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Better financial controls encourage risk-taking-Nobel laureate

Date: Sunday, July 8, 2007
Author: Jan Dahinten

SINGAPORE, July 6 (Reuters) - Nobel prize-winning economist and former hedge fund manager Robert Merton believes better risk controls will make financial markets more efficient but also encourage investors to take on ever higher risks.

Merton was awarded the Nobel prize in economics in 1997 for inventing the Black-Scholes options pricing formula together with his colleagues Fischer Black and Merton Scholes.

However, the 62-year-old Harvard professor is mainly known in the financial community as the co-founder of Long-Term Capital Management (LTCM), the hedge fund that nearly collapsed under multi-billion dollar losses in 1998 due to highly leveraged bets.

The debacle triggered investor fears of a market meltdown amid financial crises in Asia and Russia and prompted a bailout by a group of Wall Street banks organised by the Federal Reserve.

"The good news is that in the 10 years since the (Asian) crisis we collectively have learned a lot. We've developed a financial system that is much more robust," Merton said on the sidelines of a risk management conference on Friday.

"When you get a safety improvement, you of course could use that to make yourself safer. But how else might we use it?

"We use the safety tools not to actually make ourselves any safer than we were but rather to get the benefit we can do things even more efficiently, faster, more conveniently, more reliably and we take the benefit in that form," he said.

Merton said that financial innovation, for example in the form of hedge funds, could help to absorb shocks.

"You have all the hedge funds and all those assets as they come and that creates concerns because it's new and there are many of them and they're not all fully understood."

"But they play collectively an important intermediation role."

Merton said that rapid growth in certain markets or asset classes, such as high-risk, or subprime, mortgages, "is not just some wild speculation but trying to meet a need".


"The subprime market: why did it grow so quickly? Because it was a segment of the population that needed to have their housing financed.

"Now leave aside whether it was done well, leave aside whether we clearly see there were mistakes made, lots of money being lost -- that's not uncommon in the financial system, we've been doing that and we'll continue to do that."

Last month, Bear Stearns (BSC.N: Quote, Profile, Research) launched the biggest bailout since a group of Wall Street banks rescued LTCM, by providing up to $3.2 billion for a struggling hedge fund it manages.

The move sent shockwaves through global markets as investors grew worried that the funds' main investments -- a type of bond known as a collateralized debt obligation, or CDO -- may be riskier than previously reckoned.

Merton cited the biggest-ever hedge fund meltdown -- Amaranth Advisors -- as an example for how resilient markets have become to external shocks.

The Greenwich, Connecticut-based hedge fund collapsed after sustaining $6.4 billion in losses last September on a series of bad bets in the natural gas market.

"Pretty dramatic if you're an investor in Amaranth. But I don't think the rest of the market-place felt much out of that. I don't think anyone saw anything close to a systemic problem. Does that mean we can't have it? Of course not."

He stressed that the improvements in managing risk did not necessarily mean there was less of a chance of a crisis in the future because investors used those improvements to achieve other goals than making their investments safer.

Merton declined to forecast possible crises in global markets but noted that an unexpected change to the very low volatility could translate into "some shocks to the system".

"I think that one of the things you want to be looking for when you see shock events is whether you see a second one. If we have a second shock of roughly the same magnitude before we made any other adjustments, the impact of that tends to be considerably larger."