‘Markets’ Category

Mere Spec­u­la­tion

We’re read­ing a new book about the finan­cial cri­sis that is very thought-provoking. We’ll write more about the book in the com­ing days and weeks, but while read­ing it, a rather depress­ing thought kept pop­ping into our head.

If after Scott Brown’s elec­tion vic­tory – and as some pun­dits pre­dict – the Obama admin­is­tra­tion plans to veer towards more pop­ulist posi­tions and actions, we wouldn’t be sur­prised to see more indict­ments of investors and traders who were respon­si­ble for large losses at both large banks and at hedge funds dur­ing the finan­cial crisis.

The Pres­i­dent and his staff already demo­nize Wall Street, and while some of the rhetoric is jus­ti­fied as it per­tains to moral and eth­i­cal fail­ings, crim­i­nal­iz­ing poor judg­ment and greed and hon­est error is an entirely dif­fer­ent issue. (We wrote about that before, but can’t find the link today.)

Nonethe­less, we could imag­ine such tri­als as showy diver­sions away from the administration’s prob­lems with health care, ter­ror­ist tri­als, bud­get deficits, job­less­ness, etc. (Other than get­ting out-​of-​the-​way, we don’t think the admin­is­tra­tion can do much about job­less­ness, the prob­lem is that they think they can and when they can’t, they may try to divert fur­ther atten­tion away from their self-​perceived fail­ings onto oth­ers, includ­ing “greedy fat cats.”)

More­over, at firms that sur­vived the cri­sis we could see cyn­i­cal man­age­ments – in par­tic­u­lar, cyn­i­cal new man­age­ments – act with the gov­ern­ment against indi­vid­u­als, pri­mar­ily for­mer traders and struc­tur­ers, and pos­si­bly risk man­agers, as ways to (1) per­son­al­ize (rather than insti­tu­tion­al­ize) the losses, and (2) sep­a­rate them­selves from the old guard, i.e., attempt put the behav­ior of the past behind them.

Indeed, we see it is as a threat espe­cially if the admin­is­tra­tion can’t pass new leg­is­la­tion and pro­posed finan­cial reg­u­la­tions through Congress.

Per­haps we are overly-​influenced from watch­ing Dr. Zhivago the other night, but as we said, it’s a rather depress­ing thought.

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.)

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.

…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.

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.

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:

Given the past two days’ front page head­lines in the The Wall Street Jour­nal, it seems that banks are doing a lot of brac­ing. Monday’s head­line announced that Banks Brace for Bonus Fury, and today’s head­line announces that Banks Brace for Bailout Fee.

The first arti­cle notes of com­plaints by the pub­lic and gov­ern­ment offi­cials about bonuses paid for 2009 ‘results.’ The sec­ond arti­cle describes a likely attempt by fed­eral offi­cials to, in some sense, mon­e­tize those com­plaints by levy­ing new fees onto banks. (Soon, we’ll soon pub­lish a related post regard­ing the inef­fi­ciency of many of the bonus plans.)

There is some­thing dis­turb­ing about large bonuses at sev­eral, if not all, of the firms that are fre­quently men­tioned in the press. That’s because firms like B of A (and its sub­sidiary Mer­rill Lynch) and many oth­ers did not gen­er­ate last year’s gains and prof­its on their own. They could not have gen­er­ated those prof­its on their own. So, regard­less of their repay­ment of the TARP funds, it doesn’t seem that all those prof­its should be theirs to use or dis­trib­ute in what­ever man­ner that they choose.

Thus, the pub­lic has a right to com­plain about the pay­ment of the sub­si­dized bonuses, but don’t blame the employ­ees at the firms; instead, blame the gov­ern­ment for not hav­ing thought through the impli­ca­tions of its guar­an­tees and promises when it made the invest­ments. It was another case of very short-​term think­ing by our elected and appointed officials.

To be sure, it is highly likely that many dili­gent and earnest work­ers per­formed well and earned their bonuses, but for many others, profits were rec­og­nized only because the fed­eral government’s guar­an­tee kept many of their firm viable and/​or credit-​worthy.

It wasn’t the pre­ferred stock invest­ment that kept the firms alive when their counter-​parties and oth­ers had lost faith nor the sub­se­quent increase of some silly cap­i­tal ratio. You seen cap­i­tals ratio et. al., are non sequiturs dur­ing a liq­uid­ity cri­sis. If the firm doesn’t have cash and can’t raise it because no one will buy its hold­ings or invest in it, its can’t sell the cap­i­tal ratio or use it for collateral.

