According to the June 22 letter, the review identified “valuation concerns” where “appraisal documentation is missing or incomplete,” or where property-assessment methods were “insufficient/lacking.”
Other missing information included employment confirmations, phone numbers, credit reports and rent verification, the letter said. The review also found “income calculation errors.”
Another fine example of six sigma in banking. Imagine if Dow and Dupont ran their chemical plants like this. Holy crap. Or Boeing built planes this way. Yikes. But then again, in those industries lives are at stake. Banking. [shrug] Just money. Ok a few billion hundred billion. But still, it’s not like anyone died. Sheesh.
Hmmm. In 2002 – yes 2002, seven years ago(!) – I wrote:
In a recent speech, Jack Welch, the former chairman of General Electric, made exactly this point: “…[if] you put six sigma in an investment bank, they would all gag!” In case you think he was just engaging in some gratuitous banker bashing, consider this: six sigma quality means havingfewer than 3.4 defects or errors per million operations in a service process. That is 99.99966% perfection.
Contrast this benchmark with the assurance once made to me — by a senior syndicate manager of one of the largest and most respected global bond underwriters — that it was perfectly normal and necessary to expect and reserve for 5%-10% errors in the allocation of a jumbo multi-tranche bond deal! Assuming an average of 200 individual orders (including splits) on a typical new issue, to reach six sigma quality levels you would need to have fewer than four errors over 5000 issues!
…And therein lies the next major opportunity for capital markets bankers over the next decade: to use technology not only as an enabler of innovation (as has been the case over the past 15 years) but as a driver of industrial efficiencies.
The guys in IT thought it was an interesting take on things (with $ signs in their eyes) but the ‘business’ side, well, let’s just say it didn’t strike a chord. Banks were special. Bankers were (even more) special. All that re-engineering and total quality management and painful restructuring and shifting centres of power…all good for manufacturing and you know, “other” industries. The ones they advised and financed and funded LBOs of… but not banking. Banking is “different.” You wouldn’t understand…What. A load. Of. Crap.
Well now they are paying for it. We all are paying for it. Rivers didn’t catch on fire but the financial system was well and truly polluted. But there is a bright side. The bright side is that there has never been a better time to come in and build businesses in banking and financial services that have an engineering DNA, businesses that are natively adapted to an industrialized and digital way of doing business. Indeed some of the pioneers in this mold have already enjoyed tremendous success (Markit Group comes to mind.) Others are emerging. And the incumbents have never looked less frightening (even if, especially because, they are now too big to fail.)
Last summer I wrote a post highlighting the fact that the global financial system is a scale-free network. This in itself is not particularly insightful – although I wonder how many of the most senior executives, regulators and politicians understand this explicitly and more importantly use it as an intellectual framework on which to base their ideas on systemic risk management and regulation. This is important because understanding the mathematical underpinnings and topology of such networks is crucial if we ever hope to construct a system of monitoring and regulation that is robust and well adapted. I was reminded of this late last night as I was re-reading an article written in 2003 by Albert-Laszlo Barabasi and Eric Bonabeau published in Scientific American on scale-free networks where they (presciently) note that:
Understanding how companies, industries and economies are interlinked could help
researchers monitor and avoid cascading financial failures.
For anyone wanting an introduction to scale-free networks this paper is an excellent place to start but basically as a reminder (via John Robb):
A scale-free network is one that obeys a power law distribution in the number of connections between nodes on the network. Some few nodes exhibit extremely high connectivity (essentially scale-free) while the vast majority are relatively poorly connected. The reason that scale-free networks emerge, as opposed to evenly distributed random networks, is due to these factors: Rapid growth confers preference to early entrants. The longer a node has been in place the greater the number of links to it.
This in a nutshell is why some financial institutions are ‘too big to fail’, or (as we heard much chatter about when first Bear Stearns, then Lehman Brothers went down) more accurately, ‘too connected to fail’. Scale-free networks are extremely resilient to random failure but highly vulnerable to specific failure of the most important hubs (Barabasi and Bonabeau):
In general, scale-free networks display an amazing robustness against accidental failures, a property that is rooted in their inhomogeneous topology. The random removal of nodes will take out mainly the small ones because they are much more plentiful than hubs. And the elimination of small nodes will not disrupt the network topology significantly, because they contain few links compared with the hubs, which connect to nearly everything. But a reliance on hubs has a serious drawback: vulnerability to attacks.
