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Trusted Transactions, or Trusted Relationships?

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Justice Potter Stewart once remarked, with respect to pornography, that it was virtually impossible to define it, but, “I know it when I see it.”

Ditto for trust. It’s both a verb and a noun. Its objects are implied and contextual, as in “I trust my dog with my life – but not with my ham sandwich.”

Increasingly, we need to make explicit another dual-meaning of trust. We trust relationships, and we trust transactions.  I trust John – to have my best interests at heart. I trust eBay – to create trustworthy transactions with strangers. It does not follow that I trust an eBay customer to go out on a date with my daughter.

Much of the public dialogue today confuses these two distinctions. Is it Congress that people don’t trust? Or is it members of Congress who themselves are considered untrustworthy? To the average voter, it’s a distinction without a difference. I suspect the inability to tease them apart is itself a source of anger. But if we fail to separate them, we doom ourselves not only to nasty public discourse, but to failed solutions.

Lessons from the 2007 Financial Crisis

Back in 1970, the US mortgage industry was still adequately described by the perennial Frank Capra Christmas movie “It’s a Wonderful Life,” with Jimmy Stewart as George Bailey, president of the Bedford Falls Savings & Loan. Bailey (for he and the company were inseparable) made loans to people he knew personally.

The bank’s depositors were Bailey’s friends and neighbors. The depositors were also the borrowers; likewise, the employees. The loans stayed on the S&L’s books, presumably to term. Those who took out mortgages had no intention of doing anything other than paying them off, with burn-the-mortgage parties at the end.  No moral hazard here.

This was relationship trust. The strength lay in personal ties, cemented over time. A man’s word was his bond, and anyway you knew where he lived. His reputation was everything, at least until it wasn’t. Relationship trust served business and society well.

But relationship trust was about the only kind we had, and it had its limits.

Transactional trust in George Bailey’s world was shallow and fragile indeed. The S&L was at risk of being forced out of business by a single competitor, the evil Mr. Potter. It was at risk of the low-tech deposit processes of Uncle Billy. Most importantly, it was at risk of a bank run. It was a good thing George Bailey worked the relationship trust game well, for he had precious little else to depend on.

Trusted Transactions in the Mortgage Business 

Fast forward to 1995, Dwight Crane, Robert C. Merton and others published The Global Financial System: a Functional Perspective. A masterpiece of what sociologists knew as “functionalism,” this book laid out the case for transactional trust, viewing the mortgage business as one part of a complex and, ideally, integrated financial system.

In the chapter on mortgages, they ran down the characteristics of a system you could trust. It would have markets – markets for deposits, markets for mortgages, markets for loan originations. The book listed the costs of not having a systemically integrated system: risk of meltdowns, differential pricing within very narrow geographic regions, low liquidity, gross inefficiencies.

In short, George Bailey’s relationship-driven-trust was considered too risky, too costly, too uncreative and too unresponsive. Above all, it was too expensive. Consumers – the would-be purchasers of mortgages – were subjected to higher prices than necessary, driving up the cost of home ownership, and therefore driving down the economic livelihood of those seeking the American dream.

You simply could not trust such a system, the good professors opined.  “It’s a Wonderful Life” was now half a century old. George Bailey was quaint. (No one noticed that only one year before the 1995 book, contributor Robert C. Merton had become a Board Member of the soon-to-be-notorious little hedge fund called Long-Term Capital Management L.P.)

In business, Progress was synonymous with all these terms: systemic, low-cost, efficient, market-based, liquidity. No one was about to cast doubt on the important and positive nature of all these terms.  The academics and wunderkind of Wall Street were creating institutions you could trust.

The new trust was almost entirely cast in terms of systems and transactions. Transactions replaced relationships. Where markets couldn’t handle the job, models could. Of course, from today’s vantage point, this looks as naïve as the academics’ view of George Bailey a few decades ago.

In a few short decades, the “trust” pendulum swung from a man’s word to the solidity of a system. We went from high personal trust to high systemic trust – each extreme without the moderating influence of the other.

We Need Rich Trust

The transactional revolution in mortgage banking indeed delivered on most of its systemic promises. Markets were established, costs were lowered, liquidity was raised. But it all, as we know, ended very badly.

The confusion over trust went way beyond semantic. Alan Greenspan himself in 2008 famously said:

“I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.”

In other words, Greenspan thought that transactional trust would have the same sort of reputational bias that relationship trust had. He was, sadly for all of us, mistaken.

Transactional trust absent relationship trust had its own internal seeds of destruction. The absence of long-term relationships was crystallized in the Wall Street acronym IBGYBG – I’ll be gone, you’ll be gone, let’s do the deal. Just as personal trust doesn’t scale easily, so transactional trust doesn’t easily foster ethical behavior.

George Bailey wasn’t wrong, he just had no system. The professors weren’t wrong, they just assumed relationships. The truth is: we can’t afford just one form of trust or another, we need a rich mixture of both.

Well Beyond Mortgages

The mortgage industry is but one example. The electorate, reflecting it all, ends up exerting single-issue us-vs-them pressure on its own.

The polls are basically right: we do have a crisis of trust. But what crisis? It is not just a failure of morality. We cannot fix it solely by getting back to ‘family values,’ or seeking out leaders of impeccable morality. Those are, in fact, necessary conditions, but they’re not sufficient.

On the other hand, those who insist that the system is sound, it just needs tweaking, are dead wrong as well. This is not a matter of incentives needing adjustment. This is not a matter solely of transparency in markets. Those too are necessary conditions – but not sufficient.

