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

Last Thursday, Warren Buffett, MS ’51, and Bill Gates visited Columbia Business School. During the event, Gates identified energy — including renewable sources, like solar — healthcare and IT as the three sectors he sees as having the most opportunity for transformative growth in the foreseeable future. Buffett highlighted the high energy-efficiency and low environmental impact of rail transport as one of the key drivers of Berkshire Hathaway’s recently announced purchase of Burlington Northern Santa Fe Railroad. More MBAs than ever are looking for career opportunities in developing and investing in renewable energy. Where can they be found?

This past weekend, 50 Columbia Business School students were among the 2,400 attendees at the 2009 Net Impact conference at Cornell University. Net Impact is an organization for MBA students who share an interest in using business to make an environmental or social impact. Among the many panelists were leading investors in clean energy from Blackstone, Kleiner Perkins, JPMorgan Chase and Sequoia who spoke about what technologies and business models they believe have the greatest growth potential.

The investors focused on technologies that could, in the long run, be competitive without any subsidies or government support. To this end, they identified specific niches within energy-efficiency and waste-to-energy, as well as solar power.

Solar energy is viewed as an area with tremendous growth potential, with the U.S. market projected to grow 20-fold by 2020. Traditionally, solar energy has been extremely expensive and reliant on erratic government subsidies; however innovative leasing models, falling silicon prices and technological breakthroughs have reduced costs dramatically. Continued cost reductions along with carbon prices could make solar cost competitive with coal and natural gas.

Within solar energy, there are many technologies, and each has its own value proposition. Photovoltaic panels can be installed on rooftops for residential, commercial and industrial applications, or standalone, for us in utility-scale plants. Thin-film PV technology is very low cost but less efficient, making it the optimal solution for sites with plenty of space. Concentrating Solar Power (CSP) plants use mirrors to concentrate sunlight, which generates steam that spins a turbine to allow a much larger scale operation. All these technologies also have their downside — distributed PV generation does not permit economies of scale. Desert sites like those in the Southwest are most attractive for CSP, but CSP also requires a lot of water for cooling, as well as a challenging permitting and transmission environment.

In addition to solar, there is tremendous growth in wind, geothermal, combined heat and power, waste-to-energy and efficient energy. Nuclear energy is also slated for resurgent popularity. Repowering the world will provide tremendous opportunities for MBAs to generate value as investors, developers and operators of clean energy companies. Famed VC investor Vinod Khosla has invested in dozens of clean energy startups in the belief that the space will generate many $10 billion+ companies.

Photo credit: greenlagirl

Behind every great man, some say, is a better woman.

Last Thursday, I had the rare and exclusive privilege to attend “Keeping America Great”, a CNBC-moderated town hall event at Columbia Business School with two incredible men: Warren Buffett, MS ’51, and Bill Gates. Buffett and Gates, the introduction announced, were returning to school, not to learn, but to teach.

Students asked questions about the influence of greed on the financial crisis, Buffett’s purchase of Burlington Northern, career advice, Steve Jobs and what keeps them up at night.

One student asked what advice they had for those who were unclear about what to do in life?

“First of all,” Buffett replied, “I’d say marry the right person. And I’m serious about that. It will make more difference in your life. It will change your aspiration, all kinds of things. It’s enormously important who you marry.”

“Oddly,” writes Roger Lowenstein in his Buffett biography, “when Buffett graduated in 1951, both (Benjamin) Graham and his father advised him not to go into stocks.” Buffett offered to work for Graham for free but Graham turned him down, saying he was still overpriced. Rather than take another job on Wall Street, Buffett returned to Omaha where he began to court Susan Thompson. The two married in 1952. Two years later, he was hired by Graham and the Dow had its best bull run since 1942. In 1954, the Dow (including dividends) rose 50 percent. Three years later Buffett opened his Partnership and the rest, as they say, is history.

Similarly, Bill Gates met his wife at a Microsoft press conference in 1987, “coincidentally” just before the company’s meteoric rise (see stock chart below).

Now, if I learned anything in statistics, there is clearly a positive correlation here. This poses an interesting question. Would Buffett and Gates had such tremendous runs as single men?

Which leads me to a question posed by Dean Glenn Hubbard. He asked the two men how they would develop business leaders who understand context and connect the dots.

“Some never learn, you know,” Buffett replied. “Having sound principles takes you through everything. And the bedrock principles that really I learned from Graham and Dodd, I haven’t had to do anything with them. They take me through good periods. They take me through bad periods. In the end, I don’t worry about them because I know they work.”

Teaching principles has become the new hot topic among business schools. “A year after the collapse of Lehman Brothers,…” a recent article in The Economist questioned, “will (MBAs) be taught to do things differently?”

Along these lines a student asked Buffett whether ethics could be taught in business school.

“Well, I think the best place to learn ethics,” Buffett replied, “is in the home.” (see video clip)

As the event progressed, I began to realize that the event was less about teaching future business leaders about business and more about teaching future business leaders folksy home-grown values.

So allow me to attempt to provide context and connect the dots: a strong partner leads to a successful marriage, which leads to good family values and ethics, good business, and keeping America great. Or in mathematical terms:

Then again, I should have gathered this from the event’s own introduction. Buffett and Gates were returning to school, the introduction announced, “not to learn, but to teach, showing the next generation of business leaders that wealth is not about the money you amass, but the number of lives you enrich.”

So was Buffett’s marriage his most important investment?

If so, please take note: We don’t need a revised MBA curriculum, just more social mixers! Two Columbia Business School students, Mandy Tang ’10 and Lori Clement ’10, are already leading this charge with a new company called Pom Pom Love, a “NYC-based, fun-loving singles events company.”

Cover photo credit: Eileen Barroso

“I was told when I graduated that I had to come back and take a few classes,” Warren Buffett, MS ’51, deadpanned as he took the stage with Bill Gates on Thursday as part of a community forum at Columbia Business School. More than 700 students from the Business School were in attendance at the event, which was filmed for global broadcast by CNBC.

A major theme of the 90-minute Q&A session was optimism about U.S. economic prosperity in the long-term, with a nod to future energy issues. That theme underscored Buffett’s comments about Berkshire Hathaway’s recent acquisition of Burlington Northern Santa Fe for $34 billion last week.

“The railroads are tied to the future prosperity of this country. You can’t move a railroad to China or India or anywhere else,” he said. “As the country grows, the transport of goods will grow — [people] will be moving more and more goods back and forth to each other. And you have the most environmentally friendly and the most efficient way of doing that on the railroads.”

The theme returned later in Gates’ discussion about areas he sees with the most growth potential in the United States. He said those include information technology, energy and medicine. Gates discussed the growing field of alternative energy as a driver for a long-term economic development.

“Solar-thermal, solar-electric, nuclear [energy] is going to go through some of the revival and see if it can solve some of its cost challenges. As a country, we want to make sure all of those get lots of R&D and regulatory enablement because one of them is going to give us much cheaper power,” he said. “We don’t have quite as much R&D going into those things as I’d like to see. We have quite a bit, but I think the government policies could drive for more.” He added that he foresees an energy revolution and the United States is expected to lead the way.

Buffett also discussed his value-investing strategy, saying that it had not changed in light of the financial crisis and the fundamentals were the same. “We like companies with a durable, competitive advantage,” he said. On the economy, both Buffett and Gates lauded the actions of the government and the Federal Reserve.

Both men offered advice and inspiration to students. (Marry the right person, said Buffett. Act on your self-confidence, Gates added). Buffett signaled his optimism for future MBA graduates of Columbia Business School, making a promising offer to those in the audience.

“I would pay a $100,000 dollars for 10 percent of the future earnings of any of you,” Buffett said. “If that’s true, you’re a million-dollar asset right now.”

CNBC will broadcast “Warren Buffett and Bill Gates: Keeping America Great” moderated by Becky Quick on November 12 at 9 p.m. and 12 a.m. ET . Join the conversation with other students on Facebook and on Twitter.

Photo credit: Eileen Baroso

They are two icons of American business — Warren Buffett, MS ’51, and Bill Gates. On November 12, Columbia Business School students will have the opportunity to connect with them in person. They will appear together in a special hour-long community forum at Columbia Business School, which will be filmed by CNBC for global broadcast. During the event, Buffett and Gates will field questions from students about the economy, the future of capitalism and corporate social responsibility.

It is the first time Buffett and Gates, who met each other in 1991, have appeared together at Columbia University. The last student forum they participated in was in 2005 at the University of Nebraska at Lincoln. Of the many bonds in their friendship, philanthropy and a shared philosophy of giving back to society is one of the strongest. In 2006, their relationship made the history books when Buffett announced that he would give the bulk of his estimated $40 billion fortune to the Bill & Melinda Gates Foundation.

Gates and Buffett’s latest ventures have been in recent headlines. Last week, Berkshire Hathaway announced a $26 billion deal for the railway company, Burlington Northern Santa Fe. Earlier in this year, Berkshire invested in BYD, a Chinese electric car company.

In a speech in October, Gates called for a new green revolution in agriculture and announced a $120 million package of agriculture-related grants to nine institutions around the world. Taking a page from Berkshire’s playbook, Gates wrote the foundation’s first annual letter this year and said the foundation will give away $3.8 billion in 2009.

CNBC will broadcast “Warren Buffett and Bill Gates: Keeping America Great” moderated by CNBC’s Becky Quick on November 12 at 9 p.m. and 12 a.m. ET . Join the conversation with other students on Facebook and on Twitter.

Photo courtesy of Columbia Business School

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.

Russian gangsters, $230 million in allegedly stolen funds, a hedge fund investor and YouTube. The makings for a thriller are now a case study at business school. Professor Ray Fisman, director of the Social Enterprise Program, is teaching a case about Bill Browder’s tangle with the Russian government. Browder, the CEO/founder of Hermitage Capital, has accused the Russian government of organized corruption that took $230 million in a scam. The firm has approximately $3.5 billion invested in the country, making it one of largest foreign investors in the country. Countering his claims, the Russian Interior Ministry is seeking his arrest for illegally evading taxes. The story took turn on October 9 when Browder posted a documentary-style video on YouTube in English and in Russian to publicize his case. (Browder spoke at Columbia Business School in October 2006.)

In a recent commentary in Forbes.com, Fisman, writing with Eric Werker from Harvard Business School, wonders if this latest development in the story represents the “epigraph to a new chapter of capital flight from Russia.” However, underscoring the story about Browder’s standoff with the Russian government are larger questions about governance, economic development and foreign investment. Fisman writes:

Economic development requires investment. For their part, investors typically explore the upside and downside of any given opportunity: What is the likelihood that we will strike oil? At what price will we be able sell our product? What are the wages and taxes we will need to pay? Understanding the costs and risks, they then decide to invest if the profits are high enough.

Many of the risks come not from uncertainty over resource availability or technologies, but whether the “rules of the game” will be changed after the investment is made. That is, will an investment partner try to rewrite the contract to get a bigger piece of the pie? Or will a sovereign state--like Venezuela or Russia--try to up its share through higher taxes or even outright expropriation? If investors don’t trust the legal system to enforce the rules, the potential downside makes investment a whole lot riskier. So economists emphasize the role of contract enforcement and predictable government policies to foster investment and growth.

Photo credit: Josef F. Stuefer

In September, Professor Bruce Kogut and Cheryl Rathbun, managing director and chief operating officer of Citi’s Institutional Client Group’s (ICG) Risk Management, participated in a question-and-answer fireside chat about the future of financial regulation.

While Rathbun made clear that “we’re not out of the woods yet”, she did say that some of “major contours” of the new financial landscape are appearing.

“I don’t think we’re going to see major money center banks growing and growing and we’ll just have three or four major institutions. I think we’ll see a paring down,” she said. “At the same time we’re going to have increased regulation and capital requirements, which will force the money center banks to have somewhat of a different model. It’s a little more retro and maybe going back to what we saw in the 1970s … we may see some reincarnation [of that era] and some bit separation between [securities and commercial banking].”

To learn more of Kogut and Rathbun’s exchange, watch the complete video coverage.

“Your Business School years have coincided with an extraordinary time and now you have a huge opportunity,” Paul Calello ’87 told students in a recent lecture. “The themes of this time are change and responsibility.”

The CEO of the investment bank and a member of the executive boards for Credit Suisse Group and Credit Suisse, shared his views on the financial crisis and gave mentor advice on September 17 as part of the Silfen Leadership Series. Calello serves on the School’s Board of Overseers.

In discussing the impact of the crisis on the financial industry, Calello talked about the ways banks have had to innovate new solutions. He pointed to Credit Suisse’s executive compensation strategy as an example. The bank made headlines last December when it announced it would use its illiquid assets to fund some of its executive compensation packages.

“At first it was internally unpopular … but it was the right and responsible thing to do,” Calello said. “It was a way to align with the interests of shareholders, continue to rid the firm of these risky assets and, at the same time, address employees’ needs.”

Looking into the near future for the finance industry, Calello said he expected “many more significant developments to come in the next two years,” particularly from regulators. In response to a question about job opportunities, he said flow trading areas and products that are exchange-traded and centrally cleared would be strong.

As for practical advice for MBA students, he said there was no alternative to hard work and urged students to learn all they can about the crisis they’ve been living through.

“You will be part of an era of reform,” he said. “We’re relying on you to not repeat mistakes that have been made, but to help restore trust and confidence in our industry.”

Photo courtesy of Columbia Business School

Dean Glenn Hubbard called the selection of James P. Gorman ’87 as the new chief executive of Morgan Stanley a “recipe for success.”

Morgan Stanley announced the news on September 10 that Gorman, currently in charge of the firm’s global wealth management division, would replace John J. Mack as CEO starting Jan. 1, 2010.

Gorman has been with Morgan Stanley for four years. In that time he has had key success, including turning around the bank’s retail brokerage operation. Prior to joining Morgan Stanley, he ran the global private client business at Merrill Lynch. Gorman has been a member of the School’s Board of Overseers since 2006.

Dean Hubbard, who has known Gorman since his days at Merrill Lynch, said Gorman was a “terrific pick” and a “strategic thinker”, underscoring industry reports that Gorman was favored as CEO for his ability to switch quickly between jobs and his long-term thinking for the firm.

Photo courtesy of Columbia Business School

A year ago this morning, we woke up to the news that Lehman Brothers had collapsed. The overnight demise of the investment bank is an important milestone, but it is only one failure in a series of calamitous events in the last year that shook the financial world and changed it forever.

Entire markets essential for world commerce effectively shut down and some markets continue to remain moribund today. Last year at this time, the whole banking system was on the verge of collapse and the world economy was tanking. Now that the economy is stabilizing — even perhaps tentatively recovering — and the financial sector is healthier, it is easy to forget just how bad things were.

It is true that investors today are now more cautious and banking will (hopefully) become more boring. But the financial and economic landscape has been permanently altered. The single biggest change pre- and post- Lehman Brothers’ failure is the role and the actions of the government and other financial authorities.

Before Lehman’s fall, the government played a relatively small direct role in financial markets. Now, the most important player, and still in some cases the only player, in financial markets is the government. The government essentially chose Lehman’s fate and allowed some of its peers to survive. Masses of money — tens of thousands of dollars per U.S. household — were injected by the United States Treasury to save the banking system from itself and bail out bankrupt industries. Unprecedented intervention by the Fed in markets, still continuing today, has slowly enticed investors back.

But now one year later, we can look back at how the government led us out, but the big question is: Where is it going to lead us next?

Photo credit: T. Shein

If the financial crisis taught business schools anything, it's that the curriculum can no longer turn a blind eye to pressing policy issues that impact business, says Professor Bruce Kogut. (See yesterday’s post about some of the ways the School is incorporating the financial crisis into course work.)

In a recent article in BusinessWeek magazine, Kogut elaborated on his view of the financial crisis and said that it might be best seen through a political perspective, rather than a technical or managerial one. Abundant liquidity and “unprecedented income inequality”, he wrote, paved the way for a flawed incentive system. Kogut argues that there should be more focus on “regulation of the financial markets and less deference paid to financial innovation.”

What does this view mean for business education? Kogut says that politics must have place in the MBA education. He writes:

	Do you share this view? Please leave a comment.

Financial crises are the children of troubled politics, yet management education often eschews political questions. This is a fundamental flaw of most, if not all, business schools. If such questions are left unaddressed, we will produce business leaders with limited perspectives who may not be equipped to deal with the pressing issues of the day. In other words, we must make the case to our students that the political questions, while difficult, are critical to the practice of business — even if this kind of analysis may not appear to serve their immediate self-interest. …

The crisis has reshaped the financial landscape, shifting the value of management education toward pedagogies that strengthen students’ understanding of the fundamental relationships in society — how managerial, technical, ethical, and political elements work together.

