Wednesday, December 29, 2010

Cheating in College Sports

The two most recent newspaper investigations into the Michigan football program revealed something interesting about how college football fans view "cheating" in the sport. With the Michigan athletic department facing questions about its academic advising policies* and excessive football practice time, a majority of Michigan fans had the same response to both allegations--a collective shrug**. Major fansites led vicious attacks on both newspapers, and fans seemed to say that, even if the allegations were true, they weren't a big deal.

Some believed that a simple "but-every-school-does-it" response justified Michigan's actions. As for the excessive practicing allegations, based on message board posts, many believed that college athletes should just suck it up and work harder.*** And, of course, other schools pay players, they say, and that's certainly much worse.****

But isn't exactly the opposite true? Academic policies***** and practice time restrictions are in place to protect players. Restrictions on paying players are in place to protect...well, I'm not sure exactly who******. If you actually care about the well being of players and student athletics, shouldn't you be much more concerned about providing athletes a good education and a good athletics-life balance than about their mother getting some extra money from a booster to pay the rent?

In a very cynical sense, college football fans are being extraordinarily selfish. They care about bribery because they get screwed if there team plays by the rules and misses out on top recruits. On other other hand, when schools provide crappy educations and work players too hard, it's only the players that are hurt. Another new class of freshmen will make the fans forget about the seniors that graduated soon enough.

It's unfortunate fans feel this way. All of these raise very important questions about the future of college athletics, that, as far as I can tell, are occasionally raised in public but never really addressed. Instead of worrying about these problems, fans and media are too busy enforcing absurd rules and wringing their hands over the need for a playoff in college football. Good to know we have our priorities straight.

* I guess this isn't technically "cheating", but the point remains.
** Although I suspect if the Columbus Dispatch had written these stories about the Ohio State football team, the tune of Michigan fans would have been slightly different.
*** Yes, I realize most people objected to the Free Press's reporting methods and interpretation of NCAA rules, but, my general sense was that, even if the allegations were true, people weren't really bothered by them.
**** As I said in **, Michigan fans are obviously quite biased about the situation. That said, the reaction to the Cam Newton allegations seems to suggest fans and the media consider paying players a great blight upon college athletics.
***** As I said in *, the academic policies aren't technically illegal, as far as I know, but the fans' response to the allegations were still illuminating.
****** Different conversation, but can someone point me to anyone that has an even somewhat valid point as to why college football players should not be paid? It's on my long list of things I really can't even begin to understand the vehement objection to. As if it's somehow OK to pay football players to arbitrary amount (tuition+room/board), but nowhere beyond that point.

Wednesday, December 22, 2010

The "Mythical" National Championship

Let me preface this by saying that this post has nothing to do with whether or not the BCS system is, on the the whole, good for college football. Although I have not read Death to the BCS, I would have no difficulty believing the BCS system--like much of big-time college athletics--is simply a bunch of old men exploiting 20-year-olds for their own financial benefit. Certainly, that problem should be addressed.

That said, I have more difficulty accepting arguments that a playoff system is somehow a more legitimate method of crowning a national champion. For instance, on Spider and the Henchman a few weeks ago, Fox Sports Kevin Hench derided the BCS title as a "mythical" national championship. Like many others, he seems to presuppose that a playoff system would somehow be a much better way to pick a winner.

But a playoff system wouldn't necessarily prove that the team that won was the best team in college football; rather, it would prove that the team that won happened to win two or three games in a row in the middle of December against other teams that had equally good years but may have been unlucky in the match-ups they had those two or three weeks. Perhaps that's the way you prefer to define a national champion, but it's not the only way--and certainly not the way to prove which team is "best," if that's the end goal*.

Many compare the possibilities for a college football playoff to March Madness, one of the most exciting events in sports each year. But, really, the NCAA Basketball tournament is a horrible measure of picking a true champion--it simply picks a tournament winner. By playing only one game each round, it creates more opportunity for random outcomes. Exciting, certainly, but meritocratic, certainly not. If Butler had won last year, would anyone really believe they were the "best" team in college basketball**?

For all the criticism about the length of the NBA playoffs, it really is a much better system for picking a champion. Long series eliminate some of the randomness--if you prefer the best team advancing, changing the opening round to seven games was a great idea. Obviously, because match-up problems still exist, there are some problems, but this is probably as close as you can get to picking a real champion, save European-style soccer leagues--as opposed to cups--where only the regular season counts.

