Mitigating Bubbles

8/4/2019 Mitigating Bubbles

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T a m ing G lo b a l V illa g e R isk II:Under s t and ing an d Mit iga t ingBubb l e sR O D N EY N . S U LLIV A N

EY N . SULLIVAN

viUe, VA, andFinancial Speculative asset bubbles and theirsubsequent bursts have been a part ofcapital markets since modern capitalmarkets began to evolve some 300years ago.' Curiously,financialbubbles, wh enviewed from a distance, apparently build andburst in much the same way. History suggeststhat three common, although not exclusive,factors often precipitate asset bubbles: finan-cial innovation, the em otions and psychologyof investors, and speculative leverage. Al thougheach bubble environm ent certainly has its own

distinguishing characteristics, these three ele-ments form the p ertinent ingredients in bubbleenvironments over time. This article exploreshow these features present themselves in dis-ruptive market bubbles and offers some sug-gestions for improving our risk managementapproaches in light of these features.^The origins ofthe current global creditcrisis can be found in the time-worn bubblestory. Financial inn ovation , leverage, and masspsychology link together to form a dynamic

feedback loop. Innovation gives rise to com-plexity, but investors and regulators have a falsesense of confidence in their abihty to managerisk and predict outcomes from the innova-tions. Buying begets more buying in a rushto ride the latest wave. This Ponzi approachworks for a while as the asset bubble escalatesand the success serves to embolden investors,who then take on even more leverage toindulge in imprudent speculation. Armed with

groupthink, investors pile on to reap therewards of the latest innovation. Asset pricesrise, but the shift of investors to the same sideof the boat means market balance and diver-sification begins to break downuntil a tip-ping point is reached. Then, the bubbleim plo des: Inve stors deleverage, asset deflationreplaces asset inflation, innovations are rec on-figured, and humility is (hopefully) restored(Minsky [1974]). We will return to the cur-rent bubble later, but first we w^ill explorelessons from past bubbles. By understandingour past, we can enhance our abihty to bettershape our future.LESSONS FR OM PAST BUBBLESA N D R E A C T I O N S

An exploration offinancialhistory showsthat our current bubble is not unique. Rapidinnovation is often followed by herding intothe "n ew " and into speculative leverage, wh ichultimately produces an asset bubble. Theexhibit reports selected asset bubbles.Goetzmann and Rouwenhorst [2005]discussed thefinancialrevolution that occurredin Holland du ring the 1600s. Th e appearanceof the world's first stock exchange (Ams-terdam), the development ofthe modern cor-poration (Dutch East India Company), and theinvention of derivatives (options on tulips)partnered to revolutionize investing. Interest-ingly, Holland was also the site of the world's

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E X H I B I TBubb les in History

EventTulips: Holland (1634-16 37)Mississippi Shares: France(1719-1721)South Sea Shares: GreatBritain (1719-1720)Stocks, Bonds: U.S.(1791-1793)Stocks: U.S. (1921-19 32)

Real Estate and Stocks:Japan (1965-)NASDAQ Stocks: U.S.(1999-2000)Real Estate and C redit:Global (1987-)

PercentageRise+5,900+6,200

+1,000

+50

+497

+3,720

+733

+260*

PercentageDecline- 9 3-9 9

-8 4

- 3 3

- 8 7

-

- 7 8

-

InnovationStock exchange.DerivativesFiat money

Fiat money

Bank of U.S.

Communications,transportation, open-ended investment trustsLiberalization ofJapanese economyTechnology, m edia,communicationsNew structured creditvehicles

Notes: Fiat money is paper money.*Change in S&P/Case-Shiller Composite-0 Home Price Index.Sources: Knoop [2008], Goetzmann and Rouwenhorst [2005], and author analysis.first recorded asset bubble, tbe mucb-storied Dutcbtulip bubble, often referred to as "tulip mania," during tbeyears 1634-1637.In the early 1700s, Scottish businessman John Lawand tbe French government introduced an innovativefinancial architecture to solve France's financial woes.Am ong these innovations. Law introduced paper or fiatmoney to Europe. Law's contribution to bubble historycame with the Mississippi Company. ExaggeratingLouisiana's wealth. Law convinced France to convert itsnational debt into tradable equity shares in tbe formerlyderelict Mississippi Company. T he governm ent, in retu rn,granted the Mississippi Company monopoly trading rightsto the territories of Louisiana. With the market awash inliquidity, the equity shares rose roughly 65-fold beforeultimately collapsing. Law's conversion of paper into

money, together with other innovative financial ennee ring and Law's selling of shares in the Mississippi C opany, precipitated a frenzy of speculation that ultimatproduced the very first stock market crash, in 1720.^At about the same time, the British fashioned South Sea Company to mimic the success ofth e Missippi Company in raising money for the government. Tfate ofthe South Sea Comp any and the British market palleled the experiences in France and culminated in building and bursting of the famous South Sea BubbInterestingly, tbe Mississippi and Soutb Sea bubbles wgovernme nt-led events. Tbey were initiated and supp orby innovation, not in tbe private sector, but by tbe gernments of France and England.

