Performance-based compensation and novel financial instruments: an explosive combination

Econbrowser draws a connection between known problems with performance-based compensation, given to CEOs to “align” their interests with those of shareholders, lack of regulatory oversight, and financial innovation (emphases mine) …

Econbrowser: Executive compensation

… That the incentives for CEOs need not necessarily coincide with those of the shareholders is a well understood phenomenon that is a special case of what economists call the principal-agent problem. This arises in situations when an agent (in this case, the CEO) has better information about what is going on than the principals (in this case, the shareholders) who rely on the agent to perform a certain task. One way to try to cope with these problems of asymmetric information is to tie the agent's compensation directly to performance.

What caused that principle to go so badly awry in the present instance? I believe there was an unfortunate interaction between financial innovations and lack of regulatory oversight, which allowed the construction of new financial instruments with essentially any risk-reward profile desired and the ability to leverage one's way into an arbitrarily large position in such an instrument. The underlying instrument of choice was a security with a high probability of doing slightly better than the market and a small probability of a big loss. For example, a subprime loan extended in 2005 would earn the lender a higher yield in the event that house prices continued to rise, but perform quite badly when the housing market turned down. By taking a leveraged position in such assets, the slightly higher yield became an enormously higher yield, and while the game was on, the short-term performance looked wonderful. If the agent is compensated on the basis of current performance alone, and the principal lacks good information on the exact nature of the risks, the result is a tragically toxic incentive structure…

In point form then the contributing factors were:

1. the well known principal-agent problem
2. poorly designed performance based compensation (an attempt to mitigate the principal-agent problem, but the time scales are not aligned)
3. leverage without regulatory oversight
4. novel financial instruments with a no more than average* (probably below average when expenses are incorporated) expected value but a skewed probability distribution – so there was a high probability of slightly above average returns and a low probability of catastrophic failure

It’s a persuasive argument, consistent with Lewis and Einhorn on repairing the financial world, Lewis (again) reporting on the “end of Wall Street” and Henry Blodget writing for the Atlantic – Why Wall Street Always Blows It.

My take away lessons are:

1. We need to be very careful with performance based compensation. The problem isn’t that it’s not an effective incentive, the problem is that it’s too effective an incentive. The physician “pay for performance” crowd should pay attention to this, but they won’t.
2. We need regulatory oversight. Yeah, we knew that.
3. Novel financial instruments, whether they provide new ways to skew probability (2008), or new forms of leverage (1929), need to set off red flashing lights and screaming alarms in the Treasury, Congress, the White House and the Federal Reserve. Our government and regulatory agencies need to be doing continuous “war gaming” about how new technologies will transform finance, and constantly about how to avert future catastrophic scenarios.

See also:

1. Jumping the canyon of Great Depression II
2. Stimulus and the scale of under-utilized global productive output
3. Lewis and Einhorn: repairing the financial world
4. The role of the deadbeats
5. Complexity collapse
6. Disintermediating Wall Street
7. The future of the publicly traded company
8. Marked!
9. Mass disability and income skew
10. The occult inflation of shrinking quality
11. You get what you pay for. The tragedy of the incentive plan.

* In this sense “average” refers not to the averaging over the lifespan of the instrument, but rather all the probable outcomes – an expected value calculation really.

Obama falls for the Jena meme

Not Obama's best speech line ...

Obama Addresses Homophobia, Anti-Semitism and Xenophobia Among Black Americans | The New York Observer

... We have a deficit in this country when there is Scooter Libby justice for some and Jena justice for others...

Except the Jena story wasn't that simple. Wikipedia provides excruciating detail.

The speech would have been better without that line ...

Obama knows what he’s doing – calming the right …

I didn’t like the Warren choice, but I’ve been worried about culture shock on the right. Maybe Obama, who is perhaps a bit better at politics than I am, has been worried too. Maybe he’s been trying to calm their anxieties.

Maybe it’s working …

In McCain Country, Acceptance of Obama Grows

… In interviews in the week leading up to Mr. Obama’s inauguration, many people here said a tolerant spirit toward his presidency has been hastened, paradoxically, by some of the same groups that voted mostly Republican in the election. Those include active or former military personnel, and people who identify themselves as evangelical Christians, two groups with traditions of respecting hierarchical order and strong leadership…

… Leonard Nelson, 63, a 23-year veteran of both the Army and the Navy, said he had voted for Mr. McCain mainly through military fealty, believing that Mr. McCain’s own military record would make him a better commander in chief.

“But I’ve come to think the better man won,” said Mr. Nelson, owner of the Humidor Cigar Shop, an aromatic haven of pipes, blended tobaccos and customers on a first-name basis. Mr. Nelson said that Mr. Obama, through his cabinet selections, sent a signal of centrist government intention that feels all right to him.,,

… At one of the city’s biggest evangelical megachurches, Victory Christian Center, with 17,000 members, there were also mixed messages of enthusiasm.

