The attendance at the MEAFA Forum on the Crisis in Financial Markets has exceeded our expectations with more than 60 participants from 10 disciplines across the Faculty of Economics and Business plus externals from the private sector and regulatory bodies. The forum comprised of a number of short talks from distinguished scholars from the University of Sydney (from the FEB and the US Studies Centre), covering an eclectic range of topics related to the global financial crisis.
Prof Graeme Dean (Accounting) welcomed the speakers and the audience, and initiated the discussion by drawing analogies to the work of Nassim Nicholas Taleb (2007) Black Swans and specifically on Taleb’s criticism that weak academic theory is an endogenous factor to the crisis, and to the work of Robert Shiller (2005) Irrational Exuberance and The Subprime Solution who claims to have predicted the crisis well before it manifested itself. Prof Dean identified certain key areas that are currently under scrutiny, including lax and fraudulent lending, excess leverage, the creation of complex and risky investments through securitisation and derivatives, the global distribution of such instruments across rapidly growing unregulated and opaque markets, faulty credit ratings, inappropriate risk management and irrational valuation of downside risk. Prof Dean identified a number of critical conundrums, namely (i) the ex post attempts to put a potential brake on an out of control market which may be an anathema to the very foundation of the -free- market, (ii) regulating the role of the modern corporation with a controlled information flow and versatile arrangements especially over the creation of new instruments, (iii) the rescue of failed corporations including their failed executives. Finally, Prof Dean pointed out the unique teaching opportunity for contesting widely accepted academic dogmas of accounting, finance and economics.
Prof David Johnstone (Finance) defended the role of Finance as an institution of knowledge, first by explaining the basic corollaries derived by the foundations of Finance, and second how these are often misinterpreted or purposefully adapted to suit individual goals. Prof Johnstone outlined the notion of an efficient market, and under which circumstances it works very well or collapses entirely, like in the case of a black swan, i.e. an extraordinary event that surprises the entire market. The Efficient Market Hypothesis (EMH) is always an academic casualty in a financial crisis, but as Prof Johnstone explained, we should not blame the EMH but the out-of-context interpretation of the EMH. Prof Johnstone argued that if we were to single out one factor for the causation of this crisis, that would be leverage and especially the behavioural aspects that lead to excessive and mindless leverage. Prof Johnstone believes that now there is greater need than ever for more balanced resourcing between the technical mathematical financial modelling of Finance and the examination of the inherent association of Finance to sociology and psychology. Indeed, a deeper understanding of the behavioural aspects of market players may give input for answering questions related to the excessive leverage model. Prof Johnstone identified certain specific endogenous sociological problems that contributed to the crisis, including the blind belief to an unbounded positive relationship of risk and reward, the clear incentives of financial institutions to increase lending but not to improve or screen lending, the governmental subsidies of individual investments, the short-term focus of the corporation that is supposed to have a long-term going concern, the endogenous culture of credit rating agencies, the excessive rewards for upwards performance and absence of penalties for downwards performance (even in failure), the morality of repackaging and masking securitised cash flows, the outsourcing of asset creation and asset management and the repurchase of ready-made products funded by securitised loans by those who purchased the assets etc. Certain key psychological factors were identified as well, including the pop culture of quant finance, the class attitude of modern executives, seeing patterns in randomness, too little awareness of adverse selection risk, lower thresholds to risk aversion especially by traders etc. Finally, Prof Johnstone noted that Finance theory is certainly not a foolproof handbook to market participation, with much of its technical detail being grossly reliant to untestable assumptions (like all social science disciplines). Moreover, in theory, markets best operate without intervention, but in reality, the behavioural aspects of a market call for some type of intervention.
