Whom to trust?

Many months back, I wrote about the central issue around the financial crisis was one of trust. Until trust is restored, the gears of the financial system remain jammed. Most of the current activities around restoring market confidence have been about ensuring that there is adequate money supply however; this has not really been the central issue in this meltdown. If anything, the current solution will likely lead to inflation down the road. The central issue is not the supply of money but the velocity of money. It’s not moving and it’s not moving because it is difficult to ascertain who is credit worthy.

The here’s an article about the notion of quarantined assets in order to isolate toxic assets. Not sure about the mechanics of this but it’s an interesting idea. The moral hazard issue remains unresolved.

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Market Volatility and Interbank Lending

The markets have been taking a wild ride these past few weeks. Those of you who crave volatility must be having a field day however; one can’t help but be puzzled as to what’s causing the recent market swings.

We know that the roots of the current financial crisis lie in the securitization of sub-prime mortgages and a general failure in containing risk within these portfolios. We know that there are significant funds being made available to the financial institutions to make loans as well as to purchase toxic assets off the balance sheets of these institutions. So why all the uncertainty and when will recent measures actually bring stability to the markets?

Banks form the base of the economic pyramid given that businesses depend on them for loans for various projects that otherwise would not be carried out. At the end of the day, banks make money from these transactions and have typically relied on the ability to borrow from each other should they experience a shortfall of cash reserves at the end of each business day. The recent revelation regarding financial institutions with unprecedented levels of toxic assets on their books has resulted in a disintegration of trust among banks. This has caused banks to start hoarding cash instead of freely lending to each other.

Interbank lending rates such as LIBOR can be used as a rough proxy for the measure of trust between banks. Despite cuts of the benchmark lending rates by the Federal Reserve and the Bank of Canada, LIBOR has jumped to the highest levels since December of last year. In other words; banks do not trust each. After all, without clarity on how these assets will be divested, they could end up lending money to insolvent institutions. Furthermore, banks have no reason to believe that borrowing banks will no longer engage in the activities that got everyone in this mess to begin with. To the best of my knowledge, there has been no notable change in regulations, executives or boards of directors at any of the offending institutions. Perhaps there is a concern that any such move would be interpreted as an admission of wrongdoing. In any case, it is unclear when banks will free up capital and when business will have access to prior levels of debt financing. While this is the case, I am not sure that we can expect stable markets anytime soon.

2008 Financial Meltdown

As the US House declines to dole out $700B in “the largest government bailout of Private Industry in US History”, articles all over the web are fired up about how this happened and who is to blame. At the heart is the question of what the government did or did not do to bring about this crisis. It is refreshing to see the tide of the conversation shift from treating this as if it were a natural disaster. Let’s be clear, this is not a disaster in the sense that no one could have seen it coming – this is something that was well known and to some extent knowingly engineered by the financial institutions (in some cases by the very institutions that are crumbling as we speak.) I say it was knowingly engineered because the causes are rooted in the general culture of the financial institutions.

The most interesting assertion is that the problem was caused by the deregulation of the financial markets. I am not in the financial industry and do not scrupulously stay on top of financial regulations the way I do legal aspects affecting the technology industry, however, I highly doubt that this outcome is a result of regulations or lack-thereof. To understand why this is so, we have to delve a little bit into what’s the cause of the current meltdown and how the financial institutions are very adept at circumventing regulations through derivatives without breaking any laws.

Money lenders take funds deposited in savings accounts and turn around and lend these funds out to other customers who require a loan. Most people think that these institutions only make money on the spread between the rate of interest paid out and the loan interest – that’s not the case. Instead, institutions combine these loans into large bundles and then turn around and sell the whole thing to other institutions (or even individual investors). They then take the money raised from this sale and go at it again. In this way, institutions can lend out far more money than they actually have in deposits – in some cases, they lent out more than 30 times the amount of money they had in deposits. Of course, the whole thing works just fine so long as only a reasonable number (determined by statistical means) of the loans default.

For an individual loan, it is relatively simple to determine the risk of default – you look at the equity the individual owns, their credit history and come up with some assessment of risk. When you now combine loans together and bundle them together, you actually take advantage of well understood concepts of risk diversification so that the overall risk of the bundle is much lower than that of any individual loan in the bundle. This result of risk diversification however only holds true as long as the components of the bundle do not strongly correlate to one another. In other words, the more different the items making up the bundle, the stronger the effect of diversification. With credit default swaps for sub-prime loans, this principle seems to have gone out the window. If you were to take a bunch of rotten loans and put them all into a bundle, you don’t get any benefit of diversification – all you have is a rotten bundle. If you were to then turn around and sell this bundle, well, the problem is no longer yours – caveat emptor.

So is the bailout a good idea or a bad one? One of the least appealing aspects of the now defunct legislation is how it attempted to throw out the tried and true free-market economic policies of Hayek in favour of the Keynesian philosophy of government interventionism. As illustrated above, the failure of the markets was caused by people knowingly engaging in poor decisions in favour of short term interests (Yes that is a polite way of saying unbridled greed.) The companies that are therefore facing bankruptcy are simply facing the consequences of their own actions. If the free-markets truly embody the survival of the fittest philosophy then these businesses should collapse and better players would swoop in and buy up the functioning pieces. Bailing out the executives and the boards of directors who knowingly let this happen is absolutely the wrong thing to do. Of course, there can be grave consequences to the economy if the current crisis is not contained within the financial institutions. Financial institutions form the base of the pyramid that supports businesses that rely on them for financial services such as loans and diversification of risk through hedging. These services are essential to keep the economy functioning well. The institutions and executives who let things get to this stage have known that this fact alone would compel the government to bail out an all out collapse. The current crisis therefore illustrates that the moral hazard that some economists fear would come about as a consequence of this bailout in fact already exists today.

