I'm pleased to be here at the Foster School of Business here at the University of Washington.
I graduated from the MBA program in 1976. There's been a lot of change since then--except for Balmer Hall! I'm especially excited about recent new investment and new construction under the leadership Dean Jiambalvo and University President, and now Weyerhaeuser Board Member, Mark Emmert.
It's an honor and a privilege to serve on the Foster School's advisory board during this exciting time of growth and expansion for the university.
Ironically, this growth occurs at a time of tremendous uncertainly for our economy overall.
As I thought about my remarks for today, I wanted to be sure to take a step back, and provide some big-picture perspective on the economic events of the past several months. I want to discuss where you might look for understanding, and what may be required moving forward to ensure that mistakes aren't repeated.
In my talk today, I'll touch on six main themes:
- First, I'll set the stage,
- Second, I'll discuss some economic models that might help provide insight,
- Third, I'll discuss how we can learn from game theory and sociology,
- Fourth, I'll touch on how the concept of sustainability might aid in our thinking moving forward,
- Fifth, I'll briefly discuss what's needed in a solution, and
- Finally, I'll wrap up with a call for leadership.
1. Setting the stage
So first, let me set the stage.
In this Fall's presidential election, we heard a lot of talk about Wall Street and Main Street. At first, the debate addressed each as separate and distinct. But over time, the debate changed. Our political leaders and the public realized that our economy is a chain, no stronger than its weakest link. Wall Street and Main Street are inextricably connected, not only to each other, but also to the world.
As an example, the other day I read a heartbreaking story about a group of school districts in Wisconsin that got in over their heads with collateralized debt obligations investments, which, in a "what were they thinking" moment, were purchased with borrowed funds. They now find much of their investment gone, and their fate linked to banks in Canada, Ireland and Germany.
That's just one of many similar stories. Stories that show us over and over again, that Wall Street is Main Street. Main Street is Wall Street.
In conducting a post-mortem of the crisis, pundits will scratch their heads for quite some time wondering how things got out of control. Some will wonder why their warning calls weren't heeded in the first place. Trust me--there will be a lot of finger-pointing.
I'm reminded of the story of Cassandra from Greek mythology. Apollo promised Cassandra the power of prophecy in return for her love. But Cassandra spurned Apollo. As punishment, he doomed her with the gift to see the future, but withheld the power of persuasion. Tragically, no one believed her when she warned of soldiers hidden in the Trojan horse, and the subsequent fall of Troy.
When history looks back on the economic crisis of the past few months, we'll find many Cassandras. Why weren't their voices heard?
Some might say it's simply due to the variety of contradictory economic outlooks available at any given moment. Or as playwright George Bernard Shaw famously said: "If you laid all of the economists in the world end-to-end, they'd never reach a conclusion." I don't think that's a valid reason
Ultimately, I believe our collective failure to hear Cassandra was the result of a general lack of principled decision-making, and a failure of leadership on many levels. I'll talk about that later. But first, let me briefly discuss a few economic models and theories that might help shed some insight.
2. Using Economic Models to Provide Insight
In his book Critical Mass, British writer Philip Ball describes how certain mathematical models used in particle physics might apply to economics. One that seems relevant is a specific behavior called clustering--used to describe a small but significant tendency of certain particles to be attracted to similar like-particles. Eventually particles clump into clusters. Then clusters clump into herds. For the chefs in the room, we see this behavior in salad dressing when oil and vinegar separate.
The mathematical models that describe this process in physics also work well in economics. Essentially, during bursts of extreme exuberance or pessimism, people engage in herding behavior that's not much different than their molecular counterparts.
As you know, our recent crisis is not an anomaly. History is punctuated by periods of mass mania and then pessimism. Ball cites tulipmania in Holland in the 17th century, considered by many to be the first recorded speculative bubble and subsequent collapse. Our most recent examples are the "Tech Bubble" of the late 90's, and the "Housing Bubble" that we're now experiencing.
Since the Tulip Bubble, economists have been modeling cycles to explain this behavior. Most economists agree that there's a close correlation between the credit cycle and the general economic cycle.
But models of herding behavior and cycles only provide limited insight. Confounding matters, some economists even say that economic cycles aren't even cyclical. In my opinion, cycle theory provides only limited insight. It's weakness it that it fails to adequately explain the underlying behavioral component that contributed to our current economic meltdown.
3. Game Theory and the Social Sciences
Two areas that might help us understand the behavioral component better are sociology and game theory.
