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Good Reading -- February 2011

Quoted I'm having a good time reading the Financial Crisis Inquiry Report, but unfortunately that's because I have a perverse sense of humor. The entire thing follows the usual Washington track of bland reporting without any analysis or insight. They had subpoena powers, so it's kind of amazing that there wasn't more substantive new information unearthed. Anyway, at the least we got a strong nominee for Most Amazing Statement of All-time courtesy of our old friend Angelo Mozilo:

Mr. Mozilo, the commission said, described his company Countrywide as having “prevented social unrest” by providing loans to 25 million borrowers, many of them members of minority groups. Never mind that throngs of these loans have resulted in foreclosures and evictions. “Countrywide was one of the greatest companies in the history of this country,” Mr. Mozilo maintained, “and probably made more difference to society, to the integrity of our society, than any company in the history of America.”

Facts and Figures

  1. $160 million -- amount spent by Fannie and Freddie (i.e., American taxpayers) defending themselves and their executives from lawsuits alleging accounting fraud and securities fraud.

  2. Capgemini says there are 10 million people in the world with investable assets of $1 million or more (that's 1.4 bps assuming 7 billion people)

  • including everything (home, unvested pension assets, etc.) the total rises to 24 million (50 bps);

  • those 24 million people control $69 trillion in assets (a third of the global total),

  • >40% of them live in the U.S.

  • only 16% of the total inherited their wealth, while 47% were entrepreneurs


  1. "Secrets of Greatness: How I Work" -- I just came across this Fortune article profiling people's work habits. It's now pretty dated (March 2006), but still has some good nuggets (along with some wacko garbage). The discrepancy in technology competence and usage is amazing.

  2. Charts from the Economist comparing individual U.S. states to foreign countries in terms of population and economic size.

  3. "How the Recession Changed Us" -- huge chart with a lot of interesting facts and stats.

  4. "Japan Blocks the Young, Stifling the Economy" -- sort of a follow-up to last month's demographics articles. Also a perfect case study in what not to do.

  5. "Everything You Know About Fitness is a Lie" -- this obviously has nothing to do with business or investing, but the perspective is similar to value investing...OK, even that's a stretch, but it's still good reading for all you gym rats out there.

  6. "When Irish Eyes are Crying" -- after Greece, Michael Lewis made a trip to Ireland. It's too long and kind of lacking in places, but this is still an interesting portrait of a truly incredible bubble.


  1. "Blaming the Rat" -- Michael Mauboussin discusses the relationship between incentives and behavior. Make this one a priority.

  2. "The Rise of the New Global Elite" -- related to the income inequality article from last month, although this one's not as good. (I'd also beg to differ that George Soros is "arguably the most successful investor of the post-war era," but that's for another time.)

  3. "Taking the Government Out of Housing Finance: Principles for Reforming the Housing Finance Market" -- the latest white paper from Ed Pinto, the best thinker I've found on the topic.(See below for more on the topic.)

  4. "Ditch the Experts" -- an old but very worthwhile article on how worthless experts' predictions and forecasts really are.

  5. "The Value of Predictions..." -- same as above, except written by Howard Marks.

  6. "Pavlov's Bulls" -- Jeremy Grantham's latest letter. I didn't like or agree with parts of the "Pavlov's Bulls" section over the first five pages, although the analogy holds at a basic level. But skip to page six and his speech, "On the Importance of Asset Class Bubbles for Value Investors and Why They Occur" for some good stuff.

  7. "Bridge with Buffett" -- article from several years ago by Edward Thorp. Some random but interesting nuggets in here. More reading from Thorp's website here -- all very worthwhile and highly recommended.

  8. "Cracking the Scratch Lottery Code" -- this is pretty cool. Just when you thought the lottery couldn't suck any more than it already does, you find out that it's also easily plundered and a perfect vehicle for money laundering. But first, if you want to get depressed, here's the dumb money at this very large table: "The North American lottery system is a $70 billion-a-year business, an industry bigger than movie tickets, music, and porn combined. These tickets have a grand history: Lotteries were used to fund the American colonies and helped bankroll the young nation. In the 18th and 19th centuries, lotteries funded the expansion of Harvard and Yale and allowed the construction of railroads across the continent. Since 1964, when New Hampshire introduced the first modern state lottery, governments have come to rely on gaming revenue. (Forty-three states and every Canadian province currently run lotteries.) In some states, the lottery accounts for more than 5 percent of education funding. While approximately half of Americans buy at least one lottery ticket at some point, the vast majority of tickets are purchased by about 20 percent of the population. These high-frequency players tend to be poor and uneducated, which is why critics refer to lotteries as a regressive tax. (In a 2006 survey, 30 percent of people without a high school degree said that playing the lottery was a wealth-building strategy.) On average, households that make less than $12,400 a year spend 5 percent of their income on lotteries."

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  1. "The Sure Thing" -- great article from Bethany McLean about the debacle at BankUnited.

  2. Robert Shiller on Human Traits Essential to Capitalism -- a few interesting thoughts and some great book recommendations to boot.

  3. "Paul Samuelson's Secret" -- I don't know how much of a secret it was that Samuelson had a hedge fund, but I'd like to take this opportunity to again point out that one of the founding fathers of academia's "efficient markets hypothesis" (a) ran a hedge fund in the first place, and (b) repeatedly invested a ton of his own money in Berkshire Hathaway. Paging Austan Goolsbee! (As a sidenote, I asked Prof. Goolsbee when he wrote that article if he'd care to substantiate it with some actual facts, such as the exact purchase date and price for his share of BRK/B. He replied: "I think in 2003, maybe--it was around 2500 or something." That would be about $50 today, adjusted for the split. At $83, it's up ~66% from there, or roughly 2x the market return.When I asked late last year if he'd care to update his "analysis" of that investment, or the "Apprentice" situation he was so worried about, he didn't respond.)

  4. "SEC Hurt by Disarray in Its Books" -- wow, could the SEC be more incompetent? That's not a rhetorical question -- I honestly wonder if it's possible. Every time I think the SEC has hit rock bottom, something like this happens. But I'm sure the clowns in D.C. will keep saying the SEC just needs more money -- that will fix it! Nevermind that the SEC's budget of $1.1 billion has tripled in the past decade (a decade of Enron, Worldcom, Fannie and Freddie, Madoff, Stanford, Lehman, et al.). Nevermind that $1.1 billion equates to almost $300,000 in annual resources per employee. Nevermind that despite the cumulative billions allocated to the SEC over the years it can't even buy halfway decent systems and technology. Seems like the $15 million spent annually on office space in Manhattan that's been vacant for five years could buy some computers. What a joke.

  5. "How Great Entrepreneurs Think" -- very interesting article. Be sure to check out the link to the full study (embedded in the article and here).

  6. "Dimon Calls Fannie, Freddie 'Biggest Disasters of All Time" -- Amen to that! Also note that Treasury recently announced plans, finally, to wind down the GSEs by gradually phasing in higher guarantee fees. As usual, light on some key details, but hey, it's a big step in the right direction. The press release is here and the full presentation is here. Pretty amazing to read the government telling everyone what an abomination it created over several decades...

The Sure Thing

BankUnited's resurrection illustrates everything that went wrong in the housing bubble.

By Bethany McLean Posted Wednesday, Jan. 26, 2011, at 7:22 PM ET

On Jan. 24 BankUnited, a smallish thrift based in Coral Gables, Fla., filed a prospectus for an initial public offering. It was an astounding resurrection. Not quite two years earlier BankUnited had filed for bankruptcy, brought down by bad residential real estate loans concentrated in its home state of Florida. Subsequently BankUnited had been taken over by a consortium of investors—including big-name private equity firms Blackstone, Carlyle, W.L. Ross, and Centerbridge—that put in $945 million to recapitalize the bank. Now BankUnited and its investors are having their moment of triumph. The IPO is supposed to raise some $630 million, almost $500 million of which will go directly into the pockets of the private-equity firms—a stunning windfall, especially in these days of more meager returns for private equity.

If you took BankUnited's rebirth to be a parable about the private market's ingenuity and its capacity for renewal you would be missing the point. What it really illustrates is private equity's ability to make a fortune off a government guarantee. Most of the risk in the deal is borne not by the private equity firms, but by the Federal Deposit Insurance Corporation's deposit insurance fund. The FDIC expects to take a $5.7 billion loss on BankUnited, making this the second most costly bank failure ever, right behind the notorious IndyMac. Nor are BankUnited's customers getting any government handouts. Even as the FDIC shields investors from too much downside risk, one way the private equity firms can collect from the FDIC is by kicking people out of their homes. If you were searching for an example of what went wrong in the bubble years, you couldn't do much better than BankUnited.

