Business Case Studies, Executive Interviews, David Conklin on Government and Business

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Executive Interviews: Interview with David Conklin on Government and Business
January 2010 - By Dr. Nagendra V Chowdary

David Conklin
David Conklin, is a professor at the Richard Ivey School of Business

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  • What were the prime reasons for the US Financial crisis that has engulfed global economy forcing everyone to turn this crisis as worse than Great Depression?
    All free market economies are subject to business cycles, and underlying this recession were a number of traditional business cycle forces. However, what made this financial crisis and recession so severe was what we might call a ‘legal fraud’ that created particularly significant bubbles in financial and real estate markets. While most participants in this ‘legal fraud’ did not break the letter of the law, the long chain of participants no doubt realized that the bubble would burst and that millions would be hurt. The key point is that these participants simply did not care. They did not care about the interests of the ‘innocents’ who would be hurt, including the shareholders of financial institutions. This perspective emphasizes the importance of corporate ethics and corporate culture in decisions that do not involve an explicit violation of the law.

    In the securitization process, the ultimate purchasers of collateralized debt obligations (CDO’s) had no way to understand the risks that they were assuming. It is now clear that the ultimate purchasers significantly underestimated the risks that they accepted in expectation of high rates of return on these investments.While some commentators, even Alan Greenspan, believed that securitization improved the functioning of capital markets and gave investors new opportunities to choose their desired combination of risk and return, in fact the inability of the ultimate investors to understand the risks created an unsustainable component of the financial system. When this component of the financial system collapsed, the entire financial system was severely damaged to the degree that financial institutions collapsed, those holding the securitized assets lost much of their investments, and the destruction of public confidence substantially reduced consumption and investment. As part of the securitization process, many came to rely on credit default swaps, and this hedging against default created a complex web of counterparty relationships with a concentration of risk in a few very large firms that created huge systemic damage when they failed.

  • It is generally believed that globalization is all about interplay between 4Cs – credit markets, capital markets, currency markets and commodity markets. Was the imbalance created between these four markets in some way responsible for the financial crisis?
    The financial crisis arose apart from the global imbalances. The global imbalances did create a dangerous situation, which continues, where capital volatility could suddenly increase with substantial impacts on exchange rates and flows of trade and investment. The US fiscal deficit and balance of payments deficitmean that the exchange rate of the US dollar could fluctuate rapidly and substantially for many years. Also, the huge increase in commodity prices, together with the possibility of periodic declines remains an ongoing threat. The growth of the carry trade means that changes in the differences in interest rates among countries can rapidly lead to capital flow changes that will alter exchange rates. Going forward, of course, is the likelihood that rapid inflation will develop in a couple of years, due to the enormous increases in themoney supply as part of the global attempts to revive the economy. The chaos that has been built into our global system in this respect will stand out as another extraordinary crisis.

  • Who do you think should squarely be blamed for getting the world into such a catastrophicmess – the Wall Street firms with their insatiable desire for ‘derived’ returns, or the regulators or the governments? What was it about the regulatory framework that contributed to the crisis?
    As I said earlier, the central cause in the financial crisis was the ‘legal fraud’ in which the mortgage providers offered mortgages to people who could not afford them, often on terms with increasing interest rates over time. These mortgage lenders realized that they were involved in a legal fraud. They sold their ‘subprime’ mortgages to banks that securitized them and sold them on to other investors under the pretense that the new instruments were safe investments. Meanwhile, rating agencies placed unrealistically high ratings on these instruments. Certainly, many bankers must have known they were involved in a legal fraud, fooling the ultimate investors. The providers of insurance also knew they could not honor their commitments in the event of a collapse in the markets for the CDO’s. The central issue in this chain of misinformation concerns the nature of the business culture and the corporate culture that permits employees to engage in unethical activities. There are limits to the degree to which regulators can prevent all frauds. As long as corporations are willing to allow such behavior on the part of their employees, such financial disasters will recur from time to time.
    The special role of CDO’s rested on the reality that one cannot divide a pile of mortgages into different tranches with specific differences in risk and in interest rates. My colleagues in finance have developed a case in which they offer students a portfolio of real estate mortgages, and ask the students to securitize the portfolio and determine the appropriate differences in interest rates. Students inevitably realize that they cannot do this with any degree of accuracy or on the foundation of any principles. Bankers must have known this as well, but they did not care about the inevitable losses that others would suffer. The fraud was legal.

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