New Media – Perils & Power in the Economic Crisis


It seems like experts in all financial fields agree on one thing these days – that the recession is here and there is no quick way out of it. In such bad times, the new media has surprisingly come into the spotlight as one of the possible causes of the crisis. Cynthia Owens, Adjunct Associate Professor in Communications and New Media, says new media is a scapegoat, but it also provides a solution.

“The economic crisis clearly demonstrates the power and peril of the new media,” says Adjunct Associate Professor Cynthia Owens.

New media plays such a huge part in our current lives that almost everything can be linked to it. Like a coin, the new media has two sides to it.



“The Internet moved information instantly to people more quickly than ever before, possibly hastening stock market declines,” points out Adjunct Assoc Prof Owens.

But she explains that new media or the Internet didn’t cause the crisis. The real peril of new media is the threat to conventional media.

Business leaders and executives know that the worldwide web is a tool that facilitates quick and effective communication. Now they are learning that they can go directly to their stakeholders via this useful instrument. This makes the Internet a powerful and cost-cutting gift from the new world.

Adjunct Assoc Prof Owens believes that this is bad news for both new and old media.

She says that “new media” is really a misnomer. “Mainstream newspapers and television news channels are the most popular news avenues on the Internet. The number of new online-only news sites that are widely read, influential and trusted is relatively small.”

Indeed, in financial news, new technologies do move news more quickly to larger audiences, but Adjunct Assoc Prof Owens wants to remind everyone that in the world of finance, news always moved fast.


Some past examples

She brings up the example of the 1929 stock market crash in the United States of America, where information raced around by ticker tape.

In the instance of the 1987 crash, before the modern Internet was a available to the world, bankers and stock traders were linked around the world by in-house computer trading and communications systems.

“The news media has been criticized for failing to predict the current crisis,” Adjunct Assoc Owens identifies. “But as long ago as 1999, mainstream and business media in the USA reported on questionable mortgage practices. Regulators did nothing.”


The Truth is….

The truth is that media reports the news and covers trends. But when the best minds in the finance and economic sector, including the heads of every major central bank, fail to recognize the danger, it is almost impossible for the media to report that a crisis is looming.

“The proliferation of information on the Internet does force the public to decide what to believe,” says Adjunct Assoc Prof Owens.

Some on Wall Street, including bankers at the now defunct Bear Sterns, have alleged that anonymous and malicious rumours circulating on the worldwide web caused the massive selling. However, that is nearly impossible to prove.


The Power

Adjunct Assoc Prof Owens is not ordering a witch-hunt on the Internet. “Going forward, what is clear is that business leaders are beginning to realize that the new tools give them a lot more opportunities to connect and engage with their stakeholders, both internally and externally.”

In fact, the new media can even be a tool to help companies recover in the next year and prepare for a quicker recovery after the crisis.

The Internet can help companies get clear information out quickly, listen to their customers and increase transparency within their organization.

She encourages reluctant Singaporean executives to follow the footsteps of organizations like Dell and Deloitte that are using web 2.0 tools to engage the public and win new customers.

“Coming out of the crisis, the news media will be just one way for successful companies to reach customers, employees and other stakeholders.”

Cynthia Owens is an Adjunct Associate Professor in Communications and New Media with the NUS Business School, where she was named CNM outstanding adjunct lecturer in July 2008. She is one of the region’s most experienced journalists and media executives with two decades of experience with top news companies including The Wall Street Journal, ABC News and CNBC Asia. Adjunct Assoc Prof Owens is the founder of AsianEdge Network and helps companies develop communications strategies and trains business leaders in communication skills. She also spoke at the recent ‘MBA Back to School’ Seminar.


Leadership in Times of Crisis


The world is now in the midst of a financial crisis. Critics and academics alike are predicting that this recession will be the worst the global economy has seen since The Great Depression. In bad times, fingers are being pointed at the people on the top. Professor Richard Arvey, Head of the Management and Organization Department of NUS Business School, analyses what the leaders have done to deserve the blame and the only way out of this gloom.

Everyone has imminent questions as bad times looms over our heads, threatening our livelihoods. They look to the leaders of various institutions for a clearer picture and a prediction for better times ahead.

“As an organizational psychologist, I have a particular perspective or ‘lens’ on the ongoing financial crises and what brought us here,” says Professor Richard Arvey.

According to him the determinants of the economic crisis are fairly well known. Banks and financial institutions provided mortgages to individuals who could ill afford them. When interest rates increased, these individuals defaulted on these loans, leaving banks, investors and other creditor institutions saddled with huge losses.


Effective Leadership

Executives and managers of financial institutions engage in highly risky decision-making practices.

“Effective leadership involves decision-making under unknown and risky situations,” points out Prof Arvey.

One has to balance the taking of risks. Taking no risks can lead to eventual downfall for organizations that tend towards extreme conservative postures. On the other hand, taking excessive risks can lead to disaster as we have witnessed.

“One of the roles of an executive is to guard and protect the resources of the firm – to act judiciously to make sure the firm and all the stakeholders are protected,” he adds.


The Secret Behind Effective Leadership

In the current instance, the protective role of executives was seemingly abdicated.

