‘Risk’ Category

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:

Here’s a great sports– and science-​related arti­cle in today’s edi­tion of The Wall Street Jour­nal: The Africans Are Hear­ing Foot­steps. We think it’s great because it exposes what claims to be a “sci­en­tific” approach to long-​distance train­ing as some­thing that seems to be quite the oppo­site, i.e., some­thing that seems to be quite non-​empirical.

The arti­cle describes how Amer­i­can long-​distance, Kara Goucher, is suc­cess­fully using “African” meth­ods – which were, in fact, used by most Amer­i­cans prior to the 1980’s – to train for marathons. As described, her method seems to focus more on run­ning than on the mea­sure­ment of var­i­ous aspects of run­ning. (We under­stand that one might argue that today she is in posi­tion to dis­card the meth­ods that put her in that posi­tion, but we”ll ignore that point-​of-​view for the sake of argument.)

Any­way, the arti­cle reminds of of our favorite Ein­stein quotes: “Not every­thing that counts can be counted, and not every­thing that can be counted counts.”

Now, to be able to say any­thing about the sub­ject in less than many, many pages, requires us to keep much con­stant and gen­eral. So, we’ll ignore issues like whether African run­ners are genet­i­cally supe­rior as well as whether they are bet­ter moti­vated because, they’re, well, from Africa. (That seems to be the argu­ment.) More­over, we know that Ms. Goucher is a very small sam­ple size of one, and we don’t fol­low run­ning care­fully enough to know about other run­ners who have switched train­ing meth­ods and have failed miserably.

How­ever, given the lit­tle that we do know, it does seem that – at least at world-​class, élite lev­els – there isn’t much empir­i­cal sup­port for the rather tech­ni­cal approach that most Amer­i­can run­ners and run­ning pro­grams adopted in the 1980s and con­tinue to use today.

More pre­cisely, if the hypoth­e­sis is that com­pre­hen­sive record-​keeping, etc., improves run­ning per­for­mance – as mea­sured by world cham­pi­onships – then it seems that such a con­jec­ture should be rejected. Again, there are any num­ber of rea­sons why our crit­i­cism may be incor­rect: per­haps the for­eign­ers have been able to mask their use of per­for­mance enhanc­ing drugs.

Regard­less, our point is that mak­ing a process overly-​quantitative and struc­tured doesn’t make it the least bit “sci­en­tific.” It may make it abstruse and bureau­cratic and, there­fore, may obscure the real dri­vers of suc­cess and rea­sons for losses, espe­cially when one (or many) take com­fort in those cal­cu­la­tions rather than actual performance.

Given our back­ground and skills, we’re cer­tainly not den­i­grat­ing quan­tifi­ca­tion, esti­ma­tion, and the use of data or the advanced appli­ca­tion of math, but – per our motto – we are say­ing that there should be thought before cal­cu­la­tion and after­wards, too. In that respect, there is no dif­fer­ence between train­ing for marathon run­ning and val­u­a­tion or risk management.

It is ironic that so much infra­struc­ture is devoted to mon­i­tor daily per­for­mance and results, but there seems to be so lit­tle mea­sure­ment and feed­back (eval­u­a­tion) of the effi­cacy of the infra­struc­ture. Expen­sive train­ing reg­i­mens that lead to decades of fail­ure aren’t much dif­fer­ent than “risk” man­age­ment report­ing processes that record ter­abytes of daily data and sense­lessly extrap­o­late things like daily volatil­i­ties and cor­re­la­tions to deter­mine worst-​case sce­nar­ios, yet left so many unpre­pared for the finan­cial crisis.

In both cases, the system-​wide feed­back loops seem to be dis­con­nected and dan­gling in the ether.

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 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.

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.

There’s an excel­lent opin­ion col­umn in yesterday’s (May 28) edi­tion of The Wall Street Jour­nal. It is Crazy Com­pen­sa­tion and the Cri­sis by Alan S. Blinder.

Why do we write that it is “excel­lent” the dear reader may ask?

Well, for the obvi­ous (and self-​serving) rea­son that we have been writ­ing the same cri­tiques on these pages for much of the past year or so.

Mr. Blinder iden­ti­fies sev­eral prob­lems that cre­ated the poten­tial for the cri­sis and its sub­se­quent real­iza­tion.¹ We will cat­e­go­rize the prob­lems that he iden­ti­fies as:

1. Wrong legal form/​organization struc­ture for some firms,
2. Incom­pe­tent boards, and
3. Lax con­trols and poorly-​designed incentives.