A look into the beginnings of the United Stareveals another bubble event. Shortly after the Revolution

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War, a fmancial revolution put the United States on agrowth trajectory that would eventually allow the co untryto flourish. In the short run, however, this innovationbrought speculative fever and pain. The Bank of theUnited States, formed in 1791, was a semi-public nationalbank, an institution to safeguard all pecuniary transac-tions. It acted aggressively to restructure the U.S. debtbuilt up during the war. The bank not only stimulatedthe economy but also enhanced the shaky credit of thegov ernm ent. Th e Federalists were for it; the Jeffersonianswere against it. Within two months of opening, the bankflooded the market with its discounts (loans) and banknotesand investors eagerly participated in the sale, driving pricesto lofty levels. Th en, the bank sharply reversed course andcalled in many of the loans. This drain forced speculatorsto sell their stocks, and when the largest speculator wentinsolvent in March 1792, the short-lived market paralysisknown as the Panic of 1792 occurred."* The bubble andpanic were remembered for many years by opponents ofthe bank and eventually led to its demise in 1811.

The three common ingredients of fmancial inno-vation, investor emotions, and speculative leverage caneasily be discerned in more recent times. Consider theU.S. equity market bubble during the "roaring" 1920s.Innovations that took place during this era included rapiddevelopments in utilities (telephone and electrification),transportation (automobiles), and fmance (open-endmutual funds). In many ways, the rapid innovation thatdescribes the early part of the 20th century in the U nitedStates parallels that of the late 20th century, which isdefmed by innovations in internet/technology, media, andtelecommunications (sometimes known as the TMTbubble). Both periods were defmed by the building andbursting of an asset bubble built on the back of wide-spread technological innovation, leverage (equities werespeculatively leveraged by unrealistic future earningsexpectations), and the mass psychology of a new economythat was believed could not falter.

Th e reaction to the crash of 1929 that followed the1920s bubble was a plethora of fmancial market legisla-tion. After examining the causes of the crash, the U.S.Congress set to work passing laws meant to prevent itsrecurrence. The Securities Act of 1933 directly addressedvarious fraudulent practices in the marketplace, and theGlass-SteagaU Act of 1933 created deposit insurance forcommercial banks and sought to reduce speculative secu-rities activity by, in part, erecting a wall between com-mercial banking and investment banking activities.^

The Securities Exchange Act of 1934 created the Secu-rities and Exchange Commission to oversee the securi-ties industry. From these activities, it is evident how theenorm ous cost of systemic risk o n society d ominated themindset of the public and prompted the demand foraggressive legislative reforms.The markets in the 1980s also experienced greatinnovation in the form of portfolio insurance and programtrading.^ The initial success of the newly developed con-stant proportion portfolio insurance (CPPI), coupled withthe technological innovation of program trading, bredimitators. CPPI purportedly guaranteed portfolio valuesby insuring against market declines, but eventually herdinginto these products caused a breakdown in market diver-sity and the markets wobbled. The interaction of the wide-spread use of CPP I and program trading caused a vicioussystematic feedback loopinitial selling off begat moreselling oFand a rapid decline ensued. U ltimately, the panicand m arket dechne was short lived, although deep, withmarkets declining some 20% in a single day. The intense,painful sell-off in October 1987 is not considered a bubble,but the crisis might have been much more severe. Therapid response of the Federal Reserve Board (FRB) topump liquidity into the markets limited any systemiceffects, but also entailed the long-term consequence ofmoral hazard. Indeed, after such market intercessions wererepeated by the FRB in subsequent crisis situations, thehazard earned the moniker "the free Fed put," meaningthat the FRB would no t allow anything to go wrong withthe economy or with capital markets.^

Another market crisis arose from the increasingprom inence of the lightly regulated hedge fund industryduring the late 1990s. In this case, investors and regula-tors underestimated the impact and complex dynamicsproduced by the rapid expansion of hedge funds. Anexample is the initial success and eventual collapse in 1998of Long-Term Capital Management (LTCM). As withmany hedgefonds,LTCM operated with Utde transparencyand used significant amounts of leverage. In addition tothe huge implicit leverage of its equity book, ultimatelyLTCM's balance sheet leverage reached some 100 to 1(Lowenstein [2000]).In this situation, the F RB rushed to organize a con-sortium for a preemptive strike against a hedge fund sohighly leveraged its solvency threatened the entire fman-cial system. Observers agreed that the eventual bailout ofLTCM was necessary to avoid significant ripple effectsand disruptive financial panic*

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LESSONS FROM THE CURRENT FINANCIALCRISISThe recent market bubble had all the ingredientsthat have historically combined to form market bubbles.

It was characterized by innovative and overconfidentlenders crowded around the table to package mortgageloans and overconfident investors speculating on real estateasset prices . Easy credit was facihtated by easy m oneta ryconditions, and weak regulatory oversight allowed sys-temw ide excess in borrowing and risk taking. A self-rein-forcing positive feedback loop ultimately led to aself-reinforcing negative feedback loop and ensuing riskcascade. Th e new p roduct structures and im pruden t risktaking expressed through speculative financial leveragecombined to put us in the mess we now find ourselvesin. Let's now explore the interplay of innovation, psy-chology and leverage with more discussion of the cur-rent crisis as illustration of these factors.LESSONS FROM INNOVATION

In recent years, we have witnessed a great wave ofinnovation in financial markets and products. Typically,the inn ovation has been driven by the desire to affect riskbearing (by reducing, sharing, or transferring it), the desireto improve market pricing, or simply investors' hungerfor higher returns. We do not want to eliminate or puUaway from beneficial innovation.'

Bu t as is clear in current and prior asset bubbles, manyinnovations fail to deliver on the promises made on theirbehalf They perpetuate excessive risk taking by maskingit and spreading it around rather than mitigating it. If a newfinancial product obscures information, that innovationmay not reduce risk or the occurrence of risk, but mayactually, instead, multiply risk in the system. Consider themassive degree of systemwide complexity, leverage, andconcentrated risk created by the recent introduction ofsophisticated structured credit products. These productspurportedly conquered risk, but they were so complexthat, in reality, few understoo d them or their riskiness.

