The Opportunities Brought to You By Distress

“Bubbles” are old. Variations on the most legendary one, Holland’s tulip craze of the 1630s, have recurred time and again. In the past decade alone, we’ve experienced the “dot-com” boom and bust, only to be followed by the current financial meltdown triggered by the decline in U.S. housing prices and reduced credit. Now, sifting through the debris of today’s crisis, economists and policy-makers alike are trying to assess why risk management systems and regulatory constraints didn’t kick in before the global economy became engulfed in red ink. Executives are trying to assess what the whole business means for how to run their companies. And nearly everyone is trying to get over the shock.

But Andrew W. Lo is a lot less surprised than most seasoned observers. As the Harris & Harris Group Professor at MIT’s Sloan School of Management, director of the school’s Laboratory of Financial Engineering and founder and chief scientific officer of AlphaSimplex Group LLC, an investment adviser in Cambridge, Massachusetts, Lo has been studying the connections between financial decision making, neuroscience and evolutionary psychology for over a decade. His ideas about the role of human behavior in the financial markets have recently attracted the attention of policy-makers in Washington, who in addition to sorting out what led to the current crisis want to learn how to head off future destructive events.

Testifying before the House Committee on Oversight and Government Reform last November, Lo pointed out that credit crises have been regular occurrences over the past 35 years and that typically they are resolved without regulatory interventions. “Financial crises are an unfortunate but necessary consequence of modern capitalism,” he explained. Financial losses, he added, are a byproduct of innovation, “but disruptions and dislocations are greatly magnified when risks have been incorrectly assessed and incorrectly assigned.” In Lo’s view, “behavioral blind spots” (which he defines as evolutionarily hard-wired reactions to perceived risks and rewards) are particularly dangerous during periods of economic extreme: bubbles and crashes. (See “When Is Our Risk-Assessment Worst? Only When We Need It Most.”)

MIT Sloan Management Review Editor-in-Chief Michael S. Hopkins and Contributing Editor Bruce G. Posner caught up with Lo at his office at MIT in January to talk about the fallout from the financial crisis and what it means for managers.

What’s the Crisis Trying to Tell Us?

What’s the most important implication of the financial crisis?

For CEOs and other corporate leaders, the single most important implication is what it says about the current state of corporate governance. Many corporations did a terrible job in assessing and managing their risk exposures, with some of the most sophisticated companies reporting tens of billions of dollars in losses in a single quarter. How do you lose $40 billion in a quarter and then argue that you’ve properly assessed your risk exposures? I don’t think it’s credible to argue that this was just “bad luck.” If troubled companies want to explain away 2008 as a “black swan,” then someone should take responsibility for creating the oil slick that has tarred the entire flock!

What allowed this crisis to happen? How could so many seemingly smart people be so blindsided?

The very fact that so many smart and experienced corporate leaders were all led astray suggests that the crisis can’t be blamed on the mistakes of a few greedy CEOs—in my view, there’s something fundamentally wrong with current corporate governance structures and the language of corporate management. We just don’t have the proper lexicon to have a meaningful discussion about the kinds of risks that typical corporations face today. Maybe 10 years ago the risks of systemic shocks and correlated credit events were minor and we didn’t have to worry about them, but those days are gone.

So I think one of the biggest take-aways from this crisis is that we have to change the language with which we discuss and debate corporate strategy, and the way we think about shareholder wealth and corporate governance. A prime example is the limitation of standard accounting practices for capturing risk. Balance sheets and income statements are perfectly adequate for measuring a company’s realized profits and losses, but where does corporate risk appear? If a corporation enters into a five-year credit default swap today with a BBB-rated counterpart for a notional amount equal to five times the corporation’s total market capitalization, does this transaction appear on the corporation’s balance sheet or income statement? The answer is that it appears on neither, because a swap is neither an asset nor a liability when it is initiated. However, such a transaction definitely alters the risk profile of the company and should be actively measured and managed.

Why Too Many Risks Were Taken

Were executives just not able to assess the risks they faced, or did they understand the risks but make bad judgments anyway?

