A conversation with the Nobel Prize-winning economist.
Robert Engle: I’m Robert Engle. I’m the Michael Armellino Professor of Finance at New York’s Stern School of Business.
Question: Is the investment banking model fundamentally flawed?
Robert Engle: My way of understanding this financial crisis is in terms of two different observations. One is that risk managers and investment bankers and actually, all kinds of investors took on more risk than they expected. So there was a failure of risk management. There was a failure to recognize how much risk there was in some of these securities that people bought.
But a second and perhaps more important point is that many of these same people were paid very well to ignore the risks, and so there are incentives which are – which distort our ability to measure risk. That is, many times we’re not risking our own money, we’re risking somebody else's money, or maybe that someone is going to back stop or downside, but we still get the upside. There are a lot of ways that investment banking models work, but these risks are not internalized by the people that are taking them. And so, I think that’s something that investment banks have worried about for a long time and are continuing to worry about, but it’s not an easy solution when you have lots of people betting the company’s money, how do you really allocate those risks? How do you make sure that the people that take the risks are feeling the risks in an appropriate kind of fashion?
Question: Do you agree with author Nassim Taleb that we put too much faith in financial experts?
Robert Engle: Oh well I would agree with that. I don’t agree – I agree with a lot of the points in Taleb’s book, but I don’t agree with many of his conclusions. It seems to me that he rightly points out that risk managers miss a lot of the risks, but the conclusion is that he draws, is that we should abandon risk management, whereas my conclusion is we should improve it. I don’t see what the alternative to risk management is. If it’s just getting rid of the models and instead using the smart people who can figure it out? How do you train them? What do you teach them? Do you just put them in a cockpit and let them stumble for 10 years of their life and then after that they’re good at it? I think that **** have gotten so complicated that we need risk management, but we just need to make it better. We need to be able to understand better where these risks are coming from.
And I think actually one of the – coming back to one of your previous points about investment strategies. One of the things we might come out of this crisis and I think that Nassim is sort of an example of this as well is that we might invest a part of our assets in portfolios that we don’t expect to do well not, but we would expect them to do well if we have another crisis. And this is a different way of thinking about asset allocation. It’s an old idea in economics, but it hasn’t’ really been at the center of much investment analysis, but I think now there’s a lot of interest in these so called hedge portfolios which will out perform in a crisis. I mean, we’ve always had gold bugs, but now we sort of realize that Treasure Bills might be in the same category. And we have derivatives like credit default swaps which are in this category, and we have derivatives like volatilities that are actually an asset class that we can invest in which are now – would out perform if we have another financial crisis.
And so thinking about these different assets and I should say, this extends to lots of other kinds of long term risks, for example, if we think about the long term risks of global warming. You know, some of the portfolios we might consider buying are portfolios which would do especially well if we have an economy-wide, or I mean, a global climate change that impacts us very negatively there are some companies that will do well, and so it might make sense to hold some of those in your portfolio.
Question: What is short selling, and should it be allowed?
Robert Engle: Well if you’ve got information about a company, or you believe that a company is undervalued, you can go out and buy their stock and you can make some profit on it. And if a lot of people feel like this company is undervalued and go out and buy the stock, the stock price will go up reflecting the higher value of this company. You might have information because you trade with them or because you’ve done some research on them.
On the other hand, if you have information that a company is not as good as its stock market valuation, you don’t have a way to sell that stock unless you already own it. And so that information doesn’t get incorporated in the company’s stock price as fast if you don’t allow short selling. And so allowing short selling is allowing people to sell – instead of having to buy the stock and then sell it, which doesn’t do much; allow them to sell it, and then buy it. In which case they can express that information and the idea is that you would get more accurate valuation of companies by letting people express both their positive information and their negative information through either long or short selling.
Question: Is the collateralized debt obligation really such a bad thing?
