reading roundup

it's been a really, really long time since i did one of these, and even now that i'm finally getting around to one, it's kind of a cheat. the following were already posted on my tumblr, in one form or another. figured i'd aggregate them here as well in one post. at some point i'll do a proper roundup and clear the 300+ items on the delicious tagged "toread".

• this might actually qualify as a 're-blog'. i first blogged about this fantastic Business Week article way back in 2006. i bookmarked it too. i knew i’d want to re-read it when the proverbial shit eventually hit the fan. since it’s hit, many in the industry have fallen back on excuses of “no one saw this coming” and “this was unprecedented”; nice ways of saying “don’t blame us”. and yeah, maybe no one could have forecasted the exact number to represent how bad things would get. but there were tons of people out there who saw that things didn’t smell right. that things just didn’t make sense.

sure, one of the things we'll have to learn from this crisis is how to more accurately forecast the number to represent the badness. but one of the more important lessons is not going to come from better models or refusing to sell CDOs again. it has to come from the people with decision-making power in this industry learning to ask for contrarian opinions and oftentimes, listening to them. ignoring information because no one wants to be the first one to pull out is not a strategy. i get that this is a very basic, very naive maxim, but in order to change the culture, those of us who work in finance can’t afford to be adolescents that go along with the crowd until we get caught and then hide behind excuses and hope everyone forgets. we have to take ownership of our actions, be accountable, and be independent. otherwise, we’ll just end up here in 5 years wondering, yet again, “what went wrong?”.

• from the New York Times, a run-down of what finance executives will have to do in order to live on the $500,000 salary cap that's been handed down from Washington. last year, before the shit truly hit the fan, a fellow risk manager asked me why i was always so cynical about people’s motivations. my reasoning was exactly what they lay out in this article. that for many of these executives, they are expected to keep a certain lifestyle in order to maintain their social and professional status. and keeping this lifestyle means that every time they face a marginal deal, they have to calculate the odds that the deal will blow up against the fact that they’re putting out $16,000 next month for a one-week family vacation. in fact, the question in their minds is no longer: “will this deal blow up?”, but “will this deal blow up before i get paid?”.

a large part of the solution to the crisis will have to be a fundamental shift in the culture. the agency problem is not going away anytime soon, but i’ve worked at firms where extravagance was frowned down upon and the difference in behaviour is remarkable. when the collective focus was not on ‘how much do i need to make in order to cover my bills this month?’, people thought more about ‘is this actually a good deal for our clients? for our firm?’, and accepted/rejected ideas on that basis instead.

• the Wall Street Journal this time, on the proposed pay packages often paid out to retain top brokers. i’ve never quite understood this rush to pay brokers to keep them. i hear the arguments from the banks (“we have to keep our top producers”). but producers of what? how do they segment brokers and decide which ones to keep and which ones to toss? it seems that there’s only really one criteria that they use: who brought in the most revenue.

as far as i'm concerned, this is sheer lunacy. revenue from short-term account churning or from blowup-prone derivatives is only revenue until it's a write-off. real, ongoing, fee-based revenue should be the main consideration. if there’s no better way to determine which brokers to retain and which to toss than revenue, fine. but at the very least, these banks need to get an understanding of the economics of what they’re paying for and get their brokers to accept that not all revenue is created equally, and so, not every dollar necessarily merits payment.

• finally, some neuro-cognitive-behavioural stuff for you from Neuron, via Scientific American. apparently for gamblers, “near misses" (getting two cherries out of three at a slot machine) significantly increases the desire to keep gambling. there's an attraction both to keep going because nothing has happened, and a sense that the system must be under control since nothing has happened. i couldn't help but see the current financial crisis in this research.

over the last few years, a lot of risk managers mistook the fact that “nothing has happened” to mean “we made sure nothing happened”. i run across risk managers all the time who are excited because “our VaR is the same as last month!”, or (even worse) risk managers who say “well, VaR is lower than last month, so we can go ahead and put on more trades”.

this is completely the opposite of risk management - it's risk-seeking behaviour. if there’s been no negative consequence to what they’ve been doing (i.e. increase in VaR, blowup on the desk, etc), managers interpret that to mean that they’re necessarily doing a good job at managing the risk, even if the lack of incident has nothing to do with them whatsoever. this is a completely false and dangerous attribution. measurement does not equal management; the lack of a disaster does not equal disaster-prevention.

risk culture across the Street needs to have this point drilled into their (our) heads and it has to come from the very top: just because the world didn’t end today doesn’t mean that you saved it.