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2008 – Retrospectives – HBS & the Financial Crisis

By many accounts, the economic crisis has been the defining story of the year, but for many students who are still looking for full-time and summer offers, the question still remains, “What does all of this mean for me?”

The National Bureau of Economic Research reported on December 1, 2008 that the US economy had sunk into a recession – actually a year ago, in December 2007. The news itself was not a big surprise – rather that it escaped being officially reported until now. As if on cue, that day the Dow Jones industrial average plunged nearly 680 points, or 7.7 percent. In what seems to have become a daily reassurance, Ben Bernanke said that it was “certainly feasible” that the Fed’s overnight rate would drop below 1%. Henry Paulson promised to look a new ways to use the bailout money. President Bush, in the last gasps of his administration, said that he would do whatever was necessary. As if September, October and November were not devastating enough, as the New York Times put it, “December blew in with a mighty chill on Wall Street.”

By many accounts, the economic crisis has been the defining story of the year – topping even that of Barak Obama’s meteoric rise to the Oval Office. Here at HBS the continuing story has not been lost and the HBS administration has done its best to give students a better understanding of the underlying reasons for and consequences of the crisis – the consequences for the economy as a whole, and the job market. And of course, there have been lots of people asking the age old HBS cold call question, “What should the protagonist [student] do?”

The largest effort by the school to give students a better understanding of the current economic situation has been the Turmoil on the Street series, hosted by Carl Kester, Deputy Dean for Academic Affairs. Starting with in late September and running through the end of the year, the series has offered a wide variety of information and distinguished view points on specific topics relating to the crisis.

The speaking series started with a panel discussion featuring Dean Jay Light, Professor Robert Merton, Professor David Moss, Lecturer Nicolas Retsinas, and Senior Lecturer Clayton Rose. Dean Light began, “It is an anxious time.ÿ A worrisome time. Probably even a dangerous time. It’s a historic time. A time that we will be teaching about in our classrooms for some time.” Even in late September, early in the life of the crisis, as one student put it, “in typical HBS fashion, Light effectively reduced the entire crisis we’re facing to three letters: LTL. Too much Leverage and too little Transparency resulted in drying up of Liquidity, which in turn resulted in the write-downs and collapse of some of the stalwarts of American finance.”

Broadening the larger discussion, Professor Kaplan’s presentation on October 16 titled “Managing in the Financial Crisis” pointed to a few other factors as underlying origins of the crisis. Through stagnant wage growth and rising prices the middle class in the US was squeezed, precipitating the need for more cash, subsequently financed through debt and mortgage refinancing. Large financial institutions helped facilitate this leverage through derivatives. One example, the CDS market was grossly unregulated to the point that Professor Kaplan guessed “that there is any regulator out there who knows how much CDS is outstanding today.” Kapan spoke to that market’s enormous growth. “Let’s say that the underlying debt issuance globally is about $10 trillion. It is estimated that the entire CDS market outstanding is $60 trillion. Basically, you had a big casino develop all around this underlying market. Maybe it would have been smart to limit the size of the CDS market to the size of the underlying – but that was not done.”

Professor Kaplan also had harsh words towards some of the policies of the US government, as an underlying cause. “The government of the United States, and other governments around the world, are also pretty highly leveraged. If you took the present value of all future obligations, such as Medicare, you would see that financially the US government may not look that much better than GM. While all this has been going on, the policy responses of the government have been a massive tax cut that had an extremely high percentage of that distributed to the top 1% and 5% of earners. And there really have not been any other policy adjustments that have helped the middle class, which is the engine of the economy.” Kaplan pointed to healthcare reform as one needed policy adjustment, as it is a significant cause of bankruptcy.

Next, on October 23, Professor Robert Pozen’s gave a talk on “Washington’s Responses to the Financial Crisis.” Speaking on the failure of Lehman Brothers, Pozen said, “Paulson knew that he could not bail out everybody. Everyone was lining up. Municipalities were lining up. Schools were lining up. Pretty soon supermarkets were going to line up and say, “We’re too big to fail.” He had to let somebody fail and so LB took the hit.” Leading his talk as a classroom discussion, Pozen challenged the student attendees to assess the current proposals on the table and to make their own suggestions. Taking a jab at the current offerings, he said, “We have two political candidates who have absolutely no idea what to do about these things. And one of them is going to be president, so hopefully they will have some good advisors.” The discussion that followed covered everything from a reinstatement of the Glass-Steagall Act, to more stringent regulation of rating agencies, to bailout fund regulation, dividend policy and executive compensation.

Professor Andre Perold spoke on “Investment Management in the Current Financial Environment” on November 13 and then was followed by Professors Josh Coval and Erik Stafford on “The Economics of Structured Finance” on November 17. Professor Coval discussed in detail the spectacular growth and ruinous downfall of alphabet soup financial instruments such as CDOs and CMOs and how hedge funds believed that they had “created yield out of thin air.” As he uncovered, these instruments were extremely sensitive to correlation of assets and initial assumptions on underlying default risk. In the end, he concluded that the ability of the economy to broadly supply cheap credit will be significantly curtailed and if investors learn their lesson structured finance is unlikely to ever return to popularity again.

On November 19, Professor Paul Healy gave a talk on “Financial Reporting, Financial Markets, and the Subprime Crisis” and just this past week Professors Ken Froot and David Scharfstein spoke on “Saving the Financial Sector from Itself: Issues of the Current Financial and the New Financial Reconstruction.”

Student attendees have found all of the talks enormously helpful in gaining a better understanding of the crisis, and the responses to it. The posting of the recordings online have been well received also.

For many students who are still looking for full-time and summer offers, the question still remains, “What does all of this mean for me?” Career Services has reported that, as of early November, full-time postings in the job bank were down 18%. Along with reassuring emails regularly sent to students, Career Services has tried to attack the challenging job conditions by hiring new career coaches, extending walk-in hours, scheduling new programs and boosting outreach efforts.

Just prior to the Thanksgiving break Tim Butler released a note, “Bringing Discipline to the Dream” pointing to need for students to manage their expectations and calling for “a renewed effort in articulating our career vision.” He concluded his letter that “there is, in fact, less opportunity for the fantasy play: the eighty-yard touchdown pass.. That should not distract us from the excitement of running the play that is right for the moment. If we know our goal well, there will be just as much excitement and opportunity in executing well and coming that much closer to whatever “winning” means for us, our family, our organization, and our community.ÿ This is a time to dream more deeply and more skillfully, not dream less.”

December 8, 2008
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