A Week When Risk Came Home to Roost

By GRETCHEN MORGENSON
Fair Game
The New York Times
August 12, 2007

FOR something that everybody assured us was “contained,” the subprime mortgage mess certainly has spread.

Last week, the hemorrhaging credit markets bled right into the stock market. The major indexes are still up for the year, thankfully, but the Dow Jones industrial average, which hit 14,000 just three weeks ago, has lost 5.4 percent of its value since then. And the Standard & Poor’s 500-stock index is down 6.4 percent from its July peak.

Why are the bond market’s troubles something for stock investors to worry about?

The easy answer is that all markets, both here and around the globe, are intertwined. And despite Wall Street’s insistence that diversification — and therefore safety — could be found in different types of assets, investors are again learning that diverse holdings often behave similarly. This is especially true in periods of uncertainty like the one we are enduring now.

But there are other reasons that the stock market is getting dinged by bond woes. One involves private equity firms, which provided perhaps the biggest push to stock prices when they paid significant premiums to acquire public companies. If these firms cannot borrow money in the bond market to finance their buyouts, or if they must pay more for those borrowings, their business models do not work as well. And that means the private equity bid for stocks fades away.

Even more surprising, to young hedge fund managers at least, is the way the credit crisis has begun to hammer seemingly conservative equity investment funds. This is another explanation for the stock market’s upheaval last week.

Using what are known as market-neutral strategies designed by computer models, hedge fund traders have been blindsided by a correlation between bonds and stocks that they never expected would occur.

Portfolios of this stripe are often known as quantitative funds; some of their most common trades are called statistical arbitrage. These bets are suggested by brilliant mathematicians and academics, using computer models to scour the markets for interesting trading patterns that continue for long periods.

For example, a computer might trace the relationship and trading characteristics of two similar assets, like shares of General Motors and Ford. The fund manager then makes trades, going both long and short, based on the way these shares generally trade. If Ford typically trades cheaper than General Motors, the manager would short Ford and buy G.M., capturing what might be small profits, but on a large volume.

Another type of trade might involve stocks’ performance immediately after an analyst downgrade or upgrade. Trades are placed on thousands of stocks to try to capitalize on the “typical” behavior that the computer coughs up.

Seeing that such bets typically generated profits over long periods left traders believing that their stakes were conservative.

The only trouble is, financial markets do not always trade in a way that is typical or predictable. And when they deviate from the norm, all the wonderful and smart trades stop behaving according to plan.


ANALYSTS call it model misbehavior.

In a research report from Lehman Brothers last week, Matthew S. Rothman described the phenomenon. Fund managers experiencing losses in their fixed-income portfolios who were unable to sell their positions then tried to unwind the trades they could sell — that is, stocks. They cashed in the shares they had purchased and bought back the ones they had sold short.

The result was that stocks that had historically been weaker became stronger, and vice versa.

“It is not simply that model returns are flat (or not working),” Mr. Rothman wrote, “but specifically that the models (ours included) are behaving in the opposite way we would predict and have seen and tested for over very long time periods (45-plus years).”

As a result, “risk models are miscalibrated for the current market environment,” he wrote.

Compounding the problem, of course, is the borrowed money these funds use to enhance their performance. When things start to unravel, leverage aggravates an already painful fall.

Mr. Rothman also pointed out that so many fund managers had the same trades on their books that when they went to cash out of them, the ill effects were exaggerated.

The losses that investors are suffering this month, he wrote, are comparable only to those in the 1960s and during the bursting of the Internet bubble. “This appears to be an event with little precedent,” he wrote.

None of this would be a problem, of course, if fund managers were not relying so heavily on just that — precedent — to make their decisions. Computer models seem so perfect, so scientific, so flawless, and they are advertised to investors in precisely that fashion. Ingenious models lull investors into a dangerous complacency about the risks they are taking. It is almost as if the models eliminate risk entirely from the markets.

But risk is never gone, as investors are recognizing with a jolt. And that is so even if Wall Street assigns conservative-sounding labels to portfolio strategies that are, in fact, aggressive.

“They have their standard deviations, correlations, ‘stable value’ and ‘real return’ funds and nothing for what the normal human being would call risk at all,” said Frederick E. Rowe Jr., a money manager at Greenbrier Partners in Dallas. “They’ve taken the word ‘risk’ and hijacked it. The concept of risk — the permanent loss of capital — vanished in the minds of the people who speak the new language.”

Risk, and all that it should connote to investors, is back in the language now. Unfortunately, it has brought an awful lot of losses with it.