I have heard the argument that those at AIG should not get bonuses because they destroyed the firm, or because they destroyed the firm and in doing so helped precipitate the current economic calamity to boot. This sort of argument doesn’t make sense to me. The vast majority of those in the bonus pool at AIG had nothing to do with precipitating the firm’s failure. They were marketing insurance products, managing call centers to handle customer inquiries, and other exciting stuff like that. They just happened to live in the same corporate city-state as the evil-doers. Pulling their bonuses based on such an argument is collective punishment.

A more reasonable argument is that without the government assistance, AIG would have gone bankrupt. And if it had gone bankrupt, those who are pulling in bonuses not only would have had no bonus, they likely would have had no job. So then, the argument goes, why should the government’s bailout money – which of course is tax payer money – go to give out-sized bonuses?

That makes sense. But then we come to some follow-up questions.

One is why Paulson didn’t include compensation controls as one of the terms for keeping AIG afloat. You could ask the same thing of Geithner, who frankly is taking on far more grief than he deserves, but the time to have done this was back when the government bought the majority stake in the company.

A second is why the argument stops with the boundaries of AIG. We should ask who beyond AIG would have gone bankrupt if the government did not keep AIG from default, and make the same demands on bonuses that are being paid there.

Think of it this way: If time had not been so tight, the creditors would also have been in the bailout meetings. These creditors would have include those on the hook in the event of default due to their CDS exposure. The meeting would have started off with Paulson saying, "We can pull AIG from the brink. It will take a lot of taxpayer money to do so. We want concessions all around, both from AIG and from its creditors, and especially from those creditors that will go under with it.

That is the correct route to collective punishment. A route that starts with questions like this:

True or False: If AIG had gone into default, Goldman Sachs would also have failed.

My Time article about the quant meltdown of August, 2007 started with “Looks like Wall Street’s mad scientists have blown up the lab again.” Articles on Wall Street’s mad scientist blowing up the lab seem to come out every month in one major publication or another. The New York Times has a story along these lines today and had a similar story in January.

I was invited to speak on Friday at the XBRL Risk Governance Forum, hosted by the IBM Data Governance Council. Having said that, most everyone is going to be tempted to yawn and stop reading further. Don’t. Within the work of this Forum are the seeds of reducing the risk of future market crisis. Indeed, it could be the foundation for a quantum leap in risk management.

To explain why, let me start by going through the dynamics of market crises. A market crisis occurs when there are highly leveraged investors in a market that is under stress. These investors are forced to sell to meet their margin requirements. Their selling drops prices further – especially because the market was under stress to begin with. So you get a cascade down in the price of that market. A shock that might have initially led to only a five percent drop gets amplified, and the market might drop multiples of that. We have seen this in various guises in the current crisis, from the banks' 'toxic waste', to the downward spiral in housing prices, to the deleveraging of the carry trade, to the quant fund crisis in August 2007.

And the dynamic gets worse. Many of those under pressure to liquidate will discover they no longer can sell in the market that is under stress. If they can’t sell what they want to sell, they sell whatever else they can. So now they move to a second market where they have exposure and start selling there. If many of those who are in the first market also are in the second one, and if the investors in that market are also leveraged, then we see the contagion occur.

Here are two examples of what I am talking about.

Example one is LTCM. The proximate cause of LTCM’s demise was the Russian default in August, 1998. But LTCM was not highly exposed to Russia. A reasonable risk manager, aware of the Russian risks, might not have viewed it as critical to the firm. So how did it hurt them? It hurt them because many of those who did have high leverage in Russia also had positions in other markets where LTCM was leveraged. When the Russian debt markets failed and these investors had to come up with capital, they looked around and sold their positions in, among other things, Danish mortgage bonds. So the Danish mortgage bond market went into a tail spin, and because LTCM as big in that market, it took LTCM with it.

