Revealing the Hidden Forces Behind Investment Decisions

there there is this idea that's too big to fail idea we saw it in the financial crisis when you know just before these banks were held were were bailed out they all had investment grade ratings they the the rating agencies knew they were going to get bailed out and so this thinking permeates their their their credit process and what it creates at investors is this idea that not that we have to understand what's going on with these institutions we have to make sure we keep understanding which institutions are too big to fail and so it sort of divorces the the the credit process away from actually looking at credit metrics and it becomes this sort of game of why okay which institution today is so systemically important that if there's a crisis it's it's going to be fine because the the the uh government's going to bail them out i think that that that has it does raise a number of issues and particularly the issue that you raised about moral hazard it does change the calculus of moral hazard and it provides a safe haven for larger larger financial institutions that isn't accorded to the other you know 7 000 financial institutions who live and die by the decisions they make this is rob johnson president of the institute for new economic thinking i'm here today with jim nadler he's the co-founder chief executive of kbra bond breaking agency prior to today we've had some lovely discussions about all the challenges that we face in the realm of credit municipal wants educational institutions and the whole which you might call spectrum of things that fall under the umbrella that people are rising to explore now called esg environmental social responsibility and governance jim thanks for joining me thanks rob it's great to be here so let's start with big picture i'm talking to you about public policy but you're also a person who's serving clients investors trying to keep them from losing money we all know we're in a world of change i make a joke that the pandemic is what really unmasked us in terms of the need for transition in our social philosophies designs and implementation but you see this very clearly from our previous conversations and how do you see your role in society as a new and innovative rating agency thanks for that rob that's it's a great question because it is you know rating agencies historically have been viewed as a protection protecting investors and that is our number one priority that is why we're in business it's a raison d'etre but we have another role and that is to facilitate commerce and i like to say that the the reason that rating agencies are in that role is a little bit like why we put brakes on cars you don't put brakes on cars so they can go slow you put brakes on cars so they can go faster and it's our job to make sure that the investors know that the brakes work that the brakes are there and that there's someone always fine-tuning the brakes and one of the things that the great financial recession of 2006 2007 showed us was that the the two big monopolies that are in this space were asleep at the at the wheel and we were born out of that crisis and our goal was to bring this new thinking the landscape the financial landscape is changing so rapidly and you've got you know you've got this monopoly that is continually looking in the rearview mirror and that isn't going to be that's not going to do for investors the work that needs to be done going forward we've got to be more nimble the information landscape is changing so rapidly that you have to be part of that and part of that discussion to make sure that investors are being looked after and that they're getting the best possible information and and protection and so it's one of the reasons that we decided to to build the bond rating agency it's one of the reasons we've been successful and it's really the mission that we're on to change the this this entire landscape let's talk about this new phenomenon i mentioned in the introduction esg investing one of our board members julian tet from the financial times now has uh changed her presentation to what's called moral money she's exploring the esg environment every week but tell me how you see what it is what the dangers are of a false consciousness and what its potential looks like you know the the the really so i'll start with a really positive aspect of esg and that is the awareness of esg and its importance in i just in the last i would say 12 to 18 months has increased dramatically that alone is something that we should all be happy about that that that you know there have been people ever since uh rachel i believe her name is rachel cohen wrote uh silence spring uh i don't think i got her name right but ever since silent spring was richard rachel carson carson carson sorry about that ever since rachel carson wrote silent spring there have been a number of activists in the environmental space uh you know we know about the the social change that's gone on this in this country been happening since the you know since the early beginnings of our country but today the awareness is broad and it's in it's on everybody's it's on everyone's plate everyone's looking at it the downside is and you you you raise this is that there are there there are people who are trying to take advantage of it there there there's this phenomenon known as greenwashing where it's just you know taking some old product you know putting a little green wrapper on it and getting investors to buy in to it being sort of this new type of security that's that's that's green i i think that that that we have to be careful about that there are a number of what are called esg ratings out out there and our competitors have their own esg rating scales i think those are those are very detrimental and i think they they they stand to do an enormous amount of harm to the investing uh community because they boil everything down to one number or one grade and the esg space is just not it's not built like that there are so many nuances that come with each of the different disciplines whether it's environmental whether it's social responsibility or whether it's governance each of these disciplines are so vast and so nuanced that it's