…trying to think about it in terms of stimulating more research and trying to get people more interested in this problem.
And also relating this to the idea of financial intermediaries
and the important functions that they provide to the financial markets.
So, I only have about forty minutes to talk, and also I talked this morning, so, given, and I have another session after this,
so I may be a little bit tired, but we’ll see if we can go through this and keep it exciting.
When we looked at the actual Miller-Modigliani model, both Merton Miller and Franco Modigliani were awarded Nobel prizes,
and Miller for his work on capital structures.
Basically, the idea is that the value of the firm is really independent of how the firm is financed.
Or another way to put it is that even though the cost of capital is a constant depending on the assets that a firm has
and the money that the firm makes, the risk of the underlying assets and the way that they are financed is not really material.
So we'd have a situation where, if the required return on debt appears to be lower, if you use debt, then, correspondingly,
it would end up that you would have a higher required return in the equities.
So just that the weighted average of the two is independent of how the firm is financed.
And that was a revolutionary idea.
But then some people started to talk about the Miller-Modigliani capital structure framework
and they said there’s holes in the model, there’re holes in what’s being done,
because obviously that when corporations use debt in their capital structures,
the debt interest is tax deductible and that adds value to use debt.
So debt crowds out equity, because the equity returns are not tax deductible to the corporation and then taxable again to individual investors.
Now, the second argument was that bankruptcy costs, or the idea of bankruptcy also affects the amount of debt a corporation has.
Merton Miller, in his presidential address, which was cited also by the Nobel Foundation, argued that these two,
the deductibility of interest, even though it appears on the surface to add to the, that debt is more valuable than equity,
it’s a little bit deceiving.
The reason it’s a little deceiving is because of the fact that you have to take account of the personal tax rate as well.
And if the personal tax rate is low, then it might be on capital gains etc.,
might be that the corporation and the personal tax rate is high on income,
it might be that producing a corporate form will dominate.
So you have to take both the personal and corporate tax into view.
And he argued that the differences were small.
And bankruptcy costs, he said, themselves are not very large.
In fact, he likened it to a stew that included the horse and rabbit stew.
One horse and one rabbit, you know, the idea that the rabbit was the bankruptcy costs
and the horse was the actual advantages or not any advantages of the debt versus equity.
So, the interesting problem is that we look at risky debt, and risky debt itself also doesn't effect the proof.
If you use the option pricing technology, we have the value of the debt,
the value of the firm is equal to the sum of the debt and equity, that you can think of equity as a call option.
This is very important, we talk about financial institutions and intermediaries
or we're moving towards here in the idea of liquidity and risk transfer,
but you think of the equity as being a call option to buy the firm by paying off the face amount of the debt,
which is B – the amount you owe, on the debt at some future time period.
And basically, if the value of the assets or the value of the firm is less than the promise,
okay, then the equity will not exercise its option to pay off B at exploration of the debt,
it'll pay and the debt holders will end up owning the firm.
So, basically, if you look at the value of the debt,
the value of the debt is equal to the value of the firm, times N of minus d1, which is in the option framework,
is the value of accumulative normal density function from minus infinity to minus d1,
which is essentially defined as the number of deviations from the mean,
where the mean is under the Black-Scholes framework is equal to the risk-free rate plus one half the volatility.
So, as a result, if the value of the assets of the firm are very much above the face amount of debt,
then the value of d1 becomes very large, and so minus d1 becomes very small.
So, therefore, the debt itself will look almost riskless,
it will be equal to just the discounted value of the face amount of debt, so that would be riskless debt.
But as it turns out, as the value of the firm's assets falls
or the value of the underlying assets falls relative to the debt, then the debt takes on more and more characteristics of equity.
So we have, in risky debt, when the promise on risky debt is high,
basically the debt itself becomes more and more akin to an option or put option,
where the debt holders are paid off only if the value of the firm is above the promise,
and then they get the value of the firm if it's below.
So this creates a huge problem for financial institutions.
The huge problem for financial institutions is they end up in what I call the inflexibility trap.
The trap that if the value of their assets fall, as we’ve seen over the recent time frame,
and they promise to pay off the debt holders a certain amount that, as a result,
the value of the equity becomes more and more like an option and the value of the debt is also risky
and it has more equity-like features.
