Issue link: https://www.e-digitaleditions.com/i/56540
Blind Faith in Financial Models Nothing provoked more eye-rolling in my classroom than my disdain for financial models. "I could teach you a fancy model for foreign currency options pricing," I would tell my stu- dents, "but it doesn't work." I might add, "Stop trying to quantify the unquantifiable, and have a little more faith in analysis and experience. Com- mon sense trumps models." My tirades reached a peak in 1998 with the federal bailout of Long- Term Capital Management (LTCM). LTCM was a hedge fund founded by a group of Nobel Laureates and financial whiz kids, who created a model that enabled them to take huge, highly leveraged risks in global financial markets. For a time LTCM earned fabulous returns, but in the end it foundered on its blind faith in the efficacy of financial models. Remarkably, LTCM's brilliant models had not taken into account the corre- lations between markets, especially in bad times; when things go bad, they go bad all over. A lot of things went wrong at once, and the Fed brokered an extraordinary rescue of LTCM by 14 leading banks. To me, LTCM represented a new low in the annals of U.S. banking. In fact, reliance on models can produce even riskier behavior since it lulls traders into a false sense of security— much like a skier wearing a helmet may ski more recklessly than some- one with a bare head. "And don't even get me started on the Fed's intervention," I would warn. I would point out that this is why banks and traders take exces- sive risks—because they believe that the government will bail them out in the end. Or else they believe they're too big to fail (AIG), too connected with other banks to fail (Bear Stearns), or too connected with power brokers to fail (everyone else). Once the risk-return tradeoff is subverted, markets will get stupid again. And again. And again. It's the People, Stupid Occasionally I would reminisce in the classroom about my early days as a "baby banker." I couldn't remem- ber all five C's of credit—collateral, covenants, cash flow, and something else—but I always remembered the most important C, character. Long after my students have forgotten debits and credits, I sus- pect they still will remember my story about the CEO of an up-and- coming Southern company with which I worked during my baby banker days. I brought the vice chairman of the bank—my boss's boss's boss's boss—down to meet with this CEO. But the CEO was distracted throughout dinner by sev- eral attractive flight attendants at the next table. He sent over champagne, winked and flirted, and ended the evening by bearing them off to an impromptu party in his hotel. My boss's boss's boss's boss was unamused. "Cut them off," he ordered me as we drove back to the airport. "I'm not trusting my deposi- tors' and shareholders' money to a man who can't keep his mind on business when one of America's top bankers comes calling." I nearly drove the car off the road. It was many years before I fully came to understand how much character actually counts. But that was before I learned of Tyco's CEO Dennis Kozlowski, who billed the company for a $6,000 shower cur- tain for his Fifth Avenue duplex. And before I knew about Wall Street "analysts" who hyped hot new stock issues to their unsuspecting clients while their internal e-mails trashed the stocks as "dogs." And what are we to think of Wall Street traders who packaged dodgy mortgages into incomprehensible derivatives with valuations that defied logic—all for the sake of the $30 million Manhattan penthouse or the third home in Vail? Today's public outrage over executive com- pensation is nothing more than a rerun of the outrage over Michael Milken's $550 million pay pack- age in 1987. This outrage distracts us from the real reforms that are required—but market participants do need to feel real pain before les- sons can be learned and incentives can be readjusted. Remedial Studies Truly, there is nothing new under the sun. Finance wizards who seek enormous rewards must, by defini- tion, be running enormous risks. Finance wizards who put their blind faith in models must, inevitably, be disappointed. And princes of finance who lose their moral compasses in pursuit of absurd riches must, invari- ably, turn into frogs. Those who do not remember the past are con- demned to repeat it—ad infinitum and ad nauseum. Perhaps we should bring some Wall Street types back to business school for remedial studies. I'm sure my students could help them learn some of the business basics we stud- ied in my classrooms long ago. ■ z Jane Hughes served on the faculty of Brandeis's International Business School in Waltham, Massachusetts, for 17 years. She currently serves as a consultant and teaches at the State University of New York's Levin Institute. BizEd JANUARY/FEBRUARY 2009 61