Tuesday, November 18, 2008
Allen Greenspan, former Chairman of the US Federal Reserve System, coined the cautionary term “irrational exuberance” to describe the asset bubble in dot-com and telecom equity stocks in the late 1990’s. That bubble burst when the accounting fraud scandals at Enron and WorldCom exposed many company values as illusory.
“Irrational Exuberance” takes over markets when prudent judgment and sound valuation methodologies lose traction in the minds of investors. Speculation, grounded on expectations of every rising equity values, drives out sound thinking and ushers into financial markets mere enthusiasm for self-advancement.
Certain styles of decision-making tend to favor the rise of “irrational exuberance” over more responsible approaches to valuation.
The Ethical Leadership Profile, developed for the Caux Round Table by Michael Labrosse and his associates, indicates that there are for most people, in general, four distinct decision-making modes of thought.
First is the Inquiring frame of mind. This approach to decision-making emphasizes analysis of data, conceptualization to see the “Big Picture” and future trends, to find meaning in facts by giving them weight and by putting them into patterns and categories. Here we find much of Barack Obama’s approach to decisions.
Second, and opposite to the approach taken by Inquirers, are the Pragmatists. These people look to experiences of practical success as the guide to their choices and recommendations. They are focused on immediate results within the context that is given them by society’s institutions. At their best, they have a dedication to craft and substance in what they do or produce. They tend to ask how can we complete the task and less why should we be doing this? The “why” question is of more interest to Inquirers than to Pragmatists. George W. Bush and his father, George H.W. Bush, both lean heavily towards pragmatism in their decision-making. George H. W. Bush became known for his cautionary mantra: “Wouldn’t be prudent.”
Third, on a different dimension than the continuum linking Inquirers and Pragmatists are the Unifiers. Their preferred approach to decisions is to find what is best for the organization to which they belong and for them as a loyal member of that structured community. They place priority on resolving issues of hierarchy and fairness within the organization; they place loyalty to their group over concern for outsiders; they stand up for their peers and reward loyalty with loyalty. They may often defer to the organizations rules and regulations and thus appear bureaucratic and happily bound up in red tape. Hillary Clinton with her passion for control and her distance from outsiders seems to have much of the Unifier orientation in her personal approach to the use of power.
Fourth, and opposite to Unifiers are the Entrepreneurs. They plan their moves with most concern for their own recognition and advancement. Their loyalty to the group responds to the group’s interest and ability to advance their careers and ambitions. Entrepreneurs are responsive to others, creative, intense and industrious. They are always drumming up some kind of profitable business for themselves. John McCain with his penchant for quick and decisive action would seem to embrace much of the entrepreneurial spirit in his approach to decisions.
But people are rarely active only at one of the paradigmatic poles; more frequently, they combine something from the Inquirer/Pragmatist axis and something from the Unifier/Entrepreneur axis. So, we might consider Bill Clinton as an eEtrepreneurial Inquirer – a man focused on his own opportunities but with strong intellectual gifts. Barack Obama would be an Inquiring Unifier, bringing conceptual clarity to the tasks and challenges of the organization and looking at the whole of the group and not just partisan sub-cultures. George W. Bush with his war in Iraq would be comfortable mixing pragmatic action with entrepreneurial risk.
Of these four dispositions, being an Entrepreneur is most conducive to promoting “irrational exuberance”, especially when compensation structures are commission or fee based so that deals done translate directly into personal reward and advancement. Entrepreneurs are less likely than Inquirers to consider the long term consequences for others of what they are doing. Entrepreneurs have a propensity to see the world in terms of sales; if you can sell it, do so and let the buyer beware of the consequences. You will move on to the next deal.
Nor are Entrepreneurs that considerate of the risks to their organization. They think of themselves not their organization as the vehicle of opportunity and success.
But when Entrepreneurs and Unifiers are mutually engaged in the same business, it can be a very risky combination. If the Entrepreneurs are “bringing home the bacon” for the organization, the Unifiers will stand by them, reward them, and not question the effect of their activities on those outside the organization.
In the case of Enron, both Jeffery Skilling and Andy Fastow were of the Entrepreneurial frame of mind. As long as they produced ever growing revenues for the Company, Ken Lay, the Enron Board, Arthur Anderson partners working in effect for Enron, and others loyal to the company had no complaints and rewarded them with high compensation and discretionary power. The conflict of interest rule was waived for Fastow so that he could be even more entrepreneurial for both himself and Enron.
In the companies that promoted the sub-prime mortgage bubble, the CDOs that derived from those mortgages, and the credit default swaps that were to give added security to those CDOs, Entrepreneurs and Unifiers came together with toxic consequences. Their business marriage of convenience led to a massive over-leveraging and resulting asset bubbles in housing and derivative CDOs.
Entrepreneurial mind sets kept up the deal flow for both sub-prime mortgages on more and more risky terms and CDOs which were sold in ever increasing amounts. Compensation for placement of mortgages and issuance of CDOs was fee based, an incentive system perfectly fitted to drawing out Entrepreneurial thinking and behaving in financial services.
As the asset bubble was growing and fees were being earned, Unifiers like the senior managements and boards of Merrill Lynch, Bear Sterns, Lehman Brothers, JP Morgan Chase, Citibank, AIG, etc., were loath to reign in their productive agents. Concern for the benefits to the organization trumped more strategic thinking about if and when the bubble should ever burst and prices would fall.
Largely left out of the decision-making dynamic that gave us the current economic crisis were the Inquirers and the Pragmatists. Inquirers were valued only to the extent that they could rationalize and justify with complex calculations and algorithms the deals that were being promoted by the Entrepreneurs. Pragmatists were thrown into the task of churning out more and more of the deals that could earn fees. Their reservations about the quality of what they were doing were mostly ignored.
Had the governance of these financial institutions been more evenly divided among Inquirers, Unifiers, Pragmatists, and Entrepreneurs, outcomes might well have been different.
More strategic thinking from Inquirers about long-term trends and consequences might have undercut the rush to “irrational exuberance”. More focus by Pragmatists on producing quality products that were reliable and durable would have slowed the deal flow and dampened down the accumulation of debt and the scope of the bubble in asset prices.
The possible learning from this reflection on the four decision-making tendencies highlighted by the Ethical Leadership Profile is that application of the Profile and seeking a proper balance of decision-making styles might have minimized the onset of this global crisis.
Thursday, October 9, 2008
Great American financial houses – even Lehman Brothers that survived the Great Depression of the 1930s - are no more; banks in America and Europe have been propped up by governments; and massive amounts of liquidity have been injected into the financial system by the US Federal Reserve System and other central banks.
This is not business as usual. Trillions of dollars in private wealth has been destroyed in a matter of weeks, some of it never to be regained. And governments have been forced to step in to protect the economically vulnerable where markets have failed.
Yet, ironically, inadequate regulation and government policies also contributed in various ways to risks being negligently addressed by financial markets, thereby paving the way for the current crisis.
Beyond dealing with the immediate crisis, the critical task will be to address the underlying causes through reforms to restore trust and confidence in financial markets. Functioning and sound financial institutions, despite their current failure to meet their fundamental responsibilities, remains of first importance for supporting a successful free market economy. Credit is now scarce and capitalism cannot properly function without it.
The triggers to this crisis were centered on a lack of: prudence in the extension of credit; rigor in valuations; and of transparency in management. This was compounded by the mispricing of risk via the bundling and sale of debt through collaterised debt securities and via complex derivative based credit default swaps. These failures reflected profound shortcomings in private sector governance both as prescribed and as applied. In short, risk was not appropriately managed; it was not even properly understood both by those creating it and by those bound to mitigate it.
Driving this lack of prudent management was a dysfunctional and shortsighted system of incentives and personal remuneration.
Compensation of senior executives, traders and fund managers was built on greed and self interest and was decoupled from long-term wealth creation. Compensation based on fees earned and other incentive-based benchmarks blinded otherwise intelligent managers to the long-term dire consequences of their decisions. Rewards rose with excessive risk taking and was provided in ways that has largely shielded senior corporate officers and fund managers from liability for their decisions.
As a result, the best interests of customers, owners, employees and communities have been systematically overlooked. Decision-makers, driven by short-term interests, paid too little to no attention to managing risk accumulation.
Short-term speculation dominated, with part of the market enriching itself by betting on and contributing to the destruction of wealth via short-selling. Not only did the regulators fail to halt the growth in systemic risk, some of the contributing market activity and behavior was allowed to remain unregulated.
This global financial crisis has further exacerbated the very low levels of trust which the global community places in business. The fact that the profits were in effect privatized to those who created the crisis through excessive rewards, and the losses are now being socialized to taxpayers has further outraged the community. Though justly perhaps, the shareholders of the ‘failed’ financial institutions responsible for the crisis have lost most of their ownership wealth.
This is not the first time that market capitalism has so failed. Less than a decade ago, global markets lived through the bust of the dot-com and telecom bubble in equities and the accounting scandals of Enron and World-Com. Before that, world financial markets were upset by currency collapses in Thailand, Malaysia, Indonesia and Russia. And before that, the United States lived through the savings and loan/junk bond bubble and bust.
