Nerd Intersectionality

Infancy is not what it is cracked up to be. The child seems happy all the time to the adult, because the adult knows that the child is untouched by the real problems of life; if the adult were similarly untouched he is sure that he would be happy. But children, not knowing that they are having an easy time, have a good many hard times. Growing and learning and obeying the rules of their elders, of fighting against them, are not easy things to do. Adolescence is certainly far from a uniformly pleasant period. Early manhood might be the most glorious time of all were it not that the sheer excess of life and vigor gets a fellow into continual scrapes. Of middle age the best that can be said is that a middle aged person has likely learned how to have a little fun in spite of his troubles.

It is to old age that we look for reimbursement, the most of us. And most of us look in vain. For the most of us have been wrenched and racked, in one way or another, until old age is the most trying time of all.

— Don Marquis, “The Almost Perfect State”

I was browsing the online portal for the My Emotional Wounds Are Bigger Than Your Emotional Wounds Victims’ Society¹ this morning, O Dearly Beloved, when I encountered an essay by feminist firebrand Laurie Penny in which she took MIT Professor Scott Aaronson to task for justifying nerds’ insensitivity to male privilege in the technology industry. Notwithstanding some hyperbolic posturing about what Penny calls the “disaster of heterosexuality” [sic], it reads as a sensitive and revealing first person demolition of the notion that white male nerds faced some sort of unique hell growing up that can possibly justify their current behavior. I’ll let you go ahead and read it, if that’s your sort of thing.

If it is not, or you are back already, I would prefer to direct you to an earlier essay by computer nerd Pete Warden, cited approvingly by Penny and unfamiliar to me until now. In his essay, Warden, a die-hard, early adopter hacker type übernerd, correctly points out (in inimitable nerd fashion) that technology nerds, far from being the underdogs they so painfully remember being in their adolescence, are now Kings of the Hill:

We’re still behaving like the rebel alliance, but now we’re the Empire.

This is spot on. But then Warden goes and ruins the ride when he corrects Marc Andreessen’s assertion that nerds and bros are natural enemies with this:

Sure, we used to be picked on or ignored by the bro’s, but that was when we had no money or power. Now we have status, bro’s are happy to treat us as buddies instead of victims, to the point that we’re unlikely to think of them as bro’s. I’ve pitched most VC firms in the Valley at one time or another, and a lot of the partners come from business or finance backgrounds. There are nerds in there too of course, and they do control the culture, but they also get along perfectly well with the preppy MBAs. The same holds true across the whole tech industry – they might have tried to steal our lunch money twenty years ago, but now they’re quite happy running biz-dev while we do the engineering.

This is very muddled thinking as well as remarkably tone deaf observation as to what and who constitutes a “nerd” and a “bro” and the differences between them. But what should one expect from a nerd?²

* * *

Mr. Warden seems to identify the venture capitalists (“VCs”) and business development (“biz-dev”) colleagues he interacts with as bros because they have business or finance backgrounds, MBA degrees, and/or wear “preppy” clothes. This is just dumb. I have met a number of Silicon Valley venture capitalists and BD personnel over the years, and I can tell you from personal experience most of them would only come across as bros to someone who lives in a basement cave and thinks real women look and dress like Lara Croft in Tomb Raider. These people are as nerdy as they come. Sure, they prefer to geek out over cash flow statements and Definitive Purchase Agreements rather than hexadecimal code and API protocols, but geek out they do. They are just as scary smart, obsessive compulsive, and single minded as any computer hacker/programmer, and they tend to have the same awkward social skills as everyone else on the Asperger Syndrome spectrum they share with Mr. Warden and his peers. To the casual observer they may look and dress the same as a B– average fraternity brother from a state school, but they didn’t earn summa cum laude economics degrees from Stanford or the Ivy League, get Baker Scholarships at Harvard Business School, and claw their way into a partnership on Sand Hill Road from Morgan Stanley or Goldman Sachs because they liked to drink beer and flick bottle tops at computer science majors from the porch of their frat house.

Successful venture capitalists, private equity professionals, hedge fund managers, and investment bankers are as nerdy as they come. I mean, please: look at John Doerr, David Bonderman, Bill Ackman, and Lloyd Blankfein, for chrissakes. Those were the kids the football team beat up for lunch money in high school. Apart from shorter haircuts, plaid shirts, and an unfortunate predilection for chinos as casual wear, financial professionals share remarkably few of the features of true bro culture. In fact, you’re much more likely to find them running an ultramarathon or climbing Machu Picchu in their spare time than eating nachos on the couch in front of a football game. They are weird, they are driven, and they are the same awkward misfits who spent Saturday nights in high school doing extra credit calculus problem sets while the popular kids went out to drink beer and try to get laid. That is what I did, and I guarantee you it is what most of my colleagues and counterparts did too.

Now as is the case for all such qualities (and inconveniently for our current cultural obsession with identity politics), nerd-ness and bro-ness do not fall neatly within clearly identified boundaries of specified human communities. There are individual variations, there are community sub-groupings, and there are temporarily adopted behaviors that blur the picture. Within investment banking, for example, the tendency toward bro-ness tends to be larger in the capital markets division and, within that grouping, most strong among salesmen and traders. These are often the closest you will find to the backslapping, hail-fellow-well-met stereotype of good looking, easygoing bros who would be happy to watch football on TV instead of running another ultramarathon with that nut job client Ted from Citadel. But these folks have good degrees and sharp intelligence and nontraditional pastimes, too. The days of the high school graduate or C student on the trading floor are long gone. You’ll also find derivatives structurers within large bank capital markets divisions who I wager even Messrs. Warden and Andreessen would have a hard time differentiating from hardcore hackers and computer geeks. That is because that is exactly what they are, or were, before they donned the button-down and chinos uniform of their chosen career.

There is also, at junior levels, a lot of bro-ish posturing done by male investment bankers early in their careers when they are young, single, and so overworked they couldn’t spend all the money they make if they tried. In the boom years before the Crash, this often manifested itself in the desire to live the “models and bottles” lifestyle, where 23- and 24-year-old men went hunting for pretty women and expensive booze and mostly made obnoxious fools of themselves instead. (Of course that lifestyle—or, rather, the aspiration to that lifestyle which mostly generated exaggerated stories and outright lies—is long gone.) It still takes the form of the aggressive one-upmanship and macho dick measuring³ junior bankers haze each other with when they feel insecure, which is almost always. You only have to overhear this once, however, to realize it is nothing more than a bunch of awkward, self-conscious nerds who didn’t get laid enough in high school desperately trying to convince each other they did.