We live in an interconnected world: transactional trust is critical for us to do live a life built on global commerce without it.

At the same time, there is no social structure or business process that can work without humans. There is no lock that can’t be picked, no code that can’t be broken. There is no inhuman system that can’t be perverted by humans.

Did anyone say Facebook? Uber? Airbnb? Zuckerberg and Sandberg today are as enamored of the potential for better algorithms to solve trust problems as Crane and Merton were about the potential of markets to unilaterally fix trust back in their day.

Trusted transactions? Or trusted relationships? Yes. We need ‘em both. Always have, always will.

Six Reasons We Don’t Trust Wall Street

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In 2013, finance is the least trusted industry globally.

It hasn’t always been this way. Within the industry, it’s tempting to think that trust can be regained by reputation management. Reputation is seen largely as a function  of communications or PR departments in 50% of companies in one survey.

But it goes deeper than that – deeper even than enlightened views of reputation management. There are serious structural issues that have driven down trust in the sector, and it’s hard to see how trust can be restored without directly addressing some of them.

But let’s let you be the judge of that. Here are Six Reasons we’ve lost trust in Wall Street.

1. “Wall Street” Ain’t What It Used to Be.  In 1950, a discussion of “Wall Street” unambiguously meant the NYSE, the Big Board, and brokerage firms like E.F. Hutton. Today, Wikipedia says:

The term has become a metonym for the financial markets of the United States as a whole, the American financial sector (even if financial firms are not physically located there), or signifying New York-based financial interests.

That means “Wall Street” came to include commercial banking (think Chase and Bank of America), mutual funds, hedge funds, investment and trading operations like Goldman Sachs, private equity, and insurance companies like AIG.  I think it’s fair to say the “new” financial businesses have had more than their share of the negative press that financial services has gotten over the years.

Many years ago, the president of GM could say – in good conscience – “What’s good for General Motors is good for America.”  Can you picture Lloyd Blankfein saying, “What’s good for Goldman Sachs is good for America” with a straight face?

2. Finance Has Shifted to Zero-sum Uses. In traditional banking, borrowers create increased value with the money they borrow from lenders and put to good economic use. By contrast, in pure trading, no value is created. It is a zero-sum proposition. And the proportion of the financial sector represented by essentially pure trading has increased dramatically.

At the same time, Paul Volcker says the financial services’ share of “value-add “in the US economy grew from 2% to 6.5%.  That’s not “value added” in the economic sense – it’s just an increase in price over cost. And, Volcker added, it was due not to innovation, but to increased compensation. As he famously put it, “The biggest innovation in the industry over the past 20 years was the ATM machine.”

Wall Street has increasingly focused on the “point spread,” not the fundamentals. In the NFL, they don’t let players bet on point spreads. But on Wall Street, that’s the name of the game.

The industry’s counter to such data is that they have increased liquidity, thereby lowering risk and volatility.  Yet volatility in the stock market has steadily increased for decades, while the industry has gotten less efficient. And “black swans” have become part of our lexicon – we have massively underestimated risk.  The value of the added liquidity is far outweighed by the risks it has entailed.

3. Finance Is a Larger Part of the Economy. In 1950, the US financial sector accounted for 2.8% of GDP. By 2011, that number had grown to 8.4%.  In 2011, the financial industry generated 29% of all US profits.  That proportion had never exceeded 20% in all of the 20th Century.  From 1980 to 2010, the profit per employee in the financial sector of the US economy grew by over a thousand percent – far more than all the rest.

And as finance became less efficient, more profitable, and more zero-sum oriented, it also came to dominate business more. In 1937, 1 percent of the graduates of Harvard Business School went into finance. In 2008, that number hit 45%.

4. The Shift to the Short Term. 
As of 2011, 60% of the daily turnover in US stock markets was accounted for by high-frequency trading something that didn’t exist a decade before.  In 1960, the average holding period for stocks on the NYSE was 8 years. By 2010, it was down to 3-4 months.

In 1950, the marginal tax rate was 85%, putting a brake on short-term trading, since capital gains taxation of 25% kicked in only after 6 months.

A short-term mentality has always plagued the US in comparison to Europe and especially Asia. The shorter the timeframe, the more focused we become on transactions, and the less value we place on relationships. And that kills trust.

5. The Transactionalization of Finance.  J.P. Morgan once said, “A man I do not trust could not get money from me on all the bonds in Christendom.”  For several years now, we’ve had the IBGYBG problem on Wall Street: “I’ll be gone, you’ll be gone – do the deal, who cares.”

Can you say “moral hazard?”

In the Christmas movie It’s a Wonderful Life, local employees of a local bank lend mortgage funds to local borrowers, with the bank then holding the mortgage itself. By 2007, the lending was done by non-local employees of non-local mortgage companies who then resold the mortgage to non-local banks, who then securitized and sold to global investors. A relationship business had become thoroughly transactionalized.  This drives down trust.

6. The Attack on Regulation. The LIBOR rate-rigging scandal shocked everyone last year. But rate-rigging turned out to be not a bug, but a feature.  The chairman of the CFTC said LIBOR rates “are basically more akin to fiction than fact.” The truth is more like the Wizard of Oz saying, “Pay no attention to that man behind the curtain.”

It’s a market that turned out to be mythical – can you say “Bernie Madoff?”

