Perspectives - Spring 2014

Perspectives

WHO HAS A SEAT AT YOUR TABLE? HOW DIFFERENCES DELIVER INNOVATIVE THINKING

Spring 2014

College of Business at the University of Illinois at Urbana-Champaign

W

hen students have the chance to tackle real-world business problems, we all benefit.

have the chance to

[ CONTENTS ]

That’s because the opportunity to assess a situation, develop a strategy, and

communicate a plan not only provides a practical way for students to apply what they’ve learned in the classroom, it also helps create a collaborative skill set that makes future

tackle real-world

leaders and their businesses better.

On page 28, you can read about the recent Professional Responsibility Strategy

business problems, we all benefit.”

Competition, which provided just this kind of deliberative, hands-on work. Hosted by our Center for Professional Responsibility in Business and Society and BP, the event challenged students not just to provide creative business solutions but also to find creative ways to bring their diverse backgrounds and experiences to the task of building a strong team dynamic.

This issue of Perspectives also examines other topics with ties to group dynamics, corporate social responsibility, and collaboration—all of which have important real-world implications. Denise Lewin Loyd shares her work on how diversity impacts idea generation in organizations; W. Brooke Elliott, Mark Peecher, and Kevin Jackson detail their research on how investors perceive a company’s commitment to corporate social responsibility; and B. Joseph White and students in his Campus Honors Program course explain how collaboration and feedback inform their knowledge of business. provide opportunities for students to succeed inside and outside the classroom.

And in the real world, too.

Sincerely,

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Who Has a Seat at Your Table?

Deep-level diversity is what brings innovative thinking to the table.

6 12

Do Good Strong corporate social responsibility statements translate into more than just goodwill.

A Big Gamble Does the derivatives market have the potential to topple the economy?

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From Old to Resold

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A Growing Concern

30

From a Distance

What does remanufacturing mean for profits and the planet?

A crop insurance safety net helps farmers ride out risk, but is it really free disaster aid?

What impact do distant speculators have on housing markets?

Josef and Margot Lakonishok Endowed Dean MANAGING EDITOR Mary Kay Dailey EDITOR Cathy Lockman CONTRIBUTING WRITERS Tom Hanlon Cathy Lockman Doug McInnis

SHORT TAKES

PHOTOGRAPHERS Mike Helenthal L. Brian Stauffer Thompson • McClellan Photography

Perspectives

PROOFREADER Cristy Gillespie

College of Business at the University of Illinois at Urbana-Champaign

ON THE COVER Will there be agreement, dissent, debate, or new ideas generated by your organization? It depends on the deep-level diversity of the people you have seated around your conference table, says Denise Lewin Loyd, associate professor of business administration.

WHO HAS A SEAT AT YOUR TABLE? HOW DIFFERENCES DELIVER INNOVATIVE THINKING

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IN-DEPTH

DEAN Larry DeBrock

Larry DeBrock

Spring 2014

[ MY ] PERSPECTIVE

At Illinois, our faculty are committed to sharing their expertise so that we can

Photo taken in the Board Room of the Alice Campbell Alumni Center.

DESIGNER Pat Mayer

Perspectives was named an Award of Excellence winner for 2013 by the University & College Designers Association.

SPRING 2014

“When students

10

Legacy

16

60-Second Profile

18

Intersections

20

Reality Check

28

The Main Event

32

The Reason Why

34

Parting Shot

The University of Illinois at Urbana-Champaign is an equal opportunity, affirmative action institution.

Printed on recycled paper with soybean ink.

[ COVER STORY ]

“Organizations need to

WHO HAS A SEAT AT YOUR TABLE?

allow for dissent. They need to embrace that as part of their culture and realize that dissent is part of the value of bringing people together to solve problems.”

Denise Lewin Loyd

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Perspectives SPRING 2014

Y

our pet project has stagnated. It needs an infusion of fresh, new ideas and solutions. You bring together a team to hash it out around the table: people from sales, marketing, engineering, and IT. Brilliant people all. And diverse: white, black, Asian. Male and female. Company veterans and new hires. You need some people to rock the boat and head the project in a new direction. Surely this diverse group will be just the team to do it.

To your amazement, the meeting is a bust. No new ideas.

No alternative pathways. No solutions. Just a lot of like-minded thinking and agreeing with each other.

What happened? It could be, says Denise Lewin Loyd, that you have assumed the surface-level diversity apparent among the group—different races, genders, and departments—would reflect deep-level diversity.

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“If we are only looking at that functional difference in terms of who is ‘expert’ on what information, then we will lose out. We need to stop making assumptions by which we are effectively limiting people from giving their input and positively influencing the group.”

Denise Lewin Loyd

GOING DEEP Managers have long valued diversity, and for good reason, says Loyd, who has been researching diversity and group dynamics for years. “It’s important to have people who are different engage and work

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with each other because they can bring different perspectives to the table,” she explains. “Ideally, those different perspectives will help us make better decisions overall.”

However, Loyd warns that many people assume that groups that are obviously different on the surface are also different on a deeper level.

Instead, she says, not all people who appear similar think alike, and not all people who appear different think differently.

That thinking brings added social pressure to homogenous groups.

“If you’re in a homogenous group, it’s harder to disagree,” Loyd says. “The expectation is that we are likely to agree with each other. We want people in this group to like us, and we care what they think about us. So disagreements are harder to accept and more uncomfortable to voice.

And it can hinder the group’s ability to be successful.”

That, says Loyd, is one important benefit of diversity: it helps reduce the expectation that everyone will agree with one another and the social pressures to be liked.

“Diversity can enable people to feel more comfortable expressing different perspectives,” she says.

“There is reduced concern about

interpersonal interaction and everyone being in agreement, and it allows people with different perspectives more comfort in sharing those perspectives. The group engages more in sharing and discussing their different perspectives when there is surface-level diversity present. And that can lead the group to being more open to considering that different perspective. So when companies put together people who have some differences, they are leveraging the different perspectives that they want to hear from.”

THE VALUE OF DISSENT It’s important for organizations to create norms for dissent to be expressed, Loyd adds. “It’s difficult for people to express different perspectives,” she says. “Organizations need to allow for dissent. They need to embrace that as part of their culture and realize that dissent is part of the value of bringing people together to solve problems.”

It’s also important, she says, for companies to identify, up front, the value that people from different areas are bringing to a meeting.

Everyone knows Smith is from marketing, and Jones is from engineering, but they don’t know “the

background and other factors that might influence and validate the perspectives that each person brings to the table,” she explains. So, for example, Jones might have some great marketing ideas that should not be dismissed—“and the team can engage with those ideas if leadership has made it clear in advance the value of each person on the team” beyond their obvious surface-level characteristics, Loyd says.

Loyd sees an important role for companies in “structuring things to help us make better decisions and engage with each other in a way that is beneficial.” To that end, it’s good to not only bring people from different functions together, but to let people speak to other functions.

“It’s a mistake for organizations to ignore a good marketing suggestion made by someone outside of marketing,” she says. “If we are only looking at that functional difference in terms of who is ‘expert’ on what information, then we will lose out.

We need to stop making assumptions by which we are effectively limiting people from giving their input and positively influencing the group.”

