The Princeton Financier: Fall 2011

THE EURO’S ROCKY FUTURE An interview with Nobel Laureate CHRISTOPHER SIMS

MONETARY UNION IN EAST AFRICA? Professor IQBAL ZAIDI

The Princeton

Financier FALL 2011 Volume 1 | Issue 1

EDITORS-IN-CHIEF Dilek Izek ’13 Nivedita Singh ’13

MANAGING EDITORS Philip Shin ’12 Luke Cheng ’14

DESIGN Luke Cheng ’14 Mianna Chen ’14 Dilek Izek ’13 Nivedita Singh ’13

CONTRIBUTORS Alexander Pretko ’12 Jingwen Du ’13 Julian He ’14 Sunny Jeon ’14 Jason Nong ’15 Thomas Mbise ’13

COPY EDITOR June Yoon ’14

PCFC Board FALL 2011

PRESIDENT & FOUNDER Daniel Condronimpuno ’12

CLUB MANAGEMENT Anastasia Auber ’13

EDUCATION & MENTORSHIP Zara Mannan ’13

MEDIA, MARKETING, & TECH Craig Limoli ’12 Luke Cheng ’14

INDUSTRY INSIGHT Philip Shin ’12 Alexander Pretko ’12 Jingwen Du ’13 Dilek Izek ’13

FINANCE & MEMBERSHIP Ani Deshmukh ’13 ALL CORRESPONDENCE MAY BE DIRECTED TO: The Princeton Financier 5575 Frist Center Princeton, NJ 08544 pcfc@princeton.edu www.princetoncfc.com

STORY

THE

BEHIND

IT ALL: In February 2011, given the backdrop of sluggish economic growth and persistently high unemployment rate, jobs and internships in the financial industry were difficult to get even for students from top colleges. At the time, I was fortunate enough to have emerged out of the internship search process successfully. The idea to start the club emanated from my gratefulness to the Princetonians who had trod the same path and helped me enormously as I searched for internships both in my junior and sophomore years.

Back in my sophomore year, I was unfamiliar with the financial lingo, knew little about the distinction between the various segments of the financial industry, and had not even heard of private equity or venture capital. Yet, just like so many others at Princeton, I applied to the investment banking divisions of the industry’s big names. I was not even sure precisely why I had applied; perhaps I was just a go-getter keen to land a “prestigious” internship.

As someone completely new to the internship search process, I received one rejection after another until I received an email from an alumnus who worked at the Macro Structuring Desk of Goldman Sachs in Hong Kong, offering to give me an interview. We connected very well over the phone, and after that conversation, he guided me in every step of my eight interviews with Goldman Sachs.

Under his generous guidance, I managed to secure internship offers from both the Macro Structuring Desk and the Fixed Income Sales Desk of Goldman Sachs –

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even though I had applied to neither in the first place. This was how I first discovered the power of networking and had a glimpse of the potential impact of connecting current students who are in the job search process with alumni who have been through it successfully.

I made full use of my experience at Goldman Sachs to explore the multifarious niches within the financial industry, which ignited my budding interest in the field. In the fall of my junior year, knowing what internships I wanted to pursue and how to prepare myself, the internship process was almost seamless. I asked for and received a tremendous amount of help from recent graduates, all of who had received job or internship offers from top investment banks.

Princeton is unique in that it does not have a business school despite the large number of students who are interested in working in the financial industry. This added, in my view, to the value of a club that would organize financial accounting and valuation workshops, and help Princeton students connect with alumni and other students who have successfully navigated the ups and downs of the job or internship application process. Many alumni in the industry shared their concern with me that Princeton students are usually not as interview-savvy as students from peer institutions, even though they are, naturally, just as capable. The Princeton Corporate Finance Club strives to provide the solution to this problem.

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Daniel Condronimpuno ’12 President & Founder

INTERESTED IN GETTING INVOLVED? Send an email to pcfc@princeton.edu

The Princeton

Financier 4 6 10 14 21 25 27

INSIDE: Success on Wall Street: Prof. O. G. Sexton Interview by Philip Shin Can an ETF Collapse?

by Andrew Bogan, Brendan Connor, and Prof. Elizabeth Bogan The Euro in Crisis: Prof. Christopher Sims Interview by Dilek Izek and Nivedita Singh Moving Toward a Monetary Union in East Africa

by Prof. Iqbal Zaidi The FDIC & Moral Hazard in the Financial Industry

by Dilek Izek Life of a Trader

by Julian He Word on the Street

by Jingwen Du, Sunny Jeon, and Jason Nong

ABOUT PCFC: The mission of the Princeton Corporate Finance Club is to provide an educational and networking platform for Princeton students interested in investment banking, private equity, venture capital and the field of corporate finance at large. Established in March 2011, the Princeton Corporate Finance Club has quickly become a prominent club on the Princeton campus with over 300 student members and 27 officers working in seven divisions: Education, Mentorship, Events, Industry Insight, Finance, Marketing, and Communication & Technology.

Our core values are fraternity, entrepreneurship, leadership, responsibility, integrity, professionalism and mutual respect.

Success on Wall Street:

A Conversation with Professor O. G. Sexton

Professor Sexton, member of the Board of Directors at Morgan Stanley, looks back on his 38-year career in Investment Banking. Having started his career at Morgan Stanley in 1973, where he served as Managing Director and Advisory Director prior to his current position, Professor Sexton has abundant experience in the industry. He is also an adjunct professor at Columbia Business School and has taught at Princeton University as Visiting Lecturer since 2000.

4 | THE PRINCETON FINANCIER

PF: You have been with Morgan Stanley for about 38 years now. What made you stay for so long when finance is usually a field with such high turnover?

“Well, it didn’t used to be so that the field had such high turnover. When I joined Morgan Stanley, it was much more the norm that you stayed for your career, so a lot of the people that I joined Morgan Stanley with had lifelong careers there.

The turnover in the field of finance is a relatively recent phenomenon that began in the last 20 years or so, so it didn’t seem so odd at the time.”

PF: What is it like being on the Board of Directors of one of the most important financial institutions in the world?

“It’s definitely engaging. You have to pay very close attention to world events and, of course, specifically what’s going on with the firm. Everything that happens in the world seems to affect the business of Morgan Stanley.”

“So being on the Board is exciting in many ways, but it is also quite demanding and requires you to pay close attention to what is happening. There is a lot of risk involved with the business so you have to be continuously observant.”

PF: Before you started working for Morgan Stanley, you were a naval aviator. Can you tell us about that experience and whether it helped shape your career in finance?

“I’m sure it did. When I got out of Princeton in 1965, I was in the NROTC in the regular program, so I was commissioned as an ensign in the regular U.S. Navy when I graduated. I went to flight school, and after that I spent three and a half years in the fleet.”

“It was a wonderful experience—great people and a wonderful mission. When a young man gets to fly jet airplanes off carriers, it’s a great experience. I’m sure it must have shaped me in many ways, but I couldn’t tell you exactly how because I am not sure what the alternative would have been. But it’s an experience I have always been very grateful for.”

PF: All of the major banks have taken a significant blow in the past six months because of the crisis in Europe. What is your opinion on what needs to happen both domestically and in Europe for the banks to start recovering?

“As long as the world economy remains very sluggish, the banks are going to struggle. Growth is not something that is a given in the economy. People become more optimistic or less optimistic for reasons that are not fully controllable by governments or by anybody else. So I think that we are going to have to get a period where people’s outlook becomes more optimistic and we start to see some growth coming back, at which point that would be the biggest single factor that would help the financial institutions.”

“We have a situation where what used to be thought of as safe-haven assets are no longer thought to be so safe, and that is causing fear and uncertainty to spread in the marketplace, which is very bad for financial institutions. It always has been, so this is nothing new. I think that most of the ones in the United States are strong enough to withstand the cynicism and skepticism that is in the marketplace right now, but no financial institution can withstand a complete breakdown. So we’ll just have to see.”

“We need for optimism and growth to return in the marketplace, and nobody sees how that is going to happen right now.

And you have to say, that’s why people are so pessimistic. That tends to be a mark of the bottom, so maybe we are at the bottom or getting there—we hope.”

PF: What changes do you see happening right now on Wall Street and what direction do you think the major banks are headed toward?

“Wall Street always reacts in the short run to pessimism and bad news. And in the way that most businesses do, they cut expenses and reduce the amount of risk that they are willing to take. And that is what has happened. I don’t think that, given the very low interest rates, it is a matter of banks being unwilling to lend so much as

it is borrowers not having good projects.

