Responsible intelligence

It's been over a year since the collapse of Fannie Mae and Freddie Mac (7 September), Lehman (15 September), and Washington Mutual (25 September). In reflecting, I solemnly made a resolution to myself that I would step off the bandwagon and encourage others to do the same.

Approximately a year ago, on a late night in the office, I remember my colleague being on the phone with a trader at one of the large banks, which has since been lucky enough to survive the global downturn. The trader had told my colleague, "This isn't good. Wait. This is very very bad." Similar statements of hopeless fear and utter panic were allegedly heard everywhere that night on Wall Street, in Canary Wharf, and every other financial district in the world.

Who knew that a year on, the markets would be back up and still functional? Sure, there are ample liquidity problems and trading strategies are now more vanilla than ever, but a year ago, the financial services industry thought, This is it. The world is over.

Regardless of whether or not we call the current downturn a recession or depression, no one would disagree that fourth quarter 2008 was some of the most panicky months the world has seen in decades. Emergency measures were taken by several governments and central banks, including an interest rate cut down to pretty much zero. Money has been lent, guarantees were given (albeit arguably belatedly), and now the hottest topic is about figuring out a regulatory framework for the financial industry going forward.

The best thing about time is that it keeps going, and the great thing about that is that we can now look back and think - critically - about what happened and why.

The general media has been horrible about this, in a time when they should be the ones spearheading a more critical approach. One could understand the polemical stance the Times took last October, when one journalist concluded:

The stresses in the financial markets partly reflect bad policy decisions that made sense at the time - such as central banks keeping interest rates low after 9/11, and owing to the effect of Chinese imports in restraining inflation. But this time, there is a justifiable anger at the insouciance of the bankers, who irresponsibly exploited those decisions. The demonology has new life in it.

But recent news about the G20, proposing to regulate bankers' pay, coverage of the Kraft/Cadbury merger, to the private lives of certain bankers, continue to sustain this so-called 'demonology'. And it's not helping the situation, at all.

To be fair, certain media outlets have always been rather sensationalist, because it no doubt brings in the dough. In a time when advertisements are being cut, and less people are spending on superfluous things, most media firms and their journalists are likely to make an extra effort to make news sound more scandalous, more evil, more conspiratorial, and therefore more of a 'must-read' item - a bigger deal - than it actually is. If that's what some media do, then so be it; not every outlet can be a saint.

However, I came upon a rather shocking phenomenon recently, when in conversations with my friends about the financial crisis, they came up with some of the most uninformed, uncritical statements about the causes and who was to blame. According to them, bankers were to be despised, the fault was at the bulge-bracket banks, none of the governments' emergency measures were effective, and so on and so forth.

The shocking part was, although I give them the benefit of the doubt that most of them have done their reading, my friends all happen to be very well-educated, and ambitious, critical thinkers. All of us were brought up and educated that way - to be critical of our sources, the things that we read, hear, and see. And yet a good handful of them had jumped onto the bandwagon in the last year with the rest of the world, pointing accusatory fingers at the towers along Wall Street or in Canary Wharf, or to No. 10 Downing Street or the White House in DC, and all those who dwelt, left, or continue to dwell in them.

But I say: GET OFF THE BANDWAGON. Be responsible about your intelligence. It's been a year now, and it's about time we look at the so-called "Great Recession" with a more critical eye. Look past the headlines and the polemical opinion columns, the supposedly less-polemical editorials, even the blogosphere - yes, even this one, too! - and the likes of Wikipedia. Step back and take a critical - not skeptical - view: What caused the financial crisis?

To point my own finger on one of many broader causes, I will outwardly wonder about what is going through the heads of the CFOs, the CEOs, the top regulators and central bankers of the world, if some of my smartest friends have ditched the recognition that we no longer live in an era where causation is linear. In fact, the human species probably never has lived in an era where causation was entirely linear; we just chose to see it that way. And now, with the tangible effects of globalisation, we can see with our naked eyes that causation is circular, networked, and widespread. In short, there is no one cause to an effect; there are many, many more than we can probably fathom.

No single bank or trader, or hedge fund, could have crippled the entire financial system in the way it was last September. The subprime mortgage crisis preceded it. So clearly, that was a factor. US interest rates were kept low all through out it. That's also another factor. What was once simply hedging instruments became tradable on an exchange - also another factor. The list is endless.

