Book reviews – Page 8 – Compliance Building

The Physics of Wall Street and its Failures

Warren Buffett famously warned, “beware of geeks bearing formulas.” After the Great Panic of 2008, many pundits placed the blame on derivatives and other “complex financial instruments.” That would lead one to believe that the blame lies with the physicists and mathematicians who dreamed them up. James Owen Weatherall decided to look behind that blame and explore the history of how physicists came to Wall Street. The result is The Physics of Wall Street: A Brief History of Predicting the Unpredictable.

The book is an engaging exploration of the men who took turns trying to create mathematical formulas to explain stock price movement, with the hope of predicting that movement.

The early models always failed. Weatherall pins the crashes in 1987, 1997, and 2008 on the failure of the models. Although he shifts the blame from the physicists to the heads of the Wall Street firms. Their failure came about because they failed to think like physicists. Models, whether in science or finance, have limitations. They break down at the edges and under certain conditions. In each of those financial crises these sophisticated models fell into the hands of people who didn’t understand their limitations.

Don’t think the book is focused on financial models and mathematical derivatives. It’s focused on the individuals, their stories, the steps they took before creating their models, how their models ere adopted (or not), and, ultimately, how their models failed.

One item I found fascinating was that most of the physicists starring in the book took their first steps towards wealth creation in gambling, and not finance. You can make your own joke about that. Each took an attempt to better define probabilities so they could make better wagers. Early on, it was dice games. Blackjack was popular. One gentleman even tried to devise a computer to predict roulette. Ultimately, they each discovered that there was more money to be made on Wall Street.

Each model got better and better. But each ultimately failed. Some of that can be traced back to success causing a failure. As more firms adopted the model, their behavior changed and therefore the model became based on outdated behavior. Ultimately, the book seems to lend credence to Taleb’s Black Swan theory. The improbable will happen and all the financial models fail to account for the improbable financial calamities happening more often than the models predict.

I have to admit that I thought the book might be a dry slog on finance and probability. But, it was surprisingly enjoyable to read. If you have any interest in the quant side of Wall Street or probability theories, this book provides a great historical background.

The publisher was nice enough to send me preview in hopes that I would write about the book. It goes on sale January 2, 2013.

Vanderbilt: The First Tycoon

There were the rich, the super rich, and Cornelius Vanderbilt. T.J. Stiles takes you through the life of the Commodore in The First Tycoon: The Epic Life of Cornelius Vanderbilt.

Sons are notoriously prone to exaggerate the importance of their fathers, as are biographers with their subjects…

Vanderbilt founded a dynasty. The First Tycoon starts with one of the final challenges to that dynasty. The Commodore had left the vast majority of his estate to one of his children. The rest were challenging his will. He wanted his business empire to continue through his children, without it being severed and control lost.

Cornelius “Commodore” Vanderbilt was born in relatively humble family on Staten Island during George Washington’s presidency. He started in his father’s footsteps as a boatman. He latched onto the power of steam and assembled a huge fleet of steamships. After conquering the water, he assembled a railroad empire. We see Vanderbilt’s role in transportation revolutions, battling the physical growth of the nation with better and faster means of transportation. Along the way he helped shape the growth of the modern corporation

T. J. Stiles argues that Vanderbilt did more than perhaps any other individual to create the current economic world. His steamships and railroad lines took vast amounts of capital, requiring more than one individual to fund the growth and expansion.

Compliance professionals and securities law aficionados may be fascinated by the growth of the corporate entity. At the time they offered less liability protection than we would expect today.

The history of Vanderbilt is also full of stock manipulation and anti-trust issues. Transportation companies routinely gathered together to set rates and limit competition. When competition did break out, it was a vicious battle between the rivals. Sometimes the battle was waged in the stock market with the players trying to corner securities and punish the wealth of their rivals.

The book does a remarkable job of balancing the epics tales with a fast-moving narrative.

The Richer Sex: The New Majority of Female Breadwinners

Almost 40% of US working wives now outearn their husbands. Washington Post reporter Liza Mundy argues that “the Big Flip” in gender roles “is just around the corner” in her new book: The Richer Sex. Soon “women, not men, will become the top earners in households” and that will transform the dynamics of male-female relationships.

