Archive for January, 2010

Inno­v­a­tive Man­age­ment Solu­tions ~ Cre­ative Web Design

We have changed our site’s and the firm’s motto to bet­ter reflect our broad busi­ness mix. We have dropped the nar­rower “Thought before Cal­cu­la­tion” for the more gen­eral “Inno­v­a­tive Man­age­ment Solu­tions.” Inno­va­tion isn’t always thought­ful, but in our case it is.

Plus, we have added “Cre­ative Web Design” to rec­og­nize a large part of our prac­tice. Through sheer serendip­ity, we design and develop the kind of web sites that “every­body wants.” Our sites are good-​looking, orga­nized, easily-​self-​managed, and search-​engine opti­mized. What’s not to like?

We men­tioned the answer to our ques­tion in Sunday’s post, Bernanke: No, but it is worth repeat­ing as a stand-​alone post.

Many sup­port­ers of Ben Bernanke (and other politi­cians) cite last year’s increase in the stock mar­ket as evi­dence that the he or they “saved the econ­omy” and/​or “pre­vented a depression.”

For those read­ers who don’t have the per­cent­ages mem­o­rized, the Dow Jones Indus­trial Aver­age increased about 20% in 2009. From its nadir early last March, it increased about 61% by year-​end. (Yeah, Jan­u­ary and Feb­ru­ary ’09 were par­tic­u­larly cruel.)

That seems impres­sive, right?

Well, in 1932, the Dow Jones Indus­trial Aver­age increased about 64%.

Recall that the Great Depres­sion is sup­posed to have started with the stock mar­ket crash in Octo­ber, 1929, and ended around 1940 or so. (Among econ­o­mists who care about such things, there isn’t as much con­sen­sus about its end­ing as its beginning.)

Now, whether one takes the absolute peak or some other smoother mea­sure of the index’s lev­els, it took until 1954 or 1955 to approach the highs of 1929 & 30.

So, while it’s very nice when­ever equity mar­kets increase, note that the extra­or­di­nary stock per­for­mance in 1932 did not sig­nal an end to the depression.

Also, note that it took another 22 years (or so) to attain new equity index highs, and those lat­ter highs were not adjusted down­ward (for the infla­tion) dur­ing the inter­ven­ing 22 years.

So, while every rea­son­able and sane per­son hopes that the worst of the eco­nomic cri­sis is over, note that it need not be for many, many peo­ple or for the econ­omy as a whole.

Now, per­haps we are inat­ten­tive, but we haven’t heard Mr. Bernanke take any credit for last year’s per­for­mance. We would attribute that to the fact that he knows more about the Great Depres­sion than many of his sup­port­ers do.

We Missed It a Few Months Ago

On the front page of the The ‘Money & Invest­ing’ sec­tion of today’s edi­tion of The Wall Street Jour­nal, there is an arti­cle enti­tled, At SEC a Scholar Who Saw It Com­ing.

The arti­cle is about Henry Hu, who man­ages the newly-​formed Risk, Strat­egy and Finan­cial Inno­va­tion divi­sion at the SEC.

Though he sounds like a good guy, we don’t know much about Mr. Hu, but that’s not why we’re writ­ing. It also men­tions that in Novem­ber, Mr. Wu hired Richard Book­staber to lead staff train­ing and data analy­sis, and that is a good thing. (The print ver­sion incor­rectly iden­ti­fies him as David Bookstaber.)

If you haven’t heard of Mr. Book­staber, he has much knowl­edge and much expe­ri­ence work­ing at large trad­ing firms and hedge funds. In fact, he takes “par­tial credit” for a few of the past crises, includ­ing the Crash of 1987.

Mr. Book­staber is also the author of the 2007 book, A Demon of Our Own Design, which dis­cusses those crises, his roles in them, as well as his approach to risk (and uncer­tainty) management. We highly rec­om­mend the book to any­one in the finan­cial ser­vices indus­try and within par­tic­u­lar roles in other indus­tries, too. For exam­ple, we recently rec­om­mended it to the chief of secu­rity at a large, U.S. based, multi­na­tional that oper­ates fac­to­ries and plants through­out the world.

In the book, Mr. Book­staber makes the excel­lent point that overly-​rigid or overly-​complex risk mon­i­tor­ing and safety sys­tems can actu­ally increase the prob­a­bil­ity of fail­ure and the loss given fail­ure and dis­cusses it both within and out­side of finan­cial ser­vices. (Recently, we made sim­i­lar points in our analy­sis of intel­li­gence fail­ures and bad infor­ma­tion sys­tem design.)

Besides read­ing the book, we also encour­age our read­ers to visit Mr. Bookstaber’s blog, espe­cially to read his tes­ti­mony before Con­gress – the links in the right-​hand col­umn). It is well-​written and not overly-​technical.

Regard­ing risk and uncer­tainty man­age­ment, Mr. Book­staber makes points sim­i­lar to ours, with the main inter­sec­tion being that not every cri­sis is pre­dictable, but thought­ful­ness and con­tin­gency analy­sis goes a long way to mit­i­gat­ing crises. In fact, prepar­ing (rather) gen­eral responses to pos­si­ble, spe­cific crises can pre­pare one for com­pletely unknown ones, too. (See our essay on uncer­tainty man­age­ment and almost any of our posts cat­e­go­rized as uncer­tainty or risk. By the way, we really like our post with the tongue-​in-​cheek title, The Role for Sur­vival­ists and Depres­sives in Uncer­tainty Man­age­ment, because we think that per­son­al­ity traits like skep­ti­cism and pes­simism are under-​weighted and under-​valued in most risk man­age­ment hir­ing process.)

The best that we can tell, we tend to place more empha­sis on stress-​testing and sce­nario analy­sis than he does, but that’s because we think that imag­i­na­tion, like skep­ti­cism, is under-​estimated, too.

One topic where we do dis­agree is his insis­tence that every­one (that mat­ters) under­stands the lim­i­ta­tions of the use of nor­mal dis­tri­b­u­tions in risk mea­sures like VaR (Value at Risk). To explain, 2e’ll try to be con­cise but thor­ough but will err on the side of brevity.

