nick baily's two cents

EPIC WIN FTW! (Also known as best presentation I saw at Launch Conference)

Why bother with an intro. Meet.... DOMO!

 

Advice to Startup Founders: Be Yourself (not too much)

In the many years I've known Adeo Ressi he's never failed to be an inspiration, for sheer energy if nothing else, but also an unbounded optimism, bias towards getting things done, and a willingness to toss aside the old in favor of a vision of how things could be. So its no surprise that his most recent endeavor, the Founder Institute, a "school" (or bootcamp?) for startup founders, has grown so rapidly.

It's a no-nonsense semester long class that takes in people at all stages, united only by their desire to be entrepreneurs. A crash course intensive, it covers direct hands-on issues and skills required to run a startup, as well as the intangible stuff that really matters but is rarely taught -- like dealing with stress, or partners, and how to explain yourself and what you do (a message Adeo has a gift for delivering with brutal clarity, as this video makes clear).

So needless to say it's been a blast to participate in this semester's NYC chapter as a mentor, with chapter head Gabe Zichermann. I had the pleasure of presenting at the semester's first formal class a few weeks ago, dubbed "Vision & Values," about the big picture questions that face every founder as they get started.

Here's the video, and there's a link to the slides below. Also you can see this clip as well as the great presentations on the same night by fellow presenters Carter Cleveland (art.sy) and Gary Whitehill (NYEW) too via this Vimeo link

Belgrave Trust Founder Nick Baily Speaks at NY Founder Institute Session #2

Slides also viewable here, as PowerPoint and PDF

A good summary of just about everything I find interesting

Now here's a hell of an infographic: a history, timeline, and taxonomy of complex adaptive system dynamics. I'll get to every bubble one of these days.... no I swear...

 

Huffington Post Story on Startups & "Contest Economics" (Stone-Age Blogging Edition)

So my piece this week for the Huffington Post has been generating some discussion. Well at least on Twitter, which people tell me is a quite important site on the interwebs these days. It was a fun post to write, the entire thing was actually just a riff on a single sentence that Jason Calacanis wrote for his email listserv, which was:

The proper protocol in the valley is to at least try and partner, or purchase, the startups who have innovated in a space you’re going into.

The idea of one of the most highly competitive sectors of business "playing nice" just wedged in my head. It's one of those against the laws of physics sort of observations that you can't help but struggle to reconcile.

But alighting on word "cooperation" reminded me of something I wrote a couple years ago for this here little neglected blog of mine, and it seemed like there was actually something interesting going on here.

Only problem was it was real late after a marathon day in the office and I was walking down the stairs to get on a pretty long subway ride. And my brain can become Swiss cheese when I'm tired, it wasn't gonna work the next morning. So... I became a blogger, except with a pen and my notebook, in longhand. 

Came out pretty much in final form, with one exception being the crack-brained idea of feeling like it just had to have poker as the main theme. That didn't work out (though I emailed that part to Jason and he used it, so all was not lost) but otherwise all was OK. 

Anyways, so I was wondering if I'm the first ever blogger to use this method. I think it needs a name, how about "offline blog leveraging."

Oh wait, I think it's called "writing."

Damm. 

Ah well, hard to be original in this world. Feel free click through and read for yourself if you're bored. Here's the first part: 

For decades, there's been a gentleman's agreement in the Silicon Valley. If you're the big guy, when small companies get some traction in an area you dominate, you partner with them, or buy them. Taking young startups' ideas and using dominance and power to overrun them isn't sporting.

"Microsoft killed Lotus, WordPerfect, and Netscape. But the recent hurricane of criticism is hitting Facebook, and not just on privacy. They almost got into an all out war with Zynga (makers of the extremely lucrative Farmville and Mafia Wars games) and have been accused of rampantly "borrowing" ideas from Twitter, FourSquare, and many others.

"That's just not how things are done."

...so, um, why?

I don't think I believe in "Marketing Guru" types...

I mean, I believe in marketing. I could even define it, it's basically a combination of messaging and outreach. Simple enough. Plenty of variations, like which message will motivate which people, and what medium will be effective in reaching them, and so on and so forth. But at root it's the message that matters, followed closely by who you're talking to. If either one are off the entire thing's a lost cause. 

Sometimes people confuse that idea of messaging. We often hear the "if you have a great product people will flock to it" and the converse which is that "if the product sucks marketing is just lighting money on fire."

