Technology Drives Stock Market Change?

Will Technology Continue to Drive Changes in the Stock Market Model?

Published: September 30, 2009 in Knowledge@Emory

Technological developments and a broad move to strike down political barriers to commerce have helped lead to an explosion in the pace and scope of investment trading. For example, from the inception of the New York Stock Exchange, more than 100 years passed before Big Board trading volume topped the 2 billion share mark in January 2001, yet by September 2008 it peaked at 9.3 billion shares.

 

Even in today’s depressed market, share volume frequently surpasses the 5 billion mark.

 

But while technology has sped up market trades and made the process more accessible to a wider audience of investors, it has also led to disruptions, say faculty from Emory University’s Goizueta Business School.

 

To explore the possibilities and pitfalls of the changing market, Knowledge@Emory spoke with Benn Konsynski, a chaired professor of business administration for information systems and operations management, and with Ramnath Chellappa, an associate professor of information systems and operations management.

 

Knowledge@Emory: We’re hearing that technological, social and other developments are driving creative disruptions in the stock-trading model. Would you agree?

 

Konsynski: Without a doubt. We’re seeing an evolution and a migration in the markets. At one level, the changes are as basic, though dramatic, as ending the New York Stock Exchange’s position as the dominant exchange for blue-ribbon companies. Microsoft, for example, is still on the NASDAQ, as is Google.

 

But the changes go beyond that, as the reasons for the existence of the major markets themselves are diminishing. We’re seeing the rise of virtual activity, where it’s easier for buyers and sellers to meet, and for both to tap multiple sources of information. This activity is known as neo-intermediation.

 

Chellappa: We’re also seeing changes in the way that the trading firms themselves execute their activity. As market volumes rise and the trading activity itself accelerates, more trading firms are utilizing risk management programs that pull information from a variety of sources—similar to data mining techniques used by consumer research and other organizations—and alert the firms about certain conditions, such as whether they may be over-concentrated in a particular security or a sector. The software itself is of course still being developed, but many domestic and off-shore firms (such as Infosys and Tata Consultancy Services) appear to be making some impressive advances.

 

Knowledge@Emory: What does the development of neo-intermediation, or neo-intermediaries, mean for investors and for companies? What other kinds of developments can we expect?

 

Konsynski: More competition and more choices when it comes to information. Neo-intermediation involves unbundling services, and the transformation of products and services. It also drives a change in the categories of securities that can be traded. With the increase in information flow, investors can bid on indices, portfolios, electronically traded funds and other asset classes and instruments with greater confidence. With the advent of neo-intermediaries, investors are able to access information from a wider range of sources, rather than relying on a limited number of gatekeepers. Under this new model, the traditional broker structure is no longer as useful as it once was. Instead, a self-structured model now has the opportunity to take on an enhanced role.

 

We’ve already seen the emergence of many new facilitators, including information resources like bloggers and websites such as thestreet.com and seekingalpha.com, that offer commentary and analysis.

 

Chellappa: The technology-driven advances in trading are also resulting in the development of new, more-powerful computing models. This is likely to accelerate the move to cloud computing [an emerging model of computing today that was originally defined in the 1990s by Chellappa as a condition where most applications and activity reside on and take place in cyberspace], since it would be inefficient and prohibitively expensive to do the computing at local workstations as quantitative models become more complex and as data become increasingly voluminous.

 

A traditional computer is likely to be used as a front end for traders, but the heavy-duty work will be done in the cloud.

 

As more companies embrace cloud computing and the computing models it enables, more trading firms will develop proprietary methods that may enable them to better evaluate the risk issues in their portfolios. But to be effective, the capabilities must be made available to appropriate employees across departments and information sources. The risk monitoring systems will essentially function as back-end operations that will help traders make decisions about risk across a broad range of areas.

 

Knowledge@Emory: Technological and other advances may bring unintended consequences. The factories and automobiles that increased the world’s productivity, for example, also gave rise to pollution. The development and use of antibiotics may also be accelerating the development of resistant diseases. Is it likely that neo-intermediation, the resulting boost to the use of cloud computing, and other developments will also lead to unintended consequences?

 

Chellappa: Undoubtedly. For one thing, much of the development and external cloud hosting is likely to take place in India and other off-shore destinations. As sensitive data is exchanged across borders, privacy and security issues may arise, particularly if U.S. privacy laws are more stringent than the laws in some of these other locations.

 

Konsynski: We’re also likely to see more volatility in markets, since an increase in the variety of instruments traded and data available can create a kind of information overload. When there are so many sources of information, how can investors tell the trustworthy ones from the ones that are not valid? How can you assess reputation when fragmentation quickly increases?

 

In 1929, 1987, and most recently in 2008, we saw how unintended consequences and a lack of regulatory control helped to break down the market. Short-selling, derivatives and other behavior and instruments need to be monitored to see if they’re creating unacceptable risk.

 

Knowledge@Emory: Some observers would argue that excessive regulation hinders the market instead of helping it.

