James Tobin's Hirsch Lecture

James Tobin's Fred Hirsch Memorial Lecture "On the Efficiency of the Financial System" was originally published in a 1984 issue of the Lloyds Bank Review, and republished three years later in a collection of his writings. Willem Buiter discussed the essay at some length about a year ago in a provocative post dealing with the regulation of derivatives. Both the original essay and Buiter's discussion of it remain well worth reading today as guides to the broad principles that ought to underlie financial market reform.

In his essay, Tobin considers four distinct conceptions of financial market efficiency:

Efficiency has several different meanings: first, a market is 'efficient' if it is on average impossible to gain from trading on the basis of generally available public information... Efficiency in this meaning I call information arbitrage efficiency.

A second and deeper meaning is the following: a market in a financial asset is efficient if if its valuations reflect accurately the future payments to which the asset gives title... I call this concept fundamental valuation efficiency.

Third, a system of financial markets is efficient if it enables economic agents to insure for themselves deliveries of goods and services in all future contingencies, either by surrendering some of their own resources now or by contracting to deliver them in specified future contingencies... I call efficiency in this Arrow-Debreu sense full insurance efficiency.

The fourth concept relates more concretely to the economic functions of the financial industries... These include: the pooling of risks and their allocation to those most able and willing to bear them... the facilitation of transactions by providing mechanisms and networks of payments; the mobilization of saving for investments in physical and human capital... and the allocation of saving to to their more socially productive uses. I call efficiency in these respects functional efficiency.

The first two criteria correspond, respectively, to weak and strong versions of the efficient markets hypothesis. Tobin argues that the weak form is generally satisfied on the grounds that "actively managed portfolios, allowance made for transactions costs, do not beat the market." He notes, however that efficiency in the second (strong form) sense is "by no means implied" by this, and that "market speculation multiplies several fold the underlying fundamental variability of dividends and earnings."

My own view of the matter (expressed in an earlier post) is that such a neat separation of these two concepts of efficiency is too limiting: endogenous variations in the composition of trading strategies result in alternating periods of high and low volatility. Nevertheless, as an approximate view of market efficiency over long horizons, I feel that Tobin's characterization is about right. 

Full insurance efficiency requires complete markets in state contingent claims. This is a theoretical ideal that is impossible to attain in practice for a variety of reasons: the real resource costs of contracting, the thinness of potential markets for exotic contingent claims, and the difficulty of dispute resolution. Nevertheless, Tobin argues for the introduction of new assets that insure against major contingencies such as inflation, and securities of this kind have indeed been introduced since his essay was published.

Finally, Tobin turns to functional efficiency, and this is where he expresses greatest concern:

What is clear that very little of the work done by the securities industry, as gauged by the volume of market activity, has to do with the financing of real investment in any very direct way. Likewise, those markets have very little to do, in aggregate, with the translation of the saving of households into corporate business investment. That process occurs mainly outside the market, as retention of earnings gradually and irregularly augments the value of equity shares...

I confess to an uneasy Physiocratic suspicion, perhaps unbecoming in an academic, that we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. I suspect that the immense power of the computer is being harnessed to this 'paper economy', not to do the same transactions more economically but to balloon the quantity and variety of financial exchanges. For this reason perhaps, high technology has so far yielded disappointing results in economy-wide productivity. I fear that, as Keynes saw even in his day, the advantages of the liquidity and negotiability of financial instruments come at the cost of facilitation nth-degree speculation which is short sighted and inefficient...

Arrow and Debreu did not have continuous sequential trading in mind; when that occurs, as Keynes noted, it attracts short-horizon speculators and middlemen, and distorts or dilutes the influence of fundamentals on prices. I suspect that Keynes was right to suggest that we should provide greater deterrents to transient holdings of financial instruments and larger rewards for long-term investors.

Recall that these passages were published in 1984; the financial sector has since been transformed beyond recognition. Buiter argues that Tobin's concerns about functional efficiency are more valid today than they have ever been, and is particularly concerned with derivatives contacts involving directional bets by both parties to the transaction:

[Since] derivatives trading is not costless, scarce skilled resources are diverted to what are not even games of pure redistribution.  Instead these resources are diverted towards games involving the redistribution of a social pie that shrinks as more players enter the game.

The inefficient redistribution of risk that can be the by-product of the creation of new derivatives markets and their inadequate regulation can also affect the real economy through an increase in the scope and severity of defaults.  Defaults, insolvency and bankruptcy are key components of a market economy based on property rights.  There involve more than a redistribution of property rights (both income and control rights).  They also destroy real resources.  The zero-sum redistribution characteristic of derivatives contracts in a frictionless world becomes a negative-sum redistribution when default and insolvency is involved.  There is a fundamental asymmetry in the market game between winners and losers: there is no such thing as super-solvency for winners.  But there is such a thing as insolvency for losers, if the losses are large enough.

The easiest solution to this churning problem would be to restrict derivatives trading to insurance, pure and simple.  The party purchasing the insurance should be able to demonstrate an insurable interest.  [Credit Default Swaps] could only be bought and sold in combination with a matching amount of the underlying security. 