The point, Loyd says, is this: different perspectives are valuable no

matter where they come from. You can find diverse perspectives from a group that, on the surface, appears very homogenous. Or you can find different ideas from a group that has not only surface-level diversity, but deep-level diversity as well.

PULL UP A CHAIR Denise Lewin Loyd shares three important ideas for managers to understand in terms of group dynamics.

BRINGING DIFFERENCES TO THE TABLE So back to that project meeting.

What could you have done differently to cultivate the fresh ideas you needed to move your project forward? You could have made sure you were inviting people with deeplevel differences in opinions and ideas. You could have actively solicited different perspectives. You could have brought in people who are not afraid to rock the boat.

Creating a culture that sees beyond surface-level differences and encourages exploration of deep-level diversity demonstrates an organization’s respect for what each employee brings to the table. And that maximizes an organization’s potential.

“Diversity is not an intervention,” says Loyd. “It just is.”

Tom Hanlon

•

1

Value diversity.

It can increase information processing and complexity and willingness to engage with different perspectives.

2

Cultivate a culture of respect for differences.

Get the most out of the differences that are present in your group—both the obvious and not-so-obvious differences.

3 Don’t be afraid to actively solicit different perspectives.

Challenge people to step outside of their stereotyped boxes.

Perspectives SPRING 2014

“A surface-level difference doesn’t necessarily indicate a deeplevel difference,” says Loyd, associate professor of business administration.

“A surface-level category is one I can place you in that doesn’t require that I know something about your perspective or opinions. Surface level is what’s obvious—gender, race, hair color, age, and in some cases, department or function. Deep-level diversity—where you see differences in personalities and opinions— comes out through conversation and interaction.” That’s where the real boat rocking, and the potential for innovative thinking, takes place.

Loyd’s work has focused, in part, on alerting people that these two types of diversity are not always in sync. “I wouldn’t say that surface level and deep level are never aligned,” she says, “but many people feel that they are always aligned, that I’m always like people who look like me. And that’s not the case.”

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[ CORPORATE SOCIAL RESPONSIBILITY ]

Do Good.

CAN GOOD WORKS TRANSLATE INTO MORE THAN GOODWILL?

“In North America, we recycled 176.8 million pounds of consumer electronics and appliances in fiscal 2013.”

—Best Buy “We achieved a rating of 100% on the Human Rights Campaign Corporate Equality Index for the eighth consecutive year.”

—Chevron “In 2012, we banned sandblasted apparel and are working with vendors who use responsible alternatives to achieve the same look.”

—Target “We are founding members of the Global Roundtable for Sustainable Beef and also participate in sustainable beef initiatives in Australia, Brazil, and the U.K.” —McDonald’s “Our employees donated $29,444,311 in 2012, all of which was matched dollar for dollar through Bank of America’s Matching Gift program to support 23,386 organizations.”

—Bank of America “In 2012, we increased the availability of front-of-store recycling by an additional 453 stores in the U.S. and Canada.”

—Starbucks

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Perspectives SPRING 2014

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ll of these statements are part of each company’s corporate social responsibility report, the place where they share their efforts to be good global citizens. The reports focus on issues such as the environment, human rights, philanthropy, diversity, and employee well-being— all of which leave an emotional impression with the reader. And a new College of Business study says that when that impression is a positive one, it pays dividends for the company—and not just in goodwill. It can actually translate into cold, hard cash.

In fact, the research has found that potential investors are willing to pay more for a company’s stock when it has a favorable corporate social responsibility record. They also put a higher valuation on the company.

That’s in contrast to a second group of investors who, when prompted by researchers to explicitly assess the company’s social responsibility performance, gave a less extreme estimate of the firm’s worth and stock value.

And while that quick emotional judgment could be good for the company, it might not be the best decision-making tool for the investor, the study found.

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Co-author Kevin Jackson, a PricewaterhouseCoopers LLP Faculty Fellow, says that investors do these things naturally. “Their reaction to good or bad corporate behavior is changing their perception of what future earnings will be.

That doesn’t necessarily have any-

thing to do with reality. Rather, it shows the power of emotions to sway our decisions. We see this in many dimensions of our everyday lives, not just financial. For example, when you see a presidential debate, the candidate who wins the debate in our minds tends to be the candidate we wanted to win the debate.”

The study, “The Unintended Effect of Corporate Social Responsibility Performance on Investors’ Estimates of Fundamental Value,” was also co-authored by Deloitte Professor of Accountancy Mark Peecher and former graduate student Brian White, who now teaches at the University of Texas at Austin.

It appeared earlier this year in The Accounting Review.

BOOSTING THE BOTTOM LINE

“[Investors’] reaction to good or bad corporate behavior is changing their perception of what future earnings will be.

That doesn’t necessarily have anything to do with reality.”

Kevin Jackson

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The idea for the research surfaced some ten years ago in discussions between Jackson and Elliott, then new members of the faculty. “If we had published this ten years ago, I don’t think anyone would have cared,” says Elliott. Corporate social responsibility was on fewer people’s radar back then. “Now people do care about this issue,” she says.

All members of the Fortune 100 issue public reports on their corporate social responsibility records. Investors have responded accordingly.

Some $3 trillion in managed investments currently follow a socially responsible investment strategy, according to 2009 estimates by The Social Investment Forum. The issue is particularly important to millennials, the generation born between the early 1980s and the early 2000s.

For these and other reasons, a good track record on CSR can add value to the bottom line. Responsible corporations can avoid costly run-ins with regulators or bad press that might drive some customers away, for instance. Companies who set CSR goals may achieve savings through better energy management or recycling efforts as well. Plus, their efforts may actually be a boost for the company’s own employees.

“With millennials, if you want them to be loyal employees, you have to take into account that they value social responsibility,” says Peecher. “And that has value. They may be better employees, or the company might have less turnover” when the corporate and employee values align.

more rational decisions,” says Elliott.

“There’s nothing wrong with taking the environment or how workers are treated into account when making investment decisions. But you should be aware of why you’re doing what you’re doing.”

Corporations, on the other hand, have good reason to empha-

size positive performance on social and environmental issues since a growing number of potential investors care about it.

“Over the last ten years, the demand for CSR reporting has changed quite a bit,” says Elliott.

“And a lot of that demand is driven by stakeholders.”

Doug McInnis

•

“With millennials, if you want them to be loyal employees, you have to take into account that they value social responsibility.”

Mark Peecher DECISION TIME The new study represents some of the latest thinking in a line of research focusing on how psychology affects financial decision making, a field that traces its roots back to the 1970s. As researchers have looked deeper into the decision-making process, they’ve found that decisions aren’t always logical. “The whole idea is that people are not really well

versed in what is affecting their decisions,” says Peecher.

People might fare better by shifting from emotive reasoning to deliberative reasoning. “But it takes longer, and it’s more exhaustive,” says Peecher. “There is a reason we can’t do that on every decision.”

The study has implications for both investors and corporations.

“Investors can use this study to make

“The basic idea is that people have emotional reactions. And they may not realize that their emotional reaction is causing them to bid up the price of the stock.”

W. Brooke Elliott

Perspectives SPRING 2014

“The basic idea is that people have emotional reactions,” says W. Brooke Elliott, the Professor Ken Perry Faculty Fellow and one of four co-authors of the study. “And they may not realize that their emotional reaction is causing them to bid up the price of the stock.”

