This Is the End


Markets, Risk and Human Interaction

February 28, 2009

Mapping the Market Genome

I was invited to speak on Friday at the XBRL Risk Governance Forum, hosted by the IBM Data Governance Council. Having said that, most everyone is going to be tempted to yawn and stop reading further. Don’t. Within the work of this Forum are the seeds of reducing the risk of future market crisis. Indeed, it could be the foundation for a quantum leap in risk management.

To explain why, let me start by going through the dynamics of market crises. A market crisis occurs when there are highly leveraged investors in a market that is under stress. These investors are forced to sell to meet their margin requirements. Their selling drops prices further – especially because the market was under stress to begin with. So you get a cascade down in the price of that market. A shock that might have initially led to only a five percent drop gets amplified, and the market might drop multiples of that. We have seen this in various guises in the current crisis, from the banks' 'toxic waste', to the downward spiral in housing prices, to the deleveraging of the carry trade, to the quant fund crisis in August 2007.

And the dynamic gets worse. Many of those under pressure to liquidate will discover they no longer can sell in the market that is under stress. If they can’t sell what they want to sell, they sell whatever else they can. So now they move to a second market where they have exposure and start selling there. If many of those who are in the first market also are in the second one, and if the investors in that market are also leveraged, then we see the contagion occur.

Here are two examples of what I am talking about.

Example one is LTCM. The proximate cause of LTCM’s demise was the Russian default in August, 1998. But LTCM was not highly exposed to Russia. A reasonable risk manager, aware of the Russian risks, might not have viewed it as critical to the firm. So how did it hurt them? It hurt them because many of those who did have high leverage in Russia also had positions in other markets where LTCM was leveraged. When the Russian debt markets failed and these investors had to come up with capital, they looked around and sold their positions in, among other things, Danish mortgage bonds. So the Danish mortgage bond market went into a tail spin, and because LTCM as big in that market, it took LTCM with it.

Example two is what happened with the Hunt silver bubble. When the bubble burst in 1980, guess what market ended up being correlated almost one-to-one with silver. Cattle. Why? Because the Hunts had to come up with margin for their silver positions, and they happened to have large holdings of cattle that they could liquidate.

Could we have ever anticipated beforehand that we would see a huge, correlated drop in both Russian MinFins and Danish Mortgage bonds? Or in silver and cattle? There is no way these dynamics can be uncovered with conventional, historically based VaR type of analysis. The historical return data do not tell us much if anything about leverage, crowding and linkages based on position holdings.

This is not to say VaR is not of value. I think everyone who is involved in risk management understands the limitations of VaR, what it can and cannot do. It is sometimes put up as a straw man because it is not doing things it was not designed to do, things it cannot do, such as assess these sorts of liquidity crisis events and the resulting cascade of correlations that result.

But the proper use of mark up languages along the lines of XBRL can give us the data we need to address market crises as they start to form. What we must do is have a regulator that extracts the relevant data – in this case position and leverage data – from major investment entities. These would include, as a start, the large banks and largest hedge funds. With assurances of data security – the data would not be revealed beyond the regulator – a government risk manager would then be able to know what currently cannot be known: where is there crowding in the markets, where are there ‘hot spots’ of high leverage, what linkages exist in the event of a crisis based on the positions these investors hold?

For these reasons, the first recommendation in both my Senate and House testimony was “get the data”. How can we do that? Well, first, by legislative demands to require investment firms -- including large hedge funds -- to provide the data. Then by the proper application of a mark up language so it can be done in a consistent, aggregatable way.

To give an analogy for this, one that came out in the conference and that illustrates how far behind we are in financial markets, a mark up language for risk would do for the financial products what bar codes already do for real products. If we discover a problem with peanuts being processed in some factory, we can use the bar codes to know where each product containing those peanuts is in the supply chain, all the way down to the grocery store shelf.

Having the proper tags – the proper bar code, if you will – for financial products, ranging from bonds and equities to structured products and swaps will allow us to understand the potential for crisis events and system risk. It will help us anticipate the course of a systemic shock. It will identify cases where many investors might be acting prudently, but where their aggregate positions lead to a level of risk which they on their own cannot see. It also will give us the means to evaluate crises after the fact. Just as the NTSB can use the black box information to help improve the airline industry by evaluating the causes of a airline accident, this position and leverage data will act as the black box data to help us understand how a crises started, and, coupled with interviews of the key participants, help us understand what we need to do to improve the safety of the markets.


