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Good Reading -- April 2011

----------------- Quoted

  1. Kerry Killinger, CEO of Washington Mutual, in internal memos to his chief risk officer:

  • (2005): "I have never seen such a high-risk housing market."

  • (2006): "[The housing market will be] weak for quite some time as we unwind the speculative bubble."

  • (2007): "For the past two years, we have been predicting the bursting of the housing bubble. The scenario has now turned into a reality."

  • (April 14, 2008, at annual meeting): "Clearly, 2007 was an extraordinarily difficult year for WaMu but you know today I believe that we are at the beginning of the road back, back on a path to profitability and to creating the shareholder value that we all desire. Now I expect that when we look back a year from now we are going to view April 2008 as a turning point [in] this company's history...You know, we did see a slowing housing market coming. In fact the board and management took major actions to prepare for that slowdown and we raised new capital on several occasions. But the actual magnitude of the housing downturn and the unprecedented disruptions in the capital markets have simply overcome much of our preparation."

  • Later in 2008, the aforementioned chief risk officer is fired after he took his concerns about weak internal controls and rising losses to both the board and to the OTS. WaMu also rebuffs JP Morgan's acquisition bid before, n September, being seized by the FDIC in the biggest bank failure in U.S. history.


  1. "There's Always Something to Do: The Peter Cundill Investment Approach" -- I didn't know much about Canadian value investor Peter Cundill before, but I enjoyed this book and it's a worthwhile read for all investors.

  2. "It's Hard to Make Predictions, Especially About the Future" -- a review of the new book "Future Bubble" by Dan Gardner. I have not read it yet but this review made me put it on the list.

  3. "The Big Secret for the Small Investor" -- preeminent value investor Joel Greenblatt is out with a new book. Again, the title makes it sound like something you'd expect to find on a bad infomercial, but I can assure you that Greenblatt is as good as they get. I haven't read this yet, but his other books are excellent and at the top of my list of recommendations. The topic of his latest effort is value-driven indexing for small, retail investors. An interview with Greenblatt is here and a review of the book is here.

Facts and Figures

  1. 975 -- the number of people employed by GE's tax department; by sheer coincidence, GE's effective tax rate in the U.S. has recently been zero (or lower). [Not that GE is the bad guy here; any blame goes to the politicians, bureaucrats, and lobbyists responsible for the tax code.]

  2. $17.1 million -- the aggregate amount of compensation earned by the CEOs of Fannie Mae and Freddie Mac during 2009 and 2010 (both GSEs were nationalized in 2008, since which time the U.S. Treasury has invested $154 billion -- and counting -- in taxpayer dollars to stabilize them).

  3. Fun with pensions and actuarial math (courtesy of The Economist): < >Since 1940, the life expectancy of a man in the U.S. has increased from 11.9 years to 17.5 years; retirement ages have barely budged during that time Ida May Fuller, the first American to receive a monthly Social Security check, paid in $24.75 and received $22,888.92 before her death. When Gertrude Janeway died in 2003, she was still getting a $70 monthly check from the VA for a military pension earned by her the Civil War. (They were married in 1927 when he was 81 and she was 18.)

  4. (NYT) As things stand now, a couple of 56-year-olds with average earnings will contribute about $140,000 in dedicated Medicare taxes over their lifetimes, and they will receive about $430,000 in Medicare benefits.


  1. "Why Leaders Don't Learn from Success" -- good article from HBR.

  2. "Taking the Government Out of Housing Finance: Principles for Reforming the Housing Finance Market" -- the latest from Ed Pinto and friends. A review of the article is here.

  3. JP Morgan Annual Letter to Shareholders -- Jamie Dimon always writes a great shareholder letter, and this is no exception. He touches on a wide range of topics -- from a candid review of JPM's results to macroeconomic conditions to financial regulatory reform -- so there's something for everyone.

  4. "If Charlie Munger Didn’t Quit When He Was Divorced, Broke, and Burying His 9 Year Old Son, You Have No Excuse" -- Janet Lowe's book is pretty good, but not great. Either way, this article encapsulates a great dose of inspiration. "At 31 years old, Charlie Munger was divorced, broke, and burying his 9 year old son, who had died from cancer. By the time he was 69 years old, he had become one of the richest 400 people in the world, been married to his second wife for 35+ years, had eight wonderful children, countless grandchildren, and become one of the most respected business thinkers in history. He eventually achieved his dream of having a lot of money, a house full of books, and a huge family. But that doesn’t mean he didn’t face unbelievable challenges and tragedies."


  1. "Ajit Jain Interview -- Times of India" -- Buffett also said recently that “[Jain] loves what he does, he’s not looking to take my job. If he was, the board of directors would probably put him in there in a minute.” He later added that, “Ajit has probably made a lot more money for Berkshire Hathaway than I have." Related video interview is here.

  2. Warren Buffett Interview with Guy Rolnik -- interesting thoughts on a variety of topics. "What would you say are the key lessons you took from the financial crisis? 'They are not new lessons. Never owe any money you can't pay tomorrow morning. Never let the markets dictate your actions. Always be in a position to play your own game. Never take on more risks than you can handle. But all of those were old lessons, unfortunately. Even though I didn't see it coming, those lessons which are timeless allowed us to in effect profit from it rather than suffer from it. Good businesses, good management, plenty of liquidity, always having a loaded gun; if you play by those principles you will do fine no matter what happens. And you don't ever know what's going to happen.'"

  3. "The Coffee Can Approach" -- the latest from Michael Mauboussin. Good stuff as always.

