Wednesday, January 30, 2013

Where Angels Fear to Tread

What about this strikes you as rational?
“Asps. Very dangerous. You go first.”

— Raiders of the Lost Ark

For a rapacious and unapologetic facilitator of the accumulation and redeployment of financial capital in the modern economy, I must admit in confidence to you, O Dearly Beloved, the perhaps surprising and somewhat disconcerting fact that I am an admirer of cogent Marxist analysis. While I remain unconvinced—and have been ever since some flaky antipodean professor/activist on sabbatical visited my college eons ago and completely failed to convince me his ideas had any practical political application whatsoever1—that Marxism has much useful to say about the practical organization of social and political institutions to reduce economic repression and increase socioeconomic justice, I do believe its focus on the interaction of capital and labor can offer interesting insights into economic and financial issues of perennial interest.

Marx thought capital was important. I think capital is important. Perhaps it is less surprising than a naive observer might otherwise think that I find Marxist analysis occasionally insightful.

All of which is typically verbose preamble to the observation that I find the work of C.J.F. Dillow almost always interesting, provocative, and insightful. I read his blog Stumbling and Mumbling regularly, and I recommend those of you who can absorb a Marxist analysis on an regular basis without blowing a physiological or psychological gasket do the same. His views are cogent, well-supported with copious references, and almost uniformly thought-provoking.

That being said, however, I must take issue in these pages with one of the points Mr. Dillow advanced in a recent post. While tying his remarks to some recent research which showed a correlation between stock market investment and business investment, Old C.J.F. asserted that

a correlation between investor sentiment and capital spending might exist simply because rational expectations of the future determine both. If so, then current weak sentiment and weak investment are a sign of weak future growth.

But Lee and Arif’s work suggests this might not be so. They estimate that, in most advanced countries, high investment leads to weaker GDP growth and falling profits. That’s exactly the opposite of what you’d expect if sentiment and investment were rationally determined.

This leaves us with another possibility - that it is irrational animal spirits that drive sentiment and capital spending. And herein lies the point that is not widely made. It’s that the economy is being depressed in part by company bosses being irrationally pessimistic. We’re paying the price for stupidity in boardrooms.

But this equation of businesses’ failure to invest now, when economic conditions are depressed and, presumably,2 opportunities for investment are particularly attractive, with irrationality, stupidity, and (thoughtless) “animal spirits” is cheap, sloppy, and simplistic. What Mr. Dillow seems to overlook is that business investment in any economy is characterized in large part as a collective action problem.

* * *

Businesses do not invest in existing or new business lines in a vacuum. In addition to exogenous factors over which they have no control and usually very little ability to predict, like customer demand, general economic conditions (including the exogenously determined market cost of the capital which it decides to invest), and competitive response, no business has the ability to predict with high confidence the actual financial or operational results of any investment. Businesses make investment decisions under often daunting conditions of significant uncertainty. When general economic conditions are weak or unsettled, as they are now, the uncertainties surrounding any investment decision are that much more worrisome.

Based upon my years of experience and interaction with senior business executives and company directors through both good and bad economic times, I can tell you with confidence business decisionmakers typically react to such conditions with the most natural, intelligent, and rational human response imaginable: caution. Failure to invest under conditions of economic malaise, recession, or disruption is not cowardly, stupid, or irrational. It’s often just plain common sense. Furthermore, executives and directors of corporations owe a fiduciary duty to their stakeholders to make rational and prudent decisions. If prudence dictates caution, who will gainsay a CEO’s or board’s decision to defer that new manufacturing line or acquisition until conditions become clearer? Who indeed, other than a central planner or politician who would like someone, anyone, to take the first step.

Now it is true that if every business in an economy exercises so much caution that they don’t invest, it will be difficult if not impossible for that economy to grow its way out of recession. This is well understood as the paradox of thrift. By the same token, when uncertainty decreases so much that every business feels comfortable investing in new capacity and new business lines, it is logical to expect the economy in total will suffer from overinvestment and subsequently sub-par returns. In aggregate, then, rational behavior on the part of individual businesses can lead to collective and individual outcomes that are suboptimal and, hence, in some fashion “irrational.” But this irrationality is a structural feature of the situation, not an individual failing of each independent actor.

We have an old riddle in the Colonies which may be unfamiliar to Mr. Dillow that captures the essence of my argument:

Q: How can you tell which settlers are the pioneers?

A: Simple. They’re the ones with arrows in their backs.