BankUnited was founded in 1984 as a state-chartered savings association by Alfred "Fred" Camner, a Wharton graduate who also got a law degree from the University of Miami. The bank got a federal thrift charter in 1993 and became the largest financial institution headquartered in Florida. BankUnited was known as a conservative lender that focused on residential real estate. As other companies were being sold to industry giants in the consolidation wave that followed the savings and loan crisis of the late 1980s, BankUnited became known as a survivor.

The bank lost its reputation for sobriety during the more recent bank crisis. As lending fever took hold in the aughts, BankUnited executives dove into the riskiest of risky loans: so-called option adjustable rate mortgages. An option ARM allows the borrower to choose how much to pay every month. One of the borrower's options is a minimum monthly payment that allows the borrower to pay an amount that's even less than just the interest owed. That results in a phenomenon called "negative amortization," wherein the principal, instead of shrinking, actually grows because the unpaid interest gets added to the original principal amount. Once the balance of the loan reaches a certain level—usually 110 percent to 115 percent of the original principal—the minimum monthly payment option is withdrawn and the borrower is now required to pay in full a monthly mortgage that is suddenly a lot more money. Given that the borrower probably selected the minimum payment because that was all she could afford, you can see how this arrangement would usually end badly. According to a letter written by the law firm that represents the FDIC, BankUnited's mortgage portfolio more than doubled from $6.1 billion at the end of 2004 to $12.5 billion at the end of 2007, by which point option ARMs represented a stunning 70 percent of the total mortgage loans outstanding. By 2008, option ARMs represented 575 percent—yes, that's the right number—of the bank's total capital. (A bank's capital isn't the same thing as its assets; it's the money on hand to serve as a cushion in the event of losses.) By spring of that year, fully 92 percent of the option ARM portfolio was in a state of "negative amortization," meaning borrowers probably couldn't pay, according to an audit report later done by the Treasury's Office of the Inspector General. By the following year, the stock had gone into free fall, and the regulators stepped in.

The FDIC's lawyers alleged that the bank's former executives had committed "wrongful acts committed in connection with the origination and administration of unsafe and unsound real estate loans." BankUnited, the FDIC lawyers also said, had made "the special Option ARM lending product—appropriate for only a small portion of the population—available to every potential bank customer." (Camner, in a statement to theSouth Florida Business Journal, called these assertions "nothing more than unfounded speculation.") According to one confidential witness in a class action lawsuit, there were "numerous customer complaints about not understanding the effect of negative amortization." Another witness said that managers told loan officers to "sell Option ARMs to every customer, including those that could not afford them."

After the FDIC took BankUnited into receivership three separate groups submitted bids. The FDIC chose the investor consortium of Blackstone, Carlyle, and various others. The new owners installed as CEO John Kanas, a highly regarded bank executive who'd made a fortune after he built, and then in 2006 sold to Capital One Financial, North Fork Bank. Kanas reportedly invested $23.5 million of his own money in the BankUnited deal.

Why such competition to acquire a failed bank? Because the FDIC agreed to a "loss sharing agreement." "Sharing" is here a euphemism for "covering" because the FDIC will absorb 80 percent of any losses on BankUnited's entire existing loan portfolio, along with some other BankUnited securities. Should total losses exceed $4 billion, the FDIC will absorb 95 percent of the remainder! BankUnited's IPO prospectus says that even in a worst-case scenario, if all the assets covered by the loss sharing agreement lost 100 percent of their value, the bank "would recover no less than 89.7% of the [unpaid balance on the loans] as of the acquisition date." This, of course, explains why the FDIC expects to lose that $5.7 billion. (Technically this won't be paid by ordinary taxpayers because the FDIC's deposit insurance fund is funded by fees collected from banks. But the banks typically pass along such costs to consumers. And there have been worries that the fund, whose balance has declined precipitously, could go bust, at which point ordinary taxpayers would be on the hook.)

It's no knock on the highly skilled John Kanas and his new management team, who may yet provide a great deal of value, to observe that the resurrected BankUnited's chief market advantage right now isn't management brilliance but corporate welfare. "[A] majority of BankUnited's revenue is currently derived from assets that are covered by the loss sharing agreements," the IPO prospectus boasts. As a result, BankUnited is "one of the most profitable and well capitalized bank holding companies in the US," with an enviable 17.7 percent return on equity.

You could argue that, amid the current fragile recovery, banks need a lot of money right now so they can revive the economy by making new loans or restructuring old ones. But out of the $630 million that the BankUnited IPO is expected to raise, BankUnited itself will receive a mere $86.2 million. The rest of the money from the IPO will go to the sellers, who include Kanas and some other smaller investors. (Kanas will still have 5.5 million shares projected to be worth more than $100 million, and the private-equity firms will own stock projected to be worth some $1.4 billion, so they aren't bailing out.) The FDIC, which in a way is making the IPO possible in the first place, brings up the rear: It's expected to get a payment of $25 million.

The FDIC says this is a good deal. Jim Wigand, who oversaw many failed bank dispositions and is now director of the FDIC's Office of Complex Financial Institutions, points out that by statutory mandate the FDIC must limit losses to the deposit insurance fund. At the time the deal was struck, he says, this was the best option to achieve that goal. Indeed, the FDIC says it would have cost the fund an additional $1.5 billion to liquidate BankUnited rather than sell it. And BankUnited is required to participate in a loan modification program that the FDIC deems acceptable. When a homeowner can't meet mortgage payments, the bank is required to look into a modification and choose the "most effective loss mitigation strategy," according to its prospectus and the FDIC agreement. That means the bank must calculate which option would bleed the FDIC fund the least: a foreclosure, a short sale, or a restructuring. If foreclosure is the choice, the homeowner gets nothing—but the private equity firm still gets 80 percent of its losses reimbursed by the FDIC.

The FDIC's Wigand says that quite often foreclosure isn't the least costly option; loan modification is. In those instances, presumably mortgage holders stay in their homes. One person familiar with BankUnited says that in the long run loan modifications are more profitable to the bank than foreclosures. But here's what the IPO prospectus says: "Homeowner protection laws may also delay the initiation or completion of foreclosure proceedings on specified types of residential mortgage loans. Any such limitations are likely to cause delayed or reduced collections from mortgagors. Any restriction on our ability to foreclose on a loan, any requirement that we forgo a portion of the amount otherwise due on a loan or any requirement that we modify any original loan terms could negatively impact our business, financial condition, liquidity and results of operations."

In other words, when the government bailed BankUnited out, it didn't necessarily do homeowners delinquent on their mortgages any favors. Like Slate on Facebook. Follow us on Twitter.

Bethany McLean is a contributing editor at Vanity Fair and the co-author of All the Devils Are Here: The Hidden History of the Financial Crisis.

Robert Shiller on Human Traits Essential to Capitalism Yale economist Robert Shiller argues that rising inequality in the US was a major cause of the recent crisis, and little is being done to address it. He chooses books that give insight into human nature