It is well-​known – though not wholly-​agreed-​upon – that assum­ing nor­mal­ity (or log-​normality) mis-​specifies mod­els of returns, and we think that many ‘quants’ do know that, but they use those assump­tions nonethe­less, and that’s for a few reasons:

1. There is no other choice, or no other tractable choice.
2. Depend­ing upon the con­text, it may not mat­ter much.
3. Ease of cal­cu­la­tion and effort. (This is dif­fer­ent than (1).)
4. As a way to reduce mea­sures of risk characteristics.
5. Ease of com­mu­ni­ca­tion to others.

We are very sym­pa­thetic to the first two rea­sons, and being some­what lazy, we are also sym­pa­thetic to the third. However, the fourth rea­son hints at cyn­i­cism and greed and, depend­ing upon who is using the mea­sure, it can be very destruc­tive. Also, if such assump­tions are used for oppor­tunis­tic rea­sons, that can indi­cate the tra­di­tional weak­ness of risk man­age­ment vis-​a-​vis revenue-​generating departments.

The fifth rea­son hints that maybe – just maybe – not every­one under­stands the cal­cu­la­tions and assump­tions and their flaws.

We have dealt with very high-​level man­agers at very large firms who are quite igno­rant of the basic char­ac­ter­is­tics of nor­mal dis­tri­b­u­tions. To their credit, a few were quite will­ing to admit as much. (They are the least harm­ful of the bunch.) But given those expe­ri­ences, it is dif­fi­cult to believe that most board direc­tors under­stand the arith­metic; so, it is dif­fi­cult to accept that all senior man­agers (at such firms) under­stand the cal­cu­la­tions; so, it is dif­fi­cult to believe that all other man­agers, traders, sales­men, and investors are knowl­edge­able and well-​informed. (And, boy, could we tell you sto­ries!) The fact that, as Mr. Book­staber points out in his tes­ti­mony, such top­ics appear in text­books is a non sequitur.

When one com­bines cyn­i­cism with mis­com­mu­ni­ca­tion – whether pur­pose­ful or not – there’s a good chance that the orga­ni­za­tion is bear­ing more uncer­tainty and risk that it imag­ines or mea­sures, and that’s not good. So, that fact that “every­one knows” some­thing – even if it that some­thing is true – doesn’t mean that it’s not abused. For exam­ple, pick any vice that every “knows” is wrong but folks do it any­way. The abuse of ille­gal drugs and obe­sity are two anal­o­gous exam­ples. (Oh, by the way, gov­ern­ment reg­u­la­tion doesn’t seem to help much there, either.)

Finally – almost – these last two issues hint at incen­tive prob­lems – both moral haz­ard and adverse selec­tion – that exist within firms, and we’ve writ­ten exten­sively about that, too, e.g., Incen­tives and the Finan­cial Cri­sis and many more.

In sum, while we have never met Mr. Book­staber and likely never will, we are encour­aged to see the SEC hire such a knowl­edge­able and wise per­son. We wish him the best in his new role. (We only wish that we would have done so a few months earlier.)

There is a short arti­cle about sus­tain­abil­ity in ‘The Jour­nal Report’ sec­tion of today’s edi­tion of The Wall Street Jour­nal. We think that is worth men­tion­ing, espe­cially to small busi­ness own­ers and man­agers of small, not-​for-​profit agen­cies and organizations.

The arti­cle is enti­tled, How Green Should My Tech Be? It Depends on the Tech. The author, Robert Plant, lists and pri­or­i­tizes four cat­e­gories of tech­nol­ogy projects from ‘no-​brainers’ to ‘distractions.’

We are writ­ing to men­tion a ‘no-​brainer’ that he doesn’t. Small and medium-​sized busi­nesses should con­sider out­sourc­ing their server oper­a­tions to shared host­ing accounts (and/​or ded­i­cated servers).

“What’s a shared host­ing account” you ask? It’s a lease of server capac­ity – usu­ally with lim­its on monthly band­width and on hard drive stor­age. Like cell phone com­pa­nies, web host­ing firms offer tiered pric­ing pack­ages based upon expected usage, but many very small busi­nesses need only with the cheap­est packages.

For small busi­nesses with small infor­ma­tion sys­tem needs – web server, e-​mail server, etc – the energy costs of oper­at­ing their own server 24 hours a day, 365 days per year, are likely greater than the annual cost of a shared host­ing account.

Depend­ing upon the con­fig­u­ra­tion and age, elec­tri­cal con­sump­tion can cost between $200 — $400 per year for a sin­gle server, and many small busi­nesses can obtain an appro­pri­ate shared host­ing account­ing for well less than $200 per year. Like we said, it’s a no-​brainer: no (sep­a­rate) hard­ware costs; gen­er­ally no soft­ware costs, espe­cially for those using open source web appli­ca­tions and servers; and no repair costs.

Now, of course, lower util­ity bills aren’t nec­es­sar­ily bet­ter if other costs are higher or if the real­iz­ing sav­ings requires one to assume addi­tional risks, but shared host­ing accounts are, in fact, less risky than run­ning a server from a back office or closet. Among the benefits:

• Reli­a­bil­ity and uptime are greater and aren’t affected by local power, cable or tele­phone outages.
• Through a rep­utable host­ing com­pany, your server will be located in a well-​managed, well-​maintained and well-​designed server farm with redun­dan­cies, back­ups and speeds of repair that you could not rival with­out a large invest­ment and near obses­sive atten­tion to it.
• There is little-​to-​no risk of fire or theft of equipement, and your server man­age­ment con­soles can be accessed from anywhere.
• Depend­ing upon the num­ber of employ­ees, your firm’s poli­cies and pro­ce­dures, and you dis­ci­pline adher­ing to those pro­ce­dures, data may be safer.
• If required for web-​based trans­ac­tions, sta­tic IP addresses and SSL cer­tifi­cates are avail­able for shared host­ing accounts, too.

While it is out­side the scope of this post, medium-​sized firms with greater infor­ma­tion demands should con­sider leas­ing ded­i­cated servers at such server farms via the same types of web host­ing accounts: annual cost approx­i­mately $5,000 or so.

One note of cau­tion: like any­thing else, the cheap­est host­ing ser­vice isn’t always the best. Get a rep­utable one that replies quickly to inquiries and ser­vice requests, prefer­ably in Eng­lish. For that we whole-​heartedly (and with­out com­pen­sa­tion) rec­om­mend Fused Net­work.

