As the vitriolic debate on healthcare reform dominates the news, healthcare industry leaders continue to focus on several issues: innovation to drive growth and promote cost efficiencies; new offerings to generate higher value for each healthcare dollar invested; and the emergence of attractive new global markets and technologies. They recognize that continued economic weakness and new sets of competitive and regulatory pressures create a more challenging environment to drive business growth. At the same time, they see tremendous opportunities to develop cost-effective products and services that can dramatically improve patient care on a global basis.

At Columbia Business School’s 6th Annual Healthcare Conference held on November 6, nearly 500 students, alumni and other professionals heard more than 35 speakers and experts discuss these issues. The attendees benefited from panels on an array of healthcare topics including biopharmaceuticals, medical devices and diagnostics, healthcare services and information technology, venture capital/private equity, mergers and acquisitions and emerging markets. The day concluded with a networking reception and career fair where attendees met with the event’s 20 corporate sponsors.

Fred Hassan, chairman and CEO of Schering-Plough, gave the opening address. Despite economic, competitive and regulatory pressures facing the pharmaceutical industry, he was confident that new therapies and vaccines would be developed to address large areas of unmet needs, most notably Alzheimer’s disease, which represents a devastating social and economic threat to society.

Following his remarks, three concurrent panels took place in the morning. They focused on information technology solutions, growth strategies of Big Pharma and small-cap biotechnology companies, venture capital and private equity investment strategies in healthcare, and the impact of proposed healthcare reform initiatives on payors and providers.

Mike Barber, vice president and head of Healthymagination for GE, reviewed GE’s new $6 billion global commitment to develop new technologies and services to reduce costs, improve quality and expand access for millions of people around the world. Among other objectives, this initiative will accelerate healthcare information technology, support consumer-driven healthcare, create new wellness and healthy worksite programs and facilitate access to cost-effective healthcare in rural and underserved areas.

Three concurrent afternoon panels covered healthcare mergers and aquisitions, medical devices and diagnostics, and challenges and opportunities for healthcare companies in the emerging markets. Alex Gorsky, worldwide chairman for medical devices and diagnostics at Johnson & Johnson, discussed emerging opportunities to develop new therapies to extend and improve a patient’s quality of life, as well as new cost-effective and less invasive medical devices and procedures. He also commented on the changes underway in global healthcare companies and how employees need to expand their skills and experiences, such as seeking new functional roles and positions in new geographic regions to broaden their understanding of different healthcare systems and customers.

Photo courtesy of the Healthcare Conference

Monday, November 9, is the deadline for banks to apply for the Treasury’s Capital Assistance Program. Chances are, none will sign up.

The program — CAP for short — is the other shoe of last spring’s stress test. Announced on February 9 as a “core element of the Administration’s financial stability plan,” the program was designed to backstop banks that are unable to raise sufficient private capital. Secretary Geithner presented the plan to the Senate Banking Committee on February 10 and it was featured in Chairman Bernanke’s Senate testimony two weeks later.

Under the CAP, a bank receives government funds by issuing preferred securities to the Treasury. These CAP securities include complex embedded options for both the bank and the Treasury. In current work with Zhenyu Wang of the New York Fed, we have estimated prices at which these “structured products” would sell in a market transaction between private participants rather than as part of a government program. We have applied our method to the 18 publicly traded bank holding companies that participated in the stress test. (The 19th stress test bank, GMAC, is privately held and received funds through a special program for the auto industry.) Our estimates indicate that the CAP securities represent significant value — one might even say a huge potential subsidy — to eligible banks.

So why no takers? In many respects, the lack of participation is good news: the mere availability of CAP funds may have been enough to boost confidence in the financial system. The nine banks that were required to raise additional capital following the stress test all report being on track to meet their targets through the private sector, though some of the new capital, like the $2.1 billion in deferred tax assets claimed by Bank of America, falls short of a ringing endorsement from investors. But even if all the capital raised is solid, the question remains: Why pass up a good deal?

The circumstances suggest several possible explanations. A bank may avoid taking government funds if the strings attached require it to forgo other profitable opportunities. Citi’s sale of Phibro and troubles with Banamex illustrate this possibility, but such costs are unlikely to offset the value of the subsidy. In an odd twist, weak corporate governance may save taxpayers money. This explanation applies if bank executives pass up CAP funds to protect their own positions rather than the interests of shareholders. Senior management at any of the top banks would be unlikely to survive another injection of government capital.

These considerations apply to all the TARP programs, but one other explanation is specific to the CAP preferred securities. In our analysis, much of the value to a bank of the CAP securities lies in the option a bank gets to convert them to common equity. This feature comes at the cost of higher dividend payments than shares issued through earlier programs, which did not include a conversion option. But Citi negotiated conversion of some of its earlier shares, and remarks from Treasury officials and banks indicate that similar conversions have been discussed at other banks. Banks may be reluctant to pay for an option they think they can get for free.

Complex structured products designed in the private sector have drawn criticism for contributing to financial instability through a lack of transparency. The complexity of the Treasury’s design of the CAP shares — intended, no doubt, to avoid direct government purchase of bank stocks — may well have been a final factor in discouraging participation.

The reasoning went that if you could gain large market share in a growth market, you could capture a major cost advantage. That would give you a competitive advantage over smaller-share rivals.

You remember the matrix, of course: the 2x2 grid in which you plot the growth rate of your market against your position in that market. The high/high box (big shares in growing markets) were “stars”; the high/low box (big shares in slow-growth markets) were “cows”; the low/low box (small share in slow-growth markets) were “dogs” and the remaining quadrant (small share in low-growth markets) were question marks.

The strategy advice was to invest in stars, use the cows for cash, sell off the dogs, and … well, it was never quite clear what to do with the question marks. At one time, an academic study found that 75% of all CEOs of American companies were aware of and had used some aspect of the BCG matrix in making portfolio allocation decisions. It later transformed into the famous GE Matrix and also found its way into other tools offered by consulting firms such as McKinsey.

Well, it was too good to last, I suppose, because as the model gained in popularity, criticism of it grew. Observers argued that it was fundamentally flawed and led to starved cows, mis-fired stars, lost opportunities for profit and worst of all, the wholesale abandonment of markets whose domestic growth might have stalled, but which were growing globally (such as televisions).

The academics weighed in as well, with studies by Columbia’s own Don Hambrick and Ian MacMillan empirically testing the conclusions in the model (see references). But wait — it’s back!

In the May issue of the Harvard Business Review is an article (“Is Your Growth Strategy Flying Blind?”) on growth strategies that advocates a granular approach to analyzing possible markets, based on — you guessed it — market growth rate and market share (among other things). The approach differs from the old BCG approach in that the units of analysis the authors suggest are smaller — right down to individual product lines, customer segments and regions, but the strategic advice remains pretty much the same. Invest in those segments that show high growth rates, in which the position is strong and in which there is momentum. A great idea whose time came … and went … and has come again.

References: Hambrick, D. C., I. C. MacMillan & Day, D. L. 1982. Strategic attributes and performance in the BCG matrix: A PIMS based analysis of industrial product businesses. Academy of Management Journal, 25(3): 510-531.

Hambrick, D. C. 1982. The Product Portfolio and Man's Best Friend. California Management Review (pre-1986), 25(000001): 84.

	From left to right: Prof. Yusheng Zheng, Wharton School and Cheung Kong Graduate School of Business, paper award winner Guoming Lai and Prof. Fangruo Chen.

Channel stuffing can lead to all kinds of distortions and ultimately hurts the long-term value of a company. So what are the incentives for a manager to engage in the practice? That was the winning topic for the Best Paper Award at this year’s Conference of the Overseas Chinese Scholars Association in Management Science and Engineering (OCSAMSE), which took place in Shanghai in July.

The conference was sponsored by Columbia Business School’s China Business Initiative, which is part of the Chazen Institute for International Business. OCSAMSE is the only organization representing overseas Chinese scholars in management science and engineering. The conference series was focused on integrating theory and practice and panelists discussed supplier relationship, supply chain and operations management.

Professor Fangruo Chen awarded the research prize to Guoming Lai and Lin Nan from David A. Tepper School of Business at Carnegie Mellon University and Laurens G. Debo from University of Chicago Booth School of Business for their paper “Manager Incentives for Channel Stuffing with Market-Based Compensation.”

The winning paper authors suggest that managers find real earnings management more attractive in the wake of the Sarbanes-Oxley Act. However, managers also now face more “real” constraints, such as bounds on physical inventory and often their interests are not aligned with long-term stakeholders. The results create three effects that drive the manager’s incentives for channel stuffing.

Other speakers at the conference included Dr. Weihua Ma of China Merchants Bank, Qinghou Zong of the Wahaha Group, Weimin Sun of Suning Appliance Co. Ltd., Steve Graves of M.I.T. and Mike Pinedo of New York University Stern School of Business.