really requiring a you know a new way and a broader way of thinking the last thing i'll say on the topic is that this new sort of awareness of esg is great but now the hard work begins and that's what kbra is all about we are all about the hard work of esg it's why we're developing we're on a project to develop how to think about carbon with respect to companies you know companies are afraid to talk about carbon publicly because they're afraid it's going to be used against them by investors by regulators by taxing authorities we've got to find a way that companies are comfortable discussing carbon and how it's priced so that we can get a handle on it we're working with community banks to help them find an effective and cost efficient way to disclose their carbon footprint to disclose some of the esg attributes and so and this is hard work this is not something that happens overnight um and and so we're committed to doing this hard work and we've got a lot of you know we've got a lot of hard work ahead of us in this but it's our mission also to sort of get other people to start doing the hard work of esg i come back to you from listening with two notions one is a famous old uh notion in philosophy abstraction enables cruelty meaning it it provides a mask for for yeah that's right and the other is my dear friend charles goodhart who is the monetary economist at london school of economics is now emeritus and goodheart's law was essentially any time you put some kind of measure or marker rule in place it starts to lose its power because people figure out how to work their way around it so deep dive into the texture of understanding these things and understanding what you might call a map of what rules producing behavior and what that does for the environment i think is essential to making progress using the power and the energy of capital uh around the world you're you're absolutely right rob i think one of the things that we realized early on and it's why i spend so much time in washington and why we spend time in brussels uh is the regulatory environment around esg is going to be critical and what we want is we want regulators to understand how nuanced each of these fields are so that we don't end up with regulation that causes unintended consequences and we we we end up with when regulators do come out with you know with regulations and with that these regulations are able to evolve because this area of esg is growing it's changing and so regulation as well as credit analysis has to keep up with it and i i would say you know to be really fair this is we're in the process of a learning curve you're taking a cutting-edge role in protecting your investors as one part of the mission contributing to say minimizing unnecessary losses from cumbersome how we say constraints on behavior allocation of capital and what have you and but we're in a learning curve just as in the technology sector i thought i would think it would be terrifying to work at the federal trade commission right now unless you really knew tech inside out and how many people do i mean they know how to program they know how to you know play with cryptocurrency or this or that but how do you how do you govern something that is so what you might call powerful but not yet completely understood and defined and you got to be careful of weeding out the good while trying to protect from the bad and and i would imagine also in the realm of things like intellectual property rights market share and monopolies you're going to have guys on some side that are pretending something is bad because it would allow new entrants in that compresses their profit margin we see that in the pharmaceutical research and approvals that lobbying is quite intense i i you know rob i think you've hit on a couple of really interesting points i think that the uh the idea that the the the you know regulation uh needs to not only incorporate the understanding of esg but understanding technology because today the the world of technology and the world of esg are are coming together in ways that are dramatic and in ways that are that are speeding up the pace at which we get and and and analyze information in the esg space and i think one of the biggest concerns uh both from a regulatory standpoint but also when i think about our uh you know our our competitors who are much larger than we are is that they are behind the eight ball that they're not understanding how rapidly this intersection of of credit with respect to esg and technology are are merging and integrating that in the way that they evaluate what's going on in esg you know just a small example the technology today to understand to look at a state and and determine with heat maps where we're going to see the next problem with wildfires is astonishing and that technology is only getting better every every time i meet with this company that's doing it there are several that are doing it it's getting better and better and so understanding that and understanding how to use that information and use that data productively both from a from a rating standpoint but also just throughout the entire landscape of the financial sector so that all stakeholders understand it and are using it in a way that makes them more knowledgeable and helps them make better understanding i know a lot of people have used a lot of technology in that realm for instance uh using online sites with photographs so for instance you can detect unrest in baltimore maryland about five days before it hits the newspapers and uh i know palomir and other companies there have now worked closely with people like bridgewater capital are very good at uh helping people see things sooner and and more how do we say more accurately i know years ago i was involved in a conversation with the federal reserve system about the aggregation of credit card data things on google's website and others where you could discern the ebbs and flows in the economy all the way down to zip code but you could aggregate it up to state region sector what have you and instead of the federal reserve waiting six weeks for an employment number to come out 72 hours after the transactions occurred they were much how do you say much more accurate and much more timely