Give Thanks for Academic Sleuths
From the Magazine: Monday, November 17, 2008
Data detectives are making financial markets safer and better for investors.
Academic researchers typically work in obscurity, but in a growing number of celebrated cases their relentless sleuthing is prying the lid off industry-wide financial fraud and improprieties that manage to elude the watchful eye of regulators.
By detecting and interpreting unusual statistical patterns or flawed practices, these researchers have set off early-warning alarms in such murky areas as subprime loans to risky borrowers, backdated securities options, improper trading procedures (a.k.a. late trading and market timing), and collusion among initial public offering underwriters. Their published studies have led to major government investigations and prosecutions and, ultimately, comprehensive new practices and safeguards in finance and regulation. Moreover, financial innovations such as tradable emissions permits and prediction markets—which provide the public and private sectors with strong market-based solutions to policy problems—are also products of aggressive academic probing.
The cases that follow describe how a new and determined breed of academic researchers is using its behind-the-scenes craft to turn the spotlight on fraudulent, deceptive, and questionable practices that populate the financial landscape.
Sounding the Alarm on Subprime Lending
The prime driver of the current crisis is irresponsible subprime lending that sent the residential mortgage market into a tailspin. While these challenges came as a surprise to many policymakers in Washington, the late Edward Gramlich, a Federal Reserve governor and professor at the University of Michigan, warned more than ten years ago of the dangers of subprime lending.
By unearthing statistical abnormalities and curiosities, researchers have brought to light financial abuses.
Subprime mortgage originations have grown from about $35 billion in 1994 to about $1 trillion last year. As Gramlich was quick to point out, that remarkable growth in subprime lending brought both good news and bad news. On the positive side, subprime mortgages—or mortgages made to individuals who do not qualify for prime mortgages—helped expand home ownership and made it easier for low-income borrowers and minorities to get mortgages. On the otherhand, subprime products often involved loans with very low teaser rates that would reset to much higher rates after a few years. If house prices kept going up, borrowers could refinance out of these products into a more traditional fixed-rate mortgage before the reset. However, the level at which home prices were appreciating between 2002 and 2005 was unsustainable, and as home prices began to drop, defaults on subprime mortgages began increasing dramatically, causing significant ripple effects throughout the economy.
Gramlich had warned of this very scenario years ago. In fact, Gramlich urged the Fed in 2000 to closely examine the mortgage lending affiliates of large banks. In June of last year, he published Subprime Mortgages: America’s Latest Boom and Bust, which provides a virtual roadmap to the current crisis. He noted that “only 20 percent of subprime lenders face the rigorous examinations faced by commercial banks and thrifts,” and that “mortgage brokers are not really supervised at all.”
Policymakers are finally paying attention to Gramlich’s prescient work. In June 2007, the Fed and other financial regulators issued guidance for subprime lending, a first step toward what Gramlich had urged more than seven years prior. Their guidance emphasized “prudent underwriting standards and clear and balanced consumer information so that institutions and consumers can assess the risks arising from certain ARM [adjustable rate mortgage] products with discounted or low introductory rates.” In July 2008, the Fed went a step further by issuing regulations tightening mortgage lending practices and prohibiting so-called “liar-loans,” loans that do not require any documentation of the borrower’s income.
Fannie and Freddie
One of the most dramatic events in the current financial turmoil was the government intervention that placed mortgage giants Fannie Mae and Freddie Mac into conservatorship. The academic world has long been warning about the systemic risk posed by these two government sponsored enterprises (GSEs).
The late Federal Reserve Governor Edward Gramlich warned more than ten years ago of the dangers of subprime lending.
Peter Wallison, a scholar at the American Enterprise Institute, wrote powerfully as early as 2001 about the dangers of the housing finance giants in his book Serving Two Masters, Yet Out of Control: Fannie Mae and Freddie Mac. Lawrence White of New York University argued for reform of Fannie and Freddie as early as 2002. And the following year, William Poole, an economist who served as president of the Federal Reserve Bank of St. Louis, wrote an article entitled “Housing in the Macroeconomy” that examined the volume of housing finance concentrated at Fannie and Freddie, and concluded that shock to either firm could result in a crisis in U.S. financial markets.
