Against the Gods: The Remarkable Story of Risk (62 page)

Where does the necessary cash come from to reliquify insured portfolios when stock prices are falling? From the stock market itself-all
the other investors to whom the insured investors will want to sell
their stocks. But no reserves or collateral exist to guarantee that the liquidity will be there when called upon. The market had no legal obligation to bail out Leland and Rubinstein's clients and other insured
portfolios against loss. Those other investors were not even aware of
the role they were expected to play. Leland's brainstorm assumed that
the buyers would be there, but he had no way to guarantee that they
would actually show up when called upon to do their duty.

The chickens that Leland and Rubinstein hatched in their laboratory came home to roost on Monday, October 19, 1987. The preceding week had been a disaster. The Dow Jones Industrials had fallen by
250 points, or about 10%, with nearly half the drop occurring on
Friday. A huge overhang of sell orders had then built up over the
weekend, waiting to be executed at Monday's opening. The market
dropped 100 points by noon, nearly another 200 points in the next two
hours, and almost 300 points in the final hour and a quarter. Meanwhile, as the managers of insured portfolios struggled to carry out their
programed sales, they were contributing to the waves of selling that
overwhelmed the market.

When the dust had settled, the owners of the insured portfolios
were in better shape than many other investors. They had all done
some selling during the bad week that preceded October 19, and most of them got out either at or only slightly below their designated floors.
But the selling took place at prices far lower than anticipated. The
dynamic programs that drove portfolio insurance underestimated the
market's volatility and overestimated its liquidity. What happened was
like a life insurance policy with a variable-rate instead of a fixed-rate
premium, in which the company has the right to raise its premium as
the insured's body temperature rises, degree by degree, increasing the
probability of early demise. The cost of portfolio insurance in that
feverish market turned out to be much higher than paper calculations
had predicted.

The unhappy experience with portfolio insurance did nothing to
quell the growing appetite for risk-management products, even though
portfolio insurance itself virtually vanished from the scene. During the
1970s and 1980s, volatility seemed to be breaking out all over, even in
places where it had been either absent or muted. Volatility erupted in the
foreign exchange markets after the dollar was cut free from gold in 1981
and allowed to fluctuate freely; volatility overwhelmed the normally
serene bond market during the wild swings in interest rates from 1979 to
the mid-1980s; and volatility shot up in commodity markets during the
huge jumps in oil prices in 1973 and again in 1978.

These unexpected outbreaks of volatility soon littered the corporate
landscape with a growing number of dead carcasses, providing grim
warnings to executives that a fundamental change in the economic
environment was taking place. For example, Laker Airlines, a fabulously successful upstart in transatlantic travel, ended up in bankruptcy
after ordering new McDonnell-Douglas aircraft in response to soaring
demand; with most of its revenues in pounds and with the foreign
exchange value of the dollar climbing higher and higher, Laker found
it impossible to earn enough to pay off the dollar obligations on their
DC-10s. Reputable savings and loan associations went under as the
interest rates they had to pay their depositors mounted while the
income they received on their fixed-rate mortgage loans never budged.
Continental Airlines succumbed when oil prices went through the roof
during the Gulf War.

As a consequence, a new kind of customer appeared in the financial markets: the corporation seeking to transfer the new risks in exchange rates, interest rates, and commodity prices to someone better
equipped to carry them. The corporation was responding as Kahneman
and Tversky would have predicted, but with an added flourish. As we
might have expected, the pain of potential losses loomed larger than the
satisfaction from potential gains, so that risk aversion influenced strategic decisions. But when volatility exploded in areas where it had never
been much of a concern, corporate managers, like the farmers of yesteryear, began to worry about the very survival of their companies, not
just about a sequence of earnings that was more irregular than they or
their stockholders might have liked.

Even though corporations could execute hedges in the liquid and
active markets for options and futures-which now included interest
rate and foreign exchange contracts as well as commodities and stock
indexes-these contracts were expressly designed to appeal to as many
investors as possible. The risk-management needs of most corporations
are too specific in terms of both coverage and time spans to find ready
customers in the public markets.

Wall Street has always been a hothouse of financial innovation, and
brokerage houses are quick to jump into the breach when a new demand for their talents arises. Major banks, insurance companies, and investment banking firms with worldwide business connections lost no
time in establishing new units of specialized traders and financial engineers to design tailor-made risk-management products for corporate
customers, some related to interest rates, some to currencies, and some
to the prices of raw materials. Before long, the value of the underlying
assets involved in these contracts-referred to as the "notional value"was in the trillions of dollars, amounts that at first stunned and frightened
people who were unaware of how the contracts actually worked.

