I've said it before and I'll say it again, we don't need more financial innovation! I'm glad both Pauls, Volcker and Krugman, are on the same page.
Ask a banker why he/she is entitled to a multi-million dollar bailout and the answer is this: its the only way to attract and retain talent in a dynamic industry like finance. And without talent, there would be no financial innovation.
So explain again how financial innovation has benefitted us (the general public)? Well, I am told that financial innovation has made the capital markets more efficient, price discovery has improved and risk has can be better managed by distributing them across different parties through the use of derivatives.
So let me ask you again, what has financial innovation done for society? Let's look at specifics, let's look at good and the bad:
The Good:
- ATM Machines: No more waiting in line at the bank teller.
The Bad:
- Subprime Mortgages: You get a giant loan to buy the house of your dreams and you don't even have to prove you can afford it! Oh wait, you think you can afford it because you've been lured in by teaser rates (adjustable rate mortgages) that go from 2% to 20% after the first two years.
- Alt-AA Mortgages: Same as the Subprime, it's a little harder to get because you have to make up a more a believable income when you fill in the forms. But don't worry, no one really checks on what your REAL income is.
- Asset Backed Securities (ABS): Package a bunch of these mortgages together, pretend they make money and sell them off a sucker (preferably a bank too big to fail)
- Collateralized Debt Obligations (CDO): Package a bunch of ABS's, take them off your company's balance sheets, complicate things by dumping them in a Special Purpose Vehicle (SPV), tell everyone that it's 100% safe because its bankrupcty remote, and just mint money!
- CDOs Squared: CDOs of CDOs. Now things have gotten so complicated, neither the buyer nor seller really understands what they own or are trying to sell. But does it really matter when money is made so easily?
- Naked Short Selling; Removal of the Uptick Rule: You get to drive a proper brick and mortar business into bankrupcty by continuously short selling and driving the price down. Bankers say its better for us because it makes pricing more efficient.
- Derivatives: It's a bet on whether the price of something else goes up or goes down. There are two ways you get to profit from it consistently, i) you can predict the future because you are God; ii) you have information that no one else has (don't ask me how he got it).
- Credit Default Swaps (CDS): Get insurance companies and treasury deparments to write banks a blank check. Hey, what's a $50 billion write-down when AIG, the Federal Board of Reserve, Bank of England and the Swiss National Bank will bail you out regardless? Wait, it gets even better, you get to write $50 billion off AND pay yourself a bonus.
Banks should be boring utility companies providing credit that greases the wheel of the economic engine, no different than a gas or water company providing us with things essential to the running of a modern day society. All other functions are unecessary, dare I say, even parasitic.
Wednesday, December 9, 2009
Monday, May 18, 2009
Interview with Charlie Munger
Charlie Munger has been another consistent voice of reason. It is only fitting that Warren Buffett's long time partner at Berkshire Hathaway get some air-time. There's really not much for me to add to his wisdom, I'd recommend you go through the entire interview which can be found here. It's recent, topical and addresses many of our concerns about finance and the global economy.
Did you know Google was supplementing your brain?
The internet has revolutionized the way we find and sort information. What most of us don't realize is how it has affected the way we think, to the point where we are "infantizing" our minds.
Many of us have lost the ability to read deeply. Research that used to take us days of being holed up in a library is now available in neatly formulated abstracts at our fingertips. We quote and act upon internet extracted information without having a solid grasp of the underlying principals or the broader context. An especially dangerous undertaking in the world of investments. It's even argued that when we jump on the search engine, we are really searching for convenience rather than actual information.
This makes complete sense if you understand what the world's most powerful search engine--Google is trying to accomplish. Sergei Brin and Larry Page, the founders of Google, view working on a search engine as a way of working on artificial intelligence. Page was quoted last year as saying that Google "was really trying to build artificial intelligence and to do it on a large scale."
The more we rely on Google, the more we rely on artificial intelligence and less on our brains. Now, I am not suggesting a search engine boycott but I am contemplating a serious review of my work habits. Our challenge going forward is to continue to harness the power of enabling tools such as Google without impairing our ability to read and think.
The whole debate can be found here.
Many of us have lost the ability to read deeply. Research that used to take us days of being holed up in a library is now available in neatly formulated abstracts at our fingertips. We quote and act upon internet extracted information without having a solid grasp of the underlying principals or the broader context. An especially dangerous undertaking in the world of investments. It's even argued that when we jump on the search engine, we are really searching for convenience rather than actual information.
This makes complete sense if you understand what the world's most powerful search engine--Google is trying to accomplish. Sergei Brin and Larry Page, the founders of Google, view working on a search engine as a way of working on artificial intelligence. Page was quoted last year as saying that Google "was really trying to build artificial intelligence and to do it on a large scale."
The more we rely on Google, the more we rely on artificial intelligence and less on our brains. Now, I am not suggesting a search engine boycott but I am contemplating a serious review of my work habits. Our challenge going forward is to continue to harness the power of enabling tools such as Google without impairing our ability to read and think.
The whole debate can be found here.
Sunday, May 17, 2009
Personal Credit Crisis
Count yourself lucky if you've no debt related problems. But regardless of what your financial sitation may be, you'd still find this personal account of a credit crisis both chilling and illuminating.
You'll see just how slippery a slope the debt spiral can be. More importantly, how one can go from being financially sound to being avalanched by a mountain of debt in a short period of time.
Awareness of the onerous terms that creditors were seeking proved to an inadequate defence. The writer, believe it or not, is a financial journalist who had written about sub-prime mortgages. One emotional slip was all it took for the misery to follow.
The price of financial independence? Eternal vigilance.
You'll see just how slippery a slope the debt spiral can be. More importantly, how one can go from being financially sound to being avalanched by a mountain of debt in a short period of time.
Awareness of the onerous terms that creditors were seeking proved to an inadequate defence. The writer, believe it or not, is a financial journalist who had written about sub-prime mortgages. One emotional slip was all it took for the misery to follow.
The price of financial independence? Eternal vigilance.
Thursday, May 7, 2009
Truth, not Sophistry
For the unaware, there's a huge debate raging over how business schools should be fixed.
It is argued that business schools are the root cause of the crisis, the singular focus on the upside combined with economic imbalances have resulted in taking our eyes of the more important systemic risks. Business schools have also fueled the crisis by becoming banking factories, churning out everyone ranging from the "just following orders" financial sector rank and file to the very leadership deemed to be the most culpable. This is also a debate cutting across philosophy, education, ethics, financial incentives and many other areas of expertise which are beyond me.
However, if I had to pin down a single aspect of business school I would like to see changed, it would be this: Business schools should be institutions and purveyors of Truth, not Sophistry. We all know what truth means. But the truth (no pun intended) of the matter is, we've allowed that thin divide between truth and sophistry to disappear entirely.
So for the sake of clarity, "Sophistry" is defined by Merriam-Webster's as: subtly deceptive reasoning or argumentation.
Sophistry is now embedded in almost every aspect of modern business. Some argue that the seeds were sown with the case method, where students are essentially rewarded for finessing questions from professors and later in life, clients. Others think that it begins with the job interview process where students form dedicated teams to come up with model answers evidencing their "passion in finance".
Subtle deception, compounded over decades and practiced en masse, unchecked, unappreciated, institutionalized and internalized by students is best exemplified by the enormous build up of complex derivatives sold and held by the "too big to fail" banks over the years. Think of the number of mental contortions that transpired to get us to where we are:
1) You began by securitizing and splitting up worthless assets so they could appear to be valuable.
2) Then you had to take them off the balance sheets so they would not appear worthless at the corporate level.
3) Eventually, you sold them to other people fully knowing what you had done in 1) and 2).
4) Finally, you believe your own twisted logic and start buying worthless derivatives from other banks thinking that if they do the same and sold it to you, it might be valuable.
There is nothing particularly insightful here, you don't need sharper critical reasoning to see the madness that lay within, what you needed was conscience and strength of conviction. You needed to be focused on the truth.
It is argued that business schools are the root cause of the crisis, the singular focus on the upside combined with economic imbalances have resulted in taking our eyes of the more important systemic risks. Business schools have also fueled the crisis by becoming banking factories, churning out everyone ranging from the "just following orders" financial sector rank and file to the very leadership deemed to be the most culpable. This is also a debate cutting across philosophy, education, ethics, financial incentives and many other areas of expertise which are beyond me.
However, if I had to pin down a single aspect of business school I would like to see changed, it would be this: Business schools should be institutions and purveyors of Truth, not Sophistry. We all know what truth means. But the truth (no pun intended) of the matter is, we've allowed that thin divide between truth and sophistry to disappear entirely.
So for the sake of clarity, "Sophistry" is defined by Merriam-Webster's as: subtly deceptive reasoning or argumentation.
Sophistry is now embedded in almost every aspect of modern business. Some argue that the seeds were sown with the case method, where students are essentially rewarded for finessing questions from professors and later in life, clients. Others think that it begins with the job interview process where students form dedicated teams to come up with model answers evidencing their "passion in finance".
Subtle deception, compounded over decades and practiced en masse, unchecked, unappreciated, institutionalized and internalized by students is best exemplified by the enormous build up of complex derivatives sold and held by the "too big to fail" banks over the years. Think of the number of mental contortions that transpired to get us to where we are:
1) You began by securitizing and splitting up worthless assets so they could appear to be valuable.
2) Then you had to take them off the balance sheets so they would not appear worthless at the corporate level.
3) Eventually, you sold them to other people fully knowing what you had done in 1) and 2).
4) Finally, you believe your own twisted logic and start buying worthless derivatives from other banks thinking that if they do the same and sold it to you, it might be valuable.
There is nothing particularly insightful here, you don't need sharper critical reasoning to see the madness that lay within, what you needed was conscience and strength of conviction. You needed to be focused on the truth.
The China Paradox
China is emerging from rubble of the economic crisis looking better than any other country I can think of. In terms of policy, it is pushing all the right buttons. The fiscal stimulus packages are working: The Chinese stock market has taken notice and it is up +40% for the year; the government has announced plans for full medical insurance for 90% of the rural population by 2010--thereby unlocking the high savings rate and unleashing China's huge consumption potential; but perhaps most important of all, China does not have an insolvent banking system riddled with complex derivatives resulting in bottomless liabilities.
