A matter of common sense

MIT's Franco Modigliani Professor of Financial Economics Stephen A Ross gives his take on understanding the 2008 financial crisis. By Genevieve Cua


PROFESSOR and finance professional Stephen A Ross has little patience for the blame game that ensues when the topic of the 2008 financial crisis comes up. In conversations, presentations and articles, brickbats are typically hurled at investment bankers, rating agencies and Wall Street in general who collectively 'fleeced the unwary'. But Prof Ross is having none of that. 'I'm getting tired of talking about the crisis. It's extremely frustrating because there are all the things I think I should know about but I don't . . . There is all the talk about how Wall Street fleeced the unwary. This is a complete misunderstanding of how financial markets work. Markets are there to protect the innocent. Competition is the best protection for the innocent, but nothing protects the innocent from themselves.'


Prof Ross is widely recognised for having pioneered the agency theory and for seminal work on models to price derivatives. Both areas of research are arguably germane to understanding the crisis. The agency theory, in particular, looks into the ubiquitous relationship between principals and agents - as, for instance, between a company and its employees - and hot-button issues such as executive compensation and conflict of interest.

At a recent talk in Singapore organised by the Centre for Asset Management Research & Investments (Camri), he tells his audience of a city manager who invested heavily in mortgage backed securities which subsequently bombed.

'(The manager) said, 'I didn't understand the product; the investment banker told me to buy.' I don't care where you're from. Do you think the investment banker is an angel from God who walks into your door? You have a world where you can get 5 per cent from a government security and someone walks in saying 'I can give you 7 per cent risk-free', and you buy it.

'You can't plead innocent after the fact; that's nonsense. You are the one that's greedy. You thought you could get something for free. The following is true: If it's too good to be true then it's not true. The only way to get more return is to take more risk. Sometimes, people twist that around and say - if I take more risk, I'll get more returns. It doesn't work that way. If there was a guarantee you'd have more returns, there wouldn't be risk.'

So derivatives have a bad rap. But there are trillions of dollars in derivatives out there. Some other people think they're very good. You can't run some businesses without them, because you'll take interest rate risk, equity risk. You don't want those risks. You want the value and you're willing to lay off some of the risk and return to produce a better outcome for you. Even the government recognises that it can't stop this and shouldn't. I hope they have the common sense to let that market continue as it is.

He is sceptical of efforts to raise financial literacy, however. Among investors, such lapses in judgment are a failure of common sense, he says. Can common sense be taught?

'We've gone from a society where if you have a problem, you bear some blame, to one where we say, 'They did it, but I didn't do it'. Before the crisis, returns on capital for taking risk were very low. If you increased risk, you had a very little increase in yield. In the effort to get higher returns, we pushed that too far.

'There are a couple of reasons why that occurred. One is the agency situation: People making decisions were rewarded on a short-term basis for a higher return. Another was that people suspended belief. I don't know if it's naivety, but I do think it's a failure of common sense.'

He recounts the experience of his late brother-in-law, a successful surgeon. He was offered property some years ago, by an individual who had subdivided it into four plots. The attraction was that a highway would ostensibly be built near the land. He bought one of the plots; the seller would himself keep one. 'I said, why did you do this, you don't know this man. 'I listened to what he said - it was very clever.' I said to him, I don't think you understand what you're doing at all.

'If the opportunity is so good, why is he giving it to anyone? If he doesn't have enough money to capitalise on it himself, what kind of record does he have as a businessman? Just ask common sense questions.

'It turns out that the highway was built and the land rose enormously in value. But what the seller did was he kept one for himself and sold three. He kept the one next to the highway, and three are in the hills behind. You know you're not going to win. Do you teach that in school? I don't think so. We all make mistakes. But it's a serious mistake when the institution that takes care of people's welfare and pensions makes mistakes like that. The people who run those institutions - they are the greedy and selfish ones.'

Prof Ross's roll call of achievements in financial research is almost daunting. Based on his profile at the Massachusetts Institute of Technology (MIT), where he is the Franco Modigliani Professor of Financial Economics, he is credited for having invented the arbitrage pricing theory and theory of agency. He was also co-discoverer of risk neutral pricing and the binomial pricing model for derivatives. Models developed by him and his co-workers are standard tools in major securities trading firms. That's in addition to numerous awards for financial writing and options research.

Today, he says sheepishly that he manages his time badly. Still, he is committed to teaching, which he calls his 'fun time'. He teaches one course at MIT during the fall, taking under his wing less than a handful of doctorate students in finance. Speaking about them brings a gleam to his eyes. 'I love my students; they've turned out to be spectacular . . . Several of the greatest professors in the world were my students; how can I not be proud? The biggest thing you can do for students is to get out of their way. They can figure out what to do. You encourage them but don't interfere with them. Otherwise, there is too much of a tendency to motivate them to do what you want them to do, and not what they want.'

Yet, it is not just in academe that Prof Ross is making his mark. He has also parlayed his derivatives expertise into what appears to be thriving businesses. He heads Compensation Valuation, which specialises in valuing complex option contracts and provides valuation services for companies seeking to expense employee stock options.

He is also principal and chief investment officer of Ross Farrar, an investment manager that specialises in the use of derivatives to help alter the return profile of funds and to help hedge corporate risks. Not surprisingly, he bristles at the odium that has been heaped on derivatives in the aftermath of the financial crisis.

