Author: ken

HOW EASY TO FORGET, HOW HARD TO CHANGE

We all forget unless we are reminded.  The past is simply stored away, along with all its lessons and resolutions – unless the present nags at us to keep its memories alive.

So who is nagging us now about financial reform, collectively, as we are clawing our way out of The Great Recession?  As The New York Times reminded us Saturday on its front page (See “A Year After the Cataclysm, Little Change on Wall Street”), and as The Wall Street Journal noted Friday on page 16 (See, “Finance Overhaul Falters as ‘08 Shock Fades”), we seem already to have moved onto other things.

To be sure, the finance industry doesn’t want to remind us.  As it strives to get back to business as usual, it doesn’t want to shake our faith in its capacity to generate profit.  It doesn’t even seem particularly interested in reminding itself.  The faith it had in the rational market may be diminished, but it’s faith in its own competitive savvy is just as robust.  And that cannot be a source of confidence for the rest of us.

Our politicians never had much enthusiasm for restraining those who funded their campaigns – and, besides, they are now almost entirely focused on health care reform.  If they lack motivation, to begin with, surely it would be asking too much for them to take on the health care and financial industries at the same time.

And the public simply wants prosperity and jobs to return.  Locking the door on future excesses is not foremost on its mind – if they ever clearly understood what reforms are needed.

The newspapers, of course, do reflect back to us daily what we are doing and not doing, though, like the broadcast media, their primary focus is always on the new events and issues coming up.  They are easily distracted.

Public officials should be concerned – deeply concerned – as they know the problems best and they will be blamed if another meltdown occurs.  But as Gretchen Morgenson reminds us in today’s Times, their previous record is hardly inspiring:  how can we “believe that regulators who snoozed during the credit bubble will be alert to emerging problems on their beats when the next mania begins.”  (See “But Who is Watching Regulators?“)  She proposes a new oath of office for regulators in which they pledge greater accountability, putting the public interest above their own.  But, at best, that proposed reform will be added to the list of other proposed reforms – and nothing much will change.

The Journal’s Friday article reported that last week in London, “Mr. Geithner implored policy makers to continue fighting for tougher financial regulations in their own countries. ‘We can’t let momentum for reform fade as the crisis recedes,’ he pleaded.”  But “imploring” and “pleading” strongly suggest that he is having trouble getting through.  And that wasn’t even in Washington or New York.

What we don’t know we know about memory is how powerless it is all by itself — and how hard it is to change.

Another Good Idea Gone Bad

When corporate America discovered outsourcing in the 80’s, it seemed a smart thing to do. Companies could sub-contract many of their support services to others who could do them more efficiently, economically and with greater technological sophistication. Not only were the services better performed, the companies that outsourced were spared the need to divert resources into activities outside their core competencies.

At first, outsourcing was limited to such services as billing, monitoring inventory, devising compensation packages for executives, cleaning offices, factories, and so forth. But then, ingenious corporate managers saw the potential for greater profit: dramatically improved international communication made possible the use of cheap educated labor abroad. The results were mixed. Money was saved, but getting help from someone in Bangalore with an imperfect grasp of English has been frustrating for consumers, to say the least.

Donald Rumsfeld then applied outsourcing on a massive scale to the Pentagon. Again, one could make the case that civilian companies could do a better job or preparing food and cleaning toilets, but soon we had Blackwater’s cowboys wielding guns and shooting Iraqi civilians in the service of protecting diplomats and contractors. Yes, one could make the case, as Rumsfeld obviously did, that the task of protecting civilians is not exactly the same as fighting war, but neither is it so different: the private guards had weapons, the license to kill if necessary, and they were often under attack from a population that could not tell the difference between them and real soldiers. That recipe produced a public relations disaster and, even, serious allegations of war crimes.

Last Monday, The New York Times reported on the “outsourcing missteps” that led to Boeing’s two year delay in producing its new plane, the Dreamliner. “The company’s chief, W. James McNerney Jr., concedes that Boeing lost control of the process by farming out more design and production work than ever and not keeping close tabs on suppliers.” (See “A Dream Interrupted at Boeing.”)

