Wal-Mart vs. FEMA

I read this not-very-interesting research paper today that compared Wal-Mart's response and FEMA's response to Hurricane Katrina.  The reason why this paper isn't particularly interesting is because, as we all know by now, FEMA's response was just awful.  In fact awful is probably an understatement.  It might even a little generous.  Actually, if all Wal-Mart did was ship half a carton of Ramen noodles to New Orleans, they would still have beaten FEMA's response by a mile (FEMA's head, Michael Brown, apparently didn't realize that many of us would consider waterboarding of displaced 9th Ward residents an "ineffective response").

All kidding aside, you can read the report if you want but I'm sure you won't find it enlightening. What you may find dis-enlightening, however, is the report's conclusion... that the government is incapable of responding to disasters and therefore FEMA should be replaced by Wal-Mart. Ummm... what?  

I've written about this type of cynical assumption before - that conservatives in power purposefully wreck the government then turn around and point at the wreckage as proof the government doesn't work. Horwitz's paper does exactly that.  It celebrates the Wal-Mart response as proof the private sector should be allowed to run everything and that the government should step aside.  

It's typical that Dr. Horwitz, a conservative professor who has previously blamed the entire financial crisis on Fannie/Freddie and the Community Reinvestment Act (both of which are debunked Republican talking points), would leave no room in his conclusion for managing FEMA properly. He doesn't care that governments in other countries work just fine or that the government's response to 9/11 worked well. As a free market champion Dr. Horwitz's response to any governmental failure is proof the government doesn't work rather than proof this government doesn't work.  So his concluding proposal is for future administrations to seriously consider more outsourcing to private companies rather than for future administrations to fix the wreckage Bush created.  

Strangely, what's missing from Horwitz's report is the examination of the millions the Bush administration doled out to private companies like Bechtel, Halliburton and Gulf Stream Coach, all tasked with rebuilding New Orleans. Where, I wonder, is the report on the private sector's efficiency regarding the rebuilding effort?  Well, perhaps Horwitz is happy to see free market efficiency at it's finest -- after all, what's more profitable or efficient than for Bechtel to take piles of money without actually y'know doing anything with it? That's the absolute pinnacle of profitability. That's a free lunch. Money for nothing. Arbitrage. All hail the efficiency of the private sector...  

...in the meantime, please just look the other way on accountability, since none of these private companies will be held accountable for not actually doing anything with taxpayer money. 

Truly Useless Information

Free Exchange has an interesting post today about Insidious MBAs.  It adds to the general sentiment in the comments from my last post on the subject -- namely that MBA students arrive at B-School with no morals (or an amoral world view). 

Shortly after the Enron debacle [my professor] asked me how business schools could better teach ethics to help reduce such behaviour in the future. I told him you cannot teach ethics to MBAs. By the time you're an MBA student (typically mid to late 20s) you're either an ethical person or you're not. No business school class can make you realise embezzling money is wrong if that's your inclination.

I agree with that sentiment but will add that MBA professors are definitely trying their hardest to turn out highly moral individuals. Nearly all our professors dispense lessons and teach with an almost heavy-handed approach to morals.  The types of books we're given to read (especially in the more qualitative classes like HR, Management, Leadership) when not conveying direct strategic lessons often extol the benefits of highly virtuous management.  Gentle, magnimous management styles are encouraged and case studies back up the benefits of leading in such a way.  The benefits of corporate social responsibility and the stupidity of trying to defraud customers or shareholders is a constant, constant, constant drumbeat. 

Professors should be applauded for their work in this regard, but what if examining bad moral decisions isn't enough? Mark Thoma points to the problems with financial engineering and says MBAs and Financial Engineers may not be learning enough (or enough of the right stuff) as it is. As his post notes, and as Nassim Taleb has famously decried in his book The Black Swan, our Financial Engineering program teaches Black-Scholes up the yin-yang but little else, but Black-Scholes is a formula that doesn't translate beyond academic mathematics -- it simply doesn't work in the real world.

So the FE students and the brave few MBAs who took this class have spent four months studying their brains out for nothing. This, despite the fact that our derivatives professor admitted to the class yesterday that, as a former engineer, he's quite familiar with Nyquist Sampling, Brownian Motion and Mandelbrot's fractals and could probably teach them. 