The debate over naked credit default swaps is contentious and continues to rage. While market liquidity and stability have been central themes in this debate to date, it might be useful also to view the issue through the lens of functional efficiency. More generally, we ought to be asking whether Tobin was right to be concerned about the size of the financial sector in his day, and whether its dramatic growth over the couple of decades since then has been functional or dysfunctional on balance.

Reflections on the Flash Crash

Index Universe observes that much of the unusual trading activity last Thursday involved exchange traded funds and notes:

Nasdaq has released a list of 281 securities that saw unusual activity during yesterday’s “flash crash” on the market... In all, 193 of the 281 securities (68.7 percent) on the NASDAQ list were exchange-traded funds or exchange-traded notes... The New York Stock Exchange has published a similar list, detailing 173 different securities whose trades will be cancelled. In all, 111 of those securities (64.2 percent) were ETFs or ETNs...

It was not immediately clear why ETFs dominate the lists.

Izabella Kaminska follows up on FT Alphaville:

ETF and ETN trading is closely related to high-frequency trading... Constant market-making and arbitrage opportunities are provided to authorised participants (often high frequency trading firms) by the ETF model’s dependence on converging to the net asset value on a daily basis. A typical fund has about five authorised participants.

The so-called creation and redemption mechanism allows authorised participants to lock-in profits when the shares of ETFs over-price or under-price the NAV, since only they are allowed to redeem or create shares at the official NAV price of the funds.

Dynamic hedging is needed to protect the arbitrage until the moment the creation or redemption process can take place... A significant change in any constituent stock in the interim can can hence fuel frantic fine-tuning of positions ahead of NAV publication time.

Can the algorithmic strategies used by authorized participants making markets in exchange traded funds help account for the crash? Not really. Index arbitrage of this kind simply brings the prices of exchange traded funds in line with the prices of their constituent securities, and is non-directional. This activity could explain a spike in volume as a result of sharp movements in prices, but this is a symptom rather than a cause of the crash. Something else caused the prices of the funds and/or the constituent securities to drop, and index arbitrage activity picked up as a result. What was this cause?

Some have pointed to the fact that liquidity vanished from the market during the crash, or that stop loss orders were triggered as prices fell. While these effects certainly accelerated and amplified the decline, there must have been an independent source of massive selling pressure that ran through the available bids, triggered stop orders, and caused electronic market makers to shut down. Again, where did this overwhelming selling pressure come from?

The best explanation that I have seen is contained in a message by an anonymous analyst that Yves Smith posted earlier today. The hypothesis is that the initial trigger came from algorithms implementing volume-sensitive technical strategies:

Volume was gigantic yesterday before we really went into freefall. As of 2 p.m., some 40 minutes before Armageddon, we were tracking for a massive 15.6 billion share day (we ended up doing 19.3 billion – the second largest day ever after the October 10th, 2008 whitewash). Half an hour later, at 2:30 p.m. – still ten minutes before the bottom fell out – volume had surged and we were tracking for a 17.2 billion share day. The period between 2 p.m. and 2:40 p.m. saw immense selling pressure in both the cash market and the futures market, and that occurred with the E-minis still north of 1120...

In other words, it was not a sudden, random surge of volume from a fat finger that overwhelmed the market. It was a steady onslaught of selling that pressured the market lower in order to catch up with the carnage taking place in the credit markets and the currency markets...

So what happened here? Three things:

1. Sellers probably had orders in algorithms – percentage-of-volume strategies most likely, maybe VWAP – and could not cancel, could not “get an out.” These sellers could be really “quanty” types, or high freqs, or they could be vanilla buy side accounts. It really doesn’t matter. The issue here is that the trader did not anticipate such a sharp price move and did not put a limit on the order...
2. Sell stop orders were triggered which forced market sell orders into an already well offered market. 
3. While the market was well offered, it was not well bid. Liquidity disappeared... Bids disappeared, spreads blew out, and no one was trading except a handful of orphaned algo orders, stop sell orders, and maybe a few opportunists who had loaded up the order book with low ball bids (“just in case”). High frequency accounts and electronic market makers were, by all accounts, nowhere to be found.

It boils down to this: this episode exposed structural flaws in how a trade is implemented (think orphaned algo orders) and it exposed the danger of leaving market making up to a network of entities with no mandate to ensure the smooth and orderly functioning of the market (think of the electronic market makers and high freqs who can pull bids instantaneously as opposed to a specialist on the floor who has a clearly defined mandate to provide liquidity).

This rings true to me. Accounting for the crash requires us to go beyond the mechanics of the trading process (automation, scale, speed) and to examine the kinds of strategies that were being implemented by the algorithms. A market dominated by technical analysis is always going to be vulnerable to this kind of instability. The fact that the prices of some securities and funds crashed to absurd levels that were clearly out of line with fundamentals made this obvious and resulted in a quick recovery. But what if the trading strategies had given rise to upward rather than downward instability? It would have been more difficult to establish conclusively that assets were overpriced, and accordingly more risky to enter positions to bring them back in line with fundamentals. This, presumably, is how asset price bubbles get started. 

Algorithmic Trading and Price Volatility

Yesterday's dramatic decline and rapid recovery in stock prices may have been triggered by an erroneous trade, but could not have occurred on this scale if it were not for the increasingly widespread use of high frequency algorithmic trading.