Part of the surge in structured credit products camefrom the success of government-sponsored m ortgage enti-ties in issuing mortgage pass-through securities over thepast 40 years, which confidently led to new structuredmortgage services.'" Using technological advances, invest-men t banks and o ther parties developed n ew ways of secu-ritizing mortgages through such structures as collateralized

debt obligations (CD Os) and structured investment vehcles. The market for credit default swaps (CDS) as insuance against the failure of CDOs and corporations algrew rapidly." Access to mortgage credit also wideneThe introduction of subprime mortgages facilitated mogage lending to a group of borrowers wh o w ere previouinehgible for loans. This w idening pool of borrowers lhowever, to a cycle of hom e price inflation. Memb ers th e U.S. Congress even encouraged the expansion of tsubprime mortgage sector (WSJ [2008]). Lenders usthe new tool of financial engineering to create weakand weaker mortgages. Indeed, subprime mortgagbecame increasingly popular C D O ingredients. M ortgalending thus became increasingly separated from mo rtginvesting and left the mortgage originator with httle intive to pay attention to the creditworthiness of borroweTaken together, these activities, practices, and trends spurenthusiasm among investors and dispersed the risk broadacross the financial system (not to mention producingglut of housing). But financial markets do not obey tlaws of mathematics and an overly zealous Congress.

Like all good things run amok, the success of innvative mortgage securitization went beyond the pointsocietal value. The straightforward securitization of holoans, used properly, supports worthy public goals. Brecent mortgage securitization created imprudent produstructures with layers of complex securitization and llending standardsall features that exacerbated the restate bubble. These overly com plex and opaque structushould have been received w^ith great skepticism.Innovation in CDOs obscured rather than clarifiwho was taking on what risks. In risk sharing, the risof two parties combine to offset each party's risk (Jaco[2009]). So, risk sharing parses risk by dispersingthrough out a system. For instance, a residential mortgawith , say, a 75 % loan-to-value ratio suggests that the brower and lender to gether share the risk of a price declin the house. This risk-sharing arrangemen t m ust be dtinguished from risk shifting, wh ich can actually lead tounintend ed consequence of propagating risk in the systeContrary to widely held views, those structured mogages with a 100% (or higher) loan-to-valu e m erely shifrisk from one party to another. Such residential mogages, by design, included an em bedded optio n that shithe risk of a decline in the value of the home from borrower to the lender. Those borrowers w ith residenhom e m ortgages having high loan-to-value ratios canthe event of a decline in home prices, simply walk aw

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from the property and "put" the home back to thelender.'^The interconnections between innovation and theregulatory framew ork are important in our understandingof the genesis of asset bubbles. We cannot know ahead of

time how the economy will absorb a shift in technologyor structure associated with innovation. Consider againthe pooling of residential mortgage-backed securities bygovernment-sponsored enterprises (GSEs) into ever morecomplex structures. Th e im pact of those innovations andthe dynamics they created were not well understood byeither regulators or users. Regulation always lags innova-tion. Regulators respond to market dynamics and newinstitutions and technologies as they evolve and grow.Such lags, sometimes combined with lax regulation, pro-vide opportunity for some users to stretch innovationsbeyond their initial and prudent intended use.And as for users, rarely are such innovations fullystress tested in regard to their economic impact in advanceof their commercial application. Moreover, complexityobscures risk and diminishes an investor s ability to under-stand the degree of risk to which they are exposed. Makingmatters worse, investors fear admitting ignorance and toooften lack the will to admit the emperor is wearing noclothes. Indeed, the implications and ultimate uses of inno -vative products and institutions may not be fully under-stood even by their creators, confounding the market'sability to comprehend fully the innovations' risk-associ-ated effects.'^

In short, the complex innovations of recent yearshave increased macroeconomic unknowns, making themanagement of risks by both regulators and investorsinherently challenging. Therefore, whereas recent inno-vations were an important agent of fmancial growth, theyultimately contributed, ironically, to fmancial instabilitya "Minsky moment."In the repackaging of home mortgages, the fman-cial productsalthough promoting tremendous growth

of the sectorallowed and encouraged erosion in resi-dential mortgage lending standards. The grow th in m ort -gage structures, in turn, promoted expansion of new,complex structured products with poor transparency.According to the Bank for International S ettlements, thenotional amount of CDSs grew from a trivial amountearly in this decade to some $45 trillion in notional valueby the end of 2007. Similarly, subprime originations tripledfrom about $200 billion in mid-2003 to more than $600billion in 2005, when they accounted for approximately

20% of all new residential mortgages, up dramatically fromthe historical share of this sector of around 8%. A majorcontrib utor to the rise was overconfidence o n the part ofinvestors in their abilities to predict outcom es on the basisof complex risk models that were built on the consis-tently rising hom e prices of the prior decade; the m odelsapparently ignored periods of falling real estate prices.'''

Although not all innovations are considered com-plex, many certainly seem to be constructed with thenotion of "the more com plex, the better."But complexitymay disguise and amplify the true degree of fmancial risk.For example, consider the byzantine n ature of some exoticsecuritized CDOs. By placing a variety of asset-backedsecurities in to a single pool, CD Os purportedly reduce riskvia diversification. Diversification can, indeed, reduce risk,but in recent years, the ingredients of the C D O trancheswere obscured and presented as of higher quality thandictated by economic reality.'^ Rather than diversifyingrisk, such pooling merely concentrated risk in the "toxicwaste" tail of the return distribution.

