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If you want to know what market momentum is all about, here you have it. Get in now to profit.

Sources

Bill Gross Calls High-Yield Corporate Debt `Overvalued’: Video (video here) – Bloomberg

Related posts:

• The market is moving. You should be too.
• Selling the good news does not a bull market make
• Richard Bernstein: Once a huge market bear, now a bull
• Jeremy Grantham: The market is 25% overvalued; 15% correction coming
• U.S. pre-market trading suggests a major selloff

In the wake of a few significant elections in the American states of New York, New Jersey and Virginia, a lot of pundits are putting their spin on what these elections mean for Barack Obama and his political agenda. On the whole, I find most of the conclusions partisan leaps of faith.

So, I wanted to take this issue on and outline my thoughts on American politics and the feedback loop with the economy. I will then try to take on what the election last November and just this past week mean in regards to Obama’s political agenda and the missteps I believe he made early in his tenure as President.

Confabulation and the human need to explain

First, let me start off with a basic concept of behavioral psychology: confabulation.  Back in April, I quoted from an article in New Scientist about how people will develop false narratives to explain away decisions already made. This is called confabulation. The article says:

As anyone who has ever been in a verbal disagreement can attest, people tend to give elaborate justifications for their decisions, which we have every reason to believe are nothing more than rationalisations after the event. To prove such people wrong, though, or even provide enough evidence to change their mind, is an entirely different matter: who are you to say what my reasons are?

But with choice blindness we drive a large wedge between intentions and actions in the mind. As our participants give us verbal explanations about choices they never made, we can show them beyond doubt – and prove it – that what they say cannot be true. So our experiments offer a unique window into confabulation (the story-telling we do to justify things after the fact) that is otherwise very difficult to come by. We can compare everyday explanations with those under lab conditions, looking for such things as the amount of detail in descriptions, how coherent the narrative is, the emotional tone, or even the timing or flow of the speech. Then we can create a theoretical framework to analyse any kind of exchange.

What experimenters here have shown is that there is a real human need to explain. Things happen for a reason, don’t they?  Why did the stock market rally? Why did Harry do that? Why didn’t we do something to stop this? Why did I vote for that guy back then, when I now don’t like him as much?

To the degree there is an explanation void, it will be filled. The question is: filled with what?

Confirmation bias and the psychology of politics

In politics, how the void gets filled has much to do with philosophical/political predisposition and one’s world view.

Drew Westen, a professor of psychology at Emory University, published an interesting book a few years back called “The Political Brain.” Recently, Westen has had some important things to say about the psychology of the health care debate (see Washington Post article here). But, in the book, the most memorable political psychological experiment Westen described is very much related to confabulation. I quoted from Wikipedia’s synopsis of this experiment to explain confirmation bias in the econoblogosphere back in May:

In January 2006 a group of scientists led by Westen announced at the annual Society for Personality and Social Psychology conference in Palm Springs, California the results of a study in which functional magnetic resonance imaging (fMRI) showed that self-described Democrats and Republicans responded to negative remarks about their political candidate of choice in systematically biased ways.

Specifically, when Republican test subjects were shown self-contradictory quotes by George W. Bush and when Democratic test subjects were shown self-contradictory quotes by John Kerry, both groups tended to explain away the apparent contradictions in a manner biased to favor their candidate of choice. Similarly, areas of the brain responsible for reasoning(presumably the prefrontal cortex) did not respond during these conclusions while areas of the brain controlling emotions (presumably the amygdala and/or cingulate gyrus) showed increased activity as compared to the subject’s responses to politically neutral statements associated with politically neutral people (such as Tom Hanks).[2]

Subjects were then presented with information that exonerated their candidate of choice. When this occurred, areas of the brain involved in reward processing (presumably theorbitofrontal cortex and/or striatum / nucleus accumbens) showed increased activity.

Dr. Westen said,

None of the circuits involved in conscious reasoning were particularly engaged… Essentially, it appears as if partisans twirl the cognitive kaleidoscope until they get the conclusions they want… Everyone… may reason to emotionally biased judgments when they have a vested interest in how to interpret ‘the facts.’[3]

The study was published in the Journal of Cognitive Neuroscience 18:11, pp. 1947–58, a peer-reviewed scientific journal.[1]

Even before being peer-reviewed and published, Michael Shermer used the presentation by Dr. Westen as the basis for his July 2006 Skeptic column[4] in the magazine Scientific American.

In essence, political partisans with a well-developed political world view were confronted with data that did not fit their particular view.  This created cognitive dissonance and mental stress (remember, the brain areas for reason were not activated here, emotions were at play).  Their brains, rather than trying to resolve the conflict objectively, looked for ways to incorporate the new information into the previous pre-conceived view. When the subjects successfully accomplished this back flip, they were massively rewarded by the areas of the brain for pleasure.

In sum, our brains are NOT hard-wired for non-confirmatory evidence. We are not rewarded for seeking non-confirming data. Therefore, we generally seek confirmatory evidence after we have made any decision.

When you read the narratives of the recent election results, you should realize that confirmation bias is very much at play in tweaking the conclusion to fit a preconceived world view.  A perfect example is a recent piece by Charles Krauthamer in the Washington Post.

Speaking of a huge Democratic loss in Virginia, Krauthamer says:

In the aftermath of last year’s Obama sweep, we heard endlessly about its fundamental, revolutionary, transformational nature. How it was ushering in an FDR-like realignment for the 21st century in which new demographics — most prominently, rising minorities and the young — would bury the GOP far into the future. One book proclaimed "The Death of Conservatism," while the more modest merely predicted the terminal decline of the Republican Party into a regional party of the Deep South or a rump party of marginalized angry white men.

This was all ridiculous from the beginning. The ‘08 election was a historical anomaly. A uniquely charismatic candidate was running at a time of deep war weariness, with an intensely unpopular Republican president, against a politically incompetent opponent, amid the greatest financial collapse since the Great Depression. And still he won by only seven points.

Exactly a year later comes the empirical validation of that skepticism. Virginia — presumed harbinger of the new realignment, having gone Democratic in ‘08 for the first time in 44 years — went red again. With a vengeance. Barack Obama had carried it by six points. The Republican gubernatorial candidate won by 17 — a 23-point swing. New Jersey went from plus-15 Democratic in 2008 to minus-four in 2009. A 19-point swing.

Obama also benefitted in 2008 from unique circumstances with the recession and economic crisis favoring a change candidate. That uniqueness can be seen in the huge drop in young and black voters last week as well as the switch in independent voter allegiance from Democrat to Republican. I guarantee you we would have seen similar results in favor of George W. Bush had the recession of 2001 and 9/11 occurred one year earlier. None of these factors favored Democrats in 2009.

Krauthamer goes on to make some partisan claims about left-leaning agendas, hubris and taxation that I found unconvincing (Clive Cook also does this). I wished he had stopped here because he makes a valid point: the 2008 election was not some magical moment in American history in which we saw a sea change in political alignment at one moment in time. That’s confabulation, pure and simple.

What happened is Americans voted for those people who they felt would change course because they felt the country was headed in the wrong direction. That’s certainly what exit polling told us in November 2008.  Making up some other explanation is not necessary.

I know change when I see it and this is not it

So, what Charles Krauthamer and Clive Cook are doing along with Frank Rich and Paul Krugman is filling the explanation void. I agree with the analysis, but some of the conclusions are more dubious. I have done my share of filling that void (I see Frank Rich’s narrative as the one closest to mine).

But, for a moment, let’s leave the explanations aside. The great thing is humans are capable of complex decision-making and thought without having to explain those decisions. We know how to distinguish a frog from a prince and a pig from a princess – no explanation required.

And so it is here again. If you asked 1000 people in those exit polls from November 2008 – or even last week, “what would make you know America was headed in the right direction,” you probably would have gotten 700 different answers.

But, one thing is clear: Since January 20th, a lot of people are saying to themselves, “I know change when I see it and this is not it.” That’s what all polls are saying. So, whatever Obama and the Democratically-controlled Congress are doing, it’s not working.

Enter the Demagogue

That’s where demagoguery comes into play. Demagogues love an explanation vacuum.  Since time immemorial, where there has been public disenchantment with the status quo, there has always been some demagogue waiting in the wings with a ready-set explanation of what’s wrong and how they were going to fix it. These are people who are considered fringe elements in good times, but when economic hardship comes their ready-made explanations and confabulation become a toxic mix which propels them to prominence. (For the record, I am not connecting the gentlemen mentioned above with demagoguery. I am making a separate point here).

I would argue, that’s where we are right now. The global economy has just experienced an incredible shock. In the United States, more than one in six is unemployed or underemployed. Personal bankruptcies and foreclosures are still happening in record numbers. The economic situation is, in a word, grim.

Therefore, people are going to more open to a wider range of ideas and this is a prime opportunity for demagogues to advantage themselves and their allies. It also should make any incumbent politician very afraid of losing their job.

With this in mind, I look back to the early days of Barack Obama’s tenure and I can’t help but conclude that his economic strategy was too timid, too much aligned with the status quo. It’s not as if this should be a shocker; I pointed this out in January and again in February. His economic team erred in believing, as the Bush Administration had done, that the economic and financial situation was better than it was.  Remember, Obama’s stimulus plan was based on a forecast of 8.0% unemployment.

Future policy decisions

But that ship has sailed and here we are a year after Obama’s election in a technical but unsatisfactory statistical recovery. What should Obama do going forward?

Well, first of all, what he needs to do is give voters a sense that the recovery is for real. And that means unemployment, foreclosures, and stagnant personal income must be attacked. On some level, the health care debate is a net negative in that it consumes a lot of political capital without any obvious and immediate economic benefit. The bailouts and financial reform agenda also have been net negatives as well for similar reasons but also because they have not been seen as fundamental change and they further disenchantment.

Moreover, we know that the explanation vacuum is being filled by voices decrying big government and socialism. If you listen to people like Charles Krauthamer, you are likely to see Obama as a dangerous shift in America to the left. He makes a compelling argument which will sway those who are constitutionally predisposed to hating big government or deficit spending. So this means Obama is now constrained. In my view, fiscal stimulus is a political non-starter.

So, I see jobs as the first area for Obama to attack. The question is whether he does this directly via some modified private-sector controlled W.P.A.-type program or indirectly via something like a payroll tax cut. After jobs comes foreclosure. Personal income and taxes are the least important area going forward (especially as any tax cuts will either increase deficit spending or have to be made up by tax increases elsewhere).

If the economy turns up vigorously and permanently, we can put some of these thoughts to rest. You have to believe many fewer people would be yelling socialism or corporate communism if we were in a robust upturn. However, I don’t think that is a likely economic scenario. Even so, the unique circumstances of 2008 are unlikely to be repeated. That spells trouble for the Democrats in 2010 and 2012 unless they start doing something dramatically different.

Other sources

People Sometimes Seek The Truth, But Most Prefer Like-minded Views – Science Daily

Humans prefer cockiness to expertise – NewScientist (think demagogue here)

Related posts:

• Through a glass darkly: the economy and confirmation bias in the econoblogosphere
• Loss aversion and finding a bottom
• What motivates Hillary? Part 2
• Peer pressure and bubbles
• US Senate passes Economic Patriot Act 74-25

If you have been wondering whether a statistical recovery is at hand, today’s ISM manufacturing report should be the clincher.  The report was definitely bullish with the ISM index rising to 55.7 and sub-components supporting the understanding that the manufacturing sector is expanding. This is quite a contrast to last month’s weak data and demonstrates that last month was a one-month aberration in what should now be seen as a full-blown technical recovery.

I want to talk about this recovery briefly in the context of the signs that came before it, my own forecasting psychology and what the future holds.

The ISM data

The key data points to see as evidence of a fairly broad-based expansion in manufacturing come from new orders, production and inventories.  The production number came in at an incredibly bullish 63.3, marking the fifth consecutive month of increase. New orders slipped slightly, but were also in striking distance of the 60 range. (50 represents the demarcation between expansion and contraction).

But, from my perspective, it is inventories which are the most bullish data points. The inventories data show that inventories in the manufacturing sector were still being purged in October even while production is increasing.  That means that inventories are likely to make a huge contribution to GDP going forward in Q1 and Q2 of 2010. GDP could again surprise to the upside.

My mea culpa on forecast herding

All of this suggests the economy has been growing since the beginning of Summer. In the early Spring, I indicated that jobless claims were peaking (which added to my stock market bullishness at the time). This call turns out to have been accurate. However, at the time, this post produced very negative sentiments, albeit more from readers on Naked Capitalism than Credit Writedowns – in my opinion because most people erroneously extrapolate a current trend into the future (see my reaction to this from a post weeks later, “Through a glass darkly: the economy and confirmation bias in the econoblogosphere”)

Nevertheless, a piece from NBER guru Robert Gordon that I reported demonstrated to me that I was not alone in seeing the trend reversal in jobless claims. Eventually, in May I indicated that the jobless claims data were pointing to an imminent recovery and remarked that the data had usually been fairly accurate in the past.