Prof Arvey points out and examines a list of forces for executives and business leaders to follow:

  • Avoid following phenomena. There are a variety of institutional forces such as pressure form stockholders, competition from other banks and financial institutions, encouragement from public policy makers, etc. that might have led executives to engage in excessive risk taking. Therefore, as a business leader, stick to your own set of believes, what everyone else is doing is not necessarily the right thing to do.
  • Be objective about strategic business decisions. There were large personal and institutional gains associated with these loans. Prof Arvey quotes International Herald Tribune (10 Nov 2008): “They had found this huge profit potential, and everybody wanted a piece of it. But they were pigs about it.” Hence, as the leaders of large organizations it is important to be objective and reasonable at all times.
  • Study the industry/market. Always remember that the decisions made by executives and business leaders have consequences that will implicate more than one individual. One wrong move may cause an immediate domino effect. Hence, study the market and the industry carefully and be well-informed.
  • Take risks, but take only calculated ones. Decision makers often discount the notion that improbable events will really happen. Always take into consideration the possibility of a disaster.


The Only Way Out

Prof Arvey emphasizes that we need more thoughtful and objective risk taking in the future.

“Ultimately, CEOs and executives need to realize that they can destroy firms perhaps more easily than making them ‘great’.”

In other words, decision-makers have a major stake in the protection of the firms they manage.

Professor Richard Arvey is a Professor and Head of Department at the NUS Business School. He has a PhD in Industrial/Organizational Psychology from the University of Minnesota in 1970 and also a MSc in Psychology from the same institution in 1968. Prof Arvey has taught in several prestigious colleges all over the world, such as the University of Lyon in France, the University of California, Berkeley, the University of Tennessee, and the University of Minnesota. He joined the NUS Business School in 2006 and has written many articles in esteemed journal collections and has also co-authored several books.



Getting A Firm Grip On Securitization



By Associate Professor Anand Srinivasan
Associate Professor, Department of Finance
NUS Business School


The current credit crisis and the resulting market drop and volatility have prompted the United States government to propose several measures to help banks.

The Federal Reserve extended loan guarantees to investment banks earlier this year. Congress recently approved a US$700 billion (S$1 trillion) bailout plan, using taxpayers’ money to buy toxic assets from banks.

And on Tuesday, the Fed proposed yet another plan to buy unsecured short-term debt (commercial paper) directly from banks and corporations.

The premise of all these interventions is that a reduction in asset values is fundamentally bad for an economy. Indeed, what constitutes a financial crisis in the press or policy circles appears to be a large reduction in prices in the stock or bond market.

A further presumption is that such reductions may lead to downward price spirals – fire sales, in effect – over and above the reductions in fundamental values. If not stopped, such fire sales, it is believed, will lead to a domino effect throughout the economy.

In joint research with Viral Acharya at London Business School and Sreedhar Bharath at University of Michigan, we found that fire sales can indeed affect debt prices negatively. On the other hand, experiments by Nobel laureate Vernon Smith have disclosed the possibility of bubbles building up in asset prices.

One possible reason for an inflation of asset values into a bubble is something popularly called ‘the greater fool theory’. You would buy an asset even if you thought it was overvalued if you believed you could resell it to a greater fool for a gain. Such risk-taking behavior can give rise to bubbles. As John Maynard Keynes put it memorably: ‘Successful investing is anticipating the anticipations of others.’

So where are we now? In a fire sale world or in a bubble correction world? Even if we were in a fire sale world, do we need massive government intervention? One must answer this question before proposing reasonable policy responses.

The policy responses of the US government make it obvious that it believes we are in a fire sale world. Furthermore, it assumes private investors generally would be unwilling to buy these heavily discounted assets. Mr Warren Buffett’s investment in Goldman Sachs and Temasek Holdings’ in Merrill Lynch are obvious counter-examples to this notion.

Even if one took the view that the need of the hour is a quick response – the detailed analysis can wait – what form exactly should that response take? I would argue that, in any crisis, the quick response should be crafted to minimize the adverse impact on economically disadvantaged sections of society.

In the current crisis, only a reduction in interest rates, which may benefit some economically disadvantaged households, would satisfy this criterion. The US$700 billion bailout plan and the proposal to directly buy commercial paper are not exactly targeted at the poor.

Understanding the cause of this crisis is essential before we decide on short-term, as well as long-term, responses. The crisis was caused principally by lax lending standards caused by a particular model of asset securitization. The originate-and-sell model used for mortgage securitization implied that the lender of a mortgage had no stake in conducting proper due diligence on the borrower, for the loan was quickly securitized and sold to investors around the world.

Indeed, recent academic research by the London Business School’s Vikrant Vig and others showed that lenders (banks, for example) were less rigorous in approving mortgages that were marked for securitization as compared with mortgages that they planned to hold themselves. This is a clear example of moral hazard. The lax lending standards, in turn, resulted in an unusual increase in demand for homes, ultimately leading to a housing bubble.

Given this fundamental cause for the housing bubble and resulting credit crisis, what should be done? The regulatory responses to the Internet bubble and Enron bankruptcy provide clues. As in the current crisis, investors lost billions of dollars in those debacles. The regulatory response was the passage of the Sarbanes-Oxley Act that put a greater burden on the top management of companies to make sure that they made proper disclosures. Several major Wall Street firms also paid fines to regulatory agencies in part for putting out unduly optimistic analyst reports.

Corporate governance and transparency are of crucial importance in the prevention of a crisis. They are also important in promoting a speedy recovery once a crisis occurs. The appropriate regulatory response to the current crisis should insist on greater disclosure of the assets underlying mortgage-backed securities or any other asset-backed security.

The government could also help by conducting orderly auctions of these securities (without actually participating in the auctions itself). For the longer term, the securitization industry should evolve standards in terms of the minimum amount to be held by the lenders who actually made the initial loan. Further, rating agencies would need to re-examine the processes by which they rate securitization pools.

