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Monday, May 25, 2009
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The New Manager - Interview
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Energy studies now on the MBA menu
Dr Arthur D. Warga, Dean, Bauer College of Business, University of Houston.
Houston, which is also known as the energy capital of the world, is quite appropriately at the centre of academic research into the energy sector. In keeping with this tradition, the Bauer College of Business in the University of Houston is all set to offer the first carbon emission trading course in the world.
In Chennai recently to attend the convocation for the fifth batch of PGPM graduates of the Great Lakes Institute of Management, Dr Arthur D. Warga, Dean of the Bauer College of Business, spoke to The New Manager about a range of issues including the new programme and the impact of the financial crisis on management studies. Dr Warga, the Judge James A. Elkins Endowed Chair of Finance and Banking at the university, is also the founder and director of the Fixed Income Research Programme, which provides research databases on bond pricing to major universities around the world as well as to the Board of Governors of Federal Reserve System and regional banks. Excerpts:
On the programme in carbon emissions trading:
We will start the first carbon emissions trading course in the world in September. We think it is inevitable that countries such as China, India and the US soon introduce so-called cap-in-trade programmes that limit the amount of emissions by companies. And then we need a mechanism to monitor it and to trade those carbon credits between companies. We have developed the legal and the scientific expertise for such a programme.
We have a long history of teaching energy trading. In spite of Enron, we invested in the subject at the height of the Enron episode. We realised that there was a structural need for energy trading to clean up the problem caused by Enron. We have invested in faculty and programmes for the last eight years, at least since I was dean.
Our course will be both Undergraduate and Graduate. It is starting off first in our MBA programme. We have one of the few energy management programmes — an honours college programme that would focus on management roles in the energy industry.
The programme is part sciences and part finance. Finance is getting a bad name because of the derivatives and banking scandals but finance is a loosely used word. Every company needs it — a blend between accounting and the financial market — and so we should be doing it in the right way to deal with this financial debacle.
While most schools are trying to figure out what to do, we have an advantage in that our faculty are among the most experienced in the field of fixed income and debt markets.
What has been the impact of the financial crisis on b-schools per se? In fact some of the executives involved in the crisis have come out of the Ivy League institutes. Has it cast a pall of gloom on b-schools? How are the schools reacting to this?
There is a generational effect going on. I built my expertise in fixed income securities analysis of which mortgage markets are a part. But that was not a very common field for academics to get into, the main reason being that it was originally about bonds. And bond data — both government and corporate — was not readily available in the electronic form unlike stock data was. Government bond data became easier to get earlier than corporate. But it was not until 2001 that you could get transactions in the bond market because the governing body required companies, traders to report them electronically for the first time then. But before that, as b-schools were developing, most faculty studied stock markets and the reason unfortunately was that there was no bond data available. They had all these models that they could try out but there was no data available to try them on and so there was much weaker involvement by finance departments and faculty at business schools. You had much stronger studies of equity markets. Only in the last six to seven years has the b-school world emphasised on having faculty who even know how to calculate yield. Faculty were wholly ignorant of many important features of bonds and mortgages.
Despite the fact that there was a vibrant bond market..
Well, was there a vibrant bond market? Probably, not. The corporate bond market would typically trade weekly, a few papers would trade monthly and most just once a year. So, vibrant? I don’t know. There may have been a single $100-billion issue or there might have been very weak trading in volumes and frequency. So you could not count on getting a transaction.
The current crisis has to do with the debt market. It originated with the gross oversupply of the mortgage securities and then the derivates derived from underlying mortgages and bonds.
Are you beginning to see the unraveling of the crisis. The bail-out plans, are they going to work?
We still don’t know. I believe that we have begun the turnaround. Certain things will get worse. For example, a class of mortgages — Alt A — were issued but these mortgages were issued without production of proof of income of potential home owners or with a re-set interest rate that would go up based on the person’s income and if the income dropped the interest rate could go up. A tremendous number were issued and we know that in the next couple of years many of them will have their interest rates increased. So we know with a strong probability that there will be more defaults.
How did the banks expect these people to repay?
They did not care, because they made commission on what they were selling. And then it was not their business..
Because they were passing on these mortgages..
They were then bundling these mortgages together — just like the Fannie Mae and Freddie Mac mortgages — except that these were not even conforming mortgages that should never have been allowed to be sold. But they found buyers keen on a higher return. Obviously the banks went bankrupt when it turned out that they should never have made these mortgages.
Basic banking norms were not followed. And nobody seems to have said anything. This was happening as Fannie Mae and Freddie Mac were building up and the Wall Street Journal for the last 15 years has written editorials every month saying look at the dangers of what might happen. It’s not as if people did not notice, but there were political forces — people getting elected on the promise that everyone could own a house; but it was absurd. Every American could not own a house. I do not know of an economy where everybody can own a house. Unfortunately politicians were being elected on that basis. It’s not necessarily fraud or dishonesty or unethical behaviour; it was individual politicians trying to do good things and realising that they have to make compromises with other politicians so they go along with them.
What were the reasons behind the financial crisis? Despite all the research on the financial sector how come such crises keep repeating?
Well, I used to say that this sort of thing happened every 10 years going back to the savings and loan crisis in the US. But it has obviously accelerated to eight, seven, even six years. It is a combination of several things. I believe that it started with the US government subsidising mortgages through Fanny Mae and Freddy Mac.
These were originally set up to create an easy mortgage market where contracts were written out in a standard form and transactions became cheap and easy and the Government subsidised the interest rate and encouraged, actively, Americans to become home owners. Unfortunately, this saw millions who really had no business owning a home become homeowners. And the kinds of homes we have in America are out of scale with what they should be — they are too large and too inefficient and they waste a lot of our important resources. But we had everybody owning them. So, that began a lot of the problems that we have…There was then a tremendous supply of mortgages that Fannie Mae and Freddie Mac purchased so that the banks that originally issued them to the home owners could have their capital replenished and lent it to more people.
I have done studies for the US Treasury and the Congressional Budget Office that tried to measure the size of the implicit subsidy that the US government was giving and it was in the tens of billions of dollars easily. It obviously grew to even more. But the first time I studied them in 1995, I was amazed that these companies — Fannie Mae and Freddie Mac — had about $300 billion in debt — they borrowed $300 billion by issuing bonds and then used the money to buy mortgages from banks so that the banks could issue more mortgages.
Do they on their own directly also give out mortgages?
No, they do not. They do a lot of secondary market activity but it is not with original issue of mortgages. They have written down a standard contract for banks to be able to issue what is called a conforming mortgage which means that the contract behind it is written in legal language that allows people to do amazing things — good or bad depending on how you look at it.
It allows them to take say a thousand mortgages for $400,000 each that they lend to home owners and pool the mortgages together to create a new financial instrument called the mortgage-backed security, which is really just a portfolio of a hundred or a thousand individual home mortgages. And then it allows them to sell bits and pieces of that to institutional investors such as insurance companies and pension funds. It allows them to buy these things and there were so many mortgages issued — trillions as it turns out — that the financial world got very creative and a whole variety of new financial instruments that apparently we did not fully understand and were not tracking close enough to know where all the money had gone.
Who had bought what from whom and it snowballed into what we see happening…
And the underlying asset of that house was depreciating when the housing market fell..
The home ownership increased as house values increased and then all of a sudden there was this crash in the housing market and what you suggested occurred.
Carbon emissions market: A bubble in the boom?
Carbon credits: Silver lining to global warming
Accounting debates on carbon credits
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