Many of you likely saw the following article in the New York Times detailing Bank of America’s plea to the government for a bailout of the mortgage markets (see A ‘Moral Hazard’ for a Housing Bailout). Edmund Andrews writes:

A confidential proposal that Bank of America circulated to members of Congress this month provides a stunning glimpse of how quickly the industry has reversed its laissez-faire disdain for second-guessing by the government — now that it is in trouble.

The proposal warns that up to $739 billion in mortgages are at “moderate to high risk” of defaulting over the next five years and that millions of families could lose their homes.

To prevent that, Bank of America suggested creating a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates.

This, in essence, would represent a public bailout of the banks. Mike Barnett, a guest blogger to this site, recently expressed his concern about the message that such a bailout sends to the bankers, and some broader implications it might hold for our society at large (see Reward Without All That Nasty Risk).

With that in mind, I asked Mike if he’d like to comment on this piece. Here’s what he wrote back:

Mike Barnett’s comments: The New York Times article talks more about the moral hazard we’ve been seeing in action — few morals, many hazards. The same folks who wanted government to stay off their backs now want government to carry them on its back. It’s like the kid who wants his parents to stay out of his affairs until the bills and the problems mount, and then fully expects mommy & daddy to bail him out. And that’s really the problem here — because mommy & daddy (the government) have an attachment to little Johnny (the banking industry), they’re prone to covering for him; little Johnny knows this, and he abuses this, time and time again. What’s a parent to do?? As the article notes, what’s good for Bank of America is good for America . . . then again, for the long-term sake of America, maybe we need to let little Johnny make his own way for once, or he’ll never learn.

My comments: Mike is pointing out how the moral hazard plays out in this case. In the previous post he pointed out some of the second order effects (aside from saving the banks and incentivizing the moral hazard) that might result from such a bailout (e.g., a larger U.S. populous feeling disenfranchised by a system as that privatizes profits but socializes losses). Realistically, I think it’s becoming clear to most market participants that some form of public bailout is likely to occur. The issue now is what form should that bailout take. We’ve recently seen proposals similar to that of Bank of America floated by Rep. Barney Frank that would allow the government to buy distressed mortgages (see Bernanke Calls Plan to Buy Mortgages ‘Worthwhile’). Likewise, Alan Blinder offered a thoughtful alternative in which the government would revive an agency (HOLC) created during the depression to rescue families from foreclosure (see From the New Deal, a Way Out of a Mess). As I’ve mentioned before, I am not an expert in issues of social welfare; however, I agree with Mike Barnett that if we are to move forward with a bailout, it must take a form that: a) penalizes those who had a hand in creating this debacle, and b) enacts regulatory measures to make sure that we never end up in a situation like this again.

Mike Barnett expressed some serious concern about the functioning of our capitalist economy in his prior post. Nouriel Roubini recently expressed a similar view. He writes:

This is indeed a one-sided game where financial insiders privatize profits while the massive losses of their reckless behavior – searching dangerously for yield, gambling for redemption, being subject to distorted incentive not to monitor their lending and risky investments – are systematically socialized during a crisis. This is actually “crony capitalism” of the worst kind, as bad as the one that plagued emerging market economies and led to their severe financial crises in the last decade.

Any government-led intervention (bailout) must, at all costs, try to avoid being perceived in that way.

I’ve recently exchanged e-mails with Mike Barnett, a friend and colleague from the University of South Florida, who has not taken too kindly to the socialization of losses as a result of the credit crunch. Issues of social welfare are not my forte, but it is right up Mike’s alley – as one of the foremost young scholars in the field of corporate social responsibility. So I decided to give him a forum to express his ideas as a guest blogger. Hope you enjoy his perspective. I’m hoping he will chime in from time to time with his thoughts.

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I hate losing money – can’t stand it. On the other hand, I love gaining money – nothing better than a major windfall. Problem is, you typically have to risk losing money in order to get the opportunity to gain money; be it a trip to Vegas, a wild ride on the stock market, or the financing of a new firm. Most people, like me, are risk averse. Our hatred of losing money outweighs the joy we get from winning money by enough that we seldom take big risks, and so we don’t usually lose big, but we also don’t usually win big. However, we respect the risk takers, and we don’t begrudge their windfalls, because we know that the winners had the courage to bear the risk of losing big, and so they deserve the rewards of bearing that risk.