…The Achilles’ heel of scale-free networks raises a compelling question: how many hubs are essential? Recent research suggests that, generally speaking, the simultaneous elimination of as few as 5-10% of all hubs can crash a system.
Hopefully readers will recognize in this why the failure of ‘hubs’ like Bear Stearns or Lehman Brothers was potentially so damaging, setting off a cascading epidemic throughout the financial system. It is also why the Madoff failure in and of itself was not at all systemically threatening, whereas LTCM was – the key difference being ‘connectedness’ not size per se. A further consideration – based on the application of diffusion theories used to predict the propagation of a contagion throughout a population – is that the critical threshold (for propagation of an ‘infection’) is effectively zero for a scale-free network. That is all ‘viruses’ no matter how weakly contagious, will spread and persist in the system. In other words it is mathematically impossible to eradicate such sources of failure from a scale-free network. More bluntly, any attempt to eradicate or prevent financial viruses, say for instance poorly conceived sub-prime mortgages, is an act of futility.
Why is this important? Because most financial regulation, is conceived and implemented with this objective as a founding principle and worse ignores the topology and structure of the network it is trying to protect. Not only does this vastly increase the probability that the regulatory framework will ultimately fail to achieve it’s goal, but it imposes severe additional costs on the system for no greater gain in stability or robustness. Current financial regulation distinguishes far too little between the different nodes in the network, the vast majority of which are of no consequence to the overall robustness of the system. Fifty percent of financial firms could probably fail without any risk of catastrophic systemic failure as long as none of those firms were important hubs. I’m exaggerating of course (but not as much as you think.) That is why for instance the EU’s recent draft legislation on alternative investment funds – with rules uniquely predicated on size and leverage – is so wrong-headed: it misses the point. Not completely, but this is mainly due to the fact that correlation between size and connectedness is not zero (all other things being equal, bigger firms are likely to be more connected.)
However wouldn’t it make much more sense if the regulatory framework focused explicitly on the root cause of systemic vulnerability rather than accidentally or obliquely? Before any agitated readers get too excited, I realize that what I have outlined has been grasped (belatedly) to some extent by the regulators, bankers and politicians and has started to shape the discussion on the reformation of financial regulation, especially in the US where it seems increasingly likely that the new regulatory proposals will be much more concerned with the effective systemic impact of a market participant rather than their legal or organizational structure. The recognition that the fact that an organization is a bank or insurance company or hedge fund or whatever is less important than the exact types of activities it undertakes and its connectedness to the rest of the system is obviously a welcome development but it doesn’t go far enough.
Wouldn’t it make much more sense to build a set of rules that explicitly addresses the vulnerabilities of a scale free network and as such focuses disproportion attention and resources on protecting the hubs from attack or failure. The beauty is that the digital global financial system of the 21st century and advances in the science of networks actually now allows us to do this: we can empirically and quantitatively observe, measure and manage the ‘connectedness’ of institutions. Forget the rating agencies, companies like Bonabeau’s IcoSystems and others could help the regulators create, maintain and monitor network ‘maps’ and score each market participant in terms of their connectivity. This should be the defining core metric of financial regulation and mirroring the power law distribution of the underlying network, financial regulation should focus its attention and resources in geometrically increasing fashion.
This would have a number of (self-reinforcing) beneficial effects:
It would impose (geometrically) increasing costs on institutions as they grow in complexity and systemic connectedness creating a natural optimal equilibrium that balances the benefits (to the institution) of such growth against the external costs it imposes on the system. It effectively puts a price on the negative externalities and avoids the tragedy of the commons without needing to dictate to firms how big or complex they are allowed to become (which is doomed to failure due to the law of unintended consequences and the problems of quantum thresholds (ie clustering just below the threshold.) I doubt very much that a firm like Citigroup would have come into being under such a regime.
The size of a financial institution would not be a driver and so simple, relatively unconnected firms could operate with a very light regulatory touch. This would allow the system to naturally exploit economies of scale that don’t give rise to incremental systemic risk.
Innovation would be allowed to flourish without anyone – regulators, executives, politicians, super-intelligent alien forces – needing to decide which innovations were toxic and which were beneficial. As long as the key players in the system were vaccinated against these viruses and protected against mutations, you could let Darwinian evolution progress more or less unimpeded in the long tail of systemically unimportant firms. Indeed by allowing an increased rate of failure in the overall network, you would be able to more quickly and less painfully identify dangerous risks as they emerge in the network.