 

Konsynski: I agree that a balance must be struck, but the fact is that the broad community suffers when financial and trading instruments get out of hand. Some regulation is necessary to govern financial instruments, but we also need an assessment of risk, and a clear chain of responsibility for trading activities.

 

But we shouldn’t stifle innovation. Instead we need to assess risk and other implications and maintain accountability.

 

Perhaps the increased regulation could include systems and procedures to monitor activity and provide an alert if there’s an overly broad market risk. So the idea would not be to control or constrain, but rather to amplify weak signals that indicate when action needs to taken.

 

Chellappa: While there is some truth to that, much of the compliance-type regulations will result in greater need and investment in technology, since these rules are likely to be embedded in systems.

 

Knowledge@Emory: What other kinds of changes do you see coming about as a result of the new trading technology?

 

Konsynski: I think people will realize that the growing global trading platform means it’s unnecessary to separate trading markets by region. Instead we need to recognize that global markets will influence each other, and that there are no regional immunities in a global market. Retreating to protectionist policies of the 19th and 20th centuries is not an option, but regulators will have to settle on appropriate global risk and other controls.

 

The power of technology lies in creating engines that tolerate more complexity and offer more trading opportunities, especially as more advances are made in cloud computing.

 

In fact the market meltdown we’ve just experienced may offer a unique opportunity to restructure our trading environment with new patterns that offer, for example, a more robust trail of accountability, and that enable buyers and sellers to better deal with new kinds of financial instruments, with the continued unbundling of services, and with the introduction of new intermediaries.

 

A few months ago I was on the floor of the New York Stock Exchange and I saw parts of the facility that have remained unchanged from the last century. In years to come, however, I expect to see very little resemblance to today’s facility or trading model.

 

 

Chellappa: I believe we will see the required skill sets become even more interdisciplinary, combining elements of quantitative studies and domain knowledge from finance and technology. We should never forget that successful firms have a holistic view of people, process, and technology. These are complementary, and one cannot simply substitute for another.

 

Smaller financial institutions may find it difficult to meet the costly tech requirements that may come with these advances, just as we’re seeing smaller publicly listed firms complaining about the cost of complying with Sarbanes-Oxley [financial reporting and other] requirements. In fact, there is evidence that the steep costs associated with Sarbanes-Oxley compliance has driven some public firms to delist.

 

Invariably some combination of off-the-shelf products and outsourcing/offshoring will emerge to help smaller firms.

 

Technology advances can help with the decision-making process, but their use can also be controversial because of the possibility of unintended consequences. Consider security and privacy issues in general or “flash trading” in the financial industry. This has always been the nature of technological innovations. Initially, you think about automating some process and it leads to a host of other benefits and challenges.

Photo: Professors Ram Chellappa, left, and Benn Konsynski stand next to an “old school”  trading post once used at the NYSE and donated to Goizueta. The two innovative thinkers foresee more change.

Firms That Thrives on Adversity

Thriving on adversity

 

Oct 1st 2009

From The Economist print edition

Some companies are finding opportunities in the recession

JUST after Barack Obama was elected president, his incoming chief of staff, Rahm Emanuel, told a conference of American captains of industry, “You never want a serious crisis to go to waste.” Here’s hoping his audience was paying attention, because recessions—particularly gut-wrenching slumps like this one—provide as many opportunities for business people as they do for politicians. Although they are often called “slowdowns”, recessions shake things up rather than slowing them down. They reward strengths and expose weaknesses, create new opportunities and kill old habits, release pent-up energy and destroy old business models. Distressed assets can be bought for a song, talented people hired cheaply and new ideas given an airing.

 

The most striking example of this was the Depression. Most people think of the 1930s as an economic desert littered with foreclosure signs and unemployment queues. But for the canny few it was a huge opportunity. DuPont invested heavily in research and development (R&D) and hired unemployed scientists. By the late 1930s 40% of its sales were from products that were less than a decade old—including world-changing inventions such as nylon and synthetic rubber. Procter & Gamble (P&G) invested so heavily in radio advertising that it created a new artistic form, the soap opera. The list of companies which took off during the Depression includes Revlon, Hewlett-Packard (now HP), Polaroid and Pepperidge Farms, the last of which was founded by a society lady whose husband was a victim of the Wall Street crash.

 

More recent recessions have produced a similar pattern of creative destruction. Two studies by management consultants show that they dramatically rearranged the pecking order of companies in many fields. Bain & Company discovered that twice as many firms made the leap from “laggards” to “leaders” (ie, from the bottom quartile of companies in their industry to the top quartile) during the recession of 1991-92 than during non-recessionary times. McKinsey discovered that one-third of banks and two-fifths of big American industrial companies dropped out of the first quartile of their industries in the recession of 2001-02. These shake-ups can have long-lasting consequences: more than 70% of the companies that made big strides during the previous recession in the Bain study preserved their gains during the subsequent boom, whereas fewer than 30% of the companies that lost ground were able to make it up.

