Robert Pozen on the Financial Crisis, Social Security, and the Mutual Fund Industry

There is always a risk that credit rating agencies will be influenced to try to provide better ratings because you know you will get more business as a result.

The ratings should be done in the interests of the investor, not the issuer.

Even if you have more independence among rating agencies, you still have a problem of the differential expertise between the people at the investment banks who are developing new vehicles and the folks at the credit agencies trying to understand them. And if I’m a PhD in Math graduating from MIT and I have an offer from Goldman Sachs and another offer from Moody’s, that’s normally not going to be a tough decision.

How do you deal with the issue of the relatively weak expertise at the credit agencies? There’s no easy solution to that problem. Perhaps what needs to happen is that the credit rating agency should not only issue a rating but also disclose most of the background that led to the rating. That would open up the ratings process to scrutiny by sophisticated investors who should be able to make their own judgments on the merits of a rated bond.  

Let’s talk about regulation. There has been a proposal from the US Treasury to create an overseer of all regulation.  What is your view?  Would that be a solution?

People have talked about creating something like the FSA in the UK, a financial services authority which would oversee all financial institutions. But I think that’s just bureaucratic shuffling that doesn’t change things.  I would like to see improvement in the quality of regulation in each of the particular areas.  For instance, in bank capital, it doesn’t really matter whether we have two or three or four bank agencies.  They key is to develop sound substantive requirements for bank capital.

That’s an area where we made pretty big mistakes. We had something called Basel I until 2007.  It said if you have a regular loan, you have to put 8% of capital behind it, but if you have a mortgage you have to put only 4% of capital behind that.  That is because mortgages were deemed inherently less risky, and that was just plain wrong. 

Now we have a new system called Basel II, where we say to large banks that they can design their own capital requirements based on their own risk models.

Generally, it’s a bad idea to let people set their own capital requirements.  Moreover, these risk models are so complex that very few people can understand them.  But we know one thing about these models: they were wrong, because they made assumptions like housing prices can only go down once every 50 years. 

That’s what we need to do – change the capital requirements and spend less time on reshaping the bureaucracy.

What is your thinking on how to minimize the likelihood that we run into a similar problem with unregulated areas?

We have this concept in the proposed US legislation of systemic risk monitoring and there is a lot of back and forth as to who should take the lead in that area.  In any event, somebody should have the mandate to look at the new instruments or products that are developing that don’t fit neatly in an existing regulatory cubby hole.  Then they could alert the relevant agency to decide how to deal with them. In the area of CDS, we will have some sort of centralized clearing corporation in which we will know who is on each side of those deals, and we will know what margins are set up and marked-to-market daily, so no one can get so far out of line as did AIG.

So presumably one of the things we could do, under your suggestion, is have someone whose responsibility it is to monitor emerging and fast-growing investment areas.  In the case of CDS, which went from $1 to $60 trillion, someone would have said “hold on a second.”

You are absolutely right.  We need to have some sort of system monitor. One of the areas they should look at is new and fast-growing products.  The second area is to ascertain when there are mismatches between assets and liabilities -- that was the case in the S&L crisis.  The third is, as we discussed, very high leverage. When you have highly leveraged institutions, they are very vulnerable to liquidity crises.  So those are some of the indicators you should look for.

There clearly is lots of responsibility for the all of the issues we have run into.  Nobody has a monopoly on culpability.  To what extent do boards of the financial institutions have responsibility, and more importantly, are there things that could be done going forward?

That’s a good question, because as you know, in 2002 Congress passed the Sarbanes Oxley Act and we wound up with a lot more independent directors and elaborate procedures. Nevertheless, though banks like Citigroup had a lot of independent directors, and they followed those procedures, the boards don’t seem to have done a very good job in setting risk and compensation. Why is that? First, those boards were very large – 16 or 17 members.  We’ve learned that small boards with six, seven, or eight members are much more effective.  If you have a large board, people then tend to take much less responsibility.

