Contagious Systemic Risk: My Warning in 2005

Durham , NC — In late January 2005, Fuqua finance professor Cam Harvey traveled to Davos, Switzerland, for the world’s most important annual economic forum. From his panel discussion on corporate earnings to his encounters with senators and celebrities, Harvey shared his experience in journal form.

January 27, 4:25 p.m. “When do you leave for the airport?” asked one of the two BA453 students in my office working on Assignment 2. “In five minutes,” I replied.

January 27, 5:15 p.m. Arrive RDU. My flight to Newark is delayed two hours. I will miss my flight to Zurich. An earlier RDU-Newark flight is running three hours late – but it is scheduled to depart at 5:25 p.m. I pass through security, sprint to the gate and somehow convince the agents to break the ten-minute rule and let me on the flight.

January 28, 11:55 a.m. The flight to Zurich is slowed by strong headwinds and arrives late. I have 15 minutes to clear customs, buy a train ticket, and get to track #5 for a three-hour ride to Davos. I make it. Why the rush? I must register before 4:00 p.m. In addition, my BA453 lecture begins at 4:30. I will teach remotely.

January 28, 3:59 p.m. I jog to the registration center, which was a long run – and the temperature is -4° F. Security is intense.

At the World Economic Forum (WEF) registration, participants get an ID badge which has your picture, name and a built in chip with a wireless antenna. You cannot get near the Congress Center without the badge. You can’t even drive by the Congress without police stopping you and asking for your badge.

All participants also get an IPAQ handheld computer. The IPAQ is loaded with stuff including detailed descriptions of each session, bios, pictures, and e-mails of the participants. You register for sessions with the IPAQ and the wireless network allows you to sync with the conference network. At the entrance of each session, the microchip reader only allows in people that have registered for the particular session.

January 28, 4:25 p.m. I arrive at my hotel, the Morasani Posthotel. Most of the celebrities and politicos are at the Steigenberger Belveldere which is the only five-star hotel. However, with four stars, the Morasani looks OK.

To get into the hotel lobby, you have to pass through a metal detector, and put all your bags and coat through an airport-style X-ray machine. I quickly check through. I see at least a dozen security people in the small lobby.

January 28, 4:29 p.m. I call Tim Searles (Fuqua’s multimedia guru) on his cell phone from my room. He is in Fuqua’s RJR auditorium ready to make the call to the hotel. Good thing the connection is only audial – with the combination of no sleep and no shower, I look awful!

January 28, 4:30 p.m. We connect via telephone. I ‘take control’ of the computer in RJR remotely using a high speed Internet connection. The lecture starts. The students can hear me – but I have trouble hearing them. We will have to work on that for next time.

January 28, 7:15 p.m. I begin my second lecture, BA456. During the break between lectures, I load up some pictures I took on the ride through the Alps. I start the lecture with a slide show. While my course is Emerging Market Corporate Finance, I take the liberty to go off topic a bit and to focus on the subject of my presentation at the forum.

January 28, 8:45 p.m. My second lecture finishes. I go to a local restaurant off the beaten path and grab some quick Raclette and Schnitzel.

January 28, 10:15 p.m. There is a reception for new faculty. However, it is not just for faculty members. I am immediately approached by a hedge fund manager who thinks I work for Duke University Management Company (DUMAC). “We talked to you last year, you guys made a mistake not putting money with us. We are up 30 percent.” I explain that I am not part of DUMAC but I know some of the people there. Out comes the Blackberry. “We talked to Neil Triplett.” “Yes,” I said, “a former student.”

I am struck that Harvard, Wharton and Columbia are very well represented at the forum. Wharton has five faculty at Davos. Most of the Harvard faculty are from the Kennedy school but HBS is well represented. While Duke only has one person, I meet a Fuqua grad who is associated with the WEF, Chris Holt (’96 ). Chris works for a hedge fund in Toronto and has been a consultant for the WEF for ten years. He organizes 15 sessions. I know there are two other alumni here. Malvinder Singh (’98) says hello and that he got the email from Dean Breeden involving my appointment in the Western Finance Association. Malvinder is President of Ranbaxy Laboratories in India. I get an email on my IPAQ from Vidhi Tambiah (’04) apologizing for not making the reception. He is in a meeting with a Sri Lankan politician to see whether the forum can help with the peace process. An interesting assignment for such a recent Fuqua grad!

