Monday, March 16, 2009

Free markets: if this is not the bottom, can we still be positive?

As bad as the news is, should we be optimistic about the future? Yes. When we read about massive job losses, and individual companies deciding to lay off thousands, should we be confident in the future? Yes. Why would I say such a thing? Four reasons:

1. Cut fast and cut deep. The worse thing any company can do in an economic downturn is ignore and put off what must be done. We should hope that the cuts announced are overly aggressive, and that they will not all be needed. We should want the biggest possible cuts to insure that they are not only realistic, but overly pessimistic. Trust me; the investment markets want realism and clarity. Honesty that sales will decline will be better received than false optimism in forecasts. By over-doing it, favorable comparisons of sales, and operations and profits will come sooner, thereafter leading to more employment, investment and growth.

2. Inventories are not a problem. This thing started in 2007. Even the automotive manufacturers were cutting production back then. The same is true of appliance manufacturers like Whirlpool. The truth is that inventories are not a problem, unlike past recessions. Yes, if demand falls to zero, then theoretically we have too much supply, but that is absurd. All industries are poised to ramp up production to meet increasing demand, and when they do, the profits will be real and significant. Employment, in turn will increase rapidly.

3. The cost of money is historically low. Companies will be able to invest and expand with an increasing margin. I would not be surprised if the US benefits disproportionately on both the domestic and the trade fronts. I believe that “outsourced” jobs in all sectors will come home in the next three years, and that simultaneously, our exports of all goods and services will rise. Yes, this poses significant problems for the rest of the world, but that is a subject for another entry.

4. Demand for goods & services are global and real. As odd as it sounds today, we will need to build more homes by 2012 to keep up with family formation in the United States. It seems unbelievable, but demand for all products in India and China exists; it has just been put off until we find a new equilibrium. Replacement alone for everything we have in our lives accounts for approximately 60% of our consumption today.
So be realistic, but do not panic. Be optimistic, because it will speed our recovery. Work hard and save, because this is the real lesson from the recession of 2007-2010…entitlement is dead.

Thursday, March 12, 2009

Free markets? Part 2

My friends, we are indeed in a severe recession. But should we call into question all of our beliefs in capitalism? No. The issue we face is one of financial market collapse. The collapse was not caused by the complex but rather by the simple. Many pundits will talk about the “CDO with ABS,” and yes, there was excessive financial engineering. But the real root cause of our troubles rests with institutions which lent money poorly. In my last blog post, I discussed my own observations as a young MBA graduating with a degree in finance from Wharton. We believed we should use advanced mathematics and some of the new learning’s from physics to “measure and eliminate risk.”” As the Financial Times recently noted, we thought we could “complete the markets.”

What would be an example of the “slicing and dicing” of traditional investment vehicles? I have discussed the dismemberment of bonds. The other interesting case study is mortgages. Perhaps it is now self-evident, but for my parents, born in 1938, the only mortgage they knew included 20% cash down payment and a 30 years fixed rate. Of course today, we have zero down payment, and no payments until 2010! Radio advertisements that sound like furniture store sales tout 1% interest rates for three years with as little as 5% down payment. The absurdity is that it continues and yet this is what caused much of the problem!

But why would banks lend to people who don’t have a job, a down payment nor a respectable credit history? Well that’s where the slicing and dicing comes home to roost. Banks used to generate a mortgage loan (literally, you would go to the bank and apply for a mortgage and speak to a bank employee). Then the bank would keep that mortgage as an asset (they own the right to receive both interest and principal from you). They made these loans based upon the checking and savings deposits, and the Certificate of Deposit held. But today there has been a radical separation of the process AND of the mortgage instruments themselves. Banks and “mortgage banks” generate loans – they accept your application and sell you a product (see above). But they DO NOT hold them. Indeed, because they do not hold them, they are more risk oriented in their lending practices. But who would be foolish enough to buy mortgages with a high probability of default? The answer is institutional investors and sovereign nations. Why? Because they were bundled together in large denominations, say $100 million dollars, backed by “quasi-government” agencies and given an AAA rating by Moody’s. With 1,000 to 5,000 individual mortgages with a “Collateralized Debt Obligation” the risk had to be reduced…right? Well, not everyone was so sure. That’s where Fannie Mae and Freddie Mac come in. They GURANTEED these debt instruments. But why did they do it when the risk of default was higher than in the past? Because of the Community Reinvestment Act, signed into law by Bill Clinton and extended under George W. Bush. This allowed FNMA and FDMA to accept mortgages into their bundling programs when the borrower had less than 20% down and when the rates were not fixed, and indeed highly speculative. This was done in the name of “allowing every American the chance to own a home.” So much for progressive intervention into the market.

