September 23, 2008
Keep It Simple
Posted by Karl Okamoto

When I meet someone who claims to live by just a few “tried and true” simple rules, I tend to wrinkle my nose. How unsophisticated! Un-nuanced! Anti-intellectual, even! After all, the world is a complicated place. Life by platitude must, therefore, oversimplify, over-generalize and exclude the gray areas that matter.

Oddly, though, many of the most successful people I know – successful in all kinds of ways – from making fortunes to finding inner peace—share a certain certainty about things. They have a few simple rules, and they live by them.

So, for example, over the last few days I am quite certain the boring certainty of a John Bogle (of Vanguard Group fame) is looking pretty sophisticated. While not completely unscathed, if you followed the standard asset diversification advice given by such unsophisticated, old-fashioned guys like Mr. Bogle, your volatility these last few days would have been quite tolerable. More importantly, you would be in a position to hold on, play another day (or decade for that matter) and see your portfolio recover and indeed prosper as good times return. In fact, counter-intuitive as it may feel, assuming you didn’t “lose your seat” last week, you should be looking at your nest egg with an even greater sense of ease. Last summer your nest egg was much less likely to grow as a source of wealth for your needs than it is from here. While I now have less of it, I am much more confident that the money I do have will be adequate for the job I expect it to perform.

Of course, this is precisely why the Fannie Mae’s, Lehman’s and AIGs of the world have gone to heck. Instead of making certain that they would always “keep their seats” and “live to play another day,” they piled the chips on double zero and rolled the dice. They did that because along the way they forgot to “keep it simple.” Higher returns require higher risk. “Absolute return strategies” that offer returns above that of government bonds do not offer “absolute” returns by definition. A simple rule tells us that. No risk, no reward. Ask any hedge fund manager how he makes money after the world quickly discovered the easy money one could make in the early days of arbitrage or currency trading. He’ll tell you, he takes risk.

So let me offer one more anti-intellectual suggestion. As we ponder the regulatory solutions to the current mess, my suggestion is we keep it simple. The reason why financial institutions blow up is the same reason houses go into foreclosure. People take risks they cannot fully insure. Normally people are pretty good about avoiding such extreme positions because they understand the downside and wisely avoid it. So if I am going to lose my 20% down payment on this condo if I can’t support next year’s mortgage payments, I’ll buy a cheaper one where I am certain I can “keep my seat” in a down-turn. By appealing to human’s natural optimism and avarice while at the same time masking or often eliminating the downside cost, the home lending market created a “heads I win, tails who cares” environment for home buyers that eliminated the “old fashioned” calculus that defined prudent home buying and finance.

Similarly, both a hedge fund manager and the CEO of an investment bank or multi-line insurer (both being not much more than a hedge fund in some other drag), face a similar temptation. If I take cheap and plentiful financing (put simply, borrowed money), put it into so-called “absolute return” investments (put simply, those complicated deals that some Math PhD can demonstrate will not lose money in any scenario within a standard deviation of x and certainty level of y, blah, blah, blah), I get to keep 20% of the upside (which the model and my own natural optimism tell me is very likely to be big) or take early retirement (or hit the beach until the next cycle of mania comes) if it all blows up (which it probably won’t). Well, hindsight bias tells us that it was obvious this was a bad choice for Fannie, Freddie, Lehman, Bear, etc. But put yourself into their position ex ante if you can. It’s a “no brainer.” I for one, would swing and swing hard, just like they did. Black Scholes tells me that the option value alone of the proposition means a rational person would put as many chips as possible on the most volatile positions he can get away with. And that is exactly what they did.

So how do we keep it simple if we are going to “regulate” this problem? We change this equation. Make people play with their own money, and lose it if they are wrong. That means, for one, no bail outs. It also means that the new transparency the world needs through regulation is the means to better understand whether the people on the other side of a trade have any skin in the game. It turns out, as a simple rule has told us all along, it makes a big difference when we deal with people with something to lose.

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Comments (12)

1. Posted by Hillary Chybinski on September 23, 2008 @ 10:16 | Permalink

Good point Guest Blogger Okamoto. . .I'm a big fan of tolerable risk. . .after all - the best things in life are risky - love - family - money. . .it's all about how much risk you can tolerate and still be happy, healthy and wise.

And don't even get me started on accountability. . .


2. Posted by Morgenstern on September 23, 2008 @ 10:17 | Permalink

I agree with you that "skin in the game" is important, but:

1. "No bailouts" is probably unenforceable, although this is an issue I am interested in considering further. I suppose you could argue that people's expectations can be adapted, as they were with inflation, but financial crises don't seem well-suited to this because they are infrequent so resolve can't be demonstrated and the decisionmakers change frequently.

2. Who is it exactly that had no skin in the game in this scenario? The originate-to-distribute crowd, yes. Maybe some cash-compensated traders. But my understanding is that the CEOs of the stricken companies all had significant equity compensation. In any event, I'm not sure disclosure-related reforms are needed in that the amount of skin in the game seemed apparent to those who were willing to look.

