How to solve to big to fail

We have been in a conundrum recently because some institutions have been deemed "to big to fail" and hence received government bailout money even though they were some of the very same institutions that created the problems in the first place.

Some have argued that they should have been allowed to fail.

Others have argued that if they had been the economy would have tanked, there would have been massive dislocations and unemployment.

I'm inclined to believe the latter. I'm inclined to believe that there was no choice. And it's water under the bridge anyway.

But what about next time.

An easy solution would be to make sure that no one is to big to fail in the first place. Isn't it a market failure if anyone is to big to fail? In a competitive market someone would be there to step in if another failed. So why didn't they just let Ban of America and Goldman Sachs go down. The reason is that they do not operate in a competitive market. To get technical the market they are in is oligopolical. Which is a market or industry "dominated by a small number of sellers (oligopolists). "

The easy solution is to break them up. And it would be easy. The market here tends toward oligopoly but does not need to be that way.

Goldman Sachs is primarily an investment bank. From Wikipedia:
An investment bank is a financial institution that raises capital, trades in securities and manages corporate mergers and acquisitions. Investment banks profit from companies and governments by raising money through issuing and selling securities in capital markets (both equity, debt) and insuring bonds (e.g. selling credit default swaps), as well as providing advice on transactions such as mergers and acquisitions. A majority of investment banks offer strategic advisory services for mergers, acquisitions, divestiture or other financial services for clients, such as the trading of derivatives, fixed income, foreign exchange, commodity, and equity securities.

Providing advice, raising money, issuing bonds. Mergers and Acquisitions. None of these things are naturally monopolies. Quite the opposite. We want competition in this space. Competition is multiple competitors, not one giant (Goldman Sachs currently) who dominates.

Goldman gets an enormous social (and monetary!) windfall from having all the key players in their space under their roof. They have the connections to Washington DC. They make the rules. At least that's the perception. Plus if things are about to blow up, Goldman is to big to fail and hence has an implicit government guarantee and that implicit government guarantee is well almost priceless.

The big loser is everybody else. You. Me. Any company that wants to raise money in the capital markets or engage in M&A or anything else like that will have to either a) Go through Goldman and pay through the nose. or b) go with a bit player with no name and no implicit government guarantee of being around.

But what if Goldman was broken up into 10 or 15 different pieces who competed against each other (and against the other current bit players in the space). I think things would be far far better. The energy of the resulting players would be spent on competition instead of on manipulating and controlling Washington DC and on protecting and expanding monopoly profits (which is what they do now).

Lets open emergency 0% loans to everyone next time

In late 2008 we needed to infuse lots of capital into the likes of AIG, Citigroup and Goldman Sachs because there was no other way to stop collapse.

Maybe we should create "another way" so next time (and there will be a next time) the engineers of the problem are not in control of the choke points and therefore in position to reap yet another big payday when things blow up. Which is what just happened.

We know that Goldman (and a few others) were extended the privilege of borrowing money from the Federal Reserve bank at close to 0% and this privilege was extended as a way to get money flowing into the banking system. Goldman's latest profit numbers show they made a huge amount of money "trading". Some of that "trading" was just borrowing at 0% from the fed and buying bonds or stocks yielding something. To make money when you can borrow at 0% is child's play.

So why not have an emergency plan in place that gives 0% access to federal reserve money to all Americans. It may sound impractical but it's not. And the benefits would be largely the same as funneling the 0% borrowing through the Goldmans of the world: money would flow into the banking system. The big difference is that no one would be in a position to reap a windfall by controlling the choke point(s) - as Goldman clearly has.

According to http://cop.senate.gov/reports/library/report-040709-cop.cfm " as of April of this year, "the fed extended 1.5 trillion in loans in conjunction with the financial stabilization activities"

That is $5000 for every person in America.

Wouldn't it be better if the fed had just lent that money to individuals directly? The very same effect would be achieved. At present they can't do it because the mechanism is not in place. In a crisis you have to act fast and use whatever mechanisms are available. It just so happens that the Goldmans and Bank Of America's of the world made sure that they had the kind access to the fed that put them in position to reap the windfall.

It would be very easy to create an emergency plan that would allow *anyone* to borrow at 0% from the fed next time. And as I said above there will be a next time.

All you have to do is sell deeply discounted Treasury securities online. Right now anyone can purchase treasury securities online from treasurydirect.gov.

In a financial emergency like last fall they could be deeply discounted and there is your lending.

