Thursday, November 20, 2008

Amoral MBA Students

MBA students, perhaps not to anyone's surprise, are cheaters.  MBA students cheat on the GMAT's so they can get into top B-Schools.  MBA students also willingly admit to cheating once they're in B-School, and MBA students obviously act amorally and immorally once they're out of B-School.  
Keep this in mind as I present the results of an informal, professor-administered poll taken in my Derivatives class this Tuesday.  The class discussion began with talk of everything that's been happening lately, as usual, and the professor believed illegal actions will eventually come to light regarding actions at the Wall Street firms (pressuring ratings agencies, exchanging favors for good ratings on toxic CDO's etc.).  Some students expressed anger at the immorality of it all, others questioned whether anything illegal had actually happened or whether it was simply irresponsibility that caused it all.  In light of the class discussion, the professor presented a class with the following situation:
You work somewhere in the finance industry nine months from now, and I present you with an opportunity to make $5 million.  However, you have to do something illegal to get the $5 million. The chance you'll be caught for doing this illegal act is 50%. Further, the maximum sentence you'll receive is four years and the chance of receiving the four years is also 50%. No matter what happens, if you're caught and sentenced to three years, you'll still get to keep the $5 million.  Would you do it?
Almost everyone in class raised their hands.
Here are the demographics of the class, as best I can guess.  It's a mixed class with both MS and MBA students since Derivatives is an elective for MBA-ers.  The class size is roughly 90 students, all ranging in age from 26-34 (my best guess).  The mix is approximately 50% Asian and South Asian, 40% American (all races) and 10% other (from the accents I'm guessing Russian, German, South American and Latin American).  Males comprise about 70% of the class.
There were little demographic differences among those who raised their hands, at least as far as I noticed, other than the few married women who didn't.  If you must know, I also raised my hand, but it's not a static answer for me. I'm on the upper end of that age range and four years is a long time for me to be rotting in a jail cell.  I've got friends and family I love dearly and wouldn't want to miss seeing.  I'm also certain that if I figured out who exactly I'd be damaging with my immoral / illegal actions, I might not follow through.  I find it's a lot easier to answer "yes" to a question of an illegal act when the question is asked in a void, but it's also much tougher to actually follow through on that act in real life.  
All this is beside the point, however. MBA Students (and MS - Finance students) are supposed to be smarter and (I suppose) less immoral than rest of the world.  I imagine the results of this poll would skew quite high if given to the population at-large, but the class this poll was asked of are supposed to be future leaders -- future leaders of large corporations that will hold the financial well being of tens of thousands, or even hundreds of thousands of workers' lives in their hands.  
All the students wrote essays to gain admittance to school, and all their essays discussed the "good" they'd like to do in their future career as well as the unique and interesting career paths they believe that earning an MBA will open for them (management consulting and investment banking, at the time the essays were written, are unique?).
Anyway, nearly all the students I know are in B-School to make more money.  There are few non-profit, humanitarian types in the program but for the most part we're all here just to earn larger paychecks. That's it. Plain and simple.  
So basically, 90% of MBA students are not just generally a bunch of cheats but also liars since their admissions essays were anything but honest!  And yes, I'm completely comfortable extending generalizations to every B-School and MBA student in the country after the completely unscientific and informal polling I conducted at mine.  I wonder if, when they're reading the admittance essays, the adcoms aren't just looking for the most riveting piece of fiction they can find since we all lied about our future hopes to save the whales and the rainforest? Well, maybe after we make our first $100 million we'll have whaletanks installed in our mansions and rainforest terrariums installed in our million dollar greenhouses, thereby following through on the empty promises we wrote in our essays.
All this pretty much got me wondering whether financial gain attracts the amoral / immoral or whether the amoral / immoral are attracted to financial gain?  I have to admit that I give the professors a lot of credit for trying their hardest to sway us and the HR Profs do an especially admirable job in this respect, but if the students are already money chasing cheaters, what difference can a few enlightened lectures make?  
Anyway, in the wake of the meltdown and news items claiming MBA degrees are no longer worth it, I'm really starting to think I should have earned my Master's in something less sleazy, more honest and more respected....  like law!  Hey, at least I'd have a job next year prosecuting all those immoral MBA-ers who caused this mess. 