And for the record, I have said I see a recovery happening probably in Q4 2009 or Q1 2010 (see my post “The Fake Recovery”).

The real question is how robust a recovery are we going to have and this is directly related to why the jobless claims series has been sending a false signal.  Now, initial claims has been sending a recovery signal since January. Yet, continuing claims continued to rise more quickly until last week.  In the past, one had seen these two series as harbingers of imminent recovery.  But, I am talking Q4 here.  Why? Deleveraging.

In the end, consumers are going to be forced to reduce debt and save more in this more cautious financial environment.  Team Obama does seem intent on re-kindling animal spirits but the personal savings rate has gone up nonetheless.  This will be a drag on GDP growth going forward and means that the economy’s rebound will be more tenuous and slower to develop.  In my view, this means recovery will be delayed and once it gets going it will be weak.  The potential for a double dip is very high.

So, to be clear, first derivatives are starting to turn up and since recession is a first derivative event, we are probably going to see an end to this recession soon enough.  But, with structural problems still remaining, the U.S. economy will be weak for a long time to come.

Why do I bring this up?  Because, despite the data pointing to recovery, I decided the start of the recovery process would be delayed until this quarter or Q1 2010 by consumers repairing their balance sheets – and, in retrospect, in part due to a desire to avoid being too far out of step with the consensus.

I must admit to falling prey to forecast herding, something I talked about in June (admittedly without mentioning my own culpability which I should have done). At the time, I said:

No one wants to go out on a limb with a bold call only to see this prediction proved wrong.  If one fails, it is better to fail conventionally.  The necessary corollary of that statement is this: market forecasters and analysts play it safe by making sure their forecasts are not often far from the consensus forecast.  Think of the consensus forecast as an anchor which restricts the outlook of any individual forecaster afraid of failing unconventionally.

In Roubini’s case – and this logic also applies to media darlings like Meredith Whitney – it does NOT pay to up the ante.  What Faber is saying is that they have already benefitted from the bold and unconventional contrarian market call they initially made.  There is little payoff and much risk from continuing on that path.  A bearish analyst who misses the turn gets the stick.  Just ask the original Dr. Doom, Henry Kaufman.

Roubini is not running with the herd

The one thing that makes me think about my error in tweaking my bullishness has to do with Nouriel Roubini. In the quote above, I said he has little incentive to double down on a bearish forecast at this point in time.  Both he and Meredith Whitney, two voices of caution leading into crisis, have been much more upbeat of late. Are they hedging as I did?  Hard to say.

But, with Nouriel Roubini’s recent FT Op-Ed, this is over. Roubini decried the easy money policy he believes is leading to a dollar carry trade and an increase of risk appetite across a wide variety of asset classes. He believes this experiment will not end well. I share his view.

Roubini, in going public in this way, is officially departing from a more hedged nuanced position he has been using over the last few months as the recovery has taken hold. Yves Smith says:

Nouriel Roubini has officially left the “hedging your bets on the economy” camp.

I applaud him for coming out with this piece and suggest you read it because it may come to be seen as the make or break call in determining his reputation as economic soothsayer.

Recovery is happening, but watch asset prices

For my part, I will look to avoid a repeat of the ‘jobless claims incident.’ Hopefully, I have done by writing my depression post at the beginning of last month, which outlines my view that we are in a cyclical recovery in the middle of a longer-term depression.

I would like to make some amendments to my thinking at the time though. First and foremost, I have come to doubt whether we are seeing a balance sheet recession right now. One reason I am writing this post is because the ISM manufacturing data turned up in May at precisely the same time that the credit revulsion-induced savings rate turned down. Translation: there is no balance sheet recession in the U.S., at least not yet. (see my post “Americans are not increasing savings”). This means the recovery could surprise to the upside. Moreover, the ISM data point to potential upside surprises from inventories, leading to an even more robust outlook.

What I believe is happening has much to do with Nouriel Roubini’s comments. U.S. economic policy is geared toward reproducing the status quo ante via reflation of asset prices (something Bill Gross thinks is the right policy and even Dilbert has made fun of). The policy has been wildly successful so far, with asset prices bubbling over globally. I have called this the fake recovery, but as recently as September I was on the fence about how much uptick we were to get. I never dreamed the recovery process could be so robust given the headwinds we faced.

However, reflation has also given investors a license to take risk. Look at the return of John Meriwether as a telltale sign.  Reflation policies are inflating assets far and wide: European high yield, American high yield, Swedish house prices, London house prices, Chinese property prices, and inducing reckless lending. The list is endless. Even Bill Gross’ piece pointed to inflated prices, a view shared by Jeremy Grantham.

The long and short is we are seeing another asset bubble inflating courtesy of easy money. While Morgan Stanley worries easy money will lead to inflation, former Morgan Stanley economist Andy Xie fears this will end in a double dip. To make matters worse, there is a dollar carry trade now spreading a liquidity seeking return dynamic abroad. This is the additional risk of which Roubini writes, believing it could precipitate another crunch or crash. Ironically, a strong recovery is not necessarily bullish.

Is a double dip or crash a baseline scenario? No, not necessarily – but it is increasingly likely. So, as bullish as I believe the data are, I am more worried about a bad outcome, not less.

Related posts:

• ISM shows manufacturing sector close to recovery
• Both initial claims and continuing claims now pointing to recovery
• Jobless claims may signal the end is near
• ISM: September manufacturing data disappoint; market sells off
• Morgan Stanley: Recession will ‘end by mid-to-late summer’

This is a guest post from our newest contributor, Charles D. Bull.

Greetings Writedowners,

Ed has gone to bed already. This is Charles D. Bull speaking.

You know, my wife told me yesterday that the local shopping area already has the Christmas tree up and is all geared up to drum up holiday season sales.  Shoppers were out, the sun was shining and the place was really looking pretty, she said. It warmed my heart. I was so excited for the holidays. I couldn’t wait.

Then, I wake up this morning and along comes this guy, what’s his name, David Rosenberg — with his tales of doom and gloom like the Grinch who stole Christmas. Forget about Nouriel Roubini, this guy makes him look like Mary Poppins.

Check this out:

BULL RUN MAY BE REVERSING
The S&P 500 is riding a four-day losing streak. And while we have seen these corrections turn around before during this massive bear market rally that started last March, the difference this time is that the uptrend line from the lows has been violated across a fairly broad front, including the S&P 500, Nasdaq and the Russell 2000. When trend lines get violated, and when this happens on high volume, it usually, though not always, signals something big.
So many people are deluding themselves that we have some sort of durable recovery on our hands and yet consumer confidence, at 47.7 in October, is unbelievable — the lowest this every got in the 2001 recession, which included the 9-11 terrorist attacks, was 84.9. Think about that for a second. If the equity market is catching on to the view that we could be in for some slowing in the data, then a significant correction after a 60% surge is very likely. This is a time to be raising cash if you haven’t done so already — valuation, technicals, fund flows and fundamentals at this juncture are all near-term obstacles.

In terms of valuation, we said yesterday that the P/E ratio on the S&P 500 on a normalized 10-year basis is 20x and the long-turn norm is 16x. Just to go back to the norm, let alone compress to a level commensurate with an unusually high level of economic and financial uncertainty, would suggest that we would see the S&P correct down towards 875.

ONLY ECONOMISTS SEE THE RECESSION AS BEING OVER
The man on the street sees it a little differently, perhaps less enthused by the fact that a lower rate of inventory destocking is arithmetically underpinning GDP growth at this time. Put simply, a Wall Street Journal/NBC News poll just found that 58% of the public believe the economic recession still has a ways to go — and that is up from 52% in September and means that the private investor, unlike the hedge fund manager, is not interested in adding risk to the portfolio even after a 60% surge in the equity market.

Only 29% of those polled believe the economy has hit bottom — imagine having that psychology with nearly zero interest rates, a bloated Fed balance sheet and unprecedented fiscal deficits (poll was taken from October 23-25). Nearly two in three (64%) said the rally in the stock market (still a bear market rally — not the onset of a new bull market) has not swayed their view (or ours for that matter). There is going to be some very tough slogging ahead as far as the economy is concerned.

OK. Enough already. I think Dave needs to take a few happy pills.  Dave, did you see that rally today? Dow up 200. S&P up 23. Now, that’s what a bull market rally looks like, my friends: stocks way up, bonds way down, lower dollar, lower gold prices.  That’s what I’m talking about!

As for you shorts out there, you’re probably grabbing your ankles, crying “thank you, sir. May I have another?” Serves you right. In the ‘real’ America, we’re doing just fine, thank you.

Stop listening to those clowns Ed Harrison and Marshall Auerback, writing here about depressions and pulling the rug from under our trusted banks. Earth to Ed: we are going into a V-shaped r-e-c-o-v-e-r-y, not depression. Our banks need to be bigger, not smaller. And, um, Eddie, take off the blinders. I don’t know if you noticed it, but we just printed 3.5% on GDP. So, me, I AM popping the cork on the Moet. In fact, I’m sipping it right now.

I don’t know what Ed and Marshall are smoking, but don’t pass it around.

See, I’m an optimist. I knew we would pull out of this one. My motto? Remember, there’s always a bull market somewhere. You just need to know where to look.

You’ve probably been sitting there wondering, "What is The Secret?" I’ll tell you, it’s called positive thinking.

Anyway, I’m sure you pessimists are going to try to bring me down in the comments: aitrader, Lavrenti, kbob, Vangel, you know I’m talking to you – you too Wadsworth. I can take it. As my boy Nails would say, “I love it, baby… Pile it on, bro.”

Charlie has left the building.

Charles D. Bull is a pseudonym. He has been loosed on this site to post purely for your amusement… and ridicule.

Related posts:

• Rosenberg: Market rally is just multiple expansion
• Overbought?
• An amazing market rally. What’s next?
• Rosenberg thinks U.S. market may Test March lows
• Back to the future: Rosenberg says it’s like the crisis never happened

Every time I hear the word ‘bureaucrat’ used to make a point for or against government’s role in the economy, I cringe. I see this label as unfair and dehumanizing.

I grew up in Washington , D.C. where my parents and their friends rose through the ranks of government, often to the very managerial positions which are being used to characterize government employees as bureaucrats. So I have a lot of insight into what goes on in and around Washington that affects the decisions made by these so-called bureaucrats.

I bring this up because of my recent post “Why you won’t hear me using the word bankster” in which I talked about a similar rhetorical tool used to label bankers. I see these labels as cheap, underhanded tactics meant to elicit an emotional response rather than a logical one and bias the reader against one’s preferred whipping boy. It is akin to invoking Adolf Hitler as an analogy in any debate – something sure to elicit a reptilian response instead of a well-reasoned one.

The question I was actually looking to have answered with the bankster post was more of a philosophical one: should we assign collective guilt when we see ‘moral’ or system-wide failures of the sort we have just witnessed in the financial services industry? It is the sort of question that I am asking myself due to the five recent posts here related to greed and morality in our capitalist system.

• Greed is not good
• More on greed, regulation, Lehman and the financial industry
• Guest post: Why do bankers make so much money?
• Keep your hands off Goldman’s bonuses
• Guest Post: Did Gordon Gekko inspire Wall Street or the other way around?

Here are the questions I have been asking myself: Is “individual greed but collective progress” the underpinnings of laissez-faire ideology? Is greed ever good? Are bankers greedy? If so, should government cap their pay or is that a violation of their liberty? Is market failure a sign of collective guilt?

I think these are fundamental philosophical, political, even moral questions that cannot be divorced from the conversation about economics and markets. They go to the core of our value system and, hence, to the fundamental nature of how we want our system of capitalism to function. It seems to me it is a major cop-out to say in effect “these issues are irrelevant because individual decisions of morality are swamped by the collective whole. Large systems are inherently amoral and thus we individually can be as well.” That’s what extreme forms of laissez-faire capitalism suggest.

As far as collective guilt goes, Wikipedia has a workable definition:

Collective guilt, like guilt, is the unpleasant emotional reaction that results among a group of individuals when it is perceived that the group illegitimately harmed members of another group. It is often the result of “sharing a social identity with others whose actions represent a threat to the positivity of that identity”.[5] Different intergroup inequalities can result in collective guilt, such as receiving unearned benefits and privileges or inflicting more extreme forms of harm on an outgroup (including genocide). Individuals are generally motivated to avoid collective guilt in order to maintain a positive social identity. There are many ways of decreasing collective guilt, such as denying harm or justifying actions. Collective guilt can also lead to positive outcomes, such as promoting intergroup reconciliation and reducing negative attitudes towards the outgroup.

The WaMu example I cited is a good one to think about:

The White House is pushing for a new consumer regulatory agency to end these sorts of abuses, but the banking lobby and even federal banking regulators are opposed. Banks say more regulation would kill innovation.

"I hated that loan," said Mary Kay Morse, a 20-year veteran at WaMu whose job was to persuade independent brokers to make option ARM loans. "It’s just not a good loan. It wasn’t good for the borrower."