He treats them in a dif­fer­ent order than we list them; we’re going from top-​to-​bottom, which is con­sis­tent with Our Con­trol Frame­work. Clearly, the three cat­e­gories are related. For exam­ple, see our pop­u­lar post, SOX’s Roles in the Finan­cial Cri­sis of ‘08, which hits on all three top­ics, and crit­i­cizes gov­ern­ment reg­u­la­tion to boot. In our mind, they all pro­vide evi­dence of the fallen nature of man. (We’re not com­plain­ing about that nature. We accept it in our­self and, to a lesser extent, in oth­ers. We’re only try­ing to profit from it.)

Wrong Legal Form/​Organization Structure

We wrote about this on Sep­tem­ber 26, 2008, when we asked Will Invest­ment Banks Go the Way of the Dinosaur? In that post we spec­u­lated that part­ner­ships may make a come­back because “They pro­vide con­trol mech­a­nisms and lev­els of over­sight and scrutiny that seem dif­fi­cult to dupli­cate in pub­lic corporations.”

Mr. Blinder made explicit what was implicit in our post: the dif­fer­ence between one’s level of risk-​taking when man­ag­ing OPM (Other People’s Money) ver­sus what he refers to as MOM (My Own Money), or one’s own money.² Those fac­ing unlim­ited per­sonal losses tend to be more con­ser­v­a­tive than those with lim­ited losses.

In Jan­u­ary, in a cri­tique of The Wall Street Jour­nal’s edi­to­r­ial board, What Did They Expect?, we wrote, “We also dis­agree with their [the edi­to­r­ial board’s] assess­ment that “com­pen­sa­tion lev­els are a busi­ness judg­ment made under the pres­sure of com­pe­ti­tion.” That might be true if the firms were part­ner­ships or oth­er­wise privately-​owned, there was no agency costs, and there was no self-​dealing, i.e., the firms were run by inde­pen­dent and knowl­edge­able boards.”

But with D & O (direc­tors’ and offi­cers’) insur­ance, the lim­ited down­side of losses severely decom­presses that so-​called “pres­sure of com­pe­ti­tion” for boards. More­over, share­hold­ers of bank hold­ing com­pa­nies (and other cor­po­ra­tions, too) implic­itly per­mit­ted man­agers to take greater risks. In fact, Mr. Blinder seems unwill­ing to blame share­hold­ers when almost every stock­holder was quite capa­ble of sell­ing their stakes. So, we have no sym­pa­thy for folks who wanted the oppor­tu­nity for large gains with­out bear­ing poten­tial lia­bil­i­ties if the firm.³

Incom­pe­tent Boards

While “Incom­pe­tent Boards,” may seem a bit harsh to some, we think that it is milder than many alter­na­tive and equally fair char­ac­ter­i­za­tions, and there is no short­age of evi­dence. See Direc­tors Are Faulted at Home Loan Banks for example.

Reg­u­lar read­ers will note that we often ask whether a party is igno­rant or cyn­i­cal, and in this case we’d pre­fer to believe that many direc­tors were unqual­i­fied to under­stand the uncer­tain­ties and risks asso­ci­ated with invest­ing and trad­ing, par­tic­u­larly with deriv­a­tives and other struc­tured prod­ucts. In some way, that seems more “decent” and eth­i­cal than the alter­na­tive: the cyn­i­cal and devi­ous behav­ior of under­stand­ing the poten­tial for loss but ignor­ing it due to one’s own lim­ited lia­bil­ity.⁴

For exam­ple, with the recent changes in the com­po­si­tion its board, Citi­corp has as much as admit­ted the lack of req­ui­site exper­tise of its past board. We’ve writ­ten about these top­ics in the past, par­tic­u­larly in: The Fail­ure of Boards to Direct, The Seventy-​Year-​Old Teenager, When the Going Gets Tough…Quit, and Idio­syn­cratic and Con­cen­tra­tion Risk, Again. (Update: within hours of pub­lish­ing this post, B of A announced that one of its direc­tors was resign­ing: see BofA Says Sloan Quits Board Seat. There was much spec­u­la­tion that it was due to gov­ern­ment pressure.)

Those (gen­er­ally weak and) incom­pe­tent boards per­mit­ted senior man­agers to main­tain the lax con­trols and poorly-​designed incen­tives about which we have often writ­ten, and here is a summary.

Lax Con­trols and Poorly-​designed Incentives

As Mr. Blinder notes, poorly-​designed incen­tives – pri­mar­ily via com­pen­sa­tion schemes – led to ex post “exces­sive” risk-​taking. We write ex post as in 20 – 20 hind­sight as in “there are mas­sive losses, so some­one must have done some­thing wrong,” but, in fact, we’re note using that logic. Instead, we note that there was no short­age of indi­vid­u­als warn­ing about the risk and uncer­tain­ties ex ante.

