Is it all about trust or about honor?

The financial crisis is causing people to reflect on trust, but I think the core issue is honor. Honor has to be in place before trust can be established, otherwise the trust is simply empty and truly meaningless. For quite some time I have thought of Wall Street (and even most banks) as "Thieves Without Honor." Without a core of intense honor, any firm is just one giant Ponzi scheme, one ethical error away from disaster. Wall Street wants to take a CDO approach to "managing" trust -- with bad assumptions about the maximum default rate on their synthesized approach to "honor". We need a return to hard-core, true honor not the synthetic, artificial contrived appearances that Wall Street and banks in general have made their stock in trade.

In the old days, lots of marble, polished brass, fine-tailored suits, and an impressive-looking vault were all we needed to "trust" a bank. No more. Sadly, Wall Street and most banks still believe in a lot of that crap, albeit with a "fresh modern" veneer of a lot of slimy marketing as icing on their cake, but all of that needs to go.

The really tough thing is that trust is based on appearances for so many people. How do we go about emphasizing, measuring, auditing, and rewarding honor as "Job #1"?

-- Jack Krupansky

Financial models, variables, parameters, assumptions, "Garbage In, Garbage Out"

It is so easy to blame so much of the current financial crisis on complex "financial weapons of mass destruction", but it is not necessarily so simple. I have read descriptions about how CDOs (Collateralized Debt Obligations) are supposed to work. The actual ideas are not that bad. Clearly the models for these instruments ultimately failed, but as far as I can tell the basic models are in fact reasonable.

Like all models, there are plenty of variables and parameters. If you do not get the variables and parameters right, then of course the models will fail.

Any wizened old computer programmer can tell you a simple truth about even the most perfect computer software: GIGO - Garbage In, Garbage Out. In fact, it does not matter if you get 99.9% of the variables and parameters absolutely right, even one bad key parameter can spoil the entire model.

In the case of CDOs, a key parameter is the maximum default rate, how many people can fail to pay their mortgage payments before the model begins to fail. If the default rate is below some threshold, the models work extremely well and almost everybody makes lots of money. But, if the default rate is above some threshold, the models, as they say, "blow up" and either nobody makes any money (a CDO of absolute junk subprimes) or many people get wiped out and some indeterminate number are still magically protected by the models. But unless you can accurately predict how many will be protected, the safe assumption is that none will be protected. Unfortunately, we need to know the expected default rate in the future for a given pool of securities, and that is the one most important thing we do not know at this stage, unless the government steps in with a guarantee.

The crisis appears to have occurred because the assumptions about the near future and resulting parameter values were simply wrong, really wrong. Sure, the modelers may claim that they did not "know" that junk mortgages were being sold and that the housing boom was actually a bubble, but models are supposed to incorporate all of the variables and parameters of the real world, not some idealized world.

During the housing boom, modelers set their parameters on the assumption that the future would resemble the past. No gung-ho modeling group anxious to share in the corporate bonus pool was going to set their parameters based on the near future resembling The Great Depression (or worse.)

Wouldn't it be a hoot if it was all that simple, great models, but just a few "bad" parameter values?!?!

-- Jack Krupansky

The financial crisis and the Nuremberg Excuse

There is no shortage of finger-pointing as to the causes of the current financial crisis. I was somewhat stunned to read the following anecdote by former Federal Reserve Chairman Paul Volcker in a recent speech:

One of the saddest days of my life was when my grandson -- and he's a particularly brilliant grandson -- went to college. He was good at mathematics. And after he had been at college for a year or two I asked him what he wanted to do when he grew up. He said, "I want to be a financial engineer." My heart sank. Why was he going to waste his life on this profession?

A year or so ago, my daughter had seen something in the paper, some disparaging remarks I had made about financial engineering. She sent it to my grandson, who normally didn't communicate with me very much. He sent me an email, "Grandpa, don't blame it on us! We were just following the orders we were getting from our bosses." The only thing I could do was send him back an email, "I will not accept the Nuremberg excuse."

What else is there to say?

-- Jack Krupansky

Thomas Friedman: The government should give money to venture capital funds

I am no fan of Thomas Friedman, but I do agree with most of what he says in his latest Op-Ed in The New York Times entitled "Start Up the Risk-Takers" in which is proposes a fairly simple model for government investment to create new jobs:

Call up the top 20 venture capital firms in America, which are short of cash today because their partners -- university endowments and pension funds -- are tapped out, and make them this offer: The U.S. Treasury will give you each up to $1 billion to fund the best venture capital ideas that have come your way. If they go bust, we all lose. If any of them turns out to be the next Microsoft or Intel, taxpayers will give you 20 percent of the investors' upside and keep 80 percent for themselves.

