Soul Trust

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).

Are You Connected? Or Just Linked?

Are you connected? Or just linked? You know the difference when I phrase the question that way. It’s obvious.

• If you’re three degrees of separation away from someone on LinkedIn, you might be a Linker—but you’re not connected.

• If someone’s birthday is in your Act or Outlook database, and it links to their MySpace page and auto-triggers digital happy birthday emails from you to them, then you might be a Linker—but you’re not connected.

• If someone picked up your business card at your tradeshow booth, you might be a Linker—but you’re not connected.

We all know the difference.

But we all forget it—frequently, regularly, unconsciously. And we all suffer because of it. Here’s what I mean.

The ability to “link” is what freed up the mortgage industry. When a local savings bank sold loans to a larger aggregating bank, it “linked” to them by a financial contract; you pay me X, I give you rights to a mortgage. Ditto for that same savings bank paying mortgage originators to find mortgages. And for the aggregating banks to securitize their mortgages, and link to buyers of mortgage-backed securities.

The links, in every case, were one-off contractual transactions. They replaced connections. Connections were relationships, not transactions. They were ongoing, not one-off. They were between people, not just between corporate entities and lawyers. Connections presumed lots of links; but links alone don’t presume connections, any more than one night stands presume relationships.

The wholesale replacement of connections by links is a key feature of the economic landscape today. It is by no means all bad.

“Linking” has been key to outsourcing, and to globalization. Chop business processes up into smaller and smaller pieces, then Link them to a third party, maybe in Bangalore, maybe in North Dakota. The result is global scale of processes; global markets; and global risk-sharing. All good, per se—as far as they go.

“Linking” has meant greater efficiencies of the things being linked. Ten companies all with separate HR departments cannot run HR as efficiently as one company outsourcing HR services to ten users. One does a dramatically better job of forming markets for daters than a thousand bars in the Naked City could ever do.

There’s just one thing wrong with Linking. If allowed to entirely replace connection, linking will destroy connection.

If no one is connected across the whole mortgage business—if no regulators or companies or customers have stakes in the system as a whole—then the “market” will eat itself alive, as everyone maximizes their own good. The Invisible Hand simply does not work in a Linked-only system—it works only if someone has a stake in the market as a whole, and over time. A market of strangers linking once-off and then disappearing into the haze of transaction-land is what you see in dating bars at closing time, operating by rules of caveat emptor.

This is why eBay has buyer ratings. This is why stocks go up when governments intervene after linking-only has gotten pathological enough. This is why the internet (and new media channels) will drown in spam if they are nothing more than links. To be vibrant, these new marketplaces must find community—a sense of connection.

Our financial markets right now don’t suffer from just liquidity, or even solvency. They suffer from lack of trust. And nothing kills trust like the drowning of connection in a sea of links.

Failing Trust Has Led to Failing Markets

Trust has taken a leap to the foreground given the implosion of financial markets. And rightly so.

Irish economist and market researcher Gerard O’Neill writes:

"…the essence of the present financial crisis is a collapse in trust: including trust between banks and other banks; between banks and their customers; and indeed between banks and governments."

O’Neill cites a BBC program that asks the question, “Is trust evaporating in contemporary society? Does more monitoring of people and politicians increase trust, or encourage paranoia?”

Robert Reich, former US Labor Secretary turned academic, has also been waxing eloquent on the subject, on TV Talk Shows and on the radio:

…why are the free marketeers in the Bush Administration rushing to Wall Street’s aid? The answer goes deeper than the subprime mess. The Street has suffered a serious decline in trust…Yet trust is its most important asset. Financial markets trade in promises — that assets have a certain value, that numbers on a balance sheet are accurate, that a loan carries a limited risk. If investors stop trusting those promises, Wall Street can’t function.

…It worked great as long as everyone kept trusting and the market kept roaring. But all it took was a few broken promises for the whole system to break down.

There are two debates going on now. One is political, built on pent up resentment and schadenfreude—the Main Street vs. Wall Street argument. The other is ideological—free markets vs. regulation. Both are somewhat bogus, but I’ll stick to the second.

Pure free markets exist only in economists’ imaginations—thank god. Competition is inherently instable. The goal of every competitor is not to maintain a state of competiton, but to obliterate that state—often by colluding, sometimes by winning. Imagine a football game without referees. Every functioning market needs some regulation to avoid imploding into a black hole of monopoly.