You’ve chosen a fascinating topic, but quite a tough one to get one’s head around. It’s been the subject of discourse for centuries – or even millennia – so it’s very hard to summarise. If you did try to summarise it, what would you say you’re trying to get at with these book choices? I think that our economic system reflects our understanding of humankind, and that understanding has been developing, with especial rapidity lately. You have to understand people first before you can understand how to devise an economic system for them. And I think our understanding of people has been accelerating over the last century, or even half-century. You’ve started off with Adam Smith’s Theory of Moral Sentiments (which, incidentally, was also one of Karl Rove’s top five, when he did an interview with us earlier this year). It’s interesting that we have similar tastes – in that respect anyway. Tell me why you chose it. This is a remarkable book, because although in some cases it’s outdated, he has an interest in exposing human traits that are relevant to thinking about our daily lives, and he has, to me, a surprisingly insightful ability to do that. He doesn’t have any of the research methods of the modern social sciences; it’s all casual observation, and reading, I suppose, of other people and literature. But there are observations and conclusions in there that I never had before. They’re focused on a purpose, which is understanding how our society works and how people get a sense of mission, of purpose, that somehow makes things work as well as they do. Can you give a particular example of a trait where you thought, ‘Wow! I hadn’t thought of that before, but he’s so right’? Well, if you put it that way, it’s going to be disappointing – because your readers will say, ‘Yes I had thought of that before’! It’s a personal thing. But the thing he starts the book off with is sympathy. He uses the word sympathy – and he’s really focused on selfishness versus social consciousness. He sees that sometimes people are completely selfish, and that’s the problem for any economic theory – how to make a society work when people are completely, unremittingly selfish. But he also notes something else: he doesn’t use the word ‘empathy’, because ‘empathy’ hadn’t been defined yet. But it’s a very important observation about human behaviour, which is that we are wired to feel each other’s emotions and to have a theory of other people’s minds (not that he would have used the words ‘wired’ or ‘theory of mind’ either). The English word ‘empathy’ was coined around 1900, in a translation of the German word Einfühlung from a German book by psychologist Theodor Lipps. What it means is that it’s not that I feel bad because I observe that you are suffering, it means I actually feel your feelings. So people may often be selfish, but they also have empathy. Smith also talks about a selfish passion, which is a desire for praise. He argues that people instinctively desire praise, but that, as they mature, this feeling develops into a desire for praiseworthiness. This is a little bit different, and I haven’t seen it written about anywhere else. He points out that, suppose you were praised for something that you knew you didn’t do: it was a mistake, people thought you did something, so they’re praising you, but in fact you didn’t do it. It wouldn’t be such a good feeling – even if you could keep the lie going, and continue to receive the praise. He uses that to show that what people really want is to be deservedly praised. And that turn of mind, which develops as people mature, is what makes us into people with integrity. I think this underlies how the economy works. We start out with selfish feelings, which are intermixed with feelings of empathy for others, and then we develop this mature desire to be praiseworthy. I think it is central to our civilisation that people do that. Adam Smith uses the example of mathematicians. Mathematicians seem to be, in his observation, totally unconcerned with popular praise. That’s because they know they’re doing good work in their mathematics, but also that the public will never appreciate them for what they do. They live in relative poverty, and they don’t seem to care about praise, except from their fellow mathematicians. And yet they’re doing all of this work which benefits humanity. This is something that happens in our society, and it makes the system work. He doesn’t go on, in this book, to explain how this develops into something that works. But this does mark the beginning of the thought process leading to his later book, The Wealth of Nations, in 1776. Doesn’t The Wealth of Nations focus more on the negative aspects of human nature – the self-interest as opposed to the sympathy? I didn’t see a contradiction between the two books. The Wealth of Nations is realistic about human behaviour and argues that a reasonably free enterprise system works well because it combines the different, sometimes conflicting passions of man, into something that is well-directed. Isn’t Theory of Moral Sentiments also the book where Adam Smith first uses the term ‘invisible hand’? I once did a search for the ‘invisible hand’, and it was actually used before Adam Smith, but not in an economic context. I think Adam Smith was just using an expression of his time. I wouldn’t attach a whole lot of importance to it. My recent book with George Akerlof is Animal Spirits, and we say Keynes used that term. But he used it in a totally off-hand manner. Everyone was using it; any literary person knew that expression.

The Theory of Moral Sentiments

Adam Smith


Your next book is The Passions and The Interests: Political Arguments for Capitalism Before its Triumph, by the great Albert O Hirschman. This is a great book. It traces the history of an idea – an idea that is central to our whole civilisation today. The idea is that human nature is basically unruly and destructive, or has the potential to become so, but that we’ve designed a society that sets a space for this kind of impulse, where it’s acted out in a civilised manner – and that’s capitalism. So when we reflect on some of the horrors of capitalism, we have to consider that things could have been much worse if we didn’t have this system. Our fights would have been on real battlefields, rather than economic battlefields. That’s a theory, that’s an idea that really led to the adoption of capitalism, or the free enterprise system, around the world. Capitalism had quite a tough path toward acceptability, I think. Traditionally, making money was viewed as unseemly, and avarice considered a deadly sin. In medieval times, the dominant intellectual tradition was one of sin and the avoidance of sinful behaviour; lust for power or wealth were unambiguously bad things. Even in a feudal society, such passions were acknowledged by society as, in some sense, legitimate, but the view didn’t have any authority. In the Renaissance, the authority of these self-denial concepts began to recede. Hirschman talks about Machiavelli representing a different ideal (of sorts) that was emerging. But it wasn’t until the early 1700s that we saw clear thinking about really having a system that becomes stable in a military sense, because you develop a business class that has an interest in the political stability of the system, as they fight it out for their economic interests. He emphasises the philosophy of the French writer Montesquieu and the Scottish writer James Steuart. They both wrote in the mid-1700s about the ideal of a merchant society that would be orderly and looking out for the material interests of people. Was communism a big setback to this very positive view of capitalism? Hirschman doesn’t emphasise communism, though he does emphasise that all along, during this course of history, there were critics of capitalism. Montesquieu and Steuart didn’t have the final answer. Marx was obviously among these critics, but the kind of criticism that Hirschman emphasises is a kind of criticism which may be in Marx but is not a major theme. The criticism is that capitalist society is so good at reducing our passions to passions about business, that we become a kind of vulgar, lowbrow society – it doesn’t serve the spiritual interests of people.

The Passions and the Interests

Albert O Hirschman


Your last three picks are all very recent books. Tell me about Nudge. We’re now coming up to 2008, when Richard Thaler and Cass Sunstein published this book. It looks quite a bit different from the first two in that it reflects much more modern psychology. I admired Adam Smith for his personal observations, but there was no experimentation, there was no real modern psychology in it. What Sunstein and Thaler emphasise is a lot of principles of psychology that can only be understood with regard to actual experiments. So they talk about things like anchoring, availability, representativeness, heuristic optimism, overconfidence, asymmetry of appreciation of gains versus losses, status quo bias, framing, self-control mechanisms – all the things that we’ve learned about. We’re way ahead of Adam Smith now in our understanding of people, and that suggests a different model for our economy. Nudge doesn’t present itself in a grandiose way at all, but it’s a very important book. It really is a different model of our economy, and how government should be involved. How should we be organising our economy post-crisis? The book points out that the free enterprise system emphasises choice. The classic theory of capitalism is that information is decentralised – it can’t be centralised – and so the important thing is that people should be, as Milton and Rose Friedman put it in their 1980 book of that name, ‘free to choose’. If people are free to choose, that will allow the economic system – and this is Adam Smith again – to adjust its activities to take account of all of their diverse information. But what Thaler and Sunstein point out is that individual people are not experts in making any of these choices. They succumb to these psychological errors. As a result, they say that what our society should be doing is providing what they call ‘choice architecture’. The government, which in their model is benevolent, sets up rules that encourage people to make the right choices, that nudge people to make the right decisions. But in cases where people have specific information that makes them want to do otherwise, they can. Can you give an example? I could give you the first example in their book, which is the ‘Save More Tomorrow’ scheme. The problem they identify is that most people – at least in the United States, but I’m sure in other countries as well – don’t save enough for their retirement (or whatever) and that that failure to save is acknowledged. A survey of people in the United States asking, ‘Do you think you are saving enough?’ found that most people said, ‘No, I’m not.’ So it’s like dieting, in that most people wish they were slimmer than they are, but they can’t quite do it. Similarly, they wish or think they should be saving more, and they can’t quite do it. That means we ought to offer policies or programmes that nudge them, that help them. In the case of dieting, you don’t leave bowls of candy out all around the house if you know you’ll be tempted by them. Our society has to try to nudge people towards other virtues, like saving. The ‘Save More Tomorrow’ plan is thus a very ingenious idea: you offer people the option of signing up for a programme that will withhold from their pay cheque any future pay increases. So you sign up today and you’ll be saving more tomorrow. And experiments with this show that it does indeed raise the saving rate. So this is the kind of thing the government needs to think more about doing. Abject acceptance of Adam Smith’s principles suggests that we should provide people with the most elaborate choices. The naive assumption has been that people can handle those choices, which isn’t right. But, instead, the government has a different role. It’s still a free enterprise system, but it’s one that has nudges in various places. But it involves politicians being sensible, rather than just trying to get re-elected. Cass Sunstein, one of the two authors, is now in a high position in the Obama administration, and some of their proposals have made it into legislation. I’m not a political scientist – government is imperfect, and it reflects special interests. But sometimes it triumphs, sometimes it does work. You bring in experts and they point out that we need to put chlorine in the water supply, and we do it! It does work. Sunstein and Thaler’s proposals will probably be somewhat adopted. But in the savings example, isn’t there something cultural going on as well? The more capitalist a country is, the worse it seems to be at saving. I lived in China, where people might be earning RMB 1,000 a month, and yet somehow they managed to have RMB 30,000 in their savings account. It’s an interesting phenomenon, and it may not be permanent. I think it may reflect the stage that China is going through. It used to be that the Japanese had a higher saving rate. In China, they have a sense of epic transformation right now. It’s a kind of patriotic feeling, as well as a sense of uncertainty, that encourages saving. It’s not the capitalist difference, I don’t think. You’re suggesting that China saves more because of some cultural values that are at odds with capitalism? I think culture plays a big role in our attitude to money. I’m originally from Holland, where we like being thrifty. That’s a stereotype of the Dutch, isn’t it? That they’re stingy? It’s true. You may have a million dollars in the bank, but you’ll still take a bus rather than a taxi. I bet it’s not true. Because if the Dutch had been conspicuous savers for centuries, they would be vastly richer than any of us. It would accumulate over centuries. I like to use another example from Holland, which is that home prices in Amsterdam, according to Piet Eichholtz at Maastricht University, haven’t gone up – they’re no higher in real terms today than they were 300 years ago. So, I’m sorry, but you can’t be right. The amazing thing about saving is that if you really save a lot and you do it for a hundred years, reinvesting interest, you will get awfully rich, and that’s a fact. The best example of that is not Holland, it’s Singapore, which has had a government imposed saving plan. In Singapore, they have a mandatory saving plan that has propelled that nation up rapidly. It’s just arithmetic. If you save and invest, it adds up, because of the power of compound interest. So in this context, Nudge is advocating a libertarian style of paternalism – a free-choice version of what Singapore is doing. Yes, that’s right – by nudging people, rather than caning them.

