Posts Tagged ‘Incentives’

…To Pro­pose a Ban on Prop Trad­ing at Insured Institutions

We applaud Pres­i­dent Obama’s pro­posal to elim­i­nate pro­pri­etary trad­ing at insured insti­tu­tions. In fact, long-​time read­ers will recall that we first rec­om­mended a ban on this site on Octo­ber 1, 2008 – near the height of the finan­cial panic.

Our rea­sons are simple.

One can argue about the need for fed­eral deposit insur­ance, but if such insur­ance exists, we see no rea­son that tax pay­ers should sub­si­dize risk-​taking at insured insti­tu­tions. If one wishes to ben­e­fit as a ward of the state, then with those ben­e­fits and sub­si­dies come oblig­a­tions and restric­tions. That’s as much a moral and eth­i­cal argu­ment as any­thing else, but there are com­pelling eco­nomic rea­sons, too.

With­out restric­tions the government’s guar­an­tees exac­er­bate the quite seri­ous moral haz­ard prob­lems that already exist because the banks are limited-​liability cor­po­ra­tions. As it seems to cur­rently stand, not only do bank share­hold­ers not have to cover losses, but they get to retain some per­cent­age stake in their firms despite bail-​outs.¹ Thus, banks share­hold­ers have an even bet­ter call option than for most other cor­po­rate share­hold­ers: all on the upside, none of the down­side, and some or much of any future upside (after the downside).

As we have men­tioned in the past, at the mar­gin, there’s not much dif­fer­ence between cer­tain types of cus­tomer trades, prop trades, or asset/​liability man­age­ment trades/​tactics. So, all things equal, we’d expect that if firms want to main­tain a high risk pro­file, a ban on prop trad­ing would lead to higher risk char­ac­ter­is­tics in both their cus­tomer trad­ing books and their bank asset-​liability management/​treasury func­tions (than cur­rently reported).

In that vein, we pre­fer bank reg­u­la­tors to have a nar­rower focus on better-​understood, more-​standardized prod­ucts than be forced to over­see the addi­tional prop trad­ing books, where it seems that (1) more inno­va­tion occurs and (2) rules are more dif­fi­cult to inter­pret, which usu­ally leads to (3) even more rules, inter­pre­ta­tions, and uncer­tainty. In other words, all things equal, make the bank reg­u­la­tors’ jobs as easy and as well-​understood as possible.

In addi­tion, there seems to be no short­age of wealthy firms and indi­vid­u­als will­ing to invest in unreg­u­lated trad­ing oper­a­tions, i.e., hedge funds et. al. So, we see any such lim­i­ta­tions on banks as boon to (most) hedge funds and traders – unless those funds are “picking-​off” the banks.

We sus­pect most traders would be hap­pier (and better-​compensated) at unreg­u­lated firms; so, what’s not to like? [2.Alternatively, if we’re wrong on that count, customer-​trading might become more com­pet­i­tive, which would be ben­e­fi­cial to bank cus­tomers. Also, such a ban doesn’t elim­i­nate expo­sure to prop trad­ing because many large banks pro­vide prime bro­ker­age ser­vices to hedge funds, etc. So, those banks would still be exposed to risks asso­ci­ated with the prop trad­ing indus­try, i.e., they would still face credit risk that is a func­tion of market-​risk and can be very dif­fi­cult to mea­sure, but in some way those risks seem to be once-​removed and dif­fer­ent tools are avail­able to mit­i­gate them.]

We sus­pect that some com­men­ta­tors and ana­lysts will com­plain that the pro­posal is gov­ern­ment intru­sion into mar­kets and “free enter­prise.” At best, such com­plaints are very silly. Ban­ning prop trad­ing at insured insti­tu­tions isn’t intru­sive. Deposit insur­ance (and other guar­an­tees) intrude into mar­kets. As we men­tioned above, one can debate the effi­cacy of such pro­grams, but if the gov­ern­ment is offer­ing insur­ance, it has every right to demand that its cus­tomers behave in par­tic­u­lar ways. If the cus­tomers don’t want the restric­tions then they need not buy the insur­ance. While our cur­rent sys­tem is far from free enter­prise, there’s no rea­son it should be about “free” losses.

No won­der banks stocks declined yes­ter­day. If there is a chance that mas­sive losses will no longer be sub­si­dized, then the implicit option in com­mon equity is – jus­ti­fi­ably – worth less.

The Out­rage Makes Them Larger

Recently, much has been writ­ten about “Wall Street” bonuses. Almost all of those arti­cles men­tion the same two things: (1) pop­ulist and gov­ern­ment sen­ti­ment against the bonuses, and (2) the com­po­si­tion of the bonuses towards long-​term, restricted stock and away from cash. At least some of the drive towards a more stock-​heavy com­po­si­tion seems to be management’s attempt to appease the gov­ern­ment and the pub­lic. In this post, we argue that such moves are need­lessly costly, which means inef­fi­cient and larger than need be.¹

In a pre­vi­ous post, Gov­ern­ment Whin­ing and Bailout Fees, we dis­cussed the out­rage and men­tioned that cit­i­zens have a right to be angry – at the gov­ern­ment. In this post, we ana­lyze the reported com­po­si­tion of many of bonuses. In par­tic­u­lar, we think the insis­tence on long-​term, restricted stock grants is inef­fi­cient for sev­eral rea­sons that we dis­cuss below.