More fundamentally, the current crisis represents the latest, albeit the most severe, fallout from the systemic erosion within the corporate world of the importance of ethics and responsibility in business decision-making. Ideological commitments to laissez-faire free market fundamentalism, social darwinism philosophies, and shareholder primacy at the expense of other stakeholders, have divorced business leadership from standards of good faith, wise stewardship and care for the public interest.
As a result, capitalism’s immune system of market discipline fails every so often and the cancer of “irrational exuberance”, greed and narrow self interest metastasizes. The object of reform, obviously, should be either to eliminate this deep cancer within capitalism once and for all or to boost society’s market immune system of accurate pricing, risk management and valuation transparency in order to keep the cancer in long-term remission.
At the core of all these market shortcomings were the boards of directors of the corporations involved. They were not sufficiently encased in an environment of accountability and transparency and ultimate accountability. The market failure, therefore, was ultimately a failure of governance.
With respect to the current crisis in financial markets, there are no clear remedies on the table. Business leaders are largely silent; academics have little to say beyond the immediate; and politicians, regulators and central banks are putting out fires. No one is focused on designing a sustainable future that removes once and for all the underlying problem.
Interestingly, the recent movement promoting corporate social responsibility via CSR standards, monitoring, reporting and ratings, has not proved adequate in preventing these failures of capitalism. It is now apparent that much of the CSR movement remains on the fringes and too removed from core of business risk management and strategy. Compounding the problem, business education has been lacking with a general absence of teachings in responsible and ethical business practices.
Uniquely, the Caux Round Table (CRT) Principles for Business provide strategic ethical guidance which, had it been followed, would have kept those institutions that have triggered the crisis more faithful to their obligations of stewardship, good governance and stakeholder risk management. The CRT Principles go to the heart of constructive and ethical behaviors that enhance risk assessment and stakeholder management, boosting bottom-line valuations of business success and sustaining responsible long-term wealth creation for society.
The way forward to free markets that are consistently reliable in their capacity for robust wealth creation is through the imposition of higher standards of good governance and transparency. Lack of good governance and transparency, again and again, leads market capitalism down wrong roads. Such opacity and lack of accountability has long been a fundamental flaw in institutions of private enterprise.
The following remedial steps to take responsible capitalism from the fringes of the business model and firmly entrench it in the heart of corporate strategy deserve priority attention:
• First, the principle of “enlightened shareholder value” should be codified in company law via non-prescriptive minimum standards for responsible decision-making and good governance. (The UK Companies Act 2006 provides an example of such legislation.)
o Directors should be required to document and defend their stewardship over company affairs via specific disclosure of:
the principle risks and uncertainties likely to affect the future development, performance and position of the company’s business; and
material risks and impacts relating to environmental matters, employees, customers, suppliers and social and community issues.
• Second, members of corporate boards should be trained corporate governance including Board oversight of the full spectrum of financial, social and business risks.
o Business is not without consequence for society and should, therefore, be attentive to the demands for responsible execution of its private office of trust and profit.
o The CRT risk assessment process of Arcturus provides an example of what can be required of companies in regard to stakeholder, social and environmental risks.
• Third, corporate boards should establish a dedicated sub-committee responsible for strategic risk consideration across the full range of stakeholder, responsibility and sustainability issues.
o The environmental, social and governance risk assessment processes and outcomes, should be subject to third party assurance.
o Boards should make annual disclosures of the material financial, environmental, social and governance risks assessment in easily understood prose that is meaningful to stakeholders.
• Fourth, executive compensation must be reformed to ensure incentives are aligned to the achievement of long-term wealth creation and reward prudent risk management rather than excessive risk taking.
• Fifth, equity and capital market regulation and taxation should be reformed to incentivize sustainable value creation and to penalize / ban market manipulation, short-selling and other value destruction.
• Sixth, derivative markets need to be regulated, including the introduction of a fully regulated exchange for credit derivatives.
• Seventh, opportunities for companies and individuals to illegally hide income by utilizing tax havens and secrecy jurisdictions should be eliminated.
These reforms will not only address the causes of the current crisis, they will have a salutary effect on a broader and longer basis. Such reforms to eliminate the underlying, systemic flaws in the system should have as an objective promotion of global social responsibility on the part of all companies.
On the one hand we can judge the quality of a principle according to a moral calculus of abstract standards of right and wrong. But, on the other hand, we can also assess the practical worth of a principle by its power to achieve ethics in the field. This might be considered the inherent potential of a principle to obtain compliance with its preferences for better outcomes. As Karl Marx said in his Theses on Fuerbach, “Up to now philosophers have only interpreted the world. The point, however, is to change it.”
This seems especially relevant in the arena of corporate responsibility and business ethics.
Overcoming the functionality of greed and short-term self-interest is the goal of those who promote responsible decision-making in business. And a daunting task they have.
The Caux Round Table published a set of ethical principles for business in 1994, the first such set of principles for guidance of global business and the only set of such principles yet designed by experienced business leaders.
The current massive disruption of financial markets initially brought on by the collapse of the sub-prime mortgage market in the United States provides an opportunity to assess the relevance of the CRT Principles for Business.
weIf they had been followed, are there reasonable grounds to believe that the crisis could have been avoided, or at least mitigated in scope and intensity?
I think the answer is, yes, the CRT Principles might have made a difference had they been infused in strategic and tactical decisions on the part of those financial institutions which contributed to the current crisis.
First, let us consider the implications of the first CRT Principle for Business:
“The value of a business to society is the wealth and employment it creates and the marketable products and services it provides to consumers at a reasonable price commensurate with quality. To create such value, a business must maintain its own economic health and viability …”
Since the crisis is about the failure of major financial houses and banks such as Bear Sterns and Lehman Brothers, the sale of others such as Merrill Lynch and Washington Mutual, and the government rescue of Freddie Mac, Fannie Mae, AIG, Fortis, and others, we can quite quickly conclude that these companies failed to meet the ethical requirement of maintaining their own economic health and viability.
Their decision-making was wrong-headed in the accumulation of too much debt and in setting imprudent values on certain financial assets such as sub-prime home mortgages and CDOs. In their collapse, these firms caused a contraction of markets, thus erasing wealth and employment in violation of what the CRT advocates as the primary obligation of business firms.
Second, the current crisis was caused by a failure to provide quality products at a price commensurate with their inherent worth.
Sub-prime mortgages were priced inappropriately for many borrowers. Excessive and imprudent borrowings were offered to home owners. In the many cases where credit standards were waived or overlooked lenders and mortgage brokers knew or should have known as professionals that the borrowers were highly likely to default if economic conditions changed.
Borrowers were effectively sold defective financial products. Such mortgages were also sold in excessive quantities, creating an asset bubble that gave rise to perverse incentives on the part of home buyers to assume unreasonable risks of future default and foreclosure.
Similarly, the terms of many CDOs sold were not of the value that was represented to buyers. They carried more risk than was reasonable for the investment goals of those who purchased them. They were also issued in excessive amounts that undermined their long-term value.
This requirement to serve customers with respect for their needs is reinforced in Section 3 of the CRT Principles for Business with the requirement that businesses “provide their customers with the highest quality products and services consistent with their requirements.”
The first CRT Principle also holds that:
“Businesses have a role to play in improving the lives of all their customers, employees, and shareholders by sharing with them the wealth they have created.”
Here has been the greatest harm done by those who create the unsustainable markets in sub-prime mortgages and CDOs – they destroyed wealth and made worse the lives of many customers, employees, owners, creditors and communities.
Principle No. Three of the CRT Principles holds that:
“… businesses should recognize that sincerity, candor, truthfulness, the keeping of promises, and transparency contribute not only to their own credibility and stability but also to the smoothness and efficiency of business transactions, particularly on the international level.”
The current crisis in financial markets was caused by a lack of sufficient transparency in CDOs valuations which eventually undermined the smoothness and efficiency of international markets for credit and liquidity.
Principle No. Four of the CRT Principles holds that:
“[Businesses] should recognize that some behavior, though legal, may still have adverse consequences.”
It appears that in general, the provision of the financial products that gave rise to the crisis was legal. No laws were violated in lending to sub-prime borrowers or securitizing those mortgages and selling off interests in them through CDOs and in providing guarantees of payment through credit default swaps. Individuals here and there are being investigated for fraud in the sale of such products, but the products themselves were legitimate in concept. What went wrong was selling them to excess on unsustainable terms. That behavior, though legal, had adverse consequences that should have been foreseen and avoided.
With respect to their owners, those responsible for the credit crisis failed to meet other responsibilities set forth in the CRT Principles for Business. For example, they failed to “apply professional and diligent management” and to “conserve, protect and increase the owner’s/investors assets”. These failures lay at the heart of the dynamic that caused the crisis. There was strategically poor judgment exercised in the development of these markets. Risk was exacerbated to the point of destabilization; it was not properly foreseen or managed.
And, finally, those who caused this crisis failed to meet the CRT standard of enhancing community environments and standards of living. Where homes go into default when mortgages can’t be paid, communities suffer disinvestment and even blight as home prices fall and homes are abandoned to the lenders.
Had the boards of directors and senior managers of Bear Sterns, Lehman Brothers, Merrill Lynch, Citibank, Morgan Stanley, Goldman Sachs, Washington Mutual, Freddie Mac, Fannie Mae, and others who thrived for a while off the issuance of sub-prime mortgages and CDOs taken their CRT responsibilities more seriously – and insisted on products and sales strategies consistent with those practices – there would have been less risk injected into the global financial system and less provision of unsustainable financial products.