The Glass-Steagall Act was repealed in the late 90s, arguably giving free reign to bankers to misbehave. The industry has fought consumer legislation governing things like credit card costs, not to mention the mix of Dodd-Frank rules.

It’s hard to trust an industry which visibly and without much embarrassment argues for more and more, after the rather remarkable feast of the last two decades.

The solutions to trust issues that I hear about most coming from the financial services industry tend to be reputation management and personal trustworthiness. I do believe that both these tools – especially personal trustworthiness – could be applied to great effect in certain financial sectors – notably financial planning, wealth management, traditional investment banking, and commercial lending.

But that’s not where the money is, nor where the biggest problems lie. And it’s going to take a whole lot more than the usual approach to reputation management to deal with them.

Until the sector can address those six areas of structural disconnect, the issues of trustworthiness will continue to dog the industry.

Part 2: Why Aren’t There High Trust Strategies in a Low Trust Industry?

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The Financial Trust PuzzleIn my last post, I asked the question: If financial services are such a low-trust industry (on average), then why isn’t someone pursuing the obvious differentiation strategy of forming a high-trust organization?

The Reasons Why

I offered five possible reasons, and commenters added two more.  They were:

  1. Wait – some companies really are high-trust.
  2. The nature of the business is highly competitive – you can’t be high trust and stay in business.
  3. The industry is full of untrustworthy, greedy, anti-consumer people.
  4. The industry is so over-regulated that trust never has a chance to get traction.
  5. The media have a bias that will sink most attempts at high-trust organizations.
  6. Greedy shareholders force companies to be untrustworthy.
  7. The industry simply does not understand the nature of trust

Here’s my take on the issue. Please weigh in with your comments, below.

1. Some really are high trust. I’ve seen many parts of organizations – business units of 100 people or so – who absolutely do run high-trust businesses. But I’ve seen very few  who have pulled it off at the corporate level (one I know of first-hand is Bangor Savings Bank). I’m sure there are others, but I’m equally sure they’re the exception, not the rule.

There’s a reason the industry is low-trust – most financial companies simply are not trusted. The data are what they are and they’re not wrong.

2. The industry is so competitive that you can’t afford to be trustworthy. I’m totally not buying this. The financial industry may appear to be “competitive,” but it is also loaded with side deals, barriers to competition, and generally anti-competitive practices. Furthermore, some extraordinarily high-trust salespeople and business units, e.g. in wealth management, are that way precisely because they are high trust. Economics 101: competitive industries are marked by low profits, not high.  The financial industry is very – very – high profit.

3. The industry is full of untrustworthy people. I’m with reader Ronald on this one – the big majority of people I know in the financial industry are not untrustworthy, selfish, dishonorable people. Sure there are Madoffs, but there are in other industries too.  The problem is that good people can get enmeshed in bad endeavors. A whole lot of unethical corporate behavior isn’t due to lax moral standards, it’s due to habits, incentives, and organizational pressure.

4. The industry is over-regulated. There is more than a grain of truth here. If you are constantly investigated and given lie detector tests, eventually you’re very likely to decide that someone’s stealing and lying, and maybe you should try and get your piece of the pie. Conflating ethical behavior with legal behavior, or check-boxes with values, is death to ethics. We can have too much regulation – at the cost of moral behavior.

5. The media done it. Is there a systematic bias against financial industries on the part of media, mainstream or otherwise? I think you can make a case that a great number of media outlets are finely tuned to seek wrongdoing from the financial sector.  But not enough of a case. If Big Finance is so powerful as to control congress, evade prosecution, and continue to collect massive bonuses – then why wouldn’t they have the power to better control their own branding? I can’t disprove it, but let’s just say I’m skeptical of conspiracy theories.

6. Greedy shareholders are to blame. There’s a lot of truth here too. The emphasis on quarterly earnings, and particularly the massive bonuses given to fund managers based on short-term performance all drive up the emphasis on profit.  (Oddly, the short-term emphasis actually reduces the profit which would be available by pursuing long-term trust-based strategies). But this explanation is as valid for high tech as it is for finance, and the tech people constantly score better trust ratings.  I’m not convinced.

And the Oscar Goes To…

7. The industry just doesn’t understand trust. Yes, you guessed it, this is my nomination for best explanation. Here’s what I mean.

First, money may be the most emotional product imaginable. The dreams that can be conjured up by perfume are trivial next to those induced by a big MegaBucks lottery. A financial planner tells me that clients would sooner talk about their sex lives than their financial lives. Money has implications for our status, our future, our children; it’s a nearly pure-emotion product.

And yet the financial industry insists on selling money services on a non-emotional basis. Credentials and qualifications are what financial planners and wealth managers lead with. Fee-only planners insist that because they’re not commissioned they are structurally more trustworthy. Bankers are fond of touting product features. About as far as emotion goes in the financial industry is to invoke symbols like the Rock of Gibraltar, or ads featuring smiling retirees who are moonlighting from pharmaceutical spots.

What you get by promoting the Merrill Barney brand, or the Smith Lynch brand, and the credentials of their employees is weak, thin trust – trust that’s getting weaker and thinner with new media and smarter consumers. Rich trust comes from personal interactions, with individuals who aren’t afraid to get personal. Emotional products call for emotional connection in the sale. Financial people are scared to death to get personal.

Second, financial institutions tend to think that trust is mainly institutional – they can’t grasp that trust at its heart is dyadic, about two people. They worry about their professionals “stealing clients” when they leave – as if the clients were property of the institution – which amounts to devaluing the key interpersonal relationships that can develop between professionals and customers.