Why he hasn't adjusted the program until now is probably because there has been no demand on Wall Street for quants with knowledge of these theorems. I recall an old Jack Welch speech from a few years ago to a bunch of students about how the market shapes what kind of MBA students the b-schools churn out.  If the market wants quants who only know Black-Scholes, then that's what the b-schools will deliver. Why would academia bother to teach them something different when Wall Street only wants Black-Scholes disciples?  Students won't get hired, paid a ridiculous salary and be able to give a portion of their piles of money back to the school if their skill sets don't match what Wall Street wants.

I suppose I might be one of the last MBA students to learn Black-Scholes. It would seem the financial world is changing and with it, B-School curriculums will change as well.  This is obviously disheartening to me for more than a few reasons, but it's mostly frustrating because I could have completely skipped derivatives (which has, by far, been the most difficult and challenging class I've had) and still earned an MBA in Finance. Derivatives is an elective course for us MBAs, and only a required course for the FE students.

So I could have easily graduated without putting myself through learning a difficult skill set I'm never going to use not just because it's out-of-vogue but because it's also completely useless.

Awesome.  None of this is helping me study for the derivatives final I have in two weeks.  

Highbrow Blogging

So I saw this blog readability site the other day (hat tip: JES) and at first I was happy about the props it was giving my writing skillz, but then I became concerned. I started wondering what kind of rating system it's using and what my rating should mean to me. 

JES and others haven't been happy with their ratings and, to be honest, at first I was hoping for a Double Doctoral Degree Rocket Scientist rating. So I conducted thorough analysis of the software (and by 'thorough analysis' I mean 'drank beers while watching tv') and concluded that the readability test works perfectly well. The system rates blogs based purely on readability and doesn't rate content at all (which should have been obvious to me since it's called a blog readability test).

Anyway, after realizing this, my rating concerned me because it could be a sign that my posts are not as clear and concise as they should be. To test my hypothesis I ran the blogs of Brad Setser and Felix Salmon (smarty pants, finance bloggers I follow) through the rating system to find out whether or not I was right. 

Nearly all of Setser's post require a Master's in finance or economics to properly comprehend, and a healthy portion of Salmon's require the same. But their blogs were rated as High School and Junior High respectively. To me, these ratings undoubtedly proved the system was rating writing style and not blog content.  

What does this mean for me?  Well, Setser and Salmon boil down exceedingly complex financial arcana into readable articles that high schoolers can understand. I turn fart jokes into scholarly dissertations. Setser and Salmon write about derivatives, leveraged financial intermediaries, fixed income arbitrage and illiquid securities while, most of the time, I'm just trying to find excuses to write the name Dick Butkus. 

I suppose I could find my blog's rating flattering. On one hand, it shows I'm in rarified Joycean air -- Finnegans Wake, after all, was nothing more than a 650-page fart joke gone horribly wrong.  But on the other hand, how many freakin' people have actually ever read Joyce? Sure we all like to lie and say we have, but we haven't. Nobody has. And the few who have are usually insufferable. Anyone who's read Finnegans Wake cover-to-cover is so bitter at having lost numberless hours to reading and trying to decipher Joyce's fart-joke prank that they have to act like it's scripture afterwards to save themselves from psychosis.  

Is this the future of my blog? Are these the type of readers I have? Am I reading way too much into this readability test?  Who knows... but on a more serious note, what do you think Dick Butkus's blog looks like?

Amoral MBA Students

MBA students, perhaps not to anyone's surprise, are cheaters.  MBA students cheat on the GMAT's so they can get into top B-Schools.  MBA students also willingly admit to cheating once they're in B-School, and MBA students obviously act amorally and immorally once they're out of B-School.  

Keep this in mind as I present the results of an informal, professor-administered poll taken in my Derivatives class this Tuesday.  The class discussion began with talk of everything that's been happening lately, as usual, and the professor believed illegal actions will eventually come to light regarding actions at the Wall Street firms (pressuring ratings agencies, exchanging favors for good ratings on toxic CDO's etc.).  Some students expressed anger at the immorality of it all, others questioned whether anything illegal had actually happened or whether it was simply irresponsibility that caused it all.  In light of the class discussion, the professor presented a class with the following situation:

You work somewhere in the finance industry nine months from now, and I present you with an opportunity to make $5 million.  However, you have to do something illegal to get the $5 million. The chance you'll be caught for doing this illegal act is 50%. Further, the maximum sentence you'll receive is four years and the chance of receiving the four years is also 50%. No matter what happens, if you're caught and sentenced to three years, you'll still get to keep the $5 million.  Would you do it?