One of the most interesting questions about the role of corporate risk taking in the current crisis has to do with what happened at Lehman Brothers Holdings Inc. Was management taking the appropriate amount of risk? Maybe they were. Maybe it’s fine to bet the farm on a very, very profitable business that was a key component in increasing Lehman’s shareholder value by a factor of 20 over the course of a 12-year period. You’d be a very happy investor if you were sitting in 2006 and looking at what Lehman Brothers did since its IPO in 1994—a compound annual return of 26%! And then along come 2007 and 2008, and the entire franchise is gone. Maybe that was appropriate, maybe not. We can’t really have that discussion unless we go back and ask, “Who was responsible for risk, were they thinking about risk properly and were there appropriate corporate governance mechanisms in place so that someone could put on the brakes without getting fired?” I don’t know the answers to those key questions, but a recent article in New York Magazine reported that Lehman’s No. 2 executive suggested in 2006 that they were taking on too much risk, and he was summarily dismissed.

Suppose management had argued that, yes, there were risks of a blowup but that the returns Lehman was getting were just too good to pass up?

In that case, I think it’s perfectly appropriate for top managers to make that call—CEOs are supposed to make those kinds of calls. But it behooves them to tell their shareholders what they’re doing; if shareholders don’t want to sail on that ship, they should be able to get off. In many cases, we have to wonder whether decisions were being made as thoughtfully and deliberately as you’ve outlined. It’s one thing if you’re being explicit and you know that you have a one in 100 chance of losing everything but a 99% chance of making a 26% return—that may be a pretty good set of odds from most shareholders’ perspectives. But I suspect that most of the folks who got in trouble weren’t looking at it that way. My guess is that the decision makers who needed certain kinds of information weren’t getting it. Instead of a 1% chance of losing everything, they were probably assuming that there was 0% chance.

In contrast to Lehman Brothers, consider what happened at Pimco [Pacific Investment Management Co. LLC of Newport Beach, California], one of the biggest fixed income managers in the country. In 2005 and 2006, some of the company’s young turks were desperate to get into the mortgage-backed securities business, but Pimco’s legendary CEO, Bill Gross, responded by arguing that the real estate market was overvalued: He thought that if the real estate market could go up by 10% in a year, it could also go down by 10% in a year, even though this had never happened in the historical data that most portfolio managers used. Apparently, he asked his overeager colleagues to do a simple, back-of-the-envelope calculation: “What if real estate drops by 10%? What would that do to a portfolio of mortgage-backed securities?” The answer he got was what he expected: “We’d get killed,” to which he ultimately responded, “No thank you!”

So what’s the difference between the CEO of Lehman, Richard Fuld, and Bill Gross? Was it personality? Was it information? Was it corporate governance? Was it just blind luck? Those are the kinds of questions that we really need to be asking now.

My guess—and at this point, it’s pure conjecture—is that those who went deep into these so-called toxic assets did so because they were blinded by their apparent profitability, and they did not ask the hard questions. As I told the Congressional Oversight Committee, financial gain can be as potent a drug as cocaine; it stimulates the same part of your brain that certain narcotics do. And we’ve all had the experience that after a couple of drinks, we’re a lot more relaxed, and not nearly as tense and anxious as before. Well, believe me, after a whole decade of cocktails, we all became very relaxed about all sorts of risks!

Opportunity, Disguised as Distress

Now that the financial landscape has been rearranged, are there things that corporate managers can do to capitalize on the current environment?

One of the things companies are surely going to have to deal with over the next year or two is greatly reduced liquidity in the capital markets. Borrowing costs are going to go up, and it’s going to be much harder to finance new ventures, so companies will have to be much more creative about rebalancing their pension fund obligations and raising capital to fund operations. Managers should be prepared for some tough times.

At the same time, there’s going to be tremendous interest on the part of, say, pension funds in finding new ventures. My guess is that starting this summer, pension funds will begin increasing their allocations to private equity, hedge funds and other alternative investments—assets will be flowing back into risky ventures with a vengeance. The money that’s currently in T-bills has got to go somewhere—and anybody who has cash is going to be in a great position. Companies are going to have to find creative ways to tap into these nontraditional sources of financing.