Third, financial institutions too often try to have it both ways: they want to appear trustworthy so that clients will trust them – but they rarely turn around and trust their customers. If someone constantly asks you to trust them, but never trusts you, then trust is rather quickly lost. Is your local bank branch empowered to make a spot decision to trust you? Unlikely. And don’t tell me no-doc mortgages were an exception – those were driven not by trust, but by greed on the part of the lenders, suborning falsehoods from customers.

Fourth, no other industry I know of forces profitability analyses to such a detailed level. Not only is the timeframe for analysis very short-term, but decisions are made based on highly quantified, narrowly defined analyses. What happens if we give people a 5-day grace period – if we lose money, forget it. What happens if we tweak the eligibility standards here – if we lose money, forget it.  To some extent, this is because the product of finance is money itself – subjecting money to financial analysis is both obvious and necessary. But it does mean there is very little emphasis put on long-term returns, or balancing offsets. Sponsoring golf tournaments is about as long-term and qualitative as it gets, and I bet every company doing it has some details specs on why it’s profitable.

Finally, as noted in point 4 above, an industry which is tightly regulated can tend to lose track of the distinction between compliance and ethics. “I am not a crook” ends up being the defense against ethical complaints, and that doesn’t do the job.

So there’s my case: I think the main reason the financial industry gets such low rankings on trust is because they simply, fundamentally, do not understand the workings of trust.

Their people are neither stupid nor venal. But the cumulative impact of putting rational over emotional needs, processes over interactions, short-term over long, regulations over ethics, is such that financial organizations simply don’t have much of a clue when it comes to implementing trust.

Too many trust initiatives end up focused on customer satisfaction methodologies, CRM systems, PR and messaging campaigns, and trumpeting credentials. Rarely do they get to the heart of trust – the personal connection between a provider and a customer.

Remember who was number 1? Nurses. Just think about the difference between finance and nursing. Our financial companies could learn a lot by studying how nurses create trust.

A High Trust Strategy in a Low Trust Industry

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A Face You Could Trust?Differentiation. It’s one of the two generic competitive strategies.

You’d think it’s a no-brainer. If everyone sells coffee in supermarkets based on price, invent Starbucks. If water is free from the faucet, invent Perrier. If fund performances are undifferentiated, invent index funds.

So, if your industry ranks near the bottom in trustworthiness – why not invent a trust-based company? Would that not be obvious?

Let’s not make it too tough, by tackling used cars or Congress, but let’s take the next-worst trust-scoring industry – financial services.

In a recent Gallup survey, of 22 professions, the most trusted was nursing – as it has been for many years. 85% of respondents rated nurses high or very high in “honesty or ethical standards.”

Financial services were represented in the survey by banking, insurance, and stockbrokers.

  • Bankers were ranked 11 out of 22, with 28% rating them high or very high. That puts bankers below psychiatrists and chiropractors.
  • Insurance people get only a 15% rating, which ranks them at number 16 out of 22 – below lawyers.
  • Stockbrokers rank 19th out of 22, with only 11% saying they are high or very high.  Well, at least they beat congress!

There is some evidence that financial planners, had they been included, would have scored better, though I doubt investment bankers, traders, mortgage bankers and credit card companies would have raised the industry’s average.  And the Edelman Trust Survey puts it even more starkly: “Financial services and banks are the least trusted industries for the third year in a row.”

Net net – by and large, if you’re in financial services, people don’t trust you, your company or your industry.

Again – wouldn’t it be a logical, obvious, in-your-face strategy to build a highly trusted company?  Sure it would.

And so, the big question – why hasn’t anyone done it?

Why Are There No High Trust Strategies in Finance?

I can think of five possible answers to this question, and the first one is to deny it.

  1. Wait – some companies really are high-trust.
  2. The nature of the business is highly competitive – you can’t be high trust and stay in business.
  3. The industry is full of untrustworthy, greedy, anti-consumer people.
  4. The industry is so over-regulated that trust never has a chance to get traction.
  5. The industry simply does not understand the nature of trust.

I’ll give my analysis in the next blogpost.

Meanwhile, what do you think?  Are those the five possible answers? Which one strikes you as right?

Trusted Transactions, or Trusted Relationships?

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Justice Potter Stewart once remarked, with respect to pornography, that it was virtually impossible to define it, but, "I know it when I see it."

Ditto for trust. It’s both a verb and a noun. Its objects are implied and contextual, as in "I trust my dog with my life–but not with my ham sandwich."

Increasingly, we need to make explicit another dual-meaning of trust. We trust relationships, and we trust transactions.  I trust John—to have my best interests at heart. I trust eBay—to create trustworthy transactions with strangers. It does not follow that I trust an eBay customer to go out on a date with my daughter.

Much of the public dialogue today confuses these two distinctions. Is it Congress that people don’t trust? Or is it members of Congress who themselves are considered untrustworthy? To the average voter, it’s a distinction without a difference. I suspect the inability to tease them apart is itself a source of anger. But if we fail to separate them, we doom ourselves not only to nasty public discourse, but to failed solutions.

Trusted Relationships in the Mortgage Business.

In 1970, the US mortgage industry was still adequately described by the perennial Frank Capra Christmas movie “It’s a Wonderful Life,” with Jimmy Stewart as George Bailey, president of the Bedford Falls Savings & Loan. Bailey (for he and the company were inseparable) made loans to people he knew personally.