Yet, few in the West are willing to concede the following paradox. Communist China (as Lou Dobbs would say), appears to be better at this "capitalist game" than many would like to admit. The US and the UK have long dominated economic ideology by way of the free market system. Few could challenge this until it recently became evident that a hefty portion of the Anglo-Saxon economic miracle can be attributed to consumers and major financial institutions over-gorging at the credit buffett table. While the developed world is anticipating negative growth in 2009, China is widely expected to maintain 8% growth and that figure is forecasted to rise to over 10% in 2010.
So how has China landed on its feet while the G7 takes a painful tumble? This is the second paradox: I suspect leadership may have something to do with. And by that, I plainly mean that China has had great leadership. Western commentary on China is often blinded by political rhetoric colored by human rights, Tibet, Taiwan, the environment and a whole host of other issues. The insistence of the Western media to link ideological disagreements to every news report has led to an under reporting of China true strengths. Complex issues become oversimplified into a "we are good, they are bad" vilification, playing straight into the Chinese strategem of "Hide your capability and bide your time".
Now, I am no expert on the Chinese political system. But China it seems, for all the valid criticism about the lack of democracy and rampant official corruption, has a system which places the best people in the highest offices. Take the following interview with Chinese Premier Wen Jiabao for example, at roughly 7:00 into the video he enters into a jaw-dropping explanation of Adam Smith's classic works. Am I hearing right? Is the leader of "Communist China" quoting the bible of capitalism? At roughly 22:30 into the interview, he goes on to quote Marcus Aurelius. He knows his stuff.
This is fascinating to me because 99% of the people I know, have at best, glossed over the classics in search of soundbites. By contrast, it really seems to me that Wen has really spent time on them. Most people cite Adam Smith's Wealth of Nations and talk about the 'invisible hand' of free market systems, refusing to acknowledge (probably because they never read it) Smith's other important work, The Theory of Moral Sentiments. In the moral sentiments, Wen identified the need for a 'guiding hand' in addition to the 'invisible hand'. While this all sounds academic and irrelevant it could not be more true--a 'guiding hand' could have well prevented the senseless deregulation responsible for our current mess.
I know it sounds like a stretch when I praise Chinese leadership after watching an interview. There is also much I don't know about Hu Jintao, Zhang Zemin, Li Peng and every significant Chinese leader since Deng Xiaoping, other than the fact that they are all technocrats. What I do know is that consistently sound policy, including the lifting of 700 million people out of abject poverty; and transitioning from a planned socialist economy to a capitalist economy without the problems that plague the former USSR, over two decades is not the result of mediocre leadership. Just take a look at the eight years preceding Obama and see if you agree with me.
The transcript for the interview can be found here.
Yet, few in the West are willing to concede the following paradox. Communist China (as Lou Dobbs would say), appears to be better at this "capitalist game" than many would like to admit. The US and the UK have long dominated economic ideology by way of the free market system. Few could challenge this until it recently became evident that a hefty portion of the Anglo-Saxon economic miracle can be attributed to consumers and major financial institutions over-gorging at the credit buffett table. While the developed world is anticipating negative growth in 2009, China is widely expected to maintain 8% growth and that figure is forecasted to rise to over 10% in 2010.
So how has China landed on its feet while the G7 takes a painful tumble? This is the second paradox: I suspect leadership may have something to do with. And by that, I plainly mean that China has had great leadership. Western commentary on China is often blinded by political rhetoric colored by human rights, Tibet, Taiwan, the environment and a whole host of other issues. The insistence of the Western media to link ideological disagreements to every news report has led to an under reporting of China true strengths. Complex issues become oversimplified into a "we are good, they are bad" vilification, playing straight into the Chinese strategem of "Hide your capability and bide your time".
Now, I am no expert on the Chinese political system. But China it seems, for all the valid criticism about the lack of democracy and rampant official corruption, has a system which places the best people in the highest offices. Take the following interview with Chinese Premier Wen Jiabao for example, at roughly 7:00 into the video he enters into a jaw-dropping explanation of Adam Smith's classic works. Am I hearing right? Is the leader of "Communist China" quoting the bible of capitalism? At roughly 22:30 into the interview, he goes on to quote Marcus Aurelius. He knows his stuff.
This is fascinating to me because 99% of the people I know, have at best, glossed over the classics in search of soundbites. By contrast, it really seems to me that Wen has really spent time on them. Most people cite Adam Smith's Wealth of Nations and talk about the 'invisible hand' of free market systems, refusing to acknowledge (probably because they never read it) Smith's other important work, The Theory of Moral Sentiments. In the moral sentiments, Wen identified the need for a 'guiding hand' in addition to the 'invisible hand'. While this all sounds academic and irrelevant it could not be more true--a 'guiding hand' could have well prevented the senseless deregulation responsible for our current mess.
I know it sounds like a stretch when I praise Chinese leadership after watching an interview. There is also much I don't know about Hu Jintao, Zhang Zemin, Li Peng and every significant Chinese leader since Deng Xiaoping, other than the fact that they are all technocrats. What I do know is that consistently sound policy, including the lifting of 700 million people out of abject poverty; and transitioning from a planned socialist economy to a capitalist economy without the problems that plague the former USSR, over two decades is not the result of mediocre leadership. Just take a look at the eight years preceding Obama and see if you agree with me.
The transcript for the interview can be found here.
Tuesday, May 5, 2009
Sleeplessness = Effectiveness?
Whether you think it's a form of justification for generous compensation or not, Wall Street's veneration for exhaustion has always perplexed me.
Bill Clinton, once said, "Every important mistake I've made in my life, I've made because I was too tired."
Sleeplessness is linked to diabetes, depression, obesity and even increased mortality. Which is why I find it strange when people talk about working absurdly long hours and being sleep deprived with such pride and admiration.
Karen Dillon, the editor of Harvard Business Review, writes about the Myth of the Tireless Leader. She argues that if anything, sleep deprivation renders you ineffective.
In managers, sleeplessness signals the inability to trust, delegate and perhaps most alarming of all, the inability or unwillingness to cultivate other effective managers.
It doesn't get any better with employees. In fact, the universal red flag for fraud is to have someone perpetually in the office. Which is exactly why most firms institute a compulsory two week compliance vacation.
By all means work hard, but let's not confuse the number of hours spent flapping around the office with effectiveness. If you're done with your work, GO HOME!
Bill Clinton, once said, "Every important mistake I've made in my life, I've made because I was too tired."
Sleeplessness is linked to diabetes, depression, obesity and even increased mortality. Which is why I find it strange when people talk about working absurdly long hours and being sleep deprived with such pride and admiration.
Karen Dillon, the editor of Harvard Business Review, writes about the Myth of the Tireless Leader. She argues that if anything, sleep deprivation renders you ineffective.
In managers, sleeplessness signals the inability to trust, delegate and perhaps most alarming of all, the inability or unwillingness to cultivate other effective managers.
It doesn't get any better with employees. In fact, the universal red flag for fraud is to have someone perpetually in the office. Which is exactly why most firms institute a compulsory two week compliance vacation.
By all means work hard, but let's not confuse the number of hours spent flapping around the office with effectiveness. If you're done with your work, GO HOME!
Monday, May 4, 2009
Hedge Funds: The New Reality
*This blog entry will be a temporary departure from our usual layman investor approach*
Vikram Pandit talked about a new reality for Citi, and here is the new reality for hedge funds--investors with bloated wallets will no longer line up and swallow your 2 and 20.
Anyone harboring ambitions of launching their own hedge fund really needs to read this. That's the blueprint for hedge fund fee structures going forward. The driving force behind this is the hugely influential Larry Powell, formerly from the Texas Teacher Retirement System, and now the head of the Utah Retirement System. The industry is changing, LP passivity will diminish considerably and fees will be scrutinized more vigorously.
Given the cynicism currently levelled at hedge funds and the inability of the industry to deliver alpha and absolute returns when they were most needed in 2008, this I promise you, is no stretch of imagination.
Vikram Pandit talked about a new reality for Citi, and here is the new reality for hedge funds--investors with bloated wallets will no longer line up and swallow your 2 and 20.
Anyone harboring ambitions of launching their own hedge fund really needs to read this. That's the blueprint for hedge fund fee structures going forward. The driving force behind this is the hugely influential Larry Powell, formerly from the Texas Teacher Retirement System, and now the head of the Utah Retirement System. The industry is changing, LP passivity will diminish considerably and fees will be scrutinized more vigorously.
Given the cynicism currently levelled at hedge funds and the inability of the industry to deliver alpha and absolute returns when they were most needed in 2008, this I promise you, is no stretch of imagination.
Monday, April 27, 2009
Talent, re-defined
In his new book, Outliers, Best-selling author Malcolm Gladwell has hit on something well-worth considering: That talent, to the extent of genius even, is not what most of us think it is. It is neither a "marked innate ability; nor a superior natural endowment of a person".
Talent is simply the desire to practice. Practice is really what seperates the talented from the untalented. This idea is further reinforced by Geoff Colvin's effort called, Talent is Overrated. However, Colvin places the emphasis on 'deliberate practice' instead. How you practice, analyze your mistakes and the results of your progress differentiates a world class performance from mediocrity.
Gladwell's recent interview can be found here.
The transcript can be found here.
Talent is simply the desire to practice. Practice is really what seperates the talented from the untalented. This idea is further reinforced by Geoff Colvin's effort called, Talent is Overrated. However, Colvin places the emphasis on 'deliberate practice' instead. How you practice, analyze your mistakes and the results of your progress differentiates a world class performance from mediocrity.
Gladwell's recent interview can be found here.
The transcript can be found here.
Wednesday, April 22, 2009
The Irresponsible Borrower
I've been tough on the banker, regulator and even the journalist. As mentioned previously, there's a fourth guilty party in this whole financial meltdown--the irresponsible borrower. Played perfectly by Steve Martin in the previous link, he's the guy who got into a subprime mortgage. The guy who lives beyond his means and rolls over his living expenses on his credit card monthly. Some will argue that the subprime crisis was triggered by his inability to pay off his debt.
