Monthly Archives: January 2012

Interloper: End of Chapter One

True to the pervasive obsessiveness of financial industry employees, I wrote a list of topics to cover with Interloper at the outset. This list, which was surprisingly unchanged as the months progressed, has now been covered.  Alarmingly, as a result of this, the last posts began to exhibit the two temptations that, in the beginning, I swore I would never succumb to – beating on near-dead rhetorical horses (the industry in playing on your imperfect psychology) and attempting to wring pearls of wisdom out of the work of others (notably Epicurean Dealmaker for some reason).

The urge to write combined with a lack of anything new to say is a time-honored recipe for masturbatory crap, so its definitely time for a hiatus. There are also practical reasons for this – I still need to find employment to take some pressure off Mrs. Interloper, who desperately needs a vacation.  Writing blog posts and hitting F5 every 90 seconds is not conducive to a sustained effort in that regard.

At the risk of going all Altucher on the people nice enough to read this, I want to also explicate a strange emotional risk that also informs the decision to take a few weeks off from blogging. I couldn’t, first of all, be happier with the way things turned out for Interloper and the five-or-so people most deserving of gratitude for this know who they are. Having readers focus on your opinions, and occasionally agree with them, has been incredibly rewarding. At the same time it also gives birth, for me at least, to an unhealthy ambition for further recognition – what was an initial, highly gratifying surprise morphs into a weird existential need. Twice during the past two weeks (and this is truly embarrassing) I’ve been on the verge of picking a fight with another blogger only to discover, with a modicum of introspection, that the root cause for the impulse was a desire for attention. Acting on this would have disqualified me from ever calling out anyone else’s behavior as infantile which, as it happens, is one of my favorite things in life.

End of therapy session. I’m not done; I just need time to make a new list. Hopefully the few very nice emailers asking what was up with the lack of writing now have some idea.

To end Interloper: chapter 1, I’ve re-framed the issues covered to date into three broad industry/investing tenets as follows:

Cui bono: Whenever you’re confused about anything involving the finance industry, look to how it benefits the investment banking department. If, for example, analysts from three large BDs all raise ratings and targets on the same stock that hasn’t moved in 5 years, first assess the potential for an M&A transaction or secondary offering.

Don’t trust your gut: The industry knows your brain better than you do, how to appeal to its less rational, emotional elements. Going with a gut feeling and winning is undoubtedly exhilarating and you’ll want to do it again. This is, however, the same thought process that built Vegas. The corollary is to be very careful when you see what you want, or expected to see. Try and practice thinking like other, successful investors with a different style, if only as a test drive.

The finance industry has its own interests, not yours, first: View every research report and every speaker on business television with the same skepticism you’d bring to Super Bowl commercials. This is not inherently cynical – good products need advertising almost as much as bad products. But don’t expect full disclosure.




End of chapter 1

Finance Defends Bain, Misses Point

Reformed Broker and Epicurean Dealmaker recently provided a necessary service in defending Bain Capital from scurrilous and misinformed attacks. I suggest, however, that this “rallying of the finance troops” is an example of preaching to the converted, and talking over the heads of an increasingly motivated anti-finance movement. Again, the anti-Bain idiocy deserved a corrective response and both Josh and TED did so effectively. However, there is a sense in which the argument is merely shoring up the walls of the finance cocoon.

The Other End of the Pendulum

It is possible to view the socioeconomic conditions of 2005 as the converse of 1975. Thirty years ago, corporate management was largely powerless in the face of labor power, taxes were extreme and government intervention was the “vampire squid” of the age.  Profits sucked and unless investors were fully exposed to the major geopolitical clusterfuck of Iran-related East tensions, returns were scarce to non-existent.  Beginning with Reagan, the pendulum began to swing back, slowly crushing labor and, for our purposes, culminating with the repeal of Glass-Steagall.

To be employed in finance in the 75-05 period was to believe fully in the primacy of bottom line, profit-related orthodoxy. If nothing else, it sustained the efforts to clear the political and regulatory anti-business, socialist clutter of 1970s. As an organizing principle, faith in the bottom line provided the advantages of clarity and measurability in addition to the obvious outsized creation of wealth.  Bain Capital, among many others, is the walking, talking, strutting embodiment of this thirty-year transition – the realization of a Platonic form dreamed up by William F. Buckley and other 1970s-era pro-business conservatives.

