C F A  M A G A Z I N E 

Cascades, Contagions, and Death Spirals

The next “Big One” is coming! So plan, now. But for what exactly? And how?

By Christopher Wright

We interrupt this market to bring you the latest crisis.

Regarding the slump in asset prices, “this was the first global bubble ever, and that it all spread across all asset classes and all countries with very few exceptions, “says perma-bear Jeremy Grantham, chairman of Grantham, Mayo Van Otterloo & Company (GMO).

It is often said that in a crisis, the markets move in sync.  (correlations go to l.)  Asset classes can also move in opposite directions. “Some correlations go to - l,” says Leslie Rahl, president of Capital Market Risk Advisors in New York City.  For example, consider the rise of REITs when the NASDAQ was collapsing in 2001.

Leslie Rahl says “People put too much emphasis on asset diversification and not enough on diversifying the more subtle risk factors such sensitivities to volatility, to flights to quality, to credit, etc.”

Managers can profit from analyzing their holdings for the correlative effects of such common factors as instrument opacity, complexity, illiquidity, and leverage.  The key is understanding a portfolio’s risk-factor concentrations.

“For instance”, says Rahl, “maybe you want a limit in your portfolio on hard-to-value investments that is independent of asset class.”

An overlooked common factor in the current credit crisis is vintage. MBS holders and credit rating agencies may have thought the assets behind these instruments were diversified by geography, but they didn’t consider that different credit standards, some looser that others, in different years.  “Most of these securities,” noted Rahl, “were built with a high concentration of a single vintage.

July/August 2008