So we see about a lot of the financial regulations or what we’ve seen lately
is that the regulators are saying the equity holders have to pay a price in the sense that if the government steps in,
they wanted to wipe out the value of the equity as in the Bear Stearns case,
or now with Fannie Mae and Freddie Mac and other banks, they don’t want to help the equity holders,
but basically what they are doing by putting in capital and supporting the banks
and these other GSEs is really helping the debt holders.
So, the debt holders are really the ones being bailed out, and it's not really the equity holders,
because the risky debt, once the government puts in capital or guarantees the debt, becomes safe debt.
So, the debt holders gain and the equity holders essentially lose.
Now, when the bank wants to recapitalize itself or generate capital,
the difficulty comes about that when it goes to issue debt,
the debt holders protect themselves and say, issue debt that is of lower quality than the debt that I have granted.
So they issue debt of lower quality, but then what happens, the equity holders suffer dramatically,
because, basically, when you issue debt of lower quality or issue stock of lower quality,
the debt holders then have more assets that are supporting their claims, and the value of their claims go up by this formulation.
So the debt holders are always going to say, no, we don’t want you to issue debt of equal to our debt,
we’d like you to issue debt that’s inferior to our debt, and that destroys the value of the equity.
So the equity holders then cannot issue debt, and if they issue equity, there’s a huge cost to issuing equities.
So it creates an inflexibility in firms being able to adjust their capital structures.
If they have too much risk, or the debt is risky itself, so, I think if the current cost of adjustment
and the de-leveraging costs are gigantic, because its banks or other financial institutions have tried to issue equity,
that the value of their existing equity has fallen much more than the amount of money that they’ve raised.
So you’ve had institutions in the United States like Fannie Mae and Freddie Mac,
who’ve lost approximately ninety-some percent of their equity value, and other banks have lost up to,
Merrill Lynch is up to sixty to seventy percent, and even the banks, such as JPMorgan Chase,
have lost forty percent of the value since one year ago, when the financial crisis occurred,
simply because the equity holders know that the debt holders are not going to allow them to issue debt,
they are going to say issue equity, and if they issue equity,
a lot of the value of the equity is transferred to the debt holders, not to the advantage of the equity holders.
So, basically, what has happened with many of the financial institutions
is that it's costly to adjust the capital structure of these antitheses when shocks occur.
It's not possible to convert assets into cash without excessive costs, because there's just no liquidity in the market place.
So, given they have what I call a lot of negative convexity, they have to make a decision,
they have to make money for investors so they keep investing,
but then at the same time they don’t have the flexibility in their operating policies
and their debt policies to enable them to adjust when shocks occur.
And so I think that what we'll see in the future is a realization that if one is an inflexible entity,
that the costs of adjustment are so large because of the debt trap that the entities are in, that, basically,
they will tend to create more flexibility in the firm itself.
And how do you create flexibility?
One is through diversification, operating flexibility, having more activities or diverse sets of activities,
unlike what was said this morning, where financial institutions should concentrate on one thing,
if you concentrate on one activity, you don’t have flexibility,
because you don’t have cash flow or an ability to adjust in your operations.
Less debt, obviously, in the capital structure allows you to have the ability to then, at times of shock,
to be able to withstand shock by having more reserves, and the third is creating more optionality.
The changing the shape of the payoffs, most banks today have linear payoffs, where if the bank makes money,
it will make money on the upside and lose money on the downside,
while it's possible to change the shape of the distributions that the banks have, or the financial entities have,
by actually giving up some of the upside for more downside protection.
These are areas in which, and ways, you can create flexibility.
But the interesting part about a bank or a financial institution or any corporation is to be cast a question:
Is it better to react to a crisis or to be proactive?
How is it possible to be proactive in deciding on what to hedge,
how to hedge and also having a risk management system that creates the correct flexibility.
It's so much easier, when you are running a business,
to not worry or try not to worry about the fact that there could be a shock and you’ll need flexibility at the time of the shock.
But it's costly to react and it's costly to be proactive, the more you diversify, the less money you are making.
The more reserves you have, the less money you are making.
The more you buy protection or optionality, the less money you are making.
Therefore, that’s proactive, but when a shock occurs, then you are able to react to a shock, because you’ve done it proactively.
As I said previous this morning you can have a rain storm or think of possible rain,
it's costly to carry the umbrella if it is not raining, but if you don’t have the umbrella and it does rain,
then there’s costs as well.