  1. "And the dynamic gets worse. Many of those under pressure to liquidate will discover they no longer can sell in the market that is under stress. If they can’t sell what they want to sell, they sell whatever else they can. So now they move to a second market where they have exposure and start selling there. If many of those who are in the first market also are in the second one, and if the investors in that market are also leveraged, then we see the contagion occur."

    This is what I call a Calling Run, which is just my reading of Fisher's Debt-Deflation. What makes a Calling Run dangerous is that it is not localized, but leads investors even tangentially involved in the crisis to get their money and put it somewhere safer. Also, it is panic behavior, which means that investors aren't really sure of the consequences of their actions, because, in a panic, unintended consequences amplify. This is what happened after Lehman, and why it was a mistake.

    However, I've read that, at the special trading session on that Sunday before Lehman, many investors suspected that Merrill would follow if Lehman went bust. This tells me that many people suspected that we could have a Calling Run. Certainly Bernanke knew, because that was a main reason for saving Bear I've read. So, there is a human element that can't be escaped.

    I've agreed with your posts about risk, but I have a concern, based upon my reading of Bagehot, and what I just wrote. Since we have a Lender Of Last Resort, it seems practically impossible to wring out all risk, since investors and bankers know that there is one. Since we have lobbyists, it seems impossible to wring out all cronyism. The same goes for regulation.

    If I'm right, wouldn't it be better to move to a system of narrow/limited guaranteed banks, and a separate non-guaranteed investment sector that is regulated as you say, with a strong emphasis on supervision and comprehension of the means and motives of investments?

    In this way, we would have an underlying system highly unlikely to be blown up, since it is highly capitalized and guaranteed.

    Don the libertarian Democrat

  2. I think the SEC has been doing a little crude data mining on XBRL filings-- note all the insider trading investigations lately.

  3. It seems to me that all of what you speak of is possible with current technology--that is outside the financial world. Companies that have developed sophisticated just in time inventory systems (like Walmart) surely have extremely complex analysis programs at their fingertips. It would seem that adapting some of this technology for the stock and bond markets would allow a regulatory body to identify concentrations, develop risk profiles, scenarios, and adapt a "just in time" attitude to regulation rather than a reactive attitude.

  4. It seems to me that leverage itself is a central problem.

    The thin trading profit margins captured by derivatives-based strategies can't be amplified into acceptable profits except through high leverage.

    Such trading does not reduce cost of credit, or enhance efficient capital allocation or benefit society at large in any way.

    The whole game -- XBRL tags or not -- seems a sham that enriches information middlemen with capital at the expense of society at large, which suffers from the booms/busts/bailouts and socialized losses.

    What's need are leverage limits, like speed limits on interstate highways.

    If a healthy financial system is a public good -- like highways, air, clean water, safety from crime, etc. -- then it should be regulated as such.

    We don't tolerate bright young men (and women) in HumVees driving 130 miles per hour down Interstate 81. They would pose a supreme danger to other drivers.

    Leveraged hedge funds, private equity and investment bank trading desks are analogus.

    Identifying the risks they take won't solve the problem. They will find ways to game the system to their advantage at society's expense.

    Severe limits on their activities -- either through leverage limits or taxation of speculative trading profits -- are the only answer.

  5. I think Andrew Lo has also recommended to Congress something like an NTSB for financial blow-ups.

  6. I also proposed that analogy in my October, 2007 House testimony:

    "It is as if the NTSB were not given flight recorders or allowed to investigate the crash site, or the NRC were not allowed access to nuclear power facilities. For example, in a few days in early
    August many quantitative long/short equity hedge funds suffered large losses, in some cases of over 30 percent. We do not know what set off the wave of these losses or why the losses affected so many of these funds."

  7. On the comment about controlling leverage:
    I agree that leverage should be controlled. As I point out in my book, it is leverage (which is a source of what I call 'tight coupling') and complexity that are at the source of most financial crises. But regulators do not have the data to monitor leverage at the fund level. That is why I said we need both position and leverage data. My point is, first get the data, and then let the data help us design the right approach to control leverage along with crowding.

  8. 'With assurances of data security – the data would not be revealed beyond the regulator....'