Of course, for some of us, this never changes.

* * *

Stepping back a little, I think I can assert without meaningful contradiction that, far from being limited to nerds or geeks or some other subculture, having a traumatic adolescence is almost universal. Everybody who makes their way through high school is, in some more or less meaningful way, faking it. Everybody wants to belong, be liked, fit in, and be popular. Everybody. It is human nature at that age, when we are still trying to define who we are. Why shouldn’t we look to our peers and popular culture for affirmation? But very few of us get it, to our satisfaction, so we channel our energy and ambition and hurt into schoolwork, or programming, or geeky hobbies instead. And many of us turn that sublimated effort into meaningful careers in geeky, nerdy fields like technology or finance, and find ourselves many years later, grown up, to be the socioeconomic successes we never dreamed we could be when we looked longingly at the cheerleaders and football players we could never have or be.

There is no cure for adolescence but to grow up. There is, however, a cure for adolescent trauma: get over it. And don’t use it as an excuse to oppress or traumatize others.

Unless, of course, you are Carl Icahn.

Related reading:
Laurie Penny, On Nerd Entitlement (New Statesman, December 29, 2014)
Pete Warden, Why nerd culture must die (Pete Warden’s Blog, October 5, 2014)
Taxonomy (January 14, 2007)

¹ Also known as the internet.
² Please, before you embarrass yourself, let me stop you before you argue there are very specific definitions for terms such as “nerd,” “geek,” “bro,” and the like. Really? You want to go there? Trust me: you don’t. Go back to arguing about lightsaber construction methods on the Star Wars wiki instead.
³ About pivot tables in Excel and PowerPoint formatting, no less. I ask you.

© 2015 The Epicurean Dealmaker. All rights reserved.

Shine On, You Crazy Diamond

Claudio: “Benedick, didst thou note the daughter of Signior Leonato?”
Benedick: “I noted her not; but I looked on her.”
Claudio: “Is she not a modest young lady?”
Benedick: “Do you question me, as an honest man should do, for my simple true judgment; or would you have me speak after my custom, as being a professed tyrant to their sex?”
Claudio: “No; I pray thee speak in sober judgment.”
Benedick: “Why, i’ faith, methinks she’s too low for a high praise, too brown for a fair praise, and too little for a great praise; only this commendation I can afford her, that were she other than she is, she were unhandsome, and being no other but as she is, I do not like her.”
Claudio: “Thou thinkest I am in sport: I pray thee tell me truly how thou likest her.”
Benedick: “Would you buy her, that you enquire after her?”
Claudio: “Can the world buy such a jewel?”
Benedick: “Yea, and a case to put it into.”

— William Shakespeare, Much Ado About Nothing

Matt Levine put an instructive and amusing post up at Bloomberg View two days ago on the nonsensical phenomenon which is CYNK that is worth your attention, Dearest of Readers, if only for a slow news Friday leading into a World Cup finals weekend. I recommend you enjoy it as an all-too-rare example of a financial journalist who actually tends to know what he is talking about trying to explain arcane and confusing epiphenomena of the financial markets to plebeians with wit and style. Levine, of course, is a former Goldman Sachs banker, which means, inter alia, that 1) he tends to know whereof he speaks (writes) and 2) you are free to disregard everything he writes as the sophistic outpourings of a confirmed agent of Satan sent to Earth to separate you and your orphaned, widowed Mother-in-law from any semblance of financial wherewithal and pin money. (These two things, by the way, are not necessarily mutually exclusive.)

Anyway, I have no particular interest in glossing Mr. Levine’s more than adequate gloss of this financial chicanery other than to point to a by-product of the CYNK story which features briefly in his story and which lesser mortals have been making quite the to-do about as this little passion play makes the rounds of Cialis-financed stock market news programs; namely, the purported market cap of this fraud professional short squeeze piece of shit security. As the Squid alumnus states,

Something about a company with no revenues and a brilliant but undeveloped business model (buy friends on the Internet! friends not included) having a $4, 5, 6, whatever billion dollar market cap struck me as fishy.

No shit.

* * *In fact, if you segue on over to the font of all financial market wisdom, Yahoo! Finance,¹ you will find that venerable market oracle calculates the market capitalization of this special snowflake without apparent substance or reason for being to be a delightful and highly substantive $4.05 billion as of Thursday’s “market” closing “price.” This is, of course, prima facie ridiculous, and it has been cited ad nauseam by every journalist and sundry whose secret brief and deeply held belief is that everything to do with the mysterious financial markets is bizarre, impenetrably obscure and opaque, and just plain dumb. On its surface, it is plain dumb, and, I am here to tell you, Delightful Readers, as your Guide to All Things Valuation, that the surface is all there is.

For a delicate glissade of the mouse over to CYNK’s historical price page on Yahoo! reveals that CYNK’s trading on Thursday (the last day of trading before exchange officials woke up from their bureaucratic pay scale-induced comas to ponder that something might not be quite right) occurred in a range of $9.80 to $21.95 per share for a total volume of 386,100 shares. Yes, that’s right, children, you read that right: 386 thousand shares. In other words, the blowout day of trading in a four billion dollar public company involved somewhere in the neighborhood of six million dollars² of stock trading hands. Do you see the problem? Of course you do.

Imputing a “market value” to a public company on the price which obtains when 0.13% of its total shares outstanding actually trade is a dubious business, especially when it is clear that the supply of available shares is, as in this case, severely constrained. It would be another thing entirely if everyone holding CYNK’s 291 million other freely tradable shares looked at their Quotrons and said, “Huh. $21.95 per share. Yeah, that seems totally reasonable. I think I’ll hold my current position for future price appreciation potential.” But when supply is artificially constrained from meeting demand, the price which obtains in a market is not the equilibrium price, and the value which that price imputes is not the equilibrium value of the asset.

