Economics and Finance Symposium - The Evolution of Financial Technology

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LO: I'd like to join Dean Schmittlein in welcoming all of you to this wonderful celebration of MIT's 150th anniversary. It's a real honor for me to be sharing the same stage with five of the founding fathers of modern finance. To paraphrase John F. Kennedy, I think this is the most extraordinary collection of financial talent and knowledge that has ever been gathered together at Kresge, with the possible exception of what Paul Samuelson came into this auditorium by himself 15 minutes too early for a faculty meeting.

But before turning the podium over to our distinguished panelists, I'd like to make a few introductory remarks to set the stage for the discussion. But before that, I'd like to begin with some important thank yous. I'd like to join my co-organizers, Jim Poterba and Bob Solow, in thanking David Mendel and the MIT 150 Symposium Planning Committee for giving the economics department in the Sloan School the opportunity to hold this wonderful event.

And of course, I thank all of our panelists this morning who made time in their busy schedules to be here today. In fact, you should know that the 10 panelists for the two morning sessions were the first 10 individuals we contacted. We had 100% acceptance rate, and the common response was, wow, MIT's 150th? Count me in. So we're really grateful to them for coming.

I also want to thank Ted Johnson, Rebecca Tyler, Lily [? Mignet, ?] and the entire MIT 150 office for doing the heavy lifting in arranging all of the logistics, not just for the Economics and Finance Symposium, but for all five symposia, which is a huge task. We're also grateful to Cathy Levine, Nicole Silva, Eva Cabone, and the MIT Conference Services Office. Gale Gallagher, Joe Cohen, Lee Corbett in the Institute Events Office. Jessica Colon and Lisa Desforge from the MIT Economics department and Jayna Cummings from Sloan.

Clearly, it took a village to put this together. So please join me in giving them a round of applause.


And of course, we'd like to thank all of you for braving the weather and in some cases coming from very long distances to be with us today. I see many former students and former colleagues. It's great to see all of you reconnecting with your intellectual roots.

And I have to say that I've never had the pleasure and privilege of attending MIT as a student, but I do have a connection to MIT that I've often told to my students, which is the fact that my older sister was an undergraduate here in the 1970s. In fact, that's how I first heard about MIT. And as an impressionable high school student from the Bronx High School of Science,

I'd come here during the fall with my family to drop my sister off for the semester. We'd come back in May to pick her up at the end of the semester. And I'd spend many happy hours in the Student Center playing pinball machines and eating the badly charred hamburgers from Twenty Chimneys. And I remember being impressed by everything about MIT, including the fact that the buildings were identified only by numbers.

When I asked my sister about this, she said that not only were all the buildings identified only by numbers, there was actually a logic to the numbering. She said that the numerical values of the buildings were inversely proportional to the importance and intellectual substance of the department in that building.

Now, think about this. Building 1 is the President's office. Building 2 is mathematics, the queen of all sciences. Building 3 and 4 were physics, and so on. And so as a math and science geek in high school, I was just terribly impressed by this. I thought all schools should do this. So years later, when the MIT Sloan School offered me a job, I couldn't resist by asking the Dean at the time, excuse me, but what's the Sloan School's building number?

And despite the fact that it was E52-- it's actually gotten worse, now it's E62-- I accepted the offer without hesitation, and it's because of the MIT Sloan finance tradition that was built by the individuals sitting on the stage and their colleagues.

Now, as with almost every other field of modern economics, finance begins with Paul Samuelson who I'm told made enough money from his bestselling economics textbook in the 1950s and 60s, that he actually had to start thinking about how to invest that money. And so in the 1960s, he decided to study finance and reinvented the field along the way.

Now, Paul did have some help, and there's some extraordinary individuals that grace the halls of the Sloan School. Fortunately, many of them are with us today. You'll have an opportunity to hear from them directly as to how they came to develop the ideas that have really transformed an industry. The financial thinking that came out of this place from this incredibly small but elite group of faculty is truly breathtaking, and so you can see why it is that so many of us who came afterwards were absolutely delighted to join this extraordinary faculty.

But what's unusual about this set of ideas that was developed, and here's just a partial list-- oh, I'm sorry. You can't actually see up there, can you? I'm moving forward these slides. These are the individuals that I had up there. And the extraordinary ideas that were developed here over a period of 15 or 20 years is extraordinary not only for its breadth, but also for the impact that it's had both on academia and on practice and in policy.

In fact, if you look at these ideas, from dynamic asset allocation to efficient markets to option pricing theory to arbitrage pricing theory to real options, virtually every single idea that came out of the Sloan School in finance has had an indelible impact on industry. In fact, our second panel, titled Finance in Action, that includes prominent practitioners and practitioner academics, will make this point much more eloquently than I could.

The tight link between theory and practice in financial economics is unprecedented, not just in economics but among all the social sciences. In fact, that's why the term financial engineering has become common usage, quite organically and without any prompting from academics.

We build stuff. And most of the time, it actually works. Sometimes it works too well. Now, all of this sounds very impressive, but what about the financial crisis? Those of you who were here yesterday saw quite a bit of hand wringing, teeth gnashing, and finger pointing with respect to all that's gone wrong in economics over the past three years. What about finance? Is finance to blame for the financial crisis?

Now, I realize that I'm a bit biased and hopelessly conflicted, but I have to say that when I hear people blaming the crisis on too much financial engineering, I just find it bizarre because it seems a bit like blaming accounting fraud on arithmetic and the real number system. I mean, it's true that those elements were involved, but there must be something else going on.

Now, this isn't the time or the place to have an in-depth conversation on the financial crisis, but I'd be remiss if I didn't provide a quick summary of it just so we can turn to the future of finance. And I've managed to reduce the entire financial crisis to just one slide, and I think I can do it in under a minute, all graphically in fact.

So we start off with a number of financial institutions, not just banks but also investment banks, mortgage lenders, Fannie Mae, Freddie Mac, politicians who during the 1990s engaged in a variety of innovations and policies that really created enormous amounts of assets directed in a very specific way.

Those assets were gathered through the help of rating agencies and insurance companies from a variety of sources-- pension funds, mutual funds, sovereign wealth funds, and so on-- and systematically and aggressively pumped into the US residential real estate market thanks to an incredible sales force.

With the idea that all of these mortgages, that had various different features-- adjustable rates, reverse amortization, and so on-- would create cash flows that would provide investors-- a large pool of investors-- with attractive rates of return. That was the idea. But of course, as we know, what happened was that we overextended ourselves and eventually, as interest rates rose--


Sorry about that. I recently read a book on how to make PowerPoint more effective, and so you're my Guinea pig. As interest rates rose, we started to have more and more defaults. These defaults obviously reduced those cash flows--


--to the various financial institutions--


--destroying those institutions--


--and systematically--


--causing losses. The only group that made some money--


--was maybe John Paulson, the hedge fund manager. That's it. That's the financial crisis. Now what does this all mean? Thank you.


How did this happen? What went on? Well, let me show you a graph from Bob Schiller's book, Irrational Exuberance. This is a graph from 1890 to 2006, the peak of the US housing market, of the real home price index. It takes into account inflation.

Anybody see anything unusual about this graph? Well, clearly something different occurred over the last 10 years. And although there's a lot of debate about what the issues are underlying the financial crisis, it's pretty clear that financial innovation and a particular financial technology played a role.

And I don't want to minimize the pain, suffering, and dislocation that this crisis has caused. And millions of Americans are facing the consequences of a very, very difficult recession and hopefully a recovery soon. But I have to tell you that when I look at this chart, I see something else. To me, this is a proof of concept of the potential for financial innovation.