And so, businesses must decide how much flexibility to build into their financing policies and their investment policies.
And it's very hard to make those decisions, because if you haven’t had, if the bank hasn’t had enough flexibility,
then at times of shock it's very expensive to garner the flexibility at that particular moment.
So if we look to why the costs are very great, is that we can look at liquidity and risk transfer.
The entire financial intermediation business or industry, banks, other intermediaries,
investment banks and others make money by really providing liquidity to the market place,
being willing to fashion contracts for them and provide liquidity.
We know that if an entity does provide liquidity or risk transfer,
that they make returns for providing liquidity in the market place.
And also, risk transfer is slightly different from liquidity
in the sense that risk transfer goes back to the idea that hedgers,
or if there’s a demand for hedging of risk or risk transfer in the economy by entities that want to transfer risk,
that, basically, that someone has to take the risk from the other side.
Mr. Greenspan said one of the great advantages of our global financial markets was the increase in hedging, risk transfer.
But if everyone is hedging, someone has to be receiving the risk,
you can’t transfer risks in the market place without someone receiving those risks.
So the speculators are the ones who are carrying the risk, the financial institutions carry risks,
and just the same way why it is that people want to transfer risks is because it provides flexibility for them
and it provides a way for them to economize on the amount of equity they have.
So, basically, we see that in the commodity markets,
the Miller transfers generalize risk to the market place and keep specific risks.
The reinsurance markets, where an insurance company designs a product for a client, it markets that product,
it handles that product, it understands that product.
The more it sells, the more risk it takes on to its own books,
so the reinsurance company then transfers the risk to the reinsurance company, or some of the risk to the reinsurance company,
and makes its money, its expertise by the way it fashions the contracts, the marketing, the design of its insurance contracts.
And the risk management is then transferred, or hedges its risk by transferring risks to the reinsurance market.
So, there’s risk transfer as such an important part of making the economy more efficient,
and the banks and other financial institutions make their money by risk transfer and liquidity provision.
The interesting part is that the key evolution of finance in the last twenty or thirty years
has been this idea of trying to understand risks and what risk to keep and what risk to transfer.
So you know that to run a business, to bake a Starbucks, where Starbucks is selling coffee,
it is necessary for Starbucks to concentrate on selling coffee.
That’s what their business is, or creating an ambiance for people and then they can drink their coffee there.
But at the same time that Starbucks has to concentrate to make money, to make money a business has to concentrate.
But then, at the same time, it has other risks, it has the generalized risk of coffee, the price of coffee changing,
or the economy becoming weak or real estate prices changing.
So, as a result of that it can decide to keep the generalized risk or it could hedge those risks.
And so it depends on the cost of hedging versus equity.
The more equity a firm has, then it can handle generalized risks and idiosyncratic risk.
As a result, there’s a cost of hedging and a cost of equity.
So, the strategic use of hedging, which is a growth area and has been a growth area for the last number of years,
to produce products and clients for services, have permeated the financial institutions
and has started to permeate many corporations.
The corporation has to decide what risk to keep, what risk to get rid of.
You can’t get rid of idiosyncratic risk, that’s the risk that the business has that makes money.
The risks that are transferable are generalized risk,
such as changes in interest rates or changes in commodity prices and alike,
and those are being traded off against getting rid of risks allows you to economize,
allows these corporations to economize on the amount of equity capital that’s necessary,
and as a result of economizing on equity capital, which is the expensive that we have a competition,
we have competition between hedging and equity capital.
If we look at the classical definitions of liquidity under Demsetz or others, it's for the price of immediacy,
the price of being able to convert assets into cash, and the price of inventory risk, essentially for risk adverse traders.
But the problem is that the price of liquidity and the price of risk transfer are not constant.
And most of the literature and academic literature has concentrated on, or assumed that the price of liquidity is constant.
And when we have incomplete markets with frictions,
it's not possible to define the information set in such a way as to actually understand all the possible states of nature
that could arise in which we would want to hedge.
So we have a problem, that you can’t specify the state when you want to be able to convert from assets into cash,
that each of us might have a myopic plan which depends on our level of demands
and how we are going to be able to actually want to change our portfolio,
but we have an aggregation problem in the sense that there’s also the possibility
that there is multiple demanders of liquidity at the same time.