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[ LEGACY ]

STANDING PROUD

T

he southwest corner of

Illinois alumnus Lorado Taft.

Association Spring Luncheon,

Green and Wright streets

It depicts a figure in academic

shown in the photo at the right.

has missed its favorite

regalia in its center and two other

iconic trio. In August 2012, the Alma

figures that represent “Learning”

That was the 26th annual celebration. This year the College of

Mater traveled 150 miles north from

and “Labor,” in a nod to the

Business will mark the 54th year of

her campus home to a conservation

University’s motto.

the event. Plan to join other alumni:

studio in Forest Park for repair and

The Alma Mater has been

restoration (see photo below). Years

the backdrop for hundreds of

Thursday, May 1, 2014

of water damage and corrosion

thousands of graduation photos

at the Hyatt Regency in Chicago

took its toll on her appearance and

over the years and an iconic

structural integrity, but when she

symbol of Illinois pride. In fact,

returns later this year she will

paintings of her image have long

The Alma Mater won’t be there, but this year’s alumni

again stand proud—and pretty—

been given as gifts for outstanding

award recipients will be. To

on the campus she’s called home

service to the University commu-

make your reservations, visit:

for 83 years.

The 13-foot, 10,000-pound bronze sculpture is the work of

nity—like those presented to

go.business.illinois.edu/SL2014

award recipients at the 1986

or call 217-244-6669.

College of Commerce Alumni

James Cook ‘71 (center), the president of the College of Commerce Alumni Association, congratulates the alumni award winners at the 1986 Spring Luncheon. Arthur Wyatt ‘49, ‘50, ‘53 (left), then principal at Arthur Andersen, was honored as the recipient of the Distinguished Alumnus Award; and T. Emmerson Cammack (right), professor

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Perspectives SPRING 2014

ALMA MATER PHOTO BY MIKE HELENTHAL

of finance and associate dean of students, was named the winner of the College’s Appreciation Award.

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[ ACCOUNTING FOR RISK ]

“More money has been bet on derivatives than exists in the entire world by several times.”

Rashad Abdel-khalik

Gambling on the Future

the-counter derivatives market totals at least $700 trillion and could be much larger. Data aren’t available from most countries, he says. “I am still shocked by this increase.”

“More money has been bet on derivatives than exists in the entire world by several times,” Abdel-khalik says. Moreover, derivatives are spread throughout the global economy. “Every enterprise of any size has derivatives as invest-

ments or hedging instruments,” says Abdel-khalik.

Since he first read the GAO report, he has turned his opinion into action, introducing the first university course anywhere to teach accounting students how to quantify derivatives’ risk in financial statements. He followed with a textbook on the subject, Accounting for Risk, Hedging and Complex Contracts, published late last year by Routledge.

DERIVATIVES HOLDINGS AT MAJOR BANKS U.S. banks hold more than $240 trillion in derivatives as of the third quarter of 2013, but almost all of that is concentrated at four mega banks.

Here are the numbers:

JPMorgan Chase Bank NA $71.8 trillion

Citibank National Association $63 trillion

Goldman Sachs Bank USA $47.5 trillion

Bank of America NA $41.4 trillion

WHAT ARE DERIVATIVES? Financial derivatives fall into two classes. Approximately $45 trillion worth are sold through regulated exchanges. These are used for legitimate business purposes such as hedging. For instance, airline companies take out hedges to protect themselves against sudden jumps in the price of jet fuel. Farmers use them to cover against the rise and fall of farm commodity prices.

But the $700 trillion are unregulated derivatives sold over-thecounter. It is this OTC type that Abdel-khalik believes has the power to topple the global economy. Others agree. TIME magazine looked at the derivatives market last year and ran a critical piece under the headline: “Why Derivatives May Be the Biggest Risk for the Global Economy.” And at this year’s World Economic Forum at Davos, Switzerland, hedge fund CEO Paul Singer said derivatives were a key reason risk remains in the financial system.

“I don’t believe markets are safer. I don’t believe they are safe,” said Singer, CEO and chief investment officer at Elliott Management.

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I

n 1994, A. Rashad Abdel-khalik came across a report titled Financial Derivatives: Actions Needed to Protect the Financial System, put out by the General Accounting Office. The report convinced the accountancy professor that unregulated derivatives represented a major threat to the financial system. Today, he believes they could topple the global economy.

Wall Street has already gotten a taste of what can happen when derivatives—a type of complex financial contract—go wrong. In the turmoil of 2008, derivatives helped sink Lehman Brothers and triggered such huge losses at insurer AIG that it required the largest government bailout of the Great Recession.

Abdel-khalik plans to write a book for the general public to voice his fears of the even larger meltdown he believes could strike.

In the 20 years since the GAO report, the derivatives market has not only flourished, it has expanded exponentially, government reports show. “In 1994, the global derivatives market stood at $12.4 trillion,” Abdel-khalik says. Today, the over-

Source: U.S. Office of the Comptroller of the Currency

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“More money has been bet on derivatives than exists in the entire world by several times.”

Rashad Abdel-khalik pay off if a borrower defaults on a loan. These instruments make a lot of sense for those who issue loans; their loans are covered if the borrowers can’t pay.

But third parties that have no stake in the loan can also take out a swap contract on it. These investors will also get paid if the loan goes sour, says Abdel-khalik. In fact, any number of investors can hop on the bandwagon to buy default swaps on that loan. They—as well as the insurer—are essentially gambling on the outcome, just as pro football fans who have no investment in professional sports bet on the point spread when the Bears face the Lions.

But therein lies the problem. If a firm defaults on a $1 million loan, the insurers of credit default swaps have to pay every investor who bought a swap on that loan. “The problem is that they might not be able to pay,” says Abdel-khalik.

“That was the problem with AIG. It couldn’t pay.”

The same thing can happen with other sorts of derivatives bets as well.

Among countless other things, investors can place bets based on the movement of interest rates up or down, currency fluctuations, even the weather, Abdel-khalik says.

WHOPPING WAGERS It’s these over-the-counter bets that have ballooned the international derivatives market to mindblowing proportions. When Abdelkhalik tells colleagues how big this market has become, “some of them don’t believe me.” They think he has gotten the numbers wrong. But he hasn’t. The numbers are available online through reports issued by the U.S. Comptroller of the Currency and through the Bank for International Settlements.

The top 25 U.S. banks held more than $240 trillion in derivatives as of the third quarter of 2013, according to the Comptroller of the Currency.

To put those figures into perspec-

tive, the U.S. Gross Domestic Product for 2012 was estimated at $17.1 trillion.

“Even when the economy isn’t bad, betting on derivatives can cause serious problems,” says Abdel-khalik.

“But when things go wrong as they did in 2008, the problems from derivatives will be much worse.”

An early taste of trouble came in 1994, just seven months after the GAO report was issued. California’s populous Orange County, in a bid to boost investment income, bet on derivatives tied to changes in interest rates. The county lost the bet when interest rates rose. It landed in bankruptcy court.

