Spero Consulting

Posts Tagged ‘financial crisis’

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.

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.

(His Rec­om­men­da­tions Were Ours)

Paul Vol­cker had an excel­lent op-​ed col­umn in Tuesday’s edi­tion of The Wall Street Jour­nal that we’re finally get­ting around to men­tion. It is enti­tled, “Moral Haz­ard and the Cri­sis.” It’s not actu­ally a col­umn but excerpt of a speech that he recently gave in Beijing.

If they haven’t read it, reg­u­lar vis­i­tors of our site can skip Mr. Volcker’s speech because we have already dis­cussed just about every­thing that he pro­posed, includ­ing the elim­i­na­tion of prop-​trading at insured insti­tu­tions; the tit­u­lar prob­lems of moral haz­ard and the cri­sis and how the government’s response will exac­er­bate anti-​social behav­ior; our call for nation­al­iza­tion (or receiver­ship) as a way to mit­i­gate moral haz­ard; and issues with mark-​to-​market account­ing, par­tic­u­larly in our post on A Wee Bit on Mark-​to-​Market Pro­pos­als. (The account­ing issues are where we would dis­agree most as there are fewer true mar­kets by which to mark than Mr. Vol­cker seems to believe.)

Mr. Volcker’s rec­om­men­da­tions sound so sen­si­ble, con­ser­v­a­tive. and market-​oriented that we won­der how he could have endorsed Mr. Obama for Pres­i­dent in early 2008? Whether one con­sid­ers Mr. Obama’s approach to be a “light touch” (as Mr. Obama states) or heavy-​handed med­dling (as we see it), prior to (and after) the elec­tion, Mr. Obama has been con­sis­tent in his stated desire for more gov­ern­ment involvement. As we wrote many times prior to and after the elec­tion, we don’t see how such involve­ment would mit­i­gate any of the crit­i­cal prob­lems that the finan­cial sys­tem faces. It only makes them worse. (See our archive on TARP, espe­cially the older posts on the sec­ond page.)

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:

Yes­ter­day, in And You Thought We Were Depress­ing we referred read­ers to an excel­lent arti­cle about the finan­cial cri­sis by Simon John­son: The Quiet Coup.

Regard­less of your level of inter­est (or dis­in­ter­est) in finance and the finan­cial cri­sis, it’s def­i­nitely worth read­ing, and it is an excel­lent sin­gle source by which to under­stand the cri­sis. (It’s not short.)

One of the phe­nom­ena that he describes is how indi­vid­u­als move from jobs in the finance indus­try into gov­ern­ment jobs and back. There’s plenty of other cases to sup­port Mr. Johnson’s posi­tion, but an arti­cle on The Wall Street Journal’s web site pro­vides fresh evi­dence of links between indus­try and the government.

The arti­cle is enti­tled Hedge Fund Paid Sum­mers $5.2 Mil­lion in Past Year, but we’re less inter­ested in the head­line than some of the other facts cited a bit fur­ther down in the column.

We don’t begrudge Mr. Sum­mers his hedge fund pay or other $2.7 mil­lion he received for speak­ing engage­ments. We’d be happy to accept $135,000 for a speak­ing engage­ment – even for a whole day’s work – and we’re will­ing to project that most of our read­ers would gladly accept it, too.

No, what inter­ests us is the men­tion of the sub­stan­tial amounts that other offi­cials received, and it’s likely that the Jour­nal pub­lished com­pen­sa­tion fig­ures for only a small sub­set of appointees.

We’ve not checked other sites for a more com­pre­hen­sive list, but that’s nei­ther here nor there. Instead, with­out com­ment, we’d encour­age our vis­i­tors to read the brief WSJ arti­cle and then read the longer, more com­pre­hen­sive Atlantic arti­cle, or reverse the order. It doesn’t matter.

When fin­ished with the two, you might think such moves form an excel­lent career path, or you may be deeply depressed. Of course, those thoughts and feel­ings are not mutu­ally exclu­sive (and that’s depress­ing, too).

The Wall Street Jour­nal has an arti­cle today enti­tled, Mack and Thain Lose ’08 Bonuses.

We’re nei­ther sym­pa­thetic nor antag­o­nis­tic towards Mr. Thain, who has only been in his posi­tion for a year; so, we take no glee in his being shut-​out. Hope­fully, he’ll be able to make-​do with his $750,000 salary, $15-$20 mil­lion sign­ing bonus from late 2007, and his other accu­mu­lated wealth from his past exec­u­tive positions.

What inter­ests us in the arti­cle is the men­tion that Mor­gan Stan­ley plans to imple­ment com­pen­sa­tion schemes that include “claw back” fea­tures. That means that in the future, the firm could recoup ear­lier bonuses if, say, a trader later blows up.

Please note that we are writ­ing in gen­er­al­i­ties and not attempt­ing to con­struct an opti­mal con­tract, but we do see claw-​back fea­tures as mov­ing in the right direc­tion for both firms and employ­ees. (We’ve writ­ten pos­i­tively about sim­i­lar fea­tures before.)

