Spero Consulting

Archive for November 28th, 2008

That’s a title we never thought that we would write, but before we chase away our reg­u­lar read­ers who share our polit­i­cal and eco­nomic world-​view, please let us explain: it’s not as bad as it looks.

In Kim­berly Strassel’s WSJ col­umn, Hillary of State, Ms. Strassel describes how the main­stream media have now returned to pro­vid­ing a favor­able opin­ion of Hillary Clinton’s for­eign affairs qual­i­fi­ca­tions (to be Sec­re­tary of State). 

We must admit that that this is the first time in our life that we viewed overly-​favorable cov­er­age of any Clin­ton to be a good thing, or even the pos­si­ble indi­ca­tion of a good thing.

But, again, we cau­tion reg­u­lar read­ers: it’s not as bad as it looks. 

Take that excla­ma­tion both ways: first, we’ve not changed, and sec­ond, we spec­u­late that the econ­omy isn’t as bad as the recent losses in the stock mar­ket sug­gest. Although, we have no doubt that cur­rent gov­ern­ment offi­cials could turn that neg­a­tive per­cep­tion into real­ity, and may have already done so with their extant actions.

So here’s our short argument:

1. Prior to the col­lapse of the stock mar­ket, losses were highly con­cen­trated among finan­cial intermediaries. 
2. Now, words can hurt…the econ­omy. The hyper­bole and/​or out­right pan­icky speech (or some com­bi­na­tion of both) by elected offi­cials and appointees, pri­mar­ily Messrs. Paul­son and Bernanke, helps cre­ate the recent collapse. 
3. Mis­guided actions can be dam­ag­ing, too. The government’s effort to stem the crises, which we believe that they still con­sider to be a sin­gu­lar cri­sis, has been very dam­ag­ing, too.
4. So, equity val­ues have decreased sub­stan­tially and the econ­omy is less sound than it was. There maybe be some­thing close to a depres­sion or not.
5. For­tu­nately, the media’s gen­eral high regard for Mr. Obama, and their desire to help him suc­ceed dur­ing the new administration’s hon­ey­moon period, may gen­er­ate suf­fi­cient good­will to pos­i­tively influ­ence the atti­tudes and per­cep­tions of con­sumers and investors to pre­vent the poten­tial dis­as­ter that we have been talked and erred into by said offi­cials. Ergo, in this instance, media bias may be a good thing if it influ­ences the zeit­geist towards opti­mism and away from eco­nomic devastation.

Now here’s the longer argument.

Con­cen­trated Losses

We very much enjoyed Peggy Noonan’s col­umn this week, Tur­bu­lence Ahead. Much of it deals with the lack of evi­dence for what she abbre­vi­ates as GDII, or Great Depres­sion II.

Despite the eco­nomic slow-​down this autumn and the stock mar­ket crash, we’ll take her obser­va­tions as evi­dence of a phe­nom­e­non that we have writ­ten about exten­sively: the high con­cen­tra­tion of losses in this mort­gage and finan­cial cri­sis com­pared to ear­lier ones. Please con­tinue to ignore the “domes­tic” auto man­u­fac­turer (as most of you have through the many years of buy­ing “for­eign” cars that were made in other coun­tries and in our coun­try). The out­sized pub­lic­ity that the indus­try receives about its prob­lems far over­state its value to the econ­omy. More­over, bank­ruptcy does not imply liq­ui­da­tion; so, there is no rea­son to think that at least two of the three will not survive.[1. Smart Japan­ese or Ger­man man­u­fac­tur­ers might wish to con­sider mov­ing their head­quar­ters to the U.S.A., and becom­ing a lead­ing domes­tic man­u­fac­turer. Think of the good­will such an act would engen­der, includ­ing the invalu­able free publicity.]

While not directly related to this post, Ms. Noo­nan spec­u­lates about the nature of GDII, and her com­ments are wise and con­sis­tent with our obser­va­tions liv­ing in a rel­a­tively depressed region of the coun­try: West­ern Penn­syl­va­nia, dur­ing and after the col­lapse of the steel indus­try. She talks about the grad­ual, almost imper­cep­ti­ble changes that may take years to real­ize. Those who spent their lives here were/​are much less sen­si­tive to the change, whereas hav­ing spent a decade away, we noticed the gen­eral unkempt shab­bi­ness imme­di­ately upon return; one can con­tinue to see it in the peel­ing paint and dirty facades of many small businesses.