Now let’s modify that a bit; more accurate is that I hate losing my money. I’d be glad to lose someone else’s money all day long. And I especially love gaining huge sums of money for myself while risking losing someone else’s money. Imagine if a casino offered you the opportunity to gamble without the risk of loss; all losses would be forgiven, but all gains would be yours to keep. If you’re playing with house money, why not bet the house? It’s only rational.

We should expect exactly this type of behavior – moral hazard – when the government bails out failed risk-takers. In recent decades, the government has pulled back the taxes on large gains, giving the risk taker more and more of his reward; and so we get more risk-taking. That’s typically good for an economy in the near term (though it can harm tax bases & middle classes over time, and so be bad in the long term; a whole other issue). But the government has not pulled away the safety net, and so the risk-reward ratio has become asymmetrical – the rewards are high and the risks are low. If you fail, the government (through the taxpayer) bails you out. So why not take a lot of risks?

Consider what’s going on with the mortgage meltdown. The banking industry made huge profits off of writing risky loans, often in very creative fashion. But now that defaults are on the rise, and profits have turned to losses, bankers seek to shift the losses to the government. For example, Credit Suisse is pressing HUD to have the FHA guarantee mortgage refinancings (see Worried Bankers Seek to Shift Risk to Uncle Sam). Should we, the taxpayers, guarantee a bad mortgage that Credit Suisse probably should not have made in the first place? And sadly, Credit Suisse is not the only culprit. Other examples of shifting losses to the government abound.

We can admire the tight rope walker who spans the skyscrapers. He deserves the attention; he’s crazy enough to take this risk. But if we come to find out that it was a camera trick, and left outside of the frame was the fact that he was only three feet in the air, with a cushioned mat below him, then we lose respect. And this is how we lose respect for the free market system, too. If gains are privatized but losses continually socialized, we run the risk of disenfranchising many in society who will come to perceive the system as “rigged”. Socializing losses can be likened to a form of corruption, and in the long-term this is risky to the stability of our society.

Ultimately, we can’t justify huge winners unless they’re risking huge losses. So when we find out that they got their huge gains in prior years without walking a tightrope, we do begrudge their gains, and we don’t feel sympathy for their losses. And now they want us to absorb those losses??

We all love a free market, so long as we get to control it. The folks making obscene gains in some years gain the power to pervert the regulatory system and build a personal safety net for lean years. And, as taxpayers, we share less and less in their gains and bear more and more of their losses – the losses are increasingly socialized while the gains are increasingly privatized. Yip, it’s as corrupt a system as it sounds – Robin Hood in reverse.

There are two ways to go – go with a true free market and let folks fail, not just win; or put in a safety net via regulation that does not provide incentives for market participants to take reckless risk in the first place. Like I said, I’m risk averse, and so I don’t like the volatility of the former. Going for the latter would remove the asymmetry at the root of today’s turbulent market and create sound rules for a “fairer” game. So let’s not pull the net; let’s just lower the roof and use the excess material to build a stronger net. In Senate testimony today (Feb. 14), Bernanke reaffirmed the role of the Fed in providing “adequate insurance against downside risks.” It’s a question of who pays the premiums, who provides the reinsurance, and who acts as the ultimate backstop that determines the fairness of the system.

The Economist today published its first ranking of distance-learning MBA programs (see The Socratic E-mail). I found this ranking rather fascinating.

In the interest of full disclosure, I have to say that I haven’t fully kept abreast of the distance-learning movement in higher education. I know that it’s there, but I thought it hadn’t quite caught on. I remember that it was all the rage for awhile – circa 1997-2000; however, I thought that most schools had come down in favor of the face-to-face education paradigm – arguing that the quality of the face-to-face model exceeded that of the distance model. For this reason, I was shocked to see some really reputable universities on that list.

But it also made me wonder: Is there an economic difference in the value of a distance-learning MBA degree versus a face-to-face MBA degree? I think it would be really interesting to examine some of the issues. There are several really interesting, and fruitful, angles to explore, including some of the following considerations:

1. cost differential to earnings differential – Is any difference in price between the two forms of education offset by ex post earning differentials? That is, distance-learning degrees might cost less, but are the benefits/salaries upon graduation significantly different?

