If the cascade down in price is due to a liquidity-driven crisis, the best approach for the individual investor is to stand back and be patient.

Most crises occur due to liquidity needs. That is, investors are forced to sell, and they drive prices down in the process. The liquidity needs often come about as a result of high leverage.

Mr Richard Bookstaber, author of A Demon of Our Own Design.

While it is not strictly true that I caused the two great financial crises of the late twentieth century the 1987 stock market crash and the Long-Term Capital Management (LTCM) hedge fund debacle 11 years later lets just say I was in the vicinity.

With these solemn lines begins A Demon of Our Own Design Markets, Hedge Funds and the Perils of Financial Innovation (Wiley, 2007), by Mr Richard Bookstaber.

If Wall Street is the economys powerhouse, I was definitely one of the guys fiddling with the controls. My actions seemed insignificant at the time, and certainly the consequences were unintended

Arguing that market crises like what the US has seen with the subprime mess are an inevitable result of the markets penchant for leverage and its abuse of derivatives and other innovative securities, the Demon created a stir on Wall Street.

It is no wonder, therefore, that regulators, closer home, spend sleepless nights thinking about hedge funds. The recent fund flows, it has been reported, were largely driven by hedge funds, operating through FIIs (foreign institutional investors). Last week alone witnessed a little over $2 billion of net flows from hedge funds/FIIs.

What could be the best method to regulate hedge funds? Regulating hedge funds would be a bit like deciding to come up with a set of safety regulations to cover all modes of transportation, says Mr Bookstaber, responding to Business Line over the e-mail.

Hedge funds come in many shapes and sizes, and they operate in many markets using many different strategies, he reminds. I dont really think hedge funds can be reasonably defined as a single type of entity. And that makes regulation difficult. I am not saying some degree of regulation is not appropriate, but it is a difficult place to have as your regulatory focus.

A more efficient focus, Mr Bookstaber suggests, is to add regulation or oversight to the institutions that provide the leverage and the innovative products in the first place, the banks and the investment banks. There are far fewer of them, they are large and already are well suited to regulation.

A Ph.D. in economics from MIT (Massachusetts Institute of Technology), Mr Bookstaber runs a market neutral equity hedge fund at FrontPoint Partners. He is the author of four books and scores of articles on finance topics ranging from option theory to risk management. Mr Bookstaber has received various awards for his research, including the Graham and Dodd Scroll from the Financial Analysts Federation and the Roger F. Murray Award from the Institute of Quantitative Research in Finance.

Excerpts from the interview:

First, about your research work.

My dissertation was on a somewhat mathematical topic: how markets behave when there are sets of people in the market that have different sorts of information. I started my graduate work at MIT in 1974 and received my Ph.D. in 1977, so I completed my Ph.D. in three years. I then was a professor for five years before coming to Wall Street.

While in academics I did research in option theory and wrote a book on options that was pretty widely used. This is why I was recruited by various Wall Street firms ending up initially at Morgan Stanley because there was high demand for people who understood how to model options and other derivatives.

What in your opinion was the most important cause of the 1987 market crash?

The key cause of the 1987 Crash was the use of portfolio insurance. This caused a wave of stock index futures selling on the morning of Monday the 19th, because these programs had to increase their hedge in reaction to the drop in the market the previous Friday. The selling of futures led in turn to selling of stocks, and the specialists dropped the stock prices so far and so fast in an attempt to find the other side of the market that many investors decided to wait on the sidelines, unsure of what was happening. This required yet further selling, continuing the downward cycle.

How would you define a financial market disaster? Has it got something to do with the rate of acceleration of a falling index?

Most crises occur due to liquidity needs. That is, investors are forced to sell, and they drive prices down in the process. The liquidity needs often come about as a result of high leverage. A market shock puts a set of investors with high leverage under pressure; they need to reduce their positions because the market has dropped to the point that their creditors are demanding a reduction in exposure. Their selling drops prices, which causes an increase in pressure on them and possibly now on others who might not have been forced to sell based on the initial shock. This then leads to another wave of selling, and so on.

Can such disasters be avoided? If so, how?

If you want to avoid these crises, you have to first understand what causes them. In my book I point to two causes of market crisis.

One is complexity of financial instruments. This complexity leads to surprising and non-linear linkages between markets.

The second causes tight coupling, a term I borrowed from engineering. A tightly coupled process moves from start to finish with little opportunity to intervene. A space shuttle launch is an example of a tightly coupled process. The mechanistic trading programs of portfolio insurance were the tightly coupled process behind the 1987 Crash, and the effects of forced liquidation due to high leverage is an example of a tightly coupled process prevalent in the markets today.

So if you want to reduce the crisis-prone nature of the markets, you need to reduce complexity and reduce tight coupling. And that means reducing the flood of innovative products on the one hand, and reducing the level of leverage on the other.

How does a small investor take a long value approach if he sees the value tumbling from day to day, week to week, month to month?

If the cascade down in price is due to a liquidity-driven crisis, the best approach for the individual investor is to stand back and be patient. Once the liquidity demand has abated, the market should return back to where the value of the assets dictates it should be. Those who are highly leveraged do not have this luxury of waiting the crisis out. They are the ones who both cause the problems and who are forced to liquidate at the worst time.

You say, Risks have nothing do with the intrinsic value of the stocks or the economy. If so, would it not mean there is a dichotomy between the economic performance of a country and its financial market, with the latter having a life of its own?

Market crises do have a life of their own, usually separate from value. The reason is that those who must liquidate due to their high leverage have to do so independent of any longer-term notion of value. They may know that what they are doing is a poor decision from an investment perspective, but they have no choice; the creditors are not investors, but rather are looking only at the current market value, depressed as it is by the forced selling. Simply put, the creditors want their money back, and want it back now.

If you look at the large crises of the last decades the 1987 Crash, LTCM, even the sub-prime meltdown they do not mirror any similar crisis in the underlying economy. And if you look at any major political crisis Pearl Harbour, the assassination of Kennedy or 9/11 you do not see a market crisis erupting in its wake.

The possibility of a mortgage crisis can be low if borrowers opted for fixed interest loans for the whole term of their loan, even though financial institutions will stand to gain if they convinced the borrowers to opt for adjustable home loan interest. Your comments.

As I mentioned, I point to both leverage and complexity as sources of market crisis. And the mortgage market has a lot of both of these. Without a doubt, much of the problem with the mortgage crisis is the complexity of the mortgage instruments. Many homeowners have ARMs (adjustable rate mortgages), often with teaser rates that suddenly go up after a few years. And in some cases the homeowners are being qualified based on their ability to pay the teaser rate, not on their ability to pay the higher rate that will kick in a few years down the road.

There are even mortgages that backload interest payments and initially require no principal pay-down. Granted the homeowners should take the complexities into account, but for various reasons they do not maybe ignorance, maybe a hope that they will somehow have a change in circumstance. If mortgages were all fixed rate with defined and constant interest rate payments, obviously these issues would not arise.

D. MURALI
GOUTAM GHOSH