Copied Below

  1. "Bill Would Bar Insider Trading on Capitol Hill" -- I learned a couple of years ago that insider trading is, in fact, legal in Congress. And by insider trading, I mean that Congressional subcommittee XYZ is considering a bill that would regulate Company ABC into oblivion. While working on said bill, Congressional staffer Joe Blow (or even the Congressman himself) could realize that the bill is likely to pass, and then run out and short shares of Company ABC before anything is made public. And amazingly, that would be legal. This bill would -- in the year of our Lord two thousand eleven -- finally end the insanity.

  2. "Gold, China, and Facebook: Detecting Market Bubbles" -- I have not read this book, but it sounds worthwhile. If you want more on the insanity in China, here's an interesting video clip.

  3. "Tools for Thinking" -- some good nuggets about cognition with investing implications in a David Brooks column.

  4. "Investment Strategies: All About the Benjamins" -- it's certainly a worthwhile thought exercise to answer the question, "If the market were only open for one hour every year, would your investment strategy change?"

  5. "[Investment Management] Industry Overpaid by $1,300 billion" -- not vouching for the data, methodology, or specific conclusions, but hard to argue with the basic premise.

  6. "An Old Problem is Back, and Reform May Have Missed It" -- no, reform definitely missed it, but there's not much regulation can do for an inherent and psychological bias that leads to undue emphasis on short-term results and the price of a company's equity at the expense of long-term value. Also, more great stories about our old friend Kerry Killinger of WaMu infamy.

  7. "'Five Books': Johah Lehrer on Decision Making" -- a great interview with five excellent book recommendations.

Bill Would Bar Insider Trading on Capitol Hill


U.S. lawmakers, their staffers and executive-branch employees would be banned from making investment decisions with nonpublic information under a bill proposed this week by two House Democrats.

The Stock Act, which was first introduced by Rep. Louise Slaughter (D., N.Y.) in 2006, would create insider-trading rules for government workers who often have privileged access to information. Rep. Tim Walz (D., Minn.) is also behind the latest effort.

Under the proposed bill, lawmakers and staffers would have to disclose any stock, bond or commodity-futures transactions in excess of $1,000 within 90 days. The bill would also require firms that specialize in helping investors get access to information on Capitol Hill to register with the House and Senate, much like lobbyists.

The Justice Department is currently investigating an insider-trading case focused largely on these companies, known as expert-network firms. There's no evidence that their work in Washington is part of that broader investigation.

Currently, insider-trader rules that govern Wall Street do not apply to members of Congress.

"This is a matter of equality under the law," Mr. Walz said in a written statement. "The same standards we have established for Wall Street should apply to Congress. The potential for abuse is obvious."

Previous efforts to pass such a measure have failed and there's no indication that this effort will fare any better.

The Wall Street Journal published a series of articles last year detailing ways in which lawmakers and their staffers are frequent stock traders using approaches permitted under current congressional rules.

Gold, China, and Facebook: Detecting market bubbles

Posted by Nin-Hai Tseng, writer-reporter

March 18, 2011 10:49 am

It's not always so difficult to know when an asset is in a bubble. The real challenge is determining when it will pop.

Suppose we can travel back in time and detect all the market bubbles that went bust. How much pain would we save ourselves? How much wealth would we forgo?

Vikram Mansharmani, managing director at Boston-based hedge fund SDK Capital, thinks he has nailed the formula to detect bubbles. He has laid out some obvious and admittedly quirky signs of market bubbles in his first book, Boombustology: Spotting Financial Bubbles Before They Burst, which was published this month.

I caught up with this self-proclaimed "boombustologist," who taught an undergraduate seminar at Yale called "Financial Booms and Busts." We discussed the five signs of a market bubble, a few potential bubbles today and the biggest one that is due to burst very soon: China's real estate market.

How do you spot a bubble?

There are five lenses. The first is a situation where there is a self-fulfilling dynamic going on -- when asset prices are rising rapidly and it's usually fueled by credit at the same time. A classic case would be the housing market, where a bank lends money to someone and that creates a new buyer. In securing the loan, the buyer drives up the price of the collateral. The bank then feels more secure, potentially even smart about its decision. So then it issues more loans, thereby creating more buyers to drive up the prices of real estate that are securing their loans.

The second is looking at the cost of money, how it's allocated and whether there is overcapacity. The South China Mall in southern China is a great example. It was designed for 1,500 tenants. As of last year, I think they had a dozen tenants. The president of the shopping mall was recently interviewed by Bloomberg, saying he would continue expanding the mall, despite it being 90-something percent vacant.

The third is overconfidence. Are we seeing signs of hubris? One indicator that I love to point to is the world's tallest skyscraper, because it signals a speculative instinct. Skyscrapers are never built by their intended tenants. It's usually a developer who is hoping to attract tenants after the building is complete. The tallest building in the world today is the Burj Khalifa in Dubai, which has been bailed out by the government of Abu Dhabi. So if you look forward at where the world's tallest towers under construction are today -- five of the 10 largest towers under construction are in China.

Also, watch for spikes in Sotheby's (BID) common stock prices. This also signals overconfidence. Over long periods of time the price of the art auction house has generally been around $15 to $25 a share. In 1990, it rose considerably. If you look back and listen to what they were saying about the markets at the time, it was that world record art prices were being set left and right by Japanese buyers. In 1999 we had another surge in Sotheby's stock price driven by a couple of things. For one, we had Internet buyers, and two, Sotheby's launched Sotheby', so it played into the mania that was going on. In 2007 we had Russian billionaires, hedge fund managers, private equity executives all driving the art markets. Sotheby's stock price reflected that and it spiked back up. It fell back down immediately after that bubble imploded.