Mundy sprinkles interviews with women and men throughout the book to highlight her positions and theories. She sees the emergence of a country (and world) where both sexes are “freer to make purely romantic choices” based on individual preference rather than constrained by long-held stereotypes about who should be the primary breadwinner. For large parts of the US economy, you don’t need physical strength and stamina to put food on the table and a roof over your head.

Mundy speculates that women are better adapting to the knowledge-driven economy of the United States. Middle skill jobs are disappearing. Men lost 75% of the 7 million jobs that disappeared during the Great Recession. Industrial jobs are being outsourced. That means making the educational leap to higher tier jobs. Women receive 57% of bachelor degrees and account for 60% of graduate school enrollment.

Mundy concludes that the bread-winning woman is dramatically changing the face of marriage and quality of marriage. They prefer a marriage of equals, or at least a man with strong career ambition and intellect. That means women would choose being single to being in a bad marriage. With their earning potential, they don’t need a husband for financial support.

Mundy relates the story of a high-powered executive in a lackluster marriage, with a husband that was resentful of his wife’s career. (He didn’t have one.) They fought over getting a dog. He thought the dog would absorb too much of her time and affection. She ended up getting the dog and he got mad. Then she had a brainstorm. Get rid of him and keep the dog. “The dog is very supportive of her achievements.”

This growth of female breadwinners is not just a US phenomenon. It’s happening in South Korea, Japan, Singapore, France, Chile, Ireland, Belgium, Canada, the Philippines, and Norway. As the world economy is starting to rely more on brainpower than musclepower, women are the winning participants in the economy. There is still great inequality. But it’s changing. This book looks ahead to where that may lead as women overtake men as the breadwinners.

I first heard of this book while listening to an interview of Liz Mundy on a podcast of C-SPAN’s Book TV. (Yes, I’m that much of a geek.) The interview was great and prompted me to run down to the library and borrow a copy. I suggest you do the same.

The Power of Habit and Compliance

One of the keys to success in life is instilling good habits. We are creatures of habit. We may like to think that our daily actions result from deliberation and willpower. But mostly they are the products of our unconscious habits. These habits make our lives more efficient. (Try to remember how many steps it took you to get from your front door into your office chair.) Charles Duhigg, an investigative reporter for the New York Times, presents an exploration of this subject in his latest book: The Power of Habit.

Habits are about organic efficiency. They do not distinguish between what is good for you and what is bad for you. I suppose one of the goals of a good compliance program is to instill good habits in your company and to shut down bad habits. But how?

Duhigg has loaded the book with information on how habit patterns work in the brain and suggestions on how to change them. The scientific study of habits is extensive. Biologists have investigated the habit formation aspect of the brain, but it’s the marketers who have pushed the envelope. They realize that creating habits means products moving off the shelf.

Take the background story on the crafting of Febreeze, the odor eliminating spray. Procter & Gamble came up with a powerful product. One test subject was a park ranger who regularly had to wrangle wayward skunks. Her clothes, her car, and her home all stunk of skunk. Febreeze changed her life. Less odoriferous customers loved the product, but ended up rarely using it.

Then the marketing scientists focused on the habits of cleaning. Febreeze was scent-free. A person would spray it, but the application wouldn’t produce a sensory trigger to create a habit from using it. They added a fresh scent and advertised it for use as the final step in cleaning. “No one craves scentlessness. On the other hand, lots of people crave a nice smell after they’ve spent thirty minutes cleaning.” The addition of scent turned Febreeze from a smart product into a billion dollar product.

The Power of Habit is divided into three parts. The first focuses on individuals and how habits shape lives. Duhigg includes stories on how habits can be broken, reset, and persist. You can be trapped by a predictable cycle: you feel tired in the afternoon, you head out to Dunkin’ Donuts, and then you get the reward of feeling much better. Marketers reinforce these routines by fiddling with the Pavlovian rewards.

