Not sure new taxes is enough...

We need some much more honest talk about how money works within our economy soon if we're going to turn around some of the political idiocy we see from both parties.

We need to rethink the whole way we organize ourselves around material gain. If you look at the components of wealth and measure the interactions, it’s pretty apparent that we can figure out better, fairer, and simpler (maybe) ways to organize our approach. All that’s required is that the small minority that has most of the stuff give up a significant chunk of said stuff. Sadly, the list of volunteers for the role of “giver-upper”, while growing, is small, and the amount of energy (and money, of course) used in efforts to reverse that karmic flow is substantial.

This is made more complex when, every couple of generations, the group of people that believes most strongly that the group of people who control the majority of a society’s assets deserve to do so (and those making the rationalization are closely aligned to the wealthy in terms of membership), that group pushes conditions of wealth inequality past sustainable levels - and the system collapses. As we’ve gotten more efficient at implementing markets, we appear to have a bevy of government/regulator/market-related professionals who have deluded themselves for years with concepts such as “equilibrium’ who cannot help but think it must have been something, anything else that explains what happened.

What happened really isn’t in denial. Repeat after the me:

The Banking System in the US and the EU, plus the UK and some of the Scandinavian countries, crashed. Strictly by letting the industry run according to the best tenets of the prevailing economic wisdom of the time:

o The Rich got Richer and fewer.

o The Poor got Poorer … and so did everyone else in the middle.
And then,

BOOM

The world's economic structures crashed. Nothing worked as it was supposed to.
And we still don't talk about how it happened. Some do, to be fair. But they're kept off to the side while the Players try to control their information. It's a really strange place we live in.

* * *

Every time I think I am amazed at the state of political dialogue in this country, something else happens that reinforces my previously held analysis and its resulting mix of disgust, chagrin, and wonder at how the old barriers to information managed to wash out on a wave of technology and leave a lot of people on the beach who had apparently been swimming sans trunks for quite some time.

Read My Lips: We Need Taxes!

It feels like we've been having this conversation for a long time. Politicians love to tell their constituents that they will lower their taxes. It makes for good politics. But when the cold, hard truth comes out - We need taxes to make the country run - for some reason, this seems to come out of left field for the country. Pity President George H.W. Bush for his punishment for failing to deliver on his promise of "Read My Lips: No New Taxes." But the fact of the matter was that in the aftermath of the crash of 1987 and the negative reverberation in the markets in 1989, he didn't have any choice but to make up for the losses in the markets (and incomes) by raising taxes.

And the truth hasn't changed. We need taxes to run the country. Today we have trillion dollar wars ongoing (happily, one of them being ramped down), we have a country in the midst of its worst recession since the 1930s, and an increasingly stratified country in terms of the "haves" and the "have-nots." We have a ballooning deficit and an unemployment rate that is making most of us uncomfortable, if not shaking some long held beliefs about our economy and the American dream.

Here's a concept - the richest people in the country should pay more taxes than the people that make very little money. The rich folks would have you think this makes no sense at all (in a related story see "Why Wall Street is Deserting Obama") - but from my perspective, it is the only way we can run this country of ours. The people who make very little money spend it - they have to. They need to pay for housing and food and clothes. The people who make too much to spend it all, save it. They don't need to worry about food and housing and clothes. I know from tracking my own expenses - food only makes up about 2% of what I spend each month. We can tax the spenders, but that leaves them little to spend. And they don't have much in the first place.

The widening disparity between the socio-economic classes is well documented. A recent study found that the gap between the rich and the poor is now at the same level it was just before the crash in 1929. In a recently published book by David Schweikart ("After Capitalism"), the author describes the disparity:

If we divided the income of the US into thirds, we find that the top ten percent of the population gets a third, the next thirty percent gets another third, and the bottom sixty percent get the last third. If we divide the wealth of the US into thirds, we find that the top one percent own a third, the next nine percent own another third, and the bottom ninety percent claim the rest. (Actually, these percentages, true a decade ago, are now out of date. The top one percent are now estimated to own between forty and fifty percent of the nation's wealth, more than the combined wealth of the bottom 95%.)

As blogger David Chandler shows on his website, www.lcurve.org, the L curve - not a bell curve - illustrates the income distribution in the US:

The bottom 99% of the population measure their incomes in inches. The top 1% measure their incomes as stacks of $100 bills feet or even miles high! The total wealth of the few people in the vertical spike equals the total wealth of the rest of the population combined. [Chandler shows this as a graph looking like a football field; most people are on the field, the top 1% are on the endline - the vertical spikes off the page.]

What does that income disparity result in? Most of the country trying to get by - going to work, raising their kids, going to movies, paying mortgages and watching TV and Netflix. But as for the other 1%:

People on the vertical spike can use their influence single-mindedly and very effectively. A single billionaire can get the undivided attention of any politician he wants, any time he wants. If he doesn't get what he wants he can, in fact, "fight city hall," the statehouse, and even the federal government. People on the horizontal spike must pool their limited individual power and organize to have any effect at all. This is a very difficult thing to manage, in practice.

This widely skewed allocation (can't even call it distributed) of wealth and income is repeated in many different studies (see http://sociology.ucsc.edu/whorulesamerica/power/wealth.html, http://www.businesspundit.com/wealth-distribution-in-the-united-states/, http://www.levyinstitute.org/pubs/wp_502.pdf). It's a fact of life in the US today.

So is it not better to tax the savers, since they have alot of money? OK, even I find this argument a little difficult - I save money (and don't spend it) because I make enough to do so. Why should I let the government take that money from me?

Here's why.

