Paranoid Bull

Rather than trying to fit all of my thoughts into a blog post, I took a shot at creating a video blog post explaining where we are in the crisis, reiterating what I see as the causes and where we should go from here.

A number of you have asked me to sum up my thoughts on the causes of the current crisis.  One way to surmise this is to read some of my some of my posts over the last year, but I will also try to write an extensive post about this at some point soon.
 
In the mean time, at a basic level, my opinion is that the causes of the current turmoil boil down to this:

1. Hubris: People massively overestimated their ability to analyze the future with simple financial models.
2. Leverage: Regulatory institutions encouraged risk-taking by turning a blind eye to capital controls and other limitations on leverage.
3. Innovation: Financial innovation pushed the envelope as securitization driven by 1) and 2) fueled a massive real estate and private equity boom.
4. Incentives: At each step of the process, incentives were put in place for individuals to create deal flow, issue more mortgages, buy more companies, and otherwise push more paper. At no point did any individual feel that the risks they were creating would be born by them personally…and as it turns out, even by their firms.
5. Reinforcement: A continuing rising tide convinced each of the players that the models worked, that the system was properly tuned and that nothing was wrong.
6. Reality: It turned out that the models were vastly over-simplified, that the world was different than expected, and there was too much leverage in the system gone haywire to turn it around.

The key takeaway from all of this is simple: Finance is as much art as it is science, and as such it is much more difficult to model than any other science.

Never forget: Finance is not Physics. The so-called “risk free” rate is not analogous to the speed of light. It is not a truth in any hard sense. 

Nicholas Taleb explains in this article why some risks are difficult to estimate: The Fourth Quadrant: A Map of the Limits of Statistics

When Nassim Taleb talks about the limits of statistics, he becomes outraged. “My outrage,” he says, “is aimed at the scientist-charlatan putting society at risk using statistical methods. This is similar to iatrogenics, the study of the doctor putting the patient at risk.” 

Without any of the above factors, we would not be where we are today. Where to go from here is something I am also hoping to spend some time thinking about soon.

Imagine watching the water rise in your home…first just a trickle through the bottom of the door, then to your ankles, then to your waist…

People in New Orleans and now Galveston have experienced the feeling of literally watching their homes flood before their eyes.

Thankfully, many people in Galveston evacuated before Hurricane Ike hammered the island south of Houston before this weekend’s storm. However, even those who left are now facing the aftermath of a storm that flooded most of Galveston Island.

Some of these homeowners will be able to pick up and start over thanks to the flood insurance policies they purchased. Unfortunately, some homeowners did not buy insurance, and for these unlucky few, when they return home they will have almost nothing left.

A similar phenomena has been occurring in the financial markets.

Many institutions took risks, and rather than buying insurance (in the form of conservative practices), they decided to rough it, perhaps convinced like a few stubborn Galveston homeowners, that because it had not flooded for the last twenty years, that it would not flood this time around.

The horrible irony of the flood analogy is that for many of these institutions, and more offensively their shareholders, they did not have to buy insurance because the federal government stood waiting in the wings to bail them out. At the same time, many home owners will not be as lucky…sure they might get a FEMA check to help with some of their relocation expenses, but they will be wiped out – because they took a risk (living by the water) and did not protect against it (buy flood insurance).

Tonight the Federal Government has agreed to loan AIG $85 B dollars in exchange for a majority stake in the company in order to avoid the dreaded CDS Scenarios alluded to in my previous post (AIG Gets $85 Billion Fed Loan, Cedes Control to Avert Collapse).

In the most twisted of ironies, the Federal Government is acting as an insurer to an insurer who failed to insure itself like any responsible citizen.

Although it is unclear from the current news whether AIG shareholders will be completely wiped out, if they – like their Bear Stearns brethren before them – receive anything more than $0, this is truly a deplorable decision.

As I mentioned at the time of the Bear Stearns decision, I understand that the government feels the need to prevent the kind of systematic calamity that would exist if a massive counterparty failed  – especially one the size of AIG who is a participant as a principal in far more markets than Lehman or Bear Stearns. However, they should do as they did for Freddie and Fannie and eliminate the equity value of the firm. If AIG has truly failed, then let it be so.

The alternative – for the Fed to act as an after-the-fact insurance policy when the storm comes – undermines the very free market that the current administration claims to support.