Unfor­tu­nately, many such folks were dis­missed either fig­u­ra­tively or lit­er­ally by senior man­age­ments. (It’s anal­o­gous to the SEC’s treat­ment of Harry Markopo­los. See Cas­san­dra, the SEC and Mr. Mad­off.) More­over, it is con­sis­tent with the per­spec­tive that risk man­agers gen­er­ate no rev­enue and are costs to be min­i­mized (and often voices to be ignored).

So, yes, traders (and their man­agers) took gam­bles because they bore (or thought they bore) lim­ited down­side risk but instead focused on the poten­tial for sub­stan­tial (enor­mous) com­pen­sa­tion rewards, but lax con­trols and igno­rance are big­ger issues than just poorly-​designed com­pen­sa­tion schemes because said traders were allowed to take those gam­bles with OPM.

That lack of con­trol has many facets, but can be sum­ma­rized in terms of as greed, igno­rance, and inse­cu­rity. Notice that, of course, those emotions/​human con­di­tions are always present, but pre­cisely the job of senior man­agers (and boards and own­ers) to design schemes and mech­a­nisms that take those as given and mit­i­gate them – rather than exac­er­bate them – while the orga­ni­za­tion attempts to achieve its objec­tive. (We’ll have more to say about that below.)

Igno­rance, and its rel­a­tive, inse­cu­rity, were cru­cial to the con­trol fail­ures. Few folks are will­ing to admit that some­thing is immea­sur­able or nearly impos­si­ble to quan­tify because that can be turned-​around and used against them as a per­sonal short-​coming:, e.g., “that’s just because he doesn’t know enough.” So, per­sonal inse­cu­rity and incen­tives often induce employ­ees to “take the easy way out” and endorse or embrace a sim­plis­tic and inap­plic­a­ble val­u­a­tion or risk model. 

For exam­ple, in early Novem­ber, we wrote The Under­state­ment of the Year! in response to an arti­cle in The Wall Street Jour­nal enti­tled, Behind AIG’s Fall, Risk Mod­els Failed to Pass Real-​World Test. While the entire post is rel­e­vant to this dis­cus­sion, we par­tic­u­larly like this extended excerpt:

The prob­lem, dear reader, is that few senior man­agers (and almost no board members) understand the val­u­a­tion and risk mod­els used for secu­ri­ti­za­tions, and many of the traders, con­sul­tants, and ana­lysts who wield such tools often suf­fer from, what one may call, “fram­ing” issues; we don’t mean that aspect of home con­struc­tion despite its recent relevance.

We mean that if one’s only tool is a ham­mer, then lots of things look like nails. The metaphoric ham­mer may be an intan­gi­ble Visual Basic or “C” pro­gram­ming algo­rithm, but the point remains the same; it’s just harder for senior man­age­ment to see what one is pound­ing in their cubi­cle, office, or trading-​floor seat.

To be sure, if any­one within most of the larger firms would have com­plained of the sys­tem­atic risk — and how every­thing could go bad all at once — and the inap­plic­a­bil­ity of the stan­dard mod­els, which gen­er­ally don’t per­mit such events, then that per­son most cer­tainly would have been told that they don’t know what they’re talk­ing about. Pos­si­bly, that they are unso­phis­ti­cated or too negative.

Ear­lier this week in Uncer­tainty: In God We Trust, we noted “Too many senior man­agers neglected their respon­si­bil­i­ties and per­mit­ted the sub­sti­tu­tion of cal­cu­la­tions for thoughts.” That as been a pet peeve of ours for quite some time and is the antithe­sis of our motto: thought before cal­cu­la­tion. See The Dif­fer­ence Between Risk and Uncer­tainty for a rel­a­tively short expo­si­tion of the issues.

Those dys­func­tional behav­iors were not nec­es­sar­ily mali­cious or anti-​social by intent, but does that mat­ter, espe­cially since thought­ful design of con­trol mech­a­nisms could have inhib­ited them? See Prin­ci­ples Lost and More, in which we con­trast Saint Thomas More’s actions in the 16^th cen­tury with the more recent actions of many less holy indi­vid­u­als prior to and dur­ing the Finan­cial Cri­sis; there’s a rea­son he’s a Saint and we’re not.