All true, and doesn't conflict at all with what I said above. Your message has to be some elaboration on why what you're doing is of genuine interest to the audience in question. I added the extra double bold there for a reason. You have to communicate with your audience. But you also have to tell the truth. 

If the product is amazing but nobody knows how to use it you have problems. If its benefits aren't immediately apparent you have to communicate. If it doesn't have benefits to someone and you tell them to buy it anyways you're not marketing, you're lying. And if you present your product to an audience in a way that they find offensive or just stupid or silly you've lost your shot, the product won't save you if you lose them on the way in. You always have to communicate clearly and compellingly and to the right people -- in the right way. 

That's kind of it. 

There are tricks: like how to time media, how to augment free press (PR) with targeted advertising. How to respond to a crisis or disaster or product failure. How to change entrenched perceptions of you or your company as you move into a new sector, etc. There's also process stuff that just plain works, as this very highly recommended article about QVC in The Atlantic gives as one great example. 

Then there are the other kind of tricks. The ones where trick is synonymous with gimmick. Where it's all about some "system" or obsessing about logos and mission statements and gobbledygook. 

Now -- in fairness -- there's something called "Corporate Culture" which matters a whole lot. I read Tony Hseih's book "Delivering Happiness" and it's one of the best I've ever read on management philosophy, with a concentration on the employee and workplace culture as paramount. Get it. 

But I'm not talking about that, I'm talking about this:

 

 

 

But to be honest, hey, it is a nice card I suppose.

In my opinion that's not actually as insane as an idea I heard from a billed "Marketing Guru" recently, and I don't think they were kidding. It was bizarre enough that I finally just decided I had to see what it was like to try and execute, just out of sheer morbid curiosity. 

Want to know what it was? I already wrote a blog post on that one elsewhere... read all about it here if you're interested. Here's a sneak preview:

 

The Buzz on Google Buzz

If there's one maxim in the world of tech media you can count on it's that when Google sneezes, it's news. So when Google makes a bold move to create a next-generation social media platform, it's really big news. This week's announcement and debut of Google Buzz was met with the expected level of breathless hype and cataclysmic predictions. Longtime commentator and internet celeb Jason Calacanis was among the first to weigh in with an unequivocal first impression:

BREAKING: Google Buzz is brilliant, Facebook just lost half its value.

My 30 second review of Google Buzz:

1. Google Buzz 1.0 is better than Facebook after six or seven years.

2. Facebook’s history is one filled with stealing other people’s innovations and doing them better (i.e. Zuckerberg has stolen every idea Evan Williams and the Twitter team have released). How ironic now that Google has out “Facebooked” Facebook.

3. Google has excellent privacy record and Facebook is a disaster. Most folks do not trust Zuckerberg and Facebook any more because of their privacy record (filled with lawsuits) and because they steal every good idea they see (i.e. Twitter’s innovations and FourSquare’s checking in).

4. Google Buzz auto generates your network–this is MUCH better process than Facebook’s.

5. Google Buzz is way faster than the sluggish Facebook–this is a HUGE advantage.

6. Google Buzz puts relies and updates into your GMAIL as threads–this is BRILLIANT and a HUGE advantage.

Facebook is going to see their traffic get cut in half by Google Buzz.

This really is game over for Facebook because you know Microsoft and Aol are going to copy Google Buzz as quick as they can. In fact, Aol would have a HUGE renaissance if they simply knocked off Google Buzz’s exact feature set. You would than have a reason to keep your @aol email address.

This could actually derail the Facebook IPO. It’s that serious. Facebook usage is going to plummet in the next year or two because of this. There really is no reason for non-game playing people who useGMAIL to log into Facebook.

If Google Ads social gaming to Google Buzz Facebook is 2012’s Pointcast.

Wow…. this is just stunning.

The "Facebook-killer" meme spread quickly (check Google News for proof) but is this revolution, or evolution? Let's take a look at some of the key features, straight from Google themselves:

• Auto-following: You don't have to build or rebuild your friend network, it happens organically as you send and receive email.
• Rich, fast, sharing experience: It pulls together a stream of information from your friends, media, photos, comments, in a dynamic way that feels more like a conversation.
• Public and private sharing: Self-explanatory, though it's hard to see how this is a huge differentiatiator. Twitter is of course public, Facebook is mixed (and a bit opaque on this point), but nonetheless.
• Inbox integration: This is the "killer" that threatens to make this a killer app. Let's face it, how much patience do people have to join yet another social network, especially a very generalist/aggregating one like this. It's a tough hurdle to jump -- but boy does it help to have 176 million unique users a month and a war chest of about $32 Billion in cash. Or so I would have to imagine.
• "Just The Good Stuff": This sounds like marketing hype, and is to some extent, but they're aiming for at least some substance with this point. The social media feed is prioritized, at least according to their claims it shows you the posts and updates you're most likely to read, and buries the stuff you least likely to be interested in. An innovation, but interestingly also something that Facebook ramped up hard as well, just this month.