A final point regarding innovationtoo many finan-cial innovations are designed w ith the seller in m ind ratherthan the user. The problem is akin to that of the mis-alignment between the interests of agents and their p rin -cipals. Consider how rating agencies, the guardians of riskassessment, fell short in their due diligence responsibili-ties to principals. Many seller-motivated products are, evenat best, overly sophisticated and complex and, therefore,almost always hamper an investor's ability to accuratelyassess risk. At the sleaze end of the spectrum, the sellermisrepresents the investment risks. The result is high uncer-tainty ab out how markets will react during crises.LESSONS FROM INVESTOR PSYCHOLOGY

These effects of innovation are com poun ded wh encombined with another key ingredient in bubblesthepsychological makeup of investors. The success of inno-vation brings imitators seeking to achieve similar success.Investors (wrongly) convince themselves that they fullyunderstand how the innovation works (exhibiting over-confidence) and herd into the newfound success to "get apiece of the action." Success encourages more imitators,and with investors basing their investment decisions onprior success, the cycle continues. The euphoria isgrounded in a false behef, however, that prior success ispredictable and will continue into the future.'* N ot onlyinvestors but also regulators develop a false sense of



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confidence in their abihty to predict outcomes related tothe use of innovations.

The initial success of innovations, therefore, engen -ders overconfidence and complacency and feeds herdingbehavior. Under the charm of groupthink, investorstransfer success into speculation. A widening pool of spec-ulators is made possible by investors providing the n eces-sary credit and hquidity for a cycle of price expansion.W ith continued speculative herding, risk becom esconcentrated in a narrow set of market sectors. Whenconcentration trumps diversification and herding displacesindividual judgment, markets become unbalanced anddisrupted. The bubble becomes larger but also thinner.LESSONS FROM LEVERAGE

To make matters worse, investors, in their efforts toenhance returns from the newfound "sure thing," con-tribute the third key ingredient to the bubblespecula-tive leverage.'^ Excessive economic leverage factorsprominently in market meltdowns.Not that risk and leverage are evil twins. Risk takingand leverage are required ingredients in a prosperous cap-italistic system. Risk taking often takes the form ofleverage. Thin k of our fractional reserve banking system.This system allows credit expansion and demand depositaccounts that trade at the buck. This works well as long

as everybody doesn't w ant all their cash at the same time .As such, leverage is not possible without liquidity.As discussed in SuUivan [2008], the availability of hqu idityis mostly determined endogenously by profit-seekingfinanc ial intermed iaries or hquidity providers that existoutside of the direct purview of the central bank. Theseintermediaries compose the so-called shadow bankingsystem that consists of unregulated levered intermediariesseeking profit and risk. Consequentiy, the system is finan-cially fragile and volatile.The pool of risk capital driven by this shadow

bank ing system therefore oscillates with the ebb and flowof liquidity. In this sense, market hquidity rehes on thefaith ofthe financial markets. Increased risk appetite amonginvestors facihtates greater liquidity via easing credit con-ditions. This chain of events precedes a willingness tounderwrite greater risk and increasing financial leveragevia investment vehicles such as CDOs, SIVs, and the like.And as we've seen, liquidity can dry up with star-thng rapidity depending solely on the market's tolerancefor risk. In the case of a sudden, systematic reduced risk

appetite, the ensuing hquidity withdrawal precipitatforced selhng that can affect prices negatively and ccreate a self-reinforcing cyclea downward Minsky-tyspiral of delevering and coUateral-related liquidity seekiby levered investors.'^ H ence , market instability can quickerupt into a high-intensity risk-aversion storm . A seemingly minor economic shock may become severely desbihzing, join ed by a run on the shadow bankisystemand risk.

Consider how problems in one corner ofthe Umarket spilled over into other completely unrelated coners; from subprime mortgages into the entire fixeincome market, and then into the equity market, and thinto the global economy. The extent of the propagatirelates to the confluence of risk, leverage, liquidity, athe interconnectedness ofthe financial system. Leveragrisky positions impacted by a sudden reduced risk appe tresults in the need to hquidate in a market that cascaddownward in price as liquidation orders rise and hquidproviders diminish.PO P

Alas, all bubblespast, present and futureevenally collapse under their own weight. The bubble grothinner and thinner until eventually it must pop. Initiala few investors sell, causing prices to fall. Levered investmust sell assets to meet m argin calls. Pessimism replaexuberance in the herd as more and more investors sand deleveraging ensues. A downward price spiral folloas investors rush to get rid of iU-fated assets and to mlenders' demands. Asset deflation may then spread iother market segments, even affecting safe assets as invesseek to pay off outstanding habilities. Thus, the bubmay spiU over into the real economy. A seemingly ilated event that began in the financial sector evolves ia systemic crisis. In this way, the partnership of finaninnovations with leverage and overconfident investorsparticularly troublesome."FROM LESSONS TO CRISIS MITIGATION

Einstein purportedly commented that "today's prlems cannot be solved by thinking the way we thouwhen we created them." New, robust ideasnot prosional and makeshiftare clearly needed to ensure a mstable economy. Lessons from the past and present crihowever, can serve as a sohd foundation to bu ild a be

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way forward. Re cent events underscore that we must avoidcrises that undermine the entire fmancial system. Themarket regulatory framework in free-market countries isbuilt on the premise that government isan important a ux-iliary overseer of capital markets, though not a substituteoverseer. The private sector must assume primary respon-sibility for investment oversight and must begin with theprinciple of ethical dealing. In the realm of financial mar-kets, public policymakers have three principal objectives:fmancial stability, investor protection, and market integrity(Bernanke [2007]). For success in its regulatory role, over-sight agencies must aim to reduce thefrequencyand severityof global asset bubbles and banking crises. The primarygoal is to preserve the benefits of innovation, whue ensuringa fundamentally sound financial system. Additionally,investors must be allowed to bear the consequences of theirrisk decisions; the discipline of markets is powerful. Ofcourse, the tug of war between innovation and safety cannever be won by e ither side. Policymakers, therefore, willnot be able to completely prevent financial shocks andperiodic bouts of damaging financial instability, but a globalregulatory framework with agencies working togetherwould come closest to achieving such a goal.