As I wrote a few years ago in Moral Capitalism, “Directors and corporate officers are hired to be agents not just for their fidelity but also for their skill. Their responsibility is to guard against high risk and imprudent courses of action.”
In that book, I also pointed to the intertwining of interdependencies and the need for trust in transactions. Capitalism breeds interdependencies through the specialization of function and the division of labor. Reliance and trust are essential for capitalism to thrive. Destruction of either leads to trouble in markets. People lose confidence and withhold their ideas, labor, and capital from productive exchange. The economy then contracts. That is what is happening now. The current crisis is really only a crisis of confidence; trust has been lost.
But how do you restore trust when it has been abused?
I wrote in Moral Capitalism that “where mistrust prevails, people fear entering into dependency relationships. Mistrust always raises the risks of enterprise. Who would invest where risks are excessive and returns uncertain?”
This dynamic explains the collapse of value in Bear Sterns, Lehman Brothers and Washington Mutual – they had billions of dollars of assets on their books but no one wanted to buy their shares. The value of Bear Sterns was $80 per share on the books, but only $2 per share in the market. Lehman Brothers went bankrupt and its owners could not realize the value of the company’s book assets as no one wanted to buy those assets encumbered as they were by debt and uncertainty.
I also noted in Moral Capitalism the sometimes negative effect of desire for money. “The interest of owners and investors in making money introduces a challenge to moral capitalism. Money is easily idolized, provoking heresy by turning us away from the things of God to the things of Mammon. There are times when we may sell our souls to gain what money promises in way of power and license. This is especially true in today’s culture of consumerism, where we have sanctified appetite over character.”
How much did this dynamic contribute to the current crisis?
I close these thoughts with a quote from an ancient Chinese text, the Annals of Lu Bu Wei, who wrote about 250 BCE
“In making judgments, the early kings were perfect, because they made moral principles the starting point of all their undertakings and the root of every thing that was beneficial. This principle, however, is something that persons of mediocre intellect never grasp. Not grasping it, they lack awareness, and lacking awareness, they pursue profit. But while they pursue profit, it is absolutely impossible for them to be certain of attaining it.”
Manhattan’s great investment banks are gone. The last two – Goldman Sachs and Morgan Stanley - are converting into banks, submitting to more intrusive government regulation in return for more secure sources of capital.
Communism couldn't kill this Wall Street; capitalism, however, did. Adam Smith won out over Karl Marx.
This "Wall Street" died at its own hands in a form of negligent suicide. It lived by the sword of extreme market capitalism and died by that same sword. It overdosed on toxic behaviors as did John Beluchi, Jimi Hendrix, Janis Joplin, and Jim Morrison.
The epitaph, I suppose, for "Wall Street’s" mighty rise and astonishing fall should be "Sic Transit Gloria Mundi" - "thus passeth worldly glory".
Street talk for what killed Wall Street’s investment bank titans is that it was “greed” that did them in. As in a Greek tragedy, excess and hubris worked through a cycle of boom and bust to humble even the best and the brightest. It’s an old story, really, new in its techniques of subprime mortgages, CDOs, and credit default swaps, but very old in its moral fundamentals.
But I don’t think it was greed precisely that was the cause of the losses and bankruptcies.
Greed - understood as seeking a profit, as pursuing one’s interest in business transactions – has not always been so terribly dysfunctional and hurtful to the common good. Indeed most of our modern life was devised, produced, distributed and sold by capitalist behaviors and motivations. There was a baby in Wall Street’s bathwater to be sure.
Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Sterns and their predecessors brought companies to life by raising capital for them. America’s growth and resulting economic well-being rested on robust capital markets. Without them there would have been no railroads, steel mills, General Motors, Ford, Boeing, Microsoft, or all the other Fortune 1,000 and smaller companies that ever sold stock or debt securities to finance their businesses.
So what went wrong? When did this “Wall Street” of once sound investment banking houses start walking on the wild side towards perdition?
The short answer is too much leverage – too much debt. Lehman Brothers, as an example, was leveraged 30 to 1 when it failed. When its chickens came home to roost in questions about how it was going to pay off its debt as the market turned sour, Lehman had insufficient capital of its own to be credibly self-reliant in down markets.
This answer raises a further question: why the need for so much leverage?
The answer to this question gets us closer to the culprit. Lehman wanted to buy securities and other tradable assets to resell them for a profit. It borrowed money to buy assets. It was not raising capital for other companies and taking a fee for the service. That was the traditional role for investment banks. No, Lehman had become a big trader on its own account as well. Lehman and the other investment banks were buying and selling any number of assets – short sales, currencies, options, puts and calls, stocks, bonds, many sorts of derivatives – to speculate on price movements.
When done well, such trading earned huge returns and permitted lavish bonuses and life styles on the part of its owners and employees.
The point to note is that trading is not real investing. It is playing in the space left open by other buyers and sellers. Trading is short term; it is not designed to hold rights to the income or the capital appreciation of companies over the long haul. The time frame for trading is “right now”.
Trading is not a special, distinct part of capitalism with its genius for engineering modern economic growth. Trading has been with us since the dawn of time. Markets predate capitalism by millennia. Capitalism is a recent evolution in human social practices, substantially starting in Holland and England only in the 1600’s.
In the ancient Chinese state of Qi before the time of Confucius, there was a famous Prime Minister, Quan Zi. His lord, Duke Huan, loved purple cloth but grew annoyed when the price for such beautiful cloth rose too high even for him. A shrewd judge of human nature, Quan Zi advised his Duke as follows: since the dye used to make the cloth purple left a smell, the next time someone approached the Duke wearing purple clothes, the Duke should hold his nose as if the smell was repugnant to him. The Duke did so and all the courtiers, suddenly fearful of offending the Duke by wearing purple, sold all their purple clothes. The price of purple cloth in the markets of Qi immediately dropped. Quan Zi bought up all the purple cloth for a song and gave it to his now very happy Lord.
Such trading in markets has a long history throughout human history. But capitalism seeks patient capital to invest over the long haul in companies that need the cash for working capital, wages, raw materials, plant, equipment, etc. For capitalism to succeed, the right kind of investment capital markets is very necessary. But it must be a market that attracts investment, not speculation. A market in speculation is a casino.
From the beginning of capitalism, old trading habits were brought over to finance and trade the new possibilities created by the new, emerging economic system. But trading habits loosed inside capitalism have been disruptive.
The first boom and bust irrational exuberance in capitalism was the tulip mania in Holland in the early 1600’s. That mania for buying tulip bulbs was not systematically different in its origins, dynamics or eventual losses from our current boom/bust cycle in buying certain financial products.
Trading and investing thrive on different and inconsistent incentives. Traders like to take a fee from every trade; investors look to dividends and the sale of appreciated ownership shares as a company becomes successful in its business for their returns.
Trading is akin to speculation: you pay money for a chance to win. You don’t always win so your winnings over time need to compensate for your losses and the risks associated with the gambles taken. Trading and speculation are inherently short term and limited in their consideration of consequences. Their spirit is at odds with the motivations and perseverance needed to grow a business.
Capital markets exist to accommodate traders and trading in financial instruments. Investment capital is raised by selling equity and debt contracts. We can’t, as far as I can tell, eliminate trading from capitalism. Providers of capital and companies need the liquidity which the ability to sell into a robust market of buyers permits; trading sets prices, which give vital information on values and trends, successes and failures.
But the goose that lays the golden eggs is not one that lives on trading alone. Firms need patient capital - investors, not speculators renting stock for a while in order to profit from market movements. Speculators can easily divert management’s attention away from long term strategies to short term manipulations of stock prices.
The most important role of financial intermediaries is to provide capital; therefore, short term trading in capital contracts should be subordinate to the mission of finding ways to raise money for companies so that they can create jobs, products and services – and, in consequence, the precious commodity of real economic growth.
From here on out, I suggest, that financial markets be so structured that trading beyond a certain band is burdened with responsibilities that will reduce the appeal of more and more speculative trading and so bring incentives in financial markets back to the provision of patient capital.
We need a trading regime that performs useful services without spinning out of control and throwing us into spasms of wasteful excess.
We might want to consider having different kinds of markets – one for trading and one for investing, or pricing arrangements that add to the purchase price of the trade as the risk associated with each new, incremental trade gets bigger and bigger. If risk were properly priced, the demand for financial instruments would contract as risk conditions change adversely given the growth of excessive supply. Too much supply financed with debt leads to a boom, which sets us up for the ensuing bust.
But, this strategy would require taking into account up front all the external consequences – both positive and negative - for consumers, society, workers, lenders, investors, suppliers, government – that will flow from the activities funded by the extension of credit.
Thursday, September 18, 2008
Over time, free markets reject fraud, abandon products that have no sound purpose or accommodating price, and undermine false or misleading valuations.
That Bear Sterns with balance sheet assets worth $80 pre share was sold for $2 and then for $10 per share, that Lehman Brothers with billions in assets nonetheless went bankrupt, wiping out owner’s equity, and that Enron as an enterprise was gone within months of revelation regarding its true debt obligations and real income flows, testify to the cruel discipline of markets at work.