Today Sotheby's stock is elevated once again and it's being driven by Chinese art buyers.

What do you think is the biggest bubble today?

China's economy. It exhibits all the tell tale signs that have characterized all the great speculative manias throughout history. We have reflexive dynamics under way that are self-fulfilling. Look at property prices -- they're rising rapidly, driven by increasing amounts of credit. It's not an overly leveraged situation yet, but it's increasingly so.

There's also misallocated capital. We can see this, for instance, with South China Mall and the skyscrapers under construction. And then there's the moral hazard factor. A lot of state-run banks are lending money to projects because they're told to politically -- not because they're economically rational projects to lend against. We have state-owned banks lending money to state-owned enterprises to buy land from the state. How we can possibly think that's market oriented and not self-dealing is confusing to me. It's all funny money.

If there's a bubble in China, when do you think it will pop?

The reality is that we have signs that it's getting increasingly mature. I would be very shocked if it didn't manifest itself in the next three to five years.

What are some of the possible bubbles you see in the U.S. today?

Gold. Everyone has an opinion about gold. That by itself indicates that it's quite bubbly. Now, you ask, what are the signs? We have to ask are there any financial innovations that allow for embedded leverage to take place in gold? Absolutely. We have these Exchange Traded Funds (ETFs) that allow anyone to buy gold and have increased speculative tendencies in that market. Also, you have to wonder if gold is over-popularized. I don't know about you but even as I walk through New York City I find signs of people offering to buy gold and sell gold. And perhaps the most interesting phenomenon is that there are now gold vending machines. They have it in Dubai and a couple of other places but they've now introduced them in the United States.

Another potential bubble is the social networking industry. It's very loftily valued. I don't know if it's a bubble or not but I'm telling you some reasons for why it could be bubbly. In the Internet era, there's some thinking that earnings don't matter, it's eyeballs we want -- we want website traffic, we don't care about cash flow. So with Facebook today being valued at $50 to $60 billion it's hard to answer the basis for that. It's a new industry -- it's social networking. How do you value that? Because it's not well established you have the possibility of any valuation metric you choose. So lacking that valuation anchor results in a bubble potential.

Prices for many commodities are rising -- are these bubbles?

There are some commodities -- iron ore, zinc, lead, cotton, soybeans -- where China is a massive portion of the demand, making up 40%, 50% and sometimes even more. Given my China perspective, I think they're quite vulnerable and potentially prone to a bust because in the quest to meet this growing Chinese demand they've grown their capacity even faster and a slowdown in China will result in massive overcapacity in those complexes.

What's not a bubble?

Energy is something I'm quite bullish on. China today represents 10% or 11% of global oil demand. It's actually not that large. It's a large percentage of the growth in oil demand, but it's that large of a percentage of overall oil demand. It's harder to find, it's in more difficult places -- geopolitically and technically. It's one of the few resources today that is well suited for transportation purposes. And so given those dynamics I think oil is not in a bubble. Will it have ups and downs along the way? Sure. There will be people who will speculate in the futures markets and drive it up short-term but it will come back. But fundamentally we have a scarce resource in oil.

Tools for Thinking


A few months ago, Steven Pinker of Harvard asked a smart question: What scientific concept would improve everybody’s cognitive toolkit?

The good folks at organized a symposium, and 164 thinkers contributed suggestions. John McWhorter, a linguist at Columbia University, wrote that people should be more aware of path dependence. This refers to the notion that often “something that seems normal or inevitable today began with a choice that made sense at a particular time in the past, but survived despite the eclipse of the justification for that choice.”

For instance, typewriters used to jam if people typed too fast, so the manufacturers designed a keyboard that would slow typists. We no longer have typewriters, but we are stuck with the letter arrangements of the qwerty keyboard.

Path dependence explains many linguistic patterns and mental categories, McWhorter continues. Many people worry about the way e-mail seems to degrade writing skills. But there is nothing about e-mail that forbids people from using the literary style of 19th-century letter writers. In the 1960s, language became less formal, and now anybody who uses the old manner is regarded as an eccentric.

Evgeny Morozov, the author of “The Net Delusion,” nominated the Einstellung Effect, the idea that we often try to solve problems by using solutions that worked in the past instead of looking at each situation on its own terms. This effect is especially powerful in foreign affairs, where each new conflict is viewed through the prism of Vietnam or Munich or the cold war or Iraq.

Daniel Kahneman of Princeton University writes about the Focusing Illusion, which holds that “nothing in life is as important as you think it is while you are thinking about it.” He continues: “Education is an important determinant of income — one of the most important — but it is less important than most people think. If everyone had the same education, the inequality of income would be reduced by less than 10 percent. When you focus on education you neglect the myriad of other factors that determine income. The differences of income among people who have the same education are huge.”

Joshua Greene, a philosopher and neuroscientist at Harvard University, has a brilliant entry on Supervenience. Imagine a picture on a computer screen of a dog sitting in a rowboat. It can be described as a picture of a dog, but at a different level it can be described as an arrangement of pixels and colors. The relationship between the two levels is asymmetric. The same image can be displayed at different sizes with different pixels. The high-level properties (dogness) supervene the low-level properties (pixels).

Supervenience, Greene continues, helps explain things like the relationship between science and the humanities. Humanists fear that scientists are taking over their territory and trying to explain everything. But new discoveries about the brain don’t explain Macbeth. The products of the mind supervene the mechanisms of the brain. The humanities can be informed by the cognitive sciences even as they supervene them.

If I were presumptuous enough to nominate a few entries, I’d suggest the Fundamental Attribution Error: Don’t try to explain by character traits behavior that is better explained by context.