Robert Engle: Oh I think it’s a wonderful creation. The collateralized debt obligation, the CDO, is a structure which allows you to more or less continuously choose how much risk you want to take in a whole batch of securities. And the reason why they got us into so much trouble is that it’s hard to figure out how much risk you really are taking. And so, you could construct these things made with sub prime loans and believe that you weren’t taking any risk at all, even though all the loans in there were lousy. So, I think what we need is better understanding of how to do risk analysis of a CDO, but that they still can perform a very valuable function because they can aggregate these risks and pass them around so that mortgages or other kinds of loans can be packaged and sold to investors all over the world, who in most times, would justify a small amount of each one. They don’t – It turned out they thought they were so good they bought large amounts of them and then took enormous losses on them.
Question: Can you explain collateralized debt obligations?
Robert Engle: I have a little example I like to tell. I don’t know whether you want to hear it or not, but it’s like from cooking. Something may be on the Cooking Channel. You combine in a glass some sand, some water, and some high class Tuscan Extra Virgin Olive Oil. And you shake it all up and you ask somebody, how much would you pay for a little bit of this? And the answer is, not too much because you’re gonna get sand and water in with your oil. But if you wait, it’ll settle out and if you take it from the top, you’ll get oil. And if you take it from the bottom, you’ll get sand. So, the roll of the CDO is that, you’ve got all these **** and you don’t know which ones are the oil and which ones are the sand. But over time, oil rises to the top and the triple A, or the senior **** have very few defaults and the equity **** at the bottom have lots of defaults. So, you pay different amounts depending on whether you’re going to take it from the bottom or take it from the top.
But it happened that no one expected was it got shaken up again. It didn’t have time to settle out. We had housing markets that deteriorated volatilities went up, correlations up, as soon as all these different parts were correlated, then the top is no better than the bottom. It’s only if it settles out that the top is better than the bottom. And so the failure of risk management was to recognize – was not to recognize that there could be increasing correlations and increasing volatility that would make the mixture more, more homogeneous and therefore less desirable.
Question: What are the benefits of credit default swaps?
Robert Engle: There are all these risks that we face in our businesses. Some of them might be that a bond we own defaults, but much more important, I think, are that we sell things to another company and they go bankrupt before they can pay us. We provide coffee to the lunchroom at some company, but you work up quite a bill after awhile, so what do you do if they go bankrupt? Credit default swap gives you something to do. You can buy some credit default swaps from them to protect yourself against the bankruptcy of people who owe you money. And so this credit default swap gives you the ability to reduce your risks by paying a small fee. And if you pay attention to where your exposures are, you might tend up buying credit default swaps against a variety of people that you – companies that you deal with.
So, this is the way it can reduce risks for all sorts of different kinds of activities. And really not just for people who happen to be bond holders. That’s why I don’t think the idea of requiring these to be only sold to people who have already own the bonds, in other words, this naked position that the Germans have recently put into their financial regulation and has been discussed here. I don’t think that makes any sense.
So what is the role that credit default swaps can play in an economy? Well my feeling is that if these things actually will now be traded on either exchanges or some kind of central clearing, they are going to be a very good measure of the credit worthiness of different companies. A better measure, in my opinion than rating agencies provide. I think the credit default swaps can take the place of the rating agencies who really have missed the ball in this procedure and are quite conflicted by the way the ratings are paid for. So, I would like to see credit default swaps become an evermore important way of understanding credit risk in the economy.
Question: What can we learn from the recent financial crisis?
Robert Engle: Right. So, I think we’ve learned a lot from this crisis. And I think one of the things is kind of what we’ve been talking about. That when firms take a lot of risk, to some extent, they’re taking risk beyond what they feel themselves. In other words, when large companies take on risk, then they impose risks on the rest of the system. And these are systemic risks and these systemic risks we never used to think were really that important, but as soon as we recognize how the financial sector – the risks the financial sector takes on can impact the entire global economy, we realize that those risks needed to be controlled for the social good. And reduced the systemic risks.