The church’s pastor and founder, Billy Joe Daugherty, said that the selection of the Rev. Rick Warren, a prominent evangelical minister from California, to give the inaugural invocation went a long way to easing fears in Mr. Daugherty’s mostly conservative congregation about a liberal social agenda…

“What I’m sensing from Obama in making the choice he did — he’s saying to all groups, ‘Why don’t we come together?’ ” Mr. Daugherty said in an interview…

When Bush “won” in 2000, he acted as though he’d won by Obama’s 2008 margin. Obama, who really did win big, behaves like he just squeaked by and needs every vote.

What’s next, a visit to Limbaugh?

We don’t deserve this President, but I’ve never been in favor of getting what we deserve.

I find this all very hard to believe …

Cheney is left to twist in the wind ...

Neither Libby, nor Cheney ...

Bush Commutes 2 Border Agents’ Sentences - NYTimes.com

... There had been speculation that President Bush would grant clemency to some high-profile defendants, but the White House official said the two ex-agents would be the last to benefit.

I. Lewis Libby Jr., former chief of staff to Vice President Dick Cheney, could have been granted a pardon for his role in the leaking of a C.I.A. agent’s name and an attempted cover-up. In July 2007, Mr. Libby’s prison sentence was commuted. Nor was there any clemency for former Alaska Senator Ted Stevens, who in late October was convicted of ethics violations for not reporting gifts and services given by friends. Mr. Stevens would lose his bid for a seventh term....

I don't think the Bush and Cheney families are talking any more.

Why I ignore Amazon's "helpful" ratings ...

I think this sort of thing is pretty common, even when it doesn't involve bribery ...

Slashdot | Belkin's Amazon Rep Paying For Fake Online Reviews

... recently discovered that Belkin's lead online sales rep, Michael Bayard, has been secretly paying internet users to review his company's products favorably on Amazon.com and other websites like Newegg, whether or not they've ever used the devices. Bayard instructed the people he was paying to 'Write as if you own the product and are using it... Mark any other negative reviews as 'not helpful' once you post yours.'..

I always read the negative reviews. I never bother with the "helpful" rankings because they're often obviously gamed.

I kind of figured this out when I realized that my positive Amazon reviews were always "helpful", but my negative reviews were often "not helpful".

Jumping the canyon of Great Depression II

I'm now working my way through lectures by James Shenton, part of a 1996 Teaching Company course on the History of the United States.

It's radically abridged history; stories of a thousand pages become a few sentences or nothing at all. Even then there's too much attention to the idiosyncrasies of various presidents, but Shenton changes gears when he gets the Great Depression. Things get vivid, perhaps because Shenton was born in 1928..

Sheton's lecture took place at the height of Clintonian prosperity, in the midst of the roaring 90s, near the time Greenspan warned of "irrational exuberance" (alas he changed his mind) and four years before the dot com crash of 2000. Shenton might have wondered if he was replaying the 1920s, but that doesn't come across in the lectures.

Listening in 2009 it's eerie hear him walk through the prelude to Great Depression I, and comparing his list to our our time.

• A culture of acquisition? Check.
  
• Stocks couldn't go down? Depends when date the start of our troubles. If we go with 2000 then that's true again, even in 2007 the "home prices never fall" meme was in play. (Of course home prices fell big time in GD I.)
  
• Income inequality? Check.
  
• Great dust bowl? Not here, but how about China?
• Exotic new financial instruments (margin buying)? Check (derivatives)
• Excessive consumer debt (installment buying)? Check (credit cards)
• Technological transformation (auto, electricity, radio)? Check (computer, net)
• Complexity collapse (Keynes)? Check.
• Collapsing banks? Not quite. This time we might have learned something.
• Deflationary spiral? That's the current worry.

So are we going to lose 50% of our GDP, face 25% unemployment and 25% underemployment?

I really don't think so. Yeah, the bridge is out, but the engineer is turbocharging the train engines. Maybe we'll get through the bank crisis and the deflationary crisis before massive unemployment hits -- meaning the train jumps the canyon.

If we make it across the canyon though, we'll have one hell of a clean-up job ahead.

Obama's going to need 8 years, and pray Reason the unreformed GOP doesn't make a comeback.

Annals of idiocy - AT&T spams customers about a TV show

We live in numbing times. There's not much outrage left, we have to marshall what we have to deal with the Cheney/Bush torture program.

Still, lunacy like AT&T's recent bonehead move deserves at least a whimper or two (emphases mine) ...

AT and T Sends Customers ‘Idol’ Ads - NYTimes.com

Some AT&T Wireless customers have voted an emphatic no on a promotion for “American Idol” that popped up on their phones this week.