On the sociology front, I think Irving Janis and his studies of groupthink are relevant. Janis described groupthink as a phenomena where the individual's desire to conform outweighed the motivation to express contrarian opinions, or evaluate alternative courses of action. The result--hasty, irrational decision-making. In this past cycle, nearly everyone wanted a piece of the action, regardless of the long-term consequences. Some might call this irrational bad behavior.
Game theory can help drive understanding of so-called "rational bad behavior," where individual self-interest is logical, but has unintended negative consequences for other players. Let me explain.
To do so, it helps to remind ourselves of the fundamental workings of the market. Many of you will remember this quote from The Wealth of Nations:
"It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own self interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages."
This is Smith's invisible hand at work. Markets are guided by individual self-interest, or the desire to gain, if you will. I sell you dinner not because I want to feed you, but because I want to feed myself. What keeps me from taking on too much risk? This very own self-interest. If I'm a baker, I will bake no more pies that what I think I can sell. I will make no more than what I think the market can bear--knowing that if I do repeatedly, I go out of business by incurring costs that I can't recover.
It's all too clear that our mortgage and financial markets during the recent boom sold more than what the market could bear. I believe that de-sensitization to risk was one of the primary contributing factors to the subsequent market collapse. In recent remarks, Alan Greenspan seems to agree.
How exactly did risk perception change? Historically, banks provided mortgages to homeowners and retained the risk of default This was expressed on their books as "credit risk." That credit risk tempered the behavior of banks by ensuring that loans were made to those most likely to pay them back.
During the past cycle, however, banks and mortgage bankers began to pass along the risk in the form of securitization vehicles such as mortgage-backed securities and collateralized debt obligations.
These vehicles fundamentally changed the market by moving risk away from the originating lender, and transferring and spreading it across a broad cohort of worldwide investors--including, apparently, the school districts in Wisconsin.
Essentially, loan originators, who were paid for making the loan, behaved as if there was less risk in the marketplace than actually existed. That means they wrote more loans to less credit-worthy borrowers.
As evidence of risk-desensitization, just look to the sub-prime spread. This is the premium banks charge for the riskiest loans. A 2008 Federal Reserve study showed that the sub-prime spread actually fell 280 basis points from 2001 to 2007. This was a period when the market was actually piling risk on top of risk. In a well-behaved marketplace, we would have expected the spread to increase as more risky loans were originated.
But--the opposite occurred. Essentially, lenders were building even higher, an already-delicately-balanced house of cards--taking the most risk, with the least spread, to a borrower with no downpayment and essentially no assurance of repayment. An insane business proposition!
So that brings me back to game theory. I believe that game theory can provide insight into how this shift in risk created a payoff matrix that provided an incentive for rational bad behavior on the part of a single institution. It's uncannily similar to selfish behavior described in the Tragedy of the Commons or the Prisoner's Dilemma.
Interestingly, we might learn something from Robert Axelrod's studies of the Prisoner's Dilemma. Axelrod found that greedy, self-interest wasn't the best way to win if the game is played on an iterative basis. He reached the seemingly contradictory conclusion that selfish individuals for their own selfish goodwill tend to play fair. Playing fair, however, requires principled behavior and a long-term perspective.
I'll leave it to someone writing a Ph.D. dissertation to develop the precise model. Essentially, however, the payoff matrix created an incentive for behavior that was different from the equilibrium strategy. We're all acutely aware of the result.
Today, an estimated one in ten mortgages is delinquent or in foreclosure. It's the result of unsustainable behavior on the part of lenders that failed to see the big picture, long-term, inter-related consequences of their individual actions. Now, even those who played fair and refrained from issuing high-risk mortgages, or homeowners who acted responsibly are being penalized.
4. The Role of Sustainability
Playing fair even when those around you aren't.
Thinking about the long-term consequences of short-term actions. These are concepts that lead to a discussion of solutions. Essentially, they have the ring of a concept we use every day in the forest products industry. I'm sure you've heard it. It's called sustainability.
At Weyerhaeuser, we know a lot about sustainability. It's more than an environmental concept. Instead, it's a comprehensive set of principles that guide all of our decision-making. Yes, it's a term rooted in ecological beginnings. But it has evolved into a more comprehensive long-term set of operating principles.
Let me explain. Many of you have probably seen companies that use tree-saving metrics in their sustainability measures. At Weyerhaeuser, we know we can't save individual trees. They're not immortal. They will rot and die--or die and rot. Either way, they decompose, returning nutrients and their stored carbon to the earth and atmosphere. We can't save a tree, but we can save a forest--a forest can last forever.