Tuesday, November 18, 2008

NFL Overtimes

There's a lot of animosity in the local media here in Philly directed toward Donovan McNabb for not knowing that NFL games can end in ties.  Presumably, McNabb might have played differently if he'd known that games can end in ties but I don't want to weigh in on that debate. Instead, I'd rather ask why the NFL hasn't converted to the college system? NFL overtimes don't grant equal possessions to each team (which has been a problem for a long time), and the sudden death format is unfair because of this.
College overtime games can sometimes have ridiculous 70-69 scores if there are multiple overtimes and the league probably doesn't want to invalidate old touchdown, yardage and scoring records, but there are ways to ensure the scoring doesn't get blown out of proportion in "equal possession" overtimes. 
The easiest way to do this is for the NFL to adopt the college model but simply adjust it.  NFL teams should begin the 1st overtime with equal possessions from the 20. Then from the 30. Then from the 40. Then from the 50. The second overtime should, like college, require a two-point conversion if the team scores a touchdown.  It's still possible overtime games could end up with high scores, but the chances under this kind of system would be greatly diminished while satisfying the "fairness" problem of the current overtime system, providing fans a much more exciting game and also eliminating ties (something I think American sports fans hate more than losses).  
Update: Apparently McNabb also didn't know that playoff games and SuperBowls don't end in ties.  Which makes me wonder what he thought would have happened then?  Did he think teams that end up tied in a playoff game both advance?  How miserable would that be for the poor third team that has to play the other two??? Sheesh...

Good Financial Innovations?

I missed the opportunity a few weeks ago to offer my thoughts on the debate between Dani Rodrik and Steve Randy Waldman about financial innovation.  Rodrik sparked the debate by asking for:
... some examples of financial innovation -- not of any kind, but the kind that has left a large enough footprint over some kind of economic outcomes we really care about.  What are some of the ways in which financial innovation has made our lives measurably and unambiguously better?
My answer to Mr. Rodrik would be... Mortgage Backed Securities.
Unbelievable huh? How can I possibly say Mortgage Backed Securities are financial innovations that have made our lives measurably and unambiguously better?
Well, I can say it because the creation of the secondary mortgage market has been invaluable to millions of Americans (perhaps even hundreds of millions).  By creating a secondary market for mortgages, more people are able to borrow to get the home they want.  MBS's allow regional banks to diversify their mortgage pools and stay afloat, even if tough economic times hit their region.  For instance imagine if, in sunnier economic climes, the automakers collapse but no secondary mortgage market exists.  All the Michigan autoworkers would default on their mortgages and the regional banks holding all those mortgages would also fail (if the banks had been willing to lend to everyone in the region in the first place). The domino effect caused by failing banks in a state that's also decimated by job losses would be catastrophic.  Failing regional banks would cause "Main Street" problems on a terrible scale for whatever region they're in. But by packing up mortgages and sending them somewhere else (or by buying mortgages from a different region), the regional banks, and the region itself, are more insulated and protected from this kind of catastrophic failure. 
What we have to understand (and what Mr. Rodrik should understand) is that the ability to securitize a mortgage has been exploited and although Mortgage Backed Securities are now seen as tools of financial destruction they've probably helped every homeowner who is reading this blog to buy their home.
Financial engineering instruments are tools, plain and simple. They're neither inherently good, nor inherently evil, they're just tools. So the right question isn't "what financial innovation is good?"  The right question is, "How do we stop shysters from using financial innovation for evil?"
After all, nobody asked whether or not airplanes were good after 9/11.  We asked how to stop terrorists from flying them into buildings. The current situation is no different. There are a huge range of financial innovations that offer loads of potential benefits to millions of people both directly and indirectly.  When I pull out my "FE toolbag" (if you will), I'm able to structure payments and cash flows from any investment in any way imaginable.  Smooth cashflows from an investment are incredibly helpful and desired by every business on the planet.
But, as the good finance profs teach, all financial engineering relies on prior assumptions about the underlying investment. If your assumptions are wrong, then your FE instruments won't matter in the least -- and might actually exacerbate your problems. Financial Engineering in its (relatively) short rise to popularity, has instilled a lot of false confidence in the investors who have used them. First it was Salomon in the '80s, the LTCM in the '90s and then (apparently) everyone in the 2000s.  All these people, at some point in their use of FE instruments, either believed they had successfully engineered their way out of danger, or had magically FE'd their way into fantastic profits. They all forgot, or didn't care, that if the assumptions about the underlying investment are wrong, then all the FE instruments in the world won't matter in the least when the piper comes calling.
Now then, I can understand if Mr. Rodrik, and others, want to say that FE instruments have no value because accurate predictions about the future of any investment are a crap shoot at best... but that's a completely different argument. The argument should be whether or not we can stop the exploitation of financial innovation for profit (and also the disturbing tendency of risk managers to blindly trust derivatives as perfect hedges). It doesn't matter whether the answer to this problem is oversight and regulation of the instruments, oversight and regulation of the people who use them, or even if the eventual answer is a consensus that abolishment is the only way to stop their abuse.  In the end, the only thing that matters is making sure financial innovation isn't abused anymore.
And if, in the end, we can't stop people from profiteering through financial engineering tools and abolishment becomes our only answer, then that says more about human beings (and the MBA whizzes on Wall Street) than it does about the instruments themselves.