Example two is what happened with the Hunt silver bubble. When the bubble burst in 1980, guess what market ended up being correlated almost one-to-one with silver. Cattle. Why? Because the Hunts had to come up with margin for their silver positions, and they happened to have large holdings of cattle that they could liquidate.

Could we have ever anticipated beforehand that we would see a huge, correlated drop in both Russian MinFins and Danish Mortgage bonds? Or in silver and cattle? There is no way these dynamics can be uncovered with conventional, historically based VaR type of analysis. The historical return data do not tell us much if anything about leverage, crowding and linkages based on position holdings.

This is not to say VaR is not of value. I think everyone who is involved in risk management understands the limitations of VaR, what it can and cannot do. It is sometimes put up as a straw man because it is not doing things it was not designed to do, things it cannot do, such as assess these sorts of liquidity crisis events and the resulting cascade of correlations that result.

But the proper use of mark up languages along the lines of XBRL can give us the data we need to address market crises as they start to form. What we must do is have a regulator that extracts the relevant data – in this case position and leverage data – from major investment entities. These would include, as a start, the large banks and largest hedge funds. With assurances of data security – the data would not be revealed beyond the regulator – a government risk manager would then be able to know what currently cannot be known: where is there crowding in the markets, where are there ‘hot spots’ of high leverage, what linkages exist in the event of a crisis based on the positions these investors hold?

For these reasons, the first recommendation in both my Senate and House testimony was “get the data”. How can we do that? Well, first, by legislative demands to require investment firms -- including large hedge funds -- to provide the data. Then by the proper application of a mark up language so it can be done in a consistent, aggregatable way.

To give an analogy for this, one that came out in the conference and that illustrates how far behind we are in financial markets, a mark up language for risk would do for the financial products what bar codes already do for real products. If we discover a problem with peanuts being processed in some factory, we can use the bar codes to know where each product containing those peanuts is in the supply chain, all the way down to the grocery store shelf.

Having the proper tags – the proper bar code, if you will – for financial products, ranging from bonds and equities to structured products and swaps will allow us to understand the potential for crisis events and system risk. It will help us anticipate the course of a systemic shock. It will identify cases where many investors might be acting prudently, but where their aggregate positions lead to a level of risk which they on their own cannot see. It also will give us the means to evaluate crises after the fact. Just as the NTSB can use the black box information to help improve the airline industry by evaluating the causes of a airline accident, this position and leverage data will act as the black box data to help us understand how a crises started, and, coupled with interviews of the key participants, help us understand what we need to do to improve the safety of the markets.

I spoke last night at a small gathering hosted in the Paley Center by the Financial Times. The topic was the current economic crisis, and the audience, and two of the three panelists, were what I guess is considered ‘of the journalistic persuasion’. Most all were in one form or other bloggers; whether they become viewed as journalists, time will tell.

We all know that the world of journalism has been turned on its head. All you have to do is hold up a copy of Time Magazine and watch it wave in the wind to tell there is a problem with the weeklies. And when there are murmurings of the New York Times shutting, you know we are in a changing world. Replacing traditional print journalism is the blogging community. Will the world be any different? And if different, worse off?

Here is my stream of consciousness view of blogs. I am employing a stream of consciousness approach in this post out of respect for my topic, because I want to write about blogs in the same way most blogs are produced and read.

When we were young, we – and I mean anyone in the baby boom generation onwards – were fed TV fare that included Sesame Street. Childhood education specialists discovered what would have been self-evident if they had any kids of their own, that kids have short attention spans and are attracted to movement and activity. So they helped design shows that fit what these unformed brains craved. A string of little spots lasting a few minutes each with frenetic activity, the cognitive equivalent of a string of Star Burst candies. Our brains liked it, but being fed it incessantly, didn’t see much need to develop out of that mode. So as we got older, we gravitated toward the adolescent equivalent, MTV. The average scene in an MTV clip was under half a second, the average clip under five minutes; it was Sesame Street on hormones – and we were now Sesame Streeters on hormones.