But neither is “more” regulation the right answer. Regulation by bureaucrats, cronies, incompetents or the venal is not much better than anarchy.

“Who” and “how” are critical regulatory questions. And there are some basic principles. You’d think they’d be obvious, but they are frighteningly easy to lose track of.

One is transparency. Nothing cuts out envy, suspicion, and temptation better than sunlight. Yet the SEC and Congress allowed an entire set of financial products and markets to be invented—out of sight. Opponents of mark-to-market accounting—please explain to me how politicians can make valuations more transparent than accountants plus a market can do?

Another is time. The more fragmented and transactional the business model, the more is needed some timeframe over which society can see relationships and consequences between those transactions. If the industry manages itself solely through zero-sum one-off deals, then regulators must provide that longer-than-a-nanosecond view.

A third is the connection of the parts to the whole. The mortgage industry is a perfect example: it used to be that mortgage agents, lenders, home-owners and mortgage-holders interests’ were all aligned. A year ago I wrote about a 1995 economists’ view of the industry as it looked then, vs. the disaster-in-the-making it had become. The difference was all disconnected parts with no one minding the holistic store—no one in industry, no one in regulation.

I usually write about personal trust; that’s the “pure” version of the stuff. But make no mistake, trust is critical socially. Some industries can self-regulate, based on the three principles above. Though just now, offhand, I can’t think of any examples.


30 Minutes, 30 Cents, 30 Billion: Fragmenting Business

A few weeks ago I sat next to an investment banker on a long flight. He works hand in hand with some of the super-quants on Wall Street who perform high-wire arbitrage through mathematical techniques so arcane that “I’d have to get two more math degrees just to understand them,” as my seatmate put it.
“Basically what they’re focused on is predicting the next 30 minutes,” he said. (Actually it may have been “the next 30 seconds,” I forget.  Anyway, day-trading for the Big Bucks, with lots of Other People’s Money).

At my destination, I heard a senior exec of one of the world’s high-tech success stories talk about their business model—“30 cents a transaction times billions of transactions, pretty soon you’re talking real money.” (How many of you remember Everett Duerksen, the originator of that line? Hey I’m not old, just well-read!).

30 minutes, 30 cents, 30 billions. Not your father’s bizmodel.

There is no shortage of economists who will gladly tell you the wonderful role these business models play. They mitigate risk; they lower costs; they create greater liquidity; they globalize geographically fragmented businesses.

Gosh, is there no downside? Of course there is. And it’s one of those two-sides-of-the-same-coin things.

The business world of today is heavily driven by two trends—fragmentation of processes, and globalization of scale. Break everything into tinier and tinier processes, and scale them globally. You get all the benefits listed above, but—what happens if no one has the big picture anymore?

You occasionally get myopic consultants and bankers—for a great example see this blog post from last year. 

But more importantly, you get situations where everyone is transaction-oriented, and no one has a stake in the integrity of the entire process.

The airline industry, many decades ago, was largely financed by insurance companies. The insurance companies tended to have ties to multiple airlines, partly to hedge their own risk.  Then the banks got into the business. Each bank picked a favorite—and given the peculiar economics of the airline industry, all the airline-bank pairs began to beat each other into the ground with excess capacity. The industry hasn’t made money for decades.

For a more current example, of course—subprime mortgages. When an industry gets dissected, disaggregated, and disintermediated, there may or may not be a problem. If a regulatory agency is there to see the big picture, that may be OK. If a risk-assessing industry is in place (bond ratings, accounting firms), that may serve to keep things in check.

But if none of those things are true—if Glass Steagall has been eviscerated, financing products escape regulatory purview, if financial institutions are selling off and collateralizing loans and if credit card companies are chasing fees (read transaction) instead of loans (read relationship)—then watch out. No one’s minding the business store.

In such cases, business becomes a combination of Russian roulette and musical chairs. He who gets in and gets out fast wins. He who stays is a sucker.

How fast is 30 minutes? How small is 30 cents? Small, and getting smaller.

Decaying Social Trust and Moral Indignation

Pop quiz!