Epic Gov­ern­men­tal Mismanagement

See most of what we wrote about the cri­sis since Sep­tem­ber although we might have crit­i­cized Mr. Paul­son before that. This morn­ing, in More Evi­dence of the Lack of Fore­thought that is TARP we sum­ma­rized our crit­i­cism of cer­tain aspects of the government’s response: the words and actions of elected and appointed offi­cials have been extremely dam­ag­ing and their efforts often coun­ter­pro­duc­tive at best.

As we wrote sev­eral months ago, no sin­gle firm could destroy our econ­omy. Such an out­come can only be achieved through gov­ern­ment action.

Like Ms. Noo­nan, we’ve really not seen any panic among con­sumer – whether they are fam­ily, friends, acquain­tances or strangers at the mall. How­ever, the government’s response to the cri­sis has the con­tin­ued poten­tial to (con­tinue to) harm the nation’s eco­nomic psy­che and make bad times worse.

When Will We See the Bottom?

We had a con­ver­sa­tion with friend ear­lier in the week who was much con­cerned about the future (who’s not?). He won­dered if equity mar­kets had reached their nadir and had cited some anec­do­tal evi­dence sug­gest­ing that his acquain­tances were inter­nal­iz­ing their sub­stan­tial loss of wealth. They were not par­a­lyzed with fear but had sur­veyed the eco­nomic envi­ron­ment and their own weak­ened finan­cial con­di­tion and were get­ting on with life.

The Poten­tial Ben­e­fit of Media Bias

Clearly, words do mat­ter, and the media can frame and empha­size issues and perspectives. Directly and indi­rectly those words affect the behav­ior of cit­i­zens, con­sumers, investors, and entrepreneurs. 

If the mass-media’s desires to aid Mr. Obama pos­i­tively affect per­cep­tions and improves the gen­eral eco­nomic out­look of the nation (and there­fore the world), then the prob­a­bil­ity of escap­ing truly dev­as­tat­ing eco­nomic con­di­tions improves.

In that and many other respects, we cer­tainly hope the best for Mr. Obama.¹

So, start­ing today and con­tin­u­ing for a few months, we’re all for left-​wing media bias.

Of course, we ask Obama? BWAMA?

This post greatly expands upon a com­ment we made about reg­u­la­tion in Even A Per­fect Bailout Will Fail and pos­si­bly elsewhere.

Reg­u­la­tors as wise monkeys.

Today’s The Wall Street Jour­nal has an arti­cle enti­tled, Bank Exam­in­ers Are Told to Step Up Sanc­tions on Lenders.

The first sen­tence of the arti­cle says it all: “The U.S. government’s armies of bank exam­in­ers have been ordered to be more aggres­sive in apply­ing for­mal sanc­tions to finan­cial insti­tu­tions when prob­lems are found.”

Unfor­tu­nately, order­ing does not make it so, and we doubt that it will work. We’re not mak­ing a blan­ket con­dem­na­tion here, but we’d be inter­ested in know­ing if and how the gov­ern­ment deals with the incen­tive prob­lems that we address below.

Unless the Fed, the OCC, and the OTS imme­di­ately trans­fer and reas­sign exam­in­ers, we doubt that many new issues will be found. Fur­ther­more, if such issues are dis­cov­ered, we doubt that those issues will be reported. (In this post, we’ll call such bank-​related prob­lems “issues,” and reserve the word “prob­lem” for the dys­func­tional incen­tives that may exist within the reg­u­la­tory agen­cies.) Of course, there are many obvi­ous issues that can be noticed with­out for­mal exam­i­na­tions and investigations.

Incen­tive Problems

There are, in fact, a cou­ple of related incen­tive prob­lems worth men­tion­ing. (1) Many exam­in­ers spend many years exam­in­ing only one firm. At large insti­tu­tions, the exam­iner is usu­ally located on the bank’s premises – pos­si­bly shar­ing office space, e-​mail sys­tems, and din­ing room priv­i­leges with bank employ­ees and managers. (2) Many exam­in­ers seek (and gain) employ­ment with the same finan­cial insti­tu­tion that they pre­vi­ously examined.

