Archive for January, 2010
New Motto
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?
How Were the Last Nine Months of 2009 like 1932?
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.
Good (Late) News from the SEC
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:
- There is no other choice, or no other tractable choice.
- Depending upon the context, it may not matter much.
- Ease of calculation and effort. (This is different than (1).)
- As a way to reduce measures of risk characteristics.
- 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.)
Go ‘Green’ with Shared Servers
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.
What ‘Miranda’ Rights?
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.
Bernanke: No.
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.
The “Oppressed”
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.
Bravo Conan!
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.
The Volcker Rule: Obama’s Right…
…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.
- We’ve written a few times about the possible return of partnerships as a solution to excessive risk-taking – well, not a solution as much as a mitigation. ↩
“A Brilliant Campaign!”
What if It Were Luck?
Update: This article, White House Toughens Tone, from Monday’s (January 25th) 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?
Should Haiti Choose To Be a U.S. Territory?
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 20th century.
Worse than Katrina?*
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.
Idle Speculation about Spam and Terrorists
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?
Inefficient Bonus Schemes
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:
- 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.
- 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.
- 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:
- More precisely, “inefficient” means either: (1) with a different compensation mix, the same “expected” pay levels could provide employees with a greater level of expected satisfaction or (2) employees could receive the same level of expected satisfaction with a different, cheaper mix. We focus on the latter, here. ↩
- We’ve written a lot about it in the past few years. ↩
- A formal analysis can show that there are other cases where, for example, results are perfectly serially-correlated when nothing is learned by observing a sequence of cash flows or returns. The first return tells it all. ↩
- We’re making lots of implicit assumptions, here. ↩
- We’re not using “impatient” pejoratively. ↩
Good for Google!
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.
