Spero Consulting

Posts Tagged ‘adverse selection’

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.)

What Should It Mean to Earn a Master’s Degree?

We don’t answer that ques­tion here, but shouldn’t one be required to mas­ter something?

It Was a Mat­ter of Time

Since early Octo­ber, we’ve won­dered when we’d see the first edi­to­r­ial crit­i­ciz­ing MBAs and busi­ness schools for their role in the ongo­ing finan­cial cri­sis.¹ In our mind, much of the blame should be shared between busi­ness types, i.e., MBAs, and so-​called “quants,” with the major­ity of the blame placed on senior man­agers who per­mit­ted lax con­trols and mis­aligned incen­tives to exist.

We didn’t write about it when the thought orig­i­nally occurred to us nor dur­ing the inter­ven­ing six months-​or-​so, but we’ve been tempted to write on any num­ber of occasions.

Two events occurred last week that moti­vated us to write today. First, our excel­lent, for­mer TA, Brid­get Ardoyno, wrote to us that she has been blog­ging at http://​econ​mom​.blogspot​.com, and that reminded us of teach­ing MBAs (but in a good way).

The Main Shortcoming

The other event was the appear­ance of an excel­lent opin­ion col­umn, How Busi­ness Schools Have Failed Busi­ness, in last Friday’s edi­tion of The Wall Street Jour­nal. The col­umn, by Michael Jacobs, lists three main fail­ings of busi­ness schools with respect to the teach­ing and the cri­sis, but in fact, his three are all exam­ples of the lack of the qual­ity instruc­tion regard­ing con­trol and incen­tives.² Basi­cally, incen­tive issues are a type of con­trol prob­lem that arise in decen­tral­ized orga­ni­za­tion, where sub­or­di­nates are per­mit­ted a degree of auton­omy to act as they see fit.

The Root Causes

There is much to like about Mr. Jacobs’s crit­i­cism of busi­ness schools. How­ever, while we real­ize that edi­to­r­ial space is limited, he ignores the two main causes of the prob­lems that he iden­ti­fies: (1) poorly-​prepared stu­dents, and (2) an over-​emphasis on enter­tain­ment and teach­ing rat­ings that moti­vates instruc­tors to offer sim­plis­tic lessons at the expense of sub­stan­tive learn­ing. The first is related to the pathetic under­grad­u­ate edu­ca­tions most folks receive and the sec­ond is, well, an exam­ple of an incen­tive prob­lem. (We’ll get back to both of these below.)

Incen­tive Prob­lems Are Easy to Iden­tify, but Dif­fi­cult to Solve

Incen­tives prob­lems are as nat­ural and as old as recorded his­tory: every­body wants what they want. In the Old Tes­ta­ment, were Adam and Eve any­thing if not incen­tive prob­lems? Cain? We could go, but there’s no rea­son. All of the indi­vid­u­als were free to act in a decen­tral­ized set­ting, and failed to live up to their responsibilities.

In the New Tes­ta­ment, Jesus dis­cusses incen­tive prob­lems on any num­ber of occa­sions. Two of our favorites: (1) the para­ble of the faith­ful and unfaith­ful ser­vants (Luke 12:41 — 48) and (2) the para­ble of the good shep­herd, (John 10:11 — 13). All con­sider the fallen nature of man and his (com­pletely nat­ural) self­ish behavior.

That being said, there is not a more com­plex topic to address in busi­ness schools – or any type of school, for that mat­ter – than incen­tives. That’s because the topic involves social (or multi-​party) sit­u­a­tions where one needs to be able to pre­dict how another party will respond autonomously and freely to con­trol mech­a­nisms like com­pen­sa­tion schemes.

Many of our read­ers already know that deci­sions can be cat­e­go­rized as games against nature – single-​person decision-​theory – and games against oth­ers, i.e., game the­ory. Gen­er­ally – though not pre­cisely – one can think of the inves­ti­ga­tions in the nat­ural sci­ences as exam­ples of single-​person deci­sions and inves­ti­ga­tions in the social sci­ences as exam­ples of multi-​person deci­sions, e.g., how does one respond to a sur­vey so how should the researcher inter­pret that response?

Incen­tive or agency prob­lems – and infor­ma­tion eco­nom­ics prob­lems in gen­eral – can often be mod­eled math­e­mat­i­cally using game the­ory or sim­i­lar meth­ods. In many of these prob­lems of inter­est to busi­ness stu­dents, one decision-​maker – say, the supe­rior or prin­ci­pal – is attempt­ing to max­i­mize his own expected sat­is­fac­tion or prof­its while ensur­ing that (1) the other per­son – the sub­or­di­nate or agent – is will­ing to par­tic­i­pate with him (in the social set­ting like a firm or orga­ni­za­tion) and (2) with full knowl­edge that the sub­or­di­nate or agent will do what’s best for himself.

Those two con­di­tions – par­tic­i­pa­tion and incentive-​compatibility – con­strain the principal’s abil­ity to max­i­mize his own expected sat­is­fac­tion, and the lat­ter prob­lem is espe­cially vex­ing to solve because it means that one of principal’s con­straints is the other person’s opti­miza­tion prob­lem. How do you do what’s best for your­self while real­iz­ing that the other per­son is also behav­ing oppor­tunis­ti­cally (by doing what’s best for himself)?

Objec­tively mod­el­ing these issues as math­e­mat­i­cal prob­lems tends to require a rather high level of sophis­ti­ca­tion, and solv­ing the resul­tant prob­lem – or even know­ing when a math­e­mat­i­cal solu­tion exists – requires an even greater under­stand­ing of advanced cal­cu­lus, opti­miza­tion, real analy­sis, and other math­et­i­cal the­o­ries and tech­niques.³

Very few MBA stu­dents are pre­pared to tackle those top­ics (and their appli­ca­tions) at that level of understanding.

Our Root Causes, Again

A larger set of stu­dents can han­dle sim­pli­fied illus­tra­tions and exam­ples of prob­lems that tend to be more numer­i­cal in nature. Often, when taught in con­junc­tion with a math soft­ware pro­gram, they can gain a keen under­stand­ing of the sub­tle issues that arise in the study of incen­tives, e.g., pay­ing more for more out­put isn’t nec­es­sar­ily opti­mal nor incentive-​compatible.⁴

Unfor­tu­nately, the root causes that we iden­ti­fied above – igno­rance and selfishness/​greed – make it dif­fi­cult for most instruc­tors to offer and suc­cess­fully teach such a course to MBA students.

We’ll empha­size the stu­dents’ igno­rance and not the instruc­tors’; instead, we’ll focus on their selfishness.

Most MBA stu­dents are poorly pre­pared to think clearly, abstractly, and quan­ti­ta­tively, and that makes it a chal­lenge to teach them either (1) quan­ti­ta­tive sub­jects or (2) top­ics that can be effec­tively mod­eled, illus­trated, or explained in a quan­ti­ta­tive manner.

Incen­tive prob­lems fall into the lat­ter cat­e­gory. (What we’d call) sim­ple math­e­mat­i­cal or numer­i­cal mod­els pro­vide (by def­i­n­i­tion) abstract illus­tra­tions of par­tic­u­lar phe­nom­ena and behav­iors. They’re rarely solu­tions to real world problems.

Most MBA stu­dents are not sophis­ti­cated enough to han­dle that dis­tinc­tion; they want recipes, not thought processes, and recipes are eas­ier to teach and grade. It’s not because the stu­dents are stu­pid, but it often is because they were poorly-​trained as under­grad­u­ates and in require, core classes. Per Mr. Jacobs’s essay, there’s gen­er­ally not much evi­dence of profs teach­ing compensation-​related recipes in busi­ness schools because of the lack of rel­e­vant incentive-​related courses. Thatt’s evi­dence of absence (of the courses), rather than an absence of evidence.

There’s much more evi­dence of that behav­ior in finance classes, where stu­dents want recipes for val­u­a­tion. They’ll take abstract mod­els, with either unre­al­is­tic assump­tions or very, very spe­cial­ized assump­tions and unwit­tingly (and unknow­ingly) treat them as very prac­ti­cal and pre­cise meth­ods that cal­cu­late the one true value of the thing.

Unfor­tu­nately, they’re often encour­aged to do so by their pro­fes­sors because it’s much eas­ier to teach numer­i­cal – though irrel­e­vant or mis-​specified – recipes than it is to teach (and grade) thought processes.

In fact, that ten­dency to dumb-​down teach­ing even extends to some fac­ulty mem­bers’ research agen­das. Dur­ing our aca­d­e­mic career, we attended any num­ber of sem­i­nars where we heard the pre­sen­ter jus­tify his or her overly-​simplistic and vac­u­ous model by argu­ing that “we want to be able to explain it to MBA students.”

Imag­ine if med­ical research were con­ducted in the same man­ner? Or any seri­ous field of inquiry for that matter?

From our per­spec­tive, it’s com­pletely ass-​backwards (and, in fact, its pres­ence goes par­tially to explain why we’re in the pri­vate sec­tor, today).

In an ideal words, the ped­a­gog­i­cal empha­sis would be on edu­cat­ing the stu­dents by attempt­ing to pull-​them-​up to a level that they had not antic­i­pated nor even known existed, and not pre­sent­ing dumb-​downed “research” papers for enter­tain­ment or pre­tense, but, hey, the lat­ter alter­na­tive is easy, and one can gen­er­ally gar­ner higher teach­ing rat­ings by not chal­leng­ing the stu­dents, espe­cially if that per­spec­tive and tech­nique is per­va­sive within the school. (We knew any num­ber of fac­ulty mem­bers at very expen­sive and seem­ingly pres­ti­gious insti­tu­tions who would pro­vide “sam­ple” or “prac­tice” exams before test dates – the actual exams would have slightly-​changed num­bers; who would sched­ule fre­quent guest speak­ers because “the stu­dents like it (and we don’t have to pre­pare);” and would show videos of fac­to­ries or what­ever once per week because, again, “the stu­dents like it (and we don’t have to pre­pare).” (Geez, it’s almost enough to make one cynical.)