My heart goes out to the families in Galveston, and the workers at Lehman and on main street who are suffering in the midst of our nations greatest financial challenge since the Great Depression.

I only hope our leaders use these decisions as lessons learned to develop more reasonable principles and to reach fairer decisions in the future…and in the mean time, I hope they have not done what it appears they might have done in jeapordizing the financial wherewithal of the federal government to protect shareholders of irresponsible institutions.

As I write this, according to the Financial Times (here), some of my former colleagues are shuffling out of their offices at Lehman Brothers’ Headquarters on 7th Avenue in New York. The Internet is swarming with news suggesting that Lehman Brothers may be filing for bankruptcy tonight, marking the end of an era for a great firm, who also happens to be my first employer.

Only on a weekend when my hometown of Clear Lake (a suburb of Houston) was hammered by the biggest hurricane of my lifetime and my great-aunt passed away, could the news of Lehman going bankrupt be the third worst piece of news I have received over the last few days.

The failure of Lehman is not only sad because of the fact that so many of my friends and former colleagues will likely be unemployed tomorrow, but it is also scary because it has massive implications for the various different financial players who have contracts with Lehman as a counterparty.

As I noted here in January: The Fan, the risk of a major CDS counter-party failing has been my biggest fear about the credit crisis since I first started blogging about all of this last summer.  This post explains CDS: CDS = Crazy Derivatives Stuff.

Thankfully, the Federal Reserve appears to have orchestrated an emergency trading session today (Derivatives Market Trades on Sunday to Cut Lehman Risk) in an attempt to avert disaster Monday morning.

However, given the fact that the various players in this market were unable to anticipate Lehman’s failure, how can we have confidence that they will be able to anticipate the wide-ranging implications that Lehman’s bankruptcy will have?

It is hard to imagine that it was only last week that the government decided that it would be necessary to bail out Fannie and Freddie: Government Bails Out Fannie Mae and Freddie Mac

Apparently Mr. Paulson and the SEC orchestrated meetings with all of Wall Street’s leading players on Friday and over the weekend in an attempt to find a savior for Lehman. That no one was willing to step up to the plate only indicates how dire the situation truly has become.

If I had to guess, I would imagine that the challenge of estimating the potential liability associated with Lehman’s massive balance sheet in addition to the challenges in valuing its large real estate portfolio were stumbling blocks.

However, the larger reason why no one saved Lehman may be because no one could. Although some commentators at the WSJ speculate that Potential suitors were selfish in their analysis, the more likely reality is that any potential buyer is facing large challenges of their own today.

Remember, the Federal Government, the buyer of last resort, has already been tapped to support the entire real estate market through its support for Fannie and Freddie, suggesting that another Treasury backed purchase is not only impractical but likely infeasible. Furthermore, Goldman, Morgan Stanley and the other Wall Street players have billions of dollars of illiquid assets and untold counterparty risks of their own to wrestle with.

Apparently, Bank of America may be swooping in to save Merrill Lynch from the backdraft from Lehman’s implosion, but even this move is not without a large degree of risk for the largest domestic retail banking institution who has already taken on the risk associated with its Countrywide purchase last fall.

And if all this news isn’t bad enough, AIG is also on the brink of a downgrade which may force it to tap the Fed for up to $40B in loans as it seeks to avoid Lehman’s fate (AIG Seeks $40B Bridge Loan). As an insurer, AIG’s failure would have even broader implications for the derivatives markets than Lehman’s failure will.

I hope that by some miracle we wake up tomorrow and Lehman is still standing with no bankruptcy filing in hand. (Update: Just after Midnight EST Lehman confirmed that the holding company is filing for Chapter 11). I sincerely believe Lehman is a great firm filled with brilliant and good people, which is what makes its failure all the more difficult to stomach.

Unfortunately, it is also a product of a system that has collectively overestimated its ability to predict the future and assess risk. The collective machine that is our financial markets was ruled by hubris and incentives that created innovation and leverage based on a worldview that turned out to be flawed.

And as we continue to witness the unwinding of this leverage, which unfortunately still has a long way to go, we will unfortunately continue to see more failures and losses borne by individuals who are a product of this system that is beyond anyone’s control.

This was a sad weekend. Let’s hope for a brighter tomorrow.