That loan affected her opinion of WaMu.

"I always felt like I worked for a really honest industry that cared for the borrowers they dealt with," she said. The corporate culture changed to: "We just want to do the most we can to make money for the bank."

What blame could/should an individual like this bear for alleged predatory lending at Washington Mutual (I hate to pick on the employee in this example as her instincts seem to be in the right place)? If we individually make the wrong moral decisions, do we collectively risk a market failure like the one we saw in the recent spate of predatory lending?  I think the answer is yes. But I also think it is difficult for one individual to make a difference in a system where the incentives go against doing the right thing. This is a major argument in favor of regulation.

I would love to hear your comments on these issues as I have made mine.

As for the terms ‘bankster’ and ‘bureaucrat,’ I am looking to bring a bit more civility and logic to the debate about government, regulation, the banking industry and their roles in our capitalist system. Cheap shots and emotional pandering have no role in a mature discourse about these important topics.

Related posts:

• Why you won’t hear me using the word bankster
• WaMu: Mr. Smith goes to Washington and turns predatory
• Quote of the day: Gordon Gekko – greed is good
• Intent and motive
• Deregulation as crony capitalism

This contribution from Daniel Berger is a letter to Michael Smerconish in response to a commentary Smerconish wrote on 10 May 2009 in the Philadelphia Inquirer “Head Strong: Did Hollywood inspire the meltdown men?” A shorter version of Berger’s piece appeared at New Deal 2.0 in July.

Given my recent two posts on greed (“More on greed, regulation, Lehman and the financial industry” and “Greed is not good”), Berger’s remarks bear posting.  What I find most interesting about this commentary is the tie between the belief in market forces and greed – which on an individual level is defined as selfish and excessive. The question is whether greed, which has historically been viewed as a negative on a personal level and condemned by most major religions in the past, can actually be beneficial on a society-wide level.  Berger says no and I agree. Markets are not self-correcting. As a result, regulatory oversight is necessary to prevent harm from excessive risk taking.

Michael:

I read the May 10 column in the Inquirer and, while I disagree with the ultimate conclusion which you imply, you, nonetheless, deserve credit for raising a provocative subject: whether people on Wall Street were influenced by Oliver Stone’s film “Wall Street” in engaging in beyond risky, reckless behavior which has brought down almost the entire edifice of modern American finance and has threatened an economic calamity akin to that of the 1930s.

In my view, your column actually raises two interesting issues: First, do the arts and popular culture (including film) influence society, or is it the other way around; and, second, what do attitudes expressed in Stone’s film say about professionals working in financial markets, the America financial elites and the financial system as a whole? In quoting the memorable words in the film of Stone’s character Gordon Gekko that, “greed is good,” you really are raising a larger question of whether unethical behavior was primarily responsible for the current crisis. Indeed, lack of ethics – - which undoubtedly was rampant on Wall Street in the period leading up to the crisis – - is a popular explanation for what happened. So it is interesting to explore the role of ethics, as well as Stone’s film, in the current crisis. Recently, Howard Jackson, your editor, wrote that the purpose of the Inquirer’s Commentary section is to stimulate debate and an exchange of ideas on important subjects of public interest. It is in that vein that I write to you.

Starting with the influences of film, I think that, upon reflection, you have gotten the role of art (and film) exactly backwards: Life rarely imitates art; but rather just the reverse. The general proposition is that art (including film) holds up a mirror to life and society – - which is a good thing. In holding up a mirror to life (to culture, society, the political system, the family, human nature and so on), art has the capacity to discover and communicate significant truths about these subjects, even ones which are inconvenient and from which conventional wisdom shrinks.

So what is the message – -the inconvenient truth – - of Stone’s film and how does it relate to the current crisis?

In considering the meaning of Stone’s film, it is important to consider certain aspects of the film with which you might not be familiar and some of which Stone was apparently not aware, either. The back story to Stone’s movie was not the leveraged buy-out craze of the 1980s – - as you allude – - but rather the insider trading scandals of that period. Moreover, the model for Stone’s protagonist, Gordon Gekko, was not a reputable figure (like those mentioned as being responsible for the current financial crisis), but was more of a Bernie Madoff type, Ivan Boesky. Boesky was simply a low-life stock trader who was thought to be uncannily adept at stock picking, but who was, in reality, paying people off for inside information and who got caught by the authorities.

Rudy Giuliani did not either uncover or prosecute Ivan Boesky, but rather it was the SEC who discovered the illegal activities of another rogue trader, Dennis Levine, who turned Boesky in to the SEC. Boesky, in turn, informed the SEC about his passing involvement with Michael Milken, a true financial visionary of the 1980s who both was a major figure in the leveraged buy­out field and who single-handedly created an entirely new field of finance, the market for “non-investment grade” securities (”junk bonds”). It was Milken who Giuliani prosecuted and whose prosecution made Giuliani’s career.

Had Stone’s film dealt with the complex motivation and actions of Michael Milken which were at once heroic and dishonorable, the film could have courted artistic greatness. However, Stone failed to take advantage of a golden opportunity to achieve possible film immortality and focused on Boesky which limited the scope and power of the film.

Additionally, Gekko’s striking (even iconic) remarks about greed and finance were not original to Stone. In fact, Stone (or his researchers) must have learned of them from a speech that Boesky gave at Brandeis or Yeshiva University. (Because of his unexpected success in the market, Boesky – who, in his own irony, had become an observant Jew – - was also a philanthropist of Jewish institutions.)

And, in yet an additional irony, the phrase “greed is good” was not original to Boesky, either. Boesky’s speech-making, like his trading, was also phony – - plagiarized from others. Interestingly enough, Boesky’s source for his provocative statement about greed and finance originated from none other than the much reputed economist and pundit, the late Milton Freidman ( a fact of which Oliver Stone was apparently unaware).

It is in the context of Milton Friedman’s words – not Ivan Boesky’s – - that Gekko’s stark view of actions on the Wall Street takes on the potential for real insight, even wisdom – - but not for reasons which ever occurred to Stone or to which you alluded to in your column.

Because of the importance in conventional thinking in attributing the excesses of Wall Street responsible for the current crisis to unethical behavior, it is worth pondering both the origins and meaning of Freidman’s views involving greed and finance. Milton Freidman was a leading economist and public intellectual in the United States in the early to middle post – World War II period. Freidman was the principal exponent of the so-called Chicago School of Economics and what has become known as the signature idea of the Chicago School pertaining to finance and the financial markets, the “efficient market hypothesis.”

Freidman was also the leading advocate in the U.S. of the free market system and market capitalism, believing in an extreme form known as laissez-faire capitalism (which has also become known as free market fundamentalism) and which postulated that markets were both self-regulating and self-correcting and that government intervention in the market system (including government regulation) would cause economic inefficiencies and harm the economy. In so far as financial markets were concerned, laissez-faire capitalism took the form of the efficient market hypothesis which postulated that the most efficient allocation and use of capital came about by the unfettered operation of financial markets and that open, unregulated markets perfectly established the economic value of financial assets.

According to Freidman, the market and its vaunted efficiencies came about as a result of competition among market participants, so-called “market forces” and sometimes referred to as the “invisible hand” of the market. Because of the presence of competition, the self-interest of market participants cancelled itself out and was an engine of economic progress.

Freidman argued that not only was economic self-interest not to be feared, but was a force for social good, because the effect of competition was to drive the system toward efficiency. Thus, Freidman argued the more unrestrained self-interest the better – - indeed, the greater the degree of naked self-interest exhibited in the market place, the greater the level and intensity of competition.

Naked self-interest is just another term for greed, as Freidman recognized, leading him to conclude that, “greed is good.” According to Freidman, the one and only worthy economic objective of corporations or individuals trading, not just in financial markets but in the economy as a whole was “to make as much money as possible,” to “maximize profits,” i.e. be as greedy as possible. In this way, the economic system would supposedly realize economic efficiency and maximize the economic welfare of society as a whole.

Freidman’s views on capitalism and greed epitomize the current state of an extremely prominent economic philosophy in the U.S.: the laissez-faire, unregulated free market school of political economy. From an economic policy perspective, free market fundamentalist views amount to endorsing a form of economic organization (market capitalism, so called “free enterprise”) based on acknowledged immoral motives and promoting or acquiescing in immoral activities in economic decisions and policy making. Supposedly, for policy reasons, society as a whole is better off with the free enterprise system than it otherwise would be, because – - not in spite – - of its reliance on the unrestrained exercise of self-interest (i.e. greed) in the market place. The reasoning is that the greatest good for the greatest number will result from the adoption of naked self-interest as the basic driver of the economic system.

Alas, while there is substantial social scientific evidence supporting the general functioning of markets in accordance with a rough approximation of the tenants of neoclassical economic theory, there is no empirical validity to the broad, sweeping assumptions of free market fundamentalism and laissez-faire capitalism. The competitive free enterprise system (as a system) is neither self-correcting of market mistakes or changed circumstances, nor self-regulating against abuses and excesses. In fact, the apparent near instant replay of 1929 et. seq. with which we are currently contending demonstrates just the opposite.

Nor is the efficient market hypothesis empirically true. Similarly, self-interest, or even competitive forces which it may generate, are not always engines of social good. Indeed, greed (or unrestrained self-interest) is usually just that – - and in need of restraint in economic decision-­making, as in life generally.

To begin with, it is now abundantly clear that the efficient market hypothesis about financial markets is invalidated on a daily basis. Ask yourself who is the most respected stock trader in America? By a wide margin, the answer would be Warren Buffet. Buffet is the principal advocate in the U.S. of the “value” investing approach to stock market investing. In value investing, investors look for companies whose stock prices are undervalued by the stock market and which will rise in absolute terms and relative to their industry sector and the market as a whole. Under and overvaluation of stocks by the market is routine and represents the antithesis of an “efficient” market which postulates that the price of a stock at any given time always reflects it true economic value. If the efficient market hypothesis applied, stocks would never be under or overvalued relative to the market.

In the 1980s, Michael Milken demonstrated that the exact same situation existed for corporate bonds. By establishing that the default rate on non-investment grade securities was relatively low, Milken showed that non-investment grade securities were grossly undervalued by the credit markets. By contrast, the recent sub-prime mortgage crisis has shown that mortgage-backed securities were grossly overvalued by financial markets.

Even more troublesome than routine mispricing of financial assets by the “unfettered” operations of market forces in financial markets, the assumption that the financial markets, or even the economy as a whole, represent a self-regulating, self-correcting system is also demonstrably false. In fact, financial markets – - indeed, the entire money economy – - are inherently unstable and experience cycles based upon the expansion and contraction of credit.

This phenomenon is dramatically illustrated by the current crisis which originated in unsound, speculative mortgage lending practices and which resulted in gigantic “asset bubbles” in real estate and finance, a crash and a paralysis of liquidity and a vast credit crisis leading to what you have described as a “financial melt-down.” A “melt-down,” “sell-off,” “freeze,” “panic,” “collapse” – - whatever it is called – - is the antithesis of a market “correction.”

In fact, but for the drastic and unprecedented actions by the Fed and the U.S. Treasury which have flooded the financial system with liquidity, made massive amounts of capital available to financial institutions, and even gone so far as to guarantee certain private financial obligations, the value of financial assets in the U.S. would have totally collapsed and the operations of financial markets would have shut down completely generating a 1930s – style Depression. Thus, the current behavior of the financial system is not – - and has not ever been – -self-correcting.

The financial crisis, in turn, has caused a collapse of the real economy, in a pattern eerily reminiscent of the Great Depression of the 1930s. An economy-wide contraction of economic activity has left the economy operating far below full capacity (including resulting in a massive increase in unemployment) where it would remain indefinitely, but for massive intervention by the national government to bolster and/or restart economic activity. Again, the current behavior of the economy is self-evidently not self-correcting.

In response to the economic crisis of the 1930s, an entirely new field of economics was developed to explain what happened called macroeconomics or Keynesian economics. Then, largely like now, the prevailing economic orthodoxy was represented by free market fundamentalism. Then, like now, the collapse of the financial markets leading to a genuine implosion of the real economy was viewed as highly improbable – - before the fact. It was also said, at the time, that the financial markets and the economy would self-correct and return to normal – - at least “in the long run.”

Keynes stunned the world of business and government with his brilliant explanation of the Depression as resulting from a collapse of aggregate demand caused by a financial market collapse stemming from a sharp, unexpected contraction of credit in response to unsound real estate lending by the banking system and financial speculation in real estate and stocks in the 1920s. Moreover and more importantly, Keynes showed that a pure free market system could stabilize indefinitely below full employment of its productive resources and, without outside assistance, would be unable to revive itself. Indeed, in response to the assertion of the then economic orthodoxy of a natural return to long-run full employment, Keynes responded, “Yes, but in the long-run, we’ll all be dead.”