Photo courtesy of Mei Xue

The key challenge that healthcare enterprise leaders face is determining how to drive innovation while addressing problems of affordability, inefficiency and gaps in quality. This task is now complicated by strong economic headwinds that limit the resources available to attack these problems. Industry executives are also dealing with new sets of competitive and regulatory pressures on their efforts to drive business growth.

At Columbia Business School’s 5th Annual Healthcare Conference held in New York City on November 21, over 500 students, alumni and other professionals heard more than 40 speakers and panelists discuss these issues.

The featured healthcare leaders said they are embracing change to develop creative solutions to the industry’s growing problems and to provide attractive investment opportunities on a global basis. A career strategies panel of executive and corporate recruiters also presented their views on the skills and talents necessary for healthcare professionals to succeed in this dynamic environment. This was followed by a concluding career fair and networking reception with the conference’s 17 corporate sponsors.

Ed Ludwig ’75, chairman and CEO of BD (Becton, Dickinson), gave the opening keynote address. Ludwig said that a successful global healthcare company must use technology, scale, global reach and operational excellence to offer value-added products. These products should reduce costs, enhance the quality of patient care and generate sustainable earnings growth.

Following his remarks, four concurrent panels took place in the morning session on the topics of pharma and biotech, medical devices, diagnostics and payor/provider issues.

The pharma and biotech panel discussed the trend among companies to narrow their therapeutic priorities, focus on biologics, pursue licensing and target acquisitions and seek enhanced productivity and cost savings. Numerous early-stage biotechnology companies are turning to larger pharma and biotechnology firms to survive as they are unable to secure capital from the public market. Global medical device companies are seeking to introduce innovative and cost-effective products in a challenging regulatory and pricing/reimbursement environment and pursuing acquisitions and new markets to meet growth objectives. The consensus of the payor/ provider panel was that any healthcare reform in 2009 would likely be incremental due largely to economic and political headwinds, and that a key focus would be on information technology and expanding access to those without insurance coverage.

Robert Essner, former Chairman and CEO of Wyeth Pharmaceuticals and now executive-in-residence at Columbia Business School, provided the lunchtime keynote speech. He suggested that although the pharma industry faces significant challenges, the combination of new drugs, biologics and vaccines in key areas of unmet need (e.g. Alzheimer’s, cancer, congestive heart failure) and the massive influx of informed baby boomers, who are demanding health solutions, provides favorable long-term growth prospects for innovative global pharmaceutical companies.

Three afternoon panels covered M&A, life science investments and emerging markets. It is anticipated that healthcare M&A will remain active across all sectors and that consolidation among Big Pharma companies appears inevitable. Early-stage life science companies and investors face a capital squeeze, which is threatening the viability of existing companies with lower levels of funds available for new investment. Emerging markets are an increasing focus for global pharmaceutical and medical device companies that are seeking new markets for their products.

The final panel of the day focused on the changing talent acquisition and development strategies of major healthcare enterprises. Panelists commented that successful leaders will need to have global and cross-functional experiences; that employees should be open to lateral moves that broaden their skills and experiences; and that healthcare companies considering new hires are seeking a broader “toolkit” of skills that reach beyond the traditional focus on healthcare backgrounds.

For more information about the conference and sponsors visit www.cbshealthcareconference.com.

With at least 2,000 car dealerships from Chrysler and GM slated to close this year (and more than 1,000 dealerships overall that closed last year), the existing American dealership model is in crisis. The closings appear to underscore just how over-extended — and over-stocked — the U.S. dealership system has become. One of the fatal flaws for dealerships has been an inefficient distribution network.

My research, conducted with my colleague Gérard Cachon at The Wharton School at the University of Pennsylvania, shows that the current structure of the U.S. brands’ dealership network led to inefficiencies in the distribution system. These inefficiencies add to the total distribution cost, which accounts for 30% of the price of a new car.

A major inefficiency is the pattern of holding inventory — an important part of the distribution cost. Most of the vehicles in the U.S. are purchased directly from dealer stock and holding inventory is expensive, especially when credit is scarce as it is now. The graph below illustrates important differences in the monthly days-of-supply for Chevrolet, Ford and Toyota.

The popular press suggests that 60-day supply is the ideal level of inventory for the auto industry. This is, in fact, the industry average, but the figures show that Toyota is consistently below that benchmark while Chevrolet and Ford are usually above it (other brands of Ford and GM also show a similar pattern). Overall from 2000 to 2004, Chevrolet held about 130,000 more vehicles in inventory relative to Toyota (300,000 compared to 170,000 units), even though the two brands sold about the same number of vehicles in the U.S.

The huge number of GM dealerships explains most of this difference in inventory performance. As of 2007, Chevrolet had around 4,000 dealerships compared to 1,200 Toyota dealerships. That means that an average Toyota dealership sells three times as many vehicles.

Source: Automotive News 2007 Yearbook

Due to economies of scale, managing inventory for a Chevrolet dealership is much more costly than for Toyota. In general, dealerships from domestic manufacturers carry substantially more days of supply. Consequently, they require more cash to operate, their inventory is less fresh and they tend to have more overstock at the end of the model year, which in turn leads to more rebates. All of this translates into higher distribution costs and lower profits for the dealer.

How could U.S. auto dealerships be improved? Reducing the number of dealerships can do several things.

First, it will reduce cannibalization between dealerships, increasing average sales per dealership. Dealers can take advantage of economies of scale in the distribution process and have more frequent deliveries and lower safety stocks, thereby reducing the amount of inventory held without hurting (and possibly improving) customer service. It also helps to keep a fresher stock to better match customer preferences and to lower markdowns at the end of the season.

All of this leads to a more profitable dealership and a more efficient distribution network. Higher dealership earnings can be used to invest in better showrooms and better training of the sales force, which can improve customer service and further boost revenues.

Photo credit: never a safe second

In a recent Forbes.com op-ed, professors Bruce Kogut, Patrick Bolton and Tano Santos argue that in order to be effective, a good regulatory system must distinguish between prevention and resolution. The current system, they say, has failed to do so, instead relying on “stop gap” prevention measures.

Kogut, Bolton and Santos say that the current system failed to follow the principles of crisis prevention by allowing incentives to become misaligned, creating risk-blind structural silos and failing to require the disclosure of risk exposure, particularly in the case of credit default swaps. The solution, they propose, is the creation of a new entity — the Crisis Resolution Board. They write:

A new regulatory system must also be capable of crisis resolution, because the hallmark of modern financial crises is that the limits of institutions and markets quickly bleed into one another, and the problem rapidly takes on a global scale. The data show that as the most recent crisis hit, all the crickets began to sing in harmony — all markets behaved erratically simultaneously. A “regulator of regulators” — which we will call the Crisis Resolution Board — should be charged with monitoring and responding to systemic risks.

The Crisis Resolution Board cannot be merely an honorary posting. Effective intervention by the Crisis Resolution Board will require social capital — crises always rely upon the personal knowledge among the players. Thus, this oversight board should include the chiefs of the Treasury, Fed and an FSA regulatory agency, as well as industry and investor representatives. In addition, the board must have more than global access to data — it must have knowledge of the global exposure and the systemic risk provided by a research staff that continually tests its instruments against the dynamic evolution of markets.

Concretely, what would the Board do? First, it will have power to monitor the exposure of all financial institutions and markets, and to issue early warning signals. This is hardly a radical idea. The IMF plays a similar role at the global level in monitoring national reserves. The role is clearly feasible for a national regulator and will lead to a strengthening of global financial market coordination.

Second, like any good fire brigade, which has a deep respect for plumbing, when things get hot the board will ensure that the financial markets’ plumbing is functioning. Markets depend on brokerage, exchanges and settlement. That’s their plumbing, and it’s also the key to systemic risk. It must be charted and tracked globally if we are to know what to do when the next crisis comes.

Regulatory reform should seek to distinguish between crisis prevention and crisis resolution. Prevention relies upon a tripartite structure and clear rules of accountability. Crisis resolution demands an integrated approach to systemic risk. Both structures are required and yet, no country has yet to design such a system. This is the time to do so.

Photo credit: SKPY/Scott

The Credit Cardholder’s Bill of Rights, which was signed into law on May 22, is the first major overhaul of credit card regulation in 30 years. Is the bill a game-changer for the way consumers use credit or the way lenders dole it out? We spoke with assistant finance professor Enrichetta Ravina, who has done research on the credit card industry and consumer behavior, about the relationship between the lenders and borrowers, how it might change, and whether credit cards make us happier.

Now that credit card holders have a bill of rights, how might that affect consumer behavior?

1. Better debt management More transparency in the credit card terms could mean that consumers are more informed and better understand the terms of their credit card contract. They might avoid paying fees due to their inattention/misinformation and to switch to cheaper forms of credit if they need to borrow. The caveat is that more information doesn’t always lead to restraint. In the same way that knowing that fats are unhealthy doesn’t make everybody restrain from fast food, it is unlikely that being better informed on the terms of the credit card contract will make everybody manage their debt more carefully.