Microeconomics and common sense tell us that not everyone in the market for any asset must have the same individual supply and demand preference for that asset. There is some portion of buyers who are willing to pay more than the current market price, some sellers who are willing to sell below the current price, and many on each side of the market who are not. This is neatly illustrated by the following diagram of a hypothetical market operation, familiar to many a student who did not sleep through the first month of Micro 101:

The point is that there is a “market,” of sorts, at almost every quantity of asset supplied, and if the supply of willing sellers is abnormally constrained or abnormally bolstered, one should expect sales to occur along the buyers’ demand curve until a local “equilibrium” is found. That being said, a sensible person would not view such an abnormal market as a good indicator of the normalized value of the underlying asset in question.

So, therefore, one should firmly embed notions such as the “market capitalization” of short squeeze scams such as CYNK in pulsating neon scare quotes, so the great unwashed and their blinkered guides in the media do not take them as anything other than arithmetic exercises. So, also, one should not take reported implied market values from the technology economy, such as Series D or pre-IPO round investments by professional investors in vaporware startups, as anything other than the revealed price preferences of that particular investor in that particular company. The fact that Fidelity invested $100 million for a 1% stake in the illiquid equity of Doofr-rama does not make a strong case that Doofr-rama’s “value” is $10 billion. All it really tells you is Fidelity desperately wanted 1% of Doofr-rama. If you want to know why, you better go ask Fidelity.

* * *

Value is a highly subjective and evanescent thing, O Dearly Beloved, a fact which I have addressed in these pages before. Perhaps the greatest proof we have of this in the financial world is the unpredictable and often fraught process whereby private companies enter into the public agora via initial public offerings. What makes the rest of us take some comfort in the reliability of seasoned publicly traded stocks is that they are traded freely by and among hundreds if not thousands of individual investors daily, all of whom can express their wacky, idiosyncratic notions of value to the limit of their appetites and checkbooks, in competition and cooperation with other lunatics with contrasting notions, to their hearts’ content or distress during market hours. If there is some constraint or check on fully free trading, such as artificially constrained supply (e.g., CYNK) or a dangerous mix of newly released limited supply supported by underwriters’ legal stabilization techniques (e.g., every new IPO), the wise judge of value should look at any arithmetic calculation which purports to give such an entity’s worth with a gimlet and highly jaundiced eye.

The wisdom of crowds in the market, as everywhere else, does not arise from the wisdom of each and every member of the mob. It comes from the diversity of idiotic, ill-considered, and just plain dumb opinions held by everybody, which, by some thankful magic of human nature, usually tend to cancel each other out and supply a workable if not entirely transparent answer. It’s when we have only one lunatic, or a small handful, making value decisions that we tend to get the silly answers.

Of course, if you find that one special snowflake whose worth has no price, feel free to dive in headfirst. I won’t judge you: it’s your funeral. Just don’t expect the rest of us to follow.

Related reading:
Matt Levine, Cynk Makes the Case for Buying Friends, Naked Short Selling (Bloomberg, July 11, 2014)
Go Ask Alice (September 14, 2013)

¹ Yes, I am aware that such a citation perhaps does not give you a great deal of confidence you are dealing with a professional’s considered opinion, but 1) it’s probably close enough, and 2) you don’t really think I’m going to spill my special secret top quality financial data sources into this pig trough, do you?
² Based on the clearly incorrect assumption all 386,100 shares traded at the average of the high and low prices of the day. The correct calculation would involve what is know as the volume-weighted average price, or VWAP, of shares traded. But in order to get that, you would have to subscribe to a real market data service, for which you are definitely not paying me in your current subscription price. My ballpark estimate is close enough.

© 2014 The Epicurean Dealmaker. All rights reserved.

Where Angels Fear to Tread

“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.

A Photograph, Not a Circuit Diagram

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!!

Sigh.

* * *

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.

The Laughing Policeman

A society that admires its shock troops had better be bloody careful about where it’s going.

— John le Carré, A Perfect Spy

This picture is beautiful. Just beautiful.

It was posted earlier today by Twitter account @reclaimuc. I have no idea whether it was posed, photoshopped, or merely a serendipitous tableau. I have no idea why the policemen and woman in the picture are laughing. But the framing—capturing the police, the telephone booth ad, the TD Bank branch entrance, and the building address of Two Wall Street—is simply spectacular. As an extra bonus, and for extra frisson, the tonality of the photo perfectly evokes that in The Matrix movies. Urban photojournalism doesn’t get any better than this.

Kevin Roose of New York Magazine later tweeted to explain that the ad in the picture is a fake, designed to promote an upcoming series on Cinemax. This makes sense, as it seems unlikely any real organization would be so tone deaf as to publicly advertise its services in earnest in such a way.¹ I don’t care.

Sometimes fate and fiction collide in such a way that the veil of dissembling and polite convention covering our everyday life is torn aside, revealing the slightly sordid truth beneath. It would be hard for anyone to pen a better exposé of the naked power structures undergirding the surface of my fair city in the Year of Our Lord Two Thousand and Twelve than this serendipitous little photograph.

Mayor Bloomberg must be exceedingly annoyed.


¹ Although behavior by certain Presidential candidates recently exposed in the news does plant a seed of doubt in my mind as to just how clueless members of the plutocracy can actually be.

© 2012 The Epicurean Dealmaker. All rights reserved.

All Together Now

“Do you mean, sir, that these birds are cannibals?”

“That’s an odd question, young Master,” the banker said. “I merely said the birds drink blood. It doen’t have to be the blood of their own kind, does it?”

“It was not an odd question,” Paul said, and Jessica noted the brittle riposte quality of her training exposed in his voice. “Most educated people know that the worst potential competition for any young organism can come from its own kind.” He deliberately forked a bite of food from his companion’s plate, ate it. “They are eating from the same bowl. They have the same basic requirements.”

— Frank Herbert, Dune

Steve Randy Waldman got me thinking today.¹

In an extensive follow-up piece to a previous post on complexity in finance, Steve answers objections to and elaborates on his argument that not only is opacity integral to the financial system of a complex society, it is essential. You may recall the core of his original idea:

Finance has always been complex. More precisely it has always been opaque, and complexity is a means of rationalizing opacity in societies that pretend to transparency. Opacity is absolutely essential to modern finance. It is a feature not a bug until we radically change the way we mobilize economic risk-bearing. The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear.