The bank’s depositors were Bailey’s friends and neighbors. The depositors were also the borrowers; likewise, the employees. The loans stayed on the S&L’s books, presumably to term. Those who took out mortgages had no intention of doing anything other than paying them off, with burn-the-mortgage parties at the end.  No moral hazard here.

This was relationship trust. The strength lay in personal ties, cemented over time. A man’s word was his bond, and anyway you knew where he lived. His reputation was everything, at least until it wasn’t. Relationship trust served business and society well.

But relationship trust was about the only kind we had, and it had its limits.

Transactional trust in George Bailey’s world was shallow and fragile indeed. The S&L was at risk of being forced out of business by a single competitor, the evil Mr. Potter. It was at risk of the low-tech deposit processes of Uncle Billy. Most importantly, it was at risk of a bank run. It was a good thing George Bailey worked the relationship trust game well, for he had precious little else to depend on.

Trusted Transactions in the Mortgage Business.

In 1995, Dwight Crane, Robert C. Merton and others published The Global Financial System: a Functional Perspective. A masterpiece of what sociologists knew as “functionalism,” this book laid out the case for transactional trust, viewing the mortgage business as one part of a complex and, ideally, integrated financial system.

In the chapter on mortgages, they ran down the characteristics of a system you could trust. It would have markets—markets for deposits, markets for mortgages, markets for loan originations. The book listed the costs of not having a systemically integrated system: risk of meltdowns, differential pricing within very narrow geographic regions, low liquidity, gross inefficiencies.

In short, George Bailey’s relationship-driven-trust was too risky, too costly, too uncreative and too unresponsive. Above all, it was too expensive. Consumers–the would-be purchasers of mortgages—were subjected to higher prices than necessary, driving up the cost of home ownership, and therefore driving down the economic livelihood of those seeking the American dream. 

You simply could not trust such a system, the good professors opined.  “It’s a Wonderful Life” was now half a century old. George Bailey was quaint. No one noticed that only one year before the 1995 book, contributor Robert C. Merton became a Board Member of a little hedge fund called Long-Term Capital Management L.P.  

In business, Progress was synonymous with all these terms: systemic, low-cost, efficient, market-based, liquidity. No one was about to cast doubt on the important and positive nature of all these terms.  The academics and wunderkind of Wall Street were creating institutions you could trust.

The new trust was almost entirely cast in terms of systems and transactions. Transactions replaced relationships. Where markets couldn’t handle the job, models could.

In a few short decades, the “trust” pendulum swung from a man’s word to the solidity of a system. We went from high personal trust to high systemic trust–each extreme without the moderating influence of the other.

We Need Rich Trust.

The transactional revolution in mortgage banking indeed delivered on most of its systemic promises. Markets were established, costs were lowered, liquidity was raised. But it all, as we know, ended very badly.

The confusion over trust went way beyond semantic. Alan Greenspan himself in 2008 famously said:

"I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms."

In other words, Greenspan thought that transactional trust would have the same sort of reputational bias that relationship trust had. He was, sadly for all of us, mistaken. 

Transactional trust absent relationship trust had its own internal seeds of destruction. The absence of long-term relationships was crystallized in the Wall Street acronym IBGYBG—I’ll be gone, you’ll be gone, let’s do the deal. Just as personal trust doesn’t scale easily, so transactional trust doesn’t easily foster ethical behavior.  

George Bailey wasn’t wrong, he just had no system. The professors weren’t wrong, they just assumed relationships. The truth is: we can’t afford just one form of trust or another, we need a rich mixture of both.

Well Beyond Mortgages.

The mortgage industry is but one example. As recently described in a New Yorker article on the US Senate’s inability to develop energy legislation, the political process has become as ugly and dysfunctional as anything involving collateralized mortgages. Lifetime politicians are continually compromising principles and relationships for another shot at enhancing their power.

Yet they are not wholly to blame. They are caught up in a system which insists on money and soundbites, with ever shortening cycles of time. The press, caught in its own compressed cycle, competes with reality TV and blogs to capture the public’s insatiable desire for more intensity, faster. The Shirley Sherrod case—a grievous rush to judgment for the sake of ratings—dramatically showed how compromised the press has become. And another case—a Bloomberg news reporter’s bizarre attack on Prudential—shows how blasé we’ve become about it.

And the electorate, reflecting it all, ends up exerting single-issue us-vs-them pressure on its own.

———– 

The polls are basically right: we do have a crisis of trust. But what crisis? It is not just a failure of morality. We cannot fix it solely by getting back to ‘family values,’ or seeking out leaders of impeccable morality. Those are, in fact, necessary conditions, but they’re not sufficient.

On the other hand, those who insist that the system is sound, it just needs tweaking, are dead wrong as well. This is not a matter of incentives needing adjustment. This is not a matter solely of transparency in markets. Those too are necessary conditions—but not sufficient.

We live in an interconnected world: transactional trust is critical for us to do live a life built on global commerce without it. 

At the same time, there is no social structure or business process that can work without humans. There is no lock that can’t be picked, no code that can’t be broken. There is no inhuman system that can’t be perverted by humans. 

Trusted transactions? Or trusted relationships? Yes. We need ‘em both.   

Financial Planners Who Sell From Trust

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The banking and financial services industry has recently plummeted into the "least trusted groupings" of industries. And not without reason, as this blog and others have pointed out.