2. quality of enrollees – Is there a difference in the “quality” of the “typical” student that enrolls in distance programs versus face-to-face programs? This might have an impact on ex post earning potential as we would expect higher quality inputs to receive higher quality outcomes. In economic parlance, this is a selection effect. If higher quality students are overwhelmingly choosing (selecting) to go to face-to-face programs, this can cloud our interpretation of any earning differential we find as we would, of course, expect higher quality students to eventually earn more money. Thus, it would not be the difference in the programs (distance versus face-to-face) that determines the outcomes but the ex ante sorting (the matching of high quality students with face-to-face programs and lower quality students with distance programs) that drives the results.

3. quality of curriculum – Is there any discernible difference in the quality of the offerings between the two programs? Do students in one program “learn” more than students in the other?

4. signaling value of the type of degree earned – Might there be any stigma among employers toward students who graduate with one type of degree versus another? Do the schools that offer the distance MBA programs require graduates of that program to reveal that their MBA is somehow different? Is the actual diploma that they earn different? Should it be different?

5. reputational impact of offering distance-learning programs – Do the schools that offer distance-learning programs bear any reputational costs? For example (and not to say that this is true, just a hypothetical), let’s assume for a moment that the students that do go to distance programs are somehow inferior on some quality metric. Now, you have two sets of graduates (distance graduates and face-to-face graduates) from the same school carrying the same brand (both sets of students went to Florida let’s say, which by the way is an exceptional institution). Now let’s assume that for whatever reason, the distance graduates end up doing poorly ex post – they aren’t as successful, their employers find them less capable, etc. Does that have a negative impact on the school? Also, does that have a spillover effect on the face-to-face graduates, who, when others find out they graduated from Florida, are then painted with the same brush as the face-to-face students. Face-to-face students who fork over big bucks to attend their MBA programs understand very well that the school’s overall reputation impacts them, and the value of their degree. So they should be concerned about the school’s distance offerings.

And Finally, and in my opinion one of the most interesting angles to pursue,

6. value of the social networks – It has been argued that one of the most valuable parts of receiving an MBA is the opportunity to network with, and befriend, the future captains of industry while on campus. Developing a strong social network can be extremely powerful for future business opportunities. One of the interesting things about distance-learning programs versus face-to-face programs is that it seems that the opportunities to network with classmates, professors, and industry-types who visit campus are greater for face-to-face students. So the question then becomes, to the extent that ex post earning differentials exist, what portion of those earning differentials could be associated with the added-value of the social networking benefits provided by face-to-face programs?

Anyhow, these are just a sampling of some of the interesting considerations associated with distance-learning programs. I’m sure there are many, many more.

If you’ve been following my blog, you’ve known that I have a side interest in how practice perceives business schools (see Ever and Easy Target, Practically Irrelevant, and/or On Managerial Relevance).

The latest piece from the Financial Times (see Why Business Ignores Business Schools) seems especially damning (hat tip, Kenneth Amaeshi).

There are three main criticisms in this article. First, the article claims that business practitioners rarely show up at academic business conferences, unlike their counterparts in law and medicine. Now I don’t much attend academic law or medical conferences, but I certainly agree that I don’t meet many practicing managers at the academic conferences that I do attend.

Is that necessarily a bad thing?

I’m not sure I see academic conferences as the type of venues in which we should exchange information with practicing managers. In our field, we have specialized, practitioner conferences for the purposes of engaging in dialog with practice, and for distilling the knowledge that we’ve created in a manner that can be translated for, and transmitted to, managers.

The second criticism is that practitioners pay little attention to us. The author writes:

Chief executives…pay little attention to what business schools do or say.

That sounds about right. But to be fair, I’d be hard pressed to think of a CEO who has much time for anything outside her responsibility to run her company. If I were a shareholder, I’d be very skeptical of my CEO if she spent much time attending and/or participating in academic business conferences. So that begs the question, are CEO’s really our target audience? Probably not. In many ways, our true target audience (depending upon what discipline within the business school you are in) is middle-level managers and/or consultants. It is the middle-level manager or consultant who is the consumer/user of our information who, in turn, impacts the behavior of organizations at the highest levels.