By the late 1990s, critics sought to regulate derivatives. Chief among them was Brooksley Born, the head of the little known U.S. Commodities Futures Trading Commission, an agency that had the power to impose constraints on OTC derivatives. But Born’s efforts to regulate the industry drew a groundswell of

opposition from Wall Street and its allies in Washington, a powerhouse group that included Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert Rubin, his undersecretary Lawrence Summers, and SEC Chairman Arthur Levitt Jr. Wall Street contended that regulations would cause serious economic disruption. Wall Street won that fight when Congress passed the Commodities Futures Modernization Act of 2000 and President Clinton signed the act into law just before he left office.

ROLLING THE DICE ON ANOTHER MELTDOWN The Act barred the Commodities Futures Trading Commission from regulating OTC derivatives. It also stripped states of their former power to regulate so-called bucket shops. Bucket shops were unregulated securities dealers that flourished in the early 20th century. New York passed legislation outlawing

them after the financial crash of 1907, and other states followed suit.

Those existing laws would have enabled individual states to unilaterally target the unregulated derivatives market. But once the act was passed, neither the federal government nor the states could rein in OTC derivatives. “This was a one-two punch,” says Abdel-khalik.

Congress passed the bill even though the world had narrowly averted a derivatives crisis even as the bill was being debated. The crisis was triggered by the sudden meltdown of Long Term Capital Management (LTCM), a derivativesbased fund that had yielded dazzling returns. The fund operated on the basis of sophisticated mathematical

WHEN THE CHIPS ARE DOWN

$6.2

Here’s a sample of derivatives losses from 2012 to the present.

BILLION

$400+

$988

MILLION

MILLION

$618 MILLION

2012 Prudential Financial Inc., a major finance and insurance company, lost $618 million.

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2012 JPMorgan Chase, the largest U.S. bank, lost $6.2 billion, triggering a Congressional inquiry. JPMorgan agreed to pay $1,020 million in fines to settle cases brought by U.S. and British regulators in relationship to the culprit managerial actions.

Sources: The Wall Street Journal, Financial Times, The New York Times, and CNN

$984 $988 million

BILLION

MILLION

2013 2012 Met Life, Inc., the largest U.S. life insurer, lost $984 million.

$128

MULTI Monte dei Paschi di Siena, Italy’s third biggest bank, lost $988 million.

2013 Italy faced multi-billiondollar losses on derivatives contracts it restructured during the Eurozone Financial Crisis.

2013 The New York Times reported that derivatives losses had struck institutions across Japan. Among the losers were two universities, which lost more than $200 million each, and a Buddhist temple.

MILLION

2014 Sallie Mae profits skidded on derivatives losses of $128 million.

Sallie Mae is a major player in the student loan industry.

models the company thought were foolproof and protected the fund from disaster. But they weren’t, and they didn’t. When the Russian financial crisis struck in 1999 and interest rates suddenly changed, LTCM began to sink under mounting losses, says Abdel-khalik.

The Treasury Department and the Federal Reserve quickly recognized the danger and warned that LTCM’s troubles could spread to the entire financial system. The Federal Reserve Bank of New York then swiftly orchestrated a private bailout by major banks that kept LTCM afloat.

Free from the threat of regulation, the derivatives market chugged along until the financial crisis struck eight years later. It has now been more than six years since the heart of the Great Recession and two decades since the General Accounting Office issued an early warning.

But nothing has been done to rein in the threat derivatives pose to the economy, says Abdel-khalik.

“There has been no regulation of any kind for over-the-counter derivatives, not even a requirement for simple transparency,” he says. “The Dodd-Frank Act has elements that call for establishing regulations, but these efforts have been stalled in the procedural maze of Congress. The banks lobbied against regulation, and so far they have the upper hand. As long as everyone is making money, they don’t care how it’s made.”

Doug McInnis

•

Perspectives SPRING 2014

Derivatives usually lurk in the background of the financial system, making little splash until something goes wrong, says Abdel-khalik. Perhaps that’s because they are devilishly hard to understand and so most people have little grasp of what they are, he says. Even accountants struggle with them. “The transactions are extremely complex,” he says. “And accounting for these transactions is even more complex.”

The actual definition is quite simple. For example, Investopedia.com defines derivatives as “a security whose price is dependent upon or derived from some underlying asset.

The derivative itself is merely a contract between two or more parties.”

But that doesn’t begin to explain what derivatives are or why they can backfire spectacularly.

One way to understand them is to skip the definition and simply look at one example, such as credit default swaps. These are insurance contracts sold over-the-counter that

Sources for this story include PBS Frontline, The New York Times, The Wall Street Journal, Bloomberg News, and CNBC.

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[ 60-SECOND PROFILE ]

7,500 The approximate number of undergraduate and graduate students Hüseyin has taught in the 25 years he has served as a professor of organizational behavior and organizational design.

T EACHING A SSOCIATE

OF

F INANCE , R ETIRED

12

9&9 The total number of years and months that Hüseyin served as head of the Department of Business Administration during three separate appointments.

During Ruth’s teaching career, she had 12 offices: 1 at Middle East Technical University and 1 at Bilkent University, both in Ankara, Turkey; 1 at Northwestern University; and 9 in her 25 years at Illinois, where she taught communications and language skills in the English Department, the College of Engineering, the MBA Program, the MSBA Program (now MSTM), and the MSF Program.

10 The number of academic journals Hüseyin has been involved with in an editorial capacity, including the Journal of Professions and Organization, for which he serves as a founding editor; its inaugural edition will be published by Oxford University Press this spring.

23 2

3

The number of native languages spoken by Ruth’s students.

A native of Turkey, Hüseyin has been involved in the founding of three business schools at Turkish universities: Bilkent University, Sabanci University, and Sehir University.

5

The number of writing/communications consulting centers Ruth helped establish for Illinois students.

5,529 & 5,763

The number of majors created within Business Administration during Hüseyin’s tenure as department head: Management, Information Systems, Business Process Management, Marketing, and Supply Chain Management.

The number of miles from Champaign to Lugansk, Ukraine, where Ruth trained university teachers for the U.S. State Department in 2008; and the number of miles from Champaign to Bilkent University in Ankara, Turkey, where Ruth taught as a Fulbright Scholar in 1992.

70 The number of poems Hüseyin has written, an avocation that developed from listening to his father, a Turkish lawyer and judge, recite poetry.

62 With this many cookbooks in Ruth’s collection, she has plenty of recipe resources to explore her love for cooking.

13

The number of top law firms Hüseyin has been tracking to understand the growth of law firms between 1978 and 2006; and the number of law school deans whose careers he has studied as part of his research on the evolution of the legal profession.

The number of years Ruth appeared on the university’s List of Teachers Ranked as Excellent.

7 The number of Illinois degrees in the family; Ruth has three; Hüseyin has two; and their two daughters, Leyla and Sibel, each earned an Illinois degree. Granddaughters Julia, 13, Giselle, 4, and Jenavieve, 2, could add to that total.

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Ruth and Hüseyin met while they were students at the University of Illinois. They had their first date 40 years ago at Krannert Center for the Performing Arts and have been married for 38 years.

P ROFESSOR

OF

B USINESS A DMINISTRATION

Perspectives SPRING 2014

250 & 1,500

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[ INTERSECTIONS ]

BROADENING THE PERSPECTIVE

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ciety,” says White. “No matter what career path students take, they are all affected by business, either as employees, as consumers, or as investors. So when I left the presidency of the university in 2010 and became an active faculty member in the College and Dean DeBrock asked me to consider creating a course for the Campus Honors Program, this course immediately came to mind. It was the perfect intersection of my dream to teach such a class and the dean’s invitation that provided the opportunity.”