Any­way, that com­bi­na­tion of poor prepa­ra­tion of most stu­dents and the mis­aligned incen­tives of b-​school pro­fes­sors make true learn­ing about these thorny and dif­fi­cult (social) prob­lems, which all firms and orga­ni­za­tions face, nearly impos­si­ble to achieve.

Why It’s Dif­fi­cult to Teach about Incen­tives Issues

It’s not just the math­e­mat­i­cal nature of the most com­pelling mod­els of incen­tives that makes teach­ing dif­fi­cult. It’s also because the prob­lems are not par­tic­u­larly robust. By that we mean, illus­tra­tions and exam­ples must be care­fully (and empa­thet­i­cally) con­structed, or they’re either (1) extremely stu­pid and un-​insightful, or (2) extremely spe­cial­ized, detailed, and so qual­i­fied (by assump­tions) that they need a very high degree of math­e­mat­i­cal under­stand­ing to com­pre­hend and solve (and they end-​up say­ing very lit­tle, anyway).

The fer­tile mid­dle ground requires instruc­tors and stu­dents to pos­sess a rather high level of eco­nomic rea­son­ing and strong math skills. We’ll avoid crit­i­ciz­ing instruc­tors, here, but unfor­tu­nately, many MBA pro­grams have de-​emphasized, elim­i­nated, or con­sol­i­dated micro­eco­nom­ics courses, and those courses are (or were) the best place to develop the req­ui­site level of eco­nomic rea­son­ing. In those courses and well-​designed incen­tives courses, there is no sub­sti­tute for a lot of hard work.

By the way, we unsuc­cess­fully tried to estab­lish just such a Con­trol & Incen­tives course at our last aca­d­e­mic employer, but there were no required econ courses and only a few very moti­vated, very curi­ous, or previously-​trained stu­dents would enroll in the elec­tive. (Too much work!) As a pub­lic ser­vice, we’ll attempt to put that course mate­r­ial on-​line in the near future.

But Dif­fi­culty Is Really No Excuse

It’s up to trustees and deans to ensure that schools and pro­fes­sors edu­cate MBAs, rather than attempt to be “pop­u­lar.” That’s true at both the indi­vid­ual level and the sum of the indi­vid­ual lev­els, i.e., the school level, where administration’s allow them­selves to be sub­jected to the whims of Busi­ness Week writ­ers and sur­vey respon­dents. As a fac­ulty mem­ber, we won our share of teach­ing awards while try­ing to do the right thing; so, there’s no sour grapes here, and we know that it can be done; how­ever, we sus­pect that the short-​term empha­sis will not change. There’s too much iner­tia and very lit­tle confidence.

From our self­ish per­spec­tive, it’s not as bad as it seems because that gen­eral fail­ure to learn and teach presents many oppor­tu­ni­ties for con­sul­tants who under­stand both incen­tives and risk – peo­ple like our­selves. (We’ve writ­ten exten­sively about both issues, espe­cially as they per­tain to the cur­rent finan­cial cri­sis. Please search the archives if you’re inter­ested. Our Illus­tra­tions dis­cuss many of these issues, too.)

Are you sure that your firm or orga­ni­za­tion isn’t about to do some­thing stu­pid with incen­tive pay or claw­backs or whatever?

We’ll likely con­tinue to revise and edit this post in the near future. (It’s long and there’s prob­a­bly a few typos, but then TQM is rarely optimal.)

Copy­right © 2009 Spero Consulting.

Foot­notes:

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

Reg­u­la­tors as wise monkeys.

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

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

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

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

Incen­tive Problems

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

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

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

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

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

Sunk Cost Fallacy

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

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

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

How It Relates to Regulation

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

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

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

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

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

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

Reg­u­la­tion as a Crutch (Causes Atrophy)

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

In today’s (Novem­ber 26) edi­tion of The Wall Street Jour­nal, there is a Deal Jour­nal arti­cle enti­tled, “Paul­son Plan: ‘Truly Idiotic.’”

Although we’ve not gone that far in describ­ing TARP et al, we’ve been harshly crit­i­cal of Mr. Paul­son. In fact, we’ve men­tioned that his series of actions don’t seem to con­sti­tute an actual plan, because the word “plan” implies a cer­tain degree of, well, plan­ning or fore­sight and forethought, and those pre­req­ui­sites seemed absent in his Panic of ’08.

The quoted accuser in the Deal Jour­nal arti­cle is Charles Calomiris, a prof at Colum­bia, and he make sev­eral good points, includ­ing “we’re using half-​measures designed in an inap­pro­pri­ate way,” and “The prob­lem is the com­pletely opaque dis­tri­b­u­tion of losses because no one knows how to value these mort­gage losses.”

We’ve made sim­i­lar remarks any num­ber of times, and it is exactly those opaque joint dis­tri­b­u­tions of cash flows (and there­fore losses) that cause all the trou­ble and makes the pools impos­si­ble to value with any degree of precision.

While we do agree with his crit­i­cism, we don’t agree with his rec­om­men­da­tions. Pri­mar­ily his sug­ges­tion that “the gov­ern­ment offer to buy any mort­gage for 40 cents on the dollar.”

It is unclear how the 40% solu­tion is derived, and think­ing in terms of Akerlof’s Lemons Model, you can be sure that only one type of mort­gage would be offered: one with a value between zero and 40% of face value.¹ Thus, if the gov­ern­ment com­mits to pur­chase any mort­gage, it would cer­tain over-​pay, and thus sub­si­dize the worst cases, and if the gov­ern­ment does not com­mit, then it is likely the mech­a­nism would fail with few or any trans­ac­tions. (The dif­fi­culty of valu­ing the mort­gages does com­pli­cate mat­ters as does their cur­rent book value.)

Why not try a pri­vate solu­tion? Why not offer mort­gage invest­ment tax cred­its or per­mit imme­di­ate and accel­er­ated amor­ti­za­tion (depre­ci­a­tion) of the pur­chase price of those mort­gages and mortgage-​related secu­ri­ties for prospec­tive buy­ers? Then set low tax rates for prospec­tive real­ized cash flows.

We’re sure that many buy­ers have some val­u­a­tion model, but likely (and jus­ti­fi­ably) do not trust it. Giv­ing a 30% — 40% tax break should pro­vide them with an ample cush­ion to take a chance. How could such a plan be any worse than a government-​administered plan, or a government-​regulated, fixed-​price one? (Remem­ber the government’s suc­cess at other attempts at price con­trols: both sup­ports and ceilings.)

By the way, folks who think this Thanks­giv­ing week’s mini-​rally sig­ni­fies that the worst is over are likely to be sadly mis­taken. We do hope that we’re wrong, but doubt it.

Noth­ing has solved the over­whelm­ing prob­lem that the mar­kets do not trust the large finan­cial inter­me­di­aries, and those banks do not trust each other. The mort­gage cri­sis informed about the banks’ short­com­ings; so, solv­ing that mort­gage cri­sis won’t cause any­one to believe that the bank’s judg­ment has improved – at least for quite some time. In that respect, Mr. Calomiris is quite right. Mr. Paul­son has done noth­ing to help.

Thank god we live in a coun­try that can with­stand such epic mis­man­age­ment. What was the total $7.5 trillion?

(New read­ers can search the archives from the past sev­eral months to find many related articles.)

Note: We’ll likely expand and edit this post in the morn­ing, but wanted to cir­cu­late the idea before bedtime.

We’re rather dili­gent – but not obsessed– about keep­ing up with finan­cial new.¹ We’ve heard many finan­cial firms announce lay-​offs and have read how at a few, like Gold­man, senior man­agers have decided to forgo bonuses.

As we recall, most banks have announced with­drawals from sub­prime mort­gage orig­i­na­tion and loans, which seems like a wise move, but given the mag­ni­tude of their errors and mis­takes, we’re very sur­prised that we haven’t read more about banks tak­ing dra­matic and dras­tic actions to limit risks and exposures.

We don’t mean hoard­ing cash and the knee-​jerk reac­tions not to lend. We’re think­ing more about their invest­ing, trad­ing, and struc­tur­ing operations.

Maybe the banks are elim­i­nat­ing desks and floors, but they just aren’t talk­ing about it, or maybe they have men­tioned it, but we’ve missed it.

We’d cer­tainly encour­age finan­cial firms to change their ways. In fact, while we’re close to Lib­er­tar­ian on many eco­nomic issues, we wrote on Octo­ber 11, to Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions as a way to mit­i­gate moral haz­ard and pro­tect tax-​payer interests. (Once they’re insured, it is no longer a free mar­ket, and there should be quid pro quo, not just subsidization.)

On Sep­tem­ber 24, in our post Could a “Bailout” Pro­long the Finan­cial Cri­sis?, we wrote:

So, if the government’s pur­chase of these thin­gies is approved, we would expect to see a con­tin­u­a­tion of the pan­icky behav­ior until the secu­ri­ties are actu­ally trans­ferred to the gov­ern­ment because it is unlikely that any­one will know who has the worse ones so (means that) all remain sus­pect. (Also note that the most pan­icky firms might be ones who are pro­ject­ing their port­fo­lios onto oth­ers, and so might be the ones that other firms would like to avoid.)