Almost everyone in class raised their hands.

Here are the demographics of the class, as best I can guess.  It's a mixed class with both MS and MBA students since Derivatives is an elective for MBA-ers.  The class size is roughly 90 students, all ranging in age from 26-34 (my best guess).  The mix is approximately 50% Asian and South Asian, 40% American (all races) and 10% other (from the accents I'm guessing Russian, German, South American and Latin American).  Males comprise about 70% of the class.

There were little demographic differences among those who raised their hands, at least as far as I noticed, other than the few married women who didn't.  If you must know, I also raised my hand, but it's not a static answer for me. I'm on the upper end of that age range and four years is a long time for me to be rotting in a jail cell.  I've got friends and family I love dearly and wouldn't want to miss seeing.  I'm also certain that if I figured out who exactly I'd be damaging with my immoral / illegal actions, I might not follow through.  I find it's a lot easier to answer "yes" to a question of an illegal act when the question is asked in a void, but it's also much tougher to actually follow through on that act in real life.  

All this is beside the point, however. MBA Students (and MS - Finance students) are supposed to be smarter and (I suppose) less immoral than rest of the world.  I imagine the results of this poll would skew quite high if given to the population at-large, but the class this poll was asked of are supposed to be future leaders -- future leaders of large corporations that will hold the financial well being of tens of thousands, or even hundreds of thousands of workers' lives in their hands.  

All the students wrote essays to gain admittance to school, and all their essays discussed the "good" they'd like to do in their future career as well as the unique and interesting career paths they believe that earning an MBA will open for them (management consulting and investment banking, at the time the essays were written, are unique?).

Anyway, nearly all the students I know are in B-School to make more money.  There are few non-profit, humanitarian types in the program but for the most part we're all here just to earn larger paychecks. That's it. Plain and simple.  

So basically, 90% of MBA students are not just generally a bunch of cheats but also liars since their admissions essays were anything but honest!  And yes, I'm completely comfortable extending generalizations to every B-School and MBA student in the country after the completely unscientific and informal polling I conducted at mine.  I wonder if, when they're reading the admittance essays, the adcoms aren't just looking for the most riveting piece of fiction they can find since we all lied about our future hopes to save the whales and the rainforest? Well, maybe after we make our first $100 million we'll have whaletanks installed in our mansions and rainforest terrariums installed in our million dollar greenhouses, thereby following through on the empty promises we wrote in our essays.

All this pretty much got me wondering whether financial gain attracts the amoral / immoral or whether the amoral / immoral are attracted to financial gain?  I have to admit that I give the professors a lot of credit for trying their hardest to sway us and the HR Profs do an especially admirable job in this respect, but if the students are already money chasing cheaters, what difference can a few enlightened lectures make?  

Anyway, in the wake of the meltdown and news items claiming MBA degrees are no longer worth it, I'm really starting to think I should have earned my Master's in something less sleazy, more honest and more respected....  like law!  Hey, at least I'd have a job next year prosecuting all those immoral MBA-ers who caused this mess. 

NFL Overtimes

There's a lot of animosity in the local media here in Philly directed toward Donovan McNabb for not knowing that NFL games can end in ties.  Presumably, McNabb might have played differently if he'd known that games can end in ties but I don't want to weigh in on that debate. Instead, I'd rather ask why the NFL hasn't converted to the college system? NFL overtimes don't grant equal possessions to each team (which has been a problem for a long time), and the sudden death format is unfair because of this.

College overtime games can sometimes have ridiculous 70-69 scores if there are multiple overtimes and the league probably doesn't want to invalidate old touchdown, yardage and scoring records, but there are ways to ensure the scoring doesn't get blown out of proportion in "equal possession" overtimes. 

The easiest way to do this is for the NFL to adopt the college model but simply adjust it.  NFL teams should begin the 1st overtime with equal possessions from the 20. Then from the 30. Then from the 40. Then from the 50. The second overtime should, like college, require a two-point conversion if the team scores a touchdown.  It's still possible overtime games could end up with high scores, but the chances under this kind of system would be greatly diminished while satisfying the "fairness" problem of the current overtime system, providing fans a much more exciting game and also eliminating ties (something I think American sports fans hate more than losses).  