Nobody wants to borrow because they don’t see a way of paying it back, and that all has to do with optimism. Right now there is very little of it.”

PF: Many of our readers are students who want to break into Wall Street. Do you have any opinions on job prospects in the next few years?

“Right now, I would think that the prospects are probably as grim as they have been in some time. But there is always some hiring going on, and Princeton students tend to have an advantage because of their proximity to Wall Street and because they are viewed as being very bright, aggressive, and good employees.

So I would think many, many Princeton graduates, even in today’s environment, will find employment.”

“It may not be exactly what they might have gotten in better times, and it may not be for the same salary levels that they might have gotten in better times. But at least they’ll be able to get into the game.

Longer term, I think that Wall Street is going to be there, jobs are going to be there, careers are going to be there the same way they have been for the last couple hundred years. So longer term, people should take a fairly optimistic attitude, but short term I think it’s going to be tough.”

PF: Do you have any general advice for aspiring investment bankers?

“Persistence. Wall Street responds to persistence, and it always has. If you are turned down in your job search, redouble your efforts. If you try hard enough for long enough, eventually you will succeed.

That’s my experience on Wall Street.”

Interviewed by Philip Shin ’12.

THE PRINCETON FINANCIER | 5

CAN

ETF

AN COLL APS E?

BY ANDREW BOGAN, BRENDAN CONNOR,

AND ELIZABETH BOGAN

[

Exchange-traded funds (ETFs) are similar to mutual funds, but are listed on a securities exchange like a stock, providing intra-day liquidity that is not available to traditional open-ended mutual funds, which trade at end-of-the-day prices. In the past decade, ETFs have become extremely popular among investors in the United States, and increasingly in international markets as well. The average daily dollar turnover of the five largest ETFs in the United States was $11 billion in 2008, which was roughly three times that for the top stocks (according to NYSE Euronext ETFs Fact Sheet, 2009).

Like many innovations in finance that emerge from nowhere to explode in popularity with unknown consequences, ETFs have gone from obscurity when they were first invented in 1993 to making up more than half of all the daily trading volume on American stock exchanges today.

They also made up 70 percent of all the canceled trades during the Flash Crash on May 6, 2010 despite representing just 11 percent of listed securities in the United States, suggesting that ETFs remain poorly understood by both investors and regulators.

The extraordinary popularity of ETFs is undeniable. However, the source of this

6 | THE PRINCETON FINANCIER

popularity would seem to have two very different origins. ETFs are bought by many retail and institutional investors looking for low-cost and highly liquid vehicles with which to buy whole indices in a single trade, and ETFs serve that function well. But they are also extremely popular with, and widely used by, hedge funds and other traders looking for a simple way to mitigate broad-market risks with a single trade.

The appeal to a hedge fund manager of being able to short an entire market index or a whole sector with one transaction, instead of say 500 separate stock shorts to span the S&P 500 Index, makes ETFs very widely used as hedging vehicles by

]

short-sellers. It increasingly looks like many new ETFs are now being designed for the purpose of marketing them to short-sellers.

These seemingly opposite interests in ETFs make for a large and lucrative market not just for the ETF operators like BlackRock’s iShares and State Street Global Advisors’ SPDRs, but also for the authorized participants—institutions that can create or redeem large blocks of new shares in an ETF (called creation units) for sale, and countless brokers that profit by trading ETF shares.

Although ETFs often appear to be a benign innovation as compared to some of

Wall Street’s arcane derivatives, a closer look at the mechanics of short-selling ETFs, which have become one of the most prevalent securities to short, raises some serious concerns.

While an ETF owner believes their ETF shares represent ownership of the underlying stock in the index that the ETF tracks, that stock is not always all there.

Because of explosive short interest in some ETFs, owners of ETF shares often far outnumber the actual ownership of the underlying index equities by the ETF operator.

One might ask how that can be possible, but the creation and redemption mechanisms inherent to ETFs mean that shortsellers need not be concerned about the availability of shares outstanding when they sell an ETF short—since they believe they can always create new shares using creation units to cover short positions in ETFs in the future. In essence, there appears to be little risk to being short an ETF since the short seller can always “create to cover”.

This has led to some ETFs having shockingly large short interest as compared to their number of shares outstanding; and for every additional ETF share sold short, there is another owner of that share.

Take the SPDR S&P Retail ETF (NYSE: XRT) as an example. The number of shares short was nearly 95 million at the end of June 2010 while the shares outstanding of the ETF were just 17 million.

The ETF was over 500 percent net short!

Or to look at it from another perspective, the ETF’s operator, State Street Global Advisors, believed that there were 17 million shares of the SPDR S&P Retail ETF in existence and owned shares in the S&P Retail Index portfolio to underlie those 17 million ETF shares.

In the marketplace, however, there were another 95 million shares of the ETF owned by investors who had purchased them (unknowingly) from short sellers.

78 million of those ETF shares were serial short—that is they had been borrowed and re-sold more than once—or

they were naked short (not borrowed at all). The short sellers had promised their prime brokers to create those non-existent shares (above and beyond 100 percent of the shares outstanding) if necessary to cover their short in the future.

In both cases, the share-buyer, however, is completely unaware that his ETF shares were purchased from a short-seller and no doubt assumes the underlying assets in the index are being held by the ETF operator on his behalf, but no such underlying stock is actually held by anyone.

Clearly this creates a serious counter-party risk and quite possibly the potential for a run on an ETF—where the assets held by the fund operator could become insufficient to meet redemptions.

ETFs Become Fractional Reserve Stock Ownership Systems through Short-Selling The unique structure of ETFs, which allows for massive short positions to build up with little regard to the number of shares outstanding, creates a fractional reserve stock ownership system. As short interest builds in the ETF shares themselves, the underlying index equities held

assets held in index stocks by the ETF operator. The difference between the value of the total ownership of the ETF and the value of the underlying assets is promised back in the future by a series of unknown short selling counter-parties (myriad hedge funds) that post collateral, of unknown composition, against all their short positions (traditional or serial) in the ETF. Only a fraction of the ETF owners’ underlying index shares are actually available from the ETF fund operator, the rest are effectively loaned out. The ETF, through short-selling of the ETF securities, becomes a fractional reserve system for owning the underlying index shares.

To illustrate this fractional reserve behavior, consider the SPDR S&P Retail ETF (NYSE: XRT). On June 30, 2010 it had 16.9 million shares outstanding and index stocks underlying those shares outstanding worth approximately $600 million held by the ETF trust.

But the total ownership on June 30 of XRT was about 112 million shares (since 94.9 million shares were sold short in addition to the 16.9 million shares outstanding). That means the total value

IN CONTEXT:

The first ETF, introduced in 1993, was Standard & Poor’s Depository Receipt (SPDR), nicknamed “spider,” which tracked the S&P 500 Index. Spiders were soon followed by other products, each tracking a different index, such as “diamonds” based on the Dow Jones Industrial Average and “cubes” based on the NASDAQ 100 Index. by the ETF operator become a fraction of the implied ownership of the ETF in the market—the rest is promised by borrowers (short-sellers through their prime brokers in this case).

The market value of the total ownership of the ETF far outstrips the underlying

of the long positions at XRT’s price of $35.65 on June 30, 2010 was $4 billion.

The ETF operator only held 15 percent of the implied ownership in underlying assets (actual shares of the index equities)—it held a 15 percent fractional reserve of the S&P Retail Index stocks it

THE PRINCETON FINANCIER | 7

tracks. The remaining 85 percent ($3.4 billion) was promised back, should it be needed, by short sellers who had posted collateral with their prime brokers.

characteristics of a fractional reserve system apply to either a traditional listed stock or to a traditional stock mutual fund—or to most derivatives.

Similarly, if all the counter-parties can make the payments equivalent to the shorts created in ETFs, then there is no problem.

To the long holder of XRT, there was no transparency whatsoever as to which hedge funds were short, which prime brokers were holding collateral, or what the composition of the collateral was.

In the case of the stock, it is not redeemable at all by anyone, so there can be no rush to redeem with inadequate assets available­ —no assets are available; one holds a share ownership of a business that can be sold, but not redeemed.

But when financial markets are in trouble, many dealers and hedge funds cannot meet their obligations. And since there are more shares owned of the ETFs than actual equities behind them, many owners of ETFs would be shocked to realize they had no claim on the underlying shares and their ETF could be worthless.

