Where do I stand on the Obama Presidency?
I stand at about the same place I did last year at this time.
President Obama has put too many projects into his “top priority” list. After a year in office with not a whole lot to point to, he still insists that he will stay the course and continue to pursue the things he has been pursuing.
My experience in leadership cautions me that a leader cannot have too many top priorities. This is true if things are running pretty smoothly and it is especially true if one is in a turnaround situation.
To me, Obama’s job was to execute the turnaround of a pretty sick patient!
Leadership is to bring focus to a situation, identifying what is immediately important and what can be put off for awhile. Leadership is about communicating this focus to others so that they know what they are to concentrate on and they can get on board with the leader. Then the leader needs to bring sufficient resources to bear on the problem so that the goals and objectives of the organization can be met.
There will be diversions along the way. That is just the way the world is. Because the leader knows that she or he will face these other, unknown bumps along the road, having a disciplined agenda will allow the leader to take care of these “diversions” while still pursuing the major goals and objectives.
President Obama put too many projects on his “top priority” list. He did not focus. He had the “Audacity of Hope” driving him on. And, while that may be very appealing and good speech material, everything would have had to go “just right” for the president to achieve all the goals he set for himself.
Someone once was elected to office by focusing on the claim, “It’s the economy, stupid!”
But, this tunnel vision never seemed to be a part of the Obama persona.
Looking back one year, however, it is easy for us to now say, “It was the economy, stupid!”
Last year at this time we were tottering on the brink of another “Great Depression.” There was a lot of fear in the country. America’s biggest banks were on the edge, the economy was in the tank, and unemployment was growing. Foreclosures were rising as were bankruptcies. And, most of the rest of the world was in at least as bad shape as was the United States.
The Obama administration, along with Congress, produced a stimulus plan. There was the interjection of the government into the auto industry and one or two other efforts to head off problems. The Federal Reserve pursued “quantitative easing” keeping its target interest rate around zero.
Things did get better. Analysts are claiming that the “Great Recession” ended somewhere in the second half of 2009. But, unemployment still remains high. Foreclosures and bankruptcies are still taking place at near record rates. There remain over 550 banks on the problem bank list of the FDIC. And, the economy seems lethargic. Our consumer advocate, Elizabeth Warren, is raising concerns over the demise of the middle class. There is the criticism that the focus of the recovery was on Wall Street and not Main Street. Some prominent economists, Stiglitz, Krugman, and Roubini, are worried about a double-dip in the economy.
News about the President’s efforts on the economy were quickly displaced by trips around the world, about health care reform, about global warming, about energy policy and a myriad of other initiatives.
Of particular concern here was the Obama health care effort. I will just make three points here. First, President Obama turned the development of the legislation over to the Reid/Pelosi leadership in the Congress to craft the bill. Obama disappeared. Questions about where the president stood or what he was for received vague, disconnected answers because he was not leading the charge.
The story I heard for this tactic was that the health care bill presented by President Clinton failed because it was crafted in the White House and did not include sufficient Congressional participation in the process. Obama was not going to make this mistake. President Clinton, of course, denies this reason for the failure of the 1993 effort at health care reform.
Second, the emphasis that was placed on obtaining 60 votes in the Senate to pass the legislation put several self-seeking Senators in the driver’s seat. (Who says ‘moral bankruptcy’ is just centered in the Wall Street banks?) Rather than focusing on the health care bill itself, the nation was appalled by the behavior of a few of America’s elite holding everyone else hostage in order to get their special interests taken care of.
Third, the size of the effort was overwhelming. All people heard was universal coverage, coverage of pre-existing conditions, public option, and so forth and so on. The picture that came through to ordinary people was “huge plan” must be connected with “huge cost.” This was the way the government worked. All the efforts and machinations of the politicians to build a plan that would not cost the American people “one dime” just did not resonate with the public. Universal efforts were expensive and always cost more than expected. And, this would just add to the huge deficits predicted for the next ten years or so.
And, this was going on while the president spoke, always eloquently, about his other concerns.
Then, there was Iran, and Iraq, and Afghanistan, and the Christmas terrorist bomber, and Massachusetts (and Virginia and New Jersey) and other detours.
The consequence? Confusion, uncertainty, frustration, anger, you name it, on the part of the people. What are the priorities? Where does the president stand? What does the president want us to do? What are the rules? Who is in charge, Congress or the President? What is important?
And, the economy? I don’t know when I have seen a situation in which such uncertainty exists. First, the big banks are helped. (Yesterday we heard that the crucial thing was that the economy did not collapse, not how much money Goldman or the French or whoever got.) Then the big banks became the big bad guys. Now we need to re-regulate them. But, how are they going to be regulated? What about foreclosures? Can anything be done about them? And, then the small- and medium-sized banks aren’t lending. How can we get credit flowing again? And, so on and so on.
People and businesses can’t follow if they don’t know where their leaders are heading, what their main priorities are. People and businesses can’t plan if they don’t know what the rules and regulations are going to be. People and businesses can’t commit if they are plagued with uncertainty.