Resource allocation for regulators becomes much easier and more transparent. The amount of regulation and regulatory attention each firm would receive would become directly proportional to their systemic importance.
We can’t prevent dangerous risks from developing in the financial system but we can work with the grain of the underlying structure to mitigate the systemic danger instead of against it, or at best ignoring it. The robustness of scale-free networks to accidental failure has many advantages in that it allows our financial system to operate very efficiently and robustly most of the time. And by explicitly recognizing the mechanisms by which catastrophic failure can occur in our approach to regulation we will be much less likely to suffer such failures in the future and the costs of regulation will be appropriately borne within the system creating a virtuous circle that drives the system to self-organize into the optimal configuration of complexity and connectedness.
If you know Tim Geithner or Charlie McCreevy or Lord Turner, please send them this link. Hopefully it’s not too late!
And if you are looking for the perfect Father’s Day gift for the financial regulator or Senate Banking Committee member in the family, you could do worse than Bonabeau’s book Swarm Intelligence: From Natural to Artificial Systems.
John Kay is one of the most lucid, accessible economic thinkers out there: pragmatic, insightful, skeptical and perhaps most importantly not prone to hyperbole. If you don’t already read his weekly FT columns (also archived and published here), I highly recommend them. (Perhaps one day I’ll get the opportunity to meet him, and be able to convince him to join our advisory board.) His column yesterday, “Why ‘too big too fail’ is too much for us to take” was particularly articulate and on target:
Commercial success and democratic election are the only sources of legitimate authority in a society that no longer relies on spiritual leadership nor respects hereditary titles. An organisation exempt from either of these disciplines represents an unaccountable concentration of power. As we have today at Citigroup, Barclays and Deutsche Bank.
If “too big to fail” is incompatible with democracy, it also destroys the dynamism that is the central achievement of the market economy. In principle, there is no reason why disruptive innovations and radically new business models should not come from large, established, dominant companies. In practice, the bureaucratic culture of these organisations is such that this rarely happens. Revolutions in business generally come from new entrants. That is why so many of today’s market leaders – Microsoft and Google, Vodafone and Easyjet – are companies that did not exist a generation ago. These companies could not have succeeded if governments had been committed to the continued leadership of IBM and AOL, AT&T and British Airways.
If there is one single learning we as democratic capitalist societies need to take away and apply in earnest from the Crash of ’08 it is to put in place mechanisms, policies, regulations, norms – whatever is needed, to ensure that no private or public commercial entity is ‘too big to fail.’ The externalities on society are too important (and the mis-pricing of these is probably the largest contributing factor to the excessive rents that accrue to such entities in times of stability.) The wonderful thing is that with the technology and economic infrastructure of the 21st century, it is entirely possible to implement a market-based pricing of intangible externalities if – and sadly this is far from a given – sensible, good faith laws and rules are put in place. The markets in pollution permits is an obvious example, although as has been seen in the carbon markets, all too often we see the entrenched power of incumbents forcing a distortion of the rules to dilute their effectiveness (think free allocation of CO2 permits vs. auctioning.)
(One of) the analogs in finance you could imagine would be a market in Central Bank liquidity rights: the right for a bank to borrow say 12mo funds from the Central Bank at a set rate or margin. Banks would have to hedge the committed lines of credit they extend with these liquidity rights. Designed correctly (tricky no doubt but doable), these could trade in a free market, with the Central Bank auctioning off and participating in secondary market operations to manage their supply and demand. With these you could actually price liquidity (perhaps not perfectly but still) and if they had existed, I suspect that banks would have been much more cautious before writing trillions of dollars worth of committed back-stop facilities to structured finance vehicles (SIVs, etc.) and corporates at derisory pricing.
For those of you that aren’t bankers – for years these kind of facilities were written even for weak credits with tiny commitment fees, most between 5-15 basis points (ie 0.05-0.15%.) They were never ‘expected’ to be drawn, and so were often treated as free money when in effect they were just out-of-the-money options sold without regard to the tail risk. Another ‘picking up nickels in front of a steamroller’ strategy that failed catastrophically. Of course everyone knew that these facilities were underpriced, and for most banks (but some of the dumb money smaller banks) they were notionally acknowledged as loss leaders to win other business. This in itself is not a problem per se. The problem arose because these ‘loss leaders’ actually made revenues and accounting profits (of course while storing up enormous contingent risks but these were invisible and seen as so unlikely as to be irrelevant, just like for super-senior CDO tranches) and so it was only too easy to keep selling more and more of them. A loss leader than makes you money: what’s not to like about that?
