Miscalculating risk in housing, credit

P&I round table panel: Investors didn't heed lessons from the tech bubble's bursting

120808 roundtable
Participants in the round table (from left): Leslie Rahl, Cliff Asness, Bennett Golub, Peter L. Bernstein and Harrison Hong.

Institutional investors — when it came to risk management — took their eye off the ball, even after the tech-stock bubble burst in the early part of the decade, according to a risk management round table assembled by Pensions & Investments.

“People felt this was a low-risk environment,” which encouraged them to take high risks, said economic historian and consultant Peter L. Bernstein, founder and president of Peter L. Bernstein Inc., New York., arguing that such complacency led nearly everyone to ignore all the warning signals that the housing market was throwing off.

But for many money managers, getting out of the market too soon was equally fraught with danger. “(If you take) less risk, you can look like an idiot for quite long enough to be put out of business,” said Clifford S. Asness, managing and founding principal of AQR Capital Management LLC, Greenwich, Conn.

Indeed, as Leslie Rahl, president and founder of New York-based Capital Market Risk Advisors Inc., pointed out: “I don't know how to make money without taking risk, so risk unto itself isn't bad.”

But given the scale and depth of the market bubble, panelists at the “Picking up the Pieces” round table found it hard to overstate its aftermath. “It certainly is a big mess,” said Bennett W. Golub, vice chairman and head of risk and quantitative analysis of BlackRock (BLK) Inc. (BLK), New York.

Mr. Golub attributed the credit market chaos to a variety of reasons, including the increasing complexity of financial products and the dependence by many investors on other investors who specialize in specific products like mortgage-backed securities to determine the appropriate and fair pricing of those products. Thus, “when the shock occurred, we ended up in this sort of massive liquidation,” he explained.

Ms. Rahl added: “The fact that people were not holding to maturity significant pieces of the products they were producing created a different set of incentives and a different set of ways of doing business that have hurt us badly.”

Harrison Hong, the John Scully '66 professor of economics at Princeton University, Princeton, N.J., said he thought innovation, also known as financial engineering, provided overconfidence that investors had conquered risk, leading “very, very smart guys” for the first time to take “too much leverage” on what seemed like safe securities.

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Financial weapons?

Using derivatives to crank up the leverage in portfolios became popular during the real estate bubble's expansion and P&I's panel debated whether derivatives were, as Warren Buffett, chief executive officer of conglomerate Berkshire Hathaway Inc., Omaha, Neb., famously labeled, financial weapons of mass destruction.

“I don't think they are weapons of mass destruction in general,” Ms. Rahl said. “However, it's like giving a 16-year-old a Porsche. They are not for everyone, and certainly the newer-fangled ones that have been created, especially the credit default swap market, have some characteristics that can be very troublesome if not managed well.”

She added that she advises clients to spend more time on due diligence and risk management on investments that are complex — whether or not they are derivatives.

Derivatives might have made markets and investments more linked, but the fundamental problem that led to the crisis, according to Mr. Hong, was that “a lot of banks made a lot of bad loans.”

He added, however, that derivatives might have led investors to take more risk than they otherwise would have because of a false sense of the risk involved.

Mr. Asness was more aligned with the investment tycoon. Derivatives are “maybe not mass destruction, but (they are) an effective weapon,” he said, adding, however, they also are “not necessarily a bad thing” because they give investors a way to bet on something.

“The key was things got way, way overvalued,” he added. “Derivatives are largely (what) lost. They're redistributing what's going on. And maybe they made us overconfident and maybe they did lead to a somewhat larger bubble, but that's innovation.”

Without mincing words, Mr. Golub argued that investors need to distinguish between derivatives as risk transference tools and derivatives as obfuscation tools.

“You can make a whole lot more money basically ripping someone off by selling them something that they don't understand than you can by trying to make markets complete or doing transactions,” he said.

Neither investors nor money managers debate the question of whether the housing market was a bubble. In fact, “you can make a lot of money riding bubbles,” Mr. Golub said, pointing out that the trick is to know when a bubble is going to burst. That, panelists agreed, is not science but art, and thus is not so easy to figure out.

“You just need to know when to get out of them,” Mr. Golub said.

Indeed, in Ms. Rahl's analysis: “There was a lack of awareness of the amount of risk that people were taking” and thus their ability to know when to get out.

The panelists agreed that one problem was that investors failed to learn from recent history, underestimating, for example, the tech bubble of the early 2000s.

“We came out of the tech bubble, things were kind of fine, and in some ways you would have thought the technology was pretty great coming out of the tech bubble,” Mr. Hong said, suggesting that while “it's not even clear it was a bad thing,” the bursting of the tech bubble did inflict damage on investors.

And so with real estate, as prices rose and the housing bubble inflated, investors lost sight — if they ever had it in the first place — of the risks that came along with that inflation. Wall Street financiers, with their eyes firmly fixed on profits (and bonuses), took advantage of that and created the plethora of real estate-related products that few could understand and then leveraged those to extreme levels.

“Where it might look like ruin now,” Mr. Golub added, “it was a free ride.”

Black swan

One common question is whether the market collapse represented a “black swan,” as defined by Nassim Nicholas Taleb in his 2007 tome — “The Black Swan: The Impact of the Highly Improbable.” Mr. Taleb's black swan is an unpredictable event that has high historical impacts and yet was predictable in retrospect.

“I don't see (the tech bubble, the real estate bubble and the ensuing collapse) as three independent black swans, (but) collectively as a group they are a black swan,” Mr. Asness added. “It's not (been) a normal decade.” Still, he said he thought the equity market is now returning to “normal.”

For the last 15 years, Ms. Rahl has kept a chart on “once-in-a-lifetime crises.” The problem, she said, was that those crises seemed to be occurring every three to four years. After the real estate bubble burst, she crossed out years and put months. But now she's thinking of crossing out months and putting weeks.

Mr. Golub completed the metaphor with a touch of humor: “If you look at the world from the credit markets ... we think that there's a flock of black swans that are doing nasty things to our lawn.”

Mr. Hong, however, thought the crisis becomes less extraordinary when viewed in a historical context. “If you took the totality of all the evidence ... it's not so clear to me that you would label kind of what we're going through as all that sort of abnormal,” he said.

Mr. Asness pointed out that investors typically have short memories and any lessons learned from today's crisis might soon be lost, though risk management is likely to remain a focus for some time to come. And investors aren't likely to forget about 2008 as quickly as they forgot about, for example, the crisis surrounding the collapse of hedge fund Long Term Capital Management in 1998.

“This feels a lot worse than 1998,” Ms. Rahl said.

Pointing out that “the Great Depression scarred at least a generation about equity,” Mr. Asness said investors' collective memory is likely to linger for years, potentially keeping them largely out of the stock market during this period.

“It's not just equities; it's trust,” Mr. Bernstein added. “I mean, the financial system cracked apart, and the financial system depends on trust, and building that back up can't happen fast because you won't believe it if it's fast. You believe it only if it takes time.”