So what happens when the Sesame Streeters grow up and are looking for news – or, more precisely, are looking for entertainment in the ‘feel good’ form of news? It was a long time coming, but now we have it: blogs. When I jump from one blog to the next, the same neurons seem to be firing that did back in my Sesame Street days. Both in timing and content. Blogs are all bite sized – probably because of how we spent our formative years, our stream of consciousness episodes last about as long as the Sesame Street spots. And the content is mostly retread, so we get to read the same thing over and over again. Thus it is both easy on our eyes and our brains. And filled with attention-grabbing activity; since you can take leave of journalistic standards that constrain the traditional print journalist, you can be edgy, even insulting. How am I doing so far?

My book, A Demon of Our Own Design, was a finalist in the Business Books category for the Loeb Awards, so I got to attend the awards dinner. The place was packed with traditional journalists. I didn’t win; the person who did wrote about Tom Perkins building a really big sail boat – I still haven’t figured that out. But, anyway, continuing on with my stream of consciousness…. Many of the winners expressed their appreciation to their employers for allowing them the freedom and funding to work on the difficult and time consuming topic that led to their prize. Topics that uncovered business abuses through months of dogged investigative work. At that dinner I felt proud for the journalistic profession, because I was seeing the fruits of the labor of some of those who had signed up during the Woodward and Bernstein era, when many were driven toward journalism to improve the world, to speak for those who had no voice.

Will this role continue in the world of bloggers? If we are talking about factoids being thrown out into the light of day, the answer will be ‘yes’. A blogger can grab something that is predigested and put it into a post. So there is no reason Harry Markopolis’s whistle blowing analysis of Madoff couldn’t have found its way into the blogosphere, rattling around until it caught the attention of the mainstream media. But would a blogger have spent the time to develop such an analysis. Mainstream journalists missed on this one, but I could well imagine an alternative universe where the Madoff Ponzi scheme emerged through the efforts of an investigative journalist. Plenty of other things have.

What will the landscape of journalism look like in five or ten years, as the dinosaurs of print journalism breathe their last. Well, when the dinosaurs disappeared from the earth, the earth became overrun with rodents.

For a start, we can stipulate that there are a lot of people in the banking industry (and especially in the subset of that industry which, up until September of this year, would have been called the investment banking industry) who are still making obscene amounts of money while the companies generate losses for the shareholders and force taxpayers to cough up bailout funds. And then there are the end of year bonuses paid to employees. Attacking the second does not get us very far in addressing the first.

Employees in banks and investment banks get part of their pay bi-weekly over the course of the year, and then get the rest of their salary in the form of an end of year bonus. It is called a bonus, but a large portion of it is deferred salary. Even if they perform their job at a hum-drum level, they will still expect and get a sizeable “bonus”, because, however you want to put it in technical terms, the simple fact is that when they receive their bi-weekly paycheck, some of their pay has been held back. Taking away their year-end bonus would be like telling workers on a weekly pay cycle to return the second and fourth payment they received each of the last twelve months.

We are talking about the workers who install and maintain the computers, do the back office accounting, run the HR functions, generate PowerPoint presentations and maintain the client relationships. Some of those accountants are called traders, and some of the PowerPoint generators are called investment bankers, but most are a far cry from the multi-million dollar traders and investment bankers that we read about. There are a lot of extras and bit parts in movies, too.

Before getting too apoplectic, let’s at least look at the breakdown. My bet is that the majority of bank workers whose bonuses Obama finds outrageous and Dodd wants to claw back are workers who get modest base salaries during the year and whose bonuses make up more than half of their total salary. These bonuses already were cut far below those of prior years. If they are already seeing their annual salaries cut by forty percent or more, do we go further?

One of the great things about having Obama as president is that Paul Krugman will now put more focus on economics and less on polemics. I was a classmate of Paul’s at MIT, and I remember him as the most natively brilliant of all of us in terms of economics. There were others who had stronger mathematical skills or who walked in the door with more economics training, but it seemed that he was genetically wired for economics. And now that there are fewer Republicans for him to kick around, he can get focused on what he does best.