Transitions in life seem to come up more often when one is in graduate school…or at least I have convinced myself that I am at yet another transition point as I head into the final year of my four year JD-MBA program.

On the one hand, this next year will be just like any other in my life:  it will consist of 365 days, some of which will be good and some bad. I will meet people, get back in touch, travel, do things, learn…

But I guess the idea that the world is my oyster waiting for me to paint the canvas down the path less traveled into the wild blue yonder only has so much of a half-life.

I used to morbidly joke with friends that if I hadn’t become famous or successful by the age of 27 then my life would be over – figuratively and literally.

That year came and went, but thankfully I had school in my back pocket to justify why I was still waiting to make my mark.

Now that the prospect of graduation is looming on the horizon, I guess I am realizing that I don’t have any more ready-made society-tested excuses for not yet being “great”.

When I was in junior high school, the disciplinarian assistant principal, used to sit me down in his office and tell me about how his next-door neighbor “had so much potential, but never made anything of it…because he was a jerk.” Although the story didn’t get me to joke less or pay attention more, the idea of being stunted in realizing my potential has subconsciously haunted me for as long as I can remember.

So now as I head into the final year of this important-sounding program, I look in the mirror and search for the potential-realized, and when I am honest, I know that it has not yet happened.

A friend of mine who is successful by almost any measure recently talked with me about this feeling, which is exemplified by the test crammed for, the race ran three-quarters speed, the first-draft of a blog-post hastily thrown out into the Interwebs. By never putting a full effort forward, we avoid both great accomplishment and disappointment because we have a built in excuse…of course we could have done better if we had only given it our “full effort.”

So maybe this year marks the transition to when I finally need to stop putting my accomplishments in the distant future. I want to give it my all-or-nothing, everything-at-once very best effort.

The only thing is…I still don’t know what to do with or where to put all of these so-called efforts.  That’s the trouble with life: it doesn’t come with a guidebook.

So maybe instead, these “transitions” will keep coming…at moments where reflection dominates, places change, faces are new, and questions of the future direction of the current chapter come into focus.

That doesn’t mean I will stop fretting about this transition year. But maybe it means I have a bit more time before I have to stop dreaming about doing something truly great.

I have decided that I am going to try to stop with all of the dark talk here and elsewhere. The bells have been sounded, the destructive trend was anticipated, and for those close to me who actually listened, hopefully I saved your retirement account a few dollars or something like that.

But as I head into my final year of graduate school, I am realizing that many of the sayings that have echoed in my head about this being “my only shot” and my only having “one life to live” and such sound cliché for a reason – they are true.

Because of that, I am going to try to focus on the “bull” side of the persona and to start using my energy to think of solutions rather than throwing stones in this massive glass house we have constructed for ourselves.

(Those who know me well hear notice the word “try”…old habits die hard).

Part of the inspiration for this move came from an event last night called Mind Share, which featured innovative speakers on a wide variety of topics.

The program, which brings together brilliant and creative people from across Los Angeles for a monthly event of conversation and ideation, featured some brilliant scientists who spoke about some really cool stuff that is going on in the area of vision research, augmented reality, and mind-driven software. I can’t begin to do justice to how cool these technologies were – for example, we saw software that allows you to overlay Darth Vader on a moving scene and a competition between a mind-controlled and traditional remote-controlled pong players.

But the most inspirational part of the talk came in the second half, which was entitled “the Future of Bicycles.” My expectations were low given the title, but the talk turned out to be remarkable. It featured entrepreneurs who were building customized motorized bicycles (www.derringercycles.com), helping to integrate bikes into city living (www.bikestation.org), developing bicycle-based wheelchairs for invalids in the Third-World (www.intelligentmobility.org), and an organization dedicated to sharing the hopeful innovations that are happening around the world including an incredible story about how bicycles helped to revolutionize the coffee industry in Rwanda (www.greenlivingproject.com) and (http://www.spread.org.rw/home.php).

The point is: in the midst of all the darkness in the financial markets – innovation, creativity and solutions continue to exist around the world and especially here in this great country.

Because of this, I am convinced that we will continue to solve the problems that we face – including the pressing problems in the financial markets and in particular in the residential real estate markets where homeowners continue to lose their homes at record rates. Perhaps more importantly, innovative creators will find ways to solve the challenges around global warming and our dependence on fossil fuels. And we will continue to find cooler and more efficient ways to interact with one another.

