Angela LaGamba: Welcome to Northeastern University’s online Master of Science in Finance Innovation in Finance webinar. My name is Angela, and I will be your moderator for today. Before we begin, I’d like to go over a few logistics for the presentation and address some commonly asked questions. The first one is that all participants today, including yourself, are going to be in listen only mode. We will be recording the session for future use, and we just want to minimize the background noise. To ask questions, feel free to type your questions into the chat box that’s located on the right-hand side of your screen. Feel free to type in the question, then hit enter, or simply hit the word “Send” beside the box, and that will come through.
We will be addressing your questions throughout the webinar. We also have a dedicated Q&A at the end of the presentation. Your panelists today are Robert Mooradian and Khurshid Iqbal. Robert is a professor of finance and faculty director of the Master of Science in Finance program at Northeastern University D’Amore-McKim School of Business. In the online MSF, he is lead faculty for the international financial management, financial risk management, and finance seminar courses. Khurshid is an enrollment advisor on Northeastern University’s online Master of Science in Finance. His role is to help prospective students through the application and admissions process. Let’s get started. I’m gonna hand it over to Professor Mooradian to talk a little bit about the Masters of Science in Finance program. Go ahead, Professor.
Robert Mooradian: I first want to start a little bit to introduce the D’Amore-McKim School of Business at Northeastern University. I want to start by saying that this school has been a real leader in program and curriculum innovation. One of the great things about Northeastern and the D’Amore-McKim School of Business is that faculty have a nice balance of teaching and research. The faculty are very much engaged in applied research, and they’re pursuing, largely, real-world, practitioner-oriented problems. The nice thing that I’m going to do for you with this webinar is give you a chance to see how some of my research relates to real-world issues in finance.
What’s great about the online Master of Science in Finance program is that it’s really targeted both for prospective student’s already in finance, as well as to students who, perhaps, want to change to a career in finance. You can complete the degree in as few as 16 months. As I’ve said, you’re working with instructors with real world experience, both in terms of research and consulting. May of your instructors are CFAs, so there is overlap, in terms of the MSF curriculum and what you need to know to prepare for the CFA exam. It’s not a CFA prep program, but there’s overlap in what you need to know. Then it’s also possible to do this program joint with the MBA, online MBA.
You can get a joint degree, as well. The way the program is structured, there’s a set of required courses, but there are also elective courses that allow you to do a little more specialization in corporate finance or in investments. Examples of electives that would fit into corporate finance would be courses in mergers and acquisitions, a course in evaluation and value creation, and then courses specifically directed to people interested in investments, there’s a course in portfolio management and fixed income securities and risk, and in real estate finance and investments. Then we have other courses that really fit in either specialization.
There’s a course in investment banking, and there’s a course in financial risk management. That helps students who have – they can specialize more in corporate or more in investments. There are a number of potential career paths for MSF graduates. Some of the students in the program are already along a particular career path related to one of these positions that are listed here. The program is great because it can advance your knowledge in your current career path, but it also can be used for people interested in a change, so learning skills on a new career path, as well. What I want to do now is move toward the presentation that I prepared.
As I said, I’m not covering everything in financial innovation. That’s a huge topic. But I’m focusing on some examples that relate to some of my own research to give you an idea of some of the applications of my research and to see how it fits into real-world problems that people are interested in right now. I’ve been a professor of finance at Northeastern University now, this is my 20th year. I have a variety of publications from very academic journals, like the Journal of Finance, which is the association journal of the American Finance Association, to more practitioner-oriented, high-quality journals, like the Financial Analyst’s Journal.
I’m teaching in a number of different areas, and specifically in the online MSF program, I’m teaching in the international financial management class, the financial risk management, and the finance seminar. The international financial management and the seminar are required courses, and the financial risk management class is an elective course in the program. What I want to start with now is the presentation that I prepared for you. Really, the question here with financial innovation is can it be beneficial to financial market participants, or can it be also detrimental? I’m gonna give you some examples where innovation can be beneficial. It can be helpful.
