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Richard Bookstaber is author of 'A Demon of Our Own Design' ()

Book: Market Complexity Is at the Root of Crises

Nov 13, 2007 (All Things Considered)

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The cockroach has survived for hundreds of millions of years, in every kind of environment, outliving insects that are much more complex in evolutionary terms.

To Richard Bookstaber, that makes it the perfect model for big Wall Street firms now struggling through the subprime mortgage crisis.

In his book A Demon of Our Own Design, the former risk-management executive at Morgan Stanley and Salomon Brothers argues that the explosion of growth of structured finance products has made the markets much less stable.

"The basic premise in my book is that we've structured financial markets in a way that makes them crisis prone," he says.

Creating the Demon

Bookstaber should know. He came to Wall Street in 1983 after a brief career in academics at the Massachusetts Institute of Technology.

At the time, big firms such as Salomon were starting to harness computer power to design a new generation of hedging products, and they needed mathematicians like Bookstaber to create them.

They succeeded so well that these securities — also called structured finance products — are now used widely throughout the financial markets.

Complexity and Crisis

But Bookstaber argues that the growth of these products has made market meltdowns like the current subprime crisis inevitable.

First, he says, the new products tend to be so intricately designed and so leveraged with debt that they can ricochet out of control in crises, in a way that can be difficult to stop. He points to the October 1987 stock market crash, which was precipitated by a hedging product called portfolio insurance.

"The computers would say 'Sell,' the selling would drop the market, the drop in the market would say 'Sell.' And you just had this continuing cycle," Bookstaber says.

The new products are also extraordinarily complex, often composed of different investments behaving in opposing and very complicated ways. In a market crisis, an investor can have trouble figuring out how much they're worth, and often will decide to sell another asset instead.

This makes for some strange bedfellows. The Russian debt crisis of the 1990s caused many investors to dump Brazilian assets, even though Russia and Brazil had relatively few economic ties, Bookstaber notes.

It's also why the subprime mortgage crisis spread so quickly through the economy, affecting many investors who never put a cent into these investments, he says.

How the Subprime Crisis May Be Different

That's where the cockroach analogy comes in. It has outlived other insects because its defenses are simpler, allowing it to adapt easily to changing environments, Bookstaber explains. Being too complex can thus be a disadvantage.

Bookstaber is no Cassandra. He says market crises often blow over in time, and the impact of meltdowns — such as that of Long Term Capital Management — on the economy has often turned out to be less severe than many people feared.

"It's not the case that every time a hedge fund fails it'll turn into a crisis, and it's not the case that every time it does turn into a crisis it'll have a systemic effect," he says.

But because the subprime mortgage crisis affects consumers so directly, it could be the exception, Bookstaber adds.

"Subprime may be a little different because this is a crisis, if you want to call it that, a dislocation, whatever, that really is hitting a pretty substantial and critical part of the economy — the housing markets and the credit markets. And I think the jury is still out on whether this can have a systemic effect."

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Read an excerpt from the book in which Bookstaber describes his role in some of the major financial collapses of years past.

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