Cornell Financial Engineering Manhattan Advisory Board Members On Credit Crisis Panel
In the middle of the most tumultuous week in the financial markets in more than 75 years, Professors Robert Jarrow and Maureen O'Hara and Johnson School Executive-in-Residence Richard Marin discussed the credit crisis before a large audience. All three are members of the Johnson Graduate School of Management faculty, and Jarrow is a member of the Field of Operations Research. Jarrow and Marin are members of the Cornell Financial Engineering Manhattan (CFEM) Advisory Board.
The discussion was broadcast to a second classroom and videotaped for viewing on the web. The next day it was front page news in the Cornell Daily Sun and the Ithaca Journal and was featured in an article in the Cornell Chronicle.
Jarrow, the Ronald P. and Susan E. Lynch Professor of Investment Management, is one of the founders of the Financial Engineering Concentration at Cornell and is managing editor of Mathematical Finance. He regularly teaches courses in derivative securities that are part of the Concentration. Marin is the former chairman and Chief Executive Officer of Bear Stearns Asset Management. O'Hara, the Robert W. Purcell Professor of Management, is an expert on market microstructure and executive editor of the Review of Financial Studies. She is chairman of the board of directors of Investment Technology Group, an electronic trading firm.
In the panel discussion, Jarrow discussed the root cause of the crisis, O'Hara spoke on "credit markets and liquidity - what's next," and Marin discussed the recent business model of Wall Street, the components that have been revealed to be broken, and his views on the business model that might evolve from the crisis.
Jarrow observed that bonds based on subprime mortgages - home mortgages issued to high risk individuals, with low loan to value and debt to income ratio - are complex derivative securities. Rating agencies such as Moody's and Standard & Poors, who provide letter grades (e.g. AAA, Baa, etc.) to such securities, did not correctly rate the bonds derived from subprime mortgages, and other bonds (e.g. Collaterized Debt Oblications) derived in turn from them. "Combined with misaligned incentives of the major players, these two observations are the root cause of the credit crisis," he said.
Jarrow pointed out that the agencies rated the bonds using "historic data, not representative of the current situation" but covering only a sample period in which housing prices rose and interest rates are low. Moreover insurance companies (e.g. AIG) insured the bonds but did not understand the risks, which unlike their traditional business do not follow the statistical "law of large numbers." They needed "capital to cover the tail of the distribution - if you misestimate the risk of hitting the tail you don't have enough capital," he said.
Credit Markets and Liquidity
O'Hara built on Jarrow's talk to tell a more immediate story, the reasons why "it all fell apart." She provided vivid observations of the recent events, including the collapse of the short term market for loans among banks, the "run" on money market funds, the "implosion" of the $1.7 trillion commercial paper market, and the responses by the government and conversion of Morgan Stanley and Goldman Sachs to regulated banks. O'Hara noted that "liquidity depends on confidence," "runs are difficult to stop," and the market "has to be convinced that something will be done." Once the immediate concerns are deal with, we "need to start over with our regulatory structure," she said.
"Wall Street is Dead; Long Live Wall Street"
Marin addressed the future of investment banking as an industry. He noted that there are several aspects of investment banking, such as advisory services, facilitating mergers and acquisitions, underwriting new businesses, private banking and investment management that are "not broken" though some are impacted by a shortage of capital. However the capital markets segment, consisting of derivative securities and so-called structured products, are "really broken," as are the lucrative activities, known as prime brokerage, of selling repurchase agreements and lending securities to cover short selling.
Marin predicted as a result that the Wall Street business model will change, with surviving hedge funds and private equity complexes creating the next version, in part because "that's where a lot of the intellectual capital resides." He credited "greed and the lack of transparency" for the problem, noting in the question and answer segment following the talks that there is "enough blame to go around for everybody."
The panel discussion was moderated by Associate Dean Douglas Stayman, a marketing professor at the Johnson Graduate School of Management.