So we have a new push to understand systemic risk, where it comes from, how do you measure it, how do you regulate it. And the financial regulation that has been discussed for a year in the U.S. and which is about to be put into place, I think, and which is being discussed in Europe and everywhere, the focus is very much on systemic risk that those are the risks that you want to spend most of your regulatory time worrying about. So that leads us to regulating more carefully the largest or the most systemic risky companies and institutions.
Question: Is deregulation effective for financial markets?
Robert Engle: I think we’re fooling ourselves if we think that regulators are going to be able to outsmart the bankers. So, the task of designing regulatory reform is trying to make more or less foolproof regulation and that’s one of the advantages of the systemic category where, if you can **** that some smaller number of banks or financial institutions are the ones to worry about, then you can give them more scrutiny and more attention, you don’t have to have rules that apply to everybody. And I think that you can do sort of what the Fed has often done, which is said – called “leaning against the wind.” In other words, if you think that there’s too much risk being taken and that the financial sector is being super heated, you can actually increase the capital requirements at that point.
When Greenspan, who’d had no appetite for regulating risk thought that things were getting out of hand, he coined the phrase “irrational exuberance” to cover it. But all he had was talking points. And with this new regulatory environment there would be more than talking points, there would be things that could be done. I do think that the reason the regulators were asleep at the switch in part was because we have had so much success in the U.S. history with deregulation, it’s done valuable things for the trucking industry, for airlines, for telecommunications. We’ve expanded deregulation, gotten government out of one sector after another and I think that the Greenspan approach and the Cox SEC were in that tradition of let’s deregulate and see what these markets do. And one of the things they immediately observed is that these markets took off. But they took off by taking more and more risk, which it turned out to be risks that the taxpayers were really taking.
So I think what we’ve learned is that deregulation is not as effective in the financial sectors where at least it can’t go as far in the financial sectors as it has I some of these other sectors, and so I think while they were asleep at the switch, I don’t think it was really just the regulators that were asleep at the switch, I think that they were appointed to be asleep at the switch. And that Congress, Congressional Oversight wanted them to be asleep. And so that it was really across the board. It was just not that the regulators missed it. They were appointed to not do anything.
Question: Will Americans post-financial crisis be smarter investors?
Robert Engle: I think they’re more cautious. On the other hand, that was true in 2003 also, when they had run up the internet bubble in 2000 and 1999, and then all of a sudden it blew apart. So, people were cautious for a while, but then they jumped on some other bubbles. We had an energy bubble, and then we had the banking bubble, and those – and I guess the housing bubble. So I’m not really sure whether Americans are going to be better investors.
Question: How will financial regulatory reform help financial markets?
Robert Engle: Well there’s several features. I mean, it’s a pretty complicated set of topics that have been legislated. I like to focus on systemic risk, I think that there’s going to be a systemic risk regulator, which will probably be the Fed, and will chose in committee, select a subset of all the financial institutions that they can consider to be systemically risky and subject them, first of all to more scrutiny, but second of all, to more careful behavior. In other words, restrict their capital requirements so they can’t take on quite a much risk, or maybe put on a systemic risk tax, which is kind of gives them the incentive to become less systemically risky. So, that’s I think, an important part of the legislation. I really like the emphasis on trying to reduce the inner connections of firms through the over-the-counter derivatives market. The fact that this vast array of derivatives are traded over-the-counter means that they’re counter party risks between all sorts of pairs of individuals that are not adequately margined or controlled so that any one company goes bankrupt, it affects a wide range of other companies.
So these also contribute to systemic risk, and what the legislation is proposing is that as many of these over-the-counter derivatives as possible be moved to some kind of centralized clearing so that there is no more counter party risk and improved transparency in this markets, and I think that actually is going to be a very substantial reduction in systemic risk for the system as a whole.