And what are the regulators now going back to? More stress tests, more financial modelling, more scientific and mathematical analysis of trades, companies, and risk. But, do they not see what they're doing? What have they learned? Where is the critical thinking, the investigative spirit? So I will boldly point a finger to one (of many, to be precise) cause, right here and now: lack of critical thinking.

We relied on financial models to tell us how a trade would perform in the future. We have, thus far, relied on stress tests to find out how much stress a bank can undergo before its legs give away and the whole thing comes tumbling down. One can even distill this trend on hiring patterns: most of the financial services vacancies advertised will ask for numerical skills, or some background in finance, risk management, or credit risk analysis.

Clearly, we haven't learned anything. As one market participant recently told me, "Investment bankers have the memory of a dragon fly." But that probably applies more broadly than we'd like to admit. The lack of critical thinking prevalent amongst my peers, goes all the way up to the CEOs and CFOs and CIOs and regulators, central bankers, and to the governments' finance ministers. The exact approach - reliance on modelling and number-crunching - that we thought heralded the credit boom in the mid-2000's, was the exact thing that turned the boom into a crunch, and is now the exact thing that we're turning to once again to bring about a boom. Needless to say, it's more likely that it will simply stretch out the recession, than resolving it.

Most importantly, demonising bankers, or certain banks, could end up hammering the last nail in the coffin, so to speak. The global financial industry currently stands at a crossroads: we can choose to learn from the mistakes, learn from the ways certain financial instruments and their investors (mis)behaved, and rebuild the industry from there, or we can choose to condemn those instruments and all involved in their (mis)behaviour, install rules and regulations, and effectively, start from scratch. Hence, as one regulator aptly put it, the regulations we adopt today will have no bearing on future financial crises. Of course: if we take the latter road, we are effectively reinventing the wheel.

Some of us are educated about certain things in the world more than others. I have no doubt that the ability to think critically about causal relationships - actively asking oneself, what is the cause and what is the effect - is an acquired skill, and a cherished one at that. But for those of us who do have the means to understand what happened, who have the means to read a newspaper article and think twice about it, should. Rights come with responsibilities, and being responsible about your acquired intelligence, is one of them.
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Property rights: overrated?

A friend of mine posted on an interesting topic, and I thought it might be worth actually posting a response to theoncominghope's most recent post, "Piracy: Capitalism at work."

While I agree that piracy involves stealing and violating rights, remains a major concern amongst almost all sectors, and for the person whose product has been pirated the experience is far from pleasant, I'm not sure if one can make the leap from 'piracy' to the 'annihilation' of property rights.

For example, in the context of pharmaceuticals, I think you have to look at why piracy occurs to begin with - that is, the unavailability of certain pharmaceuticals. If everyone had access to most drugs when they needed it for a reasonable cost, I don't think you would have the same kind of problem of 'piracy' (or in this case, violation of intellectual property rights). On the one hand, such a situation would virtually nullify any incentive to reproduce a drug because it wouldn't make economic sense; if you can purchase it at a reasonable price/cost, then why spend the time, effort, and money to reproduce it? On the other hand, the same situation would also incentivise those who think they can reproduce the drug at a lower cost, supply it at the same price as the original, and make a profit.

In either of those scenarios, property rights aren't completely annihilated, because while pirated products do tend to find themselves distributed widely, the market for the original product continues to exist (albeit arguably in a less dominant manner than in previous generations). The products and processes used to create that product have been adapted. And for all intents and purposes, until a new form of technology comes along (which is probably more just a matter of time), or the downsides of a less-quality product are heartfelt by its consumers, the effects of one act of piracy are quite temporary.

This, of course, is not to say that the various consequences of these actions are any less significant, and I will get to this point shortly.

Either way, whether or not property rights are destroyed in either of the abovementioned scenarios is a mull point, because neither of those situations currently exist in the pharmaceutical sector. Certain pharmaceutical products are either unreadily available because the cost of production is too high for mass production, or are mass-produce-able but supply is limited, demand is uncontrolled and unsatiated, thus artificially pushing up prices, allowing companies to make a large profit. My humble opinion is that, given the political economy of pharmaceuticals, a little bit of piracy might actually do some good.

And to quickly address the profit-making incentive: government subsidies for R&D coming out of taxation, and removal of any taxes in the production of pharmaceuticals.