Algorithmic trading can be based on a variety of different strategies but they all share one common feature: by using market data as an input, they seek to exploit failures of (weak form) market efficiency. Such strategies are necessarily technical and, for reasons discussed in an earlier post, are most effective when they are rare. But they have become increasingly common recently, and now account for three-fifths of total volume in US equities:

Algorithms have become a common feature of trading, not only in shares but in derivatives such as options and futures. Essentially software programs, they decide when, how and where to trade certain financial instruments without the need for any human intervention... markets have come to be dominated by “high-frequency traders” who rely on the perfect marriage of technology and speed. They use algorithms to trade at ultra-fast speeds, seeking to profit from fleeting opportunities presented by minute price changes in markets. According to Tabb Group, a consultancy, algorithmic and high-frequency trading accounts for more than 60 per cent of activity in US equity markets.

This is a recipe for disaster:

[In] a market dominated by technical analysis, changes in prices and other market data will be less reliable indicators of changes in information regarding underlying asset values. The possibility then arises of market instability, as individuals respond to price changes as if they were informative when in fact they arise from mutually amplifying responses to noise. 

Under such conditions, algorithmic strategies can suffer heavy losses. They do so not because of "computer error" but because of the faithful execution of programs that are responding mechanically to market data. The decision by Nasdaq to "cancel trades of 286 securities that fell or rose more than 60 percent from their prices at 2:40 p.m." might therefore be a mistake: it protects such strategies from their own flaws and allows them to proliferate further. Canceling trades can be justified in response to genuine human or machine error, but not in response to the implementation of flawed algorithms.

I don't know how the losses and gains from yesterday's turmoil were distributed among algorithmic traders and other market participants, but it is conceivable that part of the bounce back was driven by individuals who were alert to fundamental values and recognized a buying opportunity. The following clip of Jim Cramer urging viewers to buy Proctor and Gamble just moments before a sharp recovery in its price is suggestive:

I would be very interested to know whether the transfer of wealth that took place yesterday as prices plunged and then recovered resulted in major losses or gains for the funds using algorithmic trading strategies. I expect that those engaged in cross-market or spot-futures arbitrage would have profited handsomely, at the expense of those relying on some form of momentum based strategies. If so, then the cancellation of trades will simply set the stage for a recurrence of these events sooner rather than later.

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I thank Charles Davi for alerting me to the Financial Times piece on algorithmic trading, and Jens Kayenburg (a student in my Financial Economics course this semester) for sending me a link to the Cramer clip.

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Update (5/7). David Merkel is also opposed to the cancellation of trades:

[My] sense of the day is that some algorithmic trading programs went wild, and made trades that no sane human would... NASDAQ should not have canceled the trades.  It ruins the incentives of market actors during a panic. Set your programs so that they don’t so stupid things. Don’t give them the idea that if they do something really stupid, there will be a do-over. In the absence of fraud, trades should not be canceled.

And here's Yves Smith's take on the events of yesterday:

The idea that a fat-fingered trade out of Citi was the cause has been denied by the bank. The downdraft did have the look of a monster sell order, but the more credible explanation is that it was either a sudden rise in yen or the euro hitting the magic number 1.225 to the dollar that set off algorithmic traders. And enough of them look to similar indicators and technical levels that it isn’t hard to see this as the son of program trading, mindless computer-driven selling when the right triggers are hit.

But another side effect of today’s equity market gyrations is further distrust in the markets, particularly by retail buyers. I am told that various retail trading platforms were simply not operating during the acute downdraft and rebound. I couldn’t access hoi polloi Bloomberg news or data pages then either. The idea that the pros could trade (even if a lot of those trades are cancelled) while the little guy was shut out reinforces the perception that the markets are treacherous and the odds are stacked in favor of the big players (even though we all understand that, it isn’t supposed to be this blatant).

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Update (5/8). Here's an important point about liquidity by Paul Kedrosky:

Largely unnoticed... the provision of liquidity has changed immensely in recent years. It is more fickle, less predictable, and more prone to disappearing suddenly, like snow sublimating straight to vapor during a spring heat wave. Why? Because traditional providers of liquidity, market-makers and other participants, are not standing so ready to make the other side of the market. There are fewer traders prepared to make a market for the sake of market health. This is partly because they can, but mostly because of what has happened with high-frequency trading, algorithms, and the like, which increasingly jump into the trading queue in front of and around orders, creating some liquidity, but also peeling pennies for themselves, frustrating market participants and heretofore liquidity providers, but in the course of normal business generally accepted as a price that gets paid to the market's battle bots.

But all of this changes market microstructure in insidiously destabilizing ways. For the first time we have large providers of this shadow liquidity, algorithms and high-frequency sorts, that individually account for large percentages of daily trading activity, and, at the same time, that can be turned off with a switch, or at an algorithmic whim. As a result, in market crises, when liquidity was always hardest to find, it now doesn't just become hard to find, it disappears altogether, like water rushing out sight via a trapdoor to hell. Old-style market-makers are standing aside as panicky orders pour in, and they look straight at shadow liquidity providers and say, "No thanks. You battle bots take it". And, they don't.