Nudge: Improving Decisions About Health, Wealth, and Happiness

Richard H Thaler and Cass R Sunstein


Your next book is Fault Lines, by Raghuram G Rajan, a former chief economist at the IMF. I admire this book because it’s not superficial. It goes for the ultimate causes of the economic crisis we’ve been through. Most people tend to focus in on something approximate. I don’t know that I exactly agree with this emphasis… What was the ultimate cause of the crisis, in Rajan’s view? The title of his book is Fault Lines – so it’s plural. He notes that it’s not one cause; he actually has several different classes of causes. The first of them is political, and the politics that lead to rising inequality. That’s been a trend in recent years in most nations of the world. Inequality has been getting worse, particularly in the US, but also in Europe and Asia and many other places. One thing that this has done is it has encouraged governments, who are aware of the resentment caused by the rising inequality, to try to take some kind of steps to make it more politically acceptable. He gives other examples as well, but historically, that has often taken the form of stimulating credit: instead of fixing the problems of the poor, lending money to them. He has a chapter entitled ‘Let them eat credit’. The US in particular has stimulated the housing market, it has subsidised lending to people, which drove up home prices in an unsustainable way. And there wasn’t that much concern about, or understanding of, the sustainability of this. That’s his first fault line. The second one is trade imbalances. Here he looks in particular at the developing world, notably China, that has an export-led growth policy. The Chinese noted that the export-led growth model was a huge success for other countries like Japan, Korea, Singapore – and so they want to follow that model. But it involves them running a trade surplus – and so, by implication, the rest of the world has a trade deficit. Advanced countries like the US then become dependent on this constant inflow of capital. That’s another imbalance which is also fundamental. The third set of fault lines comes from a clashing of systems. In the US, and in advanced countries, there is more of a sense of trust, and advanced financial solutions can be achieved better than in a developing world where people are still mistrustful. In the developing world, people prefer to make only short-term loans because they don’t trust tying up their money. It often needs to be denominated in foreign currencies so they won’t be devalued on, and they like to lend to local banks rather than to international ones because they know the local banks will be bailed out if there is ever a crisis. But that means the economies are more fragile. He’s talking about the Asian financial crisis in particular, of course – but there are other examples. Because people can withdraw their money quickly, there’s too much reliance on ‘too big to fail’, so the economies don’t function right. Those are the main fault lines that he talks about, and these are deep and difficult problems that don’t have easy solutions. And to what extent do you agree that these are the causes of the crisis? They are part of the causes. This is a theme that I stressed in my 2000 book, Irrational Exuberance – any big crisis always looks mysterious, because it doesn’t have a single cause. It has multiple causes, and the reason it’s a big crisis is because a number of different events chanced to happen all at the same time and created the extremeness of the event. In my book, I acknowledge these same causes that Rajan talks about, but not with his eloquence. I also emphasise something that is only secondary in his book, and that is the kind of social epidemic that happened, that produces bubbles in speculative markets. So we had a speculative bubble in the housing market in many advanced countries in the early 2000s – as well as in developing countries. I don’t think those really can be explained entirely in terms of these fault line theories. ‘Let them eat credit’ was a factor, but I think that there was something else. There was a change in thinking that explained both the bubbles and the public policy. It’s something more permanent, more sociological. One thing that economists are very poor at is sociology. They don’t read about it and they don’t think about that discipline. But sociology tells us that our culture has its own internal dynamics and drift and we have to appreciate that it can drive things, it can change things. That was the theme in my own book, Irrational Exuberance: that there were cultural changes that had many dimensions that brought on this crisis. I even brought in some things that might seem peripheral to some people, like the rise of a gambling culture, or a winner’s culture. I didn’t say ‘winner takes all’ – but it’s a culture where we tend to admire the winners, and we have less sympathy with the poor or the unsuccessful. It’s a zeitgeist. I may be getting down even more to ultimate causes here than Raghuram did, but I very much admire his book. It says things that are not in my book, that I hadn’t thought of before. If you were in Washington now and you could implement whatever you thought was necessary to prevent another crisis from happening, what would you do? I’ve written several books about this! First of all, I don’t think this crisis is the end of the world. It is serious, but I wouldn’t do anything so radical as to hamper our engine of growth, which is capitalism. In fact, in many ways, I would like to expand it – capitalism has its own solutions to its own problems. Risk management may have failed us recently but the general principles are valid. So a lot of the things I talk about doing involve expanding our markets. For example, I advocated – and we did actually create – a futures market for single family home prices. I think that would actually help stabilise home prices. We have that going on the Chicago Mercantile Exchange, but it’s not a success yet. But beyond that, let me talk more in sync with Raghuram’s book. I think inequality is a huge emerging problem, and that our society has to think about dealing with it in a constructive and real way – not through ‘Let them eat credit,’ not through wishful thinking. We have to understand how we get inequality and what we can do about it.

