David Sokol knows how Buffett and Munger think. He knows what would be attractive to them.

So, even if the initial comments from Buffett were negative on the purchase of Lubrizol, Sokol, having more data, could be confident, because once the full data were available to Buffett and Munger, the deal would likely be done.

Sokol has been one of Buffett’s CEOs for awhile.  You think he can’t recognize another man who would be a good fit for Buffett?  I suspect he knows the pattern intuitively.  Buffett likes managers who think as he does; Sokol knows what sort of manager that is; once Buffett talked to the CEO of Lubrizol, the deal would be done.

With that as background, I fault Sokol for buying a lot of shares of Lubrizol, knowing that he would recommend the purchase to Warren, where the odds were in his favor that Warren would buy.  This also takes into account the goodwill that Sokol has with Buffett and Munger, given his management of MidAmerican, and his turnaround of NetJets.  Don’t think that that means nothing, even if Buffett says otherwise.

My view is that it was unethical, but not illegal, for Sokol to recommend the purchase of Lubrizol without disclosure of the size of his position in Lubrizol.  Mere mention of a position is not enough, unless it was a small position.

Yes, Sokol could not force the purchase, but he could have not brought it to Warren, in which case he would have made or lost money off of operations.  By buying, and then recommending the stock to Buffett, he raised his odds of a successful outcome.  That is a way of misusing your influence within the organization that you serve, which is unethical.

UPDATE 9:30 AM 3/31

Kid Dynamite did a post on this, and asked me to comment.  Here it is:

You have not misinterpreted me, KD. But in the cold light of morning, I have thought of one more issue… why is Buffett so loosey-goosey with things that ought to be mandatory disclosures for avoiding potential conflicts of interest?

Every firm I have worked for, and even now at the current small firm that I run, there were/are mandatory disclosure rules. My promise to clients is that I get the same results they do, win, lose or draw.

Regardless, it highlights a weakness in Buffett’s highly qualitative way of managing his company and managers. You not only have to avoid breaking the law; you have to avoid the appearance of breaking the law, or even the “fairness code,” however defined. And, he has said as much to his managers in his biannual memo to them:

The priority is that all of us continue to zealously guard Berkshire’s reputation. We can’t be perfect but we can try to be. As I’ve said in these memos for more than 25 years: “We can afford to lose money – even a lot of money. But we can’t afford to lose reputation – even a shred of reputation.” We must continue to measure every act against not only what is legal but also what we would be happy to have written about on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter.

Sometimes your associates will say “Everybody else is doing it.” This rationale is almost always a bad one if it is the main justification for a business action. It is totally unacceptable when evaluating a moral decision. Whenever somebody offers that phrase as a rationale, in effect they are saying that they can’t come up with a good reason. If anyone gives this explanation, tell them to try using it with a reporter or a judge and see how far it gets them.

If you see anything whose propriety or legality causes you to hesitate, be sure to give me a call. However, it’s very likely that if a given course of action evokes such hesitation, it’s too close to the line and should be abandoned. There’s plenty of money to be made in the center of the court. If it’s questionable whether some action is close to the line, just assume it is outside and forget it.

And Buffett implicitly confirms such a view by accepting Sokol’s resignation, with no hint that he tried to argue him out of it, as he did twice before. Implicitly, Sokol’s unethical behavior led to him leaving Berkshire Hathaway — one can try to dress is up otherwise, but it fails the smell test.

Recently, I made a visit to the Cato Institute, and I bumped into a guy who indicated he was interested in investing with me.  We exchanged cards, and around 10 days later he called me, telling me about his scheme for investing the money of (my and other) IRA investors in wind farms that he had in upstate New York.

He talked for a while, and I said, “So are these limited partnership interests?”  He said no and rattled on about the opportunity.  I then asked, “Is this a private company, and you are offering shares?” He said no and rattled on about the opportunity.  I then asked, “Are these general partnership interests?  He said no and rattled on about the opportunity.  I then asked, “Is this some sort of structured note?”  He said no and rattled on about the opportunity.

I then said, “Stop.  If after five minutes, I can’t tell what it is that you are doing, it can’t be anything good.  I have worked in almost all areas of the securities markets, and if you can’t tell me the legal form of what you are doing, I have no interest, particularly not for my clients.” He rattled on about the opportunity, and I hung up on him.

Note: confidence is not a bad thing, but hyper-confidence is.  If someone is not willing to quickly trot out the risk factors on an investment, avoid them.  All investments have risk.  REPEAT: ALL INVESTMENTS HAVE RISK.  There, I feel better now.

I have said before, and I will say it again, “Don’t buy what someone is trying to sell you.  Buy what you have researched and want to buy on your own.”  Hey, I got cheated on penny stocks when I was young and inexperienced.  Many of us make mistakes when our knowledge is immature.

Also, even in institutional investing, I can tell you that complexity is the enemy of the one receives it.  I avoided most complex transactions when I was a corporate bond manager.  While working for the hedge fund, I happily set up a structured note that reflected my view of the world, after refusing one the broker created.  We won on that one.