Not all habit are good habits. You probably feel trapped by your bad habits. Duhigg argues that you can also escape from the trap of the routines that trigger bad habits. Alcoholics Anonymous has proved so successful in part because it replaces one routine (drinking to feel better) with another (going to meetings and talking about your addiction to feel better). You re-wire your mind to appreciate and seek out the new reward.

The second part looks at the habits of organizations. Duhigg argues that managers can change entire firms by changing habits. A handful of these are “keystone habits” that can change the entire culture of a firm. Duhigg uses Paul O’Neill as a poster child. O’Neill transformed Alcoa by focusing on safety. Worker appreciated not getting injured (or killed) and mangers appreciated the more productive workers. This focus on safety turned out to be a keystone habit that transformed the workplace, increasing a focus on principles and increasing communications across the firm. At first the communication was about safety issues, but that evolved into a more open dialogue.

The book’s third part looks at the habits of societies. Duhigg argues that some of the greatest social reformations have in part been produced by rewiring social habits. He links the pressure of weak ties and social norms with habit.

That all sounds interesting, but can reading The Power of Habit help your compliance program? Yes. I’m rethinking some of my approaches (and own personal behaviors). The appendix is focused on techniques to help focus on habits and how to change habits. Finding keystone habits could help improve your organization.

If you’re interested in more of the research, the book’s notes go on for 50 pages citing hundreds of primary sources and research papers.

The book is full of interesting ideas and based on an impressive collection of research. But it does a great job of balancing intellectual seriousness with practical advice. Even better, it’s written in a lively style, making it easy to read and digest. (The book was on my to read list before the publisher sent me a review copy.)

Why The Law Is So Perverse

In Why the Law Is So Perverse, Leo Katz, Frank Carano Professor of Law at the University of Pennsylvania Law School, examines features of the legal system which seem to not make sense on some level.

I admit that I offered to read and review the book based on the title. I’m not sure that Professor Katz makes the case that the law is perverse. He does show the complexity and the complexity in human decision-making in the legal system.

The better title would be the Impact of Multi-criterial Decision Making in Legal Analysis. I suppose that title is not quite as catchy.

That title is more closely aligned with the style of writing and content. For me, the book was like stepping back into law school and analyzing choices and consequences of actions in the context of legal decision making. That means there are some interesting puzzles and thought exercises. It also means that it’s a bit disconnected from the real world.

Two disclosures. First, the publisher supplied me with a free copy of the book. Second, some of the statements in the book left me bitter with the way Professor Katz characterized the legal profession. The most notable was:

The exploitation of loopholes is in fact the lawyer’ daily bread, which makes it all the stranger that both lawyers and non‐lawyers profess such outrage about it. Actually, the point should probably be put the other way around: What is strange is that, given the contempt in which loophole exploitation is held, it is nevertheless central to legal practice. What can a profession say for itself whose main preoccupation consists of this kind of activity?

I don’t know any lawyers who get excited looking for loopholes, or who would even call their daily practice exploiting loopholes. On the criminal side, it’s all about the evidence and culpability. On the business side it’s about trying to figure out what the government will allow and not allow. The law is complex and the decision-making is difficult, but that doesn’t make it perverse and doesn’t make the lawyer’s job one of merely searching for loopholes.

In a whimsical example of a loophole, Professor Katz uses children cutting in line. According to playground law, line-cutting requires the consent of the party who will be immediately behind the cutter. So you can let someone cut into the line in front of you, but no backsies. The loophole is to allow the cut in front, then let the consenting party cut in front of you. A-Ha! A tremendous loophole. Professor Katz even parades a cartoon involving a playground lawyer to illustrate the point.

Where Professor Katz sees a loophole, I see a flawed law. It should either be cutting allowed or no cutting allowed. By allowing only one type of cutting, the law creates a distortion in behavior.

The law can be changed and flawed laws should be changed.

The central thesis is that the transitive law of math that we learned in elementary school (A>B and B>C, so A>C) only works with a single criteria and can fail once there are multiple factors in the decision-making: multi-criterial decision-making.