All these measures would require little taxpayer money. But they would provide good short-term relief, as well as long-term solutions. While none of these measures would, by themselves, stop bubbles and crashes – which are often based on herd behavior – they would at least prevent loose lending standards being the cause of further crises in asset-backed security markets.

Lastly, the current crisis does not mean the end of mortgage or asset securitization. Rather, it signals a characteristic misstep most markets make in the early stages of their evolution.

Securitization makes full economic sense. It is here to stay.


The Straits Times©, 09 October 2008

Singapore Press Holdings Ltd

Permission required for reproduction

Liquidity Shortages: Some Solid Facts


By Professor Allaudeen Hameed
Professor and Head, Department of Finance
NUS Business School


Financial markets have suffered multiple crises over the past two decades: the 1991 Gulf war, the 1997 Asian financial crisis, the 1998 collapse of Long Term Capital Management, the 2000 bursting of the dotcom bubble, the Sept 11 terrorist attacks, the 2002 Worldcom scandal, and the first 2007 sub-prime crisis. In each instance, stock market prices fell and market liquidity declined simultaneously.

What is liquidity? There are two types of liquidity: asset liquidity and funding liquidity. It is important to understand the differences between the two.

Asset liquidity refers to the ability to buy or sell securities quickly without a significant impact on their prices. Assets such as houses and cars are less liquid as the seller would usually incur significant losses to unload them immediately. Financial assets such as stocks and bonds are more liquid, for buyers and sellers can transact significant quantities of them at ready prices in organised markets.

Funding liquidity refers to the risk of a firm having insufficient capital to meet liabilities when they become due and being unable to attract additional capital at short notice. Both types of liquidity are interdependent and are relevant in the current financial crisis.

In normal circumstances, financial intermediaries and market makers provide ready prices and, hence, asset liquidity. New York Stock Exchange specialists and Nasdaq dealers, for example, play this role. Over the past decade, however, hedge funds and the proprietary trading desks of investment banks have become significant competitors to market makers. In fact, the profits from some of their trading strategies are essentially returns for providing asset liquidity.

As increased competition led to lower returns from these trading strategies, the funds resorted to bigger borrowings or leverage to increase their capital base. And since their capital requirements do not fall within federal regulation, they became excessively leveraged. For example, Lehman Brothers, the investment bank that went bust, borrowed more than 35 times its capital, pledging the assets it held as collateral.

During times of financial stress, both types of liquidity tend to evaporate in financial markets. A large drop in asset values and a concomitant increase in uncertainty about valuations precipitate panic selling. Investors reduce their risky holdings in favour of safer assets, a phenomenon referred to as a flight to safety.

Government securities are believed to be the safest investments. Investors fleeing to safety buy liquid US government bills. As an indication of how nervous investors have been in recent weeks, the yield on Treasury three-month bills has dipped to close to zero percent. The Treasury paid almost nothing to borrow money and investors were only too happy to lend to the government in return for safety.

An imbalance between the number of sellers and buyers in crisis situations reduces asset liquidity. This calls for greater provision of liquidity, especially for risky, more uncertain assets. But the provision of asset liquidity in crisis periods is constrained by limited capital. Drops in market prices amplify the leveraged positions of investment banks and hedge funds, forcing them to liquidate (deleverage). The forced sale of assets not only leads to a further depression of prices, but also erodes the equity capital of investment banks, making it even more difficult for them to raise new short-term financing.

Nevertheless, when capital does flow into the market, assets that have been pummelled can be purchased easily. This in turn leads to prices reverting to norm. When short-term dislocations in the financial markets arise from liquidity shortages, an infusion of capital, either from the government or private sources, can reverse the fall in asset prices and restore the health of financial institutions.

The current financial turmoil is more complicated because of several factors. To begin with, financial institutions need to deleverage their holdings of ‘troubled’ assets, mostly linked to housing mortgages. The financial institutions which bought these assets at ‘market’ prices underestimated their riskiness and overpaid. The worsening economic situation suggests that these assets are not likely to become valuable in the near future.

The extent of exposure in the financial sector to these troubled assets is so huge that the US government has concluded that markets or private capital flows cannot be relied on to sort them out. A large financial firm selling these assets at low prices could have systemic effects leading to the insolvency of many other firms.

For example, if a private fund bought mortgage-backed securities from a failing bank at 20 cents on the dollar, accounting rules would require other institutions holding the same or similar securities to mark down the value of their holdings to 20 cents on the dollar. This ‘mark to market’ process could quickly become a self-fulfilling death spiral. As part of its response to the crisis, the US government now allows firms to use other information to value illiquid assets on their books rather than marking them down to fire-sale prices.

We are also witnessing a freeze in the market on short-term financing. Companies which used to borrow short-term by issuing commercial papers are no longer able to do so as lenders have become extremely cautious. Even banks have become less willing to lend to other banks in the interbank market, thus raising interest rates on such borrowings.

Hence, to stabilise the financial system and rebuild investor confidence, the US Treasury proposes to bail out financial institutions by buying their troubled assets. There might be lessons here from the Japanese government’s bailout of the country’s troubled banks in the 1990s.

The Japanese crisis was started by the bursting of its property and stock market bubbles of the 1980s. Tokyo invested in insolvent banks, delayed the resolution of massive bad debts and failed to make fundamental reforms in lending practices or close down insolvent firms. These worsened the banking crisis and led to Japan’s ‘lost decade’.

What is unclear about the US Treasury’s current bailout plan is whether it would solve a funding liquidity problem or an insolvency problem. If it accomplished the former, that would be a good thing. If it did the latter – bailed out insolvent, badly managed financial firms – that would not be a good thing, as Japan’s experience suggests.


