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I am really excited about this interview.  He was my favorite teacher when I was getting my MBA at the University of Rochester's Simon School.  He has won every teaching award there is and is also extremely well published.  The interview took place on Wednesday February 13, 2002 by phone so if I didn't get every word quite right I apologize but I think it came pretty close.  Enjoy!

An interview with Clifford W. Smith from the University of Rochester's Simon School.  Clifford W. Smith Jr., is one of the most respected business professors in the nation. Smith has published 14 books and has been a featured author of more than 80 articles.  His primary fields of research include corporate finance, derivatives, and financial intermediation. Smith received his bachelor's degree in economics from Emory University in 1969 and his Ph.D. in economics in 1975 from the univerity of North Carolina.  In 1974, Smith began his career as an assistant professor at the Simon School, he worked his way to becoming a full professor in 1986. Currently he is the Louise and Henry Epstein Professor of Business Administration and Professor of Finance. 

While very well written, when I think of Professor Smith it his teaching that comes to mind.  He has an amazing ability to at once be both a storyteller and educator, to hold everyone’s interest while simultaneously challenging them with the intricacies of finance.  Indeed, if imitation is the most sincere form of flattery, then I would be remiss if I did not let it be known that to this day I model my class room teaching on his methods. 

Possibly best known for his ability to synthesize a great deal of research quickly and succinctly, I  had the fortunate opportunity to interview him to kick off the new FinanceProfessor interview series.  I hope you enjoy it as much as I did:
 
 
 

Jim:  Thank you for taking some time to talk with me for this interview.  I am sure that the readers will enjoy it immensely.  I guess we can start with why you are finance?  Both your undergraduate degree and PhD are in economics.  What led you into finance? 

CS: There are really two answers to that question: First my father was president of a bank in small rural town in Georgia and also had an insurance agency, so growing up there were financial services discussions that regularly took place.  In fact my first job was in the bank.  So I had an interest.  The second part of the answer is that when I accepted a job at the Simon School (which as you know was quite small) I was not departmentalized away.  My interests were allowed to develop across fields in a way that more or less gravitated me towards financial economics. 

Jim:  Given your tremendous track record on picking research topics, I am sure many readers would be interested in how you do develop or choose your topics.

CS:  As I look over my career, I think a lot of the ideas have grown out of the classroom.  In the classroom I try to put together a set of lectures that cover a series of topics that I think the students ought to know about.  As I go through the material many interesting questions arise.  Some of these logical questions have yet to be answered by the literature.  These are then something worth spending some time on.

Jim: That suggests a strong synergy between your research and your classroom activities. 

CS: Yes.  So many people say there are only so many hours in the day and that to do more of one thing is to give up another.  What they are overlooking is that in a social science as relatively young as finance there are a large number of pragmatically important, managerially interesting, and academically challenging questions that we have not gotten around to answering.  Some of these become apparent either in the classroom or in preparing to teach the class. 

When you think about what to communicate to the next generation of managers, you want to be able to say not just what to think, but how to think about things and have some evidence, some empirical verification, that shows that this is a useful way to think about things.  That it is a useful framework or an useful guide that will help these managers make the correct decisions in the future.

Jim:  Given your many publications, is there any one that is your favorite?

CS: I have enjoyed a whole series of them.  One in particular was a challenging paper to “Get right” was the paper with Ross Watts in the Journal of Financial Economics where we were trying to look at determinants of leverage, dividend policy, and compensation.  It seemed to us that underlying characteristics of the firm logically drove these choices.  In particular, the firm's investment opportunity set and the regulatory environment which had been suggested by the existing literature.  There was however little empirical evidence. 

That was very satisfying.  But from first draft to published paper took about 10 years.  Of course we had a lot of balls in the air, but still it was a real challenge and very satisfying in the end. 

And this was a paper that grew out of what we do in the corporate finance class.

Jim: Changing gears a bit here, what is your take on the Enron case?