Who wrote: “This is how the world will end—not with a bang, but a whimper.”

a. T.S. Eliot
b. W. H. Auden
c. Robert Frost
d. e.e. cummings
e. Alfred E. Neumann

Answer at the end; no fair peeking.

I don’t know about the world, but the subprime/mortgage/credit crisis shows how social trust ends. Not with a whimper, but with righteous moral indignation—on all sides.

We are in the midst of the deflation of a debt or credit bubble, itself based on an asset bubble—overpriced houses. As of today, according to the Mortgage Bankers Association, 24% of subprime mortgages are delinquent or in foreclosure; ditto for 4% for prime mortgages; and for all mortgages it’s a record 7.9%, the highest since records began in 1979.

Everyone played musical chairs. And the more frantic the music, the more rightous the talk.

Here’s the Heritage Foundation—mind you, just last November, 2007—demonstrating its utter subordination of logic to ideology, arguing against H.R. 3915, a House bill to reign in predatory lending:

[the bill] would establish an explicit series of credit standards for lenders, which could have the effect of excluding many moderate income borrowers from the ownership market. In sum, the enactment of H.R.3915 would delay the housing market recovery that is now struggling to get underway.

Yup, Congress killed the real estate bubble appreciating market.

A year earlier, in September 2006, the Mortgage Bankers Association stated that

“the subprime market has evolved dramatically in recent years, providing significant benefits to consumers…increasing regulation could decrease competition and increase rates that the subprime market offers consumers.”

But this is not a populist rant.  Consumers were far from just hapless victims.

An FBI Mortgage Fraud report 3 months ago stated that up to 70% of early payment defaults may have been linked to buyer misrepresentation on loan applications.

What about FICO credit scores?  Courtesy of BusinessWeek, meet “credit doctors,” companies who will manipulate credit ratings by blitzing credit agencies with disputes about old reports (which have likely been lost), setting you up as an “authorized user” of an account owned by someone with good credit, or just creating paper accounts.

“All legal,” they protest. Of course. No miscreants here.

So—end game—bang or whimper?

Dateline, CBS Evening News February 12, 2008.  Meet Karen T., a married San Francisco suburbanite who bought a condo as a second home for $505K, financing it 100% with mortgage debt. Now it’s worth $340K, and her adjustable mortgage goes up $900 this June.

They own another home. They can afford the rate increase. So—what to do?

Karen’s answer?  Walk away. Default.  Give it back to the bank.

Is Karen distraught? Not really. “I’m not doing anything illegal.  Everything’s negotiable in business—this is just another business decision. I don’t see why this is any different. I’m within my right to walk away from a bad deal.”

And 60% in an LA Times Real Estate blog poll agreed with her.

Karen is morally indistinguishable from a landlord turning off the heat under rent control; insurance companies withdrawing sole-provider coverage from unprofitable markets; banks charging usurious credit rates; emergency rooms turning out the uninsured; de facto mortgage redlining; and a thousand forms of “fine print."  Or—come to think of it—from a banker foreclosing on a never-should’ve-approved-that-loan loan. 

The rallying cry is always, “I’m not doing anything illegal.”

But here’s the kicker.

Karen’s not morally indignant about walking away. To her, that’s “a business decision.”

No, her moral indignation is reserved for the consequences she might face.  She leans her face on her hand, her voice intensifying, as she says, “It is devastating to think that my credit scores are going to drop 200 points," she said.

OMG, it’s just so, like, unfair!

Huh? Devastated because you were educated, had the money, and placed a 100% bet on an overheated market—and lost? And you can afford to pay the piper—but don’t want to?

Take a trip to Vegas, Karen, and see if the blackjack dealers buy it.  Better yet, go tell it to someone with half your education and income who’s been foreclosed on after having spent their last money trying to pay the bank. 

It doesn’t matter who started the food fight.  It seems that the decay of social trust is accompanied by higher levels of self-righteousness and narcissism on both sides.

When business and consumer alike choose moral bankruptcy over financial bankruptcy—without even thinking about it—and then justify it indignantly through Darwinian arguments—well, Houston, we’ve got a problem in trust-land.  Not to mention ethics-land. 

Oh yeah—T.S. Eliot

European Fish, the Commons, and Business

The sea and its denizens have long been fertile subjects for myth and metaphor. That tradition continues in The Economist, December 15-21, “A Fishy Tale”.