I am no apologist for the native intelligence of corporate executives or their directors. In this I agree with Mr. Dillow wholeheartedly. But let us not mistake the natural equilibrium outcome of independently derived rational decisions with individual irrationality or stupidity.

That is just dumb.

1 Which failure to convince me and my classmates drove the loopy bugger to foaming-at-the-mouth distraction and encouraged him to beat a hasty retreat to more amenable climes once the semester was over. It is perhaps not unfair to note that my college was not a seething hotbed of sympathetic vibrations to such worldviews.
2 Really? You want to bet your company on that (Warren Buffet-like) conventional wisdom? Be my guest. You go first.

© 2013 The Epicurean Dealmaker. All rights reserved.

Tuesday, January 8, 2013

Wherein Your Droll, Semi-Victorian Bloggist Jumps the Shark

Feel free to stare. Yes, I'm handsome and modest, too.
Let it never be said, O Dearly Beloved, that your Curmudgeonly Interlocutor is loathe to trot out his sesquipedalian stylings for the benefit and punishment of the broader world at large. Approach me in a suitably submissive and humble manner, bearing burnt offerings of fruit bats and breakfast cereals, and there is no telling what pearls of wisdom I might let drop from my coruscating lips.

Such were the tactics of one Charles Reinhardt, intrepid reporter from the literary hinterlands of Brooklyn, who approached me on behalf of his employer and online literary magazine Volume 1. Brooklyn. I must admit I initially considered his proposal of interviewing a semicoherent apologist for the financial industry on behalf of his distinctly hip, educated literary audience an intriguing, albeit unorthodox (and perhaps ill-conceived) project. But I am not immune to flattery. And I must own that the hook was set when I subsequently viewed his employer’s motto on the website:
If you’re smart, you will probably like us.

Well, of course then.

In any event, Mr. Reinhardt served up several appropriately non-financial softball questions for me to toy with, and toy with them I did. A sample:

How did the blog start?
The beginnings of my blog are shrouded in the mists of internet time. I dimly recall beginning to read certain online blogs like Marginal Revolution, Calculated Risk, and Going Private in the 2005-2006 timeframe and thinking–if not exactly that I could do that myself–that it might be quite nice to have my own soapbox. Part of it, I suppose, was driven by the sense I had that few people commenting or reporting online actually knew what the hell they were talking about when it came to finance. I thought I could actually add something valuable–or at least factual–to the conversation. Part of it was undeniably driven by boredom with the quotidian concerns and demands of my profession which, I am the first to admit, can be staggeringly sterile, routine, and blinkered. And part, of course, was driven by a desire to test whether I could write entertaining and informative prose, bolstered by the narcissistic conviction that I could. I started blogging in January 2007, and the world has been suffering miserably ever since.

There is much, much more. Go read it.

And if enough of you flatter my ego by reading it, I just may cancel my new project of selling artisanal cupcakes in Williamsburg on the weekends. Then again, maybe I won’t. I’m beginning to dig my new hipster cred.

Related reading:
Charles Reinhardt, The Bookish Banker: An Interview with The Epicurean Dealmaker (Volume 1. Brooklyn, January 8, 2013)

© 2013 The Epicurean Dealmaker. All rights reserved.

Sunday, January 6, 2013

A Photograph, Not a Circuit Diagram

Oh, good. Now, would you mind explaining this to me?
Except in the simplest cases, one cannot expect observation alone to reveal the effect of the use of an aspect of economics. One cannot assume, just because one can observe economics being used in an economic process, that the process is thereby altered significantly. It might be that the use of economics is epiphenomenal—an empty gloss on a process that would have had essentially the same outcomes without it, as Mirowski and Nik-Khah (2004) in effect suggest was the case for the celebrated use of “game theory” from economics in the auctions of the communications spectrum in the United States.

— Donald MacKenzie, An Engine, Not a Camera: How Financial Models Shape Markets 1

By now, many of you may have already read Frank Partnoy and Jesse Eisinger’s lengthy, outrage-y article in The Atlantic about the ongoing horror that is bank accounting, and/or one of many, many responses and reactions to it. I will not try your patience (or mine) by addressing their each and every substantive argument, but I thought it might be useful to lay out in summary form here why I think the entire premise of their screed is wrongheaded.