But of course, that’s not true of everyone. There are some interesting examples of trustworthy and successful behavior in the financial sector. Here are two.

A Long-term Perspective: Hanson McClain 

One of the Four Principles of Trust is to adopt a long-term perspective, focusing on relationships rather than transactions. What would you think of a financial advisory business that invests in new clients five years before seeing a return?

That is pretty unusual for the financial advisory business. Normally, the focus is much shorter term. In addition, garden variety wisdom in financial advisory is that you look for high net worth clients, because the typical compensation structure for the business varies with asset levels. What would you think, then, of an advisory business that focuses on lower net worth individuals?

Hanson McClain has adopted both these heretical approaches, and married them to a narrowly defined and specialized target segment — retirees from the telecommunications and public utilities industries. The results are striking.

That segment has been relatively stable, with excellent retiree benefit plans, and has a disproportionately high percentage of its workers due to retire in the not-too-distant future. It also has some arcane aspects to its retiree plans.

But this isn’t just smart segmentation and targeting. If the common short-term orientation and focus on “big is better” had been applied to this group, the advisors would not have generated the tremendous referral network they have. The effect is to lower cost of sales, since existing clients identify and market to new ones, which also then increases sales yield rates. 

Trust is key to it.
Making Business Personal: Design Underwriting  in Grand Rapids, MI

Ed Thauer, Jr., runs a full service financial agency. He started in insurance 34 years ago, and branched out. He has gotten his business to Top of the Table status in the Million Dollar Round Table system. (That means he’s done very well).

Ed attributes his success  to a variety of things, but one of them stands out. 

Ed still does all his own enrollments. That means he personally does a job that is all-too-tempting to parcel out to others—initial data collection.  

Not everyone does this; automating and delegating is an obvious way to make your time more efficient—right? So why does Ed do it?  

As a mentor Ed cites once said,
“You dress up and show up and see the people, see the people, see the people. Nothing happens unless you see the people.”

Ed is also partial to a particular sales model for his industry—but clearly the model hasn’t gotten in the way of his central view of personal connection as key to the customer relationship.

Yes, there is trust in systems. Reliability, accuracy, comprehensiveness are all trustworthiness-enhancing variables. But their impact is less than the softer sides of trust—intimacy and low self-orientation; a sense that the seller actually does care about you.
I haven’t met Ed, but I think he gets that.
 
 
 
 
 
 
 
 
 
 

Wall Street, We Have a (Simple) Problem

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Let’s keep it simple.

The first step toward dealing with a problem is admitting you have a problem.

I try to stay away from politics in this blog. But I know something about business, trust and society. And when issues of business trust arise, they need to be written about. 

The fact that some might view this as “political” is a deplorable bit of collateral damage brought about in great part by those who have abused business and trust in the first place.

So much has been written about the problem with our financial sector that it’s easy to become numbed. So let’s keep it very, very simple.

Does the financial sector “get it?” Never mind the suggestion of the President of the United States that they don’t. How about financial eminence grise Paul Volcker?

Here’s what Volcker had to say about excessive compensation at a high level bankers’ conference:

“Has there been one financial leader to say this is really excessive? Wake up, gentlemen. Your response, I can only say, has been inadequate.”

Translation: too many don’t get it. 

Again, let’s keep it simple. The financial sector has grown, grown and grown in recent years. First, some perspective on profit and compensation growth from the IMF’s former chief economist:

From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.

Then, some perspective on the financial sector as a percentage of GDP from Nobel-prize-winning economist Paul Krugman: 

Even during the “go-go years,” the bull market of the 1960s, finance and insurance together accounted for less than 4 percent of G.D.P. The relative unimportance of finance was reflected in the list of stocks making up the Dow Jones Industrial Average, which until 1982 contained not a single financial company…

On the eve of the current crisis, finance and insurance accounted for 8 percent of G.D.P., more than twice their share in the 1960s. By early last year, the Dow contained five financial companies — giants like A.I.G., Citigroup and Bank of America.

Some say these data don’t account for the relative importance and innovation created by the financial sector. 

Here’s what Paul Volcker had to say about such claims:

[Volcker] said that financial services in the United States had increased its share of value added from 2 per cent to 6.5 per cent, but he asked: “Is that a reflection of your financial innovation, or just a reflection of what you’re paid?”

[a clearly irritated Mr Volcker said that] the biggest innovation in the industry over the past 20 years had been the cash machine…“I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence.”

Let’s keep it simple. Forget the mind-numbing details of what Warren Buffet called “financial weapons of mass destruction.”  There are some simple facts we need to remember.

This is a legitimate social question: not just a business question, and surely not just a political question. The financial sector has gotten too big. It pays itself too much. There are plenty of fine people in the industry, and I’ve had the privilege of working with many; but on balance, perhaps not enough.

Too much of the sector is built and managed on the basis of financial returns only, and on the short-term rather than the long-term. It is not—on balance—an industry being run for the betterment of society. The social benefits of globalized, digitized, productized, market-driven structures have been overwhelmed by the social costs of illiquidity (aka credit freeze), risk protection (aka bailout), opportunity cost (aka our best and brightest designing nano-second trading models) and social misery (aka unemployment).

A critical sector of the economy has become–on balance–systemically untrustworthy, and therefore unworthy of being trusted. Sellers’ needs are vastly over-emphasized relative to customers’ needs. On balance, the sector has come to equate ethical behavior with the absence of legally prohibited activity, and to do so unconsciously.