John Kay finishes his argument with a succinct recommendation:
“Too big to fail” – whether the claimant is a bank or an auto company – is not a status we can live with. It is both better politics and better economics to deal with the problem by facilitating failure than by subsidising it.
There has been much noise (on both sides of the Atlantic) on the appropriate role of government with respect to giving a financial boost to new ventures and entrepreneurs, especially given the vast sums that have been targeted towards failed giants. This is a debate for another time, but I suspect the single most effective thing governments could do to help entrepreneurship, innovation and economic renewal sustainably, over the long term and with the least risk of unintended consequences, would be to heed Mr. Kay’s call and ensure that henceforth no company in any sector is ever again too big to fail.
Obviously, Citigroup has continued to be much in the news of late, first becoming a penny stock and then enjoying a nice bounce this week because, well…(short covering?) For better or worse, I try to focus mainly on the tremendous opportunities that exist in the context of inventing the future of such a vital yet stale industry that is finance. So why, I asked myself, so many posts about Citi?
I guess it is impossible to write a blog like the Park Paradigm without posting relatively frequently about Citigroup; every hero need a nemesis right? So I guess in this context they’re the Joker (and I’m, um…Batman???)
Clearly much of the price appreciation is due to a vicious short-covering rally that Messrs. Pandit and Lewis kicked off. But the fact is, what do they have to lose? If they can fool us long enough, credit spreads will come in and recovery will become a self-fulfilling prophecy. Otherwise, Congress (read: the US taxpayer) will bail them out once again. Citi, B of A and AIG have each had multiple bites of the bailout apple, so what’s another bite among friends? They are inclined to do this because their reputations are already severly damaged; in essence, short of outright fraud, they can’t get any worse. Therefore, they are motivated to throw caution to the wind, be super-positive and hope for the best. If new management with fresh reputations were on the scene, the would be much less inclined to release bullish statements without empirical data to back it up. This is a major flaw of TARP: letting incumbent managements stay around. It has created perverse motives that serve neither the troubled institutions nor its shareholders very well.
So with this in mind, I’ve been curious to see how the whole (non-executive) Boardroom shake-up that has been hinted at would play out. Well today Reuters reported that Citi would be adding (at least) three new outside directors, and confirming that – due to mandatory retirement at age 72 (not gross negligence and/or insanity) – 2 current directors would be leaving. Speculation was that the new directors would be:
Wow. That will really shake things up. I mean these new guys, they bring a completely new perspective to the existing Board, right? A real diversity of experience and knowledge. Two plus two equals five stuff…
I don’t know much/anything about Messrs. Grundhofer, O’Neill or Thompson, but I’m pretty sure they are all very talented, experienced managers with great track records; and there is no reason to believe they won’t be an improvement on whomever they replace (admittedly a fairly low hurdle…) But c’mon! Where are the new Board members who will challenge the industry (not just the corporate) status quo? Who have a vision of what finance might/should be in the 21st century? Where is the new Board member with a firm grasp of the latest trends (and implications thereof) in information and communications technology and how they will shift the societal and cultural framework in which Citi operates over the coming years? Where is the independent Director who isn’t a paid-up member of the Fortune500 great-and-good (and so will be more likely to bring a different perspective to the table, and less baggage)? Where are the Board members that manage their own email inbox (or at least read and respond directly themselves), that have a Facebook or a Twitter account, that write and/or read blogs? That have bought at least one iPhone app and feel more panic when they don’t have access to broadband/the web than when they don’t have a mobile/voice signal?
Every successful team I’ve ever seen or been a part of has one common denominator: diversity. Diversity of experience. Culture. Expertise. Seniority. Temperament. Gender. And even better if there were one or more ‘independent thinkers’ amongst the group. And just to be clear, I’m not talking about box-ticking compliance driven ‘diversity’ (although by accident rather than by design, this can sometimes help at the margins, by at least avoiding the ten 60-something white guys out of central casting…) but diversity that creates intersections. Of ideas, world views and aspirations. Because that’s where interesting things happen. (You can bet that my bank‘s Board will have this principal as its foundation.)