First, I will take the liberty of condensing and paraphrasing Messrs. Partnoy and Eisinger’s 9,500 word confection for the benefit of those among you with limited time and attention spans:
Banks are opaque and hard to understand! This is scary! Even big, sophisticated investors don’t understand the risks big banks take! Financial reporting for banks is scary and complex and mystifying! To calm ourselves, we tried to understand stodgy, prudent Wells Fargo’s financial statements. What did we find? Wells Fargo is big, opaque, complex, and scary!! Even their friendly investors relations person could not or would not answer our questions! We are scared! What should we do? We should send more bank executives to jail for scaring us! Oh, and come up with better, more understandable financial disclosure! Otherwise no-one will ever, ever, ever invest in publicly traded banks again! And then, disaster!!

* * *

Before I begin, I think it is fair to concede our Cassandras’ contention that large commercial, investment, and universal banks2 are highly complex, risky, and opaque institutions. It is also fair to say that most of the bad or downright naughty things which have occurred in the financial sector over the past several years (although not all; viz., Bernie Madoff) have bubbled up from the bowels of large, complex, opaque banks and their brethren. But the notion that there is some sort of magical accounting regime which could simultaneously shine sunlight into the deepest reaches of multi-trillion-dollar global financial institutions, clearly convey the actual and potential risks these institutions face or create in their daily operations, and therefore usher everybody into a new era of financial transparency, trust, and mint juleps on the sun porch is simply ludicrous. It completely misunderstands what accounting is and what accounting is for.

It is a rookie mistake.

First, accounting is—as Donald MacKenzie characterizes (academic) economics in the quote above— an epiphenomenon to the actual day-to-day activities which any business conducts. It is a way to keep track of the financial outcomes of a firm’s true activity, which is conducting business. It is passive, it is backward looking, and properly used under normal circumstances it drives none of the important business decisions or activities which firm executives pursue. When accounting consequences do drive decisionmaking, as in tax avoidance strategies or manipulating earnings, it introduces distortions into the underlying business which can lead to all sorts of economic inefficiences, up to and including fraud.

Accordingly, reading a set of financial statements can tell you very little about how to run an actual business. That is why every business of even modest complexity runs its own internal management information systems which provide the people running the show with real time, targeted information which they can use to make decisions. These systems have very little, if anything, to do with generally accepted accounting principles. The daily trading book and profit and loss statement for a Wall Street trading desk will bear little resemblance to the balance sheet and income statement of its investment bank parent. Of course at year and quarter end each desk’s results do get rolled up and reconciled into its parent’s consolidated financial results, but this process by necessity compresses and distorts the actual real-time, granular information used to run a business into standard, pre-approved accounting categories. In addition, the backward looking nature of accounting for the period just ended means the more dynamic and changeable an underlying business process is—for example, sales and trading at a securities firm—the more out of date and potentially misleading the reported numbers can be to the current state of the business.

And it is not a matter of simply providing more, more detailed information more frequently. Put aside the common tension that most businesses compete with others, and detailing too much information in publicly available accounts would undermine their competitive position. (This is particularly important for market-making investment banks.) No, such a strategy would increase the complexity of a firm’s accounts, which seems exactly contrary to Messrs. Partnoy and Eisinger’s stated objectives of greater transparency and shorter financial reports. Not to mention still not get at the idiosyncratic risk and business practices of each such firm, because it is the entire point of public accounting to standardize reporting to enable comparability across firms.

And this last gets directly at a critical point which seems to have eluded our intrepid reporters: what accounting is for.

* * *

For that is what public accounting is: a public accounting of the financial results of a firm for the benefit of external stakeholders of various stripes, including lenders, creditors, business counterparties, regulators, and investors. It is meant to be an intermittent report on the health and progress of a firm to potentially interested parties, filtered, standardized, and formatted into a presentation which can allow those parties to compare the firm to its peers and competitors both within and outside its industry. It is not meant to be a real-time profile of the actual business operations of an individual firm; nor is it meant to give outsiders such operational knowledge of the firm that they completely understand and perhaps could even run the business themselves. It is a report card, not a class curriculum or even lecture notes.

And you should not think that regulators—who we might indeed prefer to have much more detailed, real-time operational knowledge of systemically important risky financial institutions—are hobbled in any way by the limitations of their regulatees’ public financial reports. Securities and bank regulators always have intimate access to the current operations and results of firms under their supervision and, arguably, should have much more. But this is true whether a firm files public reports or not.

Lastly, Messrs. Eisinger and Partnoy’s concern for the confidence of equity investors in banks is completely ass-backwards. A quick peek at the balance sheet of their subject Wells Fargo reveals that it derives only 10.4% of its outside funding from equity investors: the vast bulk is in the form of retail and other deposits, and the balance comes from other debt and preferred investors. Show me a retail depositor who decides whether to keep her money at Wells Fargo based on the footnote disclosure in its annual report and I—after I pick my lower jaw up off the floor—will show you a hot January. Likewise, equity investors were not the funders first to the lifeboats when Bear Stearns and Lehman Brothers ran aground. Stock investors were not the parties who cratered failing banks in the financial crisis.