Finally, it is equally obvious that unrestrained self-interest, i.e. greed, either by itself or in combination with competitive forces it may generate, is insufficient even to maintain stability in financial markets, let alone drive the financial markets to the efficient creation and use of capital. This has now been authoritatively acknowledged by none other than Milton Freidman’s intellectual successor and most recent high priest of free enterprise and laissez-faire capitalism, Alan Greenspan. In recent Congressional testimony and in response to the question of what went wrong in financial markets, Greenspan admitted to a “flaw” in his and Friedman’s “greed is good” logic: Namely, Greenspan had believed that self-interest would have prevented market participants – - both individuals and their firms – - from engaging in the risky, reckless financial speculation which imposed large losses on them and caused the current crisis. Self-interest and competition, far from disciplining the market, resulted in windfalls, either windfall profits or unanticipated, catastrophic losses.

However, neo-con free-marketers fear not. All is not lost for the private property-market -and-self-interest driven economic system. Markets have been proven to work across a wide range of economic conditions, to be relatively efficient and to have produced, at least cyclically, high levels of income and employment. However, as the above analysis demonstrates, they have drastic deficiencies and flaws which render them neither self-regulating nor self-correcting. Markets, particularly financial markets, need to be systematically regulated by the government to prevent excesses and abuses by market participants and to maintain stability.

Once again, we have learned that history will repeat itself, if society is uninformed or deluded enough to make the same mistakes of the past. We have also learned (once again) the heavy costs of free market fundamentalism and laissez-faire capitalism. It is, as they say, an expensive history lesson – - which was totally avoidable, and should have been avoided.

To summarize my main points:

First, art generally does not influence society, but it is the other way around.

Second, it was not greed that brought down the financial system, but deficiencies and failures in the system, as Greenspan put it, “flaws” in the theory of free market fundamentalism and laissez-faire capitalism. The collapse of the market is NOT primarily a matter of values, but of system dynamics. If it were the former, we would have to get rid of the free enterprise system which is based on unrestrained self-interest as an engine of prosperity, and as, inter alia, an immoral system. However, from a public policy perspective, it is not self-interest that is wrong, since self-interest and the market forces which self-interest generates work at least partially to self- regulate abuses and excesses of the system. Rather it is free market fundamentalism and the belief that markets are always self-regulating and self-correcting which is wrong.

Third, there undoubtedly was unethical (and illegal) behavior on a massive scale in the period leading up to the financial crisis and which was a contributing factor to its scope and magnitude. This type of behavior – - both in terms of negligence and intentional wrongdoing – -can and should be discouraged. But it was flaws in the market system, not the ethics of market participants, which was the principal problem. To quote the comedian Chris Rock in another context: “Don’t hate the player, hate the game.”

Fourth, the answer to the problem is to fix the system. Once again, experience shows that there is no such thing as a self-regulating and self-correcting economic system. As a result of the collapse of the financial system 70 years ago which resulted in the Great Depression, a mixed system of private markets and public oversight was instituted. Nor was the approach limited to the financial sector, but was extended to markets for labor (labor organizing, wage and hour, child labor, occupational health and safety, and anti-discrimination regulations) and goods and services (antitrust, environment protection, and consumer protection regulations and so on).

The “mixed” economy of private markets and government oversight/regulation was the correct response to the financial/economic crisis of the 1930s. And a return to the mixed economy is the correct response now. Indeed, if you consider the fundamental challenges to the country now, such as energy, environment and health care, they are problems which the private market does not deal with well and as to which market forces will not produce least cost, let alone optimal, outcomes.

Fifth, and finally, although it will be difficult for conservatives – - even moderate conservatives – - to accept, the overwhelming weight of historical evidence shows that the vaunted market system has flaws; that there is such a thing as the “public interest” which consist of the interest of society as a whole and which is greater than the sum all of the private interests in society; and that there is an important role for government – - particularly at the national level – - in protecting the public interest.

Anyone who tells you differently is either a deluded ideologue or ignorant of history – -or both.

Daniel Berger is an attorney in the field of complex litigation, including securities and anti-trust litigation, and has a broad-based knowledge concerning the structure and functioning of the US economy and US financial markets.  He practices in Philadelphia.

Related posts:

• Quote of the day: Gordon Gekko – greed is good
• Guest post: Why do bankers make so much money?
• Guest post: Regulation in Defense of Capitalism
• Greed is not good
• Public anger at Wall Street begins to boil over

That was the title of an e-mail I received from my bank today. Here is what the e-mail looked like:

This is what happens when markets go up. I don’t recall getting anything like this when the market was tanking. Obviously, there are a lot of people depending on you to invest in order to put food on the table.

I wonder if this is a contrarian indicator though.

Related posts:

• The wisdom of crowds, the precision of models and going contrarian
• Marc Faber makes bullish comments on Bloomberg
• Regional banks: Zions falls
• Selling the good news does not a bull market make
• An amazing market rally. What’s next?

Back in February, I asked you if we were experiencing a recession or depression.  A plurality said it was a depression with a small ’d.’ I agreed and went on to explain why. Since then, things have changed and we seem to be on the verge of what I call a technical recovery (or a fake recovery – take your pick).  We may even be on the verge of a multi-year economic expansion – something bears like David Rosenberg should not rule out. But vigilance is still required. I will explain why.

Since the recovery talk has gathered steam, a lot of well-respected economists and policy makers have begun to construct what I consider a revisionist history of events. It goes something like this:

We have just experienced a major economic downturn. Coupled with a financial panic of major proportions, the global economy suffered a severe shock.  However, we have learnt how to deal with such crises due to our experiences during the Great Depression. The liquidity crisis was overcome through deft monetary policy. And fiscal expansionary policy aided a return to business as usual much sooner than many would have believed.

As a result, it is quite obvious we have been through a severe contraction, but nothing more than a garden-variety recession complicated – of course – by a financial panic. Back in February, a lot of economists made alarmist predictions of woe, foretelling a global Depression. This was wrong-headed and reckless as we see today. GDP has likely turned up in this third quarter and will continue rising for the foreseeable future. With the worst of things behind us, we can normalize monetary and fiscal policy and return to a more robust economic path.

On the surface, this narrative is compelling.  But, I believe it is based on a flawed analysis.  I would like to present a different narrative here for you to dissect.

GDP is a poor measure of growth

As Joseph Stiglitz recently wrote, GDP is a very poor measure of growth and economic health.  And he is right. There are many questions of statistical accuracy in its measurement. But, more than quantity, I have problems with GDP as a measure because of quality. Robust 4% growth that is underpinned by savings and capital investment is not the same as robust 4% growth underpinned by debt and consumption.

The problem I have with the recent history of growth in the United States, the United Kingdom, Spain and Ireland in particular is that the growth was underpinned by high debt accumulation and low savings.  As debt is a mechanism through which we pull demand forward, the debt and consumption has meant we have been growing today at the expense of future growth.

Low quality growth can go on for a long time

This dynamic can continue for a very, very long time. In the United States, by virtue of America’s possession of the world’s reserve currency, an increase in aggregate debt levels has been successfully financed for well over twenty-five years. Mind you, there have been a number of landmines along the way. But, time and again, these pitfalls have been avoided through asymmetric monetary policy and counter-cyclical fiscal expansion.

So, poor quality growth can continue for very long indeed. And it is this fact which allows the narrative of easy money and overconsumption to gain sway.

The boy who cried wolf

A soothsayer who counsels against this type of economic policy, but who warns of impending collapse will surely be seen as the boy who cries wolf. Think back to 2001 or 2002. Did we not witness then the same spectacle whereby the bears and doomsdayers were let out of their holes to warn of impending doom from reckless economic policy? By 2004, unless these individuals changed their tune, they were long forgotten or even laughed at – only to resurface in 2007 and 2008 with their new tales of woe. Knowing this shapes the psychology of economic forecasting and is why missing the turn is disastrous for one’s career. Efforts to avoid missing the turn are also part of a very large pro-cyclical psychological force underpinning a cyclical bull market.

The fact is: low quality growth does not lead to immediate economic calamity. It can continue through many business cycles. Even today, it is wholly conceivable that we could experience a multi-year economic expansion on the back of renewed monetary and fiscal expansion.

Marc Faber: “Don’t underestimate the power of printing money”

You will recall that I wrote a post at the depths of the market implosion highlighting a phrase by Marc Faber, “Don’t underestimate the power of printing money.”  This quote has stuck with me as asset markets have soared in the intervening time.  What Faber was alluding to was the fact that printing money works.  It does goose the economy as intended and it can induce a cyclical recovery.

Nevertheless, the recovery is likely to be of poor quality due to significant malinvestment. Debt levels will rise and capital investment will be directed toward riskier enterprises. Look at what’s happening in China.  Are you telling me stimulus is not working? It most certainly is.

In the west, stimulus is also working. It is designed to stop people from hoarding cash and to consume. It is also designed to get people out of savings accounts and into riskier asset classes. it is doing just that. In response to a Spanish-language article on just this topic, I wrote in today’s links:

Europeans are abandoning savings accounts in favour of riskier assets as low interest rates have created a liquidity-seeking-return dynamic. This is true as much in the US as it is in Europe and it proves that a wall of liquidity can induce a cyclical recovery based on asset price inflation aka the fake recovery. The question is what comes next?

Liquidity is seeking return. It is pure speculation whether the upturn that underpins this dynamic has legs. I see an even chance that it does, which is why, despite my recent mild bearishness, I am a lot more upbeat about the economy and markets than a lot of others in the blogosphere.

So where does that leave us?

The outlook is unclear.  The Obama Administration looks ready to take a victory lap judging from recent statements. Officials say they are also withdrawing liquidity in anticipation of an upturn in the economy (though some believe these claims exaggerated). So, that is the one side – which Goldman’s Jim O’Neill takes.

On the other side of the argument is the fact that employment is still weak and incomes are down – the most since the Great Depression. After a decade with no income gains and still weak employment prospects, the ability of households to refuel a debt-induced upturn seems limited – as the recent data on consumer credit demonstrates. This is the side that David Rosenberg takes.

I take neither side. I am just not that clairvoyant. Both scenarios are plausible outcomes. But, I am still very worried about the low quality of any growth we will get in an upturn and the widening gulf of economic fortunes that result. I am equally worried about how even a low quality upturn will sap the will for reform in the financial arena. Mostly, I am worried that the eventual collapse – if it doesn’t happen now – will be much worse when it does happen.

Background

Please listen to the half-hour audio clip with Marc Faber from yesterday.  He does an excellent job of giving voice to some of the ideas I just laid out in his usual semi-apocalyptic style.  The clip comes via Bloomberg’s On the Economy podcast, a show I recommend highly. Click here for the show’s webpage and instructions on how to listen to broadcasts.

(mp3 Audio embedded below)

Related posts:

• When Giants Fall: No green shoots here
• Economic recovery and the perverse math of GDP reporting
• Andrew Smithers’ view on economic outlook
• Subprime housing bubble timeline
• The psychology of economic forecasting

In a BBC Two interview, former Fed chief Alan Greenspan waxed fatalistic, saying that another financial crisis is inevitable due to animal spirits.  In his view, booms and busts are endogenous to the capitalist system, crises being the outcome of long periods of prosperity. I agree with this assessment. But, it is surprising to hear coming from Greenspan as he sounds almost like Hyman Minsky, suggesting that economic stability leads to instability.

However, lest you thought he had given up his free-market ideology, he concludes warning that increased regulation would only make matters worse.

In order to prevent the situation arising again financiers and governments should look to clamp down on fraud and increase capital requirements for banks, the former central banker said.

Greenspan view on global economy

Regulations targeting the latter would mean banks would be forced to hold enough money to cover their normal operations and honour withdrawals.

However despite his belief in a brighter future, the former Fed chief did warn that the path to recovery should steer clear of protectionism as applying strict regulations could hamper recent developments that have opened up global trade.

"The most recent endeavour to re-regulate is a reaction to the crisis. The extraordinary impact of these global markets is making a lot of financial people feeling they have lost control.

"The problem is you cannot have free global trade with highly restrictive, regulated domestic markets."

On the whole, Greenspan’s analysis makes sense. However, his conclusions are flawed.  Greenspan, in his ideological fervour, has forgotten that his role as a central banker was antithetical to the concept of free markets.

Last night in the links, I ran a story from the Sydney Morning-Herald which is more to the point. There is no such thing as a free market.  There is more restrictive regulation, where we seem to be headed. And there is less restrictive regulation, which I prefer. But markets are never completely free. The zeal shown by Greenspan is deregulation as crony capitalism and makes the inevitable busts of which Sir Alan speaks that much more destabilising.

Source

Market crisis ‘will happen again’ – BBC News (nice video included)

Related posts:

• Greenspan: “If they’re too big to fail, they’re too big”
• Ms. Watkins, why does Charlie have lit dynamite?
• Ted Forstmann: the credit crisis will get worse
• Nouriel Roubini: Bloomberg Interview on Banking Crisis Plan
• Frontline – The Warning: Who Knew About the Looming Financial Crisis?

You have heard me use the phrase “liquidity is seeking return” to describe the increase in the price of riskier assets due to monetary stimulus. The Bloomberg News video clip below points to an increase in lending for buyers of riskier loans like high yield and mortgage bonds.

