Column: This innovation could lead to the next financial crisis

Traders work on the floor of the New York Stock Exchange (NYSE) in New York on October 4, 2017. Photo by REUTERS/Brendan McDermid

History might not repeat itself, but it does rhyme. Robert Z. Aliber, an emeritus professor of international economics at the University of Chicago and expert on financial crises, has noted that an innovation is at the root of every financial crash. In 1987 it was portfolio insurance; for the Great Recession in 2008 it was securitization. The obvious candidate for the next crisis is Exchange-traded funds, or ETFs.

What is an ETF? It is a pool of securities whose shares are traded in real-time on stock exchanges. Buying a share of an ETF is like buying a share of a company. Like mutual funds, ETFs are diversified within an asset class — such as an ETF that mimics the S&P 500 index. Unlike a mutual fund that mimics an index, however, these shares trade during trading hours, while a mutual fund is effectively traded at the close of business each trading day at a price that equals the net asset value (NAV) of the fund. Thus, an investor inclined to time the market will be attracted to an ETF, because waiting until a price at the end of the day might result in a missed opportunity.

Now let's get into the weeds a bit (more). ETF sponsors do not trade directly with investors. Investors buy and sell only with market makers or authorized participants. Each ETF might have some 30 authorized participants who together create a secondary market for the shares of the ETF, which investors buy on an exchange.

The ease of buying or selling shares of an ETF creates some risks. If orders to buy or sell greatly exceed what the market will bear, the price of the ETF might diverge from the net asset value of the underlying assets. In such cases the authorized participants, in their role as market makers, arbitrage the difference. These efforts could lead to a sudden rise in market orders, which are information-less: they do not result from any specific knowledge of the securities being sold. Extreme situations could result in fire sales.

Two aspects make innovations like ETFs ripe vehicles for mischief that can lead to financial crises. First, they have force: while dumb ideas are quickly discarded, good innovations provide purchase for the imagination, which is fueled by seeing others making money. Second, an innovation is new and untried, so the imagination is unconstrained by adverse experience. Leading up to 1987, for example, portfolio insurance was promoted as the vehicle to protect against stock market losses. It became popular among large investment operations.

But what might work for a single operation might very well become a disaster when many investors act at the same time. In the late 1980s, the idea was that you would sell futures to hedge a declining market. But when everyone tried to do this at once, the market seizes and crashes as it did on Oct. 19, 1987.

While dumb ideas are quickly discarded, good innovations provide purchase for the imagination.

Two decades later, the Great Recession was fueled in large part by the widely accepted assumption that the securitization of mortgages made ownership of mortgages less risky. The securities were diversified by including many mortgages within a pool, and diversified geographically. And the rating agents stamped their approval. Congress, likely impressed by this innovation, also put pressure on Fannie Mae and Freddie Mac to increase home ownership by issuing questionable mortgages — which were entered on their books as "sub-prime." At the root of it all was an untested innovation.

Leading up to 2008, investors and policymakers alike lulled themselves into believing that house prices only rise. Mortgage-backed securities were being bought and sold with little attention to the underlying mortgages and no one cared while house prices kept rising. But eventually, house prices not only stopped rising, they declined to the point that the value of a mortgage security depended on the ability of the homeowner to repay. Many couldn't and the collateral no longer covered the mortgage.

Both the 1987 and 2008 crises exhibited the marks of an experiment many of us did in grade school. Remember mixing a slurry of cornstarch and water? It was easily done, if done slowly. But what happened when you tried to stir too fast? It locked up solid. The stock market is a cornstarch-in-a-water slurry. If trading is moderate the market clears, but if everyone rushes at once for the exit, the market freezes or goes into a freefall search of buyers.

So why might ETFs be the next innovation to go awry? For starters, the concept of an ETF is a sound idea: they offer real-time trading and broad diversification. But it is untested, in the sense that ETFs have yet to be exposed to a real-life stress test. Investors are operating with the belief that they're liquid and tradable in real-time, and they are well diversified within their asset class. But how liquid are they really?

The billionaire investor Howard Marks has made a persuasive case that an ETF is only as liquid as the underlying assets. What if those underlying assets can't be readily sold? What happens if investors suddenly find cause to press the sell button on their smartphone? Can those orders be refused? At some point, the authorized participants (market makers) will be forced to liquidate a portion of the underlying assets in informationless trades. In other words: Sell, period. The result is a fire sale.

One might think that an S&P 500 ETF would be less susceptible to sudden illiquidity. But think of October 1987. And then consider that the volume of the S&P ETFs, reportedly, far exceeds the volume one might expect if S&P ETF investors were mainly patient, buy-and-hold, long-term investors. It appears that many institutional investors use these ETFs to hedge positions. What would happen if this trading suddenly dried up or, worse, if these ETF positions were suddenly liquidated forcing the authorized participants to sell heavily the underlying shares? And let's remember that investors buy ETFs to avoid the need to study many businesses.

We know what happens when investors know little or nothing about the underlying assets. Remember securitized mortgages?

My gosh, The Efficient Market Hypothesis has taught us that studying 500 companies is a waste of time; the market knows everything already, so just buy the ETF! But this puts the average investor way outside his or her sphere of competence. We know what happens when investors know little or nothing about the underlying assets. Remember securitized mortgages? How reliable are your decisions when you know little about a matter? We lull ourselves into thinking that diversification gets us off the hook. But can we be sure that the slurry won't freeze up again under extreme, not-yet-tested conditions? As Mark Twain wrote in his novel "Pudd'nhead Wilson," "Behold, the fool saith, 'Put not thine eggs in the one basket'—which is a manner of saying, 'Scatter your money and your attention'; but the wise man saith, 'Put all your eggs in the one basket and—WATCH THAT BASKET.'"

Pudd'nhead Wilson is wise. Modern finance and human nature have lead us to confuse volatility with risk of permanent loss. We prize diversification because it reduces volatility, but does that reduce permanent loss, particularly when we know little about the underlying assets? Perhaps we should think of it a little bit more as a marriage: make one good decision, and then LEARN TO HANDLE THE VOLATILITY that arises along the way.

Warren Buffett observed long ago that one should only own a stock if one is prepared to have the price decline 50 percent, because sooner or later it will. Otherwise one risks the urge to sell at the worst time. My guess is that the majority of ETF investors are not prepared for prices to decline 50 percent, or less. The ETF has deluded investors into thinking they are safe— and they can get out by pressing the sell button.

I began by arguing that an innovation is at the root of a financial crash. But remember, innovations aren't the cause of a crash, they exacerbate them. The economist Robert Aliber notes that crises are often caused by a shift in foreign capital flows into the United States. Aliber thinks that shift has again happened, drying up the capital inflows buoying stock prices, and a significant decline is imminent. Innovation put off the day of reckoning and, in doing so, exacerbate the reversion to the mean.

Recently, billions of dollars have been flowing into all manner of ETFs. Yet there hasn't been enough attention paid to the potential systemic risk of ETFs. Charlie Munger, the vice chairman of Berkshire Hathaway, was right when he said that if you haven't overturned a long-held view in the past 12 months, you haven't been thinking. It's time to start thinking. That doesn't mean we should rush to throw out good ideas; it means we should take the time to examine them properly. A clearer-headed view of the risks of ETFs is a good place to start.

Recently in Making Sen$e Columnist