There’s resolution authority saying these companies that are too big to fail just need new kinds of bankruptcy-type provisions. And then we can actually unwind them quickly and without doing so much damage to the entire economy. A lot of ambitious code has been written into the law for those and we will have to see if it actually works, if we have another example of a big financial institution going bankrupt.
I think global coordination is tremendously important. I hope we can see this happening through the G20 and through coordination of regulatory regimes around the world. I guess those are the main features of this bill that are important.
Question: What advice would you give to Barney Frank and other legislators?
Robert Engle: Well, I would say, first of all, congratulations. Because Barney Frank could have been wiped out by the Freddie and Fannie problems, but really, he was instrumental on, but in fact, he rose to a new level, I think, in recognizing what needed to be done to fix the financial system. And I think his bill was really very good. It has a few things I don’t like in it. It has a few exemptions for companies that don’t want to trade their derivatives on exchanges, but I think basically, it was very forward thinking of him to get it out so early to make a statement and pretty much the Senate came along with what he did.
Question: What else would you like to see from Congress?
Robert Engle: I’d like to see a little more action on the energy side of things. I’ve been pushing for some kind of a carbon tax for years, and it seems to me we’ve had lots of opportunities to do it. Today, we’re terribly worried about the size of the budget deficit. We’re talking about should we increase taxes? Why not put a tax on carbon emissions. It would raise a lot of money, it would reduce the environmental damages in the future, it would solve so many problems, and it would be a much more constructive thing to do than to think about raising the income tax.
Question: Will China cut off its credit line to the U.S.?
Robert Engle: I don’t think it can. The – I mean, what the only way China – China’s got this big problem, which is so much of its reserves are tied up in dollars so that if it were to cut off the credit line in dollars, how would it maintain the exchange rates, the fixed exchange rate that it has. I mean, it would only be able to do that if it allows the yuan to appreciate. And so, it’s accumulating dollars because they sell goods to the U.S., the dollars show up in China, what do you do with those dollars? Well, you can either buy Treasuries with them, you could hold them in green piles in the bank, but that’s really the same thing. You can buy goods in the U.S., which is what we would like them to do, and if – I mean I think ultimately that’s what should happen. I think ultimately China will decide they are a big player in the international economy, they will not be able to maintain the fixed exchange rate, they’ll have to go to a floating exchange rate and their dollars that they own will depreciate because yuan will appreciate relative to the dollar. So, in fact, some of their nest egg will be eroded by doing that. So, they’re not anxious to do this. They prefer the status quo. All the talk they have, in my opinion they have about the U.S. doing – moving to special drawing rights, or some other kind of reserve currency isn’t really what they want. They like the status quo, the way it is now and I think they’re going to continue this way as long as they possibly can, but ultimately are going to have to let the economy open. It’s just too big an economy. You can’t run it without allowing capital flows in and out.
Question: How will China’s growing middle class change the relationship between China and the U.S.?
Robert Engle: See now I think what’s going to ultimate happen. If the Chinese economy can be opened so that currencies are convertible, Chinese tourists can take money and go see the world. Chinese businessmen can go and buy property in the U.S. and France and every place. All of a sudden, it’s just going to be a blossoming global economy. I think it’s going to be good for everybody. And I think the Chinese consumers are going to ultimate drive that because they have a lot of money, many of them do now. And they don’t really have an easy way to spend it. They don’t have an easy way to travel.
When Japan was this big power in – and grew so rapidly in the, I guess the ‘80’s, we saw Japanese tourists everywhere for the first time. It was the first thing we saw. But we don’t see this large influx of Chinese tourists as what we would expect to see. And New York is one place where you might expect to see a lot more of them. It’s gonna happen, they travel all over China. You go to China and you see it’s all the tourist spots are full of people, but they’re all Chinese tourists because that’s where they go. That’s, you know, they can’t really go out of the country very easily. So, I think it’s going to be a happy day for everybody in China and outside of China when these borders are opened a little more.
Recorded May 25, 2010
Interviewed by Andrew Dermont