Saturday, November 15, 2008

Fear and the Liquidity Trap

Paul Krugman put up his analysis of liquidity traps and how he thinks they can be stopped.  I love Krugman but I think his use of expectation theory (as to how it relates to the money supply) is a little off base. Expectations about the future of the economy and expectations about future job security are what drive future spending (or cash hoarding) much more than expectations about the future of the money supply or future monetary policies.
Krugman believes the government has to fool the public into believing it's going to keep interest rates low and the money supply high almost indefinitely to avoid a liquidity trap. If sufficiently fooled he believes this will lead to spending and will stop people from hoarding cash.
I find this hard to believe.  Fear of unemployment and fear of future economic conditions are greater fears.
Economists tend to look quite a bit at the unemployment rate when calculating the severity of a recession, but the duration of an inflated unemployment rate is just as important. US Unemployment spiked to over 25% in 1932 and remained  above 14% for nearly 10 years (from 1930-1939).  Contrast that to our non-Great Depression high of just over 10% in 1982, that lasted less than two years.
An inflated unemployment rate of 10% that lasts for more than few years affects more than just 10% of the workforce.  During that time, it's not a constant 10% of the people who remain unemployed, but rather a revolving, cycle of workers gaining and losing jobs that ultimately affects a much larger portion of the population. People who have lost their jobs, fought for another one and then lost it again will have a hard time being convinced that jobs and money are future guarantees.  People who have experienced a decade long cycle of this may never be convinced again.  Which goes a long way toward explaining why Great Depression survivors hoarded cash their whole lives.
Okay, so that helps explain the Depression, but what about Japan in the 1990s and their liquidity trap?  Their recession was not nearly as deep nor as long as the Great Depression, so why the liquidity trap there?  Why did it take ten years for their people to resume spending and producing?  Well (and I admit this theory may be a bit of stretch) the Japanese are a different culture.
They're a small, tightly-knit group of islands that value honor and work above most else. Japan's population is a largely homogeneous group that holds a collective devotion to 'honor' and views the loss of a job and the loss of money, as disgraceful and dishonorable. Failure is nearly always viewed as a personal flaw in Japan as opposed to we Americans who frequently blame everyone and everything else failures.  The Japanese worker's ability to provide for his or her family in the future, and the loss of their honor if unable to do so, resulted in hoarding of cash when the country faced economic uncertainty.  There are, of course, a number of other factors and more hard and concrete evidence that the Japanese government may have flailed a bit during the years following the Asian crisis and that may have exacerbated the problem, but taken together with the Japanese mindset so fixated on honor, it seems likely that a liquidity trap couldn't be avoided.
In short, I believe the length and duration of the coming recession are what could potentially cause a liquidity trap in the United States, not misdirected fiscal policy or wrongheaded government spending.  If (as the Austrian Economists like to say) the boom leading to the collapse is sufficiently large, then the resulting recession will match it in length and depth. So if this recession is long enough and deep enough, and if consumers weren't saving enough during the boom period, then nothing will stop the recession from being deep and long. The end result could quite possibly be a universal skittishness, constant fear and a lifetime of uncertainty about the economy that will haunt the recession's survivors.
My grandparents and great grandparents are perfect evidence of this.  They lived through the Great Depression and those years affected them so deeply that they really never increase their spending for most of their lives.  They put their money in CD's, low-risk bonds and savings accounts that, most of the time, didn't beat inflation.  My American grandparents, in particular, were doing this until their recent passing just a few years ago. No amount of fiscal or monetary policy or even decade long booms convinced them of the resilience of the US economy, nor did long, sustained booms convince them that jobs and money weren't impermanent, ephemeral things.  In short, they were motivated to hoard by their fears just as the Japanese were motivated to hoard by their fears.
Let us hope this recession is not as deep and long as some fear (though Mr. Krugman himself was on CNBC last week predicting the recession and inflated unemployment would last through 2010 or perhaps 2011… yipes).
In closing, I'll leave you with a nice video of Peter Schiff, an Austrian School adherent who runs his own brokerage firm.  Mr. Schiff is seen in the video predicting the recession and collapse and debating with Felix Salmon's personal enemy, Ben Stein (who appears particularly gas-baggy in these clips) about the economy and the value of financial stocks.  Most of the people Mr. Schiff debates with laugh at him.
Oh, and lest you think I'm an Austrian School devotee myself, please realize I don't share their views about the uselessness of the Fed and government, in general.  