However, there is also no doubt in my mind that he's much less culpable. To begin with, he's probably a victim of predatory lending practices, such as the adjustable rate mortgages (ARMs) offering enticing teaser rates for the first few years, only to jack up the interest rates after the borrower has been locked in. What the investment banks did was to take a whole bunch of subprime mortgages, bundle them together (in a process called securitization), and sell them to suckers (usually other banks and insurance companies) telling them they were safe because Moody's (a ratings agency) rated them far more creditworthy than they actually were. Voila, banks started figuring out a way of printing money by selling worthless securities at inflated prices. Allow this to continue unchecked and you've created a credit bubble that runs in the trillions.
Still with me? If you are, you've basically understood how subprime mortgages work and what the roots of our current crisis are.
However, there is also no doubt in my mind that he's much less culpable. To begin with, he's probably a victim of predatory lending practices, such as the adjustable rate mortgages (ARMs) offering enticing teaser rates for the first few years, only to jack up the interest rates after the borrower has been locked in. What the investment banks did was to take a whole bunch of subprime mortgages, bundle them together (in a process called securitization), and sell them to suckers (usually other banks and insurance companies) telling them they were safe because Moody's (a ratings agency) rated them far more creditworthy than they actually were. Voila, banks started figuring out a way of printing money by selling worthless securities at inflated prices. Allow this to continue unchecked and you've created a credit bubble that runs in the trillions.
Still with me? If you are, you've basically understood how subprime mortgages work and what the roots of our current crisis are.
Editor of the Financial Times: "Mea Culpa"
Aren't journalists supposed to be our canaries in the mine? Where were the warning signs for the financial crisis? I don't know enough about the journalism business but Lionel Barber, the editor of the Financial Times does.
Barber acknowledges that the media has failed us, and this is why:
SUMMARY
- Journalists did not understand the consequences of the proliferation and use of complex derivatives; did not understand the consequences of implicit state guaruntees to "too big to fail" institutions like Fannie Mae and Freddie Mac; did not understand the consequences of off-balance sheet financing; did not understand the consequences of an imploding financial sector on the real economy.
- Excacerbating the fact that the journalists didn't fully grasp alot of important things, it was in their interests to "run with the good news". Why pursue stories on mortgage lending scandals or predatory lending practices when your biggest advertiser is the property industry? Why would anyone give Jim Cramer a hard time when most of his viewers are Wall Street bankers and traders?
- The public's addiction to 24 hour news. Credit markets, where derivatives are transacted, are just too opaque. People want to hear day-to-day news, and derivatives can lie dormant for months or years before terms mature or get triggered. The need for market noise is simply filled in by comments on stock movements and public company earnings disclosures.
- Other important unanticipated events included: the rise of radical islamic terrorism; opening of the Chinese economy; two giant credit bubbles.
An abridged version of his recent speech at Yale University can be found here.
COMMENT
Just pause awhile and reflect on this admission. It must be truly humbling for the editor of the Financial Times to come to this conclusion, let alone mention it publicly. So if the bankers, regulators and guys who write about the industry didn't anticipate any of this, what chance do we have?
The sad thing is that we had plenty of opportunities to see it coming. Most of us suspected something, but lacked the persistence to seek the truth. Here are some questions you may have asked: How did housing prices rise so quickly and why are they suddenly a good investment? How did oil get to $150 a barrel and why are gas prices $4 a gallon? How does a guy who earns $50,000 a year move into a $2 million house? Why did prices of everything in NYC shoot up almost overnight? Why are there so many fresh college grads earning six figure salaries out of school? And why do they all seem to work in finance?
These were all common sense questions and have one answer in common. Ultimately, these anomalies were only made possible by the massive credit boom, the era of easy money. The past two decades saw a shifting of one giant asset bubble to another to another (stocks, housing, credit...etc) which was made possible by the de-regulation of safeguards put in place after the last big credit bubble--the Great Depression.
Why was it so hard to be contrarian? Three main reasons:
1) Because it is really that difficult to go against the crowd. We were stampeding along with the herd. How dare you impugn the knowledge and wisdom of the Head Analyst for a Wall Street firm who tells you otherwise? How can I be the only one thinking this is unsustainable when everyone else goes on with life?
2) Someone once told me that there is "nothing more unsettling than watching your neighbors get rich". The truth is, I am no exception to this. The fear of "missing out" when everyone else seems to be raking in the good times can be emotionally exhausting.
3) We've become enamoured by the personalities and the products of the financial industry. Goldman Sachs CEOs are as widely revered on Capitol Hill as they are on Wall Street. We admire success and often choose to ascribe superhuman characteristics to those who are successful, it's convenient and a story we like to hear. "John Doe is so successful, it must be because he's a financial genius." I've heard people talk about financial personalities in the same way a golf fan would talk about Tiger Woods, "what amazing natural born talent"! It is downright nauseating.
I also want to re-emphasize the need to fully understand consquences. A potential pitfall for many investors is the ego massage they get from understanding a derivative instrument. "I just got my banker to structure an XYZ instrument for me, as long as the volatility remains moderate, I'll make a healthy profit even in a flat market." Understanding how something works, isn't the same as having a full appreciation of the risks involved. Although you'll feel smarter when you get glazed looks after throwing out fancy financial terms at a cocktail party, the only thing you've succeeded in doing is locking yourself into an expensive and dangerous investment that could wipe you out.
The other ego massage pitfall is the "hard to access" trap. Imagine one of your buddies boasting about how he's gained access to the latest private equity or hedge fund. The fund hires the smartest people and they get fantastic returns and they don't let just ANYONE invest. Well, it turns out, sometimes genius fails. And those fantastic returns could turn out to be too good to be true.
Barber acknowledges that the media has failed us, and this is why:
SUMMARY
- Journalists did not understand the consequences of the proliferation and use of complex derivatives; did not understand the consequences of implicit state guaruntees to "too big to fail" institutions like Fannie Mae and Freddie Mac; did not understand the consequences of off-balance sheet financing; did not understand the consequences of an imploding financial sector on the real economy.
- Excacerbating the fact that the journalists didn't fully grasp alot of important things, it was in their interests to "run with the good news". Why pursue stories on mortgage lending scandals or predatory lending practices when your biggest advertiser is the property industry? Why would anyone give Jim Cramer a hard time when most of his viewers are Wall Street bankers and traders?
- The public's addiction to 24 hour news. Credit markets, where derivatives are transacted, are just too opaque. People want to hear day-to-day news, and derivatives can lie dormant for months or years before terms mature or get triggered. The need for market noise is simply filled in by comments on stock movements and public company earnings disclosures.
- Other important unanticipated events included: the rise of radical islamic terrorism; opening of the Chinese economy; two giant credit bubbles.
An abridged version of his recent speech at Yale University can be found here.
COMMENT
Just pause awhile and reflect on this admission. It must be truly humbling for the editor of the Financial Times to come to this conclusion, let alone mention it publicly. So if the bankers, regulators and guys who write about the industry didn't anticipate any of this, what chance do we have?
The sad thing is that we had plenty of opportunities to see it coming. Most of us suspected something, but lacked the persistence to seek the truth. Here are some questions you may have asked: How did housing prices rise so quickly and why are they suddenly a good investment? How did oil get to $150 a barrel and why are gas prices $4 a gallon? How does a guy who earns $50,000 a year move into a $2 million house? Why did prices of everything in NYC shoot up almost overnight? Why are there so many fresh college grads earning six figure salaries out of school? And why do they all seem to work in finance?
These were all common sense questions and have one answer in common. Ultimately, these anomalies were only made possible by the massive credit boom, the era of easy money. The past two decades saw a shifting of one giant asset bubble to another to another (stocks, housing, credit...etc) which was made possible by the de-regulation of safeguards put in place after the last big credit bubble--the Great Depression.
Why was it so hard to be contrarian? Three main reasons:
1) Because it is really that difficult to go against the crowd. We were stampeding along with the herd. How dare you impugn the knowledge and wisdom of the Head Analyst for a Wall Street firm who tells you otherwise? How can I be the only one thinking this is unsustainable when everyone else goes on with life?
2) Someone once told me that there is "nothing more unsettling than watching your neighbors get rich". The truth is, I am no exception to this. The fear of "missing out" when everyone else seems to be raking in the good times can be emotionally exhausting.
3) We've become enamoured by the personalities and the products of the financial industry. Goldman Sachs CEOs are as widely revered on Capitol Hill as they are on Wall Street. We admire success and often choose to ascribe superhuman characteristics to those who are successful, it's convenient and a story we like to hear. "John Doe is so successful, it must be because he's a financial genius." I've heard people talk about financial personalities in the same way a golf fan would talk about Tiger Woods, "what amazing natural born talent"! It is downright nauseating.
I also want to re-emphasize the need to fully understand consquences. A potential pitfall for many investors is the ego massage they get from understanding a derivative instrument. "I just got my banker to structure an XYZ instrument for me, as long as the volatility remains moderate, I'll make a healthy profit even in a flat market." Understanding how something works, isn't the same as having a full appreciation of the risks involved. Although you'll feel smarter when you get glazed looks after throwing out fancy financial terms at a cocktail party, the only thing you've succeeded in doing is locking yourself into an expensive and dangerous investment that could wipe you out.
The other ego massage pitfall is the "hard to access" trap. Imagine one of your buddies boasting about how he's gained access to the latest private equity or hedge fund. The fund hires the smartest people and they get fantastic returns and they don't let just ANYONE invest. Well, it turns out, sometimes genius fails. And those fantastic returns could turn out to be too good to be true.
Wednesday, April 8, 2009
What are derivatives? The Chinese explanation
It is no secret that China is a relative newcomer to the world of modern investing. Thus, it is somewhat surprising that the clearest and most coherent explanation of derivatives I have ever heard comes from a gentleman called Gao Xiqing.