David Murphy, who is always worth reading, thinks that its time to put some sand in the algorithmic wheels:

It is time to... throw some sand in the cogs of the algos. If every trade executed in the same, say, five second interval got the same price, instability would be greatly reduced, yet ordinary investors would not notice the effect. And if every trade were executed on the NYSE, or at least using the same market conventions, then officials could actually stop everything when things get out of hand.

I spoke with Zack Goldfarb of the Washington Post yesterday for an interesting article that ran today. The point I was trying to make is this: the problem lies not so much with the method of trading (algorithmic or otherwise) but with the underlying strategies that are being implemented. Algorithmic trading allows technical strategies to profit and proliferate, and markets dominated by technical analysis will tend to be unstable. If destabilizing strategies are prevented from taking losses when they misfire, the result will be more frequent and significant departures of prices from fundamentals. Hence my concern over the cancellation of trades.

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Update (5/9). CBS Evening News had a report on this yesterday, including a couple of clips from a conversation I had with Tony Guida earlier in the day. As with most media reports on the topic, the focus is on automation, scale and speed rather than the kinds of trading strategies that these methods allow speculators to implement. We did cover this ground in the interview but (understandably, I suppose) it didn't make it into the broadcast. 

Reputational Capital and Incentives in Organizations

The following passage, jarring in light of recent revelations, appears in the opening pages of Akerlof and Kranton's recently published book on Identity Economics:

On Wall Street, reputedly, the name of the game is making money. Charles Ellis' history of Goldman Sachs shows that, paradoxically, the partnership's success comes from subordinating that goal, at least in the short run. Rather, the company's financial success has stemmed from an ideal remarkably like that of the U.S. Air Force: "Service before Self." Employees believe, above all, that they are to serve the firm. As a managing director recently told us: "At Goldman we run to the fire." Goldman Sachs' Business Principles, fourteen of them, were composed in the 1970s by the firm's co-chairman, John Whitehead, who feared that the firm might lose its core values as it grew. The first Principle is "Our clients' interests always come first. Our experience shows that if we serve our clients well, our own success will follow." The principles also mandate dedication to teamwork, innovation, and strict adherence to rules and standards. The final principle is "Integrity and honesty are at the heart of our business. We expect our people to maintain high ethical standards in everything they do, both in their work for the firm and in their personal lives."

If the preservation of its reputation for serving the interests of its clients was a major organizational goal for Goldman, then something clearly went terribly wrong. Consider, for example, Chris Nicholson's report on the manner in which the bank managed to shed its holdings of mortgage backed securities shortly before they collapsed in value, allegedly serving itself "at the expense of its clients." Nicholson reproduces the following email from an employee at the European sales desk to the head of mortgage trading: 

Real bad feeling across European sales about some of the trades we did with clients. The damage this has done to our franchise is very significant. Aggregate loss of our clients on just these 5 trades along is 1bln+. In addition team feels that recognition (sales credits and otherwise) they received for getting this business done was not consistent at all with money it ended making/saving the firm.

Felix Salmon considers this email to be "particularly damning" for the following reasons:

Illiquid things like CDOs are sold as much as they’re bought, and Goldman’s highly-paid sales team was aggressively going out and selling instruments which were at one point on Goldman’s balance sheet and which wound up cratering in value.

The effects were twofold: firstly, the Goldman clients who got stuck with this nuclear waste when the music stopped were understandably none too impressed with Goldman. And secondly, Goldman managed to stick the losses on those instruments to its clients, rather than taking those losses itself, and as a result its profits were billions of dollars higher than they would otherwise have been.

Was the hit to Goldman’s franchise value a hit worth taking, given the billions of dollars it saved? Probably yes, until the SEC and Carl Levin came along.

But the possibility that the SEC and Mr. Levin would eventually come along was always there. This is a form of tail risk that is not unlike that taken by the folks at the AIG financial products division when they sold vast amounts of credit protection in the mistaken belief that they would never be faced with significant collateral calls. Raghuram Rajan, in a remarkably prescient 2005 paper, described this process as follows:

Consider the incentive to take on risk that is not in the [compensation] benchmark and is not observable to investors. A number of insurance companies and pension funds have entered the credit derivatives market to sell guarantees against a company defaulting. Essentially, these investment managers collect premia in ordinary times from people buying the guarantees. With very small probability, however, the company will default, forcing the guarantor to pay out a large amount. The investment managers are, thus, selling disaster insurance or, equivalently, taking on “peso” or tail risks, which produce a positive return most of the time as compensation for a rare very negative return. These strategies have the appearance of producing very high alphas (high returns for low risk), so managers have an incentive to load up on them. Every once in a while, however, they will blow up. Since true performance can be estimated only over a long period, far exceeding the horizon set by the average manager’s incentives, managers will take these risks if they can.

As in the case of tail risks arising from the sale of credit protection, damage to the firm's franchise value does not appear in standard compensation benchmarks. The problem in Goldman's case was not that such damage was "a hit worth taking" but rather that the incentives faced by its employees did not adequately reflect the value of the firm's reputation in the first place. To the extent that employee behavior is responsive to such incentives, the sacrifice of reputation for immediate profit will be made regardless of whether or not, in the broader scheme of things, the damage to franchise value exceeds the short term gains.

