Saturday, January 31, 2009

Wall Steet Compensation: Gaming the System

I have written about the practice of re-labeling expenditures with a different, nicer sounding name. Financial service companies are masters at this practice. Want to advertise an eye-catching low interest rate. Use a different word for the finance charges. Labels such as: transaction fee, points, rebate, origination fee, can all be used as reasons take money from consumers without using the emotionally charged label “interest.”

Given that financial institutions are masters at re-labeling, I am completely mystified by their use of the word “bonus” in labeling parts of employee compensation. This past week John Thain was fired when it became public that the day before his failed company, Merrill Lynch, was taken over by Bank of America he dispensed over $4 billion in bonuses. At the same time, the full extent of liabilities Bank of America had assumed was not fully disclosed. Probably because no one really knows just how much bad debt Merrill Lynch owned. Bank of America, after discovering that it had acquired a deeper and possibly bottomless money pit than it previously thought, was forced to go back to the government and plead for more bailout money.

Meanwhile a report that total year-end bonuses on Wall Street exceeded $18 billion brought a rare public display of anger from President Obama and promises to rein in Wall Street compensation packages. The practice of executives rewarding themselves while their companies and clients are ruined is described succinctly in a Forbes Magazine piece titled “Five Legal Scams” by William Baldwin. One scam labeled “Heads I win” is this: “Be a hedge fund manager. Pocket 20% of the gains if you are lucky, but chip in for none of the losses if you aren't.”

Executives on Wall Street defend bonuses as being performance-based and necessary to attract top financial talent. Which makes me wonder why they haven’t re-labeled “bonuses” with the word “commission.” From their defense of the practice its sounds to me that the kind of compensation they are describing is known as a “commission” in most other industries. The public might wonder why anyone would pay for the kind of “performance” and “talent” that created the mess on Wall Street. But, if a car dealership went belly-up no one would dispute that the salespeople should still receive their commissions.

However, the fact that it has never occurred to these executives to use the word “commission” is a telling statement about the kinds of products they sell. Auto salespeople are paid commissions for selling a tangible product. Each car manufactured has a vehicle identification number that is recorded and tracked by the manufacturer, dealership, state government, insurance company, lien holder and owner. As cars arrive and leave the lot it is nearly impossible to fake selling them. It is difficult for dealers to simply make up sales figures.

For financial services firms, making up numbers to describe profits and losses is easily doable. As the financial system unravels it is apparent that many firms did make up numbers. The fact that someone like Bernie Madoff could get away with a $50 billion Ponzi scheme for more than a decade is telling about the lack of real accountability in the financial services sector.

Perhaps instead of a different label executives should rethink their compensation packages and incentives. As it stands now, workers and managers have an incentive to “game” the system. I have written in my book, The Two Headed Quarter, about what I call “The Numerical Outcome Principle.” Once a number is used to judge outcomes, people will adjust their behavior to maximize that particular number. The actual outcome no longer matters. Because numbers are so fluid on Wall Street that is exactly what happened.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Tuesday, January 20, 2009

Bailout Money: The Problem with Null Experiments

One of the difficult problems in experimental science is drawing conclusions from a null experiment. Suppose a theory forbids an event to happen—faster than light travel for example is forbidden by the theory of relativity. Looking for faster than light travel and not succeeding is a result consistent with the theory. But, the result doesn’t “prove” the theory. Your experiment might not have looked for faster than light travel in the right way, in the right place, or at the right time. You could spend a lifetime looking for an event that shouldn’t happen, not see any examples, and still not know for sure if the event could never happen.

Contrast that situation with an affirmative experiment. For example relativity predicts the bending of light by gravity. Einstein became famous after astronomer observed the bending of starlight as it passed by the sun. That affirmative result doesn’t “prove” the theory either, but at least you know light bending by gravity is a real effect. You don’t have to keep looking.