The Financial Crisis was a clear representation of the other end of the socioeconomic pendulum, and the excesses, arrogance, avarice and overall public destructiveness of finance was clearly analogous to that of organized labor and misguided government in the 70s. To blindly defend Bain now is to associate ourselves with the spluttering, enraged defenders of organized labor in the early 80s. In both cases, an intellectually-consistent orthodoxy not acclimated to criticism had ceased to function for wide segments of the population, in the current case the un- or under-employed.

We are conditioned, in finance, to accept as an axiom that aggregate corporate profitability should be the end goal of almost all government policy.  Primarily, we only really argue about the means to achieve this. Outside of the finance cocoon however, this is exactly the mode of thinking they believe is the problem.  For people who haven’t experience real wage growth in a couple decades (i.e almost everybody in numerical terms), finance-generated, corporate profit-friendly policy solutions to the current economic malaise are a ridiculous, tragic joke. “Oh, really? You want license to fire more of us in the pursuit of productivity?  While cutting unemployment insurance? Where do I sign up?”.

Incumbent politicians and the banking industry will use all of their considerable intellectual capital to maintain the current, rent-seeking status quo. The truth in the end, however, is that many of the actions of the investment banks during the lead up to the GFC were entirely indefensible, and eventually history will show this. It does not, importantly, mean that the economically important aspects of finance should be “thrown out with the bathwater” of reform or that every element of the business is corrupt.  But, in defending the finance industry from attempts to reform we are going to have to understand that for most Americans, referrals to the benefits of increased profitability are going to fall on deaf, increasingly angry ears.

Happy Enough: Finance is Regulated As Much As We Want It To Be

Like any sensible person, I view Tyler Cowen and his work at Marginal Revolution with a mixture of envy and awe, the first arising from his prodigious intellectual gifts and the second from the professor’s incredible productivity. The bi-weekly “What I’ve been reading” posts point to a ridiculous breadth of knowledge on literally hundreds of complex topics. One wonders if he ever sleeps, particularly in light of the fact that he returns all of his emails from readers. (It occurs to me that he might not be happy I mentioned that).

One Marginal Revolution reader once asked Cowen to explain how he remained so productive. He responded, I think paraphrasing someone else, that:

The first step in time management is understanding that right now you are doing exactly what you want to be doing.

How can this be in the absence of both Mila Kunis and a Fijian beach? The professor’s point, to the extent I understand it, is that each moment is a reflection of the extent of available options, in a context generated by all previous decisions.

The average American male is 5’9 ½”, 191 lbs, has a BMI of 27.8 (18.5 to 24.9 is “normal” range according to the hardly-unbiased Livestrong) and watches 28 hours of television per week.  For most, this implies a need to separate “what you want to be doing right now” from “optimal”.

There are people on both sides of the argument, but any survey will tell us that no one regards the current state of financial regulation as optimal. The question that follows from professor Cowen’s philosophy is then the extent to which the current status quo reflects an aggregate “exactly what we want to be doing”, a homeostasis of conflicting political and economic points of view.  Outside of the rent-seekers themselves, there exists little support for ongoing levels of corruption but, on the other hand, there is no support for widespread obesity either.

There are ten different ways to take this, but it seems to come down to an assessment of whether there is a pent-up willingness to sacrifice shorter-term gains for longer term, closer-to-optimal outcomes. If shown direction, does the social will exist to fight the long, arduous battle to curb the financial industry’s clear success at regulatory capture? I suspect that the average level of determination among American citizens in this direction is building, possibly but not probably inexorably. It will depend of the frequency and strength of political and economic catalysts.

It is also infinitely possible that we are “happy enough” with the status quo for all its faults, unable to let go of higher corporate profits, underwriting, big bonuses, televised drivel or Baconators in favor of some egghead-derived reflection of full-employment Utopia. Either way, the exercise of looking at finance, politics, media and anything else as potentially “exactly what we want to be doing right now” has been a really interesting one, at least for me.