The government should tax my savings because I don't need all of it. And there's a good to come out of it. Admittedly, I am biased, because I worked for the government once, for four years, and had a salary because of the taxes collected from my fellow Americans. But I also know that as a result of my taxes I have roads and bridges, schools and libraries, art museums and repertory theaters, national parks and golf courses, an armed militia and a sizable government that takes care of things like courts for overseeing litigation, making sure that our environment is protected, monitoring consumer products and providing services for our returning veterans. I think all that stuff is pretty darn good. And I'm willing to pay for it.

Postscript to last post

While there's still lots of jumping up and down and angst about the May 6th market crash/recovery, I think Christopher Whalen has pretty much nailed it -- the markets worked fine.  Did exactly what they were supposed to do.  It's a question of whether or not we want to let them act this way -- which is a question of values, not one of economics.

Perfect trading QUARTERS -- 4 of them!

The NY Times reported today that Goldman Sachs, Citigroup, JP Morgan Chase, and Bank of America all achieved perfect trading quarters in the first 3 months of the year.  In other words -- every day in the quarter, they toted up their winnings and losings after the markets closed (note -- this never actually happens, the markets don't close for global traders, they just follow the sun around the planet), and discovered they had made money.

Every single day.

From what I can tell, this is the first time this have ever happened for even one firm, much less four.
This struck me as being pretty unlikely, to say the least.  So I started to think about how to calculate the odds.  Turns out, someone else had beaten me to the punch -- see "More On Goldman's "Perfect Record".
According to his calculations, the odds on this happening for one firm are 8.67 x 10^-19.  That's not very good odds, to say the least.  8.67 times in 10,000,000,000,000,000,000, compared to a rough chance of 1 in 500,000 of getting hit by lightning walking down the street.  That's a million times less likely than a one-in-a-trillion chance.  If you take the odds on this happening, again for one firm, and spread them out over the approximately 936 possible quarters since the founding of the US, you end up with something like close to 100,000 times less likely than a 1-in-a-trillion chance.

Not what I would call gambling odds.

But the whole point is that it didn't happen for one firm.  It happened for four. At this point we're way past my willingness to count zeroes ...but I don't think the odds are better.

Seems to me that the banks could give the casino boys in Vegas some lessons about how to set up the house odds.

And it seems that we still can't figure out why the markets did their plummet/climb last week (other than all the buyers ran away at the first sign of trouble).

Gotta love "free" markets ...

The Drop

We'll have a much better picture in the next few days, but for 90 minutes today on Wall Street, there was quite a bit of anxiety as we watched the Dow plunge almost 1000 points. There was talk of the Greek crisis, and the ECB and rates, but it was the specter of that graph on CNBC with the steep ski slope that really made us gasp. Could it be?

Could it be that the contagion that is Greece had just made the US markets go into free fall? Had we not learned anything about systemic risk in 2008? Was there anything to keep us from going into a free fall? Of course not - there's been no legislation to make any changes. The legislation that would have gone into effect (but did not today) was the circuit breaker rule (for when the market drops 10%) that would have given the markets a breather and allowed them to assess what was going on in the event of a rapid drop. That was enacted after the Market Crash of 1987.

But no, it was not in free fall. We watched with open mouths as the Dow, again, spectacularly, shot right back up 500 points in several minutes. Anyone that had been around in 1987 knew what this was too - program trading. No one person can trade in that volume - only machines can. There was talk later of a possible person involved in making a mistake with an order, and maybe that will turn out to be true (person error - an operational risk - not necessarily systemic risk!), but the sweep of the trading wave was awesome to watch.

What will we learn from May 6, 2010? Time will tell.

Game Change

It's been over 18 months since the Crisis hit us full force in September 2008. At that point, when the government had to step in and prevent a crisis by injecting liquidity into the major financial institutions in the US (which is not the way the financial institutions would recount the story, by the way), many of us said this is surely going to change things. How could it not? Secretary Paulson and his Treasury staff went to inordinate lengths to prevent a complete meltdown of the markets, which looked imminent in that first week of September, and indeed, not many days later, the credit markets completely locked up. Money was not flowing from anywhere except the Treasury. Trust in our markets had been shaken to its roots, and not only here at home, but around the world. It was pretty scary, even to those who had spent their lives in the financial world.

Discussions I had with my friends around that time and several months thereafter focused on thoughts of how things were going to change: "Wall Street will have to change the way it's been doing business" and "this will force people to take another look at the way they live their lives - pursuing the almighty dollar." Many of us were hopeful that finally the Naked Emperor that was Wall Street would be seen for what it was - simply a source of money, not a producer of goods. Why should the financial markets be nearly half of our economy - it didn't make sense. What, as Paul Volker has argued, had financial firms done to help the economy since creating the ATM?

After reading and learning about exotic derivative instruments that helped bring down the markets, I and many others (including Warren Buffet) questioned that these instruments did anything for anyone other than make money for the investment banks that created and sold them (and made money more than one way in the same transaction). The investors (as has been painfully evident) did not benefit (at least in the same way) most of the time.

But it seems apparent that Wall Street hasn't gotten it, and is vehemently opposed to change. At least that's what you'd have to take from the hordes of lobbyists on Capitol Hill at the moment, trying to subvert the financial reform legislation that is trying to make its way through Congress. I've heard people say, You can't rush this kind of thing through. Look at what we did after Enron! They are referring, of course, to Sarbanes-Oxley, the financial reform legislation that, heaven forbid, made chief financial officers of public companies annually review their internal controls and attest to the effectiveness of the internal control structure and procedures of their company for financial reporting. That's the kind of legislation I am in favor of.