Gao Xiqing is the President of the China Investment Corporation (China's sovereign wealth fund managing USD $250 billion). The following article is an extraction of a very candid interview with the Atlantic appearing in the December of 2008 issue. In his presentation to the Chinese State Council in either 1999 or 2000, including Premier Zhu Rongji, Gao was faced with having to explain derivatives with government officials with little or no background in finance.
"If you look at every one of these [derivative] products, they make sense. But in aggregate, they are bullshit. They are crap. They serve to cheat people... So I wondered, How do I explain derivatives?, and I used the model of mirrors.
First of all, you have this book to sell. [He picks up a leather-bound book.] This is worth something, because of all the labor and so on you put in it. But then someone says, “I don’t have to sell the book itself! I have a mirror, and I can sell the mirror image of the book!” Okay. That’s a stock certificate. And then someone else says, “I have another mirror—I can sell a mirror image of that mirror.” Derivatives. That’s fine too, for a while. Then you have 10,000 mirrors, and the image is almost perfect. People start to believe that these mirrors are almost the real thing. But at some point, the image is interrupted. And all the rest will go.
When I told the State Council about the mirrors, they all started laughing. “How can you sell a mirror image! Won’t there be distortion?” But this is what happened with the American economy, and it will be a long and painful process to come down.
I think we should do an overhaul and say, “Let’s get rid of 90 percent of the derivatives.” Of course, that’s going to be very unpopular, because many people will lose jobs."
It appears that Warren Buffett, who has in the past referred to derivatives as "financial weapons of mass destruction", would be in complete agreement. He discusses and criticizes derivatives extensively in his 2002 letter to Berkshire Hathaway shareholders. An excellent summary of that can be found here.
Gao Xiqing is the President of the China Investment Corporation (China's sovereign wealth fund managing USD $250 billion). The following article is an extraction of a very candid interview with the Atlantic appearing in the December of 2008 issue. In his presentation to the Chinese State Council in either 1999 or 2000, including Premier Zhu Rongji, Gao was faced with having to explain derivatives with government officials with little or no background in finance.
"If you look at every one of these [derivative] products, they make sense. But in aggregate, they are bullshit. They are crap. They serve to cheat people... So I wondered, How do I explain derivatives?, and I used the model of mirrors.
First of all, you have this book to sell. [He picks up a leather-bound book.] This is worth something, because of all the labor and so on you put in it. But then someone says, “I don’t have to sell the book itself! I have a mirror, and I can sell the mirror image of the book!” Okay. That’s a stock certificate. And then someone else says, “I have another mirror—I can sell a mirror image of that mirror.” Derivatives. That’s fine too, for a while. Then you have 10,000 mirrors, and the image is almost perfect. People start to believe that these mirrors are almost the real thing. But at some point, the image is interrupted. And all the rest will go.
When I told the State Council about the mirrors, they all started laughing. “How can you sell a mirror image! Won’t there be distortion?” But this is what happened with the American economy, and it will be a long and painful process to come down.
I think we should do an overhaul and say, “Let’s get rid of 90 percent of the derivatives.” Of course, that’s going to be very unpopular, because many people will lose jobs."
It appears that Warren Buffett, who has in the past referred to derivatives as "financial weapons of mass destruction", would be in complete agreement. He discusses and criticizes derivatives extensively in his 2002 letter to Berkshire Hathaway shareholders. An excellent summary of that can be found here.
Black Swans...Updated April 2009
Nassim Taleb's two books, Fooled by Randomness and Black Swans, have been garnering mainstream media attention in light of the breakdown of the global financial system. To his credit, he had already forewarned of many things that did in fact play out in 2008. He has updated his views in a recent Financial Times article entitled Ten Principals for a Black Swan-proof world. The black swans theory refers to a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations. In addition to the financial meltdown in 2008, Taleb has cited other examples including the rise of the internet, the invention of the personal computer, World War I and the September 11th attacks as "Black Swan" events.
I've reproduced his article in its entirety because, as it stands, the article is a summary in itself.
However, I'd like to make it accessible and applicable to the individual investor. Theories are just theories, unless they are actionable. Essentially, Taleb's ten principles can be distilled and applied:
- Stop using leverage and stop buying structured products (which are derivatives). You don't understand them and even your banker who claims to understand them, does not. The evidence for this can be seen in the way almost every major bank, British, Swiss or American, is having to write-off tens of billions of dollars and potentially more. What you and your banker both don't understand about leverage and structured products is how risky they really are. On top of that, your financial advisor usually isn't incentivized to protect you, they have more to gain by selling you risky products than not. It is like a "lion hired to protect the gazelle."
- Compensation must change. Banking greed is certainly culpable but governments and regulators also have blood on their hands for falling asleep at the wheel. Going further, if you think about it enough, you'll also see that the government/regulatory slip is really a greater reflection of our own indifference and ignorance. Society as a whole, bought hook, line and sinker into a key tenet of Reaganomics--that any kind of regulation is bad. The only acceptable regulation, is no regulation. As a society, we got lazy, abdicated our minds to the convenience of "trickle down economics" and now we pay the price. The standard 2 and 20 hedge fund fee gets criticized but few of the key players do anything about it. Calpers has announced that it will, but I've yet to hear specifics.
- You cannot hope to store value by investing in the stock market. You should be into businesses, not markets. This is consistent with what Buffett has always said, the only real hedge against inflation is your income.
- We need entrepreneurs--real businessmen to drive the economy again, creating real value, not a bunch a of financiers shifting money around. For this to change, we need regulatory oversight and it won't come easily. Be informed, follow the issues and let your representative know how you feel.
Here is a reproduction of Taleb's Ten Principals for a Black Swan-Proof world in full.
1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.
2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.
3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. The economics establishment (universities, regulators, central bankers, government officials, various organisations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.
4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.
5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.
6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.
7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.
8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.
9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).
10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.
Then we will see an economic life closer to our biological environment: smaller companies, richer ecology, no leverage. A world in which entrepreneurs, not bankers, take the risks and companies are born and die every day without making the news.
In other words, a place more resistant to black swans.
I've reproduced his article in its entirety because, as it stands, the article is a summary in itself.
However, I'd like to make it accessible and applicable to the individual investor. Theories are just theories, unless they are actionable. Essentially, Taleb's ten principles can be distilled and applied:
- Stop using leverage and stop buying structured products (which are derivatives). You don't understand them and even your banker who claims to understand them, does not. The evidence for this can be seen in the way almost every major bank, British, Swiss or American, is having to write-off tens of billions of dollars and potentially more. What you and your banker both don't understand about leverage and structured products is how risky they really are. On top of that, your financial advisor usually isn't incentivized to protect you, they have more to gain by selling you risky products than not. It is like a "lion hired to protect the gazelle."
- Compensation must change. Banking greed is certainly culpable but governments and regulators also have blood on their hands for falling asleep at the wheel. Going further, if you think about it enough, you'll also see that the government/regulatory slip is really a greater reflection of our own indifference and ignorance. Society as a whole, bought hook, line and sinker into a key tenet of Reaganomics--that any kind of regulation is bad. The only acceptable regulation, is no regulation. As a society, we got lazy, abdicated our minds to the convenience of "trickle down economics" and now we pay the price. The standard 2 and 20 hedge fund fee gets criticized but few of the key players do anything about it. Calpers has announced that it will, but I've yet to hear specifics.
- You cannot hope to store value by investing in the stock market. You should be into businesses, not markets. This is consistent with what Buffett has always said, the only real hedge against inflation is your income.
- We need entrepreneurs--real businessmen to drive the economy again, creating real value, not a bunch a of financiers shifting money around. For this to change, we need regulatory oversight and it won't come easily. Be informed, follow the issues and let your representative know how you feel.
Here is a reproduction of Taleb's Ten Principals for a Black Swan-Proof world in full.
1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.
2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.
3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. The economics establishment (universities, regulators, central bankers, government officials, various organisations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.
4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.
5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.
6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.
7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.
8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.
9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).
10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.
Then we will see an economic life closer to our biological environment: smaller companies, richer ecology, no leverage. A world in which entrepreneurs, not bankers, take the risks and companies are born and die every day without making the news.
In other words, a place more resistant to black swans.
Monday, March 23, 2009
Judgement, not more Regulation
If not for the fall from grace, he'd be a hero today. In fact, he'd also have every right to wag his finger at us smugly saying, "I told you so."
Prior to his downfall, Eliot Spitzer was the person Wall Street arguably feared the most. As the former Governor and Attorney General (AG) of New York, Spitzer developed a reputation for a vindictive and no-nonsense approach of taking white collared crime to task. Price fixing, investment bank stock price inflation, fraud, predatory lending practices and even excessive fees and compensation were some of the areas Spitzer actively pursued during his tenure as the AG--long before they became household topics in 2009.
Spitzer has finally broken his silence, granting an interview with Fareed Zakaria which was televised over CNN on March 22nd 2009, following his resignation as AG following his involvement in a prostitution scandal. It is evident from the interview that although the scandal has tainted his legacy, it has in no way diminished his expertise on financial regulation nor has it interfered with his clarity of thought. I found several of his responses to be deeply profound. Here are some of his views:
ON CAPITALISM AND THE FINANCIAL SERVICES:
"Recklessness, greed and a misunderstanding of what capitalism is all about, and a belief that financial services alone could generate wealth.
Financial services doesn't really generate wealth. Financial -- the capital markets are designed to raise money and then apportion it to industries that are creative, whether it's biotech or automotive, or anything else.
Financial services should be a conduit. Instead, we became enamored of the products themselves. And what resulted was this enormous bubble in assets, ginned up and supported by a financial services sector that, because of a series of improper incentives, got us to where we are right now."
ON REGULATION:
"...After the last round of scandals -- Enron, et al. -- we passed Sarbanes-Oxley. And we said, aha, we've solved the problem. Now we have another set of scandals.
There are enough laws, enough regulations on the books for smart, aggressive regulators and prosecutors to make all the cases. What was missing was judgment. And you can't legislate judgment. You can't regulate judgment. Either the people who are the regulators will walk into a bank and say "Your leverage is too great. We are going to take actions to pull it back," or "This type of investment is flawed," or they won't. You can't pass a law that says, you must use sound judgment... Bubbles have been there through history, through over-regulation and under-regulation. This is a question of judgment and of failure of judgment."
