Monday, April 26, 2010

Would you bet on pro wrestling?

I have been a longtime advocate of thinking about your assumptions before taking action or coming to a conclusion about a situation. The Goldman Sachs affair makes me take issue with the dogmatic defenders of Ayn Rand and her ideas about efficient and self-adjusting free markets. What bothers me is that the Goldman Sachs defense boils down to "buyer beware, the investors are all big boys" and "as long as it's not illegal it's ok."

I have not always been a fan of the Obama White House, but I agreed with President Obama when he admonished the bankers last week (full text here):

I believe in the power of the free market. I believe in a strong financial sector that helps people to raise capital and get loans and invest their savings. But a free market was never meant to be a free license to take whatever you can get, however you can get it.

While I agree with Obama that there is a problem, I believe that the Volcker approach favored by the White House is overly heavy handed. A better approach is this.

Examine your assumptions
Let me make this clear. I do believe in free markets and I do believe in the ability of free markets to efficiently allocate resources, but those principles only hold under certain conditions and assumptions.

Those of us who remember the basics of microeconomics know about the elegance of supply and demand curves. Underlying the elegance of these mathematical models (and that’s all they are) are assumptions about the symmetry of information and the rationality of human behavior.

Math majors all know about proof by counterexample. You can disprove an axiom if you can show a counterexample that violates it. So here are some proofs by counterexample.

Consider how the Dederot effect spur people to spend beyond their means. Also consider this example of how Costco breaks long cherished microeconomic assumptions about human rationality. Closer to home, read this account of the manipulation of the silver market. Behavioral economics show that people aren’t necessarily rational at all, but biological and chemical:

Despite what we’ve been led to believe, the market isn’t rational or efficient at all—it’s all about feelings. The major plot points of the crisis largely turned on emotion: Dick Fuld was too egotistical to sell Lehman Brothers when he had the chance, so his pride drove it into the ground; Bear Stearns hedge-fund managers lost huge sums of money on subprime mortgages despite the fact that they suspected the worst (“I’m fearful of these markets,” Ralph Cioffi e-mailed a colleague back in 2007); Merrill Lynch was the “fat kid,” as the investor Steve Eisman has put it, so desperate to be like Goldman Sachs that it barreled into every dumb investment imaginable and had to be bailed out by Bank of America. Almost every single bank chief doubled down on mortgage junk at exactly the wrong moment. Emotions led otherwise intelligent men—because, let’s face it, all of them were men—to make terrible decisions.

According to a new breed of researchers from the field of behavioral finance, Wall Street’s volatility is really driven by our body chemistry. It’s the chemicals pulsing through traders’ veins that propel them to place insane bets and enable bank executives to make risky decisions—and those same chemicals tend to have the same effect on everyone, turning them into a herd of overheated animals. And because the vast majority of these traders and finance executives are men, the most important chemical in question is testosterone.

How the Street lost its way
Goldman Sachs and others on Wall Street used to believe in getting rich slowly. You serve your clients well and you will be well rewarded in the end.

Somewhere along the way, the Street lost its way and sacrificed client relationships in its search for short-term profits. Tom Brakke at Research Puzzle wrote about how this attitude affected his relationship with his brokers when he was on the Buy Side [emphasis mine]:

To be clear, no one ever tied me down and made me buy anything, but I developed a general wariness of the Street and its practices. Even though my firm generated tons of trading business and those on the sell side were adept at acting like intermediaries, their actions were often those of adversaries.

The firms (the majors especially) often knew facts I didn’t know or figured the odds better than I did. That’s not surprising, since they were full of talented, well-paid hard chargers who were placed perfectly at the center of the flow of ideas and money. I expected that to be the case. What I was slower to understand was that even as a big client they weren’t going to tell me the whole truth if it meant extra profit for them.
The credo at Wall Street firms went from “serving our clients well” to “hey they are big boys” and “if it’s legal it’s ok”. Tom Brakke continued [emphasis mine]:

The practice of skirting the edges of regulations, client relations, and possible conflicts of interest, so much a part of the Wall Street model of yore, needs rethinking, even at the cost of near-term profits. It simply hasn’t worked, other than to allow for outsized payoffs for the edge-pushers (until the inevitable retrenchment due to enforcement action or market failure). It’s not long-term greedy, it’s long-term stupid.
In the pursuit of short-term profits, Wall Street has destroyed its own franchise of integrity and client service. Todd Harrison put it best when he reflected that [emphasis mine]:

Ruby Peck was my grandfather and the bond we shared is difficult to describe. He was my guiding light, my inspiration, my role model and my best friend.

He taught me how to be a man and what a man should be…We used to take walks and hold hands as he passed his pearls of wisdom to me:
What goes around, comes around.,,
And, above all else, “All we have is our name and our word.”
And it’s coming around. Wall Street may have irreparably damaged its own franchise and the resulting loss of confidence could bring the whole edifice tumbling down. While the Ayn Rand followers may rail about government regulation and the destruction of the finance industry that is essential to America, they missed the boat when they kept silent while Wall Street dismantled its own reputation.

Let me put it another way. You may bet on professional boxing because you enjoy the sport and believe that the matches are fair and not fixed, but would you bet on professional wrestling?

In finance and in life, all you have in the end is your name and your reputation.


Breck Carter said...

Perhaps the Ayn Rand followers (like me) were silent because the dark secrets were being kept from them as well... or are they expected to be prescient?

Some Ayn Rand followers (like me) might say that a free market would have allowed the failing banks to fail, and that the current situation is not a failure of the free market since the free market was not allowed to operate. Other banks, ones not failing (like the ones that did not need or take bailout money) would rush in to fill the void... if the government would only get out of the way.

Yes, sure, some new regulations might be needed to deal with the frat boy mentality... but do you really trust the creation of those regulations to the folks who brought us the Community Reinvestment Act and are hiding the disaster that is Freddie Mac et al?

Otto said...

"....would you bet on professional wrestling?"

Depends...what odds are you offering? :-)

Flippance aside, good as always Cam. thanks

Cam Hui, CFA said...

Breck -

Note that my proposals allow the market to work:

1) Bring back the partnership investment bank - this would make the risk/reward equation symmetric for bankers and would naturally reduce the level of risk in the system. How many legal and accounting firm failures have threatened to bring down the system?

2) List OTC derivatives - greater transparency for market participants so that they can better price risk.

Note that there are no proposals on firm size, the nature of their businesses (e.g. derivatives as per Volcker), compensation, etc. These are sensible approaches and not heavy handed regulation.


fboness said...

Goldman Sachs is channelling Otter from Animal House: "You fucked up. You trusted us!

There is nothing Randian here.

Christian Prophet said...

Ayn Rand is so thoroughly misinterpreted! You may or may not have seen the article: "Ayn Rand, 20th Century Prophetess."

SurfDog said...
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