We’ve writ­ten much, much more on this topic, but as we noted in The Prob­lem of Induc­tion, we’re not under­es­ti­mat­ing the dif­fi­culty of the prob­lems faced by traders, struc­tur­ers, and risk man­agers. In fact, if any­thing, we’re overly con­ser­v­a­tive by stat­ing that not all uncer­tain­ties and losses can be quan­ti­fied and the prob­lems are much more dif­fi­cult than some sup­pose and/​or communicate.

What To Do?

Unfor­tu­nately, Mr. Blinder notices that there has been little-​to-​no struc­tural change in cor­po­rate gov­er­nance. He attrib­utes the dif­fer­ences in mar­kets – the illiq­uid­ity or lack of trad­ing – to fear, rather than to newly designed or revised con­trols, and that seems about right to us. As we noted last month in Learn­ing the Dif­fer­ence Between Risk and Uncer­tainty, or not, job descrip­tions and hir­ing require­ments for many trad­ing and risk man­age­ment posi­tions don’t seem to have changed; so, it doesn’t seem the firms have “re-​engineered” or redesigned their oper­a­tions or controls.

In Octo­ber, we wrote a tongue-​in-​cheek post about The Role for Sur­vival­ists and Depres­sives in Uncer­tainty Man­age­ment, but in all seri­ous­ness, hir­ing such per­son­al­i­ties and lis­ten­ing to them is one way to com­pen­sate for flawed risk models.

To be fair, we have read about a few firms, like UBS, that have changed their com­pen­sa­tion schemes to include fea­tures like claw­backs. See Claw­backs: the Good, the Bad, and the Ugly and Incen­tives at UBS and in Gen­eral. How­ever, it is not clear whether such changes have been thought­fully man­aged. As we men­tioned in Busi­ness Schools, Incen­tives, Uncer­tainty, and the Finan­cial Cri­sis, it seems that lit­tle has been done because: (1) such incen­tive prob­lems are very chal­leng­ing to solve, and (2) uni­ver­si­ties don’t do a par­tic­u­larly good job of train­ing busi­ness stu­dents to solve them. (Of course, for the right fee, we would be glad to help.)

So what to do?

Mr. Blinder calls for change, but doesn’t exactly explain how or what.

We’ve made sev­eral rec­om­men­da­tions in past, includ­ing this post from early Octo­ber: Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions. Every­thing in it – and there’s a lot – holds up well, and we’ve not heard a com­pelling argu­ment against such a ban. As we wrote back then:

We’re com­pletely for the free-​market—more so than most bank man­agers — but until such insti­tu­tions for­sake their gov­ern­ment insur­ance, we’ll insist that they have an oblig­a­tion to the cit­i­zenry — through the gov­ern­ment — to behave in a respon­si­ble, low risk man­ner. If that gen­er­ates lower returns for them on aver­age, then so be it. That’s the nature of the risk-​return spec­trum and their legal and fiduciary responsibilities…

We think that such a ban is fea­si­ble and would sub­stan­tially mit­i­gate many of the risks that those banks by elim­i­nat­ing the (socially) unde­sir­able behavior.

Now, that (max­i­mum) risk-​seeking behav­ior is not uni­ver­sally unde­sir­able, but it is within sub­si­dized insti­tu­tions. We’re all for per­mit­ting “prop” struc­tur­ers and traders to oper­ate in unreg­u­lated part­ner­ships and hedge funds, and wish such orga­ni­za­tions the best of luck.

P.S. Although this post is rife with links, we’ve writ­ten much, much more about the top­ics of risk man­age­ment, incen­tives, and the cri­sis. Feel free to peruse the archives, and let us know if we’re wrong about any­thing – other than a few predictions.

P.P.S. As posted, this is rather long, and we’ll likely revise it in the near future as we dis­cover typos, etc.

Mary Anas­ta­sia O’Grady has a good inter­view with Richard Fisher, the pres­i­dent of the Dal­las Fed­eral Reserve, in this Saturday’s edi­tion of The Wall Street Jour­nal. It is called “Don’t Mon­e­tize the Debt”.

Reg­u­lar vis­i­tors of our site, who are sym­pa­thetic to our crit­i­cisms of the Fed; elected and appointed gov­ern­ment offi­cials; and finan­cial reg­u­la­tors, will find much with which to agree.

We’re writ­ing today to men­tion a few parts that are directly related to our site. First, per our motto in the header, Thought before Cal­cu­la­tion, Ms. O’Grady writes:

And finally, he says, there was the ‘math­ema­ti­za­tion’ of risk.” Insti­tu­tions were “build­ing risk mod­els” and rely­ing heav­ily on “quant jocks” when “in the end there can be no sub­sti­tute for good judgment.”