Besides loopholes, Professor Katz focuses on a few other “perversities.” One involves the law’s refusal to allow people to consent to certain things – prohibiting people from selling a kidney to a willing buyer or allowing criminals to choose torture instead of a long prison sentence. Legal decisions are essentially made in an either/or fashion—guilty or not guilty—but does not allow in-between verdicts. Legal systems don’t punish certain kinds of highly immoral conduct while prosecuting other far less pernicious behaviors.

Professor Katz contends, sometimes persuasively and at other times less so, that these thorny issues arise from their multicriterial’ character. If you miss law school, Why the Law Is So Perverse will take you back through some of the best and some worst features of law school.

If you’re interested, you can read an excerpt from Why the Law Is So Perverse (.pdf)

Margin Call

With the announcement of the Oscar nominees, try watching Margin Call to combine movie watching and compliance. Margin Call received an Oscar nomination for best original screenplay.

The movie sets Kevin Spacey, Demi Moore, Jeremy Irons, Stanley Tucci, and Simon Baker as the key players at an investment firm during the earliest hours of the 2008 financial crisis.

Tucci is the head of risk management for the mortgage trading desk, but gets laid-off in the first few minutes of the film. On his way out, he hands an unfinished project to a low-level risk analyst to find the problem. He finds it and it’s big. The holdings on the mortgage desk could lead to the downfall of the firm. that leaves it up to the firm’s employees on whether to save the firm at the risk of fleecing millions of investors.

Unlike Inside Job, Margin Call does not paint the characters as evil, mustache-twirling, robber barons. They’re humans staring at the face of a monumental choice. One choice is to hold and likely bankrupt the company. The other is to sell the garbage and likely being painted as a bad guy. They’re up all night thinking about the problem and trying to find a way out. Dawn comes and they all need to make choices.

Defending Jacob

Being a lawyer, I like a good legal thriller. If you’re looking for a legal thriller to keep you up at night, try William Landay’s latest novel: Defending Jacob. Jacob is a fourteen year old boy whose classmate is found murdered. Jacob’s father is an assistant district attorney. You can guess from the title that Jacob gets accused of the crime.

Before I go on, I should point out a few of my biases. I’m friends with the author. Our sons went to daycare and preschool together for many years. So I see bits and pieces of him and his family in the story. (But not that I think Bill’s son will grow up to be accused of murder.) I think I see flashes of Bill, his family, and the community in the book. Maybe that distracted me from the characters or maybe it made me like them more. I’m not sure.

Not being a trial lawyer, I can’t vouch for authenticity of investigative procedures or the trial. Again, with a title like “Defending Jacob” you would expect there to be a trial. You end up with the expected clash between the clash of guilty and not guilty against the question of whether Jacob actually committed the crime.

That’s what kept me reading chapter after chapter. Who was Jacob? Could he have committed the crime? Did Jacob’s father really know who he was? Facts quickly start being revealed, twisting the story through reveals and lies. It pushes the father, son, and mother to the edge until…

Defending Jacob should be on the bookshelf of your local bookstore on January 31 and is also available through Amazon.

Why How We Do Anything Means Everything

An acquaintance in the compliance field sent me a copy of Dov Seidman’s How and I let it sit around for months. (My “To Read” stack has grown very tall.) I assumed How was vanity book and would rattle on and on about Seidman’s company: LRN. I recently moved and my “To Read” stack was tumbled around in a plain cardboard box. How resurfaced in the stack and I noticed the forward was by President Bill Clinton. That was enough to catch my eye.

Seidman spends the first half of the book talking about transparency, trust, reputation, and the new inter-connected world. He does a fine job with these topics, but I’ve seen them handled better elsewhere. The second half of the book, which focuses more on Seidman’s philosophy of business, is when the book becomes more valuable.

Seidman highlights an empirical study about reputation using eBay’s seller reputation information. Chrysanthos Dellarocas used eBay as an experiment. In a study selling the same product, in the same way, through eBay sellers with different levels in the site’s reputation scores, the researchers found a measurable difference in price. A seller with a high reputation on average would get a measurable price premium over a seller who did not.

