During the week of August 6, 2007, a number of quantitative long/short equity hedge funds experienced unprecedented losses. It has been hypothesized that a coordinated deleveraging of similarly constructed portfolios caused this temporary dislocation in the market. Using the simulated returns of long/short equity portfolios based on five specific valuation factors, we find evidence that the unwinding of these portfolios began in July 2007 and continued until the end of 2007. Using transactions data, we find that the simulated returns of a simple market-making strategy were significantly negative during the week of August 6, 2007, but positive before and after, suggesting that the Quant Meltdown of August 2007 was the combined effects of portfolio deleveraging throughout July and the first week of August, and a temporary withdrawal of market-making risk capital starting August 8th. Our simulations point to two unwinds—a mini-unwind on August 1st starting at 10:45am and ending at 11:30am, and a more sustained unwind starting at the open on August 6th and ending at 1:00pm—that began with stocks in the financial sector and long Book-to-Market and short Earnings Momentum. These conjectures have significant implications for the systemic risks posed by the hedge-fund industry.

We propose the National Transportation Safety Board (NTSB) as a model organization for addressing systemic risk in industries and contexts other than transportation. When adopted by regulatory agencies and the transportation industry, the safety recommendations of the NTSB have been remarkably effective in reducing the number of fatalities in various modes of transportation since the NTSB’s inception in 1967 as an independent agency. The NTSB has no regulatory authority and is solely focused on conducting forensic investigations of transportation accidents and proposing safety recommendations. With only 400 full-time employees, the NTSB has a much larger network of experts drawn from other government agencies and the private sector who are on call to assist in accident investigations on an as-needed basis. By allowing the participation in its investigations of all interested parties who can provide technical assistance to the investigations, the NTSB produces definitive analyses of even the most complex accidents and provides actionable measures for reducing the chances of future accidents. It is possible to create more efficient and effective systemic-risk management processes in many other industries, including financial services, by studying the organizational structure and functions of the NTSB.

Although the precise origins of the term "complex adaptive system" are unclear, nevertheless, the hackneyed phrase is now firmly ensconced in the lexicon of biologists, physicists, mathematicians, and, most recently, economics. However, as with many important ideas that become cliches, the original meaning is often obscured and diluted by popular usage. But thanks to the fascinating article by Gai, Haldane, and Kapadia, we have a concrete and practical instantiation of a complex adaptive system in economics, one that has real relevance to current policy debates regarding financial reform. Since there is very little to criticize in their compelling article, I will seek to amplify their results and place them in a broader context in my comments.

The hedge fund industry has grown dramatically over the last two decades, with more than eight thousand funds now controlling close to two trillion dollars. Originally intended for the wealthy, these private investments have now attracted a much broader following that includes pension funds and retail investors. Because hedge funds are largely unregulated and shrouded in secrecy, they have developed a mystique and allure that can beguile even the most experienced investor. In Hedge Funds, Andrew Lo--one of the world's most respected financial economists--addresses the pressing need for a systematic framework for managing hedge fund investments.

MIT Sloan Prof. Andrew Lo authored this opinion piece supporting the creation of a “Capital Markets Safety Board’ (CMSB) patterned after the National Transportation Safety Board, dedicated to investigating, reporting, and archiving the ‘accidents’ of the financial industry.”

The quantitative aspirations of economists and financial analysts have for many years been based on the belief that it should be possible to build models of economic systems—and financial markets in particular—that are as predictive as those in physics. While this perspective has led to a number of important breakthroughs in economics, "physics envy" has also created a false sense of mathematical precision in some cases. We speculate on the origins of physics envy, and then describe an alternate perspective of economic behavior based on a new taxonomy of uncertainty. We illustrated the relevance of this taxonomy with two concrete examples: the classical harmonic oscillator with some new twists that make physics look more like economics, and a quantitative equity market-neutral strategy. We conclude by offering a new interpretation of tail events, proposing an 'uncertainty checklist' with which our taxonomy can be implemented, and considering the role that quants played in the current financial crisis.

We apply machine-learning techniques to construct nonlinear nonparametric forecasting models of consumer credit risk. By combining customer transactions and credit bureau data from January 2005 to April 2009 for a sample of a major commercial bank's customers, we are able to construct out-of-sample forecasts that significantly improve the classification rates of credit-card-holder delinquencies and defaults, with linear regression R-squared's of forecasted/realized delinquencies of 85%. Using conservative assumptions for the costs and benefits of cutting credit lines based on machine-learning forecasts, we estimate the cost savings to range from 6% to 25% of total losses. Moreover, the time-series patterns of estimated delinquency rates from this model over the course of the recent financial crisis suggests that aggregated consumer-credit risk analytics may have important applications in forecasting systemic risk.

This document is the revised written testimony titled "Hedge Funds, Systemic Risk, and the Financial Crisis of 2007–2008" submitted to the US House of Representatives Oversight Committee for its hearing on hedge funds and the financial market, held November 13, 2008, and is not a formal academic research paper, but is intended for a broader audience of policymakers and regulators. Academic readers may be alarmed by the lack of comprehensive citations and literature review, the imprecise and qualitative nature of certain arguments, and the abundance of illustrative examples, analogies, and metaphors. Accordingly, such readers are hereby forewarned—this paper is not research but is instead a summary of the policy implications that I have drawn from my interpretation of that research.