2. Prevent early onset debt New restrictions for issuing cards to people below 21 will make it harder for students and very young consumers to have easy access to credit. The legislation is aimed at protecting a category that might be less financially educated, has fewer incentives to be financially responsible and preventing that they become overwhelmed by debt even before starting their working life.

3. Harder to get easy credit The new legislation requires credit card companies to wait until the account is 60 days late before applying a penalty interest rate and to give 45-day advance notice before changing the interest rates or any other terms. Thus, the credit card companies’ pricing strategy will change. A better ex-ante assessment of the creditworthiness of the consumers will be necessary and credit card contracts will have lower credit limits, higher interest rates for certain categories of consumers and more upfront fees. Lower credit limits and higher interest rates will make it harder for overly optimistic, financially uneducated consumers to get into unmanageably high levels of debt.

What does a consumer’s spending say about his or her behavior?
Most consumers are very predictable in their credit card use. In my research I find that consumers exhibit a high degree of habit in their consumption choice and that they prefer a smooth, increasing consumption path. Demographics like gender, age and income bracket are important, but mostly people’s spending on catalog and online shopping and on other credit cards are the best predictors of their behavior and of whether he or she will carry a balance, pay late or always be on time.

Who are credit card companies making money from?
The most profitable consumers for a credit card company, and therefore the most sought after, are those that spend a lot, pay late and carry a balance (which 45% of Americans do). People’s attitudes to money and their finances tends to be remarkably consistent across financial instruments and therefore people that miss payments on other credit cards and auto loans, stretch themselves with high loan-to-value mortgages are more likely to do the same on this card. Among these very profitable consumers, however, are those that “hide” and who will generate charges only for a short period and will soon default.

Can credit card companies tell who might default from their spending behavior?
It is very difficult to predict this behavior early in advance. These consumers that are very risky are those with limited financial education. Such consumers do not understand the terms of the credit card contracts, are not good at budgeting, saving and spending within their means. At the beginning, they are very profitable for the credit card companies because they generate fees and interest charges. However, once an income shock hits them, or their spending habits get out of control, they rapidly become the worst type of accounts.

What is the upside to easy credit?
Credit cards constitute a tremendous opportunity for some consumers and are very important for economic growth. They allow entrepreneurs to finance the very first stages of their companies when it is hard or impossible to get a loan from a bank. They also allow households to finance durables, consumption goods and other projects. For these reasons, they promote economic activity and a more efficient allocation of economic resources. Compared to other countries where credit cards (and debt) are less diffused, U.S. consumers face more dangers, but also more opportunities and more means to fulfill their projects.

Does this greater opportunity and means to fulfill projects translate into more happiness?
In my research I find that happiness is a relative concept. Above a certain level of consumption that satisfies the necessities of a comfortable life, happiness doesn’t depend on the amount we consume, but rather on the amount we consume compared to the people around us. The reference group we belong to are work colleagues, neighbors, people with a similar socioeconomic status to which we tend to compare ourselves. Credit cards can be used to consume more than the reference group (even though the income is not enough to cover spending), in the hope that income will continue to grow or that no emergency comes to disrupt this fragile equilibrium. Such a use of the credit card is usually associated with short-term happiness and economic problems and anxiety down the road.

Photo credit: Andres Rueda Lopez

The outbreak of swine flu, which is responsible for at least 159 deaths in Mexico, has put the U.S. vaccine industry into overdrive. However, the New York Times reports that federal officials are warning consumers that a swine flu vaccine will not be available until late November at the earliest. What does this long lead time teach us about supply chain risks?

In the case of vaccines, it underscores how dependent the U.S. supply is on a traditional — and slow — manufacturing process that involves growing the vaccine viruses in hen eggs. The process takes approximately six months for a finished product to be ready for market.

Professor Awi Federgruen, who has written in Ideas at Work about his research on supply chain risk in general and the flu vaccine in particular, says that the vaccine industry is lacking adequate incentives for investments in better and faster technology and larger capacities.

“When the need arises for a new type of vaccine — like we have now — and to act on it with traditional technology, it takes an enormous amount of time to produce something that can be used,” says Federgruen. “That’s a real problem because by the time it gets to market the epidemic may have done all the damage. If we had an industry that was more agile, we would be in much better shape. How do you provide an incentive structure to invest in such technologies?”

While faster technology does exist, it has not been implemented on a scale that would be needed to supply an entire domestic market. Part of problem, says Federgruen, lies in the roulette-nature of flu vaccine manufacturing in general, where assessments are made far in advance of flu season or potential pandemics and easily result in mismatches of supply to the demand.

“This is another way in which we collectively pay a big price in that we have suppliers operating with inferior technology,” Federgruen says. “And they are operating with inferior technology and low capacities because to change these amounts to large investments, the long term benefits of which are too risky. The federal government has started to address the problem by providing roughly $1 billion in grants for construction costs and guaranteed vaccine purchases. However, considerably more needs to be done to provide adequate incentives to the industry.”

Photo credit: hmerinomx

This post is part of a special series celebrating the School’s Alumni Forever Week (March 30 through April 3).

Profile
Rob Torti ’07
Turnaround Consultant, AlixPartners LLC

Tell us about your career path.
Like every other former investment banker, I wanted to be in private equity. I pursued that but I learned it was a solitary job and that my real passion was for management, and that was something I was good at. After school, I took the summer off and traveled and then came back and looked for jobs at turnaround firms. I wish I could say that it was the result of having foresight, but realistically I liked the job description. The job entails a lot of finance, business analysis and strategy as well as some law; there is a huge management aspect where you get parachuted into a company and take a senior management role.

Looking back at your Columbia Business School experience, what was your aha! moment?
While I was in school my ideas changed dramatically. I took Turnaround Management with Gregory Rourke during the first semester of second year and that opened that whole world to me that I didn’t know that existed. I also took Professor Ralph Biggadike’s Top Management Process class. I really enjoyed the complexity of management, and I realized I had a passion for working with a lot of different people and solving complex problems.

In your industry, what trends are you watching and where is there opportunity?
I probably have a more doom-and-gloom view of the economy in the next two years than most. Having been an investment banker myself, I know that some of these companies just cannot survive. Given the distresses out there, I am looking at the end of 2010 for the economic recovery — and it won’t be a quick bounce back. If you see your company headed for a bad spell and think that bankruptcy will be a real possibility, rather than put everyone in bind at the eleventh hour, you need to get professional help. The bankruptcy process is not something to be feared; you have to embrace it. Don’t wait for a white dove to save you. There won’t be a huge turnaround.

What advice do you have for current or prospective MBA students?
Think of your career as a tree: move along the trunk and don’t jump to a branch too early. When you work for a distressed company, you are given more work and you learn so much more. If the company has a good management team and you are there to help them through the process and see the nuts and bolts at a unique time in their business, you will be successful. This climate allows you to learn at a magnified rate.

At Friday’s community forum, Professors Paul Glasserman, Trevor Harris and Hitendra Wadhwa (pictured at right) held an open discussion with students about how best to move forward from the financial crisis. The forum covered economic issues ranging from risk management to accounting to the importance of not allowing the near-constant stream of negative news to affect your decision making.

Professor Glasserman began the event by speaking about capital requirements for banks as they relate to the banks’ risk management practices. He offered three main points:

1. Tightly linking capital requirements to risk can lead to dangerous procyclical behavior

   “When a bank’s assets start to look more risky [as a result of a downturn], it must hold more capital. How does it hold more capital? It cuts back on lending. So at the worst possible time, there’s an incentive — in fact, a requirement — for banks to cut back on lending.”

   To help prevent this, Glasserman suggested that banks take countercyclical measures, such as averaging out their risk over the business cycle. He also recommended that banks be required to hold additional capital in good times so that in down times there’s a buffer for them to draw on.

2. Banks should continue to bear the responsibility of regulating their own risk
   

   While it’s understandable that the recent trend of forcing banks to regulate their own risk has received a lot of criticism, Glasserman said, putting the burden back onto regulators might make matters worse.

   “If you go to an environment where the regulators are specifying a very precise set of rules, you’ve created an enormous incentive for banks to manufacture products that look low-risk by regulators’ standards but are in fact high-risk in all the ways the regulators haven’t anticipated. And that’s a large part of what’s led to the current crisis.”

3. Systemic risk must be factored into capital requirements
   

   “A traditional view of risk management says, ‘What harm can the market do to me?’” Glasserman said. “When you ask about systemic risk, you’re asking, ‘What harm can I do to the market?’ It’s a fundamentally different approach, and it’s not been part of the way capital standards have been set to date.”

Professor Harris referred to the situation described by Glasserman as a “classic accounting problem.”

Harris spoke about a critical flaw in the subprime mortgage-backed securities that are a big part of the crisis, is that all parties (originators, intermediaries, investors, rating agencies and auditors) lost sight of the underlying fundamentals of people who had borrowed more than they could afford.