in helping in the management of our macroeconomic society so i think there's a lot of potential here right but i also think there's something that's that you alluded to uh early on the word monopolies you know habits are hard to break and when you're profitable perhaps for reasons that have less to do with your value added and more to do with your value extraction it may be difficult to change your habits because if you can stay in the saddle and just keep turning the crank and making money that how'd i say that's very satisfying to some people yeah i mean you know moody's in s p even after the financial crisis still have operating margins in excess of 50 um and today their their stocks have a pe of over 30. uh you know it's it's astonishing but it it's true and what that what you just described what that does is that uh doesn't uh that's not a great environment for innovation and for changing the way that you do business and we see that today in manifest itself in the way that they evaluate all sorts of of different types of assets uh i'll give you a couple of examples and then i'd love to talk more about the impact that is happening in municipals and large you know when you look at municipals as a whole but particularly in in higher ed um but a couple of great examples when when we started crawl we i've always been fascinated by uh the bank uh the financial institution ratings at our two biggest competitors they seem to be very size biased they seem to a lot you know bigger banks get better ratings and and there doesn't seem to be a lot of of uh sort of uh differentiation among the financial institutions it's really has a lot to do with size it's correlated highly towards side and what that evolved in over the years is that they they just had this notion that they didn't like uh you know small regional banks and large community banks now there are there are probably 2 000 small banks that have uh that have uh you know assets under 800 million dollars those are never going to be investment grade but there's a large segment of those banks probably six five or six hundred four or five hundred that you know are are probably you know could could benefit from a a rating and particularly a smaller group that could benefit from an investment grade rating and so we did a very large study that looked at how financial institutions fared during the financial crisis and what we found was antithetical to what was being done we actually found that this mid level of regional and community banks performed better than the larger banks that had to be bailed out during the financial crisis and so we started rating these banks of investment grade giving them access to cheaper capital giving investors more uh high quality rated paper that they could invest in and what happened over time is that all of our competitors set up units to start rating these mid-sized banks now i assume they're using our research because i still haven't seen any research from them but i think that that's one area where they were just set in their ways and once they saw us doing it because it was a competitive issue they started doing it and so i do think we we've been able to have a positive impact on the industry by being more forward thinking we've done this in a few areas airports is another one uh they were sort of bound up in old criteria we did new uh new research and and started raiding airports now i thought you find when you look at our competitors they've all updated their criteria but this is an issue that broadly impacts ratings generally but it's partic particularly important in the municipal area where i think that that the the there's a there's a combination of things that are happening the landscape is changing very quickly esg is impacting these communities in ways that you know particularly if you are a community that is that may uh have to deal with changes in storm patterns or you're a community that is on the atlantic coast and you're worried about uh rising sea levels or you're a community in california you're worried about forest fires and so this that's just one example so this is changing very quickly and this antiquated thinking and antiquated way of looking at these type of bonds has a real impact not only to investors it could put them in jeopardy could put them in you know their investments in harm but it also in some cases like in the community bank illustration could deny access to the capital markets to a group of companies that really deserve that access to the capital market and so you know we see this in a number of places i think higher ed is a great example i think particularly when you look at the historically black colleges and universities that's an area where you know the criteria that was developed 40 years ago even though you say to the world yeah we look at it every year and we rethink about it um if you're not really thinking about it in the context of today and the next 10 years you're really doing a disservice to these these universities and i know there have been several studies we're actually in the middle of doing our own study but i know there have been several studies that show that historically black colleges and universities pay more in fees in the market end up spending you know their debt cost them more and so i think that that's a huge red flag and i think that that a company like ours has a responsibility to not only our investors but to those schools to make sure that they're treated fairly when they're when they are when their credit is assessed and that you you put them in the appropriate light so investors can make much more well i think how do i say triggering all kinds of things but first what i want to say is that they say that imitation is the sincerest form of flattery so when you got them to do the middle-sized banks you should be grinning and you look in the mirror uh say it it does make me happy i wish they'd waited a few years but uh but you know it does it does it does make the second thing because i'm proud of working with the united states senate banking committee is i see this question of the large banks which some call the too big to fail banks uh it's difficult to rate them when you know that their scale and size means that if they fail