One could argue that SOX, as it's commonly known, created an annuity for accounting firms, but I would argue, accounting firms already had an annuity in that public companies needed to have audited opinions to be listed and traded on an exchange. As an investor and long-term shareholder, I think SOX made things better. And I refuse to listen to the complaints of how much SOX cost and continues to cost companies - I am very happy to have my company spend a few million making sure that their internal controls work, and that people are being held responsible for the financial health of the company.

But I digress. To counter the critics: The financial reform legislation now in Congress arrived TWO YEARS AFTER the Crisis. That's not really rushing something through. The National Institute of Finance group of volunteers who developed an idea for an Office of Financial Research, to help try and identify systemic risk issues ahead of the next crisis, spent a good year working on their proposal before it was included in the Dodd legislation now before Congress. There is some criticism that the reform legislation is trying to fix something for which the cause of the problem is not known. I think that's fair criticism, but on the other hand, as my co-blogger and I have written, there is some pretty decent evidence that the shadow banking market was largely to blame for the regulators having no idea of what was going on from a transactional point of view in the financial world in the lead up to the meltdown. But wouldn't you know, it is the legislation that tries to bring transparency to that shadow market of over-the-counter derivatives, that is the piece of legislation that is getting the most attention from lobbyists, who are all trying to create loopholes in that particular legislation for their clients.

Is there any hope to change the game of Wall Street? I like to be optimistic, but at the moment, I'm finding it hard to find the sun shining anywhere on Capitol Hill.

More Goldman Sachs discussions

Blooming all over the web, they are ....

Though a bit strongly worded, this one is good, and inadvertently makes the point that if the Tea Party folks want to be upset about something, they're pointing in the wrong direction at the moment.  Chris Whalen, as usual, has some cogent thoughts on his Institutional Risk Analytics site.

And Paul Krugmans's column in today's NY Times has the quote "For the fact is that much of the financial industry has become a racket — a game in which a handful of people are lavishly paid to mislead and exploit consumers and investors."

And, from Crazy Eddie's old CFO, we have this really interesting assessment.

What did Goldman do?

After reading through the SEC complaint, it’s really pretty simple in concept. A shark worked with his bookie to set up a couple of patsies. The shark has not been charged, and from what I’ve read in the press and heard from the rumor mill, I don’t think it likely …

I’ve tried to diagram it out, probably still needs some work. (Suggestions welcome!).

The core of the complaint seems to be in paragraphs 38 and 41 of the SEC doc, where they state:

“Similarly, a 65-page flip book for ABACUS 2007-AC1 finalized by GS&Co on or about February 26, 2007 represented on its cover page that the reference portfolio of RMBS had been “Selected by ACA Management, LLC.” The flip book included a 28-page overview of ACA describing its business strategy, senior management team, investment philosophy, expertise, track record and credit selection process, together with a 7-page section of biographical information on ACA officers and employees. Investors were assured that the party selecting the portfolio had an “alignment of economic interest” with investors. This document contained no mention of Paulson, its economic interests in the transaction, or its role in selecting the reference portfolio. “

And then (paragraph 41):

"On or about April 26, 2007, GS&Co finalized a 178-page offering memorandum for ABACUS 2007-AC1. The cover page of the offering memorandum included a description of ACA as “Portfolio Selection Agent.” The Transaction Overview, Summary and Portfolio Selection Agent sections of the memorandum all represented that the reference portfolio of RMBS had been selected by ACA. This document contained no mention of Paulson, its economic interests in the transaction, or its role in selecting the reference portfolio."


Early notes from GS to some clients make it look like the GS defense will come down to “Caveat emptor – we’re all big boys here, and, besides, if you look at this from our accounting perspective (the one we’re using here, anyway), we lost money on this deal”. As one GS client who shared a note with me said: “True, but irrelevant”. The fact that Paulson made $1B, and Goldman’s customers, who they pitched the deal to, lost that $1B, is not mentioned.

The ethics of playing both sides have always been a bit murky in the markets, especially when it comes to intermediaries. Setting up your customers is not. Or at least it didn’t use to be.

There's a lot more coming down the pike here -- Goldman is just the biggest baddest wolf in the pack, so the SEC smacked them in the face first. Check out this piece -- "Other Major Banks Did Deals Similar to Goldman’s" on ProPublica.

A friend of mine, who runs derivatives operations at a large bank, sent me these thoughts yesterday:

The regulators have grown brand new serrated teeth in rows and funnily enough are now teething....

Was on the ABS call with SIFMA.....

Wall St. Chief of Compliance & General Counsel conversation "What's that sound?" "Incoming.....!!!!!"

It's going to be an interesting couple of months -- this is all clearly tied to activity on the Hill regarding financial regulatory reform ....

The Beat Goes On: Proxies and Probing

We are now in the midst of proxy season, and companies are disclosing (as required in their proxy statements) the pay packages awarded to their officers and directors, raising questions about the size of such packages (a news story that gets air time every year at this time, by the way). And this past week, the Financial Crisis Inquiry Commission looking into the reasons for the Crisis of 2008 grilled a few of the titans of Wall Street about the size of their pay in the face of their failure to foresee the crisis - when it's now clear that there were plenty of signs that could have been heeded along the way. (See "Who's Not Sorry Now," NY Times, 4/11/10)

[We started talking about the executive compensation issue on our blog back in December, when bonus season arrived for Wall Street firms (See "Money Talks" 12/23/09). Additional related thoughts on excessive compensation were shared here in January ("Conventional Thinking" 1/12/10, and "Shareholder Interests" 1/31/10) and February ("Money Talks (2)" 2/25/10).]

