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Your Turn What I Would Tell My Past Students Recently I've been wishing I could address some of the students I used to teach at Brandeis's International Business School. I'd remind them about my endless rants on debits and credits, on federal bailouts, on financial models. I think my students learned key lessons, but it looks like many denizens of Wall Street failed to pay attention when they were in business school. Because every single thing that has gone wrong in the current deba- cle was studied and put right in our classrooms. All of this has happened before, and it will happen again until we finally learn the lessons of the past. Risk and Return When I was teaching, I liked to draw a risk-return graph on the blackboard and say, "I'll teach you a year's worth of financial theory in 30 seconds. When return goes up, risk goes up. That's all you need to remember about finance." The students would roll their eyes and then race out of class to tattle on me to their other finance professors. Since the time of William Duer in 1792, every single financial cri- sis/debacle/scandal in America has reflected a foolish hope that this basic relationship has been overturned. The bankers who loaned gobs of money to Latin America in the 1970s and early 1980s forgot that the reason for the sky-high interest rates on this debt was unacceptable risk. Those who poured money into Enron in the late 1990s were gleeful- ly anticipating 15 percent growth in earnings every year, never mind that the company had to take bigger and 60 BizEd JANUARY/FEBRUARY 2009 bigger risks in the natu- ral gas trading market to achieve that growth. Financial mythol- ogy holds that old Joe Kennedy realized that stocks had flown too high in 1929 when his shoeshine boy started giving him stock tips. My own "aha!" moment came at a bat mitz- vah in Silicon Valley in 1999, when I was seated next to a newly minted millionaire and entrepreneur. He confided that a venture capital firm had just given him $18 million for a Web site that would provide weather forecasts—despite the fact that weather.com was already offering that service for free. The following week, I told my students the story, and I warned them that the Internet bubble was going to burst. This time, Wall Street should have had its "aha!" moment when banks started offering mortgages with zero percent down and no credit approval process. When markets become stu- pid, a crash is inevitable. Derivatives Fallout Veteran Wall Street banker Felix Rohatyn famously warned in 1994, "Twenty-six-year-olds with comput- ers are creating financial hydrogen bombs." If Part One of the current mess is the mortgage market's descent into madness, Part Two is the derivatives fallout. As I told my students, derivatives themselves are not evil. Derivatives are simply financial products that derive their value from underlying assets, including gold, foreign cur- rency, oil, and stocks. Used for good, derivatives can help companies pro- tect themselves against price fluctua- tions and stabilize the economy. by Jane Hughes Misused, how- ever, derivatives can be hydrogen bombs. I loved to teach the case study of Nick Leeson, who landed at Barings Bank Singapore in mid- 1992. His job was to make risk-free trades between the Singapore and Japanese stock markets, to take advantage of tiny price differences. Instead, Leeson made unauthor- ized trades in derivative products— and manipulated a secret account to hide his losses. He was viewed as a star trader at the bank's headquarters in London, lauded for having single- handedly earned one-half of the 1994 profits for the entire firm. Apparently no one was even mildly curious about how these fantastic profits could result from such a low-risk operation. In the end, Leeson fled, leaving behind a handwritten note that said, simply, "I'm sorry." Barings—banker to the English royal family and one of Britain's most venerable financial institutions—was suddenly insolvent. The Bank of England chose not to intervene, and eventually the Dutch bank ING agreed to assume most of Barings' liabilities for one pound. Fast forward to 2008 and AIG. Like Barings Singapore, the insur- ance giant's London unit was run by an individual who received almost no oversight from the parent institution. Joseph Cassano plunged into the arcane world of derivatives trading, like Leeson, and initially recorded enormous profit margins. But as the credit crisis unfolded in 2007-08, Cas- sano's derivatives portfolio suffered $25 billion in losses that swamped the London unit and eventually the entire company. The U.S. government bailed out the insurer for $85 billion.