So avoid complex investments.  Particularly avoid investments that you don’t understand.  At minimum, find a competent friend, or some neutral party that will look at the deal.  If you can’t find such a friend/party, don’t do the deal.  The friend is important, because he does not want you to come to harm, or lose you as a friend if things go bad.

I have a friend, the son of a dear deceased friend of mine, who seemed to attract Nigerian-style scams the way dryer traps collect lint.  I finally took him aside and said to him, “Ignore these.  If it is too good to be true, it most likely is too good to be true.”  Happily, he took the hint, and did not lose a dollar to the scammers. (I lost a couple hours proving the opportunities were bogus.)

Financially, this is a dangerous world, outside of the well-established channels for investment.  (I write this as one with significant private equity investments.)  Be careful in how you allocate your funds, and don’t give into a slick pitch that promises high returns (over 7%), or extreme safety (no way you can lose), without significant due diligence.

Update: One more note.  I often find it useful to ask the seller to send me all of the documents, and tell him that that I might pass them by my lawyer.  I don’t have a lawyer; for practical purposes, I am my own lawyer on securities matters.  I can read the documents myself as well as any lawyer.  But that usually cools the ardor of any con man; he knows that the deal will not get done, and he gives up.

I often have to deal with practical “small institution” problems, because of the church I belong to.  Here are two of them:

1) The pastors have a defined contribution plan.  There are two questions.  Are the funds the best that we can get?  Are the asset allocation options that draw from those funds properly calculated? (Two-thirds of the pastors use those.)

For the first question, we have a board member who works for a major fund consultant.  He will easily be able to answer the question.  As for the second question, I have analyzed how the offered funds have done over the last 20 years.  Those allocations have done well in the past.  The problem is, when did the consultant do the look backwards and set the percentages?

The tendency is that once the percentages are set, future performance tends to decline.  Select managers who have done better than they normally would, and watch them regress to the mean, or worse.

My view is select managers that have done well for reasons that are not common to the environment that they were in.  There are often trends that benefit certain managers, then once the trend goes, they are gone as well.  But who did well in spite of the trend?  Those are managers to look at.

2) Recently, four members of my congregation came to me and said, “Here’s the list of managers in my401(k), who should I invest with?”  and “Here’s the portfolio my husband left me (after death), what should I do?  I can never turn down a friend, and particularly not a widow.

This was interesting.  As I looked into the mutual funds, I relied less and less on the performance statistics, and Morningstar stars, but looked at the actual portfolios in concert with performance, and decided that those with unusual portfolios with reasonably good performance were better choices.  Why?  They aren’t following the market.

Today, I ran into a name for that concept: Active Share.  How much does a manager vary from the index?  If you’re going to be an active manager, you ought to vary from the index quite a bit.  That is what you should be paid to do.

“But wait,” says the fund marketer, “Beating the index is the best, but missing the index is the worst.  We survive best with performance that is out of the fourth quartile.  So hug the index as you make modest bets against the index.”

Those are the portfolios I want to avoid.  An article in the WSJ concurs.  Don’t pay active fees for index-like performance.

I feel that way about my own investing.  If I am not looking at stocks that are less considered than most, then what am I getting paid for?  I would rather fail unconventionally than succeed conventionally.

And yet I know that managers that have high active shares, though they may do well on average, get excluded by fund management consultants, because they are too unpredictable.

Look, I am trying to make money for clients.  Consultants are a necessary evil in that process.   Clients would be better off without consultants, but that will never happen, because clients want to stay out of the fourth quartile.

My active share is large, and I have done well.  Does that mean that a lot of people will invest with me?  Probably not, because they are not willing to endure an odd portfolio that isn’t mainstream.  Well, that is their loss.

There is one main reason why I have never been tempted to read any book by Ayn Rand.  Her disciples are monomaniacs that if they were anything more than a tiny minority of society, would make life miserable for most people.  I have never met one that I would want to have as a neighbor.  They have the zeal of a religious cult, and twice the negative wisdom.

I write this as one who is a libertarian, but with a sense of ethical values, and a belief in regulating financial promises.  Selfishness is never a virtue.  Anyone who has raised children would know that.  Anyone familiar with what it is like to work in an office with one who is selfish would know that.  Anyone who is the child of a selfish person would know that.  And, surprise, most political scandals involve someone who has been selfish in the use of their office.

Selfishness makes life hard on those nearby, who have to live with the backwash of the actions of the selfish one.  We have seen in corporate America the actions of selfish people who run corporations, and goose their own pay to the detriment of shareholders and employees.  It leads to losses for all, when leaders more farsighted might earn more in the long run than asset-strippers and body-cutters.

Business is a cooperative game, and those that can motivate people to work efficiently and creatively can create a lot of value for many.  But that means sharing the value, not being selfish.