As a closing note, this also raises the question of why we as fans need to have ONE champion. Isn't it simply enough to say we had at least three teams that had excellent seasons? Granted, sports is all about competition, but it's still sort of odd that people demand that only one team receives recognition for being the best in any year. Especially as more styles of play develop, it is becoming less likely that there really is one team better than every other--there are always going to be some styles of play that don't match-up well. The "everyone-is-winner" mentality is a bit of overkill, but, on the other hand, so is the other extreme.

* Which, admittedly, is very difficult to do. Do we consider a team "better" for getting hot at the end of the year, or playing consistent throughout the season? If a star player gets hurt, should we take that into account? Obviously, many of these distinctions are completely subjective--it all depends what qualities you believe demonstrate excellent. But it also shows why the idea a playoff is somehow objectively better is a bit absurd.
** Again, assuming this is what we believe a national championship should measure.

Monday, December 20, 2010

Greatest TV Seasons Ever*

*Well, more like Greatest TV Seasons of the Past 10 Years*
** Actually, more like Greatest TV Seasons of My Favorite TV Shows From the Past 10 Years***
*** Limit one season per show

As promised, I hope to blog more in the upcoming weeks. Given my recent declaration that the first season of the cancelled-too-soon Terriers was one of my favorite TV seasons ever, I decided to start things off with an actual list. Despite thinking about it a bit, I've probably left some shows off, so feel free to mention your own favorite in the comments. I've limited it to 10 seasons total and one season per show, which means some of my own favorites didn't make the cut.

In no particular order:

30 Rock Season 2: Unfair as it may be, I tend to view the NBC comedies relative to each other-And I don't remember enjoying any of them more than I enjoyed Season 2 of  30 Rock. I once thought this might be because it was so funny we would communicate almost exclusively through quotes from it each week, but I rewatched it somewhat recently and it held up (I had even forgotten some great lines, like Kenneth calling bagels "Jewish doughnuts"). They also managed to integrate NBC gimmicks (such as Green week) while also skewering them. Greenzo Out. (Honorable Mention for the NBC comedy slot: Office S2, Parks & Rec S2, Community S1.)

Sopranos Season 6, Part II: A bit of a cop-out, I know (I'll take Season 1, I think, if you don't accept this), but David Chase put together a terrific set of episodes to end the show-nearly every one was a classic. One episode after the next, Chase portrays Tony at his most petty and reprehensible as his world closes around him-forcing Bobby to commit his first hit after losing a fight to him, running up his gambling debts with Hesh, etc. The directors also did a tremendous job creating tension in scenes such as Bobby's death at the train store and, of course, the final shot at Holsten's. The entire Season 6 probably could have been perfect had the renewal of the show not meant Chase had to draw out part one longer than originally anticipated.

Wire Season 3: If only for this scene.

Arrested Development Season 2: Possible I've made a huge mistake, but really hard to go wrong with any of them.

Terriers Season 1: Still depressed this got cancelled. Really struck a great balance between episodes that could both standalone while advancing the season-long story arc. Watch it if you haven't already.

Freaks and Geeks Season 1: I wonder if F&G would have lasted any longer than it did if it were on today.  Networks seem to be at least somewhat more receptive to critical support today (even if that didn't help Terriers). Plus, a Judd Apatow  production now is worth a lot more than it was then. Somewhat extraordinary how many stars this show produced for an 18-episode season about high school outcasts. In addition, much like Terriers, it had a perfect ending.

Seinfeld, Season 5: You kind of forget when you only watch it in syndication that Seinfeld actually had season-long story arcs. That said, this selection has nothing to do with that, and more to do with the solid collection of episodes (e.g. The Cigar Store Indian, The Marine Biologist, and, of course, The Opposite).

Friday Night Lights, Season 3: First season was a bit too long. And the second season never happened.

Da Ali G Show, Season 1: When I saw this commercials for this, I thought it looked awful. Then I watched it. I'm still laughing.

West Wing S2: I always thought it was funny that Sorkin originally imagined President Bartlet would be a minor character on the show. Probably a good thing Sorkin expanded his role.

I'm certainly wrong about some of these, so feel free to tell me so in the comments.

(EDIT: Seinfeld technically breaks the 10-year rule I set out above, but you get the point.)

Wednesday, December 8, 2010

Coming Soon...

It has been far too long since I last blogged. I promise to rectify that soon. You can expect many new posts in the upcoming weeks--with potential rewards for a lucky reader if I don't follow through. Anticipate less finance and more random thoughts. Please e-mail/comment with any ideas. Also, if anyone would be up to join for a guest blogger debate or conversation, that'd be terrific, too.

Thursday, May 20, 2010

Going Once, Going Twice, SOLD (Out Their Own Clients)

As expected, a number of bloggers have defended Goldman Sachs after the New York Times skewered the bank on the front-page the other day. Some critiques of the story had merit; others did not. I’m going to focus on part of one made by the Atlantic’s Daniel Indiviglio.

