Friday, March 28, 2008

“It is an easy thing for men to be deceived by the specious name of Liberty.”

Well, if we’re going all CC on each other…
“During the time men live without a common power to keep them all in awe, they are in that condition called war; and such a war as if every man, against every man… To this war of every man against every man, this is also in consequent; that nothing can be unjust. The notions of right and wrong, justice and injustice have there no place. Where there is no common power, there is no law, where no law, no injustice. Force and fraud are in war the cardinal virtues.”
Thomas Hobbes, Leviathan

EBL, I think you miss the point of Garbo’s original post. It seems to me that it was an argument for the need to reregulate the financial industry, while your response focused largely on the merits of a federal government bail out (of both lenders and borrowers). I think the following line from Garbo’s follow-up clearly states the original point, which you don’t address: "the ultimate goal was not retribution or even the reimbursement of funds lost through speculation, but the formation and structuring of a sound banking system." Yes, Garbo’s post did assign blame for the current crisis, but by focusing on that, you miss the crux of his argument. It was meant to be a forward-looking discussion, regarding how we can avoid the same mistakes that were made.

To address your argument regarding a bail out, however, I disagree with much of what you said. You wrote that
“The problem with Garbo’s argument is that, at best, it only singles out half of the reason for the predicament and as such doesn’t necessarly address the greater issue of Americans procuring more than they can afford”
but this imposes a false equivalency between lenders and borrowers. As financial professionals, lenders were in a position to better know the market, to understand what houses should be worth, and what borrowers would actually be able to pay. Clearly, buying a house is the largest investment most people will ever make, but regardless, most people don’t spend years researching housing markets. They haven’t received training, either through advanced schooling or through their employers, designed with the explicit goal of providing them with an understanding of housing and financial markets. While they are parties to these deals, they aren’t as well prepared to bear the burden of investigating and understanding the deals intricacies. Lenders are, and are often (rightly or wrongly) thought of by borrowers as acting in the borrowers best interests. They are clearly in the more powerful position in this relationship; their standing aren’t equivalent and should not be thought of as such.

You go on to state that

“One could argue that the crisis itself right now is its own best future medicine and overly zealous homeowners who purchased a home with no equity have suffered pain and won’t engage in the same behavior again. But that doesn’t mean it won’t happen in the future when they either forget or are offered an enticing bill of goods”

While Garbo retorts that “When you assert that this crisis may perhaps be its own medicine, you imply that the market somehow could be self correcting, but it is not.”

There are a couple of problems with this line of reasoning.

First, the crisis has already been stopped from playing itself out. For better or worse, the Fed and Bush Administration (read: Treasury Secretary Paulson) have already intervened, with Wall Street rabidly cheering them on. By opening its discount window to non-commercial banks and pushing the JP Morgan-Bear Stearns buyout, the government has effectively announced that a bailout of the financial players is necessary. The question is no longer whether or not the government should interfere with the private market at all (which EBL seems opposed to), but whether it should do so on both sides. As Martin Wolf wrote,

“Systemically important institutions must pay for any official protection they receive. Their ability to enjoy the upside on the risks they run, while shifting parts of the downside on to society at large must be restricted… An unregulated, but subsidized, casino will not allocate resources well. Moreover, that subsidization does not now apply only to shareholders, but to all creditors. Its effect is to make the costs of funds unreasonably cheap. These grossly misaligned incentives must be tackled.”

This highlights the real problem with the “Bank X is too big and important to fail” argument: the bank’s profits are accrued privately by the banks, its employees and shareholders, while the costs of investments gone awry are being nationalized.

Second, pain now won’t serve as an effective deterrent to repeating the same mistake.

1) People who aren’t currently in the housing market aren’t effected by the pain. If they aren’t paying attention now, the current problems give them no incentive not to do the same things in 10 years time.

2) Even people who are being hurt now may misremember or misinterpret what led to their predicament when looking back on it later.

3) As noted in my original post, “experts” always manage to rationalize why this time, its different and it isn’t a bubble. Again, look at what people were saying during the housing boom, the dot-com boom, and pretty much any bubble since the advent of academic economics. Every time, you’ll find people explaining why this case is different because something has fundamentally changed the market. Sometimes its true, most of the time its not. Either way, each bubble is different from the last, and has provided little guidance to those in the midst of it to allow them to realize whats actually happening around them.

Letting the system work itself out will also hurt many innocent people, while failing to adequately punish many of those responsible. For the extreme examples, think of Merrill Lynch’s E. Stanley O’neal. Yes, he eventually lost his job as a result of Merrill Lynch’s losses, but before the bubble burst, he also made hundreds of millions of dollars, which he now gets to keep. In the long-term, the interests of financial institutions and borrowers converge – nobody benefits from a borrower defaulting on a mortgage. In the short term, however, finance executives can reap massive rewards while setting their institutions up for an eventual fall. There is a large misalignment between finance executives, and the financial companies that they run.

The solution to all of this is regulation. Prevent the bubbles from being created and getting out of hand in the first place. By definition, bubbles burst; better not to let them inflate in the first place.