Recently, I have reviewed two books: Secrets of the Moneylab, and Priceless.  One major conclusion of the books indicates that people are not rational profit maximizers.  They care for status and their own sense of ethics.  They don’t want to promote greedy people, and they want to see their own relative status in society preserved.  They care what others think about them.

In one sense, followers of Ayn Rand are no better than Communists because they have the wrong model of man.  Instead of trying to create The New Communist Man, they try to create the New Selfish (Randian) Man.  Both are unrealistic for anyone caring about treating people fairly.

To the man who only has a hammer, everything looks like a nail.  In my own life, I have found that the more I act honestly, and look out for the good of others, the more I get rewarded.  I have known people who try to be tight in every transaction, and they don’t get done what I could, because they aren’t trusted like me.

Trust.  We trust those who are altruistic far more than those who are selfish.  I earned a lot more for my clients by being altruistic to Wall Street than being combative.  I got Wall Street to trust  me, and it yielded dividends for my clients.  Cooperation leads to more benefits than competition.

I have little respect for a woman who wrote a bunch of boring books, partially to justify her immoral life.  I don’t care if she favors free markets or not.  It is far better to consider whether ethical behaviour is present in the markets.

Ayn Rand was an intellectual lightweight, and a moral failure.  Following her is akin to intellectual suicide.

There are three things that I am happy with when it comes to writing about investments:

• I am glad that Jim Cramer invited me to write for RealMoney seven years ago.  Motown Josh Brown put together a great piece on the influence that TSCM has had on the financial media.  I heartily agree, and I don’t think we know the half of it.  I interacted with a lot of young TSCM staffers, and it amazed me what an education they got in the markets working for TSCM.  TSCM blended respect and skepticism for the markets, and though you couldn’t have done it without Cramer, the effect on the financial media exceeds him, and for that we can all be grateful, because the financial media is a lot sharper than it was 15 years ago.  (Okay, leave out much at CNBC.)  And who knows, maybe I will return to TSCM someday in some capacity; the door is open.
• I’m glad I started my blog.  I still think that financial bloggers are the conscience of Wall Street.  There is a need for knowledgeable people to write about economic/investing/finance issues.  It does not replace journalists, but supplements them.  Intelligent commentary complements “neutral” reporting on a topic.  Journalists learn from area experts, playing them off against each other to get a fuller picture of the debate.  (As an aside, the motive to start the blog began on one of the comment boards at TSCM for Cramer.  Readers were fascinated that I would post there, and told me I needed to develop my voice.  A few called me the anti-Cramer, but I never took up that moniker.)
• I am grateful that I am a CFA Charterholder.  Harry Markopolos recently spoke to the Baltimore CFA Society, mainly about his uncovering of the Madoff scandal, but he spent a decent amount of time explaining why the CFA Institute and our ethics code can make a huge difference in reforming Wall Street.  I was impressed; his beliefs in honesty and fair dealing drive his actions.  (I talked with him afterward, and we realized we must have met seven years before, at a regional meeting of the Northeastern CFA societies, when I was sent by the Baltimore CFA Board to represent us in a ticklish issue regarding the leadership of AIMR.  He had helped lead the effort to replace the existing leadership.)

But that’s not my major reason for writing tonight.  I want to comment on two pieces in the Wall Street Journal that comment on shady practices.

The first one is entitled Shining a Light On Murky 401(k) Fees.  The Department of Labor has the dubious distinction of being less effective than the SEC on investment regulation.  A lady I sat next to at the Denver conference regaled us with how her daughter’s 401(k) plan had expenses equal to 12%/year of assets.  I hope she made a math error, but she is a Ph. D; it’s not likely.

From my own experience at Provident Mutual in the nineties, it was easy to see how expenses could get layered.  We tried to be among the more ethical in that business, but the temptation to pay a lot in order get more business was dangled in front of us regularly, and we refused.  We had a rule that if comp was not disclosed, agents had to disclose that comp was not disclosed. And if they took nondisclosed comp, they could not have additional disclosed comp, because it would give the illusion of “That’s all I am paid.”

Do we need limits on 12b-1 fees?  I would prefer a full disclosure of fees — who and how much, poking through relationships to explain who ultimately is giving services to the 401(k) plan, and who is collecting rents as “gatekeepers” for the plan.

There is a lot to be done here.  Would that the DOL would invest a little money in buying skeptical experts, and really grasp the complexity of what is going on there.

The second one is entitled Structured Notes: Not as Safe as They Seem.  When I (along with others) was taking a demo of a custodian recently, the rep of the custodian went out of his way to show the area of the website that offered structured notes.  I commented, “Those are evil. They offer yield, but they make people short expensive options.”  After an embarrassed pause, the rep said, “Let me demonstrate an area of bonds that is not evil,” and he moved onto Agencies.  I didn’t have the heart to tweak him twice.

I wrote a piece a while ago called “Yield, the Oldest Scam in the Books.”  Structured notes offer above market yield, while that yield, or some of the capital, could be negatively affected if events perceived to be unlikely would occur.  The investment banks can hedge those risks more effectively than the Structured Noteholders can, and they pocket large profits.