It can correct a market inefficiency, some kind of market imperfection. In finance, there’s a lot of research about how financial institutions are created to try and mitigate conflicts of interest because there are always conflicts of interest when money is involved. Everybody is looking to make more for himself. How do we mitigate some of these conflicts? Then also, just for full disclosure, I want to be up front that there are areas, as well, where one would argue that these innovations are detrimental to investors, that there’s a dark side, as well. As I said, I’m not gonna cover everything in this area, but I’m gonna try and give you enough so that you get a sense of how my research relates to some of this.
Recently, if you’ve been looking at innovations in finance, you see all these acronyms, CDOs, collateralized debt obligations, structured investment vehicles, residential mortgage-backed securities. The argument is that these are oftentimes just set up to exploit investors, that you hook investors that don’t really understand what they’re getting. For example, the investment banks that are creating them, they make a lot of money, but the investors end up taking a lot more risk than they realize and getting a lot lower return than what they had expected. One example that I’m gonna give you, from 2001 to 2005, Morgan Stanley issued about $2.2 billion of stock participation redemption quarterly pay securities.
These sparks have payoffs that are tied to the stock price of major listed companies. No advantage, as far as hedging is concerned. They weren’t particularly liquid. If anything, there was a tax disadvantage the way they were set up. Yet, they were issued at an 8 percent price premium, so they did worse than riskless investments. You would have been better off to just put your money in a bank CD. This isn’t the only security of this type. These kinds of structured equity products also became very popular in Asia and Europe. At their peak, they reached about a total outstanding of over $5 trillion. These structured equity products were often over-priced, and they just looked like ways to extract money from investors who don’t understand what the alternatives are to what they’re buying.
This is clearly in the area of the dark side of financial innovation. One more area that is gonna be on the minds of a lot of individuals interested in finance is the recent financial crisis. What role does financial innovation play in this recent financial crisis beginning in 2007? There are a number of people who argue that financial innovation contributed to this. Some might even argue that it caused this. But if we look at the Rheinhart and Rogoff work that was published in 2009, what they do is they look historically at financial crises. They show that, in general, financial liberalization and credit expansion precedes most financial crises. They really tie this more to real estate booms and busts.
That’s really the heart of many financial crises. The idea here is that prices of real estate and other assets increase significantly, and then the bubble bursts and these markets collapse, and then banks and other financial intermediaries, where a lot of their lending is tied to, say, real estate, they’re over-exposed to the real estate market bust and a banking crisis follows. The take-away from Rheinhart and Rogoff is that probably, it’s financial liberalization and credit expansion that credit is more readily available for, say, mortgages, that plays a big role in explaining the recent financial crisis. Others have argued that an innovation securitization may be a cause, as well.
What I’m gonna argue is it’s probably not a cause, although one could argue that it may have exacerbated the crisis that began in 2007. What we saw during the time period leading up to the mid-2000s was that mortgage debt, as a percentage of GDP, was increasing. However, contrary to the – blaming it on securitization, really, securitization started becoming significant much earlier, as early as the 1960s, and it still wasn’t that big in the mid-2000s. It’s existed for a long time, but this is really the first time it’s been blamed for any financial crisis. For example, in the 1980s, it was the S&L, savings and loan sector that suffered in the crisis during that time period.
If we look at subprime mortgages, in particular – many would say it may be the increase in the number of subprime mortgages, particularly the securitization of subprime mortgages, that may have caused this real estate bubble that led to the crisis. What we see here is that it really isn’t until 2004 that the subprime mortgages almost reach 20 percent of all home mortgage originations. Prior to 2004, it was well under 10 percent of all home mortgage originations. Yet, much of the real estate appreciation that we saw occurred before 2004. This is before the subprime mortgages really took off. Then another bit of counter evidence is that France had a huge price increase in real estate, but had almost no securitization.
It’s difficult to say that securitization is the cause for this particular real estate boom. What I want to talk a little bit about – get at is where some of my research relates to securitization and relates to this question of whether securitization could have exacerbated the crisis. I’m talking about the crisis largely beginning in 2007. What we have seen recently is a very large number of homes going into foreclosure. Over 5 million homeowners lost their homes to foreclosure during this time period. Foreclosure can have a contagion effect. You have homes going into foreclosure because real estate values have dropped, and then with foreclosure, that has a depressing effect on real estate values, and it leads to more defaults, and then more foreclosures.