At first glance, such claw­backs may seem to impose more risk on employ­ees, but if they’re struc­tured and used prop­erly, they need not; thus, we’d expect them to be wealth-​maximizing for the firm and expected-​utility max­i­miz­ing for employ­ees. That’s if they are con­structed intel­li­gently.

We’d hope that Morgan’s scheme is so con­structed – to, say, claw back por­tions of a 2008 bonus because trades or invest­ments made in 2008 sub­se­quently go bad.

We hope that the firm does not attempt to claw back a por­tion of say, a 2008 bonus because the trader made a money-​losing trade in 2009. We under­stand the aver­ag­ing effects of long-​term con­tracts, but believe that such rep­ri­mands would likely be per­ceived as being arbi­trary and capri­cious and sub­jec­tive and would likely have two effects: (1) before-​hand, many traders would leave to join hedge funds or to trade for them­selves, and (2) those traders who did stay and win large bonus awards could be expected to become sub­stan­tially more risk-​averse in the future (because both the cur­rent period’s bonus and past bonuses were all still at stake). In gen­eral, it doesn’t seem that most trad­ing and invest­ing firms want to induce traders to min­i­mize risk; instead, it is to man­age risk intel­li­gently or effi­ciently. If the goal were, in fact, to min­i­mize risk, then pay­ing a bonus as a func­tion of prof­its would be a huge mis­take in the first place. There’s much cheaper ways to induce that behavior.

The Good: Besides claw backs, we’d rec­om­mend that firms con­tinue to pay bonuses on earn­ings even after traders have left the firm – solely to induce them to behave and act in the firm’s long-​term inter­ests while they are employed. It is very tempt­ing to want to pun­ish for­mer employ­ees for leav­ing or for a vari­ety of real or per­ceived trans­gres­sions, but it is not nec­es­sar­ily the wis­est pol­icy nor fidu­cia­r­ily responsible.

Unfor­tu­nately, it seems that UBS may have taken that course.

We’re very grate­ful that the WSJ arti­cle men­tions that UBS imple­mented claw­backs in mid-​November because we had pre­vi­ously missed that announce­ment in the press.

The Bad: In August, we com­mented on UBS’s plans to use phan­tom shares in its com­pen­sa­tion schemes in Incen­tives at UBS and in Gen­eral. That plan seemed to impose a sub­stan­tial – we mean exces­sive – amount of risk on its employ­ees. W would strongly encour­age inter­ested par­ties to read that post.

From our read­ing of a few arti­cles more recent arti­cles, espe­cially this Lon­don Times arti­cle, UBS’s plan seems down­right vin­dica­tive. While that may be jus­ti­fied in the cases of for­mer senior exec­u­tives and while it may be sat­is­fy­ing to stiff employ­ees in bad times, it’s gen­er­ally not wealth-maximizing; it seems quite sub-​optimal.

UBS calls a neg­a­tive bonus a “malus.” Get it? It sub­sti­tutes “mal” for “bon” to get the oppo­site. Very clever!

The Ugly: Accord­ing to a Tele­graph arti­cle, UBS will attempt to claw back pre­vi­ously awarded, but not dis­trib­uted bonuses, if the bank under-​performs, and it could recover up to two-​thirds of the cash por­tion, which would be held in escrow for at least a year. So imag­ine that you, Joe Trader, or more pre­cisely Josef Trader, had a par­tic­u­larly good year in 2009, but the firm had com­pletely hor­ri­ble year in 2010; so, not only do you not get a 2010 bonus, but your 2009 bonus is gone, gone, gone. How would you feel? What are the odds that it could occur? Is it worth tak­ing the chance (bear­ing the risk) of such per­sonal losses? If it’s not, you may want to seek employ­ment elsewhere.

The Times arti­cle men­tions that Share-​based bonuses won’t vest for three years and exec­u­tives will be required to retain 75% of those shares for sev­eral more years, and the “malus” sys­tem will apply to shares, too. As we wrote in August and repeated above, such plans impose sub­stan­tial risk on employ­ees. UBS should expect to pay higher com­pen­sa­tion on aver­age and expect an exo­dus of employ­ees. We’d guess that it would lose many of its best, most con­fi­dent employ­ees, and many of its most risk-​averse, and espe­cially the inter­sec­tion of the two. Would you, dear reader, tol­er­ate such a scheme?

By the way, for exit­ing employ­ees, all bonuses paid on depar­ture will be sub­ject to the “malus” sys­tem. What are the chances that will be manip­u­lated against the employee (as, say, a short-​term way to boost current-​period profits).

In that regard, we love this quote from the bank that appeared in the Tele­graph arti­cle: “This should pre­vent any pay­ments that prove to be inap­pro­pri­ate in the near future.” But, when did pre­vent­ing any, which we take to mean “all” inap­pro­pri­ate, pay­ments become the goal?