Next, the article faults Goldman for its involvement with auction rate securities. Yes, Goldman was wrong to think that these securities would be okay. But then, so was every other investment bank. Virtually all were advising clients to sell auction-rate securities, and all got out as quickly as possible when they realized how poorly the securities would perform as liquidity was drying up.

It’s true that many other banks also did this, but that should not excuse Goldman’s behavior. As my mother would say, "if everyone else was jumping off a bridge, would you do it, too?" But in any case,  Indiviglio misses some key points about this particular market.

The issue is not simply that the auctions began to fail in February 2008 — it’s that the banks had always stepped in and prevented them from failing in the past. The municipalities and nonprofit groups that issued the auction-rate securities believed they were getting a great deal — and no doubt the bankers assured them they were — because they essentially got to borrow long-term at short-term rates. Although, in theory, there was a chance the auction could fail and lead to penalty interest rates, this appeared impossible in practice, because the banks that ran the auctions had always supported them (until February 2008, at least). In fact, I’d be surprised if, when banks pitched the product to issuers, they didn’t mention their willingness to step in and prevent auction failures. With that in mind, it makes the banks' behavior a bit more egregious.

Further, Indiviglio fails to consider the perspective of an entirely different set of clients Goldman and the other banks screwed — the investors that bought what banks told them was a cash-like product. Investors purchased auction-rates securities because they provided better-than-average returns for a product that was supposed to be as liquid as cash—by always supporting the auctions, the banks had created the illusion of liquidity and sold their clients on it. But when banks stopped supporting the auctions, individuals and companies that needed the funds for day-to-day expenses discovered that the liquidity only existed as long as the banks decided it would. They no longer had instant access to the billions they had invested.*

* A number of state AGs filed lawsuits against the banks, eventually leading most of them to offer to buy back the securities from investors.

Sure, the issuers and investors probably deserve some of the blame—they should have realized that lower debt costs and better returns meant they were taking more risk, even if they weren’t sure where the risk came from. But I also would be willing to bet the banks didn’t emphasize those risks when selling the clients these products. Or make extraordinarily clear that they as investment banks had no fiduciary duties to the clients and thus wouldn’t necessarily have the clients’ best interests in mind.

But even if we assume banks behaved appropriately in their interactions with clients, it's not clear that this is what they should have done, despite this claim from Indiviglio:

But the article also blames Goldman for not breaking a contract so to treat one client more favorably regarding its auction rate securities. So the bank should have ignored a contract in order to voluntarily endure losses due to the risk a client agreed to take on? How do you think Goldman shareholders would feel about that decision? Goldman has a fiduciary duty to maximize their profit, which arguably outweighs any desire it has to protect clients form themselves.
Certainly Goldman should maximize shareholder value, but part of that is maintaining the brand name (something the old Goldman realized). An investment bank sucking every dollar out of clients today likely won’t be maximizing profits for shareholders in the future--only maximizing the current bankers’ bonuses. Most restaurants, for instance, realize it’s worth it to take a loss on a dinner someone might complain about today to convince them to try the restaurant again in the future (or at least not bad-mouth it quite as much). Pursuing a business model in which you hold every client to every contract—including those in which you provided bad advice—seems extraordinarily short-sighted. But, of course, bankers won't be worried about that when their bonus is only based on what they can extract from clients today, and not in the future.

Sunday, May 16, 2010

What Else Is He Going To Say?

It’s inevitable that during an economic crisis, journalists will turn to financial leaders for "insight". And it’s just as inevitable those people will provide quotes such as this:

And in an interview broadcast on Sunday, the U.S. Treasury secretary, Timothy F. Geithner, signaled his confidence that Europe would resolve its debt crisis and that the American economy would withstand its impact. “Europe has the capacity to manage through this,” Mr. Geithner told Bloomberg Television. “And I think they will.”

Although some have pointed to this as an example of Geithner setting himself up to look silly, I’m not sure what else he’s going to say. Even if he believed Europe couldn’t make it through the crisis, he wouldn’t admit it. And, because of that, no one will ever believe it even if he did.

I realize both the journalists and the politicians are just doing their jobs, but I don’t really see this as a situation where either has much to gain. For the journalists, there is an infinitesimal chance Geithner actually says anything newsworthy. For the leader, at best, you have people question your motives, and, at worst, you leave yourself with public comments that will in the future looks as foolish as this.

Sunday, April 11, 2010

Honesty is the Best Policy

Wanted to dust off the blog for a very quick thought on journalism. Ideally, more regular posting will resume once school concludes in a few weeks.

