Wednesday, January 20, 2010

Conventional Wisdom

The third-rate mind is only happy when it is thinking with the majority. The second-rate mind is only happy when it is thinking with the minority. The first-rate mind is only happy when it is thinking.

— A.A. Milne

A quotation is a handy thing to have about, saving one the trouble of thinking for oneself.

A.A. Milne

Serendipity, O Dearly Beloved, can be a marvelous thing.

I was reminded of this this morning when I checked my super-secret email drop box and discovered a link to a recent post by Justin Fox over at The Curious Capitalist. In it, he poses the query: "Financial capitalism, what is it good for?" This is a good question.

The conventional answer, of course, is that Wall Street and financial markets' principal function in an economy is to intermediate capital flows; that is, to direct capital from those who have it—savers and investors—to those who would employ it in productive enterprise. Unfortunately, as Justin and the correspondent who triggered his ruminations point out, there seems to be a preponderance of evidence indicating that this in fact is not Wall Street's primary function; or, indeed, that if it is, financial markets have strayed disturbingly far from the true path.

I like what Mr. Fox and his interlocutor have to say, so I will beg your forbearance while I quote the article at length:

A reader (well, this Pulitzer-winning genius newspaper columnist of a reader), e-mails after reading my book:
From the very beginning of financial capitalism, the goal seems to have been to beat the market, which is to say, anticipate and profit the upside and downside of the market—not the industry or business of the stock traded. Basically, to make money on nothing, returning no value to the world. I always thought the goal of the stock market was to capitalize growing businesses so they could return value to the world. ...

Why didn't any of these smart guys, Fisher et al., realize that in developing various kinds of mathematical models to conceptualize the "market," they were succumbing to what seems to me a fundamentally anti-capitalistic temptation? To just be money traders and NOT makers of value. And when I look at high-speed, supercomputer-assisted trading that goes on today, squeezing out profit in the nanoseconds fluctuations in stock prices, I'm appalled. I also think big, mature companies—without reasonable expectation of growth—should get out of the market, because shareholders' spiraling expectations of profit almost inevitably hollow out value in the core company, and cause companies to make products cheaper, move labor off shore, etc.
Interestingly, that last paragraph sounds a bit like Michael Jensen's famous 1989 Harvard Business Review article 'The Eclipse of the Public Corporation.' ... Jensen argued that being publicly traded was a poor fit for big, mature companies. More controversially, he argued that leveraged buyouts—what we now call private equity—provided the perfect solution to this problem.

But that's not really the main point my reader was trying to get at. It's that a big share of financial market activity doesn't seem to generate any real value for the rest of the economy. Everybody agrees that raising money for new ventures is important for the economy, but such fund-raising constitutes only a tiny portion of Wall Street activity. The rest can only be justified as (1) providing liquidity, so the economy's actual creators of value are able to cash in on their efforts and (2) allocating capital efficiently, by correctly setting the prices of financial assets.

Financial markets clearly aren't very good at (2), at least not on a short- to medium-term basis. Case in point: the fact that worthless "old GM" currently has a market cap of $500 million. I doubt anybody else (government, for example) would be any better at it. But I don't buy that today's financial markets are much more efficient (in the capital-allocation sense) than the vastly smaller markets of 40 years ago—which leaves only liquidity provision as justification for the giant size of our financial sector and the giant paychecks pulled down by some of those who labor in it.

These are interesting points, and they are worthy of further thought. Let me take you on a brief detour, and we will return to them later in the post.

* * *

Now for the serendipity part.

Repeat visitors to this site will remember I recently published a post in response to an article by Paul Krugman bemoaning the apparent ignorance or disingenuousness of investment bank CEOs about the sources of our recent financial travails. In it, I explained that—notwithstanding the irrefutable fact that these gentlemen (and most investment bankers) rank quite high in conventional measures of intelligence and achievement—they do not concern themselves with foundational issues such as these. In fact, senior investment bank executives are almost universally and intentionally ignorant of such matters. Instead, they focus their limited time and considerable energy and intellect on wrestling with competitors and colleagues over the swollen heaps of money which fall out of their firms' participation in the global financial markets. This, when you think about it, is not entirely unpredictable.