We’re not averse to math­e­mat­i­cal mod­els, and don’t mind get­ting paid to develop, ana­lyze, or val­i­date them, but we do agree with Mr. Fisher’s crit­i­cism. It must be done thought­fully. Too many senior man­agers neglected their respon­si­bil­i­ties and per­mit­ted the sub­sti­tu­tion of cal­cu­la­tions for thoughts. That being said,we think that it is nec­es­sary to add that even the best judg­ment doesn’t assure favor­able out­comes. That, unfor­tu­nately, is the nature of uncer­tainty, which we’ve writ­ten about any num­ber of times.

Sec­ondly, the penul­ti­mate para­graph describes a paint­ing by Anto­nio De Simone of a ship in a storm. Accord­ing to the arti­cle, Mr. Fisher has owned it for thirty years.

In the final para­graph, Mr. Fisher is quoted as say­ing “no math­e­mat­i­cal model can steer you through the kind of seas in that pic­ture there. In the end some­one has the wheel…On mon­e­tary pol­icy it’s the Fed­eral Reserve.”

As the reader can hope­fully see for him or her­self, we have an image of a sim­i­lar paint­ing in our header: Rembrandt’s Storm on the Sea of Galilee.

We pre­fer the helms­man on that boat to the quite fal­li­ble men and women at the Fed, who – as we see it – are try­ing too hard to “steer” the economy.

Per­haps oth­ers con­sid­ered sim­i­lar ana­logues when the nation’s offi­cial motto became “In God We Trust.” More­over, we hope that each time they notice it on our paper cur­rency and coins, our rep­re­sen­ta­tives and agents are reminded of the inher­ent uncer­tainty that they face – be it nat­ural or man-​made.

Recently, we’ve noticed a sub­stan­tial num­ber of vis­its referred by search engines from folks try­ing to under­stand the dif­fer­ence between risk and uncer­tainty. In fact, we have a post from April 20, with the tongue-​in-​cheek title of Learn­ing the Dif­fer­ence Between Risk and Uncer­tainty, or not.

In that post, we crit­i­cize finan­cial firms because they don’t seem to have changed their uncer­tainty man­age­ment tac­tics or method­olo­gies despite the mar­ket upheavals and shocks of the past few years. In fact, they still refer to the field as “risk management.”

How­ever, for those look­ing for some­thing a bit less ver­bose – but only a bit – we offer the fol­low­ing ital­i­cized dis­tinc­tion, which we’ve excerpted from that post.

The fol­low­ing para­graph is repet­i­tive, but read­ing dif­fer­ent phrases that have the same mean­ing is often the eas­i­est way to learn. That’s why many stu­dents learn bet­ter in lec­tures than by solely read­ing a text­book; the con­cepts are usu­ally men­tioned and pre­sented in a vari­ety of ways in class, whereas often the text­books strive for par­si­mony of expo­si­tion.¹

As usual, we point new read­ers to our essay, Uncer­tainty Man­age­ment, which details our per­spec­tive and phi­los­o­phy on these issues… The main point is that not all uncer­tainty is mea­sur­able, i.e., that mea­sur­able uncer­tainty, or risk, is a proper sub­set of uncer­tainty and unknow­ing. (In other words, spe­cific math­e­mat­i­cal con­di­tions must be met for uncer­tainty to be risk. So, uncer­tainty is a more gen­eral term, i.e., all risk involves uncer­tainty, but not every­thing that is uncer­tain is risky because not all uncer­tainty is mea­sur­able, which, again, has a spe­cific math­e­mat­i­cal def­i­n­i­tion that we don’t care to mention.)

The above def­i­n­i­tion of risk as quan­tifi­able uncer­tainty is due to Frank Knight, who devel­oped it in the early-​to-​mid 20^th century.

Uncer­tain phe­nom­ena are often mod­eled as risky events. While there are a host of other mis­takes that one can make in the mod­el­ing process, a huge spec­i­fi­ca­tion error is made when the phe­nom­e­non is uncer­tain and immea­sur­able, but it is treated as being mea­sur­able. That’s espe­cially bad in finan­cial and eco­nomic set­tings because such mod­el­ing errors tend to reduce or elim­i­nate the mod­eled – but not the real – chances of really bad things happening.

To be a bit more pre­cise, note that for some uncer­tain phe­nom­ena, a prob­a­bil­ity dis­tri­b­u­tion will not exist.