In today's New York Times, public editor Clark Hoyt had this to say about a reporter's use of Twitter to air some complaints about Toyota:

Hiroko Tabuchi, who said she knew the guidelines, nonetheless let frustration get the better of her on March 29, when she attended a news conference by Akio Toyoda, the president of Toyota. Her string of tweets about the event was first reported by The Nytpicker, an anonymous Web site that focuses on The Times.

With less than three hours of sleep, Tabuchi wrote, she had to get up at 6 a.m. “We love you Mr. Toyoda!” After the news conference, she wrote that Toyoda took few questions and “ignored reporters, incl me who tried to ask a follow-up. I’m sorry, but Toyota sucks.”

Lawrence Ingrassia, the business editor, said reporters have always complained to one another, about irritations at work, sometimes vividly, but when they do it “to the world, live, I think it’s unacceptable.” I would have pulled Tabuchi from the Toyota story, but Ingrassia said he decided not to because what she wrote indicated she was upset with the company’s press arrangements, not prejudiced against it or its products. He said he saw no bias in her reporting and had received no complaints about it.

Perhaps I'm alone in this, but Ingrassia's point about the newsroom banter actually suggests to me that we should encourage journalists to tweet about stuff like this. Unless they're emotionless human beings incapable of forming thoughts*, journalists are going to have opinions on a variety of issues related to the topics they cover -- even if it's just the press arrangements. Perhaps a journalist will block out experiences like this when writing her story**, but, if not, readers deserve to know about what could be shaping the reporter's opinion.

Further, what is the cost in making public thoughts journalists already parade around the newsroom? Certainly, it won't help with the persistent charges of bias levied against the press***--but those are going to continue anyway. For readers that understand and appreciate the media, this will serve as a welcome show of respect for their intelligence.

* I will not dispute this is within the range of possibility for some...
** And I'm not certain that the press accommodations aren't relevant in this situation. Given the problems Toyota is having, one would hope they would show some respect for those that want answers about safety from them.
*** A topic best saved for another time

Tuesday, February 16, 2010

Greece and Ethics***

Although I like Felix Salmon, I often suspect he's being contrarian for the sake of being contrarian. Recently, this has led him to defend Goldman Sachs on a number of fronts, including its role in the Greece debt crisis:


So while it’s entirely fair to blame Greece for trying to hide its debt, and to blame Eurostat for letting it do so, I think that blaming Goldman is harder. It was surely not the only bank involved in these transactions, and the swaps were simple enough to be shopped around a few different banks to see which one could provide the best deal. Structuring swaps transactions is one of those things which investment banks do. If countries like Greece buy swaps in order to hide their true fiscal status, then that’s the country’s fault, not the banks’. No self-respecting bank would decline such a transaction because they felt it was unfair to Eurostat.
Yes, I’m sure that Goldman put a team of people onto the Eurostat rules and made that team available to the Greeks. But let’s not blame the advisers here, for structuring something entirely legal and which the Greeks and Italians clearly wanted to be able to do all along. This is a failure of European transparency and coordination; Goldman is a scapegoat.

Sure, what Goldman did was technically legal, but does that make it right? Investment banking ethics is a bit of an oxymoron, so I'd expect to hear that reasoning from Goldman, but it's unfortunate that Salmon chooses to rationalize it this way, too. Would he also approve the work of people like Maurice Levy*?

* Obligatory watch-the-Wire-if-you-haven't-seen-it aside. Not going to waste much effort on it, though, because if you haven't seen it yet, I'm not sure how I'm going to persuade you.

Excuses such as this further entrench the inappropriate business practices of  investment banks into the financial system. They encourage the development of a system where the way to make money isn't developing deals that benefit all stakeholders, but rather tricking regulators and investors by bending the technical definitions of the law**. With the prominence of this sort of behavior on Wall Street, I'm unsure how much increased regulation and new laws can help--banks and lawyers will only make more money figuring out new ways to evade them. And bloggers for major financial publications, apparently, will continue to support their right to do it.

** Again, I must turn to my familiar rallying cry and ask if we would allow this sort of behavior in any other industry. I'm pretty sure we hold even used-car salesman to a higher standard.

*** I'm sure someone with a background in philosophy (Shaun) could write an entire book on the actual "ethics" of this, but I think you understand the point I'm trying to get it and the definition of ethics I'm using.