How, then, might a firm accomplish the subordination of short term goals to long term objectives in practice? There are two possibilities: one could hire individuals who are predisposed to behave in a principled manner even in the face of incentives not to do so, or one could design compensation schemes that adequately reward actions that preserve or enhance reputation. Economists, being fervent believers in the power of incentives, usually tend to favor the latter approach. But in this particular context, there are two possible problems with this. First, the contribution of any given transaction to the reputation of the firm is generally much more difficult to ascertain and quantify than any contribution to the firm's balance sheet. This makes it difficult to assign reward appropriately. Second, in order to serve as credible commitments to clients and customers, compensation schemes must be easily observable and not subject to renegotiation after the fact. This is seldom the case.

The alternative is to hire individuals who are predisposed to behave in a manner that meets organizational objectives: to place a premium not only on ability but also on character. But would this not create incentives for potential employees to simply misrepresent their values? As Groucho Marx famously said: "The secret of life is honesty and fair dealing... if you can fake that, you've got it made." 

Fortunately, the consistent misrepresentation of personality traits is often infeasible or prohibitively costly. There is an interesting line of research in economics, dating back to Schelling and continuing through Hirshleifer and Frank, that explores the commitment value of traits that are costly to fake. Hirshleifer went so far as to argue that the "absence of self-interest can pay off even measured in terms of material selfish gain, and... the loss of control that makes calculated behavior impossible can be more profitable than calculated optimization... we ought not to prejudge the question as to whether the observed limitations upon the human ability to pursue self-interested rationality are really no more than imperfections -- might not these seeming disabilities actually be functional?" 

One could take this a step further: not only might limitations on the unbridled pursuit of material self-interest be functional for individuals, they may also be functional for the organizations to which they belong. And in the long run, firms that manage to identify and promote such individuals will prosper at the expense of those who are unable or unwilling to do so.

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Update (5/2). At the end of the post I linked to above, Felix Salmon asks:

Let’s say you work at an investment bank and you’re in charge of a book which includes a $1 billion barrel of toxic nuclear waste. You know that barrel is going to zero sooner or later, and you manage to sell it to some European dupes just in time, for full face value, saving your bank from $1 billion in losses. How much of a bonus, if any, should you get on that deal, and where should the money come from? And should you feel bad about avoiding the losses and sticking them to your clients instead?

In a comment on that post, The Epicurean Dealmaker responds:

The answer depends. If you are a proprietary trading shop your job is to make money (and avoid losses) at all costs. In fact, you have a fiduciary duty to somebody (eg, limited partners or shareholders) to do so. You sell the crap and never look back. Caveat emptor rules.

If you are a traditional investment bank, you find out which morons allowed $1 billion of concentrated toxic risk to accumulate on your balance sheet and you fire their incompetent asses for cause (ie, no bonuses, no golden parachutes). Then you convene the Executive Committee to decide whether it is worth permanently damaging your franchise as a supposedly neutral market maker by offloading the waste before it blows up onto your clients, or whether you should eat the loss as punishment for failure...

This is why trying to run a large proprietary trading operation inside a traditional market-making investment bank introduces a fundamental, highly dangerous conflict of interest. At a small scale, this kind of stuff happens all the time, and should, in a traditional investment bank. However, it should never reach the scale that threatens the short- or long-term future of the bank.

This gets it about right in my opinion. See also the many excellent comments along these lines on Mark Thoma's page. Mark links to a related post by Richard Green, who in turn mentions pieces by James Surowiecki and Yves Smith that are both worth reading. Here is Yves' bottom line:

Legal issues aside, it isn’t merely the great unwashed public that is taking an increasingly dim view of Goldman. What is striking is the change in sentiment among professionals.

Recall Goldman’s reputation: that of being the best managed firm on the Street, and its boasting about its risk management as key to its superior profits... its once-vaunted risk management, which led observers to believe that Goldman was doing a better job of managing exposures, now increasingly looks like the firm was simply more systematic and aggressive than its peers in not just shifting risks onto customers but engaging in further profit-maximizing strategies that look downright predatory...

Goldman is increasingly beleagured. Its lobbyists are now pariahs. More private lawsuits are coming to the fore. There are rumors it is in settlement talks with the SEC. But the once-storied firm apparently turned its well oiled machine to ruthless profit-seeking. It is an open question how much damage the firm will sustain from the well-deserved backlash, and whether it can change its conduct. 

Indeed.

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Update (5/4). As usual, there are a number of excellent comments on Mark Thoma's page. Here's Roger Chittum:

Goldman and the other IBs are in a very different business now than they were in the 1970s. Formerly, their business was representing real-economy clients for generous fees in facilitating mergers, acquisitions, spin-offs, IPOs, bridge loans, restructurings, and other balance sheet transactions, in which they sometimes took participations. Their reputations were quite important to relationship building with the few firms that could afford their services and with the investors to whom they returned again and again. In fact, they used to regard proprietary trading as a business that was beneath them. Thus, Solomon Brothers, for example, which early on was very active in trading, especially in government securities, was not in the top tier reputationally.

In recent years, the businesses and cultures of the IBs have been transformed. Something like 75% of their profits now come from proprietary trading, and the top executives have come up through trading instead of the white shoe service businesses. They are essentially now hedge funds with advisory groups appendages. And they are dangerous and unapologetic predators.

