Do recent economic events represent an intelligence failure?

[Ann Lee Gibson]

A few weeks ago, in response to Bill Fiora’s provocative question, “Are we in a rut, or just reluctant to share?” I posted a comment that included these thoughts:

In some ways, the business, economic, regulatory, cultural, and political events now afoot remind me of the anarchic boomtown of Deadwood, South Dakota. More so than in a long time (perhaps the Sixties), I feel like decision-makers are confused and less able to reduce risk (or at least their anxiety) when trying to forecast what will happen if they do X vs. Y. And I don’t see scenario-planning or war-gaming providing the solace decision-makers want.

In this past Saturday’s New York Times, while the Fed was planning a $700 billion financial bailout and the cessation of independent investment banking, I read this quote:

“Everyone on Wall Street is navigating uncharted waters right now,” said Jeffrey A. Sonnenfeld, a professor at the Yale School of Management. “No one could have dreamed it would have gotten this bad, and now that it is, no one is completely certain which choices were right and which were wrong.”

Why were so many people, companies, industries, politicians, and experts of all kinds (including lawyers in my world) caught flat-footed?

Was this an intelligence failure?

[Will Robinette]

Not a failure of intelligence, but a failure of execution on intelligence. How many key descision makers of these large firms that carry so much of our economy's weight were only given a small percentage of information to base their decisions on?

[Eric Garland]

It's a massive failure. Forget intelligence, it's a failure to even look at the most basic underpinnings of a business model.

As I remark over at my Competitive Futures blog, I think this whole sordid affair will make us look at the psychology behind early warning. Does early warning work if nobody wants early warning?

“No one could have dreamed it would have gotten this bad, and now that it is, no one is completely certain which choices were right and which were wrong.” This is a ludicrous statement on its face.

If this economy is so weak that it can be SEVERAL TRILLION DOLLARS UPSIDE DOWN without anybody knowing about it, then is it a real economy? Forget advanced, sophisticated early warning methodologies, this is our leaders of business and government telling us that they really can't tell when the entire banking industry is going to collapse. It's not about competitive intelligence, it's about ANY situational intelligence.

It could be the greatest single crisis of leadership of my generation.

Then again, I may just be sore because my government just asked me for $700 billion.

[Andreas Romppel]

Eric, your are absolutely right regarding the quote of this management professor - this is indeed ludicrous, and I think it is too easy to describe this total failure of the investment bank system in terms of a typical blind spot analysis.

Maybe the question you asked - Does early warning work if nobody wants early warning? - leads into the wrong direction. I think early warning happened - anybody who could read newspapers (at least here in Europe) knew what was going to happen. But: nobody inside the financial system (anywhere) obviously was interested any more in real world events (like the real estate market).

When you take a look in Nassim Nicholas Taleb's book "The Black Swan" you will find a lot of explanations of the mess we see now. I highly recommend it to every CI analyst - not only because of references to the breakdown of the financial system but because of his insights on risks, predictions, and probabilities.

Three possible reasons:

1. Mathematicians found a way to prove that black equals white (and then died on the next crosswalk, to quote Douglas Adams). Let me just cite a footnote in Mr Taleb's book (which was published in 2007!):

"The giant firm J. P. Morgan put the entire world at risk by introducing in the nineties RiskMetrics, a phony method aiming at managing people's risks, causing the generalized use of the ludic fallacy... Likewise, the government-sponsored institution Fanny Mae, when I look at their risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup."

2. The risks were not only calculated wrong - the concept of risk was too simplistic. Taleb differentiates between risks in the land of Mediocristan (where risk is distributed along the bell curve) and in Extremistan (where a single event can cause the failure of the whole system). He says that in an increasingly connected world Extremistan gets bigger and we have to prioritize risks not by their probability of occurence but by their possible damage.

3. The system rewards greed (for commissions, bonuses, and huge gains by options and derivatives) and distributes accountability (down to the tax payer) - so it's an absolutely rational behavior of the stakeholders (at least on their level of personal responsibility) to increase their profits and let others take care of the whole system.

Those "others" are the leaders you mentioned. Is it a failure of leaders? Yes, definitely - not on an operational level, but on a political level. There were no leaders who felt responsible because they truly believed that providing rules for economic behavior (i.e. governmental intervention) is evil. And that is the really crazy part when you look at it from an outside, especially from a European perspective: The government is the biggest player in terms of demand and supply on the national markets (so at least in this role the government should take care), has the power to change rules, refuses to watch what's going on and in the end asks you for 700 billion dollars, Eric. That's trickle-down economics at its best, isn't it?