The Straits Times©, 08 October 2008

Singapore Press Holdings Ltd

Permission required for reproduction

The Truly Toxic Combination



By Professor Ivan Png
Lim Kim San Professor of Business Policy and Professor of Information Systems and Economics
National University of Singapore


Moral hazard in banking is nothing new. In the 1980s, Citibank and other major banks were saddled with mountains of bad Latin American loans. The story of how that occurred was essentially the same as that underlying the recent sub-prime explosion: lend and get bonuses now; worry about risks later.

Even the most famous financial institution do not seem to learn from their past mistakes. Why? The fundamental problem is moral hazard coupled with imperfect corporate governance.

Investment banks and commercial banks need huge amounts of capital. They draw investments from many sources: institution investors – such as pension funds, mutual funds and sovereign wealth funds – as well as individual investors like you and me.

Every investor is Merril Lynch, say whether it is Temasek Holdings or you – is part-owner of the institution. However, most shareholders, owning relatively small numbers of shares, would not participate actively in the management of the business. So there is inevitably a separation of ownership from management. Indeed, that is the essence of the modern corporation.

What bridges that separation? The solution in corporate law is the Board of Directors. The board is elected by and represents shareholders to oversee and direct the management. But academic studies have shown repeatedly that corporate boards are ineffective.

Consider, for example, Lehman Brothers. What did its board do as it veered towards collapse over the last 12 months? Earlier, while the bank was piling up leverage and derivatives, where was the board?

Lehman’s board before it filed for bankruptcy, consisted of 10 persons, including Chief Executive Officer (CEO) Richard Fuld, who doubled as Chairman. Two were over 80 years old, and three were between 74 and 77, including Broadway producer Roger Berlind. Another director had headed the Red Cross, and prior to that, the Girl Scouts. Neither Broadway nor the Girl Scouts are obvious training grounds to learn about managing leverage or CDOs (collateralised debt obligations) and CDSs (credit default swaps).

It is that combination of moral hazard with ineffective corporate governance that is truly toxic – more so that the CDOs, CDSs and other derivatives themselves.

To earn their commissions, bonuses, profit shares and so on, management must bring in more business and more profit. But, surely, more business and more profit imply more risks? There are the risks of not being able to renew funding and of the additional customers not being creditworthy.

The incentive of managers is to downplay the risk, so that their bosses would approve the additional business. This same incentive to downplay risks spirals upward, all the way up to the CEOs. If the Board of Directors is not effectively overseeing the CEO, then the bunk – literally – passes to the shareholders.

If the Board of Directors is not effectively overseeing the management of a financial institution, who is? There are two possible answers. One is rating agencies and the other is regulators.

Investors, lenders and other stakeholders look to the ratings agencies – Moody’s, Standard and Poor’s and Fitch – for objection about financial institutions and the securities that they issue. As their names suggest, ratings agencies assess financial institutions and securities and make an assessment of the likelihood of default. They assign a rating accordingly.

However, the ratings process is beset with moral hazard. It is the financial institutions that issue the securities who pay the ratings agencies to rate the securities. Recall the saying: “He who pays the piper calls the tune.”

Financial institutions are known to negotiate with ratings agencies to optimize their ratings. They would try to squeeze through the riskiest (hence, most profitable) loans and derivatives without affecting their credit ratings.

Furthermore, ratings agencies are slow to react. In a recent study, the US Securities and Exchange Commission (SEC) concluded that ratings agencies were less effective in follow-up monitoring than during the issuance period. This reinforces the incentive of financial institutions to hide the bad news until later, while taking commissions and bonuses now.

The other possible overseer of management is regulators. But investment banks such as Bear Stearns and Lehman Brothers were investment banks precisely so as to avoid the tough regulation meted out to commercial banks – Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley form a rule limiting their leverage.

The American International Group (AIG) was an even stranger beast. It was not even an investment bank. Yet it built up businesses in credit default swaps and other derivatives that were so big that the US government had to rescue it with public funds. Indeed, it was too big to fail.

This leads to the most serious moral hazard: If the government continues to rescue big corporations or investment banks that over-leverage, then they will be encouraged to take on more risk, not less.

Indeed, cynics remarked that Lehman CEO Fuld’s big mistake was not that he had taken on too much risk. Rather, it was that he had not taken on enough. If Lehman’s involvement in CDOs, CDSs, and other derivatives had resembled AIG’s in scale and complexity, US Treasury Secretary Henry Paulson would have been forced to rescue Lehman as he did AIG.

Mr Fuld reportedly received almost US$300 million (S$730 million) in total compensation between 1993 and 2007. He has lost his job at Lehman, but he is far from being down and out.

Heads, I win; tails, you lose.


The Straits Times©, 07 October 2008

Singapore Press Holdings Ltd

Permission required for reproduction

Moral Hazard: Heads I Win, Tails You Lose



By Professor Ivan Png
Lim Kim San Professor of Business Policy and Professor of Information Systems and Economics
National University of Singapore


British Prime Minister Gordon Brown has said that the week of Sept 15 would be studied for years to come as “the week the world was spun on its axis – and old certainties were turned on their heads”.

Within that single week, Lehman Brothers filed for bankruptcy, Merrill Lynch and HBOS sold themselves to the Bank of America and Lloyds bank respectively, the United States government bailed out American International Group, and then asked Congress to appropriate US$700 billion (S$1 trillion) to rescue the financial sector.