Clay Shirky’s concept of the Cognitive Surplus is an area that I am going to reflect on over the next period of time. The basic concept is that as a society we have a ton of cognitive processing power that has been wasted staring at a television screen and which we can divert elsewhere. This represents an untapped potential for us to collectively come together to solve these various problems. We have tools at our fingertips – mobile devices, keyboards attached to powerful machines with broadband connections, and other forms of technological enablers. The question now is how to direct our attention to the right problem at the right time and in a way that is organized enough to bring that energy to bear to create a solution.

I believe we will. And no matter how dark the top half of the glass may look – the rest is full…and rising.

Whoever came up with the saying about the other shoe dropping must have lived in a simpler time. They didn’t live in a world where the currency policy of China interacts with the supply of oil in Iraq to impact the availability of financing in Iowa. It is likely the complexity of the modern-day financial system that allows people to continue to be surprised as the now yawn-provoking melodrama of the credit crisis continues to play out like a broken record for those of us who have been paying attention over the past year. People are accustomed to waiting for the other shoe to drop, dodging its trail and then moving along…but this time, those who stop looking up keep getting smacked in the back of the head.

Today a friend forwarded this Forbes article, which as the title suggests, predicts that a large U.S. bank will fail before the end of this crisis:

Large US bank collapse ahead, says ex-IMF economist

I guess the difference between last summer when I started this blog and today is that last year people thought I was just “paranoid” or that those of us who warned of disaster were just being extremists.

But now, a little over a year later, Noriel Roubini, who many see as one of the fathers of the “doomsday” crowd, got a nice spread in the NYTimes magazine. Here is the appropriately titled article.

Dr. Doom

I guess this means that those who had held out hope that the aftermath of the subprime lending boom would be limited in scope have started to wake up to the realization that what we are witnessing is instead a global retrenchment of credit in reaction to years of poor underwriting across a wide variety of asset classes of which home mortgages are only one example.

Unfortunately, I think we have more pain to bear before the economy starts to turn. Moody’s said recently they expect a 10 percent corporate default rate next year, which means that in reality the default rate will be even higher. Consumers still need to restructure and mortgage finance terms are continuing to worsen even as the government implicitly (and explicitly) stands behind Fannie and Freddie.

I hesitate to even acknowledge that the crappy underwriting needs to be corrected, because, like many Americans, I have personally benefited from cheap financing and a forever rising stock market.

For an America that has become accustomed to buying stuff that we like without really worrying about our bank accounts, we are in the process of a rude awakening that is going to take years to digest.

Thankfully, the “other shoe” instead of dropping all all at once, will instead materialize in the form of a steady hail storm with some too-big-pieces on windshields and hoods. We are in the midst of a twenty-mile pile up and the fog is so thick we can’t see those stacked in front of us even though the story is blaring on the radio…and the brakes are out. But thankfully, we have time to prepare for impact, and if we keep our eyes on the road we can hopefully find a way to come out of the other side better for the experience.

The schism between the old and the new in the economy was highlighted today as those who have been resisting the concept of an inevitable U.S. recession were forced into capitulation by the revision of 4th Quarter 2007 GDP, which showed a decline rather than a gain. Although the 2nd Quarter of ‘08 showed a gain of 1.9%, or $106B, this included government transfers of $145 B and defense expenditures of $29B. In other words, without these amounts GDP would have declined in Q2 this year as well.

Perhaps more importantly than whether we have satisfied the text-book definiton of a recession, we are entering a prolongued period of economic hardship characterized by continued housing declines, increased job losses and a slow-down in the Economy. As Greenspan stated today, we are nowhere near a bottom in housing prices, which has been the leading indicator of the downturn.

The continued weakness in the economy is the inevitable result of the excess liquidity of the early-2000’s and unfortunately this pain is inevitable.

However, I have recently been introduced to the economic concept of Creative Destruction which was popularized by economist Joseph Schumpeter.

Basically, the concept, as articulated previously by Hegel in more general conceptual terms, suggests that in order to create the future we must first negate the past. In Economic terms it means that sometimes in order for innovation to occur, we must first sometimes experience the destruction of old ways of doing things.