Second, and more importantly, many of those boards had people who really didn’t have any experience in financial services.   They may have been distinguished people, but they didn’t have much financial experience.  

Third, we need independent directors to spend more time on board work. The typical bank board meets once every other month for a day.  That’s perfectly okay for a small retail company, but can you really understand a global financial company, like Citigroup, that’s so complex in six days a year?  I don’t think so.  What I’m looking for is a professional group of directors, where that is the main job they are doing.  These probably would be retired financial executives who would be on only two boards.  They would spend two or three days a month on that institution and they would really come to know it and understand its risk and set compensation in an effective way.

Are you describing the kind of approach that some of the private equity firms are using when they take over a company and try to bring to bear as much outside experience as they can?

You’re right.  This is loosely modeled on the private equity model.  Though there are differences between private equity and public companies, there are lessons that public companies can learn: small boards, relevant expertise and spending more time.

You talked about the level of complexity of some of these financial instruments.  There have been suggestions that some financial institutions have become too big to understand – even the CEO, in some cases, didn’t have a good grasp of what was going on.  To what extent do you see part of the solution changing the organizational structure of some of the financial institutions?

As an investor and running an investment management company, I’ve met many CEOs of public companies.  Some CEOs are on top of all the things going on within their company and other CEOs are not.  To reduce the complexity of financial institutions, some have suggested that we split off the securities activities of large banks and not make them a part of the deposit-taking institution.  This is sometimes called the reinstatement of Glass Steagall. 

I think that’s unrealistic for three reasons. 

First, if you look at the major problems experienced by Citigroup and Bank of America and other banks, they were not in the securities underwriting business. Unfortunately, they made bad investment decisions about the loans they issued and the securities they bought for their own portfolios.  This wasn’t a securities underwriting problem.

Second, we learned from the Bear Stearns and Lehman Brothers experience that if you have a free-standing investment bank that is not linked to a commercial bank, it does not have the advantage of retail deposits or access to the central bank window. So it is dependent for short-term financing on repos and commercial paper, supplied by a very sophisticated group of investors who can pull the plug very quickly.  So if we go back to free-standing investment banks, we are actually increasing risk by creating a group of very fragile institutions.

Lastly, as you know, in Canada commercial banks do securities underwriting.  They do so in Germany, France, China and Japan.  If we made this rule for just one country, and all the countries didn’t agree, it would take only a few days before US banks would figure out how do securities underwriting in Dubai or Shanghai.  Instead, we need to say that if a bank is involved in activities that we deem to be riskier than normal, we need to make sure that it puts a lot of capital behind those activities.  That is what we need to do.

I’d like to change direction here to talk about social security. You were a member of a panel established by George W. Bush to look at the issue of Social Security, to look at the problem and solutions.  What are the challenges going forward?

Social Security in the US, like most countries, is going to run out of money because people are living longer and the number of workers supporting them are becoming fewer and fewer.  In the US, on a cash-flow basis, Social Security will go negative around 2016 or 2017; and, if we make no reforms, Social Security will be bankrupt around 2037.   We should try to do something sooner rather than later.

In Canada, we addressed this through a significant increase in the level of payments. To what extent is that a viable solution in the US?

I think it’s a partial solution.  I don’t think people in the US are prepared for a general increase in social security taxes and also there may be a number of tax increases associated with our health care bill.  

Right now, Social Security imposes a tax of 12.4% on wages up to about $106,000 or $107,000, so there is a possibility that you could impose a surtax above that maximum at a lower rate, like 2%.  But that won’t be close to enough to solve the problem.  The biggest challenge is that we are scheduled to have an enormous growth in the economic value of Social Security benefits.  If we look at the middle income worker, and we ask what is the purchasing power of benefits in 2005 versus 2045, those benefits in real (constant) dollars are slated to go up by almost 50%.  We need to figure out how to have benefit reform, as well as some modest increase in taxes at the top.