Photo credit: Theo La Photo

“How do we make decisions under uncertainty?” Professor Wei Jiang posed the question to an audience of students last week during orientation. The question not only referred to the lecture’s topic — the financial crisis — but was offered as a framing device for students as they begin core classes in the MBA program this week.

“This will be the most important skill you can develop,” she said.

A new orientation module focused on the financial crisis was created this year to give new students an overview of the causes and issues of the crisis and provide key questions that connect it with upcoming courses in the core. In her lecture, Jiang considered different aspects of the crisis including international policy, behavioral bias, compensation structure, government regulation and risk models.

The module is part of a larger initiative by the School to use the financial crisis as a vehicle to foster integrative thinking in business training. Another element of that initiative is the creation of a new cross-discipline class, which will launch in Spring 2010, on the future of financial services. During the past summer term, former chief legal officer of Lehman Brothers, Thomas Russo, taught a half-term course looking at the crisis.

“Look ahead as well as look around you,” Jiang told students at the end of her lecture. “Think in terms of tradeoffs and equilibrium.”

Photo courtesy of Columbia Business School

A typical Wednesday morning finds millions of online banking customers checking their balances. Unless, that is, the stock market has tanked.

When the stock market goes down, sticking your head in the sand regarding your own money and investments is not uncommon. Early research findings from Professor Nachum Sicherman, working with George Loewenstein and Duane Seppi at Carnegie Mellon University and Steve Utkus at Vanguard, show that consumers undergo an ostrich effect — giving selective attention to investment information — with their bank account balances when they see bad financial news.

In their study of 3,000 consumers at a regional U.S. bank, Sicherman and his colleagues found that when the market goes down, so does online balance checking. On average, a one percent rise or fall in the stock market increases or decreases, respectively, the likelihood of a customer logging into his or her bank account by one percent. Additional preliminary results taken from the data of one million customers at Vanguard are consistent with this outcome, says Sicherman.

Initial results show that individuals with larger balances, especially those with higher percentage of stocks, check their balances more frequently. Women, for example, go online less than men, and the ostrich effect is stronger for men than for women. Their data also showed that Wednesday has the peak number of account logins and people tend to check their balance between 9 a.m. and noon.

Sicherman and his co-researchers are looking at the results to see if there is a link with patterns of trading.

“To what extent does the ostrich effect affect trading if people are reluctant to look at their account for psychological reasons when the markets go down?” says Sicherman. “The next logical thing to hypothesize is that if they are not looking, then they are trading less. But we don’t have an answer yet.”

Photo credit: Njitram lexe Nav

Read the previous post

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.

In the last post, we blogged on the growing study of social enterprise at Columbia Business School. One of the most enduring questions for the field is how to couple social objectives with the role of markets. Bruce Usher, adjunct professor in finance and economics and CEO of EcoSecurities, spoke about that question at an international social enterprise conference last March (complete video coverage of his lecture above).

	In what ways can the markets play a bigger role for social change? Please leave a comment.

“Market mechanisms can and will help social problems,” he said. In his presentation, he discussed several examples of successful ventures in the environmental sector, including Title 4 of the Clean Air Act, which reduced carbon emissions by 40% between 1990-2001. Usher also discussed the success of Renewable Portfolio Standards (RPS), Clean Development Mechanism (CDM), the role of microfinance and socially responsible investing.

“Markets force participants to internalize social costs and it becomes part of the daily way of doing things,” Usher said. “As a result participants change their behavior and they do things differently.”

Cover photo credit: Russell Smith

The authors won the 2009 Pershing Square Value Investing and Philanthropy Challenge, which was made possible through a gift from Bill Ackman and Pershing Square Capital Management LP and awarded through the Heilbrunn Center for Graham and Dodd Investing.

Participating in the Pershing Square Challenge is the type of experience you go to business school for. Where else in the world do you have the opportunity to pitch a stock to a panel of value investing legends including Bill Ackman, John Griffin, Dan Loeb and Bruce Greenwald?

Our team came together quickly — Tim and Grant worked together over the summer at Blue Ridge Capital and John and Tim knew each other through the CIMA mentor program. Despite other recruiting, academic, and personal (like Grant’s son Griffin) commitments, we all agreed that our goal was to win the competition and that would be a priority for each of us.

We were keen to find a short to differentiate our work from the other 45 teams that were going to have very strong long ideas. After reviewing different sectors, for-profit education appeared to still be attracting rich valuations despite the severe downturn in the market and a questionable customer-value proposition.

We split the sector into three areas and each of us conducted initial diligence on a subset of companies. After reviewing all the major for-profit education stocks, we settled on the Apollo Group (parent company for the University of Phoenix) for three reasons. First, it had a rich valuation. Second, it has questionable business practices, and, lastly, the company cost U.S. taxpayers $250 million dollars through defaulted loans that the government guarantees. We believed highlighting the government subsidy of corporate profits dovetailed with the philanthropic goals of the competition.

We worked on the idea all semester, coming together weekly to discuss the team’s progress and ideas for different analyses. As we neared the submission deadline the measured pace became frantic and our weekly meetings turned into daily ones. In spite of our differing styles and opinions — Grant wanted to explain every detail, John wanted to explain nothing, and Tim wanted a balance — we shared a common goal and our discussions, though at times heated and lengthy, always ended with agreement.

After all the groups presented in the finals and we were waiting for the results, the three of us were remarkably calm. We all had a feeling of accomplishment, not from winning (we hadn’t heard the results yet!), but from putting together what we thought was a thorough and convincing stock pitch. Our feeling turned out to be spot on — we had won the competition and a prize of $25,000 to be used as a gift back to the School.

We took the responsibility of directing Mr. Ackman’s $25,000 gift very seriously. We agreed the money should be used to support both students interested in investing and students who will make a broader impact on society. We hope Mr. Ackman is pleased that the money will be going to scholarships for veterans returning from military service (as part of the Yellow Ribbon Program), a student with a focus on investing and community service, and to the Heilbrunn Center to support the value investing curriculum at Columbia Business School.

We would like to thank Bill Ackman for sponsoring the competition, the judges for taking the time to give us feedback, Erin Bellissimo and the Heilbrunn Center for supporting the competition and the class, professors Paul Sonkin ’95 and Caryn Zweig ’98 for their support in and outside the classroom, and all the mentors who took their personal time to help students and provide feedback throughout the semester.

Photo courtesy of the Heilbrunn Center

The debate over fair-value and mark-to-market accounting rules has quieted down in recent weeks but it is far from over. At the heart of the issue is this question: Are hard-to-value securities worth only what the market is willing to pay, or is the market too dysfunctional to set values in a meaningful way?

A new paper, “The Subject Matter of Financial Reporting: The Conflict between Cash Conversion Cycles and Fair Value in the Measurement of Income” published by the Center for Excellence in Accounting and Security Analysis, challenges some basic assumptions in the existing model for financial reporting. (The paper was reportedly circulated among the financial regulators responsible for the recent rule change.) Authored by Andreas Bezold, a former chief risk officer and deputy CFO/board member of a large German Bank, and reviewed by Professor Trevor Harris, the paper concluded that a clearer distinction between fair-value changes as information and fair-value changes as income is essential. The paper makes these key points:

•Business activity is the primary object of financial reporting, which is characterized as investing cash in non-cash resources to be combined according to a specific economic logic to generate future net cash flows. The production of net cash flows is the business activity in its entirety, not single non-cash resources or constructs like “net assets”.

•Different business activities have different business models based on a different economic logic and that the value of a non-cash resource to an activity depends on the way it contributes to the net cash inflows under the economic logic of the activity in progress, i.e. depending on its function and use.

•Accounting concepts and measurement attributes have to be aligned with the inherent economic logic of an activity if faithful representation is to be achieved.

Click here to download the complete paper (PDF).

Photo courtesy of CEASA

In an interview with Nightly Business Report on Monday, Dean Glenn Hubbard said that President Obama’s stimulus package gets positive marks for “stopping the free fall in the U.S. economy.” However, the dean also said that improving financial markets and institutions and changing the regulatory structure are key to economic recovery.

Indeed, the Committee on Capital Markets Regulation, which is co-chaired by Dean Hubbard, released its report on Tuesday. The executive summary outlines 57 specific recommendations for overhauling financial market regulations. The recommendations cover an extensive swath that includes credit default swaps, ratings agencies, accounting standards, hedge funds and international regulation (view the complete executive summary).

A few of the Committee’s recommendations:

13. Hold Large Institutions to Higher Solvency Standards

15. Maintain and Strengthen the Leverage Ratio

31. Prohibit or Restrict High-Risk Mortgage Products and Lending Practices from Entering the Securitization Market

38. Develop Globally Consistent Standards [for credit rating agencies]

42. Increase Disclosure as to How Ratings Are Determined

47. Refrain from Reimposing Glass-Steagall

50. Increase the Role of the Fed

51. Establish the USFSA [U.S. Financial Services Authority, an organization to “regulate all aspects of the financial system, including market structure and activities and safety and soundness for all financial institutions”]

56. Enable the IMF to Play an Early Warning Role

The question of systemic risk and how to prevent it has been at the fore since the crisis hit the markets in full force last year. Leading faculty and industry experts explored the issues at the Bernstein Center’s “Preventing the Next Financial Crisis” symposium held last December (download conference proceedings, PDF).

In February, professors Bruce Kogut, Patrick Bolton and Tano Santos also proposed the creation of a Crisis Resolution Board (see blog post). In a Forbes.com op-ed, the professors emphasized that “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.”

Photo credit: Joe Hatfield

	Brad Doppelt ’10, Brandt Blimkie ’10 and Darren Bounds ’10 proudly bearing their “partner” passes while waiting for the doors to open at the annual meeting.

I could have sworn I was at a rock show, not an annual meeting. Yet there I stood outside the Qwest Center in Omaha, Nebraska at 6 a.m. on a Saturday morning alongside 35,000 other excited fans waiting for the doors to open for the 2009 Berkshire Hathaway Annual Meeting.

The annual meeting’s “cowboy” theme this year couldn’t have been more appropriate. Our tickets branded us as “partners,” not shareholders. And when the doors finally opened, I found myself caught in a stampede for the best seats in the stadium. Never in my life did I anticipate that I’d be competing in an early morning foot race against agile seniors at 7 a.m. for a chance to listen to a pair of octogenarians speak for six hours.

Fortunately, I was traveling with another student who had attended before, and he was able to guide us through the crowd into seats ten rows off stage left, giving us a perfect sight-line for the Oracle. It was 7:15 a.m.

Opening Night

The night before, we attended a shareholders’ reception at Borsheim’s, one of North America’s largest jewelers, which Berkshire purchased in 1989. The store overflowed with partners proudly bearing their shareholder passes around their necks. At the reception, I met a family represented by three generations. The grandmother’s father had been approached by Warren Buffett in the 1950s to contribute $10,000 to his original partnership but he declined the offer. Another family had a similar story. Her father had also been approached by Buffett, but had told the young Oracle to come back when he was driving a nicer car than his own. The irony is that Buffet is probably still driving a worse car than the grandfather (Buffett drove a Lincoln Town Car until 2001, when he replaced it with a Cadillac DTS). I wondered how many others had similar stories. A simple lack of trust had cost these families literally millions of dollars.

After we left Borsheim’s, we ventured over to the local Dairy Queen (also owned by Berkshire). It was hosting a book-signing with authors who had written books on Warren Buffett, while a BBC film crew was there filming a documentary. After indulging my childhood sweet tooth with my favorite DQ Blizzard, I sat down and spoke with Bill Child about his book, How to Build a Business Warren Buffett Would Buy. Child, who inherited the company RC Willey from his father-in-law, built the operation into Utah’s largest furniture store. In 1995, he sold the company to Berkshire for $175 million after being introduced to Buffett by the owners of the Nebraska Furniture Mart (which, as you might guess, is also owned by Berkshire).

I asked Child how Buffett had assessed his company. He told me that Buffett had asked him why he was selling the company and what he intended to do after the sale, and then instructed him to send over three years of financial reports along with a brief history of the company. Within three days, Child had received an offer. It was significantly lower than the $200 million he had been offered by investment bankers and other furniture retailers, but Bill decided to accept the lower offer from Buffett. I was amazed that it took Buffett only three days to feel comfortable purchasing this company and to trust his investment with Bill Child. It takes me three days just to read an annual report!

“Disneyland for Investors”

Waking up on Saturday morning, even at 5 a.m., was remarkably easy. I jumped out of bed like a kid on Christmas morning. We arrived outside the Qwest Center an hour later and, after claiming our seats, decided to go explore the exhibition hall. Two friends stayed behind to guard our prized spots.

	Darren Bounds ’10 and the author pose with the Fruit of the Loom bunch.

The hall was filled with booths from Berkshire-owned companies, including Borsheim’s, Fruit of the Loom, Dairy Queen, NetJets, Justin Boots, See’s Candy and more. We had our pictures taken with the Fruit of the Loom “fruit” and the Dairy Queen mascot. Add in a Wall Street-themed roller coaster to parody the ups and downs of “Mr. Market” and the annual meeting would have resembled a Disneyland for investors, or maybe a Star Trek convention. But instead of speaking in Klingon, people used words like “margin of safety,” “intrinsic value” and “moats.”

“Those Dilly Bars look good,” said Warren Buffett, as he walked through the crowd. “I should get one.”

As we wandered the hall, I noticed a press circle moving toward us. Before I knew it, Warren Buffett was walking directly toward me. In fact, I was in his way. I came face-to-face with my idol and froze completely, like a deer in headlights. Would security jump on me if I said hello and reached out to shake his hand? I decided to smile and politely step aside. “Those Dilly Bars look good,” he said pointing to a member of the crowd as he walked by. “I should get one.”

We returned to our seats, eager to finally hear him speak. The morning began with a one-hour video montage of commercials for the companies Berkshire owns and a few short satiric skits. In one clip, Buffett pretends to be Tiger Woods’s caddy. In another, he sells a mattress called the Nervous Nellie to a customer in the Nebraska Furniture Mart. The mattress had a compartment to store money, Berkshire shares and old magazines.

The rest of the meeting followed a question and answer format. Questions alternated between those from audience members and those submitted in advance by journalists from Fortune, CNBC and the New York Times. The questions covered a range of topics, including the improvement of financial literacy, Berkshire’s exposure to derivatives, Buffett’s view on the government bailout, the threat of inflation and Berkshire’s investment in Chinese battery maker BYD. The entire time Buffett and his partner, Charlie Munger, drank Cherry Coke, ate See’s fudge and looked happier than two kids in a sandbox. The Q&A period broke for a half-hour lunch and then resumed.

Tough questions for Berkshire

	Kiewit Plaza is home to the world headquarters for Berkshire Hathaway.

The most intriguing questions were the ones that Buffett didn’t really answer. Who was in line to replace him as CEO and head investor? There were three candidates for CEO and four for CIO, he said, but he didn’t give any names. Why does he hold Wells Fargo stock? If he could only invest in one company, he replied, it would be Wells Fargo, but he never said why. How does he evaluate and incentivize managers? That was a great question. “We don’t want relationships that are based on contracts,” he responded.

Charlie Munger added, “Our model is a seamless web of trust that’s deserved on both sides. That’s what we’re aiming for. The Hollywood model where everyone has a contract and no trust is deserved on either side is not what we want at all.” Buffett cited Peter Kiewit’s contracts (Kiewit founded Omaha’s largest construction company) as an example, without specifying what those contracts entailed.

By 2 p.m. we were all getting fidgety. I didn’t want to miss a word, but my legs were beginning to cramp. I had to get up and walk around. I couldn’t believe these two men could sit there for so long in such comfort with no break. At 3:30 p.m. the Q&A period ended and the formal annual meeting began, whereupon the board of directors were reelected by majority vote.

During the meeting, a shareholder put forth a motion requesting Berkshire to produce a sustainability report. This was my first exposure to the criticisms levied against one of Berkshire’s subsidiaries. According to the shareholder’s representative, there were allegations of labor violations at a Russell Athletics factory in Honduras. These allegations have caused several Ivy League schools, including Columbia University, to discontinue their use of Russell Athletics. The representative then passed the microphone to a worker from the factory in Honduras. She spoke for ten minutes in Spanish about the cramped workspace, long hours with few breaks and anti-union activity. Following her testimony, Buffett asked the CEO of Russell Athletics to respond. The CEO outlined the actions they had taken to improve conditions, and how a non-partisan labor rights group had been invited to monitor and evaluate the conditions. The motion was put to a vote and defeated.