That is because banks and investment banks do not rely on equity investors for daily funding or liquidity. They rely on trading counterparties, repo suppliers, short-term lenders, and prime brokerage hedge fund customers to roll over constantly maturing short term debt (often funded overnight) and keep their trading balances and assets at their firm. When these institutional investors lose confidence, a bank is toast. They refuse to roll over short-term funding, they yank their assets on deposit, and they may even put on a nice, juicy short against the beleaguered bank’s stock just for good measure. And you can bet your bottom dollar they are not going to wait for the quarterly 10-Q report to be filed 45 days after period end to make their decision.

* * *

Even the much maligned (by me) Securities and Exchange Commission understands the proper relationship of public accounts to equity investors. Remember that the SEC’s objective for public reporting is not to help you fully understand a business. It is to disclose all pertinent and relevant facts and risks about a business so an investor can make her own informed decision. Banks are big, opaque, risky, and complex. What do bank financial statements tell us? They tell us banks are big, opaque, risky, and complex. That sounds pretty accurate to me. The kind of disclosure our doughty duo proposes, including ludicrously simplistic “worst-case scenarios,” would not increase investors’ understanding of the real risks inherent in the mind-bogglingly complex business of global finance. In point of fact, these are only poorly or dimly understood by the very bankers undertaking them. Instead, it would promote a sort of unwarranted confidence that would be both dangerous and misleading.

Equity investors should be terrified of banks. After all, they are the last capital providers in line in famously and ineluctably evanescent institutions, firms whose very existence can wink out over a weekend if the depositors, counterparties, and institutional investors ahead of shareholders decide to take a powder. That is the nature of banks, then, now, and always. Banks are structurally short liquidity. When liquidity dries up, or becomes prohibitively expensive, banks fail, and they fail fast. It’s as simple as that.

And yet, notwithstanding all of poor Bill Ackman’s axe grinding, retail and institutional investors still seem to want to own bank stocks.3 Why is that? Well, notwithstanding the good money to be made owning them in good times, it seems the prices of bank stocks, whether measured by historical prices, P/E ratios, or price to tangible book value, have dropped to a level where investors feel fairly compensated for the risk they are assuming. You know: the risk disclosed in the banks’ public financial statements that they are big, opaque, risky, and complex.

Nowhere is it written that bank stocks should trade at a specific multiple of book value, no matter how accurate or believable book value is. Investors may be paying lower than historical multiples of book for bank stocks because they do not trust banks to have properly marked assets to market, they may not trust management not to destroy value by making stupid errors (or errors unavoidable in today’s volatile and unpredictable markets), or they simply fear more unanticipated systemic disruptions will sink even the best-managed, most conservatively-accounted-for banks (including threatened regulatory changes). Investors are paying lower prices for bank stocks because they require higher risk-adjusted expected returns.

This does not sound like a crisis of confidence to me. This sounds like sensible, prudent investing in an uncertain world.

Related reading:
Frank Partnoy and Jesse Eisinger, What’s Inside America’s Banks? (The Atlantic, January/February 2013)
Matt Levine, Turns Out Wells Fargo Doesn’t Just Keep Your Deposits In A Stagecoach Full Of Gold Ingots (Dealbreaker, January 3, 2013)
Felix Salmon, You can’t regulate with nostalgia (Reuters, January 3, 2013)

1 Cambridge, Massachusetts: The MIT Press, 2008, p. 18.
2 For the novitiates, simply, a “commercial” (or retail) bank is primarily a lending bank: they take in retail customer deposits and lend them out in the form of mortgages, commercial loans to businesses, and other retail loans. An investment bank acts as a market intermediary, buying and selling securities and derivatives on behalf of clients and itself and advising on mergers and acquisitions. A universal bank is a combination of commercial and investment bank. Most big banks you read about nowadays, including, e.g., Wells Fargo, are universal banks. Not enough for you? Want to go deeper down the rabbit hole? Start here.
3 How do I know this? Well, the trading volume and price of public banks and investment banks is not zero, that’s how. By the way, the price to tangible book value ratio for terrible, awful, scary Wells Fargo is currently 1.7x, or almost twice book value. Perhaps that’s because equity investors take great comfort from all those information-insensitive depositors ahead of them in the capital structure.

© 2013 The Epicurean Dealmaker. All rights reserved.