Foreclosure leads to a drop in real estate values, which leads to more foreclosures, and so forth. What you’ve seen recently is quite a bit of discussion about loan modification. You’ve seen a number of government promoted programs to modify loans, so the loans are modified so that the borrowers can remain in their homes. The terms of the mortgage are somehow altered, so that instead of the lender foreclosing on the property, the lender offers some concession to the borrower, so the borrower is able to stay in his home and avoid the costs of foreclosure. What my research has shown is that when you have securitization, it makes this kind of modification difficult.
What I show is that there’s a conflict of interest here. Perhaps the investors, who are essentially – they’re the providers of the financing for these mortgages – they may – it may be in their interest to have this kind of loan modification, but the borrowers don’t have direct contact with the investors. The idea here is that some party originated these mortgages, and then pooled them. When they pooled them, they raised funding from investors. This pool of mortgages essentially is owned by these pool of investors, but the investors don’t interact directly with the borrowers. There’s a servicer who’s the agent of the investors, who has direct contact with the borrowers.
Typically, these servicers hold what we call a first loss position. When there are defaults, they incur the losses associated with the default, at least up to a certain amount of defaults. When you have subprime mortgages, and you have as many defaults that we experienced recently, what you see is that these positions have little or no value. They’re underwater. Now, they don’t have any incentive to do these types of modifications that I’ve been discussing with you. It’s costly to them to do a modification, and they don’t get any direct benefit, so they just foreclose on borrowers who are in default. This is evidence consistent with the idea that particularly with subprime mortgages or mortgages where there’s a higher probability of default, that securitization can make a crisis worse.
It can have a detrimental effect. Consistent with this argument, there’s another paper that shows that securitized mortgages are less likely to be renegotiated than bank-held loans. The securitized mortgages you have the separation that I discussed with you. You have investors, and then you have the servicer. Whereas, the bank-held loans, the bank is the provider of the funding, and the bank has direct contact with the borrowers. In that case, there seems to be a greater willingness to renegotiate these mortgages. As I said, the securitization may be making modification more difficult and, therefore, it may play a role in exacerbating a crisis. Now, I’ve sort of covered the bad.
Now, I’m gonna focus more on some of the benefits of financial innovation. I’m gonna start by focusing on private equity. This is an innovation that becomes very important beginning in the 1970s. Venture capital, this is private equity financing for new ventures, and then leveraged buyouts, these are – this is where debt financing is used to take a large public company private. Then a third – and this third type really got started in the 1980s and early 1990s, which was the last big economic downturn. Then it reappears once again in the 2000s, with the recent financial crisis. This is something that – these are really the worst companies, worst performing.
They’re financially distressed. May not necessarily be bankrupt, but they definitely have difficulty meeting their debt service. As I said, these are some of the worst companies. These investors play a role in bringing about improvements. These are things that I want to discuss with you, as far as the benefits of innovation. The first innovation in this area that I want to discuss with you is venture capital. This is funding for – what you may be thinking of are startup companies. These are new ventures. Many of them are technology-oriented companies. These are definitely companies that we want to encourage. It’s an important part of our economy. They’re innovative companies.
They’re largely private companies. They’re very young. These companies have limited access to capital initially because initially, they don’t have positive cash flow. They’re still doing a lot of investing, and they’re not making very much money, if any, initially. It requires a specialized type of provider of financing that a traditional bank loan wouldn’t work for these companies because they don’t have a lot of assets. Their assets are intellectual capital, in most cases, so they don’t have the kinds of assets that a bank would look for to do lending, and they aren’t earning money yet. So again, a bank wouldn’t necessarily be interested in making them a loan.
This is where venture capital comes in. These are private companies, so it’s equity financing, but we call this private equity because it’s not traded. There is no public market for this stock yet. Where this started to take off is it really started, initially, after World War II, but it wasn’t until the ‘70s that the innovation came in. This is where venture capital moved to the limited partnership organizational form. It’s largely provided through limited partnership. You have the venture capitalists who are the general partners, and the limited partners provide the financing. The VCs, the venture capitalists, who are the general partners, they’re experts in terms of selecting investments.