I’d also nominate the distinction between emotion and arousal. There’s a general assumption that emotional people are always flying off the handle. That’s not true. We would also say that Emily Dickinson was emotionally astute. As far as I know, she did not go around screaming all the time. It would be useful if we could distinguish between the emotionality of Dickinson and the arousal of the talk-show jock.

Public life would be vastly improved if people relied more on the concept of emergence. Many contributors to the Edge symposium hit on this point.

We often try to understand problems by taking apart and studying their constituent parts. But emergent problems can’t be understood this way. Emergent systems are ones in which many different elements interact. The pattern of interaction then produces a new element that is greater than the sum of the parts, which then exercises a top-down influence on the constituent elements.

Culture is an emergent system. A group of people establishes a pattern of interaction. And once that culture exists, it influences how the individuals in it behave. An economy is an emergent system. So is political polarization, rising health care costs and a bad marriage.

Emergent systems are bottom-up and top-down simultaneously. They have to be studied differently, as wholes and as nested networks of relationships. We still try to address problems like poverty and Islamic extremism by trying to tease out individual causes. We might make more headway if we thought emergently.

We’d certainly be better off if everyone sampled the fabulous Edge symposium, which, like the best in science, is modest and daring all at once. 

Investment Strategy: All About the Benjamins

Bernanke vs. Graham: In whom do you trust?


Two disparate views of markets represent well the range of opinion among U.S. stock market participants today. One is a devout faith in market efficiency and the supremacy of market pricing as a reflection and forecast of fundamental value. The other expects errors and biases in market pricing.

The first should be recognizable as belonging to Ben Bernanke (easily the biggest trader and most significant market manipulator in history); the other to Ben Graham, the father of value investing. With which Benjamin do you agree?

I think a simple thought experiment best answers this question. Imagine a world where the stock market is open for trading only one hour of every year. No more scrolling stock tickers or central bank scuttlebutt on interest rate policy (and certainly far fewer insufferable hedge fund managers and Wall Street traders).

If this would change how you invest, then apparently a steady stream of market quotations is a sine qua non of your investment process; a trade makes sense to you when validated and quickly rewarded by the constant transactional opinions of your friends in the marketplace. You are a Benjamin Bernanke trader.

However, if you would maintain the same investment approach as always, then your investment decisions must be based on your expectation of the cash flows to be received from those investments, irrespective of what subsequent market quotations have to say about them. You don't care what your friends think (and you probably don't have many of them anyway). You are a Benjamin Graham investor.

To the Bernanke trader, market prices are the most information-laden depiction and forecast of the state of the world. They are neither dear nor cheap—they just are. Thus statements such as "price increases largely reflect strong economic fundamentals" (Mr. Bernanke's take on house prices in 2005).

But the wisdom of the crowd turns tragically biased when opinions are interdependent. And amplification and contagion of opinion is what markets do so well through continuous Bernanke trader herding. The Graham investors recognize this, as well as the difficulty for anyone—especially economists and analysts—to accurately predict changes in macro variables or returns on corporate investment. They treat the implicit forecasts embedded in market valuations as folly. Markets get dear and cheap, and it's pretty obvious when they do.

Clearly, lower interest rates can promote greater purchases of risky assets and thus higher stock market valuations, as market participants assume a more flush economy and willingly accept more risk to generate a respectable return. Bernanke traders do often rule the roost—and for years.

Today's stock market is a case in point. Bernanke and his traders are stampeding, as rising stock prices signal higher corporate returns and earnings to come. Among their rallying cries is the expectation that stock price volatility, when positive, will magically and recursively improve the very fundamentals being priced (the "wealth effect"). Meanwhile, Graham investors have stoically stepped aside.

History does not bode well for the Bernanke traders. Interest rate levels and stock market valuations imply forecasts of economic activity and returns that don't pan out. Low interest rates give only an ephemeral boost to stock prices and, like clockwork, are always accompanied by higher liquidity preference (or holding of cash relative to GDP). So, as today, central-bank decreed low rates don't work.

The Q ratio is the aggregate stock market valuation relative to net asset replacement cost, which accurately gauges the market's expectations of returns on tangible capital and resulting profit growth. That ratio has made a half-dozen historic highs since 1900, all of which were followed eventually by much lower stock market prices. This ratio very recently surpassed all of these highs except for the go-go late 1990s. Moreover, corporate returns on invested capital have been volatile but have otherwise remained flat, enforced by a very competitive economy.

It can always be different this time. Black swans abound. But there is a distinct difference in the consequences of failure of these two investment views. The Bernanke trader takes positions at prices often implying extremely advantageous and precise scenarios, the adjustment of which would mean severe losses. The Graham investor takes positions only at prices implying exceedingly disadvantageous scenarios, the adjustment of which would, by definition, mean far less severe losses. While the Bernanke traders bask in the market's efficiency, the Graham investors dither in their margin of safety.

So with which Benjamin are you betting? Certainly your answer to this question ought to be the same Benjamin with which you agree. But there are plenty of cognitive biases that may prevent us from betting our beliefs. And the vast professional investing community may not have the luxury of choice, as the career risk associated with exclusion from the Bernanke trader camp can be the stuff of nightmares. The only thing certain? One Ben's views will win.

Mr. Spitznagel is the founder and chief investment officer of the hedge fund Universa Investments LP, based in Santa Monica, Calif.

Fund industry ‘overpaid by $1,300bn’

By Steve Johnson

Published: April 3 2011 08:53 | Last updated: April 3 2011 08:53

The “overpaid” fund management industry is destroying $1,300bn of value annually, according to an unpublished draft report conducted by IBM.