A forest can be "saved" in two ways. It can be set aside from commercial use, foregoing economic value but serving other purposes such as recreation, refuge, or watershed. The public may choose this forest use for public lands, and will pay for its care through taxation.
But 57 percent of our U.S. forest land is privately-owned. There's a way to save private forest land, too. It is to ensure that the trees have economic value. If the trees have value, the landowner will retain the land for growing trees.
The forest is not threatened by cutting down a tree. It is threatened by lost value in the marketplace. Therefore, to save a forest, one must grow, cut, use and re-grow the trees--in the process, sequestering carbon, maintaining habitat, and providing jobs.
So you can quickly make the connection. We must not only re-grow trees. We must also ensure that trees must have value in the marketplace. To maintain that value, we met the needs of the 20th century with wood products for shelter, communication and commerce. We'll meet the needs of the 21st century with new products from wood's lignin and cellulose fiber and other chemical building blocks.
We envision a world were biochemicals from trees replace many of the petroleum-based compounds we use today. Where carbon fibers manufactured from the lignin in trees are used to build parts for cars. Where fuel refined from trees and other biomass powers those cars. Where textiles woven from new generation cellulose fibers from trees clothe us. Where wood from trees continues to shelter us.
In this way, the concept of forest regeneration and renewal spread to a much broader view of how we run our business. For us, sustainability is a holistic view of how we manage our business for the long-term.
Success measures include a range of metrics from people development and employee diversity, to investing in the communities where we operate, to reducing our environmental footprint, to ensuring that we are good stewards of our shareholders' investment, now and into the future.
This broad view of sustainability is essential for making any decision at Weyerhaeuser. In essence, it's about moving forward despite the challenges. It's about prudent management for the long-term. It's about ensuring that short-term profit doesn't have a detrimental impact on long-term prosperity. It's about moral and principled decision-making.
It all starts with a vision for what the world can be, and we've been recognized for this commitment as the only forest products company in the country to be included in the Dow Jones Sustainability Index.
Our financial institutions and markets would benefit from a similar long-term vision and holistic view of sustainability. I don't believe that regulation is sufficient or appropriate to address every potential future challenge they will face. Instead, it's up to each of us to develop a set of sustainability principles that drive decision making for the long term.
In essence, our financial markets must also learn to see the forest for the trees.
5. Some Ideas About Moving Forward
So as we think about the long-term and the role of sustainable thinking, we can't forget about the short-term. And vice versa. Any short-term remedies must fully consider the long-term implications.
Today, our economy is in a vicious negative spiral. It's a cycle that we need to stop. But it's one that no single institution wants to take responsibility for ending. And it's one where the risk of intervention creates potentially negative unintended consequences down the road.
This is the paradoxical situation of the housing market today. According to a recent article in the New York Times, owners of mortgage securities are reluctant to provide new credit terms to troubled mortgagors.
There's a host of reason for their reluctance--the complexity of the mortgage securitization process, the authority of the bond trustee, and the challenge to the fundamental premise that these mortgages represent a promise to repay.
Additional challenges emerge as renegotiation by a first trust deed lender is blocked by an uncooperative second mortgage holder.
Debt obligations are a contract. They're based on trust. They depend on confidence. Over the long-term, our financial institutions cannot lend effectively without confidence that debts will be repaid--on time, and in full. We must fix the problem without undermining the very confidence on which financial institutions are built.
You take on debt; you pay it back.
The economic and moral hazard that our policy leaders face is that by taking action to fix troubled mortgages, they signal to an entire generation that it's okay to walk away from a debt obligation.
They must stop the bleeding without killing the patient. Or in the words of the physician's Hippocratic oath, "First, do no harm."
Once we stop the bleeding, there are other interesting ideas out there that might help prevent a repeat.
Yale economist Robert Shiller, who called the bursting of this housing bubble, just as he did the earlier Tech Bubble, proposes "continuous workout mortgages" that adjust loan terms monthly against economic conditions and the borrower's ability to pay; improved disclosure around risk on the part of financial institutions; and a home price futures market where investors may speculate on the direction of future home price trends without the need to purchase the underlying asset.
6. The Necessity of Leadership
I'd like to conclude my discussion today with a call for extraordinary leadership. What exactly is extraordinary leadership?
Let me provide two historical examples.