What we may be witnessing today is the failure of some of the more challenged parts of our economy as individuals are forced to make tough choices as they suffer the cut-backs required by a retrenchment in the amount of leverage in the system. As people’s incomes are squeezed, they are at the same time choosing to drive more fuel efficient cars, utilize more technological tools rather than paper products that consume trees and produce waste, and eat less unhealthy foods. As a result, companies that rely on the old way of doing things are suffering.

Even the SEC, the stodgy old guard of the federal government responsible for the regulation of publicly traded companies, today announced that Blogs can now serve as an outlet for public disclosure in certain cases. The innovation, which is a positive for social media ventures like Twitter and others, is discussed here:

SEC To Recognize Corporate Blogs as Public Disclosure. Can We Now Kill the Press Release?

This move, in the midst of another challenging day in the markets, suggest that progress, creativity and technological innovation will continue, no matter how dark the current environment becomes.

Unfortunately, there is more bad news on the horizon for home values, financial institutions, and the economy. However, if we keep this concept of creative destruction in mind, perhaps the silver lining becomes easier to see.

The markets are up today…and a few companies that I was concerned about beat earnings. This ordinarily should be good news, and in a lot of ways it is. I am very glad that oil is starting to show some signs of cracking. Whether this is sustainable will surely take some time to decipher, and the bad housing news unfortunately does not bode well for the economy.

However, today’s moves in the markets happened to coincide with an exchange that I had with a senior, and brilliant, investor that ended with us coming out on the opposite sides of an issue. The thing is, I feel strongly about my view, and even after considering his perspective I stand beside my own. The challenge for me is that when I am faced with information suggesting some of my views are mistaken, it becomes difficult to remain confident in other parts of my thesis…

How does any of this “markets” talk relate to Twitter?

Twitter for me represents a new form of social interaction. Yesterday at the #smcla event, I experienced a now somewhat usual event: I met someone I have “known” on Twitter for months for the first time “in person.” She was as charming face-to-face as expected, and although I have had a few of these online-offline merges over the last few months, it is still somewhat jarring for the first few seconds of the conversation as the impressions from the textual communications are fused with those of the voice, image, and in person mannerisms.

Twitter has allowed me to interact with a whole new group of people that I likely would have never met if not for its existence. These interactions have also created a new “public” image of myself, where I talk about my daily-goings-on, share small observations on life, and recently, I have even linked my Twitter to this venue of more extensive expressions.

In doing so, I have *opened* myself to the world, and as a result I am now living a more public life than ever before. Even when involved in student government and other apparently public activities, I never really put my opinions out for examination in a public forum – speeches and meetings were scripted, thought out, and muted.

But on this blog, on Twitter, and now in my career, I am stating my opinion publicly – putting a stake in the ground, on the record so to speak. And in doing so, I am subject to observation, disagreement, and often I am wrong for the entire world to see.

This feeling of public mistake and the observation of it has been difficult to digest…

But the benefits that come from Twitter, and from having a conversation with those of you who read this blog are worth the angst.

Plus, we just had an earthquake here in Los Angeles – sometimes life helps to put things in perspective.

So I will continue to participate in these conversations, meet new friends on Twitter and elsewhere, and I will even take chances in my career. As the brilliant Marshall Mathers once observed, “You only get one shot…”

Here are the notes from the Social Media Club LA meeting at Mahalo.

@BrianSolis, @NicoleJordan, @JackiePeters, @Richman17 and @Chiropractic were the panel.

Define "Social Media":

Anything that facilitates conversations online.

3rd wave of communications – 1 direct, 2 interaction with site, 3rd – interaction with each other.
Shift away from email. Analogy to business is becoming more about "fun" and "social".

Still a whole world who hasn't come on board yet. Broaden the definition to get wider adoption.

We should broaden the definition.

But remember that we are left hand side of the curve – We should think broadly about the socialization of content.

Yelp! Changing the game about influence.

Normal people who have influence and something to say. Power of influence is broadening.

Jay Rosen – we are the people formerly known as the audience.

What is SocialMedia beyond the technology? How people are using it.

Social tools are old: Deja News, Yahoo!Groups.

People are thriving off interaction – but how can we use these for the greater good?

Different tribes – different cultures – immersion and observation are crucial. Conversational marketing is bs…it is not empathetic. You need to listen.