After funding, they get involved in the governance and management of these companies. Selection of investments is important, and then monitoring of these companies is also important. You have these experts. This organizational form provides better incentives. One of the benefits here with a limited partnership is that the performance-based compensation is much stronger than, say, if you set this up as a mutual fund. After World War II, the first of these were closed-end mutual funds. It really didn’t work. There weren’t the right incentives. It didn’t work very well. This organizational structure works much better, in terms of providing incentives for selecting the best investments, monitoring these investments, and then exiting these investments is very important, too.
You have to get your money out, and that’s where the initial public offering market becomes very important. There’s also a regulatory change in the late ‘70s that allows pension funds to invest both in these venture capital funds and in IPOs. It’s the combination of the regulatory change and this innovation, the limited partnership organizational form, that really makes venture capital take off. By 2008, you see the impact of this – 13 percent of U.S. public firms are venture backed firms that had gone public. They’re prior venture-backed firms. Now they’re public companies. Venture capital’s responsible for only 3 percent of corporate research and development, but responsible for 10 percent of innovation.
Clearly, this is a big benefit of this financial innovation. The next type of private equity is leveraged buyouts of large public companies. Again, the idea here is creating the right incentives. These are public companies that perhaps are not the best performers. They generate a lot of cash, but in terms of operating efficiency, they aren’t performing that well. What these leveraged buyouts do is they use debt financing to take these companies private. As a result of the LBO, these companies have debt to capital ratios of about 90 percent. What this does is it makes it possible for managers – because the equity financing is relatively a small percentage of the total financing of these companies – makes it possible for managers to have a sizable equity stake, 15 to 20 percent of the equity of these companies.
Managers’ compensation is very much tied to the firm performance, the performance of the firms that they’re managing. These leveraged buyout organizations, these buyout funds, they’re also active in monitoring these companies. What we see here is that in studies going back to the 1980s, these leveraged buyouts are very successful, in terms of returns to investors, and in terms of improvements and operating performance of the firms that they target. It’s improvements in incentives, improvements in monitoring of these companies, the buyout fund has board seats, and they’re active in governance, and they’re active in management of these companies.
That brings about these improvements in performance. The last of these ties more directly into some of my research. This is investing in distressed companies. When you think of financially distressed companies, you should be thinking about these are some of the worst-performing companies. They have high leverage. They’re having – either they’re not able to meet their debt service, or they’re having difficulty meeting their debt service, and buying the stock in these companies is generally not wise because if the firm goes into bankruptcy, for example, the stock may be wiped out. What we call vulture investors – and many of these are private equity firms, or they’re hedge funds.
What they do is they don’t purchase stock. They purchase more senior claims. When the company goes through a financial restructuring, they frequently gain control. In the financial restructuring, much of the prior debt is converted into stock. These vulture investors then end up with big blocks of stock in place of the debt that they had purchased. What we find, and what I find with my co-author, Edith Hotchkiss, is that just having vulture investors involved or buying claims, we don’t detect improvements in performance. It’s when they become active in the governance of the companies that they target that we see the improvements in performance. Again, it’s incentives.
It’s becoming active in governance and management of target firms that there’s an improvement in the performance of these companies. As I said, these are some of the worst companies. Yet, these investors – clearly, this was an innovation going back to the ‘80s. These investors are able to make a big difference, in terms of performance of these companies. Some of the vulture investors are hedge funds. Some of my more recent research deals with hedge funds that are becoming more active in the firms that they target. These hedge funds are buying blocks of stock in firms. What they’re doing is not necessarily – although in many cases, they do get on the board.
They do become active in governance of target firms. But in some cases, it’s just the threat to become active and target firms that brings about an improvement in target performance. What I have found with my colleague, Nicky Boyson, who – Professor Boyson also teaches in the online MS Finance program. What we find is that these firms that are targeted by hedge funds, we find improvements in operating performance of these companies. What’s interesting here is that this type of activism, in general – not necessarily by hedge funds, but, for example, you may be familiar with pension funds, such as CalPERS, that have also been activists.