New, complex products and insti tu t ions haveincreased in importance in recent years but bave beenleft largely unregulated. The globalization of financebas added to tbe complexity and reacb of these inno-vations. Thes e de velopm ents have critical implicationsfor how we go about putting in place a robust regula-tory framework. In hght of the scope of changes andevents, a focus on the structure and design of regula-tion in broad term s, not a narrow focus on.a single assetclass or institution makes sense. A broad focus wl allowsus to scan the wh ole m arket to suggest wh ere problemsmay occur. A focus that is too narrow, such as on asingle asset class (e.g., CDS) or institution (e.g., hedgefunds) in an attempt to pinpoint the source of risk-bearing problems will be ineffective in our complex,globally integrated , and dynamic m arkets. A broad focuson risk bearing associated wit b the agents of bubblesmass sentime nt, leverage, and innovation is required.

With regard to innovation, we need first to recog-nize that market risk is the financial equ ivalent o f energy. That is, like energy, risk cannot be eliminated via financialeng inee ring. Yes, we can shift risk, move it aroun d, andeven share it through fmancial alchemy, but once created,risk cannot be eliminated. Nevertheless, many financialinnovations are purported by their inventors to squelch

risk. Consider how the innovation of shcing up CDOsgives the appearance that risk has been elim inated thro ughdiversification when it has actually been concentrated inthe tail ofthe distribution (e.g., a toxic credit tranche).A cynic would see that much of financial innovationenriches the innovators at the expense of investors.Combining the complexity and reach of modernfinancial innovations with a rigid regulatory frameworkthat is ul equipped to handle the complex, dynamic natureof innovations increases the risk in the system by injectingadditional unknowns into market dynamics. A dynamicglobal economy requires a dynamic global policy andoversight framework.

Moreo ver, because constant tension will always existbetween the innovative forces of free markets and con-trol by regulators, regulation should n ot try to eliminatefuture financial market progress by narrowly looking in arearview mirror. Thoug h understanding prior economiccrisis is vitally impo rtant, investor safety can not be achievedby regulation that simply invokes a stringent set of rulesand guidehnes based on hindsight alone.

Instead, policymakers should endeavor to put inplace a wise, principles-based regulatory framework rathethan a rigid rules-based framework. The system must beflexible and proactive enough to cope with not only pastissues, but future issues, and it sbould use common senseand judg me nt. In this form, regulation will have a chanceto adjust to com plex adaptive markets and the fragile nter-connections of new forms of risk-bearing innovations.Such a regulatory framework, and the will on the p art ofglobal regulators to implement it fully, may be imperfectbut should foster promising prudent innovations.

As noted earlier, much of the current regulatoryframework was put into place subsequent to the marketcrash of 1929. This framework is due for refo rm. If arevamping is to be carried out, we should base our reg-ulatory structure largely on a careful assessment of tbecauses of asset bubbles and should erect a framework forcontaining systemic risk. The intention is to reduce marketcomplexity rather than layering on additional regulationsthat m ay actually increase market complexity. At the inter-national level, critical elements are consistency and m utualreinforcement among policies.

In light of these goals, policymakers must frame theirefforts broadly to simplify and clarify the machinery ofthemarket including risk-bearing innovative produ cts, institu-tions, and assets. Special vigilance must be given in regula-tions to limiting opaque innovations and firm structures^'

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as well as speculative leverage because of their destructiveeffects. Specifically, our oversightframeworkmust strive tobe guardians of financial stability. Implementing the fol-lowing suggestions should go far toward reducing futureshocks that cascade through our financial

Increasing transparency in all corners of the marketmust play a critical part in new regulation. Theembroiled toxic assets of the cur rent econo mic crisiswere hidde n assets. Transparency is necessary formarket participants to assess the risk and rewards ofinvestments and institutions. Gaining an accuratepicture means wide dissemination of informationto all parties and elimination of the problem of asym-metrical information. Because of the conflicts ofinterests inherent in principal-agent relationships,the opacity of products and institutions must be laidto rest by way of mandating op en boo ks. Oversightapplied to only portions of the market (e.g.,excluding hedge funds) will be ineffective.Transparency can be improved by the constructionof exchanges and clearinghouses to handle varioustypes of complex OTC derivatives.^-' In this effort,regulators and investors should look beyond theCD S m arket to include other sectors, such as cur-rencies and commodities. Only in this way can wemonitor an institution's full market exposure andensure that necessary collateral is in place to coverits trade-related obHgations.^"* By clearing and set-tling trades, clearinghouses would limit risk to thelarger financial system from any single firm. Giventhat CDS instruments are more an insurance con-tract than a swap contract, such instruments shouldbe allowed to be owned only by those who ownthe underlying bonds, not by others wh o wish onlyto speculate against a firm or a country.Full transparency unambiguously requires that allfinancial institutions, including hedge funds, shouldbe subject to registration and oversight. As part ofoversight, audit and custodial processes for investmentorganizations, regardless of size, must be taken seriously.In the U.S., auditors must pass muster with the PublicCompany Accounting Oversight Board. Due dih-gence must not be pushed aside in favor of hope.With the interconnectedness of markets, regulatorsand investors need to work continuously to identifythe greatest risks to the financial system and focusoversight resources on those areas. It is unlikely thatmarket crises can be eliminated entirely, however, a

