MIT Roundtable on Corporate Risk Management

VOLUME 20 | NUMBER 4 | FALL 2008

Journal of APPLIED CORPORATE FINANCE A MORGAN STANLEY PUBLICATION

In This Issue: Honoring Stewart Myers

The Contributions of Stewart Myers to the Theory 8 Franklin Allen, University of Pennsylvania, Sudipto and Practice of Corporate Finance Bhattacharya, London School of Economics, Raghuram Rajan, University of Chicago, and Antoinette Schoar, MIT

MIT Roundtable on Corporate Risk Management 20 Panelists: Judy Lewent, Merck; Donald Lessard and Andrew Lo, MIT; and Lakshmi Shyam-Sunder, International Finance Corporation. Moderated by Robert Merton, Harvard Business School.

Risk Management Failures: What Are They and When Do They Happen? 39 René Stulz, Ohio State University

Brealey, Myers, and Allen on Valuation, Capital Structure, and Agency Issues 49 Richard A. Brealey, London Business School, Stewart C. Myers, MIT, and Franklin Allen, University of Pennsylvania

Brealey, Myers, and Allen on Real Options 58 Richard A. Brealey, London Business School, Stewart C. Myers, MIT, and Franklin Allen, University of Pennsylvania

Equity Issues and the Disappearing Rights Offer Phenomenon 72 B. Espen Eckbo, Dartmouth College

Can Companies Use Hedging Programs to Profit from the Market? 86 Tim R. Adam, Humboldt University, and Chitru S. Fernando, Evidence from Gold Producers University of Oklahoma

Corporate Leverage and Specialized Investments by Customers and Suppliers 98 Jayant R. Kale, Georgia State University, and Husayn Shahrur, Bentley College

Estimating Risk-Adjusted Costs of Financial Distress 105 Heitor Almeida, University of Illinois at Urbana-Champaign, and Thomas Philippon, New York University MIT Roundtable on Corporate Risk Management

Endicott House | Dedham, Massachusetts | September 6, 2008 Photographs by Yvonne Gunner

20 Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 ROUNDTABLE

Robert Merton: Good morning, I’m Bob private equity, or any of our derivatives is not only that uncertainty and risk have Merton, and I want to welcome you all markets. important effects on value, but that cor- to this discussion. Our topic is corporate Now, there are some interesting porate risk management can be used to risk management, with perhaps a look at parallels between today’s financial envi- increase the values of industrial companies the implications for the current financial ronment and the early 1970s, when Stew as well as financial institutions. How do crisis. And I’d like to start by saying a few and I and some of our colleagues were they do that? At the risk of front-running things that might help set the stage for our looking at the effects of risk on security our panelists, let me just throw out the four panelists, who are all very interesting values. And, with hindsight, it now seems idea that, by offering firms and institu- and accomplished people. clear why the innovations in derivatives tions protection against risks they have When we think about risk and risk and risk management started in the no comparative advantage in taking, risk management, everybody says it’s very 1970s—and not, say, in the 1960s or the management helps them expand their important. When a firm or an institution 1950s. It was the need, or demand, for risk-taking in those areas where they do goes down, a lot of people lose their jobs, these new instruments that gave rise to have a competitive advantage. Used in this assets change hands, and a lot of franchise them. The demand I’m talking about way, risk management becomes a critical value can be destroyed in the process. So came from the fact that, in the 1970s, part of corporate strategy. risk management is important in the sense we saw double-digit inflation and interest Now, let me take a moment to intro- of protecting on the downside. But there’s rates in the U.S. for the first time. We also duce each of our panelists—though I don’t also a common perception that risk man- had a huge oil price shock—and we had think any of them really needs an intro- agement has very little to do with creating the breakdown of Bretton Woods, which duction, certainly not to this audience. growth and value—that you’ll never get to meant that all the currencies started to Lakshmi Shyam-Sunder is Direc- the Fortune 100 just by having good risk float. The result of all this was unprec- tor, Corporate Risk at the International management. And I think that’s a serious edented volatility in virtually all financial Finance Corporation, which is viewed misunderstanding of what risk manage- markets. And the effect of such volatility as the “private sector arm” of the World ment is really all about. and uncertainty on corporate values was Bank Group. Lakshmi is leading IFC’s Since this discussion is part of a confer- pretty dramatic: During the 18 months new Client Risk Advisory function whose ence on finance honoring Stew Myers, I from the beginning of 1973 until August mission is to anticipate and cushion the think it’s important to keep in mind that of ’74, the U.S. stock market lost roughly effects of the current crisis on projects in if uncertainty and risk were not a major half its value in inflation-adjusted terms. emerging markets. She also serves as IFC part of this branch of economics, you That’s probably the largest decline for representative on the boards of some client could teach the entire finance course in an that short a period that we’ve ever expe- institutions. After joining IFC in 1994, afternoon. Valuation would come down rienced, even if you go back to the Great Lakshmi worked in a variety of positions to nothing more than the time value of Depression. in treasury and portfolio before becom- money. You wouldn’t need any valuation The good news, though, is that this ing Director of Risk Management and models or financial instruments, and you period of turmoil in our markets provided Financial Policy. Before joining IFC she wouldn’t have to worry about incentives or the stimulus for important advances in was on the finance faculties of the MIT information costs or any of the other main the theory and practice of financial risk Sloan School and Dartmouth’s Tuck concerns that now inform our theory of management. And there were equally School—and, during that time, consulted corporate finance. But, as I think most of important developments in the field of on valuation and risk management for us understand—and if you didn’t see this corporate finance, including Stew Myers’s U.S. financial institutions and corpora- before, recent events have made it pain- work on the cost of capital, capital struc- tions, as well as institutions in emerging fully clear—risk is a major driver of value ture, and the valuation of what Stew called markets. Lakshmi holds a PhD. in finance in any financial market, whether it be the “real options.” And one of the main les- from the Sloan School, where she was a stock market, credit markets, real estate, sons underlying all this pioneering work student of Stew’s.

Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Winter 2007 21 ROUNDTABLE

Judy Lewent recently retired as Execu- NASD’s Economic Advisory Board, and and ends with one listed as forthcoming tive Vice President and Chief Financial the founder of the AlphaSimplex Group, in 2008, while including papers in almost Officer of Merck. Judy became the com- a quantitative investment management every year during this 44-year period. Even pany’s CFO, as well as a member of its company. more remarkable is the number of these Executive Committee, as far back as 1990. So, we have four people here who have papers that have turned out to provide new In 2005, after also running Merck’s Asian done a lot of thinking about and have a lot “paradigms,” new ways of thinking about operations, she assumed responsibility for of experience in managing corporate risks. and advancing our knowledge of capital corporate strategy and development as Each of them will be showing us different structure and corporate finance generally. well as worldwide finance. Judy continues aspects and dimensions of risk manage- Whether it is real options or contingent to serve on the boards of Dell, Motorola, ment, particularly the interface with claims analysis, asymmetric information, and Thermo Fisher Scientific—and is also corporate finance. And let’s get started agency costs and corporate governance, or, a trustee of the Rockefeller Family Trust, with Lakshmi Shyam-Sunder, who, as I more recently, risk capital allocation, Stew a life member of the MIT Corporation, mentioned, is director of finance and risk has shown an uncanny knack for think- and a member of the American Academy management at the IFC. ing about the implications of these new of Arts and Sciences. approaches, and how they both explain Don Lessard is the Epoch Foundation Capital Structure as Risk Management and can be used to improve the practice Professor of International Management at Strategy: The Case of IFC of corporate finance. And each time Stew the Sloan School. Risk has been a central Lakshmi Shyam-Sunder: Thanks, Bob. I’d spells out his thoughts in a paper, it seems theme in Don’s research, starting with his like to begin by thanking the organizers of to spawn a whole new field of inquiry that, work on risk management for emerging this event for the job they’ve done, and for in addition to other benefits, provides economies in the early 1970s and alter- giving me this opportunity to participate. careers for many academics. natives to conventional general obligation Having been a student of Stew’s, I’ve long Take Stew’s Presidential address to debt financing for developing countries expected this kind of event to take place, the American Finance Association in in the early 1980s. Later in the ’80s, he I just didn’t know when. And I want to 1984. The subject was an explanation of became an expert on corporate exchange say a big thank you to those who made capital structure and corporate financ- risk management; and in the ’90s, he it happen. ing that Stew called the “pecking order” began to explore the idea of risk manage- I will speak as someone who has been hypothesis. The basic idea was that when ment as a corporate core competence and away from academics for a long time. I’d making financing decisions, most corpo- strategic source of value. The focus of like to begin with some general comments rate managers do not try to balance the Don’s current research is the management on Stew’s work and then talk about how tax benefits of debt against the costs of of risk in large projects such as infrastruc- his insights help explain many of the deci- financial distress, as the then dominant ture and oil and gas exploration. sions made by the International Finance “static tradeoff” theory suggested. Man- Andrew Lo is the Harris & Harris Corporation—and let me start with the agers’ main concern is instead trying to Group Professor of Finance at the Sloan standard disclaimer that anything I say minimize the “information costs” of new School as well as director of MIT’s Labo- represents my own views and not neces- issues—a goal they accomplish by using ratory for Financial Engineering. His work sarily the IFC’s. a financing pecking order in which inter- covers everything from financial asset and When Bob sent me Stew’s resume to nal funds are preferred to external finance option pricing models to hedge-fund risk help prepare for this conference, I was whenever possible; and if outside capital and return dynamics and transparency to struck by a number of things as I read it. is required, debt is preferred to equity. I behavioral models of risk preferences and First is the remarkably long period of time remember working with Stew two decades financial markets. Andrew is currently a during which Stew has been producing ago on this question of the relative explan- research associate of the National Bureau papers on corporate finance. His current atory power of the two theories. And last of Economic Research, a member of the list of published articles starts in 1965 week, feeling a bit like Rip Van Winkle,

