Thursday, April 29, 2010

Goldman was way ahead of the curve ... they got it right!

Dear Colleagues

One of the problems with modern society is that there is so much of it ... and because of this we have to use subsets of information in order to stay in touch with events and what is going on.

To stay in touch, we have to make use of information or data flows ... in other words, we have to rely on the media either in its traditional form or some of the new Internet data flows. These are more or less flawed ... but they are essential.

I watched many hours of the Goldman Sachs (GS) testimony on Capitol Hill in Washington last Tuesday ... and learned a lot more about the financial meltdown from this than I have done reading the news articles or watching the evening news on TV. By the time the news media put their "spins" on what took place, it was difficult to recognize very much of the 11 hours of testimony that I watched!

I have my own bias. I see everything from the perspective of Community Analytics (CA) and am continuously asking the question whether or nor some aspect of CA would have helped to make things better. To do this effectively I have also got to understand as much as possible the problem ... and especially the the key cause or causes of the problem. My work in trying to make CA useful is very different from the work being done by Congress. Congress makes laws that are at the "top" of the system ... CA does metrics throughout the system, from "bottom" to "top".

Part of the CA metric is the idea of value chain analysis. This is a very powerful methodology when it is applied thoughtfully ... and not at all useful when it is simply used mechanically with little or no understanding of the linkages between the stages, and the various complexities that are in play. With CA value chain analysis it is possible to see where profits are being made, and therefore where the incentives are to "do more". The profit dimension of CA value chain analysis shows that in the sub-prime mortgage debacle there were profit incentives at every stage of the industry from land developers, builders, building supply companies, mortgage originators, appraisers, real estate lawyers, real estate agents, community banks, regional banks, Wall Street banks, sophisticated investors, rating agencies, hedge funds, the Fannies and the Federal Reserve! ... not to mention all the businesses that benefit when the economy is roaring ahead including all sorts of luxury goods and service suppliers. The value dimension of CA value chain analysis, however, tells a very different story ... virtually NONE of the steps in the value chain add value even though there is reported profit.

Because there is little or no value adding in the foundation of the sub-prime mortgage industry, everything that is reported as "profit" has no substance.

In the old days when accountancy had very simple strong PRINCIPLES ... many of the reported profits would not have been taken into account so easily. But today, and for the best part of 40 years, accountancy in the United States has let laws and rules override accountancy principles, which has proved very convenient for a lot of corporate CEOs and their stockholders, but has also facilitated a whole lot of questionable practices ... that includes, but is not limited to the "mark to market" idea!

I was alerted to this dangerous practice early in the 1980s when financial institutions were reporting profits as they replaced high interest earning assets with low interest earning assets and were reporting record profits. Using simple balance sheet analysis, this is not reasonable, but it turned out that all the fees and "points" associated with transactions were flowing into the "profit for the period" when the old fashioned accounting principle would have required that these earnings got spread out over the life of the transaction rather than being taken in full the month of the transaction closing. What this meant was that the "balance sheet" of a financial organization took second place to the transaction fee component ... and, of course, over time banks stopped being about the balance sheet but more about the fees, to the detriment of society. The seriousness of this did not become apparent until the crash of 2007/2008 when it became abundantly clear that the balance sheets of the financial sector were compromised even while profit reporting was stellar!

What GS demonstrated on Tuesday was that the market system works pretty well, but you need the staff to be paying attention and making decisions that make sense. The "short selling" that GS Sachs did was much more "prudence" than it was "gambling" ... and in a "capital market" the function of market maker is just that. GS bought and sold whatever was required by other buyers and sellers.

None of these transactions were with "retail" buyers ... they were all made to "sophisticated" investors. That is the rule ... and as far as I can see, that is what GS. Now whether or not the organizations holding themselves out to be "sophisticated" are competent or not is another question. Many have the certificate but maybe few have much sophisticated understanding ... and these people got it wrong for a lot longer than GS got it wrong.

The question of sophistication and competence goes a long way up and down the institutional structure. The performance of the "Fannies" seems to be based not on sophistication but advanced "dumbness" ... almost as bad as the performance of the Federal Reserve leadership. How so much "credit" could be created on top of such a poor underlying "balance sheet" of society defies all comprehension. Years ago there was a famous book called "Marketing Myopia" ... there needs to be a book called "Financial Myopia" starring the high profile titans of the financial sector who got things so wrong for so long ... as well as the damage done by ALL the actors in the sub-prime boom who were happy to be in the game for as long as the music played!

To its credit ... while GS got it wrong as well, unlike most of the institutions in the sector, it saw the problem it seems before everyone else, and acted prudently to extricate it from the mess. This is what is meant to happen in a market economy.

So now the next set of questions:
  • What on earth was everyone else doing while GS was getting it right?
  • How do we put CA metrics in play so that the public are better informed about what is going on?
  • Rather than simply trying to "punish" Wall Street ... what can be done to help give opportunity back to the people on Main Street
From my perspective the need for better metrics has never been clearer. Old fashioned accountancy and the computation of money profits is good, and with social value metrics and a focus on community value adding can probably do the job that is needed. Metrics are NOT regulation ... they are merely the raw material for decision making. If money profit and greed are the only pieces of the game ... there will be outcomes like the bubble series that is the norm of modern economy, but if social value adding is also a part of the game, then the outcome can be sustainable ... and rapid ... progress.

Comments are welcome!

Peter Burgess

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