    -data security at a government institution

    -personnel security against a potential leak

    -moral security of the regulated institutions to honestly report their positions

    As always, the weakest link in the Market Genome is posed by Human Genome.

  9. Well said. There can be errors -- perhaps even fraud -- in reporting the positions. There can be leaks in the regulatory body. And there can be attempts at "innovative securities" designed to allow risks and exposures in forms that defeat any given markup language.

    If we start and stop with the data, that is, if we think this is a purely technical exercise, all of these problems will pop up. Not to mention the problem of having masses of data that might not be managed and analyzed correctly.

    So, we must also have a strong market regulator at the government level. Strong means able to understand what data are needed, able to put in controls both to secure the data and to audit the integrity of the data being provided to the effort, and able to face off against the Chief Risk Officers and CEOs when necessary.

    It still will not be perfect. But it will be better than knowing nothing. And, thinking back to the NTSB analogy, it can be structured to improve over time.

  10. Fascinating report. One question: At the NTSB, real experts review flight safety problems. But in financial markets, studies show few people are truly "expert," at least to the extent they are consistently smarter than markets. Can individuals and small groups adequately monitor financial market safety? (Aviation experts need only understand how to keep heavier-than-air vehicles aloft; financial "experts" not only need to know math, but must understand how people will react to an infinite range of information, not a small ask.) Or would more safety be achieved by requiring that data about market activity substantial enough to potentially create systemic risk be disclosed to the entire market in a format that the market can analyze? To some extent, this goes to the fundamental difference between public equity markets that rely on public information and private debt markets that do not. Even though the initial ABS were published on EDGAR, the risk was concentrated in the non-public CDO and CDS markets. As discussed on my blog, I wonder if better disclosure at the initial public level might have limited the size of the house of cards built at the private level. In any case, wonderful that serious discussions about using data to restore the markets are accelerating.

  11. Revealing position information publicly is not an option. Investment funds consider such information to be proprietary, and for good reason. Initially, the only way a political consensus would emerge is if it were kept locked up. Over time, there might be compromises to reveal various aggregates of the data. But if that is posed at the outset, things will get bogged down, never seeing the light of day.

    So we get back to the point I made in response to another comment. We have to couple getting the data with having a market risk manager at the government level who knows not only what data will be valuable, but also knows how to analyze that data. Might the regulator miss something? Of course. But there is a better chance of identifying systemic risks than if this data is not available.

  12. hi hick, here is what I would add to your argument. I think one of the main reasons for the build up of risk in the first place is to do with the way we account for profit. current accounting encourages taking risky positions. for example accounting for derivative positions is, to me, in clear contradiction to something called "the principle of prudence" which is supposed to be one at the foundation of most GAAPs out there. this principle says that revenue should be recognized when it is CERTAIN, and expense when they are probable. I trade exotic options at a european bank and this is not how we do things. we take profit the instant we enter an exotic structure that can stay on the book for 30 years. is that revenue certain? not until you earned it (from delta hedges etc) it's not. it's like having Toyota produce one Prius with a cost of 100 and valuing it in the inventory at 200, according to some "model". such a rule would only encourage Toyota to produce millions of cars and not bother too much about selling them, because all the key decision makers are paid in relation to "profit". you can see the avalanche forming there. why spend effort looking for buyers while you can just print profit by simply producing more. this is exactly what banks have been doing with their structured derivatives books. similar to physical systems following the path of least resistence, banks also followed the path of least resistence in the search of quick P&L, and exploiting the weaknesses of accounting rules was the simplest way to generate PL.
    as a wider discussion, unrealized mark to market PL is not the same as realized PL. banks should striclty reserve against all unrealized PL positions untli closed. market value is an uncertain value, it's not about just crossing bid offer spreads. making no distinction between realized and unrealized also encourages the build up of an avalanche - got this from your example in the book about internet stocks :)
    in the end, from what I see around me, people care about only one number - P&L. the risk measures are abstract values that don't affect anybody's bonus. so regulators should make sure profit really means profit, this should go a long way towards preventing the kind of problems we have today. once we fix that, somebody should aggregate risks and spot other avalanches before they get too big, eventually fire a couple of cannon shots to trigger them early.