Since ETFs are redeemable through authorized participants, and they are fractional reserve in nature once short-selling occurs in the ETF securities themselves, it would appear that a run on an ETF might be possible. As the long history of fractional reserve banking has taught us, fractional reserve systems work well under normal conditions, but are very fragile in extreme conditions or panics.

That is why the United States has the Federal Deposit Insurance Corporation to insure small depositors, reserve requirements for banks, and a lender of last resort capable of printing money called the Federal Reserve to backstop the banking system. Other countries around the world have similar safeguards and institutions to protect fractional reserve banking.

There are currently no equivalent safeguards for ETFs even though the aggregate short interest in these securities in the United States was worth more than $100 billion as of September 2010. It is important to note that none of these

In the case of a stock mutual fund that is redeemable, the fund manager typically holds 100 percent of the redeemable assets and they can be delivered as cash or in kind depending on the liquidity in the underlying positions, irrespective of the financial health of various counter-parties or borrowers. That is very different from an ETF, and this difference is very poorly understood by many retail and professional ETF owners.

So what’s the problem?

An ETF is not a problem in normal markets any more than fractional reserve banking is a problem without bank runs.

Nonetheless, because everyone could ask for their money at the same time, the FDIC was created to insure deposits at banks.

With deposit insurance, though only a fraction of the deposits in banks is held in cash reserves or at the Fed, there is no reason to ask for their money if everyone knows their deposits are insured.

“Who gets left holding the bag if there are panic redemptions of ETFs? Is it the retail account holders who own defunct shares in a closed ETF? The prime brokers that were counter-parties to all those short sellers?

The hedge funds that sold non-existent shares in an ETF assuming they could always be created another day? The ETF operator?

Or the Federal Reserve?”

8 | THE PRINCETON FINANCIER

Who gets left holding the bag if there are panic redemptions of ETFs? Is it the retail account holders who own defunct shares in a closed ETF? The prime brokers that were counter-parties to all those short-sellers? The hedge funds that sold non-existent shares in an ETF assuming they could always be created another day? The ETF operator? Or the Federal Reserve?

It is not currently a responsibility of the Fed, but neither were money market mutual funds until people started to run them in 2008 and the Fed stepped in to avoid systemic risk. Would the Fed step in to cover ETFs? And if not, would there be a domino effect on other financial institutions, i.e. systemic risk?

Elizabeth C. Bogan, Ph.D. is Senior Lecturer in Economics in the Department of Economics at Princeton University.

Andrew A. Bogan, Ph.D. (P ’96) is Managing Member of Bogan Associates, LLC, a global equity fund management firm based in Boston, Massachusetts.

Brendan Connor is an investment analyst in New York City.

THE EURO

IN CRISIS:

WHAT LIES

AHEAD a conversation with Nobel Laureate Christopher Sims PF: The Euro crisis is undoubtedly one of the popular and controversial issues today.

What do you think are the implications of the Euro crisis for the theory of Optimum Currency Areas?

“I think that the optimum currency area theory emphasized the wrong thing. Not the wrong things, but just missed some of the important things about common currencies. It was all about whether business cycles were highly correlated or not and the idea was that, with the common currency, countries could not have independent monetary policy.”

“If you look at the U.S. states, they have booms and busts that are not coordinated —and it was even more so in our earlier history. Much more important is whether people are willing to integrate their banking systems and have a single regulatory regime across countries with a single regulator. That is what I think caused the problems. They tried to do this while still officially keeping the regulatory regime separate country-wise, and yet encouraging the integration of financial institutions and markets across countries.”

PF: I have read before that Europe does not

10 | THE PRINCETON FINANCIER

fit even the initial criteria set forth in Optimum Currency Area literature. What are your views on this?

“I don’t think the initial criteria are absolutely necessary, actually. That was my point about the U.S. states. You have route 128 in Boston booming, Silicon Valley booming and at the same time Detroit crashing. Nobody says it is a problem that Michigan does not have an independent monetary policy.”

“Besides the integration of the banking system, there is the issue of labor mobility. You can say that there aren’t any jobs in Detroit but people should move to Massachusetts or California. But in practice, if you are fired from a job in a motor factory, you don’t just go and become a computer programmer in Massachuchesetts or California.”

“Yet it is still true in principle that people can move—and do—more freely between states than they can between countries.

You have different languages in Europe.

But it’s not insuperable. They are trying to encourage more mobility there. They had the mistaken idea that if you first did this with money, things like labor mobil-

ity would follow, but that may have been too optimistic in that regard.”

PF: Do you think it might ever become desirable for countries like Italy, Greece, Portugal or Spain to exit the Euro from an economic cost-benefit analysis perspective?

“It could be. It all depends on what the Euro area does in terms of making deals with countries like Portugal. There is first the question of whether the European Central Bank and other Euro countries are going to back up government debt of the Southern Tier countries. That would be a big benefit to staying in the Euro.

But if they don’t and demand severe austerity—and it could be that even with the austerity they don’t actually get rid of their budget problems,—this will not improve the budgetsof Southern European countries in the short run and will increase the speculative interest rates.”

“In that case it would be hard to argue that things would be a lot worse if they got out of the Euro. Getting out of the Euro would be one way to default, and the advantage of this over straight default is that it allows you to devalue so you don’t have to get your costs in line with

the rest of the Euro area by having actual deflation of wages and prices. It would be costly in the short run, because you would lose your ability to borrow in international markets—at least temporarily.

All your contracts would be thrown into court because people would have to redenominate the contracts. The government would be saying that the contracts written in Euros, if done in Portugal subject to Portuguese law, should be in the new Portuguese currency, but there would be questions about whether they are in Portuguese law or some other country’s and there would be suits even within Portuguese courts. There would be a big mess for a while.”

rejected because he did the right thing.

But in the case of Italy, people got the idea that he wasn’t doing anything. So it may be that no matter what you do, people are going to get angry with you that you end up being thrown out of office.”

sure. And if it rescued the Southern Tier countries at the cost of starting substantial inflation in Europe, you might find Germany and Finland wanting to get out. And that could unravel it in the other direction.”

PF: Do you think the Euro could cause the disintegration of the European Union?

PF: So if the European Central Bank (ECB) does act as lender of last resort, do you think it could bring about further consolidation in the process of getting fiscal backing for the ECB?

“It definitely could. People recognize Greece as a special case because it essentially falsified its books to get into the EU. The other countries—Ireland, Portugal, Spain and Italy—that are in trouble did not falsify anything, and before the crisis looked fiscally responsible.”

“You might hope so. This is what worries the Germans. If the ECB did that, Italy and Spain would relax and they would cease to work very hard about their fiscal problems. If the ECB bails out these PF: What about the political pressures in“But if even one of them dropped out, countries, it will remove the pressure on volved? the Southern Tier countries, and then they will “I think ‘political probbe left with the option “Getting out of the Euro would be one lem’ is a better way to of staying in the Euro. way to default, and the advantage of describe it. People with If they stay in the Euro, interests in different they will have to tolerthis over straight default is that it allows countries have to figure ate inflation or put up you to devalue so you don’t have to get out how to compromise with a fiscal burden or those interests if the get out.” your costs in line with the rest of the Euro is to be saved. They Euro area by having actual deflation of have to decide who will “So it could just change have to bear the burden the pressures but make wages and prices.” of the losses on any dethe pressure for the disfaulted debt. In every solution of the Euro still country, people will preas strong as ever. What fer that they not have to pay much of the then I think there would be a snowball you would hope for is that the ECB costs. The trouble is that not everybody effect. Not because the other countries would step in and in the process extract can be satisfied. That is what politics is would think that it is a good idea—bereform in the European Monetary Union all about: balancing interests and finding cause the immediate consequences of governments that would make people ways to make compromises.” those who left would look pretty bad— confident that this kind of situation but rather because financial markets would not repeat—that if countries again “The problem is, all the politicians inwould now see the probability of every run big deficits and get into trouble, the volved in these debates are elected by country that is on the margin leaving the ECB will not bail them out again. If you purely national constituencies. They are Euro as much higher. The default precould arrange that, that would be the not part of any supranational institution, mium on interest for their government ideal outcome. so getting them to sacrifice some of the debt would shoot way up, and that may interests of their constituents for a broadmake default inevitable. And if default is PF: The main objection to the ECB acting er good is very difficult. Good politicians inevitable, then it may start to seem that as a lender of last resort seems to rest on the with strong leadership abilities might be being out of the Euro is the right thing.” claim that the Maastricht Treaty precludes able to make a difference, but some of such a possibility. How binding do you the problem is that the public in these “There is the other scenario that I menthink is the Maastricht Treaty in reality, escountries just doesn’t understand what’s tioned in class, which is what happens if pecially given how the budget deficit restricgoing on and is angry and the politician the ECB does intervene to support the tions were violated by virtually all countries who did the right thing might be rejected debt of these countries. But there is no following the financial crisis? from office.” resolution as to how there is going to be fiscal backing and as a result the ECB “What is absolutely forbidden is that they “The Greek Prime Minister was probably might end up creating inflationary prespurchase government debt. They are al-

THE PRINCETON FINANCIER | 11

lowed to purchase almost anything they want to in order to preserve financial stability. They can lend money to banks who then buy government debt. They could argue that they weren’t going against the Treaty. The Germans, of course, think that the Treaty was written the way it was precisely to prevent the lender of last resort function, so they would be angry.”

in the Euro, what would be happening is that they would be devaluing to some extent, becoming more competitive. Germany would be in trouble because its export markets would be drying up.”

PF: Considering that the United Kingdom is in a somewhat similar situation, do you think that the Euro is responsible for the problems facing Greece, Italy, Spain, and Portugal?

“The problem is that we don’t really know. Everyone is worried about what the fallout from the Euro collapse would be. An ECB lender of last resort operation wouldn’t hurt the United States, and staving of a crisis would be good.”

“Yes. Look at India. India is an example of a developing country that is heavily indebted, but its debt is mostly denominated in domestic currency. In the last few months, India’s exchange rate has deteriorated drastically, but it is just the exchange rate going down. It is causing some adjustments in the economy but it is not causing a speculative attack and people worrying that something is going to collapse. And the same can be said of England. They have got high debt and it is not exactly clear how they’re going to get rid of it. They might have to inflate, but they won’t default because they don’t have to default.”

“Hence, I think it is perfectly clear that if the Southern Tier countries were not

PF: What do you think might be the implications of the Euro’s collapse for the American economy?

“If the Euro came apart, it would truly depress the U.S. economy and hurt our exports. It would have adverse effects on many U.S. financial institutions that have lent to Europe. But we don’t have a very clear idea. This is something we have learned from the Lehman crisis. It is very hard to know where the effects of a failure or default of a big institution are going to end up. We have had financial crashes before that haven’t had widespread effects.”

the Lehman Brothers crashed, and no amount of monetary intervention actually was enough. You could hope that the Euro crash would end up being like the 1987 stock market crash. But, like I said, there is no way to know in advance.”

PF: Is there any message that you would like to share with our readers as they prepare for the first stage of their careers in finance?

“Don’t have a too narrow professional focus while doing your undergraduate education. You should take Math even if it doesn’t seem relevant. Take courses in subjects that interest you other than your major or focus. The amount you can learn about finance as an undergraduate is limited anyway, so the notion that you are preparing for your career is not true.

You never know where you might end up in the future and where your career will lead you.”

Interviewed by Dilek Izek ’13 and Nivedita Singh ’13.

“It made people a little overconfident that we’ve been able to handle the dotcom crash and the 1987 stock market crash. These were big declines in asset prices, and there was a little monetary intervention and it all went away. Then

Dilek Izek ’13 and Nivedita Singh ’13 interview Professor Sims in his Fisher Hall office.

12 | THE PRINCETON FINANCIER

MOVING TOWARD A

MONETARY UNION

IN EAST AFRICA The Theory of Optimum Currency Areas & Macroeconomic Convergence in the East African Community

By Professor Iqbal Zaidi

The countries of the East African Community (EAC)—Burundi, Kenya, Rwanda, Tanzania, and Uganda—have signed a Treaty, which states, among other things, that the EAC members shall establish “a Customs Union, a Common Market, subsequently a Monetary Union and ultimately a Political Federation.”

The Customs Union was established in 2005, the process for completing the Common Market was started in 2010, and the achievement of the monetary union is slated for 2012. Even if it seems that the target date for the EAC monetary union will likely be pushed back— because a number of preconditions for a monetary union have yet to be met—it is important to consider what steps the EAC authorities should take to ensure a successful transition to the monetary union. In this connection, this paper focuses on the theory of optimum currency areas to analyze the implications of the balance of payments and fiscal constraints of a monetary union, and what the analysis suggests for the design of appropriate fiscal and monetary institutions in the union.

Some definitions are useful at the outset.

The term “currency area” is used in this paper to refer to a territory within which there is a common monetary unit. This is clearly the case if there is a common currency, but essentially the same conditions prevail if there are different currency units with irrevocably fixed exchange rates between them, provided that no restrictions on the conversion of one unit into another are present. The term “optimum currency area” refers to a group

14 | THE PRINCETON FINANCIER

of countries for which it is optimal that internal adjustment occurs with exchange rates fixed, while external adjustment (between member countries and non-member countries) occurs through exchange rate variation.

money is enhanced and the efficiency of resource allocation is improved.

The term currency area is commonly defined to be identical with what Corden (1972) has characterized as “complete exchange rate union” or “monetary integration”. It is “an area within which exchange rates bear a permanently fixed relationship to each other even though the rates may—in unison—vary relative to nonunion currencies,” and one which is characterized by “the permanent absence of all exchange controls, whether for current or capital transactions, within the area.”

Mundell (1961) suggested in his pioneering article that the cost of the balance of payments constraint in a monetary union, or what amounts to the other side of the same coin, namely, the loss of monetary policy as a tool for stabilizing employment in a member country, depends on the degree of factor (capital and labor) mobility. He argued that regions or countries featuring high factor mobility should join together in a single currency area or a multicurrency area with fixed exchange rates, whereas those areas whose factors are relatively immobile should adopt flexible exchange rates visà-vis each other. Factor mobility between countries reduces the need to use domestic policy instruments for relieving conditions of excess or insufficient demand for output or employment.

In the optimum currency area literature, the choice between fixed and flexible exchange rates is dependent on the economic characteristics of the countries in question, and the analysis recognizes that there are both costs and benefits involved in choosing fixed or flexible exchange rates. Economists have developed various analytical frameworks for the analysis of the costs and benefits of a currency area, which focus on the particular characteristics of a country planning to join a currency area.

The major cost is that the use of discretionary monetary policy to achieve internal balance is limited because of the balance of payments constraint, which dictates that wage and price trends must be adjusted to maintain external balance. The major benefits of currency area formation are that the attractiveness of

The Balance of Payments Constraint in a Monetary Union

More specifically, if there were to be, say, an economic downturn in Tanzania and a resultant increase in unemployment, this problem could be mitigated if labor were to move from Tanzania to other countries in the EAC, and/or capital inflows were to increase, thereby promoting fixed investment and employment.

In the event of an exogenous shift in demand away from Tanzanian goods and services towards, say, Kenyan goods and services, the optimal currency area literature would suggest that some Tanzanian

workers should move to Kenya, assuming there is sufficient labor mobility (i.e., legal, economic, language, cultural and other barriers are not very important).

However, if Tanzanian workers do not move because of such barriers, then this outlet for resolving the unemployment problem is blocked, and there would be high costs from subordinating national monetary policies to the common regional monetary policy in order to maintain fixed exchange rates.

In fact, the problem could actually worsen because capital tends to move relatively quickly compared to labor in a monetary union: because of the shift in demand away from Tanzanian goods, firms may find it profitable to move capital to other EAC countries, thereby reducing investment and aggregate demand in Tanzania.

The key policy recommendation is that before proceeding to a monetary union, member countries must first implement structural reforms to ensure that not only is there free trade in goods and services, but that there is a right of establishment for firms and free movement of labor and capital.

McKinnon (1963) added the insight that the cost of sacrificing monetary autonomy also depends on the openness of the countries. Flexible exchange rates basically set the price level in terms of domestic output, whereas fixed exchange rates set it in terms of foreign goods. Thus, the greater the extent to which domestic consumers buy mostly foreign goods, the stronger will be their preferences for holding assets and doing the accounting in terms of foreign goods unless domestic money is made stable in relation to the consumption basket via fixed exchange rates.

In this sense, exchange rate flexibility in a small open economy may reduce the “moneyness” of the currency. In addition, the more open the economy is, the less effective monetary policy will be in achieving domestic stabilization objectives under flexible exchange rate, and the less costly it is to sacrifice monetary autonomy; the more open an economy,

“A single or ‘one-size-fits-all’ monetary policy for the entire union means that if countries were to first achieve a sufficient degree of economic and monetary convergence, they would face lower costs in terms of the loss of national discretion in the conduct of monetary policy.”