In eco­nomic mod­els, profit-​maximization in the short-​term or wealth-​maximization in the long-​term do not imply the all costs can be elim­i­nated. We, and every other econ­o­mist that we know, teach that there is an eco­nomic level of costs that max­i­mizes prof­its. Like­wise, in decen­tral­ized orga­ni­za­tions, all dys­func­tional behav­ior can­not be elim­i­nated with­out also elim­i­nat­ing the ben­e­fits of auton­omy; it is throw­ing the prover­bial baby out with the bath-​water or being penny-​wise and pound-​foolish. (See just about any­thing that we’ve writ­ten in our Illus­tra­tions and Fal­lac­ies sec­tions, espe­cially about extrem­ists in Com­mon Man­age­r­ial Mis­takes in Decen­tral­ized Orga­ni­za­tions.)

We what find to be espe­cially galling is the fact that intelligently-​applied claw­backs are a great idea for both firms and employ­ees, but unfor­tu­nately, if (as an early adopter) UBS botches its imple­men­ta­tion – which given the infor­ma­tion in the press seems highly likely – then other firms will likely be hes­i­tant to use them. That’s a shame.

If large firms want to elim­i­nate risk, then we encour­age to elim­i­nate pro­pri­etary trad­ing and oper­ate rel­a­tively low-​risk, low-​margin businesses. That’s what we’ve rec­om­mended for government-​insured firms in our aptly-​titled post Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions.

We’ll likely edit and add to this post in the near future.

Copy­right ©2008, Spero Con­sult­ing Incorporated.

The Curi­ous Case of Robert Rubin

The week­end edi­tion of The Wall Street Jour­nal has a front page inter­view with Robert Rubin: Rubin, Under Fire, Defends His Role at Citi.

We’ve crit­i­cized Citi’s board in the (recent) past, and we’re still par­tic­u­larly fix­ated on the fact that few direc­tors had finan­cial indus­try expe­ri­ence. That seems nei­ther wise nor even pru­dent for a finan­cial insti­tu­tion with over $3,000,000,000,000 of assets. (That’s $3 tril­lion, but we like to write it out for effect, because it seems like a lot of money.)

As the arti­cle men­tions, Mr. Rubin was “the only board mem­ber with expe­ri­ence as a trader or risk manager.”

Since 1999, Mr. Rubin has made about $119 mil­lion from Cit­i­group while hav­ing no oper­at­ing respon­si­bil­i­ties. We have absolutely no prob­lem with that, and, in fact, are look­ing for sim­i­lar “work” our­selves. (Inter­ested par­ties may use our con­tact form.)

Where we do have a prob­lem is his insis­tence that none of Citi’s prob­lems is his respon­si­bil­ity. As the inside head­line reads: “Rubin Blames Citigroup’s Woes on the Broader Finan­cial Cri­sis.” He almost seems to imply that Cit­i­group is a hap­less, unwit­ting vic­tim of some­thing big­ger than itself – some­thing it couldn’t be expected to con­sider, man­age, of fathom: “Nobody was pre­pared for this…”

In that case, exactly what type of stew­ard­ship, guid­ance, and pro­fun­di­ties did he provide? 

Sup­pose it is true that Citi and its board were fault­less. Shouldn’t they have been able to con­sider how they might be dam­aged by a gen­eral down­turn or a finan­cial cri­sis that was no fault of its (their) own. Thus, our lit­tle proof-​by-​contradiction shows the silli­ness of the argument.

More­over, we doubt that even the gullible buys the story that Citi was sim­ple a vic­tim of exoge­nous fac­tors, which were unpre­dictable and beyond its control.

There is a cri­sis of con­fi­dence, but that cri­sis erupted and sur­vives because mar­kets and investors real­ized the large finan­cial insti­tu­tions, includ­ing Citigroup, were far less com­pe­tent invest­ing and trad­ing than they pre­vi­ously believed, i.e., that in ret­ro­spect, pre­vi­ous reported prof­its were unreal and unsustainable.

Citigroup’s share price of $8.29, which is about dou­ble where it was last week­end, has lost about 85% of its value in two years. (In the first three years of the Great Depres­sion – 1929 — 1932 – the Dow Jones Indus­trial Aver­age lost the same per­cent­age with­out a back­stop by gov­ern­ment.) That is an indict­ment against Citigroup’s way of doing busi­ness far beyond the gen­eral con­dem­na­tion of the finan­cial ser­vices indus­try in gen­eral and with all of the sub­si­dies pro­vided by tax pay­ers through the var­i­ous recent gov­ern­ment guar­an­tees and bailout measures. 

Clearly, investors find fault with Citi’s strate­gic and oper­at­ing deci­sions. So, if Mr. Rubin wasn’t mak­ing oper­at­ing deci­sions, what type was he mak­ing? If they weren’t strate­gic, what remains? As other crit­ics note, Mr. Rubin is “try­ing to have it both ways.”

Of course, his pos­tur­ing is silly, as it was he, him­self, who pushed senior man­age­ment to bear more risk in 2004 — 2005. If that’s not a strate­gic, board-level, decision, what is? From our read­ing, it seems that he may now be try­ing to blame a con­sul­tant for sug­gest­ing the board instruct man­agers to take addi­tional risk.

He also blames senior man­age­ment for not exe­cut­ing the strate­gic plans prop­erly and risk man­age­ment for, well, weak risk management. 