MAKING BUSINESS BETTER White explains that “the course is designed to look at business from every angle—the good, the bad, and the ugly. I am positively predisposed to business and have a lot of respect for its wealth-creating role, but I’m not an uncritical advocate of business. I believe business can be better, and in the class we spend a good deal of time studying and discussing how that can happen.”

The course is also designed to be collaborative. During the first six weeks, White provides the students with an introduction to business through case studies, readings, and discussions of business concepts and ideas. For the remainder of the semester, the class sessions are cocreated, with each of the 20 CHP students taking the lead in making class presentations with support from the professor.

White gives the students a menu of business topics from which they can choose. They write a prospectus and collaborate with the professor, who provides feedback on how to create an interesting and informative session. The students do the research, examine potential readings to assign, and develop the presentation through facts, concepts, data, slides, and video. After the presentation, White and the student lead the discussion, which White says is always lively.

“The students in the Campus Honors Program come from every discipline and are some of the very best undergraduate students in the world. About 80 percent of the students are non-business majors, and 20 percent are in business. They have strong leadership skills and are future thought leaders. It’s such a privilege to teach and work with them.”

THE POWER OF FEEDBACK The learning doesn’t stop with the presentation. White distributes student reaction forms after the presentation, so that peers can provide their feedback on each presentation. The next day he emails the student with his evaluation of the presentation, and he distributes the reaction forms to the student presenter at the next class session. The students also submit a paper on their topic and complete a final exam that requires them to draw on all they

have learned in the class. White scrutinizes both for content and writing.

“I believe in the power of feedback,” says White. “It’s a strong business principle in general. It not only provides evaluation of past work, it readies them for what comes next—and not just for the next assignment or the next class but for their future interactions with business or in business.”

Bag, who focused on globalization for her project, says the course deepened her understanding and helped her develop a more informed opinion of what business is and can be. Elmgren, who chose corporate responsibility for his presentation, says that what he learned from his research about corporate citizenship and ethics was something he had not been exposed to before.

That’s exactly what White was hoping for when he created the course. “I want the students to come away with new insights, so that when they intersect with business either directly in their careers or through their roles as consumers or investors they will have a foundation from which to view that interaction. I want them to come away with a deeper appreciation of the importance and value of a vibrant private sector and to also be instructive critics of business in order to make it better in the future than it is today.”

Cathy Lockman

•

THE PEOPLE Professor B. Joseph White and the students in his BADM 199 course: “Business as a Force in American Society” THE IDEA Create a collaborative course that brings non-business and business students in the Campus Honors Program together to explore a range of business topics THE RESULTS Through feedback and collaboration, these students are prepared to act as well-informed, instructive critics as a way to improve business in the future

Perspectives SPRING 2014

B

efore Erik Elmgren and Pooja Bag registered for Professor B. Joseph White’s class, they didn’t have the most favorable opinion of American business. Elmgren, an instrumental music major, and Bag, a bioengineering student, were more familiar with the negative aspects of business associated with the Great Recession. But as Chancellor’s Scholars, they’re also bright and openminded, so when they had an opportunity to learn more about business through a course offered by the Campus Honors Program (CHP) they both jumped at the chance and registered for BADM 199, “Business as a Force in American Society.”

“I signed up because I thought that having exposure to a wide variety of business topics and philosophies would offer me a broader perspective as I work alongside business professionals in a bioengineering industry career in the future,” says Bag. That’s just what White, president emeritus of the University of Illinois and the Stephen F. Towey Professor of Business and Leadership, had in mind when he created this class two years ago—and even 30 years ago when he first conceived of it.

“Throughout my career at the University of Michigan and the University of Illinois, two great public universities, it always seemed to me that non-business students would really benefit from understanding business as a major institution of American so-

19

[ REALITY CHECK ]

The Reality

The Reality Check

T

I

here currently is no law in the United States that requires employers to provide paid sick leave for their workers. However, data from the Bureau of Labor Statistics indicates that 74 percent of full-time workers and 24 percent of part-time workers in private industry do have paid sick time, and 89 percent of state and local government workers have the benefit as well. For those employees, the average benefit is 8 days of paid sick time in a year. For those employers, the average cost is 25 cents per employee per hour worked.

What about the nearly 40 million who don’t have this benefit? Some state and local governments across the country are taking up their own efforts to require companies to provide paid sick leave. San Francisco, Seattle, and New York City are among several cities that have already passed such legislation. States across the country are also considering such initiatives. In 2012, Connecticut became the first state to mandate paid sick leave. But there are also 10 states that have prohibited local governments from enacting their own paid sick leave requirements, including Wisconsin, Indiana, and Florida.

s paid sick leave a burden for business or can it benefit an organization in the long run? According to Teresa Cardador, assistant professor in the School of Labor & Employment Relations, employers pondering this issue should consider the long-term perspective.

“One of the reasons why so many employers already offer paid sick leave when it is not legally required is that they realize that the incurred long-term benefits far outweigh the short-term costs,” says Cardador, who earned her Ph.D. in organizational behavior from the College in 2009. “In this case, employers may experience several gains, including benefits to workplace health, workforce commitment, and organizational reputation.”

First, with respect to workplace health, employee choices about coming to work sick or staying home without pay have implications not only for the employees who are ill, but for their healthy co-workers.

“Workers without paid sick leave will be tempted to come to work sick, which may only serve to delay recovery and increase the chances that other workers will get sick,” she says.

Second, paid sick leave may affect employee commitment.

According to Cardador, there is evidence that when organizations provide employee-friendly policies, workers reciprocate with increased commitment to the company, which translates to employee retention as well as a willingness to work hard on the company’s behalf.

Third, employee-friendly benefits, such as paid sick leave, are also associated with reputational gains for companies, which can aid in attracting and recruiting the best talent available. Conversely, if a competitor provides paid sick leave when your company doesn’t, it will be more difficult to attract staff.

“The long-term benefits to workplace health, workforce commitment, and organizational reputation may outweigh the short-term focus on employer cost per employee hours worked,” explains Cardador.

“When employees are treated well, they often respond in kind.

This established relationship is referred to as a ‘double bottom line strategy’—when organizations focus on people, productivity and profits follow.”

Cathy Lockman

Teresa Cardador, assistant professor in the School of Labor & Employment Relations, earned her Ph.D. in organizational behavior from the College in 2009.

20

Perspectives SPRING 2014

•

21

[ REMANUFACTURING ]

From Old to Resold

“If the numbers indicate that remanufacturing makes economic sense, then we ask whether it makes environmental sense. In the end, this works like anything else. You have to crunch the numbers to get an answer.”

WHAT REMANUFACTURING MEANS FOR PROFITS AND THE PLANET

Nicholas Petruzzi

22

“Our model can’t tell them what to do.

But it can help them understand how various variables, like cost, prices, customers, and remanufacturable design interact and affect environmental footprint and profits.”

Dilip Chhajed

should also benefit the environment.

“But that isn’t necessarily true,” says Nicholas Petruzzi, associate professor of business administration and a co-author of a new study from the College of Business.

