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?

[Arik Johnson]

Good catch Tim - I didn't catch it until Slate's summary in Today's Papers:

While McCain was widely ridiculed for putting much of the blame for the financial crisis on Christopher Cox, the chairman of the Securities and Exchange Commission, the NYT suggests today that the Republican candidate may have been on to something. The NYT says one of the root causes of the current crisis can be traced back to a brief meeting in 2004, where the big investment banks pushed the SEC to allow them to take on more debt. A few months later, "the net capital rule" was changed, and "the five big independent investment firms were unleashed." Although the new rules would allow the SEC to keep banks away from excessively risky activity, the agency essentially ended up "outsourcing the job of monitoring risk to the banks themselves." Cox came onboard a year later, but he made it clear from the outset that oversight of the banks was not an important priority, and regulators essentially ignored any problems that were discovered.

The piece you refer to opens with this priceless quote from Cox himself:

“We have a good deal of comfort about the capital cushions at these firms at the moment.” — Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.

But it goes on to dig deeper into your observation about the only two apparent skeptics in the whole matter.

A lone dissenter — a software consultant and expert on risk management — weighed in from Indiana with a two-page letter to warn the commission that the move was a grave mistake. He never heard back from Washington. One commissioner, Harvey J. Goldschmid, questioned the staff about the consequences of the proposed exemption. It would only be available for the largest firms, he was reassuringly told — those with assets greater than $5 billion. “We’ve said these are the big guys,” Mr. Goldschmid said, provoking nervous laughter, “but that means if anything goes wrong, it’s going to be an awfully big mess.”

Mr. Goldschmid, an authority on securities law from Columbia, was a behind-the-scenes adviser in 2002 to Senator Paul S. Sarbanes when he rewrote the nation’s corporate laws after a wave of accounting scandals. “Do we feel secure if there are these drops in capital we really will have investor protection?” Mr. Goldschmid asked. A senior staff member said the commission would hire the best minds, including people with strong quantitative skills to parse the banks’ balance sheets.

As Monday's House vote precipitated the $1.3 trillion sell off, I heard a few Broke Streeters commenting on CNBC how all these "liberal arts majors" serving in Congress just don't know anything about money and they need to just trust Paulson and Bernanke and get the bailout passed. (Disclosure: I was a History undergrad and took this rather personally.) Then, when it did pass yesterday and President Bush hurried to sign off on it, the market tanked anyway.

Maybe the idea of the bailout was just way better than the actual bailout itself? If history teaches us anything it's the old cliché about those who don't understand history are doomed to repeat it.

[Arik Johnson]

Jordan Ellenberg, an associate professor of mathematics at the University of Wisconsin, had a great piece in Slate.com today suggesting that the Fiasco was akin to a gambling strategy called the martingale. Here's an excerpt:

... the martingale strategy doesn't eliminate risk—it just takes your risk and squeezes it all into one improbable but hideous scenario. The expected value computation is unforgiving. No matter what ultrasophisticated betting strategy you adopt, you can't expect to make money in the long run by flipping a fair coin. There's always a risk of loss—and the smaller the chance of losing, the uglier the potential loss becomes. The result is a kind of "upside-down lottery." If you play the Powerball, you'll probably lose the cost of a ticket, but you might win big. In the martingale, you'll probably win a little, but if all six numbered balls match your ticket, then the bank comes around and takes away everything you've got. You probably wouldn't sign up for that game. But the news of the last few weeks confirms that we've been playing it for years. And it looks like the balls just lined up. Oh, and there's one more difference between the thickly interwoven financial markets and the lottery: If one person wins the Powerball, just one person gets rich. If one massively leveraged financial firm loses while playing the martingale, it can bring the whole system down with it. The complex derivatives behind the current financial havoc aren't literally martingales, but what's wrong with the martingale is one of the things that's wrong with the derivatives. There's no question that you can reduce risk drastically by combining different investments in a single portfolio; that's what plain-Jane instruments like index funds do. What sounds an alarm is the claim that you can get low risk and high returns in the same happy package. "Once the limits of diversification have been reached," John Quiggin, an economist at the University of Queensland, told me, "rearranging the set of claims involved isn't going to reduce risk any further, so if all parties appear to be making risk-free profits, the risk must have been shifted to some low-probability, high-consequence event." In other words, if it sounds too good to be true, it's probably heading toward some outcome too bad to be borne. Or, as financial skeptic Nassim Nicholas Taleb wrote last week, "It appears that financial institutions earn money on transactions (say fees on your mother-in-law's checking account) and lose everything taking risks they don't understand."
The martingale's bad reputation is just about as old as the martingale itself; the word, which dates back almost five centuries, is said to come from the hinterland town of Martigues in southern France, whose residents weren't known for their gambling savvy. The quantitative superstars who inhabit the back offices of the financial industry, and the people who regulate them, are no star-struck hicks. So why did they fling themselves so boldly into martingale-style investments?

