Market Crisis

· “Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis,” by Bruce I. Jacobs, Financial Analysts Journal, March/April 2009; and abstracted in CFA Digest, August 2009. Also updated version in Insights into the Global Financial Crisis, The Research Foundation of CFA Institute, December 2009, and Pensions & Investments commentary, “Mortgage Market Needs Tougher Standards,” August 10, 2009. 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.

· “A Tale of Two Hedge Funds,” by Bruce I. Jacobs and Kenneth N. Levy, in Jacobs and Levy, Eds., Market Neutral Strategies, John Wiley, The Frank. J. Fabozzi Series, 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.

· “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.

· “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. (1) 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.