Now, this may be viewed as an unfortunate example because we are just in the beginnings of tapping into new financial technologies. But what if it were the case that we were able to take the power of financial innovation, of securitization, of credit enhancement? All of the tools that we've used to create this enormous pool of assets.

What if we were able to do that and apply it to some of the most important challenges of modern finance and our society today? In particular, what if we could focus the power of financial innovation for the forces of good? And by that, I mean applying our expertise in financial innovation for society's biggest challenges.

I'm going to make a rather bold claim. I claim that if we were to apply the tools of financial engineering to society's biggest problems, that within the next two decades we can actually solve three of those challenges. We can cure cancer, we can solve the energy crisis, and we can address global warming.

Now, you might ask, how could that possibly be? How could it come out from financial engineering? And I plan to ask the panel the same questions. But I'm convinced that we can do it. And really, it's because of the power of being able to pull resources together, a form of collective intelligence that really is unprecedented in the history of financial markets.

Now, I want to conclude with a simple illustration of why it is I'm so convinced that we need more financial engineering, more expertise, not less. This is a simple example of what I'm talking about. A few years ago, I put together a list of graduates of this institution, in the engineering school as well as in the Sloan School, in finance.

And one of the stunning things you see is that the School of Engineering, over the years, produces hundreds of PhDs in engineering every year. In 2007, we produced at the School of Engineering 337 PhDs. All of those PhDs were funded by government grants. DARPA, NSF, NIH.

During that same year, we produced exactly four finance PhDs. So is it any wonder that we have the financial system that we do? We need more expertise, not less. In fact, over the next few years, we're going to be rebuilding the financial infrastructure for the next century. And the hope is that, with the help of individuals on our panels this morning, and with all of you, we actually are going to be able to revamp that system for the 21st century.

Now, let me turn to our panel. Because I've asked each of the panelists to describe briefly in their opening remarks how they came to study finance, and what their experience was like at MIT, we're going to get a bit of an oral history of the MIT finance tradition, after which we're going to open it up for questions from the audience and general discussion.

Now, I realize that it's a hackneyed phrase to say that our panelists need no introduction, but it's so obviously true in this case that I'm actually not going to provide any introductions. We have with us Stu Myers, Myron Shoals, Bob Merton, John Cox, and Steve Ross. And I think that's all we need to say.

Now, the more observant of you might be wondering what possible ordering we chose for the panel. Clearly it's not alphabetical. Nor is it in decreasing order of height, as you might think. Nor is it, as Steve Ross first conjectured, in increasing order of handsomeness. But it's by when they first joined MIT faculty. So please join me in welcoming Stu Myers to the podium.


MYERS: Okay. Andy asked me to tell you how I got into financial economics, and I'll tell you. There were three strokes of incredible luck, and with hindsight the luck came with perfect timing. The first stroke of luck came when I, as a MBA student at Stanford, started cutting classes in Finance 2.

And the professor, Alex [? Robicek, ?] called me in after a few classes were cut and asked what the heck was going on. I told him I thought finance was boring, just one Harvard case after another. And what he should have said is that I was a feckless young kid that had zero potential to be a CEO, which would have been accurate, but instead he gave me a stack of journals of finance and a couple of research books and told me to come back on Monday.

So I switched into the doctoral program, and within two years Alex and I published a book, Optimal Financing Decisions and, I'm proud to say, had set out the first clear version of the trade-off theory of capital structure.

The second lucky thing was that I came into finance at exactly the right time because there were these big ideas that were flowering all at the same time. It was Modigliani Miller. There was the capital asset pricing model. Efficient markets. Black-Scholes dynamic hedging. Agency costs. Arrow-Debreu pricing. And particularly important for corporate finance was the proof that firms could and should maximize their market values-- values on the stock market-- and leave decisions about consumption, savings, investment, risk-bearing to the investors.

And that meant that corporate finance was all about valuation. If you could figure out what things were worth, you had a theory of corporate finance. So I once had a breathless young student, an MIT undergraduate, who rushed out to me after the first class of [? 15401 ?] and said, Professor Myers, I've got it. Finance is the science of rational valuation. And I told her she was one-third right. It may not be a science, and it may not be rational, but it sure as heck is about valuation. Always.

And that's important to remember because corporate finance is all about value, and value is determined at the boundary between the corporation and financial markets. And people who study corporate finance have to operate at and across that boundary, otherwise they're going to retreat into some kind of institutional shell or behind some kind of institutional fence.

My third stroke of good luck was getting an offer from MIT. And I wanted to come to MIT because of [? Frank ?] [INAUDIBLE], but as a bonus I got all the other people-- that I got to work with all the other people that Andy just showed you.

Now, let me just add a couple of things. I don't want to go through Stu Myers' greatest hits. It would take too long.


No. But I want to make two comments about corporate finance. I'm not exclusively in corporate finance. That's my comparative advantage, so let me make a couple comments. One very interesting thing happened as a result of the research in the 1960s, the 1970s, and perhaps the early 1980s.

We came to what's called modern finance, but we also came to a practical theory of corporate finance. Not just a theory of how things should work in some ideal world, but a theory of how financial executives ought to frame financing and investment decisions, and to some extent even give them advice on how to make them.

Now, I immediately say that no textbook or theory can replace a human being who's got to make the decision, but nevertheless human beings like to have help. And I'm very proud to say, actually, that if we take this theory of corporate finance, which was all based on valuation and was very conscious of being able to operate on both sides of the border between the firm and financial markets, that that theory proved to be practical.

And Dick Brealey and I proved it was practical because we put it in a textbook and the textbook sells and people read it. And it was re-proved to be practical by other good textbooks that came along not too long afterwards, including the Ross-Westerfield books.

And I must say, if I can congratulate myself a little bit, it's really good to go out in the world now and talk to CFOs who are actually using this stuff. And I think it's remarkable in a way that a theory, which the then previous generation would have regarded as abstract and mathematical and impractical, turned out to be more practical than the old theory.

I've heard Bob Merton say, if I can quote you, Bob, that if you get the principals right, the practice follows. And I think it did. The next thing I'd like to comment on is that-- oh, by the way, one of the great things about being at MIT is that there was no boundary between the people who worked on corporate finance and the people who worked on financial markets. No boundary at all.

And for me, that was absolutely wonderful. I might never have had the option of writing down those two words-- I never would have had the thought of writing down those two words, real options, if I hadn't been around Bob and Myron and all those people, all those things that were happening, at MIT.

Now, my last comment is this. Suppose we fast forward to 2010 or 2011 and we look again at that theory that we're all so proud of in, let's say, 1985 and which we believe was practically useful. Right now, frankly, in corporate finance we've got some theory problems.

And it's ironic because, on the one hand, we know much, much more about how corporations actually make financing-- particularly financing, but also investment-- decisions because the data is so much better. The data available to somebody that wanted to test ideas about corporate finance here, and let's say capital structure, is much, much better than it ever was before. And the degree of econometrics sophistication is much, much better.

But at the same time, as we learn all of these facts about corporate financing behavior, frankly I'm getting a little uncomfortable because the old theories, the ones that are in the textbooks, are having trouble explaining all these new facts. There are ideas to explain the new facts-- lots and lots of ideas-- but these ideas are really not grounded in any kind of fundamentals in the same way that the old-- I now call it old-- theory was or is.

And it seems too easy, in empirical work and corporate finance, to find results that are consistent with almost any theory or idea, but it seems extremely difficult to disprove anything. That is, we have so many competing explanations that all seem to fit the facts to some degree and no way of figuring out what's really going on. And I think that's the big challenge for corporate finance going forward.