Now that the TA is out of TARP, it seems that this week’s equity mar­ket per­for­mance, par­tic­u­larly among finan­cial firms, sup­ports our Sep­tem­ber 24^th pre­dic­tion above, i.e., the con­tin­u­a­tion of pan­icky behav­ior until actual trans­fers occur. We dis­cussed related issues on Octo­ber 7, in Even A Per­fect Bailout Will Fail.

Or maybe they’re just tak­ing a wait-​and-​see approach. That’s what we pre­dicted in early Octo­ber when we described the very high prob­a­bil­ity of fail­ure of TARP.

Today’s Wall Street Jour­nal reports that Citi Weighs Its Options, Includ­ing Firm’s Sale, and we won­der if it will sur­vive the weekend.

As we argued in Big­ger Is Not Nec­es­sar­ily Bet­ter way back in Sep­tem­ber, we see no rea­son to encour­age mega-​mergers and we based that argu­ment on both moral haz­ard and sys­tem­ati­za­tion of idio­syn­cratic risk considerations.

So, as we argued in around Octo­ber 10, we believe that It’s Time! to nation­al­ize the worst offend­ers leav­ing no share­hold­ers, except non-​executive employ­ees, with any own­er­ship inter­ests. We reit­er­ated much of the same argu­ment in a very long post from Wednes­day: OMG, Mr. Paul­son Agreed with Us Twice in One Week! (Yeah, we have a teenager.)

It seems that given its size of around $2,000,000,000,000, we tax­pay­ers will be on the hook for Citi, any­ways, so why not elim­i­nate the mid­dle­man and pro­vide any upside ben­e­fit to the true resid­ual claimants?

In two recent posts, The Fail­ure of Boards to Direct and When the Going Gets Tough…Quit, we’ve crit­i­cized the com­po­si­tion of Citigroup’s board because of their gen­eral lack of finan­cial indus­try expe­ri­ence. (We’re sorry, but that seems uncon­scionable to us.)

We won’t repeat all of our argu­ments for nation­al­iza­tion, but the expro­pri­a­tion of Cit­i­group would cer­tainly moti­vate other banks to act quickly and largely to mit­i­gate risks and sta­bi­lize cash flows. (It would likely stop insur­ance com­pa­nies and oth­ers from buy­ing small banks or S&Ls in their beg­garly attempts to become bank hold­ing companies.)

By the way, for new read­ers, we’re not just for the nation­al­iza­tion of a few banks, we actu­ally have a pri­vate solu­tion for the mort­gage cri­sis that involves pro­vid­ing the right tax incen­tives – like invest­ment tax cred­its – to indi­vid­u­als, firms, and fund man­agers. (Read about it here: A Bet­ter Solu­tion (than a gov­ern­ment takeover).)

That solu­tion to the mort­gage cri­sis stills leaves the larger liq­uid­ity or con­fi­dence cri­sis for banks. That has arisen because the mort­gage cri­sis has informed us (and oth­ers) that despite their pseudo-​sophistication and the veneer of objec­tiv­ity and sci­ence (almost), there is a very good chance that they don’t under­stand their envi­ron­ment or have reli­able ways to value many of their prod­ucts – despite their mas­sive invest­ments and activ­i­ties for those pur­poses. In terms of an adverse selec­tion prob­lem, they’ve reveal them­selves to be low types. (See last week’s Global Warm­ing and the Mort­gage Cri­sis for a dis­cus­sion on that topic.)

So, as a nation, we should want (and attempt to moti­vate) the banks to act quickly and deci­sively (and with their pri­vate infor­ma­tion) to get their accounts in order.

The ben­e­fits of TARP don’t seem to have pro­vided the cor­rect moti­va­tion to the bank­ing firms to act to main­tain their own liq­uid­ity and cap­i­tal posi­tions. We’d argue that this is an incen­tive prob­lem and that if the ben­e­fit of the TARP “car­rots” have been insuf­fi­cient moti­vate socially-​optimal behavior. So, per­haps a “stick,” like the threat of expro­pri­a­tion, induce clean-​up. More­over, it is seems that Citi will be ours any­way, so, why not give it a try on tax­pay­ers’ terms rather than tax­pay­ers’ backs?

What Hope of Suc­cess with Typ­i­cal Bureau­cratic Efficiency?

We have crit­i­cized the “$700 bil­lion” fed­eral bailout of banks for the past two weeks and have done so for a vari­ety of rea­sons. (We used the scare quotes to denote the unre­li­a­bil­ity of the esti­mate, which seems to have been grasped from thin air.) We won’t cite all of the rea­sons for its likely fail­ure, because in this post, we’ll sup­pose that the “bailout” is per­fectly executed.

Would such per­fectly exe­cuted plan return us to the pre-​crisis, hal­cyon days of early 2007? No! To any­thing close to it? No.

Sup­pose that each and every crappy mort­gage, mortgage-​backed secu­rity, and CDO held by a com­mer­cial bank is pur­chased by the gov­ern­ment at a fair price, and so, let’s sup­pose that the banks have $700 bil­lion in cash instead of semi-​worthless thin­gies that they may or may not understand.

Now, under such an incred­i­bly for­tu­nate cir­cum­stance, would the dear reader have con­fi­dence in those banks? Would he or she have more con­fi­dence or less con­fi­dence in the bank that sold the most thin­gies to the Treasury?

This first rea­son explain­ing the bailout’s likely inef­fec­tive­ness is a “types” argu­ment. They’re lower types than we thought. 

We now know that many banks made a tremen­dous num­ber of very, very costly mis­takes and mis-​estimations dur­ing the past sev­eral years. Thus, they now seem sub­stan­tially less capa­ble they did two years ago. (Does any reader think more highly of the banks today than in, say, 2006?) The cap­i­tal mar­kets depart­ments, boards, senior man­agers, traders, risk man­agers, and trea­sur­ers seem less able today than one or two years ago.

More­over, it is not just the losers. We recall a con­ver­sa­tion with a for­mer trader and cur­rent risk man­ager whose bank seems to have avoided many pit­falls that have dam­aged or destroyed other insti­tu­tions. When asked why it was so for­tu­nate, he replied, “it wasn’t due to any com­pe­tence. In fact, it was quite the oppo­site. They had planned to be just like their peers but were inca­pable of exe­cut­ing it (the plan).” So, it seems that there are rea­sons to sus­pect the non-​losers, too.

So, we ask, do you trust the banks with $700 Bil­lion in new cash or do you think they will waste it or take exces­sive risks? Have they done any­thing to earn to earn your trust, and is there any­thing in place, like revised incen­tives schemes, that would indi­cate a change in phi­los­o­phy and an improve­ment in control?

Sec­ondly, we now know that for many banks, a sub­stan­tial por­tion of their pre-​2008 earn­ings were bogus. As those assets were los­ing value, the banks were rec­og­niz­ing income on them. Much of those earn­ings have now been reversed via losses, and it is likely that addi­tional losses will be rec­og­nized in the next two quar­ters. (Recall: we’re assum­ing that the assets trade at a fair price.) So, we know that the banks’ future earn­ings will not return to pre-​2008 lev­els, and it is unlikely that their equity base and cap­i­tal lev­els will per­mit lend­ing and invest­ing at those past lev­els. More­over, where will they invest? In real-​estate? In sum, we expect lower earn­ings for the fore­see­able future.

Thirdly, all of these points should be known – at least, col­lec­tively – by the sur­viv­ing banks. As we wrote (tongue-in-cheek) in Finan­cial Pro­jec­tion in a Cri­sis, if banks project their own abil­i­ties onto their peers, they may con­tinue to be sus­pect of each other thereby keep­ing the credit mar­kets “frozen.” How much does the dear reader trust them beyond the $100,000 or $250,000 deposit insur­ance limit?

Fourthly, with the mega-​consolidations, and an asso­ci­ated too-​big-​to-​fail mentality, moral haz­ard becomes an issue that exac­er­bates these sus­pi­cions. Will these mega-​banks take out­sized risks know­ing that the gov­ern­ment will cover losses? Will the gov­ern­ment cover such losses? So, how long will it takes banks to trust each other, now that there are fewer trad­ing part­ners? (Will banks trust the debt rat­ing agencies? Do you?)

Finally, does the reader imag­ine that once the cri­sis recedes, the fed­eral gov­ern­ment will vol­un­tar­ily give up con­trol of the new por­tion of the econ­omy that it con­trols? Gen­er­ally, to induce the gov­ern­ment to shrink requires, if not a lit­eral rev­o­lu­tion, at least a fig­u­ra­tive one, e.g., the Rea­gan Rev­o­lu­tion. With­out such a rev­o­lu­tion, what hope does the econ­omy have with more gov­ern­ment interference?

Those look­ing for reg­u­la­tion as a solu­tion should note that invest­ment banks and large com­mer­cial banks were already heav­ily reg­u­lated. Most reports to senior man­age­ment and the board of direc­tors are also sent to the reg­u­la­tors, who may ques­tion them. Did the reader not in the indus­try know that those regulators, maintain per­ma­nent offices in each bank’s head­quar­ters and are almost like employees?

Besides read­ing such reports, the reg­u­la­tors also con­duct fre­quent exam­i­na­tions, and, of course, they did so repeat­edly dur­ing the past sev­eral years. Did they catch any­thing? More­over, as we’ve writ­ten in the past, do they have the incen­tive to do so? Or would the dis­cov­ery of an risky issue merely show that they had missed it in a pre­vi­ous year?