The [EC’s] Court of Auditors recently found that the European Union’s Common Fisheries Policy does not work…A survey found 81% of fish stocks to be dangerously over-exploited.

…the commission proposes quotas that are larger than those recommended by its scientific advisers. National ministers then expand the quotas once again [by about 50%]. And then national fishing fleets break even these higher quotas.

To most Eurocrats, the problem is selfish national interests, and the solution is tougher EU-wide controls…but if countries parceled out the fish among themselves there would be none left, says one official…some fishermen quietly discard lots of fish so as to pack their holds only with the most valuable.

Many fishermen cheat because they believe the scientists are wrong, or because everyone else is, or because they cannot make a living otherwise.

And so it goes.

Economists know this as “the tragedy of the commons,” based on the problem a few centuries ago of sheep overgrazing the town lands held in common. The problem is that people’s individual search for economic self-interest ends up, paradoxically, destroying everyone’s self-interest.

The airline industry knows this dilemma well. Any given airline on any given route is incented to have a plurality of available-seat-miles. This leads to endemic over-capacity, hence lower profitability for all. The only sure-fire route to airline profitability is not clever marketing, a la Southwest Airlines—it’s domination of routes, something Southwest also knows a thing or two about.

But back to fish. Issues of the commons show up first in government, later in business, because government by default gets the un-economic propositions. But the issues are increasingly not unique to government.

The business world has its own version of the commons. When every company seeks to gain sustainable competitive advantage, maximizing its own shareholder value, driving that logic into every transaction, you end up with systemic suboptimal results.

Example: mortgages. In the old days, savings banks held the loans, lived in the community, knew the borrowers; the borrowers kept the house, and kept the mortgage company. Inefficient, yes; but the common interest was enforced.

Today, we got efficiency—but at the cost of a common interest. The players in the subprime mortgage game ended up just like Portugal, Britain and Poland duking it out over declining fish stocks. The only losers were the fish. Until the fish disappear.

Business is diving headlong into certain practices—the slicing and dicing of business processes, the slicing and dicing of securities into finer and finer tranches of ownership, the rapidly diminishing time of ownership, and the establishment of myriad markets where ownership and time can be freely exchanged.

Lots of markets, lots of efficiency—and very little overlap of the common good.

The ideology of competitive separateness is precisely the wrong ideology in a world of increasing interdependence.
Ironically, since the “commons” problems first show up in government, it is government that must provide examples for business to follow—yet we are saddled with an ideological bias that says business has nothing to learn from government, only the reverse.

The Economist’s conclusion about fish is as right as it is predictable: Europe needs to “ponder the example of one of the EU’s few uncontested triumphs, the single market, and apply its lessons to the seas. That would be rational. It might even be good for the fish.”

And for business at large. It’s difficult to believe that a global economy built on the theory of sustainable competitive advantage is going to solve the energy problem. Or the health care problem. Or the immigration problem. Or the trade problem.

We need an ideology of trust. A set of beliefs that link, rather than divide.

How To Get Your Industry Regulated, in 6 Easy Lessons

On November 15, the US House of Representatives passed HR 3915, known as the Mortgage Reform and Anti-predatory Lending Act of 2007, mainly along party lines.

Led by Barney Frank, the impetus for this legislation was the disastrous subprime lending meltdown, whose implications are looking worse every day—right up to today, December 6, 2007.

To hear the mortgage industry tell it, this legislation is a classic big-government socialist disaster in the making. The Heritage Foundation says it will “put individuals of moderate incomes, imperfect credit histories, and limited wealth at an even greater disadvantage, leading to a decline in the home ownership rate,” and if they say that’s a bad thing, then of course it must be so.

A typical letter in the Originator Times, a mortgage broker publication, predicts “this [legislation] will cripple the economy and the livelihoods of thousands of people in this industry.” Brokers, that is; never mind the homebuyers.

Aubrey Clark, of, says, “Lawmakers attempting to pass the Anti-predatory Lending Act of 2007 right now are effectively trying to tell lenders whom they can and can’t loan money. HR 3915 is vaguely written and enables borrowers to sue their lenders for giving them a loan should they decide not to pay.”