To back off from the empirical work a little bit, back off from work that's become almost descriptive rather than hypothesis testing, and to try to figure out what's really going on from an economic point of view.

On the other hand, there's some good news about the theory. And the good news I would put under the heading of Corporate Finance for Financial Institutions. In a way, it's easier to apply the old-- what I now call old-- theory of corporate finance to a bank than it is to a non-financial corporation.

There's all the same objectives and trade-offs apply, but banks are simpler. You can observe what their assets are, you can observe what their liabilities are, you can measure things that you could never measure-- measure things about the assets-- that you could never measure for a non-financial corporation. And if we actually take some of the tools of corporate finance and apply them to financial institutions, particularly in the recent crisis, you can begin to see what's going on.

I'm not going to talk about the crisis specifically except to tell you, or promise you, that it was partly a crisis caused by the old staples of corporate finance, including agency problems, moral hazard problems, information problems. And if you think hard about dead overhang, or information asymmetry, you can make significant progress in understand what went on over the last two or three or four years. So thanks very much. I'll turn it over to Myron.

SCHOLES: Thank you very much. I haven't been at MIT for many years, but sitting with my colleagues to the right, one to the left of me, one of the great things was to realize that I had the fortunate time in my life to be with a wonderful band of scholars here at MIT. And I think the band of scholars is still a band of scholars, and I really appreciate them as colleagues and continue to be friendly and interact with them in many, many ways.

I was asked by Andy to talk about how I got into finance and then my experiences at MIT and at a time when I was here and the research that was being conducted. So I guess, when I was thinking about finance and how I got into it, I was born in a place called Timmins, Ontario of Canada, which is 500 miles north of Toronto. And my family and everyone around us seemed to be trading in gold stocks and penny silver stocks, and they would go up and collapse. It got me very interested in thinking about how if these things were valued in a way that I can understand. And that always stuck with me.

I was supposed to go into my family's business, and graduated from a university in Canada at 19 and I thought I was too young to go into the family business at that time. So I had taken some economics courses and had an economic professor who was from University of Chicago and I read works from the professors there and I decided to convince my family that I should go there for a while before returning.

And I think one of the interesting things that all of us-- you here who came to MIT-- realized that I had an intuition, and at that time that I should always try to go where the best were and learn from the best and steal everything I could from the best. The best, though-- if you do that, the best will accept you if you can only keep up with them. So you have to find what level of best is for you to keep growing and to keep learning, and that intuition has served me well throughout my professional career and life.

I went to Chicago and then I had a falling out with the family. And since I was from Canada, I took a summer job at the University, the only place I could get a job because of immigration restrictions. And I got a job as a computer programmer. This was in the 1960s. But the fascinating part of that-- and as Stu said there's a little bit of luck in what you do in life-- I didn't know much about computers or even what they did at the time, but I certainly became a computer nerd that summer.

But the fascinating part is that many professors came in to ask me help for their research and working on their research programs, and I could see through that summer how much they loved what they were doing. And I could see how much that joy of getting results and then asking the next questions and the follow-on questions and learning was so much part of their life that it created a large excitement for me in thinking about what they were doing. And their love also was very infectious.

It turned out that summer, and there's always a connection between us, is that Franco Modigliani and Merton Miller were working on a test of their capital structure and variance theory, and using utility companies. Stu mentioned the availability of data and how tough it was to get data comparisons, and they were doing empirical work on that. And I worked to help them on that project.

So as Merton Miller was in Martha's Vineyard, so was Franco together, and I kept sending him results. Now, either because it was the case that they needed me or Merton and others in the faculty needed me to continue to be a research person and computer programmer for them, or because I was giving gratuitous extra results and they wanted me to have some theory as opposed to just sending extra results to them, which was confounding their research, I joined the PhD program-- they asked me to join the PhD program-- which was one of the greatest decisions I made.

So I did my work in investments, mostly at Chicago and then was fortunate to come to MIT in 1968. When I came to MIT, it was an amazing place. I think that I really enjoyed here. The students were just amazing. The ability of the students to continue to challenge and to be involved in myriad discussions. Obviously, I was a young person so I didn't look as old as I do now and they were more willing to come into my office and discuss things. And I think the first year I had about 21 Master's theses, and PhD students were there.

But the amazing thing was that basically we didn't have data. We didn't have computers that were cheap, as we have now. Everything was expensive to run and yet everyone was very interested in using and trying to understand and continue to learn. And that was a very exciting time. I met Fischer Black for lunch in my first summer of 1968 of being here, and Fisher and I talked about many ideas in investments and finance generally, and I was just learning. The field, as Stu mentioned, was very young evolving.

And at the time I was very interested in-- back-stepping for a moment-- I had spent this summer before coming to MIT in 1968 at Wells Fargo Bank and on a project to evaluate their management science group to use portfolio theory-- to use portfolio theory to construct portfolios and do it in the Markowitz-Sharpe ways. And I suggested that maybe they should change their modus operandi because they had no inputs to making these investment decisions or no clients, really, and that they should start thinking about passive investments and sort of build what later became index funds.

So that innovation-- obviously, sometimes the early bird gets the worm, but in this case it took many years and the early bird got frozen to death, but it took until the late middle '70s before it really caught on. The interesting part of that collaboration for me-- with Fischer-- what I did was I-- Fischer was with Artie Little and I involved Fisher in the project because I was teaching and doing research and being involved with students, so it's hard for me to travel.

But the fascinating part of that collaboration was I brought Fisher in to the finance group, and he and Stu and myself and Franco, and others that were here, and the PhD Students and that would be running the finance seminars, which again were great learning experiences.

I was always interested in risk and risk management. We had learned about reserves. We had learned about diversification. And through students at MIT, I became very fascinated in options and insurance and the idea of changing the shape of distributions of portfolios.

And when Fisher and I started working on options together, we worked initially in the '70s. And in May of '70, we came to our first paper on the pricing of options presented at a conference, again a band of scholars, not only MIT people but people from around other research institutions. And we did that at MIT. So we presented our first version to the profession at large here at MIT.

And I was fortunate in 1970 to have Bob Merton join me as a colleague and start a lifelong association in addition to friendship where we were able to grow. So together, we continued to learn and the like. Bob, when he came to MIT, sort of was an amazing cog in the wheel and I think we started off with just a group of us who were just interested in problem solving and understanding finance.

And there wasn't a large senior faculty group, other than Franco at that time, that was really our leadership. It was Stu and myself, with Bob, and then with Fisher indirectly. At that stage we were able to I think create many different areas of corporate finance. Investments. Thinking about how markets worked and new technologies, and new ways of thinking about problems.

But also, mostly I thought, not only with ourselves but in conjunction with the challenging questions and the innovative research that we did, but also the research that our students did and the questions that they asked us and continued to ask us over time. So for me it was a wonderful experience and a great learning experience. And I'm proud to have been here and to continue my association with the band of scholars. Thank you.


MERTON: Well, as with my predecessor speakers, I'm going to respond to Andrew's request as to how I got into finance. Everyone has mentioned so far, and I suspect the rest will make reference to it too, strokes of luck. Things that just happened that if you turned the wrong way and missed it, who knows where you'd be?

I confess I haven't studied a lot, but I have always been curious. It's clear that, ex ante, every sample path in life is probably extremely unlikely. But for those of this who survive, we did follow some sample path. So I don't know whether we're always describing that which seems like luck, but we have to follow something.