I begin with a proposal to measure systemic risk and argue that this is the natural starting point for regulatory reform since it is impossible to manage something that cannot be measured. Then I review the relation between systemic risk and hedge funds, and show that early warning signs of the current crisis did exist in the hedge-fund industry as far back as 2004. However, I argue that financial crises may be an unavoidable aspect of human behavior, and the best we can do is acknowledge this tendency and be properly prepared. This behavioral pattern, as well as traditional economic motives for regulation—public goods, externalities, and incomplete markets—are relevant for systemic risk or its converse, 'systemic safety', and I suggest applying these concepts to the functions of the financial system to yield a rational process for regulatory reform. Also, I propose the formation of a new investigative office patterned after the National Transportation Safety Board (NTSB) to provide the kind of information aggregation and transparency that is called for in the previous sections. Another aspect of transparency involves fair-value accounting, and I review some of the recent arguments for its suspension and propose developing a new branch of accounting focusing exclusively on risk. I conclude with a discussion of the role of financial technology and education in the current crisis, and argue that more finance training is needed, not less.

This document is the written testimony submitted to the US House of Representatives Financial Services Committee for its hearing on systemic risk regulation, held October 29, 2009, and it is not a formal academic research paper, but is intended for a broader audience of policymakers and regulators. Academic readers may be alarmed by the lack of comprehensive citations and literature review, the imprecise and qualitative nature of certain arguments, and the abundance of illustrative examples, analogies, and metaphors. Accordingly, such readers are hereby forewarned—this paper is not research, but is instead a summary of the policy implications that I have drawn from my interpretation of that research. This testimony focuses on three themes: (1) Establishing the means to measure and monitor systemic risk on an ongoing basis is the single-highest priority for financial regulation reform; (2) Systemic risk measurement and regulation will likely require new legislation compelling systemically important entities to provide more transparency on a confidential basis to regulators, e.g., information regarding their assets, liabilities, holdings, leverage, collateral, liquidity, counterparties, and aggregate exposures to key financial variables and other risks; and (3) Because systemic risk cuts across multiple regulatory bodies that do not necessarily share the same objectives and constraints, it may be more efficient to create an independent agency patterned after the National Transportation Safety Board (NTSB), solely devoted to measuring, tracking, and investigating systemic risk events in support of—not in competition with—all regulatory agencies.

Financial crises are unavoidable when hardwired human behavior—fear and greed, or "animal spirits"—is combined with free enterprise, and cannot be legislated or regulated away. Like hurricanes and other forces of nature, market bubbles and crashes cannot be entirely eliminated, but their most destructive consequences can be greatly mitigated with proper preparation. In fact, the most damaging effects of financial crisis come not from loss of wealth, but rather from those who are unprepared for such losses and panic in response. This perspective has several implications for the types of regulatory reform needed in the wake of the Financial Crisis of 2007-2008, all centered around the need for greater transparency, improved measures of systemic risk, more adaptive regulations including counter-cyclical leverage constraints, and more emphasis on financial literacy starting in high school, including certifications for expertise in financial engineering for the senior management and directors of all financial institutions.

Our topic is corporate risk management, with perhaps a look at the implications for the current financial crisis. And I’d like to start by saying a few things that might help set the stage for our four panelists, who are all very interesting and accomplished people. When we think about risk and risk management, everybody says it’s very important. When a firm or an institution goes down, a lot of people lose their jobs, assets change hands, and a lot of franchise value can be destroyed in the process. So risk management is important in the sense of protecting on the downside. But there’s also a common perception that risk management has very little to do with creating growth and value—that you’ll never get to the Fortune 100 just by having good risk management. And I think that’s a serious misunderstanding of what risk management is really all about.

In this article, we attempt to quantify the potential impact of hedge funds on systemic risk by developing a number of new risk measures for hedge funds and applying them to individual and aggregate hedge-fund returns data. These measures include: illiquidity risk exposure, nonlinear factor models for hedge-fund and banking-sector indexes, logistic regression analysis of hedge-fund liquidation probabilities, and aggregate measures of volatility and distress based on regime-switching models. Our preliminary findings suggest that the hedge-fund industry may be heading into a challenging period of lower expected returns, and that systemic risk is currently on the rise.

In contrast to traditional investments such as stocks and bonds, hedge-fund returns have more complex risk exposures that yield additional and complementary sources of risk premia. This raises the possibility of creating passive replicating portfolios or "clones" using liquid exchange-traded instruments that provide similar risk exposures at lower cost and with greater transparency. Using monthly returns data for 1,610 hedge funds in the TASS database from 1986 to 2005, we estimate linear factor models for individual hedge funds using six common factors, and measure the proportion of the funds' expected returns and volatility that are attributable to such factors. For certain hedge-fund style categories, we find that a significant fraction of both can be captured by common factors corresponding to liquid exchange-traded instruments. While the performance of linear clones is often inferior to their hedge-fund counterparts, they perform well enough to warrant serious consideration as passive, transparent, scalable, and lower-cost alternatives to hedge funds.

During the week of August 6, 2007, a number of quantitative long/short equity hedge funds experienced unprecedented losses. Based on TASS hedge-fund data and simulations of a specific long/short equity strategy, we hypothesize that the losses were initiated by the rapid "unwind" of one or more sizable quantitative equity market-neutral portfolios. Given the speed and price impact with which this occurred, it was likely the result of a forced liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to a margin call or a risk reduction. These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses by triggering stop/loss and de-leveraging policies. A significant rebound of these strategies occurred on August 10th, which is also consistent with the unwind hypothesis. This dislocation was apparently caused by forces outside the long/short equity sector—in a completely unrelated set of markets and instruments—suggesting that systemic risk in the hedge-fund industry may have increased in recent years.