they can do so much damage to the real economy that they've almost taken what you might call the central bank's balance sheet prisoner the contingent fiscal capacity of the united states is being reserved for those who can do harm in what some have called the mother of all moral hazards and it's very tricky i would think from the standpoint of your business thinking about the reaction function of bailouts in conjunction with what you might call the ratios and standalone integrity of a of an institution but this moral hazard is very dangerous because what it does is it anesthetizes the credit default risk premium in the funding costs for the big banks gives them a competitive advantage and they large in large market share and are able to take more risk so i think i think it's a very very complicated environment i'm curious what your thoughts are you know i think you're you you hit on a really really interesting issue and uh and and and this actually this issue i was gonna go to howard university and i i'll bring it back in a second so uh there there is this idea that's too big to fail idea we saw it in the financial crisis when you know just before these banks were held were were bailed out they all had investment grade ratings they the the rating agencies knew they were going to get bailed out and so this thinking permeates their their their credit process and what it creates at investors is this idea that not that we have to understand what's going on with these institutions we have to make sure we keep understanding which institutions are too big to fail and so it sort of divorces the the the the credit process away from actually looking at credit metrics and it becomes this sort of game of like okay which institution today is so systemically important that if there's a crisis it's it's going to be fine because the the the uh government's going to bail them out i think that that has it does raise a number of issues and particularly the issue that you raised about moral hazard it does change the calculus of moral hazard and it provides a safe haven for larger larger financial institutions that isn't accorded to the other you know 7 000 financial institutions who live and die by the decisions they make um the the the way that this this the way this carries over to howard is really interesting so howard is a federally uh chartered uh higher ed uh school um it clearly clearly has the support of the federal government they've they've as much as every time it comes up they've much has said that and so it's interesting to me that i think one of the rating agencies has howard below investment grade so first of all you think about and i'm just using this as an example but you think about how they have about a 700 dollar seven hundred million dollar endowment um and yet being non-investment grade says that you have a ten percent risk of default twenty percent risk of default in the next five years i don't think there's a person in in any financial capacity whether you're an investor or a banker that thinks that howard university is going to be in default in the next five years it's it's insanity and so why that institution is so willing to apply the standard of too big to fail to an an instant to a large financial institution but is not willing to i'm not saying that's the right way to do it but if you're doing it over here you should at least say well they're not going to let howard fail either the protections protect at least an investment grade in the way i look at them and so protections protection and so you may disagree with it but it's the reality of where we live and so what i really find interesting is the despair their willingness to on the one hand say yeah i believe the government's going to bail them out but on the other hand all evidence shows that it's true but they're willing to say but oh no no you know they've they've had a couple of management problems they've had this problem that problem they're they're really they need to show us more before we're going to give them an investment grade so i that's i find what i find really interesting is this ability to uh to separate to to uh to compartmentalize the way they evaluate the governmental support you either believe it or you don't and so i find that the most interesting uh and and it's specific to what we're talking about uh rob because it gets to the way that different institutions are viewed and it's probably has to do with the way they've been viewed historically let me ask you because we talked and i think that's what happened which was a large part of what inspired me to want to do this podcast with you when you compare something like howard where the student body is african-american and just by the numbers a lower height a lower net worth group of people then which you might call high brand name liberal arts schools places like swarthmore haverford uh middlebury what have you i'm not picking on anyone in particular but if you were to look at them blind in other words take away the name and look at them blind as as ratios and balance sheets howard might stand up pretty well with that some of the 700 million dollar endowment but there is some in inference perhaps that's being drawn that the students will all need financial aid so you're going to draw on that more at those colleges where places like bowdoin the student body is wealthy and will which you might call rally together support the institution as alumni not ever need to draw on financial aid but these are conjectures that i think that what you might call they always said a bird to hands were two in the bush that money in that 700 million dollar endowment should be raising their credit rating compared to ones with weaker ratios and it's not happening that's right and i think you you raise a couple of interesting points so the the the idea that it is somehow uh it's certainly from a you know i'm not naive it is from a from a uh a uh standpoint of preferability of course it's great to have a you know if half your students are full pay that changes the imp you know the amount of work that you have to do to raise financial aid for for other students and but i think the way that we need to start looking at this is through a different lens and that is