The State of the Union address last evening did not resolve any of these issues for me or lessen my concerns. To me the issue is leadership and the respect for a leader is earned. This is a question of the rubber hitting the road and no speech, no matter how eloquent it might be is going to change this fact. I am still waiting for the focus of intention and the focus of effort.
Showing posts with label economy. Show all posts
Showing posts with label economy. Show all posts
Thursday, January 28, 2010
Thursday, April 9, 2009
The State of the Recession--a long way to go
Going into this holiday weekend, we need to take a little time to reflect on the state of the economy and the financial markets. I certainly don’t want what I write below to sound like a “rosy scenario” but I would like to try and put some perspective on where I think we are and what is ahead of us.
First, as I have written many times, the liquidity problem is behind us. Liquidity problems are of short term nature and require immediate action. The difficulties we now face are related to solvency and the ability to work things through. This takes time and it takes persistence, things that Americans are often impatient with.
My argument here is that many of the problems we face are known. In the words of the world famous philosopher Donald Rumsfeld, in dealing with a “solvency problem” we are dealing with “known unknowns.” (To clarify my argument, I would argue that a “liquidity crisis” is related to “unknown unknowns.”) Banks and other financial institutions, along with non-financial organizations, unless they are just blinding themselves to the truth of the situation, know what they need to watch out for. That is one reason why banks are not lending much these days. (See my post “The Clogged Banking System” http://seekingalpha.com/article/129838-the-clogged-banking-system.)
The “solvency problems” has to do with assets whose value is less than that recorded on the balance sheet of an organization. This “solvency problem” has been exacerbated by the large amounts of debt financial institutions and others have used to acquire these assets thereby leaving the problem of whether or not the equity base of the company exceeds the “hole” that exists between the “real” value of the assets and the value recorded on the financial statements.
The “unknown” here is exactly how much the organizations will eventually get from the “known” questionable assets. The answer to this hinges upon the issue of whether or not the value of the asset will improve if these organizations work with the asset, especially if the asset is a loan that the borrower has some chance of repaying in large part. The alternative, of course is that the value of the asset will never increase and needs to be “charged off” right now.
There is no question that banks and other financial institutions tend to be overly optimistic about their ability to “work things out”, but this is a time when they need to be as realistic as possible about the condition their assets are in. This is a turnaround environment and having led three (successful) bank turnarounds I know how important it is to be realistic about asset values at a time like this. Good leaders, good executives, are ones that face the problem head on and do not try and postpone the inevitable.
But, there is a second issue here. The government help that has been provided to the private sector has not always been helpful. If fact, some of the actions of our leaders have created an environment of greater uncertainty, something that an uncertain economy and financial system does not really need. For example, those of you that have read my posts over time know that I am very skeptical of the actions taken last fall by the Chairman of the Federal Reserve System. (See my post on “The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)
The follow up to this was the execution of the bailout plan, fondly labeled TARP. It was obvious that our leaders were making up the plan as they administered it which led to several changes in direction that totally confused participants and the market. Plus there was never any oversight administered to the program so the money went out and no one knew where it went.
Now we have a “recovery package” that has been approved by Congress. Again, there is great uncertainty about what the “package” is and what will it do. (See my posts
http://seekingalpha.com/article/117878-the-obama-stimulus-plan-why-i-m-concerned and
http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan.)
Then, following this package we had the “summary” of a bank toxic asset program presented by Secretary Geithner that bombed and then the presentation of the P-PIP (See my post http://seekingalpha.com/article/127639-public-private-investment-program-liquidity-or-solvency.) which Nobel prize-winning economist Joe Stiglitz and others have torn into as providing a fantastic “real option” that provides tremendous upside for private investors and horrendous potential downsides for tax payers. Furthermore, in response to criticisms that this opportunity was just for “big” players, the Treasury responded that, well, smaller organizations would be let into the game—and, well, we may let the individual investor get into the scheme just like the patriotic program that allowed individuals to buy Treasury bonds during World War II.
The third issue centers on the amount of debt outstanding in the world. We write about the plight of the United States consumer and all the debt that he/she accumulated during the credit bubble of the early 2000s. This is a problem and will take a long time to work itself out with layoffs and unemployment increasing and bankruptcies, both individual and small business, on the upswing, along with rising delinquencies on credit cards and other consumer loans and with the overhang of large amounts of residential mortgages repricing over the next 15 months or so. This will be a drag on the United States economy for a while.
Real investment in the economy will not begin to rise until consumers get their balance sheets in order and feel confident enough to spend once again. However, many analysts are arguing that the economy is in for a structural shift, returning the United States consumer to a more fiscally conservative balance sheet with more of their disposable incomes going toward saving. This will require businesses to be smaller and more conservative in their operations. Both will retard recovery.