In my case, my interest in finance goes back, I guess-- I bought my fair share of stock when I was 10. It was General Motors. I didn't hang onto it, but I've hung on to other things. [INAUDIBLE] I used to hang around in boardrooms sometimes-- I know that sounds horrible-- and they all took this kid and kind of taught him about the markets and reading tapes and so forth.

And then later, in college-- I went to engineering school in Columbia, in engineering mathematics-- I still was a little involved in markets. And then when I decided to go to grad school, I decided to get a PhD in applied math, and I applied to Caltech and MIT. And I went to Caltech.

Now, one of things that happened out there, of course, is that 9:30 in New York is 6:30 in the morning. So I would be in trading at 6:30 in the morning before going to classes and then work on research at night. I traded just about everything. I thought I knew what I was doing. I found out later I didn't.

But this served me well in two ways. First, I was fortunate to do my qualifiers and everything pretty quickly at Caltech, and I had to think about a thesis. And it was water waves in the tank or plasma physics, none of which very much excited me.

I had this sense that I liked economics, but I never studied it. And then I listened to the Walter Heller story-- the Council of Economic Advisors and how they solved the macro problem. Does that sound familiar? And I thought that was pretty neat. I said, if you imagine if you could just do a little something positive and affect literally millions of people perhaps for a long time, that's not a bad thing.

That along with just interested in the markets got me thinking about maybe what I really want to do is go into another field. And I had a next stroke of luck, which is I bought a book on mathematical economics. I don't remember the authors. Good for them. It was a terrible book, but I didn't know it. So I said, gee, reading this maybe I actually could do something in this field.

So I went off and my family, my adviser, everybody thought I was crazy, but I applied to all these economics departments. And I had a reasonably good academic record, but unlike what might happen today, eight of the nine sent me back thank you but no thank you, including Columbia, my alma mater. And then from MIT comes a letter saying, we're looking forward to you joining us and, by the way, here's a full fellowship. So you could see that was a really tough decision.


I found out many years later why this happened, and this was a stroke of luck of the late Harold Freeman who happened to be on the admissions committee and recognized the names of people actually here at MIT and elsewhere who had written about my application in mathematics. And he decided to take a flyer. I'll always be indebted to him.

Not only that, but when I came I went to the graduate office and said, all right, I want to write out my program in the Economics Department. I know nothing about it, so tell me what to do. And Harold looked at what I had written down, economic history and so forth, and he said, you take those courses you'll be out of here in six months because you'll be so bored. Why don't you go take Paul Samuelson's mathematical economics course. And so I said, OK. And I went and did it. And the rest, one might say, is history.

I loved it. I loved the work. Applying mathematics had something that excited me. Paul took me in under his wing. I became his RA and lived in his office from the end of that class on. Many people have had great experiences, but I can't imagine anyone having a better graduate experience than mine.

So then, when it came to the job market, the one thing we knew at MIT is you can't hire your own. So you have to go out into the world. And so I went and interviewed everywhere, even garnered a few offers, at the very last minute Franco Modigliani comes to see me-- he was one of my professors-- and he said, how would you like to join the Sloane school in finance?

And I looked at him and I said, well, it's in the same building. How can I possibly do that? And he says, different course number.


And I said, but I don't know anything really-- I've written about finance [INAUDIBLE] things and so forth, but I never took any courses at business school. He says, I looked at your thesis. You'll be fine.

So I went and I thought, MIT is a great place. Things were going very well my research. I liked the people. I had no thought I could do this, so I went and met people. And of course, Myron and Stu were two of the people I met and they were very kind to me. So I said yes.

I lived next door in Eastgate, so I had a very short commute. That was 43 years ago. Well, 40 years ago when I went to Sloan. And I've really progressed. I live a quarter mile from the campus now.


But anyway, I joined this group. And Myron alluded to it. Stu alluded to it. And all I can say is, I didn't know how good it was until later. We were a very small group, as Myron said, really with no senior faculty by coincidence. [INAUDIBLE] had left. And while Franco was great, he was engaged both in economics department and-- so it was like all these kids and nobody to look after them. And we went and we designed all the courses, and we did the research, and we had a blast doing it.

Things seemed to work out, so the administration looked the other way. And so, essentially without any senior faculty, we get a chance to build and do things that rarely would be an opportunity certainly at a place such as MIT. And it was just fantastic.

The research flowed-- again, if this is the first thing that happens you don't know otherwise-- research flowed so fast. There were so many interesting problems, for both us and our students, that there wasn't enough time to even do them all. And that doesn't happen often either.

I guess the only thing I'll say-- I'm seeing the clock run down-- is to say about coincidence. Modern finance, as Stu alluded to, really began in the 1950s with Harry Markowitz, Jim Tobin, and Modigliani and Miller. In the '60s, again, it was very important growth. We built Sharp. [? We built ?] Chicago. [? Gene ?] [? Fama ?] and so forth.

But in the 1970s, when I started, we had this stroke of-- and it didn't seem like luck at the time, but I'll show you why-- of the horror and the mass of what happened to the economies in the 1970s. I'll just remind you, as bad as things may have seemed now, we had in the 1970s the fall of Bretton Woods, so currencies became completely unglued. Something that most of us hadn't even thought about for years.

We had the first oil crisis, where oil I guess went from about $2.50 to $30 a barrel. The US stock market fell in real terms in 18 months by 50%. We had double-digit interest rates, double-digit inflation, on top of that stagflation with high unemployment. And that's a lot of risk. And that's certainly a bad piece of news.

The good part was that it stimulated an enormous amount of research and implementation of research into practice. They say in real estate valuation the three most important things are location, location, location. And in getting innovation implemented, I believe the three most important are need, need, and need. And indeed in this period, we saw the creation of options markets, the financial futures markets, currency futures markets.

We had the development somewhat later of the swap markets. We had all of these means for transferring risk. Things that would not have happened in the 1960s. Our joint work on options, which was taken up from theory and a little bit of empirical work into widespread practice in about two years' time, really was a cause of need. And had we, or Myron, Fisher, and myself done that same work in the 1960s, it might have received-- you know, very nice work. I doubt it would have had much impact until the need arose.

So in that sense, that coincidence was extraordinarily exciting. And finally, it was great for not just our PhD students but for our Master's students. Because we all put into the regular classes-- not special seminars, but in the classes-- all this work that we were doing which we thought would be very practical. And so we exposed MIT Master's students to work that had not yet even been published let alone appeared in textbooks. And at least some of them, I think, benefited from that. So it's with great fondness that I recall this and set the stage for our set of conversations.


I've often been asked how I chose an academic career, and I've never really have a good answer because honestly, I can't ever remember a time when I didn't want to be a professor. I was interested in a lot of things, but economics was always special because it seemed to be so important to the way the world worked. And finance was at the heart of the capitalist system.

So I went off to get a doctorate in finance at the Wharton School at Penn. Bob has described how he had good luck in meeting Paul Samuelson and forming a tie there. I had similarly good luck at Penn in meeting Steve Ross, who is also on our panel today.

Unfortunately, I didn't meet Steve until just before I was graduating, but it was enough time for us to form a long and fruitful collaboration. We've also spoken about good luck and heard about good luck today, and I think that I had very good luck in timing when I graduated. This was in 1975. And at that time, the landmark work of Bob and Myron and Fisher was already published and available, and I had that to build on.

At that time, everyone realized how important that work was going to be, but very few people really understood it. So there were plenty of low-lying plums left to be picked in the orchard at that time. And it just seemed like a golden age for capital markets theory. There was so much to do. One was literally so full of ideas that there wouldn't begin to be enough time to write them all up.

