set up in 1994. It benefited from the prestigious presence on its senior team of the Nobel Prize-winning Merton and Scholes, along with a former vice chairman of the Federal Reserve as well as other heavy hitters in the financial sector. Their status meant that capital poured in, and loans to LTCM to leverage its trades were abundant at its start. In its first three years, LTCM’s returns were impressive, garnering 20%, 43% and 41% returns on capital, respectively.
“In the crucible of the Russian debt crisis, LTCM’s strategies came apart, as trades that appeared to be uncorrelated on a fundamental level suddenly became highly correlated.”
Merton and Scholes’s groundbreaking theories on option pricing had offered up a whole new approach on which to base profitable hedge fund-type arbitrage trades. Central to LTCM’s business model was a combination of aiming for low risk and diversified trades while meeting a high-return target through borrowings that were larger than usual for hedge funds. One of LTCM’s main trading strategies was to go long (buy) the risky assets it perceived as undervalued and short (sell) the safe assets it considered overvalued.
“How could such a small part of the economy create such huge problems for the whole economy? The answer lies in the way in which the risk of mortgage lending…was extended and magnified via novel financial instruments.”
Its many strategies worked well at first, generating copy-cat behavior within the industry that often served to reinforce LTCM’s profits. The firm assured itself and its investors that, in theory, its bets were not correlated and therefore would be neutral during any big, disruptive moves in the investment world.
LTCM’s Downfall Shakes the Markets
The Asian financial crisis and the default of Russia on its debt started a serious ripple in financial markets in 1997 and 1998, which led to investors’ flight to safe US assets. These market pressures, pushing up the price of secure assets amid the sale of risky assets, was of course exactly the opposite of what LTCM wanted. Bond market volatility also left the firm in trouble, alongside other hedge funds that had sprung up during the 1990s. Although they had intended their strategies to be diversified, robust and low risk, suddenly all these funds’ numbers seemed to be moving in the wrong direction.
“Shifting risk does not eliminate risk, or even reduce it; it may actually increase risk.”
Other traders were aware of the giant LTCM and its positions, and they began selling in anticipation of its predicted forced sales. LTCM was in danger of collapse. Because it was such a big player, the Federal Reserve Bank of New York felt obliged to step in and encourage LTCM’s trading partners, investment banks and brokers to settle deals to avoid defaults and massive fire sales.
“It is time to declare that the efficient market hypothesis and the rational investor are dead, inasmuch as they are meant to imply consistently correct market pricing.”
LTCM’s grand view of itself as a sophisticated supplier of liquidity to the markets, for a fee, failed at the first mad dash to safety in a crisis. The firm had not accounted for the fear and panic that can grip markets when the rational formulas, which otherwise dictate the value of assets and the relative price of liquidity, no longer apply. It also did not help that many of the models used were allegedly based only on the previous four years’ worth of data, when there had been no market upsets. In a major oversight, LTCM had not considered the impact its own size would have on the markets in which it operated, especially on the reactions of other traders.
- Big Profits from the Mortgage Business
The 2008 subprime fiasco and credit crunch had wider, real-economy implications than the first two examples. The innovation of securitization – the repackaging and tranching of mortgage debt for sale to investors – plus the input of the US agencies Fannie Mae and Freddie Mac, increased the financing available to the residential real estate sector. But this was at a cost of deteriorating lending standards, as mortgage originators no longer had to keep on their balance sheets the loans they extended. The combination of securitization, with its supposedly risk-managing technology, and a history of low mortgage defaults generated a false sense of confidence among participants.
“Investors’ willingness to take the other side of risk-shifters’ trades vanishes quickly when investor hope turns into investor fear.”
The profits in the mortgage business motivated everyone in the financing chain to maintain and increase their activity, thereby feeding the housing price bubble. The highly structured financial products resulting from the securitized mortgage debt became ever more opaque and complex, while the three big credit rating agencies continued to award dubiously high ratings to these securities.
“Financial regulators, like generals, are always fighting the last war.”
Commercial banks, limited by regulation from taking on too much leverage, found the innovation of securitizing and passing on mortgage debt an attractive way to raise their lending capacity. As interest rates moved up and the volume of prime mortgage originations started to ease after 2003, the amount of subprime loans to less creditworthy borrowers increased to fill the gap.
The Housing Bubble Bursts
From the perspective of someone versed in financial markets trading, a mortgage resembles a put option on the price of your house. If the price of your home falls below the value of your outstanding mortgage debt on that property, the rational thing to do is to default and walk away from both. With subprime loans having done away with usual down-payment practices, and with home prices starting to drop, the act of defaulting and abandoning properties was no longer a shameful exception but a common occurrence after 2008.
“Regulators must understand not only the gist of the product or strategy itself, but also the ways in which it involves other market participants.”
The murky and complicated securitized mortgage products suddenly lost their aura of safety, and the flaws of the credit rating agencies became clear. The packaged mortgage assets might have contained some geographical diversity, but they had little heterogeneity in the years of their origination, which ended up being a correlating factor in the housing bubble. “The magic of tranching” turned out to be a fantasy. The most creative financial instruments, which were essentially a secondary level of bets on securitized mortgage debt, aggravated the toxicity of the subprime bust.
Patterns of Mistaken Notions of Risk, Liquidity and Leverage
Dynamics within each of these events – the portfolio insurance problem, the LTCM collapse and the 2008 financial crisis – created a “positive feedback loop,” which provided favorable results at first but then made the eventual negative consequences worse. The existence of portfolio insurance strategies encouraged a last wave of money into the stock market just before the 1987 crash, when investor sentiment was starting to lean toward the market being overvalued. Similarly, the subprime and securitization mania fueled home prices for a few more frenzied years after prime mortgage originations began slowing in 2003.
“The bottom line is, if an investment product or strategy seems too good to be true, it probably is – particularly if it is opaque, highly leveraged or appears guaranteed.”
In all three cases, the fantasy of a low-risk strategy caused market participants to increase their exposure and leverage their bets. But the final act common to all was one of cascading asset prices and fire sales due to forced unwinding.
And each time, investors labored under the typical “illusion of liquidity,” but they quickly learned that offloading risk when events do not go according to plan becomes impossible, as no calm and reasonable buyers are waiting to buy. Contained in the models of these supposedly low-risk strategies are assumptions that markets are a separate and independent entity whose values move incrementally up and down in a random and steady manner. In other words, these theories assume that markets are efficient and that investors are rational. The modelers also tend to neglect the fact that, as their money-making strategies become more widespread, they themselves make up a significant part of the market. They believe markets to be more linear than they really are, while it is the existence of their free-lunch strategies that often makes markets less straightforward.
Complexity, opacity and innovation might, at first, add to the mystique of the free-lunch strategy, but these features eventually foment uncertainty and a lack of confidence. The combination of “seemingly rigorous mathematics, plausible theory and early performance success” proves, time and again, to be a dangerously enticing cocktail. Leverage, and the narratives explaining how these strategies have managed risk, form part of the mix. Of course, free-lunch financial strategies won’t dupe savvy investors, but many market participants may be much too clever for their own good.