Richard Bookstaber: A Demon of our Own Design

Well before the financial crisis went full-tilt this summer, Richard Bookstaber had disaster on his mind.

Well before the financial crisis went full-tilt this summer, resulting in the collapse and reorganisation of some of the world's most storied financial institutions, Richard Bookstaber had disaster on his mind. At the time his book A Demon of Our Own Design was published in April 2007, a credit crunch and the implosion of subprime mortgage lending in the US were only beginning to build into what has become the worst global economic storm since the Great Depression in the late 1920s and early 1930s.

Mr Bookstaber's thesis must have seemed a bit alarmist at the time. Now, though, the part-memoir, part-treatise on the dangers of complexity in financial markets stands as a tome of the rarest breed: one that brilliantly picks apart the faults of a system on the verge of a big time breakdown. Mr Bookstaber begins his picking-apart with a little inside baseball, treating readers to a first-hand account of his involvement in the Oct 1987 US stock market crash. He was a risk-management guru at Morgan Stanley at the time, and along with many investment managers of the era, Morgan was heavily involved in the "portfolio insurance" schemes that helped bring on the '87 tumult. Portfolio insurance attempted to insulate investors when markets went down by hedging their positions with futures contracts on market indexes - in essence selling the market short (a bet that it will go down) while at the same time holding long positions in the market (holding stocks, in other words). Yet as Mr Bookstaber lucidly explains, even he and his academia-bred friends couldn't have anticipated the tide of selling and the volatility in futures markets that blew the whole thing to pieces.

Mr Bookstaber's intense involvement in crises like these makes his take on the current meltdown all the more relevant. Since he graduated from the Massachusetts Institute of Technology in the 1970s with a doctorate in economics and mathematics he's wended a circuitous path on the front lines of financial innovation, first at Morgan, then at Solomon Brothers - which is now part of Citigroup - and then in the hedge fund business, where he remains today. Back in the 1980s and 1990s, brainy academics who could, in theory, turn supercomputers into market-beating machines were beginning to infiltrate Wall Street. Some of their ideas were successful, though like most moneymaking investment ideas they were only successful for a few years, until a bunch of other people started doing the same thing. Strategies with funny names like statistical arbitrage and relative value trading came and went as the winds of the markets changed and the so-called quants moved on.

The mere story of the birth of modern risk management, as told by an insider, would have been enough material for an engaging book, but Mr Bookstaber takes it a long stride forward by interjecting his cogent, far-reaching analysis of the discontents of the financial innovation he bore witness to and to a degree helped bring about. Marshalling an analogy from the realm of physics and engineering, he posits that the attempt to cut down risk in financial markets ironically ratchets up the risk of a systemic breakdown. In a system with "tight coupling" - one where elements are heavily interdependent - and "interactive complexity" - where there is a complex network of such elements - accidents are bound to occur, he says. He points to Three Mile Island and Chernobyl as examples of such disasters: backup systems existed, and those backups were backed up, too. Yet the addition of all these elements meant to prevent disaster merely added more elements to the system that could interact with other parts of the system, confusing its operators and exacerbating catastrophe. Put it this way: if you put in an extra warning light or sensor on a nuclear reactor or an aeroplane, that's one more thing that could fail, causing confusion and a disastrous cascade of cause and effect.

The same types of forces are at work in the financial system, Mr Bookstaber argues. The exponential growth in recent decades of derivatives - financial instruments that allow investors to bet on stocks, bonds and interest rates, often with a large degree of leverage - has given investors new tools to combat risk. Yet derivatives have also arguably raised the level of complexity in the system, paving the way for what Mr Bookstaber terms "normal accidents".

He thus argues for financial instruments that are more like the cockroach, an insect that has survived for millennia simply by using a crude method of evading predators: running away when their sensors detect a puff of air. Crudity may seem to run against our instinct to evolve through innovation, but it may also be the only long-term way for investors and the financial system as a whole to survive through downturns like the one now under way.

If you want a smart, well-reasoned guide to today's volatile markets, now is an opportune time to pick up A Demon of Our Own Design. It provides crucial context and historical perspective while giving readers an entertaining tour through the plumbing of our flawed global financial system. Publisher: John Wiley & Sons, 2007 Ratings Explained ★★★★★Excellent ★★★★Very good ★★★Good ★★Poor ★Dire * Asa Fitch