Prof Robert Walker (Accounting) targeted the least mentioned, so far, stakeholders in this mess: the auditors. We have witnessed collapses of corporations whose assets alone surpass the annual GDP of many countries. Yet, the auditors have failed to identify any early warning signals of doubtful going concern and have, admittedly, relied on other 'independent' institutions for evaluating risk (such as rating agencies). Undeniably, the auditors have a shared blame, and Prof Walker distinguished their inability to pick up failing corporations between the blindness to evaluate financial management and the inefficient assessment of creative financial reporting. With respect to financial management, many financial institutions (especially in the US) used up most deposits and relied heavily in inter-bank lending which, in times of crisis, it ceases abruptly or becomes madly expensive. Hence, it was only natural that financial institutions turned off the tap and highly geared companies were left high and try. The next step was the cessation of cross-border lending to the US, in an attempt to try and contain the toxic-epidemic to already contaminated balance sheets. The big question was why the auditors did not flag excess leverage with securitised assets? To give the benefit of doubt to the auditors, Prof Walker explained how auditing institutions are faced with an increasingly complex financial system, where business has moved to a global level, leverage takes so many different forms and accounting standards change daily. Indeed, auditing mainstream financial reporting is easy, but it quickly becomes meaningless when the auditor has no access to the necessary documentation that allows a comprehensive evaluation of risk - in this case, re-re-packaged securitised cash flows, credit default swaps, reliance on credit rating agencies, suspicious capitalised expenses and intangibles etc.
Prof Alex Frino (Finance) analysed the real-estate factor that perhaps triggered the destructive ripple-effect we are witnessing today, but also outlined a chronology of events on how ASIC reacted once Australia felt the impact. According to Robert Shiller's (2008) The Subprime Solution, there are certain key fundamentals that have strong predictive power over house prices and that the average sceptic could clearly see a property price bubble. Despite the strong observed correlation, Prof Frino is not convinced that Shiller's indicators (population, building costs, interest rates) can be used to project house prices, especially since these are ex post measures that are reported with a lag. Moreover, following a brief analysis of these measures, Prof Frino attributes most of the problem to the way real estate was priced, driven not by rational and tractable valuation models but by ad hoc approaches from greedy agents. Prof Frino argues that a key fundamental that may have power in predicting the decline in house prices and specifically negative equity, is the rate of delinquencies and foreclosures. The contrast of these rates between prime mortgages and sub-prime mortgages is astonishing, with the latter having four to five times higher rates than the former. Given this observable, Prof Frino explained how the crisis was caused from mortgaged backed securities, sub-prime loans, and the resulting toxic debt. To prove the point, Prof Frino illustrated an AAA-rated mortgage-backed security issued from Lehman XS Trust on 20 Feb 2007 worth $1.3 trillion USD and 0% delinquencies at the time. It turned out that this particular security was backed mostly by mortgages from California and Florida, the first states to experience the decline in house prices and enter negative equity. As a result, today the paper is worth only $60 billion USD, it is BB+ rated and it is associated to more than 30% of delinquencies. The big questions are how did the rating agencies concluded that this was an AAA security, and how did the auditors miss out a $1.3 trillion doubtful investment. Nonetheless, the contamination to the stock market cannot be explained alone by the financials. The market sentiment picked up the trend and soon after the commodities and all the rest followed the downward spiral. Internationally, the LSE followed almost instantly, and the ASX with a lag of 2-3 months. Prof Frino continued by portraying the regulatory response to the crisis. It has always proven a politically rewarding move to blame the speculators, most likely because the general public see speculation as evil. In reality, efficient markets cannot work without speculation, but it is true that while it can be very rewarding it can also be very punishing. The paradox of regulating speculation (that is, total banning) is that it allows upwards rewards but prevents downwards punishment (a point also picked up by Prof Johnstone). With no speculation the market has limited resources for penalising bad performers and especially those that should go out of business, and therefore it is only natural that the market index revives at least in the short-run (hence the immediate political benefits) until the effect of the rescue packages is fully absorbed. Of course, the criticism of this move is that this type of regulation simply perpetuates the problem. Prof Frino also showed how the Australian regulator (the ASIC) followed the footsteps of its US counterpart (the SEC), but in a more spasmodic and self-contradicting chronology of decisions targeting speculators, enforcing what Prof Frino called a ‘band-aid solution to a bleeding jugular’.
