Harvard Business Publishing

Besides over-leveraged companies, as you mentioned, information gaps have been a major issue in the landscape, specifically relating to economic forecasts and financial expectations.

Has the over-publication of research reports published by the investment banks, biased or not, contributed to this mess?

Hi Umair,

The Myers' link is broken in your post.

Thanks,
Dave

It seemed every other bank is going bankrupt. The whole financial systems of the country are wholly dependent on the Central Banking system, which has failed miserably.

Many countries are going bankrupt. I heard about countries going bankrupt. Emerging economies are also facing tremendous economic pain, unlike G7 nations they don’t have the safety nets.

Economist reports that American banks have lent 96 cents per 1-dollar deposited the European banks have lent 1.40 Euros of 1 euro deposited. Don’t you think that the it’s wrong doing on the part of the Bank? What exactly are the Government regulators doing?

It may be mistake of any one economy but the whole world economy suffers.
It’s just another 9/11 in Wall Street.

Through globalization the world economy is inter woven and integrated, cunning speculation, bad corporate governance, unethical values, no ethics, greed and the aftermath is job cuts, shutters pulled down, and people loosing all their heard earned savings. Funny thing that they
H\have played with pension funds also.

It’s reminds me of Henry Ford’s great words” Profit is a by-product of work; happiness is its chief product.”

A few people may have made fast bucks giving unhappiness and worries to the whole world.

Communication is certainly a major issue, but so is obfuscation. Shouldn't a part of this process include a much greater transparency? Isn't the current lack of transparency (something the corporations are fighting) a major part of the current problems and isn't it likely to prolong the malaise?

Funny how GOOG addressed this, with the voting v. non-voting stock classes. A truly primordial example of selling new DNA...

"Our DNA is good, trust us! And if you don't like what we're doing, fine. We don't care."

Umair:

I sent your piece to a good friend and these were his thoughts.

Let's see! Credit is too cheap (by government fiat), therefore equity is too expensive, therefore we need to cheapen equity by improving transparency!??? OK, but I doubt investors will see any motivation to do this. Equity holders (the owners) want their managers to finance their companies with the cheapest money and always will. Equity takes the greatest risk and rightfully expects the greatest return. That's why it is always going to be the most expensive method of finance. Only fear limits equity holders desired exposure to debt because debt holders have first claim on assets. That provides the balance. Logically, if debt is relatively more expensive then profits will go down and so will stocks (equity); if equity values fall, less risk taking will occur and growth will slow. Not Good!!! It's when management puts their own interest before the equity holders (owners) and secretly misuses debt to artificially improve profits that the system falls apart. So, will better communication systems better inform equity holders so that they will invest with less perceived risk, and therefore expect less return, and consequently be cheaper relative to debt; thereby reducing the risky level of debt that has caused the problem? Maybe, but the equity holders will always be motivated to push for higher returns, moving equity capital to more risk, again making debt relatively less expensive. Balance will be achieved when debt finds its own value level, without artificial government help.

In government and in business it is sunlight that is the nutrition and antiseptic that keeps us healthy!

Cary

Shouldn't markets be willing to pay a transparency premium (or maybe it's an opacity tax)?

Seems like money should have run from banks & businesses using instruments so complicated that no one understood them long before the markets melted down. To paraphrase Warren Buffet, don't invest in things you don't understand. So healthy equity markets should not just encourage transparency and open stakeholder dialogue + participation, but actually use these as tools to educate.

If the best new business models are open & participatory, the best companies should want to be understood by the public markets; this was clearly not the case with recent market antagonists. Transparency should be a point of pride not just for it's own sake, but because markets will pay for it. Looks like they sure ought to.

What do they think?

Nice POV Umair, I like this way of thinking.

Something I would stress is the information speed, that after reaching a critical value does not let executives and investors to behave rationally.
Indeed, people take their time to absorb an information, process it and react or neglect it.
But the system introduces lot of information, processed by many people all over the world in different ways, and causing an overreaction that increase volatility and irrationality.

Collocated in crazy leverages and easy-fast-money environment, it's like a drop of pollutant in a turbulent eddie, spreading the disease with incredible speed and capillarity.