COMMENT: It is interesting to note that as the AG, Spitzer frequently invoked, what was long considered to be an obscure and dormant piece of legislation dating back to 1921 and known as, the Martin Act to bring action against a number of offenders. The tools are there, it's more a matter of regulators getting round to using them.
ON THE MEDIA
"And I think the media -- writ large. I mean, forget CNBC. I think the entire media -- print media, TV media, et cetera -- did not ask the hard questions as these deals were being structured, as the bubble was inflating.
We turned the Wall Street masters of the universe into these icons, who bestrode the universe and made no mistakes, when I think a more inquisitive attitude would have said, "Wait a minute, guys. This won't last."
ON THE GOVERNMENT:
"...there are many on Capitol Hill who are beating their chests so loudly, you know it's just a cover-up of their neglect and failure over the last decade. They sat there and watched and did nothing, as they clearly should have known that we were building a system that was a house of cards. And they enjoyed it and prospered from it, and there was a symbiotic relationship between them and Wall Street."
ON PRESIDENT OBAMA:
"And I think one of the largest, most difficult tasks that he has is to control the outrage that is brewing in the public -- sympathize with it and garner it, but use it to get good policy, not policy based upon anger...I'm worried that we will go to the other extreme and end up with rank populism. That could be just as dangerous."
ON THE POPULIST OUTRAGE:
"Yes, yes. The outrage is legitimate, but it is being fomented by sort of a faux populism by many on Capitol Hill who saw this coming, who knew this was going on. And so, I look at them and I say, "Come on, guys. You're supposed to be more mature. Express the anger, but then say, how do we solve it? Don't just throw more oil on the fire."
COMMENT: Is the outrage being formented? Presently, it's being directed at AIG which is paying out $160 million in bonuses despite taking taxpayer dollars. However, it is not alone in that regard and while $160 million is no small sum, it actually pales in comparison to what the other firms are recieving. Some suggest that the real welfare queen is actually Goldman Sachs. AIG is neither alone nor is it the most culpable. John Thain and Merrill Lynch win that prize.
ON EXECUTIVE COMPENSATION:
" I think I might go back to a very old tort theory of unjust enrichment -- contract theory, tort theory -- and say, you know what, guys? There's a theory in the law that says -- a couple of theories -- one impossibility saying, AIG just doesn't have the money to pay you. And absent the federal infusion, it wouldn't have it, so we can't pay.
And second I would say, unjust enrichment. You simply don't deserve it. It's an equitable argument. Some courts might go for it, some courts might not.
But as a practical matter, as the president of the United States, I think I would call the CEOs into the Oval Office. And I would say, "Guys, this is untenable. We're all going to have to suck it up a little bit and show the American people that we know what it means to be part of a community, and share the sacrifice. Let's see if we can't solve this without the legal wrangling."
ON THE FAILURE OF THE SEC
"Absolutely. The power of the federal agencies to do this stuff was unlimited.
And any time I hear the SEC say, we didn't have the power to do this or that, forget it. They had more people, more power, more money than was necessary. What they lacked was the creativity and the will."
ON THE PROBLEM
"I tried very hard not to vilify individuals, because it wasn't a mid-level executive who was the problem. It was the whole structure. And that's why the global deal was with all the banks."
ON HIS OWN FAILURE
" I never held myself out as being anything other than human. I have flaws, as we all do, arguably. I failed in a very important way in my personal life, and I have paid a price for that."
CLOSING COMMENTS:
Evidently, Spitzer himself excercised poor judgement in the events leading up to his resignation from office in 2008. Something he plainly admits. However, that should not distract us from the soundness of his reasoning, there is much we can learn from him.
I also want to leave you with another thought. It should be now obvious that regulators lacked the skills, conviction and judgement to take on the Financial Services. An effective financial regulator needs to have a sound knowledge base in law, finance and business. That is ironic because having gone to both law and business school, I have never encountered a single person aspiring to become a financial regulator. The regulatory/financial services compensation gap must be narrowed, by having such a huge disparity in compensation continue for so long is tantamount to putting Wall Street on the honor code system for decades. And it is pure fantasy to think society is better off this way. Until this changes, Wall Street will always be several steps ahead of the game and we can never safely say, it won't happen again.
The full transcript of the interview can be found here.
Better still, you can watch it here.
Prior to his downfall, Eliot Spitzer was the person Wall Street arguably feared the most. As the former Governor and Attorney General (AG) of New York, Spitzer developed a reputation for a vindictive and no-nonsense approach of taking white collared crime to task. Price fixing, investment bank stock price inflation, fraud, predatory lending practices and even excessive fees and compensation were some of the areas Spitzer actively pursued during his tenure as the AG--long before they became household topics in 2009.
Spitzer has finally broken his silence, granting an interview with Fareed Zakaria which was televised over CNN on March 22nd 2009, following his resignation as AG following his involvement in a prostitution scandal. It is evident from the interview that although the scandal has tainted his legacy, it has in no way diminished his expertise on financial regulation nor has it interfered with his clarity of thought. I found several of his responses to be deeply profound. Here are some of his views:
ON CAPITALISM AND THE FINANCIAL SERVICES:
"Recklessness, greed and a misunderstanding of what capitalism is all about, and a belief that financial services alone could generate wealth.
Financial services doesn't really generate wealth. Financial -- the capital markets are designed to raise money and then apportion it to industries that are creative, whether it's biotech or automotive, or anything else.
Financial services should be a conduit. Instead, we became enamored of the products themselves. And what resulted was this enormous bubble in assets, ginned up and supported by a financial services sector that, because of a series of improper incentives, got us to where we are right now."
ON REGULATION:
"...After the last round of scandals -- Enron, et al. -- we passed Sarbanes-Oxley. And we said, aha, we've solved the problem. Now we have another set of scandals.
There are enough laws, enough regulations on the books for smart, aggressive regulators and prosecutors to make all the cases. What was missing was judgment. And you can't legislate judgment. You can't regulate judgment. Either the people who are the regulators will walk into a bank and say "Your leverage is too great. We are going to take actions to pull it back," or "This type of investment is flawed," or they won't. You can't pass a law that says, you must use sound judgment... Bubbles have been there through history, through over-regulation and under-regulation. This is a question of judgment and of failure of judgment."
COMMENT: It is interesting to note that as the AG, Spitzer frequently invoked, what was long considered to be an obscure and dormant piece of legislation dating back to 1921 and known as, the Martin Act to bring action against a number of offenders. The tools are there, it's more a matter of regulators getting round to using them.
ON THE MEDIA
"And I think the media -- writ large. I mean, forget CNBC. I think the entire media -- print media, TV media, et cetera -- did not ask the hard questions as these deals were being structured, as the bubble was inflating.
We turned the Wall Street masters of the universe into these icons, who bestrode the universe and made no mistakes, when I think a more inquisitive attitude would have said, "Wait a minute, guys. This won't last."
ON THE GOVERNMENT:
"...there are many on Capitol Hill who are beating their chests so loudly, you know it's just a cover-up of their neglect and failure over the last decade. They sat there and watched and did nothing, as they clearly should have known that we were building a system that was a house of cards. And they enjoyed it and prospered from it, and there was a symbiotic relationship between them and Wall Street."
ON PRESIDENT OBAMA:
"And I think one of the largest, most difficult tasks that he has is to control the outrage that is brewing in the public -- sympathize with it and garner it, but use it to get good policy, not policy based upon anger...I'm worried that we will go to the other extreme and end up with rank populism. That could be just as dangerous."
ON THE POPULIST OUTRAGE:
"Yes, yes. The outrage is legitimate, but it is being fomented by sort of a faux populism by many on Capitol Hill who saw this coming, who knew this was going on. And so, I look at them and I say, "Come on, guys. You're supposed to be more mature. Express the anger, but then say, how do we solve it? Don't just throw more oil on the fire."
COMMENT: Is the outrage being formented? Presently, it's being directed at AIG which is paying out $160 million in bonuses despite taking taxpayer dollars. However, it is not alone in that regard and while $160 million is no small sum, it actually pales in comparison to what the other firms are recieving. Some suggest that the real welfare queen is actually Goldman Sachs. AIG is neither alone nor is it the most culpable. John Thain and Merrill Lynch win that prize.
ON EXECUTIVE COMPENSATION:
" I think I might go back to a very old tort theory of unjust enrichment -- contract theory, tort theory -- and say, you know what, guys? There's a theory in the law that says -- a couple of theories -- one impossibility saying, AIG just doesn't have the money to pay you. And absent the federal infusion, it wouldn't have it, so we can't pay.
And second I would say, unjust enrichment. You simply don't deserve it. It's an equitable argument. Some courts might go for it, some courts might not.
But as a practical matter, as the president of the United States, I think I would call the CEOs into the Oval Office. And I would say, "Guys, this is untenable. We're all going to have to suck it up a little bit and show the American people that we know what it means to be part of a community, and share the sacrifice. Let's see if we can't solve this without the legal wrangling."
ON THE FAILURE OF THE SEC
"Absolutely. The power of the federal agencies to do this stuff was unlimited.
And any time I hear the SEC say, we didn't have the power to do this or that, forget it. They had more people, more power, more money than was necessary. What they lacked was the creativity and the will."
ON THE PROBLEM
"I tried very hard not to vilify individuals, because it wasn't a mid-level executive who was the problem. It was the whole structure. And that's why the global deal was with all the banks."
ON HIS OWN FAILURE
" I never held myself out as being anything other than human. I have flaws, as we all do, arguably. I failed in a very important way in my personal life, and I have paid a price for that."
CLOSING COMMENTS:
Evidently, Spitzer himself excercised poor judgement in the events leading up to his resignation from office in 2008. Something he plainly admits. However, that should not distract us from the soundness of his reasoning, there is much we can learn from him.
I also want to leave you with another thought. It should be now obvious that regulators lacked the skills, conviction and judgement to take on the Financial Services. An effective financial regulator needs to have a sound knowledge base in law, finance and business. That is ironic because having gone to both law and business school, I have never encountered a single person aspiring to become a financial regulator. The regulatory/financial services compensation gap must be narrowed, by having such a huge disparity in compensation continue for so long is tantamount to putting Wall Street on the honor code system for decades. And it is pure fantasy to think society is better off this way. Until this changes, Wall Street will always be several steps ahead of the game and we can never safely say, it won't happen again.