In addition, there is the problem of debt in the world. There are huge amounts of debt outstanding in the world that are going to have to be dealt with over then next three years of so. (An example of this looming problem is discussed in the Financial Times this morning, “Eastern Eggshells,” http://www.ft.com/cms/s/0/f3f00a48-249c-11de-9a01-00144feabdc0.html.) This just points to the fact that this recession is world wide in nature and the fate of the United States is going to be tied up with what goes on in Eastern Europe, in Japan, in China, in Russia, in Western Europe, and so on and so on.
This is why a growing number of people, like Niall Ferguson, author of “The Ascent of Money” is concerned that the United States—and others—are trying to resolve the problems created by too much debt and financial leverage by increasing the amount of debt and financial leverage that is in the world. These people are contending that we are all in this together and we must fight extreme national self-interest and protectionism.
The state of the nation is precarious—there is no doubt about that. However, I believe that we have progressed to the point that we are dealing with “known unknowns” rather than “unknown unknowns”. There is still much uncertainty in the economy, in the world, and people are attempting to work through the problems they face. But, because there are many people feeling a lot of pain right now and there will be more joining their ranks in the near future, there is a great deal of pressure to do a lot of “something” about it. And, in the minds of many, the effort must err on the side of doing too much rather than in doing too little. The potential downside to all these efforts is that much of what will be done may actually create more difficulties than they solve. Impatience is not always a virtue.
First, as I have written many times, the liquidity problem is behind us. Liquidity problems are of short term nature and require immediate action. The difficulties we now face are related to solvency and the ability to work things through. This takes time and it takes persistence, things that Americans are often impatient with.
My argument here is that many of the problems we face are known. In the words of the world famous philosopher Donald Rumsfeld, in dealing with a “solvency problem” we are dealing with “known unknowns.” (To clarify my argument, I would argue that a “liquidity crisis” is related to “unknown unknowns.”) Banks and other financial institutions, along with non-financial organizations, unless they are just blinding themselves to the truth of the situation, know what they need to watch out for. That is one reason why banks are not lending much these days. (See my post “The Clogged Banking System” http://seekingalpha.com/article/129838-the-clogged-banking-system.)
The “solvency problems” has to do with assets whose value is less than that recorded on the balance sheet of an organization. This “solvency problem” has been exacerbated by the large amounts of debt financial institutions and others have used to acquire these assets thereby leaving the problem of whether or not the equity base of the company exceeds the “hole” that exists between the “real” value of the assets and the value recorded on the financial statements.
The “unknown” here is exactly how much the organizations will eventually get from the “known” questionable assets. The answer to this hinges upon the issue of whether or not the value of the asset will improve if these organizations work with the asset, especially if the asset is a loan that the borrower has some chance of repaying in large part. The alternative, of course is that the value of the asset will never increase and needs to be “charged off” right now.
There is no question that banks and other financial institutions tend to be overly optimistic about their ability to “work things out”, but this is a time when they need to be as realistic as possible about the condition their assets are in. This is a turnaround environment and having led three (successful) bank turnarounds I know how important it is to be realistic about asset values at a time like this. Good leaders, good executives, are ones that face the problem head on and do not try and postpone the inevitable.
But, there is a second issue here. The government help that has been provided to the private sector has not always been helpful. If fact, some of the actions of our leaders have created an environment of greater uncertainty, something that an uncertain economy and financial system does not really need. For example, those of you that have read my posts over time know that I am very skeptical of the actions taken last fall by the Chairman of the Federal Reserve System. (See my post on “The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)
The follow up to this was the execution of the bailout plan, fondly labeled TARP. It was obvious that our leaders were making up the plan as they administered it which led to several changes in direction that totally confused participants and the market. Plus there was never any oversight administered to the program so the money went out and no one knew where it went.
Now we have a “recovery package” that has been approved by Congress. Again, there is great uncertainty about what the “package” is and what will it do. (See my posts
http://seekingalpha.com/article/117878-the-obama-stimulus-plan-why-i-m-concerned and
http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan.)
Then, following this package we had the “summary” of a bank toxic asset program presented by Secretary Geithner that bombed and then the presentation of the P-PIP (See my post http://seekingalpha.com/article/127639-public-private-investment-program-liquidity-or-solvency.) which Nobel prize-winning economist Joe Stiglitz and others have torn into as providing a fantastic “real option” that provides tremendous upside for private investors and horrendous potential downsides for tax payers. Furthermore, in response to criticisms that this opportunity was just for “big” players, the Treasury responded that, well, smaller organizations would be let into the game—and, well, we may let the individual investor get into the scheme just like the patriotic program that allowed individuals to buy Treasury bonds during World War II.
The third issue centers on the amount of debt outstanding in the world. We write about the plight of the United States consumer and all the debt that he/she accumulated during the credit bubble of the early 2000s. This is a problem and will take a long time to work itself out with layoffs and unemployment increasing and bankruptcies, both individual and small business, on the upswing, along with rising delinquencies on credit cards and other consumer loans and with the overhang of large amounts of residential mortgages repricing over the next 15 months or so. This will be a drag on the United States economy for a while.