So in that sense, in the timing of my career, I think I was extremely fortunate. After leaving Penn, I went off to Stanford for several years, but later MIT made me an offer and we moved back east. That was 30 years ago and I've been here ever since. And I've enjoyed every minute of it, even though the school and the group have greatly changed in the meantime.

Shortly after I arrived, Fischer Black and Bob Martin both moved. And that was terribly disappointing for me. But the two other giants of the group, Franco Modigliani and Stu Myers, were still here. And we were soon to be joined by some great new talent, including Andrew Lo, our moderator Jiefu Wong, Paul Asquith, John Wong, and a little bit later Steve Ross.

And the group has changed dramatically in other ways. When I arrived here, believe it or not, there were 100 people in our graduating class. And they all got MS degrees. There was no MBA back then. Now we have over 350 MBA students in each class, and an additional 60 in our new Master of Finance program. And this dramatic growth has meant big things for the finance group.

In the old days, we never had more than six or seven people at a time. Now we have over 20 full-time faculty members. So the group is just as exciting as ever, but now three times the size. And I think that we'll have even bigger and better things ahead. Thank you.

ROSS: There's a clock here that winds down. It starts when you start to talk, I just noticed.


One of the nice things about batting cleanup is that-- well, one of the bad things is that most of the fun things have been said. And one of the nice things is that you get to sort of summarize a little bit of what's happened. I gathered that the theme of this discussion, this panel, is finance, MIT, and luck.


And luck has certainly played an enormous role. I mean, I'm a very lucky guy and I'm really happy for it. And I had no prediction that this would be the case. Unlike most of you, I did not have a history with MIT prior to coming here. In fact, I'm the last person who arrived. This is, by the way, the only panel on which I've ever sat in recent memory where it was chosen on a chronological basis and I was the youngest one on the panel.

I actually grew up in Boston, but I didn't go to MIT. I chose another Institute in a somewhat sunnier climate, Caltech, and it was really quite a wonderful place for me to be. It was very good except they seemed to do a lot of things I wasn't interested in, so I spent a lot of time playing poker, which was a theme that would also show up in this panel if we probed a little bit further.


I loved playing poker. I was a physics major. I quite loved physics, but what I did not like was the mathematics of physics. I wound up solving boundary value problems and I remember being given these very, very tough problems by my professor once, one of my mentors. And I have to go in shame after about a few weeks and said, I don't have a clue how to do this. And he responded, well, no one knows how to solve it. You have to do it numerically.

And numerically at the time meant visiting a computer with a drum that moved in liquid oxygen, and you had 40K of memory and a lot of cards that you dealt with. But Caltech for me was like I think MIT was for all of you, a wonderful place to be.

But I didn't quite know what I wanted to be. I didn't want to be a physicist, I knew that. And only at Caltech, and perhaps at MIT, there was a course that you could take-- you were required to take a humanities course in your senior year. And the course that I was required to take, or that I could take, was called Game Theory in Linear Programming. That fulfilled my humanities requirement.


I loved it. I thought it was a wonderful, wonderful course and I loved the mathematics. And I said, where do you go to study this? And they didn't have a clue except, oddly, they suggested I go to a place called Harvard. And I went there and it was, I must say, a very disappointing experience. Harvard's changed a great deal.

And I knew nothing about finance. I didn't have a clue about it. I focused on mathematical general equilibrium theory, statistics, and the pure theory of international trade. And my first job was at the Wharton School, as an assistant professor at the Wharton School. I actually was in the economics department at the University, which is a nice lesson because the economics department was actually in the business school, in the Wharton School. Yet again, another nice stroke of luck for me.

And I went there and I tried to do some pure theory of international trade, which was every bit as interesting as it sounded. And I actually have a cult following for some of my earlier papers in Australia. They don't seem to have made it over the water yet. And I got truly bored and I said, what can I do that would be interesting? And I started to ask people, what should I think about doing? Because I don't really like what I'm doing. And they said, well, you should go to the mathematical economics seminar. And I did.

And I have the feeling that it was conducted by the same people who wrote the textbook that Bob referred to. There were better things to do with your time. And then I tried labour economics, which has since become quite exciting but not-- and I said, what seminar can I go to? And someone said, why don't you go to a finance seminar?

I didn't know anything about finance, but I thought it sounded nice so I went there. And the first lecture I ever heard-- the first thing I ever heard about finance-- was given by this awkward tall fellow named Fischer Black. And he was talking about something called the Black-Scholes Model. And I was just enthralled. Here it was-- unfortunately, it was boundary value problems again. But at least I knew what he was talking about.

This was just the most fascinating stuff I'd ever heard. These people had theories. Not only did they have theories, they had data. And more importantly, this is what science was about. The theory and the data had to relate to each other in some way, and I thought that was absolutely remarkable.

I remember asking Fisher a question, and for those of you who'll know, I didn't ever get an answer. What I got was he bent down and took notes. That was Fisher's style when you would ask questions in a seminar. And I was so excited about this. I resolved to become a member of this seminar. And the next week I went and I heard Richard Roll, who had won Samuelson's prize for his thesis talking about the term structure of interest rates.

Dick became a lifelong friend of mine and I made the good statistical inference, the Bayesian inference, that this was the average quality of people in finance. And I though, well, I'm on a roll. I found what I want to do. And I did. I got very excited and I started to work in finance. And I remember at the time going to one of the professors in the economics department and I told him that I-- this is a story I've told many times, so if you've heard it I apologize-- I told him that I was really quite excited by finance, and in a fatherly way he said, Steve, finance is to economics as osteopathy is to medicine.


Okay. Well, I had the great joy many years later of giving a talk in honor the econ-- when Bob and Myron won the Nobel Prize, and Fisher belatedly, of course, would have had he been there-- I had the honor to tell that story again and I could say, well now, they've given six Nobel prizes to osteopaths. That was a pretty good observation.

And while I was there, I met some very interesting people. Besides the people who visited from MIT, I met a fellow named John Cox. As John alluded to, John has-- we did some wonderful work together. And I mean wonderful in the sense that it was really great work. It was just wonderful to work on it. We had a terrific time and John was clearly a kindred spirit. And one of the great joys for me of coming to MIT-- I think it was in 1997-- was the chance to reunite with John and continue to do some work and to talk about stuff. That was a golden period in finance and I was just so lucky to be there at the time when that was occurring.

Someone once asked me, because John and I wrote a number of papers together, how did we divide up the work? And I took a phrase that I had heard from von Neumann and Morgenstern. Oscar Morgenstern had worked with John von Neumann on the theory of games, and someone had asked Oscar Morgenstern the same question, how did you and von Neumann divide up the work? And Oscar said it was his job to see to it that von Neumann wrote for two hours every day. That was my relationship with John Cox.

So as the other people have said, this is-- it's extraordinary. And for me to come back to MIT, I felt almost like I was here even though I never was because this was clearly the intellectual beacon for me in my field. I mean, the giants who sit in this panel and the others who have been here, they defined the field of finance as I understand it. And it's been just an unmitigated pleasure for me. And to come back and have the chance to reunite with them is really terrific.

When Bob came last year, it's like the old gang is back again. So I think it's just been quite wonderful, and for those of you who have had any association with finance at MIT, you're lucky too. It's really a blessing. Thank you all.


LO: So I guess I'd like to open it up now for discussion among the panelists and questions from the audience. So please feel free to come up to the podiums in the aisles and ask your questions. While you're doing that, let me throw out the first question to the panel, which has to do with this interaction between theory and practice.

Finance really seems unique in that respect, and I just wonder whether this is something that was true at the time that all of these incredibly abstruse but practical theories were being developed, or is that something that's sort of happened organically over the course of the years that it took to take these ideas and implement them?