Also, remem­ber that Fan­nie Mae and Fred­die Mac were heav­ily reg­u­lated, too. Many mem­bers of Con­gress, e.g., Bar­ney Frank, et. al., wanted less reg­u­la­tion for those two gov­ern­ment spon­sored enti­ties. When will faith in such enti­ties be restored? When will Con­gress have an approval rat­ing above 20%? (With­out search­ing to ver­ify it, as low as Mr. Bush’s approval rat­ing is, we don’t being that Congress’s is even 50% of it: some­where between one-​third and one-​half.)

As we under­stand it, while “Spero” is not an Ital­ian name, the word means “to hope” in Latin. We’re think­ing about chang­ing it to some­thing more real­is­tic when we com­ment on the bailout. Why not try our solu­tion: A Bet­ter Solu­tion (than a gov­ern­ment takeover)?

We might add to and revise this post through time.

in a Mark-​to-​Market Account­ing Régime.

Here’s a cou­ple of related issues that we can dis­cuss in the con­text of today’s The Wall Street Jour­nal arti­cle, Bailout Pro­posal Gets Hung Up Over Cen­tral Issue: Will It Work?

We’re deeply con­cerned about the moral haz­ard impli­ca­tions of any gov­ern­ment bailout, and we doubt that we are the only observer to har­bor such dark thoughts. How­ever, we also think that those impli­ca­tions could be real­ized imme­di­ately rather than, say, dur­ing the “next” down­turn in some far dis­tant time. Thus our pes­simism grows as does our annoy­ance with the fed­eral offi­cials who have pro­posed mas­sive snd expen­sive actions with­out suf­fi­cient lev­els of thought.

In that respect, can the reader say, “com­mer­cial real-​estate loans and CMBS?” And, does the reader know that illiq­uid CMBS – that’s redun­dant by the way-​is very dif­fi­cult to value, too? Not much dif­fer­ent than CDOs of MBS. We com­mented on some of those val­u­a­tion issues three months ago in this post: On Nedges and Sledges and Paving the Road to Hell.

We men­tion CMBS because we saw in the ref­er­enced arti­cle that many banks, not just the ail­ing ones, are try­ing to round-​up every­thing they don’t want, i.e., crappy loans and secu­ri­ties, to make it avail­able for sale to the government.

Can you, dear reader, blame the banks? We can’t. We’d cer­tainly like the feds to buy our Sub­ur­ban at its his­tor­i­cal cost, too. Mr. Paul­son are you listening? Can you help me, here?

As the arti­cle men­tions, it turns out that the banks would rather sell these items at their cur­rently marked val­ues than be forced to pos­si­bly devalue them at the end of the next report­ing period, which hap­pens to be next Tuesday.

It is prob­a­bly too late, so we doubt that it will hap­pen on Mon­day, but we could see a banker try­ing to con­vince a gov­ern­ment bureau­crat that the bank’s mark from June is still the best guess of where an item sells (if it were to sell to any­one in the mar­ket that doesn’t exist.)

We could also see the bankers’ expec­ta­tions of the sales (to the gov­ern­ment) to color their val­u­a­tions next week. As we wrote yes­ter­day in The Uncer­tain Value of Mort­gage Secu­ri­ties that expec­ta­tion will likely lead to greater adverse selec­tion prob­lems because of the pos­si­ble increase in the uncer­tainty regard­ing the value of each bank’s assets. In our view, this will exac­er­bate, not mit­i­gate, the cur­rent pan­icky behav­ior among banks as they deal with each other (until such exchanges with the gov­ern­ment actu­ally occur). How­ever, we could see it lead­ing to prob­lems after the bailout, too.

With that in mind, we ask the dear reader to guess the mul­ti­ple of $700 bil­lion that banks have iden­ti­fied as assets they’d like to sell? We’re guess­ing a mul­ti­ple of at least three – a few tril­lion dol­lars worth – with a sub­stan­tial amount of CMBS and inven­to­ried, pipelined, com­mer­cial mort­gages thrown into that mix. (Those are loans that con­duits made and planned to bun­dle into secu­ri­ties but are cur­rently stuck with because no one wants the CMBS that would be struc­tured from them.) Does the reader believe that only homes were over­built in for­mer boom towns?

So, for argument’s sake, and to be excru­ci­at­ingly pre­cise, let’s say that we are cor­rect that the bank’s col­lec­tively think that they’ll be able to sell $2.1 tril­lion worth of thin­gies to the gov­ern­ment at prices that the banks like. How will take affect next week’s third quar­ter val­u­a­tions, and what will hap­pen when they’re stuck with $1.4 tril­lion of stuff that they wish the gov­ern­ment had bought?

And that leads us to our sec­ond issue about the nature of dis­jointed and illiq­uid mar­kets and how a lit­tle infor­ma­tion can hurt a lot. You see, in social sit­u­a­tions, more infor­ma­tion is not nec­es­sar­ily better.

The fact that no one wants to buy the stuff doesn’t mean that there aren’t a lot of firms hold­ing sim­i­lar secu­ri­ties. So, let’s say that 20 firms are hold­ing a part of a par­tic­u­lar illiq­uid CDO issue or CMBS issue or what­ever it is that no one else wants.

If the thing is illiq­uid then – nowa­days – that means it’s not traded at all; so, there is no observ­able price; so, it is likely that the cur­rent marks vary across the 20 firms because they are all using slightly dif­fer­ent mod­els or all have slightly dif­fer­ent – albeit, likely inflated – expec­ta­tions of what a sale to the gov­ern­ment will bring.

All things equal, it would seem to us that the most des­per­ate firm would accept the low­est price offered by the Trea­sury. Again, all else equal, that’s usu­ally how its works; oth­er­wise, we have to add an adverse selec­tion argu­ment, too.

If that is true, then depend­ing upon how much of the issue the Trea­sury pur­chases, that low­est price is now an observ­able “mar­ket” price for the other 19 firms, and that’s not good with mark-​to-​market account­ing where a lit­tle bit of infor­ma­tion, based pos­si­bly upon one firm’s des­per­a­tion sale to the gov­ern­ment set the new (likely lower) mark for the other 19 firms. It might be infor­ma­tion and it might be the truth, but it cer­tainly wouldn’t help soci­ety. More infor­ma­tion isn’t always better.

That means addi­tional write-​downs may be forth­com­ing from, say, the other 19 firms. If that issue is part of our hypoth­e­sized $1.4 tril­lion above, then those write-​downs in the future after the gov­ern­ment pur­chase will be larger than they would have oth­er­wise been with­out the bailout. Of course, that’s based upon our argu­ment that the book val­ues of the issues would be higher than they oth­er­wise would have been (due to each bank’s antic­i­pa­tion of sell­ing to the gov­ern­ment at an inflated price). Such a sce­naroi would lengthen the dura­tion of the cri­sis and neg­a­tively influ­ence the behav­ior of the firms when they lend to each other in the near term. There will be more pan­ics that occur far­ther into the future.

Is this all idle spec­u­la­tion? Of course, we were a the­o­rist in col­lege. Are we wrong? It is quite pos­si­ble – the chair­man men­tions that it often hap­pens – but we doubt it in this case. Let us know what you think.

A few days ago we read an arti­cle – it was likely in The Wall Street Jour­nal–where a trader from Chicago com­plained about a ques­tion that Ohio Sen­a­tor Sher­rod Brown asked of either Mr. Paul­son or Mr. Bernanke; we don’t recall to whom it was directed.

Sen­a­tor Brown had asked some­thing to the effect of: at what price will these secu­ri­ties sell, i.e., be pur­chased by the Trea­sury? The trader com­plained that it was a stu­pid ques­tion because Sen­a­tor Brown should know that no one knows the price. We chuck­led. We know noth­ing about Sen­a­tor Brown, other than he is from Ohio and is prob­a­bly a Demo­c­rat, but we thought: dear trader, that is EXACTLY why he asked the ques­tion so that appointee would have to pub­licly admit as much.

In that spirit, yes­ter­day we asked, Could a “Bailout” Pro­long the Finan­cial Cri­sis? because the prospect of sell­ing mortgage-​related secu­ri­ties to the gov­ern­ment intro­duces addi­tional uncer­tainty into pos­si­ble val­u­a­tions (and there­fore into the “mar­ket­place”). Uncer­tainty that could be par­tially elim­i­nated – at least for the com­mer­cial banks – via their third quar­ter marks next week.

More­over, this afternoon’s news that Con­gress has agreed – not voted, yet, but agreed – to pro­vide the funds in stages will not help mat­ters and, per our think­ing, should worsen them. Such a long, drawn-​out process will cre­ate addi­tional uncer­tainty and dis­trust among lenders – not to indus­trial firms or con­sumers but to each other – so, expect more pan­icky days and mini-​runs and Chicken Littles.

In today’s (Sep­tem­ber 25) The Wall Street Jour­nal, we see that Peter Eavis and David Reilly make a sim­i­lar point about uncer­tainty in the Heard on the Street Finan­cial Analy­sis and Com­men­tary Sec­tion: Bailout’s Flaw of Large Num­bers.

In addi­tion, they make the same point that we have made about the nature of the bailout. If it is a fair exchange, the banks are only mar­gin­ally better-​off because they have a more liq­uid asset – cash – rather than one of those thin­gies (that most board mem­bers can’t explain). If it is an unfair exchange, the banks may be bet­ter cap­i­tal­ized, but then the gov­ern­ment is over­pay­ing: see last night’s post in response to the President’s speech: Sorry Mr. Bush, We Respect­fully Dis­agree. As they note, the banks need pri­vate cap­i­tal, and as we note it is not in short sup­ply: look at Mr. Buf­fet, pri­vate equity’s inter­est in com­mer­cial banks, hedge funds, etc., and also look at the low lev­els of Trea­sury yields. (Yeah, we know about flights to “qual­ity,” too.)