Fault Lines: How Hidden Fractures Still Threaten the World Economy

Raghuram G Rajan


Which brings us to your final book, Winner-Take-All Politics: How Washington Made the Rich Richer and Turned its Back on the Middle Class, by Paul Pierson and Jacob Hacker. This is a new book – it just came out. It’s about rising inequality and it traces back to fundamental causes. I like books that get back to ultimate causes and that think like social scientists about these causes. The question is, ‘Why is inequality getting worse in so many different countries?’ This book particularly focuses on the US. The traditional answer is – well, there are a number of traditional answers, but the most prominent among them is this idea that in a modern economy there is a skill bias in technical change. Our computers and communications have led to a winner-take-all society, where only the really smart can make money. Everyone else is technologically obsolete, with all these computers that are replacing people. It is, I think, a very important theory. But Hacker and Pierson point out that it doesn’t really fit the recent data. In the US, we’ve seen a rapid concentration of wealth at the extreme high end. The top tenth of a per cent of the top hundredth of a per cent of the population is getting wealthy very fast. They point out that this is not true in Europe, and yet the economies are very similar and growing at similar rates. If the technology is the same, why would there be a difference at the extreme high end? And they argue that the answer is really political. There have been political changes in the US that allow the extreme high end to garner more wealth. Ultimately, it represents a failure of our society to take account of the fact that the extreme high end can lobby and can organise for its own interests, and we’ve let it happen. So you feel inequality is central to what has gone on and that we really need to address that? Yes – and there is very little concrete talk about addressing it. It’s a very difficult problem. You might think that in a system of majority voting, the middle class and the poor would dominate and would prevent this kind of inequality from developing. But it hasn’t been that way – it’s been even less so that way lately, especially in the US. And once again, we have to attribute that to some change in our zeitgeist, in our way of thinking about what people view as important. That’s an underlying theme in all of these works, going back to Adam Smith. I don’t think he uses the word inequality very much – but it is about poverty and the alleviation of poverty. In Adam Smith, of course, the wealthy tend to be the kings and lords… Rather than hedge fund managers… They did have some wealthy business people. That’s an interesting question: in the 18th century, who were the super-rich? It doesn’t call to mind any famous, super-wealthy business people. But looking down your list of books, I was trying to figure out…is greed good? Isn’t that a line from the movie Wall Street? Gordon Gekko? Or is it not so good after all? That’s what Adam Smith is talking about in the Theory of Moral Sentiments. This is the dialogue. You’re right to use that very direct phrase to summarise the question. The idea of medieval Christians was that greed is a positive, unadulterated evil, and you must go to confession every time you have this feeling. But it led to a more advanced knowledge. We are people, and we have certain psychological traits and emotions, some that we call greed, that are programmed into us by forces of evolution. We are greedy in a way. So are all the other animals. I watch birds fighting over food, they’re greedy and they fight each other. But they usually don’t seem to get into too bad a fight. That’s a thing that develops in society and we have to understand it. But greed, in our language, is actually a name for excessive self-centredness. So it is, by definition, bad. But some degree of self-interest is just part of our society. I’m actually writing another book now with George Akerlof, where we want to get into some of these issues, but it won’t be out for years… Tell me more. The question that has always bothered people is whether society is really optimising our spiritual life, our sense of community, in the optimal way. There may be some nudges that we need, even if we remain in a capitalist system, and I think this is what Akerlof and I are trying to get at. What kind of nudges? We have to understand human psychology; we have to accept an impulse towards selfishness, which is the reality. We cannot change that: it’s through millions of years of evolution that this has come. And yet, we do have an engineered environment. Our economy is an invention, a reaction to past crises and depressions, and we can try to coordinate it. We can’t change people’s emotions, so part of what we do is we tolerate greedy behaviour, within limits. If it follows certain rules, and if there’s a certain integrity that underlies it, we tolerate it. Attitudes can vary widely, though. Here in Manhattan, there are plenty of people who can think of nothing better than becoming a billionaire, whereas if I suddenly became phenomenally rich I think members of my family would find it not only unnecessary but also rather unseemly. Why is there that difference? Is it my Dutch Calvinist roots? These are deep issues that interest me a lot. And what do these people do with the billion dollars? That’s the question. What can anyone do with a billion dollars except give it away? I’m referring to Bill Gates’s Giving Pledge, going to billionaires around the world and telling most of them to give it away. Are you religious? My parents raised me as a Methodist, but my Sunday school teacher complained I had a chip on my shoulder. I thought he was a moron, so I wasn’t very good at Sunday school. I didn’t think much of the preachers. But I suppose I have spiritual feelings. So how did you get interested in all this in the first place? I think the year was 1958, when I was 11 years old, or maybe a little after that. I read Galbraith’s The Affluent Society and it had a great impact on me. It talks about deep issues: we have rapidly growing wealth, but what is it doing for us? I don’t know that I agree with him, but there’s some element of truth to what he says, that we end up being manipulated by marketers and corporations, who try to create demand for things we don’t need. And Galbraith stuck with you and influenced your life’s work? Yes, I think that’s right.

Winner-Take-All Politics

Jacob S Hacker and Paul Pierson

Paul Samuelson’s Secret

The last two volumes of Paul Samuelson’s collected papers appeared this month, edited by Janice Murray, his assistant for twenty years. As far as I can tell, the only mention of Commodities Corp. to be found anywhere in the seven volumes appears in the final one, in the last serious piece he ever wrote, which appeared originally in Volume 1 of Annual Review of Financial Economics, two years ago, at a time when PAS knew full well he was slipping out the door. (He died in December 2009.)

“I skip here my long years as activist charter investor and Board of Directors member for Commodities Corporation of Princeton,” he writes in “An Enjoyable Life Puzzling over Modern Finance Theory.” “Space does not allow me to go into that intricate story.”

Somewhere, in the letters, perhaps, or in interviews with various colleagues that were taped and tucked away, further details of a great case study may be waiting for a scholar. Then again, maybe not. Samuelson left his share of loose ends. Reflections on his role in Commodities Corp. may be among them.

A good thing, therefore, that in the meantime we have “Paul Samuelson’s Secret,” chapter three in More Money Than God: Hedge Funds and the Making of a New Elite, Sebastian Mallaby’s very interesting book about the origins and recent history of the hedge fund industry.

It turns out that the great MIT economist was influential in the creation of one of the earliest and most influential hedge funds. Launched in 1970, Commodities Corp. blazed a trail of extremely high returns throughout the 1970s and early ’80s, before disappearing in various pieces into Bermuda mailboxes and Goldman Sachs. Many of its star traders – Bruce Kovner of Caxton and Paul Tudor Jones, chief among them—formed successful hedge funds of their own. Samuelson thus had a ringside seat at the birth of an influential industry that is still only poorly understood.

About the same time, he invested a substantial amount in shares of Warren Buffet’s Berkshire Hathaway Inc. It was in 1970, too, that he won the Nobel prize in economics, the second to be awarded. Long famous for the fortune that his pioneering textbook earned him after 1948, it turns out that Samuelson may have made more money as an investor than as an author. He was both smarter and richer than is generally understood: as an investor, a bigger winner, perhaps, than the more volatile John Maynard Keynes.

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In 1965, Samuelson published a version of the efficient-markets hypothesis — a world in which all reliably predictable events are priced right, and only surprises would remain; there would be no easy pickings on Wall Street. About the same time, Eugene Fama published his own formulation, and the idea that stock prices were properly described as a “random walk” – that it was all but impossible to outperform the market — was on its way to becoming firmly established.

Not that Samuelson himself took the finding literally. He later explained, “Experience makes me think that a few folk do have an intuitive flair for making money by sensing patterns of momentum.” Others, he said, are good at “figuring out which fundamentals are fundamental and which new data are worth paying high costs to get.”

But the services of such wizards, when they could be found, would not come cheap, he warned. And even the hottest hand would sometime turns cold. Someone proposed an experiment to Samuelson – Mallaby doesn’t say who – and the idea of Commodities Corp. was born. As one of two original venture investors, Samuelson put up $125,000 – real money back then.

The key figure was F. Helmut Weymar, whose prize-winning thesis on predicting cocoa prices Samuelson had supervised a couple of years before, along with MIT finance professor Paul Cootner. “I thought random walk was bullshit,” Weymar told Mallaby for More Money Than God. “The whole idea that an individual can’t make serious money with a competitive edge over the rest of the market is wacko.”

Weymar had gone to work for Nabisco, buying its cocoa beans. After some signal successes, he and Frank Vannerson, a Princeton PhD who specialized in predicting wheat prices for Nabisco, decided to go into business on their own. After talking to Samuelson, they raised $2.5 million, including the economist’s five percent, and, opened for business in a bucolic Princeton farmhouse with seven professionals (including Cootner) and six support staff.

Mallaby chronicles the adventures of the fledgling firm: computers and seminars, horseshoes and softball games, and, above all, ups and downs (the title of Irwin Rosenblum’s book about those years). By 1971, Commodities Corp. was on the ropes, its remaining capital a meager $900,000: one more false step would be its last. Gradually Weymar shifted gears, from beating the market with computers alone to following trends; from gauging investor psychology to betting on macro trends.

Kovner joined the firm, after a stint as a cab driver in Cambridge, Mass., having dropped out of his studies for a political science PhD. A chance conversation with a friend prompted him to read up on derivatives markets; be borrowed $3,000 on his Mastercard and turned it into $22,000 in a few days. After Kovner answered an ad in a financial publication, Michael Marcus, the red-hot trader who had placed the ad, called Weymar and announced, “Helmut, I have in my office the next president of Commodities Corp.”

By the end of the 1970s, Mallaby writes, Commodities Corp had become a prodigious success, its capital grown to $30 million, its profits in 1980 $42 million after $13 million in bonuses. Many of its traders were earning returns of fifty percent a year. The firm’s heyday, however, was passing. New strategies were being devised. Wall Street firms sought to lure away its top talents. Its hardest-won secrets were gradually becoming common knowledge. In the wings of the profession was a little-known macro-trader in London, a former philosophy student named George Soros — chapter four, “The Alchemist,” in More Money Than God.

It’s a great story. The Mallaby book, meticulously sourced, is full of wonderful stories about this brave new world of Long-Run Positive Alphas, as those hedge fund operators whose risk-adjusted returns regularly beat the market are sometimes known.

Meanwhile, by the mid-1970s, John Bogle had founded the Vanguard Group, to offer index funds to those ordinary investors who chose to buy the market as a whole rather than try to beat it. Samuelson declined to join the Vanguard board, not because he didn’t approve but because he would thus remain free to enthuse about its products – “the only mutual fund group dedicated solely to its clients’ interests,” as he described it – more vehemently than had he been an insider. That’s in “An Enjoyable Life,” too.