Real investment in the economy will not begin to rise until consumers get their balance sheets in order and feel confident enough to spend once again. However, many analysts are arguing that the economy is in for a structural shift, returning the United States consumer to a more fiscally conservative balance sheet with more of their disposable incomes going toward saving. This will require businesses to be smaller and more conservative in their operations. Both will retard recovery.
In addition, there is the problem of debt in the world. There are huge amounts of debt outstanding in the world that are going to have to be dealt with over then next three years of so. (An example of this looming problem is discussed in the Financial Times this morning, “Eastern Eggshells,” http://www.ft.com/cms/s/0/f3f00a48-249c-11de-9a01-00144feabdc0.html.) This just points to the fact that this recession is world wide in nature and the fate of the United States is going to be tied up with what goes on in Eastern Europe, in Japan, in China, in Russia, in Western Europe, and so on and so on.
This is why a growing number of people, like Niall Ferguson, author of “The Ascent of Money” is concerned that the United States—and others—are trying to resolve the problems created by too much debt and financial leverage by increasing the amount of debt and financial leverage that is in the world. These people are contending that we are all in this together and we must fight extreme national self-interest and protectionism.
The state of the nation is precarious—there is no doubt about that. However, I believe that we have progressed to the point that we are dealing with “known unknowns” rather than “unknown unknowns”. There is still much uncertainty in the economy, in the world, and people are attempting to work through the problems they face. But, because there are many people feeling a lot of pain right now and there will be more joining their ranks in the near future, there is a great deal of pressure to do a lot of “something” about it. And, in the minds of many, the effort must err on the side of doing too much rather than in doing too little. The potential downside to all these efforts is that much of what will be done may actually create more difficulties than they solve. Impatience is not always a virtue.
Friday, August 29, 2008
Uncertainty and the Economy: Some Comments
In this post I attempt to respond to some comments that were written concerning my post of August 25. (http://seekingalpha.com/article/92648-the-reign-of-uncertainty-in-financial-markets) The comments specifically related to the fact that uncertainty always exists and whether or not markets work. I wrote the post of August 25 because I believe that uncertainty is greater now than it has been for a very long time. As a consequence, the volatility of markets is extreme and will continue to be extreme as long as this level of uncertainty continues to exist. I believe that this should be a consideration in the current business and investment decisions being made.
Uncertainty exists because humans make decisions based upon incomplete information. That is, if a decision maker had complete information there would be no uncertainty about what action that individual should take because the decision maker would know precisely the outcome that would result from any action that was available. The decision maker would, therefore, take the action that would be the ‘best’ in terms of the outcome that is being sought.
Uncertainty is defined in terms of variance. That is, because a decision maker has only incomplete information to work with, he/she will not know before the decision is made exactly what the outcome of that decision will be. Usually, there is a range of possible outcomes that can occur given the choice of a particular decision. Uncertainty, therefore, is relative in the sense that a situation in which the range of possible outcomes is somewhat narrow would be considered to be less risky than a situation in which the range of possible outcomes was much broader.
Generally one argues that if the decision maker has less information, the range of possible outcomes will be greater than if there is more information available. With less information available and a consequently larger range of possible outcomes, the situation is said to be riskier than when the decision maker has more information and a resultant narrower range of possible outcomes.
Therefore, to add to my post of August 25 I would state that we are currently working with less information relative to the possible outcomes that we have to deal with than we have in quite some time. From this I infer that in the current environment that businesses and investors are facing greater risk relative to their decisions than they have in a long time. And, as a consequence of this greater risk I would argue that markets will continue to be more volatile in the foreseeable future than they have been in recent history.
There is another issue that is being stressed relative to the current uncertainty. Nassim Nicholas Teleb, in his book “The Black Swan”, writes about two kinds of situations in which a decision maker has incomplete information. The first is what most people are more familiar with. This is a situation which uses the historical information available to create statistics that people can use to make better decisions. These statistics include probability distributions, means, standard deviations, and so on. These statistics can be used in routine, repeatable cases of decision making to help the decision maker incorporate what he or she does not know into their decision making process. Gathering more information in these situations help us to refine the probability distribution related to the specific case under review and its attributes.
The second type of situation, the one that Taleb is most interested in presenting to us, depends upon what we don’t know. That is, this kind of decision does not lend itself to the use of ordinary statistical analysis because these decisions relate to situations in which we have little or no experience relating to the information we don’t know, hence nothing to guide us in our decision making. Taleb tells of the turkey being fattened up to become a Thanksgiving dinner. For 1000 days the turkey is fed very well and treated like royalty. The 1001st day, the turkey is prepared for the Thanksgiving dinner. If the only information one has is the information from the first 1000 days, the prediction for the 1001st day would be to be fed very well and to be treated like royalty. Gathering more of the same kind of information helps very little. What is needed is not known and unless one knows what types of information are missing one can gain little to help in improving one’s ability to make a prediction.