22 Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 ROUNDTABLE

when I tried to bring myself up to date highly relevant to the situations I’ve faced investment opportunities when they mate- with the current academic literature, I over the years. But before I get into this, rialize. At the same time, we don’t want to was amazed to find that this same ques- I thinks it’s important to step back and have so much equity—or “financial slack,” tion continues to be a subject of active keep firmly in mind one of the “laws,” as I think Stew was the first to call it—that research and debate. or first principles, of Brealey and Myers: we encourage wasteful behavior. After brief stints in the academic and there is more value to be made by good Another of Stew’s important insights consulting worlds, I moved in 1994 to an business or “investment” decisions than is that option-like or growth assets have institution called the International Finance by financing decisions. I suspect that a higher cost of capital—that is, a higher Corporation, which, as Bob mentioned, is failure to heed this lesson is a big reason required rate of return—than existing often referred to as the private sector arm for the crisis faced by several institutions operations or assets in place. Stew devel- of the World Bank Group. Although set up today. For example, a number of institu- oped this idea while thinking about the as a corporation, the IFC is very different tions continued to originate or invest in required return on a pharmaceutical from corporations in the private sec- assets of questionable value as long as they company’s R&D program, as compared tor. It is as close to the Modigliani-Miller could fund them mainly if not entirely to the expected return on manufactur- abstraction of perfect markets as you can with other people’s money. ing and selling patented drugs. And my find in the real world. It is an international There is also an important corollary to own thinking on capital structure at IFC financial institution that is structured as a this law—namely, that a lot of value can continues to be influenced by work that regular risk-taking corporation with lim- be lost by bad financing decisions. And Stew and I did with Judy Lewent about 20 ited liability, but it pays no taxes and is this is entirely in keeping with Stew’s over- years ago on the pharma industry—and I unregulated. And although it has many all thinking on capital structure, which imagine Judy will be telling us about this shareholders—a group comprising the has focused on the interaction between work in a moment. governments of 181 different nations—the the “real” or asset side of a business and But, again, the key insight for the shares are not publicly traded. It has no the financing or liability side. As his stu- purpose of setting capital structure is callable capital and its investments are not dents will recall, Stew encouraged people that growth options like R&D should be guaranteed by governments. to divide corporate assets into two cat- funded mainly with equity. On the other My primary responsibility for this egories, which he called “assets in place” hand, as Stew also pointed out in later organization has been financial risk and “growth options.” I’ve found that work, information asymmetries between management. Part of that responsibility thinking in these terms, while at the same management and investors can make the consists of tasks we readily identify as time taking account of the incentives of raising of equity capital a very expensive risk management—things like hedging, managers and information problems faced proposition. Thus, it is not surprising pricing, and asset-liability and portfolio by investors, provides a powerful way of that equity for IFC has been an extremely management. But another, perhaps more approaching decisions about capital struc- scarce resource. When our shareholders— important, part of the job is developing ture. My sense is that, even without an which, again, are the governments of 181 and maintaining an appropriate capital explicit knowledge of Stew’s framework, nations—explain their reluctance to give structure for the organization. much of our assessment of risks at IFC— us more capital, they almost always cite Now I suppose I could have followed including our attempt to devise a capital their budget constraints. But even in the the M&M proposition and told my bosses structure and financing framework that absence of such constraints, my guess is that capital structure was “irrelevant,” serves all our stakeholders—is driven by that this scarcity of equity arises at bot- but I’m not sure I would have kept the these considerations. Since we view much tom from concerns about the option-like job. So I tried to figure out how and why of our business as essentially a sequence of features of our “business model,” which capital structure matters for this unusual future growth options, we want to have have the effect of increasing risk, agency kind of corporation. And I found that enough of an equity cushion to be confi- costs, and asymmetric information. In many of the ideas Stew has offered were dent of our ability to fund these options or other words, our shareholders face uncer-

Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 23 ROUNDTABLE

tainty about the value of the activities they gives us a credible way of communicating problems by encouraging procyclical are being asked to fund—and the effect our basic capital needs to our sharehold- behavior and effects—behavior and effects of this uncertainty is compounded by the ers and debtholders, and other important that have been compounded by a fair value fact that, having granted us the money, stakeholders such as the rating agencies accounting system. When all institutions they have less-than-complete control over and our clients and partners. In other start measuring, managing, and trading what we do with it. words, it helps us manage our informa- risk in the same way, you can expect to So, these agency costs and infor- tion asymmetry problem. see synchronized booms and busts across mation costs ensure that we face large But given our role as a countercycli- all markets. costs in raising outside equity. And, as cal investor—as a provider of funds for So, we are now seeing perhaps some Stew’s pecking order theory of financ- value-adding projects in emerging markets unintended consequences of capital reg- ing would predict, we rely heavily on during periods of crisis or limited capital ulation and other standards. Regulation retained earnings while making moder- access—we also felt it was necessary for that is meant to protect the system may ate use of debt and maintaining enough us to view these standards as minimum actually have contributed to systemic slack to preserve our ability to invest in requirements. Financial distress for us problems. And the question this raises growth options. As the IFC has grown, would be very costly not just in finan- is how to determine the optimal level of management has generally tried to issue cial terms but, much more important, slack, and how to create and maintain it or debt to finance growth while structur- in terms of our ability to carry out our some form of contingent capital—both at ing the debt to carry a AAA rating. (In mission. Also, unlike some of our sister the level of individual institutions and for fact, for IFC issuing riskier debt would institutions, we do not have sources of the system as a whole—so that such cycli- be more like issuing equity.) But at the “callable” or contingent capital to draw cal effects are dampened? This is a very same time, having generated a fair rate of on in case of emergencies. And so we interesting, and obviously a very impor- return on our past investments as well as maintain a significant capital buffer over tant, question. some excess cash, we also volunteer from and above these minimums to allow for Another important question—one that time to time to return that cash to our growth, absorb shocks, and minimize bears directly on the first—is how to set shareholders to reassure them that their the chance of financial distress. Thus, capital requirements for, and allocate eco- capital is being used by us in a way that what appears to have been a “conserva- nomic capital among, different business meets their priorities. tive” financial structure in good times has lines within financial institutions. Stew Another important influence on enabled us today to step up to the plate, has a very interesting paper on capital our capital structure is regulatory take risks, and help our clients weather the allocation for different business lines in requirements. For financial institutions crisis we’re now facing. insurance companies. Though the issues generally, regulatory capital require- Now, in the current financial crisis, here are complex, Stew’s paper has once ments in the form of Basle II have of a lot of financial institutions have been again generated valuable insights. His course been a major factor driving capi- learning the hard way about the costs of thinking here, as in most everything else tal structure decisions. Though IFC is financial distress. For example, the costs he has done, should help guide us toward unregulated—and despite heavy criti- of raising new equity under duress have the solutions to some difficult problems. cism of the Basle II requirements for turned out to be remarkably high. And At the very least, it will keep us all busy encouraging securitzations and “pro- to the extent that one institution’s prob- for a long time. Thank you. cyclical behavior”—we have chosen to lems have spread to others, such systemic adopt some of these capital standards, effects are likely to affect the real economy Merton: Thanks, Lakshmi. Now let’s turn though in a modified form that reflects as well. to Judy Lewent, who until recently was differences in our role, our time horizon, What’s more, as I suggested, the Basle both the CFO and the head of strategic and the risks we face. Why do we do it? II capital requirements have been rec- planning at Merck. My sense is that adopting such standards ognized as contributing to our current

