Book: Market Complexity Is at the Root of Crises In his book A Demon of Our Own Design, Richard Bookstaber argues that the financial markets have grown so big and complex that understanding the real risk of an investment is nearly impossible and that big crashes like 1987 are almost inevitable.
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Book: Market Complexity Is at the Root of Crises

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Book: Market Complexity Is at the Root of Crises

Book: Market Complexity Is at the Root of Crises

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MELISSA BLOCK, host:

From NPR News, this is ALL THINGS CONSIDERED. I'm Melissa Block.

The stock market is a wild ride these days. Today, it was way up. The Dow gained more than 300 points. That made up some ground, but it's still down more than 700 points from its high earlier this year. The drop is largely because of the problems with subprime mortgages and the credit markets.

Wall Street veteran Richard Bookstaber says crises like this are no fluke. His new book is called "A Demon of Our Own Design," and it argues that the markets have become so complex that periodic meltdowns are inevitable.

NPR's Jim Zarroli reports.

JIM ZARROLI: Richard Bookstaber says, to understand what's happening in the financial markets these days, consider the cockroach. Cockroaches, he says, have survived for hundreds of millions of years in all kinds of environments.

Mr. RICHARD BOOKSTABER (Wall Street Veteran; Author, "A Demon of our Own Design"): And they've survived with a really simple defense mechanism. They don't smell, they don't see, they don't hear. All they do is they go in the opposite direction of the gust of wind.

ZARROLI: And he says there's a lesson in there for the markets, being simple can be an advantage. Bookstaber isn't trying to say something pejorative, he is himself a Wall Street veteran. He came there in 1983 from MIT. At the time, firms like Solomon Brothers were learning to harness computer power to design investment products and they hired mathematicians like Bookstaber to create new kinds of securities. These new securities were hedging products. In other words, they bundled together lots of investments that did different things when the market fluctuated.

Mr. BOOKSTABER: What that means is you would like ideally to have enough securities of different types, so that no matter what you're worried about, you can find a way to protect yourself against it.

ZARROLI: Over time, Bookstaber says these securities have become common place on Wall Street and ever more complex. And that's created a dilemma for the markets.

Mr. BOOKSTABER: The basic premise in my book is that we've structured financial markets in a way that makes some crisis come.

ZARROLI: Bookstaber says these new securities have done two things. First, he says, they're tightly coupled. That is, they're intricately designed and often highly leveraged with debt. That means they can ricochet out of control in crises in a way that's impossible to stop. That's what happened during the 1987 stock market crash, he says, thanks to a hedging product called portfolio insurance.

Mr. BOOKSTABER: The computers would say sell, the selling would drop the market, the drop in the market would say sell. And you just had this continuing cycle.

ZARROLI: And Bookstaber says, because these securities are so complex, it can be hard to figure out how much they're worth quickly. So when there's a crisis in the market and an investor needs to raise money fast, that investor may need to sell something else instead.

Mr. BOOKSTABER: If I'm under pressure and I can't sell in the market, you know, where I want to, I have to look and sell what I can.

ZARROLI: Bookstaber says this creates weird pairings between unrelated investments. For instance, the Russian debt crisis of the 1990s caused a lot of investors to dump Brazilian bonds, even though Russia and Brazil had few economic ties. It's also why the subprime crisis spread so fast through the economy, even affecting investors who had nothing to do with subprime.

David Sokolove of the hedge fund Leviticus Partners says this is one of the important ideas in "A Demon of Our Own Design." Just as a driver can be hurt by someone else's negligence, investors can be hurt by crises they had nothing to do with.

Mr. DAVID SOKOLOVE (Leviticus Partners): There's a lot of crazy people and economy malfunctions and (unintelligible) malfunctions and rain and whatever. There's a lot of (unintelligible) you don't control. You're a very small part in a very big system.

ZARROLI: Sokolove was one of about 40 people who attended a recent talk by Bookstaber in New York. In the wake of the subprime crisis, "A Demon of Our Own Design" has attracted a fair amount of attention. For the record, Bookstaber is no Cassandra. He says market crises like Long Term Capital Management can blow over in time.

Mr. BOOKSTABER: It's not the case that every time it turn into a crisis, it'll have a systemic effect.

ZARROLI: But he says there are exceptions. He also says the secretive nature of many hedge funds makes it difficult to analyze crises after the fact. And that means it can be hard to prevent crises in the future.

Jim Zarroli, NPR News, New York.

BLOCK: Richard Bookstaber describes his role in financial collapses of years past in an excerpt from his book. That's at npr.org.

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