In terms of this latter type of uncertainty, one can argue that in the current situation we don’t know what questions we should be asking or what kinds of information we need. In Taleb’s terms we are in the arena of the Black Swan.
Another question has been asked about whether or not I believe that markets work. The answer to this is yes, I believe that markets work and I have long argued that one must be careful in interfering with markets because, even though the intent of the person wanting to interfere with the working of the market may be the very best, humans, by and large have done much damage to markets, and to people, by interfering with the workings of markets. If one fusses around with markets, one must be very careful, and one must attempt to work with the processes related to markets and not to the outcomes achieved by markets.
Still, I believe that it is necessary to work with markets in order to help the markets function. There are many reasons for this. One of them has to do with incomplete information and the fact that some participants in markets may have more information than other participants do. Also, the existence of asymmetric information in markets in the short run can result in things like a liquidity crises that can cumulate in a dramatic downward spiral of prices. Another reason has to do with the existence of transaction costs and the fact that due to the existence of transaction costs markets may not function as efficiently and effectively as they could, especially with respect to the time it takes for the market to work out of a disruptive situation. Furthermore, incentives can exist that lead to behavior that is dishonest and harmful to others. Human beings are vulnerable to such incentives when the apparent marginal benefit of cheating seems to exceed the marginal cost of getting caught cheating.
Human beings are problem solvers and when they see situations that have seemingly undesirable consequences they attempt to fix them. This characteristic of human beings is what makes them especially unique among living species. It is a characteristic that has substantial survival value. But, humans must be careful when attempting to apply their problem solving skills to markets. First, as I mentioned above, in working with markets, humans need to focus on processes and not outcomes. They need to focus on rules about how individuals are to perform…such as rules pertaining to the importance of full disclosure and openness…and not what results they attain…such as the amount of people that someone hires. This cannot always be done, but it is a methodology that should be strived for.
Second, the crucial issue always has to do with the balance of interference that is achieved. My belief is that humans are always going to try and make things better…help markets operate more efficiently…and so it is a question of the balance between the two extreme goals that is important. If has always been my practice to try and err on the side of less interference with markets than more interference. Furthermore, it is always the case that this balance will change with time as we learn more and as the market adjusts to any interference imposed.
Dubner and Levitt state very clearly in “Freakonomics” that anytime any kind of incentive system (rules and regulations) is set up, there will be numerous people attempting to take advantage of the new system. This, to me, is another major argument for minimizing interference in markets…interference causes people to focus on beating the new rules and regulations imposed on the market. Thus, any new rules and regulations that are set up need to minimize the payoff for beating the new system so that more people keep their focus on making the market work rather than taking advantage of the new system. The more restrictive or the greater the interference of any new rules and regulations the more benefit that can be gained from “breaking” the system. Thus, I feel that there will be interferences with markets…with the best of intentions…but extreme care must be taken when interferences are imposed.
I hope these responses help readers understand a little bit more of where I am coming from.
Uncertainty exists because humans make decisions based upon incomplete information. That is, if a decision maker had complete information there would be no uncertainty about what action that individual should take because the decision maker would know precisely the outcome that would result from any action that was available. The decision maker would, therefore, take the action that would be the ‘best’ in terms of the outcome that is being sought.
Uncertainty is defined in terms of variance. That is, because a decision maker has only incomplete information to work with, he/she will not know before the decision is made exactly what the outcome of that decision will be. Usually, there is a range of possible outcomes that can occur given the choice of a particular decision. Uncertainty, therefore, is relative in the sense that a situation in which the range of possible outcomes is somewhat narrow would be considered to be less risky than a situation in which the range of possible outcomes was much broader.
Generally one argues that if the decision maker has less information, the range of possible outcomes will be greater than if there is more information available. With less information available and a consequently larger range of possible outcomes, the situation is said to be riskier than when the decision maker has more information and a resultant narrower range of possible outcomes.
Therefore, to add to my post of August 25 I would state that we are currently working with less information relative to the possible outcomes that we have to deal with than we have in quite some time. From this I infer that in the current environment that businesses and investors are facing greater risk relative to their decisions than they have in a long time. And, as a consequence of this greater risk I would argue that markets will continue to be more volatile in the foreseeable future than they have been in recent history.
There is another issue that is being stressed relative to the current uncertainty. Nassim Nicholas Teleb, in his book “The Black Swan”, writes about two kinds of situations in which a decision maker has incomplete information. The first is what most people are more familiar with. This is a situation which uses the historical information available to create statistics that people can use to make better decisions. These statistics include probability distributions, means, standard deviations, and so on. These statistics can be used in routine, repeatable cases of decision making to help the decision maker incorporate what he or she does not know into their decision making process. Gathering more information in these situations help us to refine the probability distribution related to the specific case under review and its attributes.