January 29, 11:00 a.m. I pass through intense security to get into the main Congress Hall. There are 2,000 participants at the conference. However, there are close to 15,000 support staff and security. For corporate leaders, with only a few exceptions, you need to be a Chairman or CEO to get an invite. There is a significant political presence: Tony Blair, Gerhard Schroeder, presidents of a number of countries, and seven U.S. senators. There are celebrities milling around the in crowd. No one is asking for autographs – it is all business.

January 29, 11:10 a.m. I meet Rik Kirkland who is a senior editor for Fortune magazine and the moderator of my session. He tells me that he has a degree in english from Duke. I then get introduced to the panel: Senator Richard Shelby, chairman of the Senate Banking Committee, Jim Turley, CEO of Ernst and Young, Herb Allison, CEO of TIAA-CREF ($300 billion under management). I am told the session is ‘off the record’. This is a disappointment because I thought the Fuqua students would have benefited from watching the video.

January 29, 11:20 a.m. The session is somewhat frustrating. Most of the talk is on the improved quality of earnings numbers. I jump in at a number of points and argue that the panelists are missing an important point. My research with John Graham and Shiva Rajgopal shows that few firms are using accounting manipulations to smooth earnings – instead, they are taking real actions (like delaying valuable investments, cutting R&D, shirking on maintenance) to hit the targets. These have serious implications. One panelist notes that the cost of compliance to Sarbanes-Oxley is about $6 billion. I suggest that this was perhaps a fraction of the true cost. I declare, “If this legislation is leading to more ‘real’ actions that sacrifice shareholder value, $6 billion could be a drop in the bucket.”

Senator Shelby defends his positive vote on Sarbanes-Oxley. Everyone agrees that the legislation needed some adjustments. From the audience, William Donaldson, the chairman of the Securities and Exchange Commission, takes the floor and agrees that some fine tuning was necessary.

In my final remarks, I emphasize that quality of earnings numbers is important but tell the crowd that this is accounting (that is reporting results rather than making real business decisions). There are other very disturbing actions going on behind the scenes – that, for instance, Ernst and Young cannot see as an auditor. The panel nodded but it was clear to me that they are more concerned with the mechanics of accounting than the way that American business is trading off long-term value for short-term earnings targets.

I then gave an example. In one of our interviews, a CFO described a situation where the (very prominent company) had an unexpected $300 million gain on an investment near the end of the quarter. They feared reporting this gain in the current quarter because they would exceed the market consensus for earnings. They were concerned that analysts would ‘ratchet up’ future quarters’ expectations, leading to the possibility of future earnings disappointments. The CFO described how he contacted his investment bank and the following deal was negotiated. The company would give the $300 million to the investment bank. Over each of the next 10 quarters, the investment bank would pay back to the corporation $30 million. “What kind of deal is that? Invest $300 million and get $300 million back? This is a blatant sacrifice of shareholder value to smooth earnings,” I said.

January 29, 12:30 p.m. One session ends and my next assignment will begin in 15 minutes – but the session is in a hotel more than a mile away. Senator Shelby is in next session too. I get up the courage to ask, “Can I bum a ride with you over to the Fluela?” He agrees. I am approached by the press who are interested in my story. We quickly exchange cards. I keep my eye on Shelby who is my ticket to the next session. A dean of another business school approaches me and congratulates me. “It is clear that what you were talking about was based on careful scientific research – while the others were just telling stories.” He then makes me a chair offer on the spot that comes with a 10 million dollar endowment and new center for financial research. I immediately say “I’ve got to go with the senator!” and whisk by the dean. Only in Davos.

January 29, 12:35 p.m. The limo area is restricted to the politicos, celebrities and other higher ups. Shelby seems to know everyone. He says that there are not that many senators here this year because of conflict with a republican retreat at the Greenbrier. He then introduces me to Senator Saxby Chambliss from Georgia.