Thursday, November 13, 2008

What Happens if CitiBank Collapses?

It's not fun being right sometimes.  For example, I wrote a blog post in March, and another one two months ago, noting that the size of a financial institution has no relationship to its stability or long-term survival.  Specifically, in both posts I lamented the size of CitiBank and wondered what would happen if the $1 trillion (now $2 trillion) bank were to collapse. 
The FDIC cannot protect all of CitiBank's depositors if the massive behemoth of bank goes under.  What's troubling is that it only took eight months for me to be proved correct.  I thought it would take much longer.
I'll re-cap the brief argument I made about the Gramm-Leach-Bliley Act (GLBA), passed in 1999 that allowed banks like CitiBank to rapidly consolidate and grow so large.  GLBA overruled the Glass-Steagall Act of 1933 which prohibited banks from offering investment, commercial banking and insurance services all under one roof.  
When the financial crisis began in September, a lot of people actually praised GLBA since massive commercial banks like CitiBank and Bank of America could swoop in and buy the failing investment banks, thereby preventing widespread bankruptcies.  I pointed out that panicky investors wouldn't be able to distinguish between losses in a bank's investment or insurance division vs. profits in the bank's commercial banking division.  Panicky investors are likely to sell and scared depositors likely to withdraw their deposits if only one part of the bank is failing.  
I noted that GLBA might indeed be beneficial in the short-term but that it was undoubtedly very dangerous in the long-term, and, like a broken record, I noted that size wouldn't save a bank from failure. I honestly didn't think it would only take two months for me to be proven right.  
CitiBank is currently in the crosshairs of the market and it will have extreme difficulty staying afloat as an independent bank. CEO Vikram Pandit elected to expand CitiBank during the crisis, hoping size would insulate him from danger, but that hasn't happened.  And now CitiBank is not only too big to fail, but probably too big to save.
Citi might well turn out to be Hank Paulson's largest and biggest headache. There's no one he can sell it to -- it's far too big already. Which means that Paulson's only real option, if things deteriorate much further from here, is nationalization. Bits of it could be sold, at a price -- the retail bank to Santander, perhaps; other bits to JP Morgan or Goldman Sachs -- but the losses to the taxpayer would be enormous, and the disruption associated with breaking Citi up and then trying to integrate the pieces in the middle of a major financial crisis would likely be devastating to the economy.
This doesn't make me happy.