THE PRINCETON FINANCIER | 15

the less likely it is that there will be money illusion or that workers will agree to contracting their pay in domestic-money terms. When money illusion declines and domestic residents get into the habit of calculating the impact on real variables of changes in the exchange rate, there will also be a decline in the effect on domestic output or other important real variables of a given change in the exchange rate.

Economists have added other criteria for the choice of a partner for monetary integration to those stressed by Mundell and McKinnon for joining a monetary union. It has been argued that prospective partners in a monetary union should have similar preferences regarding the “desired” or “tolerable” rate of inflation.

To the extent that prospective members of the union possess common tastes concerning inflation, it is easier to join because monetary integration results in an automatic transmission of inflation throughout the integrated domain.

In other words, only when inflationary preferences are similar would one expect countries to be willing to subordinate their national monetary policies to the common regional policy in exchange for the benefits of a monetary union.

The seriousness of this limitation for the union countries depends on the degree of asymmetry of shocks and the speed with which the economies adjust to these shocks. If disturbances are distributed symmetrically across union countries, a common response will suffice; otherwise the economies will need sufficient wageprice flexibility to adjust to the shocks.

A single or “one-size-fits-all” monetary policy for the entire union means that if countries were to first achieve a sufficient degree of economic and monetary convergence, they would face lowers costs in terms of the loss of national discretion in the conduct of monetary policy. In other words, monetary and exchange rate stability depend on the convergence of economic performances of the countries in a currency area, particularly on that of the GDP growth rates and relative price trends.

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In this regard, the EAC’s regional economic integration agenda includes a macroeconomic convergence program, intended to achieve and maintain macroeconomic stability in the region. According to the World Bank and United Nations Development Program (UNDP) data, all five EAC-member countries fall in the lowest category of UNDP’s Human Development Index, and poverty alleviation remains a major challenge throughout the region. Per-capita income ranges from $790 in Kenya to as low as $170 in Burundi in 2010.

Numerous studies indicate that when exchange rate changes are justified by differences in relative economic performances, such as differences in inflation rates, attempts to defer the exchange rate changes too long can result in costly distortions in the allocation of resources. In the search for stable exchange rates, the main efforts in the short and medium term must be concentrated on the convergence of prices, and monetary policy may be used to prevent unfavorable inflation differentials.

Table 1: Real GDP Growth (percent per annum)

The EAC countries have had higher growth rates in the past three years, compared to the Southern African Development Community (SADC), which is another regional association in Africa aiming toward a monetary union, but there are still significant differences in growth rates amongst the EAC countries.

Rwanda had a growth rate of 7.5 percent in 2010, compared to 3.5 percent for Burundi.

If countries agree to maintain stable nominal exchange rates amongst themselves but at the same time allow price divergences to continue, their real exchange rates, as measured by relative national prices or costs expressed in a common underwire, will also diverge. Thus, under a system that emphasizes nominal exchange rate stability, real exchange rates could get out of line, and could remain out of line for longer periods, than under alternative arrangements where exchange rate adjustments occur regularly as a result of either political decisions or market forces.

In this context, it may be interesting to review price developments in the EAC countries, focusing in particular on the extent to which national inflation rates have converged in recent years. As reported in Table 2, the average inflation rate for the EAC countries declined during 2005-07, increased during 2008-09, but has again started to decline, a trend that is projected to continue next year.

Also, there are significant divergences in inflation rates, with Tanzania’s inflation rate of 10.5 percent in 2010, compared to 2.3 percent for Rwanda.

The Fiscal Constraint & Fiscal Convergence Criteria in a Monetary Union In moving toward a monetary union, experience suggests that binding fiscal commitments are necessary, not least to prevent one country from borrowing heavily to finance unsustainable fiscal deficits, which could have serious negative spillover effects on other countries in the union. The counter argument is that such constraints are unnecessary, because

Table 2: Inflation Rates (percent per annum)

financial markets will impose the necessary fiscal discipline on individual countries. However, the recent experience in Europe indicates otherwise.

removing the exchange rate risk and thus the exchange risk premium, the Euro also contributed to Greece’s debt problem in terms of creating a moral hazard problem.

Indeed, all existing monetary unions have established some fiscal constraints as preconditions to entry into the union, and moreover, have required ongoing commitments to various criteria by all members. Regarding the European example, until recently, lenders did not add a risk premium to loans to Greece, Portugal and other heavily indebted European countries. They charged these borrowers almost the same as they charged the German government, which has pursued a much more prudent fiscal policy. The lenders eventually realized that Greece and some other countries had borrowed beyond their capacity to repay, but this only exacerbated the debt crisis as lenders became more discriminating and demanded large risk premiums.

There was widespread perception that the Euro project would not be allowed to fail because of financial distress in relatively small countries, and despite the explicit “no bail-out clause” in the Euro Treaty, market participants expected that these countries would receive some sort of assistance. These are important considerations to keep in mind in the design of monetary unions, because the Maastricht Treaty requires that members that want to remain in the economic and monetary union maintain a restrictive fiscal policy: a maximum ratio of government deficit to GDP of 3% and a maximum ratio of government debt to GDP of 60%.

Sovereign borrowers, like Greece, are generally considered low-risk because they can tax their citizens to repay borrowed money. But as Argentina, Russia and others have shown, there are limits to taxation. Unless lenders (buyers of sovereign debt) think that other countries will bail out sovereign borrowers, they will demand an interest rate that reflects their assessment of the borrower’s default risk.

When Greece adopted the Euro as its currency, it removed the exchange rate risk, that is, the risk that Greece would devalue its currency--if lenders had denominated their loans in the Greek currency--and thereby reduce the foreign currency value of what it owes its lenders. In addition to

had larger fiscal deficits than Tanzania and Uganda, attributed at least in part to the former’s relatively low reliance on donor assistance.

However, the picture is vastly different when fiscal deficits are measured without donor grants (Table 4), because it is not Kenya but the other four EAC countries that have large deficits according to this measure. When a country relies heavily on foreign assistance—as is the case for the EAC countries, except for Kenya-— government domestic expenditure is a major determinant of economic activity and the pace of monetary expansion.

Receipts of foreign assistance accrue directly to the governments in the form of government deposits with the central bank, and the initial impact on the money supply of foreign assistance, which would tend to increase the banking system’s net foreign assets, is offset by a corresponding increase in government deposits. It is only when the government spends the increased revenues domestically that the money supply expands.

This is the essence of the “domestic budget balance” approach, in which the components of the monetary accounts are re-arranged to emphasize that the

Table 3: Fiscal Deficits (including grants, percetage of GDP)

The EAC countries have taken steps in designing fiscal convergence criteria but have slightly modified the original Maastricht criteria. Even after excluding Burundi from the analysis because of the exceptional circumstances in the country during the sample period, it is still the case that there are sizable differences in fiscal deficits. In particular, Kenya has

inflow of foreign exchange from foreign assistance is translated into increases in domestic liquidity only to the extent that the government uses the higher revenues to increase the domestic expenditures.

Thus, the main transmission mechanism for fluctuations in foreign assistance to impact domestic prices and output is the government budget, and any excess li-

THE PRINCETON FINANCIER | 17

quidity is translated into demand for foreign goods and services (higher imports) and/or expenditures on non-traded goods and services.

The domestic budget balance approach suggests that the fiscal convergence criteria for the monetary union should include at least two measures of the budget deficit (i.e., including and excluding foreign grants) in those situations where there are some members that rely on large foreign grants in the government budget.

The fiscal convergence criteria for the two different budget deficits (i.e., excluding and including grants) would allow the supranational body responsible for the monitoring and enforcement of these criteria to take into account sharp fluctuations in aid inflows to member countries, and make a judgment as to whether there could be inflation and interest rate spillovers into other countries.

gence or even fiscal federalism? What does this imply for fiscal convergence criteria, and the need for credible enforcement mechanisms? There are no easy answers to these questions, but the Greek episode points to the need to regularly carry out debt-sustainability analyses (DSAs) for member countries in a monetary union to ensure that countries do not engage in excessive borrowing. In this regard, it should be recognized that the examination of fiscal and external sustainability in developing economies is a very tall task, and made all the more so when there are large aid inflows.