wise framework should provide for a global networof systemic-risk regulators charged with preventinbubble escalation through an ongoing assessment global risk, leverage, and liquidity. This network systemic-risk regulators should oversee all financiinstitutions determ ined to be systemically im portanincluding banks, broker/dealers, hedge funds, insuance companies, and others. The market-stability reulators would also have the authority to monitthese financial firms and any affiliated firms, and ensure that financial firms have sufficient capital place to reduce the risks they pose to the fmancisystem. Excessive ec onom ic leverage and speculatiin the global markets can be tamed through ongoinoversight and enforcement of high international risstandards. Given the impact of the unregulated scalled shadow banking system (Sullivan [2008]), wiits significant leverage and liquidity implications, wcan benefit from better management of the levels liquidity, financial leverage, and systemic risk in thglobal capital markets. M oneta ry policy, alone, is tblunt a tool to be fuUy effective on this front, a morobust framework is needed.

Leverage and risk taking are not to be eliminatebut policymakers need to debate, set, and review tpro per lim its to leverage. At the level of financinstitutions, excess leverage might be managed vprude nt margin and capital requirements, and at tconsumer level, it m ight be managed by, for exampsetting minimum downpayments on home puchases. Pro per ins titutional oversight must seek manage risk on a system-wide basis because, fexample, allowing some financial institutions, suas commercial banks, to shift risks from their booto others with less-stringent capital requiremenleads to undesirable mac ro risk levels. We areminded, too, that efforts to manage risk must alseek to keep pace with financial innovation.

More financial market stability is needed than reglation alone can bring to bear. Changes in markmechanisms are needed. One such change would to alter the incentive structure under which firms nooperate. Today, interest paid on debt provides a coporate tax deduction, but dividends paid on equity not. Given the dangers of excessive leverage, incen tfirms to use debt versus equity makes no sense. Wnot simply level the playing field?^^ We must resolve the "too big to fail" issue that pmeates our financial system. Perhaps if it's too big

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fail, it 's jus t to o b ig. Lo ok ing forward, o ne w ay togovern size might be to impose capital requirementsthat vary with firm size. Th e bigger the financial firm,the greater the mandatory capital requirements ratio.This approach would automatically regulate the sizeand leverage o f any single financial entity, discouragingfirms from getting too large and implementing toomuch leverage. Given the interconnectedness of thefinancial system, however, many smaller players pur-suing similar strategies could prove equally disruptive.A strong role for vigilant oversight wul still be required.Th is again suggests a role for a systemic risk-reg ulatornetwork. Better guardrails are needed to ensure theeco nom y stays on the tracks. He re, we shou ld startwi th rein stating the Glass-Steagall Act that was largelyrepealed by Gramm-Leach-Bliley in 1999.

To mitig ate the negative effects of prin cipa l-ag entconflicts of interests, incentive structures in globalfinancial institutions must be properly aligned. Forthis reason, hybrid governmentprivate ownershipstructures, such as the GSE mortgage firms, shouldbe avoided in the fiiture. Existing G SE activities sho uldbe spun off to the private sector, but remain underthe regulatory um brella. Financial firm managem ent'sgambling for the upside of $50 million paydays withthe public's money must also be stopped. Gamblersmust alone bear the consequences of their decisions.

Part of an intelligent , princip les-based regulatoryreview and oversight process is that innovations andassociated investment institutions and p roducts wou ldbe fully stress tested before they are m ade available tothe w ide marketplace. A w ise oversight process w ouldgo beyond ferreting out fraudulent agents to includea complete assessment of the risks and benefits ofinnov ations, bo th initially and o ngo ing . In practice, theprocess migh t work m uch as the U.S. Food and D rugAdministration review process works for innovationsin health care. (O r the U.S. Con sum er Product SafetyCommission might be expanded to alert consumersto dangerous financial products.) Such an organiza-tion wotild be charged with promoting and protectingour fmancial health by helping safe and beneficialfinancial products reach the marketplace.

Policymakers should give serious considerat ion tos t ruc tur ing more f requent market respi tes , whenapprop riate, to sooth investor irrationality and reducethe spread of fear and panic associated with marketcascades. Slo wi ng the frenetic pa ce of mar kets byway of circuit breakers and market closings can help

t o r e p l a c e p a n i c - i n d u c e d a c t i v i t y w i t h s o u n dj udgment . P rov id ing t ime for inves t or s t o movebeyond their emotions can help restore calm duringperiods of belief-based market volatility.^*

CONCLUSIONFinancial markets have provided tremendous pubHc

benefits in a variety of ways, bu t perhaps the m ost im po r-tant way is the efficient allocation of capital that leads towidespread improved living standards. If that a llocat ionsuddenly becomes directed by investor emotions connectedto some new innovation, however, the combination fuelsimprudent speculat ion. Emotion assigns more promise toan innovation than a clearer view would dictate. Capitalallocation directed by groupthink and a disregard for riskcan quickly become disconnected from reality.Th om as Jefferson on ce said, "T he p rice of freedo mis etern al vigilance." Th is art icle has ext end ed th e ar gu -ment presented in Sul l ivan [2008] tha t a hohst ic andvigilant risk management framework is needed to con-t rol market meltdow ns and ensuing contagion. Here , wehave explored how common features present themselvesin disruptive marke t bubb les and revealed ways to restorelo ng -te rm m arket viabi l ity . Because the form at ion ofmo der n capital markets, the interact ions of financial i nn o-vation, hub ris, and leverage have laid the gro un dw ork formarket bubbles, a clear understanding of these interac-tions can suggest better ways forward. We must anticipateand fight the convergence of bubble cocktail ingredients.