P.S. For small net­work backup needs, con­sider some­thing energy-​efficient like the Acer Aspire Easy­S­tore AH340. We love ours.

For the past few weeks, it seems that every day we hear at least one news pre­sen­ter or com­men­ta­tor com­plain that would-​be bomber, Umar Farouk Abdul­mu­tal­lab, stopped talk­ing after he was “read his Miranda rights.”

We find that very irri­tat­ing because as a for­eign national and enemy com­bat­ant, he has no such rights; so, they could not be “read to him.”

The fact that an FBI agent read or explained the Miranda warn­ing to him does not con­fer those rights upon him.

The largest error was not or is not that he was given a warn­ing that did not then and does not now apply to him. Instead, the largest error is that he con­tin­ues to be treated as a crim­i­nal rather than as an enemy combatant.

So, the ini­tial FBI error (of attempt­ing to con­fer rights upon some­one who does not have them) is cor­rectable. Instead of com­plain­ing about the actions of FBI agents on Christ­mas Day, crit­ics should con­tinue to focus on the wimpi­ness and stu­pid­ity of the Obama admin­is­tra­tion for con­tin­u­ing to treat an enemy-​of-​the-​state like a shoplifter.

Mr. Obama, take your inau­gural pledge seri­ously, and send him to Gitmo.

FWIW: we say no to a sec­ond term.

This week­end there are many reports and com­men­taries regard­ing the U.S. Sen­ate vote to con­firm Ben Bernanke to a sec­ond term as the Chair­man of the Fed­eral Reserve. For exam­ple, see the arti­cle Back­ers Rally to Bernanke in The Wall Street Jour­nal.

Mr. Bernanke nei­ther deserves a sec­ond term nor can we, as a nation and econ­omy, afford it.

Don’t Blame Him for any Bubbles

Many com­men­ta­tors, ana­lysts, and econ­o­mists blame Mr. Bernanke’s (and his pre­de­ces­sor, Alan Greenspan’s) easy money poli­cies for cre­at­ing a sequence of bubbles.

We don’t. As far as we can tell, prior to 2008, Mr. Bernanke did not force a sin­gle per­son or firm to bor­row an addi­tional dol­lar or invest in assets and secu­ri­ties that they did not under­stand. See our post The Low Inter­est Rates Made Us Do It: Oh, How Lame! from August, 2008. Note that Com­mu­nity Rein­vest­ment Account (CRA) poli­cies were not his dik­tat. In fact, their ini­tial imple­men­ta­tion in 1977 far pre­cede his involve­ment at the Fed.

His Flawed Poli­cies Aren’t Disqualifying

In addi­tion, as much as we dis­like his sta­tist pol­icy pre­scrip­tions to end the liq­uid­ity cri­sis that began in the Fall of 2008, we don’t think that alone is rea­son to deny his confirmation.

How­ever, every TARP-​addled, self-​congratulatory politi­cian, bureau­crat, and reg­u­la­tor wish­ing to take credit for staving off a new depres­sion, should note that dur­ing the “The Great Depres­sion,” the Dow Jones Indus­trial Aver­age gained 63.74% in 1932. HOWEVER, it took an addi­tional 20 years – that’s 20 years – for the Dow to reach its pre-​crash highs of 1929.

Thus, if you, dear reader, con­fi­dently “know” or strongly believe that because the Dow has ral­lied since last March, that nec­es­sar­ily means that the cri­sis has ended with lit­tle or no chance of return­ing, then you are, indeed, a short-​sighted fool (with lit­tle aware­ness of history).

So, if (1) we don’t blame him for the con­sumer and investor behav­ior that led to the mort­gage débâ­cle that led to the liq­uid­ity cri­sis and (2) we don’t think that his pol­icy response to the cri­sis, in and of itself, is dis­qual­i­fy­ing, then what is it?

His Panic & Ter­ror Were Unconscionable

It was his pan­icked response to the mort­gage débâ­cle that helped turn it into a liq­uid­ity cri­sis and severe reces­sion. It wasn’t his pol­icy pre­scrip­tions, it was the way he tried to sell them. He wasn’t alone. For­mer Pres­i­dent Bush, Con­gres­sional lead­ers, and ex-​Treasury Sec­re­tary Hank Paul­son also deserve much of the blame, and we gave it to them, but he should have known bet­ter. (See, for exam­ple, Well, This Is a Fine Mess You’ve Got­ten Us into.… or just about any­thing else that we wrote from Sep­tem­ber — Decem­ber, 2008.)

Dur­ing the spring and sum­mer of 2008, we asked on sev­eral occa­sions: why are the losses so con­cen­trated this time? See, for exam­ple, this search or this tag or this one. (There’s some overlap.)

The rather con­cen­trated mort­gage débâ­cle informed investors and cred­i­tors that bank man­agers were far less capa­ble than had been believed. As con­fi­dence in the banks shrank, our pub­lic ser­vants pan­icked and eeked and squeaked like lit­tle girls.

Their col­lec­tive panic and ter­ror destroyed pub­lic con­fi­dence – not just in the banks – that was jus­ti­fi­able – but in the econ­omy as a whole. Their threats and over­state­ments became self-​fulfilling, and per­mit­ted cyn­i­cal man­age­ments at non-​financial cor­po­ra­tions to lay-​off employ­ees. Those actions imme­di­ately deep­ened the down­turn and destroyed con­sumer and investor con­fi­dence. It still has not recov­ered. (By the way, by non-​financial, we don’t mean that hope­less and hap­less auto man­u­fac­tur­ers. Given their pre­car­i­ous states, they were doomed to fail when­ever a reces­sion occurred.)

Per­haps by 2008, he had spent too much time in Wash­ing­ton and had for­got­ten that words and state­ments have real impli­ca­tions. There are sound rea­sons why it is ille­gal to shouts “Fire!” in a crowded the­ater (and risk a pub­lic cat­a­stro­phe). In our mind, that’s what Mr. Bernanke and his cronies did. Words are not merely “throw-​away” rhetoric used to attempt to influ­ence unde­cided sen­a­tors and rep­re­sen­ta­tives to sup­port a hastily-​composed bill, espe­cially when done publicly.

