Response for @Epicurean Deal

I can safely say that, of the 400+ people I follow on Twitter, @EpicureanDeal is one of my five favorites (the others: @pkedrosky @robdelaney @zerohedge @BrokeLivingJRB).

So, when @EpicureanDeal offers to share a bottle of wine with anyone who can provide a satisfactory answer to the questions below, I cannot help but take up the offer (though I reserve the right to make the other side of the argument as circumstances warrant).

Can anyone provide a clear, comprehensive account why today’s derivatives environment can’t lead to another AIG? Genuinely interested. +
+ And please *don’t* think you can buy me off with arithmetic (netting). Explain how credit failures cannot propagate through the system.
My intuition is that people rely far too much on collateral and counterparty credit analysis (margin), which can change faster than the +
+ market and counterparties can adjust. Plus margin calls are *known* to cause selling pressure on underlyings, hence downward spirals. +
+ But I am open to having my intuitions proved wrong. Just skeptical that any such regime can protect against leverage-induced death spirals
I have a nagging suspicion there’s a lot of finger-crossing and magical thinking in finance about counterparty credit exposure.

I’d like to start by going over my thoughts on this issue in general, before proceeding to argue the case.

In gambling, the term “freeroll” is widely bandied about. A freeroll is a situation where you can win, but you can’t lose. Used loosely, it also refers to situations where you can win a lot, while risking only a little. From an amoral, self-interested perspective, you want be on a lot of freerolls. You also want to avoid being “freerolled” (meaning that others can potentially gain at your expense, without you obtaining any offsetting compensation).

The finance industry is typically well versed in the economics of adverse selection, and, yet, as a matter of self-preservation, it continuously plays down the importance of principal-agent problems. It’s clear that principal-agent problems are endemic in modern finance. Some of principal-agent tensions are inevitable and will never be rooted out; but some can, and a major function of future financial market reform should be mitigating principal-agent issues where they occur. Some obvious ones: you can’t freeroll the government (if you take customer deposits and you’re government insured, you can’t take risky gambles), transparency has to reign when possible (everything that can be put on exchanges, should be), and financial instruments that increase systematic variance without adding obvious financial benefits (credit default swaps are a possible example) should not be allowed.

In finance, the principles are the government, which is obviously clueless, and diverse shareholders, who mostly can’t be bothered and at any rate are represented by corrupt Boards. The agents are the people working for the principles. All the people you hear from are agents. People don’t graduate from agents to principles; they graduate from agents to beach houses in Maui. So what we hear from the finance industry primarily represents the interests of agents. When scumbags like Jon Corzine completely freeroll the government and everyone else, criticism within the industry has to be somewhat muted, lest comparisons be drawn with other, similar freerolling behavior.

So, in light of the above, the rest of the analysis will take it for granted that the entire derivatives industry, especially that part of it that occurs off exchanges, exists so that agents of firms freeroll principles of firms; that is, make large gambles on which they retain upside but little downside.

Here are the reasons why the derivatives industry, despite being entirely corrupt, will not likely blow up the economy at large:

1. Off-exchange derivative transactions share a similarity with one-to-one betting among individuals; there is rarely an incentive to bet with someone who might not pay you. Uncreditworthy parties might want to do a lot of business in these markets, but, in the current environment, it will be difficult for them to find someone to take the other side of their bets. For catastrophe to happen, someone would have to take the other side of their bets in extreme size; this seems unlikely. Like gamblers, financial market participants are decent at managing counterparty risk.
2. Governments have taken their responsibility as “lender of last resort” to greater lengths than anyone envisioned possible. If a financial firm has a monster loss on a derivatives position, they now have a lot of degrees of freedom in how they handle the problem. They can give the government all of their moderately bad stuff, while using their cash to pay for their derivatives losses.
3. The financial world has grown staggeringly complex, and people no longer have the attention span for it. That said, in today’s financial markets, when a financial firm shows a hint of insolvency, attention focuses intensely on the firm or firms in question (better late than never), and trading volumes in those firms become explosive. Once attention is focused, reality is revealed, or at least it becomes close to becoming revealed. Market participants now are much more vigilant than they were pre-2007. Even in the early stages of the crisis, before the new tendency towards increased market vigilance fully asserted itself, we saw this phenomena of sudden attention, followed by massive trading volumes and revealed reality; Countywide was a huge favorite…

The Center Should Not Hold

The title of Brandon’s previous post “The Center Can Not Hold” is ripped from the end of the famous TS Elliot poem The Wasteland.

Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world.…

The poem was written in the immediate aftermath of WWI when Europe was rendered a bloody mess as the various socio economic institutions and political alliances that had held Europe together since the fall of Napoleon were ripped apart.

Brandon uses the phrase to describe what he sees as happening to the poker world. Poker had experienced a renaissance of sorts ever since Chris Moneymaker won the WSOP in 2003. Moneymaker was an unknown who had learned to play poker by playing online. His success spurred the popularity of online poker websites. These websites not only helped pull in new players but helped as Brandon describes it pull the game away from the shadowy underworld that had previously operated it. In the new corporate world of poker, everyone from college kids to major Hollywood actors could play and they could do so in games kept far away from shadows. Now with the fall of some of these poker sites, this new world is being torn asunder and looks to be reverting to the old.

This development is unequivocally bad for professional poker players and Brandon is right for thinking so. If the games become harder to access then new money, dumb money will not access it and you are left staring at a bunch of wolves. However, what is bad for the pros; is good for the larger world. If there was a world that needed to be destroyed by the forces of otherworldly chaos summed up in The Wasteland, the world of poker was it.

On the surface, I should have no problem with poker. It is a zero sum game – for every winner there is a loser and vice versa. However, this is a deceptive monkier. Regardless of whether you win or lose, poker does subtract one thing and that is time. It subtracts time from people who are very talented who could be participating in positive sum games. The problem with poker over this past decade is that too much dumb money came in and too much intelligence arrived to capture that dumb money.

When guys who win the Hoopes prize for mathematics are giving up careers in mathematics to focus on poker, the world is a poorer place. And this is precisely what has been happening over the last several years. Poker went from being a fun hobby for the legions of smart people who play it to being their actual day job that they could do from home through online poker sites. They turned away from engineering, from teaching, from law and they spent their days trying to win $10,000 pots on Full Tilt while sipping coffee in their underwear. You couldn’t blame them either. The decision to play poker full time was by far the more rational economic choice and made many of them multi millionaires. 

It is hard to look at poker and not draw parallels to the world of high finance. While finance arguably has greater social usefulness then poker, much of the activity in finance over the last decade – the high frequency trading funds, the engineering of esoteric mortgage products – had very little to negative societal value. Like poker, finance drained away some of the most intelligent people in society and the world was left a worse place.

Now both industries are under regulatory attack from the government and for different reasons. The charges that are being levied though have nothing to do the most serious crime that these industries committed, the crime of being too beautiful and alluring to too many of the best and the brightest. The government can’t arrest these industries for being too beautiful so the government is doing the next best thing by trying to throw acid on their faces. Whether it works or not to detract interest remains to be seen. …

The Center Cannot Hold

In 1998’s Shut Up and Deal , Jesse May told you all you need to know about the poker world. My book, 2006’s Broke: A Poker Novel, was an afterword. In his June 1 blog, “Poker is going back to the Wolves”, Jesse said, “I looked around the room yesterday at six pm and it was nothing but lifers as far as the eye could see. Just a big group of all those with life sentences in poker and no other prospects and no contemplation that something else might come along if things go bad.”

As a Full Tilt pro, I have to contend with the fifth paragraph in Jesse’s blog:

“Many lifers showed up without patches, and their message was clear. I belong here, they said, you all know I do. Top drawer or case money, I’m a poker player first and last, in 2011 or 2054. One man, however, showed up wearing his patch and squeaking his high voice, and that was not cool. You’re supposed to leave your gang colors off at funerals, weddings, and when you’re behind on the rent. Anything else is just provocation, especially when there’s a satchel under your bed stuffed with sweatshop jeans made by 18-year old indentured grinders that you gave minimum wage. It was no wonder that tempers got raised.”

I think this is harsh. I expect to wear a Full Tilt patch during most of the Series. I’ll do this not because Full Tilt tells me to (indeed, Full Tilt sent out an email to US pros that leaves all US deals in an ambiguous standing) and not because I have a self-interest in doing so. Obviously it’s more convenient not to wear a patch on any given day, given the scorn and media interest one might receive, and certainly one doesn’t expect financial benefit from wearing a patch (my deal, for instance, only awards money if the patch is shown on TV, but one is not allowed to wear poker site logos on feature tables this year).

