Slouching Towards Wall Street… Notes for the Week Ending Friday, 3 February 2012
Capitalism: The Tree of Knowledge
Who told you that you were naked?
The creation story in the Book of Genesis is a tale of Trust, as the fledgling universe accepts unquestioningly the word of its Creator. God creates Light, separates it from the Darkness, then commands the Light to be “Day,” and the Darkness “Night.” Dutifully, the Day and Night take up their positions and forever after that is what they remain. Indeed, all creation follows God’s verbal instructions unquestioningly, taking the Word of God quite literally. The seas are seas, the dry land is dry land, and grass and trees and birds, beasts and fishes all cooperate, following their instructions to the letter.
Then along come humans and the whole enterprise starts to crumble, primarily because we have Free Choice, an ability to direct our own actions. The need to exercise that Choice arises from our unique form of self-awareness. We do not attribute to a rock, an ocean — or even a horse or a shark — a personal identity, an awareness of an unchanging, yet inchoate, kernel of the Self enwrapped in a constantly shifting mess of personality and emotion, desires and fears, appetites and revulsions. Out of this plague of awareness arises what both God and the philosophers call the Human Being, a uniquely successful and uniquely troubled species. Who would have thought the Creator of All Living would grant this creature utter dominion over all else? Truly, a compelling argument for atheism.
The straightforward and unwavering cooperation of the first days’ creatures lulls the God of Genesis into an expectation of obedience, and so it never occurs to this God to build in safeguards. There are simply a couple of rules — eat the fruit of all the trees in the garden, except do not eat the fruit of this one particular tree — but no structures to ensure they will be followed, and no early warning system to prevent them from being broken. God, in short, has no compliance program.
What is this Tree of Knowledge anyway? Religious commentators say it is our propensity to sin, born of the uniquely human freedom to choose. The drive to fulfill our own appetites, even when we know it is wrong. Psychological writers interpret it as a loss of innocence. Both approaches cast humanity and God in a struggle between the id and the superego, with the Fall from Grace being the consequence of our loss of self control. And political commentators, who see it as a dawning awareness of the underclass that they are, in fact, downtrodden — that there is someone else treading down upon them — arrive at an analysis that pits autonomy against control by the Other.
It is in our nature to be driven by a thirst for knowledge. To want to amass knowledge, the better to manage our independence. Many a commentator on Genesis finds Adam and Eve’s act at least inevitable, if not actually praiseworthy. There is ultimately no gentle way to declare one’s autonomy. No painless leavetaking of one’s parents, and no gentle nudging forth from the nest. Many readers of this story concur that eating from the Tree of Knowledge was worth the cost, because it gave our lives meaning.
Knowledge continues to be, for many, the highest human value. It is fundamental to the proper functioning of capital markets and thus definitional to modern capitalism. The issuance of disclosures around publicly traded securities created a revolution in human history, making knowledge the basis of value in the marketplace. This is a profound aspect of the culture of capitalism: not merely Price, but the very notion of Value is largely predicated on the availability and reliability of information. (It is a truism among anthropologists that a society never thinks of itself as having a distinct culture. “Culture” is an Eskimo chewing whale blubber or a forest dweller in face paint and a penis sheath. We, living in SoHo, dining in TriBeCa and working on Wall Street, have “A Life.”) The disclosure of information by a public company is a defining component of that company’s value. The dissemination of information about a company allows its owners to monetize their investment of time and effort, allows downstream investors to assess the company’s prospects for growth and profitability, and allows the market to assign a price to the growing welter of expectations arising from the data.
Writing in the Financial Times (29 January, “Knowledge Lies At The Heart Of Western Capitalism”) economist Hernando de Soto argues that the destruction of credit and capital in recent years was caused by capitalism’s loss of the knowledge required to connect up “many tiny parts that are useful only when we combine them into more complex wholes.” De Soto made a splash with his The Mystery of Capital, an economic policy tour de force published in 2000. In it, he argues that Western practices that formalize property ownership are the key that makes it possible for individuals’ capital to generate more capital. Families in poor countries, says de Soto, often own their homes and the land they farm, but they have no title, no way of proving their ownership — and also no way of enforcing it when the state chooses to dispossess them. This makes their property what he calls “dead capital.” Without clear legal ownership structures, no one can pledge their plot of land to acquire the materials to build a factory. Without clear business ownership and homeowner address records, governments can not effectively collect taxes. Without the availability of corporate structures, entrepreneurial businesses are limited in the size to which they can grow and their ability to expand by interconnecting activities. And without the information that flows from these structures of ownership, societies can not construct successful capital markets.
De Soto says Western capitalism’s brilliance is its ability to profitably combine “land, labor, credit, capital and technology,” arising from the West’s “property memory systems, which are the result of examining, selecting and validating” ownership data.
