Tough Targets and Short-Term Projects

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Wells Fargo.

The New York Times and Wall Street Journal both had big Wells Fargo fake-account-scandal retrospectives this weekend. The Times story starts:

The message to the dozens of Wells Fargo workers gathered for a two-day ethics workshop in San Diego in mid-2014 was loud and clear: Do not create fake bank accounts in the name of unsuspecting clients.

For ... two days? How? Like, you come in on the first morning and it's like:

SEMINAR LEADER: Don't create fake bank accounts in the name of unsuspecting clients.
LEADER: This is not a particularly subtle thing. There are gray areas in all sorts of ethical questions, but not in the creating-fake-accounts space. You'll pretty much always know if you're creating a fake account in the name of an unsuspecting client.
EMPLOYEES: Everything you say is true.
LEADER: So we're good on this?
EMPLOYEES: Seems that way.
LEADER: Wow, we have a lot of time left to fill.

I suppose then there were a lot of role-playing exercises. 

The Wells Fargo problem seems like a simple problem, but not quite as simple as some people think. I can't really believe that senior executives wanted employees creating fake accounts, just because fake accounts don't make any money. They wanted employees to constantly sell new products to customers, but real, money-making, loyalty-creating products, not fake ones. So they set high quotas for how many products the employees had to sell. And they told the employees -- repeatedly, and forcefully, and at length -- not to meet those quotas by opening fake accounts.

And the employees did it anyway, because the quotas were impossible to meet. This is of course a serious failure of management by Wells Fargo. If you demand impossible quotas, something will go wrong. Widespread opening of fake accounts was the obvious thing that could go wrong, so obvious that Wells Fargo management anticipated it and ran multi-day seminars to try to stop it. But even if Wells Fargo had managed to stamp out the fake accounts with better screening methods or whatever, something else would have gone wrong. Employees would have resorted to subtler forms of fraud, or at least to tacky sales tactics. ("Managers suggested to employees that they hunt for sales prospects at bus stops and retirement homes," reports the Wall Street Journal.) Or they would have just burned out and quit due to the impossible demands placed on them.

But how could they have communicated the problem to management? If senior managers tell low-level hourly branch employees to sell 15 banking products a day, it's tough for those employees to say no. From the Journal:

“If somebody said: ‘This doesn’t make sense. Where are you getting these sales goals?’ then [the response] was: ‘No, you can do it’ or ‘You’re negative’ or ‘Oh, you’re not a team player,’” says Ruth Landaverde, a former Wells Fargo credit manager in Palmdale, Calif.

Wells is an unusual case, but the basic managerial philosophy -- that anything is possible, that goals once set can never be walked back, and that anyone who disagrees just isn't trying hard enough -- is quite recognizable. It is hard to make a decision to be less ambitious, even when that is obviously the right decision.

Oh and by the way, here's Chief Executive Officer John Stumpf's answer to the question "Where are you getting these sales goals?"

In the 2010 annual report, Mr. Stumpf said he often was asked why Wells Fargo had set a cross-selling goal of eight. “The answer is, it rhymed with ‘great,’ he wrote. “Perhaps our new cheer should be: ‘Let’s go again, for ten!’

That's a goal of eight products per customer. A goal chosen not based on an analysis of market demand or customer needs or branch traffic or average employee productivity, but based on rhyme. My advice would have been: Stick with three, avoid trouble with the CFPB. Or maybe four, which won't trouble a prosecutor. Even at five, the program might survive. At six, it gets harder to fix. By seven, fake accounts are a given. Eight turned out not to be great. If they'd gone for nine, there'd have been a bigger fine. Can I be a bank CEO now?

Efficient short-termism.

Here are a paper and related blog post that I liked because they put some theory around something that I have always vaguely thought: that corporate managers like "long-term" projects, while corporate shareholders might have good reason to prefer short-term ones. From the paper's abstract:

Unlike in previous theories, a short-term bias in investment horizons maximizes firm value in the second-best case, whereas managers themselves prefer long-horizon projects. Short-termism benefits the firm in two ways: it limits managerial rent extraction by preventing investments in bad projects that delay information revelation about project quality and managerial ability, and it enables faster learning about managerial ability which allows more efficient subsequent decisions. This result does not depend on any stock mispricing or managerial desire to manipulate stock prices. The likelihood of short-termism is higher when corporate governance is stronger, and at lower levels of the corporate hierarchy.

As in much of the corporate finance literature, there is a two-period toy model and some math, but the basic intuition is pretty straightforward. You own a company, and the manager comes to you and says: We can do Project A, which will bring really huge awesome returns in 20 years, or Project B, which will bring adequate but less amazing returns in one year. Which do you choose? Project A is better on all standard corporate-finance metrics (net present value, internal rate of return, etc.), if you trust your manager. But if you don't, you have to wait 20 years to see if the returns are actually any good. In Project B, you get to find out in a year what he was up to. He obviously prefers Project A, because it gives him 20 years of job security. You might quite reasonably choose the worse but faster project.

