Institutional Investor's Alpha Magazine - November 2008 - (Page 64)

Unhedged Commentary Learning from the Wreckage BY ANDREW W LO . e are currently facing one of the most challenging economic crises of our lifetimes — and the finger-pointing has begun. There is plenty of blame to go around, with homeowners, mortgage brokers, commercial and investment banks, rating agencies, insurance companies and investors all involved in the care and feeding of the U.S. residential real estate monster and its ugly downfall. However, in the ﬁnal analysis, we may conclude that ﬁnancial calamities are an unavoidable aspect of modern capitalism, a consequence of the interactions between hardwired human behavior and the unfettered ability to innovate, compete and evolve. But even if crises cannot be avoided, their disruptive effects can be reduced signiﬁcantly by ensuring that the parties are bearing the appropriate risks. This is best achieved through greater transparency, particularly with respect to ﬁnancial institutions in the hedge fund industry that have imploded. Real disaster comes not from losing money — which investors and their portFINANCIAL REGULATORS folio managers have been doing since the dawn of SHOULD FOLLOW THE LEAD ﬁnancial markets — but OF THE A VIATION INDUSTRY , from not being properly WHICH HAS AN AGENCY prepared for it. One successful model TO INVESTIGATE CRASHES for studying blowups is AND SUGGEST WAYS the National TransporTO PREVENT THEM. tation Safety Board, an independent government agency whose primary mission is to investigate accidents, provide careful and conclusive forensic analysis and make recommendations for avoiding such accidents in the future. In the event of an airplane crash, the NTSB assembles a team of engineers and ﬂight-safety experts who are immediately dispatched to the crash site to conduct a thorough examination, including interviewing witnesses, poring over ﬂight logs and maintenance records, and sifting through the wreckage to recover the ﬂight recorder and, if necessary, reassembling the aircraft from whatever parts remain to determine the ultimate cause of the crash. Once its work is completed, the NTSB publishes a public report summarizing the ﬁndings, including speciﬁc recommendations for preventing similar future accidents. The work of the NTSB is one of the major factors underlying the remarkable safety record of commercial air travel. For example, it is now routine practice to spray W airplanes with de-icing ﬂuid just prior to takeoff when the temperature is near freezing and it is raining or snowing. We can thank NTSB Aircraft Accident Report AAR–93/02 for this procedure. But it did not come cheaply. It was paid for by the lives of the 27 people who did not survive the crash of USAir Flight 405 on March 22, 1992. The NTSB also establishes itself as the clearinghouse for all information related to an accident and communicates frequently and regularly with the press to provide as much transparency as possible to an undoubtedly anxious public. Compare this approach with the sporadic and inconsistent messages that were communicated to the public regarding the current ﬁnancial mess, which may well have magniﬁed the dislocation that ensued in stock and money market funds this fall. The Treasury and Federal Reserve Board can hardly be faulted for not providing polished presentations of every aspect of their deliberations — public relations has never been a signiﬁcant component of their mandate. But in times of crisis, when emotions run high, it is particularly important to communicate directly, truthfully and continuously with all stakeholders, no matter how bad the news. Financial crashes are, of course, considerably less dire than airplane crashes. However, the current ﬁnancial crisis, and the eventual cost of the Paulson plan, should be sufﬁcient motivation to create a “Capital Markets Safety Board” dedicated to inspecting, reporting and archiving the “accidents” of the ﬁnancial industry. By maintaining teams of experienced professionals — forensic accountants, ﬁnancial engineers and lawyers — working together on a regular basis over the course of many investigations, a number of new insights, common threads and key issues would emerge from their analysis. The publicly available reports from the CMSB would yield invaluable insights for investors seeking to protect their future investments from similar fates and would naturally drive managers and ﬁnancial institutions to improve their safety records. It is unrealistic to expect that market crashes, manias, panics, collapses and fraud will ever be eliminated, but we should avoid compounding our mistakes by failing to learn from them. Financial markets do not need more regulation; they need more effective regulation. Andrew W. Lo is Harris & Harris Group Professor at MIT Sloan School of Management and chief scientiﬁc ofﬁcer of AlphaSimplex Group, a Cambridge, Massachussetts–based asset management ﬁrm. 64 • INSTITUTIONAL INVESTOR’S ALPHA • NOVEMBER 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - November 2008

Institutional Investor's Alpha Magazine - November 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Risk Rewarded The Good Guys: In the Here and Now Interview: Minister of Finance Cover Story: The Agony of Dan Zwirn Strategies: The Early Birds Are Awake Strategies: The Call of Shari’a Profile: Sweet Home Chicago Research Center: What Stampede? Alpha Bytes: Centralize the Data Unhedged: Commentary: Learning from the Wreckage

Institutional Investor's Alpha Magazine - November 2008

For optimal viewing of this digital publication, please enable JavaScript and then refresh the page. If you would like to try to load the digital publication without using Flash Player detection, please click here.