Look,It's Someone Doing Their Job!

The New York Times today reported a story about Dr. Suzanne Stratton, a Ph.D. molecular biologist and researcher in clinical oncology, who was brought in to oversee the quality of clinical trials at Carle Cancer Center in Urbana, IL. Upon taking up her position, Dr. Stratton finds, among other issues, failures to properly consent patients in cancer trials. In the world of clinical studies, this is a major "No No." In addition to opening up the institution to considerable liability if, let's say, the patient died due to an experimental treatment that was not properly explained, that patient should also properly be taken out of the enrollment pool for the study because of the failure to properly document informed consent.

It sounds like Dr. Stratton had done her job and found this fundamental violation of good clinical practice, and had pointed it out to her superiors, along with other issues. For this, she was discharged and led out of the office the same day. In the mean time, it turns out that one Principal Investigator at Carle, Dr. Ken Rowland, "has simultaneously overseen more than 130 clinical trials in more than 20 cancer types, ..., and he personally enrolled about one-quarter of the 500 patients Carle signed up for experimental treatment in a typical year." This is analogous to a lawyer billing 5,000 hours a year--implausible to say the least.

This kind of high volume throughput does lead, just like in the financial world, to moral hazard and perverse incentives. In fact, the NYT article suggests that "doctors too often promoted trial treatments as superior to standard approaches, even when there was no supporting evidence."
Get 'em in and get 'em enrolled, and let's bill the Government based on enrollment. The primary body for regulatory oversight in this setting is the Institutional Review Board (IRB), and Dr. Stratton had the temerity to suggest that it was too deferential to researchers and did not maintain its own, independent documentation.

Kudos to Dr. Stratton for doing what she was supposed to do and for following the chain of command and for calling it like she saw it.

Complexity

An interesting item came across my desktop from Richard Herring, Professor of Finance at the Wharton School. He notes that "the 16 largest financial institutions control 2.5 times as many subsidiaries as the 16 largest non-financial firms. One of the most complex financial firms controls 2,435 subsidiaries, half of them chartered in other countries. Many such subsidiaries are formed to "minimize regulatory burdens" or reduce tax bills," he says. "Such complexity makes it difficult for anyone -- including regulators and the companies' own managers and directors -- to fully understand all the risks the firms are taking, or how those risks might interact with ones other companies are taking."

Here are some thoughts. Let's simplify a tax system that encourages and allows such non-productive activity like creating a network of 2,435 subsidiaries whose purpose is to transfer income from the Treasury to management and shareholders. Second, having just spent some time with a few directors of large financial services company, I hate to say, and I include myself, that they would be hard pressed to find pockets of radioactive risk inside of a corporate rabbit warren like the one Professor Herring cites. Unfortunately, in the case of TBTF financial institution, the directors failure soon becomes a taxpayer burden, and this chain also needs to be broken by sensible, basic regulation.

Conscience and Character

What do these have to do with the crisis of the American financial system? Nothing. And, that's exactly the problem. Wall Street fosters an environment where a person's governor or self-regulator, called a conscience is switched to "Off" during office hours. The name of the game is always to go to the edge, and over the edge. If someone calls you on it, pull back, with no consequence and go about your business. Each minute, hour, day, and quarter is serially independent of any other. "Size of the book" is all that matters, and the positive or negative sign means little. Size means you're a player, and a negative sign means that you are "aggressive."

Unfortunately, a variation of this theme applied to bank regulation during the build up to the crisis. That truth is slowly coming out. Here's a self-assessment of the Federal Deposit Insurance Corporation's loan review process reported on the Calculated Risk blog:

"The FDIC’s Office of Inspector General analyzed 23 lenders taken over by regulators from August 2008 to March and found that for 20, the agency’s examiners didn’t identify the issue early enough or should have taken stronger supervisory action after recognizing the banks had dangerously high levels of the loans before they failed. ...“It’s often we’ll see in our reports that the FDIC detected problems in the bank in a timely fashion, but in some cases forceful corrective action wasn’t required by the FDIC to be taken quickly enough,” Jon Rymer, the FDIC’s inspector general, said in a telephone interview." (Source: Calculated Risk)

So, it's not a matter of inadequate process or regulation. Examiners were in place, and they went out and followed their processes, which pointed out the issues. What is unclear is why the levels of bad loans were allowed to get so high, and why "forceful corrective action" wasn't taken. It's the same issue: a failure of character and faithfulness to one's mission. Of course, having worked for a few agencies of the Federal government, it's easy to construct a scenario where an examiner calling for shutting down lending in a go-go market in a "free market" administration might not think this was a good career move. And that's a shame.