Tuesday, February 2, 2010

Tactics vs. Strategy

In one call, [Larry] Summers said, “I have 13 bankers in my office and they say if you go forward with this you will cause the worst financial crisis since World War II.” -- Credit Crisis Cassandra
The quote above -- which occurred during a call in which Summers was fighting against regulating derivatives -- is one of the most illuminating of the financial crisis (so illuminating, in fact, it's the title of a new book by James Kwak and Simon Johnson). Viewed in the best light, it represents the extent to which regulators simply deferred to Wall Street for their cues on complex financial issues, while viewed more cynically...well...let's just say it looks a lot worse. At the very least, it's another example of why we should be wary about trusting the so-called "experts".

I highlight this quote today because the talk of naming a new Treasury Secretary had me thinking about one of the arguments made by those in support of retaining Tim Geithner*: who else would you get to replace him? I imagine many of his proponents believe that you need someone else with intimate knowledge of Wall Street in the position, but that anyone with the sort of ties to obtain that knowledge will not be confirmed**. 

* And also, in a broader sense, of why we defer to "experts"
**I seem to recall the argument for hiring Geithner and Summers in the first place--despite their involvement in supporting many of the practices that got us into this quagmire--was that they were the "only people" that knew had enough knowledge of these areas to fix it.

The fact that I'm skeptical about this argument will not surprise you. But my reason why might--it relates to the way I analyze sports.


As I allude to in the title of this post, I view the ability of fans to criticize coaches through a prism of tactics vs. strategy. When it comes to tactics--which I consider smaller-scale things, such as how a guard actually blocks or a how a quarterback actually throws--I will openly admit that every coach in the NFL (the "expert") knows way more than I do. But when it comes to strategy--bigger picture things such as play-calling and time management--I don't think that's the case (and I assume most of you would agree the same holds true for you). From awful time management to the refusal to question conventional wisdom, coaches make strategic decisions that are far from optimal all the time.

I think it's useful to consider this analogy when thinking about finance (or any other industry*, really). Certainly, all of the attendees at the Asset Securitization Forum know more than almost all the critics of the financial industry about how to structure a CDO^2 of ABS. But far fewer of these attendees have actually thought much about how the products they create and sell fit into the bigger picture.

*** If you're a television fan, think of it this way: Jeff Zucker knows way more than you do about how to actually produce a show. Still, most of you could have done a way better job than he did of running his network.


The implications of this for picking a new Treasury Secretary (and how he should perform the job once chosen) are clear. Contrary to the belief of those who believe Geithner/Summers/etc. are the "only people that could do their jobs," we don't need to someone that knows a great deal about the tactics of Wall Street. Instead, we should chose someone that has actually analyzed (and is, of course, willing to question) the big-picture strategy. I don't know enough about specific candidates to know who would be interested, by I can't imagine someone like this would be too difficult to find****.

And, on a broader note, it means that none of such feel bad about questioning what the "experts" tell us about finance. Just like our thoughts on a foolishly used time-out in a game last week, it's quite possible we know better.

**** Yes, I realize there a political constraints because this person needs to be confirmable. This suggestion, though, should, in theory, make that task much easier.*****

***** I feel like I owe a h/t to JoePos for once again stealing his technique. 

Sunday, January 31, 2010

I Guess It Really Ain't Over 'Till It's Over

Anything I wanted was a phone call away. Free cars. The keys to a dozen hideout flats all over the city. I bet twenty, thirty grand over a weekend and then I'd either blow the winnings in a week or go to the sharks to pay back the bookies.
Didn't matter. It didn't mean anything. When I was broke, I'd go out and rob some more. We ran everything. We paid off cops. We paid off lawyers. We paid off judges. Everybody had their hands out. Everything was for the taking. And now it's all over.
And that's the hardest part. Today everything is different; there's no action... have to wait around like everyone else. Can't even get decent food - right after I got here, I ordered some spaghetti with marinara sauce, and I got egg noodles and ketchup. I'm an average nobody... get to live the rest of my life like a schnook.
-- Henry Hill, Goodfellas
Just a little more than 17 months ago, I convinced myself that Wall Street bankers had finally screwed up the racket they had going and were destined, like Ray Liotta's character in Goodfellas*, to live out the rest of their lives like "schnooks." Bank stocks plummeted. Credit markets froze. And Michael Lewis -- who wrote the seminal take on industry -- even declared that Wall Street had finally reached "The End."

* Speaking of the mafia, a Jimmy Breslin quote --with a slight modification by me--seems particularly apt for this occasion. It appears to me that Wall Street bankers, just like gangsters, have  "yet to find anything that's too small to steal."

Ah, how naive we were...

As if you needed any further proof that wasn't going to happen, here it is: Lloyd Blankfein--The $100 million Man.