The full transcript of the interview can be found here.
Better still, you can watch it here.
Wednesday, March 11, 2009
Reinstate The Uptick Rule
It is no secret that short selling is controversial, critics say it allows speculators to destroy businesses and provides incentives for the spreading of malicious rumors in order to drive the stock down.
On the flipside, supporters say price discovery is improved because negative views on the stock price can be expressed.
And this is how arguments for and against shorting basically run. However, the most convincing answer I've heard lies somewhere in between.
Shorting should be thought of as medication. Taken in the right quantities it aids recovery but overdosage is downright poisonous. What really kept shorting in the right quantities was the uptick rule. The rule mandates every short sale transaction be entered at a price that is higher than the price of the previous trade. In other words, the uptick rule prevents short sellers from adding to the downward momentum when the price of an asset is already experiencing sharp declines, there must be an uptick in the price before you can short.
This rule was of course eliminated by the SEC in July 6, 2007 because the uptick rule "modestly reduce[d] liquidity and do[es] not appear necessary to prevent manipulation." This is course the same SEC which has been asleep at the wheel for everything else.
Like most other other forms of deregulation the effects were debated and unknown in the immediate aftermath, but within 12 months, it became clear that market volatility had increased and the number of stocks declining by more than 40% in one day had doubled.
It amazes me that the SEC empowered by hindsight knowledge of the 1930's, which is always 20/20 vision I am told, could ever eliminate the uptick rule. The children have been allowed to play with matches and now the house is on fire. The uptick rule needs to be reinstated immediately, and if a few hedge funds grumble, please don't lose sight of the burning house.
On the flipside, supporters say price discovery is improved because negative views on the stock price can be expressed.
And this is how arguments for and against shorting basically run. However, the most convincing answer I've heard lies somewhere in between.
Shorting should be thought of as medication. Taken in the right quantities it aids recovery but overdosage is downright poisonous. What really kept shorting in the right quantities was the uptick rule. The rule mandates every short sale transaction be entered at a price that is higher than the price of the previous trade. In other words, the uptick rule prevents short sellers from adding to the downward momentum when the price of an asset is already experiencing sharp declines, there must be an uptick in the price before you can short.
This rule was of course eliminated by the SEC in July 6, 2007 because the uptick rule "modestly reduce[d] liquidity and do[es] not appear necessary to prevent manipulation." This is course the same SEC which has been asleep at the wheel for everything else.
Like most other other forms of deregulation the effects were debated and unknown in the immediate aftermath, but within 12 months, it became clear that market volatility had increased and the number of stocks declining by more than 40% in one day had doubled.
It amazes me that the SEC empowered by hindsight knowledge of the 1930's, which is always 20/20 vision I am told, could ever eliminate the uptick rule. The children have been allowed to play with matches and now the house is on fire. The uptick rule needs to be reinstated immediately, and if a few hedge funds grumble, please don't lose sight of the burning house.
Schadenfreude
Dodging bullets before congress on Feb 11th 2009, Vikram Pandit had to justify Citigroup's $42 million private jet order after taking billions of taxpayer bailout money. Since he couldn't, he conceded, "I get the new reality and I will make sure Citi gets it as well."--And that's the closest you will ever get to the CEO of a Wall Street firm ever coming close to saying sorry for breaking the global economy.
For once, it became a joy to watch C-SPAN, mostly a sense of Schadenfreude watching Henry Waxman and the rest of Congress tag team the Wall Street executives. You almost felt sorry for Dick Fuld. The Swiss are taking it even further and are talking about the idea of banking clawbacks and performance maluses. Imagine that, bankers actually penalized for poor performance, how novel! But why does the general populace feel this way? Are bankers overpaid? Are they to blame? Or is everyone else just jealous of them?
To begin with, people are angry because the financial industry has figured out a way to privatize gains and to socialize losses. The financial industry has profitted immensely but taxpayers bear the brunt of the burden when things go wrong. That's justified outraged in my opinion, you can only call it jealousy if taxpayers didn't have to bail out Wall Street.
Fueling that rage is Wall Street's brain drain defense. “Because if you don't, the best of us will leave the industry.” Two things spring two mind. First, what has the "best of Wall Street" given us? Toxic assets, subprime mortgages, extreme risk-taking and complicated derivatives they themselves don't understand. Two, where would you go? You would leave banking and get hired by whom, and what would they pay you? You would leave banking and start your own company doing what? Yes, Wall Street is guilty of some hubris.
So this is the new reality--for the next 5 years at least.
When I graduated from college in 2000, Investment Banking (IB), Management Consulting (MC), and Silicon Valley related jobs (Venture Capital and Start-ups) were percieved to be the top jobs for a young ambitious person. Roughly 40% of my class marched into IB and MC alone. And this was a liberal arts school where kids were almost indoctrinated to do what they love and follow their passions. By the time I graduated from business school in 2003, the freshly minted MBA seemingly filed into just one job--finance. Be it IB, hedge funds, private equity or real estate, it was all finance related. The dot.coms were by now dot.gones and even the Mckinsey and Bain jobs were looking like ugly step-sisters when all-in salaries were compared.
That's when you sensed something was awry but you couldn't quite put your finger on it. Doctors found themselves sitting for the CFA, reinventing themselves as "Healthcare Sector Stock-Pickers". Science geeks started getting MBAs and still did engineering but it was the financial kind, electrical and mechanical were suddenly so uncool. Aggressive lawyers found matching personalities in their banking counterparts and crossed-over to finance as well. I've even met a Buddhist monk reincarnated as a private banker within the same life cycle! That's when you know everything is crawling out the woodwork. Finance has outpaid every other industry for decades and that’s why it attracted people from all other industries. The cliche says that no one goes to business school for reasons other than to make money, apparently that increasingly applicable to medical, law and engineering schools also. They just decide that money is more important to them at a different stage in their life. Surely these "cross-overs to finance" must, at some level, find it hard to reconcile their new lives on Wall Street. I cringe when I think of the same person talking about wanting to go to med school to alleviate human suffering. Likewise when I think of the lawyer who was supposedly attracted to law school because he enjoyed the challenge of resolving legal problems.
So when did finance start remunerating itself to the point where people from other well-compensated professions decided to drop their careers in exchange for? Doctors and lawyers have never really starved. There are some clues in this research article written by an NYU academic, Thomas Philippon. It seems like deregulation, not simply financial genius as you might have thought, is a major reason bankers get paid so much. Bankers get wealthy, increasingly influential and they in turn are able to exert influence on the legislators leading to more deregulation. The regulators, unable to attract and retain the talent needed to match the private sector, begins deregulating and undoing the safeguards put in place after the 1930's depression. We see a huge spike in deregulation and and corresponding banking salaries in the 1980's, the wonders of Reaganomics! This continues unabated throughout the nineties and noughties until today's financial collapse.
If there is a silver lining in any of this, we might at least take some comfort that regulators are now able to sift through the ranks of the unemployed and hire highly skilled financial workers on the cheap and even the playing field with the private sector.
But just as surely as we have forgotten the dangers of deregulation in the 1980's some would argue, we'll forget them again fifty years from now and deregulate until we realize it's a mistake once again. Trust me, I can go on about this but it's easy to miss the forest for the trees. I'd rather spend my energy on understanding what went wrong, what needs to be fixed, how it will be fixed and if possible, how to prevent it from ever happening again.
There's plenty of blame to go around. Who's to blame for this? I can think of four sets of people: the insitutions that invented and perpetuated the toxic assets; the regulators; the predatory lenders; and the irresponsible borrowers. That's pretty much everyone. The only thing you can do is to forgive and move on, afterall resentment is like drinking poison and waiting for the other person to die.
For once, it became a joy to watch C-SPAN, mostly a sense of Schadenfreude watching Henry Waxman and the rest of Congress tag team the Wall Street executives. You almost felt sorry for Dick Fuld. The Swiss are taking it even further and are talking about the idea of banking clawbacks and performance maluses. Imagine that, bankers actually penalized for poor performance, how novel! But why does the general populace feel this way? Are bankers overpaid? Are they to blame? Or is everyone else just jealous of them?
To begin with, people are angry because the financial industry has figured out a way to privatize gains and to socialize losses. The financial industry has profitted immensely but taxpayers bear the brunt of the burden when things go wrong. That's justified outraged in my opinion, you can only call it jealousy if taxpayers didn't have to bail out Wall Street.
Fueling that rage is Wall Street's brain drain defense. “Because if you don't, the best of us will leave the industry.” Two things spring two mind. First, what has the "best of Wall Street" given us? Toxic assets, subprime mortgages, extreme risk-taking and complicated derivatives they themselves don't understand. Two, where would you go? You would leave banking and get hired by whom, and what would they pay you? You would leave banking and start your own company doing what? Yes, Wall Street is guilty of some hubris.
So this is the new reality--for the next 5 years at least.
When I graduated from college in 2000, Investment Banking (IB), Management Consulting (MC), and Silicon Valley related jobs (Venture Capital and Start-ups) were percieved to be the top jobs for a young ambitious person. Roughly 40% of my class marched into IB and MC alone. And this was a liberal arts school where kids were almost indoctrinated to do what they love and follow their passions. By the time I graduated from business school in 2003, the freshly minted MBA seemingly filed into just one job--finance. Be it IB, hedge funds, private equity or real estate, it was all finance related. The dot.coms were by now dot.gones and even the Mckinsey and Bain jobs were looking like ugly step-sisters when all-in salaries were compared.