The concept of “contingent protection” annoys me.  The odds of triggering such protection are much higher than the average person expects.

Do not buy structured notes.  The investment banks know far more than you.  Do not buy what others want to sell you.   Use your good mind, and buy what you like.

There is no one on Wall Street looking to do you a favor, so view your broker with skepticism.

Time out.  Time to have an elementary school education for those that lead us, who have pretensions to understanding economics, at least in terms of how people really work, not the idealized Homo Oeconomicus of the introductory economics textbooks.

Time for them to get a dose of behavioral economics form books like Priceless and “Secrets of the Moneylab” (soon to be reviewed).  People don’t care as much about improving their position in life as much as they do about fairness.  Why? If I did not believe in Jesus, I would say that people assume that the games that they play will be repeated in life, and so they punish those that cheat, because they prize the integrity of the system more than short term results.

There is a simpler explanation, though.  Men/(Women) were created to judge their surroundings and rule it.  Man was created on Earth for moral purpose primarily, not for increase in consumption.  When ethics are transcendent rather than a question of economic advantage (more is better), men will act against their short term interests to promote the long term good.

This is yet another reason why people don’t necessarily act on average to maximize their short-term pleasure.  People will not normally enter into deals that they find morally repugnant even if they would gain from it.  Ask a liberal if they would encourage the Nature Conservancy to sell land to Plum Creek Timber, or one of its peers.  They will object.  Wait, couldn’t they take the proceeds, and buy up more forest elsewhere?  Sorry, this is a sine qua non for them.  They don’t deal with the enemy.

I could come up with many more examples, but I am sure that I would make a lot of people angry, and that is not my goal here.  I am just trying to make people think a little more broadly about economic policy.

So the central bank decides to finance a certain financing market in a panic.  Fairness asks this: why them, and why not me, or everyone?  We don’t care if the economy would supposedly collapse without the aid of the central bank.  Things should be fair; if you are offering it to them, you should offer it to me, or everyone, or you should not offer it.

The same applies to fiscal policy.  Stimulus, should it exist at all, should apply to the broadest category of applicants.  Don’t target troubled industries, particularly those whose products are in oversupply.  Send the stimulus to average people equitably.  Let industries fail, but let consumers choose what they need.  Why should we support industries that are not needed by the public?

So when I read Daniel Henninger in the Wall Street Journal arguing that average people don’t respect spending beyond the budget of the government, I get it.  I GET IT!!!  They have an interest in fairness, which stems from their moral sense that we can’t spend beyond our means, printing press or not.  Yes, the printing press may print, but it does not create value as much as redistribute value into the hands that the government favors, and the average person suspects they are getting none of it.

I am no fan of the Republicans, but do the Democrats understand what fury they have unleashed?  What do average people think when the government runs huge deficits in peacetime?

They look at it and wonder, Why can’t I do that? Why can’t we all do that?  The moral/ethical question pops to the top, regardless of other concerns.

The model of man that economists use is flawed.  Rather than focusing on the weak concept of more is better, they should look at fairness, and other relative comparisons of well-being that people care about.

What’s that you say?  If we do that, all the pretty math doesn’t work?  The pretty math doesn’t work already.  Tests of both microeconomic and macroeconomic theory as currently construed get rejected by the data when they attempt to apply the broadest tests of the general equilibrium theories.  If I am wrong here, please forward onto me the studies contradicting this, because this is what I learned in Grad school economics in the third year — very disappointing to save it until then… why not mention it in Econ 1 & 2?  Oh, you want to keep your jobs, because it beats working for a living?  Aye, laddie, I ken, I ken.  What I don’t get is providing intellectual cover for politicians to run a huge pork barrel.

Many people are sick of the government trying to assure prosperity and failing, to the degree that many are now thinking that the government is not trying to assure prosperity, but merely help out favorites, because that is how a lot of the policy of bailouts, stimulus, credit easing and radical quantitative easing appear.

Summary

I write this because there are many politicians, economists, and journalists/bloggers who don’t get why a large number of people are angry over what the government is doing in the midst of this crisis.  They think that everyone should be grateful that they are applying the Keynesian/Neoclassical remedies that the academics imagine will work.  They aren’t like me, where I think that most of the government’s actions are long-term harmful, and it would be better to do nothing. My hope is that one day average people will know that the government cannot assure or aid prosperity, aside from providing courts and police.

But average people look at fairness, and the snake oil “remedies,” regardless of their validity, do not provide that.  That is why many are annoyed, if not angry.

When life gives you lemons, make lemonade.  Over two dozen people that survived losing a lot of their money in the Madoff Ponzi scheme wrote down their stories.  For one thing, I’m sure it was cathartic to do so.  Something that many regarded as being one of the most dependable parts of their lives ended up proving utterly undependable.