I mean, for example, in the case of option pricing as Bob, you mentioned, the implementation occurred almost instantaneously. It was really unprecedented in any field of social science. So could any of the panelists comment on that kind of interplay between theory and practice in finance? Bob?

MERTON: Well, since you mentioned me, I'll step into it and then everybody will fix it. Myron and I worked together-- and Fisher-- and I would say it was probably about 1971. Most all the work had been done by 1970. And it was about 1971. Myron and I got a call-- actually, Myron got a call-- from somebody on Wall Street saying, they heard that you had a couple of crazy people up at MIT who had ways to value options and their risk. Is that true and if so would you like to come down and talk to us?

So Myron and I went to Wall Street. It was the firm of DLJ, Donaldson, Lufkin & Jenrette, which turned out to be sort of the lead firm in options later on. I would characterize it as this was the exception. There were always times when people from academia went to Wall Street, but for very different purposes. They actually wanted us to do the work we were doing for them and help them adapt.

We learned a lot. We learned about implementation. We learned a lot motivated by problems. For example, there was some kind of contract trading in Hong Kong called the Down and Out option. And we just solved that because we sort of had the secret way to do it. I mean, the easy way to do it. And later on that became a whole industry.

So in the beginning, most of the people I think didn't have a clue what we were doing. And that made it more difficult. You didn't have the entree. But also there wasn't as much competition. Later on, when it became more widely spread-- and when I say within two years, it was two years of the publication that that happened-- that was not by 1975, so it was a number of years later that it was actually adopted. So it changed. In some sense, everybody could get a hearing but it was a very crowded space as far as getting resources.

SCHOLES: Also, too, in terms of what we discovered in finance, in terms of taking things such as efficient market thinking and the idea of markets working and continuing to work, the idea of people wanting to support basic research in finance, such as Wells Fargo wanting to support basic research in finance on how to develop passive investing and various things that we're interested in and that. So it was all coming together at the time of people on the investment side wanting to understand how to use the ideas that had been developed in the academic world and move them into the investment world.

And I remember giving a seminar, actually it was, at MIT where many people who are on investment firms came to that seminar, the summer seminar, and other than one person who came up at the end the seminar, everyone went back and took those ideas and started to implement them and think about the idea of using quantitative techniques in investment and making investment management professional. Using measurement for the first time as opposed to just the idea of intuition. Trying to measure, trying to understand, trying to think about how to look at construction of portfolios.

The one person who didn't really get much out of the course was an older gentleman who came up to me at the end and said, you know, I took the course, but I bought 10,000 shares of IBM in 1935 or so and I still have those shares today and you talked about diversification. Should I sell it? I said, no. You took the course just to understand things. You continue to do what you're doing.

That was one area. All the investment areas got done. And then in terms of going to an understanding of option theory as Bob had said, many firms were interested, and many organizations became interested, and we were able to build the first risk management systems that were used in-- for the bankers that actually had financed the traders on the options exchanges because without risk management they didn't know how to extend credit or money to the traders. They wanted the traders to survive and without telling them how to be [? delta ?] neutral, how to run the books, how to think of diversified portfolios and that, it just wouldn't have worked.

And so everything that was being done in finance and the investment side and the option side was moving very, very quickly into the actual world of application. And there was a feedback system. We kept learning from that, as Bob said. Bob, in his paper on [? warrant ?] pricing, had on the Down and Out option.

But that asking how do you think about solving these problems allowed that interaction, gave us the experience. And I think experience is so important in creating because with experience you then see there's new ideas. And with empirical testing, there's new ideas and they feed on each other. And I think that was just very, very important for me and very important at the time.

LO: Question on the right?

FEINGOLD: I'm Bill Feingold. I'm a convertible bond trader and occasional author, but the only smart thing I ever did was marrying an MIT grad, which is the reason I get to be here today. But I have a question for Professor Myers and anybody else who wants to answer this, I'd love to hear your thoughts. You made a very interesting comment about studying banks and saying how they're easier to study because you can look at the values of what they own and what they owe.

And just, I'm curious how you go about that given what we've seen in the past several years of the volatility of the fixed income markets. How there's been, at alternate times, either basically no liquidity and no prices or arguably too much liquidity at other times, like arguably we have today. Given that volatility in the markets, how do you go about the work that you do looking at them?

MYERS: Well, as I say, my comparative advantage is corporate finance. And of course, corporate finance usually thinks of a manufacturing company or a railroad or an airline or whatever. And the assets of those companies are extremely illiquid. And so we tend to-- in corporate finance, we tend to take the assets in the short run as given and then worry about financing, which gets us into incentives, gets us into information, gets us into taxes, and so on.

My point was those factors that prove important in ordinary corporate finance for driving financing decisions, or feeding back to investment decisions-- things like information-- agency costs-- agency costs are the fact that managers must be assumed to be acting partly in their own interest-- moral hazard problems, incentive problems. They all happen in banks, too. But as you point out, sometimes at a much greater speed.

And in a way, the liquidity in the banking system is the problem, right? Because the incentives that we might see operating at a sort of glacial pace in a non-financial corporation can happen very, very fast in a financial institution.

So that's the difficulty of moving those ideas over. At the same time, you can see those ideas happening, right? Like the idea of a dead overhang says that when debt gets risky, the equity doesn't want to put more money in, or is eager to take money out, or would be happy to make it even riskier. That clearly happens. That's a standard part of corporate finance, which you can see it happening in banking.

So I was just trying to point a little bit to the road ahead as I think corporate finance and analysis of the understanding of how banks work is actually coming together. If you go to a corporate finance meeting at the National Bureau of Economic Research, half the papers now are on how banks work. So I hope that's helpful.

FEINGOLD: No, it is. I mean, I just wonder how you acknowledge that there's this other element that it all happened so fast, so it's kind of moving pieces.

MYERS: Yeah. [INAUDIBLE] and I wrote a paper several years ago called "The Paradox of Liquidity," which says that something like a treasury security, which is very liquid, you would think would be a great collateral for a loan. And if it were illiquid it would be, but if it's in a bank that can trade it overnight, all of a sudden it isn't good collateral for the loan. And that's an example of the kind of problem that you have in mind.

FEINGOLD: Thank you.

LO: Question?

CARLSON: Hi. Bill Carlson. Master, '71. In his talk yesterday, Akerlof discussed how norms are helpful to research but they also stifle progress because it's difficult to get a really unconventional paper published. I'd be interested in an intuitive guess from the panel about what norm in the finance field is most worthy of being questioned. Where should a new researcher look for someplace to do something, a real breakthrough, by questioning one of the norms.

LO: Steve?

ROSS: Well, if I actually knew, I wouldn't tell you.


Finance is-- to sort of pull on a theme that others have mentioned-- finance is liberated in a way earlier and in a way that most of economics is not. So it's not just that what we do in finance comes from practice and what happens in practice comes back to finance. More generally than practice, it's the data. So when you build a theory in finance, it really ought to be the case that the theory explains the data, or least is consonant with the data. And if it isn't, people challenge it.

And that's a new relatively new phenomenon in economics. Economics went for decades with beautiful theories that had nothing to do with the facts. So you would have these theories-- I remember early studying some of the demand theories, where they would be theories about, well, when you change the price, people would buy less of this, and-- then people did these extensive studies in these large markets in Europe.