Well, Aubrey’s reports of impending communism are slightly exaggerated. This legislation has already been watered down, and may get still more diluted in the Senate.

But more importantly—the mortgage industry, and the two main industry associations (the Mortgage Bankers Assocation, and especially the National Association of Mortgage Brokers) have no one but themselves to blame. Anyone running a services industry association has just been handed a “teachable moment” in how to shoot themselves in the foot.

It’s classic—an industry association that sees its role as pursuing the short-term interests of its constituents at the cost of the customers’ interests—and therefore at the long term cost to everyone. The (predictable) end result is government regulation—about which they then bitterly complain.

Wanna get regulated? Follow these Six Simple tips.

1. Wrap Your Business in the Flag

Testifying in the house in 2003, Mr. A. W. Pickel, President of the National Association of Mortgage Brokers (NAMB), talked about “the dream of home ownership…the joy of home ownership…We believe the record levels of home ownership in the US can be attributed to the vibrant and competitive mortgage market.”

Therefore, “addressing abusive lending requires a balanced response…Any efforts to address abusive lending practices cannot cut off access to consumer credit.”

[Try substituting another industry here. “Addressing abuse of alcohol requires a balanced response…Any effort to get bartenders to address excessive drinking cannot cut off patrons’ access to more booze.”]

The Mortgage Bankers Association (MBA) in 2006 says: “More Americans own homes than ever before…Americans are building tremendous wealth.”

Throw in some free market talk stuff too: “If consumers did not feel mortgage brokers were delivering on what was promised, they would not reward them in the market.” Of course not. Who could think otherwise?

When threatened, repeat: "We cannot allow the American Consumer to be separated from the dream of home ownership."

2. Say You’re the Hero of the Underdog

NAMB: “Subprime lending often serves the market of borrowers whose credit history would not permit them to qualify for the conventional “prime” loan market.

MBA: “The subprime market has evolved dramatically in recent years, providing significant benefits to consumers. Non-prime borrowers commonly have low-to-moderate income, less cash for a downpayment and credit histories that range from less than perfect to none at all. Before the advent of this new market, these borrowers were either simply denied homeownership or…served exclusively by FHA or other government subsidized financing.

[Inconvenient truth: “In 2005, the peak year of the subprime boom, the study says that borrowers with [credit scores high enough to qualify for conventional loans with far better terms] got more than half—55%—of all subprime mortgages].


3. Deny Bad News

In August, 2006, the MBA said, “Default and foreclosure rates are low. Some argue that [they] are at crisis levels and that a greater percentage of borrowers are losing their homes. MBA’s data does not support this—instead, it tells a different story.”

[A scant 8 months later, this headline: US mortgage default rates hit an all-time high in the first quarter of 2007.

Mr. Pickel, of NAMB: “the incidence of abuse is very small relative to the whole industry…NAMB strongly advocates that our members never originate a loan to an uninformed consumer…”

[Counterpoint, Wall Street Journal: “A study done in 2004 and 2005 by the Federal Trade Commission found that many borrowers were confused by current mortgage cost disclosures and ‘did not understand important costs and terms of their own recently obtained mortgages,’” ]


4. Blame the Consumer and the Government

“Education is key…NAMB supports federal legislation that includes provisions to address financial literacy…NAMB urges increased enforcement of existing abusive lending prevention laws.”

MBA believes that borrower education to help consumers navigate the home buying and mortgage finance process is extremely important…MBA and its members have developed a number of strategies to educate consumers about their options in the mortgage marketplace.”

Some of the barriers to fair lending include…insufficient enforcement of existing laws…NAMB believes existing laws should be better enforced by state and federal regulators as a means to eliminate abusive lending practices.”

[In other words: the problem is consumers are too stupid to follow our fast-talk—and that’s not our fault. Feel free to use taxpayer money to educate millions of consumers—and boil the ocean while you’re at it. And we don’t need no more stinkin’ laws; get some FBI agents to bust criminals, and leave us good guys alone.]


5. Say Bad Things Are Not Your Fault

HR 3915 makes lenders more responsible for assessing borrowers’ ability to pay. Listening to the industry, you’d think this is the death of civilization. (“What!? I lend a guy money and he doesn’t pay—then sues me because I lent him the money!!”).