“I wouldn’t run a finan­cial insti­tu­tion based upon someone’s view about what mar­kets would do.”

Of course, as the arti­cle explains that is exactly what he did in 2004 — 2005. (We wouldn’t doubt that he did it at other times, too, but don’t have the time or energy to search for quotes or sto­ries.) Well, he didn’t do it based upon some­one else’s view; instead, Citi’s strat­egy seemed to be based upon his own views. (We could well imag­ine board­room dis­cus­sions where inex­pe­ri­enced direc­tors imme­di­ately defer to the for­mer Trea­sury Sec­re­tary and Gold­man Sachs Co-​Chair.

Now, Mr. Rubin should know that devel­op­ing and acknowl­edg­ing such a world-​view is exactly how finan­cial insti­tu­tions are run, whether that view is explic­itly stated or not. (If it is not explicit, then not pro­vid­ing such a view and or con­sid­er­ing its impli­ca­tions seems neg­li­gent at worst and imma­ture at best, ergo, our title.) What else could strate­gic and oper­at­ing plans be based upon? How else could risks be mea­sured, uncer­tain­ties be con­sid­ered, and con­tin­gen­cies be planned? Or are those con­sid­er­a­tions too much like work? If so, it is not dif­fi­cult to see why Citi is where it is at this Novem­ber, and that is com­pletely con­sis­tent with both a spe­cific and the more gen­eral cri­sis in confidence.

As we see it, Mr. Rubin is seventy-​years-​old. He should grow-​up and accept the respon­si­bil­i­ties that come with his posi­tion and rewards, and stop behav­ing like a petu­lant teenager.

Reg­u­lar read­ers will know that we often crit­i­cize the stu­pid appli­ca­tion of math­e­mat­i­cal mod­els, espe­cially ones related to finance and eco­nom­ics; ergo, our firm’s motto, “Thought Before Calculation.”

In that light, we note that in last Friday’s The Wall Street Jour­nal (Novem­ber 7) the edi­tors excerpted a speech that Michael Crich­ton gave at Cal Tech in 2003, entitled ‘Aliens Cause Global Warm­ing.’ (For those who don’t know, Mr. Crich­ton passed away early last week.)

In the speech, Mr. Crich­ton dis­cussed the Drake equa­tion which attempts to illus­trate the winnowing-​down process of all the plan­ets in the uni­verse to ones that could sup­port life and could send intel­li­gent sig­nals (to us). There are seven vari­ables in the equa­tion, which was the impe­tus of the SETI project and one of the jus­ti­fi­ca­tions for spend­ing funds on it. For SETI, think Jody Fos­ter in the screen ver­sion of the late Carl Sagan’s Con­tact.

Mr. Crich­ton made the excel­lent points that the Drake Equa­tion is a serious-​looking equa­tion and that its seri­ous appear­ance pro­vided poten­tial inves­ti­ga­tors with a veneer of serious, scientific inquiry. This is despite the fact that NONE of the seven vari­ables can ever be known or esti­mated. Thus, the inves­ti­ga­tion was not sci­ence and was/​is not that dif­fer­ent than count­ing the num­ber of angels on the head of a pin. 

Mr. Crich­ton con­cluded that SETI et. al. “is unques­tion­ably a reli­gion.” (Below we argue it is a bad reli­gion – mean­ing a poorly-​considered one.)

More­over, he con­tin­ued his argu­ment by not­ing that with­out legit­i­mate sci­en­tific inquiry and pro­ce­dure, “soon enough garbage began to squeeze through the cracks…” (By this point, the reg­u­lar reader and the astute reader can see where we are headed by this post’s title.)

He went fur­ther to note that the achiev­ing con­sen­sus around a “model” is not sci­ence, and vice versa.

We go fur­ther to argue that such con­sen­sus is not sci­ence, nor even part of science’s broader super-set, reason. 

Yes, we view sci­ence as a sub­set of rea­son – the empir­i­cal part of rea­son. And so, we’d argue that such con­sen­sus is in fact a sub­sti­tute for rea­son. In fact, it fills the entropic chaos of unknow­ing that is the absence of reason. 

Thus, we con­trast such sci­en­tism with more fully-​developed reli­gions like, say, Christianity, which via numer­ous pas­sages, includ­ing the first chap­ter of the Gospel of St. John, defines God as rea­son (logos) and com­mands man to use that same rea­son to be bet­ter than instinc­tual, impul­sive ani­mals amidst the chaos.¹

At first glance, it might seem that the val­u­a­tion (and sub­se­quent real­iza­tion) of mortgage-​backed secu­ri­ties (MBS) and other finan­cial assets has lit­tle in com­mon with the esti­ma­tion of the cur­rent num­ber of intel­li­gi­ble planets.

However, both method­olo­gies require giant leaps of faith when mov­ing from real­ity to a model as both suf­fer from the absence of rel­e­vant data. Other galax­ies and solar sys­tems (and plan­ets) are just too far away to con­sider care­fully, and there are only (rel­a­tively) short his­to­ries of mort­gage prod­ucts and repay­ments avail­able from which one HOPES to extrap­o­late the future, and this is where and why the con­sen­sus arises. 