How­ever, before con­tin­u­ing, it is worth re-​mentioning that much of the con­tro­versy could be elim­i­nated by elim­i­nat­ing pro­pri­etary trad­ing at insured insti­tu­tions. As we have repeat­edly writ­ten, we have noth­ing against pro­pri­etary trad­ing or traders, but see no rea­son why we or other tax-​payers should sub­si­dize trad­ing losses. Note, too, that there are other good rea­sons to elim­i­nate such activ­i­ties at insured insti­tu­tions, includ­ing the fact that they diverts man­age­r­ial atten­tion away from (bor­ing and mun­dane) every­day activ­i­ties of run­ning com­mer­cial banks. We know that at the mar­gin, there’s not much of a dif­fer­ence between a bank’s trea­sury (asset-​liability) man­age­ment and cer­tain kinds of prop trad­ing, but we’d pre­fer that reg­u­la­tors keep a nar­rower focus. Finally, to get, in a sin­gle edi­tion of The Wall Street Jour­nal, Thomas Frank, Jonathan Macey, and James B. Stewart to agree with us is mind-​boggling. It indi­cates the abject per­ver­sity of the sta­tus quo.

Now, hav­ing said that, we hope that every­one receiv­ing the much-​discussed bonuses get max­i­mum enjoy­ment and sat­is­fac­tion from them. We cer­tainly don’t blame any­one for try­ing to max­i­mum his or her com­pen­sa­tion in an attempt to max­i­mize their sat­is­fac­tion, their family’s sat­is­fac­tion and well-​being, and their con­tri­bu­tion to the less for­tu­nate. The prob­lem is that there are likely cheaper ways to pro­vide the same level of sat­is­fac­tion and reward.

Aside: note that for the remain­der of this post, we’ll use the word “expected,” as in “expected com­pen­sa­tion,” in a very loose, non-​mathematical way. That’s because we are rather pedan­tic and like to empha­size the dif­fer­ence between uncer­tainty and risk. Like oth­ers, we define risk as mea­sur­able uncer­tainty, and that means that risk is a spe­cial type of uncer­tainty or unknow­ing can be (appro­pri­ately) described as a prob­a­bil­ity dis­tri­b­u­tion. Not all prob­a­bil­ity dis­tri­b­u­tions have means or expected val­ues, and that seems to be the case in finan­cial mar­kets. So, try­ing to cal­cu­late one’s expected bonus as a func­tion of mar­ket per­for­mance might not be tech­ni­cally fea­si­ble if the dis­tri­b­u­tion of returns is unknown or its moments don’t exist.²

So what’s wrong with bonuses in the form of long-​term, restricted stock?

Well, they are long-​term so they defer con­sump­tion, they are restricted so they’re are expen­sive to con­vert into con­sump­tion, and they in sotck so they are risky (uncer­tain) because they are only very weakly tied to an individual’s performance.

Delayed Grat­i­fi­ca­tion:

Are there good rea­sons for long-​term com­pen­sa­tion schemes? Yes, there are.

When employ­ees take actions or make deci­sions that have long-​term impli­ca­tions, then sig­nals from mul­ti­ple peri­ods can be used to infer whether the employee behaved appro­pri­ately – back when the the deci­sion was made.

Gen­er­ally, the use of mul­ti­ple sig­nals improves the pre­ci­sion of the infer­ence, and that means that less risk is imposed on the employee.³ For risk-​averse employ­ees, that means a lower risk pre­mium is required to ensure his or her par­tic­i­pa­tion, which means a smaller expected bonus is required.⁴ So, the key to reward­ing long-​term per­for­mance is clas­si­fy­ing cur­rent period results into the time peri­ods when deci­sions were made so that one can make bet­ter infer­ences about the deci­sions made in a prior period. It’s not as easy as it sound, but it is pos­si­ble to do.

So, yes, most traders that make long-​term bets should be rewarded on long-​term per­for­mance, and fea­tures like claw backs should be used, but in the spe­cific way that we wrote about in Claw­backs: the Good, the Bad, and the Ugly and Incen­tives at UBS and in Gen­eral.

How­ever, requir­ing some­one to wait five years to receive stock in a mega-​corporation is not the same thing. That’s because:

1. Five years is arbi­trary, and may have lit­tle to do with the length of the employee’s invest­ment deci­sion. More­over, it is a long-​time to wait for a pay-​off.
2. If we’ve learned noth­ing else dur­ing the past few years, we have learned that, in gen­eral, share prices are very volatile, which means that employ­ees who must wait five years for their reward must bear a sub­stan­tial amount of risk.
3. Other than pos­si­bly a few senior exec­u­tives, no sin­gle employee has very much antic­i­pated or expected influ­ence on share price in five years. Ex post they may have, but not ex ante.

So, it seems rea­son­able to con­clude that impa­tient, risk-​averse employ­ees would sub­stan­tially dis­count the expected value of such stock grants.⁵ That means that all things equal, it means that if they can, employ­ees will demand larger bonus grants to com­pen­sate for the delayed grat­i­fi­ca­tion and the risk.

Restric­tive:

We imag­ine that the only peo­ple who pre­fer that bonuses be in the form of restricted stock are folks who aren’t get­ting them and the envi­ous types: please see The Chil­dren who Have Eaten their Cake…

Usu­ally, there are ways to bor­row against such grants and/​or hedge the value of such grants, but not all firms per­mit such actions. More­over, they’re not cheap and they can be time-​consuming.

That means that employ­ees will bear costs of con­vert­ing the awards to nearer-​term con­sump­tion and, if pos­si­ble, will demand larger bonuses to cover those costs.

Risky and Uninformative:

For some reason,many folks (and politi­cians) believe that when employ­ees own shares, includ­ing restricted stock, incen­tives are some­how mag­i­cally aligned – kind of like Lucky Charms.

How­ever, except for pos­si­bly a small hand­ful of very senior man­agers, that’s very silly. Con­sider that Bank of Amer­ica has nearly 300,000 employ­ees, Cit­i­Group has about the same, and even smaller firms like Gold­man Sachs have more than 30,000. So, the effect of any sin­gle employee is usu­ally very small. (More­over, the pre­dicted effect is usu­ally very small. In fact, when it is large, it is often due to the firm’s fran­chise and rep­u­ta­tion and not that par­tic­u­lar person’s actions.)