It's tough to decide what angers me most about this middle-finger to taxpayers, the millions of Americans still out of work and those being forced out of their homes. Perhaps it's that Goldman--despite its protests otherwise--has benefited from government assistance in many ways other than the TARP money it claims it didn't need, from the government guarantees of its debt to its conversion to a bank-holding company to when it got billions of dollars through a back-door bailout of AIG. Or, it could be that Wall Street cares extraordinarily little about fixing the pay practices encouraging behavior that hurts shareholders, clients, and taxpayers. But maybe it's just that these assholes actually think they deserve it.

Whatever the case, it's pretty clear we're a far cry from where we were just a little while ago. I remain unconvinced that even the current plan to regulate the financial industry will do much to eliminate the worst practices on Wall Street or make the economy safer. And if it looks that way now, just imagine what it will look like in 17 months...

Wednesday, January 27, 2010

Who is To Blame?

Although it’s fun to vilify bankers, the truth is that there are many people whose interactions helped contribute to the financial crisis. People want to treat finance like physics, but it’s much more like biology. As Richard Bookstaber points out in his excellent A Demon of Our Own Design, the financial system is similar to a complex ecosystem—a minor event in one part of the world can eventually move through the system and lead to a major blow-up in another.

Unfortunately, many of the people within the system have incentives that are not aligned with the economy’s greater good. In a vacuum, many of these actors may believe there is nothing wrong with acting in their own self-interest. But when these actions are combined, the result can be disastrous.

These actors include:

Investment Banks: Salesmen have an incentive to sell products to clients (even if inappropriate for that client), traders have incentives to take risks, investment bankers have incentives to create bigger and bigger deals, etc. Not spending too much time on it because you’ve heard this all before.

Institutional Investors: Often, they are judged by relative, rather than absolute, performance. Even if a fund manager believes buying a CDO, for instance, is a bad idea in the long-term, he might need to buy them now or risk being outperformed by competitors (which would lead to funds flowing out of his funds and into the better performing ones). And even if the CDOs eventually do blow up, he can simply point to these other funds to show he shouldn’t be blamed—“no one else saw it coming, either”. As long as he does no worse than his competitors, he’s not in bad shape. This “Keeping Up With The Joneses” mentality can increase demand for products (whether CDOs or tech IPOs) from investment banks, whether or not the investments are sound.

Monoline Insurers and AIG
: They were paid for taking on risk—not surprisingly, they took on a lot of it. They’re willingness to insure many of the structured finance products allowed many of the deals to be workable (on paper, at least) for the banks. No doubt this helped drive the issuance of these products.

Rating Agencies: They are paid by the issuers of the securities, so they have an incentive to give better ratings (even if they claim they aren’t influenced by it). You’ve heard of the we’d- rate-these-if-they-were-structured-by-cows fiasco. But they also have an incentive not to look too foolish. Once they began actually downgrading the structured finance instruments and the insurers, it led to a downward spiral across the financial system.

Mortgage Originators: They were paid for making mortgages and, thanks to securitization, did not need to worry about the risks. Not surprisingly, they sold as many mortgages as they could, some resorting to boiler-room tactics including misrepresentation and fraud. They clearly did not have the best interests of the client in mind.

Regulatory Agencies: Some of them are funded by the people they regulate, so they have incentives to race-to-the-bottom when it comes to regulations. They also might have incentives to govern by rules rather than standards—easier to administrate, but also creating a demand regulatory arbitrage (triple-A requirements led to demand for the insurers). A cynic might also suggest that the regulators themselves have incentives not to question the people the regulate too much for fear of losing future employment opportunities when they move to the private sector.

Politicians: Obviously, “increasing homeownership” is a pretty good platform for both parties. Unfortunately, it leads to the creation of policies that allow many of these other actors to do bad things.


Homeowners: If they weren’t willing to trust financial professionals and take out mortgages, the investment banks couldn’t have created quite as many products (although, of course, many of the more complicated products were synthetic and, therefore, did not require actual mortgages).

A simple list that can go on and on.

The bigger point of this is that reforming the financial system requires more than just taking on banks on a few issues--it will require an extraordinary overhaul.

Tuesday, January 26, 2010

Theory vs. Reality?

A letter to the editor in the WSJ the other day caught my eye, because it highlighted a divergence between theory and how at least one investor perceives reality.

According to standard theory, shareholders actually want managers to take risks. In fact, corporations are in many ways designed to discourage managers from being too risk-averse. As Jonathan Macey said in a WSJ op-ed "the public shareholders of these companies tend to be highly diversified against the risk of failure at any particular financial institution, so they have a strong personal interest in seeing the bankers who manage their leveraged investments swing for the fences." 

