Ask the Experts with Richard Bookstaber 07/21/2007

It's a good interview if one is interested in structured finance, risk, and market events.

Maybe the author explained it already in distilled form, but many events seem so obvious in hindsight. For example, he explained that Portfolio Insurance was designed to reduce exposure to the market if the market drops, and increase exposure when the market rises. This by itself doesn't seem like a money maker since one would tend to just chase the market. But in addition, when everyone was using it, selling begat selling very quickly and led to the market crash in 1987. Just because they used options instead of common stock doesn't change any of that market behavior, since every derivative has a direct connection to the underlying. So buying puts creates the same directional pressure (e.g. due to arbitrage) as if everyone sells stocks. Or if everyones sells S&P futures that obviously creates pressure on the stocks in the index. And that might create pressure on other stocks if people sell other stocks to raise cash.

This is similar to our current discussion if gold or mining stocks would go down if the stock market crashes. Yes, it is possible if we get a total credit contraction where everyone scrambles for cash which then seems to be more valuable than gold. But if the value of the dollar gets threatened by our own authorities, then cash will not be considered safe enough, and gold will be the ultimate winner. So one cannot know, but at best have an educated guess and be prepared for either case.

Similarly, the LTCM crisis was discussed, where while LTCM didn't have positions in Russia, but other traders had. These other traders had then to sell other debt that now was also owned by LTCM and started the fund's downward spiral.

Yes, we also discuss constantly if Asian stock markets will get dragged down when the US market falls. It is obvious that they could drop, and one would be reckless to buy overpriced Chinese stocks, or even leverage up on other (more fairly priced) international stocks.

As last example the subprime situation was discussed, where loans after being packaged together would be less risky than the individual ones. This might be a small advantage, but an already much greater factor would be what the housing market will do. If housing corrects the last few years advance and drops by 20-30% (a distinct possibility), all subprime loans will default since now people are under water with their house. I don't think a subprime borrower has any wealth or good credit to begin with which he would want to protect rather then walk away from a negative $100,000 equity.

So isolated quant stuff often doesn't capture the big picture in my opinion.