Clearly, we don’t believe that “if you don’t have any­thing nice to say you shouldn’t say any­thing at all.” If we did, we would have pub­lished a total of about fif­teen posts since we started writ­ing on April 1, 2008.

We do, how­ever, think that if one have a posi­tion of respon­si­bil­ity, then one should act and speak respon­si­bly, and Mr. Bernanke did not do so when it mat­tered the most. We can for­give such behav­ior, but we can’t for­get it, so we don’t trust him. So, for what it’s worth, we rec­om­mend that Mr. Bernanke not be reconfirmed.

Poor, poor, piti­ful me!

This morning’s Gospel included Luke 4:18.

That’s where Jesus returns to Nazareth, goes to the syn­a­gogue, and reads aloud from the scroll of Isaiah.

What inter­ested us was (our para­phrase of) one of the lines from Isa­iah: “He has sent me… to let the oppressed go free.”

We won­dered: of the sub­set of the folks who were lis­ten­ing, how many of our (rel­a­tively for­tu­nate and middle-​class) fel­low parish­ioners thought, “Yes, Lord, that’s me. I’m oppressed. Please help. Please set me free. Please stop the oppres­sion by my spouse-​children-​parents-​classmates-​bosses-​teachers-​neighbors-​creditors-​clients-​patients-​etc.”

We also won­dered how many of the oth­ers thought that he or she were the sin­gu­larly most oppressed per­son in the entire con­gre­ga­tion. Of course, in that respect we knew, beyond any rea­son­able doubt, that any­one else who had drawn that con­clu­sion must be wrong.

If they con­sid­ered it, we sus­pect that they would know that we were just as wrong, and to be hon­est, they would be right.

Ah, the human condition.

He Went out with Grace.

Iron­i­cally, the last quar­ter of Conan O’Brien’s last episode on The Tonight Show may have been his best fif­teen min­utes in television.

It started with Neil Young play­ing and singing “Long May You Run,” which is one of our favorite songs and reminds us of our long-​dead Basenji bitch, Vidalia, and her chrome heart shin­ing in the sun. That song had to be about a dog.

It ended with Will Far­rell, dressed as a south­ern rocker, singing Free Bird, while Conan and many of his musi­cians jammed in the back­ground. Excellent.

How­ever, the best part was the mid­dle when Conan addressed both his stu­dio and tele­vi­sion audi­ence with part­ing mes­sage of grat­i­tude and thanks to many parties.

In par­tic­u­lar, he men­tioned that NBC had per­mit­ted him to say any­thing that he wanted dur­ing the show, and he used the time to gra­ciously thank NBC for the oppor­tu­ni­ties the net­work gave him dur­ing his more than twenty years there. He also men­tioned his incred­i­ble good for­tune of hav­ing had many of his dreams real­ized, espe­cially his child­hood dream of host­ing The Tonight Show.

For almost every cit­i­zen of the United States, when one sees the con­di­tions in Haiti – either before or after the quake – and places like that, one needs to appre­ci­ate his or her good for­tune of being born here or hav­ing been able to migrate here. Com­pound that good luck with the rel­a­tive ease of hav­ing all basic needs met along with our sub­stan­tial free­doms and seem­ingly unlim­ited oppor­tu­ni­ties for edu­ca­tion and enter­tain­ment, etc., and one can only (rea­son­ably) con­clude that we are truly blessed and very, very lucky.

In addi­tion to those bless­ings and oppor­tu­ni­ties that we all enjoy, Conan was able to take advan­tage of his chances and real­ize his dream. So, it is good to see him both gra­cious and grate­ful and real­is­tic about his good fortune.

Despite that good for­tune and his $40 mil­lion sev­er­ance pack­age, there is some­thing par­tic­u­larly sad about his short tenure at The Tonight Show. Truly money isn’t every­thing and doesn’t com­pen­sate for everything.

That makes us won­der. Given his seven-​month affair with his metaphor­i­cal child­hood love, does he agree with Ten­nyson that,

“I feel it, when I sor­row most;

Tis bet­ter to have loved and lost

Than never to have loved at all.”

A few clos­ing notes:

• For our young read­ers under twenty, note that there was a time when Jay Leno was actu­ally funny. He doesn’t seem to be a bad per­son, he’s just not been very funny for quite a long time.
• We do hope that when Mr. O’Brien returns to tele­vi­sion, he stops with the “Bush is stu­pid” “jokes.” In fact, he and his late night brethren should begin to seri­ously tease Pres­i­dent Obama. That would be good for late night audi­ences, late night hosts, and for Mr. Obama, too. (Maybe their gen­eral lack of tar­get­ing Mr. Obama as the butt of their jokes betrays a lack of con­fi­dence in him.)
• Imme­di­ately after watch­ing the end of Mr. O’Brien’s stint as the The Tonight Show host, we switched to Craig Ferguson’s show. He tends to be the fun­ni­est of the late night hosts. One of his jokes involved a state­ment about sta­pling his scro­tum to his leg. That’s when we real­ized, he’ll never be allowed to host at show at 11:30.

…To Pro­pose a Ban on Prop Trad­ing at Insured Institutions

We applaud Pres­i­dent Obama’s pro­posal to elim­i­nate pro­pri­etary trad­ing at insured insti­tu­tions. In fact, long-​time read­ers will recall that we first rec­om­mended a ban on this site on Octo­ber 1, 2008 – near the height of the finan­cial panic.

Our rea­sons are simple.

One can argue about the need for fed­eral deposit insur­ance, but if such insur­ance exists, we see no rea­son that tax pay­ers should sub­si­dize risk-​taking at insured insti­tu­tions. If one wishes to ben­e­fit as a ward of the state, then with those ben­e­fits and sub­si­dies come oblig­a­tions and restric­tions. That’s as much a moral and eth­i­cal argu­ment as any­thing else, but there are com­pelling eco­nomic rea­sons, too.

