< The Finance Professionals' Post: May 2010

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23 posts from May 2010


Hive Mind: Organizational Psychology and the Financial Crisis

Illustration by Mark AndresenEconomists agree about the mechanism for the current financial crisis: a plunge in real estate prices led to widespread mortgage defaults, crushing the value of securities backed by those assets. This caused banks to shut down available credit and sent the global economy into a tailspin. “If there hadn’t been a housing bubble, we wouldn’t be having this tragedy today,” says Hersh Shefrin, PhD, professor of behavioral finance at Santa Clara University and the author of Ending the Management Illusion: How to Drive Business Results Using the Principles of Behavioral Finance (McGraw–Hill 2008).

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Book Review: Poorly Made in China

Poorly Made in ChinaThere’s trouble in wonderland. China is increasingly the go-to spot for world global production, promising cheap fabrication, short lead times, large profit potential, and an enormous domestic target market. It’s virtually impossible not to make use of a product manufactured in China in the course of any given day. But major quality problems, such as the 2007 recall of toys containing lead paint, occur with alarming frequency. Poorly Made in China not only lifts the curtain to reveal the games behind Chinese production, it provides an acute analysis of the factors behind China’s manufacturing woes—cultural, ethical, political.

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Knowledge of Good and Evil: A Brief History of Compliance

The JungleAdam’s bite of forbidden fruit marked the first recorded compliance violation, but not the last. Corporations perpetually struggle to stay compliant with the ever-increasing complexity of laws, rules, and regulations. A board of directors that fails to oversee a system of compliance may not only call into question its fiduciary duty standards, but may give rise to claims of tort liability or even criminal liability. Effective management of compliance risk and reputational risk requires a firm to link ethical business behavior to its culture: to establish ethics as an integral part of a company’s continued business success.

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The Prudent Man Standard

Janusz Kapusta/Stock Illustration SourceAmong the most significant of the damages to result from the recent market turmoil may be the losses suffered by US pension plans. In 2008, DB (defined benefit) plans plummeted from fully funded or even over-funded status to historically large deficit levels. Pension health, as measured by the ratio of assets to liabilities, dropped precipitously during the same period, from 104% to 75%, leaving a $400 billion funding gap (Mercer 2009). Many of these now underfunded plans are sponsored by companies facing drastic deterioration in financial health or, in some cases, potential bankruptcy. The PBGC (Pension Benefit Guaranty Corporation), the agency responsible for insuring DB plans, is itself experiencing significant and rising deficits (Elliott 2009). The result may be escalating uncertainty as to the status and future of benefits for a large number of pension plan participants.

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Commentary: The Fault is Not in Our Stars

Over the past couple of decades, there has been a disproportionate focus on trying to obtain a larger slice of the total economic pie, rather than an emphasis on growing the total pie. Related to this as well was a desire for (almost) immediate gratification and an attempt to eliminate downside risk. These tendencies appeared throughout society, from corporate executives to individual consumers, and led to the accumulation of burdensome levels of debt; the passing off of risk as quickly as possible (i.e., packaging and selling of toxic debt); misaligned compensation structures; and, most disturbing, increasingly widespread fraud. This fraud ranged from lying on mortgage applications to lying on corporate financial statements (e.g., WorldCom, Enron), and from the spreading of false rumors in the financial markets to the outright fabrication of customer statements (e.g., Bernie Madoff).

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Whither Efficient Markets? Efficient Market Theory and Behavioral Finance

The notion of efficient markets has been the subject of rigorous academic research and intense debate for more than a century. As early as 1889, George Rutledge Gibson wrote in The Stock Exchanges of London, Paris, and New York that when “shares become publicly known in an open market, the value which they acquire may be regarded as the judgment of the best intelligence concerning them.” A reference to the concept of efficient markets is also found in French mathematician Louis Bachelier’s 1900 dissertation Théorie de la Spéculation. But it wasn’t until the mid 1960s, through the independent work of MIT economist Paul A. Samuelson and Eugene Fama, then a PhD candidate at the University of Chicago, that the efficient markets hypothesis (EMH) gained widespread acceptance.