We’ll briefly address the sec­ond issue first by ask­ing: what incen­tive does an exam­iner have to take a “hard-​line” by ques­tion­ing the value of assets or cap­i­tal reserved if it may infu­ri­ate or alien­ate a poten­tial employer? (We’ll return to this issue at the end of the post, too.)

The elim­i­na­tion of the prospect of future employ­ment, however, does not elim­i­nate the incen­tive prob­lem for long-​time exam­in­ers. For rep­u­ta­tional rea­sons, they may still lack the moti­va­tion to closely scru­ti­nize and report issues.

Now, clearly some degree of famil­iar­ity is ben­e­fi­cial when exam­in­ing or audit­ing insti­tu­tions because that knowl­edge reduces the set-​up and oper­at­ing costs of per­form­ing the exam­i­na­tion: port­fo­lios, sys­tems, and key per­son­nel are all known by the repeat exam­iner. In addi­tion, it becomes quite expen­sive for the gov­ern­ment to move exam­in­ers and quite dis­rup­tive for exam­in­ers and their fam­i­lies to be peri­od­i­cally relo­cated to dif­fer­ent insti­tu­tions in pos­si­bly dif­fer­ent regions of the coun­try (or to travel extensively).

It is the case that cer­tain higher-​level man­agers are rotated, but that seems insuf­fi­cient to ensure that lower-​level work­ers will nec­es­sar­ily report issues of which they know. More­over, who is more likely to dis­cover (or be infor­mally informed of) such issues?

Sunk Cost Fallacy

Our long-​time exam­iner incen­tive prob­lem is sim­i­lar to the sunk cost fal­lacy that has been exten­sively stud­ied by econ­o­mists – includ­ing infor­ma­tion econ­o­mists – who address the question: why do man­agers keep invest­ing in (seem­ingly obvi­ous) los­ing projects?[1. There are other expla­na­tions, too. For exam­ple, we like this quote by Father Joseph Holzner, author of Paul of Tar­sus,: “When a man feels the bur­den of guilt on his soul, he tries hard to jus­tify him­self before his own con­science and before oth­ers by increas­ing his false zeal, and thus he sinks yet deeper into evil.”] 

There is an option-​value expla­na­tion that if (exoge­nous) cir­cum­stances change, the poorly-​performing project may become valu­able; so, it is worth the cost to main­tain that flex­i­bil­ity (and pay the equiv­a­lent of an option pre­mium). That expla­na­tion makes the deci­sion to invest to be very much like insurance.

The infor­ma­tion story is dif­fer­ent and involves adverse selec­tion and reputation. A man­ager who made or who sup­ported the ini­tial invest­ment may feel that his rep­u­ta­tion is at stake and his judg­ment may be ques­tioned by admit­ting that a project that they had picked as a win­ner was actu­ally a loser (and so oth­ers may infer that the said man­ager is a loser, too.)

How It Relates to Regulation

Most bank activ­i­ties are long-​lived – because they are or because they are like invest­ments. Thus, for dubi­ous ongo­ing ven­tures, the exam­iner must decide whether or not to crit­i­cize or men­tion them.

Imag­ine a multi-​year ven­ture, activ­ity, or invest­ment that the exam­iner has not men­tioned or crit­i­cized in pre­vi­ous years. Gen­er­ally, it would be highly unlikely that there were no warn­ing signs in prior peri­ods, espe­cially if the examiner’s supe­rior were gifted with per­fect, ²⁰⁄₂₀ hind­sight, which is quite easy to pos­sess (and requires much dis­ci­pline to control).

In that case, we could imag­ine the undis­ci­plined supe­rior ques­tion­ing the examiner’s past per­for­mance: “did you miss it because you are incom­pe­tent or did you catch it and fail to men­tion it because you are duplic­i­tous?” (Here is an essay on Strate­gic Con­sis­tency and Man­age­r­ial Dis­ci­pline.) It seems that any exam­iner with any bit of fore­sight could also make this inference.