I've never responded negatively to one of my staff giving me bad news or taking a stand on something. Overzealousness shows passion and commitment; it can always be remodulated, if it has to be. Failing to call attention to a problem or being inhibited about bad news is a more complex problem; it's being tepid, which is a bad thing in sports, life and in the world of character and conscience.

Reverend Dr. Martin Luther King, Jr. longed for the day when a man would be judged "not by the color of his skin, but by the content of his character." Perhaps the latter is something that should start going onto performance review forms.

Silence in Islamabad

The recent brazen Taliban attacks on Pakistani military headquarters, the killing of international civilian food program officials, and the taking of hostages has been greeted by a very muted public response from the government of Pakistan. Normally, the head of state would be issuing press releases to the worldwide community, flanked by the top generals, expressing outrage and a program for reestablishing security and punishing the organizers. The most publicly quoted international official has been Secretary of State Hillary Rodham Clinton!

If I were sitting in New Delhi, I would be very worried as well, because there is no real benefit to India from a collapse of the Pakistani state, but it seems as if there are messages being sent by the Pakistani Taliban, paraphrasing Alexander Haig's famous quote, "(We're) in charge now." No targets are off limits, and that includes employees of international agencies, who had traditionally been given safe passage to do their humanitarian work. The international community has also been challenged, and there is no response. I'm not sure what it could be, but unfortunately President Obama's choices in Afghanistan will ultimately trigger events inside the frontier territories of Paksistan, which are becoming nerve centers for the wider conflict in Central Asia.

Give Me Your Tired (Old Ideas)

The New York Times had a great article about the Simmons bankruptcy. It took me back to 1986, when I was working as a sell-side research analyst, and I read about the $600 million LBO of Ohio Mattress. Ohio Mattress was itself a roll-up of lots of small mattress makers, and the company eventually became Sealy. As I heard our analyst recount the numbers, it seemed unbelievable to me that so much debt could be piled on a business that put padding on coiled springs and covered them with fabric.

Fast forward to 2009, and we read about the bankruptcy of Simmons. T.H. Lee & Partners makes a cool $90 million on their investment, but, for the record, is "disappointed." Banks have made fees and padded their earnings. Bondholders are out $575 million; "apoplectic" should appear in their press releases. Finally, the employees who dutifully went through all the changes that generated the higher cash flows required to pay off THL were rewarded with cake at their holiday parties and now have nothing. Warren Buffett, who has no aversion to making money, has railed at the private equity paradigm in his shareholder letters for years. This kind of "looting" (a term used in an academic article from 1994) is now called "financial innovation."

Ares Capital Management, the new owners, will benefit from wiping out creditors and bondholders and the cycle starts again. The bondholders, though, have only themselves to blame, as they were apparently told that the use of proceeds for the various debt issues were to pay special dividends to the owners and not to bolster the long-term earnings power and sustainability of the enterprise. Which of our compassionate political parties speaks for the employees?

The FSA Gets It Right

Lord Adair Turner, Chair of the Financial Services Authority (FSA) of Great Britain, is a former non-executive Director of Standard Chartered Bank, former vice-Chair of Merrill Lynch Europe, and a former senior executive at McKinsey & Company. Near to my heart, he studied History and Economics at Gonville & Caius College, Cambridge University. As my musician son would say, "He's got the chops."

As our Financial Crisis Inquiry Commission held its first meeting on September 17th and grinds along, I believe that the March 2009 "Turner Review" from the FSA is an excellent, informative, clearly written one-stop resource on the origins of the crisis and on the market and policy changes needed for the future. It has some very striking charts that bring home the points in sharp relief.

The opening chapter, "What Went Wrong?" should be read and actively discussed in classes and in the board rooms of financial services companies. Lord Turner has become a bit of a controversial figure, which to my mind means that he is getting to the right issues on wholesale financial services.

Summarizing the benefits of securitization, the Review correctly notes that it should: (1) reduce banking system risks; (2) cut the total costs of financial intermediation; (3) pass credit risks on to end investors, thereby freeing banks from holding unnecessary and expensive regulatory capital.

Markets in securitization-related products ballooned during a period of extraordinarily low real interest rates as everyone hunted for yields. So, for example, the credit default swap market stood at $5 trillion in 2H 2004 and soared to almost $60 trillion by 1H 2008. As the markets expanded, relatively little of the securitization production went to end investors, and much of it went to the proprietary trading desks of other banks (see Lehman Brothers et al). The retained tranches were themselves hedged via CDS. Some of the product was repackaged into CDOs and CDO-squareds. Finally, some of the product was used as collateral for short-term bank liquidity. So, the basic premise that created the securitization industry was completely turned upside down.