The second type of situation, the one that Taleb is most interested in presenting to us, depends upon what we don’t know. That is, this kind of decision does not lend itself to the use of ordinary statistical analysis because these decisions relate to situations in which we have little or no experience relating to the information we don’t know, hence nothing to guide us in our decision making. Taleb tells of the turkey being fattened up to become a Thanksgiving dinner. For 1000 days the turkey is fed very well and treated like royalty. The 1001st day, the turkey is prepared for the Thanksgiving dinner. If the only information one has is the information from the first 1000 days, the prediction for the 1001st day would be to be fed very well and to be treated like royalty. Gathering more of the same kind of information helps very little. What is needed is not known and unless one knows what types of information are missing one can gain little to help in improving one’s ability to make a prediction.
In terms of this latter type of uncertainty, one can argue that in the current situation we don’t know what questions we should be asking or what kinds of information we need. In Taleb’s terms we are in the arena of the Black Swan.
Another question has been asked about whether or not I believe that markets work. The answer to this is yes, I believe that markets work and I have long argued that one must be careful in interfering with markets because, even though the intent of the person wanting to interfere with the working of the market may be the very best, humans, by and large have done much damage to markets, and to people, by interfering with the workings of markets. If one fusses around with markets, one must be very careful, and one must attempt to work with the processes related to markets and not to the outcomes achieved by markets.
Still, I believe that it is necessary to work with markets in order to help the markets function. There are many reasons for this. One of them has to do with incomplete information and the fact that some participants in markets may have more information than other participants do. Also, the existence of asymmetric information in markets in the short run can result in things like a liquidity crises that can cumulate in a dramatic downward spiral of prices. Another reason has to do with the existence of transaction costs and the fact that due to the existence of transaction costs markets may not function as efficiently and effectively as they could, especially with respect to the time it takes for the market to work out of a disruptive situation. Furthermore, incentives can exist that lead to behavior that is dishonest and harmful to others. Human beings are vulnerable to such incentives when the apparent marginal benefit of cheating seems to exceed the marginal cost of getting caught cheating.
Human beings are problem solvers and when they see situations that have seemingly undesirable consequences they attempt to fix them. This characteristic of human beings is what makes them especially unique among living species. It is a characteristic that has substantial survival value. But, humans must be careful when attempting to apply their problem solving skills to markets. First, as I mentioned above, in working with markets, humans need to focus on processes and not outcomes. They need to focus on rules about how individuals are to perform…such as rules pertaining to the importance of full disclosure and openness…and not what results they attain…such as the amount of people that someone hires. This cannot always be done, but it is a methodology that should be strived for.
Second, the crucial issue always has to do with the balance of interference that is achieved. My belief is that humans are always going to try and make things better…help markets operate more efficiently…and so it is a question of the balance between the two extreme goals that is important. If has always been my practice to try and err on the side of less interference with markets than more interference. Furthermore, it is always the case that this balance will change with time as we learn more and as the market adjusts to any interference imposed.
Dubner and Levitt state very clearly in “Freakonomics” that anytime any kind of incentive system (rules and regulations) is set up, there will be numerous people attempting to take advantage of the new system. This, to me, is another major argument for minimizing interference in markets…interference causes people to focus on beating the new rules and regulations imposed on the market. Thus, any new rules and regulations that are set up need to minimize the payoff for beating the new system so that more people keep their focus on making the market work rather than taking advantage of the new system. The more restrictive or the greater the interference of any new rules and regulations the more benefit that can be gained from “breaking” the system. Thus, I feel that there will be interferences with markets…with the best of intentions…but extreme care must be taken when interferences are imposed.
I hope these responses help readers understand a little bit more of where I am coming from.
Monday, February 25, 2008
The Solvency Issue
Something new seems to be happening in this current period of financial dislocation. It appears to me that banks and other financial institutions are responding to their portfolio problems more rapidly this time around than they did in the past. If this is true, in my estimation it is all to the good! The reaction may result in a sharper reduction in lending in the short run than would occur otherwise, but it will mean that the system will be moving onto the future more quickly. Within such a scenario, the concern is that if all adjustment takes place at relatively the same time, financial markets could be overwhelmed. I am not expecting this…just pointing out the downside concern.
In the past, banks and other financial institutions have responded relatively slowly to problems in their portfolios primarily because many of the problems occurred in loans and other debt arrangements that were just between the banks and their customers. The assets under consideration were not market related. In the present case, many, if not most, of the financial assets that are having problems are market related. That is they are securities connected with subprime loans, collateralized debt obligations (CDOs) and structured investment vehicles (SIVs) among other things. In most cases the institutions holding these assets did not originate them but in some way acquired them from a third party.
Why does this make a difference? Loans and other debt relationships that are directly made between two parties and where the lender holds the paper on their balance sheet as an asset generally have no ‘market’ in which the asset can be traded and a value can be determined. Since the relationship is a direct one, when the borrower runs into some kind of operational difficulty in which the terms of the loan cannot be fully met, the lender and the borrower attempt to work things out. Lenders are not under a great deal of pressure to ‘pull the plug’ on the relationship and admit that the asset on the books may be overvalued. In fact, the tendency is for borrowers to take an optimistic view of things and believe that things will work themselves out. Thus, it may take a sometime before the seriousness of the situation to be recognized and accepted. Of course, the examination of assets by regulators or accountants may speed this process along but this only takes place with a lag.