AT&T, a sponsor of the show, said it sent text messages to a “significant number” of its 75 million customers, urging them to tune in to the season premiere on Tuesday night...

... Mark Siegel, a spokesman for AT&T Wireless, said the message was meant as a friendly reminder. “We want people to watch the show and participate,” Mr. Siegel said. He added, “It makes perfect sense to use texting to tell people about a show built on texting.”

... Mr. Siegel said the message went to subscribers who had voted for “Idol” singers in the past, and other “heavy texters.” He said the message could not be classified as spam because it was free and because it allowed people to decline future missives.

“It’s clearly marked in the message what you need to do if you don’t want to participate,” he said. “It couldn’t be more open and transparent.”

Richard Cox, the chief information officer for Spamhaus, a nonprofit antispam organization based in Britain, countered: “It’s absolutely spam. It’s an unsolicited text message. People who received it didn’t ask for it. That’s the universal definition of spam.”..

...Mr. Siegel of AT&T defended the use of the medium given that voting by text message had played a big role in “American Idol.”

“Text messaging is the perfect way for us to tell people about this wildly successful show and to watch it,” he said...

Mr. Siegel's soul has had a rather bad day. I hope he sends it out for some rehab. Being a spokesbot for AT&T can't be pleasant.

AT&T's cell phone spam attack is not as bad as SONY injecting malware into their customer's computers, but it still deserves a spark of outrage.

Ok, a feeble squib of outrage.

Still. Something.

Update 2/7/09: Gizmodo's comments.

American torture - what's next

Obama (praised be his name) is likely to define waterboarding as torture and pledge to follow the spirit of the Geneva convention.

So what do we do next about American torture?

Well, to get caught up with the matter, a few helpful references:

• The Torture Report NYT Editorial Dec 2008
• What do the Bushies and the Khmer Rouge share? - Nicholas D. Kristof
• Madness and Shame – Bob Herbert
• Why aren't Americans outraged? Friedman, Guardian

As to the last, we're not outraged because, frankly, our outrage engines have burnt out. At this point nobody would be shocked to discover that Cheney has a private dungeon full of missing people.

So we'll have to proceed without outrage. Panetta says it reasonably well (emphases mine) ...

Brad DeLong's Egregious Moderation: Leon Panetta on Torture

... According to the latest polls, two-thirds of the American public believes that torturing suspected terrorists to gain important information is justified in some circumstances. How did we transform from champions of human dignity and individual rights into a nation of armchair torturers? One word: fear.

Fear is blinding, hateful, and vengeful. It makes the end justify the means. And why not? If torture can stop the next terrorist attack, the next suicide bomber, then what's wrong with a little waterboarding or electric shock?

The simple answer is the rule of law. Our Constitution defines the rules that guide our nation. It was drafted by those who looked around the world of the eighteenth century and saw persecution, torture, and other crimes against humanity and believed that America could be better than that. This new nation would recognize that every individual has an inherent right to personal dignity, to justice, to freedom from cruel and unusual punishment...

Admittedly, Panetta has rather naive view of American history, but I'll take it. Creation myths have their uses. At least he doesn't resort to the asinine tactic of including "torture doesn't work" as a reason to avoid it. That stupidity implies that if we came up with an effective way to torture then things would be simply peachy.

Next steps?

We need to support an American Truth Commission. We need to support international efforts to prosecute Cheney, Bush, Rumsfeld and Rice. At the least they can be denied the comforts of Florence. We need to get the story out, and we need to write about it even when nobody wants to read about it.

Even with all the outrage worn out, we keep plodding along.

Eight years - among the worst

We've had some really bad presidents. I mean really bad.

Warren Harding was perhaps the very worst. He was completely unsuited to the job, but his friends made him look good by comparison. They stole and ruined a vast amount. It was a record of pillage, looting and waste that has stood for almost a century. But then came eight years of George Bush Jr (Frank Rich - NYTimes.com).

Wow. Rich has done a great job of summarizing an astounding record of greed, theft, and incompetence. It's easy to imagine that Bush was a Soviet "Manchurian candidate", programmed forty years ago to destroy America.

Except, of course, he couldn't have done it alone. He needed Cheney and GOP control of the House and especially the Senate.

The almost worst thing is, America reelected Bush. We stuck it to ourselves. The really worst thing is that we stuck it to the rest of humanity too.

Interview from the dark side of software

From Slashdot, a pointer the very best interview I've read in the past year.