that look at howard's ability to raise this type of financial aid and still have an endowment that is 700 million dollars and the other thing that i think you raise which is really interesting is this idea of uh you know this notion that you know if you're a small liberal arts school predominantly white that you're going to be able to rally the parents the alumni look at what's happened just recently with respect to howard and their alumni uh you know the vice president is a howard alum chadwick boseman you know one of one of the greatest films that has been done in the last few years black panther he was a star i mean the the the the um the sort of now recognition that howard has the roberta incredible alliance johnny hathaway and the musical in the 70s were continued geniuses and they were friends in washington dc at howard exactly and now now we need to change our view of that and say oh well they have the same type of alumni and they're going to rally to their support and they have rally to their support when they've had problems and so i think that this idea that so you're exactly right it's that we need to i always love the the story about the uh the i forget which orchestra it was but they weren't they just weren't hiring women and they finally um put a screen up when people were auditioning and lo and behold they started hiring women and what does that tell you and so i think your example of let's take the names off of the universities and let's just show what's happening in the numbers and start looking at it through that lens and that's going to change the way that we evaluate um evaluate uh these uh these institutions and and just broadly speaking it's going to be a much better analysis for investors and conjectures and parables and stories not just the raw science but if you if you really narrow down the signal-to-noise ratio to the scientific measures you probably will in this context improve how you serve your customers uh meaning the investors who do place a bet and i i find though and as you know i made a podcast recently we talked about with destin jenkinson brilliant young historian from university of chicago's history department who did his phd dissertation on california in these miscible bonds and the what you might call distorted ways of measuring and handling things and the very painful contortions in urban cities obviously focused on san francisco while he was at stanford but his insights into things like the detroit bankruptcy of just a few years ago are extraordinary so there are a lot of ramifications here in uh getting down to what i'll call that dispassionate science might make more sense i have one question i want to ask you about howard though when donald trump was in the white house people sensed that which might call racial polarity and inclusiveness was on the decline did howard's credit rating go down for fear that that support that bailout money wouldn't be there in the trump administration like it would be say in the biden and administration or the obama administration before that yeah you know rob that is a great question i don't i have to say i don't know i think it's kind of conjecture i'll have to look now you raise it that's a real question but you know the other thing that i i think is important here right which you might call scientifically precise and fair quality measures we talked earlier with esg about how they may guide us to do better things for society but the other thing is expertise is under so much criticism now and when you're doing false rituals quantitative rituals of expertise that aren't really expert or science or when you're bailing out the too big to fail guys and pretending like that's all okay or necessary you're you're destroying the credibility of governance and of expertise and of the institutions like moody's and s p and others that accompany or complement that process that demoralizes the public that's part of what fans the flames and builds the kind of things like january 6th and i'm not trying to draw too tight a connection but the process of integrity really matters no listen you are you're drawing the right inferences because i think that uh scientific analysis you know however you think about it uh has been under attack and this idea that institutions are somehow doing nefarious work is because these institutions have to do a better job of transparency and that's the one thing that we believe in and and first of all i think it was under assault because uh trump didn't like the the the uh results that's why it was under assault we need to all understand that but i also think that many of these institutions and i'll fault moody's and s p in particular uh because there's this notion that that you didn't have to be transparent you didn't have to tell you know you didn't have to show your work i used to have a teacher that always said show your work uh because you you know you're moody's an s p you're licensed by the sec they people have to listen to you well you know what they don't have to listen to you we've built our company based on going out and talking to investors everything in the world is not black and white there's a huge gray area particularly in the financial landscape and the gray area is messy and it requires work and you've got to go out and you've got to get a hundred opinions and you've got to bring those opinions back you have to synthesize them but you're going to come out with a more enlightened viewpoint that is transparent and people are going to believe you because you've gone through that hard process and that's what we've done and that's what i encourage all of our competitors to do in fact i encourage all institutions to do that the this idea that you can get away with it's this way because it's always been this way and because we're telling you this is like it's not going to cut it these young people today they don't buy into that if they they want to see the facts they want to see how you arrived at your conclusion and we have to be better about doing that it's it's i think it's one of the things one of the strongest things that we've done it's one of the reasons that we have such a strong connection to our investors that we service and i think it's one of the reasons that