Graham and Doddsville

After the meeting concluded, we walked over to a Columbia Business School reception hosted by the Heilbrunn Center for Graham & Dodd Investing. Professor Bruce Greenwald, Tom Russo of Gardner Russo Gardner, and Adam Weiss of Scout Capital shared their thoughts on the meeting and the enduring relevance of Benjamin Graham and David Dodd’s seminal 1934 text, Security Analysis.

To illustrate this point, Weiss cited passages warning of the dangers presented by over-levered institutions. Russo explained how his best investments had come from companies that had grown in value and benefited not only when the market recognized their intrinsic value but also when the company grew and its multiple increased. Professor Greenwald shared his perspective on the questions that Buffett opted not to answer completely. Why was Wells Fargo different from most other banks? Because it focused on local economies of scale, Greenwald said. Unlike other banks, Wells Fargo had concentrated its growth in the west (similar to See’s Candy) rather than spread itself across the country like other banks. What made Buffett’s contracts unique? They incentivized managers to not only pursue growth but to achieve profitability.

Following the reception, we made our last stop of the day. We drove to Berkshire’s legendary Nebraska Furniture Mart for a western BBQ cookout. I was expecting a large warehouse like Costco and was shocked when we arrived. At 77 acres, the Mart was not only larger than eight Costco warehouses laid side-by-side, it probably had its own zip code. Talk about local economies of scale!

A View on Trust

	Blimkie, standing outside Buffett’s house in Omaha, says the lack of a fancy security gate is one way Buffett demonstrates his trust.

On the way to the airport the next day, we drove by Buffett’s house and Kiewit Plaza, Berkshire’s headquarters. They are only a ten-minute drive apart, and you can easily picture Buffett skipping into work. Buffett owns a gorgeous brown house with a barn-style roof. It certainly was not the palace you would expect one of the world’s richest men to own. But what surprised me the most was the lack of a visible security presence. No fence. No moat. Just trust. I realized that if there was one underlying theme to the weekend, it was the value of trust.

After all, how valuable is a partner if you can’t trust him? Unlike some of the family members I met, Buffett’s original partners trusted him with their hard-earned money. Buffett, in turn, has held that level of trust in the managers of every company he has ever owned. He trusted Russell Athletic’s management to make the right decisions in Honduras. He trusted Bill Child to continue to run RC Willey exactly the same way after he bought the company. He trusted all of his managers and that partnership manifested itself as stable, predictable cash flows.

But trust is not something that appears explicitly in a P/E ratio or a discount rate. It’s not something you can model in an excel spreadsheet. And it’s certainly not something that can be quantified in a contract. This presents amateur investors like me with a challenge. If trust is so important, how do we decide whom to trust — and how to value it? I suppose that is the art of investing. After all, Benjamin Graham did not title his second book The “Value” Investor, but The Intelligent Investor. Those who recognize the additional margin of safety that trust bestows would be intelligent to follow Buffett’s lead. Trust is certainly a concept that holds enduring relevance, as Buffett’s 35,000 adoring “partners” can attest.

Brandt Blimkie ’10 is the incoming co-president of the Investment Management Club.

Photos courtesy of Brandt Blimkie ’10.

This past Monday, President Obama announced a series of proposed changes to the tax code. The changes include a reform of a long-standing tax deferral for multinational companies on revenue drawn from their foreign operations, a permanent extension of an R&D tax credit and a curb on offshore tax havens.

Professor Andrew Schmidt says the Obama administration hopes that the overall effect of the proposed corporate tax code changes results in a shift of more investments to the United States by effectively minimizing the incentive for foreign growth and improving resources for R&D in the U.S.

“The idea is that eliminating the tax deferral will drive up [companies with foreign operations’] tax rates and potentially curb the incentives to invest overseas. The result could be reduced investment in foreign operations as firms may have less cash to expand plants or factories,” says Schmidt.  “The revenue raised by eliminating the tax deferral would then be used to permanently extend the R&D tax credit, which would encourage firms to make some of these investments in the U.S. instead.”

He adds, “The R&D credit was a temporary provision and was re-upped every few years when it was about to expire. By making it permanent, firms can rely on that subsidy and not wonder if it will expire. This will be a big deal to certain industries, like Big Pharma, which has heavy R&D.”

On the issue of curbing tax offshore tax shelters — a political hot potato — Schmidt says that one effect would be a reduction in the tax gap, which according to the most recent figures from the IRS (fiscal year 2001) is between $312 and $353 billion.

Listen to an interview with Professor Schmidt on WNYC.

Photo credit: kalavinka

Nearly 35,000 people — including a group of students from Columbia Business School — descended on Omaha this weekend for the Berkshire Hathaway Annual Meeting. This year’s gathering — commonly known as the “Woodstock of Capitalism” — was under especially close scrutiny after the company’s net worth shrank by 9.8% in 2008. However, according to Professor Bruce Greenwald, those losses are somewhat “fictitious” over the next five to seven years. Greenwald, gave his view on Buffett’s annual letter on CNBC on March 2 (see video), says that Berkshire Hathaway did “surprisingly well” in a tough environment on the investment side.

But what lies at the core of Buffett’s investment strategy?

In an article written in 1983 for Hermes, and republished this year in celebration of the 75th anniversary of Security Analysis, Warren Buffett ’51 profiled nine “superinvestors.” In his own words, Buffett describes the investment principles that so heavily influenced him:

The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market. Essentially, they exploit those discrepancies without the efficient market theorist’s concern as to whether the stocks are bought on Monday or Thursday, or whether it is January or July, etc. Incidentally, when businessmen buy businesses, which is just what our Graham & Dodd investors are doing through the medium of marketable stocks — I doubt that many are cranking into their purchase decision the day of the week or the month in which the transaction is going to occur. If it doesn’t make any difference whether all of a business is being bought on a Monday or a Friday, I am baffled why academicians invest extensive time and effort to see whether it makes a difference when buying small pieces of those same businesses. Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value.

Keep reading the complete article in the Spring 2009 issue of Hermes, or download a PDF of the original here.

As with nearly every facet of the economy in the past year, family wealth has had its share of financial setbacks.

An April 2 report in the Economist estimated that the financial crisis has created a loss of more than $10 trillion worldwide for high-net-worth individuals. And the collective shudder that results from the mere mention of the name Madoff suggests that this is more than a financial crisis — it’s a trust crisis.

Family Wealth Management, a new Executive Education program launched in partnership with the Heilbrunn Center for Graham & Dodd Investing, is designed to specifically address some of the unique challenges facing families with large and complex investment portfolios.

“If people had asked more specific process and operational questions of Madoff, they wouldn’t have invested with him,” says Professor Bruce Greenwald, the program’s faculty director. “We see an opportunity to bring the principles of value investing to families. People will better understand what their money managers are doing, and because it’s their own money they have the most incentive to listen.”

For families who take an active role in investing, the first step is learning the basic framework of sound capital management.

“The Graham and Dodd approach is, we believe, the most sustainable and long-term strategy for investing,” Greenwald says. “If you’re thinking about a family that wants to preserve wealth over many generations, you want to look where there is limited impairment of capital and some upside that isn’t just market swing.”

The four-day course, which begins in May, will cover the framework of value investing, how and what questions to ask, and even behavioral economics.

“The Family Wealth Management program helps families understand what the process is about before they put their family assets at stake,” Greenwald says.

Photo courtesy of Columbia Business School

The SEC announced on April 8 that it is considering reimposing the uptick rule to limit short selling. The old uptick rule prohibited short sellers from trading in a stock at a price lower than the most recent reported transaction. The concern was that without an uptick rule, short sellers might manipulate a stock by selling aggressively and repeatedly, driving stock prices below fundamental value. The SEC has now proposed five different types of possible rules for comment.

Professor Charles Jones says that while a resurrection of the rule will likely reverse the increase in shorting activity that occurred after the rule was repealed in 2007, its impact will be limited.

“No matter what new rule the SEC chooses, it will be a reversal of what we saw in 2007 when they took it off, and we will see modest effects,” says Jones. “It won’t magically raise stock prices. We will see a modest decline in the amount of shorting, but I don’t think it will be more than a minor nuisance for long-term, fundamental shorts.”

Jones’ research (PDF) on the July 2007 repeal of the uptick rule showed that there was a slight increase in shorting after the repeal. However, Jones says that the bout of market volatility that occurred in August 2007 was not related to the repeal.

“A lot of people think that because the volatility episode was so close on the heels of the repeal the two were related in some way,” says Jones. “But there are two problems with that. First, it didn’t happen right away. The volatility was in August, a full month after the uptick rule was removed.

“Second, when we dig in and look at what happened in that volatile period, it doesn’t look like the short sellers are to blame,” he says. “We have detailed, proprietary data from the exchanges on all shorting activity. They are not piling on stocks that went down. It doesn’t look like they are conducting bear raids or being abusive or pushing prices around in any way. When all is said and done, it doesn’t look like shorts were contributing to this volatility in any way.”

Photo credit: kevingessner

If you’re in the market to beef up your investment portfolio — and have the stomach to ride the Dow roller coaster — Andrew Ang, professor of finance, says to follow this checklist before you decide to buy or sell.

1) Know your risk tolerance
This seems obvious. If you’re very risk averse, don’t hold a lot of risky assets. Unfortunately, a lot of people have learned the hard way that they overestimated their risk tolerance. Equities fell in 2008 by a lot — around 50% worldwide. You need to be very comfortable with the proportion of risky asset holdings and then stick to this. Making adjustments to your portfolio right now by selling equities could be one of the biggest mistakes you can make. You don’t sell stocks when stock prices are really low and future-expected returns are very high.

2) Diversify widely
The large negative returns that have occurred in many asset classes doesn’t mean that diversification has failed. In fact, it’s quite the contrary. If, like James Barrow, you bought 10% of Bear Stearns in 2007, you would have lost close to everything. He would have been much better off buying the S&P 500. Similarly, if your employer allows you to buy company stock, don't build up a large position. Your salary comes from that firm, and you add to that risk by having savings in that same firm. Buy the S&P 500 or something else instead. Diversification means not bearing the specific risk of an individual firm. Diversification also means recognizing your investment property in the Hamptons looks a lot like your equity portfolio.

You want to diversify widely. Hold many different asset classes. In 2008, Treasuries were one of the few asset classes to increase in value. If you didn’t hold them, you missed out. Note that diversification doesn’t mean that owning many different asset classes will shield you from many of those asset classes having simultaneous downturns, which we’ve seen over the last few months. Diversification doesn’t guarantee this. If you’re uncomfortable bearing risk, see (1).

3) Rebalance regularly
Every year, or at some regular interval, rebalance your portfolio. Suppose you hold 60/40 equities and bonds. At the end of the year, if equities increase relative to bonds, you sell equity to buy bonds. After 2008, you bravely buy equities and sell bonds. Rebalancing is inherently contrarian. You buy assets with declines in prices and pare back your exposure to assets with increases in prices. An investor doing this from 2001 to 2007 would have sold equities and bought bonds almost every year. If you didn’t do this, your portfolio by the end of 2007 would be heavily weighted into equity and you would be bearing enormous equity risk. Rebalancing tempers that risk and makes sure you are bearing only as much exposure to risky assets as you can tolerate.

4) Save, save and save
There is no such thing as a free lunch. High returns only come with high risk. For saving towards retirement, you must save, save and then save some more.

5) Keep your costs to a minimum
Avoid active mutual funds and other active management like the plague. The average active mutual fund loses money. Hold index funds instead. Keep things simple. Structured assets simply chop up positions of underlying assets with leverage and charge you a lot of money. Minimizing costs means you get to reinvest more and that means more money for you at the end.

Photo credit: Bill S.

Mark-to-market currently requires banks to reprice their balance sheet assets each day based on the assets’ open-market value. Banks claim that the rule is forcing them to unfairly mark down the value of their assets, such as their mortgage-backed securities. Supporters of mark-to-market say that it creates more transparency.

While some investors are putting a bullish spin on the news of the possible rule adjustments, Floyd Norris ’83 has a much more skeptical view. In his Friday column in the New York Times, Norris writes, “Sadly, a victory for the bankers would not help them much. Even if it were true that banks would be held in higher regard now if they had not been forced to write down the value of their bad assets — and that is, at best, debatable — changing the rules now would be counterproductive. Would you trust banks more? Would other banks be more inclined to trust banks?”

In an interview earlier this week, Warren Buffett ’51 came out in favor of suspending the mark-to-market accounting for regulatory capital purposes.

Appearing on CNBC’s The Kudlow Report on Wednesday, Senior Vice Dean Chris Mayer offered his thoughts on the issue. “The problem is, ‘What are the write-downs that are still sitting in the system?’ The continued critique of mark-to-market is that the current values are just based on illiquidity and they’re low. But we have not seen the bottom of the economy, so I don’t know how anyone can say the values are too low.”

This post contains an update.

The notion of getting a “bailout” has, by now, become embedded in American culture, emboldened no doubt by unprecedented federal support for troubled companies like AIG. So far the rationale has been to protect companies that are “too big to let fail.” There are some things that are “too small to let fail,” too — the young enterprises which are the entrepreneurial backbone of our economy.

As Americans, we hold our tradition of entrepreneurship dear. Decades of growth have been fueled by innovators and have spawned entirely new industries, high-value jobs and stock market gains. Yet one result of the financial crisis is that the current wave of these innovations will inevitably be slowed — or withheld from us as consumers, investors and perhaps even employees entirely — by the lack of adequate investment sources.

Many of these companies are now facing serious cash shortages and some outright failure, not for lack of entrepreneurial promise but for lack of dependable funding from venture funds. These budding enterprises are typically underwritten by venture funds that invest in young, high-potential companies and hope to see a return as the companies mature. But these funds are experiencing a capital drought of their own. Their principal investors, high-profile pension funds and endowments, are reeling from losses, markdowns and greatly diminished equity portfolios. As a result, some institutions are beginning to retrench on honoring capital calls and rethink their commitment to the investment category including venture capital.

Additionally, the lack of a viable IPO market is a difficulty. Public markets are a crucial capital source for these enterprises and an exit for the venture funds. Today, there is no viable public market access and none is likely soon.

Some inappropriate ventures will fail, but many could succeed. Those that do offer the promise of many desirable attributes — new technologies, new products and new efficiencies — all nice things to have on an accelerated timeframe in an economic downturn. There is also job creation, economic activity and perhaps an exciting story or two to breathe some life back into the IPO markets in the not-too-distant future.

I suggest that we place a few stimulus chips on the best of these young and soon-to-be cash-starved enterprises, rather than bet everything on outdated industries or new infrastructure. An agency could consider taking over venture fund commitments from legitimately cash-constrained institutions or making “side-car” investments alongside venture funds with promising investments. Meaningful taxpayer protections are not that difficult to devise, and the benefit is injecting some fiscal acceleration into this important entrepreneurial sector. Further, with the right kind of protections, a taxpayer might get a decent return on their invested tax dollar.

No jets full of entrepreneurs or venture capitalists are flying (or driving) to Washington to make the case for this particular form of stimulus. But think about it for a moment: in a few years, would we be better off with some of our tax dollars invested in a few years’ vintages of U.S. entrepreneurs, or in Detroit or a bridge?

UPDATE: PricewaterhouseCoopers reports “first-time financings dollars dropped in the fourth quarter to $1.1 billion, down 28 percent from the prior quarter, the lowest level invested since the first quarter of 2004. The number of companies receiving venture capital for the first time in the fourth quarter also dropped by 17 percent from the prior quarter to 236, the lowest number in three years.” (View Q4 / Full Year 2008 MoneyTree Report, PDF)

Photo credit: D.B. Blas

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

Treasury Secretary Timothy Geithner unveiled the government’s revised economic plan yesterday. From pundits to economists, response to the plan was lukewarm at best. Professor Charles Calomiris reacted to the Treasury’s announcement by saying:

I have serious problems with the plan. It will move much too slowly and not have a dramatic enough effect. The architects of the plan have added some good ideas, but their concerns to make sure that the taxpayers get a good deal have gone too far, to the point where the package may do little for the banks or the economy, which makes the bill penny wise and pound foolish.

In an interview with BusinessWeek, Calomiris said the plan emphasizes “very careful investments over a period of time with a lot of upside potential for taxpayers, and with all sorts of limits on what bankers can do.” One way he suggested that the plan could be improved was to guarantee banks a floor prices on their real estate assets.

Professor Chris Mayer offered his thoughts on CNBC’s The Kudlow Report (watch video):

“This is perpetuating a broken system… It’s not a good model and we shouldn’t be trying to fund a trillion dollars of it.”

Professor David Beim also commented on aspects of the plan on Forbes.com:

[Beim] estimates the potential losses to banks from the credit crisis at between $1 trillion and $2 trillion, an enormous capital hole that the government needs to find a way to fill, since private investors don’t appear willing to do so anymore.