Society has a right to demand that its business sector conduct itself in ways that are constructive for society as a whole, not just for shareholders and management. That right supersedes any “right” of corporate entities and their management to do what they want according to some gross misreading of Adam Smith. 

Let’s keep it simple. Wall Street, we have a (simple) problem.

Soul Trust

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From Reuters, a most curious story.
Would you pledge your soul as loan collateral?

RIGA (Reuters) – Ready to give your soul for a loan in these difficult economic times? In Latvia, where the crisis has raged more than in the rest of the European Union, you can.  Such a deal is being offered by the Kontora loan company, whose public face is Viktor Mirosiichenko, 34.

Clients have to sign a contract, with the words "Agreement" in bold letters at the top. The client agrees to the collateral, "that is, my immortal soul."

Mirosiichenko said his company would not employ debt collectors to get its money back if people refused to repay, and promised no physical violence. Signatories only have to give their first name and do not show any documents.

"If they don’t give it back, what can you do? They won’t have a soul, that’s all," he told Reuters in a basement office, with one desk, a computer and three chairs.

Think of all the literary touchstones this story elicits.  Gogol’s Dead Souls?  No, these souls are living.

How about the Robert Johnson Mississippi Delta myth of selling one’s soul at the crossroads; which led to Clapton’s Cream mega-hit Crossroad (and the comically serious Hollywood version, with Ralph (Karate Kid) Macchia doing the Robert Johnson role, with Ry Cooder standing in for Johnson/Macchia, and monster guitarist Steve Vai frankly blowing them all away as the devil).

Apparently, Mirosiichenko is not kidding. 

Mirosiichenko said his company was basically trusting people to repay the small amounts they borrowed, which has so far been up to 250 lats ($500) for between 1 and 90 days at a hefty interest rate.

He said about 200 people had taken out loans over the two months the business was in operation.

What does this say about trust?  The lender isn’t accepting collateral in the traditional sense (unless a rebuyer of souls, a la Gogol’s plotline, shows up).  Rather, he’s betting on the meaning of the oath to those who take it. 

Soul-pledging: the antithesis of asset-based lending.

Does this amount to a fear-based manipulation of primitives?  Or is it a sophisticated form of appeal to a character-based sense of honor?

Somewhat less seriously, what would Wall Street add to the question?

•    Are some souls more bankable than others?  Can a fair virginal maiden of 18 pull down a bigger loan than an aging prostitute?  
•    Are soul contracts assignable?
•    What’s the value of a tranche of securitized soul contracts?
•    Can you short soul contracts?  (Unfortunately, as of yesterday, naked shorts are now illegal).  
•    Is the soul sufficient consideration for a loan?
•    How do you foreclose on a soul?
•    What happens if the market value of a soul drops to the point where you’re underwater vis a vis the loan?  Can you go soul-bankrupt?
•    What if you commit a mortal sin after you sign the contract, thereby reducing the value of the collateral?

(co-author credits on this blogpost go to Susan Kleiner and Stewart Hirsch, specialists in soul law).
 

Bear Stearns, Enron, and Some Confusion About Trust

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Is there such a thing as an inherently trust-based business? Houston Attorney Tom Kirkendall, who writes a blog called Houston’s Clear Thinkers, seems to think so.

In a provocatively titled post called That Pesky Trust-based Business Model, Kirkendall writes:

"The fact of the matter is that Enron was — and Bear Stearns and AIG are — trust-based businesses that fundamentally depend on the trust of the markets to sustain their value. Once that trust is lost, such companies lose value quickly and dramatically. "

I’m not so sure about that. Presumably he means most financial businesses are leveraged—they lend out, or put to work, considerably more money than their base capital. And as long as people trust them, it works If they lose that trust, well, that’s when you get a run on the bank. That’s what I understand Mr. Kirkendall to mean, anyway.

But try shouting "roaches!" in a restaurant. What happens to Wendy’s stock price if someone finds a finger in a bowl of chili? What happens to a pharmaceutical company if someone finds a tainted pill bottle? What happens to a toy company if it’s found to have imported toys made of hazardous materials? What happens to a securities-rating agency when AAA-rated securities turn to junk in months?

I haven’t thought this through fully yet, but the idea that some businesses may be structurally more "trust-based" may be a distinction without a difference—or at least one of degree only.

What is clear to me is that all businesses can be run in a trustworthy manner—or not.

For example, when the CEO of Bear Stearns, Alan Schwartz, said on CNBC on the morning of March 12 that the firm’s liquidity was fine, a Bear Stearns shareholder might reasonably “trust” that the firm wouldn’t lose billions and implode in about four days.

Oopsie.

Back to Kirkendall, who goes on to say:

Although unfortunate for the owners of such companies, such a dramatic loss of wealth does not necessarily mean that any criminal conduct caused or was even involved in the loss. Rather, such loss is simply one of the risks of investing in a company based on a trust-based business model.

Granted criminality is not the only warranted deduction. There is also venality that hasn’t been outlawed. And, most common of all, garden-variety incompetence with its handmaiden hubris.

Here’s what mega-investor Saudi Prince Alwaleed had to say just a few months ago about former CEO Chuck Prince’s similar situation at Citibank:

You cannot come to the public and say that this normalization is expected in the fourth quarter and then three weeks later, not three months later, you come and say there is an $11 billion writeoff. This is unacceptable. That’s when the events changed completely. My backing was withdrawn dramatically.

