Loans, mortgage

Finance is, broadly, about two things: one is what happens to decisions within firms in terms of how much value they create – decisions regarding corporate governance, capital budgeting, and investment; the other is how the capital market reacts to these decisions and how risk gets priced in the market.

In terms of what happens within the firm, the basic principles to remember are that if you want to use finance to create value, the first thing you need is a good strategy. The second thing you need is a good internal resource allocation system so that capital is flowing to the highest-value project. The third thing you need is the right performance metrics with which to judge people so that you maximize shareholder value on a day-to-day basis. Finally, you need the right corporate culture within the organization to make sure the implicit rules by which people are being judged and rewarded make sense.

From the external perspective, capital will flow to the highest- value user. The firms that will be valued more highly are the ones that are making positive net present value investments. The market will demand a higher risk premium for investing in firms that are riskier. If you are an investor and you hold a diversified portfolio, you don’t really have to care so much about what is happening in the firm because the capital market at an aggregate level is taking care of allocating resources to the best users. You have to make sure you hold a diversified portfolio so that if one out of the 200 firms in your portfolio disappoints, the whole portfolio doesn’t go down.

One of the rules often forgotten is that of no arbitrage, or no free lunch. People often get carried away. When the market is going up, they assume everything has changed and fundamentals are no longer important. They forget that over the long run of a hundred years, on average the market gives you 12 percent to 13 percent and not 25 percent. To expect it to keep giving you 25 percent is to assume that suddenly all the rules by which the market behaves have changed, and that is not reasonable.

Another lesson that people often forget is how important diversification is. Those investors who rely on their 401(k) plan are extremely undiversified. They are single-stock plans. I don’t care how good your company is; if you are not diversified, you are exposed to a lot of risk.

In banking, one of the things that led to the savings and loan crisis (where taxpayers lost over $100 billion) was that the notion of interest rate risks, which is so fundamental to banking, was somehow forgotten because many of these savings and loan associations were making money by taking a lot of interest rate risk – by borrowing via retail deposits and one-year CDs and investing the money in 30-year mortgages. If the yield curve is sloping upward and the interest rates are higher for longer-maturity instruments, you don’t need a lot of intelligence to make money by borrowing short and lending long. The whole notion of interest rate risk is that interest rates don’t always stay the same. Sometimes interest rates flip, and short rates are higher than long rates. When that happens, you have a huge problem: You start losing money.

In banking, I think one of the most important lessons for financial institutions has been the importance of managing interest rate risk and keeping that risk within prudent bounds. The same rules of diversification, such as having a diversified portfolio and controlling interest rate risk, are absolutely critical when you lend. The role of capital is also important; if you are a bank, having a sufficient amount of capital is very important for your long-run survival and financial health.

In corporate finance, the simple rule is that if you don’t invest in positive net present value projects that create wealth for shareholders, in the long run you will drive your company into the ground. The other lesson in corporate finance is that you can never overlook the importance of how people will behave in response to any sort of system you set up. Behavior within all organizations is largely driven by performance metrics and the explicit/implicit reward system you set up for employees. Having the right compensation design and using the right metrics to judge projects and people have a lot to do with whether the projects you invest in will create value for shareholders.