Medium defines the message – blogging platforms (LiveJournal let's you personalize and privatize, vs others that don't). Twitter changes our communication.

Some brands are just about crashing and make the dialogue focused on them vs contributing to them. Pushing vs not actually being part of the conversation.

Are we all experts here?
No. We are all learning.

Is Comcast actively listening to people?

Test. @comcastcares. He replied to the email. Us this a bs strategy? He replies: yes. But we have 5 – 7 people…facilitating all this stuff internally and 1 guy has saved company money. Improving brand and relationships.

Game changer for brands?

HealthCare is notorious for not helping people.

Some people are starting to change.

Old way – you have no real way of knowing if it works. Example of Nissan and flashy ads with no results.

People are now creating ads for other companies and winning awards – brand hijacking. Smarter companies are looking at this.

A lot of big brands are adriad of negative feedback. You can embrace this feedback to make it into a positive experience. See Zappos and how he balances corporate with the humanity. We are revealing more about ourselves on a personal level.

It is about the socialization of this. Tony of Zappos.

Power of positive influence. Reputation matters.

See Virgin – anti-social.

Key is to be social.

How do you do this in a big company?
Play it safe: keep it in marketing.

See SEO…are you ok if Tony from Zappos is not a real person? Maybe. See Obama.

Issues of sincerity.

Example of real people representing a real company.

Power of real people. They connect.

People don't interact with companies – they interact with people.

Which department owns social media?

PR? In 100 percent of actual cases it comes out of customer service. They are willing to understand that social media is worth it because it is a "cost center".

All employees should keep an eye on it. PR people should keep an eye on it though a they can have a big picture understanding. But it should permeate the organization.

PR doesn't get paid to listen. Trend – outsourcing "listening" to India or Jamaica.

It all goes back to business fundamentals. AAPL – service.

Don't forget it is about people – whole foods? Buy what about fake identity?

Not trustworthy.

If social conversations are getting shorter, where are deeper conversations happening?

Conversation is thinning and spreading. Comments on variety of networks and networks – 36 hours just to respond.

Conversation is changing shape.

Social media and authenticity. Seth Godin – be remarkable, and don't be authentic. If you game the system, it is only a matter of time until you become found out.

Online conversation does get carried offline. Take in person relationships to another level.

What do we do to keep this from becoming hype? What is being done to scale it?

Sociology of this is important. Number? 50 percent? See Forrester – scale of public participation.

But we are still on the left side of the bell curve.

There is no audience anymore. Companies need to go find people and find out how they are being discussed. Are people where you are targeting. Start by listening.

Targeting is important but different for different companies and different brands.

Hard question. Fast-forward. Everyone has socialized everything to death. What happens? Are we buying minds? Do we have employees and customer service?

We will all always be on the left side of the curve. This will eventually be mainstream and we will move onto semantics and predictive markets. Predictive and semantic intersection with social world will be off the hook.

Pay attention to who the linkerati is out there. Let the people do the work…to carry your message further.

Search the key words that matter your business. Google: Essential Guide to Social Media.

Example: competitor went first to answer the questions. Outbound resource center for the people.

Smart companies are trying to do this but the various different groups are not coordinated. Internal HR issues make execution difficult. This is a key problem to address.

People think it is a campaign. BlairWitch of 2.0. They need a "social media" officer. Need it to do it 1 company at a time. What about "community manager"? They have more trust than CMO's.

Make us a viral video – it is the People that make it viral.

Analytics make it powerful.

Key is to smart small – see Google.

HomePage of Digg is still only 4,000 people.

Check out Help A Reporter: http://shankman.com

Old school people are not going to get on Twitter….son got off Facebook when she got on. Individual here can't even get her company (BigCo) to even participate in "viral" marketing.

How do we educate the masses? "But that's just online."

Question: What is your content?

Answer: Be interesting, compelling and valuable.

But we aren't even there yet. See JohnEdwards – it should not be a one-way broadcast mechanism.

Conversations are King.

IBM's social networking platform: how will we monetize this?

Answer is difficult.

Metrics matter. In corporate context – filter content. What metrics matter most? Talk later.

We all have a currency that other people don't have.

Check out Mahalo.com.
Etc.

Thanks to an excellent panel!

www.socialmediaclub.la will be the Blog.