“They're going to have to find a way to do that. Banks themselves don’t know if they are insolvent because they don’t know the value of their assets. It's a very odd situation,” Beim said.

Photo credit: Treasury Department

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

Models pose a paradox. They hold the key to extraordinary profits but can inflict destructive losses on a bank. Because a model entails a complex perspective on issues that are typically fuzzy and ambiguous, they can lock traders into a mistaken view of the world, leading to billionaire losses. Can banks reap the benefits of models while avoiding their accompanying dangers?

Our research suggests they do, and shows how. We conducted a sociological study of a derivatives trading room at a large bank on Wall Street. The bank, which remained anonymous in our study, reaped extraordinary profits from its models — but emerged from the credit crisis unscathed. For three years, we were the proverbial fly on the wall, observing the traders with the same ethnographic techniques that anthropologists used to understand tribesmen in the South Pacific. We identified a set of managerial procedures, which we call “reflexive modeling,” that lead to superior model development. (View the complete study)

The key to outstanding trades, we found, lies outside the models. It is a matter of culture, organizational design and leadership. The bank that we observed introduced reflexivity in every aspect of its organization. From the junior traders to the supervisors, everyone at the bank was ready to question their own assumptions, listen for dissonant cues and respect diverse opinions.

How? As many have already suggested, individuals certainly matter. The bank hired people with a healthy dose of humility and an appreciation for the limits of their smarts. This often meant opting for older traders rather than younger hotshots.

But the key to the bank’s reflexiveness did not just lie in individuals. By reflexiveness we don’t mean super-intelligent traders engaged in some heroic mental feat, splitting and twisting their minds back on themselves like some intellectual variant of a contortionist. Reflexivity is a property of organizations.

The architecture of the bank, for instance, was crucial. The open-plan trading room grouped different trading strategies in the same shared space. Each desk focused on a single model, developing a specialized expertise in certain aspect of the stocks.

To see why this was useful, think of a stock as a round pie. Investors on Main Street often eat the pie whole, with predictably dire consequences. The professionals that we saw, by contrast, sliced stocks into different properties. Each desk was in charge of a different property, and the different desks then shared their insights with each other. This could happen in a one-minute chat between senior traders across desks or in an overheard conversation from the desk nearby. This communication allowed traders to understand those aspects of the stock that lay outside their own models — the unexpected “black swans” that can derail a trade.

Sharing, of course, is easier said than done. The bank made it possible with a culture that prized collaboration. For instance, it used objective bonuses rather than subjective ones to ensure that envy did not poison teamwork. It moved teams around the room to build the automatic trust that physical proximity engenders. It promoted from within, avoiding sharp layoffs during downturns.

Most importantly, the leadership of the trading room had the courage to punish uncooperative behavior. Bill, the manger of the room, made it abundantly clear that he would not tolerate the view, prominent among some, that if you’re great at Excel, “it’s OK to be an asshole.” And he conveyed the message with decisive clarity by firing anti-social traders on the spot — including some top producers.

In other words, the culture at the bank was nothing like the consecration of greed that outsiders attribute to Wall Street. We refer to it as “organized dissonance.”

Our study suggests that a lack of reflexivity — that is, the lack of doubt on the part of banks — may be behind the current credit crisis. We are reminded of infantry officers who instructed their drummers to disrupt cadence while crossing bridges. The disruption prevents the uniformity of marching feet from producing resonance that might bring down the bridge. As we see it, the troubles of contemporary banks may well be a consequence of resonant structures that banished doubt, thereby engendering disaster.

This blog post was coauthored with Professor David Stark, chair of the Department of Sociology at Columbia University and author of The Sense of Dissonance (Princeton University Press, 2009). Please visit Professor Daniel Beunza’s blog Socializing Finance to learn more about his research on the social studies of finance.

Photo credit: Daniel Beunza

Transforming market uncertainty into opportunity is the theme of the 15th Annual Private Equity and Venture Capital Conference, which is taking place at Columbia Business School today. More than 700 people are expected to attend the conference’s six panels.

Dan Primack, editor of PEHub and moderator of the conference’s panel on venture capital, said that one of the questions the panel will address is how the weak IPO market affects the basic model of VC. Primack said that VC must consider these questions:

How they will honestly make money without an IPO market?
Can VC make money without an IPO market?
Do you make different types of investments without an IPO market?

“The average investor’s chances of making of money would have been better if he’d put his money under the mattress. That may be true of public markets, too, but you can’t liquidate in VC. All those median funds are a loser,” Primack said. “That shows you that the industry has some fundamental problems and there must be some considerations to radical proposals.” (He recently blogged about one such proposal.)

David Snow, the executive editor and director of PEI Media, who is moderating a panel on how LPs can think long-term in the volatile market, discussed some of the trends he sees.

“Negotiating power has moved squarely to the LPs. During the boom years, right up through 2007, there was a sense that GPs were holding a velvet rope in front of funds and raising billions in commitments while giving the impression that they were turning down extra demand. That demand from LPs allowed GPs to receive favorable terms,” Snow said.

“Now there’s far less capital available and many signs that partners are willing to concede on some terms in exchange for capital from LPs. But many LPs are heartbroken because first, they wish they had more money to commit, and what’s more, many experienced investors are aware that the best time to invest is during a recession. The inability of LPs to do more buying is causing grief and heartache. So you see huge activity in the secondaries market, as many LPs are trying to free up cash to double down in this environment.”

Snow said he would ask panelists about the role of the accounting rule FAS 157 in private equity, which requires the use of fair-value accounting.

“I’ll ask if, because of FAS 157, LPs would be perturbed if GPs assigned huge write-downs to existing portfolios,” he said. “Of course, the silver lining may be that write downs in private equity might allow LPs to invest more capital, because lower private equity valuations will equate to freed-up private equity allocations relative to the rest of the institutional portfolio. Are LPs with a long-term view on performance begging GPs to write down portfolio values?”

Professor Frederic Mishkin, a former member of the Board of Governors of the Federal Reserve System, met with students yesterday in a community forum to present his view of the current financial crisis. Framing his analysis in the historical context of the Great Depression, he said that many elements of the current crisis were “classic” and that they inspired a sense of “déjà vu.”

“The basic issue is that financial markets are the brain of the economy,” Mishkin told the students. “They are key to an economy functioning well because they help allocate capital to productive investments. But when financial systems stop working and they can no longer allocate capital, we see what is happening now.”

“A basic problem in allocating capital is asymmetric information … It’s an agency problem. What happened in this financial crisis, and in financial development, is new financial innovation, which in the long run is a very good thing,” he said. “The innovation was driven by a couple of features, technology and high-speed computers. This allowed you to do two things: cheaply bundle small loans into a security, so there were low transaction costs, and get information on people and their credit worthiness in a quantitative manner.”

“This allowed you to democratize credit and give credit to people who otherwise wouldn’t have gotten it, and then put those loans into a security and sell it off. A lot of people would like to see subprime lending never happen again but that would be a disaster. It is a real danger that regulation could kill off this market because it is something that, if it’s done right — which it easily can be — is a tremendous benefit to the average person who couldn’t access credit before.”

“But the problem is that sometimes you don’t solve all the information problems,” Mishkin continued. “Although there were all these benefits, maybe people didn’t have the right incentives to pay back [the loans] … Incentives were not aligned with those of the holder of the security.”

“We also had a huge flow of liquidity come in; poor countries were providing capital to rich countries, [like China to the United States],” he said. “As a result we had this global savings glut and huge inflows of liquidity. This, combined with the financial innovation, made the system go wild. Also what you see — and this is classic — is that when you have innovation and a burst of liquidity [together], you frequently have an asset bubble. And in this case it was in the real estate market.”

Photo credit: Randen Pederson

The application of business research provides a critical link between theory and practice. As Dean Glenn Hubbard recently told faculty members at Columbia Business School, over the coming year the world’s financial turmoil will present an opportunity for research and innovation. He challenged the faculty members to frame their research in these terms:

1. How can we address problems and opportunities posed by globalization?

2. How can we design the most efficient provision of financial services (in matching savers and borrowers, and providing risk-sharing, liquidity, and information services)?

3. How should we conceptualize strategy and high-level business decision-making?

What areas of research would you like to see developed this year? How will you frame your organization’s thinking and goals in 2009?

We would love to hear your thoughts. Please leave your comments.

As 2009 begins, the economic lessons learned during the financial crisis will quickly be put to the test. Participants in the recent research symposium, “Preventing the Next Financial Crisis: Lessons for a New Framework of Financial Market Stabilization,” which was hosted by the Sanford C. Bernstein & Co. Center for Leadership and Ethics, provided a look at some of the issues and trends that will shape the year ahead:

Monetary policy is still effective, said keynote speaker Professsor Frederic Mishkin. “I think it’s an absolute fallacy that monetary policy isn’t effective during a financial crisis. It’s just plain wrong.”

Bankruptcy should be an option, because it allows for speedy work outs, argued Professor David Skeel of the University of Pennsylvania Law School. “The problem is that if you address one form of moral hazard [with a bailout], you create another. With Bear Sterns the Fed addressed shareholders’ moral hazard, but [in doing so, it] created creditor moral hazard. That is why, I argue, firms like Lehman didn’t do a lot to try and change their balance sheets after the Bear Sterns collapse,” he said.

Regulatory process will undergo a major overhaul in 2009, said Dean Glenn Hubbard. Many panelists agreed that the systemic risk of trillion dollar markets, such as those for credit default swaps, is too great and that such instruments should be traded in regulated clearinghouse exchanges.

The price of homes must be bolstered, said Senior Vice Dean Chris Mayer, who, with Dean Hubbard, has designed a proposal to stabilize the housing market by guaranteeing a 4.5% interest rate for American homeowners. According to Mayer and Hubbard’s calculations, this would allow Americans to refinance their homes, yielding an average monthly savings of $350.

Financial literacy is poor amongst the poor. Data presented by Professor Stephan Meier about financial literacy showed that 30% of people with adjustable rate mortgages do not know that they have them. This percentage is fairly descriptive of all income groups, however Meier said that it is highest among the poorest.

On September 19, the SEC issued an emergency order to suspend short selling. The ban lasted until October 8, a few days after the U.S. Treasury’s $700 billion bailout plan was signed into law. Professor Charles Jones, chair of the Finance and Economics Division, used the rare suspension to measure the ban’s effect on stock prices. According to preliminary research Jones conducted with colleagues, which he recently outlined in an Ideas at Work article, stocks protected by the ban experienced only a temporary price bump and had their market liquidity degraded. That result, says Jones, should not have been surprising given the historical precedent.

“We want all kinds of information to be part of a stock price, including positive information, negative information, optimistic views and pessimistic views. That’s the way we get the best prices, if they reflect all the information that’s out there. Short selling gives a way for people to trade based on that negative information or opinion,” Jones says.

“But when prices fall dramatically, this kind of ban gets trotted out. There are a lot parallels with 1931 in terms of what we’re doing to harass short sellers. The last time there was a ban was in September 1931 during the Great Depression. The ban was put in place after stock prices had fallen by two-thirds. It was a two-day experiment and it went badly. We don’t repeat history, but it certainly does rhyme, like Mark Twain says.”

“During the three weeks of the ban [in 2008], stock prices cratered, falling by about one-third. Financials fell even more, completely reversing their initial gains,” says Jones. “Even more troubling was the ban’s effect on market liquidity. Stocks subject to the ban suffered a severe degradation in liquidity, as measured by bid-ask spreads.”

For the complete article about Jones’s preliminary research and data on the short selling ban, see “Assessing the Shorting Ban” in Ideas at Work.

It’s Monday again, and in what has become a too-familiar weekend drill, major financial institutions — Lehman Brothers and Merrill Lynch — failed to emerge in their last-Friday form. And Lehman’s bankruptcy and Merrill’s takeover have important lessons for policymakers.

Lehman’s demise as one of Wall Street’s oldest and most well known independent firms comes on the heels of the forced sale of Bear Stearns to JPMorgan Chase, the government’s “conservatorship” of Fannie Mae and Freddie Mac, and now Bank of America’s acquisition of Merrill Lynch. Just two Wall Street titans remain.

The Treasury and the Fed have been aggressive. The “blank check” power given to the Treasury by Congress has provided taxpayer support of unknown size to mortgage giants Fannie Mae and Freddie Mac. The Fed’s rush of liquidity injections reflect Walter Bagehot’s classic Lombard Street advice “to lend freely.” And lend freely it has, with extraordinary liquidity provisions — through a more attractive regular primary credit program, the Term Auction Facility, the Term Securities Lending Facility, and the Primary Dealer Credit Facility. Borrowers include banks, investment houses, Fannie and Freddie and, now, AIG. The credit risk on the Fed’s balance sheet will be borne by — you guessed it — the taxpayer.

Now the Treasury and Fed should not ignore systemic risk just to limit moral hazard. But all of this firefighting has left us with problems remaining. Additional write-downs are coming. We cannot and should not try to protect every institution.

But, stepping back, there are steps we should take. To limit the further spread of real estate woes to the broader economy, expanded FHA authority for mortgage refinancing can make sense. In addition, putting in place a clean-up agency like the 1930s’ Homeowner’s Loan Corporation or the 1980s’ Resolution Trust Corporation would help. Taxpayer funds used to support such vehicles offer more stimulus and stabilization than temporary tax cuts or public spending.

The financial meltdown that engulfed Lehman and the uncomfortable responses of policymakers the past several months also highlight the need for regulatory reform. The problem is actually not too little regulation — both lightly and heavily regulated institutions are in trouble. And some regulations encouraged the growth of high-risk mortgage lending.

We do need smarter regulation: a key step is to broaden capital and liquidity requirements and increase them during financial booms to lean against excessive risk-taking.

The events of the past three years highlight that risk misperceptions in a boom can lead to a scramble for liquidity if collateral values decline. Ascertaining this problem in real time will always be tough for regulators (even for the increased number of regulators the Treasury recently proposed).

Bagehot picked up on this, too. His admonition goes on to say: “The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times.” That is, regulation of capital adequacy could require more capital to support incremental risk-taking in a boom and lower such capital in a bust. With such requirements, financial institutions would find risk-taking marginally more costly in a credit boom, in which credit risk and liquidity risk are very low. In a downturn, a scramble for liquidity to meet capital requirements would be attenuated.

While strong supervision obviously remains important, this other advice from Bagehot would be an important addition to the policy tool kit. This could be implemented by raising banks’ capital requirements proportionately as risk-weighted bank assets grow. By varying capital cushions over credit cycles, consequences of risk distortions for actual lending and borrowing decisions will be reduced, along with the likelihood of asset fire sales and extraordinary central bank liquidity provisions.

I hope Secretary Paulson will be able to take Chairman Bernanke on one of his famous bird-watching expeditions next weekend.

This column also appeared on Forbes.com.

Photo credit: T. Shein

Dean Glenn Hubbard met with students in a town hall meeting on December 2 for a discussion on the state of the U.S. economy and career prospects for MBA students. The forum coincided with news from the National Bureau of Economic Research that the U.S. has been in a recession since last December.

A relatively deep recession will last through the middle of next year, predicted Dean Hubbard. He also discussed actions to bolster the economy, including fixing short-term lending, recapitalizing banks and stabilizing housing prices (see his plan developed with Professor Chris Mayer).

Dean Hubbard also voiced some optimism and pointed to market opportunities, including fixed-income securities. “The most senior secured loans,” he said, “are yielding 17-18%. The refinancing in commercial real estate that is likely to happen will yield huge returns.”

The Dean emphasized that MBAs entering the job market focus on where they want to be in five to seven years. He urged graduates to pursue activities and skills that will gradually advance them up their career ladder.

Looking forward to next year, Dean Hubbard said, “2009 is going to look a lot like 1933.” In that year, a newly elected president Franklin Roosevelt took office in March and enacted a series of government measures which restored, at least temporarily, confidence in the shaken banking system. The year marked the end of a recession that lasted from 1929 to 1933, according to the NBER.

With Security Analysis, Graham and Dodd laid out a superb analysis that has stood the test of time. But their prescription for risk management was to say, “Buy bonds.” In their time, when they looked at the overall economic environment and at risk properly defined, bonds were where they saw methods and opportunities to control risk. Today, value investors think about managing risks in more sophisticated ways.

One of the real lessons of Graham and Dodd is that you had better understand the determinants of cash flows, you had better understand companies and industries, rather than just taking a historical average and slapping a multiple on it. And you had better understand when a company’s superior returns are going to be sustainable in the face of the relentless force of competition.