I’ll wear a patch more out of loyalty, because I know and like the Full Tilt guys, and I trust them to do the right thing. Along with everyone else in poker, I’m devastated by the fact that the poker world is being ripped apart, and I’m horrified by the fact that Full Tilt hasn’t been able to meet its obligations in the short-term.

I’ll also be wearing a Full Tilt patch out of fear. Like Jesse, I also see poker going back to the wolves, but, unlike him, I view this as the worst thing imaginable. Many of the best people I’ve come across in poker are associated with Full Tilt, and, in my mind, rightly or wrongly, if they fail to do the right thing and Full Tilt goes down, then poker will have gone fully back to the wolves.

Why the fear? Shut Up and Deal is the best poker novel because Jesse May recognizes, without coming out and saying as much, that a world ruled by addiction and self-delusion can never look anything like the normal world and will never play by its rules. This is a point missed by most posts in the blogosphere, the twittersphere, and the poker forums.
Poker is a lifestyle masquerading as a career path. And as lifestyles go, it’s not a particularly healthy or sustainable one (But is a lot of fun). The online poker sites sort of successfully sold the idea of poker as a career path (obviously it was in their interest to do so), and now many people look at poker as almost like a normal industry, something that with a little effort they will be able to understand and comment on.

The thing is: poker doesn’t work that way. After being around poker for a very long time, I can tell you that it’s all shadows, blue pills, and unpealed layers. You always think you understand, but you don’t.

My fear is simply that, if Full Tilt can’t hold it together, poker will enter a dark phase.
It’s notable that since Moneymaker’s win in 2003 and the launch of the golden age of poker, there have been relatively few instances of violence in the poker world. Arguably, this has a lot to do with the legitimacy brought to the poker world by the major sites, and with the flood of money that the sites channeled from the outskirts of the poker world to the center.

To me, the threat of violence in gambling is the reason that we need regulation to hit the poker space as soon as possible. People have lost sight of the reasons why violence and gambling are natural bedfellows. First, gamblers are often sick and tend to run up debts. Since these debts are hard or impossible to collect using normal channels, force is often used. The gambling world tends to evolve over time towards people who use force (or are friendly with people who use force), for the simple reason that those are the people who get paid first. At present, many online players are entering the live world — I am sure they will win millions, but at the end they will have little hard coin and a lot of IOUs. Second, cheating and…

Gary Becker and Stephen Dubner discuss organ donor markets, applying market price to immigration, US economy

I’m posting here a link to a discussion between Freakonomics co-author Stephen Dubner and Nobel Prize Winning Economist Gary Becker conducted on ExpertInsight.com last week. It’s a 30 minute discussion, amazingly packed with thought provoking questions and discussions. In particular I found very interesting the first video segment which focuses a lot on a market for organ donation and the second video which discusses opening up immigration to anyone who would pay an immigration fee (of say, $50,000).

As I watched the videos the key thread is applying markets to solve both economic and social problems. Obviously this should come as no surprise who know Becker’s work and also know that he is a University of Chicago economist. The free marketers have taken a beating over the last couple of years due to the financial meltdown, and it would be a shame of the average person or the politicians take their mistrust for markets too far, as some of the ideas Becker has recently proposed free market solutions to make a lot of sense. In the first and third segments of the interview he talks about applying a free market/pricing to the organ donation market. I’m sure this would dramatically increase the supply and also improve matching in the market as Becker notes.

He also proposes that a price be set to immigration, something like $50,000 to immigrate to the US; and that loan programs be put in place to allow immigrants who benefit from the better opportunities to pay some of that back to the US. He notes that this would both reduce objection to immigration from the public (because it will provide tax revenue) as well as making immigration more beneficial by bringing on average higher-skilled immigrants.

He mentions among the greatest achievements of economics the move towards free trade, the notion that price controls are bad, and the realization (though many thought the opposite for a time) that communism would not succeed as an economic system.

One thing I find distinctly absent in the conversation is the concept of equity aside that of economic efficiency. I think the work of economics in general has done a much better job in solving the problem of creating economic efficiency than they have in that of economic equity. The easy response to that is to solve for efficiency and then redistribute, but redistribution tends to be a much harder political task (at least in the US, and more certainly across international borders).

