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 everyone. 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.