  13. Thanks for your reply.

    "Revealing position information is not an option" sounds like what public companies said about revealing their financial information before the government required its structured disclosure in the early 30s. In fact, I'm told there are 20,000 documents such as this -- -- already on EDGAR that have the most intricate detail about the position information of the original creators of mortgage backed securities. So original positions were already revealed! The problem was that so-called "sophisticated" investors couldn't use this information because the government, in its infinite wisdom, required issuers to "dumb it down" from the issuers' own proprietary databases into ASCII or HTML, despite knowing that ABS market size was on track to exceed public company market size. (Listen to the Dec. 04 SEC open meeting linked from my blog.)

    Heretofore, the rule has been that if you want to offer a security, you must either register it and disclose it or find an exemption. Investment firms certainly have good reason not to want to reveal what they call "proprietary information" about their securities. But when that information creates systemic risk, I'd say it's no more proprietary than information about public company finances. The government may have limited powers, but one of those powers is to enforce contracts, and contracts that have the potential to undermine the stability of the entire system are therefore fair game for substantive regulation. And yet the government itself is very bad at that sort of work compared with "substantive regulation" from the discipline of market competition.

    Just as in the 20s, and not consciously, but by simply pursuing their own self interests, certain investment funds and proprietary traders over the past few years created systemic risk by pursuing their trades on the theory that they were smarter than the market. They weren't smarter than the market, but given the power to act in secret, some of them will always be smarter than regulators -- smart enough to create systemic risk no matter how sophisticated the data and tools are that government has at its disposal. That's why I don't think it's a good idea to dismiss public disclosure as a tool. Sunlight has been the best disinfectant for every sector of the economy in which large companies participate except the financial sector, which has argued that it's somehow too important to be subject to the basic rule that all material information must be disclosed to investors. Sunlight worked for public companies, with Enron and Worldcom being the exceptions that prove the rule (that their frauds required dishonest disclosure, something the government can deter, merely proves the value of honest disclosure).

    Selling "sophisticated" risk tools to proprietary traders is probably more profitable than selling tools on a competitive basis to the entire market -- particularly since the market understands that tools that claim to help one outperform the market don't work and you're doing well to earn market returns. And merely creating such tools is not a solution to systemic risk. Helping government regulators use them may help, but again, it seems to be a sub-optimal, or at best a partial solution.

    That is not to say that every investment fund must be required to disclose every position. When positions don't have the potential to create systemic risk, there's less of a case for disclosing them. The question then becomes, what is the threshold at which it would make sense to require disclosure of positions? $1 billion? $10 billion? $100 billion? That would need to be considered in light of the quality of the disclosure. If the disclosure were timely and complete, one could accept a higher threshold; if it were late and limited, a lower threshold would make sense.

    The thousands of free writing prospectuses already on EDGAR prove that public disclosure is already an option with respect to disclosure about the instruments at the heart of the current crisis. The question remains: What should be the price and quality of such disclosure, and of disclosure about subsequent instruments built like a house of cards atop such instruments? Do we want Aeroflot price, quality, and service or Continental price, quality, and service? Would there be demand for labyrinthine derivatives built on top of ABS like those at the link above if, in the first instance, the ABS weren't dumbed down from real data to ASCII and HTML? Or would the time of financial engineers be better spent increasing the reliability and transparency of disclosure of all material facts so that markets can accurately price risk? I'd bet on the market.

  14. Hi Rick,

    Why not have the external auditors do the first data aggregation ?

    They already visit all the major companies, know about auditing risks and know how to aggregate data to relevant, accurate, complete and fairly presented information on the business level. They only have to bundle and aggregate this individual business information to sector information. Furthermore, they are also familiar with all confidentiality issues involved.

    The audit firms submit their audited sector information to a central governmental agency, who is responsible for the new anticipation tasks.

    XBRL Assurance is moving into this direction. Using Business Rules. For internal auditors, external auditors and govermental regulators (see: I will be a speaker on this topic: "On positioning XBRL Assurance Business Rules in a Computational Infrastructure for Modern Auditing", at the International Conference on XBRL "A Practical View of XBRL in the 21st Century", hosted by the University of Kansas, April 24-25, 2009.

    Philip Elsas

  15. Do investors need to know asset ownership as a primary consideration in investing? If so, who owns the assets, borrowers, lenders, trust deed/deed holders, accounting procedures like derivatives or cities, counties, states and the federal government?


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