Graham and Dodd were aware of that, but in their world they didn’t see any chance of resisting that relentless force of competition — that if a company produced 20–30 percent returns on capital, five or 10 years later those returns were going to be gone. We have a more sophisticated view of which business models are likely to survive, of why it is that Coke produced superior returns for more than 100 years whereas other firms have produced those returns for short periods of time (notably the Internet-based industries).

So the first lesson we can take from today’s value investors: understanding sources of competitive advantage in a sophisticated way is a discipline that has advanced far beyond what Graham and Dodd envisioned. That means you can look at cash flows in ways that you never could before and think about risks you are exposing yourself to when you pay eight or nine times those cash flows, which could evaporate. Understanding the business models that fell apart and those that didn’t is very much a lesson in risk management.

The second lesson is something I’ve learned more recently by listening to other value investors: be good at buying insurance and formal risk management. As we’ve experienced in the past year, there are always events that can come out of left field. Begin to do active risk management so that you have a portfolio of good companies at good prices and are protected from the fallout.

This doesn’t mean trying to outguess people in forecasting the economy. What risk management means is having a sense of when there are macro vulnerabilities and when there are vulnerabilities in the market because of people’s bizarre attitudes toward risk. About a year before the LTCM bailout in 1998, I was offered a job by one of LTCM’s senior people. He proclaimed that risk was just going away, that it ultimately was going to disappear. This was during an enormous bubble, and it was a crazy thing to believe. I declined the offer. When the market starts to sound crazy like that, that’s when you want to buy insurance, and you want to learn to buy it in a way that’s most cost-efficient. Ironically, insurance is cheapest when you need it the most, because it’s precisely at that point when things are most overvalued.

More recently, it’s not just mortgages where people went crazy: you could get credit default swaps in summer 2007 on almost any debt at ridiculous prices. At its most ridiculous, you could get a contract that would pay full face value of Dubai’s sovereign debt if Dubai defaulted at four basis points. The market was saying that this country — with a short history, living in the most dangerous part of the world, subject to the greatest possible variation in economic and social conditions — had one chance in 2,500 years of defaulting on its debt. If you had bought those credit default swaps at those four basis points, then you would have made 21 times your money and protected yourself against potential losses. Earlier this year, the same credit default swaps were at 86 basis points simply because of the change in the psychological atmosphere.

You ought to have the sense that this is an opportunity to buy cheap general insurance because what is driving that situation is a perception about risk broadly in the economy that is pervasive.

Finally, such an approach rigorously exercised would have gone a long way toward avoiding losses in the recent mortgage meltdown. Meanwhile, the bailouts today have not even begun to address risk attitudes. We should remember that however new the risk management methods of today’s value investors are, they are based on the extraordinarily durable principles of Security Analysis.

This piece is drawn from remarks made by Professor Greenwald at October’s “Celebrating 75 Years of Security Analysis” symposium in honor of the new sixth edition, which was published on the 75th anniversary of the first edition. These remarks were also published in Ideas at Work.]]> Mon, 24 Nov 2008 10:09:59 EST ]]> Capital Markets and Investments Strategy

Where are value investors looking for in today’s market? In an interview with US News & World Report on November 7, Professor Bruce Greenwald discussed the effects of the current market on the mindset of value investors, Warren Buffett’s investments in General Electric and Goldman Sachs and where the best opportunities lie. (Read the complete interview.)

Excerpted from the interview:

Photo credit: iStockPhoto

The Treasury announced a plan this week to recapitalize banks with $250 billion. Responding in the Wall Street Journal (“A Thumbs Up From the Ivory Tower” on Oct. 13) Prof. Charles Calomiris said:

Prof. Frank Lichtenberg spoke with the Financial Post about the thawing of the credit markets:

Dean Glenn Hubbard, writing with Princeton’s Alan S. Blinder, addressed the Treasury’s plan to broaden of deposit insurance coverage in the Wall Street Journal (“Blanket Deposit Insurance Is A Bad Idea” on Oct. 15). They wrote:

Speaking on National Public Radio’s On Point program on Oct. 14, Prof. Frederic Mishkin discussed the global perspective and the cost in reputation to the U.S. economic model. He said:

Photo credit: Phil Dokas

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

While everyone is looking for reasons why this nation is in a financial mess, let me toss another one into the ring. We’re in this situation because we’ve focused almost exclusively on the income statement and ignored the balance sheet.

An income statement indicates how revenues are transformed into net income, or profits after taking expenses into account. The balance sheet lays out the assets deployed in the operations to generate the revenues that drive profits. The critical factor for any firm’s success is its profitability, i.e., how much profit is the firm making relative to the amount of assets that have been deployed. Almost no one looks at profitability — we focus on raw profits instead, to our detriment.

Who’s “we”?

It’s the manager chasing growth in sales and earnings, without worrying about the resources used to obtain the growth.

It’s the financial analyst who incessantly focuses on Earnings Per Share (EPS) targets without any concern for whether the targets were met by organic growth or by value-diminishing acquisitions.

It’s the investment banker who spends most of his attention on whether a transaction is going to be "accretive" or "dilutive" to EPS, not on whether the transaction is going to improve asset productivity.

It’s the business media, which focus on these flawed metrics and increase the pressure on managers to meet rising earnings expectations, even at the cost of declining profitability.

It’s investors who focus all their attention on whether the firms meet analysts' estimates, harshly penalizing firms that miss by a few cents.

It’s the board of directors who compensate managers based on earnings targets instead of profitability targets.

It’s the regulators who have permitted firms to park many of their toxic assets off the balance sheet.

And it’s all of us in business academia for not properly explaining to our students that profit growth and profitability growth are not the same; in fact they are often opposites.

What happens when one ignores the balance sheet? First, one ignores the quantum of assets deployed for the generation of income. Consider Lehman Brothers and other firms that increased their profits quite dramatically until last year through investments in mortgage-backed and similar assets. Their profit growth was dramatic, as was their stock price performance, almost doubling from $44 at the start of 2005 to around $80 in June of 2007. However, if one considers the growth in the amount of assets on their balance sheet, the trend in profitability is much more modest.

Second, one ignores the quality of assets on the balance sheet. If one had paid attention to the rising profits from these risky investments with one eye on the balance sheet, one might have had a better appreciation for the nature of the risk involved. Of course, regulators made this worse by allowing firms to place many of their assets (such as Variable Interest Entities (VIEs), which are at the heart of the subprime mess) off the balance sheets. When people ignore what’s on the balance sheet, what are the odds that they’re reading the footnotes to see what’s left off it?

What does paying more attention to the balance sheet imply? Managers should care as much about what any new transaction brings to their balance sheet as what it brings to their income statements. Analysts should stop focusing exclusively on EPS targets and also forecast profitability targets. Investment bankers should abandon the charade of “accretion-dilution” analysis and focus on whether an M&A transaction really adds economic value (historically, most do not, and my guess is this is partially driven by ignoring the balance sheet).

The business press should stop facilitating the negative cycle caused by an emphasis on profits and growth without regard to the assets used to derive them. Boards of directors should reward managers for growth in profitability, not profit, by incorporating measures such as residual income (earnings less a charge for capital employed) in deciding executive compensation. Regulators should clamp down on off-balance sheet items, a lesson that apparently wasn't learned from the Enron debacle. Finally, business academics must train the next generation of managers, financial analysts and investment bankers to understand the critical difference between profit and profitability.

With any crisis, there is always a period of increased scrutiny, followed by business as usual. In this case, I hope all the “we’s” listed above continue to pay greater attention to the balance sheet once this crisis has been resolved.

This column originally appeared on Forbes.com on Oct. 5, 2008.

Photo credit: Dan Foy

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.

This week, Columbia Business School faculty members responded to the failure of the Treasury’s bank rescue plan to pass the House. The overall sentiment: something needs to be done, but what form it should take, and what kind of support it will have, is still unclear. On Sept. 29, Prof. Suresh Sundaresan offered his insights on National Public Radio’s Planet Money (listen to audio):

It’s a bit of a shock that the rescue plan was rejected; over the last several days some tight provisions were added on… and safeguards were added and we had two extremely informed and knowledgeable folks — the Secretary of the Treasury and the Chairman of the Federal Reserve — pleading for this assistance. … I could be wrong completely in the sense that the stock market picks up and libor goes back, but I find a low possibility of that happening unless something is done by Congress.

On Sept. 30, Prof. David Beim spoke with Tom Ashbrook on NPR’s show On Point (listen to audio), saying:

Writing in the New York Times, “Lessons From A Credit Crisis: When Trust Vanishes, Worry,” David Leonhardt cited an anecdote from Prof. Frederic Mishkin on the public’s growing skepticism and lack of support for the bailout.

Is the public’s skepticism of the bailout deserved or misplaced? The Senate is expected to vote Wednesday night on the Treasury plan. Please share your comments.

Prior to the recent financial crisis, the biggest economic story of 2008 had arguably been the rising cost of oil. After hitting a low of $50.48 a barrel in January 2007, oil prices have spent much of 2008 above $120. When the price of oil reached a historic high of $147.27 on July 11, Goldman Sachs’ prediction that oil would soon rise to $200 a barrel seemed well on its way to coming to fruition.

However, since the peak in mid-July, prices have fallen sharply, reaching $96.36 on Sept. 29. What caused this decline? Will it continue, or will oil prices quickly rebound?

Contrary to what we commonly hear from business commentators, speculators have little impact on the oil market, and storms, like Hurricanes Gustav and Ike, only cause a blip in the data. The fluctuations caused by the current financial crisis are also blips, short-run effects; however, if the crisis causes or reinforces a recession, its impact on oil prices will be more durable.

There are two main causes of the recent drop in oil prices: the global economic slowdown and the rise in value of the U.S. dollar. While the idea of a U.S. recession is something we’re all familiar with, Europe, too, has been dragged down by the recent credit crises, and even China has seen a slowdown in growth. Together, these slowdowns have caused global demand for oil to fall, resulting in lower prices.

Oil’s connection to the dollar stems from the fact that while oil is priced in dollars, most oil-producing countries — Saudi Arabia, Russia, etc. — don’t want dollars but rather other currencies. As the dollar fluctuates, these countries mark the price of oil up or down to preserve the value of their exports in the currencies that matter to them. If the current crisis leads to a drop in the international value of the dollar — which it will do if it leads to less use of the dollar as a reserve currency — we can expect some subsequent increase in the dollar price of oil.

Over the next six to 12 months, I expect the price of oil to fall further than it has. Aside from another war in the Middle East or the Caucasus — both of which are possible — I don’t see any forces on the horizon that will be strong enough to counteract slumping global demand and cause prices to increase. While OPEC will undoubtedly try to stabilize or raise prices by keeping a lid on supply, they are often not very effective in doing so. Only once have they clearly managed to raise the price of oil and hold it there for a while, and that was back in the 1970s in the context of an Arab-Israeli war.

In the long term, however, global demand will rebound, causing oil prices to rise again and eventually surpass their July 2008 highs. The growth of the economies of developing countries will play an important role in this, as early stages of growth are particularly energy-intensive.

Supply, on the other hand, is not likely to increase much. Quite simply, we are not finding much oil. For example, the Tupi field off the coast of Brazil, which was hailed as a giant find when it was discovered, has about 10–20 billion barrels of oil in it. That may sound like a lot, but when you consider that the world consumes about 31 billion barrels every year, it only adds up to six to nine months of global consumption. That certainly doesn’t represent a fundamental increase in supply. Neither would more drilling in the U.S., which would generate finds that are peanuts relative to global or even U.S. demand (which represents one quarter of global demand).

While lower oil prices may seem like a silver lining of the world’s current economic turmoil, we must realize that when we recover, the laws of supply and demand will once again force us to confront the issue of rising oil costs.

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.

The New York Fed has gotten its long-standing wish: Goldman Sachs and Morgan Stanley have become, like Citigroup, bank holding companies subject to its supervision. The increased power may please some Fed officials — and provide a great security blanket for “value” investors like Warren Buffett ’51. But as far as public policy is concerned, this is a step in precisely the wrong direction: We need more focused, transparent financial players, not more “Too Big to Fail” and “Too Complex to Manage” behemoths like Citigroup.

“How could our CEO possibly certify Citigroup’s accounts?” complained one of his lieutenants, shortly after Sarbanes-Oxley had been passed. “They are just too complicated.” Perhaps, I suggested, Citicorp should be split up into simpler units. Of course not! A flat world needed global financial institutions. If U.S. regulators didn’t back off, they’d all flee to London. Outsiders like me just didn’t get it.

In fact, the insiders didn’t. Stanley O’Neal and James Cayne famously frolicked on golf courses and at bridge tables while Merrill Lynch and Bear Stearns imploded. They weren’t callous, just profoundly — and given the complexity of their firms, inevitably — ignorant of the risks. Nor were they the exceptions. The financial system is paralyzed by fear not just of financial institutions hiding bad loans, but also that the insiders who are supposedly in charge don’t know the magnitudes of their liabilities.

American industry — businesses in the real economy — long ago learned hard lessons in the virtues of focus. In the 1960s, the prevailing wisdom favored growth through diversification. Many benefits were cited. Besides synergistic cost reductions offered by sharing resources in functions such as manufacturing and marketing, executives of large diversified corporations allegedly could allocate capital more wisely than could external markets. In fact, the synergies often turned out to be illusory, and corporate executives out of touch. Super-allocators like Jack Welch and Warren Buffett were exceptions.

The weaknesses of diversification were sharply exposed by the recession of the early 1980s and by Japanese competition. Later in the decade, raiders used junk bonds to acquire conglomerates at deservedly depressed prices and sold off their components at a handsome profit.

Banks missed the 1960s party. Prohibitions on interstate banking and the separation between investment and commercial banking mandated by the Glass-Steagall Act severely limited diversification in the financial industry. But as the rules were dismantled in later decades, financial institutions plunged right ahead.

The early results weren’t promising. Efforts to sell stocks and socks at Sears went nowhere, as did the Prudential Insurance Company’s foray into brokerage and Morgan Stanley’s venture into credit cards. But the forces that had curbed diversification in the industrial sector did not restrain financial institutions. Low-cost Japanese competitors did not show up inefficiencies--in many financial businesses, the driver of long-run profits lies in the prudent management of risks and returns, not costs.

Raiders couldn’t use junk bonds to dismantle conglomerates; financial institutions are too highly levered to be taken over with borrowed money; compensation arrangements made diversification irresistible. Many financial firms pay out nearly half their gross profits as bonuses – even if these profits are secured by loading up on risk. And bonuses paid are paid forever, even if the bets ultimately go bad.

Diversification offered CEOs the opportunity to take ever larger bets – and earn staggering personal returns without much personal risk. CEO Richard Fuld’s Lehman stock may now be worthless – but he gets to keep the $500 million he took out in previous years. James Cayne may have fallen off the Forbes 400 list, but he isn’t in the poor house. Sandy Weil has laughed all the way away from Citigroup, which he turned into a hodgepodge of investment banking, trading, retail brokerage, commercial banking and insurance.

Even now, battered CEOs seem bent on doubling up to recoup their bad diversification bets instead of cleaning house. Last year, Bank of America CEO Ken Lewis declared that he had had “all the fun I can stand in investment banking.” Yet last week, Lewis engineered the acquisition of Merrill Lynch. Now Goldman and Morgan Stanley, in their new holding company incarnation, are looking to acquire deposit-rich regional banks.

Predictably, taxpayers are footing much of the bill for the misadventures in diversification. Regulators, who looked the other way while bankers put the public’s deposits at risk and brought the nation’s economy to its knees, now have an opportunity to redeem themselves. They ought to demand an unraveling of the tangle that would help separate the good from the bad, and create institutions whose books CEOs could honestly certify.

Instead, they are encouraging more diversification, hoping to bury, for instance, Merrill Lynch’s unknown liabilities into Bank of America’s impenetrable balance sheets, and — in spite of their past failures with the likes of Citicorp — welcoming the creation of more megabanks. This is rather like giving the addict in the ER more drugs. It may soothe the tremors, but it isn’t a long-term solution to the diversification debacle.

The column also appeared on Forbes.com.

All eyes are on emerging markets in Africa. Growth is booming, particularly in Nigeria, where the market cap of the stock exchange has grown an astounding 962 percent since 2003. Starcomms, a Nigerian mobile telecom operator, is part of this growth trend; last summer, we became the first publicly traded telecom company in Nigeria, listing at $750 million.

However, growth comes with inevitable challenges, particularly in the dimension of capital markets and governance. In this capacity, Columbia Business School is playing a strong leadership role. Professors Enrique Arzac and Partha Mohanram recently joined the board of Starcomms and have brought their knowledge and expertise to this African growth story.