I suppose the problem is that from my macro perspective, piracy, or the infringement of (I)PR, or whatever you want to call it, is actually not such a 'big deal', for a lack of a better phrase. The reality is, much like financial services regulation, people will always find new ways to produce something for a lesser cost. Not even the prospect of the death penalty, or national deportation, will stop them; in fact, the higher you raise the stakes, the more profitable, and more criminal, of an industry it will become. If you really wanted to address 'piracy', you have to look at what incentives are, either by chance or purpose, in place that are driving certain people to forge a product.

The other issue I have with the violation of IPP/property rights in general from a more philosophical standpoint (wince!), is our continued obsession with the territoriality of material things. It's not that I've turned into a materialism-hating hippie overnight, but that the obsession itself is unsustainable. The reason why I take issue is because the world is changing. The best example is media. In about two or three decades, there will no longer be CD's - in fact, they will be super-expensive to produce and buy. Around the same time, broadsheets will disappear, as will consumer magazines, books, concert tickets, and flyers. My not-very-well-thought-out but gut-feeling is that the pulp and paper industry will actually turn into a consumer discretionary sector from the non-cyclical industrial sector it is now. This is to say that paper will become a luxury item, and there will only be a select few companies that will produce it. In fact, it's already starting. A Canadian newsprint company, AbitibiBowater, filed for bankruptcy in April this year, because newsprint consumption in the US fell off the cliff by 29%.

The music industry has already changed in this way. We went through a period where music became a hotly demanded commodity, and it was a ludicrous business on the production side to enter as long as you were at the right place at the right time with the right shit. On the consumer side, before MP3's became rampantly distributed, we all had to buy CD's or tapes, which we then developed the technology to copy at home and then re-distribute to our friends. But with the advent of MP3s and other alternative digital sound files that are easily distributable, CDs, tapes, and records became massively expensive to produce, and hugely inconvenient to purchase. The demand for music hardware (CDs) from consumers went down, pushing down supply (as well as the incentive to supply), while the production side of the music industry wanted to maintain the same level of income and profit. The business model is completely unsustainable. Something has to give.

Unfortunately, it will remain unsustainable until the music industry figures out a different way to fix the imbalance, or else the economy will do it on its own by scrapping the current music industry-model all together. Most likely - and this is where I stand with theoncominghope - not only will musicians have to be more creative in the way they produce and distribute their work, but their expectations for profit will also have to come down, especially given that the advertising industry will also undergo a massive change in the next few years. What the greater implications are of such changes - well, I'll leave it to your imagination to speculate.

Now, to address the more tangible issues arising from piracy: the micro perspective. Even though I basically say above in a more nuanced way, that property rights are somewhat overrated, the protection of individual rights to property ownership is quite important. In the far, tiny land of East Timor, one of the major obstacles to infrastructural development and peace, no less, is the lack of a legal framework about property rights. During its conflict with Indonesia, the Timorese underwent a series of uprooting from, and redistribution of, land the people formerly lived on. In post-conflict Timor-Leste, people continue to fight - physically and legally (in the latter case, as much as they could) - over ownership of certain pieces of land. It doesn't help that the country had been in conflict for so long that not only are 'official' records unavailble, the people themselves don't exactly have matching accounts of their ownership. The cases are also exacerbated by each party's familial (read: ancestral) attachment to the land and are wrapped up in many layers of tradition and practice with regards to conflict resolution. Many NGOs and IOs working on consultation programmes, therefore, have unilaterally pointed to the lack of property rights law as one of the most signficant obstacles to peace in Timor-Leste.

So at the micro-level, property rights are far from overrated. However, whether they are implicated in the music industry or in a small, undeveloped, post-conflict country, the importance of active regulation of property rights should be emphasised. But, that's not to say that you can just overburden them with regulation. The question to consider is the type of incentives, to place where, and when, and also recognising that even with adequate incentives, people will find ways to get around it. The fear is not underregulation, but overregulation. Some freedom - read: leniency and ability to change - will be key.
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Because we wanted to have the cake and eat it, too

Monday morning was subdued because North America was still on the beaches for Labour Day. That didn't keep media coverage off the meeting of G20 finance ministers and central bankers held in London over the weekend, ahead of the G20 meeting in Pittsburgh later this month.

The FT outlined the agreements attained at the meeting:

The G20 meeting agreed [on] three main points: banks must raise much more capital once the financial crisis has passed; complex financial institutions should develop “living wills” to plan for their unwinding; and banks should be required to retain some portion of loans they repackage and sell as asset-backed securities.

Allow me to quickly rephrase that in simple English.