At the core of the financial crisis and ensuing mess lie two words – moral hazard.

The term originates from the insurance industry. It refers to a situation with two ingredients: a conflict of interest where one party bears the consequences of the action of the other, and where the party bearing the consequences cannot control the actions of the other.

Sounds complicated? Actually, it’s quite simple. Consider the NTUC Income i-Medicare insurance, which covers my university’s staff. For any visit to the general practitioner, I must pay $5 and NTUC Income bears the rest.

Having incurred my $5, do I choose generic or branded drugs? The generic may cost only one-tenth as much as the branded drugs, but it doesn’t benefit me to economize. NTUC Income cannot control my choice of drug, but it bears the full financial consequences of my actions.

Motor vehicle insurance provides another example. Car owners who are covered by comprehensive insurance may not be careful. That is precisely why the insurance industry invented the concept of the “no-claim bonus”, to encourage car owners to be careful. The bonus aligns the interest of the insurer and the car owner.

The medical insurance industry also recognises the potential for moral hazard. Many plans include an element of co-payment: the more I claim, the more I pay out of my own pocket. This would give me an incentive to choose cheaper drugs and minimise visits to the doctor.

How did moral hazard lead to the current financial crisis? This story is as old as Latin American loans that dragged down the US banks in the 1980s.

Wall Street bank famously pay their employees relatively low salaries – mere hundreds of thousands of dollars a year. They depend on incentive compensation – bonuses, profit-sharing, performance shares, stock options – for the bulk of their income. They are almost compelled to bring in large volumes of business and profit. A quick way of raising profits is to use leverage.

Suppose that with $1 million of capital, a bank lends $1 million at five percent interest. Its interest income would be $50,000 and its return on capital would be five percent. Now, suppose that in addition to the $1 million of capital, the bank borrows $9 million at four percent (leverages up by nine to one). It then lends $10 million at five percent. Its interest income would become $500,000. It must pay $360,000 on its borrowings, so its net income would be $140,000. Thus its return on capital would be 14 percent!

Marvellous. The bank would enjoy higher earnings and it would be certainly reward its staff accordingly with bonuses, performance shares and stock options.

In recent years, investment banks have offered such lucrative compensation that they were among the top choices of graduating MBAs. Mr Richard Fuld, chief executive officer of Lehman Brothers was reputed to have earned US$45 million last year. Such fabulous compensation even lured top finance scholars to quit professorships with lifetime tenure to join Wall Street.

How could investment banks earn so much to pay so much? Leverage. Investment banks are 50 percent or more leveraged than commercial banks.

Where’s the moral hazard in leverage? Isn’t everyone happier?

In leveraging up, a bank takes on more risk. One source of additional risk is the funds borrowed. The bank might not be able to renew its borrowings at the same rate – as happened to Lehman Brothers recently and Bear Stearns earlier.

Another source of risk is the quality of the borrowers. When a bank increases lending from $1 million to $10 million, it is bringing in new clients. Are the additional clients as reliable and creditworthy as those who borrowed the first million? Probably not.

But, and here’s the rub, the additional risk won’t be obvious while the bank is leveraging up. These additional risk will become apparent only later – months later, perhaps years later.

While the bank is happily leveraging up to increasing lending, it will record (“book” in the jargon of the trade) nice increases in profit. Shareholders would be delighted and bank managers would collect their incentive compensations.

The moral hazard arises because the additional risks materialise only later, but by then, the managers would have collected their bonuses. Many might have left the bank. Indeed, some might even have retired to sunny Caribbean resorts.

Who carries the baby when the bank encounters difficulty in renewing its borrowings or its borrowers default? The shareholders of the bank – and possibly if the bank is big enough, the government. But that is another story.

A related moral hazard arises from securitisation. Financial institutions provide home buyers with money through mortgage loans. In a bygone era, the financial institution would own the mortgage and collect interest and repayments.

Today, however, financial institutions package the mortgage loans into bundles called mortgage-backed securities, which they sell to investors. The mortgage-backed securities might even be further repackaged into collateralised debt obligations. This complex process is called securitisation.

As my colleague, Professor Anand Srinivasan, will argue later in this series, banks are less rigorous in approving borrowers for mortgages that they intend to securitize as compared with mortgages that they hold. This is moral hazard, clear and simple, and to be expected. Why work so hard and be so careful when someone else will bear the consequences? Collect the fee for the mortgage and pass the risk to others.

However you look at it, banking – especially investment banking – is beset with moral hazard. Heads I win, tails you lose.


The Straits Times©, 02 October 2008

Singapore Press Holdings Ltd

Permission required for reproduction

Failures On Many Fronts



By Professor Bernard Yeung
Dean and Stephen Riady Distinguished Professor of Finance
NUS Business School



The United States sub-prime mortgage crisis has occasioned a deep economic winter. How did it come about?

The crisis is related to international payment imbalances and US economic policies. After the bursting of the bubble, the US Federal Reserve ran a loose monetary policy for several years. The Fed fund rate, for instance, dropped from 5.98 percent in January 2001 to 1.73 percent in January 2002, and stayed in that neighbourhood till the end of 2005. Easy credit fuelled US consumption, reduced savings and created high current account deficits.

The world, especially Asia, absorbed the US inflationary pressure partly by producing more. Also, Asian countries used their saving to purchase US securities to support the dollar so that they could avoid revaluing their currencies.

When capital markets are informed and rational, international imbalances can be self-correcting. A review of the events that led to the current crisis would help us understand why it wasn’t so in this case.