Do note that attempt­ing to link the effects of a par­tic­u­lar action, deci­sion, invest­ment or trade to share price today or any point in the future is extremely dif­fi­cult. (Maybe not in finance class, but it is in real life.)

Just as impor­tantly, and as we men­tioned above, even if it can be done (in expec­ta­tion) the firm’s stock price is a par­tic­u­larly noisy mea­sure of a par­tic­u­larly person’s per­for­mance. So, it’s quite pos­si­ble to con­clude that employ­ees will ignore the impli­ca­tion of their deci­sion of share prices, which is com­pletely ratio­nal, and do what’s best for them­selves. That very much reminds us of that quote of Huck­le­berry Finn that we always used when we taught: “Well, then, says I, what’s the use you learn­ing to do right when it’s trou­ble­some to do right and ain’t no trou­ble to do wrong, and the wages is just the same?”

For more on this gen­eral topic, we refer inter­ested read­ers to our essay in the Fal­lacies sec­tion of the web site: One Per­for­mance Mea­sure to Rule Them All.

For more on this topic as it per­tains to trad­ing, we encour­age vis­i­tors to read the last half of the above-​mentioned, The Chil­dren who Have Eaten their Cake…

In sum, we argue that (1) the long-​term nature that delays con­sump­tion, (2) the restricted nature that is costly to bypass, and (3) risky nature fur­ther reduces the value (think in terms of expected util­ity or cer­tainty equiv­a­lent) make such bonuses worth sub­stan­tially less than their face value. If employ­ees have any bar­gain­ing or nego­ti­at­ing power, firms will have to increase the stated value of the bonuses to sat­isfy them.

Those extra costs would be worth bear­ing if they aligned incen­tives, but unless you, dear reader, believes in magic, there is no rea­son to believe that any future actions by those employ­ees will be coöper­a­tive in nature.

So, it seems that long-​term, restricted stock awards are inef­fi­cient ways to moti­vate employees.

We’ll likely proof­read this post and edit it in the near future.

P.S. Our New Year’s res­o­lu­tion is to write more about finan­cial mat­ters, the indus­try and the cri­sis than we did dur­ing last half of 2009. Last fall’s drought occurred for a vari­ety of good rea­sons, but two related ones are worth men­tion­ing: (1) while many of our posts tend to be long, we hate being repet­i­tive, and in our mind there was lit­tle new to say, and (2) with lit­tle new to say, we found many of the events and pro­ceed­ing to be quite bor­ing. For writ­ing blog posts, “bor­ing” means too many ref­er­ences to old mate­r­ial – like above – but we’ll try to write more in 2010.

Copy­right © 2010 Spero Consulting

Foot­notes:

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

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

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

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

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

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

Wrong Legal Form/​Organization Structure

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

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

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

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

Incom­pe­tent Boards

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

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

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

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

Lax Con­trols and Poorly-​designed Incentives

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

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

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

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

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

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

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

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

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

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

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

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

What To Do?

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

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

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

So what to do?

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

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

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

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

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

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

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

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:

Does the Sum of Idio­syn­cratic Deci­sions Mean Anything?

There’s an arti­cle in the week­end edi­tion of The Wall Street Jour­nal, enti­tled, It’s a Done Deal: Mer­rill and BofA. It is sub­ti­tled, “At Thun­der­ing Herd’s Last Meet­ing, Thain Pre­sides Over Sad­ness and Anger.”

In pre­vi­ous posts we’ve already com­mented on a vari­ety of related top­ics, includ­ing our dis­like of mega-​mergers, which con­cen­trate idio­syn­cratic decision-​making and exac­er­bate moral haz­ard issues. (For merger-​related issues, see: Forced Merg­ers? Big­ger Is Not Nec­es­sar­ily Bet­ter!, Big­ger Is Not Nec­es­sar­ily Bet­ter or Idio­syn­cratic and Con­cen­tra­tion Risk, Again.) We don’t think that reg­u­la­tion or reg­u­la­tors pro­vide much over­sight or control.

Per the sub­ti­tle of the arti­cle, it seems that much of the anger was directed at the board (which does make sense since it was a board meet­ing) and we’ve com­mented about failed boards in other posts, too; see The Fail­ure of Boards to Direct and When the Going Gets Tough…Quit for example.

So, in this post, we’re restrict­ing our com­ments to a sin­gle, short para­graph from the arti­cle related more towards a human resource issue.

It seems that Winthrop Smith Jr., the son of one of the found­ing part­ners of Mer­rill Lynch, Pierce, Fen­ner & Smith spoke at the meeting. (In fact, he may have been both sad and angry.) As the reporters note, “Refer­ring to the exo­dus of long­time exec­u­tives at Mer­rill when Mr. O’Neal took over, Mr. Smith said, ‘shame on mem­bers of the board for never ask­ing any of us who loved this firm’ why they were leaving.”

In our youth, we were part of a sim­i­lar exo­dus; there were six junior col­leagues, and five left the orga­ni­za­tion within months of each other. (The other one did, too, but at a later date.) As is always the case, an idio­syn­cratic or per­sonal rea­son could be attrib­uted to each person’s deci­sion to leave: A left for fam­ily, B wanted to move to a warmer loca­tion, C didn’t like the office décor, etc., etc.

If the rea­sons were purely idio­syn­cratic, then the organization’s man­age­ment would be blame­less of poor employee rela­tions. It is even pos­si­ble that in hind­sight, some­one within the orga­ni­za­tion to try to take credit for get­ting rid­ding of the dead­wood – whether jus­ti­fied or not. (Those things are very easy to take credit for in ret­ro­spect and when the peo­ple are gone: “they couldn’t cut it” or other such comments.)