Out of loss, many of the writers rediscovered the simpler joys of life — family and friends.  Even new friends, as many of them banded together to figure out which end was up.

The tales that the authors tell are not identical, but they certainly rhymed.  Here would be my stylized example of the outline of one of their stories:

• Growing up in a lower-to-middle class family
• Being taught to work hard and be frugal
• Achieved some degree of success
• Was not sure what to do as the excess assets grew
• A family member or friend introduced me to Madoff
• Looked like a smart deal; Madoff always seemed to do well, so the person put most to all of his investable assets there.
• Sometimes even borrowed money rather than tap the Madoff funds.
• Life was good; he was charitable, enjoyed life, was generous with friends.
• The shock came that Madoff was a fraud, a Ponzi scheme.
• Adding insult to injury, learned that the SIPC would not pay off much at all of the losses, seemingly contrary to their prior actions in other cases.
• The best option for many was to file as a total loss, and recover back taxes.
• Retirement dreams turned back to work, and who would hire an old person?
• Friends and family often proved helpful, but it is hard to go from being a giver to being dependent.

Personally I would like to meet most of these people, give them a hug, and affirm to them that true wealth isn’t money, but relationships.  Poor people are poor because they lack the connections the they can trust, and have the power to help them.

Now, I don’t want to say they should not have seen this coming.  This blog is about risk control in investing.  Remember, you are your own best defender when it comes to investing, and saying “no” is almost always safer than saying “yes.”  Let me quote from a piece written near the time that Madoff was sent off to the pokey:

The sad aspect of plumbing for the financial markets today is that we are drawn to the front end of investing processes.  This man looks successful.  He has a great story; a way to make money that others do not know about.  There are documents showing his track record — impressive, though he doesn’t solicit publicly; investing with him is a family affair.  Do you want to be part of the family and gain the benefits thereof?

There are questions to be asked, particularly of nonstandard ventures:

• How are the returns earned?
• Who checks the results?  (Auditing — should not be a small firm.)
• Who has custody of the assets?
• Is the trustee a reputable third party?
• Is liquidity proportionate to the asset class invested in?
• Is this under US law?
• Do the returns look too good to be true, either in absolute amount, or always positive with low volatility?
• Is this marketed to everyone, or just a select few suckers?
• Is the profit motive of the sponsor obvious and standard?
• How are asset values calculated each accounting period?

Whether we are talking about Madoff, Stanford, or any of the other recent frauds, an attention to the details of how the financial plumbing works can pay off in terms of avoiding situations that are too good to be true.

You are ultimately responsible for losses that you receive.  Yes, no one can know everything, but if you don’t have any idea of how someone investing for you is making money, you probably should not invest with that person, because you are incapable of evaluating what they do in broad.

No one with a serious risk control discipline invested with Madoff or Stanford.  These are cases where paying a little for expert help would have paid off big.

Does that mean I look down on those that lost?  Not at all.  Most ordinary investors don’t have the vaguest idea what they are doing.  They are blessed because no one they knew would introduce them to Madoff.  For those that lost, I only have sorrow and pity.  I wish that you had friends and family that would have steered you better.  We all rely on friends, but there is still a danger in that reliance.

Quibbles

As I read more of the book, it felt like some of the authors had rehearsed story lines with each other.  Now, that is natural, because they talked with each other and planned strategy together regarding the SIPC and other hurdles.  So, I don’t begrudge that much.

What I do begrudge is the 8-page investment “analysis” at the end of the book that says that no one should have been suspicious of an 11%/year return, because equity funds from many major mutual fund companies earned 11%/year over the same period.  Total hooey.  Few would have invested with Madoff given the lack of disclosure had not the returns been so regular on a monthly basis.  The mutual funds had large runs up, and large drawdowns.  Investors, not savers, would buy such mutual funds.  The attraction of Madoff’s scam was that it was designed for savers, not investors.  No volatility, high returns, no worries.  Thus someone with the personality of a saver could put money there, and not worry, because Uncle Bernie was a genius who was taking care of them.

And indeed, Madoff took care of them, with malice.  The underfunded SIPC could do little to help, given the enormity of the fraud.

Who would benefit from this book

Anyone who wants to sympathize with and support those who lost to Madoff would benefit from this book.  It does a fairly complete job, and is not long at ~230 pages.  As I write this it is, out of stock at Amazon, but when available, you can buy it here: The Club No One Wanted To Join-Madoff Victims In Their Own Words Barnes & Noble does have copies.