But that doesn’t mean he is always right. Well, when it comes to economics I doubt he is ever actually wrong, but he might not fit the full story within the space constraints. And this is the case with a recent column of his in the New York Times related to government bail outs. He used a fictional bank called GothamGroup – I don’t know if he had any particular bank in mind, I suppose it was based on some Batman reference – to explain how the government cannot alter the basic math of the markets. If a bank has liabilities that are greater than its assets on a mark to market basis, then the bank is effectively in default. The government cannot change that; if it does not want it to fail, then it has to give the bank enough money to push it back into solvency, which means giving the equity holders a gift at the taxpayer’s expense.

The point left unsaid is that the government, unlike you or me or some corporation, is in a position to change the reality on the ground. They can take steps to alter the nature of the markets. They can push down mortgage rates, add tax benefits for new mortgage holders, and push losses forward by forcing changes in accounting rules. They can push inflation up to make all debts lower in real terms, thereby differentially taxing the lenders to the benefit of the borrowers. They can encourage the formation of clearing corporations for swaps or other instruments, thereby improving the liquidity and credit-worthiness of those markets. They can buy up weakened assets and lock them up for as long as they want, so that no one needs to look over the shoulder and wonder if an avalanche of securities is going to sweep them away should they start to invest.

An investor may be hesitant to take on the assets that are clogging up the banks. They would have a hard time finding the capital to buy them, and they have uncertainty about the future. And they fear that once they take assets on, they may not be able to dispose of them if the economy continues its tailspin. Little capital to invest, uncertainty about the future, illiquidity: no wonder the mark to market on these assets is so low.

But not so for the government. The government has no capital constraints, no concern of being forced into liquidation, and as far as uncertainty about the future, to a large extent it creates that future. The government makes the rules; if the government were clever about it, my bet is that they could make a windfall from this mess by buying up everything in sight and then changing the market reality.

There is not much mystery about how banks ended up in such a mess. It was not the malfunction of sophisticated risk models, nor was it a “100-year flood” event that swamped risk controls that would have been adequate in normal times. It was simply a huge and unrelenting build up of inventory in illiquid and often complex securities. A build-up that was there to be seen and corrected.

There was nothing tricky in fixing this problem before it got out of hand. When you are seeing the inventory of complex structured products grow from a few billion dollars to ten billion, then on their way to 20 or 30 or 40 billion, a natural question to ask in the course of the build-up is “why aren’t we selling any of this stuff”. And a natural answer to that question is “maybe we aren’t pricing it correctly”. Any risk manager with a fifth grade education will note that if the price of the inventory is off by just ten percent, that will mean a loss of billions of dollars, and so will propose selling some of the inventory, say a few billion dollars worth, and see the price at which it clears. At that point, the gig will be up.

So why didn’t this happen?

One hypotheses is asleep-at-the-switch incompetence by the risk mangers: they just missed the inventory build-up. But given the simplicity of the problem and the fact that any of these banks have hundreds of personnel in the risk management division, that’s hard to believe.

A second hypothesis is incompetence or poor incentives in senior management: the problem was passed up the chain of command and then ignored. This seems reasonable; there are, after all, tensions that pull against the in-house Cassandra. Senior management is reluctant to reduce risk because it means lowering earnings. And management gets backing for this from a powerful constituency, the traders who control the profit centers and make their money by taking risk. The traders are at loggerheads with the risk manager because of skewed incentives, the so-called “trader’s option” where if the firm wins they win while if the firm loses big time they miss their bonus for the year and head off to greener pastures. Indeed, senior management might be swayed by similar incentives.

Under this hypothesis the risk failure within the banks is organizational; it has to do with incentives, communication and plain old fashioned bureaucracy.

So how do you fix it?