It may be possible to have commercial banks and investment banks as formerly constituted have common ethical cultures that are concerned with the longer term and institutional reputations, but I don't see how that can happen that can happen in hedge funds and proprietary trading units. Each of the big IBs has a story of internal culture struggles as their businesses changed, and notice the recent reports of culture clash arising out of the dysfunctional forced marriage of BofA and Merrill.

Glass Steagall put the wall between commercial banking and investment banking. Perhaps commercial banking and fee-based investment banking in the 1970s style could thrive with a common culture, but proprietary trading needs to be hived off. There are irreconcilable differences there.

To which mrrunangun adds:

Another difference is that in Whitehead's time, GS was a partnership and the great bulk of the partners' wealth was their interest in the partnership. Any failure in the partnership had the potential of creating losses for all of the partners. The long-term success of the partnership was crucial to the long-term security of the partners.

In the public company that GS became, none of that discipline remained to restrain the people running the company from exploiting their position in order to maximize the short-term profits on which their claims to enormous annual pay packages were supposedly based. In contemporary practice, boards of directors are generally much more sympathetic to management than to shareholders. Boards put shareholders first only in small companies where the board is made up of the owners, who have a significant stake in the success of the enterprise, and perhaps their attorney and/or auditor. In medium to large company practice, the CEO generally recruits the board, probably always if the CEO serves as board chairman as well. Board members who are not inside directors rarely have a critical portion of their own wealth in the companies on whose boards they serve.

Then there's Bruce Wilder:

On the issue of "aligning incentives" for individuals, I can tell you what the right scheme looks like: it looks like a fixed salary, with modest "options" in the form of (mostly honorary in magnitude) raises and bonuses.

At the very top of a business enterprise, it makes sense to make top executives buy a substantial interest in the firm -- to essentially become "partners". The top executives don't have to own a large part of the firm, but their ownership interest has to be a large part of their personal wealth. And, it should not be a gift -- no free options; make them buy it, and make it hard to sell: a large part of their ownership interest should be tied up in trusts.

The top executives of large corporations really shouldn't be paid in "performance" contingent options. Shocking I know, but executive leadership has little to do with the piece-work of a sweat-shop or a cucumber field.

And, they shouldn't be paid in magnitudes that could make them independently wealthy in a single calendar year. 

Magnitude matters, and it can easily overwhelm any contingent "alignment" of incentives... If you promise to pay someone a vast amount, realizable in the short-term, contingent on some abstract score-keeping scheme, you are incentivizing (horrible word) them to corrupt the score-keeping. You are asking them to lie.

Rajiv Sethi comes around to this issue, via personal character and the difficulty most of the non-psychopaths among us have, in lying.

He might also consider that Goldman is a vast, hierarchical organization, embedded in a market-exchange network, all of which -- hierarchy and network -- consists entirely of generating and reporting numbers, as part of a complex scheme of compound control.
This system cannot function, if the participants have too much of an incentive to corrupt the reported numbers. If people at the top of the hierarchy, or the clients, or the counter-parties, or on-lookers in the same and related markets, get the "wrong" numbers, things go terribly wrong.

 Bruce also points to the following from Mike Konzal of Rortybomb:

To keep this in economic terms, this crisis has shown a wave of agency problems embedded inside financial institutions. The best phrase for why people were motivated to do the things they do is simple: IBGYBG–I’ll be gone, you’ll be gone.

The other obvious market failure is that in a ruthlessly competitive arena that is judged primarily on quantitative measures, any ability to juke your statistics forces others to participate in that as well. We see this in a variety of ways I can describe if people are interested, but if your competition is repo 105ing their balance sheet to make it look like they are getting better returns with less leverage, they are going to get better deals on customers and capital than you are going to get and put you out of business. So you better do that as well. The notion of Milton Friedman-ite self-regulation through reputation effects has been a complete failure.

This echoes Richard Serlin's comments below. And then there's this from an anonymous source:

My thought reading Sethi's post and also TED's latest was this:

Decades ago the investment banks stopped hiring the scions of wealthy families expecting a sinecure, and started looking for people who were smart and "hungry" (as Grisham has put it). They asked applicants "What would you do if you won the lottery?" And if you made it clear that you didn't really care about the money, you weren't the right person for them.

And as TED makes clear the people who make it to the top at the investment banks are the hungriest sharks. The people who aren't really hungry (and I think there are plenty of them), make enough and leave, or walk when they feel they're asked to do something that compromises their integrity. So there's a huge endogeneity problem here.

Finally, paine is skeptical of the idea that "we can create eisenhowerish org men and then blend em with fresh new corporate norms" on the grounds that competitive pressure transforms character. It's a fair point.

Trading Strategies and Market Efficiency

Here is David Merkel's tenth rule:

The more entities manage for total return, the more unstable the financial system becomes.

The shorter the performance horizon, the more volatile the market becomes, and the more index-like managers become. This is not a contradiction, because volatile markets initially force out those would bring stability, until things are dramatically out of whack...

Momentum persists in the short run, so play it if you must, remembering that the market gets more volatile when many play momentum.

This is an important point with some very interesting implications for market efficiency and volatility clustering.

