BY CHRISTINE ARRINGTON
Logan native and Utah State University graduate David Stowell (‘76, economics) has a ready point of view on the main factors that caused the 2008 financial meltdown. A member of the Huntsman School’s National Advisory Board, he gives lectures at USU that touch on these “crash” factors in two online courses with three in-person lectures each—hedge funds and private equity in the fall, and investment banking in the spring. The factors he cites are:
Professor Stowell thinks that CDOs should have been far more carefully constructed based on accurate data and should have included much more transparent risk disclosure. He makes a well-informed argument for distinguishing between financial tools that are constructive, that make the capital markets more efficient and effective, and financial tools that are destructive and should be changed or eliminated.
Coming from someone who was on Wall Street during the era when so many financial innovations were created — in the eye of the proverbial gathering storm — his perspective arguably carries a lot of weight. David Stowell was named Co-head of the Equity Derivatives Group at Goldman Sachs in 1989, one of the first such financial innovation teams on Wall Street, heralded on the front page of the Wall Street Journal at the time. He had just returned from four years in Japan working for Goldman, where he had helped invent some innovative financial tools called “Nikkei Put Warrants.”
After serving an LDS mission in Japan and then graduating from Utah State, David earned an MBA at Columbia Business School in 1978. When he was hired by Goldman Sachs to work in Hong Kong and then Tokyo, he was able to use his Japanese language skills. He still laughs about his memory from Tokyo of having to argue on the phone in Japanese that he had “an invasion of frogs” that needed to be stemmed in the yard of his rental home. Ostensibly, pretty good Japanese language skills would be required to convey that demand.
Beyond his yard problems, “Mergers and acquisitions just weren’t commonly done at that time in Japan,” Professor Stowell said. “They were really frowned upon.” And yet, half of his income was supposed to come from mergers and acquisitions. So instead he and his colleagues invented “Nikkei Put Warrants,” and created a good business with them.
Taking Finance 101 would expose one to “puts and calls” — options based on a contract between two parties allowing them to exchange an asset (usually a stock, in the past) at a specific price by a predetermined date. For the put option, the investor “borrows” the stock, wagering that it will decline in price, and then sells it to the other party on the expiration date. For the call option, the investor wagers that the stock will increase in price, and buys it from the other party on the expiration date.
Professor Stowell describes the “Nikkei Put Warrants” on page 163 in his textbook, “An Introduction to Investment Banks, Hedge Funds, and Private Equity: The New Paradigm,” written after he became a finance professor at Northwestern’s Kellogg School of Management, where he still teaches. Essentially an investor creates an investment position that pays off if the Japanese stock market drops below a certain strike price. If the market drops, the investor collects the difference between that strike price and the subsequent lower stock market index price. If it does not drop, the investor loses the amount invested in the position.
The investor’s analysis, then, depends on whether, why, and when that investor expects the Japanese stock market to drop.
From 1986 to 1990, the Nikkei 225 stock market index increased in value dramatically, reaching a historical high of 38,916 points at the end of 1989, Professor Stowell wrote in his book. Then two weeks later, on Jan. 12, 1990, Goldman Sachs launched its put offering in the United States. He records how the tim-ing played out: “By June of that year, the Japanese stock market had crashed, dropping by more than 50 percent.”
This was one of the earliest equity derivatives.
Professor Stowell recalled that he and the CEO of Goldman Sachs later were called to Washington, D.C., to meet with the Minister of Finance of Japan. “We had to explain to him that we didn’t cause the market to fall,” Professor Stowell said. “That would have been the tail wagging the dog.” Nonetheless, since Goldman’s license to operate in Japan was up for renewal that summer, Goldman was pressured to close down its very profitable “Nikkei Puts” business, and it did.
Another widely discussed view of the financial meltdown is that a large factor was the use of a mathematical equation called the Black-Scholes option pricing model, created by Myron Scholes and Fischer Black in 1973. The Nobel Prize was awarded for the model in 1997 to Scholes and Robert Merton who had worked on later stages of the model; Fischer Black had died by 1997, and the Nobel committee does not award the prize posthumously.
The Guardian, a well-regarded U.K. newspaper, published an article in February, 2012, arguing that this equation “was the mathematical justification for the trading that plunged the world’s banks into catastrophe.” Authors Michael Lewis in his book “The Big Short” and Nassim Taleb in “The Black Swan,” among others, acknowledge and discuss that viewpoint.
Reference to the Black-Scholes model stimulated recollections from Professor Stowell on the brilliant Fischer Black, who he knew and worked with at Goldman-Sachs. Professor Stowell said Goldman Sachs hired Mr. Black around 1989, a number of years after he had helped develop the famous equation, to do research and to meet with some of Goldman’s largest institutional clients. During those years Professor Stowell met Mr. Black and talked with him frequently.
“In meetings with these big institutional clients, Fischer Black would be asked a financial question by one of the clients,” Professor Stowell recalled. “Then he would slowly lean back, put his hands behind his head, and ruminate, not saying anything at all, for 15 seconds or sometimes longer. You could almost hear the wheels turning in his head. It could be an uncomfortably long pause. Then he would offer an answer that was almost impossible to understand, just very complex and arcane, leaving the clients totally confused.”
Eventually Mr. Black moved into a new research function focusing on risk. “He was genuinely nice, although not easily communicative,” Professor Stowell said. Mr. Black died a few years after he left Goldman Sachs.
The Black-Scholes option pricing model describes “the rate of change of the price in terms of the rates at which various other quantities are changing,” writes Ian Stewart, emeritus professor of math at the University of Warwick, in The Guardian. It provides a specific formula for assigning a value to a put option or call option when the financial contract “still had time to run,” somewhat like “buying or selling a bet on a horse, halfway through the race,” Mr. Stewart wrote.
This allows one to pin an expected final price on a moving target, with one giant caveat—it works only under the appropriate market conditions. All bets were off when “market conditions weren’t appropriate,” for example when large stock fluctuations were occurring. Ian Stewart concluded, “The equation itself wasn’t the real problem. It was useful, it was precise, and its limitations were clearly stated.” The problem was that it shouldn’t have been used when market conditions weren’t appropriate for it.
“The early success of Black-Scholes encouraged the financial sector to develop a host of related equations aimed at different financial instruments,” Mr. Stewart wrote.
Studying the Black-Scholes option pricing model in a hedge fund class at USU is undoubtedly more interesting with Professor Stowell, who can personally recall the unusual genius who was one of its creators. This and other tales from the eye of the storm come easily from Professor Stowell, bringing to life what otherwise could be difficult-to-grasp concepts.