Finally, the article claims that we academicians write in an arcane, technical, jargon-laden manner that obfuscates whatever nugget of useful information that may exist in our research. I’ve seen this done before, so I understand the criticism. And quite frankly, I’m a little tired of all the jargon too. It doesn’t bother me that business school researchers write in this manner per se (after all, I understand most of it). However, what sticks in my craw is that a researcher should be able to explain his research in a way that makes it clear to any practitioner, and many cannot. If he cannot explain his research in a simple and accessible manner, then it is not clear to me that the he understands the phenomena well enough to explain why the phenomena should be important to managers. For me, this is the ultimate litmus test for a successful academic in the field of business – one who can at once produce, and explain, academic research.

I do agree in principle with some of the criticisms levied at business schools, and in particular, at our research. However, I think it would be unfair to categorize our research as uninfluential. For example, ask the folks from the investment community and hedge fund universe if business school professors have had any impact on their practice. Ask government employees at the Justice Department whether business school economists have had any impact on the cases they bring and/or the outcomes of those cases. Ask CPA’s whether accounting faculty have had an impact on how they practice their craft.

Although the full impact of our research on practice varies depending upon the business school discipline (accounting, finance, economics, marketing, strategy, organizational behavior, operations management, etc.), I’m sure I could find an example of some profound impact that an academician from each discipline has had on practice.

So my reaction to this article is consistent with that which I’ve expressed in the past: I think the stories of our demise have been greatly exaggerated. I think we do have a profound influence on practice, although not always in ways that are widely recognized, and in ways that are often difficult to quantify.

I have just decided to switch from Typepad to Wordpress for my blog. I’m hoping that this will create a more interactive experience with my personal website. I hope you enjoy the new look. I hope you’ll find it easier to use, and I hope you’ll visit frequently. Please be sure to update your links, and be sure to let me know what you think! I will back soon with posts on regularly scheduled topics.

I missed my regular post last week. Not for lack of desire, but unfortunately I was otherwise occupied. That’s right, I was called in to fulfill my obligation to the people of the State of New York. They found me, they caught me, and there were no more opportunities to postpone. So I begrudgingly went to the courthouse for jury duty.

Although this post is certainly off-topic given the focus of this blog, I had some observations that I’ll share with you.

1. Inefficiency abounds (at least insofar as the jury selection process is concerned) – I sat idle for several hours, only to be called into service as a prospective juror in a jury pool around noon. Once inside the courtroom, they allowed each individual to raise his or her objections to serving on that particular case (in private, one-on-one with the judge). Meanwhile, we waited. Then it was time for lunch. After lunch, they proceeded to interview half of the jury pool, while the other half was made to sit in the courtroom and wait, and wait, and wait (no reading, writing, or arithmetic allowed). When they got around to interview the second half of the potential jurors, it was time to break for the day. We then came back the next morning to be questioned by the attorneys. Not only was the actual jury selection process inefficient, but many of the selection processes are still done by hand. For example, they still put names into a giant bingo machine, spin it around, and call out jurors one by one when they decide who gets selected for a particular jury pool. In addition, everything inside the court is done by hand. They even had a real life stenographer. Haven’t stenography machines been digitized yet? Now don’t get me wrong, I believe in a fair process. I believe that defendants deserve a fair trial. So in that sense I’m in favor of inefficiency, at least to the extent that it improves quality. However, I’m not sure that in this case there were any quality benefits to that inefficiency. Expediency might have even produced a better outcome. To me, inefficiency without quality is like consistency without accuracy. Sure, a consistent process will give you the same outcome every time, …too bad it will be the wrong outcome every time too.

2. The defendant’s chances of having a "fair" trial have less to do with jury selection and more to do with the competency of the defense attorney – I’m extrapolating here from a sample of 1, but it was obvious that on the case I was assigned, the defense attorney was court appointed. Moreover, the defense attorney was incompetent. I’m sure those two things (court-appointed and incompetent) are not mutually inclusive. However, if the average quality of a court-appointed attorney bears any resemblance to that of the defense attorney on my case, then those defendants who cannot afford their own attorneys are in a world of hurt. I know this is nothing new, as people have been arguing for years that "fair" trials are reserved for the wealthy. But wow, to see it this up close and personal was sobering!