Lastly, in any num­ber of posts, we’ve dis­cussed how the losses in this cri­sis seem to be highly con­cen­trated within cer­tain seg­ments of the finan­cial indus­try. Two other columns in today’s issue pro­vide fur­ther sup­port for our conjecture.

In the same Heard on the Street sec­tion, Liam Den­ning writes in Earn­ings Reports: The Audac­ity of Hope that con­sen­sus, expected growth of cumu­la­tive S&P 500 earn­ings will be flat for 2008 (over 2007) and 25% higher in 2009. In fact, ana­lysts esti­mate that finan­cial sec­tor should make more next year than in 2007, which wasn’t a bad year. (Of course, we know that these ana­lyst esti­mates needs to be taken with a grain of salt the size of Lot’s wife.)

On the edi­to­r­ial page, Andy Kessler makes a sim­i­lar point about the con­cen­tra­tion in his essay, The Paul­son Plan Will Make Money for Tax­pay­ers: “Even­tu­ally and stu­pidly, these insti­tu­tions owned them for them­selves – lots of them, often at 30-​to-​1 lever­age.” That’s the prob­lem with hubris. Some­times you can’t help falling in love with your­self, eh, Nar­cis­sus. (Of course, we don’t care that on a time-​value of money basis, the plan makes money for tax­pay­ers. If that is true, it could make money for pri­vate investors, too, who are more will­ing than even the democ­rats to extract a proper pound of flesh, er, we mean a dilu­tion in own­er­ship (per Gold­man and War­ren Buffett.)

We’re a few days late, but we think that five days with­out elec­tric­ity is a wor­thy excuse to cover our tardiness.

There was a nice arti­cle in Tuesday’s (9÷16) WSJ about Best Buy’s use of inter­nal pre­dic­tion mar­kets: Best Buy Taps ‘Pre­dic­tion Market.’

The goal behind the pro­gram is to elicit employ­ees’ pri­vate infor­ma­tion about the prob­a­bil­i­ties (and esti­mated mag­ni­tudes) of suc­cesses (or failures) of var­i­ous cor­po­rate initiatives.

We heartily applaud Best Buy’s pro­gram as both a way to (1) accomplish that goal of elic­it­ing that pri­vate infor­ma­tion and per­sonal beliefs with­out fear of reper­cus­sion, and (2) aggre­gate and con­sol­i­date that infor­ma­tion via an imag­i­nary mar­ket price in its pre­dic­tion mar­ket­place. (Pro­vided those prices are prop­erly inter­pret­ted by senior man­age­ment.) In par­tic­u­lar, Best Buy seems to have found an inex­pen­sive way to gain geographically-​dispersed infor­ma­tion with­out any threat of retal­i­a­tion against the bearer(s) of bad news, and that is quite an accomplishment.

In a some­what dif­fer­ent vein, we’ve often won­dered why other firms – par­tic­u­larly finan­cial ser­vice firms – haven’t tried sim­i­lar pro­grams. For bud­getary pur­poses, many such firms seem to pre­fer to trot out a chief-​economist to pro­vide base-​line eco­nomic pre­dic­tions, and while many such folks may be tal­ented indi­vid­u­als, they are some­times housed in mar­ket­ing (sales) depart­ments; so, it is not clear where their exper­tise lies. 

Why not sup­ple­ment their fore­casts with, say, trad­ing or invest­ment man­ager exper­tise and opin­ion in a sim­i­lar, infor­mal way? Why throw-​away the aggre­gate, day-​to-​day expe­ri­ences or obser­va­tions of tens, hun­dreds, or pos­si­bly thou­sands of indi­vid­u­als when deter­min­ing likely mar­ket sce­nar­ios? We think that such inter­nal mar­kets are excel­lent infor­mal and indi­rect ways to effi­ciently accu­mu­late small bits of infor­ma­tion that var­i­ous indi­vid­u­als may possess.

Going beyond the scope of Best Buy’s mech­a­nism, for cer­tain firms, we think it would be worth­while to keep track of cer­tain man­agers’ pre­dic­tions as a way to keep things a bit hon­est, and as a way to account for oppor­tu­nity costs, i.e., the road not taken. So, unlike at Best Buy we’d argue that for cer­tain senior man­agers it would be worth­while to hold them account­able for their pre­dic­tions because they have such large impli­ca­tions for the firm.

For exam­ple, we recall senior man­agers at one firm choos­ing to “under-​invest” in fixed-​income assets because they were con­vinced that “rates are going up.” By that state­ment they pri­mar­ily meant that the returns on Trea­suries with matu­ri­ties from two years to ten years would rise (and rise substantially).

That was five years ago, and despite some fluc­tu­a­tions up-​and-​down rates aren’t that much dif­fer­ent than in the sum­mer of 2003. Consider that two-​year, three-​year, and five-​year notes pur­chased in 2003 would have matured by now – at least once – and the oppor­tu­nity cost (of the lost inter­est income) could be sub­stan­tial, espe­cially when the yield curve is steep.

From what we’ve observed, it seems that when there is no account­abil­ity for senior man­age­ment pre­dic­tions, it is much eas­ier to develop “group think” because such pre­dic­tions were well-​publicized are well-​publicized with firms. For exam­ple, every­one we spoke with – even within mar­ket risk man­age­ment – was con­vinced that rates were going to rise: “we all know rates are going up.” (Being rather skep­ti­cal our reply was con­sis­tent: if that is so, shouldn’t rates have risen already?) More­over, if that were the case – that rates were cer­tain to rise – then there would be lit­tle need for risk man­age­ment. It would be bet­ter to fire every­one and sell short as many longer-​dated bonds as possible.

We recall another firm that seemed to have – or at least pub­li­cized – a sim­i­lar con­vic­tion. At the time, they issued medium-​term debt at what seemed to be a unbelievably-​low, fixed inter­est rate. Man­age­ment imme­di­ately swapped the fixed-​rate pay­ments to float­ing rates. We asked about the incon­sis­tency between the view that rates were going to rise and the swap to float­ing rates and were told “That’s what banks do; they swap their fixed-​rate debt to floating-​rates.” So much for putting your money where your mouth is.

By the way, there is noth­ing incon­sis­tent between our views of what’s best for Best Buy and what’s best for the other firms men­tioned here. It depends upon who’s pri­vate infor­ma­tion and beliefs the firm is try­ing to elicit. In fact, both schemes could oper­ate within the same firm – most likely, at dif­fer­ent lev­els of the organization.

We’re behind in post­ing a few of our promised essays, but these relate to the issues dis­cussed above: If One is Bad, 400 Must Be Good, Com­mon Man­age­r­ial Mis­takes in Decen­tral­ized Orga­ni­za­tions, and Strate­gic Con­sis­tency and Man­age­r­ial Dis­ci­pline.

As reg­u­lar read­ers know, our pro­fes­sional inter­ests include incen­tives and under­stand­ing the impli­ca­tions of par­tic­u­lar com­pen­sa­tion schemes and per­for­mance mea­sure­ment sys­tems. More­over, we like to think about these issues for market-​related activ­i­ties like trad­ing and invest­ing and risk management.

In this post, one day after the United States has basi­cally (and almost for­mally) nation­al­ized Fred­die Mac and Fan­nie Mae, we begin by ask­ing the dear reader a sim­ple his­tory question.

See, we need to ask the ques­tion because our dis­ser­ta­tion and much of our doc­toral train­ing involved infor­ma­tion eco­nom­ics, and our degree wasn’t granted until the mid-90’s. (Infor­ma­tion eco­nom­ics involves multi-​person prob­lems related to hid­den effort (moral haz­ard) or pri­vate infor­ma­tion (adverse selec­tion), which can arise in rela­tion­ships like trad­ing where there trader takes actions that can’t be observed or knows facts that he may be unwill­ing to share unless induced to do so.)

By the time our doc­toral stud­ies, eco­nomic his­tory had not been a required course in most PhD pro­grams for over 20 years. You see, every­thing was new and bet­ter; so, there was no rea­son to study any related thoughts that had been thought prior to, say, the mid-1800’s, espe­cially if the analy­sis was non-​mathematical in nature. (We some­times denote sar­casm with ital­ics.) Thus, while we attempt to read about the scholas­tic econ­o­mists in our spare time, we are still a bit igno­rant about such things as actual trans­ac­tions and events that had occurred in the dis­tant past – ergo, our question.

So we ask: con­sider the his­tory of human social and eco­nomic inter­ac­tion, which likely dates back at least 10,000 years. When dur­ing those ten mil­len­nia did man first learn that another might take “exces­sive risks” if the other’s upside was nearly unbounded and the down­side was sub­stan­tially lim­ited – due to, say, a guar­an­tee from a benign but very wealthy party or gov­ern­ment? We fig­ure it was right around the same moment when said risk-​taker stated to a part­ner, “Let’s do it. What do we’ve got to lose?”

By the way, here are a cou­ple of reli­able work­ing def­i­n­i­tions of “excessive-​risk-​taking:” (1) “wouldn’t do with your own money what you’re will­ing to do the others’,” or (2) “oth­ers wouldn’t want you to do with their money if they knew what you knew.” (In our mind, mis­cal­cu­lat­ing the odds if such cal­cu­la­tions are indeed fea­si­ble is less about exces­sive risk-​taking and more about incom­pe­tence.) So, the reader can think of exces­sive risk-​taking as tak­ing longer odds for a higher poten­tial pay-​off (to one’s self) than one’s investor(s) may prefer.