True, markets create liquidity and asset bubbles; but then they turn and destroy them if they are bubbles. Bubbles can’t last forever. Only well-supported valuations are sustainable.
It is better, I think, to say that market makers create bubbles and also that market makers break bubbles. Perhaps market makers are more irresponsible in making than in breaking bubbles for the breaking can only occur if bubbles have been created. And, the breaking gets us back closer to the reality of sustainable values, a salutary step towards truth.
But, in the breaking of bubbles, people get hurt as we see happen all around us in the continued destruction of wealth and value flowing from the subprime mortgage/CDO/credit default swap bubble and bust of the past 5 years.
The teaching of market makers when they lose faith in valuations and so refuse to buy more at that price, or sell to unload risk, or suddenly refuse to extend credit or guarantee an obligation, is that the valuations at play in the market have become unreliable. Prices will thereafter drop until valuations become more acceptable.
The bubble stretches credulity about valuations (“irrational exuberance” some call it) until confidence is lost and the search for “quality” and security begins.
So, in some sense the current crisis of American financial institutions is necessary and just. It is correcting a past injustice. Only, the pain of correction does not fall fairly on those who made the mistakes in the first place. They have most likely taken the money and run.
Prices go down, wealth is un-created, and the economy contracts. People lose jobs; families suffer.
The lesson of this current financial retraction is perhaps keener still. It may be telling us that the share of global cash flows appropriated by the financial services industry in general was excessive and unsustainable.
The value of the mortgage brokers, the investment banks, insurance companies like AIG, depended on their making hay while the cash was flowing. High fees, charges for all kinds of intermediation, huge bonuses, were converted into capital values. But such substantial and systematic extraction of commissions from the economy could not last if the financial intermediaries collectively were not providing real value-added to investors and players in the real economy.
And, perhaps the failed Wall Street intermediaries were not contributing enough to justify their returns. So, losing them – in the long run – is just treating them like “straw dogs” - useless playthings that will burn and disappear.
Some coldness is required to let companies and their fortunes decline and fade away as casualties of poor risk management and imprudent forethought.
Over time, market makers turn to second thoughts about values, then to third thoughts, and then to an endless series of different thoughts. It takes real worth to survive all these market-maker changes of attitude and desire more or less intact as Goldman Sachs and Morgan Stanley seemed to have done. Though they too were shopping themselves to avoid liquidation and loss of equity for their owners.
But the un-creation of value is not what we want from free markets and capitalism. We should hold the system and its leaders to the powerful capitalist standard of wealth creation on a grand scale so that the positive synergies of investment and production will flow throughout the economy improving lives for all.
The first Principle of the Caux Round Table Principles for Business sets this standard:
the purpose of a business is to create wealth, not destroy it. Other CRT Principles and stakeholder considerations add ethical obligations to the manner in which such wealth is to be created and its benefits distributed.
I would assert that the titans of financial intermediation which took the lead in building the investment bubble in subprime mortgages and subordinate contracts did not live up to this CRT ethical principle. Had they done so, the bubble would have been smaller and so its bursting would have caused less harm to society and far fewer financial losses to investors and owners.
If the CRT Principles for Business are to be assiduously implemented, there should be no bubbles at all – not ever - just a sustainable rise in valuations as a rising tide floats all boats. Such a sustainable rise would rest on sound, real value-adding, business activities of tangible, non-illusory benefit to stakeholders.
Tuesday, September 16, 2008
Is this a recessive trait of primitive tribalism where the other is presumed to be taboo and a threat to our totems and our ancestors?
Even in the 21st century the fault lines within humanity are many and active: Tibet and China, Israel and Palestine, Christian and Muslim, Sunni and Shi’a, Basques and Spaniards. In the United States we have cultural trench warfare between the Blue states and the Red states. Muslim immigrants in France, many excellent speakers of French, don’t feel welcome in the land of liberty, equality and fraternity. Barach Obama’s candidacy for president in the United States only highlights the pervasive power of racism there for over 200 years. Jesus had a parable about the “good” Samaritan to set before us the issue of who deserves honor is it group loyalty or individual character?
We give privileges and rights to those we like and trust, mostly people who are like us. Modern jurisprudence gave us the concept and status of “citizen” where all who lived under a common sovereign authority were considered equal and the principle of non-discrimination would apply across the board.
Now we really can’t homogenize all humanity’s different value patterns, cultures, foods, styles of dress, modes of music, languages, senses of humor. And we shouldn’t. That would be discrimination and degradation of what is precious in individual lives. Our identities as persons are bound up in our ties to small communities of kin, religion, region, clan, trade, avocation, or what-have-you.
So how can we square the circle? How do we get to non-invidious discrimination? Can we live in paradox where differences abound but, at the same time, they aren’t really so serious as grounds for fear, suspicion, rejection, alienation, prejudice, or subordination?
Isn’t it a mark of the mature human person that wisdom and good sense prevail over thoughtless stereo-typing and self-referential standards of right and wrong?
I always like a plea of Oliver Cromwell when faced with a contumacious parliament. He exploded: “Gentlemen, I beseech thee; in the bowels of Christ, consider that ye may be mistaken.”
An admirable trait taught by so many religions is self-command and humility. Religion, which ties us to that which is more important than our own daily passions, irritations, quarrels and diversions, puts in context our tendency to think that we are more important than we are, or more righteous than reality can tolerate.
This past weekend I had the good fortune to participate in a surprising seminar at the International Institute of Islamic Thought and Civilization here in Kuala Lumpur.
In the presence of a Cardinal from the Roman Catholic Church, a number of distinguished Islamic scholars discussed with great erudition and much good humor the substance of Islamic ethics. It turned out that such Islamic ethics were really not very far from some core principles of Catholic Social Teachings.
Catholic ideas about the dignity of the human, the moral obligation to use private property responsibly, the need to trust family and social and civil organizations and not subject them to an all-powerful state, and the solidarity with others that is necessary to protect and promote their dignity resonate with many points of guidance given by the Holy Qur’an.
In our discussions it turned out that Catholic social thought and Islamic social thought are not that far apart.
This is a discovery of great importance for the world. Where we can see common concerns among different faith traditions, believers in one religion need not be so resentful of those who follow a different liturgy or read a different scripture.
In fact, both Catholics and Muslims share basically the same understanding of human purpose in that both faiths see human persons as created from God’s spirit and so animated with something transcendent in order to make this a better world.
We far short of what we are intended to perform and much suffering results from our failures to be our best. But the common teaching of both Catholics and Islam that we should aspire to do our duty as God intends could become a point of mutuality and solidarity between the faithful of both religions.
Great efforts must be made to inspire and guide humanity towards a future that will demonstrate greater submission to the fact of human dignity. But those efforts are well worth making. And the sooner the better.
Monday, September 1, 2008
CRT Chair Lord Brennan and I were there to call on Jean Paul Cardinal Tauran, the president of the Pontifical Council on Inter-religious Dialogue. A member of our World Advisory Council, Theodore Cardinal McCarrick had suggested the meeting so that we might brief the Council on our very exciting and constructive work on Qur’anic guidance for good governance with scholars at the International Islamic University Malaysia.
After our call on the Cardinal, John Dalla Costa very kindly came down from Tuscany where he is writing so that we could visit and catch up. John has been very helpful to the CRT and has written wonderfully insightful books on ethics and business.
John took me to see a bronze statute of St Francis of Assizi near the Basilica of St John in the Lateran. Then we went to walk around the old Forum of Rome. John wanted to see the mural on the Arch of Titus where Roman soldiers after sacking Jerusalem are marching off with a sacred menorah. We reflected on all the sadness that has flown from that event, down to today’s bitterness, violence, and intransigence in the Holy Land.
We walked along the Via Sacra towards the Capitoline hill and stood by the Senate building. We walked where Cicero had walked and Ceasar, Pompey, Crassus, Cato, Brutus and Mark Antony too. In that building Cicero had called out Catiline and delivered his damning speeches on Antony’s brutal vulgarity and excessively covetous ambition.
We stood where, the story goes, Ceasar’s body was burned and riots broke out seeking vengeance against his assassins.
We stood where the Roman Republic was born and where it died.
Cicero in a casual letter to his friend Atticus put his finger on the cause of death. It was July 59 BC; the Republic was not yet dead, but the political cancer of military dictatorship that would finally kill it was already metastasizing among the Romans. Cicero in writing to Atticus pointed to a cultural change that opened the door to the growth of that cancer. He said that Romans were still free in their thoughts and words to criticize abuses of power, but that their “virtue was in chain” – virtutem adligatatem.
They had lost efficacious will and the resolve to stand up and do what needed to be done. The energy nourishing civic virtue was evaporating.
Loss of virtue is a disease of our time as well. The WTO can’t get agreement on elimination subsidies for agriculture; the G8 leaders can’t act on global warming; the EU is powerless in front of Russia’s hegemony over Abkazia and South Ossetia. Financial intermediaries have given us another round of turmoil, losses, and crisis in global credit markets.
Lord Brennan said to me in Rome that the developed world seems overcome by greed and the developing world by corruption.
So, how do we invigorate civic virtue? How do we keep our own personal virtue “unchained”?
The Caux Round Table can only succeed in a world where such virtue counts for something. Interest and material prosperity can only go so far as moral causes and they must, by the nature of their superficiality, fall short of giving us a foundation for genuine leadership.
