A Demon of Our Own Design | Richard Bookstaber

Summary of: A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation
By: Richard Bookstaber

Introduction

In ‘A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation’, Richard Bookstaber explores the development of risk management and its potential consequences, from portfolio insurance to the collapse of LTCM. This summary delves into the growing complexities and tight coupling of financial systems, demonstrating that innovation does not come without risks. By examining stories and experiences from Wall Street, the author highlights the challenges in understanding the intricacies of financial markets and the dangers of depending on mathematical models for protection.

Ed Thorp’s Rise and Fall

Ed Thorp, a mathematician from MIT, is known for pioneering analytical trading with his book “Beat the Dealer” which introduced the concept of card counting to the masses. Later, he wrote “Beat the Market” for elite traders, advocating for convertible bond arbitrage. Thorp tried to recruit author Richard Bookstaber in 1983 but faced problems. In 1984, Bookstaber joined Morgan Stanley and played a central role in developing portfolio insurance, a popular hedging approach in the 1980s. However, it assumed unrealistic market conditions and collapsed during the 1987 market crash, leading to a liquidity crisis. An options salesman foresaw the problem and reaped millions from the collapse, retiring early. Thorp’s story sheds light on the impulsive behavior of traders and how risks can be unpredictable, posing a threat to the real economy.

Lessons from Salomon Brothers

In this book snippet, Bookstaber reflects on the major scandal that hit Salomon Brothers in 1994 when Paul Mozer, the head of the firm’s bond trading desk, was caught submitting fraudulent bids at Treasury auctions. The incident jeopardized Salomon’s status as a primary dealer and significantly impacted its business. Bookstaber discusses the firm’s risk management issues, including its exposure to the mortgage securities market and flawed trading models. Overall, the account highlights the importance of risk controls and the dangers of complex, tightly coupled systems in trading.

Complexity and Consequences

In 1997, Salomon Brothers faced a crisis when its fixed-income arbitrage group lost more than $100 million due to an “inexplicable tracking error in their yield curve trades” amid falling interest rates. Jamie Diamond, brought in by Sandy Weill to tighten controls after acquiring the firm, prohibited directional bets on interest rates, resulting in the risk arbitrage group’s disposal. However, new management did not debrief traders or understand their models before the liquidation of big positions, leading to market recognition of Salomon’s need to sell. With no buyers willing amid falling prices and drying liquidity, the LTCM crisis was one of the unintended consequences. The book highlights that complexity of an organization and the sources of complexity at the outset should be reined in rather than adding and managing its consequences with regulations.

Complexity Cloaks Catastrophe

John Meriwether’s hedge fund, LTCM, specialized in relative value trades and boasted talented personnel, including Nobel laureates. However, inaccurate models and major trades without models led to its downfall. LTCM heavily invested in Russian bonds and was hit hard when Russia defaulted. Facing margin calls and no cash to meet them, LTCM was forced to sell assets but faced a cascade of sales and low liquidity. Unable to sell and survive, LTCM’s complexity ultimately brought about its collapse.

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