With­out restric­tions the government’s guar­an­tees exac­er­bate the quite seri­ous moral haz­ard prob­lems that already exist because the banks are limited-​liability cor­po­ra­tions. As it seems to cur­rently stand, not only do bank share­hold­ers not have to cover losses, but they get to retain some per­cent­age stake in their firms despite bail-​outs.¹ Thus, banks share­hold­ers have an even bet­ter call option than for most other cor­po­rate share­hold­ers: all on the upside, none of the down­side, and some or much of any future upside (after the downside).

As we have men­tioned in the past, at the mar­gin, there’s not much dif­fer­ence between cer­tain types of cus­tomer trades, prop trades, or asset/​liability man­age­ment trades/​tactics. So, all things equal, we’d expect that if firms want to main­tain a high risk pro­file, a ban on prop trad­ing would lead to higher risk char­ac­ter­is­tics in both their cus­tomer trad­ing books and their bank asset-​liability management/​treasury func­tions (than cur­rently reported).

In that vein, we pre­fer bank reg­u­la­tors to have a nar­rower focus on better-​understood, more-​standardized prod­ucts than be forced to over­see the addi­tional prop trad­ing books, where it seems that (1) more inno­va­tion occurs and (2) rules are more dif­fi­cult to inter­pret, which usu­ally leads to (3) even more rules, inter­pre­ta­tions, and uncer­tainty. In other words, all things equal, make the bank reg­u­la­tors’ jobs as easy and as well-​understood as possible.

In addi­tion, there seems to be no short­age of wealthy firms and indi­vid­u­als will­ing to invest in unreg­u­lated trad­ing oper­a­tions, i.e., hedge funds et. al. So, we see any such lim­i­ta­tions on banks as boon to (most) hedge funds and traders – unless those funds are “picking-​off” the banks.

We sus­pect most traders would be hap­pier (and better-​compensated) at unreg­u­lated firms; so, what’s not to like? [2.Alternatively, if we’re wrong on that count, customer-​trading might become more com­pet­i­tive, which would be ben­e­fi­cial to bank cus­tomers. Also, such a ban doesn’t elim­i­nate expo­sure to prop trad­ing because many large banks pro­vide prime bro­ker­age ser­vices to hedge funds, etc. So, those banks would still be exposed to risks asso­ci­ated with the prop trad­ing indus­try, i.e., they would still face credit risk that is a func­tion of market-​risk and can be very dif­fi­cult to mea­sure, but in some way those risks seem to be once-​removed and dif­fer­ent tools are avail­able to mit­i­gate them.]

We sus­pect that some com­men­ta­tors and ana­lysts will com­plain that the pro­posal is gov­ern­ment intru­sion into mar­kets and “free enter­prise.” At best, such com­plaints are very silly. Ban­ning prop trad­ing at insured insti­tu­tions isn’t intru­sive. Deposit insur­ance (and other guar­an­tees) intrude into mar­kets. As we men­tioned above, one can debate the effi­cacy of such pro­grams, but if the gov­ern­ment is offer­ing insur­ance, it has every right to demand that its cus­tomers behave in par­tic­u­lar ways. If the cus­tomers don’t want the restric­tions then they need not buy the insur­ance. While our cur­rent sys­tem is far from free enter­prise, there’s no rea­son it should be about “free” losses.

No won­der banks stocks declined yes­ter­day. If there is a chance that mas­sive losses will no longer be sub­si­dized, then the implicit option in com­mon equity is – jus­ti­fi­ably – worth less.

What if It Were Luck?

Update: This arti­cle, White House Tough­ens Tone, from Monday’s (Jan­u­ary 25^th) edi­tion of The Wall Street Jour­nal sup­ports our hypoth­e­sis. Yeah, blame Bush from your bud­get deficits. That will get you far.

We don’t mean Scott Brown’s amaz­ing vic­tory. We mean Pres­i­dent Obama’s, and we write it quite sarcastically.

For awhile, it seems that all we heard and read was that team and can­di­date Obama were bril­liant and dis­ci­plined and ran excel­lent cam­paigns against Hillary Clin­ton in the Demo­c­ra­tic pri­mary and then John McCain in the gen­eral elec­tion – as if he and his staff had solved com­pli­cated opti­miza­tions prob­lem and had picked the best strategy(ies) from many avail­able ones (to achieve their goals).

But, what if it wasn’t bril­liance and amaz­ing problem-​solving abil­ity? What if it were sim­ply good luck? What if those cam­paigns were the only type of cam­paign they could run and it just turned out to be the right cam­paign at the right time, given the nation’s econ­omy, mood, etc.

Recently, we’ve heard many com­men­ta­tors – not just con­ser­v­a­tives – ques­tion the gen­eral wis­dom and judg­ment of Pres­i­dent Obama and his admin­is­tra­tion on any num­bers of top­ics, but espe­cially with respect to judg­ing the “mood” of the nation. Many of those com­men­ta­tors have also men­tioned that the Pres­i­dent and his sub­or­di­nates have been far less flex­i­ble, adapt­able, and thought­ful than orig­i­nally perceived?

What if that’s because they are not? Like a blind pig that finds an acorn or the bro­ken clock that is right twice a day or a one-​hit won­der, what if he/​they aren’t very robust and don’t learn very quickly and were just lucky? In that case, his oppo­nents and his allies may have both over-​estimated him (and his advisers).

Regard­less of the reader’s pol­i­tics, it’s kind of dis­con­cert­ing isn’t it?

It’s a repudiation!

We ask our title ques­tion not as some­one who thinks that the United States should take-​over Haiti.

Instead, we ask as some­one who thinks that it is in the best inter­ests of the cit­i­zens of Haiti to ask to become part of the United States of Amer­ica – as a ter­ri­tory with the long-​term con­sid­er­a­tion to become a state, and with U.S. citizenship.

We under­stand that Haiti is a sov­er­eign nation, but watch­ing the news dur­ing the last three days, con­firms its abject fail­ure. Regard­less of the his­tor­i­cal causes of its poverty, despair, and fail­ure, the Hait­ian gov­ern­ment could not care for its cit­i­zens before the earth­quake; had no plans or abil­ity to deal with such a dis­as­ter; and does not have the resources to inde­pen­dently recover from it.

We ask the ques­tion out of com­pas­sion and gen­eros­ity. In fact, it seems to be the best answer to everyone’s prayers for help for the unfor­tu­nate souls who live there – their best hope to alle­vi­ate their short-​term and long-​term misery.