Perhaps a $5000 note could be purchased for $1 and you owe $4999 to the Federal Government which will be paid via an increase of $4999 in your tax burden over the next 3-5 years. In other words you are borrowing $4999 interest free and get the 'loan' immediately by purchasing the discounted note.

There would of course have to be limits or the Goldmans and Bank of America's would just swoop in and buy up the entire allotment of discounted securities before average joe had finished his cup of coffee. Maybe a limit of 10,000 per borrower or something like that would be in order.

If you can buy a security for 1$ you pretty much open it up to anyone.

Planetary engineering

I was watching "20/20" last night with some friends and they were talking with Nathan Myhrvold and his company Intellectual Ventures. The segment "Can a garden hose stop global warming" (http://abcnews.go.com/video/playerIndex?id=8904740) elicited what I have found to be typical responses to these kinds of ideas. "Every time we try to change the planet for the better it never works," "Every time humans try to improve things like this it's always a disaster," "The world is to complicated, we can never understand the entirety of it all and whenever we mess with things like this there are always unintended consequences that end up making things worse"

But here's the thing - humans have never tried large scale global engineering like this (purely to make things better). Never. The large scale engineering that has been done so far has been been either to make money, provide humans with protection from the elements or for military purposes. And they typically worked in so far as doing what they were designed to.

The re-engineering of much of the Everglades (which wiped out much of the Everglades) was done in order to create arable land so sugar growers and orange growers could make money. Damming of rivers is done either for flood control (protecting humans) or to generate electricity - IE to make money. Floods are limited and electricity is generated. Dams generally work. The great wall of china was created for military purposes. China has never been overrun. Many swamps have been drained worldwide to either create arable land, protect humans from mosquito born illness or even to create cities (Chicago for example). Humans did these things for the benefit of themselves . Thoughts of global scale engineering for the benefit of the planet as a whole are an entirely recent phenomenon. Only recently has mankind acknowledged that he is creating global scale problems and only recently has mankind achieved the engineering skills to contemplate global scale solutions. Only recently has mankind started to wisely realize that a) his fate is very much tied to the planet and b) his actions have become big and consequential enough to cause real damage.

We have attempted small scale engineering in order to generally improve some aspect of the environment around us and so far our efforts seem to have generally worked. Fish ladders alongside dams, the cleanup of Boston harbor, various remediation projects. There have been unintended consequences but none that have been catastrophic. Generally these efforts have worked well.

But the really big things humans have done so far in our history are exclusively selfish and it seems that it will be genuinely tragic if selfish destruction of the environment is largely tolerated but attempts to undo or fix what we have broken are rejected.

We are tolerating massive selfish destruction of course. It's becoming rapidly clear that mining the tar sands in Canada for oil is an environmental disaster of epic proportions. But we need the oil we say. We need the oil for our "way of life."

So we tolerate the large scale experiment of ripping up much of the tundra in Alberta to fuel our SUVs and we tolerate various massive global experiments - replacing millions of acres of prairie in North America with industrial non sustaining farms, large scale ocean fishing that has decimated world fish stocks, releasing billings of tons of CO2 from our tailpipes and smokestacks each year. We tolerate numerous global experiments - as long as they are for selfish purposes.

In my opinion it will be genuinely tragic if we do not even entertain ideals on how to fix the damage we are doing.

BTW one of my friends who was arguing against the garden hose drove back home in his SUV.

The REAL key to success

Success is often presented as going to those who work harder, have an innovative idea and best of all work hard, and have the innovative idea at just the right time. OK, so there is a little bit of luck involved.

Biographies of very successful people often have a theme somewhat like this: "he came up with a great idea", and then "he came up with another great idea", and maybe "he beat the competition yet again", leading to perhaps: "after 3 failed attempts at BIG success the time was finally right". Read: perseverance can eventually get you the "luck" needed. Read: you could have done this to if you just had the drive and gumption.

But I'm pretty convinced that reality is not so nice and neat.

A recent interview in the Wall Street Journal with Reid Hoffman (creator of LinkedIn) sheds a little light on what the real key(s) to success often are in my opinion.

At the very top of the interview it states:
"In May 2003, the former Apple Inc. and PayPal executive launched LinkedIn out of his living room, inviting 350 of his contacts to join his network and create their own profiles. By the end of that month, LinkedIn had 4,500 members."

and a bit down the page:
"I didn't know any VCs, but I knew people who knew VCs. They referred me, saying: "This is a bright young kid coming out of Stanford/Oxford – could you give him a little bit of your time?" Lots of people contact VCs out of the blue; the referrals distinguished me from some crazy person."

