Wednesday, April 21, 2010

Is Full Disclosure the Solution?

Goldman Sachs is being sued by the SEC for details related to the sale of a collateralized debt obligation that might or might not have been truthfully or dishonestly disclosed to clients. This latest hoopla in the financial services industry brings to mind a belief that has plagued, and will always plague, the investment business: with enough disclosure and/or information regarding an investment, an individual can be fully protected from disaster.

While investment practitioners, statisticians, and economists have correctly understood that risk can be minimized while uncertainty can't (an idea first proposed by the economist Frank Knight), there is something very different about when the government (or one of its appendages like the SEC) markets itself as the protector of investors. The difference is that the government is implicitly claiming it can protect against something (through "uncovering" bad practices, or making things "fully disclosed," or creating "transparency," etc.) that it can't. Who could possibly be helped by a false sense of security?

The government is treating the issue of what Fabrice Tourre did and did not disclose to investors as though it makes a difference. It does not. When an investor makes a decision to buy or sell a security, he implicitly assumes that the person who is buying or selling the security from him, knows less than he does (if the investor thought the person buying or selling the security knew more, our investor would not make the investment!). Whether or not an individual or entity related to the investment really does know more or less than the investor, still does not change the fact that uncertainty might prove that investor wrong, regardless.

A perfect example is real estate which everyone "knew" goes up indefinitely. If the government had successfully made sure everyone involved in real estate transactions was being honest, would that have saved them when the real estate market crashed? No, it would just give them one less thing to complain about when it came to a bad decision they made. The issue of loss is what is driving investors (and the SEC, which is trying to cater to investors) to cry "fraud" when they never would have cried "fraud" if their investments went up rather than down. From a legal standpoint, either both of the two possible circumstances (gain or loss) is fraudulent or neither circumstance is fraudulent.

But what if knowledge, that the investor's counterparty is very smart, will make the investor change his mind (a question I anticipate will arise from the statement I made about how investors implicitly assume their counterparty knows less)? This is entirely beside the point when it comes to legality. Should law really be based on the perception that an investor might or might not have about the person he is doing business with? How do you prove perception? What if an investor knew that Paulson (to take the actual issue the SEC is dealing with right now) was on the other side of the trade but thought that Paulson is stupid? If our investor lost money in that instance would it no longer be fraud just because the investor knew about Paulson, thought he is stupid, and therefore made the trade anyway? Or what if our investor didn't know Paulson's identity, still made the investment, and made money? Would the SEC still complain? Should laws pertaining to financial markets then be based on whether an investor makes money? Or what if investor's don't know that their counterparty's grandmother's best friend's cousin is an astrologer who believes the investor is making a horrible mistake (and this astrologer has a great track record too!)? There is an infinite amount of detail that could be disclosed to an investor, none of which changes the fact that the investor needs to know there are lots of ways he might lose money. Disclosing information about a counterparty, what that counterparty thinks, or what that counterparty ate for breakfast, is entirely immaterial.

But there is still a bigger problem here alluded to in an earlier paragraph. The very existence of the SEC gives investors a false sense of security when it comes to investing. We have seen that the SEC does not do its job because Bernie Madoff and countless others have pulled off various schemes that lost investor money (I might add that even when the SEC was tipped off about these schemes it did nothing). When investors are given a false sense of security as a result of the existence of a government regulator, they are more likely to make an investment... and then potentially lose money that they might have been less willing to invest if they knew nobody was claiming to protect them. As radical as this idea might sound, would it be worse if no entity existed to supposedly protect investors (which obviously the SEC doesn't even do, but unfortunately people think it does) thereby making investors fully aware there is a very good chance of loss from any number of unanticipated events? I would argue that under this scenario, most of the individuals who would still be willing to make investments would be the ones with a bigger risk appetite (a characteristic all investors, but not all individuals, should have!). The goal should not be to get as many people investing as possible (which is what entities like the SEC seem to be trying to accomplish). Investing should only be for people who have a risk appetite. Why are we trying to give the impression that with just enough disclosure of information or with a specific type of information, uncertainty can be taken out of investing (a venture extremely prone to uncertainty), when uncertainty can never be taken out of anything? Or why are we trying to say that X amount of disclosure is sufficient for there to be no legal problem, but a Y amount of disclosure (assuming Y > X) isn't necessary? Where is the cutoff?

This is all yet another example of the unintended consequences of government policy. Whether or not Goldman Sachs (which could be vilified for lots of other reasons, but not this one) disclosed information to clients about the beliefs of another party in an investment makes absolutely no difference here, or at the very least no legal difference. Investing is an activity inherently full of uncertainty and the more people realize that the better. This whole fiasco could have been avoided if investors were made to feel less protected by the government in their investments, something that abolishing the SEC would go a long way towards accomplishing. In fact, imagine for a moment that the SEC ends up finding Goldman Sachs guilty of fraud. Everyone will perceive that to be an example of how effective the SEC is at protecting investors. Well guess how that might affect the willingness of people to invest? So, are you really confident enough in the SEC to give those people that impression?