“My whole view is that people have forgotten fundamentals, and they’ve created lots of quant-based analytics that actually have nothing to do with reality,” Harris said. “What that leads to in many cases is the illusion of precision. We have so many techniques, including valuation techniques, to come up with point estimates, and the reality is that there’s huge amounts of uncertainty going forward, and we have to deal with that.”

He concluded, “I view [the crisis] as a great opportunity to fix a lot of systemic problems. My biggest fear is that if we come back too quickly, we won’t actually address a lot of these issues. If we don’t deal with complexity and address these fundamentals, we will actually end up in a much worse situation.”

Professor Wadhwa said that while it’s easy to allow the near-constant stream of negative economic news to affect your mood, doing so can impair your ability to make critical decisions.

“[Maintaining a positive outlook] broadens your mind, making you more aware of the periphery of whatever it is you’re looking at. It makes you more mindful of a whole range of ideas.”

To support his position, Wadhwa cited research that demonstrated a link between the mood of physicians and their ability to properly diagnose patients.

To keep yourself in a positive state of mind, Wadhwa suggested taking the following steps:

1. Break the causal link between external events and your internal mood. Do this by injecting behaviors, such as displaying gratitude.
2. Use humor and body language to project a positive mood not only outward but also inward.
3. Turn adversity into transformational opportunities.

“Even with the constraints many of us face,” Wadhwa said, “there’s a potential for us to ask ourselves, ‘What is there within this that might be redemptive?’ By the fact that certain doors might have closed on us, we are forced out of our comfort zone to think anew about our skill set and interests and who we are.”

Photo courtesy of Columbia Business School

This post contains an update.

Retailers have been stunned by how abrupt the change in the economy has been and that it has happened across all strata of consumers. It is most pronounced in the luxury sector. As recently as seven or eight months ago, luxury thought that it was invulnerable, but that is not true.

Many luxury customers are aspirational and are vulnerable to downturns in the economy. The core customer with essentially unlimited disposable funds may no longer find it fashionable to behave as they had in the past. Irrational exuberance may not return and people may not seek to live beyond their means, choosing a more conservative lifestyle. Now, the customer is saving for the first time in many years, and this recession will leave a lasting mark on consumer behavior.

Jobs, confidence are lacking
Retailers are one of the largest sectors of the economy. They are very large employers. When business declines, retailers stop hiring. Layoffs soon follow. We’re seeing this across the country. Laying off large numbers of people creates a cascade of breakage. This impacts consumer confidence; everyone knows someone who was laid off. Stores begin to close. That is very visible. At the end of the day, if people don’t have jobs, there is no recovery and that’s the end of it. The consumer has to be viable, which means jobs and a rise in confidence. Many people with viable jobs become increasingly fearful of losing their employment. We’ve gone from irrational exuberance to irrational fear.

It’s good to be different
This downturn creates powerful opportunities for organizations to emerge if they can successfully differentiate themselves. Retailers with notable products and services can create enormous energy and value. Two examples are Apple and Amazon. Apple has a highly differentiated product and a selling environment at retail that is incomparable. Their market share will continue to climb as long as they continue to satisfy their customers’ needs and wants. Amazon aggregates assortments of merchandise in an on line setting that is the best in the world and continues to acquire more and more market share. They invested in an esoteric device, the Kindle, and surprise! It looks like a $1.4 billion business next year.

On the other hand, retailers with little or no forward strategy like the department stores, who have been playing out a “Last Man Standing” end game have little likelihood of future success and vitality. Layoffs in this sector are a tragic and ineffective expression of survival. You can’t use reductions in force as a strategic blueprint. It creates enormous disruption and leads to more crises downstream.

Good news for the shopper
Currently there is an enormous excess of inventory in many retailers supply chains because of recent extreme and unanticipated shortfalls in sales. These excesses will have to be liquidated. Retailers are dumping inventory, canceling what they can and avoiding buying forward product. In the next year we’re going to see fewer stores, less inventory overall in stores and less discounting because of less inventory. Prices will come down because consumers will expect more value and will be less willing to play the high-low game as they have in the past.

This economic downturn, recession if you will, is likely to continue for at least 12 to 18 months and maybe longer. I believe that when it is over the retail landscape will be very different than it is today.

UPDATE (2/25/09): Follow up from the Retail & Luxury Goods Conference. Keynote speaker Robert Burke said, “I don't think the department stores are completely dead and I don’t believe luxury is over. … It became overused and ambiguous terminology.” View the complete video (part 1, part 2) of his speech. -CN

Photo credit: Christopher Chan

Throughout the financial crisis, one question has bubbled to the surface again and again: “Who’s to blame?” While many are pointing the finger at former executives like Stan O’Neal and Dick Fuld, others are targeting something a little more abstract: the models financial institutions use to calculate the risk in their portfolios.

A recent New York Times article chronicled the role that VaR (Value at Risk), the most widely used of these models, played in contributing to the crisis. Joe Nocera, the author of the article, summarizes how the model works: “If you have $50 million of weekly VaR, that means that over the course of the next week, there is a 99% chance that your portfolio won’t lose more than $50 million.”

The potential damage represented by the remaining 1%, however, is incalculable. And while events that trigger losses in this range don’t come along often, they do come along. The subprime crisis and subsequent credit crunch were extremely unlikely events; as such, they were just the type that models like VaR were ill equipped to anticipate.

Taking issue with the model is Professor Eric Schoenberg, who first expressed his frustration in a letter to the editor. “Relying on a faulty measure is fine,” Schoenberg says in an interview, “if the only person who suffers when that measure fails is you. But that’s not the way the system is set up. And unless people acknowledge that they basically are relying on a public utility to allow them to run their business — which very few investment banks are willing to acknowledge — it’s not an exercise in intellectual argument. It’s an exercise in power politics. It’s about what you can get away with.”

While Schoenberg admits that the issue of how much risk financial institutions should be allowed to take on is a difficult one, he believes that leverage lies at the heart of the matter. “In order to address the moral hazard problem, people have to have a lot more at risk themselves relative to what generalized risks they’re creating. There has to be a significant reduction in the amount of leverage we allow these institutions to have.”

Where do we go from here? “We must acknowledge that there is a fundamental disconnect between what makes sense for individuals and what makes sense for the group, and the only entity that can address what’s right for the group is the government,” Schoenberg says.

“Basically, this is the issue of free market fundamentalism, which is the idea that markets are best and any time the government intervenes it’s going to screw things up. Well, if you have that belief, you know, you’re going to have these things happen over and over and over again.”

Photo credit: Travel Aficionado

In a recent USA Today op-ed, Professor Seth Freeman discusses why admitting what you don’t know — and asking questions about it — can be a very smart proposition.

“Ask me to explain things like derivatives and I'll look blankly at you,” Freeman says of his ability to understand the financial crisis. “My credentials in economics, negotiation and law should qualify me to speak, but often the news leaves me slack-jawed with confusion. Bring me to a panel discussion, and I'll ask dumb questions,” he writes.

But instead of wanting his students to avoid ever asking a “stupid” question, Freeman encourages them to ask more. “In short,” Freeman says, “I am a role model. I want them to join me in the fight against the fear of looking dumb. Overcoming that fear can save them from serious traps.” Failing to ask the right questions — no matter how embarrassing — allows us to be overwhelmed by jargon and complex terms, making us more susceptible to questionable practices, Freeman says.

The value of unabashed critical thinking seems especially important in the midst of the financial crisis. In a recent piece for Portfolio, Michael Lewis chronicled the success of hedge fund manager Steve Eisman, who scored big in the years leading up to the financial crisis by betting against the banks. Eisman, famous among colleagues for his skeptical nature, became suspicious of the financial underpinnings of mortgage-backed securities when he realized that not even the banks themselves could grasp the investments’ complex nature.

Freeman communicates this point to his students through a classroom exercise that penalizes them for failing to ask “dumb” questions. Freeman describes the exercise:

Students pretend to be teams of entrepreneurs, preparing extensively. I walk into class in the role of a corporate executive and give each team a complex investment offer. Secret: My character wants to take over their businesses, using charm, jargon and complicated terms. If they understand my offer, or admit to themselves they don't understand it, they’ll walk away. Yet, it’s easy to con a third to a half of them into fatal deals.

Professor Seth Freeman is currently working on a book, Promises: Making Commitments More Reliable in Business and Beyond.

Photo credit: e-magic

Understanding the financial underpinnings of mortgage-backed securities, the investments at the center of the financial crisis, is a difficult task. The complex structure of these investments may have even obscured their inherent risk to those parties directly involved with their purchase and sale.

A December 7 New York Times article by Gretchen Morgenson chronicles the predicament of Moody’s, the credit rating agency that has fallen under scrutiny for inaccurately giving high ratings to many mortgage-backed securities, including those with questionable financial fundamentals.