In 2001, less than one percent of Nigerians had a phone line — fixed or mobile. Today, about 30 percent of the population has a mobile phone, and that number has the potential to grow to 65 or 70 percent. The emergence of a strong and competitive telecom industry has had a dramatic effect on everyone in this country of 154 million. From the cattle driver who can now call in to hear prices in different markets before deciding where to move his herd to the businessman who can now access the Internet from the field, mobile telecom is quickly transforming the way business operates in Africa.

Starcomms is Nigeria’s market leader in CDMA service and its fourth overall telecom provider. We have grown from 2,000 subscribers in 2002 to nearly two million today. As the industry itself moves to a newer, more internationally competitive phase, our advantage is our human capital, which has only grown stronger with our newly expanded board. Professors Arzac and Mohanram bring us critical and unique expertise in managing a publicly listed organization and ensuring that international best practices are brought to Nigeria. Prof. Arzac brings the experienced eye of a global financier, while Prof. Mohanram brings acute accounting knowledge to bear. The complexity of being the first listed telecom and the associated governance issues make their insight crucial. Their experience with the telecom industry in countries like Argentina and India allow them to help us blend the ideal with the practical.

In the big picture, telecom is a macroeconomic driver; it’s a multiplier and, along with the financial industry, it is helping the Nigerian economy diversify and move away from traditional dependence on oil and gas. Telecom operators have invested billions over the last six years and are reaping rewards throughout the system.

The industry’s development mirrors the wider African surge. As a continent, sub-Saharan Africa is growing at around nine percent according to the International Monetary Fund. The traditional, western view of African business was only that of the “microfinance” paradigm. However, western businesses have finally come to realize that Africa has many well-run, sophisticated small to mid-cap businesses (by U.S. standards) that need direction in the crucial area of governance, over and above their need for structured capital.

By 2010, the Nigerian government expects the country to rank among the top 20 industrialized economies and double its GDP to $300 billion. With increased human capital and continued growth of telecom companies such as Starcomms, business in Nigeria will continue to transform both the country and the continent.

As the government’s proposed $700 billion bailout plan winds its way through Congress this week, the issue of how to price banks’ mortgage-related assets — and potential taxpayer exposure — has caused concern among economists. Dean Hubbard, writing with Hal Scott of Harvard Law School and Luigi Zingales at the University of Chicago Graduate School of Business, raises the issue of price-setting in a Wall Street Journal column, “Let’s Get The Bank Rescue Right” published Sept. 24.

The [Treasury’s] proposal needs to articulate the price-setting process. Although a reverse auction has been suggested, with asset holders “bidding” to sell their mortgage-related securities to the Treasury, such an approach raises significant problems. Most significant is the risk posed by asymmetric information regarding the value of these securities. Because the holders of complex and incomparable mortgage-related securities have more information regarding their worth than does Treasury, Treasury is at a huge disadvantage and will likely overpay. … How can we design a transparent asset purchase process that avoids arbitrariness and potential favoritism? Any such process will have to be designed from scratch, because there is no U.S. precedent for such a targeted purchase of bad assets.

Professor Charles Calomiris also addressed the complications of setting a fair price for bad loans, suggesting that purchasing banks’ equity, rather than their mortgage-related assets, would limit taxpayer exposure. Writing in the Financial Times on Sept. 19, Calomiris said:

Government injections of preferred stock into banks, advocated by New York’s Sen. Charles Schumer and inspired by the Reconstruction Finance Corporation’s policies in the 1930s, are a better choice. Pricing sub-prime instruments for purchase would be very challenging, and fraught with potentially unfair and hard-to-defend judgments. If the price were too low, that could hurt selling institutions; if it were too high, that could harm taxpayers. Who would determine how much should be purchased from whom in order to achieve the desired systemic risk reduction consequences at least cost to taxpayers? How would the purchasing entity dispose of its assets?

Preferred stock assistance would leave asset valuation and liquidation decisions to the private sector, but would provide needed recapitalization assistance to banks in an incentive-compatible manner to facilitate banks’ abilities to maintain and grow assets. If executed properly, it would limit taxpayers’ loss exposure, and leave the tough decisions of managing assets, and deciding on how to allocate capital assistance from the taxpayers, to the market.

Preferred stock assistance would work best if it were required to be matched by common stock issues underwritten by the private sector, which would ensure the proper targeting of assistance, and force private parties rather than taxpayers to bear first-tier losses. Banks in need of capital would apply for Matched Preferred Stock (MPS) assistance. Initially, say for three years, there would be no dividend paid to the government on MPS. That subsidy would increase the net worth of the recipient and facilitate raising additional capital via common stock.

Goldman Sachs and Morgan Stanley have taken the plunge. They have decided to become “bank holding companies.”

In essence, this means they will enter the brave old world of depository banking, with the regulatory apparatus that this entails, and leave behind the “proprietary trading” business models that have made these institutions the envy of the financial world for the past decade.

The nature of their debts will change (from securities and money market instruments such as repos to deposits), and the level of their portfolio risks will fall as they come under the pressure of a far more intrusive regulatory regime. However, their leverage will remain high and may even increase — access to cheap and reliable sources of debt funding, after all, is the main attraction of becoming a depository bank.

The investment banks’ previous resistance largely reflected the regulatory costs and risk “culture” changes that come with regulated depository banking. Virtually all of the franchise value of Goldman and Morgan is human capital. The folks at these firms are the most innovative product developers and skilled risk managers that the world has ever seen.

Depository bank regulation, supervision and examination prizes stability and predictability over innovation, and banks bear a great compliance burden associated not only with their financial condition but also their “processes” related to both prudential regulatory compliance and consumer protection. None of that is conducive to innovation and nimble risk-taking.

Goldman and Morgan’s moves, therefore, could greatly trim their upside potential and reduce the value of their human capital for developing new products and proprietary trading strategies. What about the benefits? First and foremost, they will be able to use reliable, low-cost deposit financing as a substitute for the shrinking collateralized repo market and other high-priced, market-based debt instruments.

Second, they will be able to preserve their client advisory business and perhaps even compete better in underwriting activities. Stand-alone investment banks have lost market share in underwriting to universal banks over the past two decades because underwriting and lending businesses are linked, and non-depository institutions suffer a comparative disadvantage in funding their lending (as shown in a recent academic paper).

In this sense, the capitulation of the stand-alones marks the final stage of the victory of the relationship banking/universal banking model. Those of us who argued in the 1980s that nationwide branching would allow commercial banks to serve as platforms for universal banks with large relationship economies of scope can now say, “We told you so.”

Bank of America, JPMorgan Chase and Citigroup have all weathered the financial storm and are not under threat of failure because their geographic and product diversification has kept them resilient. It has even permitted them to engage in acquisitions and new stock offerings during the worst shock in postwar financial history.

Somehow, Sunday’s announcements did not make me feel like celebrating. It is not progress, in my mind, to move toward a one-size-fits-all financial system comprised solely of behemoth universal depository banks. Just as community banks still play an important role in small business finance (owing to their local knowledge and flat organizational structures), we need nimble, innovative risk-takers like Goldman and Morgan in the system. What will we do without them?

While I may not be celebrating, I’m also not too worried about the lost long-run innovative capacity of American and global finance, for a simple reason: ultimately, people, not institutions, are responsible for innovation. Smart, innovative people can — and will — find homes elsewhere. The financial landscape will shift, giving rise to new franchises and new structures (perhaps even spin-offs from the current investment banks) that combine features of the old franchises that don’t fit comfortably under the Fed’s umbrella. Global competition, as always, will be a reliable driver of financial efficiency.

A version of this column was also published at Forbes.com.

The U.S. government, faced with the country’s worst financial crisis since the 1930s, has announced a $700 billion plan to purchase bad mortgage assets from banks. Is this a good bailout or a bad one? The difference is important, because history shows us that bad bailouts can actually make financial crises worse.

The Japanese government’s handling of its massive bank crisis in the 1990s is an example of bad bailout policy. At first, the Japanese government ignored the problem it was facing, then it decided not to enforce its own rules requiring sufficient bank capital (“forbearance”), then it began investing government funds into insolvent banks through preferred stock and subordinated debt. This caused the crisis to only grow larger, which contributed greatly to Japan’s poor economic performance during the 1990s and for several years thereafter.

A good bailout focuses on liquidity. The government acts appropriately when it helps institutions with liquidity at a time of crisis by lending against collateral or by purchasing bank assets at fair market prices. A bad bailout is one that tries to help with solvency. The government acts badly when it invests money directly into failing banks without closing them. If a bank — even if there is more than one — is actually insolvent (i.e. its liabilities exceed the value of their assets), then best practice dictates that it should be closed.

Closing a bank is less draconian than it sounds. A closed bank is not simply blown up or thrown away; on the contrary, every effort is made to preserve the bank’s franchise value and maintain continuity with customers and employees. Normally, the government cleanses the bank of its bad assets after closure and transfers the cleaned-up business to new owners as rapidly as possible.

Good bailouts wipe out the shareholders of insolvent banks and dismiss their senior management. Why? Because these are the people who created the problem, and they must be seen to pay a high price. Remember that most banks are conservative, well-run and solvent; only a minority get over-extended.

The problem with the Japanese banks in the 1990s was not just the bubble economy of the 1980s but a continuing unwillingness by banks and the government to acknowledge bad lending practices and change them. A few banks were eventually closed; however, one of these names, Long-Term Credit Bank, eventually became Japan’s greatest banking success after it was closed and sold to an American buyout fund, which resurrected it under the name Shinsei Bank.

From 1986-1992, the FDIC closed over 2,300 banks and thrifts. The Resolution Trust Corporation (RTC) was established to move the bad real estate assets back into the economy as promptly as possible. The RTC, much admired for its speed and efficiency, did not try to buoy up failing banks; it handled their assets after the failing banks were closed.

So is the current administration plan a good bailout or a bad one? At this point the proposal is written in a very general way, and the devil is always in the details. The test will be whether the government plans to buy assets at something resembling their fair market value.

Suppose a bank has made a $10 million loan that is actually worth about $6 million. If the government buys the loan at $6 million, then it is providing liquidity assistance, which is fine. But if the government buys the bad loan for $10 million, it is in essence giving the bank a $4 million gift. Handing out gifts to misbehaving banks is characteristic of a very expensive, bad bailout.

Secretary Paulson has spoken of buying the bad assets at a deep discount, but this is not written into his proposal. It should be a requirement. That would minimize the ultimate cost to the U.S. taxpayers and increase the chances that this bailout is a good one.

Professor Charles Calomiris presented his thoughts on the long-term ramifications of the subprime housing crisis as part of last week’s annual gathering of economists in Jackson Hole, Wyo. The following excerpt was originally posted on Vox. (download complete paper)

The financial system is working through a major shock. It started with problems in the subprime mortgage market but has spread to securitization products and credit markets more generally. Banks are being asked to absorb more risk — moving off-balance sheet assets back onto their balance sheets — when their ability to do so is reduced by massive losses. The result is a bank credit crunch as the scarcity of bank equity capital is forcing banks to limit exposure to new risk.

What long-term structural changes in financial intermediation will result from the subprime turmoil? One likely outcome is the conversion of some or all standalone investment banks to become commercial (depository) banks under Gramm-Leach-Bliley. The perceived advantages of remaining as a standalone investment bank — the avoidance of safety-net-regulation and access to a ready substitute for deposit funding in the form of repos — have diminished as the result of the turmoil.

The long-term consequences for securitization will likely be mixed. In some product areas with long histories of favorable experiences — like credit cards — securitization is likely to persist and may even thrive from the demise of subprime securitization, which is a competing consumer-finance mechanism. In less time-tested areas, particularly those related to real estate, simpler structures, including on-balance sheet funding through covered bonds, will substitute for discredited securitization in the near term and perhaps for many years to come.

Professor Frank Edwards is the faculty chairman of the Corporate Governance Committee and created the new corporate governance module that is part of the revised CBS core curriculum.

There is no more basic question in corporate governance than “who gets to decide.” We are moving away from a world where shareholders are small, passive investors to a world where investors hold sizeable positions in companies and want to be heard on vital corporate decisions.

There is a growing movement to give shareholders — especially institutional investors and substantial block-holders such as private equity firms — a larger role in corporate governance. In recent years, we have seen large individual activist shareholders, such as Carl Icahn and Warren Buffett, influence companies’ policies and strategies; activist hedge funds, private equity funds and union and public pension funds have successfully persuaded or forced changes upon recalcitrant managers.

But moving away from the traditional director-primary model raises the fundamental issue of what powers should shareholders have. Will more shareholder involvement disrupt the very mechanism that makes the public corporation practical, which is the centralizing power in the board of directors?

One controversial area is the adoption of majority voting standards. In the United States, the traditional way of electing directors has been by plurality voting in which directors typically are elected if they receive one or more shareholder votes in favor. Shareholders are now demanding that the plurality system be replaced by a majority vote rule, a system used in many other countries, including the United Kingdom. Some American firms have already voluntarily instituted some form of majority voting, while many others are resisting this change.

Another area of controversy is whether or not advisory or even binding shareholder “say-on-pay” resolutions should be permitted. The law in the U.S. specifies that even shareholder resolutions receiving a majority vote are nonbinding on the board. In the past, even shareholder advisory votes on executive compensation plans have not been permitted under SEC regulations. This has changed and evolved into a new, more profound issue: should a wider range of shareholder resolutions be permitted and should those receiving a majority vote be binding on the board?

Lastly, some shareholders want the right to propose resolutions pertaining to corporate social-issue policies. Resolutions on the emission of greenhouse gases, effects of climate change on less developed countries, research on renewable energy sources and national healthcare programs have all been proposed by shareholders.

In the future, managers will have to balance shareholder involvement with the practical considerations of running a company efficiently. Understanding what good corporate governance practices are and how these can contribute to the success of a company will help mangers find the optimal balance between these competing considerations. The goal of introducing corporate governance into the CBS core is to lay a strong foundation to help future MBA managers decide these issues and to manage successfully.

Photo credit: Daniel Martini

If liquidity intervention is inevitable, the central bank must be able to supervise and regulate the beneficiaries of its liquidity insurance. Otherwise, such insurance fans moral hazard by failing to discourage taking on still more liquidity risk (read: the most recent crisis). And making that insurance more available simply raises this concern (read: where we are now).

The events of the past three years highlight that risk misperceptions in a boom can lead to a scramble for liquidity if collateral values decline.

Importantly, Bagehot’s admonition goes on to say: “The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times.”

While strong supervision obviously remains important, this other advice from Bagehot would be an important addition to the policy tool kit. This could be implemented by raising banks’ capital requirements proportionately as risk-weighted bank assets grow. By varying capital cushions over credit cycles, consequences of risk distortions for actual lending and borrowing decisions will be reduced, along with the likelihood of asset fire sales and extraordinary central bank liquidity provisions.

Remembering Bagehot’s advice would give the central bank a way to deal with bank-lending bubbles. While a central bank’s tools may be poorly suited to prick bubbles like that of the information technology boom of the late 1990s, a bank lending bubble can — and should — be addressed.

The current policy stance of holding the federal funds rate at two percent will keep monetary stimulus in place. With inflationary expectations not declining, this stimulus will almost surely raise inflationary expectations as the economy improves. This consequence can be seen already in surging commodity prices and the weakness in the foreign-exchange value of the dollar.

It is worrisome that the Fed’s own 2008 projections have risen over the year both for headline inflation and core inflation. Furthermore, the Fed’s projections of receding inflation in 2009 and 2010 coming true will almost surely require increases in the federal funds rate.

A continuation of a negative real federal funds rate and the increase in money growth accompanying it raises the risk of increasing inflationary expectations, a costly mistake to fix.

It is asking a lot for monetary policy alone to carry the burden of supporting aggregate demand.

Fiscal policy can play a role. Congress and President Bush did pass an economic stimulus package centered on tax rebates. But clarity about a positive future for the 2001 and 2003 tax cuts which bolster collateral values — along with a cut in corporate tax rates to promote investment — would offer a much more potent tonic.

Earlier this week, the SEC issued an emergency order prohibiting naked short selling in 19 financial stocks, including Fannie Mae, Freddie Mac, Lehman Brothers and other names in the news. Beginning on Monday (July 21), it won’t be enough to make a good-faith effort to locate shares to borrow. Short sellers will have to have a formal agreement to borrow the shares in these stocks before they actually initiate a short position.

Emergency orders don’t happen every day, so you might think we are in uncharted waters. But when stocks go down sharply, it’s actually a fairly common response by regulators to try to throw sand in the gears and slow down the shorts. Perhaps the SEC was looking to the 1930s for guidance.