In our mind, allow­ing Haiti to become part of the United States is the humane thing to do.

Given that, we won­der what per­cent­age of Haitians would vote to become cit­i­zens of the United States? We sus­pect that the sev­eral hun­dred thou­sand ille­gal aliens already in the U.S. would likely vote “yes.” They’ve already voted with their feet.

P.S. We know it was once a ter­ri­tory dur­ing the early 20^th century.

The Government’s Response to the Finan­cial Cri­sis of 2008

A con­flu­ence of events dur­ing the past few days reminded us of how the fed­eral gov­ern­ment failed the nation dur­ing the finan­cial cri­sis of 2008. At the time, we men­tioned that our pub­lic ser­vants pan­icked, but now we think that we can offer a bet­ter expla­na­tion of why that occurred. Bank reg­u­la­tors, includ­ing the Fed, the lender of last resort, were utterly unpre­pared for it.

The news the past two days shows how utterly unpre­pared the nation of Haiti was to face any type of large scale dis­as­ter. After this week’s earth­quake, noth­ing on its half of His­pan­iola seems to be work­ing, and inter­na­tional res­cue and human­i­tar­ian are sti­fled by the lack of access. For exam­ple, the main (prob­a­bly the only) port is destroyed, and there is only one air­port with one run­way with no lights and no fuel sup­ply (for return flights). While the injured and hun­gry suf­fer, planes cir­cle or wait on tar­macs in the U.S. and the Caribbean. (May God bless those unfor­tu­nate souls and all of the inter­na­tional efforts and vol­un­teers who are attempt­ing to help.)

Now, Haiti was a dis­as­ter before the earth­quake; so, it is under­stand­able that the nation did not have the resources to develop and fund con­tin­gency plans.

In some ways, and despite the after­math of Hur­ri­cane Kat­rina, it seems that our great nation is much better-​prepared to han­dle emer­gen­cies and dis­as­ters. Many fed­eral, state, and local agen­cies have indi­vid­ual and coör­di­nated con­tin­gency plans and train­ing exer­cises to pre­pare for a vari­ety of man-​made and nat­ural disasters.

It is also true that many fed­eral and state agen­cies and reg­u­la­tors require busi­nesses and orga­ni­za­tions in a vari­ety of indus­tries to per­form stress tests and sce­nario analy­ses and develop con­tin­gency plans to deal with extremely bad hypo­thet­i­cal events. Arguably, the most famous of these exer­cises was last spring’s Super­vi­sory Cap­i­tal Assess­ment Pro­gram (SCAP), which we wrote about (and crit­i­cized) a few times.

As many of our read­ers will recall, via SCAP, fed­eral bank reg­u­la­tors required the nation’s 19 largest banks to per­form a series of stress tests and sce­nario analy­ses to deter­mine weak­nesses and iden­tify cap­i­tal inad­e­qua­cies. Other than requir­ing cer­tain insti­tu­tions to raise cap­i­tal, we’re not sure if that pro­gram required the banks to iden­tify and main­tain con­tin­gency plans.

Note that except for the coör­di­nated nature of the pro­gram – requir­ing all the banks to per­form their analy­ses simul­ta­ne­ously – and the impli­ca­tions of the analy­ses – the fact the some firms were required to raise cap­i­tal – there was not much new about the process.

For sev­eral years, large banks have been required to per­form mar­ket and credit-​related stress tests and sce­nario analy­ses as well as develop con­tin­gency plans for liq­uid­ity prob­lems and crises, and those analy­ses were reviewed by the appro­pri­ate reg­u­la­tors. Those analy­ses weren’t stan­dard­ized, and – given the lack of uni­for­mity in assump­tions, method­olo­gies, and sce­nar­ios – the results could not be con­sol­i­dated in any mean­ing­ful way. So, it would have been very dif­fi­cult to iden­tify any sys­temic risks from the results of such exercises.

Given that fact, one would hope that reg­u­la­tors, includ­ing the lender of a last resort, would have per­formed their own stress tests and sce­nario analy­ses to deter­mine poten­tial threats to the finan­cial sys­tem. How­ever, we do not recall read­ing or see­ing any report that men­tioned that the Fed or the Trea­sury Depart­ment had per­formed any such analy­ses. (We’re too lazy to do a thor­ough web search today.)

Thus, one can explain the government’s and Fed’s near com­plete panic as result­ing from a total lack of pre­pared­ness as the cri­sis unfolded. (Since Sep­tem­ber 2008, it has been our con­tention that their behav­ior and rhetoric – to jus­tify pas­sage of the TARP bill – exac­er­bated the crisis.)

So, with­out any evi­dence to refute our spec­u­la­tion, we con­clude that our pub­lic ser­vants and reg­u­la­tors had no idea what to do when things went bad because they had never con­sid­ered the pos­si­bil­ity of that things could go bad in such a way and to such an extent. (We mean the nearly com­plete dis­so­lu­tion of con­fi­dence in the nation’s largest banks as a result of their ter­ri­ble mort­gage invest­ments.) We sus­pect that lack of con­sid­er­a­tion was true prior to when Bear Stearns failed in the spring of 2008 and that noth­ing changed in the inter­ven­ing six months.

Now, we have only two things to say about that: (1) com­pare their behav­ior in the fall of 2008 to the brave first-​responders on 9 – 11 or at any num­ber of other dis­as­ters and tragedies, and (2) these are the same folks who now want to “reg­u­late sys­temic risk.”

*We don’t mean the human suf­fer­ing. We mean the government’s incom­pe­tent response.

This post is apro­pos of noth­ing and merely idle spec­u­la­tion on our part.

Since the start of the new year, we have writ­ten sev­eral times about intel­li­gence fail­ures and bad infor­ma­tion designs.

With the recent news and those recent posts per­co­lat­ing in our head, we watched the tele­vi­sion show, NCIS, last night. In the episode, the intel­li­gence network/​community inter­cepts an e-​mail in real-​time from DiNozzo’s father – the perfectly-​cast Robert Wag­ner – because he men­tions a com­bi­na­tion of key­words related to the case under investigation.