Repeal of Glass-Steagall again seems like a horrendously bad political and regulatory decision. What it allowed was for trading books at banks to have capital requirements much lower than the capital requirements for the banking books of the parent company. As commercial banks became extensively involved in proprietary trading, when asset prices started collapsing that directly affected parent bank profitability, creating a crisis in confidence and in short-term bank liquidity. Historically, that crisis in confidence could have only occurred from a run on deposits. Now it occurred due to trading activities that were remote from the fundamental commercial bank mission of "maturity transformation."

Think Wall Street knows how to manage risk? Here are two pithy quotes, "At the individual bank level, the classification of these (Structured Investment Vehicles) as off-balance sheet proved inaccurate as a reflection of true economic risk, with liquidity provision commitments and reputational concerns requiring many banks to take the assets on balance sheet as the crisis grew..." There is a breathtaking chart showing the historical leverage ratios of the larger banks, and the charts for UBS and Morgan Stanley are poster children for irresponsible risk management.

Financial innovations (lower tranches of CDOs and CDO-squareds) had "very high and imperfectly understood leverage..." The complete failure of the VAR models have been well-documented by Roubini and others.

According to the Review, "...the development of securitized credit has ended up producing the worst financial crisis for a century." The introductory chapter talks about poor regulation and inadequate capital standards, a message that was recently reiterated by Secretary Geithner in a speech that was not attended by a single money center bank CEO. Again, it must mean he was on to the right issues.

Some basic economic points are well made. Market efficiency does not mean market rationality. Even market efficiency is not something we should take for granted on Wall Street. For example, a chart on bank CDS spreads shows that the market did not anticipate the credit problems ahead. At best, the spreads ranked the relative risks of certain banks (such as Northern Rock in Britain) accurately, but the spreads were a useless leading or even coincident indicator. Neither were the share prices of the banks themselves, and yet stock prices are a big component of US leading economic indicators.

Individual rationality does not sum up to collective rationality. Economic behavior of individuals is not dominated by the "rational maximizer" model that we study in economics and finance.

Finally, Lord Turner starts to stake out some meaningful and controversial ground when the report says that the increases in market efficiency from the creation of complex financial products is essentially trivial. This is a powerful quote that forms the basis for the recent speech Lord Turner gave at Mansion House: "Wholesale financial services, and in particular that element devoted to securitized credit intermediation and the trading of securitized credit instruments, grew to a size unjustified by the value of its services to the real economy." How did this happen? The margins in financial services, and in particular on proprietary trading of these products are opaque. There is substantial knowledge and information asymmetry in the markets. Finally, there are the principal/agent relationships between investors and banks, and between banks and the employees running the trading desks.
This leads to a fundamental economic process called "rent extraction." Trying to regulate compensation does not get at rent extraction fundamentally.

Just a word to the Financial Crisis Inquiry Commission, there's no need to reinvent the wheel. The origins and mechanisms of the crisis have been very well laid out. Let's get right to better regulating markets and the products for the future.

What Sunk the Ship?

Andy Kessler in today's Wall Street Journal makes the same basic point that we made in our last post about the futility of focusing on executive pay at banks. There is one philosophical difference that probably originates in the fact that Kessler is a former hedge fund manager. He says it wasn't excessive compensation schemes or excessive risk-taking that almost sunk the global financial system. Rather, he says it was the excessive use of leverage. He claims that Wall Street is good at managing their day-to-day risks. I have a hard time following this one.

Leverage is a decision variable that magnifies risk and returns, and so it is part and parcel of risk taking. So when Bear, Stearns or Lehman Brothers leveraged their portfolios at 35x, these were the accumulation of conscious decisions taken on their trading desks. It is the produce and distribute model for products that are as economically useful as carnival elixirs that needs to be changed and regulated. Unfortunately, there is no appetite to do this any more, as everyone is worn out by the minute-by-minute crisis watch over the past three quarters.

Just like SOX was a victory for accountants, consultants and lawyers with little impact on long-term shareholder value, so too will be the pursuit of executive compensation in banking. It's become so ridiculous that a local paper featured a story about a school board that rescinded performance pay bonuses for senior district administrators. Their performance measures, which included increasing enrollment in special programs, increases in minority performance and the like, were set a year ago; they seem clear, reasonable and measurable. The bonus amounts were a reasonable percentage of the base compensation. Now the administrators were told to give back their bonuses as contributions into special programs, "for the kids." It's not the fault of school administrators that Wall Street got the entire country into the crisis of the century!

Misguided populism is raising its head because the Administration and its Congressional lackeys don't have the guts or understanding to attack the problem at its roots because they are all running for their next campaigns. What a shame.