For oth­ers, a dis­tri­b­u­tion may exist, but its moments – which one may grossly think of as its com­mon sta­tis­tics – may not. For exam­ple, there are math­e­mat­i­cal func­tions that are prob­a­bil­ity dis­tri­b­u­tions, but which have no mean or vari­ance (so no stan­dard devi­a­tion, either). Many of them look a lot like Nor­mal dis­tri­b­u­tion and den­sity func­tions – i.e., they have a famil­iar bell shape like a Nor­mal den­sity – but their “tails” are “too fat,” and extreme events are hun­dreds or thou­sands or mil­lions of times more likely than with a Nor­mal dis­tri­b­u­tion. That dif­fer­ence in fre­quen­cies of out­ly­ing events is why para­me­ters like the expected value and stan­dard devi­a­tion don’t exist.²

The prob­lem in real life is that unless one is play­ing a struc­tured game of chance, one’s never quite cer­tain whether some­thing is uncer­tain but not risky, or whether it can indeed be quantified.

Reg­u­lar read­ers know that we often cite (1) St. James’ admo­ni­tion in his only epis­tle that one is like a “puff of smoke,” in the sense that they and their wel­fare are tem­po­rary, ephemeral, and uncer­tain; and (2) the Prob­lem of Induc­tion, which notes that regard­less of the time series of obser­va­tions, one can never be quite sure of the under­ly­ing ran­dom process.

That’s why we gave two sub­ti­tles to our essay Uncer­tainty Man­age­ment: (1) igno­ra­mus et ignor­a­bimus , which means “we do not know and will not know,” and (2) How Trad­ing is Like Play­ing in a Cul­vert on a Hot, Sunny, Sum­mer Day, although “trad­ing” can be gen­er­al­ized to any num­ber of activ­i­ties, includ­ing many social ones where, obvi­ously, behav­ior and some­times panic come into play.

Copy­right © 2009 Spero Consulting.

Foot­notes:

In the pre­vi­ous post we noted a WSJ edi­to­r­ial that stated, “The best that can be said about the stress tests is that they’re over.”

We wouldn’t go that far, but we’ve been highly crit­i­cal of the reg­u­la­tors for a num­ber of rea­sons. (See our var­i­ous posts about the stress tests, and you can search for our posts on reg­u­la­tors and cap­i­tal require­ments if you want.) Here’s a new crit­i­cism that we haven’t men­tioned before.

Within firms, it’s almost never the case that stress tests and sce­nario analy­ses are per­formed to argue for an increase in cap­i­tal allo­cated to an invest­ing or trad­ing activ­ity. (Yeah, yeah, we know about eco­nomic cap­i­tal, which is the­o­ret­i­cally fine but prac­ti­cally worth­less.) Occa­sion­ally, if the results of pes­simistic sce­nar­ios show large losses, the trader or invest­ment man­ager is required to take an action, e.g., sell the asset, end the trade, or hedge the trade to some extent. (We ital­i­cize Occa­sion­ally in the pre­vi­ous sen­tence because too often the results are dis­missed as deriv­ing from an “unlikely” or “improb­a­ble” or “unre­al­is­tic” sce­nario and noth­ing is done to mit­i­gate the poten­tial tail losses).

Now, we know that some firms are sell­ing bits and pieces of them­selves to raise cap­i­tal, but we haven’t heard of any banks sell­ing the bits and pieces of them­selves that lost the most in the stress tests or cur­tail­ing activ­i­ties that per­formed par­tic­u­larly poorly in the tests. Per­haps we don’t read enough, per­haps the banks are being secre­tive and other tac­tics are being rec­om­mended and applied, but it seems that the government’s pre­ferred response in every case is “raise cap­i­tal.” Only the degree changes.

While there is a very small chance that such a tac­tic is robust (globally-​optimal), it’s unlikely that share­hold­ers con­sider the fur­ther dilu­tion of their inter­ests to be the sin­gle best response to every sin­gle, stress-​induced defi­ciency. Reg­u­lar read­ers will recall that we think forced receiver­ship and nation­al­iza­tion have been under-​utilized tac­tics dur­ing the cri­sis; so, we’re not a shill for bank investors, but given the num­ber of con­trols and alter­na­tives avail­able, it doesn’t seem as if the Trea­sury Depart­ment and the Fed­eral Reserve have con­sid­ered those options.

In our mind, gov­ern­ment solu­tions tend to be sim­plis­tic and heavy-​handed; so, we can’t give it (them) the ben­e­fit of the doubt. For exam­ple, this week the chair­man went to pur­chase decon­ges­tant allergy pills at the local CVS. She was denied because she had already pur­chased 30 pills dur­ing the past month. We both take allergy pills; so, that’s 60 pills per month. That means we both have to make two trips per month to get the med­i­cine we need. That’s not environmentally-​friendly, and we doubt that pre­vents any­one from get­ting the ingre­di­ents they need to pro­duc­ing meth. Those restric­tions – like most air­port secu­rity pro­ce­dures – are sim­ply incon­ve­niences for law-​abiding citizens.