There are no good mod­els; so, indi­vid­u­als agree to use mod­els already in use (as a val­i­da­tion for their choice). Often, such mod­els first appeared in text­books for entirely dif­fer­ent pur­poses but were used out of convenience.

Mort­gage port­fo­lio, MBS, and CDOs suf­fer a few addi­tional bur­dens not shared by ET’s would-​be friends, including: (1) depen­den­cies and inter­ac­tions between or among bor­row­ers that would seem to be absent with plan­ets; (2) non-stationarities through time with respect to these (and other rel­e­vant) rela­tion­ships; and (3) the inter­ac­tions are endoge­nous as they involve people’s cog­nizant responses through time to eco­nomic con­di­tions and per­sonal cir­cum­stances. (In that sense, it is truly a daunt­ing task.)

Please see our ear­lier post for a descrip­tion of the mort­gage pool or port­fo­lio prob­lem. In it, we illus­trate how recent calls for more trans­parency are non sequiturs and sim­plis­tic, but do show a lack of under­stand­ing about the nature of the problem.

It seems that the soci­olo­gies of both plan­e­tary and mort­gage mod­el­ing envi­ron­ments do seem to place a pre­mium on con­sen­sus. While every indi­vid­ual trader or struc­turer may have their own idio­syn­cratic tweaks, most solve val­u­a­tion prob­lems in sim­i­lar man­ners because there just aren’t that many tractable ways to per­form the cal­cu­la­tions. But, as many for­mer traders and struc­tur­ers have dis­cov­ered, choos­ing a method­ol­ogy for its tractabil­ity is very dif­fer­ent than choos­ing one for its applic­a­bil­ity, par­tic­u­larly when the envi­ron­ment changes rapidly or drastically.

In fact, we’d argue that the recent lack of exchange or illiq­uid­ity in these mar­kets results from the real­iza­tion and inter­nal­iza­tion that these mod­els have failed, and no suit­able replace­ment yet has been found; ergo, the paralysis. 

As fur­ther evi­dence of paralysis, today Mr. Paul­son announced the Trea­sury Depart­ment wouldn’t pur­chase any trou­bled assets as part of their TARP efforts. (Recall that the “TA” in TARP stands for “Trou­bled Asset.”) It seems that the gov­ern­ment doesn’t know how to value them, either. We’d have been sur­prised by the announce­ment had we not pre­dicted it six weeks ago.

As always when we dis­cuss these top­ics, we point read­ers to our essay Uncer­tainty Man­age­ment, which presents a broader view of the nature of unknow­ing – far broader than the nar­row empha­sis on risk or mea­sur­able uncer­tainty one typ­i­cally sees.

Finally, as usual, we also note that we have pro­posed a pri­vate solu­tion to the mort­gage cri­sis that uses tax incen­tives – via the equiv­a­lent of accel­er­ated depre­ci­a­tion or invest­ment tax credit – to induce pri­vate pur­chases of the trou­bled assets. We sug­gest Mr. Paul­son con­sider that alternative.

Exclud­ing fools – which we admit pro­vides a non-​trivial exclu­sion – we doubt that finan­cial mod­el­ers or ana­lysts will regain the (mis­placed) self-​confidence they exhib­ited in the calm-​market era prior to mid-​2007. 

In our view, such well-​earned and well-​deserved humil­ity will be ben­e­fi­cial for soci­ety as a whole. Such feel­ings may spur inno­va­tion and increase the level of thought­ful of analy­ses per­formed (rather than rote, pro­ce­dural tasks). Perhaps it may change the struc­ture of contracts.

Per­haps the recent fail­ures will allow senior man­agers to gain effi­cien­cies through the real­iza­tion that irrel­e­vant details are not infor­ma­tion and so many rou­tine tasks and algo­rithms are indeed worth­less – despite the claims of reg­u­la­tors and audi­tors. (Oh, who are we try­ing to kid. The skep­tic in us sug­gests that we’re show­ing our naiveté.)

Behind AIG’s Fall, Risk Mod­els Failed to Pass Real-​World Test.

You Don’t Say! Our sub­ti­tle is the title of today’s Wall Street Jour­nal front-​page arti­cle about AIG (obviously).

As always we’ll point inter­ested read­ers to our essay, Uncer­tainty Man­age­ment, which empha­sizes the broader notion of unmea­sur­able uncer­tainty over the nar­rower notion of (mea­sur­able) risk, and there­fore per­mits really bad things to happen.

We mean bad things out­side the scope of someone’s purely math­e­mat­i­cal model, which, as an abstrac­tion of real­ity, may ignore imag­in­able and unimag­in­able bad things. (We’re all for math – when it is thought­fully and con­sci­en­tiously applied. In fact, we think such appli­ca­tion is one of the things that we do best.)

In that regard, we’ll once again note the sub­ti­tle of the above-​referenced essay, Or How Trad­ing is Like Play­ing in a Cul­vert on a Hot, Sunny, Summer Day. See dear reader, once one con­sid­ers that one could drown from a flash flood – even on a pre­sum­ably and locally Sunny day – the allure of such adven­ture dulls greatly – at least for the rea­son­able among us.