The rating agencies, however, were not alone in their misjudgment. According to a recent article by Professor Trevor Harris in Ideas at Work, all parties to the transactions — including the lenders, mortgage brokers and banks, securities firms and borrowers — failed to understand the fundamentals of these investments.

According to Harris, “[They] were making a bet on constantly rising home prices, while disregarding the real people and real homes on top of which these products were precariously built. Much like a Ponzi scheme, everyone lent to everyone else, creating a bubble and then compounding it. Returns could only continue while new money kept flowing into the system. When the money stopped, the whole system started unraveling.”

Harris suggests that by bringing transparency into the underlying fundamentals and risk characteristics of a business, regulators will be able to provide a more accurate and complete assessment of the related fundamentals and risks.

For a more detailed look at how the fundamentals of mortgage-related investments were neglected and what can be done to prevent this from happening again, see Harris’s article, “Back to Basics,” in Ideas at Work.

A crisis of trust is plaguing investors, says adjunct professor Seth Freeman in a recent column in the Christian Science Monitor. His column discusses the “promise problem” that we’re facing at the economic level — that is, how do investors know that borrowers will keep their word?

Freeman suggests that the solution is a building a “trust support,” and that doing so requires both parties to answer the following questions:

1. Who can serve as a credible bridge of trust? The government, for instance, can back borrowers’ promises.
2. How can we most effectively watch or test the promisemaker’s ability to perform? Helping lenders know what toxic assets borrowers hold might help them test for ability to perform.
3. What incentives and penalties can best encourage performance? My nephew is a case in point.
4. Are there ways to build in mild, moderate, and strong trust supports? A range can help lenders and backers intervene early and late with the least coercion necessary.
5. Does the solution satisfy all parties’ key interests?
6. What if the worst case scenario happens?

“The promise problem is as central to the current crisis as it has been to many others. It’s the issue lurking behind many of the world's biggest problems. Want to stop global warming? The spread of nuclear weapons? Human rights abuses?” Freeman writes. “Tackling the promise problem is the great and often solvable challenge behind the others.”

That diet, at least elements of it, was at the core of a panel discussion with Dean Glenn Hubbard and professors Bruce Greenwald, Pierre Collin-Dufresne and Christopher Mayer.

“We still are in a period of substantial credit stringency,” said Hubbard in his opening remarks. “Financial institutions remain undercapitalized for normal activity.” [In a separate column published on Oct. 3 with Princeton's Alan Blinder, Hubbard suggests expanding the FDIC cap.]

Prof. Greenwald followed with a discussion of monetary policy’s role in the financial crisis with a ‘tale of two decades’. In the 1960s the changes in U.S. money supply were linked to subsequent growth in the nominal GDP. In the 1990s, reforms in monetary policy led to very little movement in the nominal GDP, while the money supply was extremely unstable.

“The real heart of this crisis is that the traditional means for recapitalizing these institutions have gone away,” Greenwald said. “The movement of interest rates down to 2% has had no effect, just as monetary policy has had very little effect for a long time. If you’re going to restabilize the economy, you have to have a direct means to recapitalize the banks.”

Greenwald came out in favor of the Treasury’s bailout plan, saying, “If you don’t want to be Japan in the 1990s, just give [the banks] the money. The return in terms of economic stimulus will far outweigh the cost of any financing they get.”

Prof. Dufresne, speaking next, pointed to the location and foundation — low interest rates, high demand, insufficient models, complex vehicles — of the risks in the 1990s as key factors in the current financial crisis. “This made exposure hard to measure,” he said.

Concurring with Greenwald, Dufresne said the solution to the crisis was in bank recapitalization. (watch video)

Prof. Mayer focused on the housing market’s role in the credit crisis. “As we look at the problem in the U.S.,” he said, “we need to think about how to stop the housing crisis.” Mayer and Dean Hubbard have proposed a much-discussed plan that would allow anyone with a primary residence mortgage to refinance at 5.25% on a 30-year-fixed rate loan. (listen to NPR audio about proposal)

Mayer closed his comments considering the coming year: “We’re going to have to re-create a new lending system in the future.”

Bruce Berkowitz held up a pilot’s pre-flight checklist at the end of his presentation on developments in value investing. The analogy was clear: flying at altitude can be a risky business if you don’t know about the equipment you’re using.

The Fairholme Fund president was among the distinguished guests who spoke as part of the 75th anniversary celebration of the publication of Security Analysis hosted by Columbia Business School and the Heilbrunn Center for Graham & Dodd Investing on Oct. 2.

Three panels made up of contributors to the sixth edition of the book, including Prof. Bruce Greenwald, discussed value investing in today’s market as well developments since the book was published in 1934. The dismal news from Wall Street — and managing risk in the current environment — permeated the discussion.

“In some fundamental way, the current market is what Security Analysis is about. We do the same thing regardless of the market: we look for value,” said David Abrams, managing member of Abrams Capital Management, who spoke as part of the first panel with Seth Klarman and Howard Marks.

“Quantifying risk is an oxymoron,” said Marks, chairman of Oaktree Capital. “It cannot be measured in numbers. Volatility can be measured but the job of measuring risk requires the same thing as measuring prospective return and requires superior skill.”

Prof. Bruce Greenwald moderated the day’s second panel with Berkowitz, Glenn Greenberg ’73 and Thomas Russo to discuss what has changed in the 75 years since Security Analysis was first published. Greenwald discussed how controlling that risk has changed.

“Today, value investors are managing risks in more sophisticated ways, starting with cash flows,” said Greenwald. “One of the real lessons is that you better understand the determinants of those cash flows, rather than just taking the historical average and slapping it on. You have to understand whether a company’s superior returns are going to be able to be sustained in the face of relentless competition.”

Greenwald asked the panelists where they see the opportunity in today’s market climate. Russo pointed to international markets and consumer products, and Berkowitz said he was looking for companies with “double-digit free cash flow yields,” citing Pfizer as as an example.

What not to buy?

“Things where you can lose all your money,” cautioned Greenberg. “I am not joking. If you can lose all your money, don’t buy it. If it has great potential but is dependent on the next round of financing, we wouldn’t buy it.”

Berkowitz agreed. “You’re right. When you die, you die. There’s no more spinning the roulette wheel.”

Photo credit: Leslye Smith

In an Oct. 2 column published in the Wall Street Journal (“First, Let's Stabilize Home Prices”), Dean Glenn Hubbard and Prof. Chris Mayer propose that bolstering housing prices will improve the intent of the Treasury’s bailout plan. They write:

We propose that the Bush administration and Congress allow all residential mortgages on primary residences to be refinanced into 30-year fixed-rate mortgages at 5.25% (matching the lowest mortgage rate in the past 30 years), and place those mortgages with Fannie Mae and Freddie Mac. Investors and speculators should not be allowed to qualify.

The historical spread of the 30-year, fixed-rate conforming mortgage over 10-year Treasury bonds is about 160 basis points. So a rate of 5.25% would be close to where mortgage rates would be today with normally functioning mortgage markets. One of us (Chris Mayer) recently published a study showing that — assuming normally functioning mortgage markets — the cost of buying a house is now 10% to 15% below the cost of renting across most of the country. Rising mortgage spreads and down-payment requirements are what’s still driving down housing prices. We need to stop this decline.

The direct cost of this plan would be modest for the 85% of mortgages where the homeowner owes less on the house than it is worth. Lower interest rates will mean higher overall house prices. The government now controls nearly 90% of the mortgage market and can (and should) act on this realization. Remove the refinancing option and you can have lower rates without substantial cost to the taxpayer. Homeowners would have to give up the right to refinance their mortgage if rates fall, although homeowners could pay off their mortgage by selling their home. For borrowers with lower credit scores, the mortgage rate would be greater than 5.25%, but it would be less than their current rate.

Now, what about mortgages on homes that are worth less than the total amount of the loan? These mortgages could be refinanced into a 30-year fixed-rate loan to be held by a new agency modeled on the 1930s-era Homeowners Loan Corporation. New mortgages would be made of up 95% of the current value of a home.

The government might use two approaches to mitigate its losses. It could offer owners and servicers the opportunity to split the losses on refinancing a mortgage with the new agency. Servicers would have to agree to accept these refinancings on all or none of their mortgages, to avoid cherry-picking. Or the government should take an equity position in return for the mortgage write-down so that the taxpayers profit when the housing market turns around.

An article in the New York Times on Sept. 28 (“Wall Street R.I.P.: The End of an Era, Even at Goldman”) which proclaimed the death of Wall Street, refers to the growth of “pointy-headed” quantitative analysts in the industry. It is an epithet that fits well with the roll-your-eyes-and-don’t-even-try-to-understand-it angle of much coverage of the financial crisis. Derivatives are invariably “arcane” or “dizzyingly complex” and, worst of all, unwelcome in Omaha. The geeky dad went to work at a bank, and now we’re all living “Honey, I Shrunk the Credit Market.”