It was the government’s guar­an­tee to each firm that was deemed “too big to fail” that saved it one of them and allowed their trad­ing part­ners to prosper.

Those guar­an­tees made the gov­ern­ment the de facto resid­ual claimant despite its small, for­mal own­er­ship stake (in pre­ferred stock for the most part).¹

The prob­lem is that the gov­ern­ment didn’t do a very good job of nego­ti­at­ing the terms of those guarantees.

At the time of the TARP invest­ments and promises, our pub­lic ser­vants pan­icked. They didn’t take the time to demand covenants and restric­tions on the future use of funds nor did they charge an ade­quate fee for sav­ing the insti­tu­tions.² As we wrote at the time, we thought the fees should include many rolling heads and the elim­i­na­tion of much com­mon equity.

Given that, it’s a lit­tle bit ironic and quite a bit silly for gov­ern­ment offi­cials to com­plain about cur­rent com­pen­sa­tion lev­els and 2009 bonuses. If the gov­ern­ment wanted to do some­thing about bonuses it should have restricted them when it injected the cash and guar­an­teed the firms’ sur­vival.³ It shouldn’t whine now or attempt to apply retroac­tive fees although charg­ing sub­stan­tial fees for the con­tin­ued sub­si­diza­tion is okay with us.

A long aside: at first glance, reg­u­lar read­ers may regard our opin­ion as incon­sis­tent with our sup­port last sum­mer for Andrew Hall in his dis­pute with Citigroup, but it’s not. See Prop Trad­ing and Pay at Banks.

Our points then were:

1. The gov­ern­ment and reg­u­la­tors had no author­ity to abro­gate con­tracts, includ­ing pay con­tracts. So, Citi should give him his due.
2. Bank­ruptcy does pro­vide the oppor­tu­nity to rene­go­ti­ate con­tracts, but the gov­ern­ment wouldn’t let events run their course. Arbi­trar­ily abro­gat­ing (or dishonoring) contracts is uncon­sti­tu­tional. More impor­tantly, main­tain­ing the dis­ci­pline to uphold seem­ingly unpop­u­lar con­tracts is cen­tral to main­tain­ing the Rule of Law. It dis­tin­guishes the U.S. from many other nations, and that col­lec­tive self-​restraint makes this a great (and gen­er­ally pre­dictable) nation.
3. Mr. Hall and all other pro­pri­etary traders should find new, unreg­u­lated places of employ­ment, where they can reap the rewards of their com­bined clev­er­ness and efforts but also bear the risks of fail­ure. (It seems to have worked-​out well for him, and we sus­pect would work out bet­ter for most traders.) See our post Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions.

We pre­sume that Mr. Hall and Phi­bro would have made those gains with or with­out Citi; so, the gov­ern­ment sav­ing Cit­i­group had lit­tle effect on his trad­ing strate­gies. (Who knows? His gains may have been larger with­out Citi and with more capital.)

Why do we whine about about our pub­lic ser­vants whin­ing and try­ing to impose fees? Well for two rea­sons: (1) it’s annoy­ing to her them com­plain about com­pletely pre­dictable behav­ior that they induced and (2) the cur­rent sit­u­a­tion is no dif­fer­ent than the sit­u­a­tions that the gov­ern­ment cre­ated at Fan­nie and Fred­die when those two thin­gies were pay­ing large bonuses for “per­for­mance” that was wholly-​subsidized by the gov­ern­ment. That cre­ated and/​or exac­er­bated moral haz­ard prob­lems then and will now, too.

In con­clu­sion, note that we’re not resent­ful or envi­ous of any­one get­ting a large bonus, and we hope that folks enjoy them, but we do blame the bureau­crats at the Trea­sury and the Fed for not con­sid­er­ing this out­come in the fall of 2008 and early 2009. Fur­ther­more, we don’t see the pro­posed appli­ca­tion of an arbi­trary, ex post tax as any­thing other than vin­dic­tive­ness or the appease­ment of the pop­ulist mob. Either motive should be beneath our fed­eral officials.

Finally, note that we’ve com­plained about sim­i­lar gov­ern­ment actions in the past. For exam­ple, see The Chil­dren who Have Eaten their Cake… and Con­fis­ca­tory, Abu­sive Tax­a­tion: It’s Ali­men­tary and Dan­ger­ous.

