Andrew Lo On Fixing Finance

A hedge fund legend on fear and risk.

By SHARE

Andrew Lo, hedge fund manager and director of MIT's Laboratory for Financial Engineering, is a long-time student of investor behavior, especially the sort that belies the notion that markets move with cool efficiency. Particularly today, he sees animal spirits lurching about in some worrisome ways that could have long-term consequences for markets and the economy. "The big message is that right now all, of us are in a state of emotional shell-shock," he says. That goes for investors, regulators, bankers, and anyone else unlucky enough to get caught up in the fear and uncertainty flowing through the current financial crisis.

In this two-part Q&A with U.S. News, Prof. Lo discusses the best way to build a robust regulatory system for the financial sector (see below.) He also considers what massive changes in the investment landscape over the past few years might mean for your investments (part two will post here Monday).

Let's talk hedge fund regulation. What sort of oversight is most appropriate?
We don't need more regulation; we need better regulation. The majority of the problems we see in the current crisis emanated not from the hedge fund industry, but from the banking sector, which is probably the most highly regulated industry in the world. The main theme of my work has been to create more transparency in the financial sector, because one of the problems that arose and is still causing problems in our banking system is the lack of transparency and the fear it breeds. One of the strongest kinds of fear is fear of the unknown. That's exactly where we're at today with people fearing what they don't know about "toxic assets," about defaults, about where some of these pricing models will lead us. What should a new regulatory framework look like?


The major highlights are relatively straightforward. One is we ought to create some kind of a systemic risk oversight agency. I propose creating something like the National Transportation Safety Board for financial markets. That organization could be charged with not only investigating all of the accidents in our industry, but putting together comprehensive assessments of the risk exposure of the entire financial system. They would be charged with responsibility of monitoring--not necessarily managing--the systemic risk exposures that the financial system faces at any point and time.

I think we already have the regulatory infrastructure to deal with systemic risk. It's called the [Federal Reserve]. The Fed has to have expanded powers and access to information produced by this [NTSB-like] agency. There are smaller, commonsensical  proposals: If financial institutions become to big to fail, break them up. We've done that with the telephone companies and other companies, so I think we can do it with financial services. In mortgage markets, large parts of the problem there came from mortgage brokers that handed out mortgages to folks that really shouldn't have had them. We already have regulatory infrastructure to deal with that. When a stock broker calls you up and recommends you buy Microsoft, they have a fiduciary obligation to make sure that the recommendation is appropriate for you. They need to know you, your background, your financial condition. Otherwise, they can be charged with violations of securities law. Mortgage brokers, I would argue, need to be in the exact same situation, but even more so because they're advising on even larger assets--not just your portfolio, but your home.

Is the regulatory component of the various government bailouts addressing these issues?
I believe everybody involved here has the best of intentions. But at the same time, there are forces at work regulators and policymakers aren't fully aware of. We are all collectively reacting emotionally to a very traumatic event. You know the personal advice you often hear that if you go through a divorce, or the loss of a parent or spouse, that you shouldn't make any life-altering decisions for a year? That's very good advice, because when you're engaged in extraordinary emotional turmoil you actually can't think clearly. You'll act the way humans are hard-wired to react--the fight-or-flight syndrome. As a whole, politicians and regulators are reacting in that mode. They're trying to implement short-term fixes to stop the pain, or as they say stop the bleeding. But it's a false analogy. We're not dying. Businesses are contracting, but I would argue they should be contracting.

If you look at the way growth has occurred over the last 20 years, we've been living on borrowed time for quite a while. That kind of growth is not sustainable. The economy needs to contract. We need to lose jobs. It's a very tough thing to say. TARP and some other proposals are addressed at short-term pain, [namely], "Let's unfreeze the capital markets." But it doesn't address the question of why capital markets froze to begin with, and how we'll allow it to unfreeze in a way that's sustainable. In other words, once TARP is gone, then what? The market will freeze back again if we don't change the fundamental reason they were frozen. Unless we can step back and engage in some tough love and think about the things we want to change permanently about the system so as to to prevent this kind of thing from happening again, we're doomed to repeat these mistakes.

What needs to change in how we measure market risk?
When we think about regulating financial markets, we actually have to think holistically. We can't just think about regulating the stock market or the currency market because all of these markets are connected. When we think about mapping the global financial system, instead of using very rudimentary tools like value-at-risk, we need to think more globally. We need to think of a cobweb of financial entities, and hopefully new regulatory reforms being proposed will try to map that cobweb. As of now, nobody even is thinking in terms of cobwebs. We need to map those connections.

Say five years down the line, we have that map. What daily levers will a regulator be looking at?
There are a few. My science-fiction vision for this is a high-tech war room with hundreds of screens where the one thing you'll see is this map of linkages between every single financial institution. You'll see lots of nodes and arrows of different thicknesses that measure how important certain connections are. That's the one tool we need to build for regulators. The second set of tools will be analytics that pop up for each particular participant in the financial industry [showing] what kind of assets they're holding, how much leverage are they using, and what the likelihood is that they will fail over a three-, four-, or five-year horizon. It would be enormously beneficial to have a centralized bank of information you can quickly visualize on a real-time basis so if something happens at nine in the morning we have plan to deal with it by three o'clock.

How close are we to getting there?
I think we're pretty far away, not because the technology and information don't exist, but because I don't think policy makers and regulators are thinking in this mode. They need to change the way they think about systemic risk. It's not a sideshow. It has to be the central focus of reform. If they take this seriously, they could build it by next year.

How much will financial participants be willing to share under that kind of system?
I don't think it's going to be that much of a shift. It turns out the information I'm talking about can be gotten from four or five financial institutions. You don't have to contact 8,000 hedge funds individually. All you need to do is contact their prime brokers. Nowadays, there are only four or five prime brokers left that deal with hedge funds, and if you're a hedge fund, you have to have a prime broker. By focusing your efforts on getting data from these five, you can build this global network of linkages very, very easily. We have the technology, those five prime brokers have the data. We just have to want to do it, to create this NORAD for finance.

From your technician point of view, what has this crisis proved, reinforced, or challenged in your way of thinking about trading? What kind of stress test have these past 18 months been?
In the narrow arena of quantitative-equity strategies, the last 18 months have taught us that the so-called phenomenon of a crowded trade actually characterizes the entire financial industry. It used to be that a crowded trade affected a very small subset, but just as Thomas Friedman wrote that the world is flat, financial markets are flat too. The competition across all the various strategies means that we're not only globally integrated, but [also] that when shocks occur, we're also globally tied to those kinds of shocks. Shocks can propagate through the entire financial system very, very rapidly now, much more so than in 1998. The cause of the so-called "quant meltdown" in August 2007 was, as far as we can tell, completely divorced from the equity markets themselves. This "quant quake" really emanated far away in the area of subprime mortgages, but in a matter of weeks, this problem of subprime mortgages had an enormous impact on equity managers. The lesson we learned is that quant managers aren't immune to these kinds of  shocks, but more broadly we've discovered we're all connected. We're one big global village with one financial market, and when there's any problem in one aspect of that market, it's quickly felt throughout the rest of it. That's going to have to change the way we model risk, and on the academic side it's generated a number of new kinds of research on risk analytics.

  • Kirk Shinkle

    Kirk Shinkle is a senior editor for U.S. News Money and manages the Best Funds portal. Follow him on Twitter @KirkS or email him at kshinkle@usnews.com.

You Might Also Like