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 Inc., 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.