Although approximately two hundred firms are in this business
today, it is highly concentrated among the giants. In 1995, commercial
banks alone held derivatives with a notional value of $18 trillion, of
which $14 trillion was accounted for by just six institutions: Chemical,
Citibank, Morgan, Bankers Trust, Bank of America, and Chase.6

Almost all of these arrangements function like the cash settlement
conditions of the futures contracts, as described above. Each side is obliged to pay to the other only the changes in the underlying values,
not the far larger notional amounts. When the same institution or the
same corporation has a variety of contracts in effect with a counterparty, payments frequently net out the impact of the entire set of contracts instead of treating each contract as a separate deal. As a result, the
functional liabilities are far smaller than the staggering magnitudes of
the notional values. According to a survey conducted during 1995 by
the Bank for International Settlements, the notional value of all derivatives outstanding around the world, excluding derivatives traded in
organized exchanges, amounted to $41 trillion, but if every party obligated to pay reneged on their payments, the loss to their creditors would
run to only $1.7 trillion, or 4.3% of the notional value.7

These new products are in essence combinations of conventional
options or futures contracts, but, in their most sophisticated versions,
they incorporate all the risk-management inventions I have described,
from Pascal's Triangle to Gauss's normal distribution, from Galton's
regression to the mean to Markowitz's emphasis on covariance, and
from Jacob Bernoulli's ideas on sampling to Arrow's search for universal insurance. The responsibility of pricing such complex arrangements
goes well beyond what Black, Scholes, and Merton had so painstakingly
worked out. Indeed, all three men ultimately showed up in Wall Street
to help in designing and valuing these new risk-management products.

But who takes the other side of contracts that come into existence
precisely because they are too specific in their coverage to trade in the
public markets? Who would be in a position to play the role of speculator and assume the volatility that the corporations were so urgently
trying to shed? Few of the counterparties to these tailor-made corporate deals are speculators.

In some instances, the counterparty is another company with opposite requirements. For example, an oil company seeking protection
from a fall in the price of oil could accommodate an airline seeking protection from a rising oil price. A French company needing dollars for a
U.S. subsidiary could assume the franc obligations of an American company with a French subsidiary, while the American company took care
of the obligations of the dollar requirements of the French subsidiary.

But perfect matches are hard to find. In the majority of instances, the
bank or the dealer who originated the deal assumes the role of counterparty in exchange for a fee or spread for executing it. These banks and dealers are stand-ins for an insurance company: they can afford to take
on the volatility that corporations are trying so hard to avoid because,
unlike their customers, they can diversify their exposure by servicing a
large number of customers with different needs. If their books become
unbalanced, they can go into the public markets and use the options and
futures contracts trading there to hedge their positions, at least in part.
Combined with the risk-reducing features of diversification, the ingenuity of the financial markets has transformed the patterns of volatility in
the modem age into risks that are far more manageable for business corporations than would have been the case under any other conditions.

In 1994, a few of these apparently sound, sane, rational, and efficient risk-management arrangements suddenly blew up, causing enormous losses among the customers that the risk-management dealers
were supposedly sheltering from disaster. The surprise was not just in
the events themselves; the real shocker was in the prestige and high
reputation of the victims, which included such giants as Procter &
Gamble, Gibson Greetings, and the German Metallgesellschaft AG.B

There is no inherent reason why a hedging instrument should
wreak havoc on its owner. On the contrary, significant losses on a
hedge should mean that the company's primary bet is simultaneously
providing a big payoff. If an oil company loses on a hedge against a
decline in the price of oil, it must be making a large profit on the
higher price that caused the loss in the hedging contract; if an airline
loses on a hedge against a rise in the price of oil, it must be because the
price has fallen and lowered its operating costs.

These disasters in derivative deals among big-name companies
occurred for the simple reason that corporate executives ended up
adding to their exposure to volatility rather than limiting it. They
turned the company's treasury into a profit center. They treated lowprobability events as being impossible. When given a choice between a
certain loss and a gamble, they chose the gamble. They ignored the
most fundamental principle of investment theory: you cannot expect to
make large profits without taking the risk of large losses.

In deep trouble in a series of derivative transactions with Bankers
Trust, Gibson Greetings provided a perfect example of prospect theory in action. Bankers Trust told the treasurer at one point in 1994 that
Gibson's losses stood at $17.5 million, but, according to the treasurer,
Bankers Trust also told him the losses could be "potentially without
limit." Gibson promptly signed a new arrangement that capped the loss
at $27.5 million but, if everything worked exactly right, could reduce
the loss to only $3 million. Prospect theory predicts that people with
losses will gamble in preference to accepting a sure loss. Gibson could
have liquidated out at $17.5 million for certain but chose the gamble
instead. As a director of another company described what happens in
such situations, "It's a lot like gambling. You get in deep. And you
think `I'll get out of it with this one last trade."' But Gibson did not get
out of it on one last trade. As the loss column headed toward $20.7 million, Gibson called it quits: it sued Bankers Trust for having violated a
"fiduciary relationship."