They have bought blocks of stock in companies and tried to influence management. But the evidence on target performance is very mixed. What I attribute the difference here with hedge funds is that hedge funds have – hedge fund managers have strong performance-based incentives. Again, I’m tying this to creating the financial innovation that creates the right set of incentives, so the improvements are related to the innovation of creating the right incentives, and then the hedge funds then monitor these targets and, in some cases, they become active in the governance of firms that they target.
In conclusion, while I’ve given you some examples where financial innovation can have detrimental effects, it can be used to exploit investors, it may have exacerbated the recent financial crisis, but I’ve also given you a number of examples where financial innovation can create value, in particular, with hedge fund activism and private equity, financial innovation can create value. These improvements are often due to improvements in incentives, monitoring, or governance structure. These are the areas where financial innovation can be very beneficial, both to target firms and investors.
Angela LaGamba: Thank you very much, Professor Mooradian, for walking us through that content.
What I’m going to do at this time is before we open the question and answer session, we do always like to ask our audience what they thought of the webinar and the presentation that was presented today. We do have poll that we’ve opened up on the lower right-hand side of the screen. The question we’re asking is how did you find today’s session? Did you enjoy the webinar? If so, perhaps you would like to see future topics covered in other webinar sessions. You’re more than welcome to share your feedback with us. That poll will remain open until the end of the webinar. Let’s move on to our question and answer session.
The first question that we have for you, Professor Mooradian, is around the topic that you presented. One of our audience members wanted to know what your thoughts were on whether or not the securitization of mortgages would be likely to continue, even after the 2008 economic crisis? Go ahead, Professor.
Robert Mooradian: Yes, they will continue. They are continuing. But one of the things that – if you can see in the chart that I showed you, the number of subprime mortgage securitizations has dropped considerably.
There’s a big dropoff. Subprime mortgage securitizations as a percentage of all mortgage securitizations has really dropped considerably. It’s a very small percentage now. I would expect, as mortgage originators have increased their standards, as far as providing credit, that this will continue for some time.
Obtaining credit is more difficult, and the requirements, in terms of borrower qualifications, are going to remain strict for some time, both because the banks, and also because of the recent history _____ wanna work through the defaults and the problems that we’ve recently experienced. For this reason, I see that it’s gonna be difficult for some time, particularly in the subprime area, to obtain financing.
Angela LaGamba: Thank you, Professor. The next question that we have is for Khurshid. Khurshid, one of our audience members wanted to know about the admissions requirements. He has an engineering background, with a Master’s of Science in Engineering. Would that help with the admissions requirements for this program? Go ahead, Khurshid.
Khurshid Iqbal: Thank you, Angela. Yes, to answer that question, you do certainly qualify to apply with that academic background. We look for people who have demonstrated numerical and mathematical skills. Definitely, that is reflected out of your engineering background.
Angela LaGamba: Thanks, Khurshid. The next question that we have for you, Professor, is a follow up. One of our audience members wanted to know if we had actually started along the path again of creating a risk for ourselves, as a society, of a housing bubble that we won’t be able to overcome in certain markets?
Robert Mooradian: That’s a good question. I think that there are some who would argue that the availability of credit, the expansion in money supply, and the low interest rate environment that we have right now, there’s some who are arguing that’s gonna lead to the next crisis. I don’t know that I would attribute that to securitization, as much as one might attribute that to credit becoming more readily available and the money supply being increased. I’m not seeing it quite yet with real estate prices, but in terms of other assets, such as stock prices, there are a number of economists who are saying look, we’re already seeing what could turn out to be the start of a new bubble.
Angela LaGamba: Thanks, Professor. The next question that we have is for Khurshid. The question is how much interaction do students typically experience when they’re in the online classes? Go ahead, Khurshid.
Khurshid Iqbal: That’s a great question, actually, Angela. The way the program is structured, you are required to be participating and interacting at all levels. You’ll be getting immense opportunities to network with students, faculty, as well as your instructors. Throughout the program, you will find that you are gonna be interacting at all levels, including chat sessions and group discussions and class discussions that we have on a weekly basis.
Angela LaGamba: Thanks, Khurshid. The next question that we have is for Professor Mooradian. The question is around the venture capitalist section that you covered. That was a great section, by the way. That was the comment by our audience member. She wanted to know should public firms actually seek out venture capitalist backing to help enhance their innovation? Go ahead, Professor.