The blurb below from the associated article at Bloomberg’s website makes a more complete picture. Afterward, I have a few comments.

Banks are increasing lending to buyers of high-yield company loans and mortgage bonds at what may be the fastest pace since the credit-market debacle began in 2007.

Credit Suisse Group AG and Scotia Capital, a unit of Canada’s third-largest bank, said they’re offering credit to investors who want to purchase loans. SunTrust Banks Inc., which left the business last year, is “reaching out to clients” to provide financing, said Michael McCoy, a spokesman for the Atlanta-based bank. JPMorgan Chase & Co. and Citigroup Inc. are doing the same for loans and mortgage-backed securities, said people familiar with the situation.

“I am surprised by how quickly the market has become receptive to leverage again,” said Bob Franz, the co-head of syndicated loans in New York at Credit Suisse. The Swiss bank has seen increasing investor demand for financing to buy loans in the past two months, he said.

Federal Reserve data show the 18 primary dealers required to bid at Treasury auctions held $27.6 billion of securities as collateral for financings lasting more than one day as of Aug. 12, up 75 percent from May 6.

The increase suggests money is being used for riskier home- loan, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by Washington-based Fannie Mae and Freddie Mac of McLean, Virginia or Ginnie Mae in Washington. Broader data on loans for investments isn’t available.

How could investors return to shades of irrational exuberance so quickly?

Liquidity.

James Montier, now at Jeremy Grantham’s GMO, wrote a research paper at the beginning of June when he was at SocGen called “Forever blowing bubbles: moral hazard and melt-up.” Using research from Vernon Smith, he demonstrated that while experienced investors resist the temptation to reflate a bubble, excess liquidity can fool investors into jumping in nonetheless.

At present, monetary policy is extremely loose globally. So, the excess liquidity of which Montier speaks is at play right now. Nevertheless, consumers in much of the world are overly indebted and are loath to spend more as a result of this money. We may be in a liquidity trap.  Nevertheless, this liquidity being pumped into the system has landed on bank’s balance sheets and is looking for a home.

Hence the phrase “liquidity is seeking return,” which Stephen Roach first used a few months ago.

From an Austrian School economics perspective, this is what would commonly be known as malinvestment.  The excess liquidity being pumped into the system by the world’s central banks is inflation, pure and simple.  This inflation is now manifest in the extraordinary rise of asset prices, particularly assets of lower quality and higher risk.  However, eventually the fundamentals will re-assert themselves once the malinvestment is discovered. Let’s hope the economy is on sounder footing when this occurs.

One last thought: this policy response does seem very much like the 2001-2003 deflation-fighting campaign by the Federal Reserve which brought us the housing bubble – only on a grander scale. Are we forever blowing bubbles?

Related posts:

• The ECB is making good on Wellink’s statements
• Covered bonds are not the answer
• Connecting Fed cuts with credit writedowns and quantitative easing
• Will banks exiting TARP take back their toxic waste now?
• Are covered bonds really the solution?

As I mentioned earlier this week, I am actually on a two-week holiday in Simcoe County, Ontario, just 90 minutes north of Toronto.  We went to the Elmvale Jungle Zoo, an amazing place that has a huge variety of animals. It is really a remarkable zoo which I recommend highly.

Just near the end of our trip, I spied the best sighting there: Black Swans, right here in Canada.  Honestly, I found them stunning creatures to see up close – they seemed a bit unreal. I can only imagine what it was like for the Europeans who first saw them in Australia. No wonder Taleb was so impressed.

I wonder if this is an omen of some sort.

No related posts.

We’re not really hard wired for making money in the markets. We use a lot of gut instincts, heuristics and plain illogic in making decisions.  The result is sub-optimal investment performance. This is the nothing new as the field of behavioral economics has really moved to the forefront of academia with Daniel Kanheman receiving the Nobel Prize for his efforts. David Adler has a new book out called ”Snap Judgment” which does a very good job of giving some real world examples and advice that is helpful for professional money managers and retail investors alike.

The purpose of the book is clearly to identify specific ways our hard-wiring leads to poor financial decision-making and to give ways on how to recognize these situations and profit.  The book has five areas of concentration: Psychology in financial decisions, gambling, psychology in personal decisions, executive decision-making, and the psychology of the credit crisis.

What I found most engaging about the book was the anecdotes used to illustrate his points. 

Let me share a few with you.  The first deals with the way basic math intuition tricks us.  Adler gives a simple math problem to solve: A baseball bat and ball cost $1.10 in total.  The bat costs $1.00 more than the ball. How much does the ball cost? If you are like most people, your immediate (intuitive) answer would be 10 cents – but, of course, that’s wrong as $1.10 for the bat and $0.10 for the ball equals $1.20, not $1.10. So, to arrive at the true answer one must pause a second and work through the problem.  Thus, this simple example shows how intuition is often not enough when it comes to financial decisions.

Here’s another one.  Adler asks: Which of the following statements most closely coincides with your opinion of the Metallic Metals Act?  Adler goes on to present to suggest four answers before telling us that there is no and there never was a Metallic Metals Act. Yet, seventy percent of the people who were tested in a 1947 experiment picked one of the four choices.  Clearly, the suggestion that there was a Metallic Metals Act was so powerful that people fabricated reasons for its existence in their own minds.  The insidious thing about this second example is how difficult it is to realize that you have been tricked.

A third example I found truly remarkable is that most people were willing to take a sure $500 instead of a 15% chance at $1 million.  Adler gives a number of suggestions why this might be. But,the difference in payout is astronomical and the decision makes no sense whatsoever.

Obviously, we use heuristics or rules of thumb to simplify and reduce complex problems quickly in order to make snap judgments.  This facility may have been hugely important when we were in the wild looking to avoid being eaten alive, but it can be deadly in making financial decisions today.  And clearly, this is not just a case of retail investors making poor judgments.  So-called experts are subject to the same errors as Adler shows in his chapters on CEOs and the credit crisis.

And when some money managers are better than others at navigating the markets, ironically, this mere fact tends to pull their performance back to earth. Seeking Alpha is the holy grail of investing. But because we are all seeking alpha (looking for that risk-adjusted measure to identify how much a manager’s skill contributes to performance) and selecting our funds on that basis causes more money to flow into those funds. This drives up the price in their universe of assets and causes those assets to underperform.

So, what do we do as individual investors?  The first thing is to familiarize ourselves with the most common heuristics and their pitfalls. I’m talking about things like overconfidence, loss aversion, anchoring, the recency bias, and the scarcity heuristic.  This leads to things like excessive risk-taking, riding losers and cutting winners, and all manner of mistakes small and large.  Just knowing the biases or situations to look for is half the battle.

But, beyond that, I am not convinced we can do much else.  Adler does present a number of potential investment strategies in regards to dividends, value investing or annuities, for example.  However, it is not entirely clear to me that most people will be able to take on these suggestions without expending huge amounts of time and effort, something many of us do not have.

Adler also fails in his overarching theme of intuition versus analytics.  I found the dichotomy a bit forced and not at all additive to my comprehension of the issues. In fact, I often felt we could arrive at the same juncture making perfectly rational decisions.  It is not just a question of intuition and rationality but of market instability that is endogenous to the system. I found his formulation overly simplistic. So I took all of this with a very large pinch of salt.  The real positive in this book is in the specific examples and situations.

Overall, I did like the book.  It was a good read that used pretty straightforward language, making it accessible to virtually anyone.  Moreover, I found a number of the examples very real, and, thus, very powerful.  And I liked the fact that I could read almost any chapter without having to have read all of the previous chapters first.  So, this book is the kind of thing you can skip around in and still get the gist.  As long as you overlook the oversimplification in the intuition versus analytics theme, it is a useful book.

This is my fist book review in quite a while.  But, I hope to review more books in the near future.

Related posts:

• Choice blindness: You don’t know what you want
• Sprint: an example of stocks beaten down in the bear market
• The wisdom of crowds, the precision of models and going contrarian
• The psychology of economic forecasting
• Mobius: Still bullish on Emerging Markets

Central banks are not the only ones printing money to help get through this financial crisis.  Private citizens are increasingly turning to the printing press to help alleviate their financial problems as well.  My translation of an article from Finanzas, a major Spanish finance website, explains.

A total of 413,000 counterfeit euro banknotes were withdrawn from circulation in the first half of 2009, representing an increase of about 17% compared to the amount recovered in the previous six months, as reported today by the European Central Bank (ECB ) in a statement.

The 20 euro banknote was the most counterfeited in the first half of 2009 and accounted for 48.5% of all counterfeits detected, followed by 50 euros (34%) and the 100 (13.5%).

Fewer counterfeit banknotes were of 5 to 500 euros (0.5%), the ten-euro (1%) and 200 euros (2%). The sum of these three  intermediate bills (20, 50 and 100 euros ) represented over 95% of all counterfeits.

The majority (over 98%) of counterfeit notes withdrawn in the first half of 2009 was detected in countries in the euro area, only about 1% in EU Member States outside the euro area, and  less than 0.5% elsewhere in the world.

he ECB explained that during the period under review there was no significant new classes of forgery, so the increase is due solely to a wider distribution of the types of forgeries. The level of counterfeiting should be compared with the number of genuine euro banknotes in circulation (a total of 12.5 billion during the first half of 2009).

However, the ECB recommends that the public to be vigilant with regard to the notes they receive in cash, because the more you’re familiar with the properties and features of genuine banknotes, the easier it will detect a counterfeit.

What this article does not address is who is counterfeiting and where. Back in May, I highlighted an article in the Economist which notes that counterfeiting is endemic in countries like Peru.  Certainly, almost half of the larger denomination coins I received when I was there were counterfeit.  I quickly learned to scrutinize these coins and reject fakes after counterfeits I was passed were rejected on several occasions.

But, in the EU, there i a counterfeiting problem now as well. In fact, there has been a movement afoot to reject notes issued in countries like Portugal, Italy, Spain, and Greece. If you try to pass a Portuguese note in Germany, you might find it gets rejected as many Germans do not trust those bills. While I look at the comments of Ambrose Evans-Pritchard about Europe digging its economic grave as hyperbole from someone who is a known Euro-sceptic, the counterfeiting problem is undermining trust in the Euro.  At a minimum, this does highlight the fact that the U.S. dollar is not destined for the reserve currency dustbin just yet, despite the obvious flaws of the global financial system.

Related posts:

• The dow in euros
• Is the ECB all-in on printing money?
• Why are the Swiss now issuing debt in U.S. Dollars?
• EU planning 200 billion euro package for Eastern Europe
• Don’t underestimate the power of printing money, part 2

During Alan Greenspan’s tenure at the helm of the Federal Reserve, he was often accused of using monetary policy to target asset markets so as to keep the party going.  In short, Alan Greenspan was seen by many, including myself, as the bubble blower-in-chief. All of this came to an end with the very hard landing we have experienced after the global housing bubble.

However, despite the economy being in tatters and debt deflation looming as a threat, many asset markets have zoomed ahead. The cause: easy money in the U.S. and elsewhere.  In the U.S., we have zero percent rates with Ben Bernanke at the helm. So, naturally, you should ask yourself: Does Ben Bernanke blow bubbles too?

To get at an answer to that question, I want to highlight a recent post on MoneyWeek called “The next big investment bubble – green energy.”  In this article, research from James Montier of SocGen about investor attitudes in bubbles is quite enlightening.

James Montier at Societe Generale is a specialist in ‘behavioural finance’. This basically takes psychology and applies it to the field of investment and economics.

As someone who’s studied psychology in the past, I’d be the first to admit that it’s a pretty ’soft’ science compared to something like physics, for example. But compared to the pseudo-science that is economics, it’s positively respectable.

And given that markets are anything but rational (even the Chartered Financial Analyst Society of the UK admits that a majority of its members have lost faith in the ‘efficient markets hypothesis’), it makes a lot of sense to take investors’ all-too-human characteristics into account when trying to figure out what markets might do next.

In a recent research note, Montier took a look at the psychology of bubbles. As suggested earlier, you’d think that investors would learn. If they’d seen one bubble, they’d be more careful in future.

And in fact, they do learn. An experiment conducted by joint Nobel prize winner Vernon Smith used an investment game where investors could trade a dividend-paying equity under four different random economic conditions, each of which would result in a different dividend payout.

In the first game, investors at first undervalue the equity, then massively overvalue it, creating a bubble which then deflates. Smith then got the same people back to play the game again. What happened? Well, says Montier, “far from learning from their experience in the first round, participants generally go on to create yet another bubble!” And when they were asked why, “the most common response was they thought they could get out before the top this time!”

However, when Smith asked the same players to play a third time, this time they’d learned. “You end up with a much tighter correlation between the market price and fundamental value,” says Montier.

So twice bitten, thrice shy, it seems. And you might therefore expect the current generation of investors to have learned from the two big bubbles of the past decade.