24 Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 ROUNDTABLE

What appears to have been a “conservative” financial structure in good times has enabled us today to step up to the plate, take risks, and help our clients weather the crisis we’re now facing.…In the current financial crisis, a lot of financial institutions have been learning the hard way about the costs of financial distress. For example, the costs of raising new equity under duress have turned out to be remarkably high.

Lakshmi Shyam-Sunder

Risk Management in the of Stew’s contributions to the regulation of and present value of individual projects? Pharmaceutical Industry utilities and analysis of their cost of capi- Are companies really getting paid for the Judy Lewent: Good morning, and I too tal. But, with some help from Lakshmi, risks they’re taking, or are we missing want to thank the organizers of this con- Stew has also done considerable analysis something important in the relation- ference. Like Lakshmi, I was also one of of the cost of capital in the pharmaceuti- ship between risk and return? What risks Stew’s students—though this was well cal industry. And this analysis continues should companies be taking? What is the before the publication of Brealey and to have great relevance for the regulation value to companies of financial flexibility, Myers—and my own career at Merck has of the industry. As I will discuss later, the of preserving liquidity? benefited greatly from Stew’s teaching question of what constitutes a fair rate of But let’s go back to the issue of the cost and writings over the years. In fact, it was return for different phases of drug devel- of capital and its import for the health about 20 years ago when I asked Stew to opment and commercialization is now care policy debate. Stew was attempting talk to the finance group at Merck about more topical than ever. And how these to address the question of the “fairness,” risk assessment. Our association has con- questions get resolved could have serious if you will, of the historical returns in the tinued throughout that period, and has policy implications for the industry. pharmaceutical industry. Were the pharma many times proved invaluable in helping us So, I will start by talking about the cost companies earning a rate of return equal think through important financial issues. of capital for the pharmaceutical industry to their cost of capital, or were they earn- So, today I would like to focus on risk in and introduce Stew’s concept of the risk- ing “excessive” or “abnormal” returns? the pharmaceutical industry, try to capture return “staircase” as it applies to pharma Stew’s work showed that the net pres- some of Stew’s contributions to our think- companies. Then I want to just touch on ent value, or NPV, of investing in the ing in that area, and then mention some a few of my other favorite questions—all development of new drugs has been new considerations and approaches that of which, by the way, are on the Brealey approximately zero over the 1980s and have come from his insights. and Myers list of “unsolved problems in early 1990s. He reached this conclusion There has already been some discussion finance”: How do you figure out the risk by simulating the cash flows from pharma

Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 25 ROUNDTABLE

R&D projects over this period and then the world about the reasonableness of over time. As you pass through successive comparing them to the cost of capital pharma returns. phases of the R&D process, your required using the CAPM. This work was done in the heat of the R&D expenditures shrink; and for those But, as Stew also showed, the cost of health-care reform debate in the 1990s, projects that continue to show promise capital does not remain constant through- and its relevance has come back in full and receive funding, the probability of a out the life of a drug. Instead it starts force. By overstating the profits of the successful outcome continues to go up at a high level to reflect the higher risk pharma companies and understating the and risk goes down. associated with R&D and, for those prod- cost of capital for R&D investment, we In making this point, Stew goes on to ucts that make it, goes down with each are likely to end up making some major construct a balance sheet for an individual successive phase of testing and commer- policy blunders—policies that are going R&D project. On the asset side, you have cialization. In fact, Stew concluded that to reduce investment in R&D and, along the present value of the expected revenue the cost of capital in the early stages of with it, the competitiveness and value of stream from the project—and that present clinical testing can be more than twice the our research-based pharma industry. value of course reflects the risk of the proj- cost of capital for a mature product. Now let’s turn to Stew’s concept of the ect, with larger risks requiring higher rates Stew’s analysis also showed that risk-return staircase and its application to for discounting the cash flows. Early in the accounting, or operating, returns on pharma companies. There has been quite life of most R&D projects, the probability assets for pharma R&D are upwardly a bit written on the concept. But let me of success is low. And so the expected reve- biased measures of the true profitability give you a very brief overview of the idea, nues are adjusted downward to reflect that of pharma R&D investment. The main and then talk about its implications for lower probability—and hence their pres- reason for this bias is the accounting con- today’s looming health-care debate. ent values are also reduced to reflect their vention that requires R&D spending to The basic idea of the risk-return stair- greater risk and higher cost of capital. be expensed on the P&L instead of being case is that, from an investor’s standpoint, On the right-hand or liability side of capitalized—which understates the capital as one follows a drug through the stages of the balance sheet, you have two items: (1) base, or the “denominator,” in the rate of its life, it is very risky in the beginning and the present value of the cost of develop- return calculation. gets progressively safer as you move toward ment and (2) the equity, or expected NPV, In addition, because of the high failure the end. Stew displayed this relationship of the project, which is the difference rates in drug development, the uncer- as a staircase, with risk and the cost of between the present value of the expected tainty about the revenue and profit from capital stepping down as the product revenues and the present value of the R&D investment is very high. But when advances through each stage of discovery, expected costs. In doing the calculations you look only at the drugs and pharma development, and commercialization. for this balance sheet, Stew also argues that companies that succeed, which is the con- The R&D expenditure was characterized you should use different discount rates for ventional way of looking at the industry, as an asset with no current cash flows but the revenues and the costs—higher dis- the range of possible outcomes is skewed lots of promise, what Stew referred to as a count rates for the revenues, reflecting to the right. In other words, since invest- “growth option.” That option is an asset their greater uncertainty and higher cost ment projects that don’t work out tend to that, like a house, can be viewed as having of capital, and lower rates for the R&D get dropped from the sample and never a mortgage attached to it. The amount outlays given the greater, mortgage-like show up in the analysis, the extent of the of the mortgage is the R&D expenditure certainty of the expenditures. successes is exaggerated by the exclusion of required to get the asset to market, to take When you have done that, you can the failures. And the distortion that results it from the discovery to the development then solve for the project’s overall, or from this kind of after-the-fact analysis of and commercialization phases. As the weighted average, discount rate by cal- successful pharma companies has been an required R&D expenditures go down, the culating the ratio of the present value important subject of debate in our ongo- remaining balance and risk associated with of the R&D costs to the project’s NPV. ing discussions with policy makers around a pharma R&D project keep diminishing And the higher the ratio of R&D costs to

26 Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 ROUNDTABLE

We set up a capital structure framework for the company that is designed both to ensure our ability to fund our R&D budget and to protect us against business risks. And some of these risks have materialized, including attacks on our intellectual property, product liability issues, and late-stage failures of development projects. Thanks to our predominantly equity capital structure, we have been able to tell our major stakeholders, both outside and inside the company, that we will continue to invest in R&D, to do licensing deals and acquisitions, and to otherwise continue to grow this company—all this while continuing to maintain our dividend.