If the orga­ni­za­tion were truly blame­less, then the depar­tures could nei­ther been fore­seen nor attrib­uted to any cen­tral defi­ciency or weak­ness or dys­func­tional per­son­al­ity within the organization.

How­ever, a thought­ful, self-​critical leader should be will­ing to ask: “we’re sure that every­one has their own reason(s), but what are the odds of such an exo­dus with­out a cen­tral­ized or sys­tem­atic component?” Per Mr. Smith, shouldn’t some­one ask: “why are they all leav­ing?” One shouldn’t expect answers from exit inter­views as folks who are leav­ing have lit­tle rea­son to give more than pleas­antries at an exit inter­view, and those who do com­plain are often dis­missed as “some­one with an ax to grind” so their feed­back is never seri­ously con­sid­ered disseminated.

In all likelihood, the prob­a­bil­ity that there was/​is no sys­tem­atic com­po­nent is quite small. We have no inside knowl­edge of whether the Mer­rill board inves­ti­gated their exo­dus or not. If not, we cer­tainly empathize with Mr. Smith as it would then seem to be a case of either benign or pur­pose­ful neglect.

Of course, the pres­ence or absence of a sys­tem­atic com­po­nent doesn’t explain whether the exo­dus was jus­ti­fied or not (from management’s per­spec­tive). That is a sep­a­rate issue which will depend upon whether the observed con­se­quences were intended or not.

We talk about sim­i­lar issues in a few of our essays – par­tic­u­larly, Com­mon Man­age­r­ial Mis­takes in Decen­tral­ized Orga­ni­za­tion and the last part of Strate­gic Con­sis­tency and Man­age­r­ial Dis­ci­pline–and sev­eral posts, includ­ing Insid­i­ous Inse­cu­rity.

We’ll likely update the post when time permits.

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?

Did SOX Exac­er­bate the Cri­sis? and…

The Best is Yet to Come, Oh Yeah!

We don’t mean any base­ball teams, we mean the Sarbanes-​Oxley Act of 2002, which Pres­i­dent Bush said at the time of its sign­ing was “the most far-​reaching reforms of Amer­i­can busi­ness prac­tices since the time of Franklin D. Roo­sevelt.”

Here is a descrip­tion from Wikipedia: “… in response to a num­ber of major cor­po­rate and account­ing scan­dals includ­ing those affect­ing Enron, Tyco Inter­na­tional, Adel­phia, Pere­grine Sys­tems and World­Com. These scan­dals, which cost investors bil­lions of dol­lars when the share prices of the affected com­pa­nies col­lapsed, shook pub­lic con­fi­dence in the nation’s secu­ri­ties mar­kets.” We’ve added the ital­ics in the quote.

Well, another suc­cess for gov­ern­ment reg­u­la­tion, don’t you think?

SOX seems to have been for­got­ten dur­ing the recent and ongo­ing panic. Eek! Eek! But, we think it will be back: when the indict­ments start coming. With a gov­ern­ment bailout, some­one is going to do time, and SOX will be the means by which they are con­victed. On this topic we see no dif­fer­ence between the two Pres­i­den­tial can­di­dates. They’ll like be equally vin­dica­tive; so, the future level of pros­e­cu­tions should be about the same. (Our guess: you’ll hear both of them talk about it by late Octo­ber, when the class envy and war­fare is at its most pitched, and the two are at their most desperate.)

We do agree with Pres­i­dent Bush’s excerpted state­ment, but it is doubt­ful that we share the same inter­pre­ta­tion. He prob­a­bly meant “far-​reaching” in a good way.

SOX was and is still very far-​reaching in both its high cost and waste of cor­po­rate resources. It was and is an auditor’s fond­est and wildest dream: pro­ce­dures and doc­u­men­ta­tion to review and “test” that, as we see, pro­vide no ben­e­fit to any­one other than said audi­tors and their cousins; the cor­po­rate bureau­crats, whose posi­tions exist to val­i­date SOX processes and controls.

Depend­ing upon the level of cyn­i­cism and skep­ti­cism among investors, SOX may have also played a role in the on-​going finan­cial cri­sis. (In this case, the greater than skep­ti­cism, the smaller the harm.)

If investors are truly cyn­i­cal or skep­ti­cal, then SOX likely played no role in the cri­sis because nei­ther cyn­ics nor skep­tics would have put any weight on it in the first place. It is pos­si­ble that we are pro­ject­ing here; we’re more of the lat­ter than the former.

So if cyn­ics and skep­tics set prices, then SOX is merely a huge, but dead­weight, cost to soci­ety, and please remem­ber, this is the best case sce­nario!

On the other hand, if investors were fooled into believ­ing that esti­mated account­ing val­ues were more reli­able and rel­e­vant because of SOX, then the law and its imple­men­ta­tion have exac­er­bated the mess. Please remem­ber that marks on illiq­uid assets are noth­ing if not esti­mated account­ing val­ues, which require a process to fol­low every month or quarter.

The prob­lem is that fol­low­ing a doc­u­mented process each time an esti­mate is made doesn’t make that esti­mate reli­able or rel­e­vant (infor­ma­tive). It just makes it documentable.

For exam­ple, one could thor­oughly doc­u­ment the process of exam­in­ing chicken entrails to divine the future to any level or degree of speci­ficity. (We’ll focus on rel­e­vancy here, but there may be no reli­a­bil­ity, either. This can hap­pen if the process uses, say, an unre­lated, ran­dom vari­able in the val­u­a­tion or estimation.)

For exam­ple, one could map the var­i­ous char­ac­ter­is­tics of the entrails into the stan­dard, cor­po­rate green-​yellow-​red warn­ings of a Pow­er­Point “Dash­board” slide to pro­vide indi­ca­tors of some­thing or other for an unin­formed board of direc­tors or senior man­age­ment. If the result of that color map­ping is an impor­tant vari­able in impor­tant deci­sions, then it would be a SOX con­trol. So, the div­ina­tion process would need to be doc­u­mented and val­i­dated. It is easy to do but quite boring.