Conservatives in Power

I recently provoked a politically-fueled economics debate on another blog that is neither an economic blog nor a political blog.  As such I want to move any further discussion here. There were a number of questions floated by other commenters regarding the statements I made, but the one that drew the most criticism specifically, was a statement I made that laid a large portion of the blame for the current recession at the feet of George W. Bush.  
I further went on to say that the conservatives in this country have recently splintered into a number of differing groups (social conservatives, free-market, laissez-faire Libertarian conservatives and even big government conservatives like Ron Paul). 
I said it has become difficult to quantify conservatives across all classes, but almost all conservatives who reach a level of power in the federal government become free-market Libertarians who pray at the altar of Big Business. Dubya and the rest of the Bushies are the archetypes of this conservative Libertarian movement. 
The Bushies have had such a collective admiration for business that, once in power, they did everything they could to systematically destroy the government and privatize everything.  This isn't Sprizouse's personal conspiracy theory, but rather current 'ruling' conservative dogma. The bulk of this movement began in the 1980s with Reagan who realized that by wrecking the government, he could turn around, point at it and say, "Look the government doesn't work, we should privatize everything."
Let me borrow from Thomas Frank to best illustrate:
Misgovernment by the conservatives in power is the result of a philosophy of government that considers the free market the ideal of human society. This movement is friendly to industry not just by force of campaign contributions but by conviction.  The movement believes in entrepreneurship not merely in commerce but in politics, and the inevitable results of its ascendance are, first, the capture of the state by business and, second, what follows from that: incompetence, graft, and all the other wretched flotsam that we've come to expect from Washington.
The correct diagnosis is the "bad apple" thesis turned upside down. There are plenty of good conservative individuals, honorable folks who would never participate in the sort of corruption we have watched unfold over the past few years. Hang around with grassroots conservative voters in Kansas, and in the main you will find them to be honest, hardworking people.
But put conservatism in charge of the state, and it behaves very differently. Now the "values" that rightist politicians eulogize on the stump disappear, and in their place we discern an entirely different set of priorities—priorities that reveal more about the unchanging historical essence of American conservatism than do its fleeting campaigns against gay marriage or secular humanism. The conservatism that speaks to us through its actions in Washington is a conservatism institutionally opposed to those baseline good intentions we learned about in elementary school. 
Conservative leaders in Washington laugh off the idea of the public interest as airy-fairy nonsense; they caution against bringing top-notch talent into government service and declare war on public workers. They have made a cult of outsourcing and privatizing, they have wrecked established federal operations because they disagree with them, and they have deliberately piled up an Everest of debt in order to force the government into crisis. The ruination they have wrought has been thorough; it has been a professional job. Repairing it will require years of political action.
Frank's doomsaying is a bit further forward than mine. I don't believe the government is beyond saving, and two terms of a progressive agenda enacted by Obama and a liberal Congress should help. But I'm not going to try to predict the future, I'm just trying to point out how well Dubya followed the groundwork laid by Reagan. Bush consistently appointed incompetent people at the top of every agency in Washington, just like Reagan before him (remember James Watt of the EPA?). 
Dubya put coal industry lobbyists in charge of the Department of the Interior, BigPharma guys in charge of the FDA and grossly incompetent men in charge of FEMA which helped the conservatives in Washington "outsource" the rebuilding of New Orleans to profiteering private companies (the ninth ward is almost completely rebuilt after only four years...ummm, maybe not). 
Again, lest you think this is conspiracy theory, examine just a small collection of the Dubya appointments and judge for yourself.  
Alberto Gonzales – Attorney General
Gonzales disgraced the Department of Justice as Attorney General by putting loyalty to the President above duty to the country. 
Hank Paulson – Treasury Secretary
Bush put Paulson, a man so incompetent he doesn't understand the basics of balance sheets, in charge of the Treasury.  This is the man in charge of the Treasury?  A man who asked the American taxpayer to give him $700 million, no questions asked, no oversight?
