PARTICIPANTS

Myron Scholes (Stanford Professor Emeritus and Chairman, Platinum Grove Asset Management), George Shultz, John Taylor, Michael Boskin, John Cogan, Charles Johnson, John Shoven, John Ciorciari, and Matthew Gunn.

KEY ISSUES DISCUSSED

• Hedge Fund Operations – Scholes began by providing insights into how some hedge funds intermediate in the financial markets, using his own firm’s operations as an example. He explained how models can help hedge funds identify market inefficiencies or asymmetries. He also explained how hedge funds interact with broker-dealers and commercial banks, borrowing and lending funds and posting collateral to conduct derivatives transactions.

• Effects of Recent Market Turmoil – Scholes noted that the Bear Stearns crisis had a kind of ―cascade effect.‖ As Bear’s subprime assets declined in value, it began to liquidate other assets, driving down prices. Hedge funds and other counterparties to derivatives trades became concerned about Bear’s credit risk and began to novate their contracts—essentially assigning them to banks or dealers—to avoid putting collateral at risk. As concerns about credit risk broadened, firms throughout the financial sector began deleveraging aggressively, and overall market liquidity decreased sharply.

• Reasons for Recent Turmoil – Scholes argued that the precise reasons for the turmoil are not yet clear, but a variety of factors may have contributed. These may include models that led firms to miscalculate risk, incentive structures that rewarded excessive risk-taking, and weak management. He contended that even if none of these factors was present, financial markets can encounter significant turbulence simply due to the coincidence of otherwise benign acts by market players.

• The Federal Reserve’s Decision to Intervene – The group then discussed the Fed’s decision to bail out Bear Stearns and issue the Term Securities Lending Facility (TSLF). Scholes argued that the Fed’s actions were necessary to prevent a more serious crisis in financial markets. He asserted that the TSLF has provided necessary time for financial firms to adjust their positions and contracts. However, he added that excessive government intervention could create moral hazard. As a general policy, he argued that the Fed should intervene and issue comments sparingly, allowing for some risk and uncertainty that is necessary for markets to function properly.

• Policy Priorities Going Forward – Scholes concluded by identifying two critical issues that analysts and policymakers should address going forward. One is to improve accounting practices so that senior officials of financial firms are in better positions to assess and manage risk. The second is to improve our collective understanding of aggregated risk.