In that spirit, we ask a follow-​up ques­tion. We know that one can take “exces­sive risks” and if the num­ber of tri­als (e.g., gam­bles or trades or invest­ments) is rel­a­tively small, one’s good for­tune may carry one and his clients through to success. 

How­ever, we’re inter­ested in the “long-​run,” which despite its name may not take much time to play out.

Ignor­ing all of the knowl­edge and mea­sure­ment issues involved in Uncer­tainty Man­age­ment–as opposed to risk man­age­ment – we ask: what is the long-​run chance of sur­vival if (1) the per­son is allowed to remove all or most of his share of short-​term gains after each period, and (2) he suf­fers no adverse effects to that (separately-​kept) bounty due to sub­se­quent losses?

It is sim­i­lar to a Gambler’s Ruin prob­lem with moral haz­ard where the agent gets to select some com­bi­na­tion of prob­a­bil­i­ties and short-​term pay-​offs. As we men­tioned above, “exces­sive risk-​taking” would imply that the agent goes for big­ger pay-​offs with smaller prob­a­bil­i­ties in hopes of get­ting rich quickly…at a cost of the long-​term via­bil­ity of the entity (due to the lower prob­a­bil­ity of long-​term suc­cess and sur­vival). Why would this hap­pen? Per­haps he is less patient than his investors.

If the reader agrees with our model, then he or she is likely to also agree with our rhetor­i­cal ques­tion: how could Fred­die Mac and Fan­nie Mae not end in a débâ­cle? Lax over­sight and exces­sive risk-​taking in a poorly under­stood, non-​stationary envi­ron­ment. What’s not to like? Some of the par­tic­i­pants didn’t think that it was a poorly under­stood envi­ron­ment, and that was part of the problem.

Notice also that it seems rare for mar­ket envi­ron­ments to seem more secure than one ini­tially thought, which is why we like the sub­ti­tle of our Uncer­tainty Man­age­ment essay: Why Trad­ing Is Like Play­ing in a Cul­vert on a Hot, Sunny, Sum­mer Day.

We’ll likely have more to say about these enti­ties and our very rough ruin model in the com­ing weeks, but we must get on with other work. We do note in clos­ing that regard­less of the com­plex­ity of the envi­ron­ment, eco­nomic activ­ity is about incen­tives. It always has been and, as long as man is self-​centered and fallen by nature, it always will be. In that spirit, we note that almost 2,000 years ago, Jesus dis­cussed both moral haz­ard and pri­vate infor­ma­tion in the Para­ble of the Faith­ful Ser­vant, i.e., the anti-​social ser­vant who should have known bet­ter and the other one who didn’t know bet­ter should be pun­ished dif­fer­ently. Despite our igno­rance of his­tory, we doubt that he was the first to note these prob­lems and punishments.

There is a very nice arti­cle in Monday’s (August 25) The Wall Street Jour­nal, enti­tled “Münch­hausen at Work” by Phred Dvo­rak. He describes sit­u­a­tions where work­ers con­sciously cre­ate prob­lems and then pro­vide solu­tions in hopes of recog­ni­tion and rewards. When cre­at­ing the prob­lem the employee attempts to be secre­tive, but some­times cam­eras and col­leagues get in the way. The employee then solves the prob­lem in a vis­i­ble way to make recog­ni­tion and pos­i­tive feed­back eas­ier to obtain.

Because the topic involves incen­tives, it is very close to our small, black heart. We like the col­umn but have a few com­ments and obser­va­tions about such top­ics as infor­ma­tion hoard­ing and the endoge­nous nature of man­age­r­ial con­trol. That means the bad behav­ior might be a func­tion of management’s deci­sions and policies.

Work­ers behave in a dys­func­tional man­ner for sev­eral rea­sons. They might be evil, irra­tional, or may have been induced by con­trol poli­cies and incen­tive schemes. In this post, we focus on the last point: that firm may be unwit­tingly induc­ing them to misbehave.

Before con­tin­u­ing, how­ever, we note that despite such behav­ior being pos­si­bly harm­ful and likely irri­tat­ing, elim­i­nat­ing it might be sub­op­ti­mal. Such behav­ior may be the byprod­uct of the very best way to man­age the busi­ness — just like other types of waste are gen­er­ated from every other use­ful process of which we know. That, my dear reader, is why the expres­sion, “Don’t throw the baby out with the bath water,” was invented; it is impos­si­ble to elim­i­nate all costs with­out elim­i­nat­ing all of the ben­e­fits, too. Sad, unfor­tu­nate, but undoubt­edly true.

Thus, if one per­mits employ­ees to work autonomously (because it has been deter­mined to be the opti­mal orga­ni­za­tional design), then, given that the work­ers are not actu­ally angels on loan from heaven, they will likely waste some­thing, includ­ing their own time. Again, such is the nature of all activity; it requires trade-offs; there is no free lunch — no sus­tain­able arbi­trage.¹

Despite the above obser­va­tion, which should always be a con­sid­er­a­tion, we would argue that these Münchhausen-​like inci­dences are often the result of man­age­r­ial mis­takes and are likely the “unin­tended con­se­quences” of poorly con­structed poli­cies and schemes. That means that some­one didn’t spend enough time think­ing before they selected or imple­mented man­age­ment policies. (We’re includ­ing in these mis­steps cases where man­age­ment pur­chased off-​the-​shelf and/​or fad­dish solu­tions to chal­leng­ing problems.)

Infor­ma­tion hoarding:

Mr. Dvo­rak men­tions “Watch out for infor­ma­tion hoard­ing,” and we real­ize that like squir­rels, some work­ers have the nat­ural ten­dency to hoard. How­ever, often work­ers hoard facts and infor­ma­tion for strate­gic reasons. For exam­ple, in Pay Dis­par­i­ties we wrote the following:

This … begets a more gen­eral ques­tion related to pri­vate infor­ma­tion and man­age­r­ial con­trol: as a supe­rior, how do you treat the bear­ers of bad news? …Clearly, the treat­ment of sub­or­di­nates shar­ing bad news is an issue of man­age­r­ial dis­ci­pline. Some­thing (for you) to con­sider: if bad news is always a sur­prise, either the envi­ron­ment is extremely dynamic or your in-​the-​know sub­or­di­nates are afraid of you.

In that case, they may hoard bad news until they have a solu­tion to the under­ly­ing prob­lem or in hopes that by good for­tune, events will reverse them­selves: very, very, very com­mon in trad­ing and invest­ing. We dis­cuss this fur­ther in the sec­ond half of our essay Strate­gic Con­sis­tency and Man­age­r­ial Dis­ci­pline. We also point read­ers to our post Insid­i­ous Inse­cu­rity, or how tenure is like plea-​bargaining, which describes sim­i­lar issues.

Again, in a decen­tral­ized envi­ron­ment, where pri­vate infor­ma­tion exists, such hoard­ing is not nec­es­sar­ily dys­func­tional. In our essay, Com­mon Man­age­r­ial Mis­takes in Decen­tral­ized Orga­ni­za­tions, we ask: does one seek infor­ma­tion or wish to moti­vate? Gen­er­ally, in real sit­u­a­tions — as opposed to the­o­ret­i­cal set­ting — when sub­or­di­nates both pos­sess pri­vate infor­ma­tion and take hid­den actions for the firm, one gen­er­ally can’t have both the infor­ma­tion and the pre­ferred level of effort with­out pay­ing a high price. Such a high price may not be wealth-​maximizing. There­fore, it is often nec­es­sary to for­sake one for the other, or a lit­tle of both, like how tenure pro­vides infor­ma­tion about poten­tial recruits but cre­ates pos­si­ble effort issues and other infor­ma­tion problems.

Team­work:

Mr. Dvo­rak notes that experts state to “Stress team­work over indi­vid­ual problem-​solving.” We are not sure who these experts are, but we do know that such an empha­sis may exac­er­bate the syn­drome, par­tic­u­larly if an employee feels that his con­tri­bu­tion to the team has not been prop­erly rec­og­nized and feels under-​appreciated. 

We could eas­ily imag­ine some­one con­triv­ing to dis­tin­guish them­selves from their co-​workers because of his or her co-​workers’ dys­func­tional or uneth­i­cal behav­ior. Thus, what is observed as Münchhausen-​related may be symp­to­matic of other, more sub­stan­tial under­ly­ing prob­lems. For example, it may be evi­dence that the person’s co-​workers are slack­ers and idea thieves. As Gan­dalf says, “Things are not always as they seem.”

The Impor­tance of Reflection:

So, if nei­ther the indi­vid­ual nor his or her col­leagues are to blame, who is left? Who has induced such behav­ior? Cus­tomers? Highly doubtful. 

If such behav­ior is the unan­tic­i­pated con­se­quence of con­trol poli­cies or incen­tive schemes, that leaves only the man­age­ment and its advis­ers to blame.²

If that is the case, then we must ask: which is worst, the con­scious cre­ation of prob­lems in a Münchhausen-​like man­ner or the uncon­scious cre­ation of (unin­tended) prob­lems through poorly-​designed (or negligently-​adapted) strate­gies, tac­tics, con­trols, and poli­cies? More­over, if one observes the for­mer, is it due to the latter?

Copy­right © 2008 Spero Consulting.

Update: We have a newer post on the same gen­eral topic, Claw­backs: the Good, the Bad, and the Ugly, which we pub­lished on Decem­ber 9, 2008. It dis­cusses the pro­posed use of claw­backs at UBS and other firms.