In fact, remanufacturing isn’t always good for the environment, cautions the research, which offers a mathematical model to help companies develop insights on when remanufacturing will benefit the environment and when it won’t.

“The mathematical model enables corporations to see what happens as variables change,” says Dilip Chhajed, professor of business administration and co-author of the paper, which has been accepted for publication in the International Journal of Production Economics.

“Our model can’t tell them what to do. But it can help them understand how various variables, like cost, prices, customers, and remanufacturable design interact and affect environmental footprint and profits.”

decision may be good for profits, but it may not be good for the environment.”

GREEN BY DESIGN To determine when remanufacturing has environmental benefits, it’s first necessary to understand how remanufacturing ideally works.

Many companies now do a lot of costly front-end designing so that they can reuse as many parts as possible for the remanufacturing market. But some companies skimp on front-end design to save money, and as a result, fewer of their parts can be salvaged. These parts end up in the dump.

Cell phone manufacturing provides an example of what can go wrong. Cell phone makers constantly upgrade their products, creating a huge pool of used phones as customers opt for newer models. Many of those old phones are remanufactured for secondary markets, where customers buy them because they’re cheaper than new phones.

Sometimes the market for remanufactured phones is bigger than the market for new phones. In that case, a manufacturer might make

CALCULATING THE BENEFITS

more new phones just so there will eventually be enough used phones for the later remanufactured phone market. Of course, that could leave a lot of unwanted new product sitting around, so the manufacturer will have to determine how to make the new phones cheaper so they will all sell.

One option might be to skimp on front-end design costs, thus low-

ering production costs and the price.

But that decision may mean that fewer parts of the cell phone can be salvaged for remanufacturing. And the fewer parts that can be salvaged, the more parts end up in the electronics garbage heap, says Chhajed.

“If the percentage of the product that can be remanufactured is very low, the total environmental damage is higher,” he says. “The initial design

Responsible companies would want to know this before they begin manufacturing. The model, created

by Chhajed, Petruzzi, and Baris Yalabik, a former doctoral student in the College of Business who now teaches at the University of Bath, helps them figure that out.

“These mathematical models provide a framework for companies to do a ‘what-if’ analysis,” Chhajed says. “It’s what happens if I do this versus what happens if I do that.”

The calculations involve two steps, says Petruzzi. “If the numbers indicate that remanufacturing makes economic sense, then we ask whether it makes environmental sense. In the end, this works like anything else. You have to crunch the numbers to get an answer.” • Doug McInnis

Perspectives SPRING 2014

R

emanufacturing has become a multi-billiondollar business. By refurbishing discarded electronic products, businesses get two chances to make money while simultaneously benefitting the environment by generating less trash. Cell phones, refrigerators, wind turbines, and medical devices are only a few of the products now made new for resale.

In remanufacturing, a used product is taken apart. Good components are reused; worn out components are repaired or replaced. Ideally, when the process is complete, the product has a second life, consumers have access to a cheaper product, and the planet has less waste to worry about.

On the surface, remanufacturing should be a no-brainer. The opportunity for companies to get two life cycles from one product is not only good for a company’s bottom line, it

23

[MANAGING RISK ]

I

That’s a sturdy and widespread safety net—one that is seven times larger than the amount taxpayers spent in 2000.

Why are the taxpayers subsidizing insurance payments for farmers?

The idea is that by paying part of the premium, the government makes it more affordable for the farmers and, therefore, more likely that they will actually purchase crop insurance.

That, in turn, makes it less likely that only the high-risk farmers sign up, which could destabilize the crop insurance program. It also obligates the private insurance company to take on some portion of the risk for low crop yields and prices, rather than the government providing a remedy through disaster aid payments.

“But with ever-increasing subsidies of premiums, it stops being an insurance program and starts being a free disaster aid payment program,” says Tatyana Deryugina, assistant professor in the Department of Finance.

And that’s with significant disaster aid programs already in place.

On top of the large amount of crop insurance subsidies farmers receive, Deryugina explains, the government continues to pass disaster bills, further aiding farmers. Thirtyeight relief bills from 1989 to 2009 resulted in $68.7 billion in disaster aid going to farmers.

“It ends up being a very expensive program for the American taxpayer,” Deryugina says.

PLANTING THE SEED Federal crop insurance is administered through the Risk Manage-

24

ment Agency (RMA) of the U.S. Department of Agriculture. The RMA operates the Federal Crop Insurance Corporation, which was founded in 1938, originally to help farmers recover from the Great Depression and the Dust Bowl.

“Crop insurance was largely an experimental, small program until 1980,” Deryugina says. “That was the year there was a push to expand crop insurance availability so that farmers had access to some kind of crop insurance.”

And the original intent, she adds, was good. “It was to get farmers off of disaster payments,” she says. “It’s bad to have a situation where you’re just bailing people out sometimes but not all the time. That creates even more risk and uncertainty. It’s not necessarily fairly applied, and it’s politically hard for the government to say to a farmer without insurance, ‘Well, we’re not going to help you at all.’”

That, Deryugina adds, is why disaster aid is still given to farmers. “The government would rather have a situation where farmers would buy crop insurance and they don’t have to pass these bills,” she says. But farmers are not forced to buy insurance. So, rather than turn insuranceless farmers away, the government helps them out—and, in some cases, requires them to buy insurance for the next two years.

One reason crop insurance was quite small until 1980, she notes, is the concern that the only farmers who would take it out would be the ones who would know they would get a payout—“for example, those

Perspectives SPRING 2014

A Growing Concern

n 2012, the United States experienced its worst drought in more than 50 years.

While no farmer—or American taxpayer—wanted that drought to happen, most farmers weathered that dry spell quite well, in part thanks to the $14 billion that taxpayers spent in paying more than 60 percent of farmers’ crop insurance premiums that year.

25

BY THE NUMBERS

1.2 million

282 million The number of U.S. crop insurance policies in force last year

18

$90 million The number of acres covered by those policies

The amount taxpayers will pay for crop subsidies over the next decade

10,000+

26 Number of insurance companies designated by the USDA to provide crop insurance for 2014

The number of farmers who, in 2011, received an annual subsidy in excess of $1 million

The number of farmers who, in 2011, received more than $100,000 in subsidies

Source: Environmental Working Group, www.farm.ewg.org

“With ever-increasing subsidies of these payments, it stops being an insurance program and starts being a free disaster aid payment program.”

Tatyana Deryugina

26

ture. So that goes a long way toward making sure farmers don’t take advantage of the fact that they have insurance.”

But the subsidies, Deryugina says, have become too excessive. And one of the primary reasons for the subsidies—to help insurance companies avoid adverse selection (i.e., doing too much business with farmers who are very high risks)—can be dealt with more effectively by requiring all farmers to buy crop insurance.

The insurance companies are obligated to insure all eligible farmers,

but not all farmers are obligated to buy. If they were required to carry the insurance, it would spread the risk for the insurance companies across a more diverse population, helping them avoid adverse selection without costing the taxpayer so much money.

“States mandate that all drivers have auto insurance,” she says. “That largely gets rid of adverse selection.