The US government encouraged home ownership. That is generally good public policy. But in this instance, it led to the extension of mortgage lending to people who did not meet prime credit quality requirements – hence the term “sub-prime” mortgages.

Moreover, the mortgages were “securitized” – that is, bundled and sold as financial instruments to investors for immediate cash. This created an incentive problem: The institutions that originated the mortgages – commercial banks, saving and loans, etc – did not end up holding the mortgages. This led to excessive and irresponsible mortgage lending.

The investment banks that repackaged and sold the “expected” mortgage payments as securities were able to do so because they enjoyed high credit ratings. Their activity appeared to be old-fashioned financial intermediation, but it was not.

The problem was that the US rating agencies assigned ratings based on the investment banks’ histories. But the instruments the banks were peddling – mortgage payments from lower-quality borrows – were new. They carried rating that did not reflect their high underlying default risk. Investment banks could not resist the temptation to make a quick buck. They made a quick buck aggressively.

Additionally, the high saving from China and other countries continued to flood US markets. Foreign savers could not resist the lure of apparently safe US returns better than in their own markets. Foreigners did not necessarily invest in sub-prime instruments. But their investments increased liquidity nevertheless in US financial markets.

This translated to more money for Americans for sub-prime mortgages and other kinds of consumptions. And investment banks found the profits from derivatives like mortgage-backed securities even more irresistible because they could get cheap credit to refinance. The delinquency risks of low-grade instruments were temporarily camouflaged by high liquidity.

The bubble had to burst. Because of inflation worries caused by high energy prices, the Federal Reserve raised interest rates in 2006. Some households had difficulties meeting their mortgage and other payments. The bubble was burst.

Fears set in and investments banks could not borrow to meet their payment obligations. There was a liquidity problem. In March this year, Bear Stearns was sold under pressure to JPMorgan Chase. The government-sponsored Freddie Mac and Fannie Mae issued most of the mortgage securities sold in the first half of this year because investors would not trust investment banks anymore. Still, the fears lingered on. On Sept 8, the US government took over Fannie and Freddie in the midst of foreign investors’ concern that the companies’ debt might not be repaid.

The asset values of investment banks continued to plummet. The liquidity crisis turned into a solvency crisis. Lehman Brothers filed for liquidation on Sept 14. After refusing to bail our Lehman, the US government decided to support American International Group. The saga, dotted with such sudden U-turns, is still unfolding. Markets are now worried about a global credit crunch.

The sub-prime crisis has its roots in international payment imbalances, made worse by capital markets imprudence, which in turn became endemic because of regulatory failures.

First, investors, particularly foreigners, were swayed by US rating agencies, apparently sound institutions and US economic performance. Getting good returns first made them happy, then made them enthusiastic, and finally made them lose their common sense.

Second, there was a fundamental problem with corporate governance. Wall Street executives enjoyed extremely handsome compensations. Their fiduciary responsibilities to shareholders and investors were pushed to a corner.

And third, these common ingredients of manias – blindfolded investors and poor corporate governance – were amplified by a failure of government.

How could such a colossal failure of corporate governance and of rating agencies not have generated early government action? The US authorities’ lack of sensitivity to the warning signs is shocking.

Liquidity was already drying up last year. The US authorities, however, still played the interest rate game, reducing the Fed Fund rate in August and September last year. But by then, the liquidity crisis had turned into a systematic crisis of confidence: Investors did not want to throw more good money at investment banks holding potentially rotten liabilities. Early government to force them to recognise their mistakes and accept their losses might stemmed the bleeding. Intervention then would have been affordable.

The US likes to lecture other of the need for transparency and good corporate governance. Its failure to apply at home what it preaches abroad has serious global negative economic externalities. The question is not just whether US taxpayers should or should not bail out careless financial institutions, It is about admitting regulatory failures, accepting responsibilities and rectifying failures in governance.

Apparently, US politicians do not agree. Congress has rejected Treasury Secretary Henry Paulson’s US$700 billion (S$1 trillion) bailout package. The world has been denied any sign of relief.


The Straits Times©, 01 October 2008

Singapore Press Holdings Ltd

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How Much Are The Accountants To Blame


By Associate Professor Ho Yew Kee

Vice Dean and Associate Professor, Department of Accounting
NUS Business School



The Enron debacle gave rise to the significant debate concerning the role of accountants. The end result is the passing of the Sarbanes-Oxley Act which redefines the role of accountants and strengthens their independence and professionalism.

The main lesson from Enron is the failure of accountants as gatekeepers in ensuring that the financial assertions of firms are reliable and truthful. This naturally assumes that accountants play an important role in the provision of financial information to the capital markets for the purpose of the pricing of securities.

In the massive failures of financial institutions arising from the sub-prime crisis, again it is not unreasonable to question the role of accountants as gatekeepers.

In the valuation of financial assets and liabilities, accountants have been blamed for the use of the three m-to-m: mark-to-model, mark-to-market and mark-to-myth, as the share prices of financial institutions collapsed overnight.

The first m-to-m (mark-to-model) raises the question as to whether accountants have diligently discharged their responsibilities in understanding, parameterising and applying the models correctly. In addition, one can even question whether accountants are adequately trained to understand the sophisticated valuation models used by financial institutions.

There are at least three major failures in the context of the role of accountants. Firstly, the internal risk management function of financial institutions had failed in correctly identifying the risk of these sub-prime assets.

Secondly, accountants have failed to correctly value these assets and reporting them in their financial statements. Alternatively, they have failed to provide sufficient timely impairment losses.

Finally, independent auditors had failed to provide an independent assessment of the true values of these sub-prime assets.