The drubbing that Robert Rubin got from the Commission was the disrobing of an emperor, from my point of view. The questions he got from the Commissioners were straightforward, asking him why, when he was paid multimilions of dollars as a Citicorp Director and Chairman of the Executive Committee, he was not culpable for the near downfall of the bank. From a governance point of view, one would think that the Executive Committee of the board would have been the group responsible for talking about critical issues facing the bank. But signs of the impending credit crisis never made it upstairs to the agenda of the ExCo. And Chuck Prince, former Chairman and CEO of Citicorp, defended Rubin's lack of culpability. In fact, the ExCo only met a few times a year. Apparently risk evaluations were made in different parts of the bank.

But we pay chief executives to be responsible for everything that goes on in their company. And we pay them royally. Shareholders should have the expectation that the CEO and Directors will be informed about rising risks in the firm. That's what a good governance framework should impel in the institution.

The financial industry and its regulators are saying now that there was no way to know about systemic risk across the financial world. Indeed, we agree, understanding what was happening across the global financial institutions (and all the companies and governments that relied on them) was nearly impossible. But company C-level officers cannot use as a defense that the lack of transparency across firms prevented them from employing good risk management in their own institutions.

Risk management is a key element of any business concern. A company that does not manage its risk; does not plan for contingencies and insure against improbabilities, allows for the unexpected to seriously impact its existence as a going concern. September 11th was a enormous wake up call for the financial industry, in terms of the magnitude of that event and its impact on the financial markets and the operation of many of those businesses on that day and in the weeks afterward. But like so many of the lessons that have been learned, that one was quickly forgotten - or at least the possible relevance of that lesson was not applied to future events.

Demanding accountability from chief executives is the responsibility of shareholders. The number of shareholder proposals this year (a movement that began last year) that would allow for review of executive pay packages is a reminder to company directors that shareholders care. If we are going to give our CEOs and Directors millions of dollars, we should get something for it. In this case, the SEC is helping provide transparency for us, through the proxy process, so that we know what they are getting; and it's well within our government's right, especially in the aftermath of the worst financial crisis since 1929, to ask why we shouldn't keep those executives accountable for the pay they are receiving.

Don't miss this one

Op Ed in last Sunday's NY Times by Michael Burry, former CEO of Scion Capital.  He apparently was the first person to do CDS deals on MBS securities, targeting the sub-prime sector in 2005.

I Foresaw the Crisis. Why Didn’t the Fed?

Great title, too ;)

Guess it's not all me ...

David Brooks' column in today's NY Times is the best statement I've seen to date of what is going on in the world(s) of economics.

Some brilliant scholar has to write a comprehensive history of modern economics because the evolution of this field is clearly one of the most consequential things happening in the world today.

Unfortunately, what Mr. Brooks apparently finds too troublesome to delve into (or he just hasn't gotten around to it yet) are some of the political and policy implications of what he's discussing, especially as they apply to the US Republican party. Not to say that the Democrats didn't follow the same drunken piper, oops, sorry, naked emperor. ;)

The timing of the Acts I, II, etc., that Brooks refers to in his piece conveniently excuse this problem -- the emperor never really had any clothes on, and more than one child (or author) was pointing this out for well over 50 years. He does include a nice bit from a professor at George Mason:

In The Wall Street Journal, Russ Roberts of George Mason University wondered why economics is even considered a science. Real sciences make progress. But in economics, old thinkers cycle in and out of fashion. In real sciences, evidence solves problems. Roberts asked his colleagues if they could think of any econometric study so well done that it had definitively settled a dispute. Nobody could think of one.
“The bottom line is that we should expect less of economists,” Roberts wrote.

But note his heartfelt, I'm sure, assertion in this paragraph:

Economics achieved coherence as a science by amputating most of human nature. Now economists are starting with those parts of emotional life that they can count and model (the activities that make them economists). But once they’re in this terrain, they’ll surely find that the processes that make up the inner life are not amenable to the methodologies of social science. The moral and social yearnings of fully realized human beings are not reducible to universal laws and cannot be studied like physics.

Got news for you, David -- for the moment, I think you're correct -- but it looks like a race. What understanding we have of the ways in which people live and react is not evenly distributed amongst the population. And if you don't think marketing is as much of a science as economics has claimed to be, you're fooling yourself. If it is the case that what humans need and want can be understood well enough, then those who understand (and have resources) have no real constraints on manipulating the majority who don't understand. Guess you could count on market discipline -- not that there's any sign of it anywhere in this regard. Oh, wait, there's ethics and morality, right? To date, fairly slender reeds ... but maybe all we've got.

Is it just me?

In the past couple of months I've gotten up and spoken in front of a few industry and business groups, and done a webcast with 150+ people listening. I've spoken on topics ranging from changes in operational risk and compliance business environments and what that means for the people in those jobs, to the differences between the narratives evolving about the financial crisis between Europe, the UK, the US, and the Pacific Rim. (Actually, think I lumped the UK into the Europe bucket on that one. Clearly unfair to each. The UK should definitely be in their own bucket.)

Last week I was at a conference where I "hosted" a round table discussion, the topic being "Data and Systemic Risk." Hosting the discussion meant that I committed to show up at the table ready to talk about the topic -- it was suggested that I might even think of some questions beforehand. Conference attendees had a list of the nine tables and various topics to be discussed at each, and chose the topic/table in which they were interested. Then, 25 minutes into a somewhat stilted dialogue with complete strangers (and perhaps some well known colleagues), the conference manager signaled everyone to switch tables. My task of stimulating discussion was much simplified in the 2nd round when one of the senior-most industry kahunas joined my table; from then on we all mostly listened to him and asked questions.

But after a day of listening to speakers, and trying to get people to speak, I'm still wondering if we'll ever catch up. Usually, I get pretty energized at these industry conferences. I dread going because it makes me get out of my rut and get out and be sociable. Not that I mind being sociable, but I rarely am overly so when working ... I'm much more likely to be heads down on something. Even when managing a lot of people, I want some time to 'do some work' myself. But I digress.