So then -- what's it like? Well here's a quick overview primer:

   

And their five marketing points above leave quite a bit out. Integration clearly is core to the philosphy, leveraging Google's basket of heavyweight online properties such as YouTube, Picasa, and Blogger. The mobile integration looks to be one of the most formidable aspects to Buzz, when coupled with a GPS enabled mobile phone it enables functions ranging from finding people near you (perhaps a little creepy) to your own private Google Map that's like a bookmarks bar for the real world, geotagging your camera phone shot so you can remember where that little out of the way dumpling place was next time you're in the neighborhood. 

OK, so back to Facebook's 400 million users and near total dominance of the core social network space. Is this a threat, a complement, an eventual also-ran? Here's a little more of what the experts are saying:

Techcrunch sums it up well:

The Battle  

Without having had a chance to play with it yet, it would seem that the core idea behind Buzz is to take on Twitter and Facebook as the easiest way to share content online. Google is offering a number of compelling features such as smart curation (it gets better as you tell it what you like and what you don’t), and a rich mobile experience including location.  

Because of the features it adds on to what Twitter does, and its overall look, it’s hard not to compare Buzz to FriendFeed. That service was arguably the better product than Twitter, but never took off in the same way for whatever reason (though I would argue that simplicity was a big factor). You could say the same thing for Twitter rivals Pownce and Jaiku (which Google actually bought) in the past. But by adding it to Gmail, Google is giving Buzz a great weapon to succeed where all of those others could not.  

The big question is: will Gmail users buy into this quick sharing? Google thinks so because it’s a part of the evolution from email, to IM, to status updates. It’s also, in their eyes, a part of the evolution to the next step, Google Wave. So far, the public has proven to be not ready for Wave yet. But Buzz might be the perfect tool in getting people to think about communicating in a way beyond email and IM. Or it may be another misstep in Google’s social quest.

Core social media news source Mashable is measured, tackling the "zero sum game" question head on, but ultimately concluding that "Buzz Won’t Win the Social Web Without Facebook Integration"

We ought to consider the consequences of Buzz’s relationships with Twitter and Facebook. What are the relationships? Will Buzz, Twitter and Facebook co-exist elegantly or is this a zero sum game with a winner you can place your bets on? 

... 

I predicted at the end of last year that Facebook is well-poised to try to pry web dominance away from Google in 2010. Buzz doesn’t change my mind. Facebook is threatening Google, but Google isn’t threatening Facebook because it doesn’t offer any features so great that they incentivize people to leave behind their existing networks or spend their time updating and following yet another one when their friends are already all on Facebook or Twitter.  Facebook now dominates the social web so completely that it’s difficult to imagine an exodus to a competing service, unless that service offered some revolutionary new features that Facebook couldn’t possibly match — Buzz doesn’t. 

I can picture one other success scenario, though: a service that aggregates other services’ features and content, and then offers up its own set of unique perks (like Buzz’s noise-control algorithms) that make the social web experience better. People would feel comfortable switching for the extra perks, because they wouldn’t have to leave their existing connections behind. 

The outlook could change if Buzz integrates with Facebook the way it does with Twitter. Unless that happens, though, you’re better off keeping your bets on Facebook in the coming year or two — at least if your standard of success is something greater than niche appeal.

And tech guru Kevin Rose is witholding judgement as well:

Not sure where Buzz fits in my arsenal of social media tools, how often I’ll use it, or if it will eventually feel too much like unread email — but I’m happy to see Google taking social media seriously. It’s early days, let the attention/follower wars begin.

Indeed, let the games begin -- my thoughts as well. This was what I wrote late Wednesday night as a first take, before I read what everyone else was saying:

10 minutes in. Snap reaction -- they've got this more right than wrong. It'll stick. I don't know if it's going to kill Facebook. It actually doesn't feel that much like Facebook to me -- but I have this feeling it's going to kill something.