Update: Apparently McNabb also didn't know that playoff games and SuperBowls don't end in ties.  Which makes me wonder what he thought would have happened then?  Did he think teams that end up tied in a playoff game both advance?  How miserable would that be for the poor third team that has to play the other two??? Sheesh...

Good Financial Innovations?

I missed the opportunity a few weeks ago to offer my thoughts on the debate between Dani Rodrik and Steve Randy Waldman about financial innovation.  Rodrik sparked the debate by asking for:

... some examples of financial innovation -- not of any kind, but the kind that has left a large enough footprint over some kind of economic outcomes we really care about.  What are some of the ways in which financial innovation has made our lives measurably and unambiguously better?

My answer to Mr. Rodrik would be... Mortgage Backed Securities.

Unbelievable huh? How can I possibly say Mortgage Backed Securities are financial innovations that have made our lives measurably and unambiguously better?

Well, I can say it because the creation of the secondary mortgage market has been invaluable to millions of Americans (perhaps even hundreds of millions).  By creating a secondary market for mortgages, more people are able to borrow to get the home they want.  MBS's allow regional banks to diversify their mortgage pools and stay afloat, even if tough economic times hit their region.  For instance imagine if, in sunnier economic climes, the automakers collapse but no secondary mortgage market exists.  All the Michigan autoworkers would default on their mortgages and the regional banks holding all those mortgages would also fail (if the banks had been willing to lend to everyone in the region in the first place). The domino effect caused by failing banks in a state that's also decimated by job losses would be catastrophic.  Failing regional banks would cause "Main Street" problems on a terrible scale for whatever region they're in. But by packing up mortgages and sending them somewhere else (or by buying mortgages from a different region), the regional banks, and the region itself, are more insulated and protected from this kind of catastrophic failure. 

What we have to understand (and what Mr. Rodrik should understand) is that the ability to securitize a mortgage has been exploited and although Mortgage Backed Securities are now seen as tools of financial destruction they've probably helped every homeowner who is reading this blog to buy their home.

Financial engineering instruments are tools, plain and simple. They're neither inherently good, nor inherently evil, they're just tools. So the right question isn't "what financial innovation is good?"  The right question is, "How do we stop shysters from using financial innovation for evil?"

After all, nobody asked whether or not airplanes were good after 9/11.  We asked how to stop terrorists from flying them into buildings. The current situation is no different. There are a huge range of financial innovations that offer loads of potential benefits to millions of people both directly and indirectly.  When I pull out my "FE toolbag" (if you will), I'm able to structure payments and cash flows from any investment in any way imaginable.  Smooth cashflows from an investment are incredibly helpful and desired by every business on the planet.

But, as the good finance profs teach, all financial engineering relies on prior assumptions about the underlying investment. If your assumptions are wrong, then your FE instruments won't matter in the least -- and might actually exacerbate your problems. Financial Engineering in its (relatively) short rise to popularity, has instilled a lot of false confidence in the investors who have used them. First it was Salomon in the '80s, the LTCM in the '90s and then (apparently) everyone in the 2000s.  All these people, at some point in their use of FE instruments, either believed they had successfully engineered their way out of danger, or had magically FE'd their way into fantastic profits. They all forgot, or didn't care, that if the assumptions about the underlying investment are wrong, then all the FE instruments in the world won't matter in the least when the piper comes calling.

Now then, I can understand if Mr. Rodrik, and others, want to say that FE instruments have no value because accurate predictions about the future of any investment are a crap shoot at best... but that's a completely different argument. The argument should be whether or not we can stop the exploitation of financial innovation for profit (and also the disturbing tendency of risk managers to blindly trust derivatives as perfect hedges). It doesn't matter whether the answer to this problem is oversight and regulation of the instruments, oversight and regulation of the people who use them, or even if the eventual answer is a consensus that abolishment is the only way to stop their abuse.  In the end, the only thing that matters is making sure financial innovation isn't abused anymore.

And if, in the end, we can't stop people from profiteering through financial engineering tools and abolishment becomes our only answer, then that says more about human beings (and the MBA whizzes on Wall Street) than it does about the instruments themselves.