I’d be curious to know which headhunter(s) worked/are working on this mandate and what was their brief (and who wrote it?) I would have hoped (on behalf of US taxpayers) that the Obama administration had much input into the search criteria and that they would be looking for Directors that would focus primarily on ensuring the future success of Citigroup without regard to worrying about legacies and sunk costs (real and psychological.)
As an aside, take a couple minutes and wade through the mangroves of Citi’s corporate governance. No wonder it’s gone so horribly wrong! (I wish I had looked at this a couple of years ago, even without hindsight, it just screams sell…) They have 49 people on their Senior Leadership Committee. FORTY-NINE!!! I assume they at least have a wiki to manage committee business…
The collapse of major businesses and the failure of governments to stem the tide of bad news around the economy has created an environment rich in opportunity for entrepreneurs, according to business leaders meeting held in London this week.
Speaking ahead of the event, keynote speaker Ed Wray, chairman of Betfair, said: “2009 is going to be a turbulent year but it will provide an opportunity for entrepreneurs to come forward and help take the UK out of recession and into the next period of economic growth.
“The US will be the first out of recession because it has an economy built around mass entrepreneurship – the UK now needs a large slice of that same kind of creativity, innovation and entrepreneurial flair.
“Every great business must be able to survive a downturn and successful businesses forged in the current conditions will be fundamentally far stronger by nature. The pressure cooker conditions of the current economic climate will undoubtedly create some new household names of tomorrow.”
In a nutshell, when we are talking to investors, our number one message is that these tough economic times are exactly the right times to invest in the next generation of businesses and business models. That in times of falling multiples, de-leveraging, uncertain cash-flows and/or discount rates in mature companies and markets, building new businesses is a fundamentally uncorrelated risk. Furthermore, the risks and challenges for new companies and new approaches is almost always on balance lower than it is when the economy is booming: first and foremost, talented people are more available – financially and psychologically – and since this is the most important ingredient for 99% of young companies, this is incredibly important. Secondly, inertia is much easier to overcome, you don’t have the ‘if it’s not broke, don’t fix it’ apathy that can be very difficult (and extremely frustrating) to overcome; if you have a better mouse-trap, people will actually notice and act. Finally, the prevailing sentiment of caution and skepticism means that – and of course this is a generalization but a valid one I believe – everyone, including entrepreneurs, investors, customers, employees – tends to be more focused and realistic. This means that fewer flimsy or “me-too” start-ups are floating around and innovation and disruption are considered in a more sober and analytical context. Less froth.
So I can hear you saying, Sean, c’mon…stop talking your book – really now, start-ups? (private) growth-stage companies? No risk? No way! Some – many? – of these businesses won’t end up working, even if they have clever ideas and people. You can lose most or all of your investment.
Well, of course you can and of course there is risk. There is always risk. I’m just not convinced that it is bigger or harder to navigate or understand than some of the alternatives. Large cap public stocks for instance…had you bought say shares in RBS, just two years ago you would have lost 96% of your money.* Barclays – 86%.HBOS – 94%.Citigroup – 94%. Not to mention the 100%-ers. Blue chips. Yes well, the poker analogy does seem to hold! (* all are approximate numbers, not including dividends, etc.) Equally, not even the most bullish of analyst or executive at any of these firms would have suggested that there was the remotest possibility of a 10x, or even 5x return over the next few years at the prices then prevailing…and understanding the dynamics of what will drive the returns is enormously (exceedingly?) complex. Of course to be fair, you could have changed your mind and sold your shares in any of these companies on any day which is something you are unlikely to be able to do in a small private company. So clearly you can’t have all your eggs in this (illiquid) basket but on the plus side, the illiquidity focuses the mind wonderfully and helps avoid getting caught up in market “noise”.
So how does one mitigate the risks in new, entrepreneurial ventures? Well there are a number of approaches that can work and like anything it’s generally a combination of experience, analysis and hard work. Not very enlightening I know. Our particular approach puts a lot of focus on using our domain knowledge and focusing on one – albeit vast – component of the economy: financial services and markets. Also, we have developed a series of investment themes, built on a number of what we believe to be fundamental medium to long term secular trends that will drive the growth and shape of the industry and the economy in the decade to come. Indeed, these trends and themes are the basis for much of the material here on my blog since I started publishing three years ago. We then look for ideas and companies within these themes that are instrinsically aligned with these trends. Where relevant, using our knowledge of the structure and business models of the mainstream participants, we also look for ideas, companies and technologies that have the potential to fundamentally disrupt an existing market or business model by providing the same product or service in a vastly cheaper and/or improved way. Easy.