We tend to be pes­simistic; so, per­haps the news isn’t as bad as it seems, but con­sider these two facts, which were both reported in today’s The Wall Street Jour­nal:

1. A sur­vey by the Mort­gage Bankers Asso­ci­a­tion found that 13.2% of mort­gages on homes with one to four units were at least one-​month over­due or in the fore­clo­sure process in the sec­ond quar­ter. That’s almost 50% higher than at the same time last year, and much of that increase is due to prob­lems with prime loans, not sub­prime loans. (See Sour­ing Prime Loans Com­pound Mort­gage Woes.)
2. A June sur­vey by Inside Mort­gage Finance of real-​estate agents found that 36% of all sales involve “nondis­tressed” prop­er­ties. Of those sales, only 31% were what the sur­vey described as “unforced or optional.” Mul­ti­ply 0.36 by 0.31, and you’ll dis­cover that only 11% of sales – about one-​out-​of-​nine were “unforced or optional.” That means that nearly 90% of sales by home­own­ers involve some­thing unpleas­ant. (Improv­ing Home Sales Belie Mar­ket Real­ity.)

Now, both sur­veys may be ter­ri­bly unrep­re­sen­ta­tive of actual mar­ket con­di­tions and facts, and con­di­tions could actu­ally be much bet­ter (or much worse). How­ever, if both are accu­rate, it seems that we are fac­ing a very slow and grad­ual recov­ery. Of course, that’s IF the econ­omy is, in fact, begin­ning to recover. More­over, this can’t be good news for hold­ers of mortgage-​backed securities.

We rarely try to “time” the mar­ket and rarely make spe­cific invest­ment rec­om­men­da­tions, but we think that today was a fine day to sell a few of our mutual funds, and we did.

We occa­sion­ally write about CMBS or Com­mer­cial Mortgage-​backed Secu­ri­ties and the CMBX index. For exam­ple, last Novem­ber, we wrote CMBS Is Like Lumpy MBS and That’s Not Good. We tend to get more hits on our tongue-​in-​cheek post, How to Trade CMBS? and find that a bit scary.

What should truly frighten both CMBS hold­ers and banks with large commercial-​mortgage loan port­fo­lios more than our dis­cus­sion of our page rank­ings is this arti­cle in Saturday’s edi­tion of The Wall Street Jour­nal: Hotels Deliver Some ‘Jin­gle Mail.’ The arti­cle details how hotel own­ers are walk­ing away from highly-​mortgaged prop­er­ties and how delin­quency rates for secu­ri­tized hotel loans are almost ten times higher than they were one year ago – about 4.75%.

We sus­pect that banks that were erst­while struc­tur­ers and had accu­mu­lated an inven­tory of such loans (for later bundling that has not yet mate­ri­al­ized) may face even larger problems.

Using the logic that the last loans made before the bub­ble burst are likely to be less cred­it­wor­thy than ear­lier ones, we sus­pect that the delin­quency rates for those loans that didn’t make it into a CMBS pool before the mar­ket col­lapsed could be even higher than the nearly five-​percent rate men­tioned above.

More­over, while we’d argue that any claimed diver­si­fi­ca­tion ben­e­fit of CMBS was grossly over­stated, there is absolutely no diver­si­fi­ca­tion ben­e­fit from hold­ing the entire loan. Those banks and struc­tur­ers that are stuck hold­ing those loans bear the entire risk of default. In some ways, it reminds us of a very expen­sive adap­ta­tion of the game, musi­cal chairs. (CDOs and CDOs squared, etc., are rem­i­nis­cent of “hot potato” or blind folks toss­ing raw eggs back-​and-​forth.)

Finally, we would be sur­prised if for­mer struc­tur­ers and banks with clogged pipelines didn’t report higher credit losses in the sec­ond half of this year. If they don’t, we will won­der whether reg­u­la­tors are being par­tic­u­larly loose in super­vis­ing how those banks cal­cu­late their loan reserves.(At this point, we sus­pect those loans are no longer “held-​for-​sale,” but have been reclas­si­fied into the reg­u­lar loan portfolio.)

We hope that the finan­cial cri­sis, which seems to have sub­sided, has actu­ally sub­sided. How­ever, we have a sneak­ing sus­pi­cion that it may be per­son­i­fied by Mark Twain’s famous quote about how the report of his death was greatly exag­ger­ated. This is one indi­ca­tion that it’s not over.

The Wall Street Jour­nal has an excel­lent edi­to­r­ial in today’s edi­tion: The $100 Mil­lion Banker.

Why do we say the edi­to­r­ial is “excel­lent?” For the usual rea­son; it is nearly iden­ti­cal to what we’ve writ­ten in the past: give Mr. Hall his money and ban prop trad­ing at reg­u­lated banks.