Actual "long-termism" debates in corporate governance often seem to be directly explained by this sort of model. I mean, yes, some investors -- Larry Fink, even Carl Icahn in his weirder moods -- complain about short-termism, but the leading complainers tend to be public company executives. They are constantly accusing activist hedge funds of harmful short-termism, and asking shareholders to just trust them to implement their own plans for a few more years. Is this because the managers have a uniquely long-term perspective that protects long-term shareholders? Or is it because they don't want the shareholders to bother them so often?

Anyway, if you believe this model, then a lot of proposals to reduce short-termism -- like reforming management compensation, limiting stock buybacks or rewarding long-term shareholders with more votes -- won't work. It's a central problem of governance, not an incidental problem of incentive mechanisms.

Looking into traders' hearts.

Here is a paper in Scientific Reports called "Interoceptive Ability Predicts Survival on a London Trading Floor" that has been covered in Bloomberg, the New York Times, Reuters and the Financial Times, so I guess we should talk about it. The authors studied "18 male traders engaged in high frequency trading," meaning in this case guys who scalp futures contracts quickly, not people who write algorithms for computerized high-frequency trading. And they found that being able to silently count your own heartbeat predicts your profitability and longevity as a trader. 

This actually strikes me as a pretty intuitive result. This sort of minute-by-minute scalping is an almost athletic endeavor: It's not about deep contemplation of economic fundamentals, or building client relationships, or complex mathematical analysis, it's just shouting "buy" and "sell" a bunch of times over the course of a long stressful day where you might not even have time to go to the bathroom. There's a reason that traders are recruited from college sports teams. It makes sense that the good ones would be in touch with their bodies.

But you can spin some counterintuitive implications if you want. The authors write:

Our findings present anomalous data for the influential Efficient Markets Hypothesis of economic theory. According to strong versions of this hypothesis, the market is random, meaning that no trait or skill of an investor or trader – not their IQ, education, nor training - can improve their performance, any more than these traits and skills could improve their performance at flipping coins. We find on the contrary that the physiological state of traders does have large effects on their success and survival. Such a finding has profound implications for the understanding of financial markets, specifically by reorienting attention away from risk takers’ psychological traits towards their physiological ones.

Sure, okay. Or one author told the FT: "If we recognise that body and brain act as a single functioning unit, that they form a parabolic reflector collecting signals inaccessible to the conscious mind, then we will also recognise how exquisitely we are constructed for rapid pattern recognition. Humans can indeed compete against the machines." But the paper didn't actually test the humans against any machines. Algorithmic trading computers are extremely in touch with their own heartbeats. They can estimate their clock cycles to the nanosecond. I don't see how humans would have an advantage here. 

People are worried about covered interest parity.

Here is the Bank for International Settlements Quarterly Review for September 2016. There is some bond market liquidity, of course, but the niche worry this time is the demise of covered interest parity, in which the interest rates implied by cross-currency swaps are now different from the actual cash rates:

Since 2007, the basis for lending US dollars against most currencies, notably the euro and yen, has been negative: borrowing dollars through the FX swap market became more expensive than direct funding in the dollar cash market. For some currencies, such as the Australian dollar, it has been positive.

We have previously discussed discussed a paper by Hyun Song Shin, the head of research at the BIS, about the same topic. Shin and the authors of the Quarterly Review section come to basically similar conclusions: Covered interest parity broke down due to outsize hedging demand, as lots of issuers raised money in foreign currencies and swapped into dollars, and it remained broken down because banks don't want to fund the arbitrage trades that would fix it. Constraints on banks' balance sheets and risk capacity mean that they can't provide leverage on the trades that would push cash and swap interest rates back in line. ("Banks Are Now Too Scared To Even Make Money," writes James Mackintosh.) And so what seemed like a natural law of finance just sort of doesn't work any more. 

Is that bad? It seems a little bad, aesthetically if nothing else. I feel like if you went to regulators or politicians and said that post-crisis regulations are reducing lending to the real economy, or increasing the risk of a crash, you might get a sympathetic ear. But try telling them that regulation is making the limits of arbitrage more binding, and you'll get a shrug. Arbitrage just sounds ... bad, almost? You can always find people who benefit from market inefficiencies, but the smooth efficient functioning of markets is hard to see, and doesn't have much of a constituency.

Baseball medical fraud!

I mean, or something. I have not closely followed the story of A. J. Preller, but I gather that he is the general manager of the San Diego Padres, and he concealed some medical information about his players ("by ordering team trainers to maintain separate files about players’ health — one for themselves and a flimsier one for the industry at large") so as not to harm their value in trade negotiations, and he was found out and suspended from baseball for 30 days. Of course I cannot resist thinking: What if he had been a bond trader, and had concealed some analogous information about some bonds he was trying to sell? (I will leave it to you to come up with the information about a bond that is analogous to the health of a baseball player. It sounds material.) When he was found out, would his counterparties put him in the penalty box and not trade with him for 30 days? Would he be fired? Suspended by regulators? Arrested for wire fraud? That whole range of possibilities is available in the bond markets. Is it available in baseball? Probably, right? I mean, everything is wire fraud. Surely some U.S. attorney somewhere is not a Padres fan and is pondering a fraud indictment.