One of the things about a social gathering like the industry conference I attended is that it is an essential part of the mechanism by which we get to some state of consensus about the description of a problem that we collectively need to address. In much the same way that friends of mine who were in on and excited by the founding of the internet have been dismayed by the way in which it seems to be making it ever simpler to create echo chambers and both increase noise while making communication more complex and difficult, I fear that the complex and constant barrage of technology and related expertise will make the process of communicating and achieving consensus much more complex and challenging. At this point, I'm starting to think that we're observably losing ground -- if you're watching for it, you can see the collective "we" completely ignoring reality in multiple places.

Regulation Reform?

Two news stories caught my eye in the past two weeks. One reported on the Securities and Exchange Commission's decision to join with 12 investment banks in seeking to curb the 2003 reforms on Wall Street research. The second was a report on Alan Greenspan's speech to the Brookings Institution last week. They both reminded me of a conversation that I'd had with a friend who works for a hedge fund a few weeks ago. But let me give a little more context.

The story about the SEC was disturbing, I have to admit. I've been admiring Mary Schapiro's return to the SEC and her leadership as Chairman of the Commission for the past year. She's put many changes in place at the SEC, and although I've heard some of my former colleagues (who still work at the SEC) complain about some of them, overall I'm pleased that she is tackling the issues that need to be tackled - mostly my own gripes (shared by others I've heard in the media) that the Commission is staffed by lawyers, most of whom have never worked in the industry. Chairman Shapiro has made enormous efforts to bring on experienced staff, and create a new group to examine new products and risks in the marketplace (her strategic plan is a good read). She is working to bring more transparency to the marketplace and address the protections of financial consumers in a way that Banking Committee has not.

So the story I read last week was a let-down. After over a decade of "de-regulation" of the securities markets by our Congress, why was Chairman Shapiro joining with the banks to further emasculate our regulations? This was also a personal interest of mine - I had spent a year at an investment bank implementing those 2003 provisions of the law that required banks to separate their research teams from their business teams, required separate research compliance departments. and imposed extensive disclosures on research reports, among other things. Given the events that occurred during the Internet bubble in the late 90's, of whom Henry Blodgett was the poster child, the provisions of the Research Settlement of 2003 seemed like a good thing to me.

Greenspan's comments at the Brookings Institution reinforced some thoughts I had expressed to my friend recently. Greenspan criticized the regulatory system and the role (or lack thereof) it played in the Financial Crisis of 2008. Correctly, he cites the fact that the regulators more or less lived inside most of the leading financial institutions in the years leading up to the financial crisis, and yet the banks were still able to engage in activities that "brought them to their knees."

The fact of the matter is that you need two things for effective regulation. One, you need rules to keep the industry from engaging, or trying to engage, in behaviors that take on excessive risk. Two, you need regulators who are incented to look for these aberrant behaviors. The problem is, we lack both.

Eighteen months after September 2008, we still don't have any meaningful regulatory reform. Derivatives are still unregulated, and most OTC transactions are not transparent to anyone but those involved in the transactions (and even then, clarity is not guaranteed). There is no way for our regulators to know who is doing what right now. The means to do so exist, they are just not available to the government right now. (Although there are efforts on different fronts to make this happen. See the website for the Committee to Establish the National Institute of Finance.)

And even though Chairman Shapiro is doing what she can to beef up her troops, the fact of the matter is that those who work for the government are in a very different place from the people they regulate. As I said to my friend over lunch, no matter how hard-driving the staff of the SEC, they are not motivated by money. Government regulators work for the government because it allows them to work regular hours, have a family, and coach their kid's soccer team. On the other hand, the folks they regulate work crazy hours and take home huge bonuses. Bankers are highly incented to make money, and lots of it. Your basic government employee gets a a salary. Period. And maybe the satisfaction of seeing their case of the past year make the front pages of the Wall Street Journal. There's just no contest there.

As long as we don't have laws, and we don't have regulators who are incented to make those laws stick, I'm not sure we can say that there's any way to prevent another 2008 (or 2003, or 2000, or 1998....). Another naked emperor steps forward.

Model Risk -- What? Where?

Even before the Credit Crisis, now evolving into the Great Depression, there was some discussion among the more angst-ridden members of the financial community that maybe the elaborate mathematical models used to justify some of the explosions in CDS and structured securities trading might be, just a little, how should we say, “in need of adjustment.” Since then, it has become established wisdom that the failure to take into account “model risk” led to the downfall of the markets. (Alternatively, the complete reliance that we placed on models to accurately predict and assess risk was misplaced.)

But this collapse of established wisdom is not a topic that’s being discussed in an organized fashion. Most in the risk business seem happy either providing some “tweaks” to some of the more esoteric mathematically-based models, or moving from a “normal distribution” to a “power law curve” distribution to (in theory) account for “fat tails” (an oft-heard phrase these days, personally, one I’m getting bored with – that’s not all that went wrong, folks, not by a long shot). If anyone at this point is not clear on what is the distinction between normal distributions, power law curves, and standard deviations is, let me know, I’ll be happy to add another posting about the topic. (There are quite a few out there, but some of them don’t shed a lot of light.)

Let’s look a little deeper into the issue. Let’s back up and start with a general description of a) what models are, and b) how they’re used in practice in the securities industry.

“Models,” as the term is generally used, refer to the spreadsheets on which approximations of reality are generally described in mathematical terms. In other words, an analyst, or team of analysts, say that “The situation which we describe in words as 'blah, blah, mortgage loan default rates, blah, blah, interest rate yield curves, blah, blah' can be described with the following equations used in this order and fashion to precisely reflect what the underlying data show to be the situation we just described in words.”