I was only left to think: Although they say the law is color-blind, …I’m fairly certain the law sees green.

I don’t know what it is about business schools these days, but boy have we ever become the object of increasing attention. What’s the matter, are there not enough other things going on in the economy to write about? Have the credit crunch, subprime fallout, and prospects for a recession become passé? Or are we just easy targets?

I’ve written a bit in past blogs (see here and here) about how the relevance of our research has become a topic of considerable debate among academics and non-academics alike. Now, our curriculum has come into question. I would refer you to an interesting article that appeared in today’s Wall Street Journal questioning whether we’ve failed in achieving our larger, societal mission (Business Schools Forgetting Mission?). The journal writes:

B-schools…have lost track of their original mission to produce far-sighted leaders who can help the economy run better…M.B.A. training has deteriorated into a race to steer students into high-paying finance and consulting jobs without caring about the graduates’ broader roles in society…Panoramic, long-term thinking has given way to an almost grotesque obsession with maximizing shareholder value over increasingly brief spans…As a result…getting an advanced degree in business no longer amounts to entry into a full-fledged profession, like law or medicine. It’s just a badge that lets graduates latch onto situations where they can jostle the actual managers of companies and make a lot of money for themselves in the process.

The article goes on to conclude:

In the current environment, many brilliant young M.B.A.s don’t aspire to be corporate chief executive officers, who struggle to uphold their agendas against pressure from all sides. These students would rather be consultants who earn big money fomenting change. Better yet, they want to be the powerful investors who hire and fire CEOs. Until those dynamics change, it will be hard for top business schools to resume their traditional — and vital — role as training grounds for the next generation of corporate leaders.

I think these are important questions to ask. At its essence, the argument is rooted in decades-old questions about whether stakeholder or shareholder maximization models achieve more desirable social outcomes. I would, however, disagree with the assertion that students no longer yearn to be CEO’s. I’ve had no trouble finding students who long for that role. What I have found, however, is a greater desire among students to lead firms that they themselves have founded (whether an investment, consulting, marketing, or some other kind of firm).

Granted, the WSJ article is mainly meant to summarize the views from a book recently authored by Rakesh Khurana of Harvard. Nevertheless, judging by what’s been written about business schools of late, you’d think that we are facing an outright crisis of confidence. Given all the controversy, I’m just wondering what will they come up with next.

Months ago I commented about the relevance of academic research to practicing managers (see post here). This has been a topic of considerable interest among scholars over the past few years. It is now apparently of interest to members of the popular press. The Economist raises some interesting questions about the relevance of our research in an article that appears in the latest issue (Practically Irrelevant?). It certainly is worth a read.

To summarize some main points, they write:

LIKE other academic institutions, business schools are judged by the quality of the research carried out by their faculties. At the same time they mean to equip their students for the real world, however that is defined. Whether academic research actually produces anything that is useful to the practice of business, or even whether it is its job to do so, are questions that can provoke vigorous arguments on campus…

One of the main complaints is that the research is inaccessible to managers:

A paper in a 2006 issue of Strategy & Leadership commented that “research is not designed with managers’ needs in mind, nor is it communicated in the journals they read…For the most part it has become a self-referential closed system [irrelevant to] corporate performance.”

These are fair criticisms of the field and they are important issues to consider. However, the article goes on to make the following point:

The argument most often used by defenders of the traditional approach is that research tends to be “translated” into the business world, either by consultants or by teaching in MBA and non-degree executive programmes. But Kai Peters, the chief executive officer of Ashridge Business School in Britain, believes this argument doesn’t stack up. He says that research rarely surfaces in the classroom. Most professors, he says, teach standard practice—from a generic marketing book, for example—while spending their research time on something esoteric. “So how is it filtering into schools’ programmes?” he asks. “By osmosis?”

With this last point I must strongly disagree. I believe that we, as professors, do play an important role in bringing current research into the classroom. It is up to us to expose students to state-of-the art research, to discuss the important questions of the field, to synthesize the existing findings, to explain those findings in an accessible way, to impart received wisdom, to identify remaining gaps and unanswered questions, and to honestly acknowledge the shortcomings of our work. If we can do all these things, we (and our students) gain a better appreciation for the complexities of the real world. In fact, I believe so strongly in this charge that I feel that if we are not bringing research into the classroom, then we are failing our students. We owe them the best education possible, and it doesn’t mean spoon-feeding them “the answers”, but rather, engaging them in intellectually stimulating discourse and debate so that they can come to their own (informed) conclusions.