These critics consistently raised concerns about three frightening characteristics of the GSEs: (1) the sheer size of their mortgage portfolio— the two companies own or guarantee more than $5 trillion in mortgage debt, (2) the interconnectedness of the GSEs’ mortgage investment activities to key players throughout the global financial system, and (3) the lack of an effective regulator. These factors all posed the potential for systemic risk to the global economy.
Yet despite years of warning, Congress consistently blocked the reform which could have headed off (or at least reduced) the need for the costly bailout now taking place. Congress finally acted in July 2008 to strengthen the GSEs’ regulator, but it was already too late. Less than two months later, the financial health of Fannie and Freddie had deteriorated to such an extent that government was forced to seize control and nationalize the two mortgage giants.
Uncovering a Backdating Scandal
For years, rumors had swirled about the shadowy practice of backdated stock options. The scheme is relatively simple. Companies issue options to executives as an incentive to improve the performance of their organizations. The catch is that these executives are usually given the choice of buying the options later at the price of the stocks on the day the options were granted. So, if the option grants are backdated to periods when stock prices were particularly low, the executives stand to make a killing.
David Yermack, a professor at New York University’s Stern School of Business, began to peel away at the problem some ten years ago when he published a paper documenting that share prices often rose quickly after options were granted to executives. Yet he and other researchers never seriously considered backdating as the reason for this pattern. Rather, Yermack postulated that the trend owed to the fact that corporate executives knew when good news was on the horizon, and made sure to grant options beforehand.
A professor at the University of Iowa, Erik Lie, was the first to link this pattern to the backdating of option grants. His study, published in 2005, showed that when companies reported stock options the same day they were granted, no pattern of rising share prices resulted. The story was much different, however, among firms that delayed reporting options. In these cases, he found that Yermack’s pattern intensified.
Lie did not mention any companies by name. But after his study appeared, The Wall Street Journal published an article in March 2006 that used its own analysis to identify six companies with suspicious options-backdating practices. The case caught the eye of the media and blossomed into a backdating scandal in which more than 130 companies came under federal investigation by the Securities and Exchange Commission (SEC) and the Internal Revenue Service (IRS), and more than 40 executives stepped down under pressure or were fired. At last count, about 80 cases remained open.
Zeroing in on Mutual Fund Abuses
Another financial firestorm—this one involving illegal and unethical mutual fund trading practices—was ignited in 2003 by the groundbreaking work of Eric Zitzewitz at the Stanford Graduate School of Business. A series of papers by Zitzewitz exposed two improper trading procedures known as late trading and market timing, both of which were found to be widespread in the mutual fund industry.
Researchers noticed an interesting phenomenon: “odd-eighth” quotes were absent in about 70 percent of actively traded NASDAQ securities.
Late trading is an illegal practice that occurs when traders are allowed to purchase shares after 4 p.m. at that day’s closing price. This activity is forbidden because it allows late traders to take advantage of knowledge about developments in financial markets that occur after 4p.m., when many big corporate announcements are made. Market timing, an unethical though not illegal practice, involves trading of mutual fund shares in order to capture price inefficiencies—particularly in international markets. Traders dip in and out of mutual funds, profiting from anticipated short-term up or down moves in the market, a practice that hurts average mutual fund investors, who are the losers when market timers profit.
Zitzewitz’s first paper suggested that these improper practices were costing share holders a whopping $5 billion a year. In September2003, then New York Attorney General Eliot Spitzer announced a first round of investigations into illegal trading activities in the mutual fund industry, and credited Zitzewitz’s work. The SEC launched its own investigation into the matter, and by mid–2005 nearly all firms that had been charged had settled with either Spitzer’s office or the SEC. The largest settlement occurred in March 2004, when Bank of America paid $675 million for improper mutual fund trading; in August 2006, Prudential agreed to pay $600 million.