The Dutch were central to these studies. And they observed-- people would go into these stores and if the price was higher, they bought more of it. Or they would go in and one day they'd buy Coke and another day they'd buy Pepsi. So that probably is the start of statistical marketing because it didn't have anything to do with the theories in economics. The theories in finance are a lot less self-referential. We spend a lot less time building theories on the basis of what other theories have been built by us. And we're more excited by what is actually happening in the world.

So right now, because of the crisis, there's just an endless array of work being done on liquidity issues, the kinds of things associated with the crisis, collateral questions-- and so it's really coming from the outside world presenting us with data and requiring us to do theories that fit with that data. When you ask, what are the norms that have to be challenged now, I think some of the norms have been reversed.

So now there's a tendency to think that almost anything goes. So if you can come up with some casual psychological-- and this is very personal and somewhat angry on my part-- if you can come up with any kind of casual [? penguin ?] Freud psychological explanation of a phenomenon, it can get published. And if you come up with detailed work, quite analytic work along the lines of a pioneer at MIT, it's actually hard to get that published. So that's-- as I said, that's an angry old man's version of what's going on.

LO: Bob?

SCHOLES: Well, I guess to be-- the areas that I think of are-- I think we need to see much more of an integration of what used to be called, I guess still is called, public finance. What we would call finance, I guess you'd call private finance.

As we've seen in this, very vividly in this crisis, the boundaries or borders between them are permeable and flexible. And I think both will benefit from that. Because I think we have generally looked at-- the finance, I think, would be fair to say, is generally-- its origins are more microeconomics than macroeconomics. And probably hasn't paid enough attention to the overall systems characteristics of things. So that would be one area.

Another, despite what-- I mean, not despite, but even accepting what Steve said, is I think there's a need for a synthesis between what has been a very productive approach to finance in the last many decades with so-called transaction costs or frictions finance and behavioral finance done in a proper way. And rather than see them as competing paradigms, the synthesis is much more sensible.

The problems are too complex and too important not to use everything good, but with the rigor that Steve has alluded to because-- just one more point. We talked about all the impact that this finance has had on practice in the mainstream for a long time. I think if you look at history of economic thought, that's an exception. And if it's going to continue, then it has to do so by both being relevant and being rigorous in the analyses. Because as soon as you get off the track, then anything goes and pretty soon you lose a lot of credibility.

LO: Yes. Question?

Thank you very much. It's humbling to speak in front of the founding fathers, as it were, of modern finance. I'm a '74 graduate of Sloan School, so I had the pleasure to listen to some of the presentations that were pre-publication from Professor Merton in particular and Myers. The question I have reflects a point that Professor Myers made, and reflects actually the last question and your answers.

There has been much said about the causes of the crisis. Blame has been laid on Wall Street, which of course has been using the foundations of finance theory to great extremes. And so I ask, what do you draw as a lesson, if any, on application correctly that went overboard, as it were? Or misapplications of finance-- modern finance-- that have been used that may have been detrimental.

And what are the theoretical issues that Professor Myers, you said, that remain sort of inchoate today given the financial crisis that will lead to a renewal of new theoretical foundations of finance post-crisis? I'm not sure if that's a clear enough question.

MYERS: There's other people here probably everybody on the stage better than I am talking about some of the nuts and bolts with a financial crisis cover equity my guess is we'd all say that it isn't the models that caused the crisis, to the extent that the models had a role in it. It was misuse of the models or over-confidence in the models, or a lack of comprehension of the downstream effects of what various people were doing. Or the dangers they were unwittingly running.

It's true that modern finance, particularly in the financial market setting, is a very powerful tool. And it can be misused, but that's not a reason to discard the tool. It's a reason to use it better. One of the interesting things, and maybe the second panel will pick up on this, is to go back to risk management models and risk management systems. And I think it's fair to ask there whether the problem is with the systems or with the human beings that were trying to run it, and the organizations that couldn't take the systems' advice when it was most important.

It's very hard to-- when a model tells you not to do something that appears to be making money-- it's very hard not to do it sometimes. [INAUDIBLE].

SCHOLES: Just a couple of things in terms of lessons that I learned from the crisis is one of the interesting things is we had allowed, rightly or wrongly-- I think wrongly-- but Lehman to go bankrupt, which was-- and what do we learn from that? We ran this experiment, and it was very costly to society, but the question is what did we learn from that experiment?

So the idea of instead of thinking about how the bankruptcy rules could be changed to be more efficient, and to allow for 1.5 million derivative contracts to come due instantaneously and have to be settled throughout the world at that immediately-- there's just very interesting questions that need a lot of research, and questions about how did a company that had $20 billion worth of value the day before it goes broke all of a sudden be $60 billion in the hole?

What does that mean about our accounting system? Where did the money go? Questions about how to change the bankruptcy rules, the institutional rules that make the system work. But we threw all that out. We have a Dodd-Frank bill now that has a completely different system of financial institutions and bankruptcy. So there's a lot of research that could have been done in terms of really understanding can you let 1.5 million contracts go due in the derivatives market-- the swap market-- instantaneously for settlement.

It sounds nuts to me, but that's-- why were the bankruptcy rules written that way? How do we evolve them? How do we change them? There's so many things that we can do as scientists to really understand how to make the system more efficient.

Questions about why was there risk-taking. Why the risk-taking was done. How that risk management system should evolve from that. What type of prudential risk was taken or not taken and then to evolve. The question we raise is, should it be 50% capital or should it be new risk systems and what levels of capital should be employed? What degree of how to optimize risk?

Many of the-- at least of what I read, the question is, why? These questions are just researchers. Why were many of the senior executives of banks never seemed to read their accounting statements or information systems? Or if they had risk managers, the risk managers were called in every five or six months and asked how the weather was down in the risk management group. So it wasn't integrated.

It's sort of the idea of-- risk management is not risk minimization. It's optimization. So thinking about how to optimize. Thinking about these things was kind of a surprise to me.

If a lot of this was true, that data was not available in some of these organizations to even run systems. And basically, there's many research issues that come up that will make the system better, and they're evolving internally.

They're learning from the crisis themselves and they're making adjustments. So fundamentally, a lot of the things that we have are learning experiences. Plus we don't know, really, the role of our perceived volatility in society. And the idea is that if we think things are quiescent, maybe they are and they'll continue to be for a long time, and as a result individuals respond to risk that they perceive by adding to risks that they're comfortable with.

So again, risk management is not risk minimization. It's thinking about what is an optimal amount of risk to take. So how does volatility affect behavior and what we can do about it. What we can learn from that.

LO: Question over there?

AUDIENCE: Yes. I'm Martin [INAUDIBLE]. I'm a molecular engineer from 1963. With echoes of the PowerPoint in my ears, and part of this has already been addressed, but I wanted to talk about somebody that could do a lot of damage and who is in a position to so, namely Alan Greenspan.

And he was called before Congress long before the crisis and he said, oh, options reduce risk. And they called him back, rightfully so, more recently and he said, the problem was our models didn't go back far enough. And of course, now we have terms like tail risk and black swans and so forth. I wonder if you could comment on all that.

COX: Well, I guess several things are involved in what you said. Part of it relates to a tail risk or extreme event. And going back to Stu's comment on risk management systems, I think it's absolutely true that a lot of the fault for what happened was that risk management systems were improperly used.

I mean, [INAUDIBLE] has a nice story about that that he, at a conference, in a meeting of risk managers, he asked them why no one had sounded more warnings about the crisis. And he was told, well, many did, but they're not in the room. And the reason they're not in the room is they were reassigned or fired.

But at the same time, the risk management systems did not deal with tail risk that effectively. And neither were they really prepared to deal with what are the equivalent of modern bank [? runs ?] that [? Bayer ?] and [? Layman ?] both experienced. Those are things that are just really not integrated into the models very well.