As you might expect, the book is full of stories as examples. One that really caught my eye was the description of four factories as examples of four types of corporate culture. The factories are to be toured and the measuring stick is the use of hard hats. At the first factory, one of lawlessness and anarchy, the factory tour guide does not offer hard hats to the visitors and many workers are seen without hard hats. At the second factory, an example of blind obedience, all workers wear hard hats and the tour guide says everyone has to wear one or they get fired. The tour guide admits that he doesn’t know why he needs to wear it or why the boss also makes him wear blue pants.

The third factory is the next step up the corporate culture ladder as an example of informed acquiescence. Hard hats are there for everyone with big signs saying everyone must wear one. But when one member of the tour group asks to be excused from wearing one, the tour guide scampers off trying to find a higher-up to approve the lack of a hard hat.

At the top of the corporate culture is the fourth factory, an example of Seidman’s self-governance. The tour guide insists that everyone wears a hard hat and when that same member of the tour group asks to be excused the tour guide says no. “I take personal responsibility for what happens to you. I don’t want to offend you, and you can call my boss or the owner if you like, but I believe your safety and the safety of everyone are paramount. “

The how of culture is broken into five parts: how we know, how we behave, how we relate, how we recognize, and how we pursue.

One common theme in the book is an indictment of a rules-based culture. Rules-makers “chase human ingenuity, which races along generally complying with the rules while blithely creating new behaviors that exist outside of them.” The example that caught my eye was the clerk who insisted on wearing ties with cartoon characters. His bosses fought him and finally insisted that he obey the rules on permissible neckwear. The clerk acquiesced and showed up the next day with Tasmanian Devil suspenders.

Ultimately, a rules-based governance focuses on the things you can’t do, while a values-based governance focuses on what is desirable.

This ends up with Seidman’s Leadership Framework. I think that is better left for more to readers of the book.

If this sounds interesting to you, I ended up with a second copy of How. Rahter than have it sitting on my bookshelf, I want to share it with one of my readers. If you are interested, leave a comment on this blog post or send an email to [email protected]. I’ll pick a winner on February 1.

Boomerang – Michael Lewis Looks at the New Third World

Michael Lewis packages his stories on the effects of the global financial crisis in Iceland, Greece, Ireland, Germany, and California into one book: Boomerang. If you had ready the stories when they were published in Vanity Fair, then you’ve ready the book. If you missed some (or all) of those stories then this book is great viewpoint on how five countries got themselves into trouble with excessive debt.

I had already read the first four articles when they appeared in Vanity Fair, but I had not yet gotten to the article on California. In fairness, Boomerang was a given to me as a gift so I did not come out of pocket to put it on my bookshelf. I enjoyed revisiting the four stories and the new California story.

They each seemed to work better in the collection than standing on their own. Since each story is relatively short, they lack the depth and understanding I’m used to getting in one of Michael Lewis’ books. Collectively, there is bit more depth as you can see how the five different countries got into trouble in different ways by becoming over-leveraged.

It’s a Michael Lewis book, so that means it’s easy to read and smart. He has a gift for taking complicated subjects and using individuals to highlight how his theories work in the real world.

My gripe is not with the book, but with Vanity Fair who sponsored Lewis in writing the five stories, each of which has appeared in the magazine. I purchased a subscription to Vanity Fair just because of these Lewis articles. I thought I was choosing to upgrade the freemium model. I was willing to pay more for the superior experience of reading the article in the magazine instead of online. However, the publisher would put them on the website (for free) before the magazine ended up in my mailbox. One premium of getting access to the content first, was actually the opposite. I was getting the content later than if I had chosen not to pay for it. It’s not like the magazine is ad-free.

So why I would I renew my subscription?

Reckless Endangerment

So what caused the 2008 financial crisis? We know that the direct cause was the meltdown in the US housing market. I think we are still trying to put together the pieces and point the finger of blame. It was a big bubble and the explosive reaction when the bubble burst. It took many different forces to get the bubble so big.

In Reckless Endangerment, Gretchen Morgenson and Joshua Rosner take their turn looking at the outsized ambition, greed, and corruption that lead up to the crisis. They point the finger of blame directly at Fannie Mae and its executives.

