Bruce I. Jacobs, co-founder, co-chief investment officer, and co-director of research at Jacobs Levy Equity Management, provides insights to help anticipate the next market crisis.
On September 15, 2008, investment bank Lehman Brothers filed for bankruptcy, setting in motion a global financial crisis with severe consequences for both Wall Street and Main Street. As the co-founder and co-chief investment officer of an investment management firm, I found myself close to the center of that turmoil. And while every crisis is unique, many aspects of this one seemed disturbingly familiar.
In fact, many of the underlying causes of the 2007—2008 crisis have destabilized markets in the past. In my new book, Too Smart for Our Own Good: Ingenious Investment Strategies, Illusions of Safety, and Market Crashes (Too Smart for Our Own Good), I discuss these causes and lay out the case that, unless we acknowledge and confront them, they will lead to future crises similar to the one we suffered a decade ago.
This book challenges the notion that financial crises are merely the result of happenstance, bad luck, or the markets’ natural proclivities. Rather, they grow out of certain types of financial strategies and products that have the potential to interact in damaging ways with investor psychology. These strategies and products are intended to reduce the risk of investing. They rely on state-of-the-art computer engineering and sophisticated mathematics as well as marketing campaigns designed to overcome any doubt with extravagant claims and “guarantees” of favorable results. Yet, ironically, despite their purported safety, they have actually increased risk for all investors by creating conditions that give rise to financial storms.
Of particular interest are portfolio insurance in the 1980s, arbitrage strategies pursued by LTCM in the 1990s, and the mortgage-linked securities at the center of the 2007–2008 credit crisis. All these strategies and products seemed to offer a free lunch—the potential to reduce risk while increasing return. When they attracted large numbers of followers, however, they channeled individual investors’ hopes and fears in a way that created market instability. They magnified steep increases in market values, to the point where prices became unsustainable. Investor pessimism then set in, suddenly turning gains into losses.
While the particular strategies and instruments that are offered change over time, they share certain commonalities. These commonalities include opacity and complexity, which make it difficult to anticipate the effects of the strategies and products and to discern the relationships they forge between different market participants. They also include leverage, facilitated by derivatives and borrowing, which increases their impact on security prices, markets, and the economy. And they include the underlying, option-like nature of the strategies and products, which can make markets behave in nonlinear ways, with prices bubbling up or crashing down.
Risk-reducing strategies and products that share these characteristics can create an illusion of liquidity, a misperception of underlying risks, a flood of capital into the strategies and products, and a magnification of their effects on underlying markets and financial institutions. Consequent feedback loops between the strategies and market behavior further increase market fragility. Investors aware of the common threads between all of these market upsets can avoid repeating the mistakes of the past and contribute to a more stable financial future.
What if we fail to address the root causes of the 2007–2008 crisis and its predecessors? The conclusion of my article, “Risk Avoidance and Market Fragility,” (Financial Analysts Journal, 2004) described what would be the consequences of our failure to act. What I wrote then is just as pertinent now, and likely will be when the next crisis arises.
Who then becomes the risk bearer of last resort? It may be the taxpayer, if the government decides that the firms that offered these products are “too big to fail.” Often, it is investors in general who must bear the risk in the form of the substantial declines in prices that are required to entice risk bearers back into the market. Ironically, products designed to reduce financial risk can end up creating even more risk.
Bruce I. Jacobs is co-founder, co-chief investment officer, and co-director of research at Jacobs Levy Equity Management, in Florham Park, NJ. He holds a Ph.D. in finance from the Wharton School of the University of Pennsylvania. For 35 years, he has been a major voice for financial transparency. Jacobs is the author of Capital Ideas and Market Realities: Option Replication, Investor Behavior, and Stock Market Crashes, as well as many articles on equity management and financial crises for leading journals