It's Never That Simple in Wall
Street
Some on Wall Street want us to believe they've figured out how to
eliminate simple risk . They haven't. But by claiming otherwise, they've
made investing scarier.
By Allan Sloan Newsweek April 16, 2007 issue - found at : msnbc.msn.com
The world of high finance can be
a perverse place. Consider the possibility that by playing financial games to
make it look like they have less risk than they do, companies and Wall Street
are unintentionally making the financial markets riskier for ever
yone. It's a
function of the way accounting rules and financial markets intersect. Here's the
deal. Businesses can make their financial statements look less volatile—less
prone to up-and-down moves—by using high-cost, esoteric products that
fee-hungry Wall Street is happy to provide. However, some of those
products—ranging from old-time "portfolio insurance" to today's
derivatives that involve lots of borrowing—have blown up in the past, and
could easily blow up in the future. That's especially true today with so many
companies playing so many games involving securities whose values are based on
formulas rather than on actual transactions.
The idea that reducing visible risk can increase actual
risk isn't my insight—I wish it were. I've gleaned it from talking to smart
people over the years, and it was crystallized by two little-known business
books I happened to read recently: "More Than a Numbers Game: A Brief
History of Accounting," by Thomas King, published last year, and "A
Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial
Innovation," by Richard Bookstaber, which just came out. Neither is written
for a general audience. But they explain a lot about how accounting and Wall
Street esoterica work in the real world.
The key is that Wall Street loves predictability.
Companies want to oblige by seeming to grow smoothly even though the real world
has lots of ups and downs. Much of corporate America devotes so much time and
effort to "guiding" analysts about what quarterly profits and revenues
will be—then making sure the right numbers are hit—that last month a U.S.
Chamber of Commerce report called on companies to eliminate "guidance"
because it hurts our economy. "You do more harm than good by trying to
dampen those bleeps and blips that are a natural part of business," says
King, whose day job is treasurer of Progressive Insurance. "There has yet
to be a business that can deliver smooth earnings growth in perpetuity. Over
time, management must come up with increasingly heroic [accounting entries] to
meet ever-higher earnings targets extrapolated from an artificial trend."
King's chapter on volatility shows how U.S. companies
can account for transactions in foreign currencies three different ways, all of
them legitimate. His chapter about the Sarbanes-Oxley corporate disclosure laws
has an astute analysis of the accounting frauds at Enron and WorldCom that begat
that legislation. It's not a page-turner—but you can learn from it.
That brings us to Bookstaber, a risk-management maven
who's been on Wall Street for decades and is now a portfolio manager for a small
hedge fund. Bookstaber's book shows us some complex strategies that very smart
people followed to seemingly reduce risk— but that led to huge losses. There's
a terrific reprise of the tale of how "portfolio insurance" triggered
a sickening 23 percent one-day drop in the Dow industrials on Black Monday: Oct.
19, 1987. The idea was to limit losses on customers' stock portfolios to about 5
percent. But so many players had this "insurance"—originally called
"dynamic hedging"—that it unleashed a wave of selling that melted
the market down.
Bookstaber also takes us through a variety of other
failed strategies. The best-known: the fall of Long Term Capital Management,
once the most respected hedge fund in the country, an outfit that told its
investors it could produce stellar returns with little risk. But LTCM's
mathematical models were fatally flawed. LTCM's implosion in 1998 had so much
potential to damage the world's financial system that the Federal Reserve Board
felt obliged to convene a meeting of big Wall Street houses to organize an
orderly liquidation of the firm.
Could such a thing happen again? Absolutely, says
Bookstaber, who says the search for above-market returns with seemingly
less-than-average risk has spawned many exotic strategies that rely heavily on
borrowed money. "If you have leverage and complexity, things will
inevitably blow up," he says. That's why he thinks our financial markets
have become riskier than they were, even though our economy has gotten less
risky.
The message here: unpleasant as it is, let's admit that
there's no such thing as a free lunch. It's an up-and-down world; be prepared to
take the occasional lump. In the markets, as in life, there's no such thing as
return without risk.
Sloan is NEWSWEEK's Wall Street editor. His e-mail
is sloan@panix.com.
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