We remember discussions among hedge funds in 2007 asking why no one had created a single data base to track every asset-backed instrument to its underlying assets, identifying ownership at each step of the transaction. With no way of identifying creators, issuers, owners, and a long string of sellers of mortgages, it became impossible to hold anyone accountable for non-performing financial assets. We all remember what that led to. Nor can we trust “the non-standardized, scattered records that obscure who holds risks; and the off-balance-sheet accounting that obscures many companies’ health.”
Just as business executives put on their best suit to meet with clients, the way in which a company presents its financial information is intended to convey an impression of reliability and power, while instilling confidence that it conforms to the highest standards of Transparency, Accountability, and Trust. Thus it begs the question well known to any seasoned securities analyst: why are no two companies’ financials presented the same way? Put differently: if all companies follow the standards of Generally Accepted Accounting Principles, why are corporate filings often so opaque, requiring armies of highly paid specialists to tease out the truth? Increasingly, investors are being asked to trust companies, bankers and the salespeople who represent them, rather than to understand the investments in their portfolios.
We have often remarked on the evolution of customized investment vehicles. Complex trading facilities designed for sophisticated professionals go de-volve, moving down the food chain from the most sophisticated investors, until they wind up in the hands of the public. This was the trajectory of futures and options, commodities and currencies. But it was also the story of ETFs, hedge funds, and residential mortgage-backed securities. Once a smart person creates a new strategy, others become aware of the transaction and copy it. Soon, like Yogi Berra’s favorite restaurant, no one is doing that trade anymore, because it’s too crowded. The typical release valve, at that point, is to sell it to the retail investing public.
Which is where Trust comes in.
In retrospect, Lloyd Blankfein’s gaffe appears profoundly Talmudical, if not downright prophetic. “Doing God’s work.” It was, after all, God who first said “don’t ask questions. Just do as I say.”
We suspect the record will not show it — because no one dares keep records of these kind of meetings — but our paranoid fantasy is that in the months leading up to the financial meltdown of 2007, a number of hedge funds and other managers were coaxed, or enticed, or bullied into buying complex derivatives, not because they understood the structure or vetted the portfolio themselves, but because a major investment house was ramming the trade down their throats. Even after buying a lemon, major investors are loath to complain for fear of being cut off from future deals. To the extent they manage pensions and mutual funds, by the way, these are the people who are handling your money.
Congressional interlocutors were in high dudgeon over the jamming of “sh***y deals” — as they so lovingly and ceaselessly repeated — into hedge fund portfolios. But the dastardly sales practices that firms such as Citi and Goldman and Morgan stand accused of (though, we hasten to add, without either affirming or denying responsibility) are a direct outgrowth of what old stockbrokers knew as the “Lehman system,” created by the legendary — and late lamented — Stu Travis, and popularized among Wall Street salesmen in a series of books by legendary Uber-producing stockbroker Martin Shafiroff, whose best selling Successful Telephone Selling in the ‘80s was followed by (did you guess it?) Successful Telephone Selling in the ‘90s.
Shafiroff observed that the oil crisis of the 1970’s permanently altered the economics of the financial services industry. By 1980, he wrote, “the average cost of a personal sales visit to an industrial customer had passed the $100 mark!” Lehman’s partners were looking for ways to leverage sales talent, while keeping down the costs associated with the traditional business model of sending introductory letters, followed by in-person visits to a prospective customer’s place of business. The answer was: the telephone.
Rather than calling on potential customers and impressing them with their professionalism and sincerity, cold calling brokers caught the attention of business owners by offering to share investment ideas from the firm’s partners. Rather than finding out what investors needed and wanted, the new breed of telephone salesmen told them what they had to buy. This is when they stopped calling them Customer’s Men and started calling them Stockbrokers. The very terms express the contrast: from the focus on the Customer, to the Product.
Trust us, said the new breed of Smiler-Dialer, we are sharing with you investment secrets of the partners of our firm. The implication was that a complete stranger, who just happened to be the one who picked up the phone, was about to become privy to investment information that the partners of, say, Goldman Sachs or Bear Stearns could not get their hands on. As Stu Travis used to say, who would ever believe such a cockamamie story as that?! The truth is, millions still do.
The “smart money” is among the worst offenders. Mutual funds and other long-only managers are famous for “window dressing,” peppering their portfolios with the biggest winners before the close of the quarter so they can show winners at reporting time. This means it takes at least a few quarters before the astute reader of mutual fund reports asks, “If you’ve always got winners in your portfolio, how come I’m losing money?” The hedge fund community is arguably worse, as they market themselves as geniuses who provide “uncorrelated Returns” — meaning you are not at the mercy of the market and “alpha” — meaning profits above a market rate of return. Many of these portfolio managers spend more time trying to find out what trades other managers are doing, than trying to understand the inconsistencies in the latest financial filings of companies they already own. With so many hedge funds moving in lockstep, studies find the broad range of hedge funds providing returns that are no better than market averages.