Financial systems help us overcome a collective action problem. In a world of investment projects whose costs and risks are perfectly transparent, most individuals would be frightened. Real enterprise is very risky. Further, the probability of success of any one project depends upon the degree to which other projects are simultaneously underway. A budding industrialist in an agrarian society who tries to build a car factory will fail. Her peers will be unable to supply the inputs required to make the thing work. If by some miracle she gets the factory up and running, her customer-base of low capital, low productivity farm workers will be unable to afford the end product. Successful real investment does not occur via isolated projects, but in waves, forward thrusts by cohorts of optimists, most of whom crash and burn, some of whom do great things for the world and make their investors wealthy. But the winners depend upon the existence of the losers: In a world where there was no Qwest overbuilding fiber, there would have been no Amazon losing a nickel on every sale and making it up on volume. Even in the context of an astonishing tech boom, Amazon was a pretty iffy investment in 1997. It would have been an absurd investment without the growth and momentum generated by thousands of peers, some of whom fared well but most of whom did not.

I think Steve’s analysis and critique are essentially correct. However, I am much less sanguine than he seems to be when it comes to eliminating much of the opacity and associated “kleptocracy” he finds in our current financial system. My pessimism is based on two rather sizeable barriers: human history, and human nature.

* * *

Human beings, we are told, evolved as social animals. From the very first dawn on the ancient savannah, our ancestors must have struggled with the solution to problems of collective action: how to provide security, shelter, food, and comfort to the members of the group or tribe. Given the natural variability among members of any population—whether along simple biological dimensions of age, infirmity, and strength, or more abstract qualities like ambition, skill, and desire—humans must have come to adopt and practice the division of labor early and often. Some would stay behind to protect the encampment, make and mend clothing, and build and maintain shelter while others foraged or hunted for food. Each member of the tribe would cede some of his or her personal agency to other individuals or groups in exchange for reciprocal aid. In this way, the group became stronger than any one of its members. In this way, through trial-and-error invention of division of labor according to comparative advantage, human groupings created social surplus, and complex societies were born.

Over the course of human history, we have developed numerous systems and institutions to address recurring problems of collective action. We developed standing governments to organize and direct our individual efforts toward persistent common goals, like safety, security, and other large challenges. We developed politics as a means for people to make collective decisions about authority and power in government and elsewhere. We built economies as a means to organize collective and individual economic action toward sustained or increasing prosperity. We developed judicial systems to adjudicate inevitable disputes and promote the cause of justice. Each and every one of these systems requires the individual citizen to surrender a portion of his will and agency to the collective. And each and every one of these entities creates, thrives on, and indeed cannot function without opacity.

Think about it: Do you know how and why decisions are made and actions are taken inside government bureaucracies? Do you know what takes place in smoke filled rooms among politicians and lobbyists, whose horses are traded and for what? Do you trust politicians to have your best interests or even the interests of the people who elect them at heart? Do you trust big business of any sort—insurance companies, oil companies, auto manufacturers, pick an industry—not to cut corners when it increases shareholder returns or executive pay? For that matter, do you trust your local auto repair shop to install the brand new muffler it charges you for, and not a refurbished one? Do you really believe our judicial system promotes justice? Do you trust lawyers?

Each of these social institutions creates opacity through the simple mechanism of dividing people into insiders and outsiders. The insiders have the advantage of knowing how things really work, how to “work the system,” and how to profit—economically, socially, and/or politically—from it. Information asymmetry (the source of opacity) is built into the very fabric of the division of labor in complex societies. Furthermore, creating specialized entities to handle collective tasks each of us individually neither can nor wants to address creates institutions whose primary aims become self-preservation and continued aggregation of power. Just like in finance, insiders’ privileged position and knowledge enable them to extract rents. It’s just that rents accruing to insiders in areas other than finance can take the form of social prestige, political power, and legal authority, in addition to undeserved money.

* * *

None of this should be particularly surprising to anyone who takes the time to reflect on it. Why do we tolerate opacity in our collective social institutions and rent-seeking (if not outright corruption) in the people who work there? Because, I must believe, after thousands of years of experimenting, we have not come up with any better way. No-one except a criminal really likes a rent-seeker, and no-one but a politician’s spouse likes a corrupt politician, but collectively we have come to accept the occasional example as the price we must pay in order to outsource the prosecution of certain of our interests to other people. It is a convenience tax. And just like any tax, we whine and complain about it, but we pay. “You can’t trust bankers/lawyers/politicians/bureaucrats/pick-an-actor.” Only when the basic services they provide collapse, or the excess rents they extract become too egregious, do we take up our pitchfork and torch to revisit the social contract.

The problem of opacity and rent-seeking by the insiders of the social institutions we empower to promote our collective good is less bad than it might be—and, therefore, more durable as a feature of complex society—for a number of reasons. For one thing, most people in such privileged positions of power really are not crooked cheats simply out for themselves. Most government bureaucrats, politicians, businesspeople, lawyers, and bankers really do believe they are providing a useful and perhaps even noble service. They view their privileges and socioeconomic rents not as perks unjustifiably pilfered, but as concrete confirmation of the worth and value which society—the people, the voters, the market, etc.—places upon their efforts. They think they deserve them.² Given that society allows or even encourages such actors to enjoy such special privileges, it is hard to argue that they are wrong.

For another, the tax which insiders extract for these services is, in the main, relatively small compared to the good their actions provide to the collective. Steve Waldman himself admits that:

Over the broad scope of history, societies with financial systems that mobilize capital opaquely and at very large scale have completely dominated those that have relied only upon consenting risk assumption by well-informed individuals. Industrialization occurs in societies with corrupt and fragile big banks, or else in societies where the state coerces and obscures risk-bearing and reward-shifting on a large-scale, or (more usually) both. China is a great present day example. That does not mean it would be impossible to develop a set of institutions that would be both effective and transparent. But it does mean developing such a system is an ambitious and ahistorical project, not a mere matter of “fixing what’s broken”. Under present arrangements, transparency and what we perceive as effectiveness stand in opposition to one another. It is incoherent to demand transparency and expect “more” macroeconomically stimulative intermediation from our current financial system.