Judy Lewent total project value—a concept that Stew pharma companies, where R&D projects well-diversified investors may not care described as a project’s “R&D leverage”— are bundled into their portfolios of late- about the risks associated with each spe- the higher the overall discount rate and stage, marketed products. To get a better cific drug candidate, they care a lot about cost of capital. But, as a company’s drugs idea of the market’s expectations for the the company’s making good on its com- get closer to market, the probability of cost of capital for individual R&D invest- mitment to maintaining its investment success and the NPV increase—and R&D ments, you have to look at the smaller in R&D, to exercising its real options if leverage, risk, and the cost of capital and biotech companies—or perhaps at the you will. The risk of a company’s under- discount rates all go down. rates of return required by venture capi- investing in R&D cannot be managed by From a public policy perspective, the talists. investors through diversification. It’s top key insight from this analysis is that the From a corporate policy perspective, management’s responsibility to ensure that cost of capital, and hence the required there is another important insight from the company has the funding or access to returns or hurdle rate, for pharma R&D following Stew’s procedure of dividing capital to carry out its R&D. investment are much higher than you corporate market values between assets in How do these concepts apply to more would guess from looking at large, mature place and real growth options. Although recent developments in the industry? Today,

Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 27 ROUNDTABLE

there’s greater uncertainty not only about to company A with an option to buy it back to servicing its debt. And this means that the scientific success of R&D programs, if it succeeds, then I get that R&D cost off if pharma companies were to add lots of but also about the size of the revenue my P&L and report higher earnings.” This financial risk on top of this business risk streams that are expected to be generated kind of earnings management runs against or obligation, they could end up destroy- by even the most successful drugs. The the grain of everything I learned from Stew ing much of their value. They would be probability of success in drug development at MIT. Don’t let accounting get in the way raising, to unacceptable levels in my view, does improve as you go through the dif- of good investment decisions. Take all posi- the risk that financial distress would force ferent stages, but not to the extent that it tive net present value projects; if you have cutbacks in R&D. used to. Whether this is a function of the things that are worth doing, you should do So, working with Stew and others scientific difficulty or changes in the regu- them. Big pharma’s cost of capital, though over the years, we set up a capital struc- latory environment or other factors, there’s higher than in the past, has got to be a lot ture framework for the company that is no question that the path from discovery lower than what a smaller firm is going to designed both to ensure our ability to to development and commercialization charge you to outlicense a development fund our R&D budget and to protect has become more risky and uncertain. As a project and then sell it back to you. us against business risks. And some of result of all these factors, drug development Let me finish by making a point these risks have materialized, includ- costs are increasing. And this means higher about the optimal capital structure for ing attacks on our intellectual property, discount rates and cost of capital for the big pharma—and this is one I discussed product liability issues, and late-stage industry. The higher cost of capital, larger with Lakshmi about 15 years ago and have failures of development projects. Thanks R&D costs, and greater uncertainty about never let go of. To make this point, we to our predominantly equity capital struc- revenues have all affected the willingness— need to return to this concept of R&D ture, we have been able to tell our major and indeed the entire approach—of the leverage—which, as I said earlier, is the stakeholders, both outside and inside the pharmaceutical industry to invest in R&D. present value of development costs as a company, that we will continue to invest And from a policy standpoint, the nega- percentage of the total NPV of the project in R&D, to do licensing deals and acquisi- tive trends in each of these three variables or company. Even in the case of relatively tions, and to otherwise continue to grow are jeopardizing the ability of pharma to mature pharma companies, well over half this company—all this while continuing earn the cost of capital and thereby attract of their current value comes from “growth to maintain our dividend. new capital. options” as opposed to current products, Thank you. For example, small biotechs have or what Stew calls “assets in place.” For responded to their reduced access to mar- this reason, management’s most important Merton: Thanks, Judy. Now, let’s hear kets by monetizing, or selling off rights to, obligation is to ensure that the firm has from Don Lessard, who joined the Sloan their royalty streams. Big pharma has not sufficient equity capital—or at least access School faculty just after I did, and who has followed suit, mainly because it contin- to it—to carry out its R&D program. been thinking and writing about global ues to have better—though by no means R&D is the engine of value, the source of corporate risk management ever since great—access to markets. Nevertheless, much of the expected future cash flows— then. big pharma has increasingly been “outli- and, perhaps even more important, the censing” early-stage drug opportunities to source of the benefits for our customers. The Link Between Risk Management biotechs. And I think this is a mistake, a And this to me is the main reason why and Corporate Strategy confusion of accounting outcomes with major pharmaceutical companies have Don Lessard: Thanks, Bob. My focus maximizing shareholder value. The com- low debt levels, and biotechs almost no will be the ways in which finance and risk panies are thinking to themselves, “I have a debt at all. The basic insight is that, for management interact with real business finite R&D budget, but some projects that pharma companies, their R&D spending decisions, and can be used to improve look pretty good. If I structure a deal where is their primary obligation, equivalent to, them. It’s a delight to follow Judy Lewent I outlicense a drug development program say, an industrial company’s commitment because she is my model of a senior finance

28 Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 ROUNDTABLE

executive who has succeeded in bringing a opportunities as well as limiting downside In the late 1990s, I worked with a mul- finance perspective into strategic corporate risk. And approaching strategic or busi- tinational firm that was determining its decisions. And, as Judy just told us, Stew ness problems from a finance perspective response to the Asian financial crisis. Of Myers has provided much of the frame- often ends up providing insights into real course, my first advice was to ensure that work and specific insights that allow that business opportunities. local currency balances were “upstreamed” to happen. I first learned this in the 1970s when as quickly as possible. But our big realiza- Let me start by saying a little about a computer manufacturer asked me to tion was that the crisis could throw the the development and evolution of my own analyze the company’s FX exposure and firm’s entire distribution chain into stress, interest in finance and risk management. I assess the value added by its active cur- with a significant exposure of the firm’s started my career in corporate finance by rency risk management program. As it reputation to possible shortcuts by its local looking at risk in a classic portfolio sense, turned out, the trading program was add- distributors in response to this stress. The thinking about how investors should diver- ing a little bit of value and doing little or upshot was the recognition of the need sify across countries to reduce risk and nothing to reduce risk. At the same time, to focus on which of these distributors to how governments—particularly emerging the company was essentially giving away “prop up” and which ones to take out. market governments—should think about free currency options by quoting prices In every case, then, what started out designing their financing to lay off or cush- in a variety of currencies and allowing looking like a financial risk management ion those risks. Among other things, I tried important clients to tell them after the problem became something quite dif- without much success to persuade oil- and fact which currency they were going to ferent. The most cost-effective kinds of other commodity-producing countries to pay in. In response to this analysis, the risk management often turn out to be issue commodity-linked bonds to stabilize company decided to provide only a dol- real options, sources of operating flex- their net revenue streams and strengthen lar price list for large clients—those who ibility that can be built into a company’s their credit standing. Then I spent a good could easily take advantage of the ambi- operations. And in this sense, I feel like deal of time helping multinational corpo- guity in the firm’s pricing terms and who I’ve been on a long journey in which rations manage the risks associated with did not need currency protection—but Stew has been looking over my shoulder. international expansion, particularly cur- to continue pricing in local currency for He has always insisted that, rather than rency and political risk and uncertainty smaller customers for whom local pricing forcing the problem to fit a particular stemming from other macro fluctuations. was valuable. financial model or instrument, you have And in the past decade, I’ve shifted my In this case, getting sales and market- to start with a thorough understanding focus to the management of large complex ing right was worth much more than of the firm’s assets and operations, figure projects in infrastructure and oil and gas. any conventional FX risk management out the value-maximizing set of strategic Although I now think of myself as a approach. And I had a similar experience operating decisions, and then design the general international management person, in studying the responses of automak- company’s financing around them. I’ve never forgotten my finance roots and ers and large equipment makers to large But let’s go back to some of Stew my debt to Stew’s thinking. To go back to currency fluctuations in the 1980s. The Myers’s footprints in this area. There are the point that Bob Merton made at the most promising solutions for these com- many, but let me just comment briefly outset, most people tend to think of the panies did not involve financial hedging. on a couple concepts that Stew has either goal of risk management as the preser- Instead they called for the creation of real invented or heavily influenced. vation of capital, keeping the firm from options—different sourcing and market- The first is what I like to refer to as losing money. But what we have discov- ing options and flexible manufacturing, “risk management components and value ered using finance concepts such as “real or what I like to refer to as “a factory on additivity.” For many years, the standard options”—a term that, as Bob mentioned, a ship.” But to do this clearly requires view in corporate finance was that most of was invented by Stew—is that risk man- greater collaboration between finance and the financial risk management activities agement is a way of expanding upside operations. of publicly traded companies—including

Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 29 ROUNDTABLE

diversification into unrelated businesses along with a “swing” contract that allows result of conscious choices rather than just and the hedging of currency and interest for shifts between them. an inability to offload them. rate risk—represented needless dupli- Yet another risk management approach To summarize, then, corporate risk cation of shareholders’ diversification. involves the real, as opposed to, financial management really begins with the left- Corporate efforts to manage risks that pooling of risks. Cemex, for example, hand side of the balance sheet. It begins could be easily diversified away by hav- has acquired or built a group of cement with efforts to identify and manage oper- ing a broad base of shareholders were thus plants around the Caribbean basin that ating and strategic risks. Are our plants thought to have no effect on the corpo- has given it the ability to match capacity and workplaces safe? Are we facing threats rate cost of capital or corporate values. In and demand more closely with the result from our competitors? Companies also this standard view, it was only the own- of higher average plant loadings than need to take account of regulatory “insti- ers of private or closely held companies would be possible for a set of independent tutional” and country risks, such as the that were thought to benefit significantly firms operating these plants. Shareholders possibility of price controls, expropriation, from managing such “diversifiable” risks. owning these plants as a set of separate environmental regulation, and reduced However, shareholders cannot create firms might have been able to obtain access to markets. And, at this point, real options—nor can they pool or share similar degree of risk reduction through having taken account of all these effects volatile demand in a way that decreases diversification, but they could not have on the left-hand side of the balance sheet, average costs. obtained the benefits of this greater aver- only then should a company consider its Stew’s thinking on the corporate age efficiency. options for financial risk management. underinvestment problem and the value So, thanks in part to Stew’s thinking, a As Stew likes to say, companies create far of real options ended up providing a jus- great deal of real risk management makes more value in their investment decisions tification for managing such risks—later sense regardless of how the asset is owned than in their financing decisions. And formally developed by people like Cliff and financed. And to come back to a point the purpose of financing—of risk man- Smith, Dave Mayers, and Rene Stulz— I made earlier, companies spend too much agement from the right hand side of the that applied to public as well as private time thinking about the right-hand side of balance sheet—is to ensure that the assets or closely held companies. A classic illus- the balance sheet, and too little thinking on the left hand side are allowed to realize tration of such value-adding corporate about how risk management can affect their full potential. risk management—and it’s one that has operations. Now, an important part of this task, as been used as a model in many business The second of Stew’s footprints is what both Lakshmi and Judy told us earlier, is schools—was Judy Lewent’s currency I like to describe as a “pecking order” of preserving the financial flexibility to take hedging program at Merck. The primary real (operational) and financial risk man- on all positive-NPV projects by limiting function of that program, as Judy just told agement. Real decisions involving positive the amount of debt. But, at the same time, us, was to ensure Merck’s ability to fund NPV real options and pooling opportu- you want keep operating managers from its R&D program—a program that can nities—which are effectively a set of real having too much equity capital—which, be viewed as one very large real option as options on where to source demand— as a lot of the dotcoms showed us, is a well as the main source of the company’s come first, as do situations where one firm prescription for overinvestment and value value even today. has comparative advantage relative to its destruction. That’s the so-called agency Another kind of value-increasing risk competitors in taking the risks that are cost of free cash flow problem. And the management is the factory-on-a-ship essential to delivering value. The resulting challenge here is finding the “sweet spot,” concept I mentioned earlier—say, an “retained” risks then become the focus of the amount of debt and equity capital that arrangement that allows a multinational possible financial risk management—and provides enough flexibility, while avoiding like Caterpillar to source its components note my use of the term “retained” here the kind of slack that breeds waste and from at least two currency areas by hav- rather than “residual,” which is meant to inefficiencies. ing a “base-load” contract in both places, emphasize that these risk exposures are the But one point of clarification here:

30 Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 ROUNDTABLE

The most cost-effective kinds of risk management often turn out to be real options, sources of operating flexibility that can be built into a company’s operations. And in this sense, I feel like I’ve been on a long journey in which Stew has been looking over my shoulder. He has always insisted that, rather than forcing the problem to fit a particular financial model or instrument, you have to start with a thorough understanding of the firm’s assets and operations, figure out the value-maximizing set of strategic operating decisions, and then design the company’s financing around them.

Don Lessard

When I say that companies should think however, is that management keep in information and decision-making author- about managing their financial risks only mind its full range of operating and finan- ity have strong incentives to add value by after taking care of their operating and cial responses to risk and uncertainty. making the right decisions in the face of strategic risks, I don’t want to rule out And there’s one last matter I want to risk while avoiding doing anything that the possibility of a feedback loop. In other touch on—the question of who inside a would put the franchise at risk—and you words, there can and will be cases in which company is responsible for risk manage- also want to have reporting systems that a company’s financial risk management ment. Is it just the treasury or the chief provide enough oversight and control to solutions make possible a different oper- risk officer—or do operating managers ensure that it doesn’t happen. ating or strategic approach. For example, and line people have a major role to play? So, I’ve just given you an account of it’s conceivable that an effective currency Given the primary importance of operat- my personal tour through the discipline hedging operation could dominate mul- ing and strategic responses to corporate of corporate risk management, with an tiple sourcing options under one set of risk management, much of risk manage- emphasis on what I’ve learned from Stew. circumstances—and that changes in these ment must take place on the front line. And perhaps my most important point circumstances could cause the company It’s no coincidence that CEMEX’s CFO is that risk management is not just about to shift back to an operating solution like is also its chief strategist. You must make preserving value by putting a floor on multiple sourcing. The important thing, sure that operating people with “local” losses, it’s also about exploiting opportu-

Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 31 ROUNDTABLE

nities. At the same time, companies need But now let me turn to the topic at tions of perfect markets, that could make to pay more attention to encouraging hand: corporate risk management and capital structure and risk management front-line people to think harder about its implications for financial market cri- important contributors to—or perhaps risk while pursuing opportunities. And ses. This is very timely, of course, given safeguards of—a company’s value. I’ll stop there. that we’re now in the midst of a pretty My point here is that although the significant financial crisis. Bear Stearns theoretical explanations that give us opti- Merton: Thanks, Don, that was terrific. and Lehman Brothers are gone, Mer- mal capital structures could be the same as Now let’s hear from Andrew Lo, who I rill Lynch has been acquired by Bank of those that give us optimal risk management believe is going to warn us about some of America, and Fannie Mae and Freddie policies, they don’t have to be the same. the problems in corporate risk manage- Mac have been taken over by the govern- For example, the standard “static tradeoff” ment. ment. This is an extraordinary time for theory of capital structure attempts to bal- financial economists. And in formulating ance the tax benefits of debt against the Corporate Finance and Financial Crises my comments, I thought I would try to costs of financial distress. But while this Andrew Lo: Let me start by thanking the focus on Stew’s major contributions to the may yield an optimal capital structure, it organizing committee for putting together literature, and how they might relate to might not give you an optimal, or value- this wonderful tribute to Stew, and for financial crises. At first blush, you might maximizing, risk management policy. For inviting me to participate. It’s an honor to think that finance theory is pretty far example, the fact that risk management be here. I feel like a bit of an outsider since removed from what we’re now witness- policies are often designed and approved most of my research is on capital markets ing. But as you think about it, it becomes by committee—that is, by the Risk Com- and financial econometrics, which can get clear that there are some very important mittee—suggests that a corporation’s risk pretty far afield from corporate finance. ties—ties that I’m not sure we’ve fully preferences may be inconsistent over time But I want to mention that Stew had a big appreciated. And I suspect a number of and with respect to different investment impact on my career at the very start—in us, including me, will be working in this opportunities. These inconsistencies fact my Ph.D. thesis was actually in cor- area during the next several years. or conflicts may not be reflected in the porate finance. It was on capital structure, There are three areas, all heavily influ- trade-off between tax shields and costs and was an attempt, somewhat along the enced by Stew’s thinking, that I’d like of financial distress. So, risk is actually a lines of what Don Lessard was just sug- to focus on today: capital structure, real somewhat different animal that requires gesting, to integrate the real side with the options, and corporate governance. In taking account of perhaps a different set of financial side of a company’s decisions. my view, each one of these three areas has market imperfections, including assump- After getting my Ph.D., I became played a critical role in contributing to tions about investor behavior. more familiar with the broader literature the crisis that we’re going through today, One of the ideas that Stew proposed in both capital markets and corporate and financial research in each area may years ago—the pecking order hypothesis finance—and I discovered that the MIT help us understand how to remedy some of corporate financing—can be inter- finance tradition was quite different from of the problems. preted as a “behavioral” hypothesis in the how financial research was done anywhere With respect to capital structure, finance sense that a corporate manager’s desire to else. It was different in the sense that peo- theory begins of course with M&M, which preserve financial flexibility appears to be ple like Bob Merton and Stew Myers took says that capital structure doesn’t matter, premised on his distrust of the rationality an extraordinary interest in the practical at least in the hypothetical case of perfect of investors and markets. This view has importance and applications of their theo- markets—and risk management therefore some significant implications for capital ries. And that kind of impact on financial doesn’t matter either. So if you believe that structure, and it also has implications for practice is something that I have tried to there is a role for capital structure, and a risk management, particularly in the case emulate in my own career and through role for risk management, then you have to of financial institutions. As I think we’re my own research. start by looking at the frictions, the viola- now learning, the theories of both capital

32 Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 ROUNDTABLE

As I think we’re now learning, the theories of both capital structure and risk management for financial institutions are even more important in understanding financial crises than many of the asset-pricing models that lie at the heart of such crises...Now, the question for financial economists is whether we can model the tendency of managers to underestimate improbable events—the so-called “fat tails” of the distribution—and the need to compensate for that tendency when setting risk management and even capital structure guidelines.

Andrew Lo structure and risk management for finan- it wasn’t obvious before Stew and Dick recent example is the credit default swaps cial institutions are even more important wrote about it in Brealey and Myers. Now, of AIG, in which the company collected in understanding financial crises than in the context of financial crises, I think it huge profits for guaranteeing CDOs that many of the asset-pricing models that lie might be useful to focus on the downside, carried AAA ratings. at the heart of such crises. And, as I’ve or the risks, associated with PVGOs. What Now, the question for financial econo- already suggested, I think there’s a fairly I have in mind is that companies have not mists is whether we can model the tendency significant behavioral role in explaining only the present value of growth opportu- of managers to underestimate improbable the events that are now taking place. nities as assets on their balance sheets; they events—the so-called “fat tails” of the dis- My second topic, real options, is one also have what I like to refer to as the pres- tribution—and the need to compensate for that has received a tremendous amount ent value of “blow-up opportunities” or that tendency when setting risk manage- of attention and has become central to “PVBOs.” What I mean by PVBOs is that ment and even capital structure guidelines. the study of both corporate finance and there have been many cases in which com- Certainly the events that we’ve witnessed capital markets. In particular, the four let- panies have effectively sold what appear in the recent past—consider for example, ters “PVGO”— Present Value of Growth to be deep out-of-the-money options—or, what happened to the quantitative market- Opportunities—have been seared into my to put it another way, they have collected neutral equity funds in August 2007—call brain since I was a graduate student. It’s profits or “premiums” for underwriting into question our understanding of tail risk, the kind of concept that, once you learn events that appear to have very small prob- of how we manage it and provide proper it, appears to be obvious. But, of course, abilities of very, very bad outcomes. One pricing of assets that are subject to it.

Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 33 ROUNDTABLE

In my view, there’s nothing funda- known hedge fund Amaranth, which blew because it appeared to be an almost risk- mentally wrong with tail risks if properly up in 2006. This was a $10 billion hedge less investment; it was the proverbial $20 prepared for and properly disclosed. For fund that apparently, at least at one point, bill lying on the street. You said that this example, the catastrophe insurance indus- had something like 50 different strategies strategy would work just fine until some try has made a business of pricing and applied across hundreds of markets and disaster happened, or a takeover was bearing those kinds of risks. But when tens of thousands of instruments. But I announced before expiration. And then such risks sneak into corporations in ways say “apparently” because there’s no trans- these traders would be carted off the floor that are not fully understood or disclosed, parency in the hedge fund industry, so with massive losses. that’s when we begin to sow the seeds of we don’t have the details of exactly what Several panelists this morning have future financial crises. And, of course, the happened. But apparently this $10 bil- talked about disasters and fat tails, about risk of house price depreciation as amplified lion hedge fund ended up putting all of supposedly once-in-a-100 year events that by mortgage-backed securities has been a its chips not just on one strategy, not just now seem to occur every four or five years. great example of this temptation. in one market, but actually on one single And my question is this: In the past 25 The last topic that I want to take up is trade—the March/April 2007 calendar years, have we made any progress in think- corporate governance. This is a subject of spread in natural gas! It was literally one ing about how to measure and manage Stew’s recent work, but his abiding interest very large trade that allegedly caused the these problems? in it is clear from his textbook and many firm to unravel. That someone can choose earlier writings. to bet a $10 billion franchise on a single Merton: My answer to your question is yes, Corporate governance is an issue that trade seems to be an astonishing breach we have made progress—but the effects has been largely ignored on the capital of not just proper corporate governance, of this progress have not all been good. markets side where I’ve focused much of but reason itself. We have made a lot of advances since my research, but for many reasons, I think But my point in focusing on this those days, both in understanding and that’s going to change in the next few years. exceptional case is that, in the hedge fund measuring risks, and in managing them. What I’m referring to is the fact that risk industry, there are no disclosure require- But what we sometimes fail to recognize management as an activity in financial ments or governance standards of any is that there’s a “reaction function” that companies is really a bit of a misnomer. kind. Given the role that hedge funds are accompanies innovations of all kinds. As If you think about the most popular risk likely to play in financial crises, this is cer- you understand risk better, you measure management software vendors—com- tainly an area that bears further study. it better, and you manage it better. But, as panies like RiskMetrics, Sungard, and Thank you. things become safer and people become Barra—the output of their analytics does more confident, they tend to take more not really lend itself to risk management. Progress in Risk Management? risk somewhere else. The services they provide are really just risk Merton: Thanks, Andrew. Okay, now One of my favorite examples of this measurement, not risk management. There’s that we’ve heard from all of our panelists, tendency is four-wheel drive. I think most nothing prescriptive, nothing that tells you I want to open the floor to questions from of us who live in New England would what you ought to do, given a certain set the audience. We’ve covered a good deal agree that, if you have to go out in another of risk analytics. And frankly, risk analytics of ground. Does anyone have a follow-up couple of months when it’s snowing, you’re in the hedge-fund industry at this point question on any of these topics? unquestionably safer if you have a car with appear to me to be still a matter largely four-wheel drive rather than two-wheel of window dressing, as opposed to corpo- Robin McLaughlin: Bob, my question goes drive. But suppose I told you that, during rate governance structures for actively and back to the course you were teaching 25 the last 15 years—when four-wheel drive effectively managing risks. years ago. I remember you telling us sto- has become widely available—passenger A case in point—and one that I think ries about options traders writing naked, accidents per miles haven’t declined at all. is worthy of further study—is the well- short-term, way out-of-the-money options So, safety has not really increased.