It's a fast moving space to say the least -- in fact just as I finished writing this post I hit refresh and saw two new headlines pop up on (where else) Google News:

"Google Snags Social Search Service Aardvark" 

 and 

 "Google Buzz Surpasses 9 Million Posts and Comments" 

Nine million? Hmmmm.... this story is just a little over two days old. It's going to be interesting.

Making a Mint With The Value of Press

OK, fine I'll admit it, I'm the last human in the world to dive into Mint.com. As an OCD spreadsheet wielder with every penny I have or don't have tracked and sliced and diced I never really thought it was for me. But today I decided it might be worth giving it a shot. It had some features I wanted to try and let's face it, no matter how good your spreadsheet is, chances are you're no match for a well designed application.

I have to say, I was more than impressed, and my turbocharged spreadsheet feels like a bicycle sitting next to a Porsche 911. I had dim memories of first being tipped by Jason Calacanis via his TechCrunch event with Michael Arrington, and was trying to remember the story of Mint getting off the ground. A quick google revealed this article and sure enough, it was only two years or so ago. They've certainly blown things out since. But reading the interview with founder Aaron Patzer lent even more insight:

We didn’t have money for advertising, so we started a blog. We didn’t have money for writers, so most of our original blog content then was guest posts from other personal finance blogs, plus a couple of columns on people’s worst financial disasters.

To build demand, we started asking for email addresses for our alpha 9 months in advance of launch. Then when we had too many people sign up, we asked people to put a little badge that said “I want Mint” on their blogs to get priority access. We got free advertising and 600 link backs which raised our SEO juice.

When it came time to launch, we choose TechCrunch 40 – why pay $20k for DEMO?

We decided not to do SEM – it’s too easy and too additive. Instead, we relied on press. It’s where I spent 20% of my time. I’m spending it right now while writing this.

The net result has been millions of visitors and 1.5m users essentially for free. Mint is not inherently viral like a social network – but all good things are viral by word of mouth.

And so here we are two years later. We’ve attracted over 1.5 million users, found over $300 million in savings, managed $50 billion in assets, and helped people track nearly $200 billion in purchases.

Notice the interesting way he uses the terms "viral" or "word of mouth" and "press" almost interchangeably. It's a great illustration of a common misconception -- which is this idea that all you need is to build something truly impressive and people will beat a path to your door. 

Granted, there's more than a grain of truth to that, brilliant ideas really do spread virally, and with lightning speed. 

 

But often what people feel is an avalanche of "word of mouth" is really just great press. Sure, often the press is "following" the word of mouth buzz. A classic example, perhaps the opening shot of the Web 2.0 era (or the final screaming death of the 1.0 era, depending on how you look at things), is F*ckedcompany.com, which Phil Kaplan famously created for the hell of it over a long weekend, emailed as a link to six people, and woke up a couple days later to find tens of thousands of visitors beating a hole in his servers. 

So, it happens. But more often than not when people say they "keep hearing" about something, or that "everyone's been telling me about" something, they don't mean real actual conversations. Most people move in pretty close-knit circles. What they mean is that everyone in the media has been telling them about it. What feels like word of mouth often isn't so much the presence of tremendous chatter from close, trusted friends and but rather the absence of an over the top, in your face marketing blitz. To be specific, paid marketing, like advertising. Like Superbowl ads. Like Pets.com.

And to go back to the F*ckedcompany.com example, the viral pass-along for that site was nothing short of remarkable, it was like a direct conduit into the zeitgeist. But if my memory serves, it made the Wall Street Journal within the week, and was on to Time, Newsweek, The Today Show, Rolling Stone, and just about everywhere in the media universe in a short amount of time. How many people discovered it through an email forward or water cooler conversation vs. the number that learned about it via some kind of "proper" media channel?

That's something you can only guess at, but it's one example of many. Zappos.com is another that comes to mind in the online/startup space, and there are more examples than you can count in entertainment, music, film, etc. 

In all cases they've hit a trifecta, that combination of a great product (yes, that's still the prerequisite, if you don't have that the rest of this is meaningless) with a core evangelical base of initial users and a successful effort to get that positive word of mouth coming from those who measure their audiences in millions. 

You bet the media has changed, these days the personality with the huge megaphone might be a tech hero with a six figure Twitter follower count. But social media is media. And that personality is a media personality, the underlying point isn't diminished one inch. 