Thursday, April 15, 2010

Tuesday, April 13, 2010

How to Run a Successful Business: Send Out a Survey Every 10 Years

Imagine all of a sudden in your neighborhood a man standing outside a recently vacated building began handing out a survey. This survey contained the following question: If we dont know how many people live in this neighborhood, how do we know how many sandwiches we need? It then asked for you to write in how many people live with you. Here are some of the questions that, in turn, would probably pop into your head:

1. Why hasn't any other successful business in the neighborhood sent out a similar survey?

2. What does the number of people in the neighborhood have to do with how many sandwiches this apparent-future-sandwich-maker should make? If they are cheap, won't more people buy them, probably even from neighboring towns, and if they are expensive then fewer people will buy them? Why a survey with one question meant to provide an answer to something that is contingent on so many other factors?

3. Shouldn't the sandwich-maker be determining how many sandwiches to make as he goes along? Isn't it better to decide to make more sandwiches if after the first few rounds they all sell out quickly giving the sandwich-maker a big profit? Or to make fewer sandwiches if the opposite happens?

I bring up this anecdote because on my way home today, I saw an advertisement for the U.S. Census on the subway that said, "If we don't know how many people we have, how do we know how many trains we need?" I actually could not think of a more beautifully absurd example of why the subway system should not be run by government.

If the individuals who run the subway system are determining how many trains they need based on the census, there should be no surprise as to why the subway system is a loss-producing venture, in every single year of its existence. Literally.

A more reasonable method of determining output would of course be a profit and loss mechanism. But wait! Since the subway system is run by the government, there is no such thing as a profit and loss mechanism. That is precisely why they need to do the equivalent of "feeling around in the dark" by asking how many people there are in the area. If the subway system actually reacted, in the way a business would, to the fact that it produces losses year after year, it would have shut down long ago. In fact, a private investor or company would probably have bought the subway system and would be running it the way your local sandwich shop is run: keep operating as long as you make a profit (which means you are satiating customer needs) and innovate to try to make more profit (further satiate customer needs).

It is truly a testament to the capabilities of government agencies that they produced an advertisement like this which better than anything else displays ineptitude at its greatest.

Monday, April 5, 2010

Greenspan's Slip of the Pen

Alan Greenspan, also known as "The Maestro" (although for the amount of praise afforded to Ben Bernanke, the nickname might soon be stolen by the current Federal Reserve Chairman) has recently been working on an academic paper in an attempt to divert, rightfully or wrongfully, criticism directed at him for the financial crisis we currently face. His paper, called "The Crisis," rehashes many of the arguments he has made since the conclusion of his tenure as to the causes of the crisis, including securitization of subprime mortgages, the global savings glut, unfettered markets free of any semblance of regulation, and the rare black swan event (he calls it the "hundred year flood"). I didn't expect to extract much from his paper, which I assumed from the beginning would be just an aggregation of his previous arguments deflecting blame, until I came across two paragraphs near the end that were undoubtedly glossed over by the author himself, and made my jaw drop in their frank and profound implications.

Greenspan is discussing the role of monetary policy in potentially defusing bubbles when he writes,

There are no examples, to my knowledge, of a successful incremental defusing of a bubble that left prosperity in tact. Successful incremental tightening by central banks to gradually defuse a bubble requires a short-term feedback response.
But, policy impacts an economy with long and variable lags of as much as one to two years. How does the FOMC for example know in real time if its incremental ever-greater tightening is impacting the economy at a pace the policy requires? How much in advance will it have to tighten to defuse the bubble without disabling the economy? But more relevantly, unless incremental Fed tightening significantly raises risk aversion (and long-term interest rates) or disables the economy enough to undercut the cash flow that supports the relevant asset prices, I see little prospect of success.

Did you catch that? How does the FOMC for example know in real time if its incremental ever-greater tightening is impacting the economy at a pace the policy requires? I have another question to add to his astute observation: how does the FOMC for example know in real time if its incremental ever-greater loosening is impacting the economy at a pace the policy requires when times are tough? And here is another: how does the FOMC ever know the consequences of its policy actions that affect not just the United States but the entire world?

Greenspan would probably defend himself by saying that no actor in the economy ever knows what the definitive consequences of his actions might be, but of course that would ignore the fact that most actors in the economy face some sort of profit/loss decision-making process that the FOMC committee does not, and it would also ignore the fact that an individual actor's decisions (whether individual or corporation) do not affect the well-being of the entire world economy. Given Greenspan's slip of the pen, it might be time to substantively and radically reevaluate the role of the Federal Reserve knowing that unfortunately, the FOMC, through no deliberate fault of its own but rather through structural/institutional necessity, makes its decisions with blinders on.