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.
Monday, April 27, 2009
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.
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