Again, the case can be made, and obviously was, that it was a short step from supplying parts to outsourcing “design and construction” – but it turned out to be a disaster. Richard Aboulafia, an aviation analyst at the Teal Group in Fairfax, VA, noted that “The idea was to get the risk off their books and get other people to do the heavy lifting for them . . . . But the flaw was that led to a kind of ‘engineering light’ approach, and the problems on the 787 can be traced to that.” In other words, Boeing may have thought it was spreading risk and sharing responsibility but actually it lost control: it did not know the problems the sub-contractors were having, it could not intervene in a timely manner, and it lacked the authority to knock heads.

With every expansion of outsourcing there seemed excellent arguments to make: it was cheaper, more efficient, it engaged more people and diffused responsibility. But the obvious risk of losing control was minimized – if not totally ignored. It looked good on paper, the case was rational, but stretched too far it didn’t actually work. Management wanted to believe in it because the financial advantages were great, but, they lost sight of what they could realistically expect of the people charged with carrying it out.

What they didn’t know they knew was that their obsession with minimizing financial risk could end up endangering the whole enterprise.

— THEY MISLEAD

The Times did a nice job of reminding us today just how much official statistics are – well, just that, official statistics. (See, “Out of Work, Too Down to Search On, and Uncounted.”) The problem is that, even though we know better, we tend to take them for reality.

The jobless rate, for example, was 9.7 % in August. But that figure only refers to those who were actively looking for work in the previous four weeks, not those who are actually out of work, or even those who would like to find a job but have given up hope of finding one.

This is not a hidden fact, and we are often reminded of what the official numbers do not take into account: those too frustrated to continue searching, those who have settled for early retirement, who have moved in with others, who work odd jobs off the books, who are just too discouraged or depressed to try finding jobs.

So why do we continue pumping out these misleading figures? I do appreciate that statisticians have to draw the line somewhere for their statistics to have any meaning – but they are not the ones who set the limits. I also appreciate that the government does not want to make things look any worse than they are. But I think it is also true that we all don’t want to be reminded of how many of us are feeling hopeless, depressed and perpetually marginalized.

It’s one of those big things we don’t want to know we know, like infant mortality rates, the cost of PTSD, declines in the value of our investments, and the growing gap between the rich and the poor.

Questioning Authority

The SEC’s Inspector General released his report on how his agency failed to detect Madoff’s $65 billion Ponzi scheme. According to accounts in yesterday’s and today’s New York Times and Wall Street Journal, the report gives lots of useful information, but not much of an answer.

The Journal picked up on how “turf battles and poor communication,” hampered investigators, adding that some investigators naively took Madoff’s answers at face value and did not check up on non-existent trades when they had the chance. Implausible data was simply not looked into. Red flags were missed by “inexperienced and incompetent” examiners, agrees the Times, but their reporters stress how investigators “were cowed by Mr. Madoff, who had an inflated reputation on Wall Street.” They described how meetings were broken up suddenly, and questions unanswered – and then not pursued.

According to the Times, “One investigator described Mr. Madoff as ‘a wonderful storyteller’ and ‘a captivating speaker’ after the 2005 encounter in which Mr. Madoff, a former Nasdaq chairman, boasted of his ties to people high up in the S.E.C. and said he was on the short list to be the next agency chairman — the post that went to Mr. Cox. But Mr. Madoff turned angry — ‘veins were popping out of his neck,’ an investigator said — when asked to produce certain documents, and he tried to dictate what paperwork he would yield.”

A good performance, no doubt, aided by the strong desire to have what he wanted and the absence of scruples that marks the true sociopath. But the most compelling part of his performance seems to be his mimicry of legitimate authority, his ability to consistently appear as an insider and significant player whose motives were above question. The important aspect of this skill, though, is not how well he managed it but how easily it worked to intimidate and mislead those who should have known better.

Another story in yesterday’s Journal shed more light on that. Madoff not only bragged that he had made the “short list” to become chairman of the SEC, as the Times noted, he also “predicted that Rep. Christopher Cox was going to get the job.” The Journal notes that this “startling prediction” suggests the extent of “his behind the scenes influence.” I don’t know about influence, but certainly inside knowledge or access to informed opinion. He was talking to someone who knew something, and he let the investigators know it.