[Arik Johnson]

Great thoughts Andreas - totally agree.

Incidentally, Taleb was on the short list for the SCIP07 Conference in New York last year as keynote... his ideas about unknown unknowns are absolutely critical for the CI analyst to grapple with and I can't recommend the Black Swan (or it's rather better predecessor, Fooled by Randomness) more.

You might also remember our omniscient Prof. Sonnenfeld (quoted above) as the dork who confessed as he opened his 2004 SCIP keynote in Boston a few years back that he'd "never heard of competitive intelligence" before... it didn't go over well. But illustrates the fundamental PR problem that persists in the CI field. The questions being asked here are thankfully beginning to attack them.

Anyhow, the point is, unknown events that escape the realm of one's own imagination also escape our collective ability to forecast them. These unknown unknowns require an entirely different model to anticipate their development - one that, I would also suggest, traditional competitive assessment, market analysis and environmental forecasting are inherently unable to foresee.

One of my hobbies these past few years has been in the area of prediction markets (which you've all heard of before, whether the specific term is familiar or not) and starts to show us the way forward for CI in this new territory as well. The aggregation of information that such outcome markets enable are of course not absolute - but they do tend to offer more of what Andreas suggests as the "Extremistan" worldview: the clustering of indicators of change grow more apparent as the market approaches the event horizon; naturally, as events unfold, the market ends in 100% certainty of the postulated event. But what PMs do for the CI practitioner is to aid in the imagination process - by opening markets (however obscure) for consideration, we are able to discover the unknown unknowns only housed in the brains of the most remote members of the organization for noodling by the rest of the tribe.

Indeed, there were a few (only a few) prescient investors who have made out like bandits on precisely this current failure of the Wall Street business model of investment risk management. The real question we must wonder about is: What did they know that the rest of the investment community didn't? And when did they know it? Could they have surfaced this eventuality early enough in its evolution to have done something about it? Did they?

The ability to forecast in this way, suggests to me that we cannot oversimplify the problem as one of mere analytical or intelligence failure but, as the 911 Commission suggested back in 2004 in remarking on the Intelligence Community and its failure to anticipate September 11th, this has been a failure of imagination.

[August Jackson]

Earlier this week there was a great interview on National Public Radio's "Planet Money" podcast with William Longbrake who had been CFO at Washington Mutual from 1982 - 2002. Longbrake also stayed on at the bank after his tenure of CFO ended. He describes his efforts to make the case that the rapid increase in house prices was unsustainable (a point Eric Garland's graphic makes so very well). NPR later carried a story noting several WaMu board members confirmed (off the record) that Longbrake had long banged this drum at the bank. Longbrake's conclusion was not a conclusion based on a complex quant model, it's a simple truth that is intuitively obvious: if people can't afford to buy houses, they won't buy them. Add a dash of basic supply and demand, and you have the recipe for a bubble bursting.

The economic situation shows us a potent cocktail of some of the risk assessment, agency problems and cognitive dissonances that so many CI professionals deal with on a daily basis. I can recall in the early '00s telling telecom executives that the rapid expansion in long-haul fiber capacity, acquisitions funded by printing stock, pursuit of market share at the cost of revenue and profits and the win-at-any-cost pursuit of 3G licenses in the UK and elsewhere in Europe was a recipe for disaster. Intuitively it was obvious what the trajectory of the industry was going to be. I remember laying this out for a senior executive at a leading industry analysis firm (a firm that no longer exists, but I'm just saying). She stared at me blankly while I laid this out and simply responded "I don't understand how you could be so wrong."

So much of what CI professionals do is qualitative in nature. Often we are up against other decision-making tools that appear quantitative, and it always amazes me the faith that people will place in numbers. This is even the case for numbers that are based on countless assumptions-- effectively made-up numbers. Ditto for models.

What fascinates me about this situation is less a question of the ability to conduct the appropriate collection and analysis and more a question of basic elements of the human condition that prevent collective action in a corporate or government organization from taking preventative action or even hedging based on the possibility of disastrous scenarios. All of this has happened before, and all of this will happen again unless intelligence professionals (commercial and government alike) can find the secret formula to break through the haze. Being bellicose or overselling the risk is clearly not the solution, Rather some sort of systematic approach to motivate action is what we need to define. Reverse psychology, hypnosis, guardian angels that show us what the world would be like if we had never been born... whatever.

