This Is the End


Markets, Risk and Human Interaction

April 17, 2010

The Accidental Egalitarian: Technology and the Distribution of Income

April 17, 2010
This represents my personal opinion, not the views of the SEC or its staff.
This month’s Institutional Investor AR magazine came out with its list of the highest compensated hedge fund managers. I already have expressed my doubts about the accuracy of their approach, though you can adjust the numbers by an order of magnitude and it is still off the charts. But for all that is being written about hedge fund managers and their poorer cousins, the banking elite, about the expanding income gap, and about the new frugality and the changing American dream, the differences between the very rich and the rest of us are shrinking.

Up until the last part of the 1900’s, F. Scott Fitzgerald’s observation that “the very rich are different from you and me” certainly was true. And it wasn’t only, as Hemmingway later quipped, that they had more money. It was how that money transformed their lives and how it variegated society. But no longer.

This might sound like a preposterous statement. But when we use the dollar differences in income to measure the gap, we are measuring it the wrong way. What matters is the practical impact, how the differences in income carry through to make a difference in how we live day by day, even hour by hour. A head to head income comparison does not measure that; it misses the effect of work habits and lifestyle, and, most critically, the effect of technological progress on filling in the income gap. Don’t stop with dollars earned. Ask how people earning those dollars spend their time.

There is one thing everyone has in common, no matter what their income: They have twenty-four hours in a day. So differences in income can only be expressed by what they do in those twenty-four hours, and how they do it. Let’s observe snippets of a typical day in the life of Billionaire Malcolm III and compare it to high-earning Professional Bob and think about how much the thousand-fold income differential between the two leads to differences in what they are doing and how they do it; how many minutes of the day their activities differ.

A starting assumption is that both Bob and Malcolm III work hard. You probably do, too. You wouldn’t run off to spend the rest of your life on a beach in the south of France, really, even if you could. If the lifestyle in the get-rich-quick infomercials of sitting with unbounded leisure time is your end game, then you are on a different fork of the road than where this discussion is heading.

Now let’s look at the time that Malcolm III and Bob spend on their workday activities and see what that extra billion does:

Sleep Time. Seven to eight hours of the day, they are both asleep. They have beds, black-out shades and a sound machine. So right off the bat around a third of the day is the same.

In the morning. They shower, shave and get dressed. We are past the age of butlers drawing baths and helping lay out clothes, so there is no differences in this realm. And it’s dress-down day at work, so they both have on jeans and a polo shirt. They grab a coffee and bagel for breakfast. For Malcolm III it is ready and waiting in the kitchen thanks to his housekeeper. Bob stops for his on the way to work – his live-in girlfriend has already left and forgot to turn on the coffee machine. Still no difference worth thinking about.

To the office. Malcolm III has a driver to take him to the office, Bob takes a taxi. Or drives himself. Bob’s car is an Acura TL Type S. Malcolm has, among other cars, a Porche 911 Turbo. On the open road, it can leave Bob’s Acura in the dust. Too bad they live in New York and not Frankfurt.

At work. They both are at their desks dealing with e-mails and then plan to spend some time polishing a presentation. Malcolm III has a team of administrative assistants outside his office to take care of his mundane tasks like travel and insurance. Bob has one secretary, and she does the same for him. Malcolm’s office is spacious with an antechamber, a sitting area and a lot of doo-dads and pictures with celebrities on his bookshelves. But look at what Malcolm and Bob are actually doing. They are engaged in the same sort of work with the same sort of equipment, and for all practical purposes they are occupying a forty square-foot world. For lunch they both eat a sandwich at their desk.

In terms of their workday,
I am ignoring some characteristics that we associate with the Malcolm’s of the world, things that really don’t have to do with Malcolm’s wealth per se. For example, he oversees many people and he can order those people around autocratically. His underlings have to listen to his philosophical views about building an open work culture, which make their way into company-wide e-mails and a spiral bound volume that he hands out around bonus time. These are coincident to being a billionaire, but being a billionaire is not required to have these trappings. There are generals, CEOs and government bureau chiefs in the same situation. And army lieutenants and factory floor supervisors.

