The hedge fund quants of August

Systemic risk? Financial contagion? What really happened to the markets during one crazy midsummer week? Two MIT researchers think they know.

Published October 3, 2007 7:50PM (EDT)

When an American airliner crashes, the National Transportation Safety Board launches into action. The goal is not just to find out what happened, but to develop new safety procedures that ensure a similar disaster never, ever occurs again. The most amazing thing about this process is how well it works. As the New York Times reported on Monday, the incidence of fatal accidents has dropped to the point where only one such disaster occurs for every 4.5 million departures.

Now imagine that a similar government band of regulators -- a Capital Markets Safety Board -- descended upon Wall Street every time an imploding hedge fund set off a major market disruption. And after the forensic accountants had sifted through the wreckage, the regulators came up with a set of recommendations for improving the long-term stability and health of financial markets. And the recommendations were actually implemented.

That's the proposal made by a graduate student and professor at MIT who just released a very interesting report exploring what they think might have happened during the week of Aug. 6, 2007, when U.S. stock markets went on a wild roller-coaster ride, and a bushel of hitherto highly successful hedge funds registered huge losses. In "What Happened to the Quants in August 2007?" Amir E. Khandani and Andrew W. Lo attempt to understand why so many hedge funds that traded according to elaborate mathematical models simultaneously lost their way. (Thanks to Naked Capitalism for the link, by way of Infectious Greed.)

That many of these so-called quant funds (short for quantitative) were using similar trading strategies is not news. Khandani and Lo's chief insight is that, according to their model, all that is required for mass disruption is for one large hedge fund to suddenly start "unwinding" its positions. In a market where computers are making trades every second, the downward price pressure on stocks exerted by a single fund selling its holdings immediately sent signals that other hedge funds, operating according to the same trading strategy, interpreted as a command to sell.

Khandani and Lo draw a couple of significant conclusions from their research. The first is that markets have rapidly evolved in recent years into an ecology characterized by "greater financial integration." Everybody owns a piece of everybody else -- everybody's movements cause ripples that make waves for everybody else.

While this may be viewed positively as a sign of progress in financial markets and technology, along with the many benefits of integration is the cost that a financial crisis in one sector can have dramatic repercussions in several others, i.e., contagion.

In other words, it is easier now than ever before for a single hedge fund to flap its butterfly wings and send a hurricane ripping through global markets. This is true, whether or not the underlying economic fundamentals justify a market correction.

This means, suggest Lo and Khandani, "that systemic risk in the hedge-fund industry may have increased in recent years."

Similar disruptions occurred in global markets in 1998, when Russia's defaults on foreign bonds led to the collapse of Long Term Capital Management.

But August 2007 is far more significant because it provides the first piece of evidence that problems in one corner of the financial system -- possibly the sub-prime mortgage and related credit markets -- can spill over so directly to a completely unrelated corner... This is the kind of "shortcut" described in the theory of mathematical networks that generates the "small-world phenomenon" of Watts in which a small random shock in one part of the network can rapidly propagate throughout the entire network."

Unfortunately, we don't really know what happened the week of Aug. 6, because the people who do know aren't telling and can't be forced to. Hedge funds are mostly unregulated, so the government doesn't have access to the kind of financial records necessary to determine exactly what transpired. Khandani and Lo argue that the growing importance of hedge funds in the global economy system -- a point driven home by the wild volatility their ups and downs caused in August -- means change is going to have to come. Hedge funds have become big players in providing liquidity to the global financial system, channeling billions of dollars back and forth across markets.

Hedge funds are becoming more like banks, and the reason that the banking industry is so highly regulated is precisely because of the enormous social externalities banks generate when they succeed, and when they fail. Unlike banks, hedge funds can decide to withdraw liquidity at a moment's notice, and while this may be acceptable if it occurs rarely and randomly, a coordinated withdrawal of liquidity among an entire sector of hedge funds could have disastrous consequences for the viability of the financial system if it occurs at the wrong time and in the wrong sector.

Thus the proposal for a new kind of regulatory system:

By establishing a dedicated and experienced team of forensic accountants, lawyers, and financial engineers to monitor various aspects of systemic risk in the financial sector, and by studying every financial blow-up and developing guidelines for improving our methods and models, a Capital Markets Safety Board may be a more direct way to deal with the systemic risks of the hedge-fund industry...

The details of such a Safety Board were first outlined in a paper co-written by Lo with two other authors in 2004.

Regulators should have access to the following information from all hedge funds: monthly returns, leverage, assets under management, fees, instruments traded, and all brokerage, financing, and credit relationships. In addition, regulators should collect similar information from prime brokers, banks, and other hedge-fund counterparties, as well as information about the capital adequacy of these financial institutions, as they are likely to be among the first casualties in any systemic event involving hedge funds. This information should be archived so that over time, a complete historical database is developed and the dynamics of each entity and the industry can be tracked and measured...

It is unrealistic to expect that market crashes, panics, collapses, and fraud will ever be completely eliminated from our capital markets, but we should avoid compounding our mistakes by failing to learn from them.

By Salon Staff

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