Rewind to just a few months ago. Alarms were being raised about New York losing its prominence in the global financial services industry. Mayor Michael Bloomberg and Senator Charles Schumer commissioned a study on how best to buttress New York’s leadership position. A key finding of the 2007 Bloomberg-Schumer report (PDF) is that New York needs to expand its supply of quantitative talent to keep up with global competition. London may already have edged out New York in some markets, and increased competition from Asia is inevitable.

The current crisis does not change the logic of the Bloomberg-Schumer report. A complex industry requires a highly skilled workforce. Whereas a high school diploma may once have been sufficient for work as a trader, you’re now more likely to find someone with a graduate degree making markets. Risk management needs to be at least as sophisticated as the trading it monitors. Financial intermediaries are modern factories, producing products to manage and transfer risk. Yes, we need new measures to guard against toxic waste, but we especially need people who understand the machinery.

If Wall Street is drained of its quantitative talent, the effects will be felt within months, not years. And as the industry recovers, the consolidation wrought by the current crisis will open the way for new and smaller firms. Technology will be critical to financial innovation, while more routine work may move off shore. Will the sequel be “Revenge of the Nerds?” No, New York’s competitive advantage will rely on a base of highly educated professionals with a combination of quantitative and managerial skills, heads that operate in both pointy and broad modes. The opportunity and challenge for business schools is to develop this talent.

Professor Chris Mayer has created a new model to compute the relative cost of owning a home based on both a normally functioning mortgage market and the current distressed market. He recently discussed his preliminary findings with the New York Times.

For the last 20 years, mortgage rates have averaged at 1.6 percent above the 10–year Treasury rate. In today’s distressed market, however, that rate now exceeds the 10–year Treasury rate by more than 2.4 percent. Here are a few key takeaways from my research. (download PDF )

Home ownership costs more

The cost of owning a home has increased between 10 and 20 percent relative to what it would be if the mortgage market functioned normally. However, the analysis still underestimates the impact of the credit crunch on house prices, as many buyers who would previously been able to purchase a home are now unable to qualify for a mortgage at any price.

Downward spiral hard to break

Lenders facing losses on their housing mortgage portfolios and the prospect of further deterioration in the housing market have either exited the mortgage market or sharply reduced lending and increased mortgage rates. The rise in mortgage rates makes it more difficult for existing homeowners with subprime loans to refinance into a lower rate. It also makes it more expensive for potential new homebuyers to enter the housing market. The resulting foreclosures and falling demand from first-time homebuyers put further downward pressure on house prices, leading to a vicious cycle.

No market untouched

While house prices have come down, prices in “bubble” markets like Miami, Tampa and Phoenix still have at least 10 to 15 percent more to go. Coastal markets, such as San Francisco, Boston and New York, have already corrected. However, deteriorating mortgage markets and economic fundamentals will likely continue to hit these markets hard. Markets in relatively unscathed areas (Texas and the Carolinas) will likely fall due to increasing mortgage costs.

Cycle will adjust in the future

As house prices fall, new buyers will start to come into the market and eventually help stop the decline. Additionally, buyers who purchase today may be getting a good deal in a couple of years. As mortgage markets recover — as they inevitably will — buyers can refinance at a lower rate and housing will become more affordable for new buyers.

Adapted from remarks delivered at the Kikkoman conference, “The Economics of Green: Finding a Balance between Economic Growth and the Environment,” hosted in honor of the 35th anniversary of Kikkoman’s opening of its plant in Walworth, Wisc. — the first manufacturing plant of a Japanese company in the United States.

The challenges of climate change have inspired myriad debates about how best to arrive at an appropriate solution. Within these debates, many wonder: Who is ideally suited to spearhead the charge?

We’ve already seen that, despite public policy foot-dragging, the business community has played a very constructive role in working to solve the problems caused by global climate change. And I believe that in the future, it should be business leaders who shape the proposals currently debated in the political process.

The demands of globalization have long motivated the business community to develop creative solutions to multifaceted problems.

In 1972, Yuzaburo Mogi ’61, chairman and CEO of Kikkoman Corporation, made Kikkoman the first Japanese company to open a manufacturing plant in the United States, an accomplishment that has proven its worth by withstanding the test of time.

Kikkoman has maintained positive relationships with the surrounding community in Wisconsin, and paved the way for other foreign transplants.

Today, the company is a model of corporate citizenship at every level — from the local to the global.

Mogi recently announced that Kikkoman will sponsor an Environmental Studies Scholarship in cooperation with the University of Wisconsin-Madison, and this fall will open a research and development laboratory in Madison’s University Research Park.

This is the kind of active partnering and collaboration that will be the key to delivering workable and sustainable answers to the potentially crippling environmental challenges we face.

As we move forward, the United States should lead and take action early in the mission of environmental stewardship, while encouraging and regularly reviewing the actions of other key nations. The work of the global community needs to be coordinated to address the seriousness of the problem — and it is possible to do this while protecting U.S. economic interests.

A new report from the Urban Land Institute puts the world’s aging population as the most dramatic demographic trend. By 2030, one-eighth of the world’s population will be over 65 years old.

In the United States, the aging of baby boomers and the “coming of age” of echo boomers will lead to a dramatic increase in single-person households, driving demand for more multifamily housing in both retirement and workforce categories.

“Working with demographics, rather than against them, reduces development risk and is likely to enhance returns,” said M. Leanne Lachman, co-author of the report and executive in residence for the Milstein Center for Real Estate. “Therefore, the report’s emphasis on real estate demand has broad applicability for both investors and developers.”

Lachman, who is president of Lachman Associates, LLC, co-authored the report “Global Demographics 2008: Shaping Real Estate’s Future” with Deborah L. Brett.

The report also points out that by 2015, seven of the world’s ten largest urban agglomerations will be on the Asian continent and will be home to more than 15 million people each: Tokyo, Mumbai, Delhi, Shanghai, Kolkata, Dhaka and Jakarta. By 2030, Indonesia’s urbanization will approach that of Japan.

The report also notes that Europe’s share of the world’s population will drop from 11 percent to 8 percent by 2030, as the population shrinks by 40 million. One of a few exceptions is the United Kingdom, which will see an increase in population of nine percent, due to immigration. Low fertility rates throughout the continent will add to labor shortages and by 2030, if trends continue, Europe will have 59 dependents for every 41 working-age residents, the report notes.

In contrast, Africa and the Middle East currently have more than 17 percent of the world’s population, but this will expand to 22 percent by 2030.

Photo Credit: Holland Partners

• Drastic cuts of the discount rate;
• dramatic reductions of the target Fed funds rate;
• setting up special liquidity facilities, which allow banks to tap into the Fed’s balance sheet to acquire term funding; and
• opening up the discount window to investment banks and dealers.

While these actions have helped to calm the markets, two structural problems remain: excess housing stock and banks’ uncertainty about the subprime exposures of other banks. These problems have contributed to elevated levels of LIBOR.

How will turmoil in global money markets affect the world economy? And what can central banks do to prevent a future credit crunch?

These questions were the focus of a research conference held May 29-30 at the Federal Reserve Bank of New York and cosponsored by CBS.

The conference was attended by more than 100 participants from academia, central banks, hedge funds, investment banks, rating agencies and regulators. Opening remarks were delivered by Timothy Geithner, president of the Federal Reserve Bank of New York. Dean Glenn Hubbard and Donald Kohn, vice chairman of the Board of Governors of the Federal Reserve System, delivered keynote speeches and offered policy perspectives for the road ahead.

Hubbard noted how the evolving credit crunch has placed the relationship between capital and liquidity into sharp relief. After reviewing the actions taken by the Fed, Hubbard noted that moral hazard is a risk of prompt central bank action in providing extraordinary liquidity support, especially in the present U.S. context. He also noted that the time for economy and accumulation of capital and liquidity is during “good states” before the crisis arrives. Finally, he added that the regulatory policymakers should carefully think through the links between capital and liquidity.

Many participants in the conference noted that the actions of the Fed might induce moral hazard and encourage risk-taking behavior in the future. The opening of the Fed’s discount window to investment banks came under considerable debate, given the excessive leverage and risk-taking behavior of the investment banks.

The Fed-assisted takeover of Bear Stearns by JPMorgan was also the subject of considerable discussion. The consensus was that the actions of the Fed saved deadweight costs associated with the potential bankruptcy of Bear Stearns but might have encouraged risk taking in the future.

The conference ended with a panel discussion of the credit crunch. One consensus was that securitization will now focus on core constituencies with standardized collateral, and highly customized securitized products will not find risk capital in the near future. Participants noted that the elevated levels of LIBOR indicate that the crisis is not over yet.

Professor Charles M. Jones talked with Leonard Lopate last week on WNYC’s Please Explain about the intricacies of the futures market.

Just last week, the Commodity Futures Trading Commission announced an investigation into possible price manipulation in the oil futures market.

“It’s too soon to know exactly what might be going on in oil prices, although this big run up I think has some people’s antennas up,” Jones told Lopate.