January 29, 12:35-12:45 p.m. I have a captive audience with Senator Shelby. He is interested in my research and wants more details. I promise to deliver as soon as I get back to Duke. I try to bend his ear on the potential risks for the economy that hedge funds create. He tells me that he is against doing anything. Indeed, he and Chairman Greenspan are in strong disagreement with Chairman Donaldson and the democratic appointees on the SEC over hedge fund registration. I asked whether he would entertain a modest proposal. Why doesn’t the government, at least, collect some of the most basic data on hedge funds?

January 29, 12:50 p.m. It is an unusual session – also off the record (so I won’t identify remarks to anyone other than the senator). There are eight tables. At each table, there is a moderator of the lunch discussion. Near the end of lunch, each of the moderators makes a brief presentation. My table is filled with hedge fund managers, about $15 billion worth. There is one empty seat opposite to me. Senator Shelby picks up his name tag from another table and sits with me.

I thought the first session was frustrating – well, the second one was even more frustrating. I was talking to the wrong audience. They were hedge fund managers and they didn’t like my message. I said that most investors, even large institutional investors, do not understand the risk of hedge funds. I said returns can be higher than the market, volatility and correlation lower – but the risk higher. When an event happens like the Russian short-term debt default in August 1998, their promised low correlation turns into high positive correlations. Many will go into the tank at the same time, potentially causing serious implications for the U.S. economy. This is called contagious systemic risk.

Well, no one at my table believes this. “We will never see another situation like LTCM,” [the collapse of the multibillion dollar Long-Term Capital Management where the Federal Reserve Bank of New York had to intervene and orchestrate a bailout] remarks one manager. Most others are nodding in agreement. The managers say that the one thing hedge funds have not done well is PR. The managers also complain that they take all the heat when some large banks are effectively acting like hedge funds.

It is difficult to summarize when I am called on. I tell the session that “there was some disagreement at my table – but it was mainly me doing the disagreeing!” I make the point about some banks acting as hedge funds and then take the liberty of injecting my own opinion.

I state, “Investors are misled by the risk of many funds and there is no mechanism to provide a framework for risk analysis” [which is based on my research]. I argue that looking at correlation and volatility is potentially very misleading. I suggest that we need the most basic data. As a finance researcher, it is difficult to figure out what the returns are on hedge funds, let alone data that SEC should be collecting such as asset mix, leverage and credit lines.

The other people summarizing their tables basically praise the industry. Senator Shelby, as expected, argues against any regulation.

When it is opened up, a reporter from a major business magazine directs a question to the head of an extremely large bank, who was also one of the summarizers. “I would like to pick up on Campbell Harvey’s point that many banks are operating like hedge funds, taking advantage of internal (cheap) credit lines. The bank’s shareholders have no idea what is going on.” The banker savages the reporter and refers to a “poorly researched article” (i.e. critical of him) in the magazine last week. He then says that “hedge funds had outperformed by 5 percent per year over the past five years with lower standard deviation or risk.” He claims that “hedge funds reduce volatility – and especially reduce currency volatility.”

I was flabbergasted by this answer. This was exactly the point of my research. The extra 5 percent is not necessarily ‘outperformance’ – it could be due to extra risk taking. You need to explicitly take that into account. That’s what we do in BA453 – Global Asset Allocation. I approach him afterwards to give him a chance to clarify. He argues that their bank has the best Value at Risk (VaR) model in the industry. I left it at that – but in my head I was thinking that LTCM also thought they had the best VaR model!

January 29, 4:30 p.m. There is a special session in the Plenary Hall that will include Gordon Brown, Britain’s Chancellor of the Exchequer, the Italian Minister of Finance, the Presidents of Brazil and Tanzania, Jeff Sachs (Columbia professor charged with implementing the Millennium Challenge goals of all developed countries donating 0.7 percent of GDP to help reduce world poverty), and Bill Gates. The panel was moderated by Senate Majority Leader William Frist.