Sounds reasonable, until you substitute:

“Those kids don’t have to watch our (cereal/game) ads on TV on Saturday morning, they could be studying.”
“Those people didn’t have to move next to a chemical dump, no one forced them.”
“We’re not in charge of the nation’s diet, we just offer the high calorie high fat part of it; they can buy salads anytime they want.”
"Why should I have to drive slow just because some other folks are bad drivers, and can’t afford gas?"


6. Whatever You Do—Don’t Share Data

One of the biggest worries of the industry was that legislation might eliminate the YSP—yield spread premium. It’s money paid by the lending institution to the broker for higher interest loans.

The mortgage brokers howl at the idea of disclosing these numbers; the WSJ article shows a broker’s rate sheet with the footnote: “for wholesale use only. Not for distribution to the general public.”

In industries where the wholesaler’s payment to the retailer is disclosed, it goes by names like "advertising allowance." In industries where it’s secret, it’s called a kickback.

The brokerage association says it gives the broker flexibility to help the consumer. The Wall Street Journal calls it “a compensation structrue that rewarded brokers for persuading borrowers to take a loan with an interest rate higher than the borrower might have qualified for."

Mr. Pickel—now a CEO of a mortgage brokerage firm, and no longer head of the NAMB, says there is “a lot of play in the system. You have to operate with an ethical basis.”

He’s wrong. You don’t "have to." And not enough did.

Now they’re getting the results they in effect asked for—the prospect of regulation.

But don’t cry too hard for them: they’ve already succeeded in watering down the YSP restrictions. They have a few friends in congress—(curiously, all of them Republican—the House vote was 100% of the Democrats.)

So there’s your recipe. Are you listening, financial planners? Credit card operators? Insurance specialists? Stock brokers? Follow these easy rules, and you too can enjoy the benefits of greater federal regulation in your industry.

Of course, you could clean it up yourself.


Ben Stein vs. Goldman Sachs: Market-Makers, Brokers, and Trusted Advisors

Yes, that Ben Stein. Bane of Ferris Bueller. Droll protagonist of Comedy Central’s Win Ben Stein’s Money. Pitchman for beachball eyeball medication. And—lest you forget—economist.

In this Sunday’s NY Times, Ben Stein let fly with an article—The Long and Short of it at Goldman Sachs —that must have raised a few hackles even at that above-it-all Wall Street institution.

Stein’s breezy style is to write—as he would put it—all ‘round Robin Hood’s barn, until he ends at a very sharp point. So he does here; but he pulls his punch.

Background. Alone among Wall Street players, Goldman Sachs not only didn’t lose money in the subprime debacle—they made a great deal of money, by going short, or betting against, the very packaged subprime mortgage-backed securities they were selling to customers. (See Allan Sloan’s excellent Fortune article on a sample Goldman offering .)

Stein reminds us of Merrill Lynch analyst Henry Blodget in the last overdone market; Merrill hyped tech stocks to investors, while Blodget privately called them “junk” to his friends. In 2003, he was permanently disbarred from the securities industry.

Then he pulls the trigger.

“How different would [the Blodget situation] be from selling short the junky stock that your firm is underwriting? And if a top economist at Goldman Sachs was saying housing was in trouble, why did Goldman continue to underwrite junk mortgages into the market? …

It is bad enough to have been selling this stuff. It is far worse when the sellers were, in effect, simultaneously shorting the stuff they were selling, or making similar bets…

Should Henry M. Paulson Jr., who formerly ran a firm that engaged in this kind of conduct, be serving as Treasury secretary? Should there not be some inquiry into what the invisible government of Goldman (and the rest of Wall Street) did to create this disaster…

Bracing stuff, that—simultaneously calling Goldman Sachs a bunch of salesmen, questioning the moral rectitude of the Secretary of the Treasury, and calling for an investigation of the investment banking industry.

If you like that sort of thing, you’re probably woo-wooing and high-fiving Ben Stein. But the truth is, by demonizing Goldman Sachs, Stein lets everyone off too easily.

Here’s what I mean: What’s the difference between a market-maker, a broker, and a trusted advisor?

A market-maker is socially and legally authorized, even required, to take the other side in a transaction in order to maintain liquidity in trading.

A trusted advisor has your best interests at heart—gives you advice based on what is best for you, not necessarily best for the advisor.