Prof John Roberts (Accounting) offered a more academic dimension to the financial crisis. Prof Roberts's presentation was based on his recently published article in Accounting, Organisation and Society which was originally motivated by Alan Greenspan's self-realisation of making "a mistake in presuming that the self interest of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms… [and led him to] identify a flaw in the model that he perceived is the critical functioning that defines how the world works. Prof Roberts offered a description of self-interest by drawing inferences from the seminal work of Michael Callon on social studies in financial and economic markets. The position Prof Roberts takes is that the existence of separate agents (which can be individuals or systems such as accounting) leads to self-interests, while the existence of networks of agents (such as the interaction of individuals with accounting) leads to relationship interests, where individual self-interests are no longer easy to be separated identified. The key argument is that the more complex is the network of relationship the more difficult is the disentanglement of self-interest. Prof Roberts illustrated a very topical example, of how a simple relationship between borrower and lender has today exploded to a very complex network of borrower to lender to investment bank to hedge fund to rating agency to insurer to institutional investor. One can only wonder if this a purposeful complication of a somewhat intractable set of relationships, especially when the network's product crosses borders, changes name and is repackaged to attract institutional investors with only local knowledge. More specifically, with respect to the current financial crisis, the construction of self-interest through disentanglement was manifested through securitisation, synthetic CDOs, excessive leverage, credit ratings, mono-line insurers, pervasive reliance on models, and even the introduction of new accounting standards. Given this complex network of relationships and the opportunities for less-tractable self-interest, overflowing appears as a norm in the form of negative equity, falling house prices, mark to market losses, leveraged losses, second order contagion, and ‘credit risk’ becoming ‘market risk’ becoming ‘counterparty risk’ finally becoming ‘liquidity risk’. In this increasingly complex world, models and accounting mediate almost all relationships and are perceived as an objective view of reality. Yet, in good times we seem to forget that our world is valued based on assumptions and approximate estimates, while in bad times we panic and burn the very models that can help us recover from the downturn.
Adjunct Prof Wayne Lonergan (Lonergan Edwards and Associates) presented an overwhelming summary of most causes of the crisis. Prof Lonergan identified as the main causes the falling interest rates, excess liquidity, under-priced risk, excessive leverage, declining prudential standards, residential property boom, and implicit assumptions, and as the second order causes governmental policies, inadequate regulators, off balance sheet finance, securitisation, excessive remuneration, short-termism, accounting, valuation issues, and of course academics themselves. Prof Lonergan used a number of graphs to illustrate how all these events are in effect a chain of events that quickly spread out across the US and to its trading partners. Nevertheless, Prof Lonergan argued that the signals of this unprecedented excessiveness were obvious in all its forms (growth, leverage, bonuses etc). A big blame falls on the rating agencies, the favourite scapegoat of auditors for signing off clean balance sheets. Indeed, the top rating agencies were signing off AAA-rated CDOs' at the rate of one every fifteen minutes (62,000 in one financial year!), while at the same time they ranked only 12 corporations with AAA. Prof Lonergan's presentation offers a wealth of statistical observables from different sources that demonstrate not only how one disaster led to the next, but also how most of the damage could have been prevented by simply pausing and reflecting on the obvious excesses. Prof Lonergan argues that the Australian financial fundamentals are also ill-defined, and especially when it comes to valuing property (perhaps the favourite pass-time of the average Australian). Moreover, corporate valuation at the local level is very much the same as that of the rest of the world and again has endogenous faults that are simply not corrected based on past (and current) experience. It makes one wonder whether modern financial institutions are at all learning institutions or simply reckless by nature. Prof Lonergan ended his presentation with a well-taken criticism on pervasive academic teachings that continue to portray standard theories as the expected norm.