Full disclosure: An author sent me a copy, after asking if I would like to receive a review copy.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

This is the first time I have done something like this, but I am interviewing an author of a book on Risk Management, which delves into the nature of the current crisis.  My interview occurs before the book is published, and lends to its publicity, which I don’t mind because I think it is an excellent book. The book is entitled, “Risk and the Smart Investor,” and is written by David X. Martin.  Anyway, here are the questions that I will ask him:

1. Imagine you are talking to a bright 12-year old girl.  How would you explain to her why and how the financial crisis happened?
2. I was fascinated with the structure of your book, which I found tedious and hokey at first, but I grew to like it.  The way I see it, you introduce the topic through your experience, then explain the theory, then show neglect of it led to failure, and then you give us the stories of Max and Rob.  How did you hit upon this intriguing and novel way to write your book?
3. Why do you suppose so few people in risk management, and senior management at major financial firms, were unwilling to consider alternative views of the sustainability of the risks being taken as the risks got larger and larger relative to the equity of individual companies, the industry as a whole, and the economy as a whole?
4. As a risk manager, bosses would sometimes get frustrated with me when they wanted a simple answer to a complex question that had significant riskiness.  They did not like answers like, “I don’t know, it could have six significant effects on our company.”  How can we convey the limits of our knowledge in a way that management can get the true uncertainty and riskiness of the environment that we work in?  How can we get management to consider scenarios that are reasonable, and could harm the company, but few others in similar situations are testing for?
5. In your experience, how good are the managements of financial companies at establishing their risk tolerances?  Better, how good are they at enforcing those limits, such that they are never exceeded?
6. How do you create a transparent risk culture in a firm?  How do you get resisters to go along, even if it is management that does not see the full importance of the concept?
7. Are most cases where a person or a company fails to diversify intentional or unintentional?  Do we put too many eggs in one basket more out of ignorance or greed?
8. Why do you suppose that checks and balances for risk management are not built into the cultures of many financial companies?
9. I have a friend Pat Lewis who developed a risk management system for Bear that could have prevented the failure of the firm, but it was ignored because it got in the way of profit center manager goals.  Was it the same for you at Citigroup when your “Windows on Risk” got tossed out the window?
10. Can culture and personal judgment work in risk management ever?  Take Berkshire Hathaway – risk control is embedded in the characters of a few people, notably Warren Buffett and Charlie Munger.  If the culture is really, really good, and it comes from the top, can risk management work when it is seemingly informal?  (Remember, you don’t want to disappoint Warren.)
11. How can you teach younger people in risk management intuition about risk that helps them have a healthy skepticism for the results of impressive complex modeling?
12. Is it possible to do effective risk management in a financial firm if management is less than wholeheartedly committed to the goal?
13. Aside from AIG, and other financial insurers, the insurance industry came through the crisis better than the banks because they focused on longer-term stress tests, and not on short-term measures like VAR.  Should the banking industry imitate the insurance industry, and focus on longer-term measures of risk, or continue to rely on VAR?
14. Seemingly the big complex banks did not analyze their liquidity risk, particularly with repo lines.  Why did they miss such an obvious area of risk management?
15. How much can risk management be shaped in financial firms by the compensation incentives that employees and managers receive?
16. I have often turned down shady deals in business, saying that you only get one reputation in this world.  How do you encourage an attitude like this in financial firms among staff?
17. A lot of portfolio management and risk management is juggling different time frames.  Is there a good structure for balancing the demands of the short-, intermediate-, and long-terms?
18. Most developed country economic players assume that wars will have no impact on their portfolios.  Same for famine, plague, or environmental degradation.  What can you do to get investors to think about the broader risks that could materially harm their well-being?
19. Are Rob’s more common in the world than Max’s?   That’s my experience; what do you think?
20. At the end of your book, one of your friends dies.  Did you mean to teach us that even if we manage our risks right, we still can’t overcome problems beyond our scope, or were you trying to say something else, like creating a system or family that can perform well after you die?

In my last post on this topic, I went over the orthodox and unorthodox monetary policy responses to the crisis in the US.  Here were the orthodox options:

• Lower the Fed funds rate into lower positive territory.
• Offer language that says that the Fed Funds rate will be low for a long time.
• Buy more long-dated Treasury bonds.

And the unorthodox options:

• Lend directly to classes of private borrowers.
• Create negative interest rates for Fed funds.
• Debase the currency by expiration dates, lotteries, etc.

On orthodox policy: I’m not sure there is that much difference between Fed funds at 0.25% and 0.10%, except that money market funds will find themselves in further trouble, as yields are too low to credit anything. That the Fed will be on hold for a long time seems to be the default view of the market already, so an explicit declaration would likely prove superfluous.  On buying long-dated Treasury bonds, that will benefit the US Government by pseudo-monetizing the debt, but won’t help the real economy much.

Yes, some high-quality corporate and mortgage bond rates will be pulled down with it, but so will discount rates for liabilities.  The same applies to spending rules for endowments, and how much retirees can get if they go to buy an annuity.  The effects of QE are mixed at best, and on balance, might be depressing, not stimulating.  But what practical proof, if any, do we have that QE has ever worked?

We need policymakers to understand the bankruptcy of the theories they are working with.  So many macroeconomic models work with one interest rate.  But in the real world there are many rates, and duration and quality of lending make a huge difference in what rate is charged.  I would urge that every person who would be on the FOMC work at a buyside firm managing bonds and money market instruments.  Let them see how the markets really work, and it might disabuse them of their false neoclassical views of how the lending markets work.  Better still, if their P&L is less than the cost of capital, revoke their appointment.  It’s time to kick out the academics, with their failed ideologies, and let those who have worked in the markets successfully manage the economy.