Robert Mooradian: Typically, what public firms have been doing is they’ve been buying these innovative companies. Two ways these private innovative companies – two ways that the VCs exit their investments. I should put it that way. One way is to do an initial public offering. Once they do an initial public offering, then the stock has a public market, and the venture capital firms are able to exit their investment, so they get their cash out. The other way – and this is, for the VCs, their second choice, is for these companies to be acquired, these private companies to be acquired.
What we see is more of the big companies acquiring these smaller private companies to obtain their technology, to obtain their business model. This is more common because what we’ve seen is that these big corporate structures don’t do as well, in terms of getting these new innovations started, in terms of developing these new innovations. Most of these public companies are very active in seeking out these kinds of targets.
Angela LaGamba: Thank you, Professor. The next question that we have is for Khurshid. The question is around how the classes last? Is it a few weeks? Do you get any breaks in between? Our audience members wanted to know if you could just expand a little bit about that structure? Go ahead, Khurshid.
Khurshid Iqbal: Sure, Angela. The way the program is structured, you’re gonna be required to complete ten courses. You’ll be expected to complete one course at a time. Each course will be five weeks, and you will get a one-week break between courses. The break is longer during the holiday season, which could be two to three weeks, but on a normal – on a yearly basis, it’s a week break between every course, and each course will be five weeks.
Angela LaGamba: Thanks, Khurshid. The second to the last question that we have is for Professor Mooradian. The question is should any government legislation, in your opinion, change today, or perhaps in the next five years, to help protect the consumer against the dark side of financial innovation, and if so, what legislation should change?
Robert Mooradian: That’s a good question. I think that any kind of legislation of this type has to consider two things. One is that these financial innovators are very smart. If legislation keeps them from going in one direction, often they’ll figure out a way to go in a different direction, so it has to be very carefully thought out. Even then, it’s difficult because, as I said, there’s always a way around some new regulation. That’s difficult. I think this is where, say, Congress has had a hard time figuring out what is an appropriate response, in terms of new legislation. It’s a difficult question to address. I’m not sure –
I think there were two parts. Was there another part for the question?
Angela LaGamba: The second part was just more of a follow up. What part of the legislation, specifically, would you like to change?
Robert Mooradian: I’m not a legislator, so that’s a difficult one. I think that providing investors with better disclosure. For example, with the sparks that I gave as one example, investors should have known, but perhaps didn’t know well, what it was that they were buying. Making sure that investors have good information with which to evaluate these investments, I think, is very important. Then in the area of mortgage securitization, and in terms of originating mortgages, again, the borrowers need better information to evaluate what it is that they’re agreeing to with a mortgage. There are many that argue that the borrowers didn’t know what kind of mortgage they were taking out and what the implications were. This is one area that I would strongly recommend that there be improvements.
Angela LaGamba: Thank you, Professor. The final question that we have for today is for Khurshid. One of our audience members wanted to know if students would be able to attend graduation on campus? Go ahead, Khurshid.
Khurshid Iqbal: Basically, by you being an online student, you also do get access to many on-campus features. You will get an option to come on to the campus and audit lectures, meet the faculty. You’ll be able to take access to career services, library services, as well as you can come in for your graduation ceremony and walk the same ramp as anybody else, simply because the curriculum that you’ll be doing is the same as on campus. The faculty that you’re gonna be interacting with will be the same as on campus, as well, and the degree will be the same. It will not be stating whether you earned it on campus or online. You’ll be earning the same degree as anybody else that’s in the finance program. So yes, to answer your question, you’ll be able to come to the campus and attend your graduation ceremony.
Angela LaGamba: Thank you, Khurshid. That’s all the time that we have for today, everyone. I do have a couple of closing thoughts before we finalize today’s session. A recording of the webinar will be available on our website in the next few weeks. If you have any additional questions, please feel free to reach out to Khurshid directly, via phone or email, or even through the website. We’ve listed that information on the slide in front of you. Again, thank you to everyone, including Professor Mooradian and Khurshid, for walking us through this riveting session on innovation in finance. This concludes our webinar, and have a fantastic day, everyone.