That's when you sensed something was awry but you couldn't quite put your finger on it. Doctors found themselves sitting for the CFA, reinventing themselves as "Healthcare Sector Stock-Pickers". Science geeks started getting MBAs and still did engineering but it was the financial kind, electrical and mechanical were suddenly so uncool. Aggressive lawyers found matching personalities in their banking counterparts and crossed-over to finance as well. I've even met a Buddhist monk reincarnated as a private banker within the same life cycle! That's when you know everything is crawling out the woodwork. Finance has outpaid every other industry for decades and that’s why it attracted people from all other industries. The cliche says that no one goes to business school for reasons other than to make money, apparently that increasingly applicable to medical, law and engineering schools also. They just decide that money is more important to them at a different stage in their life. Surely these "cross-overs to finance" must, at some level, find it hard to reconcile their new lives on Wall Street. I cringe when I think of the same person talking about wanting to go to med school to alleviate human suffering. Likewise when I think of the lawyer who was supposedly attracted to law school because he enjoyed the challenge of resolving legal problems.
So when did finance start remunerating itself to the point where people from other well-compensated professions decided to drop their careers in exchange for? Doctors and lawyers have never really starved. There are some clues in this research article written by an NYU academic, Thomas Philippon. It seems like deregulation, not simply financial genius as you might have thought, is a major reason bankers get paid so much. Bankers get wealthy, increasingly influential and they in turn are able to exert influence on the legislators leading to more deregulation. The regulators, unable to attract and retain the talent needed to match the private sector, begins deregulating and undoing the safeguards put in place after the 1930's depression. We see a huge spike in deregulation and and corresponding banking salaries in the 1980's, the wonders of Reaganomics! This continues unabated throughout the nineties and noughties until today's financial collapse.
If there is a silver lining in any of this, we might at least take some comfort that regulators are now able to sift through the ranks of the unemployed and hire highly skilled financial workers on the cheap and even the playing field with the private sector.
But just as surely as we have forgotten the dangers of deregulation in the 1980's some would argue, we'll forget them again fifty years from now and deregulate until we realize it's a mistake once again. Trust me, I can go on about this but it's easy to miss the forest for the trees. I'd rather spend my energy on understanding what went wrong, what needs to be fixed, how it will be fixed and if possible, how to prevent it from ever happening again.
There's plenty of blame to go around. Who's to blame for this? I can think of four sets of people: the insitutions that invented and perpetuated the toxic assets; the regulators; the predatory lenders; and the irresponsible borrowers. That's pretty much everyone. The only thing you can do is to forgive and move on, afterall resentment is like drinking poison and waiting for the other person to die.
The Best Diet
Atkin's, South Beach, Popcorn, Slimfast...etc. Diet fads come and go but apparently fat people don't. The verdict is out, the only thing to do when you diet is to count your calories. It doesn't matter if you go low-fat, low-carb or high-protein, you need to create a calorie deficit if you want to lose weight. That means expending more calories than you'd consume in a day. That also means alot of discipline and you'll need even more self-control if you don't excercise.
What also helps is the concept of energy density. Certain foods that make us feel full are actually lower in calories than you'd think. Conversely, there are plenty of tasty fat laden carbohydrates that we can munch away on without realizing we've had about 5,000 calories worth.
So the best diet is really common sense. Just like everything else you'll find on this blog, everything boils down to hard work, discipline and common sense. But you already knew all this at the back of mind, this just means you've run out of excuses to not eat less and work out more. Enough already, go do it!
What also helps is the concept of energy density. Certain foods that make us feel full are actually lower in calories than you'd think. Conversely, there are plenty of tasty fat laden carbohydrates that we can munch away on without realizing we've had about 5,000 calories worth.
So the best diet is really common sense. Just like everything else you'll find on this blog, everything boils down to hard work, discipline and common sense. But you already knew all this at the back of mind, this just means you've run out of excuses to not eat less and work out more. Enough already, go do it!
Investing 101
There are tons of articles written on investing by people who are smarter, wiser, more experienced and more numerate than I will ever be. I have no chance of ever outsmarting them nor do I intend to, but I do want to stand on their shoulders.
Let me share with you my beliefs:
1. As with everything in life, you have to work hard to be successful. Investing is no exception to the rule. Actually, you can work hard and still lose money investing, the only solution to this is to work harder.
2. I have many flaws which make a bad investor. I am stubborn, impulsive, egotistical, careless, ignorant and emotional amongst many other things. But awareness of this is a good start.
3. I can be cheated. As cynical as I can be about the investment industry, I can still be taken for a ride. Although I've learnt from my lessons I can be vulnerable to the next person who understands my weaknesses. My cynicism can easily be taken to the other extreme, to the point where I blind myself to genuinely good investment opportunities.
4. In spite of all this I still have to keep on trying. Why? Because inflation doesn't care how I feel, neither do the taxes.
5. We all pursue happiness. But once you graduate from college, you will soon realize the obligation is not just to yourself, it's also to your family and those around you. Marriage and your choice of life partner will be the single most important decision you will ever make. It's harder to see why this is so in successful marriages but plain to see in failed ones.
If these statements resonate with you, it would be worthwhile for you to read on. If not, I doubt we're on the same page and there are other investment approaches which suit you better.
For anyone new to investing, I'd urge them to turn off the TV and shut out programs like "Fast Money" and Jim Cramer's "Mad Money". The problem I have with Jim Cramer is that some of what he says actually makes sense. However, his style evokes a very flippant attitude towards investing. I'm glad he is having fun at TV, but I'd be much less flippant about making decisions which shape the outcome of my retirement and children's future.
Part of the challenge in investing is to assemble a decent booklist to begin with. I'd go so far as to say that 99% of what is written on investments are are better left unread. The easiest trap for a new investor to fall into is to start reading a "How to" on stock picking. Did you ever consider that you should not be stock picking to begin with?
The caveat here is that these books have to be read and re-read and meditated upon. Speed reading through them will result in alot of lost wisdom. Also, these are investment philosophies, not point by point "How to do" lists. You need to invest time into them before you develop a strong enough conviction you can act upon (or in some cases not act upon). All are available in stores or with online retailers.
1. Winning the Loser’s Game: Charles D. Ellis
This book will get you thinking about the right issues and offers timeless investment philosophies.
2. Random Walk Guide to Investing: Burton G. Malkiel
This is actually a condensed version to The Random Walk Down Wall Street which is assigned reading in almost any investment class. It's supported by alot of convincing facts and figures and punctures alot of misconcieved notions about investing.
3. The Four Pillars of Investing: William J. Bernstein
This actually offers us a solid basic framework to investing, consultants will love this.
4. Intelligent Investor: Benjamin Graham, Jason Zweig and Warren Buffett
5. Pioneering Portfolio Management: David F. Swensen
*Millionaire Next Door: Thomas J. Stanley, William D. Danko. This is not an investment book per se but is relevant if you are serious about building your personal net worth.
**I would also highly recommend anything written by John C. Bogle. His works are not any less relevant than the other books, they are just not a natural fit in the sequence.
I would read them in the order I've presented and don't be afraid to revisit ones you think you've read thoroughly before. I'm still learning from them many years later. The challenge here is not in understanding what is written, the challenge is in applying it to your life with consistency.
Let me share with you my beliefs:
1. As with everything in life, you have to work hard to be successful. Investing is no exception to the rule. Actually, you can work hard and still lose money investing, the only solution to this is to work harder.
2. I have many flaws which make a bad investor. I am stubborn, impulsive, egotistical, careless, ignorant and emotional amongst many other things. But awareness of this is a good start.
3. I can be cheated. As cynical as I can be about the investment industry, I can still be taken for a ride. Although I've learnt from my lessons I can be vulnerable to the next person who understands my weaknesses. My cynicism can easily be taken to the other extreme, to the point where I blind myself to genuinely good investment opportunities.
4. In spite of all this I still have to keep on trying. Why? Because inflation doesn't care how I feel, neither do the taxes.
5. We all pursue happiness. But once you graduate from college, you will soon realize the obligation is not just to yourself, it's also to your family and those around you. Marriage and your choice of life partner will be the single most important decision you will ever make. It's harder to see why this is so in successful marriages but plain to see in failed ones.
If these statements resonate with you, it would be worthwhile for you to read on. If not, I doubt we're on the same page and there are other investment approaches which suit you better.
For anyone new to investing, I'd urge them to turn off the TV and shut out programs like "Fast Money" and Jim Cramer's "Mad Money". The problem I have with Jim Cramer is that some of what he says actually makes sense. However, his style evokes a very flippant attitude towards investing. I'm glad he is having fun at TV, but I'd be much less flippant about making decisions which shape the outcome of my retirement and children's future.
Part of the challenge in investing is to assemble a decent booklist to begin with. I'd go so far as to say that 99% of what is written on investments are are better left unread. The easiest trap for a new investor to fall into is to start reading a "How to" on stock picking. Did you ever consider that you should not be stock picking to begin with?
The caveat here is that these books have to be read and re-read and meditated upon. Speed reading through them will result in alot of lost wisdom. Also, these are investment philosophies, not point by point "How to do" lists. You need to invest time into them before you develop a strong enough conviction you can act upon (or in some cases not act upon). All are available in stores or with online retailers.
1. Winning the Loser’s Game: Charles D. Ellis
This book will get you thinking about the right issues and offers timeless investment philosophies.
2. Random Walk Guide to Investing: Burton G. Malkiel
This is actually a condensed version to The Random Walk Down Wall Street which is assigned reading in almost any investment class. It's supported by alot of convincing facts and figures and punctures alot of misconcieved notions about investing.
3. The Four Pillars of Investing: William J. Bernstein
This actually offers us a solid basic framework to investing, consultants will love this.
4. Intelligent Investor: Benjamin Graham, Jason Zweig and Warren Buffett
5. Pioneering Portfolio Management: David F. Swensen
*Millionaire Next Door: Thomas J. Stanley, William D. Danko. This is not an investment book per se but is relevant if you are serious about building your personal net worth.
**I would also highly recommend anything written by John C. Bogle. His works are not any less relevant than the other books, they are just not a natural fit in the sequence.
I would read them in the order I've presented and don't be afraid to revisit ones you think you've read thoroughly before. I'm still learning from them many years later. The challenge here is not in understanding what is written, the challenge is in applying it to your life with consistency.
The difference between Investing and Speculating
This is a foundational concept in investing and yet there are shockingly few who are able to articulate the difference. The only sensible comment I've read on this can be attributed to none other than the late Benjamin Graham. For the unfamiliar, Graham was Warren Buffett's mentor and one of the few people Buffett ever quotes.