These souped up spreadsheets generally have lots of fancy graphs and some long equations, and the quants that create them throw around enough mathematical and statistical jargon when explaining their masterpiece to produce glazed eyes and an “OK, whatever you say” result from the business people (and risk managers) who aren’t proficient in the requisite math.

Unlike other similarly arcane areas, such as technology, senior management has been under the spell of the “math gang” (at least in part because no one ever wants to admit that they can’t understand something presented to them by someone lower down in the hierarchy – though, in actuality, given the past twenty years of scientific math flooding Wall Street, it would appear that a Ph.D. in advanced physics and familiarity with the behavior of non-linear systems is just another check box on every CEO’s to-do list) – and in fairness, the "math gang" and their models have made a lot of money for a lot of people. What they've never been able to demonstrably do, however, is describe reality.

For years, people have been explaining away the variances between observations and model predictions with all kinds of sophistry and semantics, while carefully avoiding looking at the house of cards that’s become obvious from the disparity between the numbers and what most of us consider real life.

Let’s take a simple example.

Diversification is the concept that holding a portfolio of unrelated assets reduces risk (a portfolio of equity, real estate and cash, for example, diversifies risk because the assets generally behave differently in the same environment). This is a core concept of Modern Portfolio Theory (MPT), and plays a prominent role in all institutional asset allocation approaches. But MPT is based on a historical relationship between asset classes as observed in a fairly short time period (20-40 years). The historical asset classes are, by the way, are a whole lot simpler in concept than what we see live in today’s market. The entire theory of diversification pre-dates the explosive growth in derivative markets, for example.

Beginning in the summer of 2008, and culminating in September 2008 (also known as MAD-FV (Mutually Assured Destruction, Financial Version)), the historical relationships between asset classes all went out the window. In somewhat technical terms, the correlations between all asset classes went to 1 – meaning they were all moving together (there was no differentiation). Today (18 months later) the correlations have reverted a bit – to ranges of 0.7 or 0.8, depending on who you talk to, but past historical norms have shown no indication of reasserting themselves.

One would think that this disruption of the core definition of diversification would have some repercussions, or at least generate a lot of discussion - especially from those folks who provide us advice on how to invest in our 401ks. But I’ve seen nothing at all in the popular press about this. Please point out any examples you may find.

I was at a GARP (Global Association of Risk Professionals) conference in NYC a couple of weeks ago and asked a panelist about the shift in asset correlations. The bank risk officer replied that this disruption in MPT was one of his worst nightmares, in part because locating all of the spreadsheets throughout the bank that had models that were built in part on assumptions about asset class correlation was in itself almost impossible. And even if you find all of the places on all those spreadsheets, software, etc. where those assumptions have been integrated, how do you fix it? We don’t have an answer – period.

Seems to me that this could be a bit of a problem. Especially since asset class correlation is only one small subset of the “building blocks” used to create models -- models on which traders make trading decisions and on which investors make trading decisions. Including your retirement investing decisions and mine.

And we haven't started talking about VaR …

Money Talks (2)

The compensation discussion has not abated. Bonus season has basically come and gone, but the furor has not died down, and continues to be inflamed by our congressmen and women on Capitol Hill who want to make political points from the situation.

But I think, political points aside, the situation does reveal a few Naked Emperors. How is it that taxpayer funds that went to keep investment and money center banks from going under somehow ended up in the pockets of the banks' salesmen and traders? No doubt, this is a political situation, created by the government officials who created the funding that allowed the banks to remain standing in the latter half of 2008 and throughout much of 2009 with the liquidity provided by the American taxpayer. There is reason to ask for an accounting of those funds.

As I noted in my earlier post, there are some banks that get it. But as John Mack said the other day, most of them still don't: "'I still don't think the industry gets it.' Banks are reforming pay by focusing too much on structure - such as deferring bonuses to later - rather than the huge amounts being paid out, he said."

Barclays did exactly that - increased salaries and decreased bonuses - but still, enormous bonuses were paid out, much as those that were paid at Goldman Sachs and JPMorgan. But the CEOs are savvy politicians, and understood the optics, anyway. Blankfein of Goldman Sachs received a paltry bonus of $9Million; the CEO of Barclays Capital received nothing.

But the withheld bonuses are just optics. These guys (the CEOs) are not going to go hungry or go into debt because they didn't get a bonus this year, or even next year. (My cynical self said when I heard the news, well, the lawyers just went back to the employment contract and rewrote it to award the money later.) These guys have been minting millions for a long time in their chosen profession; they don't need the money. The company takes care of them 24 x 7 - they probably never have to fill a gas tank, buy lunch, or arrange for their own dry cleaning. To say nothing of scheduling their own travel or buying groceries, like the rest of us.

It's not about the money. It's about the power. That's the other Naked Emperor.

Interesting articles spotted ...

Couple of recent pieces: 

Jean-Claude Trichet's (can you tell we're getting to be fans?) talk in Syndey, Australia on Feb 9  "...the lessons to draw from central bank experience over the past half century."  He's making arguments for a particular set or flavor of lessons learned.  Not sure I get enough of it to have a real opinion, but he's one of, if not the most,  cogent people talking this stuff.

Bob Herbert's Feb 9 NY Times Op Ed.  In which he makes the case that most of the people in country earning less than $150k annually are getting wiped out.  Some real numbers, and real consequences possible if they're accurate.  A major theme not generally getting a lot of airtime.

Both worth a look.

Maybe things are going to actually get interesting ...