In other words, your mother may have been a scold, but there was prob­a­bly a good rea­son for her to warn you about play­ing in cul­verts and drainage ditches (pro­vided that she loved you, of course). She may not have dis­cussed it in prob­a­bilis­tic terms, but that doesn’t mean she can’t recall read­ing about such drown­ings, say, forty years ago, or even before you were born.

More­over, the fact that you didn’t read about any such cases in, say, the past ten years, doesn’t mean they don’t exist, and there, of course, lies the Prob­lem of Induc­tion, and the over-​reliance on infer­ences from rel­a­tively short-​duration, historical, data sets. (See our beau­ti­ful excerpt from St. James’ only Epis­tle on our Quotes page.)

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.

Per­haps we just don’t pay enough atten­tion to what hap­pens in all of the large firms, but if the reader dis­agrees with our pre­ced­ing para­graph, please note that there have been few recent suc­cess sto­ries within major firms like the gains enjoyed by Nas­sim Nicholas Taleb, John Paul­son, or Andrew Lahde–all inde­pen­dent fund man­agers. (If the new reader has read this far, then it is highly likely that they’ll like the link under Andrew Lahde’s name and his con­dem­na­tion of many things in one fell swoop.) We know that our exam­ples form a very small data set, but mostly what we’ve heard is how the more suc­cess­ful large firms haven’t lost as much as their brethren. We don’t recall any of them actu­ally do well this year.

Also, we’ll prob­a­bly have more to say about our boy, Taleb. We very much like his trad­ing style, as it reminds us of the value of the Sec­ond Amend­ment and laws that per­mit con­cealed carry. See, dear reader, carrying a pis­tol is very much like buy­ing deep-​out-​of-​the-​money puts. There’s a small, ongo­ing cost and a minor irri­ta­tion, but when cer­tain bad things hap­pen, there is an option to exer­cise to pro­tect ones self, and that value can­not be underestimated.

We haven’t said any­thing about CDS – the source of AIG’s prob­lems – in this post but plan to do so shortly.

We must admit, this is our first post that is truly in bad taste, but it seems so appro­pri­ate that we just could not help our­selves. TARP. TARP.

We’re try­ing to write seri­ously about the government’s – the Trea­sury Department’s – lat­est expe­di­en­cies and tac­tics to … well, we’re not sure of the objec­tive… pre­sum­ably, to make it all go away so that Mr. Bush and his appointees can enjoy their last Autumn and Christ­mas in D.C. (Why would any­one want to ruin Mr. Bush’s last Christ­mas in the White House by caus­ing the pos­si­ble finan­cial ruin of much of the world. Peo­ple can be so mean and self­ish some­times! Can’t we just use the tax­pay­ers’ money to pay them to go away!)

So here is our per­sonal prob­lem. Every time we think of TARP we are reminded of Garp as in John Irving’s The World Accord­ing to Garp. It has been a long time since we’ve read it; so, the details are slightly hazy, but we think we’ve remem­bered enough to draw the cor­rect analogy.

We’re not actu­ally reminded of Garp him­self, so much, but more of his father T.S. Garp, the critically-​wounded, WWII sol­dier, who spends his last days bedrid­den and sense­less in a state­side army hos­pi­tal. As we recall, he had been a ball-​turret gun­ner on per­haps the under­side of a B17 or B24, who took shrap­nel to the head dur­ing a bomb­ing raid over Germany.

“T.S.” were not his first two ini­tials, but rep­re­sented his rank, Tech­ni­cal Sergeant, which is about all of the back­ground his mother, an attend­ing hos­pi­tal nurse in the same ward, knew of his father.

As we recall, despite his dimin­ished state, T.S. Garp had one com­pul­sion, which he seemed to be able to do uncon­sciously and def­i­nitely not self-​consciously. Dur­ing these com­pul­sive episodes, he would repeat his name, “Garp, Garp.…” As his con­di­tion wors­ened, his mantra changed to “Arp, Arp…” and finally, just before his death to “Ar, Ar…”

In our mind, many of the Treasury’s recent tac­tics don’t seem that dif­fer­ent than T.S. Garp’s last efforts. How­ever, within a shorter period of time – less than two weeks – they seemed to have gone from “TARP, TARP…” to “RP, RP.…”

The injec­tion of cap­i­tal to “save the banks” seems to be noth­ing more than a Relief Pro­gram. Cor­po­rate wel­fare and crony­ism at its self-​indulgent best.

So did yesterday’s tough talk go like this? “We’re forc­ing you to take this money, which no one else will lend to you, and you won’t lend to each other. Fur­ther­more, to show you we mean busi­ness, we’re going to guar­an­tee your debt for a frac­tion of the true, underlying, insurance pre­mium, and finally, before you say any­thing, know that we’re going to insure your deposits, too. That should teach you to get into a mess like this, again.” Maybe Mr. Paul­son should read John Rose­mond, rather than con­tact­ing his for­mer employ­ees and his friends for advice on how to save themselves.

Once again, shame on them.

