are pandemic. But in trying to soothe our worries, we may only make them worse.
The New York
June 5, 2005
See a Bubble?
By ROGER LOWENSTEIN
Annual performance of major hedge funds
CSFB/Tremont Hedge Fund Index
It's a good
time to be a financial-disaster writer. Disasters abound, and even when they
don't, people are eager for your opinion on when the next bubble is going
to pop. Scarcely a day goes by without a warning of some dire calamity --
in the dollar, in housing values, in pension funds. The way people crave financial
info, we must be the best-informed, most economically literate society ever.
But we do not sleep any better for it. Is all the anxiety warranted, or even
A few years
ago, the chief claim on the public tranquillity was the fear of ''deflation,''
meaning that the price of just about everything would fall. Before that, it
was fear of ''Y2K.'' Neither transpired. This is not to say that disaster
never strikes. The number of bubbles and consequent meltdowns over the last
quarter-century could fill a proper B-school syllabus. In order of appearance,
oil drillers, precious metals, personal computer makers, the stock market,
commercial real estate, Trump casinos, junk bonds, biotechs, Russia and Internet
stocks each had their moments of glory and returned to earth.
Not every bubble
ends with a crash, but sometimes, because of a linkage or feedback mechanism,
one loss triggers another and leads to a sort of contagion. In 1929, people
who bought stocks on credit were forced to sell, which spurred more losses,
more loan repayments and more forced selling. This is what people worry about:
the Big One. Japan experienced a somewhat similar meltdown in the early 90's.
Almost by definition,
the spark for such calamities is unforeseeable. This explains our vigilance.
What is less appreciated is that excessive, or inappropriate, vigilance also
exacts a price. It does so in several ways. People who insulate their portfolios
against phantom risks pay a toll, just as they paid to protect their computers
risk, people also limit the opportunity for gain. It is common, today, for
investors to own six or eight mutual funds, each of which is likely to be
invested in hundreds of stocks. This will, they hope, assure that no little
bump, no little meltdown, overly upsets their portfolios. But since when was
investing about avoiding the bumps? Anyone investing for the longer term can
safely ignore them.
Shaw observed that every profession is a conspiracy against the laity. The
financial profession duly warns us of meltdown risk, but it has adopted a
pinched definition of risk that has led us into fruitless and sometimes harmful
diversions. The odds of a meltdown being necessarily uncertain, Wall Street
fosters an overly precise, pseudoscientific approach. Investors are told to
''balance'' portfolios (rather than to select stocks), to ''allocate'' (rather
than to ''invest'') their assets and to reckon with quarterly earnings forecasts
down to the penny per share -- an absurd irrelevancy for someone whose retirement
is years away.
properly worries about what might go wrong, but it has recast the issue in
spurious terms, detaching us from the messy and often subjective considerations
that might help us avoid truly perilous bubbles: those that (like the dot-coms)
subject us to the risk of enduring loss. If you tune in to enough financial
shows, you are bound to stop asking considered questions like ''Is the Web
going to be full of other companies competing against this one?'' and to start
toying with numerics like a stock's volatility or the percent of your holdings
in a given ''sector.'' No wonder people are jittery: this stuff changes every
second. To listen to the anchors on cable TV, we should reshuffle our portfolios
in response to each new, tangential threat -- oil prices, the dollar, real
estate. And, of course, we should diversify in the extreme.
is insurance against the possibility that we might do something stupid; it
also heightens the chance that we will do something stupid. People with flood
insurance build their homes closer to the shore, and people in the 90's, having
diversified, figured they could afford to take at least a small flier on dot-coms.
Risk prevention can lead to risk.
search for calamity has focused on those obscure but swiftly multiplying Wall
Street beasts, ''hedge funds.'' When General Motors was downgraded to junk-bond
status, it was not G.M.'s fate that seemed to preoccupy traders and journalists
as much as the fact that some of these funds had suffered possibly dire losses.
Why some private-investment partnerships (which is what hedge funds are) should
be cause for general alarm has to do with their pervasive character. They
are said to be everywhere -- determining the outcome of shareholder battles,
roiling the art market, causing a run on convertible bonds. Markets were less
worrisome when they were simpler, when they confronted us with fewer choices;
hedge funds seem an embodiment of complexity. Also, the last near market meltdown
was occasioned by the implosion in 1998 of Long-Term Capital Management, a
Greenwich, Conn., bond-trading firm that was, indeed, a hedge fund.
That is hardly
reason to indict such funds for the next collapse. L.T.C.M.'s had more to
do with its aggressive, leveraged portfolio than with anything intrinsic to
its hedge-fund form. But it is human to look for a recurrence, and since Sept.
11, fear of things going drastically wrong has become a national instinct.
The reason L.T.C.M. shook Wall Street was that many investment banks held
the same positions that the fund did, setting the stage for chain-link losses.