But I would be remiss if I blamed the government. My main point here is that the “Masters of the Universe” thought they could use math to eliminate risk and make the markets “completely free.” And they were wrong. They gave the financial markets a false confidence. Those who did not understand the models were too embarrassed to say anything, and when people finally did question them, they were marginalized because the money was flowing and who needs a curmudgeon around anyway.

Let me go into some more detail. Banks originate loans. Fannie Mae buys them and bundles them into large assets then sold in the capital markets, primarily by long-term investors like insurance companies, pensions and sovereign funds. At this point, banks are free to lend more money. They do not have the loans on their books. The turnover of mortgages accelerated.
More loans were being made against the same capital base as before. Hence the risk had to be increasing. Now what about the “collateralized debt obligations” purchased in the capital markets? Didn’t someone wonder about the risk of these large hybrids of fixed and variable rate mortgages, and other corporate debt? Yes. That’s where derivatives come in, and insurance products against default risk. Companies started to sell insurance policies to protect buyers of these “Collateralized Debt Obligations of Asset Backed Securities.” But contrary to the idea that financial engineering was “completing the perfect market,” these securities and insurance policies were not traded. Moreover, because there was no market, there was no regulation. Ironically, a large majority of these securities ended up back with the BANKS! But they were not on their balance sheets. Instead, they were placed in off-balance sheet entities called “Structured Investment Vehicles” or SIVs. Since these instruments were not traded, they were not evaluated or “marked to market.” They were not regulated. They were evaluated by complex mathematical models which held the fundamental assumption that “spreading the risk wide enough makes it go away.” In reality, two things happened: First, people who could not afford a home stopped paying; and second, the banks (both commercial and investment) found that they indeed held securities in which interest payments declined and loans suddenly became real estate from foreclosures. As the reality set in, the “house of cards” collapsed, and is still collapsing.

Is this Armageddon? No. If you want to know the truth, we could just start over. Don’t believe me? Please pick up a copy of Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay which details the ponzi schemes of 1637 (tulip mania), the South Sea Company of 1711–1720, and the Mississippi Company of 1719–1720. Speculation led to a separation of financial markets from real economic activity. Sound familiar? We will survive, but trust me, it is likely we will do this again somewhere in the next 100 or so years…

Free markets? Part 1

I want to connect two seemingly unrelated intellectual points: evolutionism and Nobel Prizes in financial economics. What do they have in common? They both are founded on a belief in reason; a belief that math and science can explain everything.

Let’s start with evolutionism.

In Darwin’s Dangerous Idea, Daniel Dennett takes a philosophical and mathematical journey. This book is not for the faint of heart, but contains a couple of really challenging ideas as they pertain to faith and evolution. To begin, Dennett’s epistemology is Charles Darwin. This is the rail that his train runs upon. Darwin’s theory of natural selection posits that organic life is continually interacting with its environment and adapting to survive. To prove that humans evolved through this process, Dennett makes the following argument:
  1. Life is a near infinite mathematical game of chance. Just as it is possible to produce a winner of a contest to correctly “call heads or tails” 1,000 times, the Homo sapiens is indeed the outcome of a truly monumental decision tree.
  2. Dennett points out that over the course of millions of years, millions of “human-like” species were constantly trying to survive. 99 .999999999999999999999999999% failed.
  3. We are the outcome of this effort. We have existed for 10,000 of the earth’s hundreds of millions years.

Now this argument is nearly flawless in its simplicity. While it may be true that it does not deal with “why” life continued to press towards intelligence, consciousness and speech, I believe Dennett would argue that it was indeed random and not purposeful.

Dennett uses a fascinating theoretical example to prove his point. He says that chimpanzees have been taught to type on a typewriter (press keys). If an infinite number of chimpanzees were put in front of an infinite number of typewriters and proceeded to randomly press keys on the QWERTY keypad, Dennett argues that they would randomly generate The Canterbury Tales, the Old Testament, War & Peace, etc. They would also generate versions with minor errors. They would also produce meaningless babble. This is his proof that we evolved from a random experiment of trial, survival or death.

Let us now turn to economics and financial markets.
So what about the application of calculus and physics to modeling the behavior of financial markets? Well here I will give you a personal reflection. As a student seeking my MBA from Wharton in 1988, we were all introduced to the Black-Scholes mathematical model of the market for a stock equity, in which the equity's price is a stochastic process. It was used extensively in valuing put and call options. We were introduced to Markowitz, whose work on Efficient Market Theory won one of the first Nobel in economics for this approach. We were told, and for the most part, we believed that we could break down the “crude market” and its financial instruments, into discreet parts and by doing so, predict cause and effect through probabilistic outcomes.