Direct Lending

But then there are the unorthodox methods.  When Social Security came into existence, they argued over where the money would be invested.  It was decided that the only fair investment was in government bonds, because it was neutral.  Investing in other assets, like the S&P 500 would be unfair, because they would be favoring a sector of the economy.

The same argument applies to direct lending by the Fed, because it would smack of favoritism.   Going back to my last article, favoritism undermines confidence in the system, and makes people less willing to invest unless the government gives them an edge — cash for clunkers, $8,000 tax credit, etc.  We are Americans, after all.  Why buy from the retailer now, when you know that there will be another sale coming soon?  Economic policymakers should not rely on people to behave “as usual” when policy becomes unpredictable and unfair to the average person.

So I don’t see direct lending by the Fed, or buying high yield bonds, or offering protection on baskets of bonds as wise moves.  It may temporarily goose an area for a time, and make an area of the economy QE-dependent, or stimulus-dependent, but at best it is helping a few, while discouraging the rest.

Negative Fed Funds

I’ve been thinking about negative rates for Fed funds, and I think that they will have the following effects:

• Banks will drop their excess reserves at the Fed to zero, and vault cash (or its short-term debt equivalents) will increase.
• Banks will try to borrow from the Fed at negative interest rates, if they allow it, and just sit on the cash, park it in T-bills, Top-top CP — it’s free money, after all.  Of course, some point free money may be construed as valueless money, but that is another thing.

Required reserves are not a large percentage of liabilities.  Unless Fed funds goes deeply negative, it’s not going to affect bank profitability that much.  Banks may just view it as a cost of doing business, and pass it on to customers.

Destructive Creative Currency Debasement

With apologies to Schumpeter, who popularized the concept of creative destruction, I’ll try to define a new concept that is the opposite — destructive creativity.  Destructive creativity is when bureaucrats or regulators get too clever, and in an attempt to solve a lesser problem, end up creating a bigger problem.

I’ve heard proposals for further debasement of the currency via placing expiration dates on currency, or randomly canceling currency through lotteries based on the serial numbers on the bills.  The idea is that people will change their behavior: save less and spend more.

I can’t say that I can see every unintended consequence with these proposals, but according to Keynes, Lenin said, “The best way to destroy the capitalist system is to debauch the currency.”  These creative means of debasing the currency might do it.

Who gets to be the one holding the Old Maid card as expiry draws near.  How much time would be wasted scanning currency at registers as money is handed over and change is handed out?  Is the money cancelled or expired?  Close to expiration?  Quick, put it into the pile to give as change to the next customer.  There may be legal tender laws, but I can tell you that there would be fights over things like this.  Would all of the dollar bills used as a shadow currency overseas come trotting home?

If the Fed wanted to write its own death warrant, it should implement schemes like these.  The Fed is already viewed with enough skepticism by average people, that it wouldn’t take much to tip the scale from “Audit the Fed,” to “End the Fed,” where it gets replaced with the currency board tied to a commodity standard.

This leaves aside ideas like expiring/canceling a certain amount of monies in savings or checking accounts.  After all, why stop with the paper money?  Move onto the blips that we transfer day after day, silently, quietly choking the economic well-being of people, making them feel less safe, less secure, more paranoid.  Would we set up checking/savings accounts in other currencies to avoid this trouble?  Would that even work, such that we would have to set them up in foreign countries, and access funds that way?  What’s that you say?  Exchange controls?  Destructive creation indeed.  To “solve” a smaller problem, a dud economy, create a much larger problem…

Want to kill the economy/country?  Taxation is one thing, confiscation is another.  There are more than enough people who have question marks in their heads over what the government is doing with monetary policy and stimulus.  Aggressive actions to debase the currency can turn those question marks in to exclamation points.

This has gone longer than I thought.  Time to hit publish, and I will finish this tonight.

I appreciate my readers.  That doesn’t mean that I am the fastest to respond to e-mails, but I appreciate what they write, even when I don’t agree.  But here is an e-mail very relevant to tonight’s piece:

Great series, David.

If you have more posts planned, it would be interesting to know what the biggest mistake you’ve made that you learned from the most.

In my short tenure as a corporate bond manager, I had a very good run in the midst of a bad environment.  Sometimes I think my lack of formal training was a plus for analyzing a situation where little was going well.

But I did make my mistakes. One was Enron — don’t get me wrong, I urged the sale of Enron bonds, but was countermanded.  Could I have argued the cause better?

• Fast-growing company in a slow-growing industry.
• Management that could not take criticism.
• Growing profits, shrinking cash flow.
• We had a peek inside the veil, because we had financed some of their private deals.  The complexity was astounding.
• Opaque balance sheet.