Rome gave me some needed clues about the source of virtue. We get it through religion.
In the Forum John and I passed the temple of Vesta, the cult of a patroness founded by Numa Pompilius, Rome’s founding king who grounded community identity and culture on something divine. Religion, a cult, liturgy, prayers, flames guarded day and night by virgins from elite families, confidence, something to value and protect – Numa set in place a complex of reassurance, motivation, guidance through the use of religious inspiration and imagery.
So too the Athenians in their heyday had the cult of Athena in the Parthenon; Hammurabi grounded his code of laws on divine inspiration. More and more examples of similar human dynamics came to my mind as I looked at the surviving ruins of Numa’s little round temple.
Later Roman religiousity sustained the theme. Walking back to my hotel, I popped in and out of several great churches, including St Peter’s. Statues and pictures of Christian martyrs glorified in these churches somehow stood out in my mind. It was their religious faith that gave them purpose, courage and sustaining willfulness. The tomb of the founder of the Jesuit order seemed another case in point on the link between faith and dedication to service.
This conclusion is far from satisfactory. Religion is divisive; it gives rise to intolerance, to obscurantism, to the eclipse of reason and common sense; it seduces us into pride and hubris that we are righteous and select – saints chosen by our God to do his or her work here on earth.
Moreover, today, conversations about religion are uncomfortable and avoided. For some good reasons, may I add. Those who need virtue in lay and secular undertakings – say, business, politics, government, journalism, academia – are more and more cut off from public affirmation of the deepest and best source of meaning and purpose. We live with disenchantment and suffer for it.
I wonder what Cicero would recommend under the circumstances? After all, his efforts to save his republic came to naught.
Monday, August 11, 2008
Capitalism is the same way: it punishes hubris and excess sometime sin grievous ways.
The business plans of those who promoted the subprime mortgage market and the CDO derivatives using such mortgages for support did not plan for great losses or that famous CEOs would lose their positions of power and influence. Nor did they plan for a global credit crunch that would lower asset values across the board and dilute the value of then ownership in big banks and investment banking firms.
But that is what happened.
Profits came in up front, to be sure, but at a cost.
To date, the score card on business success from these financial endeavors is:
Citigroup has lost or written down US$54.6 billion - that offsets a lot of past profits - and replaced its CEO.
Merrill Lynch took a US$51.8 billion hit and replaced its CEO.
UBS took a hit of US$38.2 billion and replaced its CEO.
Wachovia replaced its CEO and took write-downs and losses of US$22 billion.
HSBC took a hit of US$ 27.4.billion. The number for Bank of America was US$21.2, for Royal Bank of Scotland US$15.2 billion, for Washington Mutual US$ 14.8 billion, and for Morgan Stanley US$14.4 billion.
And, the prices for shares of all these firms dropped some 60% on average.
These market driven results do not add up to a glorious victory for business.
Thursday, August 7, 2008
First, the leaders of the G8 countries - the biggest fish in the pond of sovereign nation states - waffled on doing anything about production of greenhouse gases. Second, trade representatives from a wider array of countries failed to reach a deal on global trade in agricultural products. Movement in further liberalization of trade has come to a halt at the insistence of the Indian government on special protections for its most vulnerable farmers.
My thought is that we live in an age of modest talents on every hand. The true grit of leader-ship is only rarely found in leaders. They are skillful, to be sure, but in small, conniving ways.
Vision and principles don't seem to matter. And, therein lies a worry.
If we take for our standard, the efficacy of our leaders, then the stuff of leadership is insubstantial. Anything that works in the short run will do.
Under such conditions, why should we take seriously, say, the Caux Round Table's ethical principles for business decision-making or for governing institutions of public power?
Principles don't count; executing a public trust is for the naive and the pious, not for the big boys of money and power who alone deserve our respect and emulation. One could come to this conclusion looking at who acts on our behalf these days.
But I would counter that only principles can fill leaders with leadership. We ignore wisdom, vision, high standards, self-control and fiduciary integrity to our collective and personal loss.
The high price of gas is an example. It has changed people's behaviors. When the price was at its peak a few weeks ago, over US$ a gallon, people began to steal - from gas stations and even from syphoning gas out of the tank of someone else's car during the night. The car belonged to the wife of a local sheriff and was parked overnight in the family's driveway.
And, driving by Americans is down since gas prices rose. Car buyers have switched their preferences away from SUVs to more fuel efficient cars and fuel hybrids. This change in customer values brought on by price has brought great revenue losses to General Motors and Ford.
But if we as a species were not price sensitive, would the alternative be any more constructive? Consumers would have no power in markets to discipline producers and other sellers as to product and service preferences. The consumer is price sensitive as are the sellers. Both are therefore under discipline.
When price plays no constraining role in market decision-making, irrational exuberance can set in with harmful consequences.
Further, where administrative fiat not price determines what is produced and use, there is immediate recourse to political or theological tyranny and an evaporation of human freedom and personal dignity.
So, prices give markets and capitalism a bad reputation - turning goods, services, and individual hopes and ambitions into mere commodities, stimulating greed, forcing cost cutting and job eliminations or transfers to other communities - but we would pay a moral price for not having market prices I think.
Risk aversion - the instinct to get the best out of any situation - is a trait that does advance the cause of human civilization and happiness.
Sunday, August 3, 2008
A habit of mine to turn hours spent in an airplane flying great distances into something more educational than just watching movies is to read something I would not otherwise have time for - like the Memoirs of the Duc de Saint Simon for example.
As with Boswell’s Life of Johnson, Cervantes’ Don Quixote, or Lady Murasaki’s Tale of Genji, the Duc de Saint Simon’s Memoirs were long ago recommended to me as part of the foundational reading of well-educated men and women. Just recently, I saw a reference to the Duc de Saint Simon in the New York Review of Books and so, before leaving for a long flight to
On the flight, I got through volume 3 of his Memoirs. I can recommend it to anyone interested in a lively, insider’s view of the dysfunctions of French royalty in the early decades of the 18th century.
But the work contained a surprise – insights into the financial mismanagement that from time to time, on a regular basis, overtakes market capitalism with unseemly greed followed by panic sell-offs.
We have just come through two such episodes in the
The asset bubble and ensuing bust swirling around the Duc de Saint Simon in 1719 and 1720 arose from selling shares in the Mississippi Company. The project was the brainchild of a Scotsman, John Law, who proposed his scheme to the Regent of France as a way to earn money for the government. Sales of the stock were very successful; share prices rose to absurd heights; millions were made by those who bought early and sold early; losses, when they came with the collapse of the company, withered the entire economy of
Saint Simon, a landed aristocrat, never bought shares even when pressured by his friend the Regent to take up thousands for the cash equivalent of a pretty song. Saint Simon didn’t believe in the inherent value of paper assets.
He wrote in his diary:
One day M. le Duc d’Orleans (the Regent of
M. le Duc d’Orleans was at a loss how to answer.
At a later point in his Memoirs as the Mississippi Company was desperately writhing in its death spiral, the Duc de Saint Simon commented:
It had become necessary to substitute something real for the mirage of the Mississippi, converting to a new trading company the Indies Bank, capable of guaranteeing the exchange of 600 million in banknotes and have profits of tobacco monopoly and numerous other vast sources of revenues, but even so it was still unable to meet the demand for payments of its notes and this despite all the measures taken to lower their value which, incidentally, had ruined great numbers of the people by reduction of their savings.
All this known as of 1719 and still we have to suffer globally from the unsustainable issuances of subprime mortgages and CDOs derived therefrom.
Why can’t this great reoccurring flaw in capital markets be permanently corrected?
Is it all because of a greed that lies forever chained to the beating heart of capitalism and, from time to time, makes financial fools of us all?
Or, as I am coming to think, is it more a question of systematic distortion of pricing under certain conditions, leading to mis-pricing that opens the door of markets to “irrational exuberance” and supporting avarice for immediate cash profits.
My argument is the following:
First, when asset bubbles occur, the strategic good sense normally encouraged by micro-economic supply and demand curves does not operate. Under conventional supply and demand interactions, the marginal utility of additional amounts of supply is worth less and less. At some point it therefore becomes unprofitable to produce more of the good or service and so supply contracts and a market equilibrium at a sustainable value is reached between demand and supply. No asset bubble occurs. There is no “irrational exuberance” driving prices ever higher and higher.
Under these circumstances, the price/supply curve slopes downward to the right on the graph where supply is the horizontal axis and price is the vertical axis.
But when asset bubbles build up, the supply curve slopes very differently. It slopes upward to the right.
As price increases, so does supply, without any deterrent effect set in motion by declining marginal utility of additional units of the asset brought to market. This supply curve accurately represents the “irrational’ belief of buyers that more of the good or service deserves higher and higher prices. There is no diminishing demand curve to intersect with the supply curve at a point of sustainable equilibrium. Demand grows; supply responds; and prices keep going up. Each increment of the good or the service seems to have added value attached to it, at least in the eyes of potential buyers.
Everybody is happy; the nominal price value of the asset class keeps growing higher and higher as more and more assets are brought to market to enjoy higher and higher returns – like shares in the Mississippi Company or, in the subprime mortgage bubble, new houses built to take advantage of easy credit. There is no regulation of self-interest by price that cautions producers to keep more product off the market. There is no automatic governor on the engine to keep it from spinning out of control.