If the USDA were to make participation in crop insurance a requirement in order to get some of the other subsidies that farmers get, then that

would do something similar to subsidizing crop insurance payments, but at a reduced cost to the American taxpayer.”

Another downside to crop insurance, Deryugina says, is its lack of competition among insurance providers. The government designates what companies can offer crop insurance (currently the number of companies is 18). They also set the prices that can be charged for the insurance, determine which of the 100 eligible crops can be insured in different parts of the country, and dictate the types of insurance that can be offered (e.g., individual yield, revenue, group yield, and group revenue).

“It’s not competitive in the truest sense of what we think of as a competitive market,” she explains.

“Providers are not allowed to set their own prices. While they can compete on marketing, insurance companies can’t really innovate in the product space and they can’t really compete in price with one another. Allowing competition could be a good thing.”

GROWING PAINS Subsidy levels have risen significantly since the Federal Crop Insurance Act was passed in 1980. Acts in 1994 and 2000 raised the subsidies.

“Possibly the government thought they could make the subsidies high enough that they’d get really high participation,” Deryugina says. “The current participation is pretty high.

Most acreages are covered by some kind of crop insurance. But we’re still paying disaster payments, so the strategy of raising subsidies hasn’t really worked.”

What can work, she says, is a combination of mandated coverage and allowing providers to offer their own plans and prices.

“I think it’s a good idea to move in the direction of letting companies experiment with prices and products and see what happens,” she says.

“You can put limits on it at first and see how it goes and if it’s promising, you can loosen the reins. Competition has the potential to create innovation, improve outcomes, and possibly come up with better risk management products.” • Tom Hanlon

WHAT’S ON THE HORIZON?

President Obama in February signed into law legislation that will increase the taxpayers’ cost for crop insurance over the next ten years from $83 billion to $90 billion. Currently, the government subsidizes almost two-thirds of a farmer’s premium for crop insurance. According to The Washington Post, the estimated $7 billion increase in the new farm bill provides additional assistance to farmers to cover “the deductibles that farmers have to pay before the insurance kicks in.”

But the Agriculture Act of 2014 also eliminated direct cash payments to farmers to the tune of an estimated $19 billion over the ten-year period. Previously, these payments allowed for farmers to be paid for every acre they owned, whether it was planted or not, and regardless of prices and profits. The new system only delivers payouts if farmers take losses.

It’s a shift in costs that marks a drastic change from the 2008 farm bill, where the government paid twice as much in direct cash payments to farmers than was paid for crop insurance subsidies. In the 2014 farm bill, it’s just the opposite, with crop insurance receiving twice as much of the funding pie than direct subsidies.

What is the rationale behind these shifts in money and policy? According to supporters of the bill, the shift is necessary in order to continue to provide an important safety net for American agriculture but to do it in a way that establishes a stronger, more focused approach to managing risk so that financial support is received when there are actual losses.

But opponents believe it’s more of a wash—that the money formerly handed over in direct cash payments will now be disbursed in more subtle ways through the crop insurance program.

Sources: The Washington Post, New Republic, NBC.

Perspectives SPRING 2014

growing crops on very risky land,” she says. “So next year the insurer might have to raise their prices. And that makes their pool of insured people even riskier, until only the highest risks find it worthwhile to buy insurance, and that can completely kill a market.”

One positive about crop insurance, Deryugina says, is that there’s a lot of risk in farming, which insurance can help mitigate. “Despite advances in irrigation and crop varieties, there are still a lot of fluctuations in how much a farmer can actually produce. Having an insurance product that helps them avoid some of that risk is appropriate.”

Another positive, she adds, is how the program is implemented, with yield guarantees based on individual yield histories. That goes a long way toward preventing moral hazard—such as farmers planting a crop they know will fail so they can get insurance for it. “Suppose that a farmer just didn’t make an effort at all one year,” she explains. “The next year their yield history would reflect that, and it would be much harder for that farmer to be paid in the fu-

27

[THE MAIN EVENT ]

RIPPLE EFFECTS to various panels of realistic stakeholders. Early rounds were held at each university, and the top two teams advanced to the final round held at BP’s offices in Chicago.

During that last round, students presented to a panel at a simulated annual general meeting.

The case, set in a fictitious developing African nation, focused on a special project in the downstream oil industry. The research questions centered on building a long-term, successful enterprise, while taking the underlying professional responsibility issues into consideration.

“This is a unique competition that gives interdisciplinary student teams the chance to grapple with a real-life business problem from top to bottom,” says Gretchen Winter,

executive director of the Center.

“The members of the team bring different skill sets and perspectives to the task. They have less than a month to build their team, immerse themselves in the facts, and develop an approach that is both financially viable and focused on professional responsibility. This is real world, too.

It is exactly the type of challenge they will face in business.”

According to Kathryn Rybka, a College faculty member who coordinates the competition and serves as a coach and advisor to the Illinois teams, communicating the plan is also a critical part of the realworld challenge. “Students have to consider the business and professional responsibility interests of multiple stakeholders, some open

to their ideas, but many not. They have to defend their ideas and articulate their positions to judges who convincingly play the roles of individuals and organizations who would be affected.”

Several of those judges were BP executives. Other BP staff helped build the case documentation. Their excitement about the event and their commitment to it extended the impact of the competition as well. And, with competitions expected to continue in the years to come, there will be more ripple effects as future business leaders take on the challenge of developing realistic business goals and professional responsibility strategies.

Cathy Lockman

•

Left to right: Team members present their case to stakeholders during the 2014 Professional Responsibility Strategy Competition; Students from Illinois and Notre Dame are briefed as part of the facilities visit at BP offices in Chicago; the Illinois team of Zheng Mao, Lorita Ivanova, Wenyan Zhu, and Sreekant Vijaykumar were the winners of the competition; before the competition, judges gather to discuss how they will evaluate the various teams’ presentations.

28

Perspectives SPRING 2014

T

here may be only one winner of the 2014 Professional Responsibility Strategy Competition, but there are plenty of ripple effects that occur by providing students with this opportunity.

The competition, jointly supported by BP and the College’s Center for Professional Responsibility in Business and Society, challenged teams of students from Illinois and Notre Dame to assess how a company can meet its business objectives while remaining committed to professional responsibility. Four-person teams of undergraduate and graduate students in business, law, labor and employment relations, and engineering developed financially viable and professionally responsible business plans and presented them

29

[REAL ESTATE ]

How Distant Speculators Impact the Housing Market

and Miami, where housing prices went through the roof even while there was a boom in new home construction.

“Why Vegas and not Austin, which is also supply unconstrained?”

Chinco asks. “In Austin, there’s very little run-up in prices. Explanations like low interest rates and lax lending standards are nationwide events, so that couldn’t explain this city-specific pattern.”

THE ANSWER: DISTANT SPECULATORS

“You should think twice [about buying a second home in a distant city] if your main goal is to take advantage of house price appreciation that you think is coming down the pipeline. There are lots of other [local] people . . . who are better informed about how the market is behaving, and they are much better able to take advantage of this opportunity.”

Alex Chinco

30

So what is the explanation? Research conducted by Chinco and Columbia University professor of real estate Chris Mayer provides the answer: it’s out-of-town second house buyers who behave like misinformed speculators.