It's not strictly impossible to see success happen purely organically, without any organized plan for publicity. Though I'd say it's nearly always when a founder or principal happens to be naturally press-savvy. But exceptions aside, more often than not it's a thoughtful, considered -- and experienced -- person or team at the helm, managing the media strategy. 

So, to bring it home with a pun -- if you'd like to make a mint, you might want to think about who's minding your press. 

 

My favorite story so far involving the financial crisis.

This post and the underlying story comprise the most amusing anecdote I've read since this entire mess began. I don't know what the ethics are of blockquoting an entire post but whatever, it's too good:

How to lose on a sure-fire bet

There was a wonderful story in today's WSJ about how some big banks managed to lose some of their hard-earned TARP money. 

Let me begin with a little background. A credit default swap is sometimes described as an insurance contract written against the possibility of default of a particular underlying asset. If I buy a CDS and the specified asset defaults, I get to collect money from whoever sold me the contract. If I also have a long position in the asset in question, I might consider buying a CDS written against that asset as an insurance or hedge against the possibility that the asset loses its value. 

But I don't actually have to own the asset in question in order to buy a CDS from somebody else. I might want to buy a CDS as a partial hedge against some other asset I hold with which the specified security could be correlated. Or maybe I just feel like making a bet with somebody I think is dumber than I am. 

The fun and games begin when multiple contracts get written on a single credit event and the notional value of outstanding contracts on that event-- the total amount of money that is promised to be paid to the buyers of those CDS in the event of a default on the underlying asset-- becomes larger than the par value of the underlying asset itself. Then it would clearly pay the party who sold those contracts to buy the underlying asset itself at par, relieve the original debtors of their burdensome obligations, and be out only $X (the underlying event) rather than some multiple of $X (all the contracts written on the event). 

And so the WSJ recounts the tale of a security based on $29 million (par) worth of subprime loans in California, half of which were already delinquent or in default. Betting that the loans weren't worth $29 million sounds like easy money, and the smart guys were willing to pay 80 to 90 cents for each dollar of CDS insurance. 

It appears from the WSJ account as if little Amherst Holdings of Austin, Texas was happy to sell the big guys like J.P. Morgan Chase, Royal Bank of Scotland, and Bank of America something like $130 million notional CDS on a $27 million credit event, used the proceeds to buy off and make good the underlying subprime loans, and pocketed $70 million or so for their troubles. The big guys, on the other hand, paid perhaps a hundred million and got back zip. 

A theory in search of a name:

Every once and awhile you come across a gem in the darkest reaches of the internet. Here's a quote I saw buried in the comments on a real estate blog: 

I’ll posit the new version of Occam’s razor. Given a choice between two theories about the economy, the more cynical view is always closer to the truth.

Where Pitchfork Meets Keynes

I was having a discussion with some friends in the media and music business recently, specifically about the much-discussed (read: over-discussed) phenomenon where bands emerge and bubble up from the blogosphere and become overnight sensations in a teapot, taking the hipster world by storm, becoming ubiquitous in all the tastemaker places almost simultaneously. Someone commented that this phenomenon is really particular and endemic to the indie rock world -- where there's a massive wave of over-hype and artists are thrust out into the world not even fully formed, subject to a premature "next thing" consensus and an inevitable backlash to come. 

I don't think this is confined to music at all. Political consensus among the chattering classes is probably the most direct and clear example, with so much media, so much airtime to fill on deadline, and so many predictions that "have" to be made in the face of subjectiveness and a major herd mentality. It's also common to quickly moving technology trends (iPhone, Twitter, lots of other gadgets) and even financial opinions (Jim Cramer and Motley Fool come to mind especially). And probably quite a few other things. Just straight old TMZ style pop culture too.

But confining the discussion specifically within the confines of the music business, what I think is interesting is the degree to which the indie rock world exemplifies a certain set of attributes. You don't see the same hyper-"meta" discussions and self referential issues in other genres so much, at least not in my estimation. In straight bubblegum pop you might just as easily have the overwhelming hype and meteoric rise, and even in more esoteric niches like country or jazz or even bluegrass you definitely have flavors of the month, someone who makes a breakout performance at a festival or a last minute substitution. 

As a sidenote -- I actually think classical is a close second to indie in the herd-hype department, with that last example of a last minute substitution and seemingly coming out of nowhere being a great example of how many well known artists -- most notably Leonard Bernstein and Lang Lang, among others -- got their big breaks. And both suffered a torrential backlash several years into their career as well. 