But most hedge funds today neither rise nor fall in synchrony. As my colleague
Joseph Nocera observes in this issue, they invest in distinct asset types;
they are the bits of the chain without the link.
about hedge funds, I think, because of a Galbraithian prejudice that easy
money is bad money. At a dinner in Palm Beach, Fla., in March, I casually
inquired of one hedge-fund steward how much he controlled. Came the reply,
''Six and a half billion dollars.'' I whistled and replied that 1 percent
of $6.5 billion would be a decent living. (Hedge-fund managers often charge
1 percent of assets plus a fifth of any profits.) He smiled and held up two
fingers: 2 percent. Do the math; this gentleman's firm will earn, annually,
$130 million a year for switching on the lights each morning -- $260 million
if his fund attains a ho-hum return of 10 percent. No wonder that the London
Business School boasts a ''Hedge Fund Center'' and, according to a recent
graduate's informal survey, Harvard Business School sent 60 percent more of
its graduates to hedge funds last year than to the much bigger mutual-fund
But hedge funds
are less an expression of risk-taking than of people's aversion to risk. Most
funds deliberately try to hedge their bets (thus the name) by going both long
and short -- that is, betting that one asset will rise while a related one
falls. They are thus designed to be less volatile than ordinary stocks, which
is why they are so fashionable. The risk isn't meltdown but mediocrity, a
glimpse of which may be seen in the industry's recently lackluster returns.
the runner-up to hedge funds in the anxiety sweepstakes, could be another
matter. A recent Lehman Brothers report, ''The Changing Landscape of the Mortgage
Market,'' observed that U.S. homeowners have been ''very willing to increase
their leverage . . . through products like IO loans and MTA ARMs.'' This refers
to interest-only mortgages, and to those in which the rate begins at an alluring,
below-market level but after an interim floats according to the yield on Treasury
bills. Who in his right mind would take an ''IO- MTA ARM''? Hmmm, come to
think of it, I did.
bank did not describe it this way, an adjustable-rate mortgage is a bet between
the bank and the homeowner. If rates fall or remain stable, I win; if rates
rise, I lose. Of course, if I lose, the bank might also lose. I might, heaven
Why would a
bank finance a home that under a conventional mortgage the borrower could
not afford? Some computer in its vault was evidently mollified by the variability
of the rate. What makes this bet rather interesting is that millions of other
people have the same kind of loan that I do. If rates should take a sudden
upturn, it is conceivable that a good many will default, in which case an
instrument (a floating-rate mortgage) conceived to help the bank manage interest-rate
risk will have resulted in increasing the bank's losses.
The saving grace
is that home loans generally are the last thing people default on. But imagine
how scary it would be if, say, businesses extended floating-rate contracts
to one another -- if virtually every company were dependent on making the
right calculation about how these risk-avoidance vehicles would function.
they do. They are called derivatives. Derivatives are contracts that call
for one party to pay another according to the movement of an underlying yardstick,
like a foreign currency, a bond, a stock or even the weather. Since the 1980's,
Wall Street has marketed derivatives as a tool for making risk more palatable,
and Alan Greenspan has consistently praised them for enabling firms to spread,
or ''manage,'' their risk. For instance, a bank can hedge against the risk
that one of its loans will sour. It simply -- well, not so simply -- purchases
a ''credit default swap,'' which entitles it to a payoff if a specified company,
G.M. for instance, goes into default or suffers a material downgrade in its
credit rating. The party on the other side might be a hedge fund that is more
sanguine on G.M.'s bonds or has a way (it thinks) to hedge that risk. Every
financial firm uses some varieties of derivatives, which, again, are contracts
that call for a payment (one way or other) depending on some underlying asset.
Their growth has been explosive. Credit-default swaps, for instance, didn't
exist a decade ago; today there are $8 trillion of them. No one has any idea
of the losses that could ensue from a panic; credit-default swaps ''have never
been stress-tested,'' notes the analyst James Bianco.
Fed nor the S.E.C. has ever really clamped down on derivatives or insisted
on a form of disclosure that would tell folks what is going on. So forget
hedge funds; if you're searching for the next financial storm, try derivatives.
(Nothing much you can do about them, either.) Come to think of it, most of
the sudden financial disasters of the previous decade -- Orange County, L.T.C.M.,
Enron -- involved derivatives, too.
There is a paradox
here. A vehicle developed to help reduce individual risk has heightened risk
to the system. At some point, the anxiety turned counterproductive. There
was a time, of course, when people could buy only the homes they could afford
and invested in only a few, carefully chosen stocks -- when traders could
not run certain risks because no derivatives existed to provide a hedge. Today,
whether you are a trader or homeowner, bank or corporate treasurer, our financial
culture offers a prophylactic against every conceivable worry. Maybe weaving
a giant insurance net is really the way to manage anxiety, but maybe it has
us worrying about what we will do if the insurance fails. Perhaps, if there
were fewer traders dulling their anxieties with financial Zoloft (a drug for
the treatment of depression and anxiety) and fewer investment options available
to the rest of us, we would make better decisions -- and sleep more soundly.