What is sustainable fiscal policy and external borrowing? A brief answer would be a policy stance that can be continued indefinitely without modification, that is, no adjustment to primary deficit (government deficit excluding interest payments), no default (by higher inflation or otherwise), and the intertemporal solven-

Table 4: Fiscal Deficits (excluding grants, percentage of GDP)

For example, if the region were to find itself in a period of macroeconomic instability, and the inflation and interest rate spillover effects from the aid inflows to one or more members were sufficiently large to have adverse implications for price stability in the region, then an argument could be made for not spending the foreign aid until after the successful stabilization of the economy.

Tighter fiscal monitoring in the EAC countries may be one of the lessons to draw from the recent European experience, not least to reduce the likelihood of a replay in East Africa of the Greek scenario in the current financial crisis.

Does this mean that there will have to be progressively more de-facto fiscal conver-

18 | THE PRINCETON FINANCIER

cy constraint of the public sector must be satisfied under all likely scenarios. This last point is often translated to mean rules to stabilize the debt stock (ratio to GDP).

In this regard, the staff of the International Monetary Fund and the World Bank carry out DSAs, comparing baseline 20year projections to various thresholds of debt sustainability, and they explore vulnerability to policy/external shocks in alternative scenarios and under standardized stress tests, which could be used by the EAC Secretariat to monitor compliance of fiscal convergence criteria.

Regarding recent evolution of public debt in EAC countries, it is noteworthy that improved fiscal positions, higher growth,

and the provision of debt relief have led to a significant reduction in debt levels.

Public debt in EAC has fallen to 40 percent of GDP in 2010 from 69 percent in 2004 (Table 4). The improvement has been greatest in the low-income countries, which benefited from debt relief under the Heavily Indebted Poor Countries (HIPC) initiative and the Multilateral Debt Relief Initiative (i.e., all EAC countries except Kenya).

The fiscal convergence criteria—the set of rules governing fiscal policy for countries in the EAC Monetary Union—will have to be designed with some care for a number of reasons, including the divergences in per capita income levels, varying capacities to bear debt burdens, and differences in reliance on foreign assistance for the government’s budgetary needs.

Like all rules, they ought to be operationally simple and transparent. However, the design of these criteria must avoid an excessively mechanistic procedure for dealing with breaches of the fiscal deficit limit, because of the problem of unavoidable or unforeseen circumstances, such as sharp fluctuations in foreign assistance and/or international terms of trade. However, there should be less flexibility with regard to the debt ceiling because the member country has ample opportunity take remedial actions when it approaches that constraint.

The criteria must be designed in such a way that they perform the function of alarm bells, but with enough flexibility to ensure that policymakers’ answer is not to mute the alarm because they view the violation of the rule as sound economic policy. The criteria should garner a real commitment on the part of all policymakers to adhering to what are seen to be well-designed rules and a willingness to adopt policies of fiscal consolidation and structural reform, as and when indicated by the rules.

In fact, the convergence criteria are more than alarm bells, and are intended to foster disciplined, forward-looking fiscal policies. As with monetary policy, it is now widely accepted that the tendency

Table 5: Public Debt (percentage of GDP)

for governments to loosen fiscal discipline for political reasons can be checked through a rules-based framework for fiscal policy that constrains policymakers’ discretion. This result from the rules vs. discretionary policy debate, together with the point mentioned earlier on the negative spillover effects of excessive borrowing by one member, are the core arguments for the fiscal convergence criteria.

toward coordination of financial policies, including bank regulations, exchange arrangements, and budgetary procedures.

Considerable progress has been made in promoting a Common Market with free movement of goods, services, capital, and labor among member countries of the EAC, as well as with regard to a common external tariff on imports from other countries, but more remains to be done.

Conclusions

Given the constraints against the use of trade restrictions, exchange rates and monetary policy as instruments for stabilizing employment in member countries, ensuring the consistency of the internal goal of full employment with the balance of payments constraint is an essential responsibility for fiscal authorities. However, fiscal constraints are needed in a monetary union to reduce the risk of moral hazard and debt default by any member country. If a non-member country were to incur unsustainable fiscal deficits, it would eventually reach a point at which it would be unable to make interest payments and have to restructure its debt.

The commitment to regional monetary integration will limit the use of exchange rate and monetary policy for domestic stabilization purposes, because the exchange rates of the EAC countries will bear a permanently fixed relationship to each other (and eventually there will be one currency for the region), and the exchange rate may vary relative to nonunion currencies only in unison.

This balance of payments constraint is an important insight of the optimum currency area literature, suggesting that in the transition to a monetary union, divergent monetary and inflationary trends amongst prospective member countries would lead to external imbalances, which would have to be corrected through offsetting movements in foreign reserves.

In this respect, there may be scope for greater monetary coordination amongst the EAC countries, particularly in light of the finding that the differences between the rates of inflation among member countries have not narrowed in recent years. Indeed, this has been recognized by the EAC countries, and the member countries are presently working

Debt restructuring has its costs, but these costs would be borne by the country itself. However, these costs can be spread out to other countries in a monetary union, and in particular, political pressures might be put on the regional central bank to generate inflation to reduce the real value of the debt, which is denominated in the common currency.

Alternatively, a member country could default on its debt, which would likely mean contagion effects rippling throughout the monetary union, as lenders impose a sovereign risk premium on interest

rates for all countries with the common currency. This risk of debt distress and default by a member country spreading throughout the union is one of the major arguments for fiscal convergence criteria in a monetary union, that is, members should not be allowed to breach a ceiling for a maximum budget deficit level, or a maximum overall public debt-to-GDP ratio.

However, in the case of the low-income countries, one would have to take into account the concessional terms on which much of the external borrowing is done and varying capacities to bear debt burdens among the EAC countries. The net present value of debt and related concepts from DSAs would have to be incorporated into the fiscal convergence criteria, which suggests that they will have to be designed in a more nuanced fashion than some straightforward fiscal deficit without grants and a simple debt-to-GDP ratio. Let us acknowledge that considerable work has already been done but still greater efforts are required to meet the challenges that lie ahead in the formulation and implementation of appropriate monitoring and enforcement mechanisms in the proposed EAC monetary union.

Iqbal Zaidi, Ph.D. (GS ’ 84) is Lecturer in the Woodrow Wilson School for Public and International Affairs, Princeton University.

References Corden, Warner Max, Monetary Integration, Essays in International Finance No. 93 (Princeton, New Jersey: Princeton University, 1972).

Eichengreen, Barry “Stress Test for the Euro,” Finance and Development (June 2009), pp. 19-21.

McKinnon, Ronald I., “Optimum Currency Areas,” American Economic Review (Nashville, Tennessee), Vol. 53 (September 1963, pp. 71725.

Mundell, Robert A., “A Theory of Optimum Currency Areas,” American Economic Review (Nashville, Tennessee), Vol. 51 (September 1961, pp. 657-65.

World Bank. 2009. World Development Indicators. http:// data.worldbank.org. Accessed November 25, 2011.

THE PRINCETON FINANCIER | 19

THE

FDIC AND Moral Hazard IN THE

FINANCIAL

INDUSTRY

[

Acting Chairman of the FDIC Martin Gruenberg `75 spoke on the regulatory response to the financial crisis on November 28, in a lecture sponsored by the Woodrow Wilson School.

The first “inkling of what was to come” came in August of 2006, Gruenberg began, when he received a phone call from Martin Eakes, the CEO of the Center for Responsible Lending, a leading consumer advocacy and research group in the field of financial services.

Eakes, who graduated from the Wilson School’s MPA program in 1980, told Gruenberg that a new mortgage product had effectively taken over the subprime mortgage market. “They called it a hybrid ARM, 2/28s and 3/27s,” Gruenberg said, explaining that the two and three stand for the initial term of the 30-year mortgage during which rates were low.

“There were thousands of these mortgages being made, at an interest rate for the first two years that was relatively

low, but after the first two years, there was a sharp adjustment of three or four or more percentage points.” Eakes also told him that the big volume of the adjustable-rate mortgages had been made in 2004 and 2005, and thus would start coming due for the upward adjustment in 2007, he said.

Though this was “pretty dramatic stuff in the August of 2006,” Gruenberg remarked, “the sad truth was that, as dramatic as Martin’s warnings were, they actually underestimated significantly the dimensions of the problem.”

Although subprime mortgage lenders understood that the borrowers would not be able to meet mortgage payments at the adjusted rate, they assumed refinancing would be possible at the end

]

of the two or three year term, during which housing prices would surely rise. “Of course, when you re-finance a mortgage, you generate a whole new set of fees, and it was a very good business for these mortgage lenders,” Gruenberg said.