Such actions are showy, expen­sive, but inef­fec­tive. Now, why do they remind us of TARP and SCAP?

Is that Really the Worst-​Case?

Today’s front-​page arti­cle in the The Wall Street Jour­nal, Fed Sees Up to $599 Bil­lion in Bank Losses, is sub­ti­tled “Worst-​Case Cap­i­tal Short­fall of $75 Bil­lion at 10 Banks Is Less Than Many Feared; Some Shares Rise on Hopes Cri­sis Is Easing.”

While it is the worst of the two cases ana­lyzed by the reg­u­la­tors, it is not the worst, rea­son­able case that could be imag­ined. Per­haps that’s why the short­fall was “Less Than Many Feared.”

• It’s rea­son­ably pos­si­ble for the down­turn to be deeper and/​or longer than con­sid­ered. In fact, one could assign a rea­son­able, non-​trivial prob­a­bil­ity to it.
• It’s pos­si­ble – maybe even rea­son­ably prob­a­ble – that given the sce­nar­ios used, the banks (and the reg­u­la­tors) pos­i­tively biased the val­u­a­tion results. (Con­vert­ing macro-​economic assump­tions into asset val­ues is a highly spec­u­la­tive and sub­jec­tive busi­ness – regard­less of the num­ber of cal­cu­la­tions per­formed to gen­er­ate those values.)
• It’s quite pos­si­ble that a man-​made or nat­ural dis­as­ter could com­pound the economy’s prob­lems and shave sev­eral addi­tional per­cent­age points off of GDP dur­ing the next two years. For exam­ple, we’ve writ­ten sev­eral times in recent weeks about the need for sce­nar­ios that include the effects of swine-​flu pan­demics, but large earth­quakes in Cal­i­for­nia, severe drought in the Mid­west, and mas­sive hur­ri­canes and floods in the South­east could be just as dev­as­tat­ing. While none of them is likely, they’re all pos­si­ble – even rea­son­ably possible.

So, we ask, is that sec­ond case really the worst-​case?

The Journal’s Nar­ra­tive Fallacy

While we take issue with the sub­ti­tle of the above arti­cle, there’s another arti­cle in today’s The Wall Street Jour­nal, How the Stress Tests Stopped the Mar­ket Bleed­ing, that’s even more dubi­ous. In fact, the entire premise of it is flawed.

Does any­one other than the two cred­u­lous reporters believe the title to be the case? Geithner’s promise that none of the 19 would be allowed to fail may have had a big­ger effect, but the stress tests them­selves? The evi­dence for that is shame­fully inad­e­quate. So we ask: who are they try­ing to fool?

From our per­spec­tive, there’s noth­ing in the arti­cle to jus­tify the title’s con­clu­sion. In fact, our ref­er­ence to it as a “Nar­ra­tive Fal­lacy” is too gen­er­ous, because if it were, there would be a sequence or set of facts that could be con­cocted to tell such a tale, but there doesn’t seem to be such a set, here. Instead, it seems more like a coin­ci­dence, i.e., it seems that one could eas­ily argue that North Car­olina win­ning the NCAA tour­na­ment had more of an effect or that the mar­ket decreased as tem­per­a­tures cooled in the north­ern hemi­sphere and has begun to rise with the arrival of Spring’s warmer weather. Both of those “expla­na­tions” seem just as compelling.

As Nas­sim Nicholas Taleb has pointed out many, many times, such fal­la­cious story-​telling is all too com­mon in the busi­ness press, where reporters con­stantly ascribe causes and rea­sons to daily (and hourly) changes in prices and indices.

For­tu­nately, the Paper Is Schizophrenic

By that we mean that unlike the report­ing staff, the edi­to­r­ial page writ­ers are a bit more skep­ti­cal about the ben­e­fits of the stress tests, in par­tic­u­lar, and gov­ern­ment involve­ment in the finan­cial sec­tor, in gen­eral. In their top Review and Out­look col­umn today, Stress for Suc­cess?, they con­clude: “The best that can be said about the stress tests is that they’re over.”

We think that’s a bit too harsh, but not by much. See our var­i­ous posts about the stress tests. The next post lists a new complaint.

Or, Is It the Naïve Government’s Stress Test­ing Exercise?

More Lack of Plan­ning and Insight from Our Reg­u­la­tors and Gov­ern­ment Officials

About one month ago – on April 7, to be pre­cise – we asked, Where Will the Bank Stress Test­ing Exer­cise Lead?

