Monday, October 12, 2009

Gaming the System

One aspect of our financial system is that it is supposed to be designed to reward people financially for making good decisions, working hard, and providing good service.

That's the theory, anyway. Oftentimes, in reality, it doesn't work that way.

The problem arises when people game the system. What does this mean?

In any system of rewards and punishments, the goal of the system is to encourage people to behave in a manner that results in some social good. Unfortunately, if the system is not designed properly, there are always some folks who will figure out ways to maximize their rewards while doing as little as possible in terms of social good.

At the Patent Office, we had a system called the Performance Appraisal Plan or PAP. It was designed to reward Examiners for examining Patent Applications (and punishing those who didn't work hard).

Most Examiners worked at their jobs, doing what they were paid to do, examine Patent Applications, and the system did a pretty good job evaluating their performance.

However, some Examiners would look at the system and figure out ways to make it appear they were working harder than they were. By forcing unnecessary restriction requirements and re-filings, a savvy Examiner could dice and slice a single case into two, three, four or more and thus increase his apparent work product three or fourfold, while only working slightly harder.

Our financial system suffers from similar faults. As we have learned (the hard way) during the recent financial downturn, there were many in the finance and mortgage industries who were "gaming" the system considerably. Mortgage brokers were paid to sell mortgages, not to sell good mortgages. So they sold mortgages to people who couldn't pay them back. Either way, the broker got paid - that was how the system was structured (and you can't blame the broker for doing what the system told him to do!)

Folks on Wall Street did likewise. Some knew what they were doing was wrong. Others just followed the rules and got paid. Either way, the result was a disaster - bad debt was sold as good debt, and the entire system broke down.

In response to this crises, some have called for greater regulation. They want to tweak the rules of the system to prevent people from "gaming" it again. A similar thing has happened at the Patent Office - the PAP has been tweaked and twisted, trying to prevent people from taking advantage of loopholes.

While it is possible to make the rules of the game more and more complicated in response to efforts to game the system, eventually such rulemaking becomes burdensome. One reason our tax code is so complex is that Congress keeps adding incentives and then trying to fix the rules when people distort those incentives. For example, the rules at various times gave tax breaks to people buying diesel cars (to save gas) but also gave tax breaks to people buying 6,000 lb. Suburbans (depreciated as heavy equipment) which did the opposite. You now need to hire a tax specialist just to understand all the nuances of the Rules. And unfortunately, one of the "incentives" built into our tax code encouraged people to buy houses, vacation homes, and investment properties.

One of the best "rules systems" out there is a truly free market economy - one with a few simple, direct rules and complete transparency. Many people take away as a lesson from the downturn that a free market economy is not a good thing, and that capitalism is inherently flawed unless regulated. I would argue the opposite.

At the present time, we do not have a truly free market economy by any means. (We probably never have and never will.) To begin with, we do not have the transparency in our markets. Good solid information about investments, money, and finances are hard to come by. We do not train ourselves or our children in how to manage money. There are no courses in high schools on basic finances - just basic math. Only those majoring in economics or other financial disciplines even get a whiff of what is really going on.

And financial instruments are so complex that they obfuscate the underlying transaction. Again, my manta: The more complex you can make a financial transaction, the easier it is to skin the mark.

Thus, people investing in "mortgage-backed securities" got fleeced. But my local bank (Community Bank, NA) who wrote mortgages to local people they met in person, with 20% down and three years of financial disclosure required, has a default rate of ZERO. That's right, zero. No defaults, no foreclosures, no meltdown. And small banks across the country have had similar results. The transactions were simple and transparent: You show up in person to borrow money for a property that is within eyesight of the bank. They have a pretty good handle on what is what, at the ground level. Capitalism does work, in its simplest form.

(And you can imagine how those bankers feel, playing by the rules, doing the right thing, only to see the "big banks" playing fast and loose and taking away their business. Then it all goes horribly wrong and the big banks get bailed out and the managers pull the cord on their golden parachutes. But in the long run, the bank that did the smart thing ends up better off. Small bankers, like small investors, can only get burned if they try to play like the big boys.)

Complex financial instruments, such as derivatives, on the other hand, are understood by very few people. And as the name implies (derived from calculus) a derivative can change dramatically in value based on small changes in value of the underlying financial instrument. You may increase your speed from 55 to 60 mph, which is not much. But if you do it in one second, it is a helluva rate of acceleration. Derivatives work the same way.

Some have called for the outlawing of such instruments. The market seems to have made a massive correction in this regard. People are not so willing to invest in mortgage-backed securities these days without understanding more clearly what they are buying. Changes in the Rules and new laws will basically lock the door on the barn have the horse has bolted.

For many of us, this opacity in the market clouds our judgment of most of our investments. We purchase shares in a mutual fund. What are we buying? Few really know, other than the brand name of the fund, and some past performance data. If the boy-genius running the fund has bolted to a different company, well, "past performance is no indication of future returns" as they say. We are buying a pig-in-a-poke, and just hope that the folks running the whole scheme don't fleece us too badly.

Even buying stocks directly is fraught with peril. What is really going on at a company like GM or Microsoft? Will their products continue to sell well? Does someone have their hand in the till? Is someone really a horrible manager? Will market conditions change dramatically in the next few years to make their business model untenable? Ten years ago, with SUV sales at their height, most folks would have said GM was a good bet. Today, Microsoft seems to be doing well with a veritable monopoly on operating systems. But suppose in ten years the concept of the "operating system" dies off, as did the mainframe for IBM?

These are all interesting questions and to some extent, the market "judges" each company, in terms of stock price - eventually. But again, there are those who game the system, inflating stock prices through buying and selling, or by jiggering the balance sheets to make it appear they are making more money than they are. Interesting academic questions, to be sure, but when maybe 3/4 of the population is dependent on this system - directly - for their retirement income, it is not a funny "game" anymore.

There is probably no way to prevent people from gaming the system. And to some extent, we all do it. But recognizing that gaming takes place is the first step toward protecting yourself. Euphoric economic bubbles have proliferated in the last two decades. We had a small market crash in 1987. We had a commercial (and residential) Real Estate bubble in 1989. We had the "Tech" crash in 1995, the "dot com" bubble in 1999, the 9/11 crash in 2001, and now a Real Estate AND market crash in 2008.

In retrospect everyone sees the signs of these bubbles, but few acted on them at the time. I was fortunate (or smart) to see the Real Estate bubble and get out in time. Most were not. The key, I think, is to understand how people game the system, and see the gaming for what it is - a way of tweaking the system to make it appear your performance is greater than it is. If you can see through that and understand what the real picture is, then you can perceive the real value of an asset.

The problem is, at the time of the bubble, seeing it from the inside out, no one wants to miss out on the action. Everyone, it seems, is making money. Why not you? The answer is simple, and related to my comment about community banks above. When small banks try to do the games the big boys do, they get creamed. Similarly, when small investors try to "cash in" on the latest craze, they get creamed as well.

But this is not to say you can't profit from these bubbles. When you see a bubble building up, get ready to run in the opposite direction. When stocks shoot up in price, don't buy more, SELL. When Real Estate rockets in price, sell it, don't buy more. While you might not be able to tell when the bubble will burst, you can at least make some money along the way, and hopefully have something in a safe investment when everything goes horribly wrong.