It's the story of an extremely bright programmer who, step by step, walked beyond the limits of morality but just to the margins of the law. [Update: Or maybe well beyond the limits of the law. Via Schneier]

He's reformed now, but his look back at the software he wrote is amazing. There are clear indications of current wisdom ...

philosecurity - Interview with an Adware Author

.... Most things don’t have to be perfect. In particular, things involving human interactions don’t have to be perfect, because groups of humans have all these self-regulations built in. If you and I have an agreement and you screwed me over badly, you’ve always got in the back of your mind the nagging worry that I’m going to show up on your doorstep with a club and kill you. Because of that, people don’t tend to screw each other too much, right? At least, they try not to. One danger, perhaps, of moving towards an algorithmically driven society is that the algorithms aren’t scared of us showing up and beating them up. The algorithms will do whatever it is that they are designed to do. But mostly I’m not too worried about that....

The tech side is fascinating too. Nobody knows Windows like a black hat. I wonder how much this sort of story has informed the design of OS X 10.6 ...

Unexpected social good - a post on roaring fans

My tech blog posts are partly for my own use, and partly I'm trying to give back.

Sometimes it seems to work; some posts get very kind comments.

There's one, however, that really stands out.

An otherwise unremarkable May 2008 post on how badly written OS X print drivers cause howling, roaring, fans has earned me more “thank yous” than almost anything else I’ve done in the past few years.

Funny how that works.

China 2009 is about to become Japan 1986

So you’ve probably been thinking that after the last ten years we’re due for a respite. A bit of calm amidst the floating refuse of our crated life raft. It was a big waterfall for sure, but now we get to float for a while.

Then you hear the roar of the next cataract.

Very few people now remember than by 1986 Japan had just about finished off the American car industry and was about to conquer the American computing industry.

What'? You don’t remember the congressman taking a sledgehammer to a Japanese made IBM-clone?

I remember because my very first PC was an 8086 clone made by Panasonic. It was the most over-engineered device I’ve ever owned. It was built to last thirty years, and it cost less than the other clones on the market.

IBM, Compaq, and the like were terrified. Congress was appalled – America had lost the automobile*, now we were going to lose the computer too.

De facto “voluntary” quotas were enforced. Panasonic and other Japanese PC vendors left the desktop market. Dell became dominant.

Flash forward 23 years …

Chinese Electric Automaker Challenges Big Three

…Chinese car maker BYD Co. BYD developed an electric automobile that only costs consumers $22,000…

Gee, this feels familiar.

Wait until Chinese/Google “Chromestellation” netbooks start selling at Walmart for $124.99 (batteries not included).

Eeeeeeeyyyyyaaaaaaa …..

* The same set of “voluntary” quotas forced Japan to manufacture in the US, and also allowed GM, Chrysler and Ford time to more or less compete with Japan.

Guru-level air travel tips

I am a lowly travel worm, unworthy to learn the techniques of the travel Ninja (emphases mine) …

Being John Glaser 1/6/09

… Preventing the person in front of you from reclining their seat (Spilling soda on their head is minus 5 points. Pointing the air vent so that it blows on their head is plus 5 points.)…

… Stopping the person next to you from reading over your shoulder. (Saying “Read my stuff again and I’ll kill you” is minus 5 points. Turning the book/newspaper upside down and continue reading earns the contestant 5 points.)…

Captured via Jacob Reider’s Google Reader shared item list.

Google responds to CO2 emission criticisms

I don’t know the back story here, but clearly Google is sensitive to accusations of environmentally incorrectness. Their response is fascinating …

Official Google Blog: Powering a Google search

… Recently, though, others have used much higher estimates, claiming that a typical search uses "half the energy as boiling a kettle of water" and produces 7 grams of CO2. We thought it would be helpful to explain why this number is *many* times too high. Google is fast — a typical search returns results in less than 0.2 seconds. Queries vary in degree of difficulty, but for the average query, the servers it touches each work on it for just a few thousandths of a second. Together with other work performed before your search even starts (such as building the search index) this amounts to 0.0003 kWh of energy per search, or 1 kJ. For comparison, the average adult needs about 8000 kJ a day of energy from food, so a Google search uses just about the same amount of energy that your body burns in ten seconds.

In terms of greenhouse gases, one Google search is equivalent to about 0.2 grams of CO2. The current EU standard for tailpipe emissions calls for 140 grams of CO2 per kilometer driven, but most cars don't reach that level yet. Thus, the average car driven for one kilometer (0.6 miles for those in the U.S.) produces as many greenhouse gases as a thousand Google searches.

I think it would be interesting to compare Google search CO2 prediction to CO2 production from a 1 km walk.

2009 will be the year of machine translation

Speaking of the singularity, I've subscribed to my first foreign language blog, thanks to Google Reader's integrated machine translation services.

I've read a few predictions for 2009.

Here's mine.

This will be seen as the year that machine translation went mainstream.

The world's IQ is about to go up 10 points.

The press makes much of Apple and Palm's recent twitches, but those companies are dull as dust compared to Google. I don't think we grasp what's happening there.