Starkly put, what is a few billion dollars of excess compensation, here and there, if it enables the growth and prosperity of trillions of dollars of global economic activity?³

* * *

Finance is a critical function in today’s complex global economy. It is clear it stumbled badly in performing its basic function, and it seems beyond argument that it has far outgrown its proper place in the socioeconomic sphere and its share, deserved and undeserved, of the economic pie. But I find it hard to imagine any meaningful function performed by the financial system which can be purified into a transparent, corruption-free zone. Among government, politics, economy, and law, modern finance is a relative newcomer in the panoply of social institutions designed to promote the collective good. Given that no-one has demonstrated the ability to make any one of those older systems meaningfully transparent and corruption-free, I remain highly skeptical that we can do so with finance.

Yes, Steve, I admit the baby in the bathwater is fat, obnoxious, and ugly.⁴ But it is our baby. Do you still want to throw it out?


¹ Yes, believe it or not, it does happen on occasion. Steve is particularly good at triggering it, because he normally has such interesting things to say.
² Hence, e.g., the outraged sensibilities of financiers when you ask them to justify their relatively stratospheric pay: “But that’s what the market bears!” In other words, “I’m worth it!”
³ Especially if, as recent data seem to suggest, intragenerational wealth accumulation is more volatile and intergenerational wealth accumulation is less certain than it used to be. Personally, I am far less bothered by the rise and fall in one or two generations of self-made (finance) billionaires than I would be by the reestablishment of multigenerational dynastic wealth and all the sclerotic, corrupt sociopolitical accompaniments that would bring.
⁴ Steve also objects that our current financial system is incompetent when it comes to allocating systematic risk. He uses the examples of misallocating capital to faddish investments and the sticking of the unemployed and the indebted taxpayer with the biggest portion of the bill due from the collapse of the housing sector. But this misinterprets the proper role of the finance sector. The proper role is as servant to investors and users of capital. Investment bankers don’t sit in a back room, picking winners and losers like Chinese government ministers; we respond to capital supply and demand. Sure, such a system is widely acknowledged to be wasteful and subject to bubbles and fads, but it also has a long-term record of success I would stack up against any centrally planned economy’s any day. Given a choice between the (fallible) wisdom of crowds and the whim of a rent-collecting government technocrat insulated from market forces, I’ll take the crowds any day. Also, given that finance serves the broader society, why should we be surprised when it responds to the dictates of power by sticking failures to the little guy? That’s just politics.

© 2012 The Epicurean Dealmaker. All rights reserved.

Methinks Thou Dost Protest Too Much

Any sufficiently advanced technology is indistinguishable from magic.

— Arthur C. Clarke

Attentive Readers will realize that I have used my durable and insightful epigraph before, specifically in a post which defended my industry against accusations of malfeasance arising from the common tendency of merchants in any economy reliant upon buying and selling to conceal the true costs and profits embedded in their activities. It was my contention then and is now that no law, human or otherwise, compels a vendor to offer buyers of its wares the “best price”—whatever that may be—or, indeed, prevents it from doing what profit-maximizing enterprises are commonly presumed to do: maximize profits. As long as said vendor is not selling faulty merchandise to inappropriate customers in a fraudulent manner, we should not expect to know nor require it to reveal all of its secrets.

This, however, is not that post.

For those of you with half a brain will (or should) realize that my idyllic little précis of laissez-faire capitalism skips lightly over two critical assumptions: that 1) all this happy buying and selling take place in reasonably competitive markets, where other vendors compete to offer the same good or reasonable substitutes therefor, and 2) the manufacture and sale of these goods does not impose intolerably noxious externalities on the society in which they are sold. The first of these can be seen as simply a special case of the latter, in which the externality which society should naturally seek to limit is economic rent-seeking in all its forms: monopoly, oligopoly, producer or factor cartels, preferential government regulation, etc. Of course, this tends to assume that the economy should be servant to society, rather than vice versa, which belief seems unhappily out of fashion nowadays.¹ Go ahead, call me a dreamer.²

A cynic might say that politics is nothing more than a neverending argument over the size and distribution of economic rents in society. But let us set that question aside for now. Instead, I would like to focus on other kinds of externalities: those corrosive and destructive injuries to society which are generated as ineluctable byproducts of the activity of certain unsavory economic actors, like arms dealers, child pornographers, and television reality show producers.

And investment banks.

* * *First, some history.

One of the principal functions of investment banks is the distribution of economic risk in society, from those who wish to sell it (and its associated productive return) to those who wish to buy. In the past, investment banks generally worked pretty well as conduits for risk, passing it from natural seller to natural buyer pretty effectively while skimming a small percentage off the top as recompense for their services. On the wholesale securities side of the house, they acted as large, temporary warehouses, buying and selling securities and derivatives on behalf of clients and maintaining minimal stocks in inventory to satisfy unforseen demand. It was a model which required little equity capital to support it, so investment banks levered up with short-term financing of their short-term assets and earned a nice return on the shareholder or partner equity they employed. Operating with so little equity entailed substantial risk, as a simple mistake or unexpected market shock could send the entire house of cards tumbling down. But because they tended to deal in liquid, easily marketed instruments, failed investment banks could be liquidated with relatively little disruption to their counterparties or the financial markets. Of course, the shareholders or equity partners got wiped out, but that was understood as part of the game. Live by the sword, die by the sword.

But then came the Great Moderation, and the industry changed. Investment banks merged and converted into universal banks, with commercial lending, mortgage businesses, and retail depositors, and they began swelling like mutant ticks on a hemophiliac dog. They began to warehouse more and more securities and derivatives to accommodate increased trading volumes on the market-making side. They began to warehouse more and more financial instruments for their own proprietary trading efforts. And they began to manufacture securities and derivatives, like mortgage-backed securities, credit default swaps, and other “structured products,” to meet investors’ insatiable demand for adequate returns in a seemingly riskless world. But as their balance sheets ballooned, these banks stuck with the tried and true risk management philosophy they had developed over decades as pure investment banks: mark your assets to market in real time, get out of losing positions early, and never hold risky assets in inventory without hedging them. Unfortunately, this is a strategy which depends at its core on operating in liquid, transparent markets, where prices are well known, trading volumes are robust, and hedging instruments are effective and liquid themselves. It also depends on a key principle which every trader knows: it doesn’t matter whether the markets are liquid or not if your position has become so large that you effectively are the market.