When asked how they came by the infor­ma­tion (about the e-​mail and from where it was sent), Gibbs, the team leader, replies, “Ech­e­lon,” which accord­ing to Wikipedia, is sup­posed to be a mon­i­tor­ing sys­tem for var­i­ous types of communications.

Now, it’s likely that the gov­ern­ment mon­i­tors some (or pos­si­bly many) types of inter­net traf­fic, includ­ing e-​mails and web sites of sus­pected ter­ror­ists and ene­mies of the United States.

There’s a lot of traf­fic and a lot to mon­i­tor (and a lot to block if you are so inclined – just ask the Chi­nese government).

That made us won­der how such agen­cies would elim­i­nate cat­e­gories to search. In par­tic­u­lar, if they do mon­i­tor e-​mail, we won­der if they mon­i­tor spam or unso­licited bulk e-​mail. We won­der because those widely-​broadcast mes­sages would to be a cat­e­gory that is very easy one to elim­i­nate. In other words, we could hear some ana­lyst say, “it’s just some spam; don’t bother with it.”

In that case, it would seem to be an excel­lent way to send coded mes­sages. Like BBC radio broad­casts dur­ing World War II, a seem­ingly innocu­ous – albeit, in this case, offen­sive and annoy­ing – email mes­sage could be sent to thou­sands or mil­lions with only one intended recip­i­ent capa­ble of decod­ing its true mes­sage. No need to encrypt it and draw sus­pi­cion. In fact, many of the other recip­i­ents would never open the mes­sage and, depend­ing on their spam fil­ter set­tings may never even know they received it.

Pre­sum­ing our intel­li­gence agen­cies do mon­i­tor cer­tain types of e-​mail, we won­der if they do com­pletely ignore spam, and if so, whether any­one takes advan­tage of that fact?

The Out­rage Makes Them Larger

Recently, much has been writ­ten about “Wall Street” bonuses. Almost all of those arti­cles men­tion the same two things: (1) pop­ulist and gov­ern­ment sen­ti­ment against the bonuses, and (2) the com­po­si­tion of the bonuses towards long-​term, restricted stock and away from cash. At least some of the drive towards a more stock-​heavy com­po­si­tion seems to be management’s attempt to appease the gov­ern­ment and the pub­lic. In this post, we argue that such moves are need­lessly costly, which means inef­fi­cient and larger than need be.¹

In a pre­vi­ous post, Gov­ern­ment Whin­ing and Bailout Fees, we dis­cussed the out­rage and men­tioned that cit­i­zens have a right to be angry – at the gov­ern­ment. In this post, we ana­lyze the reported com­po­si­tion of many of bonuses. In par­tic­u­lar, we think the insis­tence on long-​term, restricted stock grants is inef­fi­cient for sev­eral rea­sons that we dis­cuss below.

How­ever, before con­tin­u­ing, it is worth re-​mentioning that much of the con­tro­versy could be elim­i­nated by elim­i­nat­ing pro­pri­etary trad­ing at insured insti­tu­tions. As we have repeat­edly writ­ten, we have noth­ing against pro­pri­etary trad­ing or traders, but see no rea­son why we or other tax-​payers should sub­si­dize trad­ing losses. Note, too, that there are other good rea­sons to elim­i­nate such activ­i­ties at insured insti­tu­tions, includ­ing the fact that they diverts man­age­r­ial atten­tion away from (bor­ing and mun­dane) every­day activ­i­ties of run­ning com­mer­cial banks. We know that at the mar­gin, there’s not much of a dif­fer­ence between a bank’s trea­sury (asset-​liability) man­age­ment and cer­tain kinds of prop trad­ing, but we’d pre­fer that reg­u­la­tors keep a nar­rower focus. Finally, to get, in a sin­gle edi­tion of The Wall Street Jour­nal, Thomas Frank, Jonathan Macey, and James B. Stewart to agree with us is mind-​boggling. It indi­cates the abject per­ver­sity of the sta­tus quo.

Now, hav­ing said that, we hope that every­one receiv­ing the much-​discussed bonuses get max­i­mum enjoy­ment and sat­is­fac­tion from them. We cer­tainly don’t blame any­one for try­ing to max­i­mum his or her com­pen­sa­tion in an attempt to max­i­mize their sat­is­fac­tion, their family’s sat­is­fac­tion and well-​being, and their con­tri­bu­tion to the less for­tu­nate. The prob­lem is that there are likely cheaper ways to pro­vide the same level of sat­is­fac­tion and reward.

Aside: note that for the remain­der of this post, we’ll use the word “expected,” as in “expected com­pen­sa­tion,” in a very loose, non-​mathematical way. That’s because we are rather pedan­tic and like to empha­size the dif­fer­ence between uncer­tainty and risk. Like oth­ers, we define risk as mea­sur­able uncer­tainty, and that means that risk is a spe­cial type of uncer­tainty or unknow­ing can be (appro­pri­ately) described as a prob­a­bil­ity dis­tri­b­u­tion. Not all prob­a­bil­ity dis­tri­b­u­tions have means or expected val­ues, and that seems to be the case in finan­cial mar­kets. So, try­ing to cal­cu­late one’s expected bonus as a func­tion of mar­ket per­for­mance might not be tech­ni­cally fea­si­ble if the dis­tri­b­u­tion of returns is unknown or its moments don’t exist.²

So what’s wrong with bonuses in the form of long-​term, restricted stock?

Well, they are long-​term so they defer con­sump­tion, they are restricted so they’re are expen­sive to con­vert into con­sump­tion, and they in sotck so they are risky (uncer­tain) because they are only very weakly tied to an individual’s performance.

Delayed Grat­i­fi­ca­tion:

Are there good rea­sons for long-​term com­pen­sa­tion schemes? Yes, there are.

When employ­ees take actions or make deci­sions that have long-​term impli­ca­tions, then sig­nals from mul­ti­ple peri­ods can be used to infer whether the employee behaved appro­pri­ately – back when the the deci­sion was made.

Gen­er­ally, the use of mul­ti­ple sig­nals improves the pre­ci­sion of the infer­ence, and that means that less risk is imposed on the employee.³ For risk-​averse employ­ees, that means a lower risk pre­mium is required to ensure his or her par­tic­i­pa­tion, which means a smaller expected bonus is required.⁴ So, the key to reward­ing long-​term per­for­mance is clas­si­fy­ing cur­rent period results into the time peri­ods when deci­sions were made so that one can make bet­ter infer­ences about the deci­sions made in a prior period. It’s not as easy as it sound, but it is pos­si­ble to do.