In that post, we wrote that the tests could be designed one of three ways: (1) with a pos­i­tive bias to ensure that all or almost all of the banks could pass the tests, (2) with no bias to get a hon­est — though not nec­es­sar­ily accu­rate — assess­ment of each bank’s finan­cial con­di­tion (with accu­racy con­strained by the implicit and explicit assump­tions built into the exer­cise), or (3) with a neg­a­tive bias to ensure that most or all banks fail the test.

Given the var­i­ous news reports that four­teen of the 19 banks may have “failed” the tests and that the four­teen have since been nego­ti­ated down to ten that may “require cap­i­tal,” it doesn’t seem that the tests were designed or biased to gen­er­ate pos­i­tive results. In ret­ro­spect, it doesn’t seem that the eco­nomic assump­tions were par­tic­u­larly neg­a­tive – see We Can’t Sub­si­dize the Banks For­ever in today’s edi­tion of The Wall Street Jour­nal for evi­dence that first quar­ter eco­nomic activ­ity and sta­tis­tics were worse than pro­jected in the exer­cise. Note, how­ever, that if they were designed with a pos­i­tive or opti­mistic bias, then the reg­u­la­tors who designed the Super­vi­sory Cap­i­tal Assess­ment Pro­gram (SCAP) wre/​are hor­ren­dously clue­less and incom­pe­tent, and that’s not out­side the realm of possibility.

As we wrote last month, we can’t imag­ine any­one design­ing a neg­a­tive bias into the tests; so, that means that, most likely, the gov­ern­ment sought an “hon­est” though not nec­es­sar­ily accu­rate assess­ment of each bank’s abil­ity to absorb addi­tional losses.

That was and is prob­lem­atic given the amount of pub­lic­ity gen­er­ated about the pro­gram. It would have been much bet­ter to per­form the tests in total secrecy – in what appeared to be a dis­jointed, dis­or­ga­nized, ad hoc, and unsys­tem­atic man­ner to belie any sense that a thor­ough inves­ti­ga­tion or com­pre­hen­sive and national approach was being under­taken. (They should have been stan­dard­ized but secret tests with no pub­lic­ity or acknowl­edge­ments of their existence.)

The three-​day delay in announc­ing their find­ings shows that the reg­u­la­tors – the Fed, the OCC, etc – were unpre­pared for the results. As we wrote back then, there was no sce­nario analy­ses of the stress test out­comes. For exam­ples, what will we do if four­teen banks require more cap­i­tal, all nine­teen, what about two giant ones, etc?

It’s another exam­ple of gov­ern­ment offi­cials being too rash and not thought­ful enough for their own – and the economy’s – sake. That’s why the road to hell is paved with good intentions.

When we find the time, we’ll expand this post later today or tomor­row, but the events of this week show that the government’s response to the Liq­uid­ity Cri­sis, which is, in fact, a cri­sis in con­fi­dence in finan­cial inter­me­di­aries, is no more thought­ful than its reac­tion to the Mort­gage Débâ­cle, and that pan­icked and over-​publicized response cre­ated the Liq­uid­ity Cri­sis in the first place.

Please, folks, first “do no harm,” which means that you have to think before act­ing or cal­cu­lat­ing. Now where have you seen that before?

Last week we wrote two related posts: A New Influenza Stress Test and Influenza Pan­demic Stress Test, Part II. Both posts dis­cuss the need for banks to per­form stress tests/​scenario analy­ses that incor­po­rate the pos­si­ble neg­a­tive eco­nomic effects of a flu pan­demic in addi­tional to con­sid­er­a­tion of pos­si­ble addi­tional struc­tural weak­nesses (and shrink­age) in the economy.

In the sec­ond post, we men­tioned a gov­ern­ment study from a few years ago that esti­mated a five per­cent con­trac­tion in GDP if the USA faced a severe pan­demic. (In our best Jack Nicholson/​A Few Good Men courtroom-​scene imper­son­ation, we ask: is there any other kind of pan­demic, Danny?)

In today’s edi­tion of The Wall Street Jour­nal, Robert J. Barro and Jose F. Ursula pro­vide addi­tional evi­dence of the pos­si­ble neg­a­tive effects of a pan­demic in Pan­demics and Depres­sions. In it they pro­vide esti­mates of the his­tor­i­cal costs of such out­breaks. Well worth reading.

We’ll have more to say about the stress tests in our next post. The past week’s events pro­vide evi­dence to con­firm one of our hypothe­ses from a post one month ago when we asked Where Will the Bank Stress Test­ing Exer­cise Lead?