You should never commit to something that you can’t deliver. Never…I am extremely disappointed with Chuck Prince and I believe that Chuck Prince let down the shareholders completely.

Both CEOs Prince and Schwartz said one thing, clearly and confidently—and were very quickly proven either liars or incompetents. Schwartz just got there a lot faster.

Alwaleed considers this patently unacceptable. Kirkendall considers it “simply one of the risks.”

But where is Kirkendall going with all this?

The sooner we all recognize and understand this risk — and avoid the mainstream media’s promotion of myths about them — the quicker we can put a stop to injustices such as this while advancing the discussion of how best to hedge the risk of such potential losses.

I’ll save you the trouble of clicking through the links. The “myths” he is talking about are that "myth" that Enron was about criminal behavior, rather than prosecutorial misconduct. Enron investors could have and should have shorted Enron (true enough). Kirkendall seems to think this is all part of a conspiracy, that Skilling has been unfairly demonized. He says, “I continue to hope that Jeff Skilling’s unjust conviction and sentence are reversed on appeal, not only for his and his family’s benefit, but also for ours.”

O-kay. That’s one view. Here’s another, from someone with standing:

Jeff was indeed the "smartest guy in the room" and a micro-manager to boot—which certainly made it clear to me that the idea that he was unaware of details of his subordinates’ affairs was utterly absurd. Likewise the idea that he was ignorant of the shades of gray and then black concerning the border between legal and illegal market manipulation insults his intelligence. So I guess I conclude "beyond a shadow of a doubt" that the prosecutors and the jury got it right.

That’s by Tom Peters. Tom knew Skilling because he worked with him. Read Tom Peter’s full post on Skilling, Lay and Enron here. It’s enlightening not just about Enron and ethics, but about what a real trust-based business looks like. Tom believes in Cowboy Capitalism. He also believes that those in charge bear some responsibility to those who entrust them with their money. Tom Peters, in my book, does Clear Thinking.

It strikes me as disingenuous at best to describe some business models as "trust-based," and to then use that as a facade for an argument against the accountability of those who are chosen precisely for their ability to navigate treacherous waters and who are paid handsomely for their doing so. If there is no line to cross, then there is no such thing as ethical behavior. And if there is a line, someone’s likely to try crossing it. C’est la vie.

The key issue isn’t whether a business model is "trust-based." It’s whether we can put our trust in the people running the business.

Quarterly Earnings and the Addiction to Lying: Can Mattel Show the Way Out?

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If you lie, the best time to ‘fess up is immediately. “Immediately” is the only time that “oops” can constitute a full apology.

The longer you wait, the more “oops” looks like a dot in the rear-view mirror. Soon, to make amends, you have to confess. And probably explain. And the longer you wait, the more you have to express remorse, do penance (or pretend that you are) and other forms of disaster recovery.

No wonder CEOs have a hard time with quarterly earnings: the more quarterly earnings increases they show, the harder it is for them to show a quarterly loss; the more they’ll lie to keep the string going.

That’s the conclusion of a very clever study in the spring 2007 issue of the Journal of Accounting, Auditing and Finance. Its authors are James N. Myers and Linda A. Myers, and reported by Mark Hulbert, in the September 22 NY Timess, How Many Quarters In A Row Can Quarterly Earnings Grow? (Hulbert is a rarity—an analytical finance type who speaks completely in common English).

The profs analyzed the heck out of tons of data to answer the question: “absent manipulation, how many companies over a 42-year period would have been expected to put together a 20-consecutive quarter string of increased earnings?”

The professors calculated that no more than 46 companies during that 42-year period should have had earnings-per-share growth for 20 consecutive quarters. But 587 companies actually reported such strings of growth, so the professors conclude that their findings constitute “prima facie evidence of earnings management.”

Additionally: companies that had increased the same percentage over five years but in less linear fashion showed six percentage points less in stock appreciation.

Finally, the longer the string of positive earnings reports, the sharper the plunge in stock price on announcement of a losing quarter. As the professor says:

Together, these various findings paint a picture of extraordinary pressure on corporate management to sustain strings of consecutive earnings increases for as long as possible.

When I was in b-school, we talked about volatility of earnings—basically, a straight line is better than jagged. But we also talked about “quality of earnings,” which suggested that cooking the books (I don’t mean illegal, just, you know, cooking) was worse than not.

I don’t recall realizing there was a tension between those two goals, but it’s clear to me in retrospect that the more powerful of the two in the market was the appearance of low volatility.

In other words, cooking the books is rewarded by Wall Street; and the more you cook them, the more you’d better keep on cookin’.

Is that yet more proof for the cynics? It certainly sounds that way.

Then again, just because everyone’s lying doesn’t mean truth-telling doesn’t work; it could just mean no one’s willing to really try it.

Which brings us to Mattel, whose CEO apologized to China on Friday, September 21, saying China had gotten a bum rap for manufacturing flaws, when design was at fault.

Mattel’s stock price gapped up Friday about 4%, and stayed up on the day. A vote for quality of earnings? One day proves nothing, but as Rick Newman at US News and World Report says,

Mattel messed up, but now the company is bringing a welcome degree of transparency to an issue that seems complex and murky to most of us. So hurry up and pay attention, before the politicians and fearmongers muddle it up.

Was Mattel’s apology genuine, or forced by the Chinese?  I suspect the markets couldn’t care less.

 Could transparency actually be worth financial returns? Now there’s a thought.