Evening Activities. Unwinding after work, they both happen to end up at The Modern, next to the MOMA, to meet business associates. Then off they go, home to have dinner, spend some time on the web, and then watch a movie. Malcolm III is doing this in a house that is five times the size of Bob's. Malcolm III’s house is a sprawling estate with a living room, dining room, library, sitting room, billiard room, sunroom, solarium, four fireplaces, a guest cottage and a pool. It has a large entry with a spiral staircase, marble floor, and mahogany woodwork. And so on.

But it doesn’t matter – he is in a 200 square foot room to the side of the kitchen sitting on his couch twelve feet from his big-screen surround sound set, beer in hand, just like Bob is.

Of course, there are some big differences, differences that will be manifest maybe twenty or thirty hours of any given month. Bob takes commercial flights, upgraded to business class, while Malcolm flies in his private jet. Malcolm shells out to be on various charity boards and spends time at gala events. In terms of pastimes, if Bob’s passion is breeding racehorses, the America’s Cup or collecting big name contemporary art, too bad.

Depending on their personalities and philosophical bent, even these differences might not matter all that much. For example, if Malcolm III is environmentally conscious, he doesn’t take a private jet. He drives a Prius rather than a Porche, and even takes the subway to work. If he is introverted or nerdish, then rather than hobnobbing at the black-tie events, his idea of a good social gathering is a small dinner with his friend who writes for Wired and the one who is researching nano biotechnology. And he will not care much about items of conspicuous consumption, because he doesn’t care about being conspicuous.
Many in the technology sector have promulgated this ethos; it is an egalitarian side effect of the boom in technology.

The point of this is to illustrate that the day-to-day impact of wealth is lower today. A century or so ago, in F. Scott Fitzgerald’s era, there was little time during the waking hours when the activities of the very rich did not differ from those a rung or two down. Even if we look back a few decades we see that gaps have disappeared. Back then, only the wealthy could have a screening room in their home; drivers would stick fake antennas on their cars to impress passersby. Now Joe and Malcolm have the same computers, high-definition TVs, Blackberries and i-Phones, game systems, Kindles, cameras – and these are the things that occupy most of their non-sleeping, non-showering lives. In fact, in terms of hour-by-hour activities, my kids are more Malcolm-like in many respects than I am. They have iPhones, Tivos, large screen monitors, Playstation 3 game systems, and subscriptions to netFliks. I don’t.

This analysis is interesting as far as it goes. Indeed, that it only goes so far is what makes it interesting. What I did for Malcolm III and Bob could also be done for the professional versus the skilled salaried worker, the skilled salaried worker versus the unskilled hourly worker, and so on down to those in extreme poverty working for a dollar a day. But as you continue down the income ladder from the Professional Bobs of the world, another dimension beyond how people are spending their hours becomes of increasing importance.

Drop one more order of magnitude in income and compare Journalist Jamie to Malcolm III and Bob. The hour-by-hour comparisons will still work; Jamie will not differ that much from Bob in what he is doing with his time; certainly the differences will be far lower now than they would have been even a few decades ago. Even though Jamie does not have a secretary to help with his daily tasks, he can quickly dispatch most everything on line – except for the crazy time spent on hold with insurance and the cable company.

But Jamie has a lot to worry about that Malcolm and Bob do not. Malcolm will never have to worry about money, Bob has a large nest egg to protect him against a downturn in his work, but for Jamie, one false step, and he has no way to pay for his house, no health insurance, uncertain prospects that extend out to the future opportunities for his children.

The reduction in the practical implications of income differences at the higher end of the income scale has created a plateau where there used to be a hill. But that plateau has a stark cliff at the edge. Jamie might be on the plateau shared by Malcolm and Bob, doing much the same with his time as they are, but he is closer to that cliff. If Jamie loses his job he is no longer looking down at the abyss, he is over the edge.