The document, seen by FTfm, claims the industry is “paid too much for the value it delivers” and that “destroying value for clients and shareholders is unsustainable”.

It also carries a prediction of swingeing job cuts in parts of the industry, such as sell side research, credit rating agencies and funds of hedge funds.

The wide-ranging report, Financial Markets 2020, is based on a survey of more than 2,600 industry participants and government officials across 84 countries by the IBM Institute for Business Value.

The bulk of the value destruction, almost $1,100bn a year, equivalent to 1.9 per cent of global gross domestic product, is seen as impacting on clients. This includes $300bn in excess fees for actively managed long-only funds that fail to beat their benchmark (this figure is quoted as $834bn in the draft report but it is believed IBM has since revised it lower), $250bn spent in fees for wealth management and advisory services that fail to deliver promised above-benchmark returns, and $51bn in fees for hedge funds that also fail to deliver their targeted returns.

Credit rating agencies, sell side research and trading are seen as destroying a further $459bn, largely due to the perceived inaccuracy of much of the analysis these sectors deliver.

Across the financial sector as a whole, IBM said “alpha generation” or the ability to deliver index-beating returns, was “pitiful”, despite the huge sums paid in pursuit of this. Perhaps unsurprisingly, it found 87 per cent of investors expressed no loyalty to their “primary investment provider”.

The report argues the industry is destroying a further $213bn a year for shareholders due to organisational complexity, largely as a result of inefficiencies.

This value destruction is “unsustainable” in a world where, according to respondents to the report, regulation is likely to become tighter in the wake of the financial crisis and investors are becoming more financially sophisticated, more price sensitive and increasingly keen to measure the “value-add” of their investment managers.

“Government influence and client behavioural shifts over the next decade will destroy the majority of today’s revenue base,” the report states.

Against this backdrop, the survey respondents indicate that significant job losses are inevitable. In particular, clients forecast a 45 per cent headcount reduction in sell side research and 42 per cent reduction at credit rating agencies in the next decade, as the buyside takes more of this activity in-house.

Funds of hedge fund staff are seen as most vulnerable on the buyside, with headcount cuts of 37 per cent forecast.

Liz Rae, senior adviser, investment and markets at the UK Investment Management Association, said fund houses were already bringing more research activities in-house, partly driven by a view that sell side was irredeemably conflicted.

Sell-side research “probably is overstaffed and there is probably too much of it”, she said. However, Amin Rajan, chief executive of Create Research, a consultancy, argued that the bulk of the industry’s post-crisis job losses were now behind it. He said much of the value destruction was caused by the “behavioural biases” of investors.

An Old Problem Is Back, and Reform May Have Missed It

Renewed pressure to please markets could prompt risk-taking by bank execs

American Banker | Wednesday, April 6, 2011

By Heather Landy


The obvious lessons of Washington Mutual and other high-profile failures in the industry have not gone unheeded, keeping banks busy these past three years fixing their approach to risk.

But reworked pay formulas, tighter credit standards, software upgrades and governance reforms address only half the equation that added up to a sector in crisis — and unfortunately it's not the half that chief executives are hardwired to focus on, day in and day out.

Maximizing share price, satiating a savage market hell-bent on seeing earnings growth every three months — those are matters that weighed heavily on bank CEOs precrisis. In the intervening years, banks got something of a pass to push their stocks sideways for a while and to miss a few quarters of financial estimates while both the industry and the markets regrouped. But there is nothing to suggest that the industry has broken free of the pressures of either the daily trading session or quarterly earnings.

If anything, concern about stock performance and bottom-line growth seems on the rise again, with CEOs from banks large and small preoccupied of late with the idea of returning capital to shareholders and replacing fee income lost to regulation.

"I think all [bank CEOs] will tell you that they're working for the long term," said Steven Gerbel, founder and president of Chicago Capital Management, a small merger-arbitration fund that invests in banks and other stocks. "But I find it hard to believe that if they were working for the long term and trying to prepare themselves for Basel III that they would be so concerned about dividends."

Of course there's nothing wrong with pursuing dividend increases per se. Distributing resources and increasing shareholder value are two of the most sacred duties of a corporate CEO.

But when those tasks are carried out more with short-term benefits in mind than long-term consequences, trouble can arise.

The short-term-versus-long-term conundrum that banks sometimes face was illustrated vividly in the complaint that the Federal Deposit Insurance Corp. filed in March against three former Wamu executives. The lawsuit cites a June 2006 company memo in which Wamu CEO Kerry Killinger noted that the housing bubble was due to burst and that the company's credit costs would climb when it did.

Faced with his own predictions, Killinger nevertheless ordered, in the very same memo, that the company heap on more credit risk, explaining that "Wall Street appears to assign higher [price-to-earnings ratios] to companies embracing credit risk."

If that kind of thinking seems more emblematic of the dot-com boom that ended six years before Killinger would have penned that memo, Shivaram Rajgopal, a professor at Emory University's Goizueta Business School, said it reflects a psychology that has never really gone away.

He sees the widely shared fixation on stock price as the product of a confluence of developments, including the proliferation of stock-based compensation, the decline in trading costs that made it economically feasible for day traders and "stock jockeys" to exert influence on the market and the waves of consolidation in different industries that relied on stock as the primary currency for acquisitions.

"The fever has probably subsided some since the dot-com days," said Rajgopal, whose research focuses on financial reporting and on the relationship between executive pay and executive behavior in areas such as risk-taking. "But I think the tendency to want to please the market hasn't changed that much."