It seems like we need to bring venture capital into this discussion as well. The structure of VC investing lowers the information barriers. VCs have much more information at their disposal during due dilligence than public market investors: interviews, product roadmaps, detailed financials, and an expertise in the area they are investing in.

The question is, how do you make this system scalable and granular. Having all investments work at the scale (1M+ per investment) and pace (50 meetings a round) clearly won't work for the public markets without leaving out the majority of investors.

Changing the information available would allow for new types of investing and analysis. Imagine a Donors Choose for public companies: constantly updated with upcoming projects and needy departments that require investment. It would have to come with radical transparency to work effectively; but for the right companies, it could turn investors into an asset, helping allocate funds.

There's also the consideration of how companies started to use equity as a replacement for cash compensation: making the cost of equity even more expensive and changing the incentives and relationship between the company and it's equity-compensated owners-managers.

Given how equity became an important part of compensation it's not surprising that managers use their positions (of power, of information, of asymmetrical information) to use whatever capital structure fits their individual benefit. Imagine all the ways we've seen this issue crop up: stock option expensing, stock option backdating, golden parachutes, change of control payment clauses, accounting and earnings manipulation, etc, etc.

It all points back to institutional decay: the financial phenomenon we're living through is a result of how we all acted according to the incentive systems we face very day. Many, many small decisions to maximise end up leading to global minimisation.

How do we fix it? Create institutional systems that force more interaction between inter-linked parties and their economic streams, increased information and decision transparency, greater interaction with customers?

Companies can choose not to participate in that system or not, maybe they need it, maybe they don't: but their choice sends a signal.

Nice POV, I like this way of thinking.

Something I would stress is the information speed, that after reaching a critical value does not let executives and investors to behave rationally.
Indeed, people take their time to absorb an information, process it and react or neglect it.
But the system introduces lot of information, processed by many people all over the world in different ways, and causing an overreaction that increase volatility and irrationality.

Collocated in crazy leverages and easy-fast-money environment, it's like a drop of pollutant in a turbulent eddie, spreading the disease with incredible speed and capillarity.

Is this an advocation of increased transparency? This sounds great when taken at face value, but looking deeper, how much transparency should a company need to provide?

Assuming that one could provide real-time financial updates to bona fide investors and shareholders, would this not expose a too much of the inner workings of a public company to competitors?

The theme underlying new DNA corresponds to building the network through edge competencies. Within this cosy and hyperconnected information ecosystem, we shouldn't forget that competition is still healthily in play. I like the idea of a transparency tax, perhaps afforded when you have invested past a certain threshold that allows one to gain access to such near real-time data.

There's a balance between accelerating public financial information that investors and shareholders should have easier access, versus providing anybody in the world with such data.

Although information asymmetry in the form of delayed financial statements (quarterly/annual reports) got us in this mess in the first place, I'm not sure that an extreme to the other side (complete real-time financial transparency) is the right way either for a majority of public companies.

Re: "As numerous observers has rightly pointed out, we face a great deleveraging -- a tsunami of debt is being sucked out of the financial system, as confidence in counterparties implodes.
But that's just the gloss of financial mechanics."

> I like to think of this Great Depression-like synthetic derivative mess we are in today, in terms of financial termites who have gathered together into colonies, where they happily reside under Wall Street.

These types of metaphors require Wikipedia interactivity, so let me set the stage: Termites, like financial engineers, thrive in, "decentralized, self-organised systems using swarm intelligence and use this cooperation to exploit food sources and environments that could not be available to any single insect acting alone."

> This group activity below ground, reminds of a different type of self-organizing activity overhead: ... "when you see geese flying south for the winter
in their characteristic V-formation, consider what science has
discovered about this arrangement:
As each bird moves its wings,
it creates a slight uplift for the bird following immediately behind.
In fact, because of this V-formation, the flock as a whole
enjoys a flying range of at least seventy one percent
greater than would be possible
if each bird flew alone."

> I'm searching for a common DNA link for the collapse of capitalism and connections to organizational structures. Thus, termites represent individual efforts which are collectively destructive, i.e, there are thousands of financial derivative deals under the surface, made by thousands of individuals, who work away undetected and unregulated -- making efficient progress, which has resulted in the destruction of the whole financial system. The individual tunnels and paths have merged into a network of weakness that has collapsed from its own weight, its own mis-management.

