Jacobs Levy - Market Crisis

Key Articles:

· “Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis,” by Bruce I. Jacobs, Financial Analysts Journal, March/April 2009. Abstracted in CFA Digest, August 2009, and in Pensions & Investments commentary, “Mortgage Market Needs Tougher Standards,” August 10, 2009. Updated version in Laurence B. Siegel, Ed., foreword by Rodney N. Sullivan. Insights into the Global Financial Crisis. The Research Foundation of CFA Institute, Charlottesville, VA, December 2009. Executive summary in Robert W. Kolb, Ed. Lessons from the Financial Crisis: Causes, Consequences, and our Economic Future. John Wiley & Sons, Hoboken, NJ, 2010. Reprinted in Walter V. “Bud” Haslett Jr., Ed. Risk Management: Foundations For a Changing Financial World. John Wiley & Sons, Hoboken, NJ, 2010. (1) article
The growth and collapse of the U.S. housing bubble was enabled by the growth of the subprime loan market, a tower of securitized products known by their various acronyms as RMBS, CDO, SIV, and CDS. These products were used to shift risk from one party to another, lender to financial intermediary, financial intermediary to investor. Each party felt its individual risk was reduced, to the point that many lost sight of the real risks of the underlying loans. This sense of safety in turn encouraged more lending, more securitized products, and more leverage. But the systematic risk of the loans remained. When house price appreciation slowed in many areas of the country, and then reversed, a large number of borrowers, especially subprime borrowers, began to default on their mortgages. The tower of securitized products, meant to reduce risk for individual entities, collapsed. Rather than reducing risk, securitized products ended up creating systemic risk.

· “Risk Avoidance and Market Fragility,” by Bruce I. Jacobs, Financial Analysts Journal, January/February 2004. article
Investors who buy "insurance" against a decline in stocks, bonds, or other financial markets are shifting that risk onto the financial institutions providing such "insurance." These insurance providers frequently control their exposure to this risk by purchasing options or by replicating options via dynamic hedging. As more and more investors demand insurance, however, there is more trend-following trading, more market volatility, and more demand for insurance. At some point, the selling required to replicate an option on the market can create a liquidity crisis. In such an event, "insurance" products can fail, along with the firms offering them, giving rise to systemic risk.

Other Articles:

· “Momentum Trading: The New Alchemy,” by Bruce I. Jacobs, The Journal of Investing, Winter 2000. article
Investors who buy "insurance" against a decline in stocks, bonds, or other financial markets are shifting that risk onto the financial institutions providing such "insurance." These insurance providers frequently control their exposure to this risk by purchasing options or by replicating options via dynamic hedging. As more and more investors demand insurance, however, there is more trend-following trading, more market volatility, and more demand for insurance. At some point, the selling required to replicate an option on the market can create a liquidity crisis. In such an event, "insurance" products can fail, along with the firms offering them, giving rise to systemic risk.

· “When Seemingly Infallible Arbitrage Strategies Fail,” by Bruce I. Jacobs, The Journal of Investing, Spring 1999. article
Seemingly infallible arbitrage strategies can fail. When they do, they can take the markets down with them. The near collapse of Long-Term Capital Management bears some eerie parallels to the collapse of portfolio insurance, and the market, in October 1987.

· “Option Pricing Theory and its Unintended Consequences,” by Bruce I. Jacobs, The Journal of Investing, Spring 1998. (2) article
Like any revolution, the options revolution that began with the publication of the Black-Scholes-Merton option pricing formula has had some unintended side effects. Of concern to all investors should be the potentially dangerous increase in market instability created by the trading strategies option sellers use to hedge their market exposures. Dynamic hedging rules that call for buying as market prices rise and selling as they fall have wreaked havoc with markets in the past and are likely to do so again in the future.

