Sunday, July 8, 2007

Dodging Bullets

It looks like we have dodged another bullet – Amaranth Advisors blew up last year with little if any collateral damage and now the failure of the Bear Stearns funds has likewise passed with barely a ripple. For the optimists, these are indications that somehow we have learned the lessons of LTCM, and the world is a safer place. So we can lever to the hilt, with the occasional failure leaving all but that fund’s investors – who, I guess, are viewed as getting what they deserve – intact. I am more of a pessimist by nature; that is probably why I have felt at home doing risk management. And if you look at these failures with that lens, the picture is not as rosy.

From the pessimists’ viewpoint, the concern is simple: When failures like these end up being contained, it emboldens us to take on more risk, even though the fact that they were contained indicates little if anything about the prospects for future market crises. After all, no one is arguing that every hedge fund failure will cascade into a systemic crisis.

As an analogy for my concern, consider one of the examples in my book: the Discovery Space Shuttle disaster. When the Space Shuttle was designed, I doubt the specifications called for foam debris hitting the shuttle during launch. But, of course, it happened. And each time it happened without any adverse consequences, it was viewed as less and less of a problem, until it got to the point that it became part of the accepted launch process. The more successful launches there were with the foam debris raining down, the harder it was for the engineers – the risk managers of the system – to argue their case that this was a design flaw of critical proportions.

The same will occur as we have hedge fund failures that do not lead to broader market crises. But it is even worse than the analogy suggests, because with the market, the lack of apparent risk will not just lead us to maintain the status quo, it will lead to taking increased leverage and allow for further complexity, making the crisis, if it does occur, that much worse.

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