One way the banks got fooled was by convincing themselves that the coin wasn't really fair. The only way to make money in the long term by betting on coin flips is to have some reliable way of predicting the outcome—for example, if you know that a flipped coin will land on the side it was flipped from about 51 percent of the time. Not long ago, the credit market was convinced that the upward trajectory of house prices had reached some kind of escape velocity and that the usual laws of finance were powerless to bring prices back down. It was supposed to be like betting on a coin that was heads on both sides.

Maybe it wasn't a failure of intelligence but selecting the wrong analytics?

[Eric Garland]

This is a fascinating, and I'd say accurate, analysis.

I think you're absolutely right to point out the analytical side of this problem. The way you think about something is only as good as your assumptions. I think there are some really basic ideas about finance that need to be examined to understand what is happening. These are not necessarily comfortable ideas for many people, but a second Great Depression isn't comfortable either.

First, I think about 70 million Americans are getting ready to retire. NONE of them want flat growth - they would love to get 8% returns no matter what so they can afford food and housing when they stop working. Financiers have maybe been skewing the majority of their analyses because people are addicted to fast growth, and will more likely go with the institution that promises it.

Second, I think because of our addiction to fast growth, we are systematically ignoring the signs of traditional economic weakness. Just a quick question for you Americans and other folks reading this: Did we really think there would be no consequence to our shipping so much of our secondary industry - manufacturing - overseas? We've taken the basics of our industrial economy and sent it to other countries. We've replaced those basics with a consumer economy in which we juice GDP growth by buying consumer electronics produced in Asia Pacific - and buying them on credit, no less. How could we NOT take some sort of a hit, or at least remain flat?

Haven't we instead begun insisting on showing growth in those retirement portfolios in any way possible? Didn't people want to see their home shoot up in value? Otherwise, we'd have to accept that our economic model - not to mention the model for social justice - is reaching some serious limitations.

This is perhaps what led to such high-stakes gambles like the one Arik is pointing out. If you really HAVE to hit it lucky to have a comfortable retirement, aren't you going to skew your analysis in favor of that one scenario?

The most dangerous strategies I've ever seen from companies are those based on one overly optimistic scenario. Pessimism can be a virtue, and we would have done well to indulge in some.

[Tim Powell]

You're right, Eric, but it's actually much worse than this. According to a recent article in the NY Times, many institutional pension funds are planning for 8% growth to make their actuarial assumptions. They're not underfunded if they can make that bogey. But if they can't, they are underfunded.

And do you think they can? Are YOU making 8% these days on ANY investment? Some institutions are, sole university endowments for example, but that's because they can invest in stuff like timberland and commodities.

In other words, in order to make their numbers, these pension funds will need to move to more risky investments. (The higher the risk, the higher the return -- it's the first thing they teach you in business school finance.)

What happens when the boomers retire (70 million sounds high, but maybe that's the total number of penioners by a certain date), and these funds cannot make their current obligations?

This is not a rhetorical questions, I'd really like to know. The problem is, this "perfect storm" of circumstances has never happened before. It really creates a vicious cycle.

Now how's THAT for some pessimism?

[Melanie Wing]

Interestingly, there are parts of the financial services industry that did see this coming and were preparing for this. While I was at Chase, we evaluated getting into sub-prime lending (talking retail here, not seconary market) but chose not to pursue because of the inevitable collapse. We were looking at refinancing volumes, housing prices, debt accumulation etc, etc. Did we do everything right? certainly not! But did we limit the exposure, absolutely and more importantly, it was a conscious decision, not luck, not happenstance, a choice based on data and foresight.

There is an interesting article in Fortune about what JPMorgan Chase did differently. I think Chase, BofA and Wells Fargo took a different approach and have not suffered as much as other institutions.

http://money.cnn.com/2008/08/29/news/companies/tully_jpmorgan.fortu...

[August Jackson]

Melanie, thanks for this insight. We know that executives at other banks were also making the case that the subprime mortgage market was destined to collapse. Why did Chase and Wells Fargo take preventative action based on this knowledge while WaMu, Lehman Brothers and so many others did not?