I’ve personally always thought of the current format of US immigration policy (or lack thereof) as a form of wealth distribution from the US to poorer countries, as our formal international aid is so meager (remittances end up being a form of international aid). Trade barriers are a very inefficient way (but still a way) to create a more equitably compensated labor force (though this may not benefit the poor/working class overall if they pay more for the protected goods). I think most economists feel more comfortable discussing economic efficiency than equity is that they can all agree that a bigger pie is better, and how the pie is cut up is a more philosophical discussion. Still – we know that only the very upper echelons of society in the US are better off now then they were 30 years ago, even with tremendous economic growth. If I had my 30 minutes with Gary Becker – I think I’d ask him about what level of equity he thinks is fair, and the best way – from both an economic theory/policy and political standpoint – to achieve it.

…

Applying Sports Performance Analytics to CEO Compensation

While many people complain about athletes being overpaid – and certainly the make a lot of money – at least in the case of baseball it would be hard to find too many professions where players’ net value was more carefully scrutinized with data. Given the tremendous amount of performance data and analysis, we would have to imagine that baseball players, at least on a relative basis, are fairly compensated – at least to the extent we can use their past performance to predict future performance.

One of my favorite concepts in baseball is VORP – Value over Replacement Player. The idea behind is it pretty simple and powerful. It asks the question, how much value are we getting from our current starting player compared to a “replacement” level player –e.g. minor leaguer at the same position. The point of the analysis is we should make our compensation decisions on the output gap between two players rather than the overall output of the players.

Ever since I have come across this concept, I have been trying to dream up ways you could apply it outside of sports. What if we could somehow measure the contribution a CEO’s or executive team made to an organization and then could compare that to the contribution of say a mid-sized company (500-1000 employees)? There were 100 CEOs with total annual compensation over $15 million in 2009/10. So my question is, if I took the top-100 managers I could find willing to work for $1 million/year, would I significantly degrade the average performance of these 100 companies? Does the VORP of these CEO’s justify an aggregate compensation of $2.25 billion (these top-100 earned $2.35 billion) over the $100 million I would pay the hundred best qualified “replacement level” managers?

I’m asking this question not because I know the answer, but because I don’t. It’s undoubtedly complex to manage corporations that are global, have billions of dollars of revenue and in some cases 100s of thousands of employees. It’s easy to argue that in a company with billions of dollars of revenue, making a mistake and underpaying a CEO to save money would be foolish and would make saving $15 or $20 million seem insane.

And that, in the end, is exactly why executive salaries are as high as they are. It’s the same principal that firms like Goldman use in the IPO market – who wants to get petty over a few million in a billion dollar transaction when the downside to not going with the best is so large? Many-a-house in the Hamptons were built on this principal, to be sure.

I would argue that low wage workers are subject to the same types of data driven scrutiny that baseball players are. The simpler the task, the more easily we can measure performance for it. Data-driven measures (customer satisfaction, absenteeism, productivity) are increasingly used on the low-end of the wage scale in promotion and firing decision, which directly impact compensation (going up upon promotion, going to zero upon firing). To be sure for line working and middle management positions, there is a huge supply of potential “replacement players,” to replace workers who don’t meet performance criteria.

What could be keeping the wages as high as they are at the CEO level is likely viewing the supply of those capable of being a Fortune-500 CEO very narrowly; Boards of Directors are typically very risk averse, and would be quite unlikely to hire a person who is not proven at the highest levels of corporate management. This assessment of the supply of capable executives, may or may not be correct.
What we would need to accurately assess a VORP for CEO’s are two things: an accurate assessment of top CEO’s current “value” to their company and a way to identify and predict the performance of the “replacement level CEO.”

I think to assess a CEO’s value the most broad measure we could construct is some measure of industry adjusted long-term total return to shareholder. This study here (http://hbr.org/2010/01/the-best-performing-ceos-in-the-world/ar/1) does exactly look at this measure of industry adjusted TRS. We could get one clue about market efficiency of compensation just by looking at excess TRS vs. total compensation in a scatter plot. If they seemed to have a strong positive correlation then we would know the market had some efficiency to it. That wouldn’t answer our question totally, but it would be a start. In fact, there have been a multitude of studies looking at CEO performance vs. compensation and there is only weak evidence for positive performance (see here for example http://www.gsb.stanford.edu/news/research/compensation_daines_ceopay.shtml). What I have yet to find is one that tries to calculate the excess pay being wasted – it would likely be an underestimate anyways since we haven’t even considered the wider market for “replacement level” CEOs.

