Blogs & Comment

Book review: Fearful Rise of Markets

Plenty of books have been published on the wild gyrations in financial markets since 2007. John Authers, a Financial Times of Londoneditor and columnist, has written another in the genre, entitled The Fearful Rise of Markets:Global Bubbles, Synchronized Meltdowns, and How To Prevent Them in the Future(2010).
But his book is an easy-to-read exposition of basic and more advanced aspects. This makes it a useful offering for people who dont scour the business pages every day or regularly imbibe financial books — yet are still curious to know why the world almost had a financial breakdown in 2008 and what can be done to avoid another encounter.
Some main factors behind the 2008 financial crisis:
Much of the book examines factors that led up to the perilous brush with financial Armageddon. Authers has quite a few of them. Here are some of the main ones.A list in the appendix has more.

  • Increasing institutionalization of investing (growth in mutual funds, pensions funds, hedge funds etc.) led to an ever greater wedge between principal and agent, resulting in less care and prudence in the management of investments
  • Herding behaviour among money managers
  • Pervasive regulatory arbitrage (circumventing regulations for profit)that eroded the banking system and led to a shadow banking system without deposit insurance, reserve requirements and other safety nets
  • Securitization of mortgages, etc. (took risk off the balance sheets of the banks originating the mortgages, giving them incentives to relax lending standards)
  • Deregulation (e.g. repeal of Glass Steagall act) andmergers creating banks too big to fail
  • Growth in publicly owned investment banks (financedthrough overnight markets)
  • Hedge funds incentives, risk taking, leverage and exposure to redemption runs
  • Greenspan Put (Federal Reserve cut rates too much whenever markets became unsettled — starting with LTCM hedge fund in 1998 — triggering a sequence of interconnected bubbles and busts (dot-com and housing)
  • Escalating moral hazard (a feeling that risk takers would always be bailed out thanks to the Greenspan Put
  • Financial theories that generated a false sense of security, such as the notion portfolio safety can be assured through uncorrelated assets

The book also provides suggestions for avoiding another plunge toward financial and economic chaos. They include:
Measures need to be taken to keep moral hazard and risk-taking from becoming excessive in financial markets; a safe place to start would be to tightly regulatetoo-big-to-fail banks — or else make them smaller (raising reserve requirements would force them to sell off asset, Authers suggests).
The constituents of the shadow banking system must be regulated as if they were banks. This will put them on the same level playing field as the banks and remove the pressure on the latter to stay in business by venturing into new and riskier fields.
The investment industry requires a culture shift and change in incentives to treat other peoples money as their own. Publicly traded investment banks might return to the partnership mode so that the money on the line would be the partners and not the shareholders. In securitization, loan originators should be required to hold a significant interest in the loan portfolio they sell to others.
The herd mentality of current money managers needs to be reined in. Closet indexing by mutual funds should be discouraged by requiring actively managed funds to publish their active share (how much portfolio deviates from the index). And paying managers a fixed fee instead of a percentage of assets would help take away some the incentive to hug the index and become a big (but unwieldy) fund.
Hedge fund investors should refuse to abide by the fee structure that encourages managers to lever up and go for broke. Instead, they should pay fixed annual fees and base any performance fees on periods longer than a year.
Investors also need to rethink diversification, i.e.avoid thinking in terms of asset classes and historic correlations between them. Instead they should think about leaving a margin for error, i.e. go with more conservative assets.
Appendix: Other factors behind the 2008 financial crisis

  • Rise of (market-cap) index funds and the pressure on them to buy overvalued stocks
  • Growth in money market funds (deposits not government-insured)
  • Too much creation of fiat currency and easy credit (lack of monetary anchor)
  • New financial products made it easierto invest in new areas(e.g. emerging-market funds)
  • Carry tradea source of funds for investing/speculation
  • Baby boomers increasingly participating in financial markets
  • Distortions produced by Fannie Mae and Freddie Mac in housing market
  • Bonus systems in financial sector encouraged taking risks
  • Use by banks of off-balance-sheet entities, such as structured investment vehicles (SIVs) for lending long term and borrowing short term
  • Rosy ratings from the debt-rating agencies
  • Rush into BRIC markets and commodities, aided byindex funds and exchange-traded funds (ETFs)
  • Speculation in credit default swaps can make it harder for an indebted company to borrow, to the point where insolvency becomes a risk