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Rome could not be conquered. It destroyed itself from inside. The afterglow of Rome’s strength remained for about another 200 years, and kept the barbarians at bay.

Wall St., the New Rome, had reached the power and stature of old Rome, but on a much grander scale. And in 2008 New Rome fell from grace. Here are 3 inferences why.

Abuse of Strategy: Up to 2007, we thought of Wall St. firms as excellent well managed companies, the crème de la crème of American Capitalism, but as of 2008 we know that their management teams had bled their future sustainability by maximizing profits today at any expense. With hind sight, Wall St. firms chased mortgage products in the “mistaken” belief that they had securitized away all risk. Really? What happened to the risk-return relationship? I suppose that was conveniently forgotten?

In the strategy world this is known as harvesting. Harvesting is a correct corporate strategy in a mature dying industry, but not as a management game at shareholders long term expense.

Misuse of the Term Strategy: A few years ago, a very senior financial executive in the mortgage industry came up to me and said “you cannot use frequencies to estimate probabilities”! Makes you wonder if any of these finance types really had any understanding of the risks they were taking? History suggests that they did not.

The unfortunate reality in financial services, is that strategy is mistaken for a new formula (see Recipe for Disaster: The Formula That Killed Wall Street) or worse still a new IT system. Worse because without a design document and proper records and audits it is difficult to figure out what went into this IT system. These are not strategies.

At best they are tactics, more often they are business necessities. In the world of finance, understanding your formulae, your systems, and your risk methodologies are a pre-requisites of the business. These are not strategies. If anyone tells you otherwise they really don’t understand what they are doing. 

Finally, the really bad news, is that if a formula or an IT system is your company’s strategy, chances are somebody else on the other side of the market or the world has probably also figured it out and is using it against you.

Incorrect Strategic Implementation: Looking at Wall St., (not to blame them but they are rich with examples of how not to do it) many Wall St. firms had very high powered Market Risk, Credit Risk, and Operational Risk committees, and they still failed. This is like LTCM, with their two Nobel Laureates, all over again.

Lets not just point a finger at these committees. Wall St. collapsed in spite of Sarbanes Oxley Act of 2002. Wall St., collapsed 5-6 years after Sarbanes Oxley came into effect.

The point here is that implementation failed.

For Corporate Strategy advice, please contact Ben Solomon at QuantumRisk LLC. (Note fix email address)

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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8 Comments

  1. Comments
    a) SOX is a legalistic driven matrix, it is rules based. Risk management does not come from rules. The SOX framework would fail it’s designer on inception. The US President said no one is going to jail for the failures. Why is this so if SOX place responsibility squarely at the CFO and CEO feet?
    b) Real risk management is more than rules and documented principles. It is also about intention, motive, objective and sound practices. I saw may deals being done purely to front end the income (slight of hand to get the money into this years bonus pool) and push all the risk and cost on to some one else. The best at this game were the 5 major US investment banks. The comments above show a good insight into some of the games that were being played.

    I’m not sure if it was harvesting or merely a huge focus on P+L and little concern for what was beyond. Many of the rain makers pumping deals knew if they slowed down they were out. So they had to keep the rain thundering today as tomorrow they would be moved on.

    2 Issues not reported in your commentary worthy of additional mention are
    i) The move to incorporation and public companies of investment banks enabled the agents to segregate the earnings from the risk takers. Investment banks need to consider moving back to private partnerships
    ii) A lack of power in risk managers. in a SOX world, the risk managers are compliance and use legal rule to stop play. (i.e. they are not risk managers but legal experts seeking to apply lower level controls to control risks.

  2. In business i heard there are three “I’s”: the Innovators, Imitators, and Idiots. We are currently in the Idiot stage of the perpetual cycle of the three I’s. Future regulation might stem the tide of the quants trying to devise new ways of addressing risks but it might squeeze credible solutions out of the market place, too.

    One thing is for sure: the laws of unintended consequences will reign under any government solution to curb abuses. What is left? The opportunist will see the results of unintended consequences and move to exploit.

    Perhaps capitalism can regain respect by providing innovative companies (with real products/services) the necessary capital to grow. We need to get back to what drove this country to greatness: get deserving start-ups producing again. Guessing by the drop in venture funds almost to zero, we don’t have the balls as investors (or remaining capital) to pursue deals. Until we fix that, the investor class might not see the next cisco or google for many years into the future.

  3. More on the intentional idiot aspect of things from the trenches.

    How we rotted from the inside…

    I have worked with the quants and modelers working in some of these places. They operate at the mercy of their management and leadership, and they know they would lose their income if they questioned the direction they get – so we can forget about conduct associated with insisting on being allowed to do a good job, or blowing the whistle when they see wrongdoing.

    Several years ago, I asked one of them to explain why employment rates were not part of the equation in the risk model, and why there was only the national perspective, or just a few regions when modern tools make it easy to consider many.

    He looked at me like I had 2 heads and then he said, “We can’t get good data on that stuff.” I found that kind of strange, since I knew where to get data on that “stuff.” Then I realized we were standing just outside his manager’s door…

    A year or so later, I interviewd a top exec and asked whether they kept an eye on fluctuation of currency values. The response to that question was, “It’s about the performance of the whole loan. It’s only about the loan.” He was serious! Can anyone tell me how that man keeps his job???