34 Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 ROUNDTABLE

What’s the key to this paradox? Well, with lags in developing the infrastructure risks. They are risks that somebody in the I have a neighbor in Maine who describes necessary to support them, which are now organization was aware of, but that were the advantages of four-wheel drive this dominating our newspaper headlines—are not in the firm’s “central field of vision.” way: You can go a lot farther into the much easier to see. But identifying the And I would also agree with your argu- woods before you get stuck. So, in the old cause of these effects is more subtle. Better ment that, while risk management of such days with two-wheel drive, if you saw four risk measurement and management have projects has become far more sophisticated inches of snow, you would put off that given people the confidence and the tools and effective, it has encouraged people to visit to the family. But with four-wheel to reduce the amount of risk capital and, accelerate the pace and heighten the com- drive you go—and instead of going 15 at the same time, to design and introduce plexity and risk of projects. miles an hour, you now go 30. Most of more complex instruments into the finan- the time, you get there more reliably and cial system. The Role and Future of Credit Ratings faster—that’s the benefit. But you also get So what we have here are two partly Marc Zenner: I think we would all agree people taking risks that were not accept- offsetting effects of innovation—one that that credit ratings have played a big role able before but are acceptable now because is reducing the risk of companies and their in the current crisis by providing cover for they can be managed better. And so we investors, and another that is encourag- a lot of this risk-taking—and I’m think- end up using a potentially safety-increasing greater risk-taking. And from a social ing not only of Freddie and Fannie, but ing innovation not to make ourselves safer, or regulatory standpoint, the goal is to of many large institutions and investors but to achieve those other benefits. find the right balance between these two with no government backing, explicit So, to return to my point, there have effects or forces. Finding that balance is a or otherwise. Many highly experienced been dramatic improvements in financial much more difficult and subtle task than and sophisticated investors allowed their risk management. The world’s financial determining whether financial innovation investment decisions to be guided by the institutions, including central banks, today is generally a good thing. For there’s no ratings. They effectively said to themselves, know far more about their risks and how question in my mind that we have made “My goal is to earn the highest return I can to manage them than they did 10 years enormous progress in understanding and while maintaining a AAA rating”—and, ago. The practice of two-way marking-to- managing risk—and I also have no doubt in so doing, they were effectively handing market of positions of over-the-counter that, given enough time, the benefits of over their risk management function to derivative contracts, with collateral trans- such progress will far outweigh the costs. the rating agencies. But, as investors have fers similar to the margin provisions And let me also say that what we need been learned the hard way, a AAA rating of exchange-traded future contracts, is going forward is not fewer financial engi- no longer carries the assurance of return now almost universal—and that’s a huge neers, but more of them—and in places of principal and interest it once did, at advance in reducing counterparty risk. of greater influence and control. Risk and least in the case of structured products. Another important advance is the infor- innovation, including derivatives, are not And in my experience, industrial compa- mation available to market participants. going away, and we need senior manage- nies have long placed too much weight The VIX-like contracts for trading implied ments, boards, and regulators of financial on credit ratings when setting their own volatility on equity market indexes and on institutions who understand them. capital structure targets. single-name stocks give us forward-looking So, my question is about the future market assessments of future return volatil- Lessard: Bob, I’m struck by the parallels role of the rating agencies. Will inves- ity. And global investing with its broader between the problems in our financial sys- tors and companies continue to entrust diversification of risks has increased by tems and some recent developments with this critical risk measurement function to orders of magnitude in the last ten years. large real projects, particularly oil and gas these relatively small groups of people— That’s the good side of financial inno- projects and big infrastructure projects. people whose recognition of problems vation. The costs of innovation—greater My sense is the big blow-ups are coming often lags the market’s, despite their complexity, speed, and trading volumes from what I call “peripheral compound” access to management? For example,

Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 35 ROUNDTABLE

in today’s markets, we now see securi- pointed to lack of transparency as a major reasonably reliable, agreed-upon way of ties with AAA rating carrying yields of contributor to the current financial crisis. determining what’s investment grade and LIBOR plus 450 basis points? That tells But let me say first that I can’t think of any what’s not. us that one of these indicators of credit past crisis where people have said, after The big challenge to me is to figure quality has got to be wrong. And if it the fact, that there’s been enough trans- out the right relationship between the rat- is the rating agencies that prove to be parency. And I would even suggest that ings evaluations and the information that wrong, what kind of trust will their rat- we now have greater transparency—or at already exists in markets—and that’s a very ings command in the future? least far more information—about loom- contentious issue in the rating agencies at ing credit problems than there was 10 the moment. There are two basic positions Lee Wakeman: To answer this question, years ago. What I’m thinking about here on the proper use of market data in set- you have to ask another one: Where do is the credit default swap, or CDS, market ting ratings. People at Moody’s have taken the rating agencies really have information that prices credit everyday. For some 800 the view that ratings should incorporate that investors don’t have? And my sense companies and nearly every sovereign, we at least some market data. But S&P has here is that the agencies have long had, now have legions of serious professionals argued that, if you rely on market data, and will continue to have, an important putting serious money into buying and you’re chasing your tail and failing to pro- edge in evaluating the credit of individual selling credit protection and trading those vide an additional or independent source companies. That’s what they know how spreads every day—and those prices are of information to credit-market inves- to do, and where they have a competi- transparent and available to everyone. You tors. My own feeling about this is that we tive edge over markets. The big mistake may disagree with some of the spreads should use all the data available to come of the agencies was being lured into areas quoted, but if you do, you’re free to enter up with the best estimate of the rating. like structured products where they have into the market on the side that you think no experience or expertise—and where is mispriced. To see the progress in this, Andrew Lo: In thinking about this ratings the history of past prices has become just compare the information and trans- question, it might be helpful to go back irrelevant, since the very nature of those parency generated by the CDS market to the fundamental insight in Stew’s peck- instruments has changed the market. And to the good old days where one relied ing order theory. We’ve just talked about so while I think Moody’s and S&P will on occasional credit ratings that rarely the rating agencies and the problems they continue to rate individual companies, I changed after being given—and where have created by covering risks they didn’t have doubts whether the structured prod- we had sparsely and infrequently traded really understand. But what about equity? ucts that I expect to return in the next corporate bonds with only dealers know- We don’t worry about ratings when buy- five years or so will carry ratings from the ing the transactions prices. And we had ing equity, right? We all know, or should same agencies. bank loans that, after being stuck into a know, that equity is risky—riskier than book, rarely saw their values changed even debt. But the important difference with Zenner: I agree with Lee’s point about though a whole lot may have changed in equity is that everybody understands competitive advantage. But even so, when the economy and the credit markets. that the value of equity is highly sensi- you see industrial companies rated AA or So, for all our problems at the moment, tive to information, and that investors are AAA now financing themselves at rates we have taken some important steps for- on their own. We all understand that if we associate with companies rated single ward. And, as for this issue of the future we want to invest in the stuff, we better B, you have questions about both parties, of rating agencies, I don’t think there’s devote resources to figuring out if it’s good the agencies and investors. Both of them any way we can do without some ver- investment, or have advisers we can rely can’t be right. sion of what we now have. There are so on for that. But, as a general rule, we don’t many investor institutions and contracts rely on third parties like rating agencies to Merton: On this question of ratings around the world that require investment- tell us that what we’re doing is okay. and rating agencies, a lot of people have grade ratings that we have to have some Now, one alternative to this has been

36 Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 ROUNDTABLE

What we have here are two partly offsetting effects of innovation—one that is reducing the risk of companies and their investors, and another that is encouraging greater risk- taking. From a social or regulatory standpoint, the goal is to find the right balance between these two effects or forces. Finding that balance is a much more difficult and subtle task than determining whether financial innovation is generally a good thing. For there’s no question in my mind that we have made enormous progress in understanding and managing risk—and I also have no doubt that, given enough time, the benefits of such progress will far outweigh the costs.