In addition, investment banks began to take on more and more counterparty risk as they waded deeper and deeper into such activities as leveraged lending, prime brokerage (lending and clearing for hedge fund clients), and derivatives and other structured products. And this was not the simple counterparty trading risk of old, where your primary worry was whether the party you traded with would deliver a security. It was counterparty credit risk, incurred as part of a trade in which your ultimate profit depended on your counterparty’s ability to satisfy its financial obligations, like repaying a loan, delivering an unencumbered security, or paying off a derivative. And let’s face it: investment banks have historically been lousy at credit analysis. Oh, sure, they’re fine when it’s short-term, secured lending, like a margin loan collateralized by liquid, easily-marketable securities with transparent market values. But lending money (or, what is the same thing, contracting for delivery of future economic value under certain circumstances) to counterparties subject to multiple financial risks and multiple financial obligations over a longer period of time? Not so much. And this is a big problem, because it seems that investment banks as a group have become their own biggest credit counterparties in many markets, particularly derivatives.

* * *

The problem is neatly illustrated by a recent Bloomberg article on the European sovereign credit default swap market:

Five banks—JPMorgan, Morgan Stanley, Goldman Sachs, Bank of America Corp. (BAC) and Citigroup Inc. (C)—write 97 percent of all credit-default swaps in the U.S., according to the Office of the Comptroller of the Currency. The five firms had total net exposure of $45 billion to the debt of Greece, Portugal, Ireland, Spain and Italy, according to disclosures the companies made at the end of the third quarter. Spokesmen for the five banks declined to comment for this story.

While the lenders say in their public disclosures they have so-called master netting agreements with counterparties on the CDS they buy and sell, they don’t identify those counterparties. About 74 percent of CDS trading takes place among 20 dealer- banks worldwide, including the five U.S. lenders, according to data from Depository Trust & Clearing Corp., which runs a central registry for over-the-counter derivatives.

Gross exposures are many multiples higher, of course, but the banks like to advertise their net exposures instead. The problem is that net exposures are not the clean, unassuming things a layperson might think they are. Take the following scenario: Bank A sells a $100 million credit default swap on Underlying Company or Country X to Hedge Fund 1. Then, in order to hedge itself, it buys an identical $100 million CDS on X from Bank B. Bank A has completely eliminated its exposure to X and can sail off into the sunset, happily counting the money it made in spread between the two transactions, right? Wrong. Bank A has not eliminated its risk exposure at all, it has merely introduced a credit risk exposure to Bank B, which is now on the hook to pay off the CDS if X craters. But what if B craters? Bank A is still on the hook, and now it is completely naked short a $100 million CDS. Now Bank A could try to protect itself against Bank B’s default by buying a CDS on Bank B from Bank C or Hedge Fund 2, but I think you must begin to see that that merely introduces a credit exposure to Bank C or Fund 2. Of course in real life all these counterparties try to ameliorate this exposure by requiring frequently refreshed margin collateral on these trades, with the objective that any party’s true risk exposure at any point in time is simply the difference between the value of the collateral held (usually cash) and the net cost to replace the instrument in question.

The challenge to global financial stability posed by investment banks conducting these activities is threefold, in my humble opinion. First, the daisy chain of trades illustrated above clearly demonstrates that investment banks never completely eliminate the residual risk involved in buying and selling investment contracts like CDSs and other derivatives. There will always be some risk attendant on any transaction which has not been completely immunized (like, e.g., Bank A buying an offsetting CDS from Hedge Fund 1, which would have the effect of cancelling the original trade), whether this is direct credit exposure to your counterparty or basis risk introduced by trying to hedge counterparty credit risk indirectly, like via short-selling its stock. Each such trade adds residual risk to the bank’s balance sheet and, given the tremendous aggregate volume of gross derivative trades investment banks do, these residual risks can accumulate to a very large and scary extent.

Second, because most big banks have overall margin agreements (Credit Support Annexes) in place with each other that aggregate offsetting daily margin requirements across all trades outstanding between the firms, the collateral protection mechanism itself can trigger contagion both within and across tightly linked firms. A bank or large hedge fund faced with a substantial margin call in one market or security might liquidate positions in other, more liquid securities in order to meet its obligations. If substantial enough, this can cascade through the markets and the trading books of interlinked investment banks, causing broader market sell-offs and further associated margin calls. This sensitivity is exacerbated by the highly leveraged financial profiles of most major financial market participants, especially the large trading banks and derivatives dealers.

Third, the ineluctably bilateral nature of many of these structured products and derivatives means that, no matter how careful and conservative any one investment bank is in structuring and managing its risk profile, nobody can be assured they are not transacting with another AIG Financial Products or, less dramatically, that systemically dangerous net exposures are not accumulating in disturbing quarters. The chief reasons that AIGFP’s collapse exacerbated the financial crisis were because it did not post collateral (due to its AAA credit rating), it transacted in difficult-to-value, illiquid markets, and it accumulated huge net exposure to mortgage-backed securities. And yet investment banks and others gleefully piled into counterparty credit exposure with AIGFP (the “dumb money”) until it cried uncle. Wall Street piled into copycat trades and lending relationships with Long-Term Capital Management, too, in a 1998 dress rehearsal for 2008’s systemic collapse. The very nature of secretive, cutthroat competition in my industry means that none of us want to share information that might reveal the existence of unsafe concentrations of credit risk in the system.³ How else can one explain why French-Belgian bank Dexia was able to write so many interest rate swaps that it required a government margin call bailout to the tune of $22 billion? Last month.

* * *

The practice of counterparty risk management on Wall Street has improved mightily since the Panic of 2008. Given that disaster, it damn well better have. But given the nature of massively connected, highly leveraged investment banks acting as conduits and collectors of the risk of the financial system, and their historical blindness to risks like counterparty exposure and risk concentration which were the very risks which nearly killed them (and us), I am loathe to take them entirely at their word that everything is hunky-dory now. Short of requiring all derivatives and structured products to be cleared through global exchanges (with associated net position limits and centralized margin posting) and sharply limiting overall financial leverage at trading banks, I do not see a failsafe solution to this conundrum. Investment banks are bred in the bone to be highly competitive and take substantial risks. Their competitive risk taking added materially to the accumulation of dangerous stresses and vulnerabilities preceding the crisis, and there is no reason to believe it will not do so again.

