Liquidity has been a sturdy support for the current bull market. This has been driven by an increasing amount of leverage as investor risk appetite has risen around the globe. At Schroders' Annual Secular Market Forum, Richard Bookstaber, hedge fund manager at FrontPoint Partners, opened an active discussion around the level of risk he sees in markets today and areas of the market that are worth watching. He discussed:

• The changing perception of risk;
• Factors that influence crisis events in the market
• Some examples, including the crash of 1987 and LTCM; and
• Whether the market has learned any lessons

Is the market more or less risky today?

Bookstaber began his discussion by assessing the risk in the market. Most measures show that economic risk has dropped as the volatility of output and inflation have fallen. He pointed out that, in the past, an economy would have been crippled by an oil embargo or strike in the steel industry, but that this is not the case today. If economic risk has decreased, as suggested, one would expect market risk to have decreased, as the two tend to be positively correlated. In fact, though, market risk has actually risen. The important distinction to make, in his opinion, is that the risk now relates mostly to what he calls ‘crisis risk'. Markets seem to be more crisis-prone, as evidenced by the crash of 1987, the Asian crisis, tech bubble and LTCM failure to name a few.

Factors that help explain the increased tendency for market crises today are the increased complexity of financial markets, including derivatives, and ‘tight-coupling'. When an event occurs, there is no mechanism to ‘put everything on hold' - a seemingly insignificant event in itself can quickly escalate to a crisis. This can often involve seemingly uncorrelated markets. The tight-coupling comes from leverage, which is due to the liquidity in the market. Economic events rarely trigger a financial crisis; it has more to do with ‘who owns what' and ‘how much they own.'

Example 1: Crash of 1987

Searching for examples to support this theory, Bookstaber first pointed to the stockmarket crash in 1987. The 20% drop in the US market on 19 October that year could be tied to the ‘portfolio insurance' that many participants held. Institutional investors would purchase what were in effect 'stop losses' as a way of protecting their downside risk. Counterparts who provided this 'insurance' would use futures and options to set a floor, using the Black-Scholes model to calculate how many contracts they needed to sell given underlying prices, time and volatility (i.e. the delta of the position). As underlying prices moved up or down, they needed to adjust the number of futures they held in order to neutralise their position.

The precursor to the crash was the fall on the previous Friday. Counterparts who were long these underlying stock positions (and therefore synthetically long futures) needed to sell an increasing number of stock futures on the way down. For example, if the stock fell slightly, they needed to sell a small number of futures, but if the stock fell a lot, they needed to sell many more futures. This hedging activity created a discrepancy between the cash futures and the stock price on the NYSE. As a reaction, market makers on the exchange began dropping their quotes on Monday morning because no trades were coming in.

Unfortunately, the more they dropped their prices (really with little actual trading), the less willing investors were to buy. The compounding problem for the counterparties, however, was that their Black-Scholes model was telling them that they needed to sell even more futures because the cash prices were falling. This process snowballed until the Fed stepped in. The Fed acted as a 'circuit breaker' and, thus, broke the tight-coupling.

Example 2: LTCM

The events leading to the collapse of hedge fund LTCM were in some ways similar to those in the '87 crash. Bookstaber highlighted that, by and large, the company did very little wrong. True, it was highly leveraged, but the banks that loaned it money thought the risk was acceptable. Russia defaulting on its bond obligations may have triggered the collapse, but what set the wheels in motion, according the Bookstaber, was when a big trading house announced that it was shutting down its proprietary trading desk. It wasn't the fact that it was closing it, but that it announced to the market that it was doing so. Now, all of the other trading desks tended to stay out of the market, knowing that the company needed to get out of its positions. Liquidity during the summer dried up.

If this had been the only thing that happened, everything would have eventually returned to normal and LTCM would probably be alive today. However, Russia defaulted, causing everyone with Russian exposure to liquidate readily available assets in order to meet margin calls. Russian assets were practically worthless, so many turned to other positions. Unfortunately - and this is easier to say in hindsight - everyone else had the same positions and many investment banks held sizable stakes in LTCM itself. Everyone was trying to sell into a relatively thin market - prices dropped sharply. The more prices dropped, the more margin traders needed to raise to place collateral with their creditors and the more they needed to sell. Again, a snowball effect. And again, the Fed stepped in to act as a ‘circuit breaker' and it broke the tight-coupling. The Fed organised the bail-out of LTCM.

Has the market learned its lesson?

History seems to suggest that crises such as the crash in '87 and the failure of LTCM are typically triggered by often unrelated events. They are not normally triggered by economic events. In both examples given, liquidity was largely one-way since most participants had similar if not the same positions, and they were leveraged positions. The crises ended only when someone (the Fed in these instances) stepped in the break the tight-coupling.

At this point in the discussion, Richard Buxton highlighted the possible correlation to today's market environment. Many investors hold similar positions and leverage is fairly high. Market bears generally point to the possibility of the global economy turning - often either due to the US housing market or China - as the trigger for a major stockmarket correction. What history tells us is that, if we are to see a correction, the trigger may be unrelated to the economy or even to the particular market in question. If, indeed, highly leveraged investors need to get out of their positions quickly, and assuming they hold similar positions, then this could be the next crisis. Predicting the trigger is much more difficult.

Bookstaber said that, when he presents, the most often asked question is what will be the next crisis. At the top of his list are the US mortgage and Credit Default Swaps markets. He sees mortgages certainly fitting the leverage criteria, with borrowers increasingly taking on debt of over four times the value of their homes. The liquidity shift may come from a demographic change however. Baby boomers caused a huge demand spike when they all began buying properties. Demand (and liquidity) could dry up as people stop buying second and third homes.

He believes that stockmarket volatility is currently low because hedge funds are arbitraging for smaller gains. Leverage is also probably rising with investors willing to take on more risk. After all, economic risk is falling, as highlighted earlier. This situation, to Bookstaber, is akin to a frog in a frying pan. If you throw a frog in a hot pan, it will jump off quickly. If, on the other hand, you put the frog in a pan and heat it slowly, the frog will get used to the slowly increased heat. The question for investors is how quickly investors notice the pan reaching boiling point.

Important information:

These notes are based on a presentation by Rick Bookstaber, hedge fund manager at FrontPoint Partners, dated 31 May 2007 and do not necessarily represent Schroder Investment Management's house view. Please note that these notes have been complied by Schroders staff and are not directly attributable to the speaker.

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