Epicurean Dealmaker Explains Banking’s Role in Asset Bubbles Without Trying

This blog has no consistent mission statement or goal and hopefully will stay that way, outlining both the problems with the finance industry and the inconsistencies with anti-finance arguments. At the same time, it became apparent during the first month of writing that there existed a large body of content in a gray area consisting of things everyone within finance believes are unarguably true, but even reporters that have been covering the industry for 20 years do not. As an example, the fact that the industry is designed as structure to generate transactions, with all of the media appearances and research reports functioning as a Marketing Department roughly analogous to that at Frito-Lay, remains hidden from most investors and commentators.

That is all to preface a terrific post by The Epicurean Dealmaker (TED) over the weekend which, in 500 words, blithely defenestrates a well-intentioned academic study attempting to link CEO pay to risky management decisions. TED’s point is that CEO pay is largely irrelevant to the discussion. The real question is how much commission revenue was generated by department heads, a number that frequently exceeds CEO annual pay, and whether this formed a catalyst for risk-ignoring behavior. In my experience, it definitely does.

I want to extend the argument a bit further to propose that investment bank revenue is a net position of between 10-20 smaller “bubbles”, for lack of a better term, composed of each component of Capital Markets. Each sub-department of an investment bank – Equity Trading, Equity Sales, Investment Banking, Bond Trading, Structured Products, Prime Brokerage, Prop Desks etc –  forms one of these components.

To backtrack briefly, one of my former global investment bank employers used Revenue per Employee as the primary measuring stick for departmental budgeting, and at first this seemed a remarkably unsophisticated, blunt tool. Over time, however, it became apparent that the system had one extremely profitable outcome – it got human assets into areas with rising revenues and profits extremely quickly. (The other interesting side effect is that by not distinguishing by salary – an admin counted against you equally to a higher-salary skilled person – it kept the number of support staff to a minimum.). At any given time, staff and budget were being removed from departments with declining revenue and added to those with rising activity.

It is very rare for all departments within Capital Markets do be doing well at the same time, and this is the primary source of bonus time animosity and a vicious form of political skullduggery that would make the Tea Party look like, umm , a tea party. . The multi-gazillionaire Masters of the Universe bond traders of the late 80s were the miserable also-rans of the mid-90s. The Structured Product departments that were a major driver of profits starting ten years ago are doubtless shrinking rapidly as I type along with the death of the CDO market. The profitability of the investment bank operations overall, and thus CEO pay, is the net position of the success or decline of each department.

TED more or less covered this, only written better.  The part I want to emphasize though, is the way in which all of this structurally encourages asset bubbles. Because, if CEO pay is based on the net profits from all departments, the commission revenue from each separate department is clearly not. Remember that finance generates revenue primarily through the number and size of transactions, not successful investments or the course of markets. The key point here is that nothing generates transactions like asset bubbles. The more money that comes in, the more commission is generated, the more staff get allocated, the more product/ideas get generated, the more money all of those staff make in bonus.  The big money attracts big talent, people eminently able to invent new ways to exploit the trend.

Importantly, this hypothetical department is generally not exposed to a potential bubble’s inevitable collapse, outside of lower commission revenue and staff cuts, so they will wring every ounce out of that bubble they possibly can. After all, market tops are notoriously hard to call and Soros himself has noted, through his Theory of Reflexivity, that all bubbles go on much longer than anyone thinks possible.  We’ll jump off that bridge when we get to it – the legal department can take care of the lawsuits down the road. The department head, who might have made $10s of millions over the course of the rally, could likely care less about getting fired after all is said and done if it makes management happy.

So TED is entirely right – the place to look for excessively risky decisions is not the CEO, who is responsible for overall profits and cleaning up any mess than results from excess bubble stoking, but the individual commission-incentivized departments generating the highest profits.  Risk Management is essentially the process of standing on the tracks in front of the money train which is, to say the least, a politically unenviable position in any organization. For regulators, always fighting the last war, by the time they even start sorting out the whos and whys and where all the money went, the bubble has moved to a new department. Current candidates for this phenomenon include the lending operations under ETFs and funky methods for I-bankers to raise capital for banks ahead of Basel III deadlines.

I suspect that, although the process described above is Fisher-Price elemental for any finance employee with rudimentary observational skills, it will come as a surprise to many outsiders as an example of the Interloper “gray area”.  The interesting question for me is, given the literally thousands of reporters and commentators on the financial industry, why this remains so.