The flatter the plateau and the more sudden and deep the abyss, the stronger the argument for social programs, because the costs of redistribution for those on the plateau are lower in practical terms, and the fall from the plateau is more crushing. In the limit, if the plateau is completely flat, so that there is no practical difference in income within the upper range, people should be indifferent about moving along that plateau toward the cliff if at the same time the cliff can be securely fenced off.

Put in other terms, more akin to the way we think about financial trade-offs, there is both the expected value of one’s income (measured by what it does for you in practical terms) and the uncertainty surrounding it. As the means from one person to the next converge, the uncertainty takes on increasing significance. As the “how you spend your time” differential shrinks, a reduction in uncertainty through an improvement in the safety net becomes of increasing importance. Indeed, in the limit, if everyone is typically spending their time doing the same things, reducing this uncertainty is all that matters.

April 4, 2010

The Municipal Market

April 04, 2010
This represents my personal opinion, not the views of the SEC or its staff.

My first blog post was in June, 2007. It was titled “What sorts of crises am I worried about now”. My answer was housing and credit. With the benefit of hindsight, this might be considered a no-brainer, although at the time it was not so clear where things would go.

Now as the dust settles from the crisis that emerged in 2008, we can start to think about what might come next. And yes, the crisis really is settling down, despite the alarmists who, thinking we were in a 1930’s style depression, pushed the panic button and stuffed their mattresses (or portfolios) with cash. For whatever reason, be it astute government intervention or the natural healing process, we are looking back at something along the lines of a bad, credit-driven recession.

I don’t think we will see a big crisis emerging for some time in banks, hedge funds or derivatives, mostly because, like with a knockout punch, the risks that matter don’t come from where you are looking. Unless the current push for legislation is a failure, which, of course, still remains to be seen, we will have steely eyes hovering over these sources of crisis. It will be awhile before the guards start dozing off at their posts.

So, where to look next. To see other potential sources of crisis, let’s first recount the lessons learned from this crisis:
  1. Problems occur when things get leveraged and complex (and thus opaque).
  2. If the problems occur in a very big market, especially in a very big market like housing that is tied to the credit markets, things can go systemic.
  3. The notion that you can diversify by holding a geographically broad-based portfolio, (“there has never been a nation-wide housing recession”), works fine – until it doesn’t.
  4. A portfolio that is apparently hedged can blow apart. So we have to look at the gross value of positions, even if they are thought to be hedged.
  5. Don’t bet on ratings, because rating agencies are conflicted and might not be all too dependable at their job.
  6. Defaults are never easy to manage, but it gets worse when there are a lot of them happening at the same time. It is harder to manage the mess, and there is less of a stigma in defaulting. And it is all the worse when, as is the case in the housing markets, those defaulting are not businessmen. As an added complication, with housing the revenue that we thought was there really wasn’t. Income that was supposed to be there to finance the mortgages – even when that income was fairly stated – became committed to other areas (like second mortgages). .
Well, guess where we have a market that is (1) leveraged and opaque, that is (2) very big and tied to the credit markets; and is (3) viewed by investors as being diversifiable by holding a geographically broad-based portfolio; with (4) huge portfolios where assets and liabilities are apparently matched; and with (5) questionable analysis by rating agencies; and where (6) there are many entities, entities that may not approach default with business-like dispatch, and that have already mortgaged sources of revenue that are thought to support their liabilities?

Answer: The municipal market.

Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.

Size and potential systemic effects. That this is a big market in the credit space goes without saying.

Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn’t just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?

Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky -- the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.

Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net – the under funded portion of the portfolio.

Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with.

Oh, and just as homeowners took their income and locked it up via secondary loans, much of the tax base for municipalities is already mortgaged, through the sale of tax-related revenues streams like tolls and parking fees. Indeed, although general obligation bonds are considered the cream of the crop, they might just as well be regarded as the residual claim after anything with solid fee streams has been sold off.

Once a few municipalities default, there is a risk of a widespread cascade in defaults because the opprobrium will be lessened, all the more so if the defaults are spurred along by a taxpayer revolt – democracy at work.

I appreciate comments, but will not be able to respond to them. Also, because this is a personal blog unrelated to my work, I will not be posting comments that do not respect that separation.