[Bill Fiora]

I'm happy to see Taleb's name on this topic. He is the type of analyst that the better Wall Street firms used to employ to balance out their risk portfolio and to hedge against this type of meltdown. It's my understanding that these types of positions have been cut back or eliminated in recent years. It appears that Goldman Sachs was still doing some of this work, but in the end even they weren't doing enough.

I am waiting for the inevitable stories of firms or individuals who did see this coming beforehand. I'm curious to hear what their sources and indicators were.

To Ann's question on whether this was an intelligence failure: From the banks' perspectives, it's more of a risk management failure, but to key providers to the banks (including law firms) and to those with significant financial dealilngs with those banks, it is an intelligence failure. Unfortunately, there may not be any penalty for this failure for top law firms, as they will get a piece of the cleanup work. For some, it may even turn out to be a windfall.

[Stephen Hollander]

My little neice knew that no good would come of lending billions of dollars to hobos on no-money-down, no-interest loans. And any accountant who wasn't living under a rock must have been aware ot the fact that the Streeters were developing financial instruments that were increasingly designed to conceal exactly what was behind them, how they were valued, and what they were really worth (which, in many cases, was exactly zero dollars and zero cents).

What's been going on, for the past few years, is a gigantic Ponzi swindle. Like all such schemes, it is now collapsing, and the public is being asked to clean up the mess. Was this foreseen? Yes sir Bob Dixie, it was. Take a look at the trends in the short interest over time. The first reaction of the insiders, of course, was to put a ban on short-selling. Sort of like killing the canary in the mine, yes?

[Stephen Hollander]

And now this, from the Associated Press:

The FBI is investigating four major U.S. financial institutions whose collapse helped trigger a $700 billion bailout plan by the Bush administration, The Associated Press has learned.

Two law enforcement officials said Tuesday the FBI is looking at potential fraud by mortgage finance giants Fannie Mae and Freddie Mac, and insurer American International Group Inc. Additionally, a senior law enforcement official said Lehman Brothers Holdings Inc. also is under investigation.

The inquiries will focus on the financial institutions and the individuals that ran them, the senior law enforcement official said.

The law enforcement officials spoke on condition of anonymity because the investigations are ongoing and are in the very early stages.

Officials said the new inquiries bring to 26 the number of corporate lenders under investigation over the past year.

You can read the full story at http://ap.google.com/article/ALeqM5gCoFFAAVoRoOM6HXGudGtpjfjcpwD93D...

So prior to this week there were 22 large financial firms under investigation--and nobody saw this coming?

As Dianne Francis said of the subprime mortgage fiasco, this isn't a business story--it's a police story.

[Eric Garland]

Here's are the numbers behind that stuff "nobody saw."

Incidentally, 1999 was when I moved to Washington. I had a sweet place in Van Ness, northwest DC, quite reasonable on my salary. What a town!

Then, my friends started buying places and reporting $200,000 gains in around nine months. I thought it was weird and dangerous.

2006 was the year my wife and I vowed to move the company to Sioux Falls, South Dakota, or Romania, whichever was more reasonable.

Housing doubled. Salaries did not. The executives took huge bonuses. People refinanced. It looked fake. It was. The banks are broken. Now they want us to pay them cash on the barrel. Neat trick.

A note to those of you who care about generational workplace issues: Generations X & Y are pretty unimpressed with this. Institutions are going to be completely replaced based on this fiasco.

[Arik Johnson]

Good post Eric.

I'm giving a workshop in December on strategy, intelligence and innovation for a conference of market researchers in the financial services sector (assuming such titles still exist in December) and this morning I was thinking about The Fiasco in the context of asymmetric decision-maker motivation: chiefly, the decoupling of risk from decisions by executive management among banks.

You might've heard about Washington Mutual's collapse overnight but you might not have heard about this:

But the seizure and the deal with JPMorgan came as a shock to Washington Mutual’s board, which was kept completely in the dark: the company’s new chief executive, Alan H. Fishman, was in midair, flying from New York to Seattle at the time the deal was finally brokered, according to people briefed on the situation. Mr. Fishman, who has been on the job for less than three weeks, is eligible for $11.6 million in cash severance and will get to keep his $7.5 million signing bonus, according to an analysis by James F. Reda and Associates. WaMu was not immediately available for comment.

When the motivation for upside reward is so completely out of whack with the shareholders' downside risk, I can only foresee a Sarbanes-Oxley version 2.0 on the horizon designed to govern the compensation of boards and executives.

Don't get me wrong - shared rewards are powerful motivators for all employees, let alone top management; but the coupling of shared risk must accompany such rewards or the bet-the-ranch decisions executives make will be based on riskier than necessary circumstances in order to produce the rewards they crave.

