The Swensen plan

David Swensen, chief investment officer at Yale University

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NEW YORK (Fortune) -- David Swensen, chief investment officer at Yale University since 1985, manages its $17 billion endowment, which is known for consistently outperforming the market. In fact, it averaged returns of 17% annually over the past 10 years.

But even he isn't immune to the financial crisis: Yale's endowment dropped 13.4% in the first four months of its fiscal year, which began on July 1, 2008.

Fortune recently sat down to chat with Swensen, recently named to the President's Economic Recovery Advisory Board - a panel of non-government experts on financial issues.

A couple of years ago, in a profile, we wrote about his investment philosophy. This time, we asked about the re-release of his book, "Pioneering Portfolio Management," a bible among many institutional investors and the endowment world. It didn't take long, however, for the conversation to turn to the economy.

Fortune: You're pretty outspoken about the government's bank bailout (TARP, or Troubled Assets Relief Program) in its original format -- let's talk about that.

Swensen: From the beginning, TARP was an ill-conceived disaster. Fannie (FNM, Fortune 500), Freddie (FRE, Fortune 500), Bear Stearns, Lehman, WaMu (WAMUQ), AIG (AIG, Fortune 500) and others were having unprecedented, monumental problems. There's no coherent explanation of why they treated one institution differently than another.

So those who supply money to financial institutions have no clue how the government will behave going forward. And private capital says because of that, they won't take the risk in terms of lending to cash-depleted institutions.

And the public is outraged still because they're not seeing banks lending yet. They're worried about where their tax dollars are going in terms of the bailout.

It's a really tough issue. The public, Congress -- they'll all have a hard time wrapping their arms around the problem. Still, it's unrealistic to think you're going to send some capital to banks and suddenly they'll start lending, because banks' balance sheets are an absolute disaster.

So sure, the general public just has to be really annoyed. But to expect that after several hundred billions of dollars, banks are going to be ready to lend, unfortunately isn't realistic.

Will any government fix be beneficial to consumers in any immediate, practical way? You have an idea we've started calling "The Swensen Plan," for instance, that seems to make a lot of sense.

From an economic perspective, we won't be past the worst until the credit markets are fixed. One of the things that would help the credit markets tremendously would be to facilitate private flows of capital to short-term debt obligations - money market funds.

But the only way to attract rational capital back to money markets is to provide a government intervention, which would include a guarantee that the funds don't break the buck. It would also incentivize financial institutions to pay fair market rates on deposits.

The idea would be to have the government set up and administer an insurance fund and have money market providers pay into the fund. Then if a money market fund breaks the buck and has to draw on the insurance fund, the manager gets put into the penalty box - for instance, perhaps they wouldn't be allowed to manage or offer money market funds for a year. Then their customers would go elsewhere.

Let's back up. What might lead a money manager to violate rules? Money market funds compete on yields, so there would be an incentive for money managers to invest in commercial paper. Now with a simple government guarantee behind money markets, the problem is you end up with moral hazard - you get guys out there simply buying the highest-yielding commercial paper, not worrying about the quality because it's got that guarantee behind it. So you have to induce discipline by saying if a manager breaks the buck, if they draw on the guarantee fund, they're penalized.

The Fidelitys, Barclays, Vanguards and others that need to provide money market accounts because they're central to their business will have a huge incentive not to draw on the guarantee fund. They'll step up and support the money market fund on their own.

Back to the economic crisis. If you could point to one overriding thing, what led us here?

A big part of the problem was we bought into the religion of deregulation. People thought markets would regulate themselves. Instead, private sector participants enriched themselves unbelievably. So we have to regulate institutions that could pose systemic risk to the financial system. That includes the banking system and hedge funds.

What would you do about hedge fund regulation?

The first thing is that regulators should require disclosure regarding transparency in both on-balance sheet and off-balance sheet exposure. Look at [the past experience of] Long-Term Capital Management: It had $5 billion of equity and around $125 billion in leverage, so it had a notional, off-balance sheet value of around $1.25 trillion. And when it started failing in 1998 it was a monumental disaster. Yet, we had that experience and did nothing in response.

We look at the SEC now and say, "Where have they been?"

The fact of the matter is you're never going to be able to rely on regulators to make the world safe for investors. Regulators just can't keep up with derivatives that are becoming more and more complex, methods of trading that change constantly. It's not possible.

So the simple conclusion is that investors cannot invest in anything they don't understand. Regulatory authorities are not going to be able to give the equivalent of the "Good Housekeeping Seal of Approval" on investments. So if you invest only in things you understand, then Bernie Madoff gets no money.

To underscore your point, professional investors - endowments, pensions, funds of funds, financial institutions, others - also need to get back to diligently scrutinizing anything they are considering investing in.

At Yale, we always walked away from funds that aren't transparent. We also don't invest in quantitative-black box models because we simply don't know what they're doing.

Recently I started scratching down on a notepad a list of, "Things We Did When We Said We Wouldn't" - in other words, the few times we became inconsistent and didn't stick to our original principles. It's interesting because the investments on that list are overwhelmingly ones that didn't work for us. So I've become even more maniacal about being true to our mission.

Hopefully, this whole debacle will cause others to get religion. For instance, perhaps in the leveraged buyout world, they'll want to build better companies than merely perform financial engineering. Also, corporate executives who rose up during the bull market have continued to behave as if it's a bull market. For one example, why else would Bank of America (BAC, Fortune 500) buy Merrill Lynch? Countrywide? They had ample time to do vigorous due diligence - perhaps now they'll get serious about it again.

Back to the government's current bailout and stimulus plans, do you have additional ideas or an opinion on other issues we need to address?

Right now it's understandable that everyone's focused on the crisis at hand, but we also need to begin to focus on the inappropriate regulatory responses regarding the issues which led to this crisis. ... The Federal Reserve knows about banks' balance sheets, but nothing about their off-balance-sheet exposure. They know nothing about their leverage, for example. They need to understand leverage across the board because leverage is implicit in derivative positions. And it's in the off-balance sheet area where leverage lurks.