    Who – with an IQ above 50 – doesn’t know that employment influences a borrower’s ability to pay? Who didn’t know that foreign investment wasn’t a prime mover in the secondary mortgage market – and that it might make sense to watch fluctation of currencies as indicators?

    I have a friend who was fired for refusing to fund a loan she knew was fraudulent.

    But this next incident struck me as the worst. It happened when I worked in an IT lab in one of those firms. A customer directed a very young and inexperienced contractor sitting next to me to hard code a total on a report owed to one of the firm’s governing bodies because the autosum in the total was not good enough.

    I was glad to hear him hesitate – and I put my hand on his wrist and suggested it would be wise to get that request in writing. The individual who had made the request left the lab in a huff, calling us obscene names on her way out. Of course, the request never came.

    If they didn’t know it before, the whole world now knows that credit risk was deliberatley obscured by the process of securitization, and that derivatives were created expressly to conceal the volatility of the underlying collateral, and that they were also overrated by the rating firms.

    Why should anyone be worried about how to restore confidence where it’s unwarranted? To believe in things that aren’t true is stupid, isn’t it?

    We are pushing the payment for these antics onto future generations. Why? Shouldn’t we starve out the organizations that failed us, instead of starving future generations? Is this the legacy we had planned?

    Instead of huge stimulus spending that will end up being the reason the debt gets monetized, we could consider waiving federal income tax for some months in each year, and we stop funding organizations that didn’t do their jobs, eh? That’s what happens to us when we don’t do ours, right? That would put existing cash into circulation at its present value right now, and that might even restore some of the public’s trust.

    Was it Plato who noticed that character is destiny? This applies to nations as well as individuals, I think.

    But who doesn’t know that in this modern economy that “playing along to get along” is how you keep a job? Sure, we have ethics hotlines and all the other similar window dressing – and then we have the reprisals. We even have laws intended to protect the public from breach of public trust. We just don’t enforce them. Window dressing?

    Who hasn’t figured out that none of what happened was an accident, and that everyone with half a brain either knew it or could easily figure it out? It was discussed openly over lunches and at the water cooler among the outraged and the arrogant perpetrators alike.

    So, I wish we could have a break from all the speculation on what Wall Street knew, and what it did or didn’t understand. They knew, and they understood everything.

    I wish we would take on the task of cleaning up our own messes instead of passing on the job to our great grandchildren.

    I wish we could start over with people like my friend who refused to fund a fraudulent loan and the young man who refused to hard code s value that would mislead an oversight agency.

    One example of the government’s solutions began with the remodeling of a board room to the tune of $1 million. What do you think – do we need this kind of help from the government?

    Why can’t we just let it all go down fast and start over without the bums who caused it? All of them — we all know who they are.

    • I hear you, Pat. It really is not all that difficult to figure out what went wrong…unless you want to obscure it with language & convoluted logic that builds on a platform lacking in common sense.

      You can’t raise home prices above median income without expecting a bubble and it’s subsequent burst. I don’t believe homeowners are responsible for this particular mess, by the way. If you wanted to buy a junk property in a bad neighborhood it would have $175K or more at one point during the bubble. What is a prospective homeowner with children supposed to do? Add to this the fact that not owning a home exposes you to the dreaded 28-33% tax bracket. So, you convince yourself you can keep up with the payment as long as your partner is also working – even though this payment will still be more than 13% – 23% of your income (the old-school standard for estimating how much you should spend on housing).

      We all got greedy, and we all got stupid. Wall Street is a gamble – there is no “safe” or “secure” investment. If you are unable to afford the risk, you are unable to afford the reward. When we started “investing” things like pension funds and college savings in blended portfolios, we exposed ourselves to the risk these portfolios provided.

      Our nation could spend more time telling the truth. Just telling the truth – plain and simple – and rigorously enforcing consequences for not doing so, as well as for obsfucation.

  4. The reason SOX failed is that to calculate required capital to cope with variations in results it took as “normal” variations those experienced during a period of time which was among the most upwardly stable in human history. When greater variations occured, the capital proved very inadequate.

    Governments did not restrain the growth of enterprises and many enterprises grew to the point of “to big to fail”. The governments then acted as insurers to the “too big” enterprises. They were, in effect, paying claims without having collected premiums. No other insurer would do such a thing. I would propose that governments collect “too big” premiums (like the FDIC does) giving the “too big” enterprises the option of breaking up into parts that would not be “too big”.

  5. SOX intent was to detect fraud, it probably did not accomplish this goal as well as it could but it definitely was not designed to identify bad business practices. The bad business practices were being recorded correctly in terms of sales, accounts payable, accounts receivable and such. The failure was that the underlying risk of the business practices was not recognized. At the time, anyone who would have suggested that the business practices were risky would have been laughed at and asked to leave.

  6. Thanks all of you for your comments.

    I though you might also find this interesting. Here is a link to Sarbanes & Oxley’s response to our current mortgage mess:

    http://www.livemint.com/2008/03/15003003/Subprime-crisis-parallels-Enro.html

    and here is a good blog on Sarbanes Oxley:

    http://www.soxfirst.com/50226711/sox.php

  7. This is cool! And so interested! Are u have more posts like this? Plese tell me, thanks


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