According to Jones, the last case of real manipulation was almost 30 years ago, when the Hunt Brothers tried to corner the silver market.

“Cornering the market and these types of manipulations can really reduce confidence in the market,” Jones said. “They’re really the regulators’ nightmare, and it’s the main thing they’re trying to prevent.”

This post is part of a series following the “Pre-MBA World Tour” organized by Shoaf and members of the class of 2010.

In London, we visited with a banker at Blackstone who works in the corporate restructuring group. Following are a few highlights from our conversation:

Restructuring is a recent concept in the EU; not many banks or corporations are familiar with the practice, so it’s a fairly nascent market. The UK has much stricter bankruptcy laws, which means that the concept of restructuring is a bit trickier to deal with.

Blackstone is one of the few firms advising on restructuring deals in the EU; Houlihan Lokey and Lazard are among their main competitors.

At most firms, restructuring generally falls under the “advisory” business, but it is very different from M&A or capital markets. While M&A transactions typically involve a fairly straightforward auction process (build a book, build a list, call the list), restructuring deals are much more complex and unique — they involve several more parties per transaction and are often less predictable. Most companies undergoing restructuring transactions are overleveraged and have serious operational issues in addition to problems with their capital structure (e.g., a liquidity crisis).

Also, there is much more tension and drama involved in a restructuring because there is generally a losing party involved. So unlike an M&A deal where each party is excited about newfound synergies, restructuring generally involves a bit of pain for the equity holders during the deleveraging process. Another difference is that with restructuring, banks are typically brought in and retained (hired) by the creditors, rather than the corporation or the equity holders as is the case with M&As.

As many know, restructuring is a counter-cyclical business, which means that when the market is hot, the restructuring guys get to play golf on the weekdays, but when the market crashes (and all the other bankers get laid off), these guys roll up their sleeves and get to work.

At the first CBS open house, a few of us were talking about going into restructuring in order to capitalize on the anticipated recession.

However, according to my new friend at Blackstone, restructuring isn’t something you get into for the short run; it’s a very specialized practice that takes a few market cycles to really understand the business and get to know the players. It also has a short window of opportunity because, unlike the weather here in London, there are typically more sunny days than rainy days in any given market cycle.

That said, Blackstone hasn’t seen any significant increase in restructuring deals . . . yet. It seems that most of the deleveraging has been taking place in the capital markets and hasn’t yet hit the corporations, which seem to still have a lot of cash on their balance sheets. A few bad quarters and this could change very quickly.

Okay, there’s my report from London. I’ll end with saying that I don’t have a restructuring background, and most of this information was derived from one conversation, so I’d love to hear anyone else’s thoughts about the matter. Is now the right time to get into restructuring?

Next stops: Paris and Frankfurt.

The following excerpt is drawn from Ben Bernanke’s remarks at last night’s Annual Dinner, at which he was honored with the Distinguished Leadership in Government Award. download the full text

Many foreclosures are not preventable. Investors, for example, are unlikely to want to hold onto a property whose value has depreciated significantly, and some borrowers — perhaps because they were put into an inappropriate loan or because personal circumstances have changed — cannot realistically sustain homeownership. However, if a foreclosure is preventable, and the borrower wants to stay in the home, the economic case for trying to avoid foreclosure is strong.

Clusters of foreclosures can destabilize communities, reduce the property values of nearby homes, and lower municipal tax revenues. At both the local and national levels, foreclosures add to the stock of homes for sale, increasing downward pressure on home prices in general. In the current environment, more-rapid declines in house prices may have an adverse impact on the broader economy and, through their effects on the valuation of mortgage-related assets, on the stability of the financial system. Thus, finding ways to avoid preventable foreclosures is a legitimate and important concern of public policy.

To determine the appropriate public- and private-sector responses to the rise in mortgage delinquencies and foreclosures, we need to better understand the sources of this phenomenon. In good times and bad, a mortgage default can be triggered by a life event, such as the loss of a job, serious illness or injury, or divorce. However, another factor is now playing an increasing role in many markets: declines in home values, which reduce homeowners’ equity and may consequently affect their ability or incentive to make the financial sacrifices necessary to stay in their homes.

On the principle that a picture is worth a thousand words, Federal Reserve staff, using detailed, county-by-county information on mortgage performance, have developed a series of heat maps, which summarize the incidence of serious mortgage delinquencies across the nation as well as some of the key drivers of loan performance. As the examples will make clear, the figures use warmer colors — orange and red — to show counties for which the factor being considered has a higher value or change. Lower values or changes are indicated by cooler colors — shades of green and yellows — indicate areas where the factor under consideration has a moderate value or change.

download all seven heat maps

What are the implications of these relationships, particularly the linkage of mortgage payment problems and falling house prices? Loan servicers are used to dealing with mortgage delinquencies related to life events such as unemployment or illness, with the most common approaches being a temporary repayment plan or the folding of missed payments into the principal balance. A widespread decline in home prices, by contrast, is a relatively novel phenomenon, and lenders and servicers will have to develop new and flexible strategies to deal with this issue. In some cases, when the source of the problem is a decline of the value of the home well below the mortgage’s principal balance, the best solution may be a write-down of principal or other permanent modification of the loan by the servicer, perhaps combined with a refinancing by the Federal Housing Administration or another lender.

To be effective, such programs must be tightly targeted to borrowers at the highest risk of foreclosure, as measured, for example, by debt-to-income ratio or by the extent to which the mortgage is underwater. Finding the right balance — particularly the need to avoid programs that give borrowers who can make their payments an incentive to default — is difficult. But realistic public- and private-sector policies must take into account the fact that traditional foreclosure avoidance strategies may not always work well in the current environment.

Most Americans are paying their mortgages on time and are not at risk of foreclosure. But high rates of delinquency and foreclosure can have substantial spillover effects on the housing market, the financial markets, and the broader economy. Therefore, doing what we can to avoid preventable foreclosures is not just in the interest of lenders and borrowers. It’s in everybody’s interest.

Should the U.S. join the Kyoto Protocol, or at least play a positive role in the search for a successor? Or is this too costly, or otherwise “fatally flawed,” as our president has suggested?

Humanity as a whole needs to address climate change: it has the potential to alter the world around us dramatically, and for the worse. Preventing or at least minimizing climate change will not be cheap, but it will still be a good buy.

Roughly speaking, reducing greenhouse gas emissions to the level consistent with limiting climate change to around 2 degrees Celsius (about 4 degrees Fahrenheit) will cost in the range of 1-2 percent of world income.¹

We need to compare this cost with that of allowing climate change to continue — a harder number to compute. The most thorough and most recent estimate put the cost at “at least 5 percent” of world GDP, with “at least” here indicating that this assumes a rather conservative estimate of temperature increase and includes in the calculation only the costs of climate change that are captured in market transactions.

So this estimate would include the costs of land lost due to increases in sea level, or of reduced agricultural output, but not of species driven extinct by changing environments, or of the spread of disease vectors in a warmer world and many other non-market costs.

My own estimates are that the nonmarket costs are probably going to be bigger than the market costs, so the total could be 10 percent or more of world income.

If you can spend 2 to save 10, that’s a good investment — if the 2 and the 10 are both spent and saved today. A problem in the climate change case is that we spend the 2 now, well before we save the 10: we invest 2 to make 10, but we invest the 2 now and get the 10 spread over many years starting in 2040 or thereabouts. So we have to worry about the discount rate: over long periods it makes a big difference. I argue that the right discount rate for society to use here is very low, so investing 2 now to make 10 in the future still makes sense. But some of my colleagues disagree.

Another element in the calculations is that there is always a small but non-zero risk that the extent and impacts of climate change will be far greater than the central estimates of the IPCC. They admit this and give quite large error bars around their figures. These error bars are asymmetric: the mean increase is in the range 2-4 degrees C with no chance at all of less than 1 degree (we are already at 0.75) and some chance of 6 to 8 degrees. The upper end of this range would not just be costly: it would be disastrous. So we have to see climate policies as insurance policies, insuring against the small risk of a disastrous outcome. We can apply techniques from risk management to work out how big a premium it is worth paying: it could be several percent of GDP.

Back to the Kyoto Protocol. If we want to reduce emissions, then there are three ways of doing this:

• Order firms to emit less (command and control)
• Tax emissions
• Introduce a cap-and-trade system, as the U.S. did for SO2 under the 1990 amendments to the Clean Air Act.

Kyoto chose the last of these three, and the European Union has embedded this in its internal approach to reducing emissions. This also seems to be the preferred method in the U.S. states that are moving to reduce greenhouse gas emissions.

To economists cap-and-trade or taxes are clearly the preferred options, and politically it seems that cap-and-trade is way ahead. Taxes are a political liability, and cap-and-trade has the merit of generating new tradable securities, which the investment banking community loves. If we follow this route, then the CO2 market could become a multi-trillion dollar market within ten to fifteen years.