But anyways, the basic concept is pretty well established. What's interesting to me is that in indie rock (which I should make sure to define here as the hipster, Pitchfork, blogger world, etc -- not in the indie=independent sense) it seems to have come to dominate the landscape. 

And of course, it conjures up parallels in economics. Specifically the classic quote about the stock market and investing from The General Theory, by John Maynard Keynes: 

"Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees."

I've always thought this was a pretty good metaphor as well for the worst parts of the hype machine that seems to swirl around indie rock, in the way mentioned above. The issue here isn't that you have a scene that's incredibly dynamic and changing, that artists come out of nowhere and get a ton of hype and then recede. There are plenty of reasons why you'd see those kinds of things happen. For example, another just-as-plausible hypothesis would be that it's an artistic scene that is intensely focused on novelty, hence the quick rise and short shelf life of many such artists. 

But I don't think that's quite it. I think it's the self-referential nature of the whole thing that is the most fundamental attribute. Everyone is looking at what everyone else is doing. In economics or ecology you'd describe it with some concepts from complex adaptive system dynamics, where you have systems or implied algorithms that are self-referential and loop back on themselves, and have both positive and negative feedback loops working at cross purposes. Not too far from the idea Keynes intuited in the 1930's in the quote above. 

So the more hype builds around you the more success you have. That's a positive feedback loop, a network externality. If 10 influential indie blogs plug you then that might lead to 30 more the next month. But there's a negative feedback loop. The more success you have the more you arouse the distaste and backlash of many members of the community. You have everyone looking at everyone else to see what they think before they make up their mind. 

People's opinions of an artist's intrinsic merit are in part based on their perception of who else likes them, what kind of people like them, how many of those people there are, and how long this has been going on. Like in the beauty contest example above, many participants are picking the prettiest competitor at a beauty contest not based on what they personally like, but based on their impression of what they think other people's impression will be. 

So you have two countervailing forces at work -- and the result is the classic boom-bust cycle that has tons of parallels. In ecology the textbook one is watching deer populations skyrocket, then they eat all the available food, and then half of them starve and die. Then they do the same thing over and over again. In economics it's the classic business cycle boom/recession wave in the stock market and economy as a whole. It's the natural outcome of a wicked combination of positive and negative feedback loops, both governing the same variable, in this case success and prestige and "hype." 

Or to simplify: 1) The more successful you are the more people like you. 2) The more successful you are the more people hate you. Pour them together, and you get breakneck change, massive and premature over-hype and massive and premature backlash. Both often divorced from any underlying actual merit of the music in question. Just like financial bubbles tend to affect the good firms as well as the bad, both on the way up and the way down. The truly great stuff endures, but when you're looking at a week to week timetable that boom-bust cycle is all you can see.

I think it's food for thought. The interaction of positive and negative feedback loops in self-referencing systems with network effects is well known in complexity theory to be the driver for some very interesting emergent phenomena, not just in simple rules-based systems but in applied social sciences as well. Perhaps there are some parallels to be drawn in marketing, media, and even entertainment and popular culture. 

Bubbles, they always seem so novel...

So the talk over the past weekend has been deafening and all on one subject, the Paulson proposal to inject $700 billion dollars directly into the financial sector with no oversight or accountability or review whatsoever. It's beyond what anyone might call a "nuclear option." 

Here's a sample of the kinds of discussions I found circulating over the weekend:

The real problem is that the underlying assets are sharply overvalued due to liberal bank credit schemes from the 2001-2007 real estate bubble. People with no savings, bad credit, and low income could buy $250K to $500K homes. If banks are unable to finance the crazy prices that people pay for homes, then home prices have to come down equally sharply.

Paulson may be able to save banks from some of their stupidity by loaning them $700 billion, but the reality is that this is a $7 to $10 trillion problem, if not greater. 

How is a 10% bailout going to help anything or anyone? Is it not slowing down the inevitable for a six month soft landing at the taxpayer's expense?

If banks can't continue to lend in the crazy format of years past, how can home prices not deteriorate exponentially? If housing prices continue to drop, banks will not be able to continue to lend due to rational reserve requirements. How will banks with no lending capability dump the foreclosed assets that they hold in mass, keeping in mind that houses deteriorate quickly without maintenance? If they sell these foreclosed homes to the government, won't the government dump them for pennies on the dollar and tank the housing market

 

Well in my opinion it's even worse than that description. Paulson's proposal is not to "loan" $700 billion dollars. It's basically to just hand it over. And it happens whatever terms he sees fit with no review or accountability whatsoever. It is quite literally insane. It's more than the entire defense budget, more than our entire social security payouts for the year. All to be given to one person with no real restrictions whatsoever on what he can do with it, with the express purpose of basically just handing it to Wall Street firms. 