A sweeping wave of regulatory intervention appearsin the making. But we must be careful. Any regulatoryframework comes with unpredictable consequences of itsown. Adding complexity and uncertainty of regulatory out-comes to an already complex market reduces our abihty tofully understand the various forces governing marketdynamics. M eeting these challenges head o n is certainly no teasy, bu t we mu st avoid haphaz ard responses to th e globalcrisis. The lasting elements of a reformed system begin witha flexible, wise, principles-based regulatory framework thatpragmatically balances risks and benefits. Our flexibleregulatory framework should be built on a solid under-standing of the common elements in bubble formations.A stable capital market foundation also insists on trans-parency of products and institutions. Finally, proper ethicsand independent decision making on the part of investorsare critically important. In response to the present globalmark et crisis, we can start with these buildi ng blocks tocreate a solid foundation for stronger capital markets.



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ENDNOTESThis article reflects the views of the author, and does notrepresent the official views of the author's employer, CFA Institute.'See Shiller's [2005, p. 2] definition of a speculative bubb le:

"A situation in which news of price increases spurs investorenthusiasm, which spreads by psychological contagion fromperson to p erson, in the process of amplifying stories that m ightjustify the price increases and bringing in a larger and larger classof investors, who, despite doubts about the real value of aninvestment, are drawn to it partly through envy of others' suc-cess and pardy through gambler's excitement."^This article expands on the discussions presented in Sul-livan [2008], which examined markets ascomp lex adaptive sys-tems that possess a large num ber of interactive agents adjustingdynamically to events in unanticipated and nonlinear ways.^Equity shares rose from around 150 to 10,000 livres (see

Goetzmann and Rouw enhorst [2005, pp. 233-234]). Althoughhistory has certainly n ot dealt kindly with Law, Goetzm ann andRouwenhorst suggested that Law was a financial innovatorworth studying more carefully.Goetzmann and Rouw enh orst [2005] discussed how thecrisis o f 1792 eventually led to the formal establishment of theNew York Stock and Exchange Board in 1817.^Legislation included the Securities Exchange Act of 1934(which addressed the secondary market), the Maloney Act of1938 (which allowed the creation of self-regulating organiza-tions, including the NASD , which is now the Financial IndustryRegulatory Autho rity), the Investment Com pany A ct of 1940

(which regulated investment companies, including mutualfunds), and the Investment Advisers Act of 1940 (which requiredinvestment advisory registration). The N ational Ho using Act of1934 created deposit insurance for savings and loans. And later,in 1970, the Securities Investor Protection Act created an insur-ance fund for customer claims from broker/dealer failures.*In the 1980s also came the development of the "junkbond" market. This innovation also got off to a rough start.According to Kindleberger and Aliber [2005], more than halfthe issues underwritten by innovator Drexel Burnham Lam-bert had defaulted by the end of the 1980s.'The investment community responded to the 1987

market crash with the implementation of circuit breakers tohalt trading when a market's decline reaches a pre-specifiedtrigger level and by terminating the use of CPPI.*For the interested reader, Lowenstein [2000] presenteda full analysis of this fascinating story.'A healthy capital market encourages a stream of inno-vation, and financial innovation brings economic benefits tosociety. History abounds with innovative financial ideas thatfulfill their promises of creating substantial public benefits. Thefinancial revolution that has been going on over the past 300years includes the development of capital markets, which has

brought enormous economic benefits. Capital markets poand subdivide fmancial resources and mobilize efficient capiallocation. They also foster impro vemen ts in m arket efficienand information sharing. Th e m arkets provide information securities prices, and the financial reporting demanded by markparticipants provides information on governance and informtion useful in managing and reducing risk.'"The creation of government-sponsored enterpris(GSEs)namely, Ginnie Mae and Freddie Macfostered tcreation of a securitized residential mortgage market. The fimortgage pass-through securities were issued by Ginnie Mae aFreddie Mac in 1970. Freddie Mac introduced collateralized mogage obligations in the early 1980s. The mortgage securitvolume of the GSEs rose from $200 billion in 1980 to m ore th$4 trillion in 2007 (Bernanke [2007]). Turning what would oerwise b e a heterogeneous, illiquid set of residential mortgages ia homogen eous pool of liquid assets via securitization facilitathe development of the mortgage-backed securities market. Thnew developments effectively lowered the cost of borrowing amade the dream of homeownership easier for millions. Homownership brings important societal benefits, of course. Peopwish to live in safe neighborhoods with good schools, librariand so on. Encouraging people to take own ership stakes in thhomes makes such neighb orhood s more likely." C D O ratings were often increased to AAA via the pchase of mono line insurance. M onoline insurers g uarantee timely repaymen t of bond p rincipal and interest when an issdefaults. They are so named because they provide servicesonly one industry.'^The de gree of risk sharing is proportionate to the loto-value ratio. M ortgages w ith loans less than 100% of the hovalue expose both the lender and the borrower to home prdeclines, and as that percentage falls, the risk-sharing arranment becomes more constructive."Some have suggested that CDSs were called "swarather than "insurance" to avoid the regulatory reserve requiments associated with insurance contracts."Lewis [2008] reported that rating agency residenmortgage models had no ability to accept a negative changereal estate prices.'^Jacobs [2009] provided an in-depth review of secur

zation preceding the current credit crisis.""The list of behavioral considera tions was discussed mofuUy in Sullivan [2008]. Also, a substantial literature on the pchology of asset bubbles exists. See, for instance, Kindleberand Aliber [2005] and Shiller [2009].''In "speculative leverage," the investment debt canreasonably be expected to b e repaid via the incom e stream gerated by the asset; that is, investor expectations are discnected from fundamentals.'^Minsky [1986] codified the insights of Keynes intfinancial instability hypothesis that suggests financial instabi