If you missed those posts, see these two recent ones: Prop Trad­ing and Pay at Banks and The Chil­dren Who Have Eaten Their Cake… Those two pro­vide links to many related ones, too. The lat­ter one promises an addi­tional new post about the dis­pute, but we’ve not had time to fin­ish it, and it won’t hap­pen today.

Yes, reg­u­lar read­ers will notice that this is a very short post for us. While we’re nearly sur­rounded by a tem­per­ate rain for­est, if the lawn is not mowed today, the for­est will be that much closer tomor­row. That what hap­pens when it rains and shine nearly every day for sev­eral weeks in the mid­dle of the sum­mer. (And, yes, dear reader, like Tol­stoy, we enjoy toil­ing in the field with the (other) peasants.)

Yes­ter­day we wrote Spec­u­la­tion about Spec­u­la­tors, which sum­ma­rizes our views on so-​called mar­ket spec­u­la­tion. In it, we restated our def­i­n­i­tion of spec­u­la­tion that we first offered one year ago: it’s when other peo­ple make invest­ments or trades that you don’t approve of, espe­cially when those trades incon­ve­nience you.

Today our favorite news­pa­per, The Wall Street Jour­nal, pub­lished a Review & Out­look edi­to­r­ial, The Pol­i­tics of ‘Spec­u­la­tion’, which offers a very sim­i­lar def­i­n­i­tion. (The edi­tors define exces­sive spec­u­la­tion as price move­ments in a polit­i­cally incon­ve­nient direction.)

Polit­i­cal cam­paigns against spec­u­la­tion are merely cam­paigns against trad­ing, and what exactly are the alter­na­tives: gov­ern­ment con­trol of more of the economy’s resources or – as they men­tioned today and we men­tioned yes­ter­day – price controls?

Through­out world his­tory much human suf­fer­ing, includ­ing star­va­tion and famine, can be attrib­uted to var­i­ous gov­ern­ments’ attempts to con­trol resources and their prices. Some may view that state­ment as hyper­bole and may argue that such events could not hap­pen here. (Of course, few believed that regional hous­ing mar­kets and global finan­cial mar­kets could crash as they did last year – much of it due to our government’s sub­si­diza­tion of mort­gages to uncred­it­wor­thy indi­vid­u­als as part of Congress’s poorly-​conceived attempts to increase home own­er­ship rates.)

Our most vivid per­sonal rec­ol­lec­tion of price con­trols involves watch­ing the gas lines form around the neigh­bor­hood sta­tion as we deliv­ered the morn­ing news­pa­per.¹ The grownups in the lines seemed so hope­less, so pow­er­less, and so cranky.

As San­tayana said, “those who do not learn from his­tory are doomed to repeat.” We would only add: why does it have to be the sev­en­ties in gen­eral, and the Carter years, in particular?

Manip­u­la­tion is the Real Issue

There’s an arti­cle in Tuesday’s edi­tion of The Wall Street Jour­nal that announces that Traders Blamed for Oil Spike.

It high­lights more of the speculation-​is-​bad com­men­tary that’s been in vogue since at least the Spring of 2008. In fact, we recall hunt­ing for and post­ing the fol­low­ing John May­nard Keynes quote dur­ing that time:

“Spec­u­la­tors may do no harm as bub­bles on a steady stream of enter­prise. But the posi­tion is seri­ous when enter­prise becomes the bub­ble on a whirlpool of spec­u­la­tion. When the cap­i­tal devel­op­ment of a coun­try becomes a by-​product of the activ­i­ties of a casino, the job is likely to be ill-​done.”

Mr. Keynes’ water and tur­bu­lence pro­vide an apt and pic­turesque metaphor, but it’s not par­tic­u­larly use­ful because it doesn’t pro­vide a clas­si­fi­ca­tion of char­ac­ter­is­tics needed to dis­tin­guish between mere bub­bles and whirlpools nor does it pro­vide a guid­ance on how to pre­vent (sup­pos­edly dan­ger­ous) whirlpools from form­ing. (We know that we’re quite demand­ing and ask a lot of a two-​sentence quote.)

In fact, that’s the prob­lem with much of the effort to dis­cern “spec­u­la­tion” in var­i­ous mar­kets in the inter­ven­ing seventy-​or-​so years since he made that com­ment. The “know-​it-​when-​I-​see-​it” approach is hard to generalize.

Mr. Keynes also said that, “Invest­ing is an activ­ity of fore­cast­ing the yield over the life of the asset; spec­u­la­tion is the activ­ity of fore­cast­ing the psy­chol­ogy of the market.”