And so the aggregation issue comes about in the sense that the non-linear,
the multiple demanders of liquidity be willing to want to convert assets into cash,
at the same time create a non-linear feedback system or a cascade which affects the liquidations,
which then leads to further liquidations.
In other words, that I as a bank I might be holding a set of assets and then another bank liquidates assets,
because a shock has occurred, which has to reduce its assets.
It can’t issue debt, it has to reduce assets.
It can’t issue equity, it wants to reduce assets, because the value of its assets has fallen,
it needs to bring its risk management back into line.
It liquidates assets, okay, causing the price to fall for the assets it liquidates.
You'd think, under economics, that if you liquidate assets, the price falls, that induces others to buy the cheaper asset,
but what it does instead of that, the other banks that I referred to, then suffers a loss as the price falls.
It, in turn, has to liquidate assets to bring its risk management, its debt-to-equity ratio back into line.
So that means it liquidates assets, maybe the same assets or different assets.
It will liquidate the ones that it thinks are fairly valued or nearly fairly valued,
that it creates those asset prices to fall and you have this cascade effect
that we are having in the financial institutions, markets around the world,
where bank A liquidates assets, bank B suffers a loss, impart in the assets that are common and liquidates other assets.
Liquidating other assets creates a commonality in another bank, which causes the cascade or prices to continue to fall.
Question, why doesn’t others then come into the market, and we’ll get to that in a moment.
That creates, liquidity tends to dry up as the prices of these assets tend to fall.
So, the de-leveraging necessary in the financial system and the aggregation problem
are the major causes of the current financial crisis.
It is true that we see it as maybe the shock occurred in subprime, but it's pervasive.
It’s across all assets to try to reduce leverage, because running a levered business or a levered firm,
because of the negative convexity problem, is a very difficult problem.
It's much easier to just buy a portfolio of securities, such as stocks in the market,
and not have to think about how you keep the risk of your position constant,
because if the bank doesn’t try to reduce its risk, given it still owes the same amount of money on its debt,
as the value of its equity falls, its riskiness keeps increasing.
The risk of its equity keeps increasing and therefore it accentuates, it gets worse and worse, so banks try to preserve,
try to manage the risk to be somewhat constant.
As a result of that, they have to reduce the assets they hold, if they have the very risky debt.
So I think that the most important part is if the bank or other entities
are involved in providing liquidity and risk transfer to the market.
In a normal situation, as prices change in the market, the demand for their services changes.
They supply liquidity and risk transfer services.
And so they understand how to, any business where a speculator in the classical sense,
in the Keynesian sense, a speculator understands why the other side of the trade,
why the hedger is willing to pay them for their services, they understand that.
The hedger in hedging is willing to pay the speculator to carry risks forward.
In the market place we know that there are demanders and suppliers of securities and there’s an imbalance that occurs,
because at times the demanders of securities are there when suppliers aren’t.
So the provision of liquidity is to provide liquidity or to, when demanders want securities, to supply those securities,
when suppliers want a supply they will, intermediaries will buy those securities and carry the inventory forward in time.
So they are stepping into the shoes of the ultimate buyer.
They compress time.
That’s the job of an intermediary.
When you provide liquidity or risk transfer services to the market,
the financial institution in its dealing business makes money by buying cheap inventory
and carrying it forward until the investors come to buy those particular assets from them.
And as a result, that’s the way they make money.
So the interesting part, that the dynamics of the business are such that, we need a process that as the demands increase,
then the institutions buy more and more of the inventory, carry the inventory, and as long as they understand the model,
they have a valuation model, and understand how to value the inventory and how long they are going to have to hold it for
and how much risk capital to put against that inventory, they are fine, they can make money.
But the problem is that when we have shocks occurring as we’ve had in recent times,
say the subprime shock and then the cascade effect, we get mini shocks, local shocks and global shocks,
that the models, the problem becomes, as the flows increase and continue to increase,
then the investment bank or the intermediaries are asked to carry more and more of the risks,
that we have essentially what I call the Heisenberg uncertainty principle of finance.
That as long as you, there’s two fundamental principles, a fundamental principle of finance is substitution.
That similar assets are going to sell, could sell at different prices,
but substitution means that as the value of one asset becomes very distorted,
relative to the somewhat similar asset and risk and return characteristic, then substitution occurs.