I see the problem as follows: We have a more or less working regulatory system for banks because they are critical to the financial infrastructure and no-bailout promises are not credible. The "shadow banking system" should be subject to these arrangements, mutatis mutandis. If MM funds weren't going to be allowed to fail, they should have been paying for insurance. If CDS coverage was so critical that an insurer's failure required a bailout, there should have been capital requirements as there are for other insurance companies. If derivative counterparty centrality is somehow analogous to the bank payments system in its importance to the economy, maybe someone other than ISDA should be involved.

I'm still developing my thinking, but I'm skeptical of pure disclosure as a remedy in situations where systemic risk means that bailouts are going to happen.


3. Posted by Elizabeth Brown on September 23, 2008 @ 10:30 | Permalink

If you want to keep things simple, you need to simplify the regulatory structure. Right now there are over 115 state and federal agencies regulating some aspect of the financial services industry. These agencies create somewhat different regulations based on whether a firm or product is classified as fitting within banking, securities or insurance. Financial products and firms no longer fit neatly within these old categories. Financial conglomerates operate across the spectrum of financial services. Financial products are increasingly fungible with one another and hybrid products are further blurring the lines between banking, securities and insurance.

Our regulatory structure wasn't modernized in 1999 when Congress passed the Gramm-Leach-Bliley Act that allowed financial conglomerates to operate across sectors. As a result, our regulatory structure wasn't designed to deal with the way financial services firms operate now.

At times the regulations of these phlethora of agencies are overlapping and duplicative and at other times there are gaps which leave innovative products, like credit default swaps, largely unregulated. As I have argued in article published in the Fall/Winter 2005 issue of the Miami Business Law Review, we need a single financial services regulator to oversee the industry, which would regulate based on the risks posed by financial firms and products and not based on outdated classifications. See "E Pluribus Unum - Out of Many, One: Why the United States Needs a Single Financial Services Agency" Available at SSRN: http://ssrn.com/abstract=757010


4. Posted by Morgenstern on September 23, 2008 @ 11:27 | Permalink

Ms. Brown - You raise an excellent point and I plan to review your article shortly. Have you had the opportunity to evaluate Paulson's plan for comprehensive reorganization and simplification of financial regulation (with three entities - one for market stability, one for prudential regulation, and one for consumer protection) in light of your analysis?


5. Posted by fedgovernor on September 23, 2008 @ 13:14 | Permalink

OPM baby.

Never have your skin in the game. Always use other people's money. That's the Chicaco way.

If I can borrow $1 billion at 2% and invest it at 4% with a 2-4% chance that my investment ever went bust, why would I not leverage myself out the ying-yang?

2% of a billion dollars isn't chump change.


6. Posted by Karl Okamoto on September 23, 2008 @ 13:23 | Permalink

My point exactly. Follow the money, and you will find the motivation.


7. Posted by Jake on September 23, 2008 @ 19:59 | Permalink

"Follow the money, and you will find the motivation."

Nicely stated. I may use that in a soon to be filed brief.



8. Posted by RE on September 24, 2008 @ 6:28 | Permalink

"Black Scholes tells me that the option value alone of the proposition means a rational person would put as many chips as possible on the most volatile positions he can get away with."

There's the problem - Black Scholes, et al. They tell you nothing! In fact, they tell you (and the conventional investment community and risk managers) less than something. These models make you believe you know something about risk with some level of confidence and precision. And being human, once you think you know something, you (irrationally) believe you can control it.

A rational person would never use Black-Scholes. Sadly, Greenspan, Bernanke, and plenty of others do...and they play with someone else's money (supply).

See Taleb, http://www.edge.org/3rd_culture/taleb08/taleb08_index.html

Cheers


9. Posted by DN on September 24, 2008 @ 7:56 | Permalink

I do not think these guys in F&F did not know the rules. The problem is that GOV forced them to take risks, or rather told them that treasure will pay the bill. Essentially, GOV decided to buy homes for everyone, and made it in credit through this strange scheme with F&F.
And now those who pay taxes pay for this credit collected from the beginning of 90ies.

The problem, again, is this sofisticated idea that profits are of F&F, but the losses are of USGov.
Were F&F private, they were never give these bad loans. Were them gov's, the losses would be parts of the every year budget. But this mess is worse than both.


10. Posted by Stephen Chang on September 24, 2008 @ 8:51 | Permalink

Hello Professor Okamoto!

1. As a whole it was boring long-established investment banks failing. Hedge funds weathered the storm much better.

2. As has been pointed out, a bailout of some level is necessary. A bailout and accountability for those on the street are not mutually exclusive.

3. Quoting the Economist professor open letter, " Americas dynamic and innovative private capital markets have brought the nation unparalleled prosperity."

4. Lastly, the insight that the incentive mechanism favored taking large risk for year-end bonuses is a flawed one, and instead a mechanism that takes into long-term consideration is spot on. I've seen a few proposals to that end, but they all feel a little artificial to me.

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