Here are some other opinion pieces for you to consider:
Bankruptcy, not bailout, is the right answer
Bailouts will lead to rough economic ride

“The Strategy Paradox” by Michael Raynor – a brief review

Michael Porter, of the Porter’s-Five-Forces fame, is a leading authority on competitive strategy. Based on his writings, firms pursue one or at most, two of three key competitive strategies:

  • Quality Leadership
  • Cost Leadership
  • Service Leadership

Competitive strategy forms the basis of how marketers position their products and brands in the marketplace. Those of you who are familiar with brands like Nordstrom’s, Disney and Wal-Mart would also recognize their respective marketing messages, namely: Service Leadership, Quality Leadership and Cost Leadership.

In the book “The Strategy Paradox”, Michael Raynor challenges these long standing approaches to strategy. His analysis shows that the companies that adopt these strategies (perhaps inadvertently) expose themselves to extraordinary risk in the face of universal uncertainty. While there are many more ventures that fail, the companies that do succeed not only attain a dominant position amongst investors and consumers but also become the basis of what defines successful strategies. Unfortunately, these decision making processes do not clearly take into account the risks taken by these firms.

To illustrate his point, the author asserts that in order to connect with customers, the firm has to capture its value through a strategy that is challenging for competitors to imitate. This “must commit” mentality forces the firm to leverage its assets and capabilities towards this end. While this approach results in capabilities that are difficult for competitors to imitate, it forces the firm to commit to capabilities in the face of uncertainty. He further observes that the longer the time horizon of the commitment, the greater the degree of uncertainty faced. If the commitments happen to be the wrong commitments, it is often non-trivial to make corrections and may result in lost opportunity or outright failure. It is this impetus to commit in the face of uncertainty that exposes the firm to risk. He calls this “The Strategy Paradox”. In his book, Michael Raynor takes a risk adjusted approach to strategy versus the survivorship bias that currently permeates business analysis and literature.

The author builds his case by combining historical data with specific cases to craft his message that failures are not just a clear cut case of bad strategy but usually “great strategy coupled with bad luck”. One such case is the infamous VHS versus Betamax format wars between Sony and Matsushita. In this example, he shows how most analysis of Sony’s failure and Matsushita’s complete dominance is largely polluted by hindsight. Attempts to determine best practices based on this approach is therefore inherently flawed in that it does not really provide today’s manager the tools to make decisions in the face for market uncertainly (which is something we wrestle with everyday). In this case, Sony managers naturally utilized existing core competencies and capabilities that it had used in developing highly successful products such as the Sony Walkman to the video standard battle. Michael Raynor demonstrates that Sony carried out detailed analysis of the situation and made sound decisions at each step of the way. It was therefore not the lack of attention or execution that was the cause of Sony’s ultimate failure. In this case, Michael sites Sony’s commitment to video quality over VHS’s longer recording time was a key difference between the competing standards. Both Sony and Matsushita made this decision in the face of market uncertainty and not because they possessed any special information or magic crystal ball. Sony’s decision was of course rooted in the very core value (quality) that had made it a success story. When it ultimately became evident which way the market was leaning, a series of missteps by Sony to re-position its product sealed Betamax’s fate to that which we know of today.

Given that market uncertainties are a reality of life, is it then merely a matter of luck or is there a rational approach that managers can prescribe to in order to tilt the game in our favour? Students of portfolio theory learn of numerous mathematical tools that, in the hands of a skilled manager, can result in better returns then those left to chance alone. These tools typically rely on statistical factors (e.g. uncorrelated returns) to eliminate idiosyncratic risk to achieve their ends. While the concepts of portfolio theory apply here, the practice is quite different since strategic managers do not have the option to really mix and match decisions like one does stocks and derivatives. Instead, the important aspect that managers have to understand is that locking in decisions in the face of uncertainty exposes the firm to both the upsides as well as the downsides. In the book, Michael Raynor, goes through numerous frameworks for how managers could characterize the nature of the uncertainty they are dealing with and how they can borrow from the world of financial derivatives in their decision-making. For instance, managers could defer commitments to a later time while continuing to invest in core initiatives that maximize the options for the firm when there is better information. This is very much akin to how derivatives such as options work – an essential element of this tool is the leverage gained by the firm by investing in core initiatives versus the outright commitment to one particular outcome. All the tools laid out in the book are beyond the scope of this article however, here are some of the realizations that I got from this reading that I would like to share with you. Wherever possible, managers, when faced with long term strategic decisions should:

  1. Understand that uncertainly is the basis of opportunity – it’s not a bad thing
  2. Appreciate that the time horizon of uncertainty is related to risk
  3. Devise experiments to determine the nature of the uncertainty
  4. Maintain an adaptive stance (i.e. do not commit) while significant assumptions remain untested
  5. Maintain investments in core initiatives that maximize the future options that the firm can exercise
  6. Understand that there needs to be significant leverage in the options, otherwise, you might as well have invested in the final decision
  7. Match the pace of organizational change to the pace of environmental change

Regardless of whether you agree with Michael’s assertions, his book is incredibly thought provoking and an excellent addition to any strategic manager’s business book collection.