That’s not bad, but we pre­fer our own def­i­n­i­tion that we offered exactly one year ago today: finan­cial or mar­ket spec­u­la­tion is when other peo­ple make invest­ments or trades that you don’t approve of, espe­cially when those trades incon­ve­nience you.

Last ⁹⁄₁₁, we wrote that it is highly likely that in the short-​term in most mar­kets, there are more daily and intra-​day fluc­tu­a­tions with spec­u­la­tion than with­out it. We doubted, how­ever, that prices would be as sta­ble in the long-​term with­out spec­u­la­tors – what­ever they are – pro­vid­ing liq­uid­ity.¹ This, of course, gives rise to sev­eral ques­tions that should be answered (more pre­cisely than we do it the foot­note): (1) what is spec­u­la­tion? (2) What is valu­able or harm­ful about it? (3) What met­ric should be used to mea­sure the harm or value?

Now, it seems that many folks like to address the third ques­tion with ref­er­ence to or in terms of price sta­bil­ity. How­ever, that – of course – gives rise to sev­eral ques­tions, too, includ­ing: (a) what exactly is sta­bil­ity?² (b) Why is it valu­able? © How should it be mea­sured or cal­cu­lated? And, (4), given that it can be mea­sured, what is the opti­mal level of it? It would seem that every­one would agree that prices should be allowed to vary; so, com­pletely sta­ble (or con­stant) prices aren’t opti­mal, yet many are unhappy when prices vary too much (and incon­ve­nience them). That’s one rea­son that we are quite happy with our pithy definition.

So, why repeat much of we wrote last year? Because per the arti­cle men­tioned above, it remains very rel­e­vant today. In fact, today, the head of the Com­modi­ties Futures Trad­ing Com­mis­sion, Gary Gensler, stated that the agency should con­sider strict lim­its of trad­ing: see Gensler Pushes for Trad­ing Curbs.

More­over – and this is sheer spec­u­la­tion on our part – we think that many folks con­fuse spec­u­la­tion, which often involves noth­ing more than wild-​ass guesses (like our own), with manip­u­la­tion. Of course, like most oth­ers, we’d agreed that manip­u­la­tion should be pros­e­cuted to the full­ness extent of the law. In addi­tion, we’d imag­ine that it would be very dif­fi­cult to find any­one will­ing to defend such manip­u­la­tion, but that’s not the nature of spec­u­la­tion. So, per­haps a lit­tle per­spec­tive is in order.

So, we ask: other than the poten­tial incon­ve­nience, what’s wrong with spec­u­la­tion? It seems to pro­vide liq­uid­ity, which many would con­clude is a good thing, and it seems to pro­vide amuse­ment and inter­est to a sub­set of the pop­u­la­tion. In addi­tion, no one really knows what would occur or would have occurred (in the past) if such activ­ity were (or had been) elim­i­nated. It’s pos­si­ble that spec­u­la­tion – what­ever it is – caused dis­tor­tions in resource allo­ca­tion deci­sions, but why would those deci­sions have been bet­ter with­out such spec­u­la­tion? NO ONE can answer that question.

So while the head of the CFTC wants to elim­i­nate things that he can’t nec­es­sar­ily iden­tify, define, or under­stand, we’d like to show inter­ested read­ers the fol­low­ing help-​wanted ad that appears on page D4 of today’s paper edi­tion of the Jour­nal. (We couldn’t find it on-​line; so, it appears as a jpeg below.)

Taken at face value, that’s quite a set of require­ments for posi­tions that pay between $60K and $153K. So, while such qual­i­fied indi­vid­u­als may exist, we won­der why they would be will­ing to work for the gov­ern­ment at such (rel­a­tively) low pay?

More­over, we’re sure that the posi­tions will be filled, but we’re less con­fi­dent that they’ll be filled with qual­i­fied indi­vid­u­als who know their own lim­i­ta­tions and the lim­i­ta­tions of their method­olo­gies. In fact, we’re more con­cerned about the dam­age and havoc of falsely iden­ti­fy­ing and either per­se­cut­ing or pros­e­cut­ing the inno­cent, because that would destroy liq­uid­ity and could cause irrepara­ble harm to the economy.

We cer­tainly hope that they live by our motto of “thought before cal­cu­la­tion.” That’s what make us con­ser­v­a­tive, and what also scares us most about the gov­ern­ment in them near future.