Wall Street has essentially collapsed into a deep well-like tunnel which is the cumulative result of years of structural decay. The decay in this case, is based on the forward swap futures, CDS, CMO, credit-linked, index-backed, non-stop magic show, which is the equivalent process of a termite colony that blindly eats its way through an infrastructure. The metaphor of parasites or cancer also come to mind, as entities that make disorder out of human order. The destruction and decay of DNA or any matter is a process of entropy: "It is a measure of the randomness of molecules in a system and is central to the second law of thermodynamics and the fundamental thermodynamic relation, which deal with physical processes and whether they occur spontaneously. Spontaneous changes, in isolated systems, occur with an increase in entropy. "

> The process of decay has an end result of fragmentation, separation and decomposition, but survival is the main component of DNA, so what is next, in the evolution of capitalism? The casino is burning, but can Rome may still be saved?

Within some insect colonies, there is a process referred to as trophallaxis: "individual colony members store food in their crops and regularly exchange it with other colony members and larvae to form a sort of "communal stomach" for the colony."

This communal trait of sharing is also found with bats; "A potential example of reciprocal altruism is blood-sharing in the vampire bat, in which bats feed regurgitated blood to those who have not collected much blood themselves knowing that they themselves may someday benefit from this same donation; cheaters are remembered by the colony and ousted from this collaboration."

> The point here is to think about the process of collapse, but to also see the opportunity in rebuilding a stronger structure for the future. It seems obvious to me, that in order to gain confidence in this system, our collective colony, our society, can't allow the termites that are the nuclear engineers of this chernobyl reactor to remain at the controls, while the authorities remain passed out. It is unfair to society to allow contaminated termites like Paulson to run back and forth between the meltdown, while spreading radiation to innocent bystanders. There must be a process to separate the toxic waste from the untainted materials that do more harm than good: "The Prudent Man Rule directs trustees "to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested"."

> Umair refers to, "an era where our economic institutions are fast becoming value destruction machines", thus IMHO, I think it's critical to realize that the termite-like workers who brought us to this point, are the individual CEO workers who did not work as a unit to share the resources of the system. The value of shared information was destroyed by a colony that focused on individual greed. Thus, the inability of individuals to be accountable and to take into account the collective nature of their group actions resulted in total failure for the system. The risk models, business plans and objectives of Wall Street have been a chaotic interlacing and intermingling of debt that was not connected to capital and the result is a decoupled financial network that has no value.

> The financial engineering system Wall Street created, was a system that failed to model its own failure, i.e, the systemic collapse was never anticipated, because the focus for model building was a narrow tunnel vision focus which was fueled by the addictive pattern of insatiable non-stop greed, which burned like desire, for these parasites.

See: Those with myopia see nearby objects clearly but distant objects appear blurred.

See Also, From Godel: "Gödel's first incompleteness theorem, perhaps the single most celebrated result in mathematical logic, states that:
Any effectively generated theory capable of expressing elementary arithmetic cannot be both consistent and complete. In particular, for any consistent, effectively generated formal theory that proves certain basic arithmetic truths, there is an arithmetical statement that is true, but not provable in the theory.
The resulting true but unprovable statement is often referred to as "the Gödel sentence" for the theory, although there are infinitely many other statements in the theory that share with the Gödel sentence the property of being true but not provable from the theory."

Umair,
How does the fact that informational advantages drives the hedge fund industry tie into your thought exercise? Hedge funds are hiring firms like Gerson Lehrman to broker conversations with industry insiders so that they can get a picture of what is really happening inside companies and industries that they can't get from management teams and other traditional sources of information. GL has built a multi-hundred million dollar business providing this type of "research" over the last few years. I would note that this service is not available to the individual investor as hedge funds pay $1K/hr or more to "consult" with these industry advisors.
Is this informational assymetry accounted for in your world-view?
T

Umair,
Something very interesting, that pleads for your professional opinion! It also reinforces my conviction that "Interactive Complexity" is still not well understood and can't be handled by computer programs for the time being. Amid all the fallout from the financial turmoil, one group has yet to feel the accusing finger of blame: the analysts who built the computer software that drove the derivatives markets that, in turn, drove the financial collapse. Since the Big Bang of the 1980s, large amounts of stocks and shares - and derivatives of them - have been traded automatically by computers rather than by humans. These so-called "algotrades" accounted for as much as 40% of all trades on the London Stock Exchange in 2006; on some American equity markets the figure can be as high as 80%.