Back in September 1931, the world economy was spiraling downward into the depths of the Great Depression. U.S. stocks had fallen about 70 percent (!) from their 1929 peak, and short sellers were blamed. A number of commentators called for an outright ban on shorting. When Great Britain abandoned the gold standard on Sunday, September 21, 1931, the NYSE capitulated and issued an emergency order prohibiting all short selling. The gold standard news should’ve led to a sharp decline, but stocks advanced, mostly because specialists and other market-makers had no ability to provide liquidity on one side of the market. It was clear that the rise in prices was completely artificial, and after two days the NYSE repealed the ban.

An even closer analogy happened in early 1932. By then stocks had fallen even further. Opponents of short selling were encouraging stockholders to throttle short sellers by not lending shares to them. But like today, most brokerage customers held their shares in “street name,” and back then brokers could lend these shares without permission from the investor. On February 18, 1932, the NYSE announced that, effective April 1, brokers would need written authorization before lending an investor’s shares.

There was ample time for brokerage firms to secure the needed signatures, but they were apparently unable to do so in sufficient quantity. This wreaked havoc on the securities lending market. Share lenders were able to extract substantial concessions from borrowers. But the effect was completely temporary. Within two weeks, conditions in the share lending market had returned to normal. Stock prices rose on the announcement, but actually fell on April 1, because the market was expecting things to be worse. Ultimately there was only a short-term, temporary reduction in short interest.

I expect something similar here. None of the 19 stocks on the list are particularly hard to borrow. The vast majority have never been on the so-called threshold list, which identifies stocks with a significant amount of naked short selling. For these stocks, the SEC’s order really just adds more hoops for brokers. There could be a temporary effect if back offices can’t figure out right away how to jump through these hoops, but it will be very short-lived. Plus there are plenty of other ways for investors to take a bearish view. If a hedge fund can’t short, it can still buy puts. The options market-maker who sells the put will hedge by shorting the stock, and it looks like that options market-maker will be exempt from the naked shorting ban. At most, all we’ve done is add a middleman. So I suspect we won’t see much effect on Monday.

The pre-borrow requirement is actually a good idea. You can’t buy stocks unless you have the money or borrow it. You shouldn’t be able to sell stocks unless you have the shares or borrow them. I just think it won’t make much difference for these 19 stocks.

This post is part of a series following the “Pre-MBA World Tour,” organized by Shoaf and members of the class of 2010 with professional, cultural and social objectives. Over the course of nine weeks, the Tour will be visiting 24 major cities throughout Europe, the Middle East, Asia and South America, meeting with prominent alumni and business leaders.

Traveling through Thailand, Malaysia and Singapore this week, we had the opportunity to visit with the senior-most executives of several different types of institutions and discuss the challenges of competing in a global industry — and within the emerging markets.

After meeting with the executives of some major financial institutions, we started to reflect on the contrasting strategies of regional and global entities. For example, how must the perspectives differ between OCBC (a regional bank in Singapore) and Citi (the ubiquitous giant in global banking)?

Any successful organization requires growth in order to stay competitive, but how does a comparatively small company like OCBC continue to grow if it has a limited domestic market? The obvious answer seems to be that it must look outside its own country and consider entering new markets, and particularly emerging markets.

It may sound simple, but the problem is that entering a new market can require the company to stomach years of losses and investment — anywhere from 3 to 15 years.

This means that only companies able to subsidize these unprofitable years will be able to sustain themselves. These are typically either large companies with large domestic markets (such as Citi) or companies backed by another large institution (such as a sovereign wealth fund). A firm with a small domestic market of, say, four million people is not able to sustain such losses, and the investment may not provide value to shareholders in the short run.

But the real problem is this: if the target market is not large enough to give ample returns on this investment (in countries such as Vietnam or Cambodia, for example), there may not be sufficient returns in the long run, either. The payback period is simply too long.

So how can a regional player compete in a globalizing industry? Perhaps the best way is to specialize, catering to the local market and focusing on profitability and efficiency rather than top-line growth. This would make the company an attractive acquisition target for a global player with a larger domestic market (such as Citi) that can grow through acquisitions, rather than organic growth. This in effect shortens the learning curve and increases the company’s ROI.

This leaves two questions: First, does it make sense for a regional bank apply a similar strategy to compete in emerging markets? And second, with local expertise, can a regional bank be more effective in servicing its customers than a global bank?

The challenges of global expansion are complex and the appropriate solution will differ with each unique institution. Our trip to Singapore gave us a valuable lesson, pushing us to consider the variations in strategy among firms with different sets of resources and at times, different goals.

A recent article quoted Professor Bob Hodrick on whether or not oil prices were being artificially driven up by the coordinated efforts of an influential group of speculators.

“The market is so competitive that that's nonsense,” Hodrick was quoted as saying. “There’s no way for everyone to communicate and get together and say, ‘We’re going to buy and drive the price up.’”

The article, from U.S. News & World Report, reports on how speculators play an important role in the oil markets and the global economy.

The Washington Post reported yesterday that although Americans’ perceptions of the economy are very negative, two key measures show that the economy is not as bad as it may seem: unemployment is at 5.5 percent and inflation at 4.2 percent.

One reason for this disparity, according to Professor Eric Johnson, may be the frequency with which consumers are seeing higher prices. “Things that you buy more frequently and that have large percentage increases will weigh more in people’s perception of inflation,” Johnson was quoted as saying.

He elaborated in the article with the following example: a person paying an extra $25 to fill up the gas tank is reminded of that cost once a week, or more often if you count the times he or she sees a $4-per-gallon price in giant numbers on a sign. In contrast, a rent increase of $100 would only happen once a month but would have the same financial impact.

Image credit: Cole Huggins

This week Fortune reported that Warren Buffett MS ’51 is betting that funds cherry-picked by money managers won’t outperform the S&P 500 index over the next 10 years.

According to the article, Buffett made the bet with the money-management firm Protege Partners in January. Protege has backed five hedge funds, while Buffett, who has long argued against “helper” fees, is betting on a low-cost S&P 500 index fund sold by Vanguard.

Each side put up about $320,000, and at the end of 10 years the pool is expected to be worth about $1 million dollars. The money will go to a charity of the winner’s chosing.

photo credit: trackrecord

If you are planning to pursue a career in venture capital after business school, a word of advice: get experience doing market sizing (OK, market estimating is probably more like it) and practice, practice, practice.

By market sizing, I mean taking a given market (e.g., the market for HD televisions or widgets or oatmeal cookies) and slicing and dicing it based on a series of assumptions.

I have had some opportunities to practice this through my internships (looking at market sizes to inform business plans or VC investments) and to a small degree in classes, but you can always improve — and the only way to improve is to practice.

If I could rewind to last summer, I might have spent some time practicing management-consulting case interviews (even though I didn’t want to go into consulting) for that very reason.

Why?

Well, case interviews require you to quantitatively walk through a business problem and figure out the magnitude of profit, revenue, etc., which guides your decision making. More important, they force you to develop your own analytic process.

Doing this repeatedly is bound to make you improve.

Bonus VC job tip: Pick an industry you know little or nothing about and spend about 10 hours (give or take) during a one-week period looking at the industry trends, value chain, competitive landscape, market sizes and value proposition for key players, and think about what you would like to invest in (if anything). After doing this, you’ll be familiar with yet another space and have another set of insights to share during your informational and formal interviews.

• 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.

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

This week the Pre-MBA World Tour traveled to Istanbul in order to better understand the current business environment in Turkey and to see what types of opportunities might be available to CBS students and alumni during the next decade.

Before arriving, we knew that (as the song goes) Istanbul was once Constantinople. But we didn’t know that Turkey is currently undergoing a significant social, economical and political transition. And somewhere in these winds of change lie several interesting opportunities.

For nearly 25 years, Turkey has been attempting to transfer its state-owned businesses to the private sector. Following a financial crisis in 1994, and another in 2001, the country’s financial system has finally shaken off hyperinflation and has begun to privatize many sectors of its economy.

Furthermore, since 2005 Turkey has been in negotiations to join the European Union. Many of the requirements to join the EU have provided an incentive for Turkish policymakers to change the way business is done.

Among these changes has been a significant movement toward privatization, and this movement (along with a new currency to curb inflation) has made foreign investors more confident. Private equity has begun to flow into the economic system, and GDP has been growing at nearly 8 percent per annum.

Although many people believe that Turkey won’t be admitted into the EU for another five to seven years, the changes that have been made to prepare for this transition have positively impacted the economy.

Whether Turkey should join the EU remains a controversial issue, yet there are clear benefits. One is that Turkey has a young and dynamic population that can contribute immensely to the workforce in Europe (where the average age of the population is increasing every year) and thus can play a role in increasing Europe’s competitiveness with such countries as China and India.

In addition, an interesting political shift has arisen relating to the election of the conservative AK Party. The AKP won the election in August 2008 for the second time, which led to the stabilization of the Turkish economy and an increase in foreign direct investment. The AKP has very strong connections with the United States and has a vision of using aggressive economic growth vision to gain admission into the EU, yet ongoing judicial debates and the party’s nonsecular policies have created uncertainty about its sustainability.

While these controversial topics remain to be tackled on an international level, Turkey is experiencing GDP growth, a stronger currency (fluctuating between 1.18 and 1.39 USD/TRY) and a lower inflation rate, leading to increased urbanization and development at the intersection of Europe and Asia.

The natural beauty and historical richness in this melting pot have increasingly attracted tourism in the past 10 years, and Istanbul remains the center of Turkish history, culture and business. We have found Istanbul to be a wonderful city full of diversity and opportunity.

Next stop: Dubai

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.”

There has been a lot of emotionally charged rhetoric surrounding sovereign wealth funds, especially with politicians and the media magnifying the “straw man” of suspicious foreign motives to conjure up advantages and ratings.

I just don’t buy it. Calls from politicians and the media for sovereign wealth fund regulation miss the larger point. Singling out sovereign wealth funds as bad guys suggests that they have the potential to be more hazardous to U.S. interests than other funds — and allows the rest of the investment field to roam freely, going largely unchallenged.

We should ask whether a fund’s national origin even matters. After all, hedge funds have an enormously extended reach and diverse investor bases. What if 49 percent of a hedge fund’s investors were U.S. endowments and 51 percent were foreign entities? And what if that calculus was opaque because the capital was disbursed through an offshore fund of funds? Variables such as these can make determining who wins and who loses far from clear-cut.

In the final analysis, it isn’t just what type of company, how big of a stake or what debt or equity instrument is owned that underlies plausible U.S. vulnerability — it is whether we have a strong political alliance in place, and the extent to which our dependence can be used against the U.S. in a negotiation for trade, security, intellectual property or what have you.

For the global economic environment to survive, we must cooperate with each other. The U.S. has a spiraling current account deficit that some argue resembles precrisis Argentina: the dollar has slid precipitously, oil prices have risen.

That we haven’t had a severe avalanche of dollar selling seems to be due to political good will with foreign central banks and the moral persuasion of the Treasury and the Federal Reserve. None of our trailing data are owed to the alpha-decision making of supposedly sovereign-neutral portfolio managers.

Given all this, pointing a finger exclusively at relatively mundane entities, such as Singapore’s GIC, seems like a diversionary tactic to distract the public from much larger, more complex issues.

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.

In our “Game Theory and Incentives in Business” course, Professor Paolo Siconolfi and I use experimental methods as an active teaching tool, simulating a strategic market environment in which students can actively participate.

In our most recent experiment, we simulated George Akerlof’s market for lemons (faulty used cars). In his paper “The Market for Lemons: Quality Uncertainty and the Market Mechanism,” Akerlof illustrates the failure of a market due to asymmetric information between sellers and the buyers.

For this experiment, we divided the class into two groups: buyers and sellers. Sellers were able to chose a price, quality grade and whether they wanted one or two units. The sellers were told the monetary costs of producing each of their units, and these costs depended on the quality grade: a higher quality grade meant a more expensive unit. Sellers did this all without knowing what their competitors chose.

After all seller decisions had been submitted, both prices and quality grades were provided to buyers. Buyers then were allowed to make purchases of at most one unit at the posted price.

Of course the purpose of all this is to make a profit, so the sellers are trying sell at a price above the cost of a unit and buyers are trying to buy at a price below the value of the unit.

This experiment had two treatments. In the first four rounds, the buyers were able to see the quality grades before they bought a product, whereas in the last four rounds the quality of the product was hidden.

Buying and selling grade-two units is the socially and individually optimal outcome (it maximizes the income for both buyers and sellers) and this was indeed the case in the first part of the experiment: the majority of the transactions involved grade-two units at approximately right prices, with very little excess supply or demand. (You can see the results in the figure below, where the theoretical demand and supply is given on the left hand side.)

However, when the quality became unknown, the buyers reacted to the possibility of buying low-grade products. In fact, in round five, only four transactions (out of a possible 10) took place. The sellers responded quickly to the demand and lowered the prices. The market quickly converged to the lowest possible price level, and only low-grade products were sold.

Some students were playing in groups, and we overheard them reacting to adverse selection and moral hazard effects in a way that proved Akerlof’s theory. Our students were masterful in understanding the incentive problems in the market.

Of course none of this could have worked without enthusiastic students. We were very lucky to have a select group who took the theory and experiments very seriously and brought their insights into the classroom.

We like to conduct these experiments before discussing key economic ideas and principles, and during the spring term we conducted a good number of them: the pervasive winner’s curse phenomenon in auctions; a persistent bubble in a limit-order market; failure of auction mechanisms in the existence of asymmetric information; behavioral considerations beyond rationality in a trust game; and many other phenomena that arise in strategic market environments. Besides giving us a chance to illustrate the shortcomings and teachings of these theories, we find that these experiments allow students to gain firsthand experience with market theories and encourage them to ponder the underlying questions and issues.

Excerpts from a talk given at CBS’s 2008 India Business Conference on April 19.

Indian growth is going to depend overwhelmingly on what happens locally in India. The reason India and China went from being peripheral players in the world market in 1980 to the powerful forces they are today didn’t have to do with changes in the global market. It had to do with local changes in India and China. In places where these changes haven’t taken place — in Russia for example — you see their participation in the global economy is what it always has been: just as a supplier of raw materials.

The reason so many Chinese goods now sell around the world is not because the demand for those goods has suddenly materialized, but because productivity growth in China — and it’s the same in India — enabled it to provide goods and compete successfully in global markets.

This trend is going to get more — not less — important in the future. If there is one enormous antiglobalization trend, it is that local services — education, medical care, housing — are becoming much more important for consumption and therefore economic activity than manufacturing or other kinds of services. There is a limited demand for manufacturers — there are only so many suits of clothes you can own, in the same way there is only so much food you can eat, notwithstanding the rising weights of Americans. Manufacturing, in terms of its importance in employment and economic activity, is going to go the way of agriculture in the 20th century.

This applies also to outsourceable services. Remember, for services to be outsourceable, you have to be able to routinize them. If you can routinize them, you can automate them. If you can automate them, those jobs are ultimately going away. So local services are going become much more important in India and all over the world.

Think locally not globally. Big global markets are extremely competitive. Chinese manufacturers do not make significant profits because they are competing with other Chinese manufacturers. In fact, if you look at the top 25 Chinese companies other than the natural resource companies — this is in terms of profitability and market capitalization — they are all local service companies: power companies, mobile companies, banks and insurance companies. If you can dominate local markets, especially where those local markets are growing, that’s where you’re going to do much better.

This applies to finance too. It is a perpetual surprise to me that overseas investors repeatedly get sucked into the kinds of difficulties that the U.S. has gotten itself in trouble with — mortgages, and before that in many other areas.

Also: when it comes to business profitability, it’s important to think not globally, which is what the propaganda is about, but locally, so that you can take advantage of growth and the benefits of growth are not competed away.

The world is not flat. There are very important differences across economies. If you spend time in India versus China, it’s immediately striking how different those two countries are. If you think about problems in those countries, they are very country-specific. I think when you arrive in India, you see the most important thing that is going to affect growth and the quality of life is actually land-use planning, and there are obviously other economies in which that is not so important.

The most striking thing I learned on my recent trip to India is this: when you sit down with Indian business people, they are superb marketers and business strategists. You talk to them about what they have to do to succeed in different marketplaces, and they are just extraordinarily well trained in talking about that. But if you go to the manufacturing plants, and if you compare these to plants all over the world, they are not particularly strikingly efficient — nothing like Japanese plants, where nobody is basically there and yet they produce enormous output. And you talk to them about that and they say, “Oh well, yes, we’re not very good at manufacturing because Indian workers are creative and not obedient as opposed to Chinese and Japanese workers.”

So if you’re going to think about growth in India and the interactions between India and the world, you have to have an appreciation for the cultural realities, and not only of India but of the different regions in India.