In a well functioning market, asset prices are supposed to reflect the best available information about anticipated earnings flows and the risk-sensitive rates at which these should be capitalized. But the only way in which such information can come to be reflected in prices is through the trading activity of those who are alert to changes in information. A market dominated by such "information traders" will tend to be stable in the sense that prices will reliably track changes in information about underlying asset values.

Such adjustments may be rapid but they are never instantaneous. This means that in a market that is functioning well, price movements (and other market data) can reveal some information about changes in underlying values to those who have not incurred the resource costs of acquiring the information directly. This, in turn, can make technical analysis profitable.

On the other hand, in a market dominated by technical analysis, changes in prices and other market data will be less reliable indicators of changes in information regarding underlying asset values. The possibility then arises of market instability, as individuals respond to price changes as if they were informative when in fact they arise from mutually amplifying responses to noise.

But if market stability depends on the composition of trading strategies, what determines this composition itself? A key determinant is past performance: strategies that have recently given rise to strong returns will come to represent a greater share of total trading volume both because wealth has been transferred to those executing such strategies, and because they will attract new funds. In stable markets with informative price movements, the incidence of technical analysis will grow. If it grows too much, the market will be destabilized and an asset price bubble could form. Information based strategies will initially suffer from this, but those with the confidence and liquidity to persist in using them will prosper eventually once the inevitable correction arrives.

In other words, one ought not to expect markets to be efficient or inefficient, but rather to experience periods of relative efficiency that are interrupted from time to time by severe disruptions. This is a phenomenon I described in a 1996 paper as endogenous regime switching:

Behavior conducive to stability... may be most profitable when the market is unstable, and behavior conducive to instability... may be rather lucrative in a stable market when it is costly to collect information about fundamentals. There is a sense in which the two groups of speculators enjoy a symbiotic relationship with each other: each group benefits from an increase in the numbers of the other.... As a result, one would expect heterogeneity of practices to persist in the long run, with the dominance of one set of practices giving way to that of the other. The implication for speculative markets is that periods of tranquility are likely to be punctuated from time to time by periods of excessive volatility.

This paper builds on work by Beja and Goldman and Carl Chiarella, who had earlier examined the price implications of heterogeneous trading strategies without allowing for endogenous changes in population composition. The model itself is simple and stylized, but I believe that the basic idea underlying it is sound. Destabilizing strategies will prosper and spread when they are sufficiently rare, giving rise at some point to market instability, and the eventual return of stabilizing strategies. Neither perfect efficiency nor drastic inefficiency can last indefinitely, as each regime gives rise to changes in behavior that serve to undermine its own existence.

Some Further Comments on the Leverage Cycle

In a previous post I discussed a paper by John Geanakoplos on the Leverage Cycle (due to appear in the NBER Macroeconomics Annual later this year). I presented this paper in the Columbia finance reading group last Thursday, and have posted my slides in case anyone is interested in taking a look.  

The paper is considerably more accessible to the general reader than most of the recent theoretical literature on the financial crisis. It avoids the standard theorem-and-proof format, and consists instead of a sequence of elaborate numerical examples that fit together like a jigsaw puzzle. It also contains a number of very interesting ideas and insights, many more than I was able to discuss in my earlier post. 

One of the key features of the Geanakoplos model is that the same set of physical assets can serve as collateral multiple times for loans of different maturities. For example, housing serves as collateral for long-term loans in the mortgage market, while the loans themselves (after securitization and tranching) can serve as collateral for short-term borrowing in the repo market. Geanakoplos shows that the extent of leverage in the long-term market will endogenously be such as to allow for a positive probability of default, and is interested in the effects of bad news in this market (interpreted as an increased likelihood of eventual default) on the market for short-term loans backed by financial rather than physical assets.

Among the main insights in the paper is the following: a decline in the expected terminal value of the physical assets will result in a far greater decline in the prices of the financial assets that they back. This happens for three reasons. Most obviously, there is a decline in fundamentals. But the effects of this are amplified because the initial prices (before bad news arrives) reflect the beliefs of the most optimistic market participants, who borrow from the pessimists in order to buy their asset holdings. In other words, the marginal buyer is (endogenously) very optimistic and this is reflected in the market price. The decline in fundamentals not only wipes out these highly leveraged optimists, but also substantially reduces equilibrium leverage in the market. As a result, the decline in the financial asset price is far greater than any market participant's expectations concerning the terminal value of the physical asset.

The careful reader will note that incomplete markets and maturity mismatch play a critical role in this argument. One of the most interesting aspects of the model is that both market incompleteness and maturity transformation arise endogenously, and the asset prices at various points in the tree of uncertainty are all correctly anticipated. The results are driven not by irrational exuberance or systematic biases, but by heterogeneous preferences and beliefs, and changes over time in equilibrium leverage. It's a precise, rigorous and carefully constructed interpretation of recent events, based on work that was done well before this crisis erupted.

In response to my earlier post on this paper, David at Deus Ex Macchiato agreed that the work is important, but added:

What astonishes me however is that this is in any way news to the economics community. Ever since Galbraith’s account of the importance of leverage in the ‘29 crash, haven’t we known that leverage determines asset prices, and that the bubble/crash cycle is characterised by slowly rising leverage and asset prices followed by a sudden reverse in both?