What sort of consequences do you think Chase executives dealt with while they were taking a strategy to mitigate the potential collapse? Often strategies of mitigation are regarded as timidity on the part of stockholders and commentators, and executives are criticized because it appears they are not taking full advantage of what, to many, still appears to be a risk-free market opportunity.

[Melanie Wing]

Of course I like to think that the reason that Chase took action was because we had a robust CI capability! :) Jamie Dimon talked constantly of a fortress balance sheet and managing risk; therefore decisions that might have looked like a sure thing to other organizations, were carefully scrutinized and if considered a risk that would jeopardize the balance sheet, then executives would certainly be considered to be making the appropriate decision.

This situation is complex. I like this explanation.

http://docs.google.com/TeamPresent?docid=ddp4zq7n_0cdjsr4fn&ski...

[Claudia Clayton]

This was a failed sociological experiment that was not publicized to the American public for political reasons and now is once again being obfuscated by those who engineered it for political gain. There is sufficient information regarding this available, but no one wanted to complain because banks would be seen as unfeeling toward low income buyers and minorities. Banks that did not go along were criticized, ostracized and impacted negatively. All of the major economists agree on this point.

Yes, there were some greedy politicians and financial institutions once the die was cast but frankly it couldn't have happened without support from the government.

We need to run our economy like an economy, run our finances effectively using sound fiscal management, and not ideology, and better educate consumers - not with sound bites but with real information based on financial realities.

All of us want to live in a better society and a better world, but everyone suffers when we lose sight of financial and economic reality. The result is chaos, financial disaster, and no one suffers more than the poor or lower income people these experiments in social engineering were supposed to help. It has also taken away the faith of hard working people around the world who worked, saved and had hopes for the future.

In terms of how we in intelligence could have better helped our companies understand the implications ... perhaps it is time that we seek the truth, ask our media to be real journalists instead of publicists, and begin to listen more to economists and financial experts than to politicians (of both parties).

Strong analysis of the impact of proposed and existing regulations (especially the potential for unintended consequences), more attention to financial experts when implementing legislation around the economy, and perhaps more focus on government regulation based on its increasing role in our economy as it increases over time -- these steps might help companies at least see the potential results of political policies beforehand.

[Antonio J. T. Bueno]

Dear Ann Lee Gibson,

As I try to address your question, let me say that an honest and straightforward answer should be: "Yes, this has been indeed a most serious intelligence failure". We all seem to know how to evaluate risks and how to hedge them, in some way. But "risk evaluation" is not altogether the same as "risk and opportunity awareness". The latter is rather an art than properly a science. This statement does not mean that science is useless or else that it should not be relied upon. Scientific models and research are in fact essential, but by all means not enough! Human failed perception of reality cannot be depended upon, unless supported by some methodical observation of data series that do not necessarily correlate (from the flawed point of view of the human observer). We have a long way to go, and need to start paying attention to details that apparently do not fit the picture.

[Gavin John Wilson]

From a UK viewpoint, the real winners (in terms of public perception) have been those whom I could call 'energetic experts'.
- On the TV, the only guy who is trusted to know what he is talking about is the BBC's Robert Peston. This man has moved markets with his inside knowledge.
- In politics, the most trusted person is the Liberal Democrats' Vince Cable. He has been sending out emails to media correspondents every week or so for the past few years warning about indebtedness. The real loser politically has been the Conservatives' shadow chancellor, George Osborne, who has had nothing of value to say.
- Expertise has been a clear differentiator here. Vince Cable used to be the chief economist for Shell; Robert Peston used to work in the City. George Osborne has no past experience of relevance, and his degree is in history.
- The prime minister, Gordon Brown has climbed in the polls dramatically as a result of his handling of the crisis, even though he is partly responsible for creating it.
a. He has been very energetic, jetting between Europe and America.
b. Almost no-one really understands what is going on to the extent that they are prepared to forecast what will happen, so there is almost no-one making strong criticisms of his current actions.
c. To criticise the PM in a time of national crisis would be unpatriotic, so few are doing so.

I think most people have given up all hope of trying to understand what is going on, so are instead putting their trust in experts. Currently our PM, Vince Cable and Robert Peston are regarded as the UK's experts, so they are the ones who have gained. I am sure there are many writers for The Economist and the Financial Times who understand this crisis even better, but they don't appear on TV, and because of that, their public image has gained almost nothing.