When professors William Christie and Paul H. Schultz put the NASDAQ stock market under their magnifying glass in the early 1990s, they noticed an interesting phenomenon. They found that “odd-eighth” quotes (that is, quotes that end in one-, three-, five-, or seven-eighths) were absent in about 70 percent of actively traded NASDAQ securities. Moreover, they concluded that this anomaly could not be explained by chance, normal negotiations, or trading activity.
Could some dealers be engaged in collusive practices to inflate the bid-ask spread of NASDAQ-listed stocks? While the exhaustive research of Christie and Schultz, published in 1994, did not provide direct evidence of collusion, the academic sleuths asserted, “We are unable to envision any scenario in which 40 to 60 dealers who are competing for order flow would simultaneously and consistently avoid using odd-eighths without an implicit agreement to post quotes only on the even price fractions.”
Authorities were also puzzled, and as a result of the professors’ research and the public attention it received, the Department of Justice and the SEC began investigating NASDAQ spread-rigging. A class-action lawsuit was brought against NASDAQ market makers, accusing 37 major brokerage firms of artificially fixing prices between May 1989 and July 1996. Eventually, the dealers settled and investors were paid $1 billion as part of the settlement.
Collusion in IPO Underwriting
Initial public offerings have also been held up to the light by academicians. In 1999, Jay Ritter, a finance professor at the University of Florida, and Hsuan-Chi Chen, from Fu Jen University in Taiwan, released a study (published a year later) showing that in the late 1990s underwriters of more than three-quarters of IPOs in the United States charged an underwriting spread of 7 percent. In 1998, those proceeds ranged between $20 million and $80 million. In 1985, by comparison, only 22 percent of the IPOs were charged a 7 percent commission. The percentage of spreads at exactly 7 percent increased dramatically after 1985.
Ritter and Chen believed that the only explanation for the 7 percent pattern was implicit collusion. They suggested that bankers and investors were probably aware of the commissions being charged on other financial deals and therefore knew the going rate. Young companies, meanwhile, were more concerned with securing the backing of a prestigious Wall Street bank that could sell their shares at a high price than they were with commission fees.
A study that found mutual funds perform better when the managers invest in their own funds could well change the way such funds are managed.
The glaring lack of price competition—which Ritter and Chen reinforced by showing that spreads received by underwriters in other countries were much lower than in the United States—was initially investigated on several fronts. Shortly after the release of their paper to the business press in 1998, a lawsuit was filed against 27 securities firms alleging that they conspired to “fix and maintain” the portion of IPO proceeds that went to underwriters. In 1999 the Department of Justice began a price-fixing investigation, and in 2000 the SEC launched probes into three major securities firms to investigate their IPO commissions. In January 2002, Credit Suisse First Boston announced a $100 million settlement with the SEC and the NASD. Yet in February 2003, Ritter reported that banks were as likely as ever to charge a 7 percent spread on IPOs.
The Work Intensifies
Work being done today by academics will continue to prompt fundamental improvements in finance and regulation. For example, a recent study at the Georgia Institute of Technology and the London Business School—which found that mutual funds perform better when the managers invest in their own funds—could well change the way mutual funds are managed, or at least give investors new criteria to consider when deciding where to put their money.
Academic researchers play the critical role of financial watchdog. By unearthing statistical abnormalities and curiosities, they have brought to light financial abuses that slipped under the radar of government regulators. Academics are proving that highly focused research is not only relevant but is making our financial system a safer and fairer place for investors.
Thomas J. Healey is a retired partner of Goldman Sachs and currently a senior fellow at Harvard University’s Kennedy School of Government. He was an assistant secretary of the Treasury under President Reagan. Matthew A. Scogin worked as the senior advisor for domestic finance at the U.S. Treasury Department and is currently a vice president at Wachovia.
Image by Todd Smith/Stock Photo.