Finally the event referred to in the opening quotes is a great new (to me) website / community – entrepreneurcountry.net – developed by Julie Meyer at Ariadne Capital; and for any prospective / budding entrepreneurs out there, here is a great 10 minute video with a few tips on raising capital from Julie herself:
(on the reasons why the Citigroup Board was finding it hard to find a replacement for Chuck Prince) But the number 1 reason is that…(drum roll please)… it is an impossible job. Citigroup (and they are not alone here, it’s just more obvious sans CEO) is too big. And more importantly too complex for any one individual to manage efficiently in its current form. Like many mega-financial services firms, it is a jumble of heterogeneous businesses, risks and activities some of which gain greatly from economies of scale, but others that equally have significant dis-economies of scale. And the combination of all these businesses injects massive complexity. Let’s just say that I would guess Mr. Coase would find Citigroup “unoptimal”. They have too many variables and not enough equations. For anyone to claim that they could “do it” would just be hubris.
My concerns really grew out of my thinking on size vs. complexity in the context of the networked economy of the 21st century. This thinking probably really started to take shape as a result of the consequences of my AmazonBay story of 2005 which unintentionally (as a by-product of the main storyline) predicted a never-ending sequence of mergers and was rightly criticized as a result. Through the Looking Glass (2005)
In addressing this criticism I was led to think of how if Coase’s theory on the Nature of the Firm was correct, how the optimal business ecosystem of the 21st century would differ from that of the 20th century as the external transaction costs dropped to and then below the cost of internal transactions within (sufficiently large and complex) corporations. And the rest, as they say, is history as I decided to try to put my money where my mouth/blog is!
Now usually I am rational enough to understand that someone else’s gain is not my loss, but it does strike me as strange that it’s pretty clear that I would have a bloody good chance of being a more effective board member in many ways than the legendary Bob Rubin…and a lot cheaper. Then again, even if by some strange turn of events I had been offered and accepted such an appointment it’s not sure I would have been listened to (ie I’d have been the strange energetic, entertaining eccentric at the table ticking the mental diversity box…been there done that, no thank you…) or worse I would have been seduced and corrupted to go along blindly with the thinking of all these very smart, powerful and rich people and look just as dumb if not more.
So I’ll stick to blogging and venture investing (for now) and continue to follow this matinee from the cheap seats. Pass the popcorn.
Last September I was asked to give a presentation at the DerivaTech conference in London on the merits of derivative markets. My basic premise was that derivatives are (just) tools: they can be incredibly useful and are not intrinsically ‘good’ or ‘bad’ but rather their utility (or danger to society) depends on how they are used. You can use a hammer to build a house. Or you can use it to bash someone’s head in. Getting rid of hammers because of this undesirable use case obviously wouldn’t make too much sense.
Further, I made the case that the industry had done itself an enormous disservice by “using the hammer” in the “wrong” way – by (deliberately) exploiting the ability of derivatives to obfuscate, the industry had not only ended up losing hundreds of billions but had done a great job in destroying perhaps its single most important core value creator. That of course would be trust. And in the bargain all the beneficial uses of derivatives risked being thrown out with the proverbial bath water.
Basically, as their traditional businesses and cash cows – agency trading, underwriting, etc. – had their margins melt and their business models / compensation structures made obsolete by the rise of the networked information economy (destroying information scarcity which lay at the core of the traditional banking business model), the banks turned more and more to principal risk taking – prop trading, derivatives ‘arbitrage’, etc. – to make up the difference. Putting aside the moral hazard (too big to fail, insured deposits etc.) issues this raised and ignoring for a moment whether or not it is an intrinsically good business model for a bank, it got worse as this shift coincided with a long period of low volatility and benign economic growth… This meant that the (real) opportunities disappeared quickly and – still needing to shore up the bottom line, to feed the blue line – what had started out as science slowly but surely slid into alchemy…
Of course this didn’t happen overnight, but slowly and therein lay the heightened danger: like the apocryphal frog boiling in a slowly heating pot, what started out as useful and reasonable ended up dangerous and irresponsible.
My guess is that this is what went down. Even though Madoff Securities was on the leading edge of automated trading, the business itself was becoming less and less lucrative. Everyone had the same computers. Spreads, the difference between the bid price and the ask price that became Wall Street trading profits, began shrinking. And the move to list stocks in penny increments instead of eighths (12.5 cents) whacked trading desks all over Wall Street.