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is endemic to capitalist econom ies. Euph oric expectations leadto a secular trend of rising debt and eventually a debt-inducedcrash. Asset prices can only move back into equilibrium viaasset price deflation or current price inflation."Warren Buffett has purportedly suggested: "First comethe innovators, then the imitators, then the idiots."^"Thanks to M arty Fridson for suggesting this analogy.^'Opacity also enables fraud as evidenced by Bernie Ma d-off's Ponzi scheme, among others.^^This section reinforces and extends the ideas exploredin Sullivan [200 8].^'A clearinghouse takes deposits in the form of marginfrom all participants and uses the money to backstop potentiallosses. This so-called initial marg in is suppleme nted with dailymarked-to-market variation margin to account for marketchanges during the contract period.As this article goes to print,a clearinghouse for standardized CDSs is being launched andother competitor clearinghouses are under construction.^"Some have suggested that creating a regulatory f ram e-work with a central clearinghouse wou ld harm investor flexi-bihty and market efficiency. Clearly, however, uniquelycustomized O T C contracts with un ique terms create an illiquid,heterogeneous, and opaque market. A less-complex homoge-neous market with standardized contracts would improve Hq-uidity and transparency. A market with a central clearinghouseand mandated disclosure would clarify the full extent of thefmancial leverage of all parties.^^William Poole [2009] takes this idea even further. Hesuggests that all commercial banks modify their capital struc-ture by inserting a new subordinated deb t com ponen t just above

preferred stock. The bank would issue this debt each year inaccordance with the size and duration of their loan portfolio.If the market accepts the new issuance, the bank can continueto expand; if not, the bank must contract and modify its loanportfolio accordingly. Un der this approach, bankswou ld replacesome portion of their FDIC insured borrowings with non FDICmarket debt.^'^For example, following the attacks of 11 September

2001, the N YSE was closed from 11 September un til 17 Sep-tember 2001. When it reopened, it did so calmly.REFERENCESAkerlof, George A., and Rob ert J. Shiller. Animal Spirits: HowHuman Psychology Drives the Economy, and W hy It Matters forGlobal Capitalism. Princeton, NJ: Princeton University Press,2009.Bernanke, Ben S. "Housing, Housing Finance, and MonetaryPolicy." Speech given at Federal Reserv e Bank of Kansas City'sEconomic Symposium, in Jackson Hole, WY, on August 31,2007.

. "Federal Reserve Policies in the Financial Crisis." Speechto Greater Austin Chamber of Commerce, in Austin, TX, onDecember 1,2008.Calomiris, Chades W , and Peter J. Wallison. "Blame FannieMae and C ongress for the Credit Mess." Wall StreetJournal, September 23, 2008, p. A29.Goetzmann, William, and K. Geert Rouw enho rst, eds. The Ori-gins of Value: The Financial Innovations that Created Modernital Markets. Ne w York, NY : Oxford University Press, 2005.Jacobs, B ruce. "Tumb ling Tower of Babel: Subprime Securiti-zation and the Credit Crisis." Financial AnalystsJournal, Vol. 6N o. 2 (March/April 2009), pp. 17-31 .Kindleberger, Charles, and Ro ber t Z . Aliber. Manias, Panics, anCrashes: A History ofFinancial Crises, 5th ed. Hoboken, NJ:JoWUey & Sons, Inc., 200 5.Knoo p, Todd A. Modern Financial Macroeconomia: Panics, Crand Crises. Maiden, M A: Blackwell Publishing, 2008.Lewis, Michael. "The End." Conde Nast Portfolio, December2 0 0 8 . A v aila bl e a t h t t p : / / w w w . p o r t f o l i o . c o m / n e w s -markets/national-news/portfolio/2008/11 /11/The-End-of-Wall-Streets-Boom.Lowenstein, Roger. When Genius Failed: The Rise and Fall ofLTerm Capital Management. New York: Random House, 2000.Markowitz, Harry. "Portfolio Selection." The Journal of FinanceVol. 7, No . 1 (March 1952), pp. 77-91 .Minsky, Hyman. "The Modeling of Financial Instability: AnIn tro du cti on ." Moiie/i'ttg and Simulation, 5,Part 1 (1974) ,pp. 267-272. Reprinted in the Compendium of Major IssuesBank Re M/aiion, Washington D C : Governm ent Printin g Office,1975, pp. 354-364.Poole, William. "M oral Hazard: The Long-Lasting Legacy ofBauouts." Presentation, CFA Institute Conference, O rlando , FL,April 28,2009.Shiller, Ro be rt J. Irrational Exuberance, 2nd ed. Princeton, NPrinceton University Press, 2005.Sullivan, Rodney N. "Taming Global Village Risk!'Journal ofPortfolio Management, Vol. 34 , No . 4 (Summer 2008), pp. 58-6

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