Robert Merton

to take a risky security and make it liq- the subprime risk on the balance sheets financial institutions. And we found docu- uid by dividing it up into segments or of the banks. Everybody was sort of saying ments that showed some AAA subprime tranches that are AAA, and thus largely that these securities are high enough up in plus alternatives being issued at LIBOR unaffected by differences in information. the pecking order, information-insensitive plus 150-200 basis points. I like to call It’s a security designed to make investors enough, that we don’t need to do our own this the Tinker Bell effect. If people say say to themselves, “This is so safe that I analysis. And we just have seen this com- “I believe” loud and long enough, Tinker don’t really need to worry about it, as long placence taken to an extreme, and with Bell comes back to life—and AAA-rated as somebody else continues to tell me it’s disastrous results. securities really turn out to be AAA securi- okay.” That’s the logic, and I think it’s ties. My question is: When and how did fairly sound on the whole. But that logic Wakeman: Early last year, we were in the people start believing that a AAA inter- just got pushed too far in recent events. business of providing independent evalu- est rate could reasonably be LIBOR plus Even central bankers didn’t understand ations of the risk of structured products to 200 basis points when LIBOR alone was

Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 37 ROUNDTABLE

meant to be a fair rate of return for bear- lot on whether you are marked-to-market caused by very large, and likely permanent, ing the risk of a lower, AA- minus credit? daily with overnight funding or a private losses in real estate and some corporate equity firm with permanent capital and assets. But liquidity problems have played Merton: I thought you were going to ask multi-year performance evaluation. People a major supporting role in this. a slightly different question. Picking up with overnight funding and daily mark- But I’m not disagreeing with your first on Andrew’s comment, a “AAA” rat- to-market are now faced with a kind of point about the inconsistency between ing has always meant to me that you don’t liquidity risk they’ve never seen before, and ratings and yields as a signal for more need to understand the underlying assets never imagined they would see. And this careful investigation. My point is only to prudently make the investment. So, on can have some big effects on behavior. that when things go bad, we often blame this basis, it doesn’t make sense for us to Imagine that you’re in the middle of a market players for not having been dili- criticize an Australian or German bank poker game—one that you’ve been play- gent enough in their risk assessment, or for investing in U.S. real estate without ing for years—and you put down your not having demanded enough transpar- understanding the risks. Though we all royal flush and go to pull in the chips, and ency. But if that diagnosis of the problem have bank accounts, I doubt any of us someone says, “No, that’s not your pot.” has turned out to be right after the fact, have a clue about the assets or liabilities You say, “What do you mean?” “We’ve it may not have been at all clear, or fair of our bank…because we assume we don’t changed the rules.” “What are the new to expect it, when the assessments needed have to know. But it’s possible we might rules?” “Not gonna tell you.” How would to be made. And when we get around to wake up one day, and discover we might you feel about continuing to play in that doing the pathology on this, I think we’re have to know that. So, that’s what “AAA” game? I think most players are going to going to find that a lot of that happened means—the confidence that someone else pull back until they are convinced they over the last few months. has done the work to verify that default is understand the new rules of the game. But now it’s time to go to lunch. And such a remote possibility that you don’t And that’s kind of what’s happened in let me thank you all for taking part in this need to worry about the risk of the under- the so-called liquidity shocks to financial discussion. lying assets. markets we have seen in this crisis. When But, to your point, we too saw struc- you’re an investor in AAA-rated securities, tured senior debt tranches with AAA it’s not supposed to matter that you don’t ratings issued at 250 basis points over know much about the assets underlying LIBOR. And we should have said to our- that security. And then you wake up one selves, “There appears to be a $20 bill day and they tell you that it does matter lying on the floor—and either it’s not very much what those assets are worth and really there, or it’s attached to something you should therefore have had the skills that’s going to get me into trouble.” Some and data necessary to do that evaluation. things are just too good to be true; and if The rules of that market changed, and someone is willing to pay you in size 250 the traditional investors in that market— over LIBOR, they must either be very des- who were not equipped to handle the new perate, or have fantastically good uses for rules—have simply exited the market. The that cash. And, as an investor, you need result has been a rapid and nearly com- to try to get to the bottom of that. But I plete loss of liquidity, where transactions agree with your point that there’s a major cannot take place at almost any price. discrepancy between the ratings and some Of course, the crisis itself is not simply of the yields we’re now seeing. the result of such liquidity shocks. The And let me just add that whether you crisis has come from a dynamic interplay decide to pick up that $20 bill depends a between liquidity and the credit shocks

38 Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 Journal of Applied Corporate Finance (ISSN 1078-1196 [print], ISSN Journal of Applied Corporate Finance is available online through Synergy, 1745-6622 [online]) is published quarterly, on behalf of Morgan Stanley by Blackwell’s online journal service, which allows you to: Blackwell Publishing, with offices at 350 Main Street, Malden, MA 02148, • Browse tables of contents and abstracts from over 290 professional, USA, and PO Box 1354, 9600 Garsington Road, Oxford OX4 2XG, UK. Call science, social science, and medical journals US: (800) 835-6770, UK: +44 1865 778315; fax US: (781) 388-8232, • Create your own Personal Homepage from which you can access your UK: +44 1865 471775. personal subscriptions, set up e-mail table of contents alerts, and run saved searches Information for Subscribers For new orders, renewals, sample copy requests, • Perform detailed searches across our database of titles and save the claims, changes of address, and all other subscription correspondence, search criteria for future use please contact the Customer Service Department at your nearest Blackwell • Link to and from bibliographic databases such as ISI. office (see above) or e-mail [email protected]. Sign up for free today at http://www.blackwell-synergy.com.

Subscription Rates for Volume 19 (four issues) Institutional Premium Rate* Disclaimer The Publisher, Morgan Stanley, its affiliates, and the Editor cannot The Americas† $377, Rest of World £231; Commercial Company Premium be held responsible for errors or any consequences arising from the use of in- Rate, The Americas $504, Rest of World £307; Individual Rate, The Ameri- formation contained in this journal. The views and opinions expressed in this cas $100, Rest of World £56, €84‡; Students** The Americas $35, Rest of journal do not necessarily represent those of the Publisher, Morgan Stanley, World £20, €30. its affiliates, and Editor, neither does the publication of advertisements con- stitute any endorsement by the Publisher, Morgan Stanley, its affiliates, and *The Premium institutional price includes online access to current content Editor of the products advertised. No person should purchase or sell any and all online back files to January 1st 1997, where available. security or asset in reliance on any information in this journal.

†Customers in Canada should add 6% GST or provide evidence of entitlement Morgan Stanley is a full service financial services company active in the to exemption. securities, investment management, and credit services businesses. Morgan Stanley may have and may seek to have business relationships with any ‡Customers in the UK should add VAT at 6%; customers in the EU should person or company named in this journal. also add VAT at 6%, or provide a VAT registration number or evidence of entitlement to exemption. Copyright © 2008 Morgan Stanley. All rights reserved. No part of this publication may be reproduced, stored, or transmitted in whole or part in any form **Students must present a copy of their student id card to receive this rate. or by any means without the prior permission in writing from the copyright holder. Authorization to photocopy items for internal or personal use or for For more information about Blackwell Publishing journals, including online the internal or personal use of specific clients is granted by the copyright access information, terms and conditions, and other pricing options, please holder for libraries and other users of the Copyright Clearance Center (CCC), visit www.blackwellpublishing.com or contact your nearest Customer Service 222 Rosewood Drive, Danvers, MA 01923, USA (www.copyright.com), pro- Department. vided the appropriate fee is paid directly to the CCC. This consent does not extend to other kinds of copying, such as copying for general distribution Back Issues Back issues are available from the publisher at the current single- for advertising or promotional purposes, for creating new collective works, issue rate. or for resale. Institutions with a paid subscription to this journal may make photocopies for teaching purposes and academic course-packs free of charge Mailing Journal of Applied Corporate Finance is mailed Standard Rate. Mail- provided such copies are not resold. Special requests should be addressed to ing to rest of world by DHL Smart & Global Mail. Canadian mail is sent Blackwell Publishing at: [email protected]. by Canadian publications mail agreement number 40573520. Postmaster Send all address changes to Journal of Applied Corporate Finance, Blackwell Publishing Inc., Journals Subscription Department, 350 Main St., Malden, MA 02148-5020.