Investors, real money investors sell the asset that is expensive and substitute into the less expensive asset.
So, that is a fundamental principle that guides the speculator,
because the speculator knows that the real money players are the,
individuals in the market place are going to notice that the assets
that they are holding are overvalued relative to the cheap asset that the speculator is carrying forward,
the inventory that is being carried forward.
So that’s the fixed point, or the idea of having that differential.
So there’s a belief that there’ll be convergence.
Now, on the other hand, flows occur, so as the flows continue to occur, alright,
then the speculators are adding to their inventory,
because the asset is becoming cheaper relative to their valuation model or relative to other assets they are holding.
So they continue to add, but then you have uncertainty, as the positive flows,
or the feedback is positive feedback where it keeps the flows continue against the intermediary,
then the intermediary is worried that, basically, they don’t have the fixed point anymore,
that substitution is being overwhelmed by the flows.
As soon as it is the case that the fixed point is lost and the velocity, they can’t add anymore to their holdings,
then they stop, they stop intermediating.
And they withdraw capital, because they know it's no longer a profitable business.
So the academic research, the research we have to do is really understand the trade-off between flows
and the negative feedback or when prices come back into equilibrium.
So right now the flows are overwhelming substitution.
In the vernacular we hear the following.
In the vernacular we hear when fear is everywhere, is in markets today, then investors are looking for,
demanders are looking for liquidity, they are willing to pay more for liquidity services,
just at the same time when the speculators or the intermediaries are not willing to provide these services.
So, they would run to the very short, they run to safe government bonds and out of stock, for example.
Or spreads widen in the market, credit spreads tend to widen and liquidity prices increase everywhere.
Asset values tend to fall.
Basically, what has happened is that in the vernacular fear is taking over, okay,
and when substitution comes back is when greed comes back to the market.
What I mean by that is investors who just rush to buy safe assets say,
I'm paying up a tremendous amount to buy these safe assets,
let me move into the slightly less safe assets that look now cheap, relative to the assets I'm holding, and substitute away.
So right now, for example, because of the mortgage crisis and the GSEs being in great difficulty, mortgage spreads are gigantic.
These are going to be guaranteed by the government, but these spreads are gigantic, versus governments,
as investors have moved into governments and out of mortgage products that are actually virtually insured by the government.
So, the problem becomes that when a shock occurs, time stops.
What I mean by that is that it takes time for speculators to re-figure out whether their models are correct, okay,
or whether the calibration of their model is correct.
Because as the flows continue against them and the force of substitution is weakened,
they don’t know how much flows are ahead, how much flows are behind it.
So they don’t want to step in.
There’s a difference between being a speculator and having a model of evaluation,
how much capital is necessary to put up against positions or how much time is going to be necessary to hold positions,
to intermediate and make the markets work and get paid for the service, that’s a speculator versus speculating.
And you are speculating when you don’t know anymore, as a speculator,
you have no model of evaluation or don’t know how long it's going to take, no way to calibrate your model.
So when time for them stops, what I mean is decision time, they withdraw capital,
because they need time, they need time to reassess their models, they need time to recalibrate the models.
And as a result of that, just when the supply of speculative services falls,
the demand for speculative services increases dramatically.
So, the price of risk transfer and liquidity jump in the market place.
So now the price of liquidity, if one looks at the government bond markets around the world,
if we examine the markets generally, there’s just complete disequilibrium,
the prices that are observed today are far out of line from what one would conceive of being equilibrium prices,
given the substitutability of one asset for the other, but that will, the question is, it's not whether it's out of line,
it's when it's going to come back into line and whether, if liquidity providers step in at the moment,
speculators step in, whether it's going to be that there’s going to be additional flows coming in.
So when time stops, counter time goes along, but when time stops, the volatility increases dramatically in markets,
and when we observe market prices of assets in the bond markets or equity markets, the reason, in my view,
we see fat tails is simply because it’s a mixture of distribution, it’s a mixture of an evolutionary process,
when things are normal and going along, and in combination with that evolutionary process is a liquidity process.
And when the liquidity prices change so dramatically as we’ve seen now, that you take those two distributions
and we mix them together, we generate t-distributions, and the t-distributions are mixtures of distributions
which themselves will exhibit fat tails.