Thus, it may be in the ratio­nal – though not con­sci­en­tious – examiner’s best inter­ests to act as a trin­ity of wise mon­keys and sup­press his pri­vate infor­ma­tion and discoveries.

Empir­i­cally and as a tax payer, we do believe it is fair to ask: how many exam­in­ers or final­ized exam­i­na­tion reports warned about any of the prob­lems that we are now expe­ri­enc­ing? How many of those unre­ported mortgage-​related issues arose only in 2008 or the lat­ter half of 2008? In that respect, the reg­u­la­tory agen­cies seem much like the government-​regulated credit agen­cies with their over-​optimistic scenarios.

We can’t hypoth­e­size all of the blame lower-​level work­ers. There are cer­tainly con­sci­en­tious exam­in­ers who may or may have men­tioned issues. Given our quite skep­ti­cal view of the (fallen) nature of man, it is quite easy to believe that in some cases their warn­ings were sup­pressed by their supe­ri­ors, who despite rota­tion, may be have attempted to main­tain good feel­ings with their sub­ject banks in their desire for a well-​paying cor­po­rate job.

Reg­u­la­tion as a Crutch (Causes Atrophy)

We’ll have more to say about the dele­te­ri­ous effects of reg­u­la­tion. We’re for­mu­lat­ing a post about the false sense of secu­rity that risk man­agers may pos­sess after they sat­isfy the ques­tions of (seem­ingly simian, albeit intel­li­gent simian) reg­u­la­tors. In other words, there is no rea­son to believe that pass­ing reg­u­la­tory hur­dles alone is equiv­a­lent to effec­tive risk or uncer­tainty management.

The Wall Street Jour­nal today, Novem­ber 28, reports Res­cue Plan Strained by Lack of Staff.

We’ve crit­i­cized the government’s response to both the domes­tic mort­gage cri­sis and the larger global con­fi­dence cri­sis since it – that which became TARP – was first pro­posed. (We use the sin­gu­lar “it” because we’ve not heard any gov­ern­ment offi­cial decou­ple the prob­lems either in their ini­tial panic or in the inter­ven­ing months.)

Since mid-​September, other than times when we were too busy to write, our crit­i­cism as been con­sis­tent, harsh, and steady: (1) ini­tially the gov­ern­ment offi­cials, led by Trea­sury Sec­re­tary Henry Paul­son, over­re­acted. That hys­te­ria – or maybe it was (indistinguishable) hyperbole – exac­er­bated the sit­u­a­tion and cre­ated real panic and extremely high volatil­ity, which remains. (2) Their solu­tion – which, as Trea­sury offi­cials now implic­itly admit did not meet the def­i­n­i­tion of a plan – was poorly con­structed and des­tined to fail. And (3) as we wrote nearly two months ago, in Even A Per­fect Bailout Will Fail, “What Hope of Suc­cess with Typ­i­cal Bureau­cratic Efficiency?”

The arti­cle cited above pro­vides evi­dence of that “Bureau­cratic Effi­ciency,” by which of course we meant inef­fi­ciency. (We should have included “inef­fec­tive­ness,” too, but it seemed like overkill at the time.) The key line in today’s arti­cle: “The cur­rent Trea­sury has so far strug­gled to keep up with the task of hir­ing enough peo­ple to han­dle the $700 bil­lion finan­cial res­cue package…”

Would any rea­son­able per­son expect any more (or less) from a mas­sive, cen­tral­ized bureau­cracy? In that regard, is the fed­eral government’s response to this dis­as­ter or cat­a­stro­phe any dif­fer­ent than its response to Hur­ri­canes Kat­rina and Ike? (Ike has escaped national atten­tion due to the more destruc­tive finan­cial cri­sis and the recent Pres­i­den­tial election.) 

Thus, our gov­ern­ment seems to be unable to deal with either large-​scale nat­ural or man-​made dis­as­ters. How­ever, while Michael Brown, the Direc­tor of FEMA at the time of Kat­rina, could never be blamed for caus­ing Kat­rina, can the same be said of Mr. Bush’s finan­cial appointees in the cur­rent crisis?