Markets for contract rights – shares, loans, mortgages, CDOs – are especially susceptible to such upward sloping supply curves. As prices paid by willing investors rise, more opportunities to buy the contracts are brought to market by creative sellers. Each additional opportunity to invest in these promises for future returns continues to have the same (or greater) utility to buyers than the previous opportunity. The marginal cost of bringing more contracts to the market is almost zero –mostly payment for secretarial formalisms. It was thus very easy for John Law and his Mississippi Company to issue more shares; very easy for Enron to create more special purpose entities with which to manage reported earnings, and very easy for banks to issue both more sub-prime mortgages and CDOs.
But rising prices for assets can only be supported by rising supplies of money with which to buy them. Here is where the price of credit seems to become dysfunctional. In a bubble, as the price of the asset rises, the supply of credit expands as well. Another supply curve sloping upward to the right. Under conditions of “irrational exuberance” official bank interest rates do not rise with the amount of credit being made available as you would think. More and more credit is made available to buyers when bubbles are growing. The buyers, using mostly borrowed money, pass the resulting cash on to sellers.
The dynamic expanding the supply of credit for subprime mortgages was the proliferation of CDO sales. Global capital markets bought up CDOs and the cash from those sales was passed back to the originators of subprime mortgages, who then lent the money out on more subprime mortgages, which kept buyers in the market for houses at ever rising prices.
In the dot.com/telecom bubble, stock prices had been kept high by the arrival of day-traders in the market, using their equity plus borrowed funds to take advantage of rising prices for stocks.
As the risk/return tradeoff inherent in the extension of credit would have it, you would think, that as more and more credit is extended, the most reliable debtors would be taken care of first, so that later extensions of credit should carry more risk, and therefore be harder to sell. One might say that the marginal utility of additional credit carries higher and higher risk for the usefulness of the money lent.
The market for credit should stabilize at the point where investors providing new credits at the margins where new lending is offered and accepted begin to question if the returns and the security they are promised will support the risks they are to undertake. At that point of decreasing returns to credit, lending investors will demand so much for use of their money, that providers of the underlying assets will balk at the price demanded for credit and the market will slowly stabilize around sustainable prices of assets.
But in bubble environments, pricing does not reliably lead to sustainable asset valuations. Rising prices bring on speculation and then growing speculation brings on yet higher prices until buyer’s remorse finally sets in at the margin, new supply is not taken up, and the market suddenly collapses.
Normally as the supply of credit expands, the price charged for increments of credit rises. The normal curve here is one sloping upward to the right. But when an asset bubble is underway, the curve is more flat; as the supply of credit expands, the price for credit does not rise substantially. Credit becomes, relatively speaking, cheaper than it should be. The gap between the thoughtful price for credit (high) and the actual price for credit (low) exposes the market to risk of future collapse.
One reason for this odd pricing of credit is the financial security seemingly provided by rising asset prices. The nominal higher and higher values of the asset offered for sale by the bubble market provide a vision of security protecting the money borrowed to own the asset. The owner/borrower feels confident that he or she can sell the asset at a moment’s notice to repay the debt and the investor/lender feels confident that the asset can be acquired from the owner and sold if necessary to repay the debt.
But when the market collapses, asset values collapse and the credit appears in truth as having been essentially unsecured. It has long been said prudentially that lending too much money to an enterprise makes one take the risks of an equity investor – in for a dollar of risk as well as for the actual dime lent on security.
As asset bubbles expand, another gap in prices emerges to undermine the sustainability of nominal asset values. Under thoughtful analysis, the value of an asset should stay reasonably steady or decline some as more and more assets are brought to market. The value/supply curve is then largely level or sloping downward to the right. This assessment of value is largely sustainable.
But, in a bubble, the value of the asset rises and rises ever higher as more and more assets
come to market. The value/supply curve slopes upward to the right. The growing divergence between the thoughtful curve and the “irrationally exuberant” curve is the gap between sustainability (thoughtful valuations) and collapse (irrational valuations). At some point, the gap between the two valuations becomes so large that it can’t be ignored. Upon the discovery that “irrational” valuations are at risk, nominal asset prices start to drop towards the level of sustainability and the market collapses.
Mis-pricing drives financial markets first to excess and then to collapse. Greed may sustain the mis-pricing and its resulting bubble, but mis-pricing gives to greed its sometime power to trump thoughtful analysis of risk and sound valuations.
Discouraging mis-pricing of both assets and credit would seem to be essential to improving the level of economic justice provided by free capital markets to all participants, but especially to the less well capitalized ones.
If we could better understand the mechanics of how mis-pricing begins in any cycle of excessive accumulation of assets, especially the contract right assets favored by financial markets, we might be able to better eliminate such erroneous pricing signals. Better pricing would tip the odds away from speculators towards genuine value investors.
Two factors, it seems to me, contribute to the onset and the maintenance of mis-pricing.
First is the fact that most providers of contract rights (equity securities, debt obligations, derivatives, etc.) take a fee out of the deal on the sale of the right and leave town so to speak. They have no incentive to price accurately for the sustainable long run. They price to sell in the market at the time. They feed speculation and they feed off of speculation.
Second, and related to the way in which originators of contract rights get paid, is the fact that those who originate contracts rights to sell in financial markets very frequently assume no long-term ownership risk for sustaining the value of the asset. These originators do not retain an interest either in the tradable contract right sold to investors or in the underlying asset, if there is one, which supports the right to future income that is sold to the investor via the contract.
If the fees charged for selling contract rights became less and less profitable as the market for such securities grew, or if ownership responsibilities became more and more unavoidable as the risk of market collapse accumulates, then market-wise, enlightened self-interest would find ways to dampen speculation and to protect asset values.
Sunday, July 20, 2008
It is Friday July 19th, 2008, and Nelson Mandela’s 90th birthday. I am in
His crime: opposing a regime using the powers of a police state to impose an ideology. Ideology is conformist; it is communal righteousness that can brook no challenge from independent thought or mere personal whim. Certain truths apparently so brittle that they can’t survive a rough passage through the storms of human needs, passions and perceptions.
Mandela had a more indefatigable truth than the white Afrikaners did. He rose above communalism and racism – and the feelings arising from 27 years in prison – to lead
Here among Mandela’s people – the Xhosa – the cultural frame for building community is “ubuntu”. The
I had come to
I could see the point. But one of the presenters – an American teaching in an African business school – made another point as well. “Ubuntu” like any community ethic comes with a price. The price is some degree of stultification and conformity to what the community believes and stands for. If there is too much “we”, what role can there be for the “I”?
“Ubuntu” also leads to fragmentation and rivalries as the circumference bounding the community expands to take in new communities. The question comes quickly: with whom do I experience “Ubuntu”? Just who is part of my “we”.
“Ubuntu” outside the mind and skills of Nelson Mandela seems no check on the divisiveness of tribalism. In
My thought is to ask in seeking an authentic “ubuntu” based regime for
Friday, July 11, 2008
In real estate the agents say that what counts is “location, location, location”. Sometimes that may be true for our understandings of the world as well. Our location can frame the path of our reflections. Consider walking along an ocean beach or setting in a mountain meadow. For many of us that context can lead to deeper, more inwardly centered, perceptions or, in a similarly restorative way, to looser flows of mental associations that lead us to more fundamental and lasting impressions of what is.
Mountain House in
I was just there with some CRT colleagues in a retreat for scholars on Tuesday and Wednesday. They left on Wednesday night or early Thursday morning and I stayed on for a day before going to
And the sounds were of birds and the breezes in the leaves.
The hustle and bustle of humanity, the nitty-gritty, the details that provide cover and sustenance for the devils in our lives, were far away from consciousness. One felt a kind of open-ended, natural superiority in life. You could breathe in encouragement and breathe out doubts and anxieties, just as masters of meditation advise for our better health and well-being.
The view from Mountain House on such a day provides scope for our proper ambitions, making us once again masters of our fates and captains of our souls in a world that is conspiring to reduce us to trivia.
The view took me back to Robert Frost’s poem “Birches” which ends thusly:
Earth's the right place for love:
I don't know where it's likely to go better.
I'd like to go by climbing a birch tree~
And climb black branches up a snow-white trunk
Toward heaven, till the tree could bear no more,
But dipped its top and set me down again.
That would be good both going and coming back.
One could do worse than be a swinger of birches.
Sunday, June 29, 2008
The roots of the word “philanthropy” are “love” and “man”. A philanthropist, therefore, is a lover of mankind, someone who loves his fellow humans and exerts himself or herself for their wellbeing.
Philanthropy is defined by the Oxford English Dictionary as “practical benevolence towards men in general; the disposition to promote the well-being of one’s fellow-men.”
Thus, while philanthropy has taken on a general meaning of charity out of a compassionate disposition, its underlying meaning points to a much more strategic scope of endeavor.
Philanthropy in gross would encompass any action aimed at improving the well-being of humanity. Philanthropy would therefore include solving problems such as disease, lack of education, poverty, war, famine, global warming, excess consumption of natural resources, tyranny, and so on.
Corporate philanthropy would be the appropriate efforts of business to address these problems and challenges. It implies more than just making charitable donations in an effort to share wealth with the less fortunate.