The first mark-to-model raises significant concerns about the competency of accountants and their roles as quality financial information providers.

The second m-to-m (mark-to-market) raises the question as to whether accountants should blindly follow the mark-to-market rule in valuing their assets. This is especially critical when the market is experiencing a free fall because of a crisis of confidence and a concern for liquidity.

In this instance, accountants – instead of providing reliable and relevant information to the market concerning the value of their assets – are literally following the market and reacting to whatever the fair value of their assets are, as determined by the market. In so following the market, they exaggerate the crisis of confidence in the market.

The second m-to-m makes the accountant a bystander in the provision of financial information. Surely, accountants must have a positive role in a period of financial crisis.

Finally, the third m-to-m (mark-to-myth) calls to attention the ultimate role of the accountants. If the first two m-to-m are not applicable in a state of crisis, what then is the role of the accountants as supplier of financial information to the market? Can the accountants play a role in shoring up the confidence in the market?

In fact, the third m-to-m suggests that accountants may not be as influential as they think; in a state of crisis, they are literally powerless to influence the market. Worse, accountants are viewed as magicians who can pull any numbers out of the hat.


Three Major Lessons

It may be still premature to ask what we can learn from the crisis concerning the role of accountants. I can suggest three major lessons for the accountants. I can suggest three major lessons for the accountants in this crisis.

Firstly, it is necessary for accountants to understand and question their valuation models. Of course, it is true that accountants are gatekeepers rather than path breakers and thus their valuation skills may lag the financial innovations existing in the market. Nonetheless, in discharging their responsibilities as gatekeepers, they need to critically assess the valuation models and the parameters used. Accountants must understand the valuation models they are using.

Secondly, accountants may need to reconsider the mark-to-market rules as the rules do not merely affect the valuation of an asset but the confidence of investors during a crisis. Much like the circuit breaker that was proposed after the 1987 financial crisis, accountants may need to seriously consider the equivalent of a circuit breaker in suspending the use of the mark-to-market rule when the market is no longer reliable or rational.

Finally, accountants need to seriously consider what their roles are in a state of crisis and how they can provide meaningful information to the market or to signal credibly to the market the true value of their assets and liabilities. This may require accountants to review their reporting responsibilities in the light of adverse financial information much like a specific accounting standard dealing with a hyper-inflation economy which is outside the norm of ordinary financial reporting.

In summary, when this financial tsunami subsides, there will be much discussion on the lessons to be learnt for the accountants and how accountants can play a larger role to prevent any future tsunami. The question is whether accountants will actually learn from this episode and what the lessons will be.


The Business Times©, 09 October 2008

Singapore Press Holdings Ltd

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Crisis of ’97 and ’08: Lessons To Be Learned



By Professor Bernard Yeung
Dean and Stephen Riady Distinguished Professor of Finance
NUS Business School


The world seems to have a major financial storm once every decade. In 1997, I was in the US, saddened by the Asian financial crisis. Fast forward, today, I am in Singapore, saddened and hurt by the US financial crisis that started with the sub-prime mortgage lending and the bursting of the US housing bubble in 2007.

We can take turns to mock each other for the exposed weaknesses in the financial markets and institutions. But, that should not be the point. The two storms have a lot of similarities and we can learn from them.

First, investors were blindfolded. Distant investors relied on rating agents which failed them. In the current US crisis, rating agents gave credit ratings based on the investment bank’s past records but did not adequately reflect the risks in the bank’s new activities, such as the peddling of sub-prime mortgage payments.

In the Asian crisis in 1997, credit ratings were built on gross macroeconomics information and did not adequately reflect the actual risks of underlying activities.

Moreover, the blindfoldedness stemmed partly from the lack of transparency. Investors, and rating agents, would not make systematic mistakes if they knew what they were getting into.

Many blamed the Asian financial crisis on the lack of corporate transparency. The inadequate public knowledge of what is really on the book in some investment banks serves the same purpose.

It is interesting why the rating agents keep failing us. Is it a matter of lack of competition amongst them? Or, is it an innate problem that new things are too challenging for old monitors?

Second, poor corporate governance is an issue. Investors are aware that smart investment is guided by more than just public information. That is why expert intermediaries are needed. Pension fund managers, investment bankers, insurance companies, private wealth managers, etc, are supposed to serve. In both crises, many of them failed in carrying out their fiduciary duties.

These intermediaries have not done their jobs, so ordinary investors lost. I suspect corporate governance is the key reason why some banks stay strong and cash-rich while others are at the brink of failing.

There is an additional level of breakdown in corporate governance. In the Asian financial crisis, a breakdown in corporate governance at some Asian family pyramids and conglomerates is well known. In the current crisis, there is an obvious breakdown in the corporate governance of some investment banks.

They over-sold securities sub-prime mortgage payments at an inflated price, which failed to reflect the underlying default risks. They pocketed the fees but did not attend to the banks’ actual risk exposures. Clearly, both reflect the “other people’s money” mentality.

Third, both crises were preceded by a period of excitement, which led to bubble-ish excess investment. Asians are familiar with the excessive construction in Bangkok, Jakarta, Seoul, etc and the overrated economic performance of various countries back in the 1990s. But, the key is that earlier economic development in the region is genuinely exciting. The early birds claimed the early profits. Later, investors got over-excited by the observed successes and then over-invested.

The concept of diminishing returns dimmed in their minds. In the US, housing construction, home ownership, and house prices surged before the crisis too. But the fact that the US had a long, sustained period of stable growth excited investors, the bubble notwithstanding.