Book:

· Capital Ideas and Market Realities: Option Replication, Investor Behavior, and Stock Market Crashes, by Bruce I. Jacobs, Blackwell Publishers, Malden, MA, 1999.
The summer and fall of 1998 witnessed some of the most turbulent financial markets the world has ever seen. The implosion of the Russian financial markets and investors' ensuing flight to quality propelled the giant hedge fund, Long-Term Capital Management, to the brink of collapse and left the investment portfolios of many of Wall Street's major banks and brokerage houses teetering on the brink. The U.S. equity market dropped precipitously at the end of August and continued over the next month to experience levels of volatility not seen since the major crash of October 1987. Yet, within months of the August sell-off, U.S. stocks had bounced back to new highs. How can markets fall so fast and recover so quickly?

Bruce Jacobs sifts through the history of modern finance, from the efficient market hypothesis to behavioral psychology and chaos theory, to determine the cause of recent market crashes. He finds that some investment strategies, especially those based on theories that ignore the human element, can self-destruct, taking markets down with them. Ironically, some strategies that purport to reduce the risk of investing can pose the greatest danger.

Of particular concern is a trading strategy that grew out of the option pricing model developed by the late Fischer Black and Nobel laureates Myron Scholes and Robert Merton. Used by market professionals, this strategy, known as option replication, requires mechanistic selling as stock prices decline and buying as stock prices rise. When a large enough number of investors engage in this type of trend-following "dynamic hedging," their trading demands can sweep markets along with them, elevating stock prices at some times and causing dramatic price drops at others.

Capital Ideas and Market Realities revisits the crash of October 19, 1987 to examine an option replication strategy known as portfolio insurance. Marketed as a free lunch, offering excess returns at low or no risk, portfolio insurance grew into a $100 billion industry by the fall of 1987. The book documents portfolio insurance's contribution to the crash, examining and dismissing multiple alternative theories along the way. It goes on to look at the so-called "sons of portfolio insurance"—instruments and strategies that have emerged since the 1987 crash, offering similar promises of no-risk returns. These include hundreds of billions of dollars in over-the-counter options and swaps, as well as various "guaranteed" equity products. Their advent has been associated with a number of market disruptions.

An investigation of Long-Term Capital Management and the summer of 1998 reveals how derivatives-dependent hedge fund strategies can have effects similar to those of option replication. In effect, when Long-Term Capital Management's supposedly low-risk strategies reached their liquidity limits, the firm was forced to sell, mechanistically, into declining markets. As with the selling related to portfolio insurance in 1987, the result was precipitous drops in wealth for most investors.

Book Chapters:

· “Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis,” by Bruce I. Jacobs, reprinted in Walter V. “Bud” Haslett Jr., Ed. Risk Management: Foundations For a Changing Financial World. John Wiley & Sons, Hoboken, NJ, 2010.

· “Executive Summary of Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis,” by Bruce I. Jacobs, in Robert W. Kolb, Ed. Lessons from the Financial Crisis: Causes, Consequences, and our Economic Future. John Wiley & Sons, Hoboken, NJ, 2010.

· “Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis” (updated), by Bruce I. Jacobs, in Laurence B. Siegel, Ed., foreword by Rodney N. Sullivan. Insights into the Global Financial Crisis. Research Foundation of CFA Institute, Charlottesville, VA, December 2009.

· “A Tale of Two Hedge Funds,” by Bruce I. Jacobs and Kenneth N. Levy, in Jacobs and Levy, Eds. Market Neutral Strategies. John Wiley & Sons, Hoboken, NJ, 2005.
The blow-ups of two notorious hedge funds hold some lessons for investors considering market neutral strategies. Askin Capital Management's supposedly market neutral posture in mortgage instruments was anything but market neutral. In fact, the firm was extremely susceptible to rising interest rates, and succumbed as the Fed raised rates in 1994. Long-Term Capital Management's sophisticated risk aggregator was supposed to ensure the neutrality of the firm's complicated arbitrage trades. Yet it failed to account for how extreme price movements would affect correlations between different asset classes and the willingness of other arbitragers to take on positions as arbitrage spreads widened. The Russian debt crisis in the summer of 1998 brought the firm to its knees, and the resulting selling pressure roiled financial markets.