Fear and the Liquidity Trap

Paul Krugman put up his analysis of liquidity traps and how he thinks they can be stopped.  I love Krugman but I think his use of expectation theory (as to how it relates to the money supply) is a little off base. Expectations about the future of the economy and expectations about future job security are what drive future spending (or cash hoarding) much more than expectations about the future of the money supply or future monetary policies.

Krugman believes the government has to fool the public into believing it's going to keep interest rates low and the money supply high almost indefinitely to avoid a liquidity trap. If sufficiently fooled he believes this will lead to spending and will stop people from hoarding cash.

I find this hard to believe.  Fear of unemployment and fear of future economic conditions are greater fears.

Economists tend to look quite a bit at the unemployment rate when calculating the severity of a recession, but the duration of an inflated unemployment rate is just as important. US Unemployment spiked to over 25% in 1932 and remained  above 14% for nearly 10 years (from 1930-1939).  Contrast that to our non-Great Depression high of just over 10% in 1982, that lasted less than two years.

An inflated unemployment rate of 10% that lasts for more than few years affects more than just 10% of the workforce.  During that time, it's not a constant 10% of the people who remain unemployed, but rather a revolving, cycle of workers gaining and losing jobs that ultimately affects a much larger portion of the population. People who have lost their jobs, fought for another one and then lost it again will have a hard time being convinced that jobs and money are future guarantees.  People who have experienced a decade long cycle of this may never be convinced again.  Which goes a long way toward explaining why Great Depression survivors hoarded cash their whole lives.

Okay, so that helps explain the Depression, but what about Japan in the 1990s and their liquidity trap?  Their recession was not nearly as deep nor as long as the Great Depression, so why the liquidity trap there?  Why did it take ten years for their people to resume spending and producing?  Well (and I admit this theory may be a bit of stretch) the Japanese are a different culture.

They're a small, tightly-knit group of islands that value honor and work above most else. Japan's population is a largely homogeneous group that holds a collective devotion to 'honor' and views the loss of a job and the loss of money, as disgraceful and dishonorable. Failure is nearly always viewed as a personal flaw in Japan as opposed to we Americans who frequently blame everyone and everything else failures.  The Japanese worker's ability to provide for his or her family in the future, and the loss of their honor if unable to do so, resulted in hoarding of cash when the country faced economic uncertainty.  There are, of course, a number of other factors and more hard and concrete evidence that the Japanese government may have flailed a bit during the years following the Asian crisis and that may have exacerbated the problem, but taken together with the Japanese mindset so fixated on honor, it seems likely that a liquidity trap couldn't be avoided.

In short, I believe the length and duration of the coming recession are what could potentially cause a liquidity trap in the United States, not misdirected fiscal policy or wrongheaded government spending.  If (as the Austrian Economists like to say) the boom leading to the collapse is sufficiently large, then the resulting recession will match it in length and depth. So if this recession is long enough and deep enough, and if consumers weren't saving enough during the boom period, then nothing will stop the recession from being deep and long. The end result could quite possibly be a universal skittishness, constant fear and a lifetime of uncertainty about the economy that will haunt the recession's survivors.

My grandparents and great grandparents are perfect evidence of this.  They lived through the Great Depression and those years affected them so deeply that they really never increase their spending for most of their lives.  They put their money in CD's, low-risk bonds and savings accounts that, most of the time, didn't beat inflation.  My American grandparents, in particular, were doing this until their recent passing just a few years ago. No amount of fiscal or monetary policy or even decade long booms convinced them of the resilience of the US economy, nor did long, sustained booms convince them that jobs and money weren't impermanent, ephemeral things.  In short, they were motivated to hoard by their fears just as the Japanese were motivated to hoard by their fears.

Let us hope this recession is not as deep and long as some fear (though Mr. Krugman himself was on CNBC last week predicting the recession and inflated unemployment would last through 2010 or perhaps 2011… yipes).

In closing, I'll leave you with a nice video of Peter Schiff, an Austrian School adherent who runs his own brokerage firm.  Mr. Schiff is seen in the video predicting the recession and collapse and debating with Felix Salmon's personal enemy, Ben Stein (who appears particularly gas-baggy in these clips) about the economy and the value of financial stocks.  Most of the people Mr. Schiff debates with laugh at him.

Oh, and lest you think I'm an Austrian School devotee myself, please realize I don't share their views about the uselessness of the Fed and government, in general.