As we men­tioned in the pre­vi­ous post, The Wall Street Jour­nal’s break​ingviews​.com col­umn today dis­cusses newly pro­posed per­for­mance mea­sures at UBS: aptly titled “UBS Seeks New Incen­tives.” (It is at break​ingviews​.com, not wsj​.com.)

We cer­tainly dis­dain UBS’s cur­rent approach of reward­ing per­for­mance with shares, but rather than restate our crit­i­cism of the (gen­eral) use of uni­ver­sal per­for­mance mea­sures, we point the reader to our essay One Per­for­mance Mea­sure to Rule Them All. Of course, those look­ing for a crit­i­cism of the con­verse, i.e., a mul­ti­plic­ity or overuse of per­for­mance mea­sures will find that, too. That one is called If One is Bad, Then 400 Must be Good.

Today’s col­umn of inter­est dis­cusses some­thing called “phan­tom equity.” We’re not sure how many jokes could be writ­ten to define that phrase, espe­cially dur­ing the con­tin­u­ing finan­cial cri­sis, but we have no desire to offend share­hold­ers at most of the larger firms; so, we will skip it.

Any­way, phan­tom shares seem to be the prod­uct of some mea­sure­ment of divi­sional earn­ings, with all the atten­dant account­ing assump­tions and allo­ca­tions, mul­ti­plied by few other arbi­trar­ily cho­sen num­bers, includ­ing some type of earn­ings mul­ti­ple that comes from who knows where. (We do like the attempt to equate three made-​up divi­sional val­ues to the over­all mar­ket value. To us, it sounds like solv­ing one equa­tion with three unknowns. We can vaguely hear some­one say, “I remem­ber that Mrs. Pfeif­fer said that we can’t solve one equa­tion with two unknowns, but she never said any­thing about three unknowns; so, let’s keep try­ing. I don’t care if the answer keeps changing.”)

Under such an earnings-​based scheme, it woud seem that once the par­ties — cor­po­rate and divi­sional man­age­ment — agreed to those mul­ti­pli­ers, divi­sional employ­ees would be rewarded based upon divi­sional per­for­mance. Unless, each employee is per­form­ing an iden­ti­cal job so that his or her indi­vid­ual per­for­mance is nearly per­fectly mea­sured by his or her share of divi­sional income, the new scheme is essen­tially no dif­fer­ent than the old, share-​based one; so, we once again refer inter­ested read­ers to our essay One Per­for­mance Mea­sure to Rule Them All, which dis­cusses both cases.

By dis­ag­gre­gat­ing the divi­sions and switch­ing from equity to earn­ings, the firm’s man­agers may pos­si­bly reduce the risk imposed upon cer­tain employ­ees — we can’t be sure of that unless we know the rela­tion­ships (think cor­re­la­tions) between and among the dif­fer­ent mea­sures. In the process, however, they trade the pos­si­ble reduc­tion in risk for the increased capac­ity to behave sub­jec­tively: they, them­selves, not their employ­ees. Thus, while decreased risk may per­mit lower risk pre­mia and thus reduce expected bonuses and increase expected prof­its, the increased sub­jec­tiv­ity usu­ally increases com­pen­sa­tion costs and has demor­al­iz­ing and demo­ti­vat­ing effect on employ­ees who become wary (or warier) of senior management.

This sub­jec­tiv­ity may be obvi­ous or not. It maybe in the form of the oppor­tunis­tic use of cost allo­ca­tion (for cen­tral­ized and shares ser­vices and resources) to reduce a par­tic­u­lar division’s income. With­out the use of effec­tive com­mit­ment mech­a­nisms by man­age­ment, that arbi­trari­ness usu­ally increases the level of dis­trust within the firm. (We recall men­tion­ing some­thing like that in a slightly dif­fer­ent con­text in If One is Bad, Then 400 Must be Good.) Note that such schemes may also either directly or indi­rectly intro­duce a level of com­pe­ti­tion within the firm, but that is not always a bad thing. They will also likely make the firm more polit­i­cal, and that is rarely a good thing.

Thus, the use of phan­tom equity may leave the the firm in sim­i­lar sit­u­a­tion as the cur­rent scheme but with pos­si­ble addi­tional prob­lems, too. A very rough anal­ogy: think of a sin­gle global per­for­mance mea­sure as a ban­quet food, say, chicken with some unknown white sauce on it. It prob­a­bly doesn’t map to anyone’s taste buds. Adding a few more items may sat­isfy a few, but it can lead to more prob­lems and higher coör­di­na­tion costs and pos­si­bly ill­ness if that food is pre­pared incor­rectly or sits too long. By com­par­i­son, a restau­rant per­mits much closer map­pings to tastes than ban­quets. (That is why few ban­quet halls oper­ate as restau­rants.) Restau­rants may be more expen­sive, but cus­tomers usu­ally think they are worth it, ergo util­ity is max­i­mized. Think of us as a food critic.

So, what is the solu­tion for UBS? The same as with any other firm. We fol­low an algo­rithm by ask­ing: how does the person’s actions and deci­sions affect wealth cre­ation? What sig­nals are avail­able of those actions and deci­sions? What are the char­ac­ter­is­tics of those signals? And, how should the sig­nals be weighed to effec­tively eval­u­ate per­for­mance? Remem­ber that is done to moti­vate effort and not for its own sake.

At its core, our approach is sta­tis­ti­cal but con­sid­ers qual­i­ta­tive fac­tors, too. Say­ing any more would betray firm secrets, and need­lessly destroy our human cap­i­tal. However, given this brief descrip­tion, we must add: what are the chances that shares or phan­tom equity would be the opti­mal choice for each semi-​autonomous employee in each of the three divi­sions? Seems that it would be rather remark­able, doesn’t it?

Finally, let us note that this post skips over a whole host of related issues like asym­met­ric infor­ma­tion and its fra­ter­nal twins moral haz­ard and adverse selec­tion. These prob­lems cre­ate the need for per­for­mance mea­sures in the first place. Dou­ble finally, we can’t resist men­tion­ing that we think incen­tive pay is quite overused and thus very costly to cor­po­rate Amer­ica and its shareholders.

Oh! What a Party We’d Have.
(Or, to mis­quote Pink Floyd, They Don’t Need No Education.)

Those read­ers of a cer­tain age and incli­na­tion may recall Dandy Don Meredith’s use of those phrases back when Mon­day Night Foot­ball was enter­tain­ing. ¹ Some­how it has been man­gled on the web to be some­thing about Christ­mas, rather than a party. ² Yes, it was a long, long time ago, and we were a very young boy — though the charm and good-​looks were evident.

Read­ing, or at least skim­ming — it was kind of long and bor­ing — Charles Murray’s opin­ion col­umn in today’s Wall Street Jour­nal reminded us of that title quote, which we swear is also from an old Willie Nel­son song, but we can’t recall the title. Any­way, Mur­ray laments the neces­sity of col­lege and earn­ing a bachelor’s degree as per the title of his essay: For Most Peo­ple, Col­lege Is a Waste of Time. Now, any­one who has stood in front of a uni­ver­sity class­room, except the very most char­i­ta­ble per­son­al­i­ties, would likely agree. ³

But, despite those sen­ti­ments — while at the same time assum­ing that those impres­sions are valid — we note that such obser­va­tions do not mean that a more effi­cient, fea­si­ble solu­tion exists, espe­cially since his solu­tion implic­itly calls for more gov­ern­ment reg­u­la­tion and inter­fer­ence in the econ­omy. (Recall that bar­bers and hair styl­ists need licenses, and has that ever pre­vented a bad hair cut? Cer­tainly, not in our town or any town that we have ever vis­ited or even on our own pre­cious head.) Dr. Mur­ray cites CPAs as an exam­ple of how a national cer­ti­fi­ca­tion sys­tem can work. (Pre­sum­ably, he has never taught intro­duc­tory finan­cial or man­age­r­ial account­ing to most CPAs attend­ing MBA pro­grams.) But he ignores that the fact that such test­ing and licenses are gov­ern­men­tally — albeit state government — mandated.

While he does acknowl­edge the mar­ket place and the pos­si­bil­ity of pri­vate test­ing ser­vices, he ignores the dif­fi­cultly of devel­op­ing and admin­is­ter­ing such tests on a national scale. For exam­ple, he men­tions ETS (Edu­ca­tional Test­ing Ser­vice), but we recall read­ing a few months ago that they no longer believe in the valid­ity of their own SAT tests.

Our read­ers can skim Dr. Murray’s essay for them­selves, but we have sev­eral com­ments about his sug­ges­tions. First, sup­pose a national cer­ti­fi­ca­tion sys­tem were indeed opti­mal, such a con­di­tion does not mean that a col­leges would atro­phy and die for lack of use. In fact, a col­lege edu­ca­tion could still be the most effi­cient way for most job can­di­dates to gain the nec­es­sary test-​related “knowl­edge,” and that is regard­less of the absolute level of college-​related waste. What mat­ters is how col­lege stacks up against other learn­ing alter­na­tives. (The gen­eral prob­lem is a net ben­e­fit max­i­miza­tion pro­gram, not a cost miniza­tion program.)

In fact, at one time in the last mil­le­nium we had an inter­est in start­ing a firm that offered such test­ing ser­vices to cor­po­ra­tions. We con­sid­ered that if the ser­vice were suc­cess­ful, a side ben­e­fit would be the accu­mu­la­tion of test per­for­mance data across pro­grams and uni­ver­si­ties, and we thought that was the best way to deter­mine the best pro­grams in a field, with­out rely­ing on the opin­ion of non-​specialist cor­po­rate recruiters, biased alumni, and past (and pos­si­bly obso­lete) reputations.