The physi­cist Michio Kaku has a short opin­ion col­umn in Thursday’s edi­tion of The Wall Street Jour­nal: Jupiter Gets a Black Eye. In it, he men­tions the Jupiter’s recent col­li­sion with a comet or aster­oid – it cre­ated a fire­ball as big as the earth – and then dis­cusses our planet’s vul­ner­a­bil­ity to rel­a­tively large and unknown space objects.

We like the col­umn because it pro­vides a nice – though not com­plete – ana­log of risk man­age­ment at finan­cial insti­tu­tions. Actu­ally, this is one instance where the gov­ern­ment may do it bet­ter. (Wow, we can’t believe that we wrote such a sentence!)

It’s likely that any­one with a web browser and the sophis­ti­ca­tion to access our site knows that there is a dan­ger that satel­lites and space debris within earth’s orbit may crash down upon them. For the most part, those risks are rel­a­tively well-​understood. Gen­er­ally, their effect would be like an idio­syn­cratic finan­cial risk to, say, a par­tic­u­lar firm. All else equal, the satel­lite or its pieces would hit a par­tic­u­lar small region and have lim­ited impact and impli­ca­tions; pos­si­bly, dis­as­trous to a few, but prob­a­bly not to very many. Of course, there is always a pos­si­bil­ity that such a nat­ural (or nearly nat­ural) dis­as­ter could start a chain-​reaction and have far-​ranging polit­i­cal, eco­nom­ics, and social impli­ca­tions beyond that of small, geographically-​isolated incident.

Out­side of the earth’s orbit – but within the solar sys­tem – are about 5,000 near-​earth objects (NEOs) that have also been categorized. These are items reside within the solar sys­tem and orbit the sun, but their orbits may inter­sect with the earth’s orbit and even­tu­ally inter­sect with the earth. Unfor­tu­nately, solar orbits not all con­cen­tric cir­cles or elipses.

Some of the NEOs are small – like man-​made satel­lites in solar orbit – but oth­ers are huge and could cause seri­ous dam­age if not com­plete anni­hi­la­tion of the earth (and its inhab­i­tants). Just look at the sur­face of the moon for some extrater­res­trial evi­dence. The earth has been hit by such items, too, and they’ve been very destruc­tive, e.g., the Tun­guska event. Impacts of smaller items could be viewed as idio­syn­cratic risks, whereas the larger ones – like giant vol­ca­noes that could cover the earth in dust – would be more like sys­temic risks that affect every­one. Over­all, it seems that gen­er­ally, these near-​earth objects are suf­fi­ciently well-​understood that they can be mod­eled with a suf­fi­cient degree of (pre­dic­tive) con­fi­dence. (That if some­thing bad is going to hap­pen, we’ll likely know about it.)

The last cat­e­gory of threats involves extra­so­lar ones. Their num­ber, size, and other char­ac­ter­is­tics are unknown, e.g., whether they have reg­u­lar or irreg­u­lar orbits (or tra­jec­to­ries). They are things things that could crash into the solar sys­tem and and earth with­out warn­ing. Those threats cre­ate plenty of uncer­tainty, but no risk because there is no way to mea­sure them (and risk is noth­ing more than mea­sur­able uncertainty).

That’s not the biggest dif­fer­ence between threats from space and finan­cial calami­ties. Despite what bad mod­el­ers (and bad risk man­agers (and bad chief exec­u­tives)) may tell you, there is a sub­stan­tial amount of immea­sur­able uncer­tainty in trad­ing and invest­ing activ­i­ties, too. The losses asso­ci­ated with either type of uncer­tainty can be indi­vid­u­ally or col­lec­tively devastating.

No, the biggest dif­fer­ence is that with enough mon­i­tor­ing devices, it is pos­si­ble to cat­e­go­rize those phys­i­cal threats and their causes and assign prob­a­bil­i­ties to them. We doubt that it will ever be the case with the coun­ter­vail­ing forces of greed and fear and their psy­cho­log­i­cal and emo­tion causes. That doesn’t mean that uncer­tainty man­age­ment–as it per­tains to the finan­cial mar­kets – is a hope­less cause: only that one should be care­ful and aware that unpre­dicted and unfore­seen and unimag­ined events can indeed happen.

Finally, note that like finan­cial mar­kets and the recent cri­sis, solu­tions to poten­tial threats could be worse than the threat itself. Mr. Kaku men­tions Hollywood’s solu­tion, à la Armaged­don, of attempt­ing to explode a large comet into a bunch of small pieces would make things worse. That would be like hit­ting the earth with a shot­gun blast, rather than with a rifle – pos­si­bly sys­tem­atiz­ing a hard, but idio­syn­cratic risk. That wouldn’t be fun.