What kinds of new market opportunities do you see emerging—things that aren’t typical?

Well, if you think about the kind of dislocation that’s affected financial markets, you’ll see that much of the current crisis stems from the fact that it’s very difficult to get information about the value of certain mortgage portfolios because they’re so heterogeneous. What if there was a service like eBay Inc. that provided a price discovery mechanism for these mortgage pools? An eBay for mortgages or mortgage-backed securities—something that’s easy to use and that allows users to value these illiquid securities quickly—could be an extraordinarily valuable service, particularly if it gains any kind of market share (like eBay).

It would allow holders of mortgage-related instruments to post their securities online and allow investors to bid on them. It would show prices on a historical basis so bidders could see how a portfolio of mortgages from a particular region of the country traded four months ago. Like eBay, it would provide a wealth of information and, ultimately, liquidity—that’s the key.

So selling a bunch of mortgages would be kind of like selling a couch?

The way it’s set up now, if you want to generate liquidity for a structured product like a mortgage-backed security, you have to call up potential counterparties and shop the deal. The best way to provide more value for these securities, to reinflate their value, is to shine the light of day on them and provide some sense that they’re not as mysterious as we think. It’s not a black hole. They have value, and it falls in this relatively narrow range. It’s a huge opportunity for creating a new set of markets that could dwarf the stock market if it were to get off the ground.

The Competitive Advantage of Transparency

In light of where we’ve been, it seems that this thirst for transparency is going to influence the market in other ways, too. How do you see this playing out in other areas, like financing costs?

Information is power, and if you’ve got an informational advantage, you have enormous market power. The fact is that if corporate leaders, portfolio managers and regulators want to make good risk-based decisions, they need to have the right data, and they need to have the right framework to be able to analyze the data. We know that the accounting profession does not really have that mandate. Accountants don’t like risk. They do not like discrepancies. They usually don’t think in terms of statistical fluctuations or probabilities. They want numbers to be clear and to add up. That’s why we need to create a whole new branch of accounting, which Zvi Bodie [of Boston University] and Bob Merton [of Harvard Business School] call “risk accounting.” It’s a huge business opportunity, and I suspect that it will be engineers and statisticians who will ultimately do this type of work. Maybe the accounting firms will draft them to do it, and we will need FASB [the Financial Accounting Standards Board] to adopt new accounting procedures. That’s going to take some time.

How have people responded to your congressional testimony?

The response has been mixed. The new administration seems to like the idea of more transparency, and the Congressional Oversight Panel and the National Economic Council like a number of the ideas. But there are other stakeholders who are worried. Hedge fund managers don’t like the notion of additional transparency, and I’m not sure how FASB views “risk accounting.” But the accounting industry is under fire—it needs to show it’s doing something positive to deal with the gaps in the current accounting framework. And this could be a whole new set of tools and analytics that they can offer to their clients, which would mean more fees for accounting firms and more value added for their clients.

Overturning Economic Assumptions

Given what you’ve recently seen, are there any fundamental, time-tested beliefs that you think have been turned upside down or are at least open to question?

One thing that has surely been tested is the belief that the current corporate governance system is designed to maximize shareholder wealth. I just don’t think that’s true. Current compensation structures are heavily weighted toward stock market valuations, and as long as stock market valuations are always rational and infinitely forward looking, corporate leaders will have the right incentives. But of course, we know that market valuations are imperfect, which leads me to the second time-tested belief that has been turned upside down: the assumption that markets and business will always react rationally to environmental change—that’s simply not true. If it were, we would have avoided the current financial crisis, and Bear Stearns, Lehman Brothers, Merrill Lynch, Wachovia and many other valuable institutions would have had different outcomes. I now view businesses very much as organic entities, like colonies of bacteria. If you understand the flora and fauna of the environment—all the relevant market participants as well as the rules of the competitive environment—you’ll have a much better grasp of business opportunities than if you attempt to equate supply and demand.

I really think that the lessons that we economists have perpetrated on our unsuspecting students need to change. We need to explain that there’s a very complex dynamic between emotion and logical deliberation, and if you don’t take that interplay into account, you can make some very counterproductive decisions.