The previous session is running late. I look over to a casually dressed person standing beside me. I immediately recognize him — Peter Gabriel. “Are you finished with all of your panels?” I ask. He responds, “No, I have one more to do tonight.” He then asks me the same question. I tell him that I did two earlier in the day. He then asks me about the hedge fund session. I tell him that my point of view was not very popular. I tell him sadly that we will have to wait for another crisis for any action to occur. It is a ‘once bitten, twice bitten’ problem. He smiles but is serious. I say that it is unfortunate because a crisis would have significant economic implications – not just for the U.S. but for the world – and especially the developing world. We talk a little more. I finally introduce myself, “I’m Campbell Harvey.” He shakes my hand and modestly says, “I’m Peter Gabriel.” As if I didn’t know. But, I didn’t let him know. Nor did I tell him that I have every piece of music he has ever released over the past 36 years. I didn’t tell him I was a keyboardist myself. No autograph. No photo. That’s Davos.

January 29, 4:45 p.m. The door opens and at least 500 people move into the Congress Hall.

This is the hall with the giant screen that we see in most of the press shots. The atmosphere is thick with anticipation.

Gordon Brown is as eloquent as Tony Blair. While Britain is not at the 0.7 percent level, he is spearheading a plan to wipe out all the multilateral debt obligations of the poorest countries. He has the agreement of four of the G-7 countries. The Italian Minister of Finance supports the debt forgiveness. Sachs, in a powerful speech, derides the G-7 countries for not keeping their words. There are only five countries at the 0.7 percent level – and none are in the G-7. He compliments France for committing to a time-table to reach 0.7 percent. Germany also gets congratulated for agreeing in principle to reaching the 0.7 percent. He praises Britain for leading the charge for the special International Financing Facility (IFF), which will allocate to the countries with urgent needs. The U.S. is heavily criticized.

Bill Gates stresses the urgency for vaccinations. He argues that 5 billion dollars to go towards vaccinations would save five million children’s lives over the next five years. That’s $1000 per head. He is a very effective communicator. In addition, he puts his money where his mouth is and kicks in $750 million from his foundation for vaccinations.

The most powerful remarks came from President Lula de Silva of Brazil and President Mkapa of Tanzania. Mkapa electrified the place with his remarks. He told us that 300 million Africans lack safe drinking water, 3,000 African children under the age of five die every day of malaria, 1 in 16 mothers die during childbirth, and the 6,000 Africans die every day of AIDS. While thanking everyone for their efforts, “promises take a long time to turn into action and my country is in urgent need now,” he says. The simplest, cheapest way to cut malaria deaths is to spend $7 on a bed net. He estimates that bed nets could save the lives of one million children in his country.

With only ten minutes left, Senator Frist opens up the session to questions. About 50 hands go up. “We only have time for a few questions.” To my right, standing in the aisle is a woman dressed in light blue (not Carolina blue). She stands out because most are wearing dark blue or black. She also stands out because she is jumping up and down with her hand up. It is clear that Frist was not going to recognize her because of her agitation. She then grabs a microphone from one of the ushers. “I have something to say.” While Frist initially tried to talk her down, she would not be talked down.

“I, for one, was very moved by President Mkapa’s plea. There are children dying in his country today. He needs help today. What are we doing to do about it, today?”

Frist interrupts. “Please identify yourself.”

“I’m Sharon Stone. Right now, I will donate $10,000 to the children of Tanzania for bed nets. Who else will join my team? Stand up right now. Stand up right now!”

A person nearby me immediately stood up and said, “I’m in for $50,000.” The place was buzzing.

Spontaneously, people stand up and volunteers begin collecting business cards. The session is in disarray – but for a good cause. By the time Senator Frist gets control of the session, five minutes have passed. Someone walks up on the stage and whispers a message. “Ladies and gentlemen, Sharon Stone has collected over 1 million dollars in the last five minutes,” Frist announced.

I looked to my left and noticed a volunteer with about 100 cards that had not even been counted.

The camera zoomed on President Mkapa, who was very emotional. He had difficulty finding words to thank Sharon Stone and all those who had donated. There were many glassy eyes in the crowd. No one expected this spontaneous gesture. The power of celebrity. That’s Davos.

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One Response to Contagious Systemic Risk: My Warning in 2005

  1. Pingback: Duke Research Advantage » Blog Archive » Cleansing and Reforming our Financial System

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