In an environment like the one just described the truth about a portfolio comes out slowly and charge offs may only come in bits-and-pieces over an extended period of time. In situations like this, Presidents and CEOs remain in place as do their management teams with the hope that everyone on board will be able to ride out the storm. But, when management stays in place there is not much incentive to change the way things are done. The status quo is maintained. Keeping things in place and hoping that the assets will begin to perform is the norm.
If things continue to go bad for the institution, eventually the organization will be acquired or a new leader will be retained to do a ‘turnaround.’ The good thing about a turnaround is that by bringing in someone entirely new, there will be no investment in what had previously been done. The goal of the person brought in to execute the turnaround is to get rid of all that is bad, bring in capable new people, scale back to what might be called the basic franchise, and then execute a new game plan built upon solid fundamentals. Since the turnaround person has nothing vested in the old way the company had been run, he or she pretty well can do what is required to change the organization. This is my experience in the three (successful) turnaround situations I have led.
These kinds of turnarounds are usually done with the same ownership. Of course, there are vehicles that have become more important in recent years that can perhaps ‘save’ an institution earlier in the firm’s downward cycle. Although these have not been used frequently with banks or other financial institutions, their methodology is instructive. These are the hedge funds or buyout funds that specialize in buying companies that are not using their basic franchise as well as they could in order to redirect them…and, in the process, make a lot of money. Whereas the turnaround specialist brought in by a troubled Board of Directors does not have the ownership control, the private equity fund or the hedge fund that buys a distressed company has absolute control. They can do what they want…change management, sell assets, close operations, restructure, and so forth. And, the organizations can do these things rapidly because they own the place and there are no governance issues that have to be dealt with.
In the current situation we have seen a much quicker response to asset difficulties in banks and other financial institutions. The reason being that the assets in question have not been originated by the organization that is holding them and there has been some kind of market in which the assets have been traded. The consequence of this, in my view, is that managements have had to recognize earlier than before the problems being experienced in these asset categories and have had to act more quickly. The result has been that the difficulties being experienced by these organizations have surfaced much earlier in the cycle that they have in the past.
In addition, Boards of Directors have not been as passive as they have been historically. The information concerning charge offs have gotten into the press earlier than ever before and the magnitude of the charge offs have made for sensational headlines. Boards could not sit idly by. They, too, had to act and the actions they took were to remove the person in charge of the organization, the CEO. I don’t believe that we have ever seen so many top executives of important companies relieved of their position in such a short time as we have seen over the past three months or so. And, in my opinion…this is good!
There is also a cumulative effect at work in this process. This is because it is easier to do something when many others are doing the same thing. It is easier to recognize losses in asset portfolios if almost everyone else is also recognizing losses. It is easier to be severe in finding losses if almost everyone else is also being severe in their judgments. It is easier for a board to remove its CEO if other boards are removing their CEO. It is easier to make major changes and restructurings as the new CEO if other CEOs are doing the same thing. Of course, one of the dangers in ‘herd’ mentality is that the ‘herd’ will go too far in the direction in which it is heading. Right now, I don’t see this happening.
What does this mean for the current situation? From my experience recognizing and disclosing problems earlier rather than later is a good thing. In a troubled time, it is good to be relatively severe in the analysis of the value of your portfolio. It is also good to replace those that have a vested interest in the current portfolio with people that do not have a vested interest in it. And, it is a good thing to restructure an organization, returning it to its basic franchise so that it can focus on what it does best. To me, the economy goes through more pain for a longer period of time if people are slow to accept that they have problems, move only slowly to correct the problems, and fail to get back to the basics of their business and proceed into the future on a sound fundamental basis. It seems to me that this time we are moving through this stage of the cycle more rapidly than before.
The assets of concern have caused people to address things earlier in this phase of the economic cycle than in the past, but these assets have some problems of their own that are creating other difficulties. One problem of major concern is how to determine the value of the securities in question. The securities themselves are very complex instruments, which mean that there are only a limited number of people that fully understand them. Also, the markets in which these securities are traded are not very active so that prices are not very reliable measures of value. An additional uncertainty is that it has not always been easy to identify the originator of the assets backing the security thereby limiting the ability of either the original borrowers or the ultimate holders of the asset to resolve problems. How these problems will be resolved is uncertain at this time. Stay tuned!
In the past, banks and other financial institutions have responded relatively slowly to problems in their portfolios primarily because many of the problems occurred in loans and other debt arrangements that were just between the banks and their customers. The assets under consideration were not market related. In the present case, many, if not most, of the financial assets that are having problems are market related. That is they are securities connected with subprime loans, collateralized debt obligations (CDOs) and structured investment vehicles (SIVs) among other things. In most cases the institutions holding these assets did not originate them but in some way acquired them from a third party.
