To understand the recent turmoil in the real estate and stock markets, you have to understand humanity's relentless efforts to harness risk.
People have been calculating risk since they dwelled in caves and, to be sure, risk-taking can be Darwinian. Imagine a cave man weighing the dangers of spear-hunting woolly mammoth against the need to eat.
Today's risk-taker is more likely to be in a suit and on Wall Street than in hides on the tundra, though the basic goal of minimizing risk and maximizing gain remains the same. And rather than a spear, money managers guard against risk with mathematical models and sophisticated computer systems, and a wide assortment of derivatives and other specialized securities.
But in a modern-day paradox, the very tools that Wall Street uses to reduce risk might actually increase it. As Wall Street's means of risk management have become increasingly complex, a confusing tangle of securities and trading schemes is making markets more volatile and perhaps more susceptible to crashes, some economists and market experts say.
The 1987 stock crash, for instance, was precipitated in part by the unraveling of "portfolio insurance," or a dynamic strategy of using futures contracts to protect against market losses. Derivatives trading led to the bankruptcy of Orange County, Calif., in 1994 and the scandals at Bankers Trust that same year. The Long-Term Capital Management debacle in 1998 stemmed from losses in swaps and other exotic investments.
Likewise, the current subprime meltdown can be blamed in part on mortgage-backed securities that spread risks associated with lending. The securities are Wall Street creations that carve the mortgage market into parts that can be traded. The securities made more capital available to be loaned out under risky terms to at-risk borrowers.
What, a cave man might ask, has Wall Street wrought?
The last few weeks for investors have illustrated how bumpy the ride can get. The Dow Jones industrial average, a basket of stocks in large U.S. companies, closed above 14,000 for the first time last month. The S&P; 500 also reached new heights.
Then, a few days later, amid worries that an era of easy credit for mortgages and corporate buyouts might be over, the indexes posted their worst week in five years. The dramatic market swings continued in the last week as problems that started in the subprime mortgage market spread to other lenders.
Richard Bookstaber is one economist who says that increased complexity on Wall Street has made it more vulnerable to calamity. He has overseen risk management at Wall Street firms such as Salomon Brothers and Morgan Stanley, and at hedge fund-shop Moore Capital Management. Now he runs a hedge fund in Greenwich, Conn.
His recent book, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, gives readers his perspective on some notable market disasters.
"Financial markets have seen a tremendous amount of engineering in the past 30 years, but the result has been more frequent and severe breakdowns," he writes. "These breakdowns come about not in spite of our efforts at improving market design, but because of them."
Bookstaber contends that "virtually all mishaps over the past decades had their roots in the complex structure of the markets themselves."
On the face of things, Bookstaber notes, markets should be more stable. Not only have they seen increased regulation, but the underlying economy has seen greater stability in economic output, and recessions, when they occur, have become shallower.
Market risk, however, has markedly increased, at least as measured by volatility. The average annual standard deviation in the Standard & Poor's 500 index, a broad measure of stocks, was higher in the past 20 years than 50 years earlier, according to Bookstaber.
But economist Peter L. Bernstein says that investors should not fear market innovation. In his book, Against the Gods: The Remarkable Story of Risk, Bernstein takes a chapter to address the controversy of derivatives.
These financial instruments are side bets that have no value of their own but derive their value from something tangible, which can be anything from gold bars to stocks to interest rates and even the weather. The market for credit derivatives, or bets on whether a company will pay its debts, is now several times larger than the actual corporate bond market.
While far more sophisticated today, derivatives have a long history. One of the most studied of derivatives scandals was the Dutch tulip mania of the 17th century. Farmers then, as they do today, used futures contracts to mitigate the formidable risk that after all their investment in land, equipment and seed, the price of their crop could drop before they have a chance to deliver it. So they lock in a price early.
Enter speculators who can bid up the price, as they did in Holland on the price of tulip bulbs in the mid-1630s. The bubble got so big that even common tulip bulbs fetched enormous sums.
Today, the notional value of derivatives being traded, or the value of the underlying assets, is in the trillions of dollars - a potentially frightening sum. But Bernstein points out that functional liabilities from derivatives, meaning what one party would be obligated to pay, are a fraction of the notional value.
Bernstein contends that derivatives don't cause volatility but merely reflect the state of the economy and financial markets. He suggests that the blame for disasters like the one at Bankers Trust, which faced damaging lawsuits when derivative transactions caused gigantic losses for corporate clients like Procter & Gamble, may lie with those who made the bets.
"No one need go broke any faster just because derivatives have become a widely used financial instrument in our times," Bernstein wrote. "The instrument is the messenger; the investor the message."
To be sure, it is possible to dodge risky investments by simply not making them.
Take T. Rowe Price Group Inc., the Baltimore-based money manager. Famous for avoiding the dot-com bubble of the late 1990s to the delight of its investor clients, the company did an encore performance with subprime. It dumped hundreds of millions of dollars of subprime holdings in December - weeks before several subprime lenders filed for bankruptcy early this year and the crisis spread.
Mary J. Miller, director of fixed income at Price, said her researchers were alarmed by lax lending standards in recent years and surmised that the housing boom masked the extent of the problem because it allowed borrowers with poor credit to sell at a profit and avoid foreclosure.
"All of this was coming together in an ugly way," she said.
And the folks at Price were right. Similarly, they didn't buy into collateralized loan obligations, securities backed by leveraged loans and used by private equity firms to fund their corporate buyout tear. The demand for CLOs has dried up lately.
Miller says the market is righting itself to a saner mix of risk versus return. As for financial engineering, she says, it is "here to stay."
"In any market cycle at peaks, you are going to get some products developed or issues sold that are stupid and require the buyer to take on too much risk," she said. "We have a self-correcting market that says I'm not going to participate in that."
Just how risky markets have become is, of course, impossible to know. Wall Street firms employ risk modeling techniques to measure how far out on a ledge they have gone, but those models are imperfect because they take into account past events, which are not good proxies for the future. As investment professionals espouse, past performance does not guarantee future returns.
What Wall Street is really worried about is a Black Swan event, or a rare happening with huge implications outside the realm of normal expectations. The terrorist attacks of Sept. 11, 2001, were such an event. Americans knew terrorists could hijack planes; an intentional crashing of those planes was outside our collective experience.
But, if history can be a proxy for human behavior, we won't stop taking risks. Although Wall Street innovation has allowed investors to foist risk on each other at levels never seen before, there is still a winner for every loser in a transaction.
And that winner could be you.