Prof Geoffrey Garratt (CEO of the US Studies Centre at the University of Sydney) finally added the political dimension to the debate. Prof Garratt defined the globality of the financial crisis as a product of the same instruments that created this enormous global wealth in the first place. Prof Garratt identifies two prime mechanisms that have created this wealth: (i) international trade and specifically Western demand to products manufactured from emerging economies, and (ii) financial market integration with global banks seeking higher leverage for achieving higher rates of returns. Given the premise that globalised commodities and capital markets originated from US-driven interests then it is not surprising to see the US pushing for a global recovery scheme. The Obama policies and the recent G-20 resolutions are at a mind-boggling scale, and it is very interesting to see that Australia is ranked as the third biggest relative rescuer in this global scheme in terms of GDP % of discretionary stimulus (following the US and China). Prof Garratt then offered his personal insight on how he believes the world might look like following the recovery from the global financial crisis. Indeed, it seems very likely that the US will replace its private debt problem with a public debt problem with serious implications especially to American citizens. In addition to the rescue packages, the Obama administration proposes an additional 3.6 trillion US dollar budget for funding enormous socio-structural upgrades in the US (e.g. nationalised health care, alternative sources of energy, restructure of education). To achieve all that, the US public debt must double in the next ten years to about 80% of GDP, and the only way to bring debt back to initial levels is by increasing taxes by 7% of GDP in an environment where federal tax is only 20% of GDP, or alternatively reduce spending by that rate. This is an improbable scenario, and the US is now facing a dilemma of increasing public debt knowingly that it will drive the US private sector down. Furthermore, Prof Garratt explained how the relationship between the US and China moved from an inter-dependent to a co-dependent relationship and it has now reached a point that it is perhaps time to be untwined. China's commitment of 600 billion US dollar rescue is specifically directed to developing the interior of the country, creating a strong middle class and strengthening domestically-driven consumption. Having burned twice by the US in a decade, China is also expected to form stronger bonds with other Asian economies and create an Asia inwards-looking cooperation. Certainly, this reaction creates some very interesting issues for Australia given the similar inter- (or co-) dependence with its major trading partner. Apart from China, domestic protectionism is spreading on a global scale in the form of direct subsidies which is a de facto barrier to global trade. This may create what the US National council predicted 'a world of multipolarity without multilaterism'; that is to say, a world in which the US is no longer hegemonous and there is an absence of global institutions that can deal with global problems even though the demand for solutions for global solutions is increasing. Prof Garratt's concluding remarks quote the Director of National Intelligence in the US who described the global financial crisis as the greatest threat to the American national security in the short-term, fearing the collapse of weak economies hence leading to global instability. Can the US do anything to prevent this? Obama is an internationalist in essence and has made it a priority to restore international links and refresh the US image. Apart from that, the country has exhausted its reserves by war and by economic crisis and can do very little to police the world. This seeming inevitable chain of events has led British historian Niall Ferguson to identify a new environment that combines ethnic conflict with economic downturn and receding hegemony which he claims it is a toxic combination for an 'axis of upheaval.
Following these insightful talks, Prof Graeme Dean welcomed the audience to pose questions or raise additional issues that were perhaps not covered by the presentations.
Emeritus Prof Murray Wells (Accounting) asked a direct question to Prof Alex Frino with regard to short-selling that has attracted a lot of attention, especially at the political level. Prof Wells argues that the problem does not lie with the naked form of short-selling which clearly brings efficiency in the markets, but with the excessive lending side of short-selling such as superfunds lending excessive stock to short-sellers for pure speculation. In addition, Prof Josephine Coffey (Business Law) extended the question to include the problematic buy-side of short-selling deals. Prof Frino identifies an inability of the ASIC to police short-selling (even with a total ban) especially when buying and lending takes place with overseas partners. There is an obvious weakness in enforcement and the Australian regulator must think more in the long-run and not take actions that are short-sighted. Furthermore, Adjunct Prof Wayne Lonergan argued that the institutional lending side of short-selling is not motivated by fees or returns which can be relatively trivial, and it does not make sense to take such huge risks at a fraction of the potential cost. Prof Frino did not agree that these deals are indeed underpriced, but was of the same opinion that the potential costs overweigh the realised revenues.
David Hoare from Principal Global Investors posed the question whether it is now time to (re)consider repositioning and re-chartering the dual regulatory role of ASIC and APRA (given their recent failure) into perhaps a joint body which will allow better communication and more efficient staff sourcing etc. James Richard Cummings from the Australian Prudential Regulation Authority remarked the separation of the two bodies has worked very well so far in Australia. Prof Frank Clarke (Accounting) added another dimension to the question, that of the absolute power of a single regulator, such as the SEC in the US, or even the extreme case of single global financial regulator. He argues that now it is more urgent than ever to revamp regulation, evaluate the elusiveness of its power and consider its international dimension.