I'd like you to turn back the clock to the American Revolution. Adams, Hamilton, Franklin, Jefferson and Washington. Many don't realize how often these great minds came into conflict. Why not? Because they got things done, and effectively channeled their differences into bold ideas like the Declaration of Independence and the Constitution.
The rivalry between Adams and Jefferson was one of the greatest. Following the Revolution, Jefferson served as Vice President for Adams. At the time, the candidate coming in second in the popular vote for President became the Vice President. The two were actually from different parties.
If we used the same system today, John McCain would be Barack Obama's Vice President. And Al Gore would have been Vice President to George Bush. Imagine that!
After Jefferson and Adams, we changed that system. That's because the two vehemently disagreed on almost every single policy issue, and their poor relationship set in motion a series of events that led to the 12th Amendment of the Constitution, which guides how we choose our Vice President to this day. In this respect, the 12th Amendment might serve as the marker for the end of the great collaboration of the Revolutionary era.
Before then, opposing ideas--even Adams and Jefferson--came together and created a government that was bold, new and different. Sometimes ideas came together gracefully. Sometimes they collided. But the result changed history.
Nearly 100 hundred years later, Abraham Lincoln welcomed political rivals into his cabinet. Lincoln's leadership effectively marshaled their sometimes bitter differences into a team that worked cohesively for the benefit of the nation during a great time of national crisis. The book Team of Rivals by Doris Kearns Goodwin offers great insight into Lincoln's leadership style. It's a style we might all learn from.
Like our Founding Fathers and Lincoln, we'll need to bring rivals together to solve our current problems. As you saw in the recent election, public debate in the U.S. today on a broad range of issues is almost always framed by the concept of dichotomies.
This is the "red state, blue state" phenomenon. It is reflected in the U.S. legal system, with plaintiff and defendant. We see it in journalism's notion of balance, where there are ONLY two sides to every story.
As leaders, we must always be aware that public debate is often filled with false choices. Those choices are fanned and fueled by those who want to influence decisions by forcing us into two oversimplified extremes, with only one seemingly desirable choice.
Many anthropologists and sociologists suspect that the human brain is wired for dividing the world into oversimplified halves for survival in a non-civilized world: flight or fight, sleep or wake, eat or wait.
In a civilized world, true leaders are obligated to move past these pre-wired polar opposites, to seek out the third or fourth alternatives. Now is the time for creative, bold new solutions. Solutions that only a team of rivals can develop.
Earlier, I talked about Janis and groupthink. Janis suggests several strategies for breaking out of the rut:
- Assign a devil's advocate role to every work group. When assigning a group with a task, refrain from stating a preferred course of action.
- Use multiple groups to examine the issue.
- Be sure to examine all alternatives.
- Invite outside experts into group meetings.
- Expect group members to challenge ideas and pre-conceived notions.
Again, a team of rivals will be necessary.
American businessman and entrepreneur Lee Iacocca once observed, "The greatest discovery of my generation is that human beings can alter their lives by altering their attitudes of mind."
Let me give you a brief Weyerhaeuser example of Iacocca's words in action. The wood and forest products industry presents many hazards that contribute to a potentially dangerous work environment: big trees, big saws, big trucks, and more--we're talking BIG!
At Weyerhaeuser, we have an aggressive and successful safety program. At its core, we call on our employees to have the courage to intervene. We empower each employee to think and act on their own behalf, and on behalf of others. This has led to creative solutions and dynamic problem solving in ways unimagined and impossible to proscribe through rules alone. Today, our safety record is one of the best in the industry.
In safety or anything else we do at Weyerhaeuser, we are not victims--nor is any industry a victim when it addresses the concerns of employees, consumer advocates, customers, shareholders, and others who depend on it for the long term.
In closing--Our country has much to do to work through the nation's current economic challenges. But--I'm confident our economy will recover.
So, I'd like each of you to leave today with a sense of optimism. All of us are capable of rising to the challenge in front of us. Economic models will provide some insight. But we must also account for, and better understand human behavior. Sociology and game theory will provide some insight there.
As we look for solutions, we must act sustainably. To move forward, effective leadership will be required. The lesson for all of us:
- Seek out contrarian opinions
- Uncover new truths and create new beginnings
- Listen and empower teams to take action
- Focus on results
- Channel differences to drive innovation in a way that accounts for the long term--in a way that would make our nation's founders proud
And the next time you think you hear Cassandra talking--be sure to listen.
Thank you. I'd now like to take questions.