This is a good question. A lot of the less formal work in this area never made it into the canonical models taught to successive cohorts of graduate students in economics. Geanakoplos doesn't mention Galbraith explicitly, but he does mention Minsky and Tobin, who themselves were surely familiar with Galbraith's work on the crash. Implicit in David's question is the accusation that the training of professional economists has become too narrow, and on this point I believe that he is absolutely correct.

Claiming Ancestors

Here is Ta-Nehisi Coates on the subject of cultural ancestry, at the end of an expansive post on slavery, the Civil War, and Robert E. Lee:

Finally, there's the question of how we claim ancestors, a question that is more philosophical than biological. Africa, and African-America, means something to me because I claim it as such--but I claim much more. I claim Fitzgerald, whatever he thought of me, because I see myself in Gatsby. I claim Steinbeck because, whether he likes it or not, I am an Okie. I claim Blake because "London" feels like the hood to me.

And I claim them right alongside Lucille Clifton, James Baldwin and Ralph Wiley, who had it so right when he parried Saul Bellow. The dead, and the work they leave---the good and bad--is the work of humanity and thus says something of us all. And in that manner, I must be humble and claim some of Lee, Jackson, and Forrest. What might I have been in another skin, in another country, in another time?

It is not often that one encounters such willingness to recognize and lay claim to one's cultural ancestors in defiance of contemporary racial boundaries. But in America, of all places, the scope for such appropriation is enormous. Ralph Ellison explained the reasons for this with crystal clarity in a remarkable essay published forty years ago:

For one thing, the American nation is in a sense the product of the American language, a colloquial speech that began emerging long before the British colonials and Africans were transformed into Americans. It is a language that evolved from the king's English but, basing itself upon the realities of the American land and colonial institutions—or lack of institutions, began quite early as a vernacular revolt against the signs, symbols, manners and authority of the mother country. It is a language that began by merging the sounds of many tongues, brought together in the struggle of diverse regions. And whether it is admitted or not, much of the sound of that language is derived from the timbre of the African voice and the listening habits of the African ear...

Its flexibility, its musicality, its rhythms, freewheeling diction and metaphors... were absorbed by the creators of our great 19th century literature even when the majority of blacks were still enslaved. Mark Twain celebrated it in the prose of Huckleberry Finn; without the presence of blacks, the book could not have been written. No Huck and Jim, no American novel as we know it. For not only is the black man a co-creator of the language that Mark Twain raised to the level of literary eloquence, but Jim's condition as American and Huck's commitment to freedom are at the moral center of the novel.

In other words, had there been no blacks, certain creative tensions arising from the cross-purposes of whites and blacks would also not have existed. Not only would there have been no Faulkner; there would have been no Stephen Crane, who found certain basic themes of his writing in the Civil War. Thus, also, there would have been no Hemingway, who took Crane as a source and guide...

Without the presence of blacks, our political history would have been otherwise. No slave economy, no Civil War; no violent destruction of the Reconstruction; no K.K.K. and no Jim Crow system. And without the disenfranchisement of black Americans and the manipulation of racial fears and prejudices, the disproportionate impact of white Southern politicians upon our domestic and foreign policies would have been impossible. Indeed, it is almost impossible to conceive of what our political system would have become without the snarl of forces—cultural, racial, religious—that makes our nation what it is today.

I came across the essay thanks to Andrew Sullivan, who posted an excerpt on his blog last October. Sullivan independently discovered the truth of Ellison's claims through the fresh eyes of an immigrant to the United States:

It struck me almost at once, if only in the music I heard all around me - and then in so many other linguistic, cultural, rhetorical, spiritual ways: white Americans do not realize how black they are. Even their whiteness is partly scavenged from the fear of - and attraction to - its opposite... From the beginning, in its very marrow, this country was forged out of that racial and cultural interaction.

Rod Dreher, himself a product of the American South, came to the same realization while traveling overseas:

I'd spent several weeks traveling around Europe the summer before my junior year in college, and came to understand after being around all those fellow white people that deep down, we Americans have been deeply shaped by the black experience... for a white Southern boy like me to spend six weeks in the Heart of Whiteness was to feel my own Americanness to the marrow for the first time... and to surprise myself by recognizing that the main reason I was so different from these people who looked just like me was because I had been raised in a culture profoundly shaped by black Americans. 

Ta-Nehisi Coates is right to insist that the question of how we claim our ancestors is "more philosophical than biological." And it is entirely appropriate that he began his post with a quotation from Ralph Wiley, who answered Saul Bellow's famous taunt "Who is the Tolstoy of the Zulus?" with the brilliant and wise retort "Tolstoy is the Tolstoy of the Zulus -- unless you find a profit in fencing off universal properties of mankind into exclusive tribal ownership."

For me personally, it was liberating to see Coates claim Fitzgerald and Steinbeck and Blake alongside Clifton and Baldwin and Wiley. I too claim Baldwin, whose Notes of a Native Son I first read with choking emotion in a village in Sierra Leone at the age of twenty-one, and whose funeral service at the Cathedral of St. John the Divine I attended just a few weeks after first entering the United States as a graduate student. He is no less an ancestor of mine than Rushdie or Kureishi, and I am no less a descendant for not having his blood coursing through my veins.