Sim­i­lar arbi­trary (and no less dis­gust­ing) processes, could be used to value any par­tic­u­lar asset. These esti­mates would then affect income cal­cu­la­tions for the period, includ­ing unre­al­ized gains and losses.

Again, none of this has any­thing to do with find­ing the “true” value, which as we often note is often an impos­si­bil­ity. Instead, SOX involves doc­u­ment­ing the process/​control that the orga­ni­za­tion has fol­lowed to arrive at the esti­mate. That’s almost always pos­si­ble to do.

By the way, if the reader doesn’t like chicken entrails, he or she may select any quan­ti­ta­tive model and his or her choice of a par­tic­u­lar and arbi­trary prob­a­bil­ity dis­tri­b­u­tion. See our essay, Uncer­tainty Man­age­ment, for our views on these and related topics.

So, we find SOX and its rules to be worth­less at best and mis­lead­ing at worst. In that way, we could see how it might have mis­led the unso­phis­ti­cated to place more faith in audited income and asset reports than is war­ranted. We could imag­ine such folks ask­ing, “What CEO or CFO would mis­lead the pub­lic given the impli­ca­tions of being discovered?” We could then see such investors con­clud­ing that the reported num­bers were firmer and truer than with­out such laws. Clearly, that would have exac­er­bated the ongo­ing cri­sis by (1) reward­ing firms for report­ing higher income, (2) encour­ag­ing them to con­tinue (to expand) and do more of the same, i.e., add to their seemingly-​profitable and valu­able invest­ments and trades.

Did any investors actu­ally believe that SOX per­mit­ted reported num­bers to be more mean­ing­ful? Pos­si­bly, but it really doesn’t mat­ter at this time. Because that doesn’t pre­clude the cyn­i­cal ones from suing. More impor­tantly it cer­tainly does not pre­vent cyn­i­cal fed­eral offi­cials from inves­ti­gat­ing and indict­ing and pros­e­cut­ing exec­u­tive offi­cers who signed and cer­ti­fied what turn out to be very mis­lead­ing finan­cial reports.

Our free advice: senior exec­u­tives at large, failed pub­lic firms should con­sider sell­ing their art col­lec­tions and vaca­tion homes and remain­ing stock – if it has any value – and build­ing a defense fund. Also, shop for and retain the best civil and crim­i­nal defense attor­neys that you can afford.

As Frank Sina­tra sang, “The Best is Yet to Come.” We fore­cast that unfor­tu­nately for these senior exec­u­tives and unjustly – in most cases – given the impos­si­bil­ity of the esti­ma­tion tasks, the next Pres­i­dent, his Attor­ney Gen­eral, and the Con­gress will seek “jus­tice” or at least the hides of the wealthy and “cor­rupt” who “got us into this mess.”

Given the arbi­trari­ness of the law, those exec­u­tives will have a dif­fi­cult time defend­ing them­selves, and may wish that they had paid more atten­tion – both on the job and in prob­a­bil­ity and sta­tis­tics class. They may also want to go long Mack­erel.

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.

There is an excel­lent arti­cle in today’s The Wall Street Jour­nal enti­tled, “Lessons of Finan­cial Cri­sis” (sic).¹

The arti­cle describes dis­cus­sions at a recent con­fer­ence fea­tur­ing Nobel Prize win­ners in eco­nom­ics (and in peace, too). While we do like much about the arti­cle, we take issue with the way the prob­lems were pre­sented: almost as if there were three inde­pen­dent ones: exces­sive risk-​taking, lax man­age­ment, and impen­e­tra­ble com­plex­ity. We see only two prob­lems with the first one listed, exces­sive risk-​taking, being a symp­tom or impli­ca­tion of lax man­age­ment. (‘Lax’ seems to be a very kind adjec­tive in this case.)

We do believe that many secu­ri­ties, instru­ments, and deriv­a­tives are impen­e­tra­bly com­plex, and like other com­men­ta­tors, we argue that this is an epis­te­mo­log­i­cal issue and is due to the Prob­lem of Induc­tion, among other things.

Our own per­spec­tive is best explained in our essay: Uncer­tainty Man­age­ment, Or, Igno­ra­mus et ignor­a­bimus, Or, How Trad­ing is Like Play­ing in a Cul­vert on a Hot, Sunny, Sum­mer Day. While we encour­age all to read it, we sum­ma­rize it as fol­lows: there are things that we don’t under­stand and never will. That is not just a per­sonal lim­i­ta­tion; it is a human one. We can develop work­able mod­els that can help us in many tasks, but at best they cheaply approx­i­mate real­ity dur­ing a rel­e­vant range of time and activ­ity. There are things that we can’t model, because we haven’t thought of them or have ignored them, and these things can dis­as­trously affect us. With humil­ity we can attempt to dis­cover a few of them through of a vari­ety of means, includ­ing sce­nario analy­sis and stresstesting. We can cre­atively attempt to find ana­logues, and with luck when defend­ing against those harms, we may also immu­nize our­selves against oth­ers, too, which are hid­den for the time being. (As we write this, it dawns on us that we are likely call­ing for some com­bi­na­tion of the Hip­po­cratic Oath and the AA’s twelve-​step pro­gram for risk managers.)