CS:  I am concerned that most of the popular discussion about Enron to date has generated more heat than light.  Most of the discussion so far has Enron being composed of 10% underlying economics and 90% smoke and mirrors.  My priors are that these numbers are closer to the reverse.  But at least so far, there has been very little discussions on what the underlying economics were and how the ultimate crisis was precipitated. 

My suspicions are that Enron had talked themselves into the proposition that they had an effective hedging strategy in position and by that had convinced themselves that a $1 a barrel, or a 25 cent a barrel or a whatever cent a barrel change in oil priced would leave them unaffected.  However, after 9-11 oil prices fell precipitously and it was one of those events that highlights that very large changes, although infrequent in the distributions that we deal with do occur and that these distributions have very fat tails.  If you look at even 5-years of daily data you can talk yourself into believing that you have more precise estimates than you really do.  It is a similar story to what happened at Long Term Capital Management. 

Certainly there were accounting issues that this case highlights, but too many other things were going on to place the blame on any one area.  At least for now it is too early to say much.

Jim: This morning on C-Span former SEC chairman Arthur Levitt was on and was speaking to the idea that accounting firms will demand more financial knowledge, in particular more instruction in valuing derivatives and in risk management.  What is your opinion of this?

CS: As an educator, I , well, anything that will shift the demand curve to the right is something that I will not speak against.  But I would warn you that a lot of people on TV have their own agendas and, I am afraid to say, that few of these agendas have at their heart finding out what went wrong and finding ways to make it less likely to occur in the future. 

One of the things I would conclude in looking at this is that anyone who takes a careful look at what has or is going on--who looks at the information disclosures at Enron--would have to conclude, that management, if they had it to do over again, would manage things to get a different outcome. 

To the extent that you have people who believe their job is to get a higher stock price versus to get an accurate stock price, this shows that there certainly is a downside.  This case may be useful in highlighting this problem.  It definitely brought about a set of consequences that are playing out in ways that are not what they had hoped.  So in a way, periodically going through this may be a good thing.

Jim:  So while these cases may serve as useful reminders, they are an expensive way to do so.  What would you say could be done to prevent future Enrons?  In particular what role might government have in the mix or should market discipline be enough?

CS: Well, if I got to make the rules (and no one has been silly enough to let me do so yet), there certainly is a role of government in making sure contracts are enforced as written.  The idea that the government is likely to be better than private institutions in designing disclosure policies is something I remain skeptical about.  I have serious concerns that a one-size fits all set of rules that limits management choices is appropriate. 

My estimation of how we got where we are now is different than you'll get from Arthur Levitt.  I believe the development of the accounting profession had a strong internal monitoring and stewardship role that goes back centuries.  Only in the last couple of 100s of years have outside investors, and at first it was only lenders, recognized that these internal numbers might be useful--they might help control problems between borrowers and lenders.  It has only been since the SEC was established in the 1930s that the idea that an important component of the accounting system has to do with its input to security investors and that this has function has been elevated above the importance of the internal uses.

I get concerned in public policy debates as more and more people take the position that what is important is the external valuation use of accounting numbers.  There are times when we make tradeoffs between internal control function and the external communication function--I personally would be more comfortable letting the market deal with going to the right margin rather than letting the government mandate what is right.

Jim:  It has been argued that managers have an intrinsic conflict of interest when it comes to selecting an auditor.  One proposed solution that has been bantered about (in fact it was on the FinanceProfessor forum) is to allow the insurance firms that provide director and officer insurance (D&O) to select the auditors.  In turn they would be able to set premium prices for differing auditors.  What do you think about that idea?

CS:   Well let me ask you: If I were an insurance company and you asked me to help choose an auditor, lets was between Joe's Audit, or AuditsRus, and PWC.  Would you predict it would impact the premium?

Jim: Yes, I think it would.  If the audit function is important at all, then the quality of the audit should affect the premium and to the extent that this quality can be signaled through the reputation of the auditor I think the premium would vary with the selected auditor.

CS: Well, I have never seen a t-statistic on D&O insurance premiums, which may be because D&O insurance premiums are not disaggregated, but I'd be dumbfounded if a company that writes D&O insurance would be unconcerned with the selection. 