Sounds like a plan. But, it is not quite so simple. True, professional venture capital firms operate in a relatively narrow range of financing and stage of development. The typical paradigm for a venture capital-funded venture is "early stage", were only a relatively modest level of capital is needed (rarely more than $20 million), and where only a modest number of jobs are generated. Sure, some venture capital firms offer "later stage" funding, but that is still for the relatively early life of a new venture when growth is high but revenue and jobs are still relatively modest. The Googles and Microsofts and Intels of the world did not require large-scale capital in their venture capital stages. So-called expansion capital on a large scale typically comes not from professional capital firms, but either organically funded from revenue and profits from dramatic early success of a Google or Microsoft or Intel, or from debt offerings on Wall Street or other non-venture capital sources. That is the stage when a high volume of jobs are created.

Professional VC firms do offer growth stage funding ($10 to $50 million), but that is still only the stage where a venture might be hiring no more than a few hundred people, not the major growth stage where thousands of jobs are being created and hundreds of millions of capital investment are being made.

Sure, I agree with Friedman -- and have already myself suggested -- that the government should temporarily step in to fund professional venture capital firms that are having difficulty raising capital from their traditional sources such as large banks, insurance companies, pension funds, and large endowment funds (all of whom are themselves struggling financially), but this is money to fuel a future wave of job creation, say three to ten years from now, and won't create millions of new jobs in the next two to three years.

There are also SBIR, SBA, and other government funding programs that can be boosted directly by the government. Government guarantees for bank loans and debt offerings for young, innovative ventures could also be a big help for growing innovative companies far beyond the early stages where venture capital is most successful at boosting promising companies and weeding out the good ideas that simple do not work in the real world.

Yes, by all means the government should ramp up venture capital investment, but that will not obviate the need for stimulating and supported significant chunks of the "old economy" for many years to come.

Besides, the last thing we need is yet another new "bubble", let alone a slew of them.

We want new ventures that are robust and durable, not flash-in-the-pan, "gold rush" style "opportunities."

Energy innovation is worthy of investment, as is filling the gap for funding of venture capital firms, but let us be careful to avoid turning this into another "dot-com boom", because we all know how that movie ended.

The good news is that it might cost only $20 billion (as Friedman suggests) to give the venture capital industry the shot in the arm that it does in fact need.

Personally, I am not completely convinced that any or many of the top VC firms could actually put $1 billion to use with their current investment paradigms and I would not want to destroy the current paradigm that works so well. To be clear, over-investment does not result in comparably greater success. Maybe $250 million average (per year) for the top 20 firms and $50 million average for the rest of the top 100 firms would be more than sufficient for the level of investment that these firms could manage successfully at this point. That works out to about $9 billion a year. Okay, double it to make sure that good businesses do not have trouble getting funded. That gets us to $18 billion, close to Friedman's number. My own original number was $2 to $3 billion a month or $24 to $48 billion per year. My model was simply that in times of financial crisis, better to err way over the top. At this point, I would prefer to hear the VC sector tell us what they feel that they need. Offer them $50 billion a year and sit back and watch the spectacle of them saying "Please give us less money."

Maybe the key thing is for the government to be able to assure VC firms that there will be "government supported" funding (e.g., debt securities) available for VC-funded companies that have advanced beyond the VC-supported stages to the point where they do need tens or even hundreds of millions to expand to the degree where individual firms are creating many hundreds or thousands of jobs. This might help to encourage VC firms to fund new ventures that will eventually require large-scale capital after they advance beyond the stages where traditional VC firms add the most value.

Finally, Friedman did not even mention so-called "angel" investing, where individual investors are funding innovative new ventures at a smaller scale than normally appeals to professional venture capital firms. Give these people more generous tax incentives, matching funds, and possibly some degree of government guarantees, or maybe outright tax credits, and you could see a dramatic blooming of innovative firms.

In any case, I do have to give Friedman credit for raising awareness of this critical issue to the national level. A single small paragraph in my own blog simply wasn't good enough to even get the ball rolling:

Provide government funding to venture capital firms which are experiencing extreme difficulty raising funds from traditional sources (big banks, pension funds, and insurance companies) due to the credit crunch and skrinkage of the economy, on the order of $2 to $3 billion per month.

-- Jack Krupansky

Death to the Hummer!!

As GM struggles to restructure to survive, it seems abundantly clear to me that the Hummer has to go. Sure, if they find a buyer they should sell the Hummer business. If they are unable to line up a buyer and the business is unprofitable, the solution is clear: they must kill off the Hummer business. Simply shut it down, kill the Hummer.

Besides, the Hummer is the epitome of excess of a world that no longer exists. Big, expensive, guzzles fossil fuel, favored by overpaid managers and executives -- including those of Wall Street.

