....MUCH MOREBefore the global financial crisis of 2008, interest rates were low, and investors were hungry for higher yields. Financially engineered mortgage-backed securitizations offered high yields with seeming low credit risk. Though these arcane financial instruments often consisted of risky loans to less credit-worthy borrowers, they were rated highly by the credit agencies. The easy availability of credit created a bubble in the housing market that eventually burst, leading to defaults on mortgages and crashing the value of the securitizations, the stock market, and the economy.Knowledge@Wharton: In your book, Too Smart for Our Own Good, you wrote about some quantitative free-lunch investment strategies that led to the formation of market bubbles that eventually burst, destroying enormous wealth. Do you see any similarities between those crises and the present stock market collapse?
Now fast forward to the present. In 2020, strong corporate profitability, low interest rates, substantial debt, and rising stock market prices set the stage for a stock market crash that could be triggered by an adverse event. Financially engineered collateralized loan obligations (CLOs) consisting of leveraged loans to highly indebted companies are today’s counterpart of the collateralized debt obligations (CDOs) of the last crisis, which contained subprime mortgage loans to highly indebted homeowners. This time, unlike 2008 and many other crises, the catalyst for the market collapse did not come internally, from within the financial system, but rather externally — the pandemic that brought the economy to a halt. However, internal factors like CLOs and high levels of leverage in general were potential time bombs in the financial system that could exacerbate and prolong economic disruption.
These insights into so-called “free lunch” strategies and their role in destroying wealth come from Bruce I. Jacobs, co-founder, co-chief investment officer and co-director of research of Jacobs Levy Equity Management in Florham Park, New Jersey, which manages equity portfolios for institutional clients worldwide. Jacobs is the author of Too Smart for Our Own Good: Ingenious Investment Strategies, Illusions of Safety, and Market Crashes published by McGraw-Hill Education in 2018. He also is the co-author with Kenneth (Ken) N. Levy of Equity Management: The Art and Science of Modern Quantitative Investing published by McGraw-Hill Education in 2017. He initiated the creation of the Jacobs Levy Equity Management Center for Quantitative Financial Research at Wharton and helped create a new quantitative finance major for MBAs by establishing the Dr. Bruce I. Jacobs Professorship in Quantitative Finance and the Dr. Bruce I. Jacobs Scholars in Quantitative Finance.
Knowledge@Wharton interviewed Jacobs about why markets regularly experience such crashes and the role that quantitative finance can play in predicting and potentially protecting investors against episodes of wealth destruction.
Bruce I. Jacobs: Quantitative finance offers tools and approaches that provide enormous benefit to investors, from security valuation to portfolio construction and performance measurement. Unfortunately, quant strategies are also subject to misuse and misinterpretation; this is especially the case with strategies that are complicated and lacking in transparency.
Free-lunch investment strategies are a good example of this. Free-lunch investment strategies are hard to resist—they offer high returns at low risk, an investor’s dream but an illusion of safety. This is contrary to Finance 101, where we learn there is a relationship between risk and return, and that higher expected return requires taking more risk, not less risk.
In the years leading up to the global financial crisis of 2008, interest rates were low, and investors searched for higher yields. Financially engineered mortgage-backed securitizations offered high yields with seeming low credit risk. Although the securitizations often consisted of subprime mortgage loans to less creditworthy borrowers, they were rated highly by the credit agencies. We all know what happened then — the easy availability of credit created a bubble in the housing market that eventually burst, leading to defaults on mortgages and crashing the value of the securitizations, the stock market, and the economy.
In 2020, unlike 2008 and many other crises, the catalyst for the crisis did not come internally, from within the financial system, but rather externally — the pandemic that brought the economy to a halt.This time around, in 2020, strong corporate profitability, low interest rates, substantial debt, and rising stock market prices set the stage for a stock market crash that could be triggered by an adverse event. Of course, this time, in 2020, unlike 2008 and many other crises, the catalyst for the crisis did not come internally, from within the financial system, but rather externally — the pandemic that brought the economy to a halt.
Nevertheless, some quantitative approaches are contributing to the instability. For example, financially engineered collateralized loan obligations (CLOs) consisting of leveraged loans to highly indebted companies are today’s counterpart of the collateralized debt obligations (CDOs) of the last crisis, which contained subprime mortgage loans to highly indebted homeowners. If the risks were not disclosed, nor transparent, and hence not properly priced, trouble could lie ahead.
Leveraged loans grew dramatically in the low-interest-rate environment of the last few years. By the fall of 2019, the amount of outstanding leveraged loans denominated in U.S. dollars was estimated at $1.2 trillion, roughly equivalent to the outstanding value of subprime mortgages as we entered 2008. More than half of these loans ended up in CLOs.
K@W: The three crises you analyzed — the October 1987 crash, the Long-Term Capital Management hedge fund collapse in 1998, and the subprime mortgage crisis of 2008 — all involved positive feedback loops that reinforced the fantasy of very high returns at low risk. Was there any evidence of this before the current crash?
Jacobs: Low interest rates, or the availability of cheap money, give rise to more borrowing by individuals for housing and other purchases, including securities, and more borrowing by companies for business investment, share buybacks, and dividend payments. This in turn leads to more consumption, more economic growth, and higher stock prices. As the good times roll on, individuals and companies take on more and more leverage because they perceive the risks are low. As I mentioned earlier, securities based on loans to highly indebted companies have been a troublesome feature of corporate borrowing.
This positive feedback or self-reinforcing behavior, where leverage increases profitability, which lowers the apparent risk, and increases the willingness to take on more leverage, resembles what happened with the interplay between mortgage securitizations and the housing market before the 2008 global financial crisis.
When positive feedback causes prices to reach a level unsupported by underlying fundamentals, a shock to the system — homeowners defaulting on their mortgages en masse or a global pandemic — can topple the house of cards. Then the leverage that was a tail wind can transform into a head wind so severe that it levels financial markets and the economy. Investors can then be hit with margin calls that force liquidations at adverse prices, deepening price declines....
Ha! Coincidentally the outro from Saturday's "Flywheel Effect: Why Positive Feedback Loops are a Meta-Competitive Advantage":
...In ecology and energy and just about any other study of natural systems, positive feedback loops are terrifying.
The same probably goes for business as well, think Amazon's endgame as an example.
And if your kids aren't insufferable enough, send 'em to Knowledge@Wharton High School:
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