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Book Review: Start-Up Nation

Start-Up Nation

As the U.S. economy attempts to recover, leaders in government, business, and academia search for ways to modernize the economy and reduce unemployment by creating high-tech jobs. In Start-Up Nation: The Story of Israel’s Economic Miracle, authors Dan Senor and Saul Singer analyze a question that might help American policymakers: How does a small country that is only 60 years old, with only 7.1 million people, surrounded by hostile neighbors, radically restructure its economy to become one of the world’s most technologically oriented and entrepreneurial nations?

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Entrepreneurial Tip Corner: Dashboards are Here to Stay

DashboardIt is said that the eyes are the windows to the soul. I believe the corollary to that saying as it relates to businesses is that dashboards are the windows to the soul of a company. What are dashboards, why are they so important, and what insights can they provide about a particular business? A dashboard is simply a pictorial description of one or more attributes of an organization. It enables the reader to quickly evaluate the performance of a particular facet of the business. Dashboards take on many shapes, sizes, and varieties, but there are certain key elements that should always be present. 

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The Three Most Common Biases of Hedge Fund Managers

An upcoming NYSSA forum will be exploring the opportunities, risks, and challenges of investing in emerging hedge fund managers. In the absence of a long track record to review, the field of behavioral finance may offer particularly effective tools, not only for identifying the best emerging talent but also for detecting manager biases that may translate into future blowups.

Cynthia Harrington, a former large-cap value manager who now uses behavioral finance principles to coach hedge fund managers, has observed that their three most common biases are confirmation bias, herding behavior, and overconfidence.

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Book Review: The China Strategy

The China Strategy

Edward Tse, the author of The China Strategy: Harnessing the Power of the World's Fastest-Growing Economy (Basic Books, 2010), is Booz & Company’s senior partner and chairman for greater China. He has been involved in China as a management consultant since the early 1990s. While his book is primarily for business executives, it contains much that is essential reading for investors and analysts. China is a unique country in intense and constant change; what you see today may not be what you see in a few years. However, some aspects of China will be familiar to Wall Steeters. 

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The Hierarchy of Risk: A New Approach to Risk Management

Risk culture is comprised of those values and behaviors, on the parts of both management and employees, which define an organization’s awareness of and approach to risk. As the financial crisis continues, the most successful firms have been those possessing risk cultures with high awareness, quick escalation, and strategic flexibility. There are echoes of behavioral finance in the way an organization’s view of risk may be skewed by its current investment appetite, its compensation and incentives, and its degree of knowledge of historical risk. Complicating this risk culture is quantitative modeling of limited historical data, decreasing transparency due to financial product innovation, and overreliance on credit ratings.

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Independent Research: Salvation in the Middle Market

Illustration by Mark AndresenThe ghost of Eliot Spitzer that has haunted Wall Street for the past five years has finally been laid to rest. After his investigation into allegations that the major Wall Street firms had mishandled conflicts of interest between their research and investment banking arms, the now-disgraced former governor of New York trumpeted the global settlement as a victory for retail investors over greedy Wall Street titans. He accused the Street of publishing favorable research reports on investment banking clients even though in private the analysts sometimes derided the companies as garbage. Spitzer’s targets never admitted fault, but in his trademark style, the then–attorney general of New York wrested payments from 12 securities houses, which agreed to fund independent research for five years and make third-party reports available to retail clients alongside their own research.

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Investing in Troubled Times

Illustration by Mark AndresenIn these troubled times, with investors unsure of when or where to place their funds for maximum benefit, one investment tenet should be clear: bet on entrepreneurs. Our research of 27,000 publicly traded global companies, employing more than 12 years worth of data, demonstrates that entrepreneurial companies consistently outperform peer nonentrepreneurial companies by a wide margin. With very few exceptions these results remain true even after adjusting for year, market cap size, region, and sector. And, following the tumultuous market collapse in 2008–2009, it appears that entrepreneurial companies are now poised to perform better than ever.

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Think Twice: Michael Mauboussin Podcast Interview

In the world of finance, there are myriad investment themes today: crude oil, China/India, Greece and all sovereign debt, a bumper crop in USD, clean/efficient energy, oil spills, OTC derivatives regulation, and the advent of the commodity investor.

How does an individual or an investment committee make sense of the confluence of themes? Michael Mauboussin is an expert in decision making within the investment process and he has a game plan to help you figure it out.