Corporate philanthropy is then the responsibility of business to make our world better, even through the products and services offered for sale and the ways and means of bringing those products and services to market..
But given the primary social office of business to create wealth on a profitable and sustainable basis for the amelioration of social conditions, corporate philanthropy should have its proper role and function. Business should never seek to substitute for bad government; rather, bad governments should be changed and new, more responsible institutions of public power should take their place. Nor, on the other hand, should business assume responsibility for non-profit operations which seek to provide public or quasi-public goods that do not respond well to market incentives.
Corporate philanthropy can embrace strategic responses to the material concerns of a business’ stakeholders, bringing the demands of corporate social responsibility within its fold. The case can thus be made that corporate philanthropy is not merely optional volunteerism, unrelated to core business functions. No, corporate philanthropy is merely another way of framing the fundamental requirement of business to meet the terms of its contract with society. Under that contract, business must enhance the social capital, the human capital, and the reputational capital on which it depends for successful market performance in order to get back from society those necessary capital inputs.
Saturday, June 7, 2008
A recent article I read on global warming is a case in point. William Balgord recently wrote an op-ed commentary pointing out a link between sunspot activity and temperatures on earth.
It seems that past periods of cool temperatures on earth correlate in time with low sunspot numbers. And to the contrary, high sunspot activity leads to warmer temperatures here.
When there is weak solar activity - few solar flares sending "solar wind" to bath the earth protecting it from cosmic radiation, more cosmic rays (high energy protons) penetrate through and ionize oxygen and nitrogen molecules in our atmosphere. These ions then become nucleating sites for water vapor that so condenses into clouds. With weak sunspot activity, more clouds form on earth and reflect back more sunlight into space, cooling the earth.
In 2007 there were abnormally few sunspots. From January 2007 to January 2008, the average global temperature fell by nearly 1 degree fahrenheit. Rare snowfalls struck Buenos Aires, Cape Town, and Sydney. China was hit by a huge blizzard. Floe ice spread in the Arctic Ocean into the Bering Strait.
The inference for corporate social responsibility of all this would seem to be that, if sunspots are a major determinant of earthly warming and cooling, what is business to do about that? And, how much effort should be made to reduce emissions of green house gases from the factories and usages of human civilization in order to prevent global warming?
From whom should business learn how best to consider its long-term self interest upon the whole set of material considerations impinging on its prospects for success or failure?
Tuesday, June 3, 2008
"Structural short termism" - now there is a concept worth pondering.
How can short-termism be structural and therefore more insidious a departure from wise strategic thinking?
One way of course if for it to be institutionalized in the goals and compensation patterns of government and business. Clearly, the notorious single-minded focus by many Americans in business on quarterly earnings and hitting the very numbers expected by "Wall Street" is institutionalized short-termism.
But a more dangerous location for structural short-termism is cultural. If short-term thinking drives our beliefs and our values, then our actions will follow along accordingly like sheep to the slaughter.
No law of nature that I am aware of requires that business focus exclusively on immediate earnings. In fact, better heads who have made a lot of money like Warren Buffet expressly look to the long run and the underlying fundamentals of valuation more than to short term results.
I would suggest that our culture is the source of "structural short-termism". A culture that has few if any truths to sustain us, many moral quandries to delude us,and a foundation of nihilism that expresses itself in the seeking of sensation and the accumulation of experiences, is nothing but short term. As John Maynard Keynes once retorted "In the long run we are all dead." So, he inferred, thinking about the long run is a waste of time.
Yet as Kishore suggests, if short-termism is a short-cut into the shallows and miseries of fate, then we should examine our culture more carefully to restore some deep sense of truth and of a sustainable sense of purpose to our lives.
Monday, May 26, 2008
The problem challenging the race over the coming decades is access to earthy resources - especially energy. It is estimated by reasonably sober minds that when human population maxes out at roughly 9 billion people and if those 9 billion will attempt to enjoy current American standards of comfort and living, they will need 5 planet earths to support them with energy and raw materials.
Those additional 4 planet earths will not be there.
So, what is to be done?
This is the great challenge to sustainability of human civilization; global warming is just part of the problem.
Well, curiously enough, he said many of the most important natural inputs to human life come from photo-synthesis - from simple little plants absorbing solar energy and transmitting it to mother earth and all who live upon her.
Animal life traces its sustenance to plants. Something feeds on plants and other, usually bigger living things feed on plant eaters, and so on up the food chain.
Our main foods - vegetable, fruit, nuts, grains, meats - trace their origins to photo-synthesis.
Our natural fibers - cotton, wool, linen, silk - similarly come from energy provided by photo-synthesis. Our wood comes from photo-synthesis.
Our energy from hydro-carbons and most of our plastics come from photo-synthesis accomplished millions of years ago and kept in deposits of coal, oil and natural gas.
Thus, if we could but create our own massive processes of photo-synthesis to convert sunlight into the energy and substances we need for life, we could sustain foreseeable human civilization on just this single planet earth - perhaps.
Bryn's comment was simple: corporate law places the management of a corporation in the hands of the board, not in the hands of the shareholders.
This basic rule for me expeditiously resolved one of the most tenacious arguments in business ethics - that between the relative claims of shareholders and stakeholders for a preferred status in the business calculations of corporate managers. Shareholders, some argue, have exclusive priority while many who promote business ethics would give the nod to stakeholders, including shareholders as one set of those who depend on corporate performance for their wellbeing.
The justification for giving preference to shareholders is that they are the "owners" of the corporation and as such have rights to full concern and attention of those who work for them. Stakeholders, on the other hand, it is pointed out are not owners but stand outside the structure of corporate power and decision-making.
Now, the fact that management of a corporation is given to the board and not the shareholders makes all the difference in this argument. Management is the prerogative of owners. It is the heart and soul of the powers of dominion that owners are given under the law. A fully empowered owner can do anything he or she pleases with property under ownership - even to the point of destroying or abusing or wasting it for no good reason.
If shareholders can't be such owners, then they are a limited kind of owner with expectations of exercising dominion less than those held by "real" owners.
Shareholders are not given rights of full ownership in a corporation; there are limits to their risk exposure. They enjoy limited liability - not full liability for the losses of the corporation, but only financial sacrifices up to the amount of their investment in the stock.
Their limited liability is balanced by limited rights and powers. Full liability as in a sole proprietorship comes with full rights of dominion. Gaining an advantage in having one's liability limited by the law is offset by having to sacrifice before the law advantages in one's ability to exercise power and dominion.
Shareholder rights are set by their contract with the corporation. They do not have rights of management.
Thus when it is argued on their behalf that they have priority over other stakeholders, we should cautiously think about the scope and expanse of such priority. They do not carry full risk of business failure; their corresponding claim to fortune should therefore be a modest one.
If they don't manage, they shouldn't ask for the deference that goes to those who are in the arena running all the risks and carrying all the burdens of success.
Shareholders do have a claim on the corporation, but not an extreme one. Their claims are as limited as their are powers of management and liabilities.
Saturday, April 26, 2008
The cynical and sad musical Cabaret has it that “money makes the world go round.” If so, then money must bear an awful responsibility for all the wrongdoing and misfortune that overtake humanity again and again.
On the other hand,
Similarly, Adam Smith proposed that seeking to make money need not be sheer malevolence when he said: “Man is never so innocently engaged as when he is making money.”
Advocates for more corporate social responsibility, however, often point to profit – acquiring cash money – as the driving force behind business negligence, abuse of market power, and willful omission to correct harmful externalities. Greed, it is more often inferred than said outright, biases judgment when greed is energized and encouraged by the availability of money.
Non monetized societies, as a rule, do not enjoy much in the way of business activity or capitalism. At the same time, they are more prone to poverty than wealth with all the conceptual opportunity costs that come with living in poverty.
If we want the fruits of wealth, which are many, but we fear the effects of greed and avarice, what role should we tolerate for money? Can we ever reach a positive moral assessment of those who strive for money?
Powerful ideas for thinking about money were given by Georg Simmel in his book The Philosophy of Money, written in 1900.
His first proposition is to accept the subjective theory of value. According to this understanding of human dispositions towards reality, the value of a thing is entirely determined by what we make of it. Value arises from our emotions and thoughts. Value, like beauty, is in the eye of the beholder not in the flower or the painting. From this perspective, there are no absolute values to be imposed on us, only the partial and relative values that we impose on ourselves and, may from time to time, attempt to impose on others.
Consciousness, said Simmel, endows objects with significance, not the other way around. No object has intrinsic significance.
Accordingly, it is our natural right to value or not value money just as we may or may not value a cowrie shell, an emu, or The Rollling Stones.
When two or more minds converge on a single evaluation, then we have a common value. What has been subjective now becomes more objective in that it has acquired a post-individualistic meaning with social characteristics and implications. Any such valuation in common takes on tangible form and public appearance, gains resilience in the presence of time and space, and acquires an aura of respect, even prestige.
Simmel pointed out that a primary function of money is to facilitate the process whereby people can reach common valuations. When they agree on a monetary amount to fix on an object, or a promise, they have achieved something social, something more objective than their individual preferences. When many people with different subjective concerns all come to agreement on a monetary price, then a market price enters social reality and conditions subsequent behaviors.