…but they can get sucked into creating them

But that’s not the end of the story. Smith found that there was a way to get experienced investors back into bubble mentality. How? He cut the amount of stock available in half, and doubled the amount of cash in the game, “effectively creating what might be termed a massive liquidity surge.” This time around, even the experienced investors were sucked back into creating another bubble, although it peaked earlier than the previous ones.

“A massive liquidity surge” is exactly what the world’s central banks are trying to create just now. Montier says he has no idea if it will be large enough to “reignite a bubble (and of course another crash afterwards).” But as US fund manager Jeremy Grantham of GMO has pointed out previously, we’re currently seeing “the greatest monetary and fiscal stimulus by far in US history”. So if that doesn’t do it, arguably nothing will.

What does that tell you?  It tells me that while many are chastened, the recent surge of liquidity is likely to result in bubbles nevertheless.  The article looks to ‘green energy’ as a likely bubble market.  But in “The next bubble” FT Alphaville look to a more conspicuous place, emerging markets.  This article is definitely worth reading.

I would also point to the recent 40% surge in U.S. equity prices as evidence that liquidity factors are at play and that a bubble mentality is returning.  Moreover, $70 oil in a period of depressed demand for oil doesn’t speak to a market running only on fundamentals. If oil prices are $70 today, they most certainly can and will rise to $100, $150 and beyond if recovery takes hold and demand returns.

Therefore, in my view, Ben Bernanke does blow bubbles too.

Below is the research note from Montier which inspired this post.

Forever Blowing Bubbles

Related posts:

• Bank leverage: forever blowing bubbles part two
• Popping bubbles
• All bubbles are equal, but some bubbles are more equal than others
• Liquidity trap of a different sort
• James Montier sees “deep value” in markets – he is bullish

So, things are looking a lot brighter we are told by most economists and policy makers.  The crisis is over and the banking system is on the mend.  Now is the time for true reform and for bankers to get back to business as usual.

While the foregoing may make for nice copy in the mainstream media, I would like to make the case for continued vigilance, especially in regards to corporate governance and incentives in the banking sector. Let’s look at this from the point of view of a big bank CEO who we will call Phil.

Now, Phil was caught unawares when the credit crisis hit.  His bank, where he had been CEO for a decade, had been growing prodigiously at relatively low risk according to internal risk metrics.  The return on capital was top quintile.  But, the financial crisis and recession had not been kind to the bank.  Big Bank had taken massive credit writedowns and was forced to take on TARP money and issue FDIC insured bonds in order to demonstrate its safety as a bank.  As a consequence, the share price was crushed, falling 80% peak to trough. All of Phil’s stock options were underwater.

But, the stress tests showed that Phil’s bank was in relatively good shape – at least compared to Big Bank’s peers. On the back of this information, Big Bank was able to issue a huge slug of new shares at a price 200% above its trough share price and fill any apparent gaps in Big Bank’s capital.  In fact, under the guidelines of the stress test, Big Bank could pay back all of the TARP money it received and return to business as usual.

There was one problem, however, and Phil knew it.  You see, Phil had become a lot more worried about the health of his bank after being caught flat-footed when the credit crisis hit.  The company had done a significant amount of work to get to grips with likely credit exposure.  And while the situation was good for Big Bank under the conditions predicted in the government’s stress tests, Phil knew that the conditions were not good at all in more adverse scenarios.  What should Phil do?

Before, we get into what Phil actually does, I should point out that this is a classic case of asymmetric information in which Phil, as a bank insider, has a lot more knowledge of Big Bank’s financial condition than the government, shareholders, or the investing public at large. Well, I would like to believe that Phil would do the prudent thing and remain ‘over-capitalized’ until he was sure that he could lend prudently without jeopardizing his firm’s capital base. But, there is clearly no incentive for that.  After all, hadn’t Phil been beaten over the head before Congress for ‘not’ lending money.  Why did Phil have so many billions of dollars in excess reserves at the Fed?  Why was he preventing the economy from regaining its footing? Was Phil hiding something?  Perhaps Phil and his executive team need to be replaced?  On second thought, Phil decides the over-capitalization route is suicidal.

As it turns out, Phil’s internal credit gurus told him there is a 60% chance that the company can lend and make shed loads of money as the economy recovers.  There is a lesser but not insignificant 30% chance that the company is under-capitalized if the economy remains fragile and a 10% chance that the company is severely-undercapitalized in a real worst-case scenario.  Big Banks lawyers and accountants have told Phil that he can legitimately claim to the public that Big Bank is well-capitalized and proceed lending.

Phil is optimistic that things will turn out well.  The fact that his underwater options depend on it is no small incentive to feel that way.  But, he has nagging doubts about the downside scenarios of which the public and the government are largely unaware.  So Phil decides to ‘reach for yield’ by taking a slightly aggressive strategy which will ensure that the company can make a lot of money now while interest rate spreads are high.  That way, if things turn down, he will have a huge cushion with which to work.

Of course, he could get burned again and be forced into an under-capitalized position.  That would be embarrassing. But, a bailout is likely if worse comes to worse and no CEOs were replaced the last go around.  Sure they made noises about replacing Vikram Pandit, but he is still in office.  And, anyway, Phil is a member of the club – the exclusive cadre of well-experienced bank executives who run America’s banking system.  Surely he would land on his feet after a time.

Notice I have not suggested that we have any evil banksters here; I am simply demonstrating that misaligned incentives lead to poor outcomes.  Phil, who has zero incentive to restrict lending, has a lot of incentives to increase lending: threats from the government and a huge options pay package being the most obvious.  And certainly, if Phil fails, it’s not as if his options will exact a penalty; they expire worthless, making Phil indifferent to all scenarios in which they are not in-the-money.

All of this points out why bailouts skew executive behavior in a way that makes the system more volatile.  Moreover, the fact that large options packages incentivize risk-taking by making executives relatively indifferent to all scenarios below the option strike price, show that executive compensation exacerbates the volatility. Certainly, this is one reason we need to address compensation and incentives more than is done in the Obama white paper.

But, more than that, the asymmetry in knowledge makes the way this crisis has been handled — bailouts, stress tests, hidden subsidies – quite disturbing.  And the Obama White Paper for regulatory reform does not go far enough to ensure that this same downside scenario will not repeat itself.

Related posts:

• Will banks exiting TARP take back their toxic waste now?
• Bank by bank breakdown of stress test results
• Should GE be a AAA company?
• Mark to market is beside the point
• Ten big banks receive approval to repay TARP funds

Submitted by Edward Harrison of the site Credit Writedowns.

During the last generation, the economics profession has veered toward a ‘science’ model of economics and finance. The intellectual underpinnings for this development began with the Efficient Market Hypothesis (EMH) and has continued in no small measure due to what is often termed ‘University of Chicago School Economics.’  If you are looking for a good read on what is wrong with the EMH view of the world, you should get ready for Justin Fox’s “The Myth of the Rational Market” which is coming to a bookstore near you.

My own view is that many economists today are really frustrated scientists looking to ply their science and math craft in economics. In reality, economics is a social science with large influences from psychology and the scientific view ignores this.  However, the fact that psychology plays a large role in economics is something that is increasingly appreciated, as the Nobel Prize received by Daniel Kahneman attests.

So, I am not going to discuss EMH or rational markets.  Rather I want to delve into the psychology of economic forecasting and why economists act as they do.  Late last month, I posted an article with an attached video in which Marc Faber made the very astute comment, “it’s very tough for a forecaster who was ultra-bearish to stay bearish, because if he’s wrong he has a reputational risk.”  What I believe Faber was saying is this: an economist who is proved wrong is an economist who loses credibility.  This statement is at the heart of economic forecasting.

What Faber is giving voice to is the very real concern that any economic forecaster feels in making a prediction. If one is proved right, then plaudits will follow.  If one gets it wrong, the Bronx cheer is what you are likely to get. This is true for macroeconomists as much as for Wall Street analysts.  I will give you two examples from Wall Street to illustrate my point.

Henry Blodget: Amazon to $400

In October of 1998, Blodget predicted that Amazon’s stock would soar to $400 a share.  At the time, he was a little known analyst at Oppenheimer, the same company for which Meredith Whitney worked until recently.  His Amazon prediction propelled Blodget to a much higher status and attracted the attention of Merrill Lynch, the bulge bracket firm to which he moved for a huge salary.  Clearly, making a bold call that comes true is a boon to a market forecaster.

Arjun Murti: Oil to $100 and then $200

Back in 2007, Arjun Murti, an oil analyst at Goldman Sachs, made a bold call that oil could rise to $100 a barrel in a ‘super-spike.’  I stress the fact that he said could because he was not predicting $100 a barrel per se, but rather he was making an analysis about the factors which could create a spike in oil prices.  When oil did in fact rise to $100, many were shocked and Murti looked to be a prophet.  Then he penned a piece which said the super spike could take oil to $150-$200.  When oil peaked at $147 a barrel and subsequently collapsed down to $33, Murti was widely vilified in the media.

In fact, if you look for his name in a search engine, you will find all manner of references to his $200 oil call as a wrong prediction that was the height of hubris.  However, if you read the above linked Bloomberg article, you can see he never said oil would rise to $200 a barrel any more than he said oil will rise to $100 a barrel.  In fact, he gave a range from $150-$200 which was arguably met when oil rose to $147 a barrel.  Clearly, making a bold call that is ‘proved’ false is detrimental to the reputation of a market forecaster.

So, in retrospect, Marc Faber was making a statement about Nouriel Roubini, dubbed by the media as ‘Dr. Doom,’ that one can easily see has having relevance in the Arjun Murti case.  The question is what impact these facts have on how forecasters act.  I would argue that it constrains their forecasting more than is readily apparent, especially due to ‘personality factors’ in the forecasting community.

Herding

The first outcome of this asymmetric treatment of bold calls gone wrong and ones proved right is what is known as herding.  This is a phenomenon known to be at work in bubbles and was popularised in a 19th century book called “The Madness of Crowds” by Charles Mackay.  More recently, herding has been seen amongst fund managers judged according to an index benchmark and relative fund performance. But, it is also evident in how forecasters make predictions as well.  No one wants to go out on a limb with a bold call only to see this prediction proved wrong.  If one fails, it is better to fail conventionally.  The necessary corollary of that statement is this: market forecasters and analysts play it safe by making sure their forecasts are not often far from the consensus forecast.  Think of the consensus forecast as an anchor which restricts the outlook of any individual forecaster afraid of failing unconventionally.

In Roubini’s case – and this logic also applies to media darlings like Meredith Whitney – it does NOT pay to up the ante.  What Faber is saying is that they have already benefitted from the bold and unconventional contrarian market call they initially made.  There is little payoff and much risk from continuing on that path.  A bearish analyst who misses the turn gets the stick.  Just ask the original Dr. Doom, Henry Kaufman.

Personality Factors: think Mr. Spock

There is another overlooked part of forecasting which contributes to the herding of analysts.  I would call this personality factor, the ‘Mr. Spock Syndrome.’ Let me explain.

In the early 1990s when I entered the Foreign Service, we were all given a personality test called the Myers-Briggs Type Indicator (you can take the test here).  This test is designed to give individuals a general sense of their own particular personality proclivities and modus operandi.  While the test has generated some criticism for not having enough real world statistical validation, it has been adopted by a wide range of human resource departments worldwide.

Now, when I took this test, I had no idea what the MBTI was. So, I found it quite interesting to hear what it was designed to achieve.  What was more interesting was how unevenly distributed different personality types are across the population. Of the four types, two make up as much as 80-85 percent of the population, whereas the other two make up as little as 15-20 percent.

When we were asked to raise our hands and self-identify after we received the test results, two thirds of the classroom identified themselves as NTs – otherwise known as rationals (I am an NT as well).  Mr. Spock, the character from Star Trek, best exemplifies the exaggerated two-dimensional version of an hyper-rational.

Given the fact that rationals make up 5-10 percent of the population, it is very unlikely that two-thirds of my thirty-odd Foreign Service colleagues were NTs by random chance.  More likely is that we self-selected based on the fit between our personality and the job ad based on self-selection (NT Diplomats unconsciously picking other NTs).

In economic analysis much the same dynamic is at play – rationals are a natural fit for the role of stock analyst or economic forecaster.  I guarantee you that you would see an equally disproportionate number of rationals in those positions were you to administer a global poll of economic forecasters (which makes me wonder if the whole ‘rational economic agent’ meme in economics is just a projection onto the broader population?).

Mr Spock doesn’t like being wrong

So, what are the personality characteristics of an NT?  Opinionated and arrogant are two things that come to mind.  But, that’s being negative.  There are many positive ones like pragmatic, even-tempered, inventive. One interesting characteristic is that rationals do not like to be wrong. It is like a blow to a rational’s sense of self to proved wrong.  So, more than other personality types, rationals take episodes to heart like the one I described with Arjun Murti.  While this might tend to makes one more meticulous and precise, I believe it also makes one more cautious.  Take a look at this post and you will see that I, as an NT, have unconsciously filled my article with qualifiers like “might’ and ‘could’ or ‘tend to.’  I didn’t realize this until I read the last sentence.  But, clearly I am doing the same thing I am accusing other forecasters of doing: qualifying my statements in order to make it easier to weasel out of a bad call.