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Byron Wien: Man of Many Years

Byron WienByron Wien is having an especially good year. Not only has the long-time strategy guru received a Lifetime Achievement Award from the New York Society of Security Analysts, Inc., he has also enjoyed a higher-than-normal batting average on his signature Ten Surprises.

Moreover, at age 75, he is fulfilling his three most important goals: he is alive, he is healthy, and he has friends. Boy, does he have friends. Called by some the Perle Mesta of Wall Street, Wien continues to collect people all over the world—people who give him ideas and feed him information, helping Wien develop the kind of insights that have long nourished his popular year-end forecasts.

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The Philippines is Buffeted by Stormy Politics and Natural Disasters


The Philippines is a key participant in Asia’s growth story: one of the few countries that can be described as a former US colony, it has many characteristics that should make investors at least pause to investigate. The US colonial heritage, for one, has left in place an economic culture favoring markets and capitalism. Low-cost, relatively educated, English-speaking labor has meant that Philippine call centers and other business-service providers can compete with India for business from firms that are offshoring their business processes. Extensive mineral deposits can also feed China’s voracious commodity appetite. Nonetheless, political and geographic factors create risks that have handicapped economic performance to below what traditional economic indicators would suggest is possible.

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Our Take: Sub-Prime CDO Fraud and Your Career

eFinancialCareersWe interrupt this earnings season for a bulletin: Practices that were considered business as usual in the securitization market a few years ago can suddenly land you in a heap of trouble.

Click here to read the article. 

Book Review: The Future of Hedge Fund Investing

Future-of-Hedge-Fund-InvestingIn The Future of Hedge Fund Investing (Wiley Finance, 2009), Monty Agarwal addresses with clarity and candor the passivity of hedge fund intermediaries in confronting the frauds and crooks they were duty-bound to detect. The Bernie Madoff scandal was merely the latest in a long and undistinguished line. Agarwal remains bullish on the promise of hedge funds and offers thoughtful ideas on how that promise can be realized. In his decade-long career as a trader and hedge fund portfolio manager, he observed firsthand the institutional investment processes the book critiques and aims to improve.

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Book Review: This Time Is Different

This Time is Different

The word “conceit” only appears twice in Carmen M. Reinhart and Kenneth Rogoff’s panoramic examination of financial crises but is fundamental to the theme of the book. In context, conceit implies an underlying attitude of smugness among bankers, regulators, and investors, who all assumed that somehow conditions are different than in the past: they are smarter, old valuation rules are irrelevant, or lessons of the dark past and other countries have been learned. This Time Is Different is a sobering antidote to that smugness and helps put the 2008 financial crisis and its recovery in perspective.

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Letter to NYSSA Members: May 6, 2010

Nanci MorrisDear Members:

During the recent past, those of us in the financial services industry have faced unprecedented challenges and likewise for the New York Society of Security Analysts (NYSSA). The Society has seen a decline in membership and enrollment in fee-based education. We are fortunate to have a strong balance sheet with the ability to use some of our cash reserves to help us weather the storm. This, combined with operational cost reductions will ensure our ability to consistently refine and improve our membership program offerings.

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Recent Research: Highlights from May 2010

"Risk Management Lessons Worth Remembering from the Credit Crisis of 2007–2009"
The Journal of Portfolio Management (Summer 2010). Bennett W. Golub and Conan C. Crum.

This article by Golub and Crum presents six important lessons worth remembering from the credit crisis of 2007–2009.The recent credit crisis revealed the inadequacy of many standard methods in quantitative risk management and called into question the general efficiency of markets. Golub and Crum’s analysis of the six lessons learned provides insights into what went wrong and offers advice on steps that institutions can take to avoid similar failures in the future.The authors present detailed analysis on risk management issues relating to liquidity, securitized products, certification,market risk, and policy risk. 

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A Primer on Value at Risk

Value at risk, or VaR, is viewed by some as a massively important measure. It is unique in how it characterizes risk. Most measures show risk either as a percentage (as standard deviation and tracking error do) or in units (as the Sharpe and Treynor risk-adjusted measures do). VaR shows risk in terms of money—that is, the money that might be lost.

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Your Track Record and Compliance History Are Your Franchise

NYSSA Commodity Instructor Michael Martin is interviewed by Stacy-Marie Ishmael of the Financial Times on OTC derivatives regulation and trader compensation at the Milken Global Conference April 28, 2010 in Beverly Hills.


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