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Lessons Learned From The Crisis: A View From The US

Publication Date: 
October 23, 2009
Luxembourg For Finance

Professor Kenneth E. Scott, a leading scholar in the fields of corporate finance reform and corporate governance, was interviewed by Luxembourg for Finance on lessons learned from the financial crisis:

“With more foresight and better judgement the crisis could certainly have been less severe. In any case, lack of information is not a viable excuse. Information was not being kept secret.” The conclusions of Kenneth E. Scott, professor of Law and Business at Stanford Law School, are frank and direct. Professor Scott was in the Grand Duchy to speak at the University of Luxembourg on lessons learned from the financial crisis.

LFF had the pleasure of meeting Professor Scott for an interview.

Where did the crisis start?

KS: It is perfectly clear where it started. It started in the US and with the torrent of subprime mortgages. These were securitised and were ultimately bought by investors around the world. The conditions that made it happen in the US were not unique to the US I think. You had a period of overly accommodating monetary policy; you had a period of cheap credit. Those conditions were not felt only in the US. That led to individuals and firms getting highly leveraged because debt was not costly by comparison with the past. That leverage occurred elsewhere in the world. The origin is one thing, the spread and the receptivity is another.

The wages of bankers and the bonuses paid was widely discussed. Is the discussion about overpaid bankers a typical one in times of crisis?

KS: If you look back at prior financial crises would you find that same element? I don’t think it is a causal factor, but it is an obvious target for public anger when they see a lot of losses and then they see some people who have profited from the process as it was growing. About a year ago the New York Times ran a story about the heads of the major Wall Street firms that had faulted … they had lost an awfully large amount money in the crisis themselves. …So if you think about it as an incentive issue, they did have something at stake in the game. Nonetheless, did they end up going to the poor house? Not quite. But they are easy targets for politicians to go after.

Are some managers overpaid?

KS: I don’t know what the level of pay is. Some of them were benefiting from poorly designed compensation incentives and packages. If the amount of compensation was really reflective of the value that they were bringing to the firm, I’d have no problem with that. But where it becomes disconnected from actual performance, when they are getting a lot of money (because) the stock market is generally going up, whatever the quality of their own performance, I think that is less defensible.

Who is going to regulate their pay?

KS: Well, the government? That is what we are now getting in the US with the firms that accepted Tarp money (the US Treasury bailout programme). When the government sets pay levels, you can be assured it will be suboptimal. When you leave it to the board of directors, in most cases it is a fairly weak monitor of the CEO. I think the best (solution) …is actually the hostile takeover market for corporate control because management hates that.

Why do people get less angry about stars from the sport or music industry earning a lot of money?

KS: If you’re a movie star or a rock star, there is a pretty good way to see what kind of revenue you personally bring in. It is very hard to see what kind of revenue is attributable to a CEO or a senior vice president. The second distinction that occurs to me is that if a rock star takes cocaine, blows up or whatever, there isn’t widespread economic dislocation and therefore the interest is more likely to be voyeuristic than economic. Whereas if a company or a whole industry blows up, then there is a lot of cost spread to others.

What about regulation and supervision? Should we have a supra- national authority or national regulation?

KS: In the EU they have come up with a board …(that advises)…this system of financial supervisors which are nationally based and they have power and authority. So everybody talks about coordinated action but when trouble breaks out there is a certain “sauve qui peut” aspect to it that usually plays a prominent role in the actions that are taken. In the US … they are still batting around various possibilities. The current one the administration seems to favour is that we have a Council….the head is from various relevant agencies…but whether the Council is going to have authoritative power … is not clear. Besides, what is the premise? The premise is: people didn’t have enough information. That is completely wrong. The information about housing prices in the USA between 1890 and 2005, for instance, is available. It was available to the Treasury, the Federal Reserve and to Members of Congress. What was lacking? Not information, but judgment and foresight.

So how do you endow this new systemic risk regulator with foresight and judgment about the unexpected?

KS: We do not have any model of systemic risk that is accepted by economists, they tell me. If you don’t have a model what are you doing? You can collect all the information that is available and stare at it. But you’ve got to have a model to analyse. And your model has to be credible, if you are going out and telling people: change what you are doing, change your financial structure, change your business operations. So I have a feeling that the systemic risk regulator is wonderful until you have to get operational about what you’re talking about.

So the right lessons have not been learnt?

KS: I think there were some things you could do which could help the present situation, but I don’t know if they would have prevented it. I think we could have made the whole securitisation chain less opaque and therefore less of a threat to solvency … if we had had… better disclosure. The SEC had the authority to do it. It did a respectable job with requiring disclosure for asset backed securities that were registered with the SEC. But almost all the stuff down the chain was not registered with the SEC, was not sold in public offerings, but was sold to institutional investors.

So you could have had two things: you could have had more demanding disclosure requirements and secondly you could have …(required that) all this information be transmitted to a central data repository. If you’re a firm believer in the unlimited capacity of computers, you would believe that it can all be analysed. And people did have models to analyse that stuff. That is what the rating agencies tried to do. They had models; (but) they didn’t always have the right assumptions fed into them and they didn’t always have the information that was necessary to do the job in a reliable matter. The situation could have been less toxic than it turned out to be.

Another lesson that could be learned is that maybe is not a good idea to make mortgage loans to people who can’t afford them. That one seems pretty straightforward but it runs into a stone wall in Congress, because the relevant members want to deliver subsidies to low and moderate income groups, their support base in Congress. They don’t want to do it through on-budget expenditure because that … subjects it to tests with competing priorities. So you do it off budget, through government enterprises like Fannie May and Freddie Mac who issue guarantees for a fee and of course they were guaranteeing more than they could pay, so Fannie and Freddie were taken over by the government. But the members of Congress …never had to come up and say: we want to give this subsidy to these people, here is how much and here is why. I would like to think that the Congress will learn the lesson, but I would not bet on it.

The financial crisis has had a devastating impact on ordinary people. Do you anticipate a social crisis in terms of poverty and unemployment?

KS: I don’t think so. Unemployment is a lagging indicator. When you get into a crunch, employment actually holds up for a while as the economy goes down. It takes people a while to adjust. When the economy turns up again, employment will keep going down for a while before people hire again. And talking about poverty, I do not think there will be riots in the streets.

So the crisis is not the main reason that the gap between the haves and have nots is increasing?

KS: There are two ways to look at that issue. One way is, do you worry most about (whether) everybody is getting better or do you worry about the fact that some people are getting better faster than other people are getting better. If you concentrate on that one, then you direct all your policy towards distribution and you ultimately end up slowing or killing the growth rate which lifts the whole population. We are not living better than we lived a hundred years ago because of the distribution. We are living better because of the economic growth.