Fur­ther­more, we note that losses asso­ci­ated with envi­ron­men­tal inscrutabil­ity — for lack of a bet­ter phrase — are com­pounded and ampli­fied by hubris and cyn­i­cism and naiveté, which is a kinder, gen­tler term for ignorance. This should be espe­cially evi­dent when one hears an employee claim that “we have every­thing under con­trol.” Really? How would one know? It is not a well-​understood chem­i­cal process; instead it is human behav­ior. This is why we empha­size uncer­tainty rather than the nar­rower, mea­sur­able risk.²

Now those fail­ings men­tioned above — hubris, cyn­i­cism, and naiveté — can be mit­i­gated through the effec­tive design of con­trol mech­a­nisms. In decen­tral­ized envi­ron­ments the exhi­bi­tion of such behav­ior can be influ­enced or mit­i­gated via incen­tive schemes, includ­ing the care­ful choice of per­for­mance mea­sures, but it seems that they rarely are. (Please see most of our other essays under the Illus­tra­tions or Fal­lac­ies tabs for more on these and related top­ics.) In fact, it seems that many schemes exac­er­bate rather than mit­i­gate these fail­ings, and that seems to be why cer­tain pro­fes­sions have such poor reputations.

BUT, hubris, cyn­i­cism, and naiveté, like exces­sive risk-​taking are not them­selves prob­lems. They are merely both­er­some symp­toms of a big­ger prob­lem, the sec­ond prob­lem in the arti­cle: lax man­age­ment.³

In some ways, lax man­age­ment is fraught with the same symp­toms and seems to be a recurse of the above lead­ing up to the board and beyond, but it is worth break­ing the cycle to make a point. It seems that per­sonal pride (and insecurity) play larger roles at higher lev­els; so, ceteris paribus, such man­agers are less likely to reveal their lack of knowl­edge and thus seem more likely to be laxer than they oth­er­wise would be. In that respect, we would much pre­fer: “You can’t do it because I don’t under­stand it” to “Great idea. I was about to pro­pose that myself.”

There is much to write and con­sult and advise on these issues, and we’ll con­tinue to write about them in the future. In fact, the break​ingviews​.com col­umn imme­di­ately above the arti­cle dis­cussed here men­tions new incen­tives at UBS. We’ll likely have a post on that later today or over the weekend.

We do note that the recent con­cen­tra­tion of losses in the finan­cial indus­try is a neg­a­tive impli­ca­tion of exces­sive risk-​taking, i.e., keep­ing it amongst them­selves (to get that lit­tle extra). New read­ers can catch-​up here.

In clos­ing, we also note that we’ll ignore the por­tion of the arti­cle that deals with an ana­logue of the FDA for new finan­cial prod­ucts. There are any num­ber of ways to attack it. We’ll sim­ply note that a hard sci­ence like chem­istry is much bet­ter under­stood than any social sci­ence; thus, it may be pos­si­ble to teach gov­ern­men­tal bureau­crats the req­ui­site chem­i­cal and bio­log­i­cal facts and knowl­edge. Moreover, away from research fron­tiers, there is less room for capri­cious­ness and arbi­trari­ness in hard sci­ences. If the FDA works at all, that might be why.

Copy­right © 2008 Spero Consulting.

Foot­notes:

Note: we fre­quently crit­i­cize poor model-​building in our posts and plan to do so in our essays, too. Before we reit­er­ate our crit­i­cisms we wish to be clear: we have noth­ing against math­e­mat­i­cal or com­puter mod­els per se. In fact, we like it when we are paid hand­somely to build, cri­tique, or val­i­date mod­els. It is just that there has been such a mul­ti­tude of recent, pub­lic exam­ples of their mis­use and mis­in­ter­pre­ta­tion that we can’t resist com­ment­ing on these events as they are made public.

Speak­ing of which, there is another good book review in today’s WSJ: Money for Noth­ing by James R. Hagerty. In it, Mr. Hagerty, a writer for the paper, favor­ably reviews Con­fes­sions of a Sub­prime Lender by Richard Bitner.

Mr. Hagerty men­tions a meet­ing in 2005 with Bear Stearns MBS traders and ana­lysts in which he ques­tioned their ini­tia­tive to orig­i­nate con­sumer mort­gages. He men­tions that the folks “dis­missed my ques­tions with ill-​concealed contempt.” They had com­puter mod­els that told them that house prices wouldn’t fall much and defaults would remain be low.

We can eas­ily imag­ine that he was shown atti­tude. What puz­zles us in this and many other exam­ples is whether the over-​reliance on mod­els is cyn­i­cal, as in “we have a com­pli­cated model (and an inar­tic­u­late quant) to blame if any­thing goes wrong,” or naïve and hubris­tic, as in “we have a model that cap­tures real­ity under every con­ceiv­able out­come, and noth­ing can go wrong.” See the end of the fol­low­ing post, for another exam­ple where that didn’t quite hap­pen: Trad­ing, Incen­tives, Orga­ni­za­tional Struc­ture and Risk Man­age­ment.

We con­clude with another line from the review. “They had plenty of brain­power but fell short on com­mon sense.” Nicely put Mr. Hagerty.

Or how tenure is like plea-​bargaining

The exter­mi­na­tor vis­ited world head­quar­ters on Fri­day. He men­tioned that in this part of the county, 90% of his busi­ness involved spray­ing struc­tures to keep car­pen­ter bees from bor­ing and yel­low jack­ets and other hor­nets from nest­ing and annoying.

After he sprayed, we spoke for a few min­utes, and he asked about the nature of our busi­ness and our back­ground. Given his degree in busi­ness and his own­er­ship of the ser­vice, he seemed inter­ested in what we had to say but maybe he was just being polite.

Regard­less, dur­ing our con­ver­sa­tion, he men­tioned that to his dis­may a close friend, who was much younger than either of us and who had achieved much early career suc­cess, would likely be forced to relo­cate to find a new job, and he was rue­ful of the loss of companionship.

He said the prob­lem was his friend’s new boss. The new boss rec­og­nized the younger man’s supe­rior com­pe­tence and viewed it as a threat. As a con­se­quence, the boss was attempt­ing to smother him and drive him away.