What has changed, according to consultant Chris Thompson, is the starting point that companies are using to determine what kinds of returns they expect to provide to the market.

Instead of deciding on the necessary deliverables and tallying up the risks afterward, some banks are first setting their risk appetite, and then determining how best to satisfy it, said Thompson, the North American lead for risk management at Accenture.

When his firm was brought in to work with the board of a company that had cut back substantially on risk-taking because of the crisis, "the question was not just 'How do we do more business — oh, and by the way, will that be risky?' " Thompson said. "It was, 'How do we take the right amount of risk over the next three years, and how do we manage that from a business standpoint?' "

Rob Carpenter, chief information officer at the mortgage lender technology provider CoreLogic Dorado, sees at least one respect in which the demands of the market have had a positive impact on his firm's clients: the reputation risk surrounding mortgage industry practices has ensured that the mortgage operations of larger banks are no longer run in virtual isolation. Instead they have captured the focus of retail banking executives who want their brand names protected.

"The market is correcting the risk profile in that way. And given that, [banks] are beginning to make decisions around technology and operations that would imply better behavior," Carpenter said. "It's not necessarily that they grew a soul all of a sudden. They're making good business decisions, and their understanding of risk is now more aligned with the events of the past three years."

Had Wamu been outfitted with the latest generation of technology — had the company not been, as the FDIC asserts in its complaint, unable to "adequately track and analyze its loans" or "measure or price for its risks" — would Killinger have ignored the siren call of a higher P/E ratio and chosen a different strategy?

Linda Allen suspects not. But Allen, an economics and finance professor at Baruch College in New York, said Killinger's chosen strategy speaks less to the state of the stock market and more to the state of the financial system, which allowed systemic risks to grow unchecked at no apparent cost to the firms generating those risks.

"This risk that was being posed on the economy was free, and it would be irrational for [Killinger], on behalf of his shareholders, not to take advantage of something that was free," Allen said. "That's why banks are different, and that's why systemic risk, which is outside the decision-making process of any individual executive, has to be internalized in some sense."

That's one option for controlling banks' behavior. Technology that promotes accountability by producing auditable trails as loans work their way through the system might be another. But even Carpenter, as energetic as he gets when discussing the workflow technology that CoreLogic Dorado makes for mortgage lenders, sees the limits to what his firm can offer clients.

"While our technology is really quite fantastic," he said, "it's not capable of providing virtuous behavior to an executive."

Jonah Lehrer on Decision-Making

Science & Technology > the mind

Frontal Cortex blogger and author of Proust Was a Neuroscientist chooses books on decision-making, and questions how we turn behavioural economics into an applied science

Extraordinary Popular Delusions and the Madness of Crowds

By Charles Mackay


So, your first book is Extraordinary Popular Delusions and the Madness of Crowds by Scottish journalist and songwriter Charles Mackay, first published in 1841. This is a wonderful eclectic history of mass human irrationality, and a great history of financial bubbles. If you ever thought that irrational exuberance was a modern invention, a by-product of CNBC and day traders, this book will put you in your place. It’s everything from Tulipmania [in the Netherlands in the early 17th century] to the Mississippi Company and he would have lovedthe sub-prime mortgage bubble. It shows that as long as we’ve had financial markets, there have been these insanely irrational bubbles: the history of finance is really the history of financial bubbles. But is it that irrational? Say with Tulipmania, if you know that one tulip bulb is not worth 10 florins, as long as you can sell it for 20 florins, it’s worth it – even if you know it’s ridiculous. Yes, and what he highlights is that these are historical moments when financial markets basically look like Ponzi schemes. They work great, until they no longer work, and then they just collapse like a house of cards. So they work well for all the people who are selling tulips for 20 florins or 30 florins, but all of sudden, for whatever reason, when they reach 101, the market disappears. And you realise you’re paying insane amounts of money for a flower. And there’s always the moment, when you read these stories, where looking back on it, it seems so absurd. And yet you know that for every person trading tulips or investing in the South Sea Bubble it felt like a very prudent investment. It felt irrational not to invest in tulips. Just like the smartest minds on Wall Street thought that it was irrational and irresponsible to not invest in mortgage-backed securities. So this book gives you a hint of what it must have felt like on the inside, to be in the grip of this irrational exuberance – just like when Cisco was the most valuable company in the world in 2000, or when dotcom stocks that had no business plan (or a barely intelligible business plan) and never turned a profit were incredibly valuable companies. And, of course, as soon as the bubble ends, we see it for what it was – a completely irrational burst of exuberance. And Mackay also covers topics like witchcraft and witch-hunts and alchemy? It’s best known for the financial escapades, and that’s the stuff I find most compelling in terms of decision-making. But it’s also just a history of human mania and irrationality generally.