To do a good job of understanding the potential to fill roles with replacement value players we could also find the industry adjusted performance of small company CEO’s (I bet company size and CEO compensation are quite correlated) and then see how much industry adjusted TRS our lower group is contributing vs. their compensation.

Of course then we would need “league adjustment factors” to understand how much performance is degraded by moving up from…

My 30 Favorite Non-Fiction Books

I’m sure I’ll omit some of my favorites here. The most glaring omission from my earlier lists was The Confederacy of Dunces by John Kennedy Toole. I love this book deeply (though, strangely, the first time I picked it up, I read forty pages and then quit).

1. The Selfish Gene. Richard Dawkins.
2. This Time is Different: Eight Centuries of Financial Folly. Ken Rogoff, Carmen Reinhart.
3. Micromotives and Macrobehavior. Thomas Schelling. Read this before you read The Tipping Point, please!
4. The Modern Mind: An Intellectual History of the Twentieth Century. Peter Watson.
5. Bad Money. Kevin Phillips.
6. Something New Under the Sun: An Environmental History of the Twentieth Century. John McNeill.
7. The China Study. Colin Campbell.
8. From Dawn to Decadence. Jacques Barzun.
9. Chaos. Gleick.
10. The Assassins’ Gate. George Packer.
11. The Fourth Turning. William Strauss, Neil Howe.
12. The Misbehavior of Markets. Benoit Mendelbrot.
13. Devil Take the Hindmost. Edward Chancellor.
14. Nixonland. Rick Perlstein.
15. The Power Game. Hendrick Smith.
16. Freakonomics. Steve Levitt, Steven Dubner.
17. Bobos in Paradise. David Brooks.
18. Story: Substance, Structure, Style, and Principles of Screenwriting. Robert McKee.
19. The Graying of the Great Powers. Neil Howe, et al.
20. The Price of Loyalty. Ron Suskind.
21. Black Swan. Nassim Taleb.
22. Reinventing the Bazaar: The Natural History of Markets. John McMillan.
23. The Money and The Power: The Making of Las Vegas and Its Hold on America. Sally Dinton, Roger Morris.
24. The First World War. John Keegan.
25. The Meme Machine. Susan Blackmore.
26. The Greatest Story Ever Sold. Frank Rich.
27. Decision-Making with Insight.xla. Sam Savage.
28. Stabilizing an Unstable Economy. Hyman Minsky.
29. The Dollar Crisis. Richard Duncan.
30. House of Bush, House of Saud. Craig Ungar.
…

20 Favorite Works of Fiction

Continuing the theme of the week, my twenty favorite pieces of fiction…..

1. More Die of Heartbreak. Saul Bellow
2. The Picture of Dorian Gray. Oscar Wilde
3. The Road. Cormac McCarthy
4. London Fields. Martin Amis
5. The Spy Who Came in From the Cold. John Le Carre.
6. Bright Lights, Big City. Jay McInerney
7. Ham on Rye. Charles Bukowski
8. A Man in Full. Tom Wolfe
9. The Corrections. Jonathan Franzen
10. This is Where I Leave You. Jonathan Tropper
11. Wonder Boys. Michael Chabon
12. Rabbit is Rich. John Updike
13. The Day of the Jackal. Frederick Forsyth
14. Lolita. Vladimir Nabokov
15. Bonfire of the Vanities. Tom Wolfe
16. All Quiet on the Western Front. Erich Remarque
17. Wormwood. David Levien
18. Fury. Salman Rushdie
19. Slaughterhouse Five. Kurt Vonnegut.
20. A Super Sad True Love Story. Gary Shteyngart
…

My Favorite Pieces of Financial Journalism

1.  The Smartest Guys in the Room

2.  The Big Short

3. When Genius Failed

4. Liar’s Poker

5. Barbarians at the Gate

6. Den of Thieves

7.  Predators’ Ball

8.  DotCon

9.  Too Big to Fail

10.  All the Devils Are Here …