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Economists, at least those of a certain ilk, have always traded on their own accounts; otherwise, they say, what would be the point? In a memorial essay for his fellow Midwesterner Cootner (who died in 1978 of a heart attack at 48), an article that is not included in his Collected Papers, Samuelson recalled one season of soybean mania in the late 1940s. The bulls of the MIT economics department on the third floor of their building and the Sloan School bears on the floor above could have saved considerable commissions by dealing directly with one another; instead, he said, perhaps all of them lost money.

Why trade in each new market as it came along? To avoid “the kind of naïveté that so often mars the works of those who analyze scars but never felt a wound,” Samuelson answered. “If Casanova is not the definitive authority on sex, neither is a eunuch.”

But why secret – or rather, an unspoken role? Samuelson’s involvement with Commodities Corp. was known around the department, but it became no part of his legend in the outside world. When Weymer took the stage at Samuelson’s memorial service last year, along with MIT president Susan Hochfield and eight well-known economists, his presence surprised more than a few in the audience. The answer seems to be that Samuelson’s low profile as an activist investor made it easier to gather information.

Field work is an old if little-honored tradition in economics. Just the other day, Malcolm Rutheford, of the University of Victoria in British Columbia, described how John Fitch spent ten months visiting Pittsburgh steel mills at the turn of the twentieth century, often guided by workers themselves – in order to document the 12-hour, seven-day-a-week schedule (including a day of round-the-clock labor every two weeks in exchange for 24 hours off two weeks later!) that was at the heart of the bitterest union disputes. Similarly economist Frederick Mills went undercover as a hobo in California, joined the IWW, rode the rails, picked oranges, slept in haystacks.

“What I did,” Samuelson wrote of his Commodities Corp. experience, “was become a useful monitor of traders.”

What did he learn? He learned that most stock-pickers were not very good; hence his growing and widely-communicated enthusiasm for index funds. He learned not to influence with his macroeconmic view the good traders with whom he dealt, for the best of them somehow had the knack to go beyond what was already in the financial pages. In time, he learned how at least some of them did it.

A favorite story, late in life, had to do with the huge profits David Ricardo reaped after the Battle of Waterloo, the details adduced by Ricardo’s biographer, Piero Sraffa. The bond trader had an observer stationed near the battle. Once the outcome was clear, he galloped quickly to where a packet ship was waiting. So Ricardo in London received the early news, and conveyed it to the British government.

Then he went down to his customary chair at the Exchange – and sold! Other traders, suspecting the worst, sold too, the prices of Treasuries tumbling, until at last, Ricardo reversed course and bought and bought and made a killing, his greatest coup ever, one that put even the Rothschild brothers in the shade.

“If not illegal, an ethical purist would have to fault Ricardo for in effect profiting from his own spreading false rumors,” Samuelson wrote. “In this millennium that might be something to criticize or even to litigate.” Even so, the ploy was not unheard of in the present day, he would confide, given that new news, not yet digested, was what sent markets spinning.

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The MIT Press worked overtime in order to produce the last two volumes of The Collected Scientific Papers of Paul A. Samuelson in time for the institute’s 150th anniversary, which kicks off this month. The tomes’ design was long ago modeled on The Scientific Papers of J. Willard Gibbs, the great nineteenth century physical chemist who was among Samuelson’s heroes.

In nearly 2,100 pages, the two new volumes contain a trove of work published since 1986, often in out-of-the-way journals, and three early pieces not included in previous volumes: a 1960 adumbration of the efficient-markets papers, “Economic Brownian Motion”; a foreword to The Political Economy of the New Left, by Assar Lindbeck (1971); and an uncharacteristically harsh 1968 review of Beat the Market, by his MIT colleagues, E.O. Thorp and S.T. Kassouf, with a preamble added in 2009.

(Thorp’s Princeton-Newport Securities, founded in 1969, was for many years Commodities Corp.’s main rival as a quantitative hedge fund, though it pursued very different strtegies. “To make stew, first catch your rabbit,” Samuelson wrote in 1968, by way of expressing doubt that a perfect hedge could be arranged. “My 1968 nihilism prepared me for the 1998 Long Term Capital Management debacle after it happened, but not before.”)

Most of the papers in Volume 6 concern, in one way or another, the history of economic thought. Volume 7, in particular, with all Samuelson’s late papers on investing, and a rich trove of biographical material on various teachers, friends, and rivals, while not cheap, at $90, is for a certain kind of person a bargain.

S.E.C. Hurt by Disarray in Its Books


WASHINGTON — If a company’s financial reporting were so bad that its auditor had pointed out significant weaknesses in its accounting for seven years running, the Securities and Exchange Commission would most likely be all over it.

But what if the company were the S.E.C. itself?

Since the commission began producing audited statements in 2004, the Government Accountability Office has faulted its reporting almost every year. Last November, the G.A.O. said that the commission’s books were in such disarray that it had failed at some of the agency’s most fundamental tasks: accurately tracking income from fines, filing fees and the return of ill-gotten profits.

“A reasonable possibility exists that a material misstatement of S.E.C.’s financial statements would not be prevented, or detected and corrected on a timely basis,” the auditor concluded.

The auditor did not accuse the S.E.C. of cooking its books, and the mistakes were corrected before its latest financial statements were completed. But the fact that basic accounting continually bedevils the agency responsible for guaranteeing the soundness of American financial markets could prove especially awkward just as the S.E.C. is saying it desperately needs money to increase its regulatory power.

Like the rest of the federal government, the S.E.C. is operating without an increase in its budget, which was $1.1 billion last year. With President Obama talking about extending the freeze and lawmakers continuing their criticism of its embarrassing performance before the financial crisis, the agency’s prospects for more money appear bleak.

That has ominous implications for investors. The S.E.C.’s technology systems, for example, lack the ability to perform sophisticated analysis of large batches of financial material. As a result, a Congressional report says, S.E.C. analysts sometimes resort to printouts, calculators and pencils. While investigating the “flash crash” of May 6, 2010, S.E.C. computers were so strained by the crush of data from just one day of trading that it took three months to figure out what had happened.

In recent weeks the commission has reduced travel to examine regulated companies, and it cannot fill many jobs vacated in the last year. Meanwhile, Mary L. Schapiro, the S.E.C. chairwoman, says that to carry out the Dodd-Frank Act, the regulatory overhaul signed by Mr. Obama last year, the commission needs 800 additional employees, more than a 20 percent increase over its 3,750-person work force.

Still, by several measures, the S.E.C. is far from starved for money. Its $1.1 billion budget in 2010 was 15 percent higher than the $960 million it received the year before — and nearly triple its $377 million budget in 2000.

Representative Spencer T. Bachus, the Alabama Republican who is chairman of the House Financial Services Committee, said last week that the tripling of the S.E.C.’s budget occurred in a period that included some of the agency’s biggest failures — the Ponzi schemes of Bernard L. Madoff and R. Allen Stanford and the collapse of Bear Stearns and Lehman Brothers.

Ms. Schapiro, an Obama appointee, came to the agency after all of those missteps. She has directed sweeping structural changes, increasing enforcement and pouring money into updating its technology infrastructure. To address the shortcomings in financial reporting described by the G.A.O., she decided to outsource those tasks to another government agency.

In an interview, Ms. Schapiro said that she understood the skepticism over her call for more resources but she noted that Dodd-Frank significantly expanded the agency’s responsibilities over hedge funds, derivatives and credit ratings agencies.

“When you look at the composite picture of how the agency has changed and I hope will continue to change,” she said, “I think we’re really poised to be that agile regulator that the country has a right to expect of us.”

Her efforts have attracted some support as well as warnings of the consequences of cutting the S.E.C.’s budget now.

“This is a serious threat to financial reform,” said Representative Barney Frank, the Massachusetts Democrat who steered Dodd-Frank through the House. “What you get is a disproportionate assault on our ability to regulate the financial industries.”

Ms. Schapiro has received plaudits for her reforms from some former S.E.C. officials, who say that the agency has for years fought battles over its budget. “She’s done an awful lot that people should be proud of and optimistic about,” said Annette L. Nazareth, a partner at Davis Polk and a former S.E.C. commissioner and division director.

At times during the debate over the Dodd-Frank legislation, it looked as if the S.E.C. was going to get a solution to its budget problems. The agency has long been a net contributor to the United States Treasury; last year it collected $300 million more in fees from Wall Street than it cost to run the agency. The difference went to the Treasury.

Efforts to allow the agency to use all of the money it collects and bypass Congressional appropriations died during the Dodd-Frank debate, despite the additional responsibilities the law gave the S.E.C.

“It’s almost as if the commission is being set up to fail,” said Harvey L. Pitt, who was S.E.C. chairman from 2001 to 2003 and who now is chief executive of Kalorama Partners.