At heart, the Hummer is a distraction to GM management. Rather than expending time, energy, and resources figuring out how to save the Hummer, GM management should focus all of that time, energy, and resources on the Volt and other paths that at least have a hope for the future.

The Hummer must go. GM should kill it while they have the chance.

What about Saab? Simply spin it off to local Swedish management for $1, let it file for bankruptcy, and let the Swedish government decide if there is anything worth saving there. If anybody actually wants to buy it for more than $1, great, sell it ASAP. Either way, get this dog off of the plate of GM management as well.

The only thing GM management should be focused on is the path to the future.

-- Jack Krupansky

Simple solution to the mortgage crisis

All manner of "fixes" have been proposed and will continue to be proposed to "fix" the housing/mortgage crisis, but none have so fare managed to gain traction. I have a simple proposal which I call the Mortgage Resolution Corporation (MRC), a government-sponsored entity (yeah, I know...), whose primary function is simply to make mortgage payments whenever the consumer fails to do so.

The bank or other mortgage servicing entity would simply electronically "debit" an account for the consumer at the MRC for the principal and interest.

In exchange, the MRC incrementally assumes a partial ownership of the mortgaged property, ahead of the consumer, and possibly ahead of the bank or mortgage servicer for the amount of principle paid down.

The MRC would maintain a debit account for the amount of mortgage payments paid so that if and when the underlying property is sold, the consumer would receive a capital gain only to the extent that they have paid down their MRC debit account. This would provide an incentive for consumers to eventually catch up on their payments and not get too much of a free ride.

The MRC would be like the old toxic waste dump "Superfund" program in that its first job is to keep payments flowing and keep people in their houses, but to also attempt to recoup costs whenever legally possible.

Initially, the U.S. government would fund the MRC, but after it has been in operation for a few years, it would be expected that the private sector would buy into the MRC and supply private capital to run the program with explicit government backing of the mortgages.

This plan would:

1. Eliminate foreclosures.
2. Keep mortgage payments flowing to banks, servicers, and investors.
3. Keep people in their houses even when they lose employment or have expensive health problems.
4. Earn the taxpayers a healthy return over a 5-10 year period as the housing market eventually bounces back.
5. Earn homeowners a profit to the extent they maintain the property for 5-10 years and eventually catch up on all mortgage payments.

Do you have a better idea??

-- Jack Krupansky

Stimulus II

Now that the stimulus bill is virtually a done deal, it is time to start thinking about what the next phase of stimulus should look like. The current stimulus package will have some positive effect on the ecnomy, but there is still a lot more painful restructuring of businesses needed that will leave millions more people out on the street in the coming months. Another 700,000 workers filed for unemployment insurance in the past week alone. The number of ex-workers on unemployment insurance is approaching 6 million. And there is no end in sight. Sure, there will be some firms that will begin rehiring over the next couple of months as some of the stimulus kicks in, but many firms will still be faced with declining revenues over those same months.

The current stimulus package is a decent stopgap measure, but it is still only a partial solution. Even if it creates several million jobs over the next two years, there will continue to be millions of people with no significant income and many millions of those who still have jobs who become more frugal, further savaging consumer spending.

By June, a lot of the reality of the current stimulus and ongoing restructuring of the economy will be somewhat more obvious, so that July might be an excellent timeframe for considering Phase II of stimulus.

My current thinking is that a "Stimulus II" package should include:

1. Direct stimulus to consumers, on the order of $50 to $100 billion per month "until further notice". Sure, some people will save much of this, but that will help to shore up consumer balance sheets, which is a necessary component of getting the economy on a sounder footing. Besides, there are so many millions of people out of work for whom "saving" is not an option. This spending would phase out as real consumer income gradually and eventually improves.
2. Increased government business investment spending on the order of $50 to $100 billion per month to spur demand for the goods and services of businesses. Businesses need to see higher demand and actual revenues before they start hiring in earnest. The simple reality is that we need a somewhat bigger government component in the economy to protect people from serious economic episodes such as this one. There is plenty of room for expansion of government services - paid for by the government, but provided by the private sector.
3. Provide government funding to venture capital firms which are experiencing extreme difficulty raising funds from traditional sources (big banks, pension funds, and insurance companies) due to the credit crunch and skrinkage of the economy, on the order of $2 to $3 billion per month.

That would be a start. I am sure that even more is needed. But, maybe not a lot more. Basically, we need to keep stimulating until unemployment is low again, and then gradually withdraw stimulus as the private sector picks up the slack.

The key is that unless there is sustained stimulus, we risk facing a "1937" problem, where the U.S. actually began recovering from 1934 to 1937, but then ran out of steam and declined again and languished until another form of stimulus appeared (World War II.)

-- Jack Krupansky