we've been able to build our company so quickly is that we have spent the time and we continue to spend the time i mentioned it before when talking about esg it's hard work the gray area the messy part of every problem is always hard work and that's where we thrive that's where kbra really shows what we're made of and that's what we've really got to change we've got to have we've got to have investors that are demanding that of everybody in the financial uh market that we demand that you that you that you show transparency that you show us how you came to that conclusion and that as as you said that makes things then then then then they're blind to these you know these antiquated thoughts that have sort of crept in to the way that we look at things because when you have to show your work you can't have a bias one way or the other if the work doesn't prove it you can't have a bias and so i think that transparency is going to be the the disinfectant that we need throughout the the market and that's really what kbra is all about is this idea of just showing your work providing a better service as a private sector entity to your customers that's a good thing but it has something like in an esg like correct side effect which is if the young people in this world see examples like you're describing your firm as if as how do you say aspiring to be then the notion that expertise isn't just a ritual in marketing for power or for whatever agenda but it's actually a public good helps improve the faith and the integrity of our system and i think i think that's in very short that faith and integrity is a very short supply right now and so you're it's so you're kind of doing well for your customers and doing good for a rebooting for our society i think these are very very important concepts and expertise whether you call it elite brand names or degrees or whatever are being laughed at on social media and there's something wrong there's something dangerous about that but the idea yeah it's very dangerous because then how would i say there there is something it's like driving the ship without a rudder so i i don't know right right well it's why you know it's how you get away with making outrageous claims that you can't support um it's because you get the the you know you get your your customers so numb to not not seeing the how you came to your conclusions or how your the expertise that that people then start to question everything and that's why i think you're exactly right rob we've got to get back to a time when people can rely on institutions we can rely on expertise and it's incumbent upon us to make sure that we're doing everything in our power to make that to make expertise important again and that i believe is through transparency you know it's interesting we uh every year we hire interns and we hire young people and the there's been a dramatic change in the last 10 years in the way young people view the the workforce they're demanding more of their companies they you know they they want to know what's your company's view on black lives matter what's your company's view on pride month what's your company's view on integrity what do you stand for and i think that that companies need to think about those things and need to be able to articulate those values in order to not only attract the the type of of investors that you want to attract and customers you want to attract but also to attract people that want to work for your company that see that see themselves in what you're projecting and so that's a that's a cataclysmic change you know when i started at pricewaterhouse nobody asked them what their views on racial diversity was nobody asked anybody you were just glad to have a job you didn't you didn't want to raise your hand you wanted to do your work and show that you could do your work that that that's not the world we live in today and i think it's a good thing because i think that the the people are are are becoming stakeholders across the board and they're wanting to be heard and i think that's going to be a real force for good and we're i think learning as a company how to take that really powerful powerful uh you know uh viewpoint and then become sort of have that help transform the way that we uh the way that we are related whether their investors or whether they're and they say well why are you so involved with us it's now about 16 000 young people and i said well i'm here to mitigate the depth in the duration of your future midlife crisis and i'm i'm making a joke but not really which is the nature of what you've done because the only thing that you have that's really scarce is time so how do you use your time when you look back and tell your grandchildren i have one grandchild and one on the way in the next couple weeks when you get back and you tell me what did you do that question of did i go to a firm where i was proud not proud of the brand name proud insight of what i saw and when i used to that's right and when i used to uh teach as an adjunct when i was in the hedge fund proud of what they said was soros fund management lots of students at columbia university would come and want to get what you might call career advice we'd go out to a local pub or something and look at their resume and talk after class and i used to say to them the early part of your career do not chase money or prestigious brand names find a person as a mentor who you would like to be like and an experience that will make you unusual and that will create an attraction and it will create the skills and the compass that helps you navigate through what odysseus called the siren songs of temptation and i think the i i just think this and by the way it's really awakened now because when i was talking to those people in the early 90s i love that right the concerns about environment the concerns about gender and race we're nowhere near as as heightened as you just described to me but this is this is very important for like i say mitigating that future midlife crisis because some of this wisdom rather than being kind of fast and loose is very important

Channel: New Economic Thinking

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Length: 47min 41sec (2861 seconds)

Published: Fri Aug 20 2021