One letter writer did not agree:
Jonathan Macey lays the blame for the fury about bank bonuses on the government's too-big-to-fail approach, stating that shareholders actually want the banks to take risks in the hopes of outsized returns ("Obama and the 'Fat Cat Bankers'," op-ed, Jan. 13).
Perhaps some amorphous institutional shareholders seek that, but the individual shareholder surely does not. We have not seen the fruits of these new profits the banks are earning. The bankers are still getting millions of dollars and stock (diluting our holdings), while we have seen our stock values fall by two-thirds or more and our dividends cut by as much as 80% or 90%. I also don't buy the argument that talent will leave. There is plenty of talent out there, and frankly, there aren't that many places to go these days.
Former Citigroup CEO John Reed is not mistaken that the bankers "don't get it." The government doesn't get it either, but don't fault the shareholder. We are not "enjoying the rewards" of this risk-taking, nor do we endorse it. Try being a small shareholder and getting heard by bank management or the board of directors.
Sure, we could sell our stock to express our displeasure, but at greatly reduced prices because of the bankers' actions. Banks should be giving something back to shareholders and reducing bonuses proportionately to do so, before rewarding more risk taking by their staffs.
Annie Eagan
Chicago

I thought the letter highlights two interesting issues:

First, the theoretical view clearly doesn't reflect the desire of some individual shareholders, especially when it relates to institutions such as banks. Certainly, many people invest in mutual funds (which should give them some diversification) but  I imagine many of the individual shareholders in the largest banks (such as Citigroup) and other "blue-chips" such as General Electric invested large portions of their holdings in these companies because they considered them "safe and steady" investments (maybe that's dumb, but it's not that point). They wish these companies took fewer risks, not more.

Second, there is clearly a conflict of interests between the institutional shareholders (who might hold some power) and the individual shareholders (who probably don't have any). Granted, the institutional shareholders are in a sense just proxies for the individuals with stakes in their funds, but I assume managers' priorities are not in harmony with those of the underlying shareholders because of various other incentives and motivations in play. Even if the individual are diversified (through owning a mutual fund, for instance), would these individual investors prefer that the institutional shareholders push the managers to be more risk averse?

Thursday, January 21, 2010

"Lure people into that calm and then just totally fuck 'em"

Over this winter break, I spent a good deal of time reading finance-related books that were written prior to the current crisis. Although many people that bear responsibility for the crisis have attempted to exonerate themselves with the argument that “No one saw it coming,” it appears to me that many people warned about the dangers of derivatives well in advance. As many of you know, I’m not exactly enamored with the practices on Wall Street. So it came as even a surprise to me that I’d finish reading these books even more outraged.

I have always been somewhat skeptical about the value of derivatives. Looking at credit-default swaps*, for example, it’s quite easy to see how they can have many negative side effects. Many people look to the CDS markets as a sign of a company’s health; a less scrupulous trader might realize this gives them an opportunity sell a stock short and then manipulate the more thinly-traded CDS market to stoke unfounded fears about a company. CDS contracts also pay 100 cents on the dollar; this gives a CDS-buying creditor holding bonds nearing default an incentive to push a company into bankruptcy to recover its full investment, rather than working out a restructuring agreement with the company and other creditors that would benefit them all. Finally, CDS allow traders to wildly speculate on a market in dollar quantities many multiples of the available underlying assets; we all saw how that whole insuring CDO thing worked out for AIG.

* CDS essentially allow a trader to buy an insurance policy that will pay in the event another company defaults. However, unlike a home or car insurance policy, you don’t need to own the underlying asset (in this case a bond) in order to purchase the insurance.


After reading these books, I came away troubled not just because of the potentially nefarious uses of structured finance products, but because we've known about these issues for many years. As the quote in the headline of this blog post indicates (from Frank Portnoy’s FIASCO), investment banks can use the complex nature of these instruments to deceive na├»ve investors (see Orange County's bankruptcy and Proctor & Gamble's $100 million+ derivatives loss) and run-up their own profits. Or they can collude with fund managers to trick government regulators and investors about the true nature of their strategies — many derivative securities are created to allow fund managers to sidestep regulations that ban them from trading foreign currencies or making leveraged bets. And in one of the more egregious abuses of derivatives, investment banks have also used these products to help companies cover-up hundreds of millions of dollars of losses, turning bad investments into something that looked like a big gain for current management, but that would surprise shareholders with enormous losses later.