Investing: That's when you buy into a business and you believe it will generate profit over time because of human effort.
Speculating: Buying into something and hoping that it appreciates over time. Buying a gold bar or a painting.
I see confusion between the two almost everytime I have a conversation about real estate. When someone buys an apartment, he has to be clear if it is for utility (a place to live) or income (an investment because you collect rent) or speculation (you just hope the price goes up when you try to sell it later). Not being clear about your objectives is like going into battle without a plan.
Investing: That's when you buy into a business and you believe it will generate profit over time because of human effort.
Speculating: Buying into something and hoping that it appreciates over time. Buying a gold bar or a painting.
I see confusion between the two almost everytime I have a conversation about real estate. When someone buys an apartment, he has to be clear if it is for utility (a place to live) or income (an investment because you collect rent) or speculation (you just hope the price goes up when you try to sell it later). Not being clear about your objectives is like going into battle without a plan.
Investment Maxims: Used and Abused
We love maxims because they are punchy, easy to use, easy to remember and they leave an impression. But they often contradict and get us into all sorts of trouble. Take the Citigroup stock priced at 99 cents just a few days ago, do you "strike will the iron is hot"? Or do you "look before you leap"? Now that you've considered both, the answer is much less clear.
In fact, there is a textbook written on the law of equity that boils the subject down into just twenty-five maxims. Imagine that, if you could apply just twenty-five maxims, you were proficient in the law of equity.
Much easier said than done.
“Here is certainly a remarkable difference of opinion. The truth is that there are maxims and maxims; some of great value, some worse than worthless. And the really valuable maxims are peculiarly liable to be put to a wrong use. A proposition, in order to gain currency as a maxim, must be tersely expressed. But the brevity which gives it currency, also in many instances, gives rise to misconception as to its meaning and application. A phrase intended to point out an exception may be mistaken for the enunciation of a general rule. An expression originally used only to state a truth may be mistaken for a statement of all truth…” --"The Use of Maxims In Jurisprudence", Jeremiah Smith. Harvard Law Review, 1895
Don’t you just love legal reasoning? This paragraph intended for legal jurisprudence was written over a century ago but rings no less true in the world of investing till this very day. You’ll find maxims thrown about by everyone ranging from hedge fund managers to relatives dispensing well-meaning but ill-informed advice over the kitchen table. That said, Maxims are a double-edged sword which are more often than not, “put to a wrong use”, and even worse, abused by some to pull a fast one over another.
Bad Maxims include:
- “You have to love a falling market.” This is a license to get investors to buy blindly every time the market falls. Here’s the counter-maxim, “Trying to catch a falling market is like trying to catch a falling knife.”
- "You have to be in it to win it." This applies to the lottery and it's frightening how gambling wisdom has creeped into the field of investing. Sure, you need exposure to the stock market to make gains, but does that mean you should be in every asset class which appreciates?
Good Maxims abused include:
- “There’s no such thing as a free lunch.” It’s largely true but I've also see this misapplied by a banker responding to a client’s request to reduce fees because they were uncompetitive. The client wasn’t asking for a free lunch, he was simply asking the banker to match the rates of his competition. If the client was asking for a free lunch, which he wasn't, he would have been asking for something unreasonable. The client was acting well within his rights.
That's not to say Maxims should be avoided entirely, we can use them if we always keep one thing in mind, "A little bit of knowledge is a dangerous thing."
There are many good ones that escape me at this time of writing. If you can think of any, please comment.
SOURCE
The Use of Maxims in Jurisprudence
Jeremiah Smith
Harvard Law Review, Vol. 9, No. 1 (Apr. 25, 1895), pp. 13-26 (article consists of 14 pages)
Published by: The Harvard Law Review Association
In fact, there is a textbook written on the law of equity that boils the subject down into just twenty-five maxims. Imagine that, if you could apply just twenty-five maxims, you were proficient in the law of equity.
Much easier said than done.
“Here is certainly a remarkable difference of opinion. The truth is that there are maxims and maxims; some of great value, some worse than worthless. And the really valuable maxims are peculiarly liable to be put to a wrong use. A proposition, in order to gain currency as a maxim, must be tersely expressed. But the brevity which gives it currency, also in many instances, gives rise to misconception as to its meaning and application. A phrase intended to point out an exception may be mistaken for the enunciation of a general rule. An expression originally used only to state a truth may be mistaken for a statement of all truth…” --"The Use of Maxims In Jurisprudence", Jeremiah Smith. Harvard Law Review, 1895
Don’t you just love legal reasoning? This paragraph intended for legal jurisprudence was written over a century ago but rings no less true in the world of investing till this very day. You’ll find maxims thrown about by everyone ranging from hedge fund managers to relatives dispensing well-meaning but ill-informed advice over the kitchen table. That said, Maxims are a double-edged sword which are more often than not, “put to a wrong use”, and even worse, abused by some to pull a fast one over another.
Bad Maxims include:
- “You have to love a falling market.” This is a license to get investors to buy blindly every time the market falls. Here’s the counter-maxim, “Trying to catch a falling market is like trying to catch a falling knife.”
- "You have to be in it to win it." This applies to the lottery and it's frightening how gambling wisdom has creeped into the field of investing. Sure, you need exposure to the stock market to make gains, but does that mean you should be in every asset class which appreciates?
Good Maxims abused include:
- “There’s no such thing as a free lunch.” It’s largely true but I've also see this misapplied by a banker responding to a client’s request to reduce fees because they were uncompetitive. The client wasn’t asking for a free lunch, he was simply asking the banker to match the rates of his competition. If the client was asking for a free lunch, which he wasn't, he would have been asking for something unreasonable. The client was acting well within his rights.
That's not to say Maxims should be avoided entirely, we can use them if we always keep one thing in mind, "A little bit of knowledge is a dangerous thing."
There are many good ones that escape me at this time of writing. If you can think of any, please comment.
SOURCE
The Use of Maxims in Jurisprudence
Jeremiah Smith
Harvard Law Review, Vol. 9, No. 1 (Apr. 25, 1895), pp. 13-26 (article consists of 14 pages)
Published by: The Harvard Law Review Association
Buffett Live on CNBC's Squawk Box March 9th, 2009
The Oracle of Omaha talked and answered questions emailed in from viewers for almost 3 whole hours on March 9th, 2009. As usual, there was plenty for us to chew on, but my main take-aways were:
- Executive Compensation and Corporate Jets: There's no point getting mad or going on a witch hunt, a bad economy won't hurt you any less. He used Bernie Madoff as an example. If you were defrauded by Madoff and trapped on a boat which had sprung leak, you were better off plugging that hole than going down with him. Getting mad is just not a productive use of time or energy.
- US Recovery: The US economy will recover. Consistent with his 2008 letter to the shareholders, he is confident that the US economy will fight it's way out of the current situation. There are 3 things that have contributed to the American economic miracle.
1) The Rule of Law;
2) A mostly free market economy;
3) A system that unleashes the human potential.
Rule of law and free market economic systems are not unique to the US. But he argues that the third limb is. The example he gave was the Nebraska Furniture Store. It was started by a Russian migrant "who worked hard, gave better deals and succeeded". You have Russians leaving Russia to become successful in the US, you don't have Americans leaving the US to become successful in Russia. Although American businesses have "misbehaved" and it was silly to give Executives a pen and "put them on the honor system", the system is largely intact and these problems are being addressed. Take-away: Have faith that the US economy will recover.
- Focus & Clarity: There is fear and confusion because we do not have clarity. We are in the midst of an economic war and not everyone recognizes this. Buffett used the Pearl Habor analogy repeatedly. In a war, the country needs to rally behind the President and focus on fighting it. After Pearl Habor, the army and navy did not engage in a finger pointing blame game of who did what wrong--which is exactly what the Democrats and Republicans continue to do. Differences have to be set aside for the greater good. Additionally, the man in the street does not know who Bernanke, Geithner or Paulson are. President Obama needs to come out and address them directly and to tell them that their money is safe.
- Gold: Buffett reiterated his belief in buying good businesses whereas gold will "sit there and look at you". He does not believe that digging something of the ground in Africa, transporting that to the US and storing it underground in the vault will do anything for you.
- Executive Compensation and Corporate Jets: There's no point getting mad or going on a witch hunt, a bad economy won't hurt you any less. He used Bernie Madoff as an example. If you were defrauded by Madoff and trapped on a boat which had sprung leak, you were better off plugging that hole than going down with him. Getting mad is just not a productive use of time or energy.
- US Recovery: The US economy will recover. Consistent with his 2008 letter to the shareholders, he is confident that the US economy will fight it's way out of the current situation. There are 3 things that have contributed to the American economic miracle.
1) The Rule of Law;
2) A mostly free market economy;
3) A system that unleashes the human potential.
Rule of law and free market economic systems are not unique to the US. But he argues that the third limb is. The example he gave was the Nebraska Furniture Store. It was started by a Russian migrant "who worked hard, gave better deals and succeeded". You have Russians leaving Russia to become successful in the US, you don't have Americans leaving the US to become successful in Russia. Although American businesses have "misbehaved" and it was silly to give Executives a pen and "put them on the honor system", the system is largely intact and these problems are being addressed. Take-away: Have faith that the US economy will recover.
- Focus & Clarity: There is fear and confusion because we do not have clarity. We are in the midst of an economic war and not everyone recognizes this. Buffett used the Pearl Habor analogy repeatedly. In a war, the country needs to rally behind the President and focus on fighting it. After Pearl Habor, the army and navy did not engage in a finger pointing blame game of who did what wrong--which is exactly what the Democrats and Republicans continue to do. Differences have to be set aside for the greater good. Additionally, the man in the street does not know who Bernanke, Geithner or Paulson are. President Obama needs to come out and address them directly and to tell them that their money is safe.
- Gold: Buffett reiterated his belief in buying good businesses whereas gold will "sit there and look at you". He does not believe that digging something of the ground in Africa, transporting that to the US and storing it underground in the vault will do anything for you.
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