Why does this make a difference? Loans and other debt relationships that are directly made between two parties and where the lender holds the paper on their balance sheet as an asset generally have no ‘market’ in which the asset can be traded and a value can be determined. Since the relationship is a direct one, when the borrower runs into some kind of operational difficulty in which the terms of the loan cannot be fully met, the lender and the borrower attempt to work things out. Lenders are not under a great deal of pressure to ‘pull the plug’ on the relationship and admit that the asset on the books may be overvalued. In fact, the tendency is for borrowers to take an optimistic view of things and believe that things will work themselves out. Thus, it may take a sometime before the seriousness of the situation to be recognized and accepted. Of course, the examination of assets by regulators or accountants may speed this process along but this only takes place with a lag.
In an environment like the one just described the truth about a portfolio comes out slowly and charge offs may only come in bits-and-pieces over an extended period of time. In situations like this, Presidents and CEOs remain in place as do their management teams with the hope that everyone on board will be able to ride out the storm. But, when management stays in place there is not much incentive to change the way things are done. The status quo is maintained. Keeping things in place and hoping that the assets will begin to perform is the norm.
If things continue to go bad for the institution, eventually the organization will be acquired or a new leader will be retained to do a ‘turnaround.’ The good thing about a turnaround is that by bringing in someone entirely new, there will be no investment in what had previously been done. The goal of the person brought in to execute the turnaround is to get rid of all that is bad, bring in capable new people, scale back to what might be called the basic franchise, and then execute a new game plan built upon solid fundamentals. Since the turnaround person has nothing vested in the old way the company had been run, he or she pretty well can do what is required to change the organization. This is my experience in the three (successful) turnaround situations I have led.
These kinds of turnarounds are usually done with the same ownership. Of course, there are vehicles that have become more important in recent years that can perhaps ‘save’ an institution earlier in the firm’s downward cycle. Although these have not been used frequently with banks or other financial institutions, their methodology is instructive. These are the hedge funds or buyout funds that specialize in buying companies that are not using their basic franchise as well as they could in order to redirect them…and, in the process, make a lot of money. Whereas the turnaround specialist brought in by a troubled Board of Directors does not have the ownership control, the private equity fund or the hedge fund that buys a distressed company has absolute control. They can do what they want…change management, sell assets, close operations, restructure, and so forth. And, the organizations can do these things rapidly because they own the place and there are no governance issues that have to be dealt with.
In the current situation we have seen a much quicker response to asset difficulties in banks and other financial institutions. The reason being that the assets in question have not been originated by the organization that is holding them and there has been some kind of market in which the assets have been traded. The consequence of this, in my view, is that managements have had to recognize earlier than before the problems being experienced in these asset categories and have had to act more quickly. The result has been that the difficulties being experienced by these organizations have surfaced much earlier in the cycle that they have in the past.
In addition, Boards of Directors have not been as passive as they have been historically. The information concerning charge offs have gotten into the press earlier than ever before and the magnitude of the charge offs have made for sensational headlines. Boards could not sit idly by. They, too, had to act and the actions they took were to remove the person in charge of the organization, the CEO. I don’t believe that we have ever seen so many top executives of important companies relieved of their position in such a short time as we have seen over the past three months or so. And, in my opinion…this is good!
There is also a cumulative effect at work in this process. This is because it is easier to do something when many others are doing the same thing. It is easier to recognize losses in asset portfolios if almost everyone else is also recognizing losses. It is easier to be severe in finding losses if almost everyone else is also being severe in their judgments. It is easier for a board to remove its CEO if other boards are removing their CEO. It is easier to make major changes and restructurings as the new CEO if other CEOs are doing the same thing. Of course, one of the dangers in ‘herd’ mentality is that the ‘herd’ will go too far in the direction in which it is heading. Right now, I don’t see this happening.
What does this mean for the current situation? From my experience recognizing and disclosing problems earlier rather than later is a good thing. In a troubled time, it is good to be relatively severe in the analysis of the value of your portfolio. It is also good to replace those that have a vested interest in the current portfolio with people that do not have a vested interest in it. And, it is a good thing to restructure an organization, returning it to its basic franchise so that it can focus on what it does best. To me, the economy goes through more pain for a longer period of time if people are slow to accept that they have problems, move only slowly to correct the problems, and fail to get back to the basics of their business and proceed into the future on a sound fundamental basis. It seems to me that this time we are moving through this stage of the cycle more rapidly than before.
The assets of concern have caused people to address things earlier in this phase of the economic cycle than in the past, but these assets have some problems of their own that are creating other difficulties. One problem of major concern is how to determine the value of the securities in question. The securities themselves are very complex instruments, which mean that there are only a limited number of people that fully understand them. Also, the markets in which these securities are traded are not very active so that prices are not very reliable measures of value. An additional uncertainty is that it has not always been easy to identify the originator of the assets backing the security thereby limiting the ability of either the original borrowers or the ultimate holders of the asset to resolve problems. How these problems will be resolved is uncertain at this time. Stay tuned!
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