As they spend our money–all of our money–the cru­elty of those two near-​homonyms, sense and cents – all 70 tril­lion of the lat­ter – becomes bru­tally clear.

When will they ever learn?

Peggy Noo­nan has another excel­lent opin­ion col­umn in today’s The Wall Street Jour­nal. It is enti­tled, Play­ing Fris­bee on a Precipice. The title and the column’s blurb say it all: “Our polit­i­cal class lacks the seri­ous­ness this moment demands.” Clearly, her essay is about the small­ness of our present day politi­cians and their advisers.

She has per­fected the abil­ity to lament, yet simul­ta­ne­ously expect, the fallen nature of man.

We’ve writ­ten about our admi­ra­tion for Ms. Noo­nan on a num­ber of occa­sions, and once again she strikes the metaphor­i­cal nail directly on the head. There is an over­whelm­ing small­ness of the cur­rent polit­i­cal class where every­thing, regard­less of the cri­sis, is attempted to be used for short-​term polit­i­cal gain. What small, small peo­ple in both parties.

It’s obvi­ous from her title that she uses the metaphor of play­ing Fris­bee on a cliff to show their utter lack of seri­ous­ness, pri­mar­ily within the two Pres­i­den­tial cam­paigns and with can­di­dates. Per­haps deep down inside, our polit­i­cal actors real­ize that they are not up to the task and there­fore con­tinue to play games as the fel­low cit­i­zens lose tril­lions of dollars. 

In that sense our politi­cians are like young sib­lings or friends mak­ing out­ra­geous claims against each other know­ing full well that their par­ents would step-​in and never per­mit such events to tran­spire. Unfor­tu­nately, the grownups are gone, and the noise down­stairs isn’t an older sib­ling try­ing to scare via a the equiv­a­lent of a Hal­loween prank.

It’s worth men­tion­ing that a month ago we used some­what sim­i­lar imagery to Ms. Noonan’s about the mort­gage cri­sis in Our Poster Boy for the Credit Cri­sis.

In that post we com­pared many Wall Street firms to our hun­gri­est Basenji, Boots. As the photo shows, Bootsy had his head buried so far in the food bag that he had no idea where he was. To his good for­tune he was in the kitchen, and not near the base­ment steps as he pushed on. 

Due to lax man­age­ment, poorly designed incen­tives, and the result­ing exces­sive risk-​taking, Wall Street’s metaphoric head was buried just as far in the food bag seek­ing ever smaller and smaller morsels as it pushed closer and closer to the precipice of the Grand Canyon – located in to hous­ing bust of the South­west, no less.

We still pre­fer our graphic to the one in her column:

By the way, Ms. Noo­nan and Sarah Palin share that trait that seems to be fem­i­nine but which Ronald Rea­gan also pos­sessed. It per­mits a severe scold­ing but in a gen­tle, humor­ous way. 

We don’t know of Mrs. Palin well enough to include her, but we’d argue that it worked for Mr. Rea­gan and works for Ms. Noo­nan because their cen­tral core was/​is so per­ma­nent, solid, and robust that one knows exactly their posi­tion before they speak. That inner sense of com­plete­ness, com­bined with the con­fi­dence that nat­u­rally fol­lows from such maturity, means that lis­tener or the reader knows the words are from the heart, the essence, the core and not just cheap rhetoric. That depth of con­vic­tion per­mits the humor and irony to be appre­ci­ated for what it is, and also what it is not: it is not mean­ness or cheap tactic.

Enough about peo­ple big­ger than us. Out of our own small­ness, we couldn’t help link­ing the failed lead­er­ship of the nation’s old­est baby­boomers, who are now in charge of many gov­ern­ment func­tions and large cor­po­ra­tions, to one of their favorite, Pete Seeger protest songs from the six­ties. It was about gov­ern­ment mis­steps, too. “When will they ever learn? When will they ever learn?”

Now Lend and Shut-​up, Mr. Fed Chairman!

Tonight, The Wall Street Jour­nal reports that the Fed Will Lend Directly to Cor­po­ra­tions. They mean the Fed­eral Reserve will lend to non-​financial corporations.

This is the first sen­si­ble action that we’ve seen any­one in the fed­eral gov­ern­ment take since the finan­cial cri­sis began. No, we’re quite seri­ous. The Pres­i­dent, Con­gress, the Trea­sury, the Fed: all dis­as­ters: seem­ingly ner­vous and clue­less but with­out the good sense to hide either emo­tion from each other or from the Amer­i­can people. 

We’ve argued that the ridicu­lous bailout plan will fail. (See almost any­thing we’ve writ­ten in the past sev­eral weeks.) We also think that the Sep­tem­ber panic-​speeches of Bernanke and Paul­son were equiv­a­lent to shout­ing “Fire” in a the­ater, and if Pres­i­dent Bush had any remain­ing inter­est in the coun­try or econ­omy, he would have fired Paul­son and asked Bernanke to resign for their shame­ful behavior.

This evening we just fin­ished writ­ing Even a Per­fect Bailout Will Fail. In it and many of other recent posts, we men­tion that the prob­lem is the banks and the banks, alone. That prob­lem is the gen­eral and jus­ti­fi­able lack of con­fi­dence in them, includ­ing – or should we write espe­cially – their lack of con­fi­dence in each other is the prob­lem. Even if all the bad assets were exchanged, would the reader trust the banks and their management’s?