So you make it up in volume. Beyond cocktail parties, Madoff really created the money management business to feed himself trades. But his strategy was garbage. He absolutely bombed as a money manager, but he desperately needed the assets under management to feed his trading operations, so he started to make the numbers up. As is usually the case, most don’t set out to be crooks, but Madoff became one when his talents proved lacking. There is your “why.”
It’s not new. This was the Enron story: They lost tons in water ventures and Indian power plants, so concocted fraudulent entities to cover up their losses. Same for Sam Israel and his Bayou hedge fund. And even (without the fraud) the Citigroup/Wall Street story, too. They tried to be investors to make up the difference of their bread-and-butter business deteriorating and were awful at it, so they levered up in off-balance-sheet vehicles.
So why are smart people seduced into these kind of strategies (ie bloody-mindedly pursuing disappearing returns to the point of destruction)? Obviously any trite answer on a blog post will fail miserably to do justice to this question, but if I had to venture a pithy hypothesis, it would be that – like it or not – most people are wired to prefer risking conventional failure over embracing unconventional success. Just ask the behavioral finance guys…I think it has something to do with continuing to dance.
So I can get my head around a ‘Madoff’ happening. What is harder to understand is what on earth the fund-of-funds who invested so much money with him were thinking? I may be obtuse, but I thought the main (the only?) reason for these businesses to exist was in order to identify, understand and monitor good investment managers. On this I have to say I agree with Martin on this (that financial companies who made money selling Madoff products should return their commissions.) And it is worth pointing out that regulators haven’t exactly covered themselves in glory either (which should be a cautionary tale for those who suggest that regulation is a panacea…)
Perhaps the only good thing to come out of all of this is that the cult of secrecy that for too long permeated finance will disappear. Don’t misunderstand me, there is a time and place for confidentiality. But too often it is indiscriminately invoked like some sort of fantastical talisman – out of all proportion and context – to hide not skill but incompetence.
And to end on a more optimistic note, the problem is with the ‘traditional’ (ie 19th/20th) business models in finance, not finance itself. And here at the dawn of the 21st century there is an abundance of opportunity to discover, invent and build the financial services industry of the future. This hasn’t changed in 2008. It just became a bit more likely to happen sooner rather than later. Remember the wise words of William Gibson:
The future is already here – it is just unevenly distributed.
I’ve heard a lot of things about him over the years. How could you not – he’s an extremely successful and high-profile financial executive. But not just from the press, also from people I know well and respect and who have or do work for him. And these people have always painted a universally positive picture of the man: as a banker, a manager, a leader and a person. Is it an indictment of modern corporate governance and organizational politics, that the pillars upon which his has built his success and reputation: transparency, truth, forthrightness, conviction, humility, passion, empathy…are seemingly the exception and not the rule? Perhaps I am too forgiving and too harsh at once. Hmmm. Perhaps you would be justified in calling out my hubris, but from what others had told me of him, I suspected we might get on famously; in particular he seems to share a similar intellectual curiosity and thirst for knowledge, which to be frank was – in its all too frequent absence – probably my single biggest source of disappointment in an otherwise very rewarding and enjoyable 16 year career in investment banking.
In any event, when I heard a couple days ago that he’d done an interview with Charlie Rose, despite being flat out on 16+ hour days, I made sure I carved out an hour to watch it, which I did while eating my lunch today. I had never heard him speak before. He didn’t disappoint. Take a look:
It certainly made me smile when he said the first thing he did after being fired from Citigroup was to go buy 10 or 20 books. And his comment about one of the sources of disagreement with Mr. Weill:
…remember I had been fighting with them for years…we set up an organization at Citi…now don’t ever do this ok? And if I ever do this at the job I’m in, just shoot me… we had tri-heads and co-heads reporting to co-heads. Globally. I told them early on it’s crazy…
(Ahem)..yes, well, moving on…
I’m sure the shareholders and his colleagues at JPMorgan would be annoyed, and I’m sure there are a million reasons why it would never happen, but watching him gave me an idea for what just might be the ticket to beat all tickets: Obama/Dimon ’08. Talk about shoring up your weak flanks. Wow. If this ever came to pass I might even go long dollars. Well, at least close my shorts…
Yet again, Microsoft strikes buying a very interesting private company with excellent potential: Powerset, who describe the deal thus:
Powerset has always been a small company with big dreams, with the ultimate goal of changing the way humans interact with computers through language. We set out to improve search by indexing Web pages based on the meaning expressed in them rather than just the literal words. Powerset licensed breakthrough technology from PARC, hired world-renowned computational linguists and search engineers, and recently released a search and discovery experience for Wikipedia articles. Our technology helps to improve search results and also makes new features possible, such as Factz, which aggregates information from many articles to summarize a topic.