Prof Tony Aspromourgos (Economics) argued that indeed it is difficult to predict what sort of regulatory structure will follow the aftermath of today's crisis. Prof Aspromourgos identifies two general directions: (i) bend the regulatory structure to include all those entities whose operations currently lie beyond the traditional banking framework and have demonstrated to generate enormous growth but also great systemic instability, (ii) pull back the regulatory structure to a more traditional banking domain so that these high-risk entities whose destructive creativity can shake the system in its foundations can no longer do so. If we go down the second path then we are effectively advocating against the role of the universal bank that does everything (especially like the US-based and the EU-based banking institutions). Dr Maurice Peat (Finance) position is that financial innovation is always a step ahead rigid regulation, and in fact regulatory arbitrage often acts as a key driver to financial innovation. Therefore, if we intend to build clever regulatory structures, then we ought to keep them as simple as possible so that when they are broken we can actually identify the violation. Prof Geoffrey Garratt (CEO of the US Studies Centre) commented on the political dimension of regulation and how it cannot be avoided given the present situation. For instance, consider the ex-Treasury Secretary Henry Paulson who was perhaps one of the greatest advocates of free market and simply loathed governmental intervention, yet by necessity he turned out to be the greatest governmental intervener since the 1930s'. Similarly, Barrack Obama has no choice but to protect his political interests but also take immediate real action to protect the domestic market and the US interest across the globe. The politics of this financial crisis are so overwhelming that regulation is simply inevitable.
Dr Chris Poullaos (Accounting) reminded everyone the China factor and the broader Asian response to the crisis. It appears that this time around, China is thinking outside the square and makes solid plans for the long-term. Prof Geoffrey Garratt agreed with Dr Poullaos and added that the Chinese remarks in the last couple of weeks were quite extraordinary because so far China has kept quiet and kept producing, whilst now they seem to want to be in the centre of the action. It seems that China has now grew strong enough (much stronger than the IMF) to pursue a new global role as a leader of an inwards-looking Asia. Karon Snowdon (ABC Radio, Asia Pacific Business) introduced a more real dimension to the discussion – the recent tie-up of Rio Tinto with China’s state-owned Chinalco. Karon Snowdon asked whether this clear international expansion (including other Chinese stakes as in Latin America and elsewhere) is a sign of what Prof Garratt called inwards-looking behaviour. Prof Garratt's response is that China has clearly underpriced the specific deal and it is likely that this new equity structure will probably drive global iron ore prices in favour of the Chinese stakeholders. In this respect, China is securing a constant rate of growth to its domestic call. Adjunct Prof Wayne Lonergan agreed that China's growth model necessitates a continuous procurement of mineral resources and it is only natural that China will do all in its power to secure these resources. On the other hand, Prof Tony Aspromourgos argues that even if China ends up inwards-looking with a domestic consumption trajectory then this would be irrelevant if China also continues supporting global demand. Prof Garratt agreed partly with these comments but in his view, past experience has shown that the multinational firm best sells in China if it has operations in China. Yet, Chinese regulation on foreign direct investment has been very stringent and this is in lined with their commitment to creating 50 world-class champion multinational firms, and the easier way to do that is by a sheltered domestic market. If this protectionism continues, then the position of the foreign multinational (including Australian) in China will be severely compromised.
Prof Graeme Dean changed topic by posing a direct question to the academic of which educational issues are implied from the global financial crisis. Prof David Johnstone sees as the most important issue the naiveness at all levels including the professionals, at topics such as market efficiency and agency theory. From the legal dimension, Prof Josephine Coffey (Business Law) identifies an opportunity here to educate the next generation the importance of not complying with the rules per se but with the spirit of the rules. Prof Carole Comerton-Forde (Finance) suggested to return back to fundamentals and give special importance to key observables that can identify disastrous situations. New students should be able to identify the early signals of bubbles, at least those with analogous characteristics to previous situations, and should be able to question pricing using the knowledge of fundamentals. Prof Johnstone's argues that it is not so straightforward and while you may 100% correct you may be correct too early (e.g. like George Soros who was betting against the dot-com bubble too early and lost a fortune). Prof Alex Frino agrees that a bubble is not at all obvious and using fundamentals cannot by itself spot the bubble, let alone tell when the bubble will burst. So, while an educational focus on fundamentals is valuable, by itself will not solve the problem.
Nonetheless, Prof Frank Clarke emphasised that university education must inform on current issues and especially how these fit in to the theory we teach, as well as how they relate to history and the lessons that we may have learned (or not) from history. Prof John Roberts warned that current issues are not well studied (yet) and there is always a lag before the eventuality of an problem and the real understanding of why there was a problem in the first place. Teaching students on truly current issues can be dangerous and may only exacerbate the problem of unintelligent education.
David Johnstone (Forum Convenor, MEAFA Founding Member)
Graeme Dean ( Forum Moderator, MEAFA Advisory Board)
Demetris Christodoulou (General Convenor)
Maurice Peat (Financial Analysis Convenor)
Richard Gerlach (Quantitative Analysis Convenor)