So, yes, most traders that make long-​term bets should be rewarded on long-​term per­for­mance, and fea­tures like claw backs should be used, but in the spe­cific way that we wrote about in Claw­backs: the Good, the Bad, and the Ugly and Incen­tives at UBS and in Gen­eral.

How­ever, requir­ing some­one to wait five years to receive stock in a mega-​corporation is not the same thing. That’s because:

1. Five years is arbi­trary, and may have lit­tle to do with the length of the employee’s invest­ment deci­sion. More­over, it is a long-​time to wait for a pay-​off.
2. If we’ve learned noth­ing else dur­ing the past few years, we have learned that, in gen­eral, share prices are very volatile, which means that employ­ees who must wait five years for their reward must bear a sub­stan­tial amount of risk.
3. Other than pos­si­bly a few senior exec­u­tives, no sin­gle employee has very much antic­i­pated or expected influ­ence on share price in five years. Ex post they may have, but not ex ante.

So, it seems rea­son­able to con­clude that impa­tient, risk-​averse employ­ees would sub­stan­tially dis­count the expected value of such stock grants.⁵ That means that all things equal, it means that if they can, employ­ees will demand larger bonus grants to com­pen­sate for the delayed grat­i­fi­ca­tion and the risk.

Restric­tive:

We imag­ine that the only peo­ple who pre­fer that bonuses be in the form of restricted stock are folks who aren’t get­ting them and the envi­ous types: please see The Chil­dren who Have Eaten their Cake…

Usu­ally, there are ways to bor­row against such grants and/​or hedge the value of such grants, but not all firms per­mit such actions. More­over, they’re not cheap and they can be time-​consuming.

That means that employ­ees will bear costs of con­vert­ing the awards to nearer-​term con­sump­tion and, if pos­si­ble, will demand larger bonuses to cover those costs.

Risky and Uninformative:

For some reason,many folks (and politi­cians) believe that when employ­ees own shares, includ­ing restricted stock, incen­tives are some­how mag­i­cally aligned – kind of like Lucky Charms.

How­ever, except for pos­si­bly a small hand­ful of very senior man­agers, that’s very silly. Con­sider that Bank of Amer­ica has nearly 300,000 employ­ees, Cit­i­Group has about the same, and even smaller firms like Gold­man Sachs have more than 30,000. So, the effect of any sin­gle employee is usu­ally very small. (More­over, the pre­dicted effect is usu­ally very small. In fact, when it is large, it is often due to the firm’s fran­chise and rep­u­ta­tion and not that par­tic­u­lar person’s actions.)

Do note that attempt­ing to link the effects of a par­tic­u­lar action, deci­sion, invest­ment or trade to share price today or any point in the future is extremely dif­fi­cult. (Maybe not in finance class, but it is in real life.)

Just as impor­tantly, and as we men­tioned above, even if it can be done (in expec­ta­tion) the firm’s stock price is a par­tic­u­larly noisy mea­sure of a par­tic­u­larly person’s per­for­mance. So, it’s quite pos­si­ble to con­clude that employ­ees will ignore the impli­ca­tion of their deci­sion of share prices, which is com­pletely ratio­nal, and do what’s best for them­selves. That very much reminds us of that quote of Huck­le­berry Finn that we always used when we taught: “Well, then, says I, what’s the use you learn­ing to do right when it’s trou­ble­some to do right and ain’t no trou­ble to do wrong, and the wages is just the same?”

For more on this gen­eral topic, we refer inter­ested read­ers to our essay in the Fal­lacies sec­tion of the web site: One Per­for­mance Mea­sure to Rule Them All.

For more on this topic as it per­tains to trad­ing, we encour­age vis­i­tors to read the last half of the above-​mentioned, The Chil­dren who Have Eaten their Cake…

In sum, we argue that (1) the long-​term nature that delays con­sump­tion, (2) the restricted nature that is costly to bypass, and (3) risky nature fur­ther reduces the value (think in terms of expected util­ity or cer­tainty equiv­a­lent) make such bonuses worth sub­stan­tially less than their face value. If employ­ees have any bar­gain­ing or nego­ti­at­ing power, firms will have to increase the stated value of the bonuses to sat­isfy them.

Those extra costs would be worth bear­ing if they aligned incen­tives, but unless you, dear reader, believes in magic, there is no rea­son to believe that any future actions by those employ­ees will be coöper­a­tive in nature.

So, it seems that long-​term, restricted stock awards are inef­fi­cient ways to moti­vate employees.

We’ll likely proof­read this post and edit it in the near future.

P.S. Our New Year’s res­o­lu­tion is to write more about finan­cial mat­ters, the indus­try and the cri­sis than we did dur­ing last half of 2009. Last fall’s drought occurred for a vari­ety of good rea­sons, but two related ones are worth men­tion­ing: (1) while many of our posts tend to be long, we hate being repet­i­tive, and in our mind there was lit­tle new to say, and (2) with lit­tle new to say, we found many of the events and pro­ceed­ing to be quite bor­ing. For writ­ing blog posts, “bor­ing” means too many ref­er­ences to old mate­r­ial – like above – but we’ll try to write more in 2010.

Copy­right © 2010 Spero Consulting

Foot­notes:

We applaud Google and its threat to leave China as a response to recent hack­ing attempts.

Last month, we wrote about A Rise in Inter­net Hack­ing Attempts at this site, and all of those hits seemed to orig­i­nate from within China. (Whether they were spoofed or not, we can’t tell.)

The num­ber per day peaked over the Christ­mas break and has since decreased.

We have no idea if there is a rela­tion­ship between what Google dis­cov­ered and what we noticed here. We doubt it because we’re tiny and have almost no fol­low­ing and in two years have writ­ten only four or five posts crit­i­ciz­ing China. How­ever, we have not seen sim­i­lar attacks at any of the other sites that we maintain.

We would like Google to pub­lish a list of offend­ing IP addresses to shine fur­ther light on the issue and so that folks like us can see if there are any matches.