What triggered the collapse of the mortgage market was that, despite having risen every year since World War II, housing prices in the United States began to fall in 2007. As mortgage rates were adjusted upward in 2006 and 2007, the wave of foreclosures was set into motion, and nearly 11 million homes have entered into foreclosure over the last five years.

The key to the crisis was the securitization of these mortgages, and the develTHE PRINCETON FINANCIER | 21

opment of a large private-label mortgage-backed securities (MBS) market, Gruenberg said. “These were Wall Street firms packaging these subprime mortgages into MBS, and selling those securities to investors and large financial institutions, not only in the United States, but around the world.”

“And selling the mortgage-backed securities wasn’t enough; they created derivative products off of these MBS called collateralized debt obligations.

And then they created derivatives off of the derivatives called CDO-squared.

To manage the risk, they used other derivative products called credit default swaps.”

“A house of cards built up, and at the foundation were these thousands of subprime mortgages that were atrociously underwritten,” Gruenberg said.

The loans were not underwritten based on the borrower’s ability to pay, but based on the assumption that as long as housing prices continue to rise, refinancing would keep the system going, he explained.

“And this whole house of cards involved not just homeowners losing their homes, but some of our largest, most systemically significant financial institutions in the United States and elsewhere that had very large exposures to these instruments having their valuation essentially collapse.” As a result, what began as a mortgage crisis evolved into a full-blown systemic crisis in 2008.

The first dominoes to fall were Bear Stearns, Lehman Brothers, and AIG— two investment banks and the largest insurance company in the US, “none of which were insured financial institutions or bank-holding companies.”

“Under our previous system, none of those institutions were subject to any meaningful prudential regulation. They were subject to certain market regulations, but in terms of safety and soundness, in terms of routine prudential examination and enforcement, they were essentially exempt.”

22 | THE PRINCETON FINANCIER

“The regulators had been trying to deal with these companies on a case by case basis,” Gruenberg said. When they realized that this would not be sufficient, “there was an effort to develop an unprecedented systemic response that was really a combination of the Treasury, the Federal Reserve, and the FDIC to provide a floor of public support for our

tution”,—once designated as such, that company is subject to the full regulatory authorities of the Fed, including capital and liquidity requirements and leverage limitations.

Since institutions such as Bear Stearns and Lehman Brothers were exempt from prudential regulation prior to

“...We had no institution, no entity responsible for looking at the system across the board to idenfity systemic risk...”

largest systemically important financial institutions. Even with all of that support, in the early part of 2009, I think it is fair to say, there was genuine uncertainty as to whether the system would hold together.”

In response, Congress undertook an effort to develop legislation that would address the clear limitations of the authority of regulatory agencies that were revealed by the financial crisis and would enable them to deal with systemic risk.

“We have a series of regulators—the Fed, FDIC, Office of the Comptroller of the Currency, Securities and Exchange Commission, and Commodity Futures Trading Commission—each of which has responsibilities for a segment of our financial system,” Gruenberg said.

“But we had no institution, no entity responsible for looking at the system across the board, at bank and non-bank financial companies, to identify systemic risk as opposed to risk that may exist in an individual institution.”

The Financial Stability Oversight Council was hence created and given the mandate to identify risk across the system in conjunction with all federal financial regulators. The FSOC has authority to designate any financial company as a “systemically important financial insti-

the crisis, the regulators were unable to identify the risks developing and were constrained in their ability to respond to the crisis once it developed. “When those companies got into difficulty, the regulators were not even clear on the exposure those institutions had, or on their condition.”

When Lehman Brothers failed in 2008, the only statutory recourse was the bankruptcy courts. “The bankruptcy courts are not set up to manage an orderly dissolution of a large, complex, systemically important financial company. And that became very apparent in the Lehman Brothers failure, which in retrospect severely exacerbated the depth of the financial crisis.”

It was clear to legislators that “a public resolution authority to place any financial company, whether bank or nonbank, and its holding company and affiliates into a public resolution process” was necessary. “The FDIC has the lead responsibility for carrying out that authority,” Gruenberg said.

In order to fulfill this new role, a new office was created under the FDIC. The Office of Complex Financial Institutions consists of three groups: one for monitoring the condition of large financial institutions from the standpoint of resolution, one for developing internal resolution plans for the closure of these

companies, and another for cross-border issues that require engaging with foreign supervisors.

In addition to the internal plans developed by the FDIC, each company is required to develop its own resolution plan, often referred to as “living wills”, to submit to regulators. For companies with $250 billion and more in assets, these plans are to be completed and approved by July 2012. “Those plans are really a complement to the internal planning process that the FDIC has been engaged in for the past year,” Gruenberg explained.

“Foreign supervisors are acutely aware of the cross-border risks that these institutions pose, and there has been a lot of international activity among financial regulators in regard to the resolution of these large financial companies,” he said. “We will be and have been engaging with the key foreign supervisors of the large foreign operations of these companies.”

Gruenberg said that the mission ahead of the FDIC is a “major operational challenge, and there really isn’t a precedent for this sort of undertaking.”

He then remarked that Washington Mutual, which was the largest insured financial institution to fail in the financial crisis with assets over $300 billion, “was relatively small, relatively simple in that it primarily engaged in mortgage lending and had no international operations” compared to the largest financial companies today.

Gruenberg pointed to the moral hazard problem created by government support to several large financial institutions as the “preeminent post-crisis issue.” The implicit belief that there would be public support for large financial institutions that might have a systemic consequence was made explicit in the aftermath of the crisis.

“The extraordinary public support to a universe of essentially 15-20 large financial companies. . . is reasonable ba-

sis to believe that these companies are deemed too big to fail,” Gruenberg said.

“And the consequence of that is the markets believe that at the end of the day, the government will come in and support these institutions. That allows them a funding advantage in the market when they seek to borrow, and that funding advantage allows them to assume risk that they would not otherwise be able to assume.”

Though not second guessing the im-

This unfair advantage “is a fundamental distortion in the operation of our financial markets that exacerbates systemic risk and creates an unlevel playing field.” mediate response to the financial crisis, without which the U.S. economy would be in a much worse situation, the perception that there are privileged financial institutions is a significant price to pay, he said.

Post-crisis legislation addresses this problem via enhanced regulatory standards that will impose higher capital and liquidity requirements on systemically important financial institutions in addition to the implementation of resolution plans that minimize risk of market disruption.

“We have to be able to demonstrate that if one of these companies mismanages itself and, as a result of its decisions, gets into difficulty, it has to suffer the verdict of the marketplace and be subject to a market discipline of being allowed to fail without thereby causing the system as a whole to be placed in jeopardy,” Gruenberg stated.

are in danger of failing, has shrunk for the first time in five years in the second quarter of this year, though over 800 institutions remain on the list.

The Deposit Insurance Fund, which had gone into negative balance as a result of the bank failures that followed the financial crisis and had sunk as far as $200 billion in the red, moved into positive territory on June 30, 2011, and increased again in the third quarter.

Bank failures are also down this year, another positive indicator for the industry. Compared to 149 banks this time last year, only 90 institutions have failed thus far, Gruenberg stated, adding that the FDIC expects the number to stay below 100 through the end of the year.

“It is fair to say there is greater uncertainty today than there was six months ago,” he said. “It looked for a while like the economy might be heading for a downturn, but interestingly, the most recent economic numbers have been more positive.”

“I think the big question mark­—and it is on the front page of every newspaper—is really the developments in Europe. There is a profound set of institutional problems and an interlocking set of problems relating to sovereign debt of European countries and bank exposure to that sovereign debt that play off of one another,” Gruenberg remarked at the end of his speech.

“And the challenge is only complicated by the institutional arrangement of the EU, where you have 17 countries whose cooperation has to be gained.”

by Dilek Izek ’13.

Dilek is an Economics major.

She can be reached at dizek@princeton.edu

Gruenberg also said that the indicators most specific to the FDIC have been improving. The problem bank list, a compilation of financial institutions that

THE PRINCETON FINANCIER | 23

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LIFE

of a TRADER

Julian He ’14 shares what it is like to be a student while trading on the side

“Beep…beep…beep…” I get up from bed to turn my alarm clock off. It is 8:15am. Before I do anything else, I turn on my laptop and open the trading and charting platforms. Though the market will not open for another hour, it is important to catch the latest news headlines and pre-market trading actions.