I was thinking about the problem with the null experiment this week because it arises in the current debate about the effectiveness of the government bailout of the financial industry. This past September congressional leaders and President Bush predicted imminent collapse of the United States’ financial system unless a $700 billion bailout plan passed. On September 29, 2008 the House of Representative rejected the proposal and the markets responded with a 777-point loss in the Dow. It closed at the end of that day at 10365.

The economic catastrophe theory appeared to be confirmed. House members quickly saw the error of their ways and within days a new version—containing additional pork to assuage some hurt feelings—passed into law. So did the bailout work? Was financial disaster averted?

In the three and half months since its passage the Dow has fallen another 2000 points and is now near 8000. The unemployment rate rose from 6.2% in September to 7.2% at the end of December. Major banks such as Citigroup are still teetering on edge of collapse and asking for more government money. Had the federal government not passed a bailout bill in October these events would be cited as the predicted catastrophe. But, because the government did pass the bailout bill a different interpretation is needed. Advocates, including Henry Paulson, have argued that without the bailout the economy could be much worse.

Which brings us back to the problem of the null experiment. Would it ever be possible to conclude that the bailout hasn’t worked? As long as the Dow remains above zero and the unemployment rate less than 100% it will always be possible to say the economy could be worse. But just because a total economic collapse has not happened doesn’t mean the theory that the bailout worked has been proved. Saying that the bailout prevented a total economic collapse because a total collapse was not observed is faulty logic. Taxpayers could feed money to banks forever on the basis of that reasoning.

It’s time for treasury officials to devise some affirmative experiments. The needs are for actions designed to produce positive economic effects that can be observed and measured. Only then will we know if the money has been productively spent.

Tuesday, January 13, 2009

Bernie Madoff and The Mediocrity Assumption

The question asked repeatedly since the exposure of the Bernie Madoff fraud: How could so many smart money-savvy people be fooled for so long? What I find especially troubling is that the answer to that question is mundane. The techniques for enticing investors into a Ponzi scheme are timeless and trite.

Early in my adult life, a "buyer's club" enticed my wife and I to visit. A salesman subjected us to a high-pressure pitch to join. The proposition was that for a $1000 one-time membership fee, a lifetime of “savings” totaling hundreds of thousands of dollars would be ours. Everything we would ever need—appliances, furniture, electronics, even cars—would be available to us at greatly reduced prices.

Of course the offer came with conditions. The invitation to join the club was exclusive and would not be repeated. Although, the price would be reduced if we “nominated” friends and family for membership. All merchandise ordered had to be prepaid and members were responsible for the shipping costs. The catalogs detailing the merchandise and actual prices were kept secret and would not be revealed until we joined. The salesman explained that if it became widely known just how low club prices were no one would shop in a retail store again. The local economy would collapse. The reason that these fantastic discounts were available is that the club profited only from membership fees, not from merchandise sales.

The last statement tipped me that this was a Ponzi scheme and I walked out. If the club profited only from membership sales that would mean that as soon as the club sold all the memberships possible it would fold. The “lifetime” membership referred to the club’s lifetime, not mine. Besides there is no reason to believe that I am special, that my money is special, or that my friends and family should be granted special buying rights denied to others. In my book The Two Headed Quarter I call this line of reasoning the “mediocrity assumption.” As much as I would like to believe that my circumstances and opportunities are special and unique, they are not. Any salesperson trying to convince me otherwise is lying.

In reading about Madoff, I am struck by all the parallels to my buyer’s club experience. The aura of exclusiveness he created, the network of friends and families, the secrecy about what he did, and most striking—that he did not charge for his services—all telltale signs of a Ponzi scheme. But, he preyed on the wealthy and famous so that it was much easier to convince his marks that they were special. I think the scam would have failed with ordinary investors who know that they are not special. Madoff knew, that ironically, those most likely to fall for his scheme would be the kind of people thought least likely to be taken in by a such a scam.