Reg­u­lar read­ers will note that for quite some time, we’ve been ask­ing why the losses seem so con­cen­trated? The short answer is that they seem con­cen­trated because they are con­cen­trated. Lax man­age­ment begat poorly-​structured incen­tives, which begat exces­sive risk-​taking, which begat risk con­cen­tra­tion, which begat the mas­sive losses. (Those who would argue that such rea­son­ing is faulty – and there are some – would have to claim that the finan­cial firms are vic­tims of very, very, bad luck, but there doesn’t seem to be much evi­dence of that.)

As far as we can tell, it is not the rest of the econ­omy – not yet, at least. There are areas of the coun­try that have been over­built, and cities like Char­lotte and New York will suf­fer because they rely so heav­ily on the banks and the finan­cial ser­vices indus­try for income, spend­ing, and taxes, but in many places the econ­omy has been remark­ably resilient. 

We see the panic-​speech and a lack of a clear artic­u­la­tion of (1) the prob­lem, (2) the place­ment of blame, and (3) the pro­posed solu­tion and how it would work as the largest prob­lems fac­ing the gen­eral econ­omy, and we see it as the rea­son why the Dow has lost over 1,400 point since the plan was approved. At best we can hope that our politi­cians and gov­ern­ment offi­cials shut-​up before they can cause too much harm.

So, we applaud the Fed, the lender of last resort, for ful­fill­ing its mis­sion and act­ing rather than talk­ing. Banks are the prob­lem, and this lat­est action avodis them and goes directly towards mit­i­gat­ing the prob­lem. By the way, new read­ers may be inter­ested in our alter­na­tive bailout plan: A Bet­ter Solu­tion (than a gov­ern­ment takeover).

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.

Back in June, we wrote Jus­tice and E-​mails in part to reply to the chairman’s ques­tion about whether finan­cial firms would con­tinue to lose money and in part to crit­i­cize the egre­gious behav­ior of few for­mer Bear Stearns employees.

At the time, we said that we expected the losses to con­tinue, and offered her a vari­ety of rea­sons. One of the rea­sons we gave was not a log­i­cal argu­ment related to finance or eco­nom­ics or behav­ior; instead, it was a “ter­res­trial jus­tice” obser­va­tion. (We’ll leave con­sid­er­a­tions of cos­mic jus­tice to higher pow­ers and pray for the best.) We spec­u­lated that the extant losses still seemed quite small given the egre­gious­ness of the behav­ior of many. In fact, they seemed to be smaller by orders of magnitude, and so for that rea­son alone, we could see the loses continuing.

We have no pre­tense about our abil­ity to mea­sure and weigh such notions, but despite the mas­sive losses incurred dur­ing the past three months, we’re still not sure if an equi­lib­rium has been reached, and that is espe­cially true after the bailout was signed into law.

Now the con­tentious reader may argue that such a post is silly, and that may be true. But we would argue that such impres­sions are real and often seem to be shared by believ­ers and athe­ists alike. Unfor­tu­nately, the fact that, say, econ­o­mists can’t quan­tify the notion doesn’t mean that it doesn’t exist. (Also note that we have in mind the eco­nomic jus­tice of finan­cial losses, not crim­i­nal jus­tice or social jus­tice – what­ever that it.)

In the cur­rent cri­sis, it seems that mem­bers of both the polit­i­cal left and right have per­formed dif­fer­ent reck­on­ings but have reached con­clu­sions sim­i­lar to ours. In fact, we believe that zeit­geist would be more evi­dent except for the loom­ing Pres­i­den­tial elec­tion. (On Fri­day we did note in What Mon­ster Hath They Wrought? that politi­cians across the spec­trum may be sur­prised by the level of cyn­i­cism that they have uncon­sciously incul­cated into the cit­i­zenry, and we hypoth­e­sized that it will lead to a result­ing fick­le­ness and feck­less­ness and, therefore, unpredictability of the vot­ing population.)

The fact that the bailout seems to have united both the prin­ci­pled right and left against the expe­di­ent mid­dle is quite an achieve­ment, indeed. In fact, for what­ever rea­son, we see the spokesman for both sides as “the car­pet­bag­ger” in Clint Eastwood’s 1976 mas­ter­piece, The Out­law Josey Wales (the Mis­souri ferry boat scene): “… …No, no, Mr. Josey Wales; there is such a thing in this coun­try called jus­tice!” We don’t think that either side has seen it, yet, and as much as it indi­rectly hurts our port­fo­lio, we don’t think that we have, either.

Read­ers inter­ested in more economics-​based argu­ments against the bailout can search on that term above and will find no short­age of prose to occupy their time. In fact, we offered our own tax-​based, pri­vate cap­i­tal solu­tion in A Bet­ter Solu­tion (than a gov­ern­ment takeover) that seemed rather obvi­ous and cer­tainly worth attempt­ing before the mas­sive gov­ern­ment takeover.