The government needs to create a market risk management function with direct lines to the Chief Risk Officer of each financial institution. The CRO should be required to provide full risk information to the government risk authority. It sees whatever he sees. And it should go one step further, to require the CRO to notify the government risk authority of any risk concerns that have not been resolved by senior management. In essence, the CRO would have dotted-line reporting to his government counterparts. Think along the lines of the Sarbanes-Oxley Act, which requires the CEO to attest to internal controls and certify the accuracy of the financial statements.

As important as the specifics of the structure is the spirit with which the regulatory role is executed. For the CRO engaged in fulfilling his responsibilities, the government risk authority can act as his ombudsman, an outside voice with the power to get things done if his own voice is not being heard within the firm. The CEO is less likely to ignore risk concerns if he knows who might be making the next knock on his door. And if the CEO has a legitimate disagreement about the degree of risk, he might welcome the outside view.

For this to work, we need to change the mindset behind regulation. Marching in with a subpoena in one hand and a sixty page questionnaire in the other is not the way forward. Which means we also need a different type of regulatory staff. Some jobs cannot be done by SEC lawyers or career government workers. We need to entice market professionals into government service, market professionals who are on par with those in industry. It might cost some money to get them on board, but I bet the bill will be way south of a trillion dollars.

Dawn Corrigan has written a rendition of Dr. Seuss's The Lorax, replacing the forests with the markets and with me in the starring role.

The original version focuses on the damage of clear-fell logging, and is used by Doctors for Native Forests in their fight to preserve, well, native forests:

I have recommended in various forums that we need a government-level market risk manager. (See my House testimony (October, 2007) and Senate testimony (June, 2008), both linked via posts in this blog, and the Preface for the paperback edition of A Demon of Our Own Design). Such a role has also been recommended by the Treasury in the form of a market stability regulator.

I was discussing this idea yesterday with a colleague in government, and he mentioned that one concern for such a role is the potential for a concentration of power. Risk taking is at the center of the financial industry, and whether it is the Federal Reserve, Treasury or SEC, the ability to dictate risk limits puts this role in the position of controlling the industry’s profitability.

To answer this concern, it is useful to make a distinction between risk management and risk monitoring. In the financial industry, be it in hedge funds or in banks, what is called risk management is really a risk monitoring function. The risk management team, headed by the Chief Risk Officer, oversees the aggregation and analysis of exposures. But it does not make decisions on the appropriate risk appetite for the firm, and it does not unilaterally set the risk limits or otherwise force the risk takers to hedge or reduce their positions. If the CRO thinks action is needed, the baton is passed up the chain of command to the firm’s decision makers. This might be the head of the trading division, the CFO, the CEO, or a risk management committee with these as its members. The decisions of how much risk to take, the limits to set, when to make exceptions all are made at this level.

A similar structure could exist for the risk management role within the government. The role of risk manager would be staffed by technocrats, in the positive sense of that word, who would develop systems to acquire the necessary risk information from the institutions, analyze that data and determine if new areas of risk are emerging. They would connect with their industry counterparts, the CROs of the various institutions, to understand areas of concern, to help identify common or emerging risks, and to constantly refine the risk management process. If a market crisis did occur, they would have all of the data at their disposal to revisit the risks to monitor and the limits to set. Think in terms of what the NTSB does when there are airplane accidents. All of this would lead to recommendations to a decision making committee, perhaps a subcommittee of the House or the Senate.

Don’t worry about too much back and forth with the decision makers. On a practical level, it would be rare for the government risk manager make one-off suggestions that this or that bank lower its risk beyond the risk targets that have already been established. More likely, the government risk manager would see that a number of banks are starting down a particular path, building up exposure to a new market or diving into a particular structured product space, and recognize that, while each bank’s actions might be reasonable on a stand-alone basis, there is too much concentration and potential systemic effect once the exposure is aggregated across the banks.

And, by the way, no one can make such an observation in our current regulatory structure.