The people who write the algorithms that drive the software are called quantities analysts, often referred to simply as "quants". They are generally physics and mathematics graduates working in risk management - calculating whether a given deal is a good idea - and derivatives pricing, which entails putting a figure on trades that in effect bet on other trades. It's enormously complex, which is why only the quants could understand it - if, that is, they did. History now suggests they didn't.

The rise of the quants has mirrored the automation of the financial markets; and as many of the newer markets, such as swaps (a sort of insurance) and derivatives, have been unregulated, the quants who have been responsible for developing the hugely complicated systems that in the end brought many of the western world's banks to their knees. As Richard Dooling wrote in the New York Times: "Somehow the genius quants - the best and brightest geeks Wall Street firms could buy - fed $1 trillion in subprime mortgage debt into their supercomputers, added some derivatives, massaged the arrangements with computer algorithms and - poof! - created $62 trillion in imaginary wealth."

Those algorithms were based on risk assessments that were seriously flawed, based only on the risk to the market at that moment, rather on cold, hard empirical data about a person's ability to pay and what would happen if a lot, rather than a few of them, stopped. As George Dyson (son of the quantum physicist Freeman) wrote in Edge last week: "The problem starts, as the current crisis demonstrates, when unregulated replication is applied to money itself. Highly complex computer-generated financial instruments (known as derivatives) are being produced, not from natural factors of production or other goods, but purely from other financial instruments." What is also becoming clear is that the financial markets are far more automated than ever before. There is a growing sense that much of this was made by machines, with the quants feeding the beast ever more intricate lines of code. Dooling has a growing conviction that we are now at the mercy of a financial system based on "arrangements so complex only machines can make". It seems we are at the mercy of the machine. Umair, Silence lies in the ocean, while words flow through the river. The oceans waits for YOU, don't wait for the river. Look to the ocean and watch its message.It will come, it will come. Regards, Mike.

Like all recovery programs, this one must be grounded in acceptance of personal responsibility and a desperation-based willingness to do the next right thing, because the alternatives are even more painful. We're just about there. Polly, Anna and their wicked stepsister, Fate, demand no less.

I like Dr. Yanakiev's machine/quant connection in relation to Umair's DNA business evolution framework, and the link to future dependence on automatized computer efficiency challenges.

My post above can be condensed to suggest that financial termites blindly work at boring randomized tunnels, which can cause systemic decay and collapse, however, if I connect termite activity to chaotic software code, I end up with another metaphor:

"A computer worm is a self-replicating computer program. It uses a network to send copies of itself to other nodes (computer terminals on the network) and it may do so without any user intervention."

It seems striking to me that there is a metaphorical relationship between the health of economic DNA and the infective environmental exposure of financial viruses and banking network behavior -- which can mutate like AIDS or cancer-like programs into chaotic, unregulated and perhaps, unstoppable structural collapse.

There is an obvious and simplistic correlation between taking risks and being safer, but does the fuel of innovation need to be so explosive that it becomes destructive? Is taking risk the objective, or it a means to an end?

The DNA of future business success stories, IMHO will depend upon proactive involvement in preventative screening -- which ensures that financial models, programs or business plans are in balance -- and not undergoing radical, unwarranted and unwelcome modifications that will impact the health of the whole system. The greatest problem in this era was unaccountability coupled with a lack of regulation. The result is chaos.

This is my case for The Termite Queen, amen.

Umair,

Not so sure about the DNA analogy - I think the BSE one is better! I mean that in that scare (the true impact which has still not finished in the population), someone in Britain decided that it would be great cost-cutting measure and in line with deregulation, to lower the temperatures in the plants where they produce feed. Indeed there was deregulation throughout Britain, including the financial sector. In the case of the agriculture sector we got BSE, in the finance sector it was bad loans, bad equity, debt, and simply bad economics. I believe the only approach to this problem is to introduce stricter regulation and better communication.