In that respect, I don't see a bailout ever coming that doesn't impose tough, new standards of the risk-reward-ratio for decisions made by executives on behalf of their enterprises; and this goes WAY beyond the financial services sector.

[Tim Powell]

YES, the credit crisis is the latest in a series of egregious intelligence failures we’ve experienced recently. Government certainly has no monopoly on this. LTCM, 9/11, the Challenger disaster, Enron – just to name some from this decade.

There are many reasons contributing to this one, and there will certainly be plenty of blame to go around. Much of the problem is due to the fact that there are many “early warning systems” and back-up systems to detect this kind of thing: The Securities Acts of 1933 and 1934. The public accounting industry. The bond ratings firms. The Wall Street analysts. Sarbanes-Oxley. And the quant models that were supposed to forecast everything.

Guess what? NONE of these systems worked as planned. I’d even submit that an over-reliance on these systems gave a false sense of security to everyone that someone was actually minding the store.

From an intelligence point of view, the problem begins with a massive lack of transparency in the financial markets. Financial derivatives by their very nature spread risk – but also spread accountability and the ability to see who owes what to whom. If I loan you money to buy a house, I’ll be darned sure you’re going to be able to pay me back. But if I’m planning to then sell that loan off to Arik J. and Eric G., I might not be so fussy. (Kidding guys – but PM me, I have a great deal for you!) It’s non-transparent, which also invites its being unethical, maybe even criminal.

Yes, there were early warning signs. Ironically, I developed a financial intelligence workshop last October that detailed some of these. This did not take any great genius -- by that time we had already had two major Bear Stearns hedge funds go down, and there were lots of other signs.

But—and here’s the key—did I take my own advice? Too little, and too late.

It’s human nature. People typically do not DO what they can with what they KNOW. (The Knowing-Doing Gap is definitely one of my all-time favorite book titles. The book itself is a must-read.) I just finished reading a history of Pearl Harbor, and that was the case there too (to simplify grossly).

Why is this? Lots of reasons, but start with “you hope you are wrong”. You think your radar is broken. Garden-variety inertia. And so on…

There’s also a pervasive lack of accountability in our whole business system. Yes, there are going to be many civil and even criminal mop-up operations. But the perps in many cases will be long gone. Ever seen a CEO trash the value of his/her company and walk away with a great severance package?

To be fair to our discpline, “Intelligence Professionals” can’t be blamed for this one because, to be frank, not enough of us have enough clout to have been at the table when key decisions were made. But I’d propose, especially in light of all the other “professions” listed above who’ve repeatedly dropped the ball, that IP’s step up to the plate ready to prove we can do better!

[Tim Powell]

I mentioned above that there would be plenty of blame to go around -- but I neglected two of the biggest -- the Securities and Exchange Commission, and the press.

Today (October 3, 2008) the NY Times has an amazing article about a meeting held April 28, 2004 by the SEC, in which they unanimously voted to reduce the capital requirements for investment banks, and basically let them monitor their own risk using "computer models". This is a day that will live in infamy, in my humble opinion.

This was public information -- at the time, it was written up in the Financial Register and is available right now in streaming audio on the SEC's web site (look for open meetings.) But the Times, which generally has excellent financial coverage, admits it never reported it at the time.

This should have been a big bright warning sign. This enabled the situation we have now -- where the i-banks are so highly leveraged they can play with 30 times the amount of capital they actually hold. That CAN work, as long as LOTS of things go in your favor.

And they did have the "models" to warn them of excessive risk. But I've built quant models, and guess what -- GIGO, garbage in, garbage out. They are (at best) only as good as the assumptions built into them.

Here's the part I find amazing. Most of these quant models being used on Wall Street DID NOT include the assumption about what the other guy who was using a similar model was doing. So everybody started dumping the same stocks at the same time. Hello, can you spell "Nash Equilibrium"? This is kind of Game Theory 101, guys.

To his credit, Bill Donaldson, then chairman of the SEC, was skeptical of this arrangement, and created a risk monitoring unit at the SEC as a backstop. But he left the following year, and his successor Christopher Cox pulled the plug on that office.

So they were doing very risk things -- but with a monitoring system -- and then the monitoring system was abandoned. All five SEC commissioners voted for this resolution, by the way.

One person did at the time warn that this was a highly unusual and risky arrangement -- a computer programmer who worked on those "magic models." His letter to that effect to the SEC was never answered.