  • As an example, bonds were originally pretty straight forward. A debt issuer (public or private) would receive a lump sum of money (the coupon) from a debt buyer in exchange for a promise to pay interest upon that amount, and then one day repays it. “Back in the old days,” a debt buyer would receive a certificate which had coupons around the border which were detached and sent into the debt issuer for payment. Upon maturity, the coupon would be returned for redemption. But when I was in school, new markets had started in the 1980s which separated the interest payments from the repayment of the “lump-sum.” The “coupons for interest” were “stripped” off the certificate and sold to a buyer who wanted just the stream of payments. There were called “strips.” The certificate leftover was called a “zero coupon bond,” and would be sold to someone who needed a “lump-sum” payment in the future.
  • This is just one example, but suffice it to say that “straddles” “swaps,” “puts,” “calls,” and all the other “financially engineered” products took off in the 1990s.
  • For home mortgages, FNMA, GNMA and FDMA were all established to lower the risk for banks lending to consumers. They allowed banks to sell off to these institutions those mortgages which conformed to certain standards – namely as 20% cash down payment and a fixed rate 30 year term. The bank would originate the mortgage locally. The government would bundle thousands together into the equivalent of a huge bond, and then markets would again split up the interest rates and the principle repayment. Imagine further how complex this became when the markets introduced variable rates!

I recall that most of my corporate finance and capital market professors worked as consultants on Wall Street and were trying to find ways to reduce risk, increase return, and basically try to tailor products to the exact needs of different types of clients. Well-intended, but as we now know, unsuccessful. The belief and early performance of these products led to an overconfidence. With the fall in REAL assets, like home values, and with REAL default due to poor lending practices, the confidence collapsed. All the rocket sciences could no longer understand the complexity of the system that they created…not in a systematic way. Rather, much like Mr. Dennett’s argument, the global financial marketplace evolved randomly. Each action was purposeful, but in aggregate they came together in ways that were not coordinated nor understood.

For me personally, I spoke frequently in the fall of 2008 about how the world economy and the financial marketplace would “learn and adapt.” I cited the savings & loan crisis of 1983-85, the Eastern European currency crisis of 1998, the “Asian Contagion” of 2003 caused by the collapse of Long Term Credit. For the US and world economy withstood the challenges and evolved. I’m not certain today. I am not as optimistic.

So how do parts one and two relate? Perhaps it is self-evident, and if it is not, my apologies.

Dennett argues that nature randomly generates something as unique as life. The corollary to economics is that a “completely free market” will generate perfect outcomes for all participants. Both are wrong.


The belief that everything is either determined by human reason – through math and science – to create and control “completely free markets” is also flawed.

So do we quit? No. We eat some humble pie, and we find the balance of freedom and regulation.

Tuesday, March 03, 2009

Where do blogs fit in the history of social media?

In my opinion, blogging is the first and one of the earliest forms of social media. Blogging is the first phase of “the wisdom of the crowd.”

As I have written before, the first websites were brochure-ware, controlled by Webmasters. After the “Dot Com” bubble burst, the web came back much improved. Some people call it Web 2.0, and some dispute whether it improved that much, but it certainly enabled anyone to participate, and to publish. Participation came with bulletin boards and forums, and participation came with blogs. Blogs let anyone sign up and start publishing. Of course for most blogs, no one knew they existed and did not read them (like mine). But even at their best, blogs are a form of “one to many” publication. Some blogs have "comments" but they are hard to use, hard to follow. They read like the dead sea scrolls...literally.

With Facebook or MySpace, you see the next evolution. Anyone can publish themselves, and others can comment or post or share photos and links. This is better but not the same as social publishing.

But there is a change on the horizon. Whether Wikia, or Ning or Wetpaint, a new evolution is arriving. They each present the first generation of social publishing platforms – the "many to many" model. A platform is created on any topic wherein everyone who cares to contribute can contribute.
My point is actually very simple...blogging is just a rudimentary form of "the wisdom of the crowd." The technology which allows anyone to comment on anything, known as blogging, is empowering. It makes no distinction between those qualified and competent, and those who are not. Blogging is not journalism. Journalists can blog, that is true. But journalism has legal and professional and commercial standards. Blogging does not...at least not in the same way. Blogging is a form of mobocracy. That is what Aristotle called the extreme form of democracy.

Now in social publishing, a funny thing happens to the wisdom of the crowd...it gets wiser.

You see, when a community publishes, it also edits. So you can get the facts straight. And you get two sides of an argument. Blogs and forums tend to ramble on, and be very one-sided. Blogs almost never reflect and organize and gain some consensus. But that will improve as social media and publishing improves with wikis. The tools exist. One person makes a case or prepares a review. Then others add, in an organized way
or correct mistakes, etc. And the "wisdom of the crowd" is actually a unique entry versus the "expert" reviewer or journalist. Wikipedia does a good job with facts. But bloggers must evolve to be the "passion" but in a more coherent and valuable way. They will do this when they stop being individuals and start forming communities.