Like the Asian situation at the beginning, the growth was justified – there was the new information technology that created many innovations. Getting too used to good returns, investors over-invested, forgot about diminishing returns, and then over-traded on what was not there.

Both the Asian and the US crises therefore illustrate the formulae of a financial crisis. Justified early excitement based on real economic fundamentals attracts blindfolded investors who then over-trade and fall victim to poor corporate governance. A bubble is generated, it bursts, investment is wasted, and the aftermath takes years to digest.


Calming the jitters

Interestingly in both cases, there are fire sales that make some smile. It is well known that some Asian production facilities were sold at bargain basement prices. We currently see fire sales of US brand-name financial institutions, some to non-US firms. In both cases, there are people who prey on ailing companies. In New York, there is now a serious investigation on strange short-selling. The over-excitement leads to the over-trading that eventually bursts into a ball of destructive fire. Then raiders of the ruins come.

Inevitably, investors herd after exciting news and may make mistakes. We cannot easily contain that, maybe we don’t even want that. But we can reduce the chance of them falling victim to greedy people. The same old advice applies – we need better transparency and better corporate governance. Yet, these are longer-term strategies. What should we do in the interim?

The Asian financial crisis did not cause the US much grief; as the Asian economies were then relatively small. The current US financial crisis, however, is much bigger because the US is much bigger. The US crisis could be a global economic nightmare.

The expected slowdown in US consumption will negatively affect us. But, that is not likely to be huge. Take China as an example, it exports about 10 percent of its GDP to the US. A 10 percent slowdown in the US will only hurt China by one percent, not counting the multiplier effect. Indeed, there will be substitute locations and markets for goods originally intended for the US.

The more severe concern is the global credit crunch following the crisis. Locations like Singapore appear to be all right. But some other locations appear to be significantly affected. We ought to be cautious and take steps to avoid a prolonged credit crunch so that our investments are not choked. Credit crunches are based on fears that financial institutions are not reliable. Savers do not give them money and so they have no money to lend.

The key is to alleviate the fear. Financial institutions should volunteer to make clear what they have suffered and recognize the losses.

The Japanese financial firms’ coming out action in this regard is the right move. Indeed, in recent days, messages from various banks are clearly aiming for transparency revelation.

Asian economies should seize this chance to strengthen their inter-reliance on one another’s consumer and credit market. It could, at the end, strengthen Asian development and her global economic presence.


The Business Times©, 23 September 2008

Singapore Press Holdings Ltd

Permission required for reproduction

Improving Team Effectiveness – What Can Companies Do?


‘High performance’ teams that outperform expectations are often more an aspiration than a common manifestation for organizations. Adjunct Assistant Professor Chung Yuen Kay considers the reasons for this and suggests how corporate leaders can create environments that inspire high performing teams.

The idea of the team has caught hold of the imagination of modern management. Teams are expected to improve performance, reduce production costs, speed up innovations, enhance product quality, utilize new technologies, and increase employee participation.

Nevertheless, Adjunct Assistant Professor Chung Yuen Kay cautions that “teamwork can be very difficult because it is open to complex interpersonal psychological issues.”

Teams are a means but whether they result in positive or negative synergy, “social facilitation” or “social loafing” depends on how well they are managed. Members of overly cohesive teams may succumb to pressure to conform leading to poor, and even disastrous decisions. Inadequate individual and team goal setting, performance feedback mechanisms, reward systems, and project management skills can also lead to team weakness.

What then must corporate leaders do to build a healthy team environment?

Adjunct Asst Prof Chung explained that improving team effectiveness requires substantial time and effort. To build and manage teams well, managers need to implement infrastructure that promotes teamwork, such as placing strong emphasis on team-working ability during recruitment and selection, emphasizing team skills and behaviors through continuous in-house training, and reinforcing the importance of teamwork through the appraisal and reward systems.

Adjunct Asst Prof Chung advised that it was important to keep both ‘performance’ and ‘viability’ in mind in measuring team effectiveness. Thus, teams need to ensure the successful delivery of an output to customers, while remaining focused on the elements of continuity, commitment, cohesion and capability.

Effective team managers and members are those who stay vigilant to threats to teamwork and alert to opportunities to induce synergy.

Drawing from her experience, Adjunct Asst Prof Chung pointed out that it was crucial to ensure that the dimensions of task, people and relationships, which form the internal system of teamwork, be monitored at the outset. Managers need to consider issues like the exact nature of work that needs to be performed by the team, the kinds of technical, task management and interpersonal skills that are required, the level of optimal diversity, the methods to engender cohesiveness, the norms that should be in place, and the roles that would be negotiated.

With performance evaluation vital to effective team operations, Adjunct Asst Prof Chung adds that “it is important not just to look at results but also the process.” She believes that aside from productivity, basic performance criteria should include dimensions of cohesion, learning and integration.

“All of these aspects need to be managed for effectiveness, on an ongoing basis. Throwing a group of people together with some objectives, and hoping that they will turn into a high performance team is just not good enough!”

Read the full article here.

Adjunct Assistant Professor Chung Yuen Kay was formerly a Senior Vice-President, Head of Learning and Development, Citigroup Private Bank, Asia-Pacific, in 2006 and 2007. Prior to that she was a lecturer, then Head, of the HRM (Teaching) Unit at NUS Business School. She is currently an Adjunct Assistant Professor at the NUS Business School’s Department of Management and Organization, as well as an independent researcher/trainer/consultant. She has consulted/trained for organizations in the public and private sectors, locally and internationally, and has also actively researched and published.