Without money, it is more difficult to find easily expressed and sustainable equivalences. With money, agreements can be more easily reached, kept and memorialized and transactions can be undertaken with far greater confidence in their having real advantages. The philosophical role of money, therefore, is to convert the intangible and the merely subjective biases and prejudices of the individual into social truth.
To probe further into the dark side of human dynamics around money, we need to consider the complex mental process of valuation.
Abraham Maslow proposed a hierarchy of human needs where prior and more immediate needs were associated with preservation of the self – responding to fears and threats, seeking food and shelter, etc..- were first attended to. Only after such necessities, as it were, were fully and satisfactorily attended to, would a person be likely to appreciate more abstract goals such as friendships, art, religious insight.
We can infer from Maslow’s notion of a hierarchy that money associates itself with goods on the lower levels of the hierarchy. Food, shelter etc. are most easily obtained with money. For most of us they are market goods which must be purchased from others.
Sigmund Freud associated money with his conception of an anal personality – someone fixated on retention and holding in. Anal personalities tend to be tight with money and stingy. They are also more comfortable as controlling personalities in their relationships with other people. Money for Freud took on a bad connotation of assisting anal personalities in their search for dominance over others.
Freud did not elaborate on the point at all but there is indeed an easily observed very strong link between money and having power. Since others need money to meet their own needs, we can use money to win their submission on a transaction basis. If we give them access to what they want, we can demand and receive in return some “price” paid by them for the goods or services we have at hand. That “price” could be money, but it could also be submission, labor, respect and public praise, help on a project, intimacy or some form of friendship.
I f our goal is indeed power, seeking money is a reasonable means to that end. What drives us, however, is not the money but the need for power.
Money, which through exchange can bring us into conditions of social objectivity, can also be conducive to the removal of the personal element from relationships. In this way money can contribute to our distancing ourselves from others and in so doing to protect ourselves from them. Money is indifferent and objective; with it we can be aloof from the desires and manipulations of others. Money can bring about reassuring feelings of inner independence and individual self-sufficiency.
Money has the amazing capacity to make possible relationships between people but at the same time leaves them personally undisturbed. It balances out respect for different dimensions of human dignity by leaving people alone in their own subjective majesty while permitting them to respond to the values and preferences of others.
And a need for power can be insatiable. When power is sought to make up for inadequacies, to fill a spiritual void of low self-confidence, to hold off fears of the infinite and the unknown, to make up for feelings of personal sinfulness and guilt or shame, then we can never enjoy enough power.
Correspondingly, such needy people can never have too much money. They are always on the hunt for what will make them feel more secure and less threatened.
At times, their approach to business can be to “cry havoc and let slip the dogs of war”. It is dominance that they seek and power that they need at almost any cost. The premises of Social Darwinism, Herbert Spencer’s theory of life and private freedom as constant rivalry and competition, fits comfortably with their understanding of who they are and what they need. Such strivers press for unconstrained competition and glory in making short term profits that they can appropriate personally not because they need the money, but because they would feel victimized without having the power that money can bring.
Avarice, as opposed to simple greed, is the will to power expressed through money where the power represented by money is experienced as the absolutely satisfying value.
Psychologists have studied motivations by using the “Ultimatum Game” where one player divides a pot of money between himself and another. The second player then gets to whether to accept the division or not. If the second player rejects the division, neither player gets any money. In this game, a stingy offer by player one to player two will usually be rejected – even though it will give player two some money. (The offers that get rejected are usually offer player two less than ¼ of the total pot.) Thus, game results imply that money in and of itself is not always a goal for human interaction. Other considerations come into play as well. The further implication is that people strive for relative, not absolute, prosperity, believing that it’s not the money but the share that counts.
In one series of Ultimatum Games played among men only, men with high levels of testosterone were more likely to reject offers with low proceeds for themselves.
Higher up on Maslow’s hierarchy of needs is having status in the eyes of others. Such status too confers a form of social protection, so it meets one’s need for power. But it has, apparently, other attractions as well.
Adam Smith noticed this quite some years ago. In his 1759 book on human moral capacities, The Theory of the Moral Sentiments, Smith wrote: “… yet we cannot live long in the world without perceiving that the respect of our equals, our credit and our rank in the society we live in, depend very much upon the degree in which we possess, or are supposed to possess, ‘the advantages of external fortune’. The desire of becoming the proper objects of this respect, of deserving and obtaining this credit and rank among our equals, is, perhaps, the strongest of all our desires, and out anxiety to obtain the advantages of fortune is accordingly much more excited and irritated by this desire, than by that of supplying all the necessities and “conveniences’ of the body, which are always easily supplied.” (p. 213)
In another recent experiment, volunteers were asked to take sips of what they were told were five different wines priced between US$5 and US$90 per bottle. But actually only three wines were used; two of them were served twice. Volunteers were monitored for brain functions. As they drank what they thought were more expensive wines, activity in their medial orbitofrontal cortices increased in tandem. What were thought to be more expensive wines triggered more engaged mental activity.
What costs more money is, pro-forma, most likely to be more exclusive, more rare, and more prestigious. Fewer people will have access to it. Participation in exclusivity generation perceptions of value; it is the reward that comes to wealth and status and most of us like it.
A dynamic money culture can indeed spawn cynicism and a blasé attitude in the face of tragedy and human need. This results, says Simmel, when the concrete values of life are reduced by our choices to the mediating value of money. What should be highly valued, is reduced to the lowest instrumental value, one completely relative at that.
Money is a servant of our desires. If abusive desires merit our concern, we might be wiser to tackle the problem directly by confronting the desires rather than indirectly by reducing the means to assuage what will still be an active command center in our psyches.
We are come to an ancient point of view: tranquilization of the passions should be uppermost in our minds. Character to govern desire removes the “love” that would and does turn money from a boon into an evil. Aristotle taught this as did Cicero and Marcus Aurelius and Confucius. In our time, an eloquent teacher of this perspective on business is the Dalai Lama.
Money in and of itself enters the world as a useful good. It is we who abuse it, as we abuse many other things in the physical world. It is a useful tool; it is an institution through which the individual concentrates his or her activity and possessions in order to attain goals that he or she could not attain directly says Simmel. Like any tool money is inert; it has no purpose of its own and functions impartially to all humanity.
Money is demonstrative of the truth that humans are the “tool-making animal”, which infers, of course, that they are “purposive” animals with goals and desires. The tool incorporates the aspirations of the human will.
Money reveals its indifferent and empty character, says Simmel, very clearly where the valuation process putting it to work is exclusively upon consumption. When desires are superficial, money facilitates the triumph of superficiality.
Simmel wrote that “the psychological structure of demand is such that in most cases it is focused upon the satisfaction itself and the object becomes a matter of indifference so long as it satisfies the need.” If what we seek are status and power, and money is not available, will we not find other means to achieve our ends? And, the alternatives may be even more cruel or vindictive than making money.
Simmel notes perceptively that exchange – the transactions facilitated by money – are the highest form of interactions between people in that they are win – win, or non-zero. In a true exchange, which is voluntary and non-coerced by power or excessive need – each party is offered more than what he or she had before. So, the social work of exchanges is to increase the sum of value that is tangible.
Exchange presumes the scarcity of goods – that the goods available are not public goods made freely accessible to all upon use or demand. Exchange uses subjective valuation of that which is limited to respond constructively to scarcity and generate positive social enhancement embracing the parties to the exchange.
As Adam Smith said in The Wealth of Nations, the butcher and the baker look to their subjective needs to supply us with meat and bread for our dinner and we look to our needs to supply them with money, which they value as a means to meet their needs. Their values and our values are both vindicated- simultaneously and separately. It is an alchemy that turns selfish reflections into social good.
Furthermore in making an exchange and paying for it with money, one is subordinated to an objective norm. We are socialized in the process and become less the wild beast or the despoiler of the innocent.
Where there is pure subjectivity and no exchange, we might have either robbery and theft or compassion and gifts.
Simmel warns that exchange with money reconciles opposites: relativism and society. Money perpetuates a relativistic world view where each can live with his or her own subjectivities. But at the same time through exchange, money permits individual relative things, as valued by individuals, to become something of social consequence and so to enter into history as objective phenomena.
Money as the expression of a concept of objective economic value brings forth, says Simmel, an interpretation of existence. Money can be philosophy too.
Money is no more than way stations on an endless series of cognitions. Cognition – valuation – is a free-floating process where elements determine their positions reciprocally and relative to one another. Truth here is relative like weight or price. Truth is an aesthetic more than a command. It works through induction far more surely that with deduction. A culture of flux and change is engendered by money. Money has no respect for any eternal verities other that the process by which it is assigned to prices reflecting our values. As Simmel wrote, money corresponds to the “many-sidedness of our being and the onesidedness of any conceptual expression.”
The ultimate principles of such a culture proposed Simmel become realized not in the form of mutual exclusion (I-It over I-Thou to borrow from Martin Buber) but in the form of mutual dependence, mutual evocation, and mutual complementation – just like in an exchange. The philosophical significance of money, then for Simmel, is that it is the clearest embodiment of the formula of all being, according to which things receive their meaning through each other, and have their being determined by their mutual relations.
It interweaves all singularities and so creates reality. Money could, Simmel affirms, thus play the role of God for a weak minded humanity.