We have to admit to igno­rance of this prob­lem early in our career. Pos­si­bly our bosses did not view us as a cred­i­ble threat or pos­si­bly they had suf­fi­cient self-​confidence to man­age employ­ees with bet­ter knowl­edge than they possessed.

We first became acutely aware of this phe­nom­e­non while teach­ing MBA classes — par­tic­u­larly, when we would dis­cuss incen­tives. Dur­ing class breaks, after class, and dur­ing office hours, the exec­u­tive and pro­fes­sional (evening) MBAs would share their stories.

This type of man­age­r­ial inse­cu­rity is insid­i­ous yet per­va­sive within many orga­ni­za­tions. In fact, we have heard of cases where C-​level offi­cers will only hire first-​level sub­or­di­nates who are unqual­i­fied to replace them. Thank good­ness those folks aren’t design­ing bridges or con­trol­ling any­thing combustible.

These types of sto­ries remind us of the best expla­na­tion that we’ve heard for the jus­ti­fi­ca­tion of uni­ver­sity tenure per H. Lorne Carmichael in the paper, “Incen­tives in Acad­e­mia.” ¹ Below is the story with­out the model. Read the rest of this entry »

A few of impli­ca­tions first: Bear Stearns cut 2,000 jobs in the last year. Cit­i­group is reduc­ing its work force by 9,000; Washington Mutual by 3,000; and Mer­rill Lynch by 4,000. How many of those folks deserve it?¹

Last week, we had this rather lengthy post of about trad­ing and incen­tives. Over the week­end, we were at a ban­quet where we encour­aged one of our friends to read Nas­sim Nicholas Taleb’s books and Richard Bookstaber’s recent book. That lead us to dis­cover this arti­cle from last Sep­tem­ber on Taleb’s web site: www​.Fooled​ByRan​dom​ness​.com.

We like this sen­tence from the arti­cle: “Peo­ple seem to pay rat­ing agen­cies for psy­cho­log­i­cal com­fort, or, more decep­tively, to jus­tify a cer­tain class of risk taking…,” and espe­cially the lat­ter justification. 

It reminds us of a visit we had with a CDO man­ager in 2007. At the time, he claimed that his firm was “arb­ing the rat­ing agen­cies.” Pre­sum­ably, he meant that for what the firm did its (ini­tial) return was out­sized given the risks iden­ti­fied by the rat­ing agen­cies. Unfor­tu­nately, his firm was the resid­ual claimant respon­si­ble for cov­er­ing (the even­tual) losses.

As it turns out, the com­pany has been in the news quite a bit dur­ing the past sev­eral months, and none of the reports has been pos­i­tive. When we spoke, his firm’s share price was in the mid 60s. Within a year, it had lost 90% of its value. I guess arbi­trage isn’t what it used to be. 

So Mer­rill Lynch has lost a lot of money in var­i­ous trad­ing and struc­tur­ing activ­i­ties. See the excel­lent arti­cle in Wednesday′s The Wall Street Jour­nal (WSJ) for the details: “Mer­rill Upped Ante as Boom In Mort­gage Bonds Fiz­zled.”

Col­lat­er­al­ized debt oblig­a­tions (CDOs) receive much atten­tion in the arti­cle, espe­cially ones backed by mort­gage secu­ri­ties (MBS) and mortgages. Here is the visual of how CDOs are struc­tured and marketed: (1) throw a bunch of instru­ments in a blender and chop until pureed; hopefully when the blades stops spin­ning, the mix­ture is some­what uni­form. (2) Let the mix­ture set­tle so that dif­fer­ent lay­ers or strata form. (3) Sell the dif­fer­ent lay­ers to investors with dif­fer­ent tastes, prefer­ably cap­tur­ing the gains to trade. Now, if that makes sense, you should be able to come with analo­gies for things like sys­tem­atic risk, i.e., some­one drops the blender or throws some­thing foul into the mix­ture.¹

The arti­cle pro­vides exam­ples of many points that we like to make, and we men­tion sev­eral below.²

It is about incen­tives & orga­ni­za­tional structure. 

Maybe the publicly-​traded cor­po­rate form isn′t the most effi­cient legal form for market-​makers and large trad­ing firms? Maybe trad­ing man­agers and traders need larger per­sonal and longer term stakes to moti­vate them to under­stand and man­age risks?

If the cur­rent legal form remains the sta­tus quo, then it seems to us that con­trol mech­a­nisms, par­tic­u­lar per­for­mance mea­sures and com­pen­sa­tion schemes must change. A sim­ple place to start is to reward employ­ees based upon aver­age results in their port­fo­lios across peri­ods of time — even if the employee leaves in the interim. We will expand upon this idea in later posts, but the point is to induce sub­or­di­nates to think beyond the end of the next bonus period while at the same time reduc­ing the risk imposed upon them. Of course, imple­ment­ing such a pol­icy requires dis­ci­pline and com­mit­ment by senior man­age­ment, and that takes us back to our first rhetor­i­cal ques­tion above.

Diver­si­fi­ca­tion benefits?

We are not say­ing that diver­si­fi­ca­tion ben­e­fits do not exist, and we under­stand how CDOs might diver­sify the risks of, say, mortgage-​backed secu­ri­ties, but that would only be with cer­tain types of uncer­tainty. See below for how it can fall apart.

We have a harder time under­stand­ing how CDOs of CDOs (CDO²) cre­ate value given the economy’s sys­tem­atic risk, but that isn’t exactly our point. We see how mod­el­ing CDO²s sim­i­larly to CDOs would show diver­si­fi­ca­tion ben­e­fits, but that doesn′t mean the ben­e­fits are real. Those ben­e­fits could sim­ply be an arti­fact of the mod­el­ing tech­nique or joint-​distribution assump­tions. (By the way, diversification ben­e­fits smooth aggre­gate cash flows in dif­fer­ent out­comes or states, and that leads to fewer out­comes with short­falls and CDO bond defaults; so, they would appear less risky despite the under­ly­ing reality.)