When we take into account the marked discrepancy between the salary and status of SEC investigators and those they investigate, the fact that the investigators move in and out of the industry they monitor, no doubt hoping for better jobs, the fact that Madoff obviously had inside knowledge and the seductive charm to display it – along with the temper to intimidate those who challenged him — is it any wonder at all that he escaped detection?

There was a bumper sticker popular 30 years ago: “Question Authority.” Far from questioning authority, the SEC investigators seem to have been dazzled by it, unable to tell the difference between Madoff’s mimicry and the real thing. Most law enforcement officers quickly discover the power of their own authority and learn to use it, but the culture of the SEC doesn’t seem to encourage much skepticism or assertiveness. Perhaps, the SEC investigators don’t know they know how little authority they possess.

. . . and Our Halting, Ambivalent Recovery

Wall Street wants stocks to recover their lost values, yet it appears to understand that such a recovery is dangerous: it might not happen without another bubble.

Last Saturday, “The Intelligent Investor” in the Wall Street Journal wrote that while stocks have dramatically risen in value since March, this was a cause for worry. “In the entire 113-year history of the Dow, only six rebounds have been bigger and faster. But the swiftness and magnitude of this bounce-back aren’t reasons to be cheerful; they are reasons to be cautious.”

Noting that corporate insiders are selling their stock at a far greater rate than they are buying it, Jason Zwieg suggests: “it is at times like these, when a rising market sweeps our spirits up with it, that investors need to evaluate their emotions and consider whether their beliefs and actions are justified. . . . The market’s light has turned yellow. Don’t try to run it.” (See “Why Investors Need to See the Light and Slow Down.”)

Yesterday, Mark Gongloff, wrote in the Journal from a different angle: “Stocks fell so far from their prerecession, October 2007, highs, that — despite a 47.5% rally since March — the Standard & Poor’s 500-stock index is still missing $4.8 trillion in market value.” He adds, “It still needs a 57% gain to return to its October 2007 high.” (See, “Bubbleless, Stocks Still Playing Catch-Up.”)

Looking around for sources of potential growth to make up the difference, he notes, “it would likely take frothy energy markets or a new credit binge to push stocks immediately back to their previous highs.” But then he adds, at the end, “Neither would be sustainable, nor desirable.”

It may not be entirely clear that we are recovering from the recession, but it does seem unmistakable that we are recovering from misplaced faith in the rational market. Worry, impatience, evaluating emotions – a new language of investment is making its appearance in our financial journals. The books on “behavioral finance” have been coming for some time now, but now mainstream financial journalists are catching up.

Two weeks ago, indeed, the Journal published a report by Meir Statman, Professor of Finance at Santa Clara University, stressing the impulsive and irrational factors at work in typical investment decisions. Statman cites the work of Daniel Kahneman and Amos Tversky, for example, demonstrating how gains or losses in wealth register emotionally far more than absolute levels of wealth, a point that could be useful to remember when you are suffering an acute loss and need to regain balance and perspective before making any further investment decisions. (See “The Mistakes We Make—and Why We Make Them.”)

Statmen offers other bits of advice, no doubt drawing on the work of other researchers into behavioral finance. He could have referred to many, many more. The field is growing rapidly, and the list of experts and advisors is lengthening, along with the bits counsel they have to offer.

This is a welcome change from the dominance the quants have enjoyed among investors – and least it is a useful addition. But it still falls short of what is actually needed. New sets of rules and new mottoes help only up to certain point.

Psychologists have known the limitations of behavioral approaches for some time. Useful when struggling against strong entrenched and destructive behaviors, such as addictions and phobias, they turn out to be not so useful with familiar problems that continually recur. Like new years’ resolutions and self-help books, they get quickly discarded as we automatically repeat what we are used to doing. It’s like any other set of rules: we forget that we decided to change.

Actually nothing takes the place of an awareness of self-knowledge and insight – but that is not so easy to accomplish. What we don’t know we know about ourselves is how hard it is to change even the behaviors we don’t want to engage in.