The easiest way to weasel out of a bad call, however, is to vote with the consensus, otherwise known as herding.  Outliers are punished if they are wrong. Now I know rationals tend to be very independent minded and are, therefore, more prone to be contrarian, but I also think that the rewards and incentives in forecasting are skewed toward consensus.  In my opinion, this is another reason why momentum is such a force in markets – no one is willing to stick out his neck.

I hope you find this post entertaining.  I look forward to your comments – positive or negative.

Related posts:

• A brief look at the Asset-Based Economy at economic turns
• Definition of the day: the law of unintended consequences
• More thoughts on the fake recovery
• Average U.S. jobless claims top 600,000
• Data point of the day: actual unemployment rates

This is an interview in five parts via Morningstar on May 28th with the one-time reputed perma-bear Jeremy Grantham who has been sounding much more bullish of late (in a bear-market rally kind of way).  Definitely worth a look.  The five parts run just over 20 minutes.

Part 1: On dipping a toe back into the market – and how a lot of people missed the huge surge in equities. He says this about the market: “It’s a very uncertain world. It may not come down again materially Of course it may. But you can’t risk being left behind for years.”

Now, on the surface this sounds like Chuck Prince heresy about dancing when the music is playing, but if you watch the later segments, you will see that he does believe the fundamentals are behind his call to increase equity weighting to at least neutral.  Note his little dig at the efficient market hypothesis as “inaccurate’ and “dangerous.”

http://www.morningstar.com/cover/videocenter.aspx?id=295077

Part 2: We expose a definition of what high quality is according to Grantham because high quality seems to have underperformed in the recent market melt-up.

http://www.morningstar.com/cover/videocenter.aspx?id=295076

Part 3: Grantham touts his seven lean years meme.  It sounds a lot like a balance sheet recession as expounded by Richard Koo, the Chief Economist of Nomura.  Note how much he stresses the psychological effects of the huge upswing and its aftermath.  My takeaway here is that consumer discretionary is not a place to overweight in this environment. See Real Time Economics’ recent post, “Which Industries Are Most Vulnerable to Consumer Shift?”

http://www.morningstar.com/cover/videocenter.aspx?id=295072

Part 4: Value investing is at the core.  He believes that return on capital is MORE important than top line growth i.e. value beats growth.  He uses China to illustrate his point, confident that they will have huge growth but not confident this will feed through to exceptional return on capital in Chinese equities. “Overwhelmingly everything comes to starting point value.”

http://www.morningstar.com/cover/videocenter.aspx?id=295075

Part 5: Inflation is top of mind for Grantham.  He is not in the deflation camp at all because inflation is where GMO is investing its extra time in navigating the investing minefield right now. By the way, this means you don’t want to be long the long-end of the treasury curve.

http://www.morningstar.com/cover/videocenter.aspx?id=295073

Related posts:

• More bullishness from Jeremy Grantham
• Jeremy Grantham: “Pull the trigger”
• Jeremy Grantham: “Many shares priced for… economic collapse”
• Jeremy Grantham: “Keep telling yourself… you’re a long-term investor”
• Jeremy Grantham and experts: credit crunch far from over

The real lecture begins about 5 minutes through.

No related posts.

You will never hear this term again on Credit Writedowns – not from me, not from Marshall or anywhere else.  I am sick of hearing this phrase and am banning it for good – hoping it goes away and dies a gruesome and painful death.

And don’t get sneaky and try putting it in your comments.  I’ll be watching!

Related posts:

• Green Shoots or Smoking Weed?
• Consumers ‘do believe in the green shoot story’
• Definition of the day: the law of unintended consequences
• The irony of falling prices and first-time homebuyers
• Morgan Stanley: Recession will ‘end by mid-to-late summer’

I just finished watching this show called Celebrity Apprentice hosed by Donald Trump.  Why I did is a question for a psychologist. You may be familiar with the show.  It pits two teams of individuals against one another in random tasks, ending in the dismissal of one of the contestants from the losing team.  The contestant leaves the show when Donald Trump as Chairman of the Board says, “you’re fired.”

I don’t know about you, but I don’t find this spectacle to be a particularly flattering image of corporate governance in America. It represents a ‘hire and fire’ mentality in vogue along with de-regulation and finance über alles over the past quarter-century, that has led to a crisis of confidence in the American system of capitalism.  What I found particularly galling in the particular segment I watched was how little of the boardroom decision-making was based on fact and how much of it was based on favouritism.

At some point in an earlier show that I did not see, two of the contestants, Joan Rivers and her daughter, let loose in a tirade that was completely out of bounds, reeling off a blistering attack of the most personal and bitter nature on two others.  Annie Duke, one recipient of the abuse, remarked that she believed such behaviour would be met with censure, sanction or dismissal in any real boardroom.  Yet, Joan Rivers ended the show triumphant.  And from what I saw, it was clear that Joan Rivers was getting favoured treatment.

But, is it  really true —  are American corporations run by captains of industry who act in the best interests of shareholders, employees, and the communities they serve without prejudice?  Or is American capitalism rife with favouritism, backroom dealing and corruption?

As for the outburst, I tracked down a copy of it to see what really transpired.  Here it is below.  Judge for yourself (you’ll notice Jim Cramer in the boardroom, by the way).  Is this the kind of thing that goes on in American boardrooms? Is Celebrity Apprentice a reflection of American corporate governance?

Related posts:

• Asymmetric information and corporate governance in bank bailouts
• John Bogle decries ‘failure to observe the fiduciary principle’
• Tendencies of irrational behavior
• Black: The Great American Bank Robbery
• A conversation about the film ‘Duplicity’ on Charlie Rose

For most of the last few years, I have been labeled a perma-bear, that is someone who looks at the situation from a reflexively skeptical glass half-empty bias. One only need peruse our archives to get that impression. In fact, that is hardly the case. Over the past few months, as the evidence of a potential bottoming has grown stronger, I have moved away from the bearish view toward a more bullish stance.  Yet, I do get the distinct impression that many commentators in the blogosphere do not share my renewed optimism. Their view is rather dark. Mind you, I am no out-and-out wild eyed bull.  Nevertheless, I do think my increasingly upbeat views stand in contrast to most of what you read in the blogosphere about the economy, the market and the banking industry. 

Why is that?

Here’s my take.  Humans are naturally pre-conditioned to seek confirmatory evidence once they have made a conclusion.  We spend a lot sorting out new information into a world view and we become attached to this view emotionally, so much so that contradictory evidence is viewed as a threat not only to our views, but an imminent threat to our person.

Drew Westen, a Professor of Psychology at Emory University did a fascinating study about this theme in 2006 regarding politics. Wikipedia sums up the study and conclusions as follows:

In January 2006 a group of scientists led by Westen announced at the annual Society for Personality and Social Psychology conference in Palm Springs, California the results of a study in which functional magnetic resonance imaging (fMRI) showed that self-described Democrats and Republicans responded to negative remarks about their political candidate of choice in systematically biased ways.

Specifically, when Republican test subjects were shown self-contradictory quotes by George W. Bush and when Democratic test subjects were shown self-contradictory quotes by John Kerry, both groups tended to explain away the apparent contradictions in a manner biased to favor their candidate of choice. Similarly, areas of the brain responsible for reasoning (presumably the prefrontal cortex) did not respond during these conclusions while areas of the brain controlling emotions (presumably the amygdala and/or cingulate gyrus) showed increased activity as compared to the subject’s responses to politically neutral statements associated with politically neutral people (such as Tom Hanks).^[2]

Subjects were then presented with information that exonerated their candidate of choice. When this occurred, areas of the brain involved in reward processing (presumably the orbitofrontal cortex and/or striatum / nucleus accumbens) showed increased activity.

Dr. Westen said,

None of the circuits involved in conscious reasoning were particularly engaged… Essentially, it appears as if partisans twirl the cognitive kaleidoscope until they get the conclusions they want… Everyone… may reason to emotionally biased judgments when they have a vested interest in how to interpret ‘the facts.’^[3]

The study was published in the Journal of Cognitive Neuroscience 18:11, pp. 1947–58, a peer-reviewed scientific journal.^[1]

Even before being peer-reviewed and published, Michael Shermer used the presentation by Dr. Westen as the basis for his July 2006 Skeptic column^[4] in the magazine Scientific American.

In essence, political partisans with a well-developed political world view were confronted with data that did not fit their particular view.  This created cognitive dissonance and mental stress (remember, the brain areas for reason were not activated here, emotions were at play).  Their brains, rather than trying to resolve the conflict objectively, looked for ways to incorporate the new information into the previous pre-conceived view. When the subjects successfully accomplished this back flip, they were massively rewarded by the areas of the brain for pleasure. 

In sum, our brains are NOT hard-wired for non-confirmatory evidence. We are not rewarded for seeking non-confirming data. Therefore, we generally seek confirmatory evidence after we have made any decision.

Think about this for a second.  When you have bought a car, a house, quit a job, gotten a divorce, taken on a new job, what have you – did you sit around looking for ways to figure out why those decisions were wrong? Unless, you are a masochist or in need of some serious therapy, the answer is no.  My reasoning is that there is no evolutionary benefit in one questioning decisions that have already been made.  The problem, of course, is that this search for confirmatory evidence extends beyond decision-making to how we view the world and how we interpret data and I believe it makes for errors in investment decisions and forecasting.  This problem is called the confirmation bias.

Wikipedia defines confirmation bias as follows:

In psychology and cognitive science, confirmation bias is a tendency to search for or interpret new information in a way that confirms one’s preconceptions and to avoid information and interpretations which contradict prior beliefs. It is a type of cognitive bias and represents an error of inductive inference, or as a form of selection bias toward confirmation of the hypothesis under study or disconfirmation of an alternative hypothesis.

Confirmation bias is of interest in the teaching of critical thinking, as the skill is misused if rigorous critical scrutiny is applied only to evidence challenging a preconceived idea but not to evidence supporting it.^[1]

So, to be clear, I am saying that we all are biased toward the pursuit of evidence that confirms what we already tend to believe.  If that view is false, we are merely entrenching ourselves more in a false belief.

John Maynard Keynes once famously quipped, “When the facts change, I change my mind. What do you do, sir?.” I applaud him for the sentiment.  But, the fact is, it is easier said than done. As a result, every step along the way, I force myself to revisit my conclusions over and over again, specifically looking for non-confirming evidence.  My post “Channeling my inner Larry Summers” was an example of that.  But, quite frankly, I find the exercise very taxing mentally – emotionally draining, if you will.  So I am sure that I am not always successful.

Well, the facts have changed.  The U.S. economy, which I have characterized as in a depression with a small ’d,’ has clearly stopped declining as quickly as it once had done.  The maximum rate of decline was December 2008 or January 2009.  Now, the economy is still contracting, but at a slower rate.  The question is: what now?  The general view in the blogosphere is that this is a pause and we will resume our downward path once the true extent of the problems are made manifest.  But, is that really true?

I would argue that it is not axiomatic that the structural problems in the U.S. portend a relapse into a deeper contraction. It is just as possible – actually rather likely in my view – that the U.S. economy, at a minimum, will leave recession within the next 6-9 months, if not sooner. For me, the question is two-fold:

1. Are we far enough into an improvement in 2nd derivative data (the change in the change of economic data like housing, jobless claims and GDP) that a reversion to deterioration is unlikely?  In plain English, have things have stopped getting worse so quickly for so long that it seems impossible that we could go back to the days when things got worse more quickly?
2. Do we have the wherewithal to conquer the expected future impediments in commercial property writedowns, credit card writedowns, commercial bankruptcies, and unemployment?

I answer “yes” to both of these questions.  And I hope to demonstrate why more fully in future posts.To date, I have summed up my view in a post called “The Fake Recovery.”  One could actually accuse me of actually fitting the data into my already dark view of the structural problems in the U.S. economy.  However, while this is not what you might term Abby Joseph Cohen optimism, I would say that this view is far enough away from the consensus or my 2008 worries of financial Armageddon that it does represent a more positive tone.

Meanwhile, much of the finance blogosphere is still very much focused on the downside risk. Mind you, I am still concerned about it (one reason you will see ‘doom and gloom’ posts at Credit Writedowns as well), but I am much less concerned than I was just a few months ago.  Count me as a part-time member of the Green Shoots Brigade.

Source

 Drew Westen – Wikipedia

Confirmation bias – Wikipedia

Related posts:

• Confirmation bias
• The politics of economics
• Cognitive dissonance
• The irony of falling prices and first-time homebuyers
• Morgan Stanley: Recession will ‘end by mid-to-late summer’

It looks like Chrysler is going down for the count. A few piggish bondholders decided to play chicken with the Federal Government. They are going to lose this game and, consequently, lots of money too. Chrysler and the Obama Administration did not have a strong hand. Their best alternative to a negotiated agreement (BATNA) was bankruptcy – not a very good fallback option. James Kwak calls Chapter 11 the government’s nuclear option because bondholders are not the only one’s who are going to lose here. The holdouts amongst the bondholders knew this and pushed their piggish agenda. Now they are going to get slaughtered.

