Why Wall Street should be more like a cockroach

Finance whiz Richard Bookstaber, one of the first to predict the subprime meltdown, says that today's financial system is dangerously complex.

By Andrew Leonard

Read more: Books, Andrew Leonard, Wall Street, Interviews, Economy, Authors, Books Interviews

Dec. 20, 2007 | Richard Bookstaber's résumé includes stints as a risk management officer (the guy who strives to keep an investment bank's traders from running wild with their bets) and as a hedge fund operator (the guy who makes the bets). He has worked for some of Wall Street's most famous firms, including Morgan Stanley and Salomon Brothers (now part of Citigroup.) He jokes in his book, "A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation," that while he didn't directly cause "the 1987 stock market crash and the Long-Term Capital Management hedge fund collapse," he was "in the vicinity."

He knows the business. Which means it was probably worth paying attention in April, when his book was published, and he confessed to what many of his Wall Street colleagues would no doubt consider heresy.

The steps that we have taken to make the markets more attuned to our investment desires -- the ability to trade quickly, the integration of the financial markets into a global whole, ubiquitous and timely market information, the array of options and other derivative instruments -- have exaggerated the pace of activity and the complexity of financial instruments that make crises inevitable. Complexity cloaks catastrophe.

Bookstaber is not the first to warn about the risks of financial innovation. But he may be the person most deeply embedded in the belly of the beast. In the crowd he runs with, it is much more common to hear the exact opposite sentiment -- that the vast modern panoply of complex financial instruments -- credit derivatives and collateralized debt obligations and all the rest -- have made the world safer, instead of more dangerous.

At the time Bookstaber's book was published, even though severe cracks in the housing market were readily apparent to anyone who was looking, the conventional wisdom still reigned supreme. The clever minds of the world's financial markets had devised a system in which risk was chopped up into millions of tiny pieces and redistributed -- dispersed -- all over the world. As a result, the overall financial system was supposed to be more stable, less prone to collapsing because of any one shock.

But with each passing day, the vast gaping holes in that theory become more apparent. The latest news -- on Wednesday Morgan Stanley alarmed the market with the announcement that the investment bank was writing off an additional $5.7 billion in losses. The bad news just keeps on coming. The biggest players on Wall Street have been stumbling and lurching all fall. For months, the stock market has lunged between schizophrenic polarities of hope and fear. No one knows how high the final toll will go -- estimates range into the hundreds of billions. Top executives have lost their jobs, millions of Americans are losing their homes, and the end is not in sight. The so-called credit crunch is now spoken of in somber terms once reserved for the savings-and-loan crisis and possibly even the crash of 1987. State-of-the-art financial wizardry has turned out to look an awful lot like a game of three-card monte. Instead of making us safer by spreading risk around, we appear to have been made more vulnerable by the placement of risk into the hands of people who couldn't evaluate it and can't afford it.

Bookstaber's basic thesis borrows a concept drawn from a particular strain of engineering analysis. We have designed a system that is too "tightly coupled" he says; we have a built an incredibly complex but fundamentally fragile machine where if one thing goes wrong, the whole system sputters to a halt. When what we need, instead, is a loosely coupled system that can withstand shocks without crumbling. Such a system might not be the most efficient, but it will get the job done.

We should be more like the lowly cockroach, he declares, a humble beast that is optimized for no environment but has managed to survive in all.

Bookstaber spoke with Salon about the issues raised in his book.

If timing is everything for a trader, then you nailed it with "A Demon of Our Own Design." Did you imagine back in April, when your book came out, that by October you would be testifying before Congress, giving your opinions on how government regulators might have been able to prevent the current mess?

I knew as I was writing it that the same sort of problems that had happened before would happen again. It was fortuitous for me that it happened right as the book was being published. The subprime crisis is sort of the poster child for the issues that I talk about it in the book.

Your basic argument was that Wall Street's addiction to financial innovation may precipitate economic disaster? Did that happen? Are we living through a catastrophe?

I don't think I use the term "disaster." I try to talk about crises. The crash in 1987 was a crisis. Long-Term Capital Management was a crisis. What we are seeing now is a subprime/mortgage/credit crisis. Now, a crisis could turn into a disaster. The question is whether this crisis breaks what you might think of as the blood-brain barrier between the financial markets and the real economy. That did not happen with prior crises and it remains to be seen if it happens in this case.

On your blog, you observed that every time Wall Street goes through one of these crises, and the trouble doesn't spread to the real economy, we only end up being set up for bigger problems, because traders and banks are encouraged to engage in more of the same behavior that created the crisis in the first place. But many of your colleagues would argue that the reason these intermittent crises haven't metastasized into a full-blown catastrophe is precisely because all these new financial products have dispersed risk so widely that no single setback can take down the whole system.

You can sort of have it both ways. Earlier this year [Federal Reserve chairman] Ben Bernanke said hedge funds were valuable because they provided liquidity, and by providing liquidity they actually reduced the volatility of the market, which makes sense, in that if somebody needs to buy something or needs to sell something and there are a whole lot of people sitting there ready to grab it, the market doesn't have to move too far. Similarly, derivatives often have value because they allow people to break apart risks and pass the risks on to people who are more willing to take them.

You can say both of those things, and then still say the sort of thing that I'm saying, which is that, from day to day, you may see lower volatility and more liquidity by having hedge funds and derivatives out there but you also have an increased probability of market crises. So, ironically, you can have reduced risks day to day, but you create a higher risk of major dislocations. And similarly, you can look at each individual derivative and say, yes, this adds value, yes we should have this derivative, but in aggregate you end up with a more complex market, and that complexity makes the market more crisis-prone.

But at the same time, many economists would argue that as far as the real economy is concerned, during this same period of increasing complexity we've been living through what they call "The Great Moderation" -- a period of generally low inflation, relatively mild recessions, etc. So why should we care what goes on in the financial markets? It almost sounds as if, to borrow your own phrasing, the real economy is only loosely coupled to financial markets. If that's true, why should we be worried when a bunch of traders lose their shirts?

You could argue that if this is the game these guys want to play, let them play it. OK: We get some sort of a crisis in the financial markets and the players in that market get hit but it doesn't seem to affect the overall economy so whatever they do is fine. But some of the people that are hit are innocent bystanders in the market. There is collateral damage; there is somebody that sees their portfolio shrink in value. So it isn't as if it is just being played by a bunch of grown-ups who are playing only against one another. The second reason is that while up to this point we haven't seen the spillover become systemic, it could become systemic, and the current crisis may be one where that happens.

Next page: The cockroach theory of financial investing