I also explained that the fast pace and high pressure of the business tend to attract individuals who do not attach great importance to deep, theoretical, or introspective thought. Rather, quickness of intellect, nice interpersonal judgment, and a certain calculating capacity akin to the ability of practiced chess players to think several moves ahead are the most valuable and prized attributes in my industry. What I did not explain was the natural corollary to these observations; namely, that due to their vocational preoccupations and intellectual predispositions, investment bankers tend to be extremely adept and quick at sussing out and acting on what is commonly known as the conventional wisdom.

This should not be surprising, either. After all, investment bankers spend all their waking hours figuring out and relaying to clients what "the market thinks" about deals, securities, and prices. Investment banks are gatekeepers to the markets, whether underwriting securities, trading financial instruments, or structuring and executing mergers and acquisitions. And what is the market itself but a gigantic, multi-tentacled, complexly interlinked engine for the real-time calculation of conventional wisdom? Figuring out, anticipating, and shaping conventional wisdom is what investment bankers do. It is the ocean in which we swim.

In any event, I decided to publish a follow-on post expounding this very argument, as part of my ongoing public penance for participating in the organized institutional rape of Main Street. I intended to illustrate it with a recent piece by Graham Bowley at The New York Times on the challenges facing the new CEO at Morgan Stanley. For my purposes, this article possessed the singular virtue of illustrating not only the peculiar (and different) forms of intellectual firepower which John Mack and now James Gorman bring to the task of managing that venerable investment bank, but also how one can ascribe much of that institution's recent success, failure, and near death to its on-again, off-again romance with the conventional wisdom of how to run a global investment bank. (For the record, they were massively criticized a few years ago for not following the herd and increasing risky proprietary trading activities early in the credit bubble and massively criticized—and nearly bankrupted—recently for barreling whole hog into those same activities right before the bubble burst. Sometimes you just can't win.)

Naturally, I began to search for a pertinent quote to headline my treatise, as is my usual practice. I recalled an appropriate aperçu by John Maynard Keynes:

Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

I directed myself to its source, Chapter 12, "The State of Long-Term Expectation" in that economist's magnum opus, The General Theory of Employment, Interest and Money, in order to verify its exact phrasing and provenance. What I found there instead, to my surprise, was one of the most perceptive dissertations I have read on the nature, benefits, and drawbacks of financial markets themselves. In particular, Keynes fields a perceptive and devastating critique not only of the ineluctable hold of conventional wisdom on financial markets, but also of the natural tendency of markets to devolve into an unhealthy preference for liquidity over long-term investment.1

Writing nearly three quarters of a century ago, it turns out that John Maynard Keynes has just the answer to Justin Fox's questions.

* * *

For the purposes of our discussion, I think it is fair to interpret Keynes as ascribing the key characteristics of financial markets to two main underlying causes: our fundamental ignorance of the future and the separation of ownership of productive enterprise from its management. While the latter, as realized in the form of financial markets, theoretically broadens the base of investment capital available to businesses in search of it, it also paradoxically increases investors' aggregate ignorance of the true value and prospects of the enterprises in which they invest, since they no longer enjoy the insight of the people who manage such enterprises day to day. In combination with our natural tendency to project current conditions uncritically into the future—which Keynes decries as unrealistic but acknowledges to be the only sensible course open to us—this leaves financial markets overly sensitive to short-term fluctuations in sentiment and opinion.

Thus markets, he argues, evolve inevitably into echo-chambers: self-referential fora for determining and anticipating conventional wisdom. His argument is worth quoting at length:

It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.


This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional; — it can be played by professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. ...

Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

* * *

It is clear that Keynes was not an uncritical fan of financial markets. It is also apparent he did not trust market prices to be clear and reliable measures of long-term value of underlying investments. So what does this have to say about the second proper function which Mr. Fox assigns to markets in general, "allocating capital efficiently, by correctly setting the prices of financial assets," and his example of "worthless 'old GM' [having] a market cap of $500 million"?