To what extent is there the political will in the US to make some of those hard decisions?

The political will is always difficult to achieve – at least until the president gets into his or her second term.  This is a very controversial issue.  I expect that if President Obama is reelected in 2012, Social Security may become front and center.  But it's very hard to deal with such a political hot potato until a president is reelected for a second term and does not have to be elected again.

Can you talk about a proposal you’ve put forward on this issue?

My proposal is called progressive indexing.  It basically divides the population into thirds.  It takes the lower-income people and keeps them on the current schedule, since they usually do not have 401(k) plans or group plans.  It takes the high-income people and grows their benefits only at the level of prices, as opposed to the level of wages in the current schedule.  The middle-income people get a blend.

The basic idea of my proposal is two-fold.  It is progressive, because it helps lower income people more than higher income workers. Second, it is justifiable because higher- and middle-income people have relatively high rates of participation in defined contribution plans and IRAs – which are already subsidized by the government.  The key is to not see Social Security in isolation from other retirement plans, but to see them together as one retirement system.

Finally, I’d like to get your perspective on some of the challenges faced by the mutual fund industry.The mutual fund industry has come under fairly intense scrutiny, both in the US and elsewhere.  Some people question whether, going forward, it is going to have as big a role as it has in the past.   What is your view on a core tenet of the industry: whether active managers can earn their fees through superior performance? 

We’ve learned in the last few years that the efficient markets theory isn’t so efficient. If markets are so efficient, why did they go way up and then way down?  That basic idea, that markets are priced correctly most of the time, has come under brutal attacks. 

On the other hand, there are some investors who are very good and some who aren’t.  Most people are average.  If we look at active managers, we can see that they do well in two circumstances.  One is that there are lots of markets in which information isn’t so readily available: emerging markets, junk bond markets, small caps, etc.  In those markets, an astute manager should be able to beat the indices, because he or she should be able to get and analyze the information that is not easily available.

As to the very large stocks in the S&P 500, we see that there is a systematic relationship.  In the years when the top 100 stocks of the S&P 500 do very well, managers do not do as well as the index.  On the other hand, if the last 400 stocks do better than the top 100 stocks, then active managers tend to beat the index.

I think these two patterns are related to the fact that portfolio managers usually don’t like to buy the very largest stocks in large volumes.  They are more interested in those stocks in the second 400.  Also, it is harder to overweight the largest stocks and easier to overweight the smaller stocks in the index. 

Morningstar has a lot of influence through its mutual fund ratings.  There has been some suggestions that its ratings are not as effective as a predictor going forward.  That is problematic, because it suggests that past performance is not a good predictor of future performance, despite the typical marketing claims that fund companies make. 

Morningstar is heavily weighted to the 10-year history of a fund.  In that time, however, the fund may have a different portfolio manager.  I have more faith in the three-year records.  To me, records of three to five years are indicative of what a manager is likely to do in the future.  It’s true that history doesn’t always repeat itself, but if you have a good manager through different market cycles, and you can see a good record through three and five years, that’s the best indicator of what a manager can do.

Financial advisors have also come under a lot of scrutiny.  Some have suggested, based on what has happened in Australia and Great Britain, that compensation should change, such as banning commissions and moving all advisors to a transparent, fee-based regimen.  What is your view?

I believe investors should have a choice.  In both countries, there are fee-based advisors who are paid an explicit yearly fee to make choices for the investor.  But an investor may be comfortable with a fund that has a trailer fee paid to the financial advisor.  That is okay too – as long as the investor really knows what is happening.  The fund industry has spent a lot of time trying to drive home what the fees and expenses are in each fund.   There are fee tables in summary prospectuses and comparisons offered by many analytic services.  Most investors, if they want to, could know exactly what fees are being taken out of the gross returns of their funds. 

Read more articles by Dan Richards