Mister, I Don’t Sell to Fish

Charlie Munger’s reticence to speak publicly is a grave disappointment because he’s proven adept with wonderfully entertaining and enlightening anecdotes like this:

I think the reason why we got into such idiocy in investment management is best illustrated by a story that I tell about the guy who sold fishing tackle. I asked him, “My God, they’re purple and green. Do fish really take these lures?” And he said, “Mister, I don’t sell to fish.”

The metaphor of investing opportunities as fishing lures works better than its more popular “market as casino” counterpart on a number of levels, most notably with respect to the initial confusion regarding who the fish really are.  The fishing lure salesman is only concerned with whether his product works to the extent that it affects repeat business and investment banks are no different. For the salesman, he would rather his product perform well, but would be perfectly happy with a world where everyone bought tackle, went fishing and nobody caught anything. The corollary for investment banks is that a world in which everyone keeps trading even though they all lose money would be perfectly fine and massively profitable.

In the real world, selling lures that don’t attract fish and selling trade ideas that always lose money would be, at best, a short-term operation. Both cases, however, imply the same subtle manipulation of its clients. The fishing lures are purple to attract fisherman, not fish and “actionable ideas” are designed to attract investors, not necessarily investment returns.  Anyone attempting to deny the finance industry’s success at this should just check the performance of the average IPO, even (and maybe especially) the massively over-subscribed ones.

The extent to which investment banks are exposed to the performance of the products they sell is massively misunderstood. This is highlighted by a commenter responding to the Interloper post “Why Anyone Not at Their Desks by 7:30 is a Nobody” who, objecting (understandably) to the aggressive tone of the piece writes:

You people work all these hours and you and your clients still can’t beat the markets

It’s a completely fair and verifiable observation. Understanding the answer is contingent on the realization that, for the investment bank, the success or failure of trade ideas and research reports is primarily determined by how much trade and commission it generated, not how much the asset appreciated. This is how target prices keep getting published when they are so often wrong. In other words, it is a matter of how many fishing lures were sold, not how may small mouth bass were caught in the end.

For the purposes of explaining the point, I have presented a more cynical depiction than actually exists in practice. The market is involved here, and fishing lures that work best in the river are much more likely to generate the highest sales and profits. Over time, trial and error by fisher, um people, and investors will mitigate the negative effects of the vendors’ partial conflicts of interest. In the financial world, however, we still have experienced investors trampling over each other to participate in deals like the Groupon IPO where history clearly indicated that the chances of short-term success were low, falling for projected growth and profitability levels that were very much analogous to the florescent purple paint on Munger’s lures.

European Debt Issues Test Investors’ Twitter-shrunk Attention Spans

How would you feel about your property value if there were a growing fire destroying an entire block of houses two miles away? Sure, it’s a little smoky when the wind blows the wrong way but you just slapped on a fresh coat of paint. Someone’s going to put the fire out, right?

The European sovereign debt/banking crisis is the fire for US investors at the moment and investors’ attempts to change focus to more positive thoughts – the ADP report this morning is the latest example –  have been continually thwarted by events.  Traders are increasingly banging their heads on the desk after another series of “false break-outs” as Italian bond yields play hopscotch with the 7% level. As the 2011 S&P 500 non-performance clearly showed, we’re stuck.

The thing is, we’re not good at this anymore. Trained by immediate, excessive news flow our collective attention spans have shrunk to the time it takes to read 140 characters. Large research reports? Forget it – if its important FT Alphaville, Felix Salmon or Megan McArdle will summarize it for us into a neat 500 word post. Next.  KardashianNFLPlayoffsADPKimJongIlIranNuclearWeaponsObamaSucksRatigan’sNewBookGorillaLooseatMall. Beer. Eat. Nap. Jon Stewart. Sleep. New day – new story, please. Oh, and if someone could just fix Europe for me overnight, so I can go back to safely piling money into the market on new economic data and attractive technical set-ups, that would be terrific.

The starting date is arguable but the origins of current developed market debt problems are at least 20 years old – 1982 and 1994 are the two most-cited start dates – which implies that expecting a quick solution is unreasonable, whether our modern attention spans can handle it or not. Even if the ECB kicks the can down the road by printing (the most likely eventual outcome from all I’ve read), there is still the issue of Basel III-related forced bank recapitalization, as Unicredit was nice enough to remind us of yesterday.