As I mentioned in my earlier post, I absolutely believe that research ought to be rigorous. I also believe that business schools, and the research that comes out of them, ought to be relevant too managers. However, I think it’s too early to conclude that we are failing in our goals to be relevant.

Take a read of the Economist article and see what you think. I’d be interested to hear your opinion.

Greetings from Spain! I will not be blogging this week because I am away on vacation. I´ve spent some time in Madrid and some time in Nerja – a beautiful town on the southern coast (near Malaga) filled with more English and Germans, it appears, than Spaniards.

I will say this about Spain: The Spaniards really understand the concept of work-life balance! They just "get it" a little better than we do. The typical work day here is 9am-2pm, then off until 4 or 5pm for lunch and siesta, followed by work until about 6-7pm. During the hours of 2-4pm, most shops are closed and everyone has an extended lunch/siesta. Although this has changed a fair amount in recent years (with the sacred hours of lunch/siesta coming under pressure due to the demands of the modern world), it is still alive and well in the small towns.

I think the rest of the world (especially we Americans) could stand to learn a thing or two from the Spaniards in this regard. Nevertheless, enjoy your vacation weekends. I´ll be back next week!

Just to clarify. Yes, I believe that private equity funds serve an important purpose in well-functioning, efficient capital markets (see The Role of Private Equity explaining why). However, this is not to say that I believe that all private equity deals are destined for success. In fact, my hunch (although I have no hard data on this, and hard data is difficult to obtain for privately held companies) is that LBO’s do not fare much better than the average acquisition. That is, most likely fail. So it came as a surprise to me that one of my students suggested that since I extolled the virtues of private equity, I must surely believe that the volume of private equity deals over the past several years are rational, sound, and bound to succeed.

This is not the case. In fact, if anything, I believe the opposite. Again, so that there is no confusion about this, I absolutely believe that private equity funds serve a purpose in healthy, well-functioning equity markets. However, I do believe that the increasing number of private equity deals of late is an exemplar of excess. Over the past few years, excess liquidity in global capital markets has been driving such deals. I refer to this as the phenomenon of stupid money chasing stupid deals. But I don’t necessarily blame the private equity firms for this. Rather, the blame falls squarely on the beast that feeds the machine. For example, if I’m a private equity manager and institutions are throwing money at me (whether the source of that money is domestic institutions, recycled petrodollars, or foreign central banks), I’m going to make deals. As a private equity manager, that’s what I’m in business to do, and with cash on hand, that’s exactly what I will do. Not only that, but besides the cash infusions that I’m getting on a regular basis, I have banks that are willing to lend me $10 or more for every $1 that I pony up. Crazy! Well if that’s the case, then heck, why not, I can buy firms with little cash, lever the heck out of them and pay myself a nice dividend in the process. Given the sheer amount of global liquidity, it’s only rationale to expect this outcome – increased private equity activity.

Now, will all these ventures be successful? Likely not. With most private equity firms flush with cash as a result of the global liquidity glut (caused by historically low interest rates and a change in attitudes toward risk) and with only a finite number of targets to buy, increased competition among LBO funds (and industry acquirers) for the same handful of firms has led many buyers to overpay. Moreover, with creditors offering enough debt to hang oneself with, many targets will become overextended. And if you buy into the arguments of Edward Altman and Nouriel Roubini (as I do), as credit contracts due to central banks tightening the screws on lending, as the housing market slows in the US, and as consumers buckle under the weight of their own personal debt, we should expect businesses to falter. That is, we should see corporate default rates rise from about the 0.6% observed in 2006 to its historical average of around 3%.

Unfortunately, if such defaults do occur – that is, if the highly levered firms that the LBO funds have taken private cannot meet there debt obligations – it will not be the private equity firms left holding the bag. Rather, it will be the investors in those funds (whose returns will be diminished) and the holders of the corporate debt that will bear the brunt of the costs.