Of course in the end Ponzi schemes fail because of the math. Security analyst and graduate of my institution—Loyola CollegeHarry Markopolos alerted the SEC in 1999 that Madoff’s investment success made no mathematical sense. In 2005 he sent a 19-page paper to the SEC titled: “The World's Largest Hedge Fund is a Fraud.” While the document is technical, the fundamental numbers on which it is based are telling. You don’t need a background in forensic accounting to realize what is going on. All you need to do is apply the mediocrity assumption. His reasoning is a classic use of that assumption. Markopolos is quoted as saying:

"No Major League Baseball hitter bats .960, no NFL team has ever gone 96 wins and only 4 losses over a 100-game span, and you can bet everything you own that no money manager is up 96 percent of the months either."

Unfortunately many people bet everything they owned that Madoff could be up 96% of the time.

A few months after I said no to the offer from the “buyer’s club” it closed its doors and its managers disappeared. The local news reported that the State Attorney General was investigating. Many people with “lifetime” memberships prepaid for merchandise they never received. That was 24 years ago. I am still alive. The same techniques for deceiving people are still in use and continue to be effective.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Monday, January 5, 2009

History on Fast-Forward

George Santayana’s observation that “Those who cannot remember the past are condemned to repeat it” remains true, but the repeats have been put on fast-forward. For the past year the economy has given me a sense of déjà vu, as if I’ve lived through the past year in another time. In fact, in my early adult life I did live through the events of the past year. It is just that back then—the 1970’s—economic trends took a little longer to play out.

Consider the spectacular rise and subsequent collapse of gasoline prices over the past year. After hitting a high in July 2008 of just over $4 per gallon of regular in the United States, gas prices have fallen to an average near $1.60 as of last week. Similar price action took place before when, in terms of inflation-adjusted 2007 dollars, gas prices went from nearly $2 per gallon in 1978 to over $3 per gallon by 1980. A fall to $1.50 per gallon followed, but it took nearly 5 years. It was not until 1985 that inflation-adjusted gas prices undercut the prices in the late 1970s.

Nominal price and real price in 2007 dollars of a gallon of gas

The causes of the 1970s oil bubble were much the same as ones that caused the 2008 bubble—wars and instability in the mid-east, massive federal deficits that weakened the dollar, trade deficits with other nations.

Then, as now, the economic and political effects of price movements of this magnitude were profound. The price run-up resulted in a severe recession, steep rise in unemployment, depressed stock market, and nationwide disenchantment with its political leadership.

U. S. auto companies had built their business model on selling large gas-guzzlers that suddenly no one wanted. Plummeting auto sales threatened the financial stability of the big three automakers. By 1979, Chrysler Corporation appeared on the verge of bankruptcy. Its chief executive arrived in Washington begging Congress for a bailout in order to save American jobs.

The ruling party in the Whitehouse was decisively voted out of office and a charismatic new president took over, brimming with confidence and optimism and promising change. On February 19, 1981, shortly after taking office, the new president had a question-and-answer session with news editors about his program for economic recovery. He stated in regards to the energy crisis: “The best answer, while conservation is worthy in itself, is to try to make us independent of outside sources to the greatest extent possible for our energy.”

But, when gas prices fell and stock prices rose, the events of the 1970s were quickly forgotten. Everyone resumed their old habits and considered the decade an aberration. Even though no one did anything to solve the underlying problems, no one planned for a repeat of the events of that decade.

It will be interesting to see what happens in the coming year, but I would not become complacent about low gas prices remaining. Oil prices started to rise this week as mid-east fight flared. It is the same war that was fought in the 1940s, and the 1970s being fought today. The same political rhetoric about energy self-sufficiency is coming from the mouths of a new generation of politicians. A new line up of auto company executives beg Congress for bailout money and promise that they have finally learned the lessons of a generation ago.

None of the problems in the 1970s were actually solved or are they being solved now. History repeats itself but this time on fast-forward.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy