Intellectual Ore

Ben Bernanke opined this morning on the Fed’s ability (more properly, inability) to regulate non-bank financial firms.  A central point of the speech was the need for Congress to give the Fed greater “explicit oversight authority” to regulate clearance, financing, and the credit risk inherent in OTC derivatives contracts.  Additionally, the speech addressed the need for having a process to dispose of a failed institution’s assets in an “orderly” fashion.  The speech took a very even tack between the costs and benefits of increased regulation; it really made for a great start to my morning.

Given how important robust payment and settlement systems are to financial stability, a strong case can be made for granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems.

Today’s Wall Street Journal has a really interesting article covering the first criminal charges from the credit crunch: “Bear Prosecutors Focus on Email”.  The article explains how two Bear Stearns fund managers were uncertain about the future of one of their funds, but were forced to reassure investors that everything was A-OK on a conference call.

Consider for a minute how most hedge funds work:

1. A fund manager figures out a high-probability trade or investment opportunity, often using sophisticated mathematical models in a highly illiquid market.
2. Fund manager convinces a credit counterparty to lend them money to put the trade into “production”
3. The use of credit allows 40-50% returns, or higher.  Fund managers and investors profit, credit counterparties get repaid.  All is well.

Every day in this business is a high-wire act, and here’s why: your investors and credit counterparties can literally will your fund out of existence.  It’s a sort of parody of Napoleon Hill’s classic book: hedge fund investors can “Think and Grow Poor”.  Look at what happened at Bear (described in the WSJ article):

1. Fund managers weren’t sure about future of fund, but market conditions were such that a selloff would lead to huge losses of capital due to distressed market conditions.  Fund managers faced being honest, which would certainly lead to redemptions and a selloff, versus lying, which is dishonest but might right the fund.
2. Investors lost confidence and pulled out, forcing the fund to dump its assets for a song.  Result: massive losses.

Here’s scenario two.  This is basically what happened at Long Term Capital Management back in ‘98 (guess who was LTCM’s prime broker — I’ll give you a hint, they’re no stranger to the mess we’re in today):

1. Fund is levered about 25:1 or so (this level of leverage is considered permissible at a public company like Goldman Sachs — I can scarce imagine what that number is for most hedge funds).
2. Credit counterparties get nervous and tighten their lending standards, requiring either more collateral on their loans or an overall reduction in the fund’s level of lending
3. The fund can’t meet its operational obligations, leading to a disorderly sale of assets and massive losses.

Among all this uncertainty, there is one surefire thing: a disorderly selloff will certainly bring a levered, illiquid fund to its knees, so fund managers have a strong incentive to do whatever is necessary, including lying, to maintain the illusion of things being under control.  And if their lying can chase back investor doubt, the market might turn at just the right time that things work out.  Maybe.

In the middle of all this, I’m reminded of the classic “utilitarianism vs. deontology” debate, whether “the means justify the ends.”  Maybe lying is the right thing to do, if you think it will put the fund back on the right track.  At the bottom, though, you have to be a bit crazy to let these people have your money as an investor or credit counterparty. 

Each morning, I wake up around 6am, take a quick shower, and get on the 1 train at 125th St. As I wait for the 2/3 express at 96th, I hear the clatter of passing uptown trains, mixed with the heat, bustle, and general commotion of the New York Subway.

The 2 (it’s typically the 2) makes its way swiftly down Manhattan’s West side, passing Times Square, Penn Station, and Fulton St. From my position standing (it’s standing room only on the 2), a parade of exquisitely-dressed professionals make their way onto the train.

“The next stop is…Wall St.”

It’s time for everyone to put their Journals away, and head to work.

I get off the train. On the way to work, I pass Deutsche Bank, Trinity Church, Pret a Manger, the New York Stock Exchange, Claremont Preparatory School, and Quizno’s. Finally, I arrive at 85 Broad St., the unmarked global headquarters of Goldman Sachs & Co.

Sebastian described New York as having a certain “energy” about it. It’s a very hard thing to describe, the feeling of lower Manhattan, but he’s right. As I ate lunch on Stone Street, the people, conversations, the overall pace of life, was simply intense. I don’t think this is what I want to do for the rest of my life, but it’s a great experience, while I’m here.

If one isn’t paying attention, it can be easy to mistake an average American undergraduate with a homeless person. They tend not to have a stable address, can be quite poor, and roam around looking for free food.

Through my undergrad years, I kept a second bank account in my hometown (in addition to one in Urbana), the idea being that it was an easy conduit through which to move money back and forth from my family. Forget sending paper checks — if I needed some cash, they could just deposit it, and occasionally I bought stuff for my parents, for which they reimbursed me.

I don’t use that account much, so I was just about to close it. I had just almost emptied it, with a credit card payment, when I saw this:

I had just paid my credit card using that account (and almost cleaned it out of money) when the mysterious “Service Charge” posted to my account. “It’s a zero-minimum checking account”, I thought, “so it can’t be going under some kind of minimum.”

It turns out that the service charge was a $25 fee my bank, Charter One, decided to institute for the privilege of overdraft protection. Paying for overdraft protection (which I don’t need, thank you very much, because I don’t overdraw my account) led to the overdraw. If this is what banks are doing in the name of making a buck, the world is a pretty sorry place indeed.  Nonetheless, I couldn’t help seeing the humor in the situation.  I was reminded of a poster I saw once about “consulting”: “If you’re not part of the solution, there’s money to be made in extending the problem.”

I went to Skylight Laundry tonight in Champaign to do my laundry. As I walked in, the lights were off and I had a hard time seeing the laundry machine. I put up with the lack of light because I just wanted to get my laundry done, and get out of there. However, I really went over the edge when four consecutive machines ate my quarters. “WTF”, I uttered to myself, as I dragged my laundry out of there to the car. “It’s incredibly frustrating”, I thought to myself, “that this machine worked fine last week, and now it’s broken.” I left to search for a different laundromat. (Note: I didn’t include any location information or details, because I don’t want to abet you in finding this hole in the wall. Go somewhere else.)

My experience reminded me of a recent article I’d read about Dell, the computer company. The business, started out of its founder’s UT Austin dorm room, has grown into a monolithic titan of procurement prowess. Dell’s storied application of “just in time” inventory management has made them the darling of manufacturing companies from San Francisco to Shanghai. A few years ago, they basically had the entire global PC market under their thumb, but they messed up along the way. Either way, I’m pretty sure MBA students everywhere are thinking about starting the next little Dell, complete with global sourcing and JIT procurement, while drinking their Starbucks coffee and compulsively checking their Crackberries. But I digress.

Dell has a problem, and it’s the sort of little problem that will compound into a bigger and bigger problem over time, if they don’t deal with it. According to Consumerist, the problem is that “Dell’s Website Prices Are Based On Caprice And Whimsy.” (To be fair, Joel Spolsky wrote about it first, but the phrase caprice and whimsy has a nice ring to it. :)) Although inconsistent pricing is bad in its own right, the even-higher-level problem, the real issue, is a top-to-bottom lack of attention to consumer experience. To the customer, it feels as though there is absolutely nobody in the entire organization that gives a damn about whether customers enjoy the experience the company provides, leading them to invent all sorts of explanations ranging from “I’m having a bad day” to “there are little demons out there trying to screw me over”. I know, because I see it all the time when non-experts use computers, and like my dad, they can’t figure out why they must read boxes full of deliberately obfuscated, curvy text to do completely pedestrian things, like ordering movie tickets online. Accenture writes:

Most companies realize that customer experience is critical to their success. Many have done a good job of theoretically defining a branded customer experience for their organization. However, in Accenture’s experience, many companies run into trouble putting the branded customer experience into practice—a puzzle that leading companies have solved to their benefit. By learning from these masters, other companies can develop the capabilities and the commitment required to turn their customers into advocates, and keep them coming back for more.

The lack of attention to customer experience leads to situations where users “press the same buttons” but get different responses, leading to learned helplessness, and ultimately depression and despair. Learned helplessness, depression, and despair aren’t the kind of words I would want associated with my company.

As I left Skylight, I was in a very foul mood because the caprice and whimsy of the laundry machine has frustrated me. But this story has a happy ending, because Stephanie helped me find Courtesy Cleaning Center, in Urbana. The minute I walked in the door of this place, I felt like I was in laundry heaven. With free coffee, tables and chairs, working laundry machines, working overhead lights, and free 802.11, I would have been happy to pay $5 to wash my clothes. At the end of the day, the place with the superior experience gets my dollar, because I don’t want to be depressed. I just want to do my laundry so I can go shopping and get some sleep.

Consumerist tipped me off that Starbucks was giving away free coffee last Tuesday. I paid my friends over at the campustown Starbucks a visit, and sampled their new standard flavor: “Pike’s Place”. Customers have spoken, and Starbucks has listened. As a pretty frequent coffee drinker, I find the new flavor far less burnt-tasting, and all-around better. If it doesn’t have 20 mg caffeine/fl. oz (like their other coffees — this is an absurdly high level of caffeine), I might become a regular drinker. Although, their 12oz is 16 cents more expensive than Bar Giuliani’s Metropolis blends, which are spot-on every day. Damn, I love Urbana-Champaign.

We felt like spies ordering it, photographing it, sniffing it, cupping it, gargling it and finally gulping it down. So here’s the scoop: Pike Place delivers a pretty great cup of joe. It’s got a light fruity and nutty aroma, a smooth feel on the tongue but nice body and no wimpy finish. This lighter roast (clearly a response to widespread complaints about Starbucks’s penchant for over-roasting) allows a broader spectrum of flavors and aromatics to emerge, things that can sometimes be burnt away in a darker roast. Starbucks might not like this, but it kind of reminds me of Dunkin’ Donuts’ house coffee. — The Chicago Tribune, via Consumerist

I watched “American Gangster” about two weeks ago. As usual, IMDB has the scoop. Apparently, what fascinates me most also piqued the interest of the Wharton Club of DC: the movie is a business school case study in efficient distribution.

Apart from the detail that he was a heroin dealer, Frank Lucas’ career would be an ideal case study for a business school. “American Gangster” tells his success story. Inheriting a crime empire from his famous boss Bumpy Johnson, he cornered the New York drug trade with admirable capitalist strategies. He personally flew to Southeast Asia to buy his product directly from the suppliers, used an ingenious importing scheme to get it into the United States, and sold it at higher purity and lower cost than anyone else was able to. At the end, he was worth more than $150 million, and got a reduced sentence by cutting a deal to expose three-quarters of the NYPD narcotics officers as corrupt. And he always took his mom to church on Sunday. — Roger Ebert, via WCDC link above

Agriculture.

While driving back to Urbana, I had a discussion with my friend Kurt about whether prostitution can rightfully be called “the world’s oldest profession”. I pointed out that agriculture predates a lot of things, including the introduction of money (by a lot), but the silver bullet came when one of us realized that there is a point, sometime in history, labeled “the invention of agriculture”, when humans switched from hunter-gatherers to agriculturists. We agreed that people have probably been fighting over sexual partners longer than food, and left it at that.

It’s interesting to me how all the hand-wringing over energy prices has cascaded into food, and its use for energy production. As any physicist will tell you, all Earth’s energy ultimately derives from the sun; the closer one gets to that source, the more energy is available. Hence the reason why many of the largest animals (pandas, giraffes, etc.) are herbivores: there simply isn’t enough energy higher in the food chain to support their enormous energy needs. I, for one, am proud to attend an institution where some of the world’s best economists, engineers, and agriculturists cooperate daily to solve the policy and technical challenges inherent in a topic as complex as food security.

Last Friday, I succumbed to consumerism and purchased a new MacBook Air. I opted for the less-expensive version with the platter-based hard disk (not solid state).

The good:

• Battery life. With moderate use (50% brightness, display flipping on and off during inactivity), I’m getting close to 6 hours of life from a single charge. Especially considering the size of the battery, I’m thoroughly impressed.
• Superior industrial design: Apple’s designers pulled out all the stops on this design, and it shows. The device has a small fold-down compartment that exposes a single USB port, 3.5mm audio jack, and external video port. The rubber feet underneath the device are just tall enough to leave about 1mm of clearance between the fold-down port bay and the table upon which the computer sits. Likewise, the MagSafe power adapter has been re-engineered to leave a similarly small gap between laptop and tabletop. The adapter also has a tiny two-color LED which glows amber for “charging”, and green for “charged” — nice.
• OS X. I’ve really come to appreciate Apple’s operating system: the platform where commercial and free/open-source software can peacefully coexist. I became really fed up with Gnome’s rough edges over the past year; the marriage of the BSD Darwin kernel with the Aqua window manager is absolutely sublime.

The bad:

• The price. Even with educational pricing, the machine cost over $1800. People say it’s a ripoff given the specs, but they’re pretty reasonable, actually: 2 GB of RAM, 80 GB HDD, and a specially-engineered Core 2 Duo.

Interestingly, Apple is starting to look a lot like an old-line consumer products company. UNIX, in general, has long embraced the idea of “separation of policy and mechanism”; provide the software as a “mechanism” for accomplishing some task, but let the user define the “policy”, that is, how the mechanism is to be used. As Miguel de Icaza has commented, separation of policy and mechanism “makes Unix suck”, because most people don’t want to fiddle around with policy, they just want a system that works out of the box, period. As “the only vertically integrated manufacturer left”, Apple (unlike Microsoft, ISVs, OEM PC manufacturers, etc.) has complete control over what they sell. OS X is about 80-90% other peoples’ work, and 10% their own, but that little wedge of innovation makes all the difference. In a way, Apple is a lot like IBM: both companies realized open-source software is in many ways “good enough”, but still rough enough around the edges to build a viable business around selling a cleaned up, polished version of something you can mostly get for free.

I’m a fan.

Jerry Corrigan, Managing Director at Goldman Sachs and former president of the New York Federal Reserve, recently delivered his opinion on the difficult macroeconomic conditions facing the global markets. The speech is eminently readable and exhibits a firsthand perspective on the difficulties of predicting the future, making it an excellent read.

As many in this audience know, I have long maintained that our collective capacity to anticipate the specific timing and triggers of systemic financial shocks is virtually nil. Unfortunately, the experience of the last 6 to 8 months provides further evidence in support of that reality. While financial disturbances (as distinct from financial shocks) occur with some frequency, financial shocks with systemic knock-on effects are relatively rare.

For what it’s worth, Mr. Corrigan and I agree that oversupply of liquidity (see the first “proximate cause” from the speech) was an important cause of today’s credit turbulence.