A broker is usually found somewhere in the middle—making markets, giving advice, and trying to avoid the perception that his own self-interest is driving the position. Which, all too often, it is.

Which was Goldman Sachs?

Some might say market-maker. You can’t be a viable institution if you don’t systematically manage risks. If you’re going to sell $100 billion in CMOs, you might also want to hedge your exposure. Goldman just hedged well.

Some will say Goldman is a trusted advisor. Some customers, perhaps. I suspect Goldman will, anyway. They point out that they were not the only ones to sell CMOs. True. Not much of a proof for trusted advisorhood, but true.

But broker sounds more likely to me. The question is only partly one of transparency. Were Goldman’s short positions really hedges, or separate bets for their own accounts? Did Goldman tell buyers of CMOs that Goldman was net short?

But transparency alone can get reduced to “letter of the law” stuff. Motives matter too. No one would accuse a pure market-maker of claiming that one side of the deal was “better” than the other—the market-maker’s job is devoid of advice.

And no one would accuse a trusted advisor of having shaded advice to suit his own ends—because his trusted advisorhood would be instantly shot.

Life in those cases is clear; there are the black hats and the white hats. And Ben Stein is pretty clear about the black hats.

The question comes when those motives are unclear. When you just can’t tell what role Goldman was playing—when Goldman itself isn’t clear, or sends out weak messages (others sold CMO’s too; we are not a crook)—or we ourselves don’t know what role we want from Goldman—that’s when we’ve got a social, institutional, broad-based trust problem.

Now that’s a real problem, Mr. Stein.

Saudi Prince Alwaleed: Tough on Trust

Many people think of trust as “soft,” and inconsistent with “hard” approaches to making money. But have a look at Saudi Prince Alwaleed.

Alwaleed has long been a big investor in major US companies—Apple, for example, and Citigroup. He is Citigroup’s biggest individual shareholder, at 3.6% of the company (or he was until two days ago, on the 26th, when a group in Abu Dhabi took a position in Citigroup even larger than his). He did not get where he is by being “soft.”

In a fascinating interview, Fortune magazine spoke with Alwaleed about the demise of Chuck Prince, former CEO of Citigroup, after he announced a second write-off (of $11B) just three weeks after the first write-off of $6B .

Turns out Alwaleed believes in trust—strongly. See these excerpts:

Fortune has learned that Prince Alwaleed and other major shareholders agreed last week that, if Chuck Prince didn’t offer his resignation after the news of the additional $8 billion to $11 billion writedowns, they would publicly call for his ouster.

Q: Did you like Chuck Prince?

A: Yes, Chuck Prince was a good man. Honest man. Decent man.

Okay—a good, honest, decent man. Does Alwaleed trust him?

A…when Citigroup pre-announced the $6.4 billion writeoff, Chuck Prince called me within five minutes of the announcement and informed me of that loss and I told him bluntly and openly, "Is this the end of the story? Did you think of everything?"

His answer was "yes" and he expected normalization in the fourth quarter…So obviously, this gave me comfort that this was a onetime event and only an aberration and I backed off.

..But what happened two or three weeks later, another $8 to $11 billion additional write-off, the situation changed completely.

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.

Q: Are you disappointed in Chuck Prince?

A: I am extremely disappointed with Chuck Prince and I believe that Chuck Prince let down the shareholders completely. Citibank did not conduct itself in the right way. The risk-management situation was very wrong at Citibank.

So—is Alwaleed sour on trust?

Q: Do you have anybody in mind [going forward?]

A: Frankly speaking, I don’t have anybody in mind. I trust Mr. [Robert] Rubin. I trust Mr. Bischoff (interim CEO). I trust Mr. Parsons (CEO TimeWarner and head of the search committee for a new CEO).

Alwaleed gets it exactly right. He views attributes like honesty and decency as important for trust. But he put one element of trust ahead of all others in the case of Mr. Prince.

Alwaleed would not trust someone who did not know himself.

Prince’s sin was not the admission of a write-off—even a gigantic one. And Alwaleed concedes Prince is an honest man.

It’s not competence or poor moral character that Alwaleed is faulting Prince for, but Prince’s flawed belief that he knew what he was doing. He gave assurances—his word—that he was in control.  He wasn’t—and he didn’t know it.