There is an arti­cle in today’s edi­tion of The Wall Street Jour­nal that attempts to frame Citi’s pay “dilemma” with trader Andrew Hall of its Phi­bro unit as some type of Gor­dian Knot: Citi in $100 Mil­lion Pay Clash. It’s not.

It seems that Citi­corp will legally owe Mr. Hall about $100 mil­lion for his com­pen­sa­tion in 2009, but Citi’s senior man­agers are con­cerned about the polit­i­cal ram­i­fi­ca­tions of pay­ing such a large amount. The last time we checked, Citi had taken about $45,000,000,000 – yes, $45 bil­lion – from wealthy, middle-​class, and poor tax­pay­ers, and those tax­pay­ers had guar­an­teed losses of a few hun­dred bil­lion more.

We sup­pose that folks at Citi are con­cerned that the Obama admin­is­tra­tion and the pop­ulists in Con­gress will attempt to penal­ize the firm – or pos­si­ble incrim­i­nate the man­age­ment – for mak­ing such large com­pen­sa­tion pay­ments. (Note: since at least the found­ing of the FDIC in 1933, Con­gress has had the leg­isla­tive power to have ban such con­tracts, but has cho­sen not to do so.)

We’ve writ­ten a few times about the impor­tance of the rule of law, and it’s quite shame­ful that many of our elected offi­cials and rep­re­sen­ta­tives place such lit­tle value on it. (These are exactly the indi­vid­u­als that our Found­ing Fathers tried to pro­tect against.) It’s almost as shame­ful as Mr. Obama stu­pidly insert­ing him­self into the Gates/​Cambridge Police mess; he does need to learn to shut-​up.

We wrote about the AIG pay con­tro­versy in It Truly Is Dis­grace­ful! and Con­fis­ca­tory, Abu­sive Tax­a­tion: It’s Ali­men­tary (and Dan­ger­ous), and we don’t see this emerg­ing con­tro­versy as being any different.

That being said, we do believe that prop trad­ing should be elim­i­nated at insured insti­tu­tions, includ­ing Citi­corp, because we see no rea­son that tax­pay­ers, includ­ing our­selves, should sub­si­dize their risk-​taking. We first rec­om­mended it in Octo­ber in the aptly titled, Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions, and men­tioned it many time since then, includ­ing our recent post, Paul Vol­cker Has It Right.

It seems that Mr. Hall earned his huge com­pen­sa­tion award because he and his trad­ing group gam­bled and won big. How­ever, it was quite pos­si­ble for him to have lost (and lost big). That would have increased the size of Citi’s losses and required addi­tional tax­payer subsidization.

We don’t know Mr. Hall, but we do wish him every suc­cess in the world. We just have absolutely no desire to back­stop him (and it’s not just his pen­chant for mod­ern art).

We pre­fer that he work for a trad­ing unit of a non-​insured insti­tu­tion or run a hedge fund so that we don’t have to sup­port him if he fails. In fact, a very short arti­cle in the Journal’s Heard on the Street sec­tion, Hedge Funds’ Pro­pri­etary Advan­tage, describes how many hedge funds are cur­rently doing quite well (after many recent dis­as­ters last year). That’s the nature of the busi­ness. Let those will­ing to take the risks, reap the rewards AND bear the con­se­quences of fail­ure. (Is it too really much to ask?)

Per­haps Mr. Hall would like to pur­chase the Phi­bro unit from Citi and accept those same risks and rewards that other fund oper­a­tors face. It seems that clos­ing the sale before the end of the cal­en­dar year would (or could) be a grand out­come for both Mr. Hall and Citi. We think that ban­ning prop trad­ing at insured insti­tu­tions as of Jan­u­ary 1, 2010, would go a long way towards slic­ing through sim­i­lar knotty sit­u­a­tions at other banks.

One final note: in the tra­di­tion of horrendously-​arranged gov­ern­ment web sites, see the above-​mentioned FDIC site. It’s ugly and busy and has no focus, and it’s just what we expect from our bureau­cracy. Does the reader have any higher expec­ta­tions? Be honest.

We are in the midst of writ­ing a rather long post on the sim­i­lar­i­ties between teenage girls with low blood sugar and daily and intra-​day changes in equity prices. Namely, one can see huge swings in behav­ior, atti­tudes, and mood caused by seem­ingly very minor under­ly­ing events, e.g., “she looked at me the wrong way.” The “she” in this case being an eight-​year-​old sister.