With any startup, the challenge is to take the seeds of an idea and grow it into a viable company. At Powerset, we transformed our idea into a world-class semantic search platform, demonstrating the future of search with our Wikipedia search experience. But building a large-scale semantic search engine is expensive, requiring an engineering effort and computing resources beyond what most start-ups could ever imagine. Because our goals around improving search align so well, Powerset has decided to team up with Microsoft. We believe that this is the fastest way to bring our technology to market at a large scale.
I have been following Powerset closely for approximately 15 months, ever since I first learned of the company and had I been up and running with my new venture at that time I certainly would have tried hard to learn more with the goal of becoming involved as an investor. Ex-colleagues can attest to my long-standing belief that search – and in particular semantic search – lay at the very heart of the core value proposition of a modern investment bank. Further, intelligent search is key to creating robust markets in just about anything. Indeed, a few years ago I tried to interest my former employers in doing what I thought was a very low risk and potentially highly valuable (strategically and financially) deal with Fast Search & Transfer (which btw was acquired for $1+ bn by Microsoft(!) in January.) Suffice to say that my views did not command a consensus amongst management at the time…
For me the value of intelligent search in financial services and markets is self-evident and so I’m not inclined to waste your time elaborating. With this in mind, despite having no ‘skin in the game’ I have to admit to feeling a certain disappointment upon hearing the news that Powerset was selling up to Microsoft. And given the valuation as guessed by TechCrunch, the investors certainly haven’t hit a home run (c. 2-3x would be my guess), so why did they do it?
The answer seems to be in a nutshell: the very significant capital costs of building the computing and storage infrastructure needed to scale up Powerset to the entire web. This certainly seems reasonable, and I get the impression that both sides are very keen to ‘over-communicate’ (see for example this great interview on TechCrunch) in order to counter the expected ‘default’ view that here is yet another great emerging company about to get swallowed then crushed by the Borg… I hope I’m wrong and “Powerset: A Microsoft Company” really does turn out to be a win-win. Still even if it does, I remained convinced that it will only be an exception that proves the rule.
The Economist framed it well in their recent article titled “After Bill”:
Mr Gates’s reply to Mr O’Reilly was not entirely reassuring. The firm, he said, now has dozens of “quests”—revolutionising television, automating data centres and creating software ten times faster. Perhaps this fragmentation of Microsoft’s ambition is only natural. In its 33 hectic years the company has swollen to nearly 90,000 employees (see charts); revenues this year should exceed $60 billion and net income reach almost $18 billion. Even Microsoft’s own senior executives struggle to grasp its growing empire. The firm now sells 75 different products, many of them in lots of versions.
I’m sorry but 90,000 employees? In a business that is wholly reliant on human creativity, initiative and in a market that demands resilience and near real-time reactions to a fast-changing environment? 90,000 employees? 75 different business lines? Too complex. Too much complexity.
In this, Citigroup and Microsoft are highly analogous: their core ‘innovation roll-up’ strategies should work a charm but in reality don’t seem to work at all. This comes down to the drag from increased complexity and bureaucracy, more than offsetting the gains from new and innovative technologies and business opportunities. Many companies fall into this trap. And yet the only time we see even the potential for breaking up these behemoths into more optimal pieces is either in situations of distress (and even rarely then) or through vigorous ‘activist’ outside shareholder pressure. It’s a mystery to me why more CEO’s don’t have ‘cell division’ on the top of their corporate agenda. Too much testosterone? (A derivative of the ‘power corrupts’ rule?) It mystifies me because if they did this, it would almost certainly bring them success and more importantly a giant ego boost: just imagine the powerful wave of growth and innovation that would be unleashed if these corporate giants divided into more manageable elements and released their excess capital in the bargain?
When I read this story on 
pops into my head…
Well now they are paying for it. We all are paying for it. ![Reblog this post [with Zemanta]](http://img.zemanta.com/reblog_c.png?x-id=5a146aa2-03b8-4e06-8804-34b683c960f2)
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