Dodd-Frank did authorize a doubling of the commission’s budget, to $2.25 billion, over the next five years — without providing the money for it. It also authorized the commission to spend as much as $100 million beyond its operating budget for new technology systems.

Ms. Schapiro said that buying new technology was crucial because it helped to attract specialists in mathematics and financial systems that the S.E.C. needed to help police the rapidly evolving financial markets.

“It’s very hard to attract great people if they think that there’s not going to be the opportunity to use technology to get the job done, which can make us so much more efficient,” she said.

Anticipating new employees, the S.E.C. has been busily leasing more office space — an effort that has drawn the attention of the agency’s inspector general. Last week, he began investigating the S.E.C.’s decision last July to lease more than a million square feet of prime office space in Washington, one of the largest federal leases in a decade.

Within a few months of that decision, its prospects for bigger budgets fading, the S.E.C. began negotiations to return some of the leased space. The latest inquiry is the second investigation of the S.E.C.’s leasing practices in a year. Last September, H. David Kotz, the inspector general, reported that a lack of adequate policies led the agency to make lease payments that could have been avoided, including more than $15 million for space in Manhattan that no S.E.C. employees have occupied in the last five years.

Agency officials say the space was leased after 9/11, when its offices were demolished, but soon proved inadequate for the New York operations, which moved to larger offices.

Lease payments also figured in the G.A.O.’s assessment of the agency’s financial reporting. The auditor found that the agency, in a preliminary version of its annual report, had understated its lease payments by $40 million.

How Great Entrepreneurs Think

Think inside the (restless, curious, eager) minds of highly accomplished company builders.

By Leigh Buchanan | Feb 1, 2011

What distinguishes great entrepreneurs? Discussions of entrepreneurial psychology typically focus on creativity, tolerance for risk, and the desire for achievement—enviable traits that, unfortunately, are not very teachable. So Saras Sarasvathy, a professor at the University of Virginia's Darden School of Business, set out to determine how expert entrepreneurs think, with the goal of transferring that knowledge to aspiring founders. While still a graduate student at Carnegie Mellon, Sarasvathy—with the guidance of her thesis supervisor, the Nobel laureate Herbert Simon—embarked on an audacious project: to eavesdrop on the thinking of the country's most successful entrepreneurs as they grappled with business problems. She required that her subjects have at least 15 years of entrepreneurial experience, have started multiple companies—both successes and failures—and have taken at least one company public.

Sarasvathy identified 245 U.S. entrepreneurs who met her criteria, and 45 of them agreed to participate. (Responses from 27 appeared in her conclusions; the rest were reserved for subsequent studies. Thirty more helped shape the questionnaire.) Revenue at the subjects' companies—all run by the founders at that time—ranged from $200 million to $6.5 billion, in industries as diverse as toys and railroads. Sarasvathy met personally with all of her subjects, including such luminaries as Dennis Bakke, founder of energy giant AES; Earl Bakken of Medtronic; and T.J. Rodgers of Cypress Semiconductor. She presented each with a case study about a hypothetical start-up and 10 decisions that the founder of such a company would have to make in building the venture. Then she switched on a tape recorder and let the entrepreneur talk through the problems for two hours. Sarasvathy later collaborated with Stuart Read, of the IMD business school in Switzerland, to conduct the same experiment with professional managers at large corporations—the likes of Nestlé, Philip Morris, and Shell. Sarasvathy and her colleagues are now extending their research to novice entrepreneurs and both novice and experienced professional investors.

Sarasvathy concluded that master entrepreneurs rely on what she calls effectual reasoning. Brilliant improvisers, the entrepreneurs don't start out with concrete goals. Instead, they constantly assess how to use their personal strengths and whatever resources they have at hand to develop goals on the fly, while creatively reacting to contingencies. By contrast, corporate executives—those in the study group were also enormously successful in their chosen field—use causal reasoning. They set a goal and diligently seek the best ways to achieve it. Early indications suggest the rookie company founders are spread all across the effectual-to-causal scale. But those who grew up around family businesses will more likely swing effectual, while those with M.B.A.'s display a causal bent. Not surprisingly, angels and seasoned VCs think much more like expert entrepreneurs than do novice investors.

The following is a summary of some of the study's conclusions, illustrated with excerpts from the interviews. Understanding the entrepreneurs' comments requires familiarity with what they were evaluating. The case study and questions are too long to reproduce here. But briefly: Subjects were asked to imagine themselves as the founder of a start-up that had developed a computer game simulating the experience of launching a company. The game and ancillary materials were described as tools for teaching entrepreneurship. Subjects responded to questions about potential customers, competitors, pricing, marketing strategies, growth opportunities, and related issues. (The full case study and questions can be found here.)

Quotes have been edited for length, though we wish we had room to run them in their entirety. Sarasvathy remained almost silent throughout, forcing the founders to answer their own questions and externalize their thinking in the process. The transcripts, riddled with "ums" and "ers," doublings-back on assumptions, and references to personal rules of thumb, read like verbal MRIs of the entrepreneurial brain in action.

Do the doable, then push it

Sarasvathy likes to compare expert entrepreneurs to Iron Chefs: at their best when presented with an assortment of motley ingredients and challenged to whip up whatever dish expediency and imagination suggest. Corporate leaders, by contrast, decide they are going to make Swedish meatballs. They then proceed to shop, measure, mix, and cook Swedish meatballs in the most efficient, cost-effective manner possible.

That is not to say entrepreneurs don't have goals, only that those goals are broad and—like luggage—may shift during flight. Rather than meticulously segment customers according to potential return, they itch to get to market as quickly and cheaply as possible, a principle Sarasvathy calls affordable loss. Repeatedly, the entrepreneurs in her study expressed impatience with anything that smacked of extensive planning, particularly traditional market research. (Inc.'s own research backs this up. One survey of Inc. 500 CEOs found that 60 percent had not written business plans before launching their companies. Just 12 percent had done market research.)

When asked what kind of market research they would conduct for their hypothetical start-up, most of Sarasvathy's subjects responded with variations on the following:

"OK, I need to know which of their various groups of students, trainees, and individuals would be most interested so I can target the audience a little bit more. What other information...I've never done consumer marketing, so I don't really know. I think probably...I think mostly I'd just try to...I would...I wouldn't do all this, actually. I'd just go sell it. I don't believe in market research. Somebody once told me the only thing you need is a customer. Instead of asking all the questions, I'd try and make some sales. I'd learn a lot, you know: which people, what were the obstacles, what were the questions, which prices work better. Even before I started production. So my market research would actually be hands-on actual selling."

Here's another:

"Ultimately, the best test of any product is to go to your target market and pretend like it's a real business. You'll find out soon enough if it is or not. You have to take some risks. You can sit and analyze these different markets forever and ever and ever, and you'd get all these wonderful answers, and they still may be wrong. The problem with the businessman type is they spend a lot of time with all their great wisdom and all their spreadsheets and all their Harvard Business Review people, and they'd either become convinced that there's no market at all or that they have the market nailed. And they'd go out there big time, with a lot of expensive advertising and upfront costs, because they're gonna overwhelm the market, and the business would go under."

The corporate executives were much more likely to want a quantitative analysis of market size:

"If I had a budget, I could ask a specialist in the field of education to go through data and give me ideas of how many universities, how many media, how many large companies I will have to contact to have an idea of the work that has to be done."

Sarasvathy explains that entrepreneurs' aversion to market research is symptomatic of a larger lesson they have learned: They do not believe in prediction of any kind. "If you give them data that has to do with the future, they just dismiss it," she says. "They don't believe the future is predictable...or they don't want to be in a space that is very predictable." That attitude is a bit like Voltaire's assertion that the perfect is the enemy of the good. In this case, the careful forecast is the enemy of the fortuitous surprise:

"I always live by the motto of 'Ready, fire, aim.' I think if you spend too much time doing 'Ready, aim, aim, aim,' you're never going to see all the good things that would happen if you actually started doing it. I think business plans are interesting, but they have no real meaning, because you can't put in all the positive things that will occur...If you know intrinsically that this is possible, you just have to find out how to make it possible, which you can't do ahead of time."

That said, Sarasvathy points out that her entrepreneurs did adopt more formal research and planning practices over time. Their ability to do so—to become causal as well as effectual thinkers—helped this enduring group grow with their companies.

Woo partners first

Entrepreneurs' preference for doing the doable and taking it from there is manifest in their approach to partnerships. While corporate executives know exactly where they are going and follow a prescribed path to get there, entrepreneurs allow whomever they encounter on the journey—suppliers, advisers, customers—to shape their businesses.