Paulson is also the man who lobbied to have looser ibanking regulations (lowering of the net capital rule) and the right to leverage through the roof, all of which led to the financial crisis (as well as a large portion of the sub-prime mess created by aggressive investment bank lending).
Joe Allbaugh / Michael Brown – FEMA
Bush first appointed his campaign manager, Joe Allbaugh, to the head of FEMA despite the fact that Allbaugh had no appropriate emergency or management experience.  Then Bush put Michael Brown in his place, a man who had never in his life managed more than two people, and whose career pinnacle to that point was investigating misconduct at horse shows.
J. Steven Griles – Secretary of the Interior
The Department of the Interior is set up to conserve and protect federally owned land.  Griles, a former coal industry lobbyist lobbied for MORE strip mining during his lobbying career.   
Scott Gottlieb – FDA
The FDA is set up to protect consumers from harmful drugs and food not properly examined for pesticides.  Gottlieb was a former BigPharma guy who had previously been critical of the FDA. Gottlieb pressured scientists at the FDA to fast track drug approvals without rigorous research, and once halted a study on a multiple sclerosis drug after three patients lost blood and one died. Gottlieb halted the study saying it was "an overreaction" because the disease, not the drug was probably to blame.  
Kenneth Tomlinson – Corporation for Public Broadcasting
Tomlinson was forced to resign after investigations found he was trying to push PBS news content in a more conservative direction.  
Stephen L. Johnson –  Administrator of the EPA
The EPA is supposed to be a watchdog on the health of the environment but under Johnson’s leadership the EPA has closed the EPA’s network of technical libraries without awaiting Congressional approval. The agency has also abandoned proposed rules protecting children and workers from lead paint and violated the Endangered Species Act in failing to consider the harmful effects of pesticides on salmon… the common thread in all these actions is service to corporate polluters above public health.  But perhaps Johnson's greatest feat is his attempt to block 17 states from reducing greenhouse gas emissions and improving fuel economy… HE’S THE DIRECTOR OF THE EPA PEOPLE!!!
I could go on and on but I'm not sure it's necessary; I think the evidence is there for anyone to see. This isn't, as I've said misgovernment done accidentally, but misgovernment done on purpose, to create cynics of the public.
When we see these governmental disasters, the natural question we ask is, "Did these disasters happen because government doesn't work?"
But the question should be, "Did these disasters happen because THIS government and THIS governments fundamental philosophy doesn't work?"
As the '08 election (I think) indicated, Americans are starting to believe that it's Dubya's philosophy of government that doesn't work.  The public's conclusion during the Reagan years, as well as the first four Dubya years, was that the government was patently incapable of functioning.  But government obviously does work in certain circumstances, not to mention how well it works in plenty of other countries.  
It's natural to blow off government failure with cynicism and lest you think I believe Democrats are immune from failure, scandal or graft when in power, believe me I'm not. I'm not excusing Democratic scandals nor excusing any future Democratic failures, but what the public should understand is that the ideals of the Democratic party revolve around a properly functioning government, while the ruling ideals of Republicans has been to govern in such a way as to increase the public's cynicism by wrecking the government.  
This systematic destruction almost always gives ruling conservatives a new lease on life. More than a few others are starting to take notice as well: (below is a nice 6:00 minute video from Rachel Maddow's interview on the Colbert Report where she says letting the Bush administration govern is like hiring a vegan to be your butcher).  
As a final thought, I'll leave you with a tidbit from an interview with Thomas Frank:
Conservatives have had a beef with the civil service for a really long time. This is part of their identity. I was able to find an article published in 1928, and it was written by—or maybe it was an interview with the president of the US Chamber of Commerce.  A man who was a big player in the 1928 Coolidge administration (a big conservative powerhouse).  The title of the article was— "The best public servant is the worst one."   
What he meant by that was that you don't want good people in government. You don't want talented folks in government, because then government will work, it will be effective. And if government is effective, then people will start to expect it to solve their problems and who knows what comes after that. It’s all downhill from there, from his perspective. And the funny thing was—then you start researching the history of conservatism and conservative’s in power say things like this all the time; that we don’t want the best and the brightest in government.