In the past few days, there have been a few good articles in the press: Paul Volckers's Op Ed piece in the NY Times on Sunday, Jan 31, and David Ignatius in the Washington Post on the same day. Couple the thoughts expressed in these pieces (a need for structural change in the capital markets; a need for more regulation, respectively) with some of the other statements that have been made publicly over the past week or so (Sarkozy's comments at the opening ceremony in Davos, Geithner's testimony in front of the Financial Crisis Inquiry Commission, Mervyn King's repeated calls for beating bankers with a stick,  etc.) and it's starting to look like those who who thought that a potential regulatory storm had been avoided may need to rethink their views. There seems to be an increasing groundswell of opinion amongst world leaders and regulators that in spite of the improvements in the financial world since September 2008, that indeed, the capital markets are not self-correcting, and that government must do something about preventing another (inevitable) crisis.

It's the bankers' fault, of course. The major financial institutions have failed to make any changes on their own (you get the feeling that they are trying to wait out the storm), and the news that the major investment banks were handing out enormous bonuses didn't help either. If anything, the outrage over bonuses has fueled the revived discussion about structural change and increased regulation. Here's a quote from Trichet, head of the ECB, in an interview last week with the WSJ:

I have been myself involved personally in numerous financial crises since the beginning of the 1980s: in particular the sovereign debt crisis in Latin America, in Africa, in the Middle East and in the Soviet Union. As Paris Club president at some point in the time in the 80’s I had to deal with around 55 countries that were in bankruptcy. The perception in the West was that it was not dramatic because the industrialized countries were not directly touched, but, as you can see entire continents were very heavily financially hampered. In the 1990s we had the burst of the Mexican, the Asian, the Russian crisis, – again in the emerging countries – and in the industrialized world the LTCM crisis and the tech bubble explosion. Then after this succession of very demanding episodes we have the present financial crisis, which started at the heart of the financial markets of the West. This was the first real test for two new entities, which are the integrated global financial system and the integrated global economy. Those entities are in particular the product of the conversion to market economies of all economies in the world and of the remarkable advances of technology, in particular Information Technology (IT), but not only IT. The least we can say that this first real stress test of global finance has demonstrated a fragility that is absolutely unacceptable. We have to correct it.

This is a central banker -- one of the two most powerful on the planet -- talking!  It's really amazing that the financial industry has been so completely tone deaf on this thing.  Jamie Dimon has come across as one of the smartest guys in the industry, but his testimony in front of the US commission investigating the causes of the Credit Crisis (now being re-named the Great Recession -- but that's another post ;) had way too much of a "Let them eat cake" ring.  "Markets crap out -- get over it.  It's normal." -- paraphrasing a bit here, of course, but you get the idea.  I can think of a few others -- the head of Goldman talking about doing "God's work", the head of Morgan Stanley being honest -- "We can't help ourselves".  The list goes on.  Are all of these people living in a bubble?  (Ok, obviously, yes).  Really makes you wonder if it's possible to reconcile some world views and belief systems.  At least without the force of law, or a baseball bat.

It does seem like things are about to get interesting...

Shareholder Interests (1)

We do it for our shareholders.
Our priority is maximizing shareholder value.
Our shareholder’s interests are paramount.
Everything we do is to drive shareholder value.

Sound familiar? While not actual quotes, I didn’t really have to go very far into my (now shrinking) memory to come up with some of the more common phrases that find themselves written prominently in annual reports, used as rationalizations for mergers and acquisitions, and spoken during interviews with the press by chief executives looking to improve the reputation of their companies.

But as has become abundantly clear over the past two years, if not already clear to many in the shareholder rights movement, these are empty phrases. It is hard today to look any of the financial services companies’ executives in the eye when they rationalize their past participation in CDO’s and CDS’s as ways to maximize shareholder value.

So here's the first of a few Naked Emperors to come, from a shareholder perspective:

Bonus Season

For some reason, the banks that played the most visible roles in the demise of the credit markets feel that their recovery is due in large part to the performance of their employees. And so they are planning to award generous bonuses to their staff come February. All well and good. But where are the shareholders who rode through the crisis with them? They get nothing. Why reward them? As Eric Dash wrote of the payouts in the New York Times last week:

“…some analysts and investors say these and other banks are rewarding their employees at shareholders’ expense. The banking industry is quick to pay its workers when times are good but slow to penalize them when times are tough. Pay for performance? Not on Wall Street, the critics say.

“The investor in America sits at the bottom of the food chain,” said John C. Bogle, the founder and former chairman of the Vanguard Group, the mutual fund giant.”

Ailing Banks Favor Salaries Over Shareholders (by Eric Dash, NYTimes.com, 1/26/2010)

Got an interest in protesting? Dump your shares.

Sellers beat Buyers, 43-2

I just finished reading Niall Ferguson's "The Ascent of Money". Just before Christmas, I was reading his description of the buildup in sub-prime mortgage sales and thinking about the corresponding changes in the industry supply chain. Specifically, I mused on the development of the "originate to distribute" part of the banking system -- loan warehouses, etc. Sometime during that same night I was reviewing some discussions on Wikipedia about the use of the term "predatory lending" and how some people there seemed to feel that there is something wrong with the very term. That it is "anti-capitalist" to describe a "freely entered into contract" with a "pejorative term" such as "predatory". This strikes me as obviously silly -- if not somewhat Orwellian -- in that it's difficult to debate either the ethics or the results of business practices if you can't use words that convey values. Besides, the underlying assumption that "if it's capitalist, it is definitionally good" strikes me as one that embodies a fair amount of value assumptions in its own right.