The “Wall of Worry” remains a helpful metaphor and it is entirely possible that the global economy “muddles through” the host of hurdles before it. It is also likely, however, that the investor contrarian reflex to buy dips, or whenever sentiment is poor, will be a perilously unproductive one if its primary basis is boredom with yesterday’s negative news. In order to understand complicated credit issues that are a) almost unfathomably enormous if we include the shadow assets and b) decades in the making, we will probably need to learn more, maybe finish a few of those large research reports, and act less. Waiting for a bottom, when the fire is either truly out or at least shrinking towards embers, may take considerably more discipline than the era of the Great Moderation has trained us for.

Consultants, Fear and Portfolio Manager Incentives

In the late 90s, I lived in a big house with four other guys, only one of whom was in finance. One, I’ll call him Rob, was in business consulting. Rob was a recent graduate of one of the world’s top engineering schools, not CalTech or MIT, but always mentioned among them. As a Microwave Engineer he had perfect timing, this being the late 90s during the great information highway build out. His company flew him all over the country and charged $500 an hour for his work plus expenses, the latter including funds to fly home every weekend which, if he didn’t use, he kept (got a nice set of golf clubs for working one weekend).

His biggest project during the period was a TMT company that had been falling behind technologically and wanted advice as to future investment and restructuring. Rob, bulldog that he was, worked 14 hours per day analyzing, interviewing and studying the competition for, if memory serves, about 10 weeks. His conclusion was that the company was unlikely to catch-up in terms of novel technology and profitability would be much better served by “sticking to their knitting” or historical core competency.

The way Rob described it, the process for these things was for him to take his giant binder of full color charts and graphs, the fruits of his expertise and hundreds of hours of effort, and present it to a partner at his firm. The partner, in turn, would present the conclusions to corporate management. After this meeting took place, the partner’s reaction was something along the lines of “ This is excellent work, but I can’t tell them this. There would be no more business in it for us”.  In the end, the partner took three graphs from the binder, and built the rest of his presentation to management out of in-house material outlining the future riches available through mass investment in the wonders of new technology.

Thankfully, I have only had passing contact with management consultants; usually they were calling me for insight after winning a new contract (for free – this pissed me off no end). I have no idea if this story is an outlier or if it is indicative of a bubble environment that has changed since.  I have had, on the other hand, extensive experience with pension consultants. Some, I’ll mention Northern Trust here, are actually very good. Others show all the hallmarks of Rob’s old partner.

In discussing pension consultants, the key is to recognize that the incentives for pension managers are, with few exceptions, very, very different than for the average investor. Investors are afraid to lose money; pension managers are terrified of underperforming the benchmark. Underperforming the benchmark gets you fired. Following the benchmark lower during a bad year is not notable. Beating the index by a wide margin is usually considered a very bad thing, indicative of risk (they still focus on standard deviation, although will provide 90 pages of other stuff) that could, the following year, result in underperformance of the benchmark. Which will get you fired.

The levels of complexity built into the simple “don’t trail the benchmark, ” rules are unbelievable. There are 25, slightly different terms for index hugging – Information Ratio, Tracking Error, Style Drift* – that turn common sense into particle physics. The creation of “appropriate” benchmarks is, of course, the sole purview of Nobel Prize winners. This isn’t the Paleolithic era – you can’t use 60-30-10! If it weren’t crazy complicated, why would you need a consultant? Of course you need to know about the complicated private real estate transactions the endowments are doing and, for a fee, we can tell you how to do it yourself!

Business and pension consultants make a fuckton of money playing on their clients’ fears of being fired. Consulting companies have armies of brilliant, well paid dudes and lady dudes like my friend Rob who constantly derive new insights for the partners to manipulate into pitches for new business. But in almost every case I’ve seen, consultants are hired to tell managers and management things they already know, the hope being that the shiny new report will give them the backing they need to do things they already know they need to do. The (usually inevitable) failure to implement the strategy results in a new round of consultancy. And so it goes, round and round, proving again that fear trumps intelligence whenever big sums of money are involved.