I would be delighted to be proved wrong about this by those who know much more about the plumbing of the financial system than I do.⁴ What is to prevent the occurrence of another AIG Financial Products? How can existing system controls prevent or dampen the cascade of credit failures through the system? Are potential leverage-induced death spirals limited to markets with illiquid, opaquely valued securities? If so, what prevents them from spilling over via contagion into other markets? What is to prevent a major securities or derivatives market meltdown from forcing another massive government bailout?

And if you are brave, knowledgeable, and/or foolish enough to try to answer these questions, please keep in mind the admonition of another very clever man whom few now trust:

There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don't know we don't know.

A wise man learns to plan for all three.

Related reading:
Committee on the Global Financial System, The role of margin requirements and haircuts in procyclicality (BIS CGFS Papers No. 36, March 2010)
Selling More CDS on Europe Debt Raises Risk for U.S. Banks (Bloomberg, November 1, 2011)

An early response:
Brandon Adams, Response for @Epicurean Deal (November 5, 2011)


¹ An economy is simply the set of organizing principles and rules which a society establishes to allocate and employ resources for the benefit of its members. How these rules are established and maintained is politics. To assert otherwise, or claim as some do that society and politics have no proper claim on the organization or maintenance of economic activity (e.g., via regulation or taxation), is the height of folly or disingenuousness.
² Those among you who cannot comprehend this concept and who would prefer to call me much less flattering names than “dreamer” are welcome to stock up on canned peaches and armor-piercing ammunition and join your fellow nutcases in Galt’s Gulch. The rest of us will come annihilate you when we can spare a moment. (Or just let you starve to death.)
³ For example, my best and most comprehensive source to-date for understanding the intricacies of the issues under discussion would not allow me to share them directly, in part because (s)he believed some of the generic information (s)he provided could provide a competitive advantage. And you people think I’m secretive.
⁴ All reasonable, informed, and specific responses are heartily welcome. I may publish or link to the most informative and interesting of these here. Please direct your responses to the email address found on this site, or notify me on Twitter (@EpicureanDeal) or by email if you have published it on another site. Please indicate if you would prefer no attribution.


© 2011 The Epicurean Dealmaker. All rights reserved.

Why Oh Why Didn't I Take the Blue Pill?

Cypher: "You know, I know this steak doesn't exist. I know that when I put it in my mouth, the Matrix is telling my brain that it is juicy and delicious. After nine years, you know what I realize? [Takes a bite and chews]... Ignorance is bliss."

— The Matrix

Well, it's been about a week since I unplugged from the Matrix social media in the form of Twitter. So far, the Prozac, Xanax, and vodka tonics have kept my DTs (delerium tweetens) to a dull roar. But I must admit I can't resist feeling for the empty plug in the back of my skull every now and then, and I miss all the wonderful imaginary friends and admirers I had collected there. The call-and-response format of the medium is highly addictive to prolix egomaniacs such as myself, and its realtime interruptions and distractions are a pleasing way to fill up the frequent, dull downtime which plagues an investment banker's day-to-day existence. (Twitter is ideal for telephonic drafting sessions and conference calls, for example.) One might even begin to suspect it was specifically designed to keep specimens such as me plugged happily into the battery piles of our Silicon Valley overlords.

At least for now, however, I remain escaped and at large. In addition to all the flattering attention and ego gratification, I miss the constant flow of clever tidbits, quotes, and links which people I followed fed into the stream. I also miss sharing the amusing and intriguing nuggets which I discovered with my followers. This forum is not appropriate for such—at least the way I have traditionally used it—and I have no intention of shaking one demanding monkey off my back only to transform this site into another. There is also the question of appropriateness, since I already try the patience of those readers who come to this site expecting wisdom—or at least amusing tirades—about things financial with poetry, pictures, and other innumerate drivel. Perhaps I will find a way to share such items in another way. I am experimenting as we speak.

In any event, friends, family, and colleagues in the real world seem to be pleased with my recent return to undistracted consciousness. The only one who is truly displeased with me is the Woman in Red, who complains I have abandoned her to other, less attentive digital louts. Sometimes I feel bad about this.

But then I remember she doesn't really exist anyway. Right, honey?


© 2011 The Epicurean Dealmaker. All rights reserved.

The Relief of Distance

After all, Facebook, like Zuckerberg, is a paradox: a Web site that celebrates the aura of intimacy while providing the relief of distance, substituting bodiless sharing and the thrills of self-created celebrityhood for close encounters of the first kind. ...

[Zuckerberg]’s a revolutionary because he broods on his personal grievances and, as insensitive as he is, reaches the aggrieved element in everyone, the human desire for response.

— David Denby, "Influencing People"

Part of the power and attraction of social media, in my opinion, is that it encourages and enables the creation of acquaintance, friendship, and even intimacy among individuals who would otherwise never be able to create or even desire such relationships in the real world. Culture, geography, distance, and existing socioeconomic ties are not insurmountable or even apparent obstacles to people commencing interaction and communication over the internet. This broadens the scope for both connection and misunderstanding to a far greater degree than has been possible to date in our local, non-virtual, geography- and time-constrained world. The potential degrees of freedom of human interaction have materially increased. While this has opened intoxicating vistas of personal possibility for millions, you can also imagine it is not always a good thing.

The other significant change embedded in these new interactions is that people can cultivate relationships over virtual social networks for months and even years without ever meeting in the flesh. Stable, long-lasting, and—it is not irresponsible to imagine it—even durable relationships of the deepest kind can be established and maintained between characters or personae that individuals adopt and present to each other. Is this wise? Is it responsible? Is it fair?

Does it matter?

Probably not, for we have already shipped ourselves out to a brave new world. An entire generation is constructing online identities—smarter, wittier, braver, and prettier than we are in the real world—and sending them out to interact and form relationships with similarly artificial simulacra. We are no longer Pygmalion in his studio, sculpting an image of female perfection according to our own desires and imaginings, and then falling in love with our own pliant and accommodating creation.

Instead, we are sculpting ourselves into our own Galateas, in form and image how we imagine others would desire us to be, and then posting our idealized version of ourself onto the global bulletin board of friendship and desire. Where will this go? How will it end?