The authors portray a company that ruthlessly leveraged the implicit government guarantee to create billions of dollars of shareholder wealth and millions of dollars in executive compensation. They beat the drumbeat of housing as the American Dream. Everyone should get a chance to own their own home. Fannie Mae used their version of the American Dream to bully Congress and their regulators to let them have a very thin capital reserve and to keep their finances very opaque. The authors pin the blame squarely on James Johnson, the CEO of Fannie Mae during the 1990s and his successor, Franklin Raines.

The rating agencies also get some of blame by the authors. I think the rating agencies have not received enough of the blame. Their shoddy rating of debt instruments let them get AAA ratings that they did not deserve. Only a handful of companies and a handful of countries get the top rating. But when it came to real estate backed securities, the rating agencies were handing them out like cotton candy at the state fair.

Institutional investors were looking for safe place for their money that could still earn a coupon. US treasury bonds were paying a very low interest rate. Pension funds and insurance companies determine their funding levels based on a projected rate or return. Many were limited to only invest in the highest quality asset either by regulation or internal policies. That meant they would only buy the top rated bonds.

Banks has to maintain their capital levels based on the quality of the loans/bonds/assets they held. With top-rated bonds, the banks had to retain very little capital. By holding AAA ratted bonds, the banks could retain less capital and put more to work.

The rating agencies were telling them that these mortgage-backed securities were top rated. (They were wrong.)

The vast majority of the book is spent sticking pins in Fannie Mae, their lobbying efforts, and their executives. I agree that Fannie Mae abused its position. I agree that Fannie Mae helped create an attitude that everyone should be a homeowner and everyone should be able to afford to buy a home. But their story comes to crashing halt in 2004 when Fannie Mae gets caught in large scale accounting fraud. Most of the manipulation can be tied directly to triggers for executive compensation.

In 2005 the first signs of bad mortgages were popping up and the buyers for the lower rated pieces of mortgage debt were not buying them. Without those buyers, the mortgage securitization would fail. Fannie Mae was leading the charge up until that point. But it didn’t stop there. That’s why have a problem pointing the finger at Fannie Mae. The mortgage/housing boom kept going.

The authors pull some of the dubious lenders into the book. Countrywide, Novastar, and Fremont all get ripped apart.

It’s not until the last chapter that they hit upon the issue that hyper-inflated the real estate bubble. The buyers for the lowest rated pieces of mortgage-backed securities were not buying as much. In part, this was because the increased quantity of junk they saw ending up in the pools. In part, it may be because they saw the bubble. Then the magic happened.

Wall Street firms packaged the lower rated pieces into new pools and sold those securities. These were the toxic assets. Somehow they convinced the rating agencies that some tranches of this pile of junk could still get the top ratings. Those high rated tranches were sold off to the institutional investors and the real nasty stuff was sold off to more speculative investors. This kept the mortgage securitization pipeline going for two more years.

Why keep going when you could see the bubble? It was their job. There were thousands of jobs tied to originating the mortgages, the warehouse lines that funded them, the organization of the pools and the selling of the final securities. It was not their job to assess the bubble and just stop working. There was no brakeman in the system. The regulators do not have the oversight, the power, or the willingness to stop an asset bubble. (Let’s see what happens with the price of gold.)

The brakes were slammed on when the Wall Street firms realized they were holding on to the lowest rated tranches of the securitizations and they couldn’t get rid of them. They stopped the production. They stopped it fast. In early 2007 warehouse lines were cut off and underwriting standards were suddenly raised to higher (more sensible?) levels.

With the pipeline cutoff, the hyper-inflated housing bubble reached the bursting point. Then mortgage-backed securities investors stopped getting their checks. They realized that their coupon-paying beauty queen was just a pig with lipstick.

I think All the Devils Are Here did a better job of putting all the pieces together and The Big Short did a better job explaining the mechanisms of the mortgage-backed securities industry. If you don’t like Fannie Mae or want to read a story of how corporate greed exploited American politics then Reckless Endangerment should be on your reading list.