It is never a good idea to get right into the market without having a plan and a sense of direction, because once the opening bell sounds, it is very easy to get lost in the market frenzy. Browsing through my favorite trading websites, analyzing charts and formulating a plan will take me about 15 minutes. Then I will come back at 9:30am, ready for a new day of trading.

My investing experience started in high school. After reading works by Peter Lynch and Benjamin Graham and playing market games online for a couple of years, I started investing in mutual funds and bond funds. I started at a great time as I made some nice returns from the market recovery and later the post-Bernanke speech rally. By the time I came to Princeton, I decided that I should get into individual stocks.

The first stock I invested in was Metalico (MEA), after much fundamental research and analysis. I thought I had my first bucket of gold when I got out of my position, even though the fundamentals were still good, after making 5 percent on my investment. However, I will never forget how Metalico went up another 50 percent after I sold my position. After Metalico, I made some small profits and losses in several other stocks. After reading some trading books last summer, I turned my focus from long-term investing to short-term trading.

As a beginner, it was very easy for me to hold on to my positions and “hope” for a comeback when I was down and my trad-

ing system was telling me to get out, especially when I had investing experience in which “buy and hold” is the rule of the game. Cutting losses is one of the first and most important lessons of trading.

Day in and day out, losses will happen— and ought to happen. Most traders will tell you that if 40 percent of your trades are winners, you are a superb trader.

The first lesson of my career as a trader was the absolute need for discipline and rational behavior. If you cannot be extremely disciplined and rational in good times and bad, it will only be a matter of time before you capitulate to the market.

It is easy to deviate from the plan in the heat of the moment, but the successful trader should never let the market tempt him to abandon his original strategy.

The second lesson I learned was to always have a stop-loss strategy when entering a trade. Not only will you be much more in control and less stressed, it will also save you when the market is tempting you to hold on when in fact you should get out. I started trading during the turmoil following the U.S. credit rating downgrade—a terrible time for the economy but a great time for trading. I made some losses in August but went right back up in September. In the meantime, I tried to learn from every single trade and recorded all the mistakes I made and the lessons I learned.

Oftentimes I make mistakes not in my trading analysis or techniques, but in my execution under pressure, and that is when it matters the most in trading. Lastly, making profits is obviously good, but as a student, learning from every single trade is much more important in the long run.

Each trader has a different trading system and trading style. Therefore, if you want to get into trading, it is important to find a trading style that fits you first. Then you

can create a trading system based on this style and test it through a paper account.

You will find that perfecting your trading system is a long process, and your system will never actually be “perfect”. That said, my trading style is swing trading with a combination of both macro insights and technical trend analysis.

My philosophy is that in the market, big macro events initiate big waves, while technical trends create small waves. I try to go with the big waves after I have done my macro analysis and have a clear view of the medium-term market direction. I then use technical analysis for points of entry, profit consolidation, loss-cutting, and exit. I find that when I am disciplined and stick to my system, even when my macro views are wrong, technical analysis will oftentimes save me from big losses or even help me to achieve small gains.

Just as there is no shortcut to success in life, there is no fast money in trading.

Sometimes, even when everything is set up right and your execution is flawless, the market still goes against you. In these situations you just have to get out, sit back, relax and tell yourself, “These things happen, and that’s life.” Being bitter and going against the market will often lead to further unwarranted losses. You will have your ups and downs. A good way to cope with the volatility is to be detached from the results and enjoy the ride as much as you can.

If you ask me what the most important trading advice is, I would say that speculating without a plan or a stop order will not get you very far. You can go crazy in an online trading game when nothing is at stake; however, in real life, trading is all about minimizing your risk and cutting your losses.

Julian plans to major in ORFE. He can be reached at junhe@princeton.edu

THE PRINCETON FINANCIER | 25

Department of Art and Archaeology Courses of Interest Spring term 2011-12

Art 101: Introducton to the History of Art, Renaissance to Modern

Mon/Wed 10:00 AM - 10:50 AM, Professor Bridget Alsdorf and other faculty

An introduction to selected periods and works of art and architecture from the Renaissance to the present as well as an introduction to the discipline of art history.

ART 201: Roman Architecture

Mon/Wed 12:30-1:20 PM, Professor Michael Koortbojian

This course will examine the architecture of the Romans, from its mythic beginnings (as recounted, for example, by Vitruvius) to the era of the high empire. Topics will include: city planning; the transformation of the building trades; civic infrastructure; and the full breadth of Roman structures, both public and private.

ART 207/MED 207: Medieval Art and Architecture of the Holy Land Mon/Wed 11:00-11:50 AM, Professor Nino Zchomelidse

This course will focus on medieval art and architecture in the political and religious contexts of the Middle East. The three monotheistic religions claimed territories (i.e.

Jerusalem) for cult practices. The situation resulted in military conflicts which introduced Western Medieval, Byzantine, and Islamic art in the Holy Land. The political conflicts in the region today are rooted in the complex situation of the medieval period. The Roman, Arab, Byzantine, and crusader invasions led to the creation of eclectic styles that characterize the region.

ART 382: Cultures of Enchantment

Tues 1:30-4:20 PM, Professor Thomas Leisten

Between the 3rd and 10th centuries, the superpowers of the early medieval world— Byzantium on one side and Sasanian Iran and later the Islamic caliphate on the other—were locked in a lethal struggle for domination and survival. The ongoing wars, diplomatic contacts and trade were instrumental in shaping cultural identities and political ideologies on the two sides. Furthermore, both blocks mobilized the visual and performative arts in an effort to assert power within their own realms and project themselves as superior to their enemies.

ART 440: Renaissance Art

Thurs 1:30-4:20 PM, Lecturer Lia Markey

“Renaissance Collecting: Art, Wonder and Knowledge, 1400-1650” explores collecting in Europe via the study of primary sources and modern theories about possessing, consuming and gift giving things. Princes, noblewomen, emperors, naturalists and artists alike acquired art, flora, fauna, ethnographica and exotica for diverse collecting spaces such as studioli and kunst and wunderkammern. These collections transcended the traditions of medieval treasuries, developed out of modes of categorization derived from antiquity, and ultimately became the foundation for the rise of the museum in the 17th and 18th centuries.

WORD ON THE STREET Marlboro Friday:

On Friday, April 2, 1993, Philip Morris announced a 20 percent cut in the price of Marlboro cigarettes, resulting in a 26 percent drop in its stock price that day. Many investors saw this as an admission that brand names were losing to generic brands. This marked the beginning of the idea of valueminded consumers preferring real value to brand names.

Alligator Spread:

Usually used in the options market, this refers to a spread made unprofitable by large commissions charged on the transaction by the broker, whether or not the market is favorable.

FISH (First In, Still Here):

An accounting jargon used to describe a company with a low turnover rate and unsold inventory.

Investors tend to avoid investing in “FISH-like” companies due to the expensive cost associated with having large inventories.

Halloween Strategy:

A game theory situation similar to the prisoner’s dilemma, in which several people go out to eat and agree beforehand to split up the bill in order to pay less.

However, each person is incentivized to spend more, thinking that the extra cost will be split among the diners.

When everybody does this, they each end up paying more than they normally would, which is the opposite of their original intentions.

Based on the premise that stocks perform worst in the summer and best in the winter, the idea of the Halloween strategy is to sell stocks before May 1, and not reinvest before October 31 to increase gains. The other six months should be spent investing in other assets or not investing at all instead of riding out the losses.

The Icahn Lift:

A term for the increase in stock price that follows when Carl Icahn ’57 buys shares of a company. The stock price rises because of Mr. Icahn’s reputation as a successful investor, who often buys shares he thinks are undervalued and raises the price by share buybacks and changes in management.

Dead Cat Bounce:

Based on the saying “even a dead cat will bounce if dropped from high enough,” this term refers to a temporary recovery in the bear market, after which the market continues to drop.

Diner’s Dilemma:

Back Up the Truck:

Refers to a large purchase of a stock or financial asset because of extreme confidence in its performance, similar to how a truck backs up to a building to load up.

The Dogs of the Dow:

Formulated in 1972, this is an investment strategy that just buys the top ten Dow Jones Industrial Average stocks with the highest dividend yield at the beginning of each year.

Big Uglies:

This term refers to industrial companies in fields such as mining, steel, and oils that tend not to be as popular as tech stocks with investors, and are often overlooked by those looking for quick profits. However, value investors like them for their low P/E ratio, since their solid longterm earnings, growth, and dividends appear attractive when markets tumble.

THE PRINCETON FINANCIER | 27

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