It was not Prince’s incompetence that cost Alwaleed’s support, but his unconsciousness of his incompetence.  He didn’t know that he didn’t know.

And if you can’t trust that someone knows what he says he knows—well, it calls everything else into question. This is what Alwaleed saw, and he didn’t hesitate to pull the trigger having seen it.

Has Alwaleed’s view of trust been shaken? Not at all. He speaks openly of trusting others, even after having been burned.

He has gotten where he is by trusting the right people, and he’s not about to stop playing the trust game because his trust was misplaced in one case.

Alwaleed believes in trust—hard, serious trust.

If you think the dictum “know thyself” is only about touchy-feely introspection, then don’t work for Prince Alwaleed.

Tony Blair and the Subprime Mortgage Crisis–It’s the Basics

On November 8, the Washington Speaker’s Bureau booked a nice commission when former Prime Minister Tony Blair was paid $500,000 for a 20-minute talk to Chinese industry and government officials in Hong Kong.

Not a bad sum, even in US dollars. Blair’s Chinese market rate is now 2X the former reigning champion, one William Jefferson Clinton (and 5X Rudy Giuliani’s rate, according to the Financial Times (print edition, Nov. 9, 2007).

But all was not sweetness and light. Several attendees groused that Blair’s talk was full of platitudes and banalities.

As the China Youth Daily paper said, "To be honest, Mr Blair’s speech sounds so familiar. It’s just like the report of any Chinese county level official and contains no novelty. If the local political and business circles paid such a high price for a speech they could have made themselves, was it worth it?

A ripoff?. A con job? A typical politician hussle—take the big bucks, give nothing in return, smile all the way to the bank—and don’t give up a thing?

So it sounds in the papers.

There is, of course, another way to put it. Maybe Blair spoke the truth, and the audience just didn’t want to believe it. Maybe the road to global leadership isn’t a “secret” after all—maybe it’s one of those platitudes like “5% inspiration and 95% perspiration,” “common sense is uncommon,” and “just keep hitting singles.”

Maybe it’s back to basics.

Maybe it’s human nature to prefer something splashy. We want cleverness—we’re disappointed when the answer turns out to be a banality we’ve heard since the cradle. We want to believe others’ success is a trick. Back to basics? Don’t wanna hear it.

Wall Street loves quantitative cleverness. Take the SIV, or Structured Investment Vehicle. SIVs are asset-based products with tiers of risk deconstructed and repackaged, which let offerors capitalize on short vs. long-term spreads.

Problem; buyers used short-term debt to fund long-term products. Back to basics: match your maturities.

Moody’s now says, “many managers have told us they now do not expect to see the SIV model survive in its current form." (FT, November 9, “SIVs Face Fight to Survive, Says Moody’s”).

Morgan Stanley saw the subprime mortgage crisis coming a year ago, and designed a clever hedge. It bought credit default swaps (a side bet against subprime mortgages). And, to get the swaps insurance for free, they bought the least risky tranches of subprime—still high return. Voila—a free lunch.

Unfortunately, the least risky tranches of subprime also crashed and burned, overwhelming the insurance. “They were so right, they were wrong” says the FT. (Morgan Stanley Peers Through the Looking Glass, Darkly”, FT, Friday Nov. 9, p. 26).

Back to Wall Street basics: pigs get fat, hogs get slaughtered.

I have recently re-discovered John Gottman’s research on marriage. He talks about “bids”—basically little reach-outs to one another. Healthy marriages average about 70 bids in a given time period—unhealthy marriages, something like 20% as many.

We resist this line of basic thought. We want to believe in flowers, candles and soft lights. The Secret. The Ice Cream Diet. The latest technology. The “this time it’s different” stock market. If someone else succeeds—they must have had an inside angle.

Then the correction happens, and we see clearly yet again. It’s the little things. It’s hitting singles, not homers. It’s blocking and tackling. It’s no pain, no gain. It’s just eat less calories. It’s practice, practice, practice. It’s buy low, sell high. If it sounds too good to be true, it probably isn’t true.

It’s the basics.

Just ask Warren Buffett. Larry Bird. Ask Oprah. Or Tony Blair. The advice might be worth it. Even at Tony Blair’s rates.