But the Wikipedia discussion did bring into focus for me a rather portly Naked Emperor that I think has grown substantially portlier over the past 10-15 years. Trying to boil it down to an axiom of some type, I came up with the following: When a supply chain becomes big enough and commoditized enough, if the target purchasers are not experts, they're toast. I know, it needs work. But phrasing aside, the idea is pretty simple, and I think stands up as observable in modern societies - and is a great example of one of the fundamental flaws in modern economics that have played such a role in crashing our economies.

The key concepts that lead to the axiom:

• Rational actors:  The theory that a person reasons before taking an action and thereby acts rationally, seems destined to hit the garbage pail.? A good thing, since it's never been more than a simplification to permit thought experiments and mathematics -- it's simple to observe in our daily lives that people don't behave rationally from an economic perspective.

• Information Asymmetries: Asymmetry describes a situation in which one party to a transaction has more complete or accurate information about the value of the transaction components and/or downstream implications than the other party.? Although commonly described as undesirable or unfair in economic analysis, it is a staple of many market situations and these unequal bargaining positions are directly exacerbated by complexity.

• Product complexity: As products (especially financial ones) get increasingly sophisticated, the level of expertise required to understand and evaluate them goes up -- significantly.

• Market and supply chain complexity: As the number of components/relationships in a given product go up, understanding the value of that product becomes increasingly dependent upon understanding the complexities of the supply chains and their related distribution channels, along with comprehending the resultant pricing issues (if they're not hidden, see information asymmetries above).

There are other factors involved, but these are the primary reasons behind a simple fact: if you are purchasing something, especially in an area like financial services where there is nothing tangible to get your hands on, examine, and measure, the people selling it to you generally know more about it.  If you're a retail investor, the odds are you will get lost within minutes of having the "explanation" of why you want the product.  Even the high powered "Buy Side" professionals are generally over-matched when it comes to evaluating complex strategies and products.  (Hence all the stories about investment bankers "ripping the face" off of their clients).

This is by no means limited to financial markets, though the effect is possibly easier to identify there.  But take a look at insurance offerings, health care plans, or cell phone contracts -- these all require significant time and effort to understand, more than most people can afford to invest in what are essentially required purchases.  Probably the worst example of this situation can be found in the political arena, where the packaged views have little relation to reality and the candidates are entirely qualified only by fund raising  ability, but we'll leave that one to the paid pundits.

Conventional Thinking

In a recent article about the upcoming bonus season on Wall Street, John Reed, a former Wall Streeter and founder of Citigroup, commented: “These guys don’t get it. They are off in a different world.” He was reacting to the news that most Wall Street firms are probably going to give out generous bonuses for a year in which, many Americans feel, the American taxpayer took all the brunt of the financial crisis and the bankers took all of the cash.

But this is what bankers and the financial world does. And has done forever. They give their people competitive salaries and then compensate them at the end of the year with the surplus that they have all contributed to – the bonus. But over time, this end of year surplus has become no longer a “bonus” but, in the eyes of most working in the banking industry, “earned” compensation. When a bonus keeps coming year after year, you come to expect it. And many people who work on Wall Street not only expect on it, they plan on it. I have to admit I was a little surprised when I learned that debt counseling was offered at an investment bank last year, after bonuses were almost cut in half. Turns out, a lot of people had already spent the money that they expected – but would not get – that year.

This compensation structure is so ingrained in conventional thinking, that it has taken some pretty radical moves by governments to get the banking industry to think a little bit out of the box. And to be honest, the US banking industry has not felt compelled to think out of the box at all. [John Reed would agree, I think.] Only Goldman Sachs, a firm that prides itself on being a first mover and leader in the industry, said last month that its top executives would get deferred stock as their bonus this year. No other bank followed their lead. But why would they? Everyone knows that the top 30 executives at Goldman are already billionaires; they can’t possibly care that much whether they get compensated this year or next - as long as they get compensated and keep their roles as leaders in their firm. Banks don’t have any incentive to change their compensation practices either - the only backlash at the moment from handing out big bonuses will be the 24 hour news cycle, during which the banks will get hammered - but their employees will be very happy.

Conventional thinking is completely ingrained on Wall Street. And given the product being sold on Wall Street, it’s not hard to see why. The basic type of financing is loans – that hasn’t changed over the past several centuries – the form of that financing can take many different shapes and flavors, but the essential transaction is the same. And the other is equity – commonly known as public shares in a company, but also a form that can have many shapes and flavors. And derivatives, the things that made everyone swoon, are just bets on the two fundamental products, loans (bonds) and equity. It’s just that the folks on Wall Street make them sound so complicated. (I leave out foreign exchange; that’s a whole different kettle of fish.)

Conventional thinking is ingrained even in the organizational structure of most banks. The pecking order – Analyst, Assistant VP, Vice President, Director, Managing Director – is pretty well known on the Street. There’s not been much to change that over the past several decades, if not century. Conventional thinking is also ingrained business process – the front office owns the business (and its revenues), and infrastructure groups (middle office and back office operations, technology, finance) are the cost centers that align with that business. This silo-ing is conventional thinking about how to run a bank. But the organization ends up providing all the wrong incentives for the business. Here’s the Naked Emperor.

Conventional thinking says that the Front Office is responsible for the profit and loss of its business from front to back – from the time the product is marketed to the time it is sold and settled in the account of the client. That should encourage the Front Office (FO) to work well with the Back Office (BO); it would seem that the FO incentive is to make sure everything runs seamlessly throughout the whole process, and to support all the folks who make that happen. But in reality, that approach has killed the relationship between the Front Office and the Back Office. Because whenever the Back Office messes something up, the Front Office just gets angry. They don’t like the Back Office anymore, because they are keeping the Front Office guys from making money. This is not how you build relationships. It destroys them. And it results in inefficiencies and inequities in the ways the groups work with each other. But this is the way it works on Wall Street. That’s conventional thinking for you.