I am an old man, a throwback to a generation which found standalone PCs with 256K of memory revolutionary, so I am not qualified to say. But I must believe it will have an effect on the form and nature of human interaction going forward.

And I also believe that one day, some restless prodigy of the Facebook generation will take all these changes and rewrite Romeo and Juliet for the brave, new, networked world of her peers. I predict it will be both beautiful and heartbreaking.

© 2010 The Epicurean Dealmaker. All rights reserved.

Thank You for Smoking

Ἔρος δηὖτέ μ' ὀ λυσιμέλης δόνει,
γλυκύπικρον ἀμάχανον ὄρπετον

Eros once again limb-loosener whirls me
sweetbitter, impossible to fight off, creature stealing up

— Sappho, LP, fr. 130, trans. Anne Carson


“Why is youth so terribly unmerciful? And who has given it permission to be that way?”

— Smiles of a Summer Night

Hewlett Packard CEO Mark Hurd resigned this evening, allegedly in response to an internal investigation about sexual harrasment. While the investigation found no evidence of wrongdoing, “it did find violations of the company’s standards of business conduct.” Given the obfuscations and protective smokescreens inherent to corporate PR doublespeak, this tells us exactly nothing. I am sure the legions of well-paid internal and external counsel beavering away in darkness to quickly settle and bury any real or purported wrongdoing will make sure we never really find out.

But Mark Hurd’s real or alleged guilt is not my subject this evening, Dear Readers. Rather, it is a larger and more persistent question. One which I believe many of you, like me, have pondered from time to time over the length of your lives. That is:

Why is it that powerful men cannot seem to keep their dicks in their pants?

This phenomenon is so trite, prevalent, and persistent that I will not insult your intelligence by drawing attention to the myriad examples from our recent or distant past to illustrate it. I will just presume that if you have not been in a coma since the age of three you probably have a pretty good idea of what I am talking about. Of course, I am talking about the sexual peccadilloes of men who are normally married, as opposed to the theoretically less objectionable rutting about of unattached and uncommitted men. You should also assume I am focused on powerful men. Naturally, a man with social status, economic wealth, or political power will have a lot more opportunity to fool around with members of the fairer sex, since so many of the distaff gender find such attributes to be catnip in a man. Poor, lowly, impotent men—I will assert with little fear of contradiction—are probably just as eager to do the nasty with attractive women as the big boys. They just get a lot fewer chances, and no-one in the gossip pages seems to care if they succeed.

* * *

Now those of you now reading who expect a lengthy, well-reasoned and well-documented treatise on the sociological, anthropological, and cultural sources and reasons for extramarital cheating among married men in positions of power will be sorely disappointed (as well as clearly lost, having stumbled upon the wrong blog site). But I can offer a few simple observations based on personal experience and observation.

For one, unlike what I remember believing in my callow youth and the apparent beliefs of many youngsters under the age of 30 today, getting older does not leach out physical desire or interest in sex from married adults like an inconvenient stain.¹ If anything, the decreasing frequency and opportunity for thrilling sex with an exciting stranger tends to make it that much more attractive to anyone not sporting ice blood in his veins.

Second, the relentless approach of age, infirmity, and death assumes a greater and greater reality and presence of mind as one ages. Most young people below the age of 30 simply cannot comprehend—on a visceral, emotional level—the ineluctable fact of their approaching decrepitude and eventual obliteration. This lurking thought grows slowly in one’s mind as one ages, hiding in the shadows but never forgotten, and it begins to affect almost every aspect of one’s behavior. For men, fear of death can make one grasp at youth, and excitement, and beauty in a desperate subconscious bid to stave off the Reaper. If the man happens to be wealthy, famous, and powerful, likely he will be surrounded by plenty of pliable young females delighted to indulge his self-deception.

But third—and, in my opinion, most important—men do not lose the need and desire for romantic love any more than do women when they age. If anything, it gets more poignant and compelling than when they were young. The young man—like the young woman—yearns for love, and pines for it, but deep in his bones he just knows that he will find it. He assumes it is inevitable. The older man knows, from long experience, that he may never find such love, or, if he has had it, experience deep, compelling romantic love ever again. If this realization does not turn him bitter, it will make him all the more susceptible to the real or imagined siren call of Eros. Stir in method, and opportunity, and presto!: peccadillo in a glass.

* * *

But don’t take my word for it. Go watch Ingmar Bergman’s Smiles of a Summer Night. And read Pauline Kael’s review of the film, if you need further convincing that romantic love gets no simpler, no less poignant, and no less powerful when you are old and married. In it she quotes a Swedish film critic, who wrote that

“... Smiles of a Summer Night is a comedy in the most important meaning of the word. It is an arabesque on an essentially tragic theme, that of man’s insufficiency, at the same time as it wittily illustrates the belief expressed fifty years ago by Hjalmar Söderberg that the only absolutes in life are ‘the desire of the flesh and the incurable loneliness of the soul.’”

Then perhaps in the future you will not sneer quite so readily at old men besotted with sex, making themselves ridiculous in the pursuit of romantic and erotic love, no matter how powerful they may be. Perhaps you will remember the words of another old man who also clung desperately to youth and love and was obsessed with sex well into his dotage. There is wisdom and magic in them.

O but there is wisdom
In what the sages said;
But stretch that body for a while
And lay down that head
Till I have told the sages
Where man is comforted.

How could passion run so deep
Had I never thought
That the crime of being born
Blackens all our lot?
But where the crime’s committed
The crime can be forgot.

— W.B. Yeats, A Woman Young and Old: V. Consolation

Glukupikron, indeed.

¹ Although there is a very long, semi-serious tradition in Western culture—disputed violently by many women, natch—asserting that married women lose interest in sex disproportionately more than husbands. This trope is neatly illustrated by one of the favorite (and most popular) jokes of Mrs. Dealmaker herself:

Q: What's the difference after sex among a prostitute, a mistress, and a wife?
A: The prostitute says, “Did you enjoy that?” The mistress says, “Did you enjoy that as much as I enjoyed that?” And the wife says, “Beige... I think I want to paint the ceiling beige.”

© 2010 The Epicurean Dealmaker. All rights reserved.