I really don’t understand why we allow so many things like this to go on in the financial sector without much questioning. There are certainly benefits we enjoy from the use of derivatives (especially the simple futures and forwards that allow for hedging) — but shouldn’t we also consider their costs? Again, I turn to the toaster analogy. If 86% of a certain type of toaster blew up, there’d certainly be some push for further regulation. But 86% of CDOs backed by mortgages (originated in 2007) have defaulted, and we’re still waiting for something to be done.

Wednesday, January 20, 2010

I Thought It Was the Dadgum Librls That Didn't Understand Business

In today’s Wall Street Journal, columnist Holman Jenkins predictably defends investment banks such as Goldman Sachs from criticism of their despicable behavior leading up to the current economic crisis. Following the reasoning of other free-market ideologues that have backed the banks, Jenkins makes his claim using two points: First, that the investment banks sold their products to “professionals” that should have known better, and second, that investment banks always take positions counter to their clients' interests. These arguments demonstrate either ignorance about the investment banking business, or a willingness to mislead readers on how it really works.

Jenkins wrote:

“Goldman chief Lloyd Blankfein was understandably wide-eyed with wonder at last week's hearing of the Financial Crisis Inquiry Commission. He pointed out that the people on the other side of every Goldman housing-related trade were, for Jiminy Cricket's sake, professional investors.”
Many of the investment banks' defenders have used the “professional investors” argument, but it stands up neither to general nor specific critiques.

Generally speaking and contrary to popular belief, caveat emptor is not a well-established legal principle (thanks contracts class!). Professionals in other fields have many avenues of recourse when they are sold a defective product—just because you’re an expert doesn’t mean you’ve disclaimed all warranties (if this wasn’t true, we wouldn’t need lawyers). Certainly, if a supplier sold GM a faulty $1 part used in a Chevrolet, we wouldn’t want to shield the supplier from liability simply because there are automotive “professionals” that also work at GM. It eludes me as to why you’re liable if a $15 toaster blows up, but not if a $1 billion collateralized debt obligations of asset-back securities does. (These arguments also fail to take into account that Goldman is certainly much more sophisticated than many of the clients it sells to. Clients such as public pension funds in the middle of Wisconsin relied on these financial professionals to give them sound advice—not send them to the poorhouse.)

More specifically, the behavior as it relates to these complex financial products goes beyond investors making a bad deal — there is evidence of fraud and misrepresentation when it comes to creation of these products. Many of the bond insurers (who similar to AIG insured these CDOs) have gone back to find documentation for mortgages stuffed in CDOs is missing or falsified. It’s one thing to fault an investor for buying a product based on the assumption that housing prices will always go up. It’s quite another to assume that they should have been aware the purchaser of a home made only $50,000 per year instead of $100,000, despite an investment bank and its lawyers telling them the mortgage application said otherwise. It seems to me that the shady mortgage origination practices, rating agency bribery, and corrupt sales techniques practiced by investment banks has gone overlooked (or has been forgotten) in this discussion.

Jenkins’ second argument is no better:
“He might have added that Goldman bets against its clients every time it buys something they want to sell or sells something they want to buy. He might have suggested that any client who doesn't understand Goldman is looking after its own interests (just as Goldman expects the same of its client) is an idiot and has no business being in business.”
This line of defenses misses two key points about the issue at hand.

First, it doesn’t fairly represent what investment banks do when they make markets for their customers. When they buy a security from a client, they’re not making a bet on the future price path—they’re simply selling liquidity to the customer. In return for the service of buying at almost any time the client wants out of a product, the investment bank “charges” the customer by buying the security for slightly less than it’s really worth. It makes it money not by holding onto the bond and praying its price will go up, but rather by quickly flipping it to another client willing to pay full price.* This has nothing to do with taking a position opposite either client.

*The idea of a bid-ask spread is familiar to anyone that collected baseball cards as a kid and read Beckett's.

But even if we take the market-makers argument at face value, it really has nothing to do with the practice FCIC chairman Phil Angelides was referencing when he compared the investment banks to salesman who sold cars with faulty brakes while taking out insurance on the driver — the origination of complex structured finance product. In this case, the banks are not taking a position against the clients — they’re just selling them a product they created. Issuing a CDO of ABS is no different than taking a company public—except with more complex models and a lot more profit for the bank. Using investment bank’s market-making business is an attempt to excuse bank's behavior by shifting the argument to a completely different service the banks provide.

It’s unfortunate the much of the furor over investment banks have focused on their outrageous bonuses. Although most investment bankers are certainly overpaid and overconfident, it distracts the public, the media and even me (at times) from digging into the real questions about their business practices. I remain unconvinced that anything will be done to taking real steps to clean up this corrupt industry.

UPDATE: Principle not principal. Thanks to commentor Nemo on the Baseline Scenario for pointing that out.