Derivatives and CLOs: The Scaremongering Continues

Greg Ip and Gillian Tett both have pieces today on that old friend of ours, systemic risks to the financial system. Ip has found a Wall Street doomsayer:

Like many pessimistic observers, Richard Bookstaber thinks financial derivatives, Wall Street innovation and hedge funds will lead to a financial meltdown.
What sets Mr. Bookstaber apart is that he has spent his career designing derivatives, working on Wall Street and running a hedge fund.

Tett, meanwhile, is worrying about European collateralized loan obligations:

The CLO sector is opaque, and pipelines operate with a long timelag. It is thus entirely possible to imagine a scenario where CLO activity suddenly collapses, producing a shock for debt prices, which could be a tipping point for credit markets that are already overstretched.

I'm not sold on Bookstaber, who seems to be talking his own book, both literally (he's written a book on this) and figuratively (he runs a hedge fund whose trades reflect his ideas). He also seems to give himself rather too much credit for world-changing events:

Mr. Bookstaber, who sold portfolio insurance to investors in Japan and managed it for such Morgan Stanley clients as Chrysler, Ford Motor Co. and Gillette, writes, "Through my role in implementing portfolio insurance, I had helped precipitate a financial crisis of monumental proportions." [He's talking here about the 1987 stock-market crash.]
In 1998, as head of Salomon Brothers' risk-management team, he tried to find out why a strategy employed by the firm's bond arbitrage desk, with some of Wall Street's smartest minds, was facing more than $100 million in losses. Even after intensive study, the cause remained an "enigma," Mr. Bookstaber writes. But he did conclude that declining interest rates were causing the strategy to lose money even though it was designed to be interest-rate neutral. His findings, he says, encouraged the new owners of Salomon, which had just merged with Smith Barney, to close the bond arbitrage unit and liquidate its positions.
Mr. Bookstaber says as Salomon closed out its positions, other traders stepped out of the way and liquidity -- the ease of trading -- in the underlying markets dried up. This, he said, precipitated LTCM's crisis.

Wow! The two biggest systemic meltdowns of the past 20 years, and they were both Bookstaber's fault!

As for Tett's CLO worries, she does concede that the market should be self-correcting, and that she's not actually predicting a crisis. On the other hand, it's perfectly rational to be worried about things which have a small but meaningful probability of happening. I'm just not convinced that a collapse in new CLO formation would have the effect that Tett thinks it might have. Rather, I suspect that hedge funds and others will step in as and when CLOs step back -- as has happened in the US mortgage market.