Or that we look at the tails or the extremes are much greater.
And if we believe that liquidity prices change dramatically,
then the risk systems that are being used by the banks today are nonsensical.
They don’t make any sense, because they are all based on portfolio theory.
They are all based on the idea that we have normal distributions and liquidity prices are constant.
If you believe, liquidity prices could go into shock, like we have today, or risk transfer prices could become extreme,
because no one wants to intermediate now, because there’s no way of evaluating their models,
then it's the case that the bank and financial institutions have to change
from looking at the centre of the distribution to understanding the tail risks or exactly planning capital for shocks.
Because if they plan for shocks, then you create flexibility for shocks.
The idea is that theory exists today.
We have the theory which says how to plan, how to allocate capital strategies.
In fact, the way banks were doing it prior to the initiatives, the portfolio theory and all those initiatives,
we are saying, given we take categories of product and we give capital to each of those categories of product,
to handle shocks is the better way of doing the business than thinking that we can use portfolio theory,
because portfolio, when you have shocks to the economy or liquidity prices change, then all assets tend to move together.
In other words, they don’t have the correlation properties that exist when you just have an evolutionary process.
We have an evolutionary process much different from a process that’s in shock, because the capital has been withdrawn,
the speculators withdraw capital just when the demanders of liquidity want more capital,
and it takes time for markets to come back into equilibrium,
and because the speculators need to recalibrate and know their models.
So, in the sense that the real issue in conclusion here is that we have to have teams
that have an understanding of how to provide financial services, how to intermediate in these markets.
And we will always have shocks, because the teams are not going to rationally step into markets
unless they can understand that their models are working or they can calibrate it.
The Heisenberg uncertainty principle again, if one can measure, has a fixed point, you can measure the velocity.
You can’t measure both, change the fixed point and velocity at the same time.
It doesn’t work.
But if you change your focus to what’s the fixed point, you have no velocity.
So things cease up and I think that the only thing that I can say that would work
is that financial entities have to plan for those times, that’s the real risk management.
It's planning for the times when the markets, when the Heisenberg uncertainty principle is in place,
they can’t intermediate anymore, because they don’t understand their models or they don’t trust their models
and don’t trust their calibration of the models.
So, I think that the idea of trying to, we’ve had over time, which is fascinating,
that we’ve had a separation of human capital or teams from the physical capital.
It's been the case that hedge funds have grown up, hedge funds have teams
and have been able to raise capital to provide liquidity and risk transfer services to the market place.
But that’s only a form, it's not a function.
To really understand hedge funds or to understand private equity or to understand banks,
it's not the organization that’s important, what functions are these organizations performing
and is that the best organizational form, the least expensive organizational form for society to revive those functions.
And I don’t have the answer to that.
Over time maybe hedge funds all disappear, because it's more efficient to provide risk transfer liquidity functions within banks.
But right now the human capital has left these organizations and gone to hedge funds,
who have the expertise and the risk modelling or attempt to have that
to be able to provide these risk transfer liquidity services to the market place.
They are marrying, the capital needs to be married with longer horizon holders,
because if one is providing liquidity with mean reverting characteristics,
then losses will occur and the staying power is crucial.
And if the banks today are providers of liquidity and then become demanders of liquidity,
then they are not the right providers of liquidity, because if one is providing liquidity and providing inventory services,
there needs to have a long horizon or a longer horizon framework, as the banks have public stock holders, all use mark-to-market.
Mark-to-market system doesn’t work for liquidity providers, because liquidity, when the price of liquidity changes,
we know that asset is undervalued relative to its substitution asset,
but, given liquidity as a high price or higher price right now, it takes time for those markets to compress.
Given that, if the shock occurs and entities are forced to mark-to-market,
and given they are forced then to liquidate assets because of the mark-to-market provisions,
then it's the case it creates a short horizon as opposed to a long horizon.
We have to think about longer horizon investments, because it’s a time series business.
Liquidity is a time series business.
Liquidity provision is a time series, not a cross-sectional business.
It's much easier to make money in a cross-sectional business than it is in a time series business.
And a time series business is the natural business of the financial institutions and intermediaries.
I’m going to have to stop there, given timing, but I notice I still had forty minutes, I guess I didn’t push the thing.
So, I don’t know if we have a few minutes for questions, I’ll be glad to do that and then we can just stop.