I made all of those points and still lost; my new bosses were not deep when it came to corporate credit; they were skilled in other areas of the bond market.  I eventually ended up selling the Enron bonds at an unfavorable price.  Would that I had sold on the date of the default, rather than a month later.

Then there was the Teleglobe situation, where I erred in many ways.  BCE, Incorporated had a unregulated subsidiary called Teleglobe.  Think of Global Crossing, and other marginal telecom ideas.  BCE was a sound company, and they offered verbal support for their subsidiary, but would not put it into writing, and formally guarantee their debt.

I did not know the company well, and I had no stock price to give me aid.  Stock prices are more sensitive than bond prices, and can give warnings before bond prices move dramatically.  My analyst went off to a telecom/technology conference, where the S&P analyst disclosed over dinner that she was likely to downgrade Teleglobe because of the lack of explicit support from the parent company.

Now given the broader picture, this should have been obvious.  There were too many situations where implicit support did not translate into real support, and Teleglobe, most than most, needed support.

My analyst called me after the comment from the S&P analyst, and I asked, “Should I sell?”  He said I should wait; he wanted to gather a little more data.  We had our opportunity to sell at $90, and waiting missed that.  By the time he returned, the S&P analyst indicated that a downgrade was likely, and the pseudo-price fell to $70.  But, we were now determined to sell.

So I called my favorite broker, who was at the only firm making a market in Teleglobe bonds.

DM: “What’s the market in Teleglobe bonds?”

FB: “$68/$72.”

DM: “Very good.  I sell you $XX Milllion of Teleglobe bonds at $68.”

FB: “I’m sorry, that’s not a real market, that is an indicative market.”

DM: “So where is the real market?”

FB: “We’ll take an order from you.”

DM: “You mean there is no real market?  You brought this deal to market, you have to maintain a market.”

FB: “We’ll take an order from you.”

DM: (Pause) You have an order for $XX million Teleglobe bonds at $65.

FB: “We will do our best for you.”

To this day, I have no doubt that she was serious with me.  Teleglobe bonds after that point traded in the $50s, but never at the main broker.  As I learned later, they had 10+ times more Teleglobe bonds than I did, and were trying to minimize their own exposure.  They lost a lot more than I did.

When BCE sent Teleglobe into bankruptcy several weeks later, we sold the bonds at $20.  The eventually went out as a zonk.  No value.

Lesson learned: bonds are asymmetric.  You are paid to be cautious regarding failure.  When in doubt, sell.  Also, don’t take your broker at face value always.

The fallout from the Teleglobe failure was twofold.  1) the client accused us of incompetence, because we had missed on Enron, KMart, and Teleglobe. 2) My boss asked me how I could have missed it, and I said, “I was following it and did the best I could.  But I am following over 500 credits.”

Sadly, he made the wrong decision, and hired another corporate bond manager, and we split the portfolio.  It led to poorer portfolio management.

Another error: I am not politics-sensitive.  I am more interested in doing what is right for clients, than what looks best.  So when the client proposed value destroying ideas that would benefit them directly, I argued against them.  The asset manager took me out of direct client contact, aside from actuarial risk management, but asked me to tell them what was up, because the client asked for weird things.  The same applied inside the asset manager, where my willingness to take or avoid risk was in sync with opportunity, but out of sync with the firm.

I had learned to avoid undue pessimism from the high yield manager who sat next to me, and that often made me more optimistic amid gloom than others in the firm.  I was not a pea in the pod, and perhaps that made those that had acquired my firm wonder about me.  I never did anything more than make my opinions known, but that is enough for some to take umbrage.

Maybe the point is this: you can be right in the long run, but wrong in the short run.  What eventually happened to the client?  Well, I mentioned all of the dismissals before, but as God would have it, the client was sold yesterday to hedge-fund manager Phil Falcone.  The new CEO of Old Mutual said:

But just to remind you of the background of the transaction, we bought US Life in 2001 with the aim of building a Life business in the United States. This has proved to be a poor acquisition for the Group, and we acknowledge it, largely due to taking excessive credit risk, the impacts of which came to a head in the 2008 global financial crisis. So we said in March we intended to explore the sale of the business.

Old Mutual pumped in hundreds of millions in capital, in addition to what they paid for it.  They lost badly.  But they did not list the real reason why they lost, which gives me little confidence that they will do better in the future.  They lost because their US life division sold policies at levels that did not cover the cost of capital.  In order to avoid the inevitable losses from selling policies too cheaply, they pushed those who invested for them to try to make it up by taking much more risk.  The risk didn’t come first; what came first was a bad management culture that pushed sales growth at the expense of everything else.

Hopefully, Mr. Falcone will see that and realize that sales aren’t everything, and dial back investment risk.  But who can tell?

My main errors came from mis-estimating people.  I was not strong enough to change the culture, and I should have realized that, and tried to be more incremental.  As it was, I was right, but frozen out from being able to effect change.

Final episode tomorrow, most likely…