But what about everyone else?  I am not optimistic that a bankruptcy can be controlled unless the administration puts in some cash after the filing.  They have promised to put in $6 billion if the Fiat deal comes through. This would make their money senior to all other claims and give them much more say over the course of events during bankruptcy.  That would also give Chrysler time to work through a bankruptcy without liquidation.  Here’s how I see things playing out for some major constituencies.

• Auto Workers.  There will likely be massive job losses here.  Let’s see what Obama does regarding funding the newly-insolvent company to prevent more job losses.  The dealer network will be cut back significantly, so the job losses will not necessarily be concentrated in Detroit.
• Shareholders.  They will get nothing. They will be replaced by the unions (new majority owners in deal with Administration), the government, and Fiat (if the deal goes through)
• Bond holders.  They are going to get stuffed..big time.  It is a case where they should say, “I fought the law and the law won.”  End of story.
• CDS insurance writers.  Get ready for major pain.  If bond holders are getting screwed, you know the companies who guaranteed credit default swaps (CDS) are not going to be very happy here.  Question: are bond holders playing chicken because they have insurance?  If so, you can consider the CDS writers another negotiating party that did not get a seat at the table and are going to be left holding the bag – a reason to want some major changes in how the CDS market is run.
• General Motors.  This is a dry run for them.  Now, they have a chance to see how things play out for Chrysler and use this as leverage to say, “see, you don’t want to hold out on us. Look at Chrysler.”  But, again, the CDS insurance problem may be at play in bondholder negotiations.
• Fiat.  This is good for Fiat.  Chrysler will be cheaper now and this also gives them more leverage over Opel and Vauxhall in those negotiations.  On that score, it is a net loss for GM, which owns those two European subsidiaries.
• Chrysler retirees.  They are going to take it on the chin.  I guarantee you there will be pain felt in Chapter 11 for the pension fund.  Chrysler can pull an airline maneuver and slough off some of the pension income and health care liabilities too.  The unions have already made large concessions here, so perhaps this will be less of a factor.

A good article to read in all this is “Exploring the New Corporate Bankruptcy Strategy” on the PBS Frontline website. It has quotes from a number of bankruptcy experts including Elizabeth Warren, now Congress’ TARP watchdog.  In her full interview, Warren gives some insight into the effect Chapter 11 has on pension funds and the net effect of ERISA and moving from defined benefit to defined contribution schemes.

Related posts:

• Opel and Fiat spells bankruptcy for Chrysler and GM
• Obama ready to put Chrysler into bankruptcy
• The case of the dissident Chrysler bondholders
• Is the GM section 363 bankruptcy plan really a stealth re-organization plan?
• Chrysler dissident lenders lose fight and disband

Watch the video below and then read the text and the linked full article. No cheating!

As anyone who has ever been in a verbal disagreement can attest, people tend to give elaborate justifications for their decisions, which we have every reason to believe are nothing more than rationalisations after the event. To prove such people wrong, though, or even provide enough evidence to change their mind, is an entirely different matter: who are you to say what my reasons are?

But with choice blindness we drive a large wedge between intentions and actions in the mind. As our participants give us verbal explanations about choices they never made, we can show them beyond doubt – and prove it – that what they say cannot be true. So our experiments offer a unique window into confabulation (the story-telling we do to justify things after the fact) that is otherwise very difficult to come by. We can compare everyday explanations with those under lab conditions, looking for such things as the amount of detail in descriptions, how coherent the narrative is, the emotional tone, or even the timing or flow of the speech. Then we can create a theoretical framework to analyse any kind of exchange.

The next time you read a story on financial markets that starts, “the markets were up (down) today because…” you should keep this study in mind.

Sometimes market rise and fall for no reason.

See the full article at the link below (hat tip Robin Hanson).

Source
Choice blindness: You don’t know what you want – New Scientist

Related posts:

• How snap judgment leads to poor investing
• Through a glass darkly: the economy and confirmation bias in the econoblogosphere

Below is a very good video of John Bogle, the legendary investor, at Columbia Business School, hosted by CBS Professor David Beim. In his speech, Bogle places much of the blame for the present crisis with the increasingly hostile corporate governance environment of the last quarter-century, a point I make in my recent post “The horrible self-dealing of Ken Lewis and the principal-agent problem.”

The pendulum has swung far to the extreme toward corporations governed by an insulated elite of managers divorced from owners’ true interests. It will take some time to correct these excesses.

Related posts:

• BofA saga continues as John Thain calls Lewis a liar
• Quote of the day: John Kenneth Galbraith – The Bezzle
• Is Bernanke Toast? If he is, Summers is a shoo-in
• The horrible self-dealing of Ken Lewis and the principal-agent problem
• Bof A’s MAC clause was as porous as swiss cheese

I don’t much like Ken Lewis. It should be fairly obvious to everyone that he is a man who has only his own interests at heart. But, his revelation that BofA bought Merrill Lynch for the agreed-upon September price, despite Merrill’s having an additional $7 billion in losses is grounds for legal action.

Let’s review the situation.

In September, Hank Paulson, Ben Bernanke, and Tim Geithner committed the financial blunder of the century in allowing Lehman to fail spectacularly without any contingency plan for the probable market fallout. (Yes, Tim Geithner was a principal actor in this fiasco.)  Now, there was nothing wrong in letting Lehman Brothers fail.  However, there was something very wrong with bailing out Fannie Mac and Bear Stearns and allowing everyone on Wall Street to believe Lehman was too big to fail.  And there was even more wrong in having no contingency plan for the fallout.

So as a direct result of that fallout, Merrill Lynch was poised to be the next to go under.  Enter Ken Lewis, our White Knight.  I have to admit to being idiot enough to have thought the Bank of America – Merrill deal was a good one.  It seemed all was well when Ken Lewis plunked down $44 billion in September (even though Barclays got much of the Lehman assets for a song days later).  But, as markets went into freefall, so too did Merrill Lynch, hemorrhaging losses.  So why did Ken Lewis buy the company without at least trying to negotiate a lower price tag?

Answer: self-dealing.

It was the real thing. The banker, as you may have guessed, is Ken Lewis, CEO of Bank of America. And the bad guys harassing him are Hank Paulson, then Treasury secretary, and Ben Bernanke, head of the Federal Reserve, aided and abetted by shadowy henchmen.

The script for this stranger-than-fiction melodrama was provided by that rabid (and fiercely ambitious) bulldog New York state attorney general, Andrew Cuomo. Mr. Cuomo, back in February, had been grilling Mr. Lewis on what his keen canine eye detected as another indignity — the awarding of $3.6 billion to employees of Merrill Lynch, the giant brokerage firm acquired by BofA on Jan. 1 of this year.

What had Mr. Cuomo frothing at the mouth was that the $3.6 billion was shelled out even though Merrill suffered losses upwards of $15 billion in 2008’s fourth quarter alone.

We must point out how fortuitous it was that losses had not reached, say, $30 billion, since by the peculiar calculus being used to reward red-ink, that would have boosted Merrill’s bonus tab to $7.2 billion. And enraging the chronically enraged Mr. Cuomo all the more was that the bonuses were distributed even while the losses manifested themselves but were not disclosed, least of all to the bank’s shareholders.

According to Mr. Cuomo’s dour narrative, the product of four hours of interrogation of Mr. Lewis, the merger with Merrill was proposed in September after two days of due diligence (sounds more like due negligence to us). It gained approval of shareholders of both companies on Dec. 5. Barely a week later comes the revelation: Merrill’s losses were spiraling ever higher, causing an increasingly frantic Mr. Lewis to weigh calling the marriage off.

He reckoned he could legally do so thanks to MAC (material adverse event), recognizing that $7 billion more in losses than had been projected when the merger was agreed to was a very big MAC, indeed. He diffidently informed the powers-that-were of his plan to nix the nuptials and was summarily summoned to powwow with them in Washington that very evening. And it was there that Messrs. Bernanke and Paulson put the screws to him to not break the deal lest he trigger a systemic calamity.

On Dec. 21, Mr. Lewis, still of a mind to ditch the merger, communicated his determination to Mr. Paulson, who bluntly warned that he would give the boot to Mr. Lewis and his board unless the acquisition went through. To that bald threat, Mr. Lewis’ retort was a resounding purr: “That makes it simple. Let’s de-escalate.”

And de-escalate he did. The merger became a done deal right on schedule. To help salve any hurt feelings, Bank of America got $118 billion in loan guarantees from rich Uncle Sam to absorb any potential losses from Merrill.

To me, this sounds like a deal was worked out whereby BofA got a bailout if it went through with the deal. But, it should be plain from the events above that Ken Lewis did NOT have his fiduciary responsibilities for his shareholders top of mind.

So, let’s recap.

• Paulson, Bernanke and Geithner blow Lehman up and everybody panics.
• Merrill looks ready to blow up and take the system down with it.
• Bank of America steps in – or better yet, is coerced in – and pays $44 billion for Merrill.
• But, the market freefall continues, taking WaMu, AIG and Wachovia down with it.  Merrill loses its shirt in this disaster.
• By December, Ken Lewis is ready to pull out of the deal, citing the MAC (material adverse change) clause as grounds.
• Paulson and Bernanke go ballistic (Geithner was prepping to be Treasury Secretary) and get Ken Lewis to do something he thinks is bad for shareholders
• By February, BofA needs to be bailed out again to the tune of tens of billions more government money from Tim Geithner.  BofA’s stock tanks – shareholders are looking at 90%+ losses.
• Now, the SEC is investigating.

This whole episode stinks to high heaven and Ken Lewis doesn’t even look the worst of the lot here. That honor goes to Paulson and Bernanke.

But, what about the shareholders? Oh, those people, right. Don’t they deserve better? Yes, they do. But, they are not going to get better because mega-corporations are run by managers who are in it for their own enrichment and shareholders have zero say. This is a classic principal-agent conflict.

The essence of the principal-agent problem comes when a principal (let’s call them the owners) hires an agent (we’ll call them the managers) to act on her behalf. Often times, one is just too busy – or too inexperienced – to manage a business or negotiate a contract or what have you. So, one hires a professional steeped in experience to do it.

For instance, sports agents, made famous by the film Jerry Maguire, are the classic agents to the sports stars principal. As it happens, the agent has his own agenda – and this may or may not be the same as the principal’s employing him. You will recall the 2007 incident when Alex Rodriguez negotiated his own contract with the New York Yankees baseball team in order to make sure the result was one that was most favorable to his wants and needs (See NY Times article here.)

In business, the same dynamic is at play. While a dry cleaner can be the owner-proprietor of his own store, he cannot run two stores or ten stores at the same time (think George Jefferson). George needs to hire managers to run those stores – and he better hope those managers don’t have their hand in the till.

In today’s age, corporations are absolutely enormous, globe-spanning enterprises whose owners – the shareholders – individually have no influence over decision-making. What’s more is, the larger the organization, the less likely anyone is to have sway over the company’s managers. Supposedly, that’s why there is a board of directors, right?

A board of directors is a body of elected or appointed persons who jointly oversee the activities of a company or organization. The body sometimes has a different name, such as board of trustees, board of governors, board of managers, or executive board. It is often simply referred to as “the board.”

A board’s activities are determined by the powers, duties, and responsibilities delegated to it or conferred on it by an authority outside itself. These matters are typically detailed in the organization’s bylaws. The bylaws commonly also specify the number of members of the board, how they are to be chosen, and when they are to meet.

In an organization with voting members, e.g., a professional society, the board acts on behalf of, and is subordinate to, the organization’s full assembly, which usually chooses the members of the board. In a stock corporation, the board is elected by the stockholders and is the highest authority in the management of the corporation. In a nonstock corporation with no general voting membership, e.g., a university, the board is the supreme governing body of the institution.

So, where was Bank of America’s Board of Directors? Didn’t they see that Merrill had imploded. Why did they allow this travesty to take place? Shareholders had approved the merger on 5 Dec 2008, 16 days BEFORE Ken Lewis had said he was willing to back out. So they obviously had no say here.

Only the board of directors could have stopped Ken Lewis consummating a merger that should never have taken place or that had been re-negotiated. You should notice that this is the exact same run of events that we witnessed in the Countrywide transaction as well.

But, in the end, the deal went ahead as planned and Bank of America shareholders got their clocks cleaned as a result.

Sources
Shareholders Be Damned! – Alan Abelson, Barron’s
Board of directors – Wikipedia

Related posts:

• BofA saga continues as John Thain calls Lewis a liar
• BofA CEO confirms government coerced him into Merrill deal
• Ken Lewis is out as Chairman of Bank of America
• Ken Lewis defends Bank of America’s stress test results
• Mea Culpa: I was too bullish on the BofA-Merrill deal