"I would literally target...key companies who I would call flagship: do a frontal lobotomy on them. There are probably a dozen of those I would pick. Some entrepreneurial operations that would probably be smaller but have a global presence where I'm dealing with the challenges of international sales...Building rapport with partners, with joint-venture colleagues as well as with ultimate users....The challenge then is really to pick your partners and package yourself early on before you have to put a lot of capital out."

Chief among those influential partners are first customers. The entrepreneurs anticipated customer help on product design, sales, and identifying suppliers. Some even saw their first customer as their best investor.

"People chase investors, but your best investor is your first real customer. And your customers are also your best salesmen."

Sarasvathy says expert entrepreneurs have learned the hard way that "having even one real customer on board with you is better than knowing in a hands-off way 10 things about a thousand customers." Merely gathering information from a large number of potential customers, she says, "increases all the different things you could do but doesn't tell you what you should do." Toward that end, many of her subjects described their preference for an almost anthropological approach to customer interaction: observing a few customers as they work or actually working alongside them.

"You can't go out and survey customers and say, 'OK, what kinda car do you really want?' I believe very much in living it. If you're gonna write a book about stevedores, go work as a stevedore for a period of time. My company was going to design and sell products for physical therapy, so I worked in rehab medicine for two years."

Corporate executives, by contrast, generally envisioned more traditional vendor-customer interactions, such as focus groups.

"I would like to get from meeting with them or getting their input on what they think of the limitation of existing programs....just kind of sit and listen to them telling me...what new features they'd like. And I'd just listen to them talk, talk, talk and then be thinking and develop something between what they want and what's possible technically."

Sarasvathy says executives rely less on firsthand insights, because they can afford to place bets on multiple segments and product versions. "Entrepreneurs don't have that luxury," she says.

Sweat competitors later

The study's corporate subjects focused intently on potential competitors, as eager for information about other vendors as about customers. "The corporate guys are like hunter-gatherers," says Sarasvathy. "They are hired to win market share, so they concentrate fiercely on who is in the marketplace. The first thing they do is map out the lay of the land."

"What information do I want about my competition? I want to see what kinds of resources they have. Do they have computer programmers? Do they have educational experts? Do they have teachers and trainers who can roll out this product? Do they have a support structure in place? Geographically, where are they situated? Have they got one center or lots of centers? Are they doing this just in English, or do they have different languages? I'd be wanting to look at the finances of these companies....I'd probably be looking at their track record to see what kind of approach they take to marketing and advertising so I know what to expect. I might look and see what people they hire, see if I can hire away someone who might have experience."

By the time entrepreneurs start seeking investment, of course, they should be as far inside competitors' heads as they can get. But the study subjects generally expressed little concern about the competition at launch.

"Your competition is a secondary factor. I think you are putting the cart before the horse...Analyze whether you think you can be successful or not before you worry about the competitors."


"At one time in our company, I ordered our people not to think about competitors. Just do your job. Think only of your work. Now that isn't entirely possible. Now, in fact, competitive information is very valuable. But I wanted to be sure that we didn't worry about competitors. And to that end, I gave the annual plan to every employee. And they said, 'Well, aren't you afraid your competitors are gonna get this information and get an advantage?' I said, 'It's much riskier to not have your employees know what you need to do than it is to run the risk of competitors finding out. Cause they'll find out somehow anyway. But if one of your employees doesn't know why they're doing their job, then you're really losing out.'"

Entrepreneurs fret less about competitors, Sarasvathy explains, because they see themselves not in the thick of a market but on the fringe of one, or as creating a new market entirely. "They are like farmers, planting a seed and nurturing it," she says. "What they care about is their own little patch of ground."

Don't limit yourself

Corporate managers believe that to the extent they can predict the future, they can control it. Entrepreneurs believe that to the extent they can control the future, they don't need to predict it. That may sound like monumental hubris, but Sarasvathy sees it differently, as an expression of entrepreneurs' confidence in their ability to recognize, respond to, and reshape opportunities as they develop. Entrepreneurs thrive on contingency. The best ones improvise their way to an outcome that in retrospect feels ordained.

So although many corporate managers in Sarasvathy's study wanted more information about the product and market landscape, some entrepreneurs pushed back on the small amount of information provided as being too limiting. For example, the description of the product as a computer game for entrepreneurship:

"I would cast it not as a product but as a family of products, which might perform a broader function like helping people make career decisions. I always look for broad market opportunities."


"I wanna use this product as a platform to attract other products literally to build a market-share play. I see this as a missionary product, an entrée into some of the best users and buyers."

The most fascinating part of the study relates to the product's potential. Asked about growth opportunities, the corporate managers mostly restricted their comments to the game as described:

"It depends on how it's marketed. I'm a little bit skeptical....I'm not certain entrepreneurs would go for that. Maybe they think they already know everything. But in terms of simulations for business schools or in further education, they seem to be very popular. And entrepreneurship degrees seem to be very popular as well. So, yeah, it could well be a lot of growth."

Here is where the entrepreneurs really let loose. Starting with the same information as one another and as the executives, they collectively spun out opportunities in 18 markets—not just academic institutions but also venture capital firms, consultancies, government agencies, and the military. As much as the ability to concoct new products, it is this tendency to riff off whatever ideas or materials are handy that defines entrepreneurs as a creative breed. Reading the transcripts, you can almost hear the enthusiasm mounting in their voices as the possibilities unfold:

"This company could make a few people rich, but I don't think it could ever be huge...You might have a successful second product about how to succeed and get promoted within a large company....That would give you a market of everybody with aspirations at IBM, AT&T, Exxon, etc....You could make another product for students. How do I graduate in the top 10 percent of my class at Stanford or Harvard or Yale?...A lot about how to be a good student is teachable. Now you've got a product you can sell to every student in the country. Next there is negotiation. You could practice being a good negotiator. There's not a salesman in the United States who wouldn't buy one of those. Then you could genericize the thing to any situation which requires some sort of technical knowledge. Or learning situations within companies where you are trying to get people to understand that company's methods or objectives. So maybe I'm gonna change my opinion about the growth potential. It's easy to see how within an hour you could name 10 products that would each address huge markets, like all employees in Fortune 500 companies, who are rich enough to pay $100 for it. It could be a hit on the scale of the Lotus spreadsheet. You can see a several-hundred-million-dollar company coming from it."

You might also glean from the preceding that entrepreneurs are eternal optimists. But you don't need an academic study to tell you that.

Leigh Buchanan is an editor-at-large for Inc.

+------------------------------------------------------------------------------+ Dimon Calls Fannie, Freddie ‘Biggest Disasters of All Time’ 2011-02-11 05:01:00.22 GMT By Dawn Kopecki Feb. 11 (Bloomberg) -- JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said government-sponsored mortgage companies Fannie Mae and Freddie Mac were “the biggest disasters of all time” and a leading cause of the U.S. financial crisis. “That one was an accident waiting to happen,” Dimon said in an Oct. 20, 2010, interview with the Financial Crisis Inquiry Commission. The congressional panel yesterday released audio files of interviews gathered during its 18-month investigation into the causes of the crisis. The Obama administration is set to announce in Washington today its recommendations on how to restructure the U.S. housing finance system. Washington-based Fannie Mae and Freddie Mac, in McLean, Virginia, have taken more than $150 billion in federal aid since regulators seized their operations in September 2008. “We all knew about it, we all worried about it, no one did anything about it,” Dimon, 54, told investigators. The companies, which were privately owned by shareholders, received federal tax breaks and other subsidies to help fulfill their public mission to bolster the U.S. housing market. Dimon said they financed risky loans like subprime mortgages that helped drive more than $1.9 trillion in writedowns at financial institutions across the world. Dimon said lax lending standards across the industry and excessive leverage and risk-taking by banks helped cause the crisis. “You kind of got sucked into this whole sense of security because there were no losses,” Dimon said. “I would also say people lied. There was more and more of that in a frothy market.” Shrinking Roles Treasury Secretary Timothy Geithner and Housing and Urban Development Secretary Shaun Donovan plan to present lawmakers with three options for shrinking the roles of Fannie Mae and Freddie Mac in the U.S. housing market. Together, the companies accounted for 67 percent of the mortgage bonds issued in the third quarter of last year, according to U.S. government data. Government mortgage bond insurer Ginnie Mae accounted for 29 percent, leaving about 4 percent to private lenders. President Barack Obama’s plan doesn’t endorse a particular option or offer legislation. All three proposals seek to end taxpayer support for Fannie Mae and Freddie Mac.

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