Jim:  Has Andersen now assumed the role of AuditsRus?

CS: By no means can we say that at the present since we do not know the underlying economics and hence we do not know the cause of the problems at Enron. 

I should stress however, that I am not trying to argue that when we finally get to the bottom of all of this, that they (Andersen) will have a zero in their blame column.  There is a lot of blame to go around here and it is unlikely that anyone will be totally free from it. 

Jim: Changing gears slightly, we have seen tremendous financial innovation over the past thirty years in all areas but especially in derivatives and risk management.  In the coming months the US will introduce single stock futures contracts.  What impact, if any, do you think these will have on the underlying equity markets and also on managerial compensation and the like?

CS:  When you look at the research of when you start trading options on a stock, the most dramatic effect had to do with the volatility of the underlying security, which seems to go down.  My interpretation is that you have increase liquidity.  To understand that you have to go back to the microstructure (you can go all the way back to the original Treynor work in the Financial Analyst Journal where you have a specialist trading with both informed and uninformed investors. 

Think about it a specialist and people trading for liquidity reasons.  Here the specialist is going to make money, the specialist will systematically lose in trades with those who have better information..  One of the things a derivatives market does is to siphon these information traders who will want to trade where they can better leverage this information. 

What this then does is to reduce the information disparity in the asset market, which increases liquidity. 

The impact if these new futures on other parts of finance such as executive compensation seems to me to be more conjectural. 

We already have a set of insider trading rules on the books and I’d expect that selling stocks, buying a put, or entering a future contract logically should all be treated the same with respect to the proprietary trading. 

Other than that I just am not ready to say what affect these will have. 

Jim:  What advice do you have for someone who is entering the filed now with a freshly minted Ph.D.?  Or to someone considering entering the field?

CS: As I said before, Financial economics is ultimately a social science and we are ultimately trying to understand things we can observer in contracts, markets, and firms on this planet.  We are trying to understand why things happen as they do. 

Some will approach facets of this at a higher level of abstraction and attempt to use a model to place structure on the events while others people will start with data and try to organize it in a way to make more sense out of it.  Ultimately we want to develop more confidence in each method by explicitly testing implications of the models and by letting the problems that got highlighted give us direction to modify the analysis to include things that have been overlooked.  This is an interactive procedure with interaction between the theory and the testing of the theory.  It is almost as if we are bootstrapping our way to greater understanding.

This can best be shown on the financial asset side of the aisle where we have developed a pretty rich description over the last 35 years.  Sharpe-Lintner came up with a basic model of asset pricing, which was then tested by the likes of Fama-McBeth as well as many others.  Problems that they found led to a 2 factor and then a multifactor model.  And the tests got more sophisticated and the models as well.  Our models today go far beyond what they were thirty years ago but we still may not understand it and we can’t quit worrying about it.

Another [example of this basic process]  has to do with option pricing where we have ongoing interaction between theory and the testing of the theory. 

I think unfortunately that there has been less of this testing in corporate finance.   This is partly due to less data availability.  And also some of the theories are less easily transferred to a regression and more simultaneous equations to look at.  These problems do not pop up in other areas with the same regularity.

Finally the last major are is Financial Institutions.  I think there are a whole range of very interesting questions that we need answering here.  We have not driven the theory as far or as hard as in some of the other areas of finance.  We still have some empirical work that need to be done.

Overall in the last 25 to 30 years if I look back I see progress that has been profound and dramatic.  The quality of scholarship today is much higher than when I first started.  It is an exciting time to be in finance. 

Jim: well thank you very much, unless you have more that you would like to mention (on any topic) I think we have pretty much wrapped up the questions that I had for you.  I  really appreciate you taking the time to chat.  I should get this done and in the newsletter that will be out this weekend.

CS: You’re welcome, but I wouldn’t worry…nothing I said here is going to change whether it is out this week or next week. 

Jim: Well again thank you.
 
 

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