How­ever, we couldn’t com­plete that post because another thought keeps divert­ing our (lim­ited) atten­tion from it.

We were dri­ving with the Chair­man ear­lier today when she men­tioned that the neigh­bor­ing county was hold­ing its fair, and that it was one of the largest county fairs in the state. She went on to explain when­ever she thought of fairs and state fairs she would think of the book, Charlotte’s Web. (We’ve never read it because it was a girls’ book in our youth, and we did not read girls’ books: not then, not now.) As she explained, she par­tic­u­larly liked the chap­ter in which Wilbur the Pig goes to the State Fair, and Tem­ple­ton the Rat tags along in the pig’s cage.

As she explained it, when the rat inves­ti­gated his new sur­round­ings, he thought that he had reached par­adise. He was amazed at the wealth of del­i­ca­cies that he could find on the ground – prob­a­bly things like pop­corn and corn dogs and ice cream cones and maybe deep-​fried Snick­ers bars.

Upon hear­ing that, a ques­tion came imme­di­ately to mind: so, did he stay there?

See, we could imag­ine the rat believ­ing that he had reached the prover­bial land of milk and honey – in this case, half-​eaten corn dogs and ice cream cones as far as the eye could see. It would seem to be an almost lim­it­less sup­ply. Except, except for the fact that state fairs only last for a week or two.

If he decided to stay at the fair­grounds after his swin­ish friend returned to the farm – if that’s where the pig went – then it could eas­ily seem to have been the best deci­sion of his life – for a week or two. Until the cleanup crews came and swept the refuse away, and until he began to face the fol­low­ing 50 weeks of depri­va­tion and hunger.

Despite its com­pletely deter­min­is­tic and cycli­cal nature, the “great bust” or ” great depres­sion” or “great famine” or what­ever phrase he would have used to described the clos­ing of the fair, would have seemed com­pletely unpre­dictable and ran­dom. Tem­ple­ton and his other rodent friends, could eas­ily ask, “who could have ever pre­dicted it? or “how could it be my fault?” Of course, it could be that things that seem to be too good to be true, often are.

Now, we are not com­par­ing the recent (and ongo­ing) finan­cial cri­sis with our imag­ined sce­nario of Tem­ple­ton the Rat’s life. In our mind, eco­nomic crises tend to have endoge­nous causes, i.e., they erupt from within the sys­tem – not from an exter­nal source like a nat­ural dis­as­ter or in this case, the pre­dictable end of a two-​week fair.

How­ever, we do think the sce­nario is instruc­tive. To Tem­ple­ton the Rat, the destruc­tion of his new envi­ron­ment would have seemed like a unpre­dictable tsunami. He wouldn’t have known when or if the good times – the fair – would end, and he wouldn’t have known what he didn’t know, i.e., very impor­tant char­ac­ter­is­tics of his environment.

It’s that aspect that is instruc­tive, and it’s why we think that trad­ing and invest­ing firms should increase the scope of their risk man­age­ment func­tions to the broader func­tion of uncer­tainty man­age­ment. “Uncer­tainty” includes the explicit real­iza­tion that (1) not all ran­dom­ness is mea­sur­able risk and (2) seem­ingly incom­pre­hen­si­ble and uncon­sid­ered bad things can happen.

Note how­ever, that just because such things are (cur­rently) incom­pre­hen­si­ble doesn’t mean that (i) that can’t be pro­tected against and (ii) they can’t even­tu­ally be imag­ined through cre­ativ­ity and rea­son. The for­mer is true because ade­quate pro­tec­tion against known harms can also pro­tect against unknown ones; putting your house on stilts pro­tects against known sea­sonal flood­ing and unknown tsunamis. The lat­ter is true because that is the nature of human progress and the expan­sion of knowl­edge through exper­i­men­ta­tion and con­tem­pla­tion: think of humanity’s rel­a­tively recent dis­cov­er­ies of bac­te­ria and viruses. Inter­ested par­ties look­ing for more should read our essay, Uncer­tainty Man­age­ment or our tongue-​in-​cheek post, The Role for Sur­vival­ists and Depres­sives in Uncer­tainty Man­age­ment.

Finally, please note that we chose our title care­fully. It’s a play on the line from the Robert Burns poem, To a Mouse, On Turn­ing Her Up in Her Nest with the Plough. We Angli­cize the line as: “the best laid plans of mice and men often go awry and leave us noth­ing but grief and pain.” We’d add that less thought­ful plans often don’t turn out that well. Read the entire poem on our quotes page.