Three times in the last 25 years, financial markets have been buffeted by severe crises that have left countless advisors and their clients reeling. The reason is endogenous risk, and planners need to be aware of it in guiding their clients.

Endogenous risk is the risk that markets may not behave as they normally do because of a change in behavior of market participants themselves. This is in contrast to exogenous risk - that is any risk generated outside of the financial system, like an earthquake. Either may impact a stock or the market, but endogenous risk is much more far-reaching.

Jon Danielsson and Hyun Song Shin from the London School of Economics use this analogy: They recount how London's Millennium Bridge over the Thames River was designed by engineers to hold the weight of numerous pedestrians, so no problems were expected with a large crowd on the bridge on dedication day in 2000.

Once the crowd gathered, however, the bridge was hit by strong gusts of wind and began to wobble. The wobbling persisted, as people on the bridge adjusted to the gusts by changing their stances at the same time. The engineers had not planned for a situation in which everyone behaved in the same way at the same time; they had assumed that whoever was on the bridge at any given time would be moving randomly relative to one another. (The new bridge was promptly closed to allow for modifications.)

A model of random movements is analogous to the buying and selling by market participants under typical conditions. But what happens when market participants all start behaving the same way, and all of them want to sell at the same time? This can lead to fear and panic, and rapidly declining asset prices.

The markets have experienced three events representing endogenous risk recently: the 1987 stock market crash, the 1998 Long-Term Capital Management bailout and the 2008 financial crisis. In all three events, a ripple effect went through the markets, causing waves of selling and plunging prices. Much of the selling was not based upon exogenous fundamentals, but was endogenous in nature - and the fact that we have seen one per decade should be cause for concern.



What are the causes of endogenous risk?

It seems clear that the financial climate has become more conducive to endogenous events, and there are several factors pointing toward the likelihood of further events:

* The emergence of a new "financialized" capitalism.

* The rise of speculation and decline of investing.

* The increase in derivatives and use of leverage.

* Shadow banking and a lack of transparency.

* The problem of too big to fail.

A major shift occurred in the U.S. after the presidential election of 1980: the beginning of financialization. This term is used to describe the separation of financial wealth from real wealth or from the production of goods and services. Essentially, through risky innovations, the financial system, made up of banks and investors, was able to create artificial wealth that enabled those involved to capture an increased share of real wealth, and this wealth was concentrated in the richest 1% or 2% of society. According to research by economist Luiz Carlos Bresser-Pereira published by Bard College, the richest 1% controlled 23% of total disposable income in 1930. In 1980, the share had fallen to just 9%, but by 2007 it had gone back up to 23%.

In recent years, even though the financial sector contributed just 20% to GDP, it reaped 40% of corporate profits. Financial engineering aimed at making money, as opposed to creating something of value, has become commonplace, and this contributes to the instability of the financial system, thus increasing endogenous risk.

It can be argued that portfolio managers and financial intermediaries are taking too much of the returns, even though it is the investors - the "owners" - who are taking the risk by providing the capital. Managers' capitalism means that corporations are being run primarily to benefit managers and not shareholders. According to the author William Pfaff, a "pathological mutation" occurred late in the 20th century, and the classic system of trying to maximize return on capital is broken. The markets have so diffused ownership "that no responsible owner exists." An unattributed quotation cited by John Bogle, founder and retired CEO of Vanguard, sums up what happens when managers' capitalism takes over: "When we have strong managers, weak directors and passive owners, don't be surprised when the looting begins."

At the end of the 20th century, the wealthiest 1% of Americans owned about 40% of the nation's wealth (which is measured differently from disposable income), the highest share since the age of the robber barons at the turn of the previous century, when it was about 45%, according to Bogle. He warns that "a society that tolerates such differences in income and wealth is a society that faces long-term disruption."



We currently live in the most speculative age in history, with annual stock turnover soaring to 215% in 2008, which far surpassed the 143% of the late 1920s. In 1951, the annual rate of turnover was about 25%, and it stayed in this low range for the next two decades, then began rising and topped 100% in 1998. Increased turnover means less stability, but Wall Street makes more money with more transactions. Intermediation costs are extremely high for investors. Bogle estimates that, on average, $400 billion per year is deducted before passing the remainder on to investors.