It struck me as insane, so literally and unbelievably crazy that I found it odd over the weekend to think that he wasn't literally laughed out of the room when he proposed it. It's the kind of thing that you'd think would cause armies of torches and pitchforks to descend upon the Capitol en masse.

We've all closed on a real estate transaction or worked up financing for something right? Can you imagine a $700 billion dollar deal sheet with the terms on 4 single spaced sheets of paper saying essentially: here's all the money, have fun, and there's no recourse to courts or anything else if we don't like what happens. It sounds alarmist but that quite literally was the proposal.

Thankfully, and somewhat to my surprise, people actually seem to have figured this out and the plan is going to be dead, or amended. As a gambit though it was classic disaster capitalism. Create a crisis and then act like we have to do something right now that gives massive power and money to the people responsible. As they say, it's not a bug in the system, it's a feature. It's the point, it's how this philosophy works. 

But returning to the above it's not just a $7 to $10 trillion dollar problem. It's much bigger than that even, by far. It's not just mortgages, the total value of credit default swaps is well over $50 trillion dollars (yes, as much as five times the entire US GDP) and as far as I can tell -- and I'm far from a complex securities expert -- many of these were traded/exchanged with no regard to the counterparties ability to pay. So it appears there are companies "insuring" perhaps $100 billion in default risk, when they have nothing like that kind of money if there in fact is a default. It's madness, again it's hard to believe it really happened this way. But here we are. 

But again, it's interesting to read the discussions of how this all relates to the real estate market as I still think it represents a classic fallacy, which loosely translates to the idea that 1) The problem is primarily based on home prices, and 2) The lack of liquidity and a newfound unwillingness to lend is a main culprit. 

Indeed, prices of homes are always affected by access to capital, and bank willingness and ability to lend. But at the end of the day -- always -- the prices of any asset reflect underlying demand. Sure, housing prices rise and fall by interest rates. But the question is why? Because interest rates help determine monthly payments. And people buy houses based on a calculation of what payments they can afford, guesses as to their future income, and perceived value of being able to actually use and live in the property (ie rental equivalence). Of course as we know the housing bubble installed another variable -- perceived appreciation. That's always been there but in this last market that became dominant. Which as we've seen is a problem. 

I think it's actually pretty instructive to put this in the context of another bubble we can all understand and remember from the not too distant past, the dot com bubble. Stock prices and home prices have some similarities. Much like the price of Pets.com stock was based on the idea that someone else would be willing to pay more in the future for the stock, the same was true of a lot of marginal real estate. When capital dried up -- and it did -- I'm sure we all remember CEO's saying that the business was on track to be successful but recent developments in the market have made it impossible to continue. Remember all those homepages that had a note to that effect?

BubbleTech.com is sad to announce we are ceasing operations, even though we had a great product and lots of users the current climate has made it impossible to finance continued growth, so sorry to everyone.

Ummm... sure. But the reason Pets.com had problems at root was not that it lost access to capital. To channel my friend, the brilliantly blunt Phil Kaplan for a minute the reason was that nobody wanted to buy kitty litter over the internet via UPS delivery at a price that could make a profit. The underlying model was, in the parlance of the time, f*cked. Completely. 

There was no relationship between the value provided by the company and the value people perceived from it and their willingness and/or ability to pay. 

What does that have to do with houses? They're pretty similar actually. Sure, problems with lending are an issue. Just like in technology, where in late 2000 there were undoubtedly actual good -- meaning potentially profitable -- ideas that could not get funded. Right now there are no doubt people with willingness and ability to pay who are having trouble getting a mortgage.  

But as a rule, housing values relate to income and perceived value (demand) and availability and quantity of housing (supply). Some things don't really ever change much. When housing prices got so out of kilter with income and rent equivalency then they were inevitably bound for a crash. That's just the way it is. Just like when dot coms spent $1 to get $0.50 back they were f*cked. Period. 

But in housing, like all markets, at root there are market clearing prices. In fact probably quite a few of these mortgage backed securities have value. Because of the way they structured them (ie first loss provisions and tranches) many of them, literally, are valueless. But some will have value. Many of these foreclosed houses have some value. 