And yet, people follow them. Many charged with overseeing the finances of a state, a municipality or a labor union will tell you they have no where else to go, now that bonds yields are down to zero. And the collateral damage (We will not insult your intelligence by averring that Ben Bernanke’s policies have “unintended consequences.” We maintain the man knows exactly what he is doing.) is that riskier transactions become the only way to obtain decent returns, creating a sequence of toxic bubbles in the investment markets. As David Graber writes in Debt: The First 5,000 Years (p. 377) “investors can indeed create value out of nothing by their willingness to accept the risk entailed by placing their faith in others’ creativity.” Who wants to be the guinea pig?
De Soto lifts the moldy blanket on an odd anthropological phenomenon: we are in love with provenance. In the right setting, a demonstrably false veneer of authenticity means more than actual information.
This is the original sin of the financial industry that puts endless resources into packaging and selling largely undifferentiated mediocre investments. But these millions can no longer cloak the reality that the emperor has no clothes. For all the suffering their act unleashed on the world, Eve and Adam at least had the decency to be ashamed.
Carlo V. di Florio, Director of the SEC Offices of Compliance Inspections and Examinations (OCIE — affectionately pronounced OH-see,” as in, “Oh see, what have we here?!) spoke at the recent SEC Compliance Outreach Program (31 January, full text at sec.gov). While he emphasized that his remarks are his own, as head of OCIE, we think it worth a listen. He stressed “the role of management and the board in compliance and ethics,” and pointed out that the forum, previously called “Chief Comopliance Officer Outreach,” is now just “Compliance Outreach,” emphasizing that compliance, ethics, and risk management must emanate from, and require the full support of the board of directors and senior management.
We read di Florio’s comments as a roadmap to where OCIE exams are headed and encourage managements to be aware of his position. He says “the federal securities laws are deeply grounded on ethical principles,” and notes that financial firms today “depend for their existence on public trust and confidence to a unique degree.” We read this as an acknowledgement that the industry has long since stopped peddling actual steak, and is now flogging the sizzle. Di Florio’s “three critical lines of defense” for effective risk governance start with the business itself, which both incurs, and must effectively identify and manage risks. Second come support functions, which di Florio lists as compliance, ethics and risk management, in that order, and stresses they must be given both adequate resources, and sufficient authority to affect the business process. Third comes internal audit and an independent verification process.
Di Florio states that examinations will “engage senior management and the board on critical business, risk and regulatory issues.” OCIE will accomplish this, says the Director, through “improving training and strengthening culture” within the Commission, and the appointment of a new senior executive to oversee investment adviser examinations, himself a former senior executive of a major investment firm. And OCIE has apparently stepped up its efforts to hire people with real experience in hedge funds, private equity, derivatives and structured products.
OCIE has also taken steps towards standardization of its process, including distribution of a new examinations manual which it intends to make public on the SEC website. This will obviously be required reading for all corporate risk and compliance officers. What di Florio is saying is, it is required for boards and senior managements as well.
To illustrate this, he points to the recently settled case against three AXA Rosenberg entities which were charged with defrauding clients “for concealing a significant error in the computer code of the quantitative investment model that they use to manage client assets.” OCIE alleged that the error had been identified internally, but that management had declined to fix it immediately — which would presumably have caused consternation, and possible significant loss of client business — and also did not alert the board. The ultimate settlement cost the AXA entities over $240 million, most of which actually went to make investors whole on losses suffered as a result of the faulty algorithm.
The new and improved OCIE will be coming soon to a hedge fund near you, its program is to improve compliance, risk monitoring, and corporate governance.
Finally, we would be less than true to Hedgeye’s hockey-playing roots if we did not give a Shout-Out to the best goaltender in the NHL. Tim Thomas, who garnered an MVP title while tending the Boston Bruins to a Stanley Cup win, recently declined an invitation to the White House where President Obama honored the team for its championship season. “I believe the Federal government has grown out of control,” wrote Thomas on his Facebook page, “threatening the Rights, Liberties, and Property of the People.” Exercising the sweeping side-to-side coverage that makes him a master netminder, Thomas even-handedly blamed “the Executive, Legislative, and Judicial level. This is in direct opposition to the Constitution and the Founding Fathers’ vision for the Federal government.”
Thomas, whose goalie mask bears the motto “Don’t tread on me,” says he exercised his “right as a Free Citizen” and declined the invitation. (Thomas is, in fact, the only US citizen on the winning squad, which is sure to resonate with folks who believe our President is not an American.) His position did not sit well with the local Boston crowd, and his Facebook page includes a number of critics accusing him of racism. But catcalls and dirty looks are not likely to faze a man who spends his working hours being shot at with hockey pucks traveling upwards of eighty miles an hour. Thomas says “this was not about politics or party, as in my opinion both parties are responsible for the situation we are in as a country.”
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