Unlike local buyers of second homes, who have much more information about their particular market, out-of-town buyers are less knowledgeable about local conditions and less likely to actually live in the community. Instead, they are

speculating in the hope of making quick, large gains on their purchases.

But there’s a price to pay for that strategy.

“As a distant speculator,” Chinco explains, “it’s harder for me to make use of my property in Vegas than it is for a local second-home owner to.

If I only live in it half a year, I’m only getting half of the benefit of living there. If I rent it out, I’m going to pay a property manager. Distance is a huge drag on your returns.”

In fact, Chinco’s research shows that out-of-town buyers actually earned 6 percent per year lower capital gains on their second house purchases than local buyers did at the peak of the housing boom.

THE TAKEAWAY: THINK TWICE The patterns of mispricing were evident not only in Las Vegas but also in Phoenix, Miami, and the suburbs of Los Angeles. Why these cities and not others? As Chinco studied the data, it became clear: out-oftown buyers played a big role in the recent housing boom.

“In cities like Las Vegas, Phoenix, and Miami, where lots of out-oftown buyers arrived, house prices did two things,” he says. “One, they rose dramatically; and two, they became unmoored from fundamentals, which meant renting became really cheap relative to owning.”

What does this mean for someone who is thinking about buying a second house in a different city?

“You should think twice if your main goal is to take advantage of house price appreciation that you think is coming down the pipeline,” Chinco cautions.

“There are lots of other people who are closer to Vegas or living in Vegas who are thinking about buying a second house who are better informed about how the market is behaving, and they are much better able to take advantage of this opportunity. I’m not saying you should never do this, but if your main goal is capital appreciation and you have price limits, then think hard about your decision.”

Tom Hanlon

•

SKYROCKETING PRICES House prices peaked in the 2000s at different times in different cities, with many cities experiencing single-year peak growth in the teens and some above 20 percent, but those peaks paled in comparison to, and were most evident in, Las Vegas, Miami, and Phoenix, where out-of-town second-home buyers flooded the market.

2000–2007 HOUSE PRICE APPRECIATION RATES Average Growth Per Year

Single Year High Growth

Las Vegas

3.69

44.3

Miami

6.48

27.3

Phoenix

3.53

39.4

Perspectives SPRING 2014

A

lex Chinco has been studying a puzzle for the last few years. And his analysis has paid off. In fact, you might say he’s found the missing piece.

Chinco, assistant professor of finance, has been poring over data related to housing prices in the United States from 2000 to 2007 to determine why pricing patterns for certain cities don’t follow conventional thinking.

For example, in a city like San Francisco where it’s difficult to build new homes due to zoning restrictions, the supply is fixed. If the demand for housing in such a city goes up significantly, you would expect housing prices to go up as well. By contrast, in areas where there are few zoning restrictions, like Las Vegas, you would expect that an increased demand would result in an increased number of homes being built, not an increase in housing prices.

But those expectations didn’t hold true from 2004 to 2008 for certain cities, like Las Vegas, Phoenix,

31

[ THE REASON WHY ] WHO Cathy Wallace, chief risk officer, State Farm WHAT Responsible for assessing the risks and opportunities to the enterprise, aggregating them, and ensuring there is capital commensurate with those risks and opportunities WHERE Has served State Farm in Illinois, Colorado, and California WHEN Graduated from the College with a degree in accountancy in 1982, joined State Farm in 1983, and earned her EMBA from Illinois in 2004

RISKY BUSINESS

WHY The CRO role, established at State Farm three years ago, helps the company manage risk and prepare for the unexpected, just as it helps its customers do the same

32

as well as their magnitude. There is quite a bit of mathematical and statistical modeling involved in risk aggregation, which tells us what is possible under certain circumstances and in given time frames. The next step then is to be sure we have the capital that is commensurate with that risk.”

How do Wallace and her team accomplish all that in an organization that is comprised of multiple companies? It starts by setting up a structure that is nimble and useful for all business areas of the organization—a framework that allows for assessment of operations, emerging risks, business strategies, insurance, and catastrophic risks.

“We help all our business areas do risk assessments, and we support their efforts,” says Wallace. “It’s important to us that our leaders think about risk management as part of their everyday role and that they understand the strategic goals of the organization and how risk management fits within that.”

LIKE A GOOD LEADER Wallace’s experience across various functions in the organization has

prepared her well for the CRO responsibilities. Over her 30-year tenure at State Farm, she has worked in accounting, human resources, credit union operations, finance, and prior to being appointed CRO in 2013 was the operations vice president in the Great Lakes Zone.

Earning degrees from Illinois has prepared her well, too. “I received a great education in accountancy, and I pursued the Executive MBA at Illinois because I believe in continuous learning. Certainly, you learn a great deal in a job over 20 years, but more formal education, like what I received through the EMBA program, gave me a chance to look outside my own organization as a way to contribute more to it.”

Both her work and her education have helped Wallace formulate her own philosophy on what makes a strong leader—no matter what part of the organization you’re in.

“First, you need to understand the company’s strategic goals so that you know what you need to accomplish as an organization,” she says.

“Second, there is no substitute for strong communication and collaboration. You need to establish a con-

stant loop of sharing information, gathering feedback, ensuring that your team is well aligned, that they’re getting what they need, and that you’re giving them the space to do their jobs. And third, you have to establish trust. In risk management, we’re working to identify trends in business and in our industry, and people need to trust that you’re there to help them because they’re sharing what’s most concerning to them.”

RISK AND REWARD Having the responsibility for risk management in a company that for 92 years has managed risks for others is a challenging and satisfying endeavor, says Wallace.

“I get the most satisfaction when I see that we have helped leaders in our organization make well-informed decisions. There’s no end to watching for risk. There’s never a dull moment, and you always have to be diligent.

Success for me is avoiding surprise.

It’s hard to know what you don’t know, but ultimately we work hard to assess the risks and the opportunities so that our business leaders have no surprises.”

Cathy Lockman

•

The lobby at State Farm’s corporate headquarters in Bloomington, Illinois, features a 1922 Model T, symbolic of the year the company was founded as a firm specializing in automobile insurance for farmers.

Perspectives SPRING 2014

S

urprise!” is not the word Cathy Wallace wants to hear when she enters her office in the morning, unless someone has won the lottery.

As the chief risk officer for State Farm, Cathy leads a team that works to stay ahead of the unexpected—a team that evaluates risks and opportunities so that there are few or, even better, no surprises.

According to Wallace, it’s a role that means “you’re always scanning the landscape to take in all the information you can about what might impact your business, to assess what that information means, to evaluate what might not yet be visible, and to prepare for those eventualities as much as possible.”

If it sounds like she and her team are trying to predict the future, they are, and there’s no crystal ball to help them. Instead, Wallace’s approach is both art and science—the art is communication and the science is actuarial.

“We’re always evaluating past and current events to look for signs of what’s to come,” says Wallace. “As we gather information, we also have to quantify it so that we have an idea of the likelihood of certain scenarios

33

[ PARTING SHOT ]

“It’s been a long, cold, lonely winter. It seems like years since it’s been here. Here comes the sun.” Those words, first sung by the Beatles in 1969, were especially true in Urbana-Champaign 45 years later. As temperatures plummeted and snow piled up outside BIF and across campus in the winter of 2014, students donned their Illini sunglasses in anticipation of spring.