People are worried about unicorns.

The thing about unicorns is that they are voracious, and if they come to your town you won't have anything to eat:

It is a story playing out across Silicon Valley, where restaurateurs say that staying afloat is a daily battle with rising rents, high local fees and acute labor shortages. And tech behemoths like Apple, Facebook and Google are hiring away their best line cooks, dishwashers and servers with wages, benefits and perks that restaurant owners simply cannot match.

There is an obvious solution to the labor shortage, and this being Silicon Valley, it has obviously been implemented:

The newest options for locals include Zume Pizza in nearby Mountain View, where robots cook the pizza. Zume delivers to Palo Alto — perhaps in driverless cars in a few years.

There is a parable of the modern economy in there. The desire for old-fashioned human craftsmanship won't go away, but it will become more exclusive. You can have fresh artisanal food made by humans, if you are on the inside -- if you work at the right startup. If you are on the outside, you get pizza made by robots. 

People are worried about bond market liquidity.

Barclays Quantitative Portfolio Strategy Research put out a note on Friday about "Corporate Managers' Performance in a Period of Diminished Liquidity," measuring the performance of "a group of large institutional investment grade credit managers" between 2003 and 2008 (good liquidity) and 2010 and 2014 (bad liquidity), and finding that bad liquidity is in fact bad:

Unlike in the first period, active returns in the second period came mainly from passive strategies. Dynamic strategies enhanced active returns in the first period, but hurt them in the second. Besides, the heavier reliance on passive strategies increased the correlation of portfolios’ returns with their benchmarks, possibly reducing their appeal to asset owners who seek better portfolio diversification.

Not a single manager was successful in dynamic strategies in the second period. Because this sudden decline in skill was so universal, it is unlikely to be explained by transient fluctuations in individual managers’ skill. It may indeed stem from the diminished market liquidity.

You could imagine a feedback loop, in which the difficulty of trading individual niche bonds pushes investors toward passive buy-and-hold strategies, which makes it even harder to trade bonds, which pushes more investors toward passive strategies, etc. Anyway this sort of liquidity effect -- that it makes it harder for investors to make money -- doesn't seem to bother the regulators much. (Again, there's not much constituency for efficient arbitrage.) The Bank for International Settlements isn't worried about liquidity after the Brexit vote: 

Before the UK referendum, many observers voiced concerns about whether markets would be resilient to an unexpected outcome. After the event, in core fixed income markets, and indeed most other markets, it was evident that the system was able to smoothly absorb the brief turbulence that followed (Graph A, left-hand panel). Markets went through the Brexit vote with little or no disruption to functioning. 

The regulatorily scary version bond market liquidity worry -- that a lack of liquidity will cause a huge crash when some negative news hits -- continues to be tested by events, and more or less works out fine. Elsewhere: "Global bond issuance highest in nearly a decade."

Me elsewhere.

I guest co-hosted an episode of Bloomberg's Odd Lots podcast, in which Tracy Alloway and I talked to James Crawford of Orbital Insight, a company that analyzes satellite images for investment managers. We've talked about Orbital Insight around here before, and there are interesting things to say about information asymmetries in finance, but my favorite part of the conversation was probably just learning how Orbital Insight's artificial intelligence systems figure out how to identify cars in retailers' parking lots based on, you know, the blotches of color that are their raw data. (Basically: A human looks at a bunch of pictures and tells the computer which things are cars, and the computer eventually gets reasonably good at figuring it out.) I feel like the term "artificial intelligence" gets thrown around a lot, here and elsewhere, and it is worth occasionally remembering how distant it is from our usual human notions of intelligence.

Things happen.

S&P 500 Gets Its First New Sector Since the Dot-Com Era. Criticism of Calpers's pension projections from the Los Angeles Times and the New York Times. Merchant-Banking Curb Would Hurt Goldman. Shadow Lenders Step In for Banks Facing U.S. Property Warnings. Unintended consequences of higher capital requirements. A Fed Insider Warns of the Risk of Low Rates. China financial stress indicator hits record high as debt surges. Funds Dump Gold at Fastest Pace Since May as Fed View Shifts. Tesla Wins Massive Contract to Help Power the California Grid. Twitter Sued by Investor for Failing to Deliver on User Growth. Finra to Unveil Winner of Bitter Vote for Board Seat. The Economist on the should-index-funds-be-illegal question. There are a lot of bank accounts in India with exactly one rupee in them. Someone applied to the Securities and Exchange Commission's whistleblower program "for rewards in 196 separate enforcement actions before the commission permanently barred him from the programme in 2014." Insider Trading Before the Supreme Court: Dirks and Salman, Part III. "Donald Trump is probably worse than any other developer in his relentless pursuit of every single dime of taxpayer subsidies he can get his paws on." "Our results show that the financial knowledge of those involved in economic and business education is at about the same level as the financial knowledge of 'average' young people." Artisanal ice. Shuffleboard rage. Self-driving shopping carts.

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Matt Levine at

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