Sec­ond, given his implicit call for more gov­ern­ment reg­u­la­tion, Dr. Mur­ray pro­vides a stereo­typ­i­cal exam­ple of a defi­ciency that many social sci­en­tists, who are not trained as econ­o­mists, pos­sess. Despite his men­tion of the mar­ket, he seems to ignore incen­tives and moti­va­tion and human behav­ior. (One need not be an econ­o­mist; hav­ing an under­stand­ing of the fallen nature of man is often suf­fi­cient for this pur­pose). To be brief, we ask: can you say, “car­tel” and, pos­si­bly, ever-​increasing test stan­dards, etc. More­over, com­bin­ing our first two crit­i­cisms, we note that screen­ing and sig­nal­ing solu­tions already exist to many such adverse selec­tion (pri­vate infor­ma­tion) prob­lems in this part of soci­ety. Dr. Mur­ray may dis­like the costs or impli­ca­tions of these solu­tions, but he pro­vides no evi­dence that his solu­tion would ben­e­fit any­one beyond the addi­tional gov­ern­ment bureau­crats admin­is­ter­ing licenses.

Third, who is to say that all ben­e­fits of edu­ca­tion can be quan­ti­fied or exhib­ited on a stan­dard­ized test? This crit­i­cism of his rec­om­men­da­tion is sim­i­lar to our fre­quent crit­i­cism of risk man­age­ment, i.e., immea­sur­able things can hurt and should not be ignored. ⁴ Like­wise, an individual’s immea­sur­able or qual­i­ta­tive traits can pro­vide huge ben­e­fits to employ­ers, may be evi­dent to recruiters, and may be devel­oped in a col­lege atmosphere.

In the past, we had a cer­tain agree­ment and respect for Dr. Mur­ray as he tack­led polit­i­cally incor­rect top­ics. It is pos­si­ble that his suc­cess has led him into an Elvis or Michael Jackson-​like bub­ble, where no close asso­ciates will pro­vide hon­est feed­back, e.g., “No, Elvis, that white jump doesn’t make you look fat,” or “No, Michael, the surgery looks good.” Does Dr. Mur­ray have an entourage? Let’s hope not.

P.S. We wrote this on a now depre­cia­ble, Vista note­book that has the hideous pointer prop­erty of select­ing what­ever the cur­sor sits on or insert­ing itself where it stops. Is the devil work­ing at Dell’s touch­pad supplier?

Copy­right © 2008 Spero Consulting.

Today’s WSJ announces that the pri­vate firm, Kohlberg Kravis Roberts & Co. (KKR), plans to sell shares to the pub­lic. It reminds us of when other pri­vate firms have gone pub­lic and that, of course, reminds us of Akerlof’s Lemons model. (Look it up.)

We will use KKR’s pre­sumed value of $15 bil­lion for our brief exam­ple. The Jour­nal reports a deal value between $12 — $15 bil­lion, which was pro­vided by uniden­ti­fied sources famil­iar with the IPO. Now, who would that be?

Now, we can all agree that the man­age­ment of KKR is smart and savvy. Excluding char­i­ta­ble work that may be quite exten­sive, we have not read reports that either the firm or the own­ers are prone to giv­ing away value in their busi­ness deal­ings. There­fore, we ask the dear reader: if the firm would like to receive $15 bil­lion when sell­ing a piece of itself, it is more likely that the under­ly­ing value is greater or lesser than $15 bil­lion? For exam­ple, is it more likely worth, say, $10 bil­lion or $20 bil­lion? $7.5 bil­lion or $22.5 billion?

Or how bank­ing in ‘08 in Char­lotte might be like steel in Pitts­burgh in ‘72

We think there is a mar­ket for spe­cial­ized, retained con­sult­ing ser­vices in smaller mar­kets. For exam­ple, finan­cial firms in small mar­kets often have dif­fi­culty — as evi­denced by their long searches — find­ing expe­ri­enced and knowl­edge­able work­ers will­ing to relo­cate to a town where the job in the local mar­ket might be unique. Instead, firms could hire a junior ana­lyst with less spe­cific knowl­edge and retain an out-​of-​town con­sul­tant to guide, train, and develop the less expe­ri­enced, and more readily-​available worker. In fact, con­sid­er­ing relo­ca­tion costs, the solu­tion could be both more operationally-​effective and more cost-​effective, i.e., the expert’s knowl­edge and cost are not wasted on rou­tine tasks or busy work.

This spe­cific recruit­ing prob­lem is an exam­ple of the gen­eral asset-​specificity prob­lem in eco­nom­ics, where with­out com­mit­ment and a long-​term contracts, there is a first-​mover dis­ad­van­tage. The coal mine/​railroad story is the canon­i­cal exam­ple. If the coal firm devel­ops the mine before con­tract­ing with the rail­road, the rail­road can “hold up” the coal mine and attempt to extract the mine’s entire con­tri­bu­tion (mar­gin) before build­ing a spur to the main line. If the rail­road builds a spur prior to con­tract­ing, the coal mine will attempt to pay no more than the mar­ginal cost per mile. That is when com­mit­ment via a long-​term con­tract is beneficial.

When one is the only expert in the local market, one isn′t a monop­o­list when the max­i­mum size of the poten­tial mar­ket is a sin­gle cus­tomer. Given trans­fer taxes, real estate com­mis­sions, and mov­ing costs, the expert has sub­stan­tially less lever­age as an employee, espe­cially when he owns prop­erty, too.

How does this relate to con­cen­tra­tion risk and cor­re­la­tion? We′ll get to that, but first we draw atten­tion to today′s WSJ arti­cle about Char­lotte, NC: A Tale of One City, Two Trou­bled Banks. We would imag­ine that with­out hefty sign­ing bonuses and other guar­an­tees, both Bank of Amer­ica and Wachovia are find­ing it dif­fi­cult to hire and relo­cate out-​of-​town spe­cial­ists in Char­lotte. (In fact, given our skep­ti­cal nature, unless the per­son were a home­town, home­sick boy or girl, we would be sus­pi­cious of any­one will­ing to move at this time with­out such compensation.)

The impa­tient reader may agree, but may again ask: how does this relate to con­cen­tra­tion risk and correlation? We′ll offer a fuller expla­na­tion below, but first we note that the WSJ arti­cle men­tions that the two banks employ 34,000 in Char­lotte, which has a pop­u­la­tion of about 630,000. We ask a sim­ple arith­metic ques­tion: if the pop­u­la­tion is 630,000 and the banks either move or close and take all 34,000 jobs with them, what is the new pop­u­la­tion of Char­lotte? Uhh, rephrased: what was the pop­u­la­tion in 1975?

To address the impa­tient reader’s ques­tion, we use the handy Socratic Method, to answer with a few ques­tions of our own. (1) Of the 34,000 employ­ees, how many of those indi­vid­u­als have home mort­gages with either BoA or Wachovia? (2) Of the sev­eral hun­dred thou­sand cit­i­zens of the area who depend on the 34,000 for their liveli­hoods, how many of them have BoA or Wachovia mort­gages? (3) Can the reader imag­ine that the val­ues of these mort­gages might be a tad bit cor­re­lated with each other? (4) Can the reader imag­ine that the val­ues of these mort­gages might then be related to each firm′s non-​Charlotte mort­gages and other assets, e.g., CMBS, et cetera? (5) At this point, does the con­cerned share­holder hope that these mort­gages have been secu­ri­tized, sold, and not repur­chased? (6) Can the reader then imag­ine that this feed­back loop could be unbe­liev­ably fast and have dras­ti­cally neg­a­tive impli­ca­tions? (7) Can any­one say “Lake Nor­man and Lake Wylie tsunamis?”

(8) Does the reader believe that either firm has con­sid­ered this issue? (9) If the reader believes (or knows) that the firms have con­sid­ered the effect of their other asset val­ues on their own Char­lotte mort­gage val­ues, then does he or she believe that they have con­sid­ered the cross effect? For exam­ple, does he believe that Wachovia has pre­pared sce­nario analy­ses to mea­sure their poten­tial losses if BoA were to dis­ap­pear or be sold and vice versa?

One would hope that any­one relo­cat­ing to Char­lotte would con­sider this issue, espe­cially if one were to work in risk or bal­ance sheet man­age­ment. (Regard­ing the asset-​specificity issues and adverse selec­tion issues dis­cussed above, if one didn’t attempt to elicit com­pen­sa­tion for such risks, is one really qual­i­fied for such positions?)

Finally, does the dear reader believe that BoA′s and Wachovia′s coun­ter­par­ties — across their var­i­ous trad­ing activ­i­ties — have con­sid­ered these sce­nar­ios? If yes, is the reader serious?

A cou­ple of notes:

1. In an anal­o­gous case, we won­der whether prior to 9/​11, group life insur­ance under­writ­ers con­sid­ered the effect of dis­as­ters befalling a sin­gle work place when set­ting rates? If any­one knows the answer to that question, please send it along. Of course, we also won­der if they con­sider it post ⁹⁄₁₁.
2. Our men­tion of adverse selec­tion and skep­ti­cism at hir­ing some­one will­ing to move reminds us of the Grou­cho Marx joke that every infor­ma­tion econ­o­mist, includ­ing yours truly, has beaten to death: Groucho claimed that he wouldn′t join a club that would have him as a mem­ber. (That’s like tenure at many places.)
3. The last time we checked the pop­u­la­tion of Allegheny County had declined by 600,000 since 1970. Pitts­burgh is the county seat, and from mem­ory we esti­mate it has lost about half of that. (Don′t bother cor­rect­ing us on the last esti­mate. We don′t care that much.)