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."
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:
...so, um, why?
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."
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 betThere 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.
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.
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.
"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."
Here's an interesting premise:
What if we slowed lending on purpose, what if we decided there wasn't any good reason to make it easier to buy homes? What if you had to have 30-50% down to buy a home? What if you had to show real income to get a mortgage again? What if you needed revenues for bank loans again? Would that be so wrong? Would it be a hardship?
In Europe folks need 50% down for homes. Perhaps too much, but 0-10% is clearly too little.
I think the answer is no, or not necessarily. What if we just went back to the same system we had as recently as, say, 1995 or so? Historically it was typical to have about 20% down, maybe 10% sometimes, interest rates weren't kept artificially low by a Fed determined to flood the economy with cheap credit, and the people who wrote mortgages actually had their own money on the line if it turned out that someone couldn't make the payments, so they'd actually have incentives to make smart loans.
The concept of "disaster capitalism" may be applicable here. Perhaps not in the crash, but in the response to it.
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
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.
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?
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
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.
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.
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.
Now there's a light topic.
Or perhaps to state it another way, is being altruistic compatible with acting in your own self interest? Aren't those two things diametrically opposed?
Or to get to the crux of the matter, can a market based approach be compatible with the goal of advancing the common good? Short answer: yes. For my stab at a long answer, see below. Of course, it depends on how you look at it.
I've been meaning to follow up on some of the ideas raised by the Prisoner's Dilemma issues in the last post, so let's start by rushing to the conclusion, with a quote from Mario Henrique Simonsen:
Moreover, as game theorists have shown, the ruthless pursuit of self-interest often results in a comparative loss for everyone. Game theorists often appeal to what is known as the Prisoner's Dilemma. Typically, the Prisoner's Dilemma provides an example of a situation in which two people are faced with a choice about whether to act in a self-interested way or altruistically, and the example shows that both come out ahead if both act altruistically. Peter Singer gives an interesting variation of this dilemma in The Expanding Circle. Imagine two early human hunters who are confronted with a saber tooth tiger. If the tiger chases them, the tiger will only be able to chase one of them but will have at least a ninety percent chance of catching and killing the one that is chased. If both stand their ground together, there is only a very small chance that the tiger could kill either of them. If both hunters are narrowly self-interested, they will both flee in order to save their own skin and there is a fifty-fifty chance for each hunter of being caught and killed. If, on the other hand, both are altruistic and both stay to help the other hunter, then in fact both will benefit. In some situations, in other words, individuals actually derive more benefit by not being self-interested!
Let's build our own sabre-tooth-model then. There are ten people who believe in cooperation in one village. Ten who only act in a ruthless and caricatured version of self-interest in another village, on the other side of the river. In each, along comes a saber-toothed tiger that's hungry. Assume that the tiger only needs to eat one person a day to be happy. Assume that the tiger is faster than any given person. Assume that the tiger is really tough to kill, but 5 people could do it together if they try hard enough.
Day one. Tiger comes. In the first village someone gets eaten as they are caught surprised. In the other, everyone runs instantly. The slowest is killed. In the first village, they get together. The fastest runners decide also that everyone will work together, the next day they gang up and try to kill the tiger. They may lose another one or two, but he's dead eventually. In the other village, the tiger comes each day and kills the slowest runner. Two weeks later, every single person is gone.
So one responds -- banding together is not altruism, obviously, since if we don't do it we all die, so the other village (who act only by ruthless self-interest) would have done the same thing, they say. They'd just do it for a different reason, because it's also in their self interest.
But how? Nobody knew he was coming back the next day. Or any given person could have just run, and hoped that 5 others were able to kill the tiger and they would have avoided all risk.
Ok, so how do you deal with a system of rewards and penalties that is infinitely more vague and complex than this minor example? People can't predict the future, they have to make assumptions. You cannot make an absolute case for self-interest against altrusim, because you cannot absolutely define which is which.