Now, as far as Green-- I mean, personally I think that Greenspan had a big role in what happened through the monetary policy that the Fed followed and throughout most of 2000. But I'm not quite sure what you meant about options. Could you explain that a little bit more?

Oh, he made the comment in the committee hearing in Washington that, oh, options are fine. This was long before the crisis. They reduce risks. They're good things. Because there was a lot of discussion about what's going on with all this stuff and--

You're talking about derivatives, generally.

Yes, derivative. I'm just using options as--

The transfer risk. That's what he said.

Yes. So, of course, later on he came back. He didn't say, I was wrong about that. He just said that our models didn't go back far enough.

COX: I don't think derivatives really played that big a role in the crisis. They've certainly gotten a lot of bad press, but if you look at things carefully it's hard to see what they would really bear the responsibility for.

I mean, it's true that credit default swaps were at the heart of AIG's problems. But this was not because of the credit default swaps themselves, but rather because of the way that AIG went about handling the business. They treated it essentially like their other insurance business, and credit default swaps are to some extent very much like insurance contracts. But they didn't take account of the effect of the collateral arrangements that they made on these contracts, which they wouldn't have had on any corresponding insurance contract.

To my knowledge, nearly all of the contracts that they wrote never had to pay out anything. So if this had been handled-- if the contracts had been set up like the traditional insurance that they were used to, they would have had no problem whatsoever. Okay? But they weren't set up in that way. They were set up so the collateral-- that AIG would have to pay collateral whenever the value of these contracts changed.

So it would be just like having earthquake contracts in California where, if there was a rumble on the San Andreas fault, even though no harm was done, the firm would still have to have an outflow of a huge amount of money. And they didn't really account for that at all in their business practices. So that's their failure and they're to blame for it, but that's not an inherent fault of credit default swaps.

LO: Steve? You had a comment?

ROSS: I have a theory which I haven't actually ever tested, but it goes back personally in my family. I have a suspicion that all major housing crises in modern times have been caused by the government. This goes way back to the Florida land bust which occurred in the 1926 period prior to the Great Depression, and at that time my grandfather was the second largest landholder in Florida.

He owned the land that Disney World is on now. And he subsequently went back to his job as a tailor up in Haverhill, Massachusetts. This is a deep, personal thing. If one goes back to the 1870s, one finds exactly the same thing. So it's good that Alan Greenspan says that.

If you really want to find the role of derivatives, and you really want to find in this crisis the roll of the government, ask yourself what would have happened if the government had, as it did, continued to pump up the demand for housing. And it pumped it up in an extraordinary fashion.

The executives of the agencies went to Washington and said, you're making us put people in houses they can't afford, which turned out to be prescient. So it wasn't as though risk management was avoided. People knew what was happening in that regard. But there wasn't a choice. They were mandated to have over half their lending--

Redlining was a bad word.

ROSS: Well, redlining is a different word. But they were mandated to have over half their lending in these things. Now, imagine what would've happened if the typical bank-- and I don't mean the Merrill Lynch's of the world-- had not had access to securitization and had not been able to diversify the risk.

So they had made all these loans because they were required to, and they were in Detroit or Chicago or Los Angeles or wherever they made the loans, and they couldn't sell them. They just had to hold them on their own books. You would have had a crisis of far more massive proportions than you actually did have.

So derivatives did what they were supposed to do. They spread the risk. The problem was the people who took on that risk didn't like the fact that they lost money. Don't blame derivatives for it. They actually made the situation less bad than it would have been.


LO: Since we're just about out of time, we have time for one more question. Ed?

ROBERTSON: Thank you. I'm Ed Robertson. I run the entrepreneurship program at MIT. Those of you on the stage are a unique group. I know that at least the majority of you have been involved in entrepreneurial activities to bring financial technology to the market. Can you share with us your insights about trying to do entrepreneurial things with financial technology as the basis for what you're doing?


We thought that all of our research was entrepreneurial and everything that evolved from that experience was a lot of things that from the left to my right is innovative and entrepreneurial and we had marketed that through our students and through and talks we gave and other ways to do things. Plus people came to us and we wanted to try to marry together the theory and our empirical testing with actual applications because we thought it was a living, growing field in which there's so many applications, so many ways to do things. So our entrepreneurial thing was having an object.

Our objective was really trying to understand how markets work and how to value contracts, how to value firms. And once we had that objective, we were persistent in that and continued to do it. And then trying to get others to understand what we were doing allowed us then to have a new group people, and it grew from there.

And it was embryonic. And then we stole from each other [? old ?] [? ideas ?] everywhere and tried to grow the business and be truthful in what we did and always be open, honest, and try to be persistent, and have a creative feedback system that essentially allowed us to grow and to allow for the evolution of our ideas to become a whole new field and an area which had, we think, added a tremendous amount of value for those of us in it and those who also took it up on their own.

LO: Bob?

MYERS: The real financial--

LO: Sorry, go ahead. Stu.

MYERS: Probably a better-- not a better answer, but a different answer. A different answer is to point out that the real financial entrepreneurs are in the next panel.

LO: Bob?

COX: I'd say that in one way we always had the opportunity pretty much from when we got started. It was hard to begin with, but it became easier to have your ideas seen. And relative to some other fields, sometimes that can be very frustrating to even have people listen to it.

That said, you have to do many other things that you normally don't want to do with good ideas, which is you have to address all the issues to actually implement it. And this is-- rightfully so, perhaps, but it is one of the most regulated industries in the world. Especially when it's global.

Right now I have to spend a lot of time just to explain things in terms of what the regulations are that they're making changes on so they understand what they're doing. Not to tell them what to do, but that they understand it. And it's now an issue where you don't just go to the State Department of Labor here in the United States or the FCC. You have to go to the European Commission and so forth.

So there are a lot of other-- those activities that are tied up with the actual implementation. And if you do it with a very large firm, which is often done, you run risks, as I'm sure you're aware, that in these firms-- you've all come to know about them because they've been in the press a lot for the last few years.

You have to have someone inside who's a champion. And those champions get moved, and you're left an orphan. So you really need to-- it's a trade-off of a whole bunch of things to do it. So it is challenging, but the opportunity to do so is there and the excitement is truly global. While the rules are different, different places and cultures are different, the tool set works everywhere in the sense if you translate it into the right language or currency.

LO: Steve?

ROSS: 100 years ago, John Cox and I-- when Mark Rubenstein worked on the binomial model--

LO: When you were young.

ROSS: And we were very excited about this because this was a model that you could actually put on an HP calculator, for those of you who remember, and someone in the pits could actually program in the value of this object. And we thought we had a real moneymaker here, and we became specialists on the Pacific Options Exchange. And our particular specialty was Levi Strauss stocks. So we were the market makers in Levi Strauss options, and whenever you went out and bought jeans we were happy.

And John and I were sitting on the east coast, and someone else-- Mark-- was sitting on the West Coast, and we had the models all set and we had our trader in place there. And we put our first trade on. And I think it must have been minutes later, I got a call. We'd lost $50,000. I said, how could that be? And it turned out he'd put it on backwards. [? He bought himself ?] [INAUDIBLE].

So what lessons have I learned? It's the same old lessons of business. It's hard to run a business from a distance. It's common sense. You have to actually be there on the ground doing. So it may be finance, and it may be entrepreneurial finance, But there's nothing new about what you have to learn in terms of how to make a business successful. At least, that's the lesson I got.

LO: Well, I think we're going to hear a lot more about that in the second panel. But meanwhile, please join me in thanking our first panel.