Derivatives are relatively new to the financial landscape, and their use has exploded. Established initially to hedge risk, they can also be used to speculate and to leverage bets. Credit default swaps totaled "only" $920billion at the end of 2001; the total grew to more than $62 trillion at the end of 2007. The sheer number of derivatives remains high. In 2009, the notional value (the face amount that the credit swaps represent) was some $600 trillion, about nine times the $66trillion gross domestic product of the entire world.

The sheer size of the derivatives market can have a significant impact on global capital markets. For example, if a firm has a losing derivative position, it may have to sell other assets it holds, such as stocks or bonds, in order to remain solvent. This then has a ripple effect throughout the markets.

Another problem is counterparty risk. A firm may have hedged its position with derivatives purchased from another firm, but if that firm goes bankrupt or is not able to make the promised payments, then the hedging has not worked. This happened in 2008, when various firms were unable to meet all of the derivative obligations they had entered into. Overuse of derivatives results in too much leverage; this can have an impact on not only the firm that has entered into the derivative contracts, but also the financial system itself.



Shadow banking is yet another problem, and it occurs under the radar of traditional bank regulation. Bankers essentially become "nonbank bankers" and leverage their lending with such activities as running hedge funds and investment banks. In a recent update of economist Hyman P. Minsky's 1986 book Stabilizing an Unstable Economy, Minsky argues that regulators played an important role in keeping financial institutions in check.

"In a world of businessmen and financial intermediaries who aggressively seek profit, innovators will always outpace regulators; the authorities cannot prevent changes in the structure of portfolios from occurring. What they can do is keep the asset-equity ratios of banks within bounds by setting equity-absorption ratio for various types of assets. If the authorities constrain banks and are aware of the activities of fringe banks and other financial institutions, they are in a better position to attenuate the disruptive expansionary tendencies of our economy."

Barring a big boost in capital needed relative to the amount of leverage or derivatives a financial institution may have, endogenous risk will remain high.

Too big to fail is another threat. There are three major problems for society when a financial institution is too big to fail. When a corporation does fail, it requires a bailout by the government, which means taxpayers are paying for it. Second, if the institution believes it is too big to fail, it creates a moral hazard and executives have a strong incentive to take on excess risk. This problem only gets worse over time. Finally, bailouts of too-big-to-fail institutions are bad for competition and the economy. Bond investors realize that the too-big institution has an implicit government guarantee, so this makes its cost of capital less than that of less-large banks.



Advisors need to understand that the financial landscape has changed. They need to prepare individuals for the possible occurrence of endogenous events because the current financial landscape is not sufficiently stable. Contrary to what many advisors tell their clients, namely that time reduces risk, the opposite is actually true. The chance that an adverse endogenous event will occur increases over time. If that risk is not taken into account, especially with retirees or individuals approaching retirement, then an endogenous event could be catastrophic for the client.

There are also serious implications for investment advisors. Individuals need to diversify more (such as by including alternative investments) and perhaps invest more conservatively. If, for example, an investor has the traditional mix of 60% equities and 40% bonds, then perhaps the mix should be modified: 40% equities, 40% bonds and 20% cash. This forgoes some potential upside, but would help to buffer the downside should an endogenous event occur. It also keeps some capital available for opportunities, keeping the investor in a position to buy when prices are low. At the very least, it may stop the client from getting discouraged (or worse) and selling positions at the worst possible time.

Another way to help to neutralize endogenous risk, at least to some extent, is to support and invest directly in sound, well-run companies rather than just in mutual funds or ETFs. Eliminate the middleman. In choosing companies, consider such criteria as reasonable executive compensation and perks, high-productivity employees with low turnover, good corporate citizenship and wise use of debt. An advisor can help in choosing such companies, with the intent that they will be held for long periods of time.

The more securities there are in strong hands not trying to chase the latest fad, the more stable our financial system will become, and the less endogenous risk there will be. This would be closer to how our financial system was 50 years ago, before day trading, hedge funds and financial engineering. Unfortunately, indexing and the current menu of investment choices in many 401(k) plans support the status quo.

For the time being, and for the foreseeable future, endogenous risk is the elephant in the room, and financial planners must take it into account when working with their clients. If advisors ignore its possibility, it is not only at their own peril but, more important, at the peril of the clients they are serving and advising.



Jim Pasztor, CFP, is chairman of the graduate degree program at the College for Financial Planning.

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