So yes, there are market clearing prices for real estate, though a discrepancy between buyer and seller expectations can demolish liquidity, compounded by a credit contraction. Nonetheless things are falling fast -- but they won't fall forever. Housing prices will probably fall to rental equivalency, overshoot, and then stabilize. Of course it's a moving target as incomes (demand) can drop too during a recession, but still, it's inevitable. 

But the banking crisis involves a lot more than just residential real estate and mortgage backed securities. The debt insurance market dwarfs this problem. The reality is that the losses have already been made. People essentially spent on borrowed money, through HELOC abuse and equity withdrawals and the like. It propped up the economy for awhile, but that's over. 

But to reference a phrase that was going around quite a bit this week - the fundamentals of our banking system are weak. I think there might be a chance that a good treasury plan will involve recapitalizing the banks (by giving the funds but taking equity in return, which is mandatory and insane that it was not part of the original plan). That kind of capital infusion could indeed work just fine. It could make the banks solvent, and return the economy and sector to some sense of rationality.

But housing prices got too high when they were decoupled from rent equivalence and incomes. Just like dot com stock got insane when it was decoupled with standard notions of profitability and return on investment and revenue. And to keep the metaphor going many people made money in technology during that time. And there will be much money to be made now in real estate for smart people. But the sector will contract and housing prices will continue to fall (in real terms -- the idea of inflating our way out of this is another issue, and another 2000 word post). But that aside there's no other way for things to go. 

That's a good thing. It just sucks for everyone holding the bag this month. 

Luxury as Absence

"I love luxury. And luxury lies not in richness and ornateness but in the absence of vulgarity."

- Coco Chanel

Two Envelopes

I was just trying to refresh my knowledge of Bayesian probability theory (don't ask) and I came across something I hadn't seen before, the Two Envelopes Problem. I'm a fan of the classic game theory paradoxes, the most commonly known one being the Prisoner's Dilemma.

The latter, as trite as it might seem after endless repetition, is still really a cornerstone of game theory, and the usual entree into discussions of how game theory can apply to economics and strategic financial decisions. For myself at least it was the first introduction to Nash Equillibrium, a state where no player can unilaterally benefit by changing strategy.

What's so eye opening when you dive into Nash Equilibrium after a heavy indoctrination in efficient markets theory is the realization that a perfectly understandable system with clear rules, where each player is acting perfectly rationally, can produce an outcome that's decidedly sub-optimal. It's a dilemma indeed, which is why cops have been using it for centuries. No matter what strategy the prisoner chooses it's nearly always optimal to confess, though clearly the optimal strategy for both prisoners is to keep their mouth shut.

Thoughtful and prudent market players acting rationally don't always produce efficient (or Pareto-Optimal, to use the jargon) results. Interesting. We'll have to get back to that one.

But back to the envelopes. To summarize, assume an actor is given two identical envelopes, each of them containing a sum of money. One envelope has twice as much as the other. The player selects one envelope and keeps whatever is in it, but as soon as they choose, and before they open the envelope, they are offered the option of switching.

Should they take the offer?

If the envelope in your hand has X amount of money, then the other envelope has either .5X or 2X, with a probability of one half. Now as any self-respecting gambler can, you should run an expected value calculation and thus determine that the value of switching will pay off at .5X half the time and 2X the other half, for an expected value of the switch that works out to 1.25X.

So switching, on average will yield a 25% better return than not switching. Of course once you've switched, and you have the other envelope in your hand, you start the problem over from the beginning. And now it makes sense to switch again, for exactly the same reason. And again, and again, and again.

Using math, we've proven that switching to the other envelope is always the better choice, no matter which envelope is in your hand. Sounds like the statistician's version of proving that the grass is always greener.

If you're waiting for the punch line, there isn't one. That's why it's called a problem.

I'll pay you to quit.

It's a story that has been forwarded around a lot this week, but I was struck by an interesting philosophy at Zappos. They offer people $1000 to quit after a month -- the idea is that people who aren't committed will take it, but the people who stay will be serious about working there.

I found it here:

I spend a lot of time visiting with companies and figuring out what ideas they represent and what lessons we can learn from them. I usually leave these visits underwhelmed. There are plenty of companies with a hot product, a hip style, or a fast-rising stock price that are, essentially, one-trick ponies‹they deliver great short-term results, but they don¹t stand for anything big or important for the long term.

Every so often, though, I spend time with a company that is so original in
its strategy, so determined in its execution, and so transparent in its
thinking, that it makes my head spin.