UPDATE: Emphasizing my point regarding Merrill Lynch's E. Stanley O'Neal, this morning's NY Times contains the article Down $900 Million or More, The Chairman of Bear Sells:
Only a year ago James E. Cayne’s stake in Bear Stearns was worth more than $1 billion. But on Thursday, Mr. Cayne, the chairman of Bear, disclosed that he had sold all of his shares in the troubled investment bank this week for just $61 million.

While he has not yet moved into his new apartment at the Plaza, which he bought for about $26 million this month, people who have spoken with him say he still has plans to do so, as soon as he sells his current residence on Park Avenue.


Mr. Cayne, unlike many lower-level Bear executives who had large portions of their net worth tied up in stock, also had the benefit of receiving large portions of his yearly compensation in cash. So, he has certainly accumulated enough to live out his retirement years in comfort.

While he lost an absurdly large amount of money in the past few weeks as Bears' stock plummeted, he also walked away having made millions over the past few years, while leading Bear to its eventual fall. I'm curious what his actual net worth is at this point, but given that Plaza apartment, it seems hes not suffering too badly.

UPDATE II: Charlie Munger, co-founder of the law firm Munger, Tolles & Olson and Warren Buffett's Vice-Chairman in Berkshire Hathaway, once wrote that

We [should] heed the general lesson implicit in the injunction of Ben Franklin in Poor Richard's Almanack: "If you would persuade, appeal to interest and not to reason." This maxim is a wise guide to a great and simple precaution in life: Never, ever, think about something else when you should be thinking about the power of incentives...

One of the most important consequences of incentive superpower is what I call "incentive caused bias." A man has an acculturated nature making him a pretty decent fellow, and yet, driven both consciously and subconsciously by incentives, he drifts into immoral behavior in order to get what he wants, a result he facilitates by rationalizing his bad behavior [like a salesman who harms her customers by selling them the wrong product because she gets paid more for selling it, versus the right product -- see, e.g., the mutual fund industry].

...Another generalized consequence of incentive caused bias is that man tends to "game" all human systems, often displaying great ingenuity in wrongly serving himself at the expense of others. Antigaming features, therefore, constitute a huge and necessary part of almost all system design.

...Military and naval organizations have very often been extreme in using punishment [the inverse of reward] to change behavior, probably because they needed to cause extreme behavior. Around the time of Caesar, there was a European tribe that, when the assembly horn blew, always killed the last warrior to reach his assigned place, and no one enjoyed fighting this tribe.

To which can be derived the following lesson, the last section of which is directly relevant to what I discussed above:

The design of tactical incentives -- e.g. bonuses -- is a whole topic in and of itself, and is critically important as your company grows. The most significant thing to keep in mind is that how the goals are designed really matters -- as Mr. Munger says, people tend to game any system you put in place, and then they tend to rationalize that gaming until they believe they really are doing the right thing.

I think it was Andy Grove who said that for every goal you put in front of someone, you should also put in place a counter-goal to restrict gaming of the first goal.

So, for example, if you are incenting your recruiters on the number of new employees recruited and hired, you need to also give them a counter-goal (and tie it to their compensation) that measures the quality of the new hires three months in. Otherwise the recruiters are guaranteed to give you what you don't want: a lot of mediocre new hires.

One of the great unwritten Silicon Valley skewed incentive stories was a major datacenter vendor in the late 90's that incented its salespeople based on bookings of long-term datacenter leases, without sufficient counter-goals tied to revenue collection or the customer's ability to pay. Sure enough, soon the company's reported bookings were heading straight up, revenue was flat, and cash headed straight down, resulting in a truly spectacular bankruptcy. The salespeople got paid, though, so they were happy.

More recently, skewed incentives in the mortgage industry -- mortage issuers getting paid based on quantity of mortgages issued, versus ability to pay -- caused many of the current catastrophic Wall Street financial meltdowns you get to read about every day.


ebl2009 said...

I'll post on this tomorrow (I'm in the library and quite tired) but two immediate thoughts come to mind.

First, re: the self-correcting aspect of the market, I agree with you and that's why I was expressing skepticism of the self-correction argument (hence the second clause in the sentence).

Second, I fully realize Garbo's argument concerning the need for regulation and I am not disputing that claim. However, my claim is that unless something is also done about the individual home owners being ignorant about their own finances, I am not convinced that similar market distortions will not occur in the future.

The one place, at the most base level, where I think I disagree with the two of you is in regards to the idea that the individual homeowner is culpable for his ignorance - I think he is whereas I believe you do not. This issue forms the crux of our disagreement is what I think we should focus on discussing tomorrow. And with that, I bid you goodnight.

ebl2009 said...

One more thing - your reference to Hobbes is misplaced. Though the quote you reference speaks to the role of the Leviathan in creating a system of law (or more accurately creating a uniform notion of justice, the right, the good, and ensuring that everyone abides by it), it is indeterminate. By that, I mean in Hobbes' Leviathan there is nothing ensuring that the Leviathan will not support the desires of the minority over the majority, just as long as the individuals under his power have contracted with each other and the Leviathan does not physically threaten their lives. So, the justice that you cite in this case could mean that rich people should be given most of the wealth of the society and lesser privileged individuals should be kept as such. You would have been better off quoting Rousseau and his notion that the legislators, e.g. the initial majority (and in terms of population this would privilege the middle class as opposed to the super rich) determine what the government should look like.