India is not destroying U.S. jobs. It has always been the case that productivity growth has caused the loss of many, many more jobs than the overseas movement of jobs. And nobody — not even the people currently running for president — have suggested that we do away with productivity growth. And I think you ought to keep the same thing in mind when you think about loss of jobs to India.

India is experiencing really the miracle of modern life. It used to be that only a very small stratum of the human race had what we think of as modern standards of living — eating a variety of foods, having the freedom to travel and real entertainment. That is happening in India now, and the most important question to keep in mind at this conference is how to persistently generate the local conditions that will allow that to continue.

Photo Credit: Jasvipul]]> Wed, 23 Apr 2008 12:03:57 EDT ]]> Capital Markets and Investments World Business As many companies file their financial results this year, they will face the challenge of implementing FASB’s new 800-pound gorilla: recording assets and liabilities at fair value. It’s a mammoth task they’ll continue to grapple with over the next few months.

This new standard formalizes the accounting industry’s age-old concept of fair value. It redefines fair value as the present-day cost to sell an asset or transfer a liability in an orderly transaction.

Previously this definition was used only to define investments in debt and equity securities, but now it has been expanded to include most assets and liabilities that take up space on corporate balance sheets. And it requires both public and private companies to adopt it.

As a result, companies — particularly those that invest in the alternative investment space — will find it increasingly challenging to mark many of their complex investments according to the new fair value definition. In addition, accountants will be required to dust off older contracts and agreements previously held at historical cost in order to comply with new requirements. (Valuation of publicly quoted investments, however, remains straightforward).

Although market volatility and subjectivity will riddle this process with uncertainty, one thing is for certain: this new fair value landscape will stimulate growth in several related career paths in 2008. Companies will need to employ more quantitative gurus in order to price these securities. In addition, regulators and auditors are likely to place a higher level of reliance on third-party valuation estimates, thereby creating a larger demand for independent valuation experts.

More good news is that this will enhance the tradability of assets and liabilities among firms by making the values of such investments more transparent to both buyers and sellers.

This new pronouncement presents fresh challenges for public and private organizations, many of which have long struggled with placing a value on complex financial instruments. Now that companies are filing quarterly financial information, we’re likely to see the effects of improved measurements and a clearer concept of what an asset or a liability is really worth.

Before working at a venture capital company, I tried for years to figure out how to quickly determine if something is a venture capital investment or a private equity investment.

Some suggested that private equity is a super-umbrella term that is called venture capital when the investment is at an early stage. However, some companies have operated for 6–10 years before they come for venture funding.

Others believe that venture capital is the original term that became popular after World War II, and private equity is the term coined in the 80’s after famous people like Henry Kravis ’69 invested in bigger companies.

But I’ve found that determining by size of the company gets tricky, as revenue of $2 million might be considered small in a developed country but large in a developing country.

The size of the investment doesn’t work either if you base it on country. An investment of $10 million in a U.S.-based company would be considered a venture investment, but might be considered a private equity investment in the developing world.

Some professionals strictly define private equity as a leveraged buyout (LBO) activity. But in developing countries like India, there is almost no LBO activity due to banking regulations, and yet billions of dollars are invested in large corporations by private equity players as equity or convertible debt. This sure looks like private equity investment, but does not fall under the LBO or management buyout (MBO) category.

There is also conventional wisdom that says if a company is not yet successful but the promoter is very confident, it is a venture capital investment, but if the reverse is true — if a company is successful but the promoter is not that confident and wants to either restructure using LBO or wants to exit — it is for sure a private equity investment.

Though there may be some truth in that, it’s not quite scientific enough and does not cover all investment scenarios.

So here’s my own litmus test: if a company has no additional bank-debt carrying capacity due to its current financial state, an investment in it should be considered a venture capital investment. Otherwise, it should be considered a private equity investment. This works for companies of any size, stage or location.

On March 21 I flew to Omaha — along with 150 of my classmates — to meet Warren Buffett, MS ’51, a man I have admired (some friends would say fanatically idolized) for close to 15 years.

After a tour of the Berkshire Hathaway-owned Nebraska Furniture Mart, we were brought to a room at the Omaha Field Club. Warren Buffett stood at the front — two of his five daily cans of Cherry Coke nearby — and for the next two and a half hours, answered our questions.

The questions covered a wide range of issues, including what he looks for in a business, the current financial situation, recent events at Bear Stearns, ethics, emerging markets, commodities, his relationship with Benjamin Graham and his typical day. His answers were a powerful reminder of his unique ability to distill complex issues down to their bare essence.

When asked about how long the current financial crisis would last, he replied, “I don’t know. I have never made money on macro calls.” Buffett said that even if he had perfectly predicted macro conditions in 1973–74, he would not have bought See’s Candies in 1972 going into a recession and would have missed out on a company that he has referred to as “the prototype of a dream business.”

After joking that our graduation was not perfectly timed, Buffett warned that we should not be discouraged from pursuing a career in finance. Finance is only going to become more important as time goes on, he said, and it is a field where one can truly stand out and be recognized.

He advised MBA students to learn as much about accounting as possible, adding that, “accounting is the language of business.” He also said that writing and verbal communication are extremely important in the business world and that students should seek out ways to improve these skills every chance they get.

Buffett urged students looking for jobs not to pay too much attention to salary. “Who you work for is extremely important, so choose carefully,” he counseled, adding that the most important decision of his own career was going to work for Benjamin Graham.

As MBA students, we are beginning our careers in an age where the image of a corporate executive has been bruised. Spending time with Warren Buffett — an astute businessman, a legendary investor, a rational and disciplined person and a generous philanthropist — afforded us the opportunity to learn much more than just how to pick stocks.

Before the trip, I was certain that no one could ever live up to the sincere, humble and generous image depicted of him in books, shareholder letters and TV interviews. I was wrong. Even that lofty image did not hold a candle to the man I was lucky enough to spend half the day with in Omaha.

The role of a central bank is to maintain the liquidity of the banking system, not to absorb the losses of the banking system. So far, that is what the Fed has been doing, and very creatively. Its various new programs to lend to banks and securities dealers to bolster their liquidity do not involve taking significant risk of loss: they are collateralized loans in which the full faith and credit of the borrower is engaged to repay the loan. In addition, these loans are secured — indeed over-collateralized — by treasuries, agencies or AAA-rated mortgage securities. That’s an extra lock on repayment. But under none of these does the Fed assume true ownership of the assets’ risk. Its actual exposure to the asset values is minimal.

An exception is the Bear Stearns transaction, in which the Fed provided a $30 billion line of credit to JPMorgan that is dependent for repayment solely upon the value of some Bear Stearns assets, presumably the worst $30 billion. But this is in the context of a failed financial institution.

It is widely accepted that government must step in when a bank fails. Best practice is immediately to close or sell the bank, dismiss the management, wipe out the equity, scrub down the balance sheet and require the new owner to recapitalize it. That is pretty much what happened in the Bear Stearns case, though not perfectly. But it is within the failed bank paradigm: the government appropriately accepts bank losses when it resuscitates a failed bank to protect the financial system.

The new idea is a radical departure from all past wisdom and best practice. By trying to put a floor under the prices of mortgage securities, the Fed would be trying to prevent large losses from occurring. This is like trying to hold back the tide. The losses must occur because they are the real result of collapsing asset prices. The (real estate) assets were previously artificially inflated in value and are now trying to find their correct value according to real supply and demand. This correction must be allowed to happen; only then can we fully sort out who has lost how much. Any effort to stop the correction will only add to the confusion over which banks are solvent and which are in doubt.

Government price fixing has failed wherever it has been tried. It has failed in the United States, in the Soviet Union, in Brazil and in many other settings. It only works briefly, then leads to distortions so painful that people begin seeking ingenious ways to game the system. Neither the government nor anyone else is smart enough to know the correct value for any risky security, especially in a period of turmoil. Even though the prices of some mortgage securities seem to imply exceptionally high default rates, given the complexity of the securities and the economy, who can say with confidence what their true value should be?

The quantity of risk and potential loss involved in this proposal is almost unbounded. And the vast potential cost would not buy stability. Financial markets will always have their cycles of over-exuberance and over-pessimism: something in the human psyche requires these cycles. When the government tries to repeal the downside of cycles, and protect people and banks from the losses they have themselves incurred, subsequent risk-taking explodes.

It’s a terrible idea that should never be tried.

And many experts such as Professor David Beim agree that Lehman is no Bear Stearns.

“Lehman has much stronger and more broadly based businesses” than Bear, Beim told a Dow Jones reporter. “There is some anxiety about it, but I don’t think it will be fatal to the firm.”

The Fed’s intervention also helped. “I think that we’ve seen very possibly the last major problem of a large financial institution,” said Professor Charles Calomiris during an interview on NPR yesterday. “And what we’re going to see now is even more aggressive action by the Fed to create liquidity for other institutions to avoid a repeat.”

“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

“We’re overwhelmed by the professors and alumni who have helped Microlumbia. It’s a fantastic thing to do at Columbia and a great example of what you can do only at business school.”

The two studied six months of transcripts from a daily CNBC show, and found that commentators most often anthropomorphize uptrends in market fluctuations (“the Dow fought its way upward”), while likening downtrends to inanimate objects (“the NASDAQ dropped off a cliff”). This gives investors the false impression that uptrends offer meaningful signals and downtrends are random, though neither follows any particular pattern.

As related in a recent Ideas at Work article, Morris and Ames found that commentators with the most colorful language may do the most damage. And charts, though seemingly harmless, can cloud thinking.

Only one anthropomorphic metaphor does work in describing the market, says Morris, and it comes from Benjamin Graham: manic-depressive.

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.

A fantastic evening in Manila last night: a small group of Columbia Business School pillars of the Philippine business community and friends gathered with me at the Tower Club to join in singing popular standards with the very talented University of the Philippines Concert Chorus. We stayed for a dinner, hosted by Board of Overseers members Wash SyCip ’43 and Al Yuchengco ’50. Conversation centered on the School, what the current students are like, and the fun CBS students had on their recent trip to the Philippines. We also debated Asian “decoupling” from the U.S. economic situation and banking opportunities to the Asia-Pacific region. This morning I joined a dozen alumni for a breakfast at the Peninsula Hotel, hosted by Nori Gonzalez Poblador IV ’96. After a vigorous economic discussion, we talked about the upcoming Pan-Asian Reunion and the CBS Ambassador interviewing program.

I was struck by the warm feelings of the Philippine friends for Columbia Business School and Columbia University. The embraces and remembrances were fond and familiar. I was also keenly aware—as I am in so many conversations around the world—of the many connections our alumni have to each other and to the business leaders generally.

Home via Hong Kong coming up—but a great trip to Asia!

“That's not going to make a great deal of difference to people's economic well-being or their pocketbooks,” Professor Lichtenberg said. “The idea that if you're on one side of the line you're in a recession and if you're on the other side you're fine — that's not really the case. Clearly, we are in a very difficult period.”

On Friday, I moderated a panel at CBS’s annual Private Equity and Venture Capital Conference. The topic: Pushback — Private Equity’s Social Impact.

The rabble-rouser among the panelists was Andrew Stern, the outspoken president of Service Employees International Union (SEIU). On the other side, defending the private equity industry, was Gwyneth M. Ketterer ’91, the COO of Bear Stearns Merchant Banking and John Franchini, Partner, Milbank, Tweed, Hadley & McCloy.

With the panel taking place less than a month after the SEIU staged a massive protest that drew police to the scene in the middle of a presentation by Carlyle Group’s David Rubenstein at a Wharton conference, the organizers of this conference were understandably nervous. They took precautions by having undercover officers in the audience, which quickly became standing-room only.

While there were no protesters this time, Mr. Stern didn’t disappoint: he threw several proverbial grenades into the room that caused sparks to fly. He derided private equity on its tax treatment, its debt load and its treatment of its employees. By constantly wrapping his arguments against the industry in the context of being an American patriot and by framing the debate as one about inequalities, he quickly gained some sympathy from the audience members (most of whom were either in private equity or students seeking to enter the industry). But when it came to offering concrete ways to improve the industry and its relationship with labor, he was short on details.

Ms. Ketterer, a feisty veteran of the industry, sparred with Mr. Stern, calling him out on his lack of specific suggestions. For example, she asked why unions were typically not willing to take equity in lieu of cash as a way to incentivize the workforce. Mr. Stern said he agreed that they should be more progressive in their thinking.

Several vocal members of the audience lit into the private equity industry, at times becoming quite emotional while Ms. Ketterer and Mr. Franchini tried to explain the dynamics of the marketplace.

Towards the very end, in effort to reach a common ground, Ms. Ketterer said she appreciated how explosive the issues had become and expressed an interest in finding a solution. But the fight seemed to never end.

Like Mr. Springer’s show, the panel ended with audience members still involved in a raucous debate.

Stay tuned for the next episode.

“We suggested a very difficult problem to him,” said Donaldson of Pandit’s dissertation, “and he made substantial progress on it.”

“His topic was to assess whether an appropriately structured dynamic heterogeneous agent model could shed light on the equity premium puzzle. The puzzle points out the implausibly high risk aversion necessary for standard homogeneous agent models to reconcile the high historical returns of stocks versus risk-free T-bills.”

A full resolution of the equity premium puzzle has yet to be found.

“In terms of theoretical explorations, he was way ahead of the curve,” said Donaldson. “His choice of dissertation topic shows that he is willing to think very carefully about complex equilibrium questions.”

In particular, Singapore’s fund bought a 9.4% stake in Merrill Lynch for $4.4 billion; China’s fund bought $5.6 billion of securities convertible into 9.9% of Morgan Stanley; Abu Dhabi’s fund put $7.5 billion into a 4.9% stake in Citigroup; and another Chinese fund invested $1 billion in Bear Stearns.

The worried commentators point out that government funds are inescapably political, not just passive investors but surely seeking to extend their influence over world events. America must certainly be at risk, they say — what will these investors do, what do they want and will they ever go away? Financial institutions provoke special anxiety because of their central role in the economy.

I find it hard to share these anxieties. To me they are just another aspect of globalization. Our largest financial institutions are no longer exclusively “ours” but have become part of the global economy. The opening of borders to flows of goods, services and investment capital brought many benefits and has internationalized most large business organizations. They have learned how to balance needs and challenges from all sides. America has long extended its investment capital into other countries, and we need to get used to other countries doing the same.

What are the sovereign wealth funds and how did they get so large so quickly? The answer is not difficult to see: America has been importing dramatically more than it has been exporting in recent years. Since governments run the foreign exchange markets in countries such as China, Abu Dhabi and Singapore, governments tend to collect the dollars that Americans pay for the excess imports. As our trade deficits have continued unabated, the sovereign funds have rapidly grown. In the past these dollars were put into passive investments such as government bonds and bank deposits. But the managers of the funds are diversifying, and in particular seeking returns higher than those available on bonds and deposits. Equity investments are as attractive to them as they are to us.

The recent transactions were a benefit to both sides. The financial institutions got large capital infusions which were badly needed after the recent wave of credit losses left them somewhat depleted. If they had sold stock to U.S. investors in public offerings, the stock prices would have been brutalized. Similarly, the sovereign funds had a golden opportunity to acquire some major blocks of stock in leading institutions without disturbing the public market.

The funds are acting carefully, limiting their future actions. The transactions involve stand-still agreements which limit the funds’ ability to expand their positions in these companies. To be sure, large shareholders can exert some influence over management, but their voice will be only one among many. Modern companies have learned how to handle their many stakeholders.

I do have some concerns, but mine are more at the macro-economic level. I see little to fear in the recent transactions taken on their own, but the broader pattern of trading assets for goods is unsustainable in the long run. We have a finite number of investment assets to sell, but an apparently infinite appetite for cheap foreign goods. America used to be a fountain of capital to the rest of the world. Now it has become the world’s largest debtor.

I believe we need to moderate our appetites. If we do not, the foreign exchange markets are likely to drive the dollar ever lower, making our imports ever more expensive until balance is restored in that way. Our huge deficits are enriching the developing world with an efficiency that foreign aid could never have accomplished, and punishing our currency.

There is much we can do to mitigate the global financial imbalance. We can start with oil. If we could double the efficiency of our automobiles, the effect on oil imports would be dramatic. We also need to rein in our foreign military adventures. Apart from their negative impact on America’s reputation in the world, they are terribly expensive. In fact, if the U.S. government could get its fiscal budget under control, that too would make some contribution to correcting the external imbalance — not one-for-one, but measurable.

So I suggest we get over our fears of sovereign wealth funds and concentrate our minds on issues that truly will make a difference to America’s future.