*”Style Drift” is an awesome, all-purpose weapon for messing with the heads of PMs. If, for example, I were looking to get my way on any question regarding a value versus growth fund, I would just move utility, bank and pipeline stocks between value and growth benchmarks. I’d have good reasons, too – see Appendix 9 for methodology.

Interloper’s Best Reads of 2011

Attempting to drink from the financial information fire hydrant is more or less a necessity for investors at this point, despite the numerous counter-productive side effects the practice entails.  One of the larger issues involved is one of prioritization in that the daily onslaught of noise-ridden details makes an assessment of yesterday’s opinion difficult. Wave after wave of advice and opinion keep coming at us, paradoxically leaving no time to learn anything from it. To paraphrase the great John Wooden, we are confusing activity with achievement.

In highlighting my favorite blog posts from 2011, I want to focus on those with persistent benefit rather than outline successful trading ideas or strategies that may or may not be useful in the next twelve months. (I will, for future reference, point out that Richard Bernstein again justified my ongoing adulation – see HERE.) The danger as always is to select articles because they reaffirm what I already believe, which would make this post merely an excellent example of confirmation bias. I hope I have avoided this pitfall, but look for readers to call me out.

Psy-Fi: The Proper Etiquette for Market Panics.    The consistently-awesome Psy-Fi Blog more or less lays out exactly why investors do what they do, why its wrong, and how to fix it.  In a market environment where returns are generated almost solely by arbing the market’s emotional overshoots, it is difficult to think of a more productive blog to read than this one. Thee were numerous candidates for applause among Psy-Fi content in 2011 but this one stood out for its “man bites dog” argument surrounding volatility. The key bit:

all the sensible indicators like whether economies are actually doing well or badly and whether companies are more or less profitable don’t always matter very much when markets go mad. Often it really does seem to be a matter of psychology rather than financial fundamentals.

However, a nice piece of research by Dion Harmon and colleagues entitled Predicting Economic Crises Using Measures of Collective Panics attempts to do exactly what it says on the label. Now, generally economists have studied volatility, the rate of change of stock price movements, as a way of investigating behaviour during market crashes. However, volatility doesn’t appear to predict crashes:

“Studies find that, on average, volatility increases following price declines, but do not show higher volatility is followed by price declines.”


The implications of the conclusion, essentially that volatility is a lagging indicator, are wide reaching, not least because we can now forget about the Vix as a predictor of anything.  If the study is accurate, the phrase “I’m not buying until the Vix goes below 30” will become a historical artifact.


Felix Salmon:  The growing crisis of institutional legitimacy . Reuters’ most visible online voice details a longer term issue that scares the bejeebers out of me:

on this side of the pond we have Rick Perry — harbinger and prime example of the way in which mistrust in federal institutions has moved from the fringe to the mainstream. Indeed, what we see with Perry is far more than mistrust — he actually denies most federal institutions their existential legitimacy, and has written a book explaining at length how everything from Social Security to federal bank regulation is in fact unconstitutional.

When Perry accuses Ben Bernanke of treachery and treason, his violent rhetoric (“we would treat him pretty ugly down in Texas”) is scary in itself. But we shouldn’t let that obscure Perry’s substantive message — that neither Bernanke nor the Fed really deserve to exist, to control the US money supply, and to work towards a dual mandate of price stability and full employment.

No matter what your political affiliation or financial caste, a complete breakdown in institutional trust will not be welcome. It should also be noted that anti-institution pressure is coming from both ends of the political spectrum – OWS hates big banks, Ron Paul wants to get rid of the Fed. It is certainly not my contention that every institution that currently exists should be maintained, but this urge this urge to tear everything down, as an extension of the ongoing infantilization of public discourse, is a process that can run out of control. (I attempted to cover the technology aspect of this, and the echoes of the violent Protestant Reformation HERE. Warning: its among my most disjointed performances).


Interfluidity: Why is finance so complex?: Some essays are so good they represent an intellectual punch to the face, necessitating the equivalent of a “standing eight count” of ponderation.  One of the undercurrents of Interloper to date has been an effort to illustrate the ways in which the industry subtly misleads its clients, with the intention that more transparency will allow for more investor wealth creation. Waldman turn this on its head by suggesting that hiding risk from investors is one of the primary, and overall economically

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