The second point mentioned is simple enough: in case a financial institution goes bust, they should outline the ways in which various instruments and deals should be cleaned up, or in financial jargon, "unwound."

The third point, while it may sound the most complicated, is also quite simple: banks should have the actual stuff they sell, deal, and work with (in this case, loans).

The most complicated of the three is actually the first point regarding raising more capital, which deals with the amount of debt (capital structure) financial institutions have. Of a given bank's debt, about 92% of it is made of bonds and other debt instruments. About 4% is made of stocks (shareholders' equity), and is there as a 'cushion' as deemed by regulation. The remaining 4% is what is called bank regulatory capital in Europe (in the US, it's called trust-preferred securities, or trups). This stuff has both debt- and equity-like characteristics.

Without going into too much more detail, the basic point of note here is that bank regulatory capital was categorically created and adopted in order to at once appease regulators' concerns about how well-capitalised banks are, and appeal to investors. In other words, everyone wanted the cake and eat it, too.

To be grossly simplistic, one could quite easily argue that most causal elements of the current financial crisis came down to this one, cliche statement about having the cake and eating it. To be more specific, it was about having the cake - not paying for it - and then eating it - and then getting away with it.

Take mortgage borrowers, for instance. A telling article in the Valentine issue of the New Yorker this year illustrated the literal foreclosure of the state of Florida. A university professor aptly described the situation as a "Ponzi scheme" where the US' hottest real estate market spiraled into a disaster. People bought homes with easy money from the banks, but when property prices fell off the cliff and people lost their jobs, no one was able to repay the mortgages. Apparently, convincted criminals were running around the market scene as well. Hence,

Fort Myers real-estate agent named Marc Joseph tells the writer, “Greed and easy money. That was the germ.”

Of course, the mortgage lenders are to blame as well. Loose credit history checks - or even none at all - and financial unplanning from irresponsible financial advisory allowed borrowers to get away with terms that defy what I would think of as common sense. You don't spend beyond what you don't have or earn - having been on a $1 per month allowance up until the age of 15, financial prudence was something my mother was very strict about. But, given high incidences of credit card spending - combined with the so-called American Dream of home ownership with white picket fences, lush-green front yards and a golden retriever puppy - perhaps the average American consumer is far from prudent.

Here, the role of the mortgage borrower and lender - what I think of as the key trigger to the subsequent fall of already-wobbly dominos - is a microcosm of the greater picture: people had the cake, didn't or couldn't pay for it, but ate it anyway, and for the longest time, didn't own up to it. And this kind of irresponsible behaviour was widespread, from the individual consumer all the way up to the private equity firms and the bulge-bracket banks. So no, the Goldman Sachs and the Morgan Stanleys of the world did not single-handedly bring down the entire global financial system - such are incredulously outlandish statements made in the blaming game, and completely ignores the fundamental cause of the financial turmoil (irresponsible borrowing, spending, and lending) and more broadly, the essence of how our economy functions. That is, capitalism.

Capitalism, which is essentially what the majority of the financial world operates in, is based on the one basic rule of supply and demand. Unfettered, efficient capitalism has at its core this simple rule that if supply goes up, demand comes down, and vice versa. And for this reason, like it or not, much of how the economy moves is based not just on tangible changes in supply or demand, but also the perception of these changes by the broader market, as well as by individual consumers.

The crux of capitalism is the freedom to supply and demand; that is, no one can tell me whether or not I can buy a pair of shoes, or produce a pair of shoes, over a pair of glasses. An efficient capitalist economy relies heavily on this liberty. But, as much as we'd like to rely upon the individual and collective conscience in maintaining an orderly and civil society, there is something to be said about the fragility of that conscience - whether it be moral, ethical, whatever. Laws and regulations govern human behaviour by permitting and prohibiting certain actions within society. Whether we had hoped too far or unrealistically expected market participants to exercise self-restraint is a mull point; the fact of the matter is, without rules or boundaries - and more importantly, a widespread perception of them - people will always look to have their cake and eat it, too. If laws have been around for most of human history to tell us what we can do and what we cannot do in a social context, it should be obvious by now that something fairly similar should exist in an economic context.

This isn't to say that burdening the financial system with piles of regulation is the solution. Going forward, rules and regulations for this particular industry will have to tread a fine line of optimum efficiency. Not an easy task, at all. But in a system where most of its participants have developed habits of having the cake and eating it without owning up to the costs, some re-training will have to occur.
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