'Derivatives are a bit like a scalpel. In someone's hand, it's a weapon, but in doctors' hands, it's life saving. You can abuse anything you want, but you don't ban knives - just as you don't and can't ban derivatives. They improve productivity dramatically.

'I have business that uses derivatives to enhance the performance of large institutional portfolios, and change their risk characteristics. That's the new world. I love doing that. You learn from business what you teach. And what you learn in academe you bring to business . . .

'So derivatives have a bad rap. But there are trillions of dollars in derivatives out there. Some other people think they're very good. You can't run some businesses without them, because you'll take interest rate risk, equity risk. You don't want those risks. You want the value and you're willing to lay off some of the risk and return to produce a better outcome for you. Even the government recognises that it can't stop this and shouldn't. I hope they have the common sense to let that market continue as it is.'

Effects of regulation

In his talk at NUS, he presented an 'idiosyncratic' view of the crisis which he believes was partly caused by the unintended effects of regulation. Basel requirements for bank capital calls for banks to set aside more capital for riskier assets. Assets of the highest quality - with a 'AAA' rating - required relatively less in reserves. This, he says, caused a rush among investment banks to create AAA securities.

'If you hold AAA securities, you can take on more leverage. So what does Wall Street do? They invent AAA securities. Are you shocked that they would create them? . . . Politicians say they're astonished at the greed. For 500 years, investment bankers have been greedy. What kind of naive politician thinks they won't be greedy now and pursue their self interest? It's what you'd expect them to do.'

The failure of quantitative models, also blamed for the crisis, is in part a failure of common sense, he says. 'You put enough data in, good and bad data, and the answer will come out correctly. But the thing you don't spend enough time doing is listening to people who are every bit as smart but don't do mathematics. They have a good qualitative understanding.

'I have a business partner who used to work at a major bank. He left the bank because he said they were making him give corporate loans that were bad loans, simply because they wanted to get more loans out. You need people like that with a good qualitative understanding to help create your data.'

He suggests that the world has not seen the last of big company failures. Part of the problem is the involvement of government in the economy. 'I think there are deep structural problems. We don't understand the role of the political economy. We don't think or write about it - it's that interaction between politics and the economy that brings about crisis.

'We wouldn't have had a crisis - at least not this one - if the US government hadn't been so insistent on supporting house prices. We have the same thing, the same villains today.'

He wonders what might have happened if the US government had not been so quick to let Lehman Brothers fail, or to rescue AIG and Goldman Sachs. What if steps had been taken to set a floor to the value of problematic securities instead? It's an intriguing thought. Today, the value of some of the securities taken over by the Federal Reserve has rebounded significantly.

'Here is a way to deal with things. There was concern then that the mortgage assets were illiquid, and everyone was afraid of what would happen so we had TARP and TAUP. Here's an easier way. I bring to the regulator portfolios of mortgages.

'They can put their guarantee on the pool, that it won't fall below 60 cents on the dollar. You sell the asset at 60 cents on the dollar, and guarantee that no more than 60 per cent will default. The instruments become instantly liquid.'

Prof Ross himself invests most of his funds in illiquid assets, and almost nothing in common stocks. 'I've always felt I had some good information and the best investments I can make are in private, illiquid things . . . I'm in the business of making investments. If I can't see good investments, I shouldn't be in business.'

Tax liens

Opportunities today are not as outstanding as they were during the 2008 crisis. 'I was just amazed. We were seeing mortgage products that I knew you would double your money in a year, and you did. Now, it's not as attractive, and it's all very niche, pockets of funny things.'

An example, he says, is investing in tax liens. These are issued on properties whose owners failed to pay their property taxes. The county in the US auctions lien certificates to generate revenue. If the owners fail to pay taxes, you end up with the property. If they do pay taxes, you earn interest on your investment.

'There isn't a lot of competition in this. You can get 18 per cent return just from the penalties that people have to pay. Best of all, if they can't pay anything, they lose the property and you get it. The tax lien is usually 2 per cent of assessed value.

'Even if the property has dropped to half or 20 per cent of what it's worth . . . you still have 10 to one coverage in terms of collateral, and the wonderful thing is you get a property for 2 per cent investment. That's terrific. That's an example of the things I like . . . funny weird old things.'

Meanwhile, the US, he says, has structural issues that cloud its near-term future. But its strength lies in its ability to assimilate great numbers of talented immigrants. 'I don't know where the world is turning, but the US is a pioneer in so many things. The greatest research in biology is going on in the US. Technology in Silicon Valley, innovations in finance. It really is a big, free capitalistic society. I see the problems and I don't talk enough about the good things.

'There are serious problems . . . The new reality is they really can't make cars as they used to, or steel. It's increasingly becoming a service economy. Service is very valuable and can be very productive. These changes are always difficult. To some extent, it has unenlightened government leadership. Deficits are running out of control. The prediction is a deficit that's a quarter of total budget, that's huge. If that's right, that's very scary.'

Singapore, he says, will do 'wonderfully well'. 'You have a giant next door called China. You're not just going to live with China, you're going to prosper. It's just what you need - great concentration of human capital, enormous skills in trade and production.

'There's a reason we call Singapore the Switzerland of Asia. Someday, they're going to call Switzerland the Singapore of Europe.'