Umair,

I love how you address the issue of illusion of value. At the end of the day the institutions leveraging funds 30+ times were just playing Federal Reserve, printing up money with no substantial value creation in terms of products or services.

I don't necessarily think the "great deleveraging" as you call it has to be all that painful in terms of our quality of life, it will just force us to be less materialistic - which can be a good thing in terms of sustainability.

I also wrote on my blog about corporate culture and earnings management at GE.

Umair:

Here is another comment by my partner Cary. I posted his first comment on October 15th above. Any comments or reply to his thoughts?

Bill, this is my comment on Umair's posting. Cary

I must admit, even after four careful readings of Umair Haque's posting, I have a meager understanding of the point being made; other than the obvious. i.e. That the unregulated derivative/credit default market was an artifice not based on real sustainable value meeting real customer needs.

Contrary to Umair's argument, I believe that great companies are creating real value for real customers. I'll use his Starbucks example as a case in point. They brilliantly created a community meeting place where they sold coffee, and other things that go with coffee. Perfect! A solid idea for a profitably meeting one of their customers' needs. To Umair's other point though, they did use a potentially incorrect scale rational to buy unprofitable market share. (scale doesn't automatically apply to all businesses) They made a poor management decision. Too many stores! Now they are closing the marginal ones. They also somewhat eroded their core market when they decided to meet the conflicting commuter consumer's need for convenience with drive-through sales windows. The question is whether they can do both sustainably. If they can they will increase sales and profit and protect against share loss to rivals who would focus on the convenience need had they not. If they cannot they will open themselves to rivals who will focus solely on the community need and take share from them. These are typical business problems. We'll see how they ultimately come out.

But no one can convincingly argue to revoke solid value chain analysis, or argue that Porter's buyer, supplier, rival, substitute, new-entrant model for understanding what a company (country) must do to sustain competitive advantage is wrong or out of date, just because some companies (countries) are poorly managed. However, the pace of change and the range of substitutes available to meet customers needs have shortened the periods for which competitive advantage can be sustained. Even perfectly understanding competitive advantage, the pace makes the problem increasingly more difficult to manage. The question is: Can any particular company, industry, economy keep up? Tom Friedman is trying to propose how the US can keep up in his new book, "Hot, Flat and Crowded." Rapid, sustained innovation is the key. Those who can master the pace of successful innovation providing solutions to big problems will be the winners.

Our current economic problems are caused by poor monetary policy not by poor DNA or re imagining the cost of equity. US growth had to be manufactured financially by the government because we weren't keeping up with the pace of global changes. The Fed's cheap money made saving unnecessary, drove housing prices in the US to unsustainable levels, and made equities over-valued relative to debt. Consumers responded by shopping, spurred by their imagined wealth in the value of their homes and equity holdings. The bubble over inflated and began to leak, and lo and behold we found that financials institutions were betting that it would never deflate. Amazing!!!

I guess (hope) we'll get through the de-leveraging in a few years.

However, in the short to medium run, especially for the United States, the test will be how well we can solve our economic problems by inventing the next big market solutions, and the next, and the next, with ever increasing pace.

How to do it will be the daunting challenge!

Interesting article!! However it overlooks one of the basic tenets: that although debt is expensive, it can be managed! This great DEBT-PRESSION has been caused by the MBA's (Mis-management of Business Asse.s).

God had it right in his divine economy. The forgiveness of debt after every 7 years.

This will allow what you called the 'new DNA'to emerge into the financial system after the purging of the bad debt.

David

The system is purging itself of unsustainable promises to baby boomers. The baby boom will not be allowed to retire. Their lifestyle must be reduced. Those who inherit or have gov pensions will prosper. Those with market styled IRA 401k will be reduced in consumption to force reductions in lifestyle. It's the old DNA, the baby boom, that is the problem. There aren't enough machines or empire to support 70 million people the way their parents generation retired.

Asset and debt reduction is the solution to retiring baby boomers. Retirement is a waste to society. Baby boomers must be forced to work until they die, not being parasites on the system. The world is always exactly the way it should be. Protect yourself, no one else can or will. The harder and smarter you work the luckier you will get. Good luck to us all.