We are not dis­count­ing the dif­fi­culty of solv­ing such prob­lems or esti­mat­ing such results. Pre­dict­ing who will and will not pay their mort­gages is very dif­fer­ent than flip­ping a coin numer­ous times. The future (the out­come) is not known in either case. With mort­gages, however, no one knows how the future is even deter­mined, i.e., how do early results affect later prob­a­bil­i­ties – kind of like report­ing exit poll results before the polls are closed.³ Of course, the ran­dom processes of coin flips are eas­ier to visu­al­ize, but that doesn’t mean it is accurate.

We pre­fer to use the inher­ent dif­fi­culty of the prob­lem as evi­dence of our claim. There aren’t any easy ways to solve these prob­lems when mulp­ti­ple assets or under­se­cu­ri­ties are com­bined into a new one.

Meth­ods that do exist usu­ally require very arbi­trary assump­tions. (Uhh, look up “cop­ula” if we seem overly cranky or harsh.) And, as we men­tioned above, those math­mat­i­cal assump­tions have implications.

Like every­thing else that comes out of any math­e­mat­i­cal model — regard­less of the level of for­mal­ity diver­si­fi­ca­tion ben­e­fits are the impli­ca­tions or the arti­facts of the model’s assumptions. 

With com­pli­cated mod­els that may be part theoretical, part empir­i­cal, or part simulation, ascertaining the con­tri­bu­tion or effect of any par­tic­u­lar assump­tion (on the over­all result) is often rather dif­fi­cult. Sim­ply the choice (from the lim­ited menu) of mod­el­ing tech­niques and assump­tions, may be suf­fi­cient — at the mar­gin — to make a col­lat­er­al­iza­tion look valu­able regard­less of the truth.

If our above argu­ment is not com­pelling, then con­sider this ques­tion. Exactly how many deals – secu­ri­ti­za­tions and rese­cu­ri­ti­za­tions – would have been com­pleted and sold with­out the cre­ation of sub­stan­tial diver­si­fi­ca­tion benefits? 

With­out sub­stan­tial diver­si­fi­ca­tion ben­e­fits, the remain­ing ben­e­fits would have to accrue from the mar­ginal ben­e­fit of mar­ket­ing “risk-​differentiated” CDOs rather than the orig­i­nal, whole MBS. In other words, ignor­ing the mod­eled diver­si­fi­ca­tion ben­e­fits, are the ben­e­fits of pro­vid­ing dif­fer­en­ti­ated CDO classes to investors with dif­fer­ent risk pref­er­ences greater than the sub­stan­tial trans­ac­tion costs and risks? When phrased that way, it seems highly doubtful.

Thinly-​traded “markets”

Yeah, that describes hous­ing, espe­cially in our neighborhood. So we ask, in a sub­di­vi­sion of x houses, exactly how many, y, have to sell at a ‘lower’ price for the remain­ing x — y houses to lose value? 

In our lit­tle part of the Shire, there are 90 houses. All things equal, we fig­ure that only three need to sell for ‘less’ before the rest lose value. In other words, after three, it is no longer about the par­tic­u­lar houses or the peo­ple or their moti­va­tions.⁴ 

In many areas, 90 houses con­sti­tute a very small plan. So, let′s say y/​x = 3.33% is the cor­rect frac­tion for us. How would you expect y to change as the sub­di­vi­sion gets larger? Assum­ing a rel­a­tively high degree of homo­gene­ity among houses, our guess is that the frac­tion decreases as x grows.

This prob­lem wors­ens if nearby sub­di­vi­sions are sim­i­lar and nearby towns have sim­i­lar sub­di­vi­sions to your town’s. (A huge inven­tory and not many trades add volatil­ity to mark-​to-​market val­u­a­tion, but that is for another day.)

So, what is our point? In cer­tain states, the down­side can­not be diver­si­fied away because deval­u­a­tions become self-​perpetuating. There is sys­tem­atic risk, and assum­ing high lev­els of such risk likely assumes away the jus­ti­fi­ca­tion to slice-​and-​dice in the first place.
 

Uh, are you sure you under­stand behav­ior and not just math?

Many peo­ple spend a lot of time, money, and energy try­ing to under­stand pre­pay­ment risk, i.e., the risk that if inter­est rates decline, the valu­able cash flows of higher-​interest mort­gages will be lost through refi­nanc­ing. The flex­i­bil­ity to pre­pay early is a call option for the bor­row­ers and is nat­u­rally called pre­pay­ment risk by lenders.

Unfor­tu­nately, the embed­ded put option in mort­gages seemed to be ignored by the same investors and modelers.

A few months ago — on Feb­ru­ary 8 to be exact — there was a very nice essay in the opin­ion sec­tion of the WSJ, enti­tled “The Rise of the Mort­gage ‘Walk­ers’” by Nicole Geli­nas. In it she argues that mort­gage investors (and indi­rectly CDO investors) seemed to ignore the (cheap) put option avail­able to bor­row­ers by just walk­ing away, and that this option is much more likely to be exer­cised when no down pay­ment is required than when 15% or 20% of the pur­chase price is required.

Debt bal­ances increased through reverse amortization, and hous­ing val­ues decreased due to reduced demand. Equity became neg­a­tive. Many bor­row­ers found it opti­mal to exer­cise their put option and returned the col­lat­eral rather than the cash. Who woulda thunk it? Com­bine lax financ­ing stan­dards with thinly-​traded mar­kets and uncom­mit­ted bor­row­ers, and you could have prob­lems. See this arti­cle for a related phenomenon.

Update: we should have writ­ten it as the time, but: com­bin­ing the points under the last two head­ings, thinly-​traded assets and put options, means a wide­spread, defla­tion­ary con­ta­gion (in home prices)becames easy to image.