Judgment under Uncertainty: Heuristics and Biases

By Daniel Kahneman, Paul Slovic and Amos Tversky


So, the next book you chose, Judgment under Uncertainty, is by, amongst others, Daniel Kahneman, the psychologist who won the Nobel prize for economics, despite, he says, never taking an economics course. This is one of the most influential books in modern economics. But first of all, it’s just this list of incredibly clever experiments. They don’t use any fancy tools, there’s no microscopes or telescopes involved: Kahneman and Tversky just asked their undergraduates hypothetical questions. So how much would a student want in return if they were betting $1 on the flip of a coin? You can’t get a simpler question to ask in a science experiment, and yet that very simple question eventually led to a thing called ‘loss aversion’. And this is now viewed as a very important phenomenon – with implications for everything from how taxi-cab drivers think, to how people act when they evaluate their stock portfolio. So what I like about this is book is how they took these very simple protocols – really just idle conversation with students – and transformed them into the first really hard proof that people consistently violate the expectation of rational agents. That we don’t think like homo economicus at all. That our behaviour, our responses to very simple questions, don’t look at all like what a rational person would do – there are these deep inconsistent flaws in the human mind. It makes no rational sense to have such a strong loss aversion, or to be so vulnerable to any one of the long list of biases that Kahneman and Tversky demonstrated. But across all the big-end, large sample sizes, this is the way people responded. So it’s an incredibly powerful piece of work that really showed that people aren’t just occasionally irrational, they don’t just act stupidly when they’re in the midst of a bubble. Irrationality is embedded deep into our operating system. But this is quite an academic book? Yes it’s a very academic book. But it happens to be about as accessible as a bunch of academic papers can be, simply because it’s just fun to go through and do the hypotheticals – these questions they’re giving to undergraduates at Hebrew University in the mid-1970s – and then testing yourself against them. And the collection does a very nice job of mixing together the original papers with subsequent results in the field of economics which then take, for example, loss aversion and apply it to the real world. So you can see how this actively influences the decisions of mutual fund managers, with very important negative consequences. And this book not only pointed out this core irrationality, but really changed the economics field as well. I think the Nobel prize speaks of the importance of the work to economics. But doesn’t it show these biases affecting all sorts of things, including potentially life-and-death medical decisions? That’s actually an offshoot of loss aversion. So there are different ways of framing a question, and one way to demonstrate loss aversion is that the ultimate loss is, of course, death. So if you go to doctors and ask them to choose between options, and one, the riskier option, is framed in terms of saving people, and the other in terms of people dying, most doctors will risk everything on the all-or-nothing approach. Even when it’s the exact same numbers, if it’s framed in terms of death, people are twice as likely to avoid that option. Because framing the question in terms of losses, making us even think about death, is so ugly, it feels so bad to us, that the person thinks, ‘Oh I’ve got to go for the risky approach.’ [Read a more detailed explanation of the experiment here] And Kahneman and Tversky argue that it does indeed affect the way doctors discuss, for instance, cancer treatments. You can get doctors who work in cancer wards to think very differently about treatment if you frame it as a five per cent chance of surviving, or a 95 per cent chance of dying. And, as a patient dealing with cancer, you often do have to make decisions based on statistics you are given – doctors say there’s a five per cent chance of this if you do that, or a 10 per cent chance of that if you don’t do this, and it’s all very confusing. Yes. We’re given all these statistics, but the human mind wasn’t designed very well to deal with statistics. What we’re left with is this feeling. A feeling of either fear – that’s a risk we’re taking – or that’s a potential gain I should pursue. A lot of it really is about these emotions which, in the end, drive our decisions. So simply by reframing the question one way or the other, you can dramatically influence these feelings. Human beings really aren’t rational agents for the most part, because we’re actually being driven by these emotions triggered by dreams of losses or gains.

How We Know What Isn’t So: The Fallibility of Human Reason in Everyday Life

By Thomas Gilovich


Your next choice is How We Know What Isn’t So by psychologist Thomas Gilovich. This is a really smart book and the reason I put it on there is that it really invented the genre of science non-fiction. Gilovich did some very interesting work (actually with Tversky when he was still at Cornell) including on the ‘hot hand’ effect. This refers to basketball when players think they have a ‘hot hand’. They make three shots in a row: fans think they’re in the zone. But actually the hot hand is a cognitive illusion. After making a couple of shots in a row, players actually get over-confident and become less likely to make their next shot. So the book is filled with case studies like that, clever demonstrations that so much of what we perceive in the world, and then use to act on, is actually based on cognitive illusions. So this book is very accessible. It was very popular and demonstrated for the first time that people love to learn about their biases. There’s really something fascinating about reading your own user manual and going, ‘Oh that’s what made me do that stupid thing all the time!’ What kind of cognitive illusions does it home in on? If you want to summarise it, a large part of the book is about positive information bias – the fact that we like to believe that we’re right and so we ignore all sorts of evidence that suggests we might be wrong. That’s why conservatives watch Fox and liberals watch MSNBC. Which isn’t the biggest revelation in the world – but there’s all sorts of clever studies that demonstrate this again and again, that show just how blinded and blinkered we are. We think we’re so objective, but there’s actually nothing objective about the human mind. We have these working beliefs and we seek evidence to confirm beliefs: that, unfortunately, is the best summary of how we seek out evidence.