Photo Credit: Mila Zinkova]]> Tue, 22 Apr 2008 10:07:29 EDT ]]> Business Economics and Public Policy Risk Management Social Enterprise

Once upon a time risk management was a highly technical discipline of interest mainly to risk management professionals, but over the past decade it has become a topic of great interest, particularly among managers, investors and regulators. And recent economic news has put an even bigger spotlight on the profession.

Of interest to me is how, and how well, risk management information has been making its way into governance frameworks of companies, and I had the chance to hear firsthand about this when I was at an assembly of large company chief risk officers in October 2007. The topic of my discussion was how risk management organizations (RMOs) and boards of directors interact — and it was clear from the group interaction that top-level practices differed extensively.

So as a followup to that assembly, my colleague David R. Koenig, the former chairman of PRMIA, and I conducted a survey of very large corporations around the world, and the results confirmed that a standard of best practices for employing risk management within a governance structure does not yet exist.

Our survey results also confirmed something else: there is substantial change occurring within governance structures toward a more robust incorporation of risk management. And we found that while some companies employ ongoing efforts for the communication and improvement of governance and risk management practices within their board and employee populations, a very substantial number of others do not have such capabilities in place.

Our survey shows a wide variety of approaches currently being used to facilitate interactions between RMOs and boards — even within the same industry — and that meaningfully different approaches to risk/governance implementation exist at many levels in the companies: at the board committee and executive level, in the chains of reporting within the executive suite and in patterns of communications to governance structures.

Not surprisingly, an audit committee is the most frequent choice for board oversight of risk management, but still was the choice of less than one third of our survey respondents. The remaining choices span a wide range of board entities. Risk committees are emerging as an important board-level committee, but they only accounted for 17 percent of the risk oversight assignments reported to us. There are many factors that can account for this wide dispersion of choices, but it certainly suggests that the board of directors interface with the risk management organization is far from settled into a widely acceptable pattern, and the relationship will continue to evolve.

We asked participants about their objectives for risk management and found they also differ even between participants in the same industry and are almost always multifold. Most of our survey participants agreed on loss avoidance and control as objectives, while a smaller number — but still a majority of respondents — also identified securing a competitive advantage as an objective.

Finally, we found the most significant task lacking with many (but certainly not all) of our survey group was effective communication and education on risk policies for employees, a surprising gap in this important element of good governance practice.

It’s clear that further study of means for effective communication of the corporate appetite for risk, risk policy and risk data/reporting expectations is warranted to ensure that firms are creating the kind of effective culture that boards are increasingly seeking to foster. And if there is an expectation that employees are engaged in best practice governance and risk management, it must be modeled and communicated from the top to be achieved.

The full study is scheduled for publication by Wiley-Blackwell later this year in their monograph series, “Corporate Boards: Managers of Risk, Sources of Risk.”

“The essential problem,” he wrote, “is that our models — both risk models and econometric models — as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality.”

Says Professor Paul Glasserman: “Mr. Greenspan’s article highlights the shortcomings in risk-management systems that result from limited historical data — particularly data from good economic times. Taking this point a step further, financial innovation can end up focusing — sometimes unwittingly — on the weak points in risk measurement. When correlations are misjudged, as in Greenspan’s example, the greatest strains get put on the weakest links.”

Photo credit: Toni Lozano

After producing thousands of semirandom solutions to derivative valuation and hedging, this efficient computer algorithm can point market decision makers in the right direction, estimating exposure to risk and providing a degree of protection.

Now, thanks to new work by Professors Paul Glasserman (CBS) and Mike Giles (Oxford), these rapid calculations of hedge ratios can happen even faster. Their recent paper in Risk magazine describes how it can be done — through the application of adjoint methods more commonly found in engineering design and fluid dynamics.

The paper — “Smoking Adjoints: Fast Monte Carlo Greeks”(Click here to download the PDF) — won the two authors Risk magazine's 2007 Quant of the Year award.

Many of my students responded, and the blog editor chose a couple to publish.

From Sean Murtagh ’08:
Needless to say, the current debate over a government-backed housing bailout is a thorny subject, with strong arguments on either side. While I personally am not in favor of excessive government intervention in the functioning of markets, I believe there are rare times when such intervention is necessary not only to restore the functioning of these markets but also to promote the overall health of the economy.

In today’s environment I fear that such an intervention may be necessary, as the albatross around the economy’s neck that is the residential housing market seems to be spreading dangerously into other important markets, such as the commercial real estate and leveraged-loan markets.

If this ripple effect shuts down these and perhaps other credit markets, I believe the consequences for the economy would be disastrous: a large portion of economic activity would grind to a standstill due to the resulting scarcity of credit, a condition that as a result of expectations could persist for a long period of time.

The real issues to be analyzed are whether or not this credit shutdown is likely to happen, and if it does occur, how long is it likely to persist, questions that are difficult at best to answer.

If, after a thorough analysis, the answer to either question suggests a mild interruption either in terms of scope or time, my recommendation would be to allow the market itself to sort out the current housing crisis. As long as credit does not totally dry up, at some price home buyers will once again enter the market eventually restoring a new equilibrium.

If, however, best estimates are for a protracted disruption in the overall credit markets, I believe government intervention in the housing market — provided it is done in as minimalist and expedient a way as possible — is sensible despite the moral hazard and other compelling arguments against such an intervention.

While I am certainly not in favor of bailing out the speculator or any of the scores of individuals who engaged in blatant fraud during the recent housing boom, I am in favor of seeing the economy as a whole remain well-functioning. I don’t believe we should allow the overall economy to suffer unreasonably just to teach certain individuals a lesson.

From Erik Diehn ’08:
I’m not sure that letting an institution like Citibank go bust is the best answer to a financial crisis — while the investors, managers and other parties who turned a blind eye to lax CDO repackaging and lending would certainly get their comeuppance, having a major financial institution melt down would result in all sorts of damage to the various completely innocent parties who hold accounts, loans, etc. in Citi’s diverse businesses. I think, in fact, that Aaron [fellow MPE student commenter] is right on when he points out that some relief is needed to keep the wheels of credit turning so that businesses and individuals can continue to borrow to expand their economic undertakings.

What concerns me more than the specific moral hazard created by bailing out bad mortgages is the impact this kind of intervention might have on the millions of nondefaulting but nevertheless indebted Americans who borrowed heavily against nonproductive assets (houses) to fuel a continuing consumption binge (cars, flat-screen TVs, etc.). We have been living through at least 15 years of continuous asset-price inflation; will a government intervention in this deflation — whether through buying up mortgages or reducing interest rates — just create more of the same?

It seems to me that ultimately, there's no quick fix for the fact that in the long run we’re going to have pay for these bubbles one way or another. My hope is that any sort of government proscribed remedy (a) lessens the pain of this readjustment so that we perhaps have a longer but less severe period of austerity and rebuilding rather than a shorter but more painful shock and (b) provides regulatory tweaks that shift incentives so that the chances of another bubble are reduced.

Of course, some people think that bubbles are inevitable and more or less a required part of the modern U.S. economy — see “The Next Bubble” and related postings from the February 2008 edition of Harper’s Magazine for a prime example of this theory. I’m not sure I subscribe to a view that extreme, but I do think that as a country we have developed an awful lot of dependence on speculative growth and create a lot less fundamental value than we used to.

One of the reasons that Modern Political Economy is such an enjoyable course to teach is that every term a real-life issue emerges that underscores the course’s contemporary relevance. What to do about the credit crisis that cascaded from the home mortgage debacle is the latest case in point.

Reports are circulating that Wall Street firms, led by Bank of America, are pushing a plan that would have the federal government buy up troubled mortgages at a discount, forgive debt above the current market value of the homes and then use federal loan guarantees to refinance borrowing at lower rates. In other words, bail out everybody who forgot about the concept of risk — from homeowners all the way up the food chain to financial institutions and investors.

Some people have viewed this gambit as somewhat ironic because Wall Street has successfully preached a laissez-faire policy on the part of the government that would encourage all sorts of financial innovations, but of course it isn’t ironic at all. As Adam Smith, the father of modern political economy, recognized more than two centuries ago, when the vicissitudes of the free market strike home, everybody from the poorest of the poor to the richest of the rich looks to the state for protection.

The case against state intervention is that if you bail out those who didn’t pay enough attention to risk, the same dynamic will be repeated in the future. That’s the moral hazard argument of the free-market purists, who argue that in the long run the market will correct itself and go forward with everybody a bit wiser about risk.

The case for state intervention was put succinctly by the always pragmatic Lord Keynes: “In the long run, we’re all dead,” he said to those who argued that market forces would eventually cure the Great Depression. He actually agreed with that perspective, but he favored government pump priming because he worried about the social and political instability that might result from a prolonged economic crisis.

So I asked my Modern Political Economy students to share their views on whether the federal government should intervene in the current crisis or simply let the market work its painful way out. A couple of the students will post their answers on the blog tomorrow. I’d be interested in what others think as well.

Photo credit: Sean O’Flaherty