In short, one learns how to balance altruism with self interest. Or more accurately, one learns that rational self interest -- and hence market based solutions -- isn't the opposite of altruism, with community, or with banding together to solve common problems.
If you view the above example through the prism of markets, and as an example of a market rendering judgement, the results of the invisible hand of said market are clear.
In one group everyone banded together, saw the oncoming existential threat to their entire community, and decided to do something about it. It didn't necessarily require the authority of command, all it took was the collective realization that the community would live or die by tackling the problem together. In the other group people refused to recognize the threat they faced, or argued that it wasn't rational for them individually to expend energy to face that threat. They ceased to exist.
When people talk about capitalism and markets that's just another way of talking about incentives.
There's no rule that says that self-interest has to be short sighted or blind. There's nothing magical about markets. But there's something very powerful about them, they present incentives and with lighting speed they channel resources towards those who adapt and thrive most efficiently.
As we face upcoming existential threats -- global climate change for example -- it's comforting to remember that we're all descendents of the first village, by definition. The second village didn't make it.
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.
Some random thoughts on a Sunday evening, following an interesting discussion I just had. The premise was that the U.S. today looks like Japan in the early 1990's, and that within the next five years the U.S. will be the #3 economy in the world, and just barely maintaining parity with India at #4.
This sentence I think sums up the argument.
The problem is that America has less and less fundamental value to offer the global economy, and this is getting worse, not better.
Let's unpack this idea a little bit.
The United States is the #1 country for GDP in the world with a rough number of $14 trillion.
Next up is China at about $7-10 trillion, followed by Japan at around $4 trillion.
India is number four at around $3 trillion GDP.
As a sidebar - this brings up the question of how to count the EU. You can make an argument that it should be compared as a whole to the U.S. economy, though I don't share that point of view -- for example it seems like similar logic could argue for including Canada in the U.S. figure based on close economic ties and border policies, even if the common monetary policy of the EU is the strongest argument.
Either way, the entire EU comes in at about $14-15 trillion, just a hair higher than the US.
And let's face it, the EU is not a country.
So for India to catch up to the U.S. we'd have to be looking at a five year trend that involves either India growing at an annualized rate of 50% or more a year and/or the U.S. declining at an annualized rate of 50% a year or more.
For reference the worst year of the great depression, 1932, saw a negative growth in GDP of about 13% annualized. And also for reference after 10+ years of stagnation Japan is still wealthy and the third largest GDP country in the world despite its tiny size.
In fairness China is much closer behind, but again, their staggering rate of growth (and it is remarkable, and hard to see as sustainable) is still in the 11-12% annual range. Even starting with an extreme premise it's very hard to see how the current rankings will change in the near term.
But as of today we have heavy, major problems in debt markets, currency markets, job market, and commodities markets, and various other lurking mayhem in the US economy.
It's also true that the economy has been spectacularily mismanaged for 7 years now. One could argue that any looming recession is a byproduct of spending several trillion dollars in national resources on a war that has led to higher gas prices and even more "crowding out" effects in debt markets. Also relevant is a regulatory policy infested with moral hazard issues, and a fiscal policy that seem guaranteed to put pressure on the currency and price level. I could go on.
But business cycle contractions are normal. One thing that's normal about them is every time they happen people go nuts like it's the first time it has ever happened. Much like people thought somehow the rules of real estate had been revoked when they decided to flip houses.
The rules always apply on the way up. But also on the way down. The media tends to gravitate towards the apocalyptic changing of civilization paradigm shifts, but much like it was smart thinking to be bullish but cautious during the bubble, it's equally rash to over react now on the bear side. Same as it ever was.
A new administration, some unraveling of the insanity in securitized debt markets, and it might just start to feel good around here again. In the 1930's people starved, in the streets. Banks failed and wiped out entire communities.
We're still around. It's fun to play mental Mad Max but it's more fun to be an optimist. With every panic lies opportunity.