The naive analysis of the early LinkedIn growth would probably go like this " LinkedIn had 4500 members after a month because Reid Hoffman had created a better product and had created a product that that people liked to use.", maybe "It had features for...", and probably "no one else had one key feature in particular." maybe ending with "users liked LinkedIn's [fill in the blank] feature(s) and they told their friends."

The naive analysis of his VC connections would probably be that they didn't really matter that much - maybe without them it would have taken him a bit more time to get LinkedIn (and his other projects) going but we know he would have gotten them going because we know he has the goods and the proof is out there in the real world with 50 million LinkedIn members. 50 million people can't be wrong.

But here is the thing. Social network sites are technically not that difficult to create. A reasonably competent programmer/web developer could probably create one on several weeks.

So this leads me to another theory entirely. Perhaps the key to LinkedIn's early growth was Hoffmans ability to influence others and Hoffmans reputation. Perhaps that often trumps product details. Perhaps LinkedIns grew from 350 to 4500 members in a month because Reid Hoffman had established a reputation as powerful or influential person and other people wanted to be linked to him. Perhaps in the beginning LinkedIn was just a mechanism to be linked to Reid Hoffman.

The key then if this is correct (and I think it is in some markets at some times) is to establish a reputation and generate a following.

I think the business press all to often anthropomorphize product features into the "key" to success of a product and underplay the value of the reputation and connectedness of the owners of the product. I suspect the analysis of LinkedIn that I have read is an example of this.

A fascinating case study is the growth of Google. At the time of Google's initial important growth, there were many competitors (Alta-Vista, HotBot, Infoseek, Yahoo, and many others). Many were doing the exact same things that Google was doing (page rankings of some sort or another). Many seemed to be well funded and well connected. The space was hot. But Google won the PR and influence game hands down. Google clearly managed to convince much of the VC communiuty and the press that "we are going to win" and "we have the momentum."

At a time (lets say 1998-2002 or so) when Google was just one of many search competitors they managed to convince key people in their space that they and they alone were "it". The momentum gained then has never been relinquished. But how did they gain it in the first place. I guess you would call that it the science of influence. Note: Google has clearly built great products over the years but a great product built by them in 2004 does not help them in 1998 (unless one of those products is a time machine). It's breathtaking that they were able to convince/influence so many key players during their rise (investors and press). In the early days I marveled how these guys could consistently get glowing nationwide press when it looked like they had nothing more than anyone else. In some cases less. In retrospect they did not have anything really noteworthy in 1999 (look at the history of AltaVista, HotBot and others to verify that Google was actually behind those guys in 1999.) But clearly they were winning the "back room" game. They were getting the press and they were getting the infusions of capital. They had convinced key decision makers in their space that they were where it was at. I'm sure books will be written about this. Those books will probably say something like "the capital came looking and found a great product". I think the reality of it may be more like "they figured out how to get capital and press when others could not and then built a great company"

Next key point in the Hoffman interview: "but I knew people who knew VCs." The power of connections. Hoffman notes that if you approach VC people directly you tend to get rejected. To get anywhere you generally need an introduction. The mother of all introductions in the tech world is of course Bill Gates 's introduction as a teenager to IBM chairman John Akers by his mother who served on United Way's board of directors - alongside Akers. Did this give Microsoft an advantage when they "sold" DOS to IBM on terms no other company got before or since? I think the answer is obvious. Did it help that Gates's father was/is an intellectual property Lawyer? I think the answer is obvious. In the case off Hoffman, we (me at least) do not know the nature of his initial VC connections back in the 90's. Were they people he met and cultivated in college?, friends of his family? We don't know. What we do know is that they were and are important.

We know of course that that George W. Bush famously leveraged his connections in various ways throughout his life.

Can anyone play this game or are facts of birth and luck predominant. Very interesting question.

This post is not meant to disparage Reid Hoffman, Google, Bill Gates or even Bush. It's meant to explore the way our world actually works - in the very important realm of success (or failure). I mean that is important isn't it!? The picture that you look at the process is not sometimes pretty - maybe not ugly either but perhaps messy. Messy and complicated. If you want to be successful how much time should you spend on things we would describe as "work" vs. social networking and managing your reputation. In some jobs social networking and managing reputation(s) is the job. Interesting difficult quesitons.



In closing, it's not ironic at all that it's important to be networked to create a successful social networking site!







The recent fascinating book "Outliers" by Malcolm Gladwell gets into some of this