Well, I have no interest in arguing that the long-term fundamental value of Motors Liquidation Company is measurably greater than zero. I imagine few rational investors would. However, you do not need to see any long-term value in old GM to make a case that its equity could be "worth" $0.64 per share, as it traded today. All a rational speculator would need to assume is that sometime in the next 30 days MTLQQ could trade 1) at a price above $0.80 per share, as it did earlier this month, and 2) on sufficient volume that he could sell his entire position at that price. Successfully done, such a Hail Mary pass could generate a nominal return on investment of 25% or more in less than 30 days, which is a hell of a risk-adjusted return in my book. Such a speculative investment depends only on short-term sentiment—including the necessary existence of numbnuts willing to buy the stock at eighty cents—and market liquidity. MTLQQ is simply a far-out-of-the-money option, and all a prospective buyer of it really bets on is random Brownian motion and the ability to monetize it.2

So, in fact, market liquidity itself can indeed create or abet silly price signals in the market, which in turn can distort the proper allocation of real capital in the real economy. Sometimes, as in the dot com boom, these silly signals can persist for very long periods of time. But, as Keynes himself might have said, just because trees have never grown to the sky in the past doesn't mean it's not rational for us to assume a growing tree will continue to grow. In the short term, at least.

I will venture to say that Keynes would not have been a popular investment adviser.

* * *

Neither was he uncritical of market liquidity:

Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is “to beat the gun”, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.

But Keynes did acknowledge that liquidity broadens access to capital from investors who might otherwise demur from supplying it:

[The] liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is “liquid” (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma. So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organising markets wherein these assets can be easily realised for money.

So, really, Mr. Fox is incorrect when he asserts the first function of financial markets should be "providing liquidity, so the economy's actual creators of value are able to cash in on their efforts." Actual creators of value, in the form of entrepreneurs and business owners, can get liquidity any day of the week, in the form of a check for all or part of the business they own. They do not need public markets for that. All they need is a buyer with enough cash and a good lawyer.

Instead, the true purpose and value of liquidity in financial markets is to reduce investors' uncertainty. It does this first through the regular publication of price data, which serves as a relatively reliable (but: see above) proxy for the true current value of their investments. Second, it reduces investors' uncertainty as to their ability to exit from their investment when they so choose. Together, these two effects turn what might be a long-term bond or permanent equity capital into what looks like a series of rolling, short-term investments with reasonably good pricing certainty. Ceteris paribus, a rational investor should require a lower expected return on such an asset. (Tell me, by contrast, that I cannot sell Apple Inc. stock before 2015, and I will be willing to pay a lot less than current market price for it and will expect a commensurately higher return. I do not think I am unusual in this regard.)

Therefore, at least in theory, market liquidity should reduce the cost of capital for businesses which require it. There is good evidence supporting this from the opposite example of private equity, which ties up substantial chunks of equity capital in entire businesses which it closely oversees for many years. Required returns in the private equity market have always been well in excess of those prevailing in the public equity markets. Call it, if you will, a premium for lack of liquidity. That this liquidity effect on cost of capital dominates the countervailing fact that private equity typically has far more intimate knowledge of the business prospects and actual potential value of its investments than the typical public shareholder can be seen in this positive differential. If it were not so, we should expect to see required returns from illiquid, intermediate investments in private companies to be the same or lower than those required in the less-informed public market.3

* * *

So, financial market liquidity broadens the availability and and likely lowers the cost of investment capital, at the price of increased volatility, unproductive speculation, and increased noise in the public signals about productive enterprise value. Whether you find this a worthwhile trade-off probably depends on your own position and interests in the markets. But Mr. Keynes says more.

He claims that the very difficulty inherent in true long-term investment behavior—like that practiced by Warren Buffett in our time—and the greater ease and potentially even greater (short-term?) profitability of speculative investing will combine, over time, with increased market liquidity—which, in fact, facilitates speculation to a far greater extent than long-term investing—to shift more and more of the market's activity toward pure speculation.

Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough; — human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money — a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.[4] For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

And, in fact, that is what we have seen over the past thirty years: markets have ballooned into giant souks where speculative activity dwarfs pure investment. Keynes wrote primarily about equity markets, but the financialization of markets has spread like kudzu across the entire landscape. Mortgages, corporate loans, physical assets, commodities, and credit assets in general have become liquified and atomized and repackaged and securitized in a billion different ways, aided and abetted by the Lego-like building block technology of derivatives and armies of eager investment bankers. All markets have become liquid, but at what price?

Arguably a leading reason why the mortgage and credit markets imploded in 2007 and 2008 is because newfound liquidity enabled the separation of ownership from management of the underlying assets. (Sound familiar?) Lenders (investors) no longer had to own or even manage (service) the loans they originated. Banks no longer had to underwrite and screen mortgages or corporate loans as if they planned to hold them to maturity, as they once did: they bundled them up and sold them off instead. A passel of morons in Mayfair wrote billions of dollars worth of naked puts on CDOs they didn't understand because the markets and their counterparties made it look like free money. Hedge funds who took a negative view on a company could purchase credit default swaps in amounts which dwarfed not only the company's entire outstanding debt but also its entire enterprise value. Everybody outsourced credit analysis and credit judgment to the ratings agencies, which were more than happy to take a fee for telling everybody what they wanted to hear. Aggregate market liquidity went up, and aggregate investor knowledge went down. Everyone became a market maker. (That, at the margin, is what a speculator is.)

Naturally investment banks swelled like a tick on a dog in this environment. Increased liquidity begat increased volume, which begat more investment bankers earning more money for moving value from one pocket of the global economy to another. (Productivity in terms of volume of deals per banker always lags overall market growth.) It didn't matter to them where the money was going, or if it was doing anything truly productive on the way. That wasn't their job to worry about. They just had to make sure the moolah got from column A to column B intact and on time.

And, of course, take their cut off the top.

* * *

But here's the thing about liquidity, as we have quoted Mr. Keynes before:

[Each] individual investor flatters himself that his commitment is “liquid” (though this cannot be true for all investors collectively)


there is no such thing as liquidity of investment for the community as a whole.

No matter how much liquidity a market boasts, it will never be enough when everybody wants to get out at once. Mr. Fox is correct to say opacity and poor organization accelerated the freeze-up of derivatives and debt securitization markets and exacerbated their collapse. But transparency and better documentation would not have prevented it.

In his piece, Keynes ventures the opinion that regulators should impose external transaction taxes, or mandatory holding periods, to counteract the pernicious effects of creeping liquidity and speculation on financial markets. Whether these are appropriate ideas or not I will leave for other minds and another day to discuss. What I will say is the prescription for regulation of both investment banks and financial markets is clear: you cannot rely on the participants to regulate themselves. We are too busy counting the paper and inflating the bubble to care. The answer must come from outside the bubble, where the real economy and society lives.

But please, whatever you do, don't take too long. We are depending on you for answers.

"I don't see much sense in that," said Rabbit.
"No," said Pooh humbly, "there isn't. But there was going to be when I began it. It's just that something happened to it along the way."

1 For those of you already familiar with Mr. Keynes' magnum opus, I apologize for my novice's excitement. While I was familiar in outline with the basic contents of his argument, I must admit I had previously included the GTEIM on my list of Extremely Important Books Which I Really Must Get Around to Reading One Day. I never said I was perfect. (Did I?)
2 IMPORTANT DISCLAIMER: For God's sake, please understand that this simplistic example is an illustration, not an actual investment recommendation. Don't even think about taking anything on this site as investment advice. I am deadly fucking serious. Christ.
3 I am ignoring, of course, the positive return differential to private equity which should arise from the extra financial risk of debt assumed in leveraged investments. I am not aware of studies which quantify such an effect, but they may exist. Nevertheless, my intuition that a term structure of required returns on equity exists for most investors—if only implicitly—still stands.

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