The Winner’s Curse: Paradoxes and Anomalies of Economic Life

By Richard Thaler


What about the next book, by economist Richard Thaler – what is The Winner’s Curse? The Winner’s Curse is something I think about every time I go on E-bay. It was probably first demonstrated by Richard Thaler, who is a very influential behavioural economist at the University of Chicago. We’ve got these economic models, but the problem is these models are based on a profoundly inaccurate view of human nature. So if we get some real data showing us that people aren’t rational agents, shouldn’t we change our economic theories? Again, it’s a pretty academic book, for the most part a collection of papers, but it is fascinating to watch ideas in psychology infecting other fields, like economics, and seeing that infection for the first time in Thaler’s work. So The Winner’s Curse is all about auctions and how people will often over-bid in blind auctions. So if you’re bidding for a free-agent baseball player, or bidding for oil rights, or Bill Clinton’s autobiography, all of these are blind auctions, and people dramatically overpaid – which is a recurring feature of blind auctions. Thaler is trying to take all these canonical examples/problems/situations in economics and saying, Well now we’ve got more accurate models of what people actually do, now we don’t have to rely on these hypotheticals, shouldn’t we revise our models? And are other economists now doing that also? There is still plenty of resistance, some of it well justified. People are saying: ‘Look it’s not like psychology is a very accurate model – the mind remains a very mysterious thing.’ So you don’t want to simply tether yourself to something that’s a work in progress. Which I think is a valid response. I think there are some economists who are very worried about turning economics into a subsidiary of psychology, which is what behavioural economics is: these are economists who use the tools of psychology, use psychological paradigms and combine them with economic models. So it really is a branch of psychology. These are valid worries and concerns but, that said, it’s hard to deny that behavioural economics and neural economics, these two branches of economics that are trying to merge with neuroscience and psychology, are both very intellectual fields at the moment. They’re everywhere, in the Obama administration, there’s now some bigwigs at the University of Chicago. This is a booming field, and given where we are right now, trying to recover from a financial apocalypse – yet another financial bubble – I think it only makes sense to once again try to understand what makes us tick. If we have learned anything from the sub-prime mortgage mess it’s that we have yet another reminder that we really aren’t rational agents. When we assume people are rational agents, we are led astray. To the extent that future regulations will be effective, it’s to the extent that they can accurately look at all these irrationalities and anticipate them and take them into account. So can you give me an example? One example that Thaler uses is the ultimatum game. It’s a very simple game: you give person A $10 and say, ‘OK you can divide it any way you want to, and the only catch is that if person B rejects your offer, then nobody gets anything.’ So economists, with their selfish rational models, would say the way person A should behave is to keep $9 and give person B $1. Person B might think that is unfair, but if they reject it, they won’t even get $1, so rejecting it would be irrational spite. So what’s supposed to happen according to homo economicus is this very rational split. But that’s not at all that happens – when economists actually started playing this game, and they played it all over the world, they found that people on average split $4.50 with person B: they actually made a fairly equitable split. The reason is that they know that if they made an unfair split, person B would be really angry, so angry they’d probably reject the offer. Person A is able to anticipate the emotions of the other person enough for them to make a fair offer. It’s not the way we’re supposed to behave, it’s neither particularly rational or selfish. And yet it’s the way we behave time and time again. In fact, the only people who actually act like they’re supposed to act according to economics textbooks are people with autism. They actually tend to make much more unfair offers.

Predictably Irrational: The Hidden Forces that Shape our Decisions

By Dan Ariely


Your last book is called Predictably Irrational. This is a very popular book by Dan Ariely, a really smart behavioural economist who is now at Duke (he was at MIT). The reason it’s important is that it really gives you a sense of all the different ways in which behavioural economics is flowering. This is a field that is just 20 years old, which by academic standards is very new. Dan Ariely is a very a creative guy. He was able to take this basic idea, that humans are irrational, and mine it in a million different directions. For example, one of my favourite studies is brand-name versus generic aspirin. He shows that for whatever reason we’ve got his heuristic, this expectation, that we get what we pay for. And when you give people more expensive things, even if they’re the exact same thing, people actually get more pleasure out of the more expensive product, they find the more expensive version more useful. And brand-name versus generic aspirin is a good way of showing this. You have the exact same active ingredient, no difference between the product, the pills are identical. And yet the brand-name aspirin is much more effective at curing our headaches. The other really important feature of his work – and this is an increasing theme of behavioural economics – is the importance of contextual conditions in shaping how people think. So one of the real flaws in the rational agent model was that people are always rational, it doesn’t matter what the situation is, people always act in this very predictable way. We’re actually not that consistent, so that even when it comes to our irrationality, we’re not entirely predictable. So the title of the book is actually sort of misleading. Very small changes in context and circumstances can dramatically alter our behaviour and our response to incentives. In one situation, in one kind of classroom, we won’t cheat and we’ll all seem like very honest souls. Tweak a few variables, make us a little bit more anonymous, and all of a sudden we’re cheating on everything. So we’re just beginning to understand how complicated and subtle our decision-making machinery is. So where does all this get us? That’s the million-dollar question. The important thing to note is that it gets you nowhere, unless you’re self-aware. You can know about all the biases in the world, and, unless you are able to take them into account when making a decision, it’ll be useless knowledge. That’s the crucial ingredient, what psychologists refer to as meta-cognition – thinking about thinking. Unless you practise meta-cognition, unless you think about loss aversion when you’re evaluating your own stock portfolio, or unless you worry about this bias for more expensive things when shopping for aspirin, you’re going to make the same mistakes as everybody else. Is that what your book is about? I saw you mentioned on your blog on Amazon that you are a very indecisive person and that’s what prompted you to write a book on decision-making. I’m pathologically indecisive as a matter of fact. My book was definitely an attempt to apply this knowledge, first of all to try and put it in the context of modern neuroscience, but also to say, ‘Well, great, people are stupid, we do all sorts of stupid things, we’re incredibly irrational, we pay a year’s salary for a black tulip. So what do we do now? How do we apply this in order to make better decisions?’ It’s a larger societal question too. As we develop better models of how humans actually behave, we can actually begin to explain how we choose which stocks we buy, what we buy in the supermarket. And then the important question becomes, ‘Great, we have these lovely models! But how do I actually use this knowledge to make better decisions? How do we turn behavioural economics into an applied science? So that next time we structure regulation we won’t be quite so tempted by subprime mortgages…’ Those are the really important questions. But at this point, given the science is so new, the best advice someone can give you is, ‘Look, what you really need to do is to learn this list of biases, these flaws, these hardwired mistakes, and begin to take them into account in your own life when you’re making decisions.’ Because that’s the only way we’re going to be able to avoid them.

Interview by

Sophie Roell

Published on Apr 9, 2010

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