 

What about the current recession? A great deal is still up in the air, of course. But it is possible to get some idea of the sorts of companies that are doing well and the kinds of strategies they are pursuing. The most obvious winners are established giants: market leaders that entered the recession with cash in their pockets and sound management systems under their belts. These companies are reaping rewards from investors who are skittish about shakier rivals. They are also using their corporate muscle to squeeze their costs (for example, by negotiating cheap rates for advertising) and so win market share from their competitors. BCG, another consultancy, notes that 58% of companies that were among the top three in their industry had rising profits in 2008 and only 30% saw their profits decline. In contrast, only 21% of companies outside the top three had rising profits, and 61% had falling profits.

 

McDonald’s is simultaneously sharpening its appeal to its core customers, even introducing computer systems that allow its outlets to adjust their prices to local economic circumstances, and moving upmarket with lattes and salads. Asda, a British supermarket chain, is building 14 new stores and hiring 7,000 new workers. PepsiCo has taken direct control of two of its biggest bottling companies, at a cost of $6 billion. Many big companies are also taking advantage of bargain-basement prices to make acquisitions. That is wise: a BCG study of mergers and acquisitions in America in 1985-2001 found that deals done during a recession generated about 15% more return to shareholders than those that took place during a boom.

 

 

 

Spend it to make it

A second group of winners is made up of companies with a record of innovation. Despite seeing its revenues fall by 23% in the last quarter of 2008 compared with the last quarter of 2007, Intel is continuing to invest heavily in innovation. Craig Barrett, the company’s former boss, insists, “You can’t save your way out of a recession; you have to invest your way out.” P&G is launching its biggest expansion in its 170 years, opening 19 new factories around the world and investing heavily in new ideas, despite disappointing recent results. IBM is holding a series of “innovation jams” designed to squeeze ideas out of its employees.

 

A third group consists of companies which are using the recession to reposition themselves. Cisco is speeding up its transformation from a backroom network plumber into a much more versatile internet giant, using its cash reserves to snap up start-ups in new fields and expand its business portfolio. Repositioning is a strategy that has paid off dramatically in the past. When the Soviet Union collapsed, plunging Finland into economic turmoil, Nokia’s response was to abandon 90% of its businesses to concentrate on telecoms, particularly mobile phones.

 

There is also every reason to believe that the current recession will produce lots of upstarts. The Kauffman Foundation, which studies entrepreneurship, points out that about half of Fortune 500 and Inc. 500 companies (lists of the biggest and fastest-growing firms in America, respectively), including such household names as FedEx, CNN and Microsoft, were founded during recessions or bear markets. A disproportionate number of these upstarts produced industry-changing ideas that established companies failed to appreciate until it was too late. Indeed, business is more likely to take advantage of this “serious crisis” than the world’s politicians.

The New “New” Economic Recovery

The long climb

 

Oct 1st 2009

From The Economist print edition

 

 

The world economy is recovering from financial disaster. But it will not return to normal as we know it, says Simon Cox (interviewed here)

NEWPORT BEACH, California, is not a bad place to contemplate the future of the world economy. Its information office promises nine miles of pristine sand, fine dining for devoted epicureans and an atmosphere of laid-back sophistication. Yet students of economic turmoil will find their subject matter conveniently close to hand. California’s unemployment rate has doubled to 12.2% since the start of 2008. Saddled with the worst credit rating in the country, the “Golden State” is cutting spending on schools, prisons and health care for the elderly, as well as closing parks and laying off staff for three days a month. It will pay its workers a day late at the end of the fiscal year so that the expense will show up in next year’s budget. Financial shenanigans are not the sole province of the banking industry.

 

Newport Beach is also the home of Pimco, the biggest bond manager in the world, which handles $840 billion on behalf of pension funds, universities and other clients. In May the company held its annual “Secular Forum”, in which it tries to peer five years into the economic future. After two days of rumination, Pimco’s laid-back sophisticates concluded that the financial markets may well “revert to mean”, which is a statistician’s way of saying that what comes down must go up. But the next five years will not resemble the five preceding the crisis. Not every change wrought by the financial breakdown will be reversed. The world economy is fitfully getting back to normal, but it will be a “new normal”.

 

That phrase has caught on, even if people disagree about what it means. In the new normal, as defined by Pimco’s CEO, Mohamed El-Erian, growth will be subdued and unemployment will remain high. “The banking system will be a shadow of its former self,” and the securitisation markets, which buy and sell marketable bundles of debt, will presumably be a shadow of a shadow. Finance will be costlier and investment weak, so the stock of physical capital, on which prosperity depends, will erode.

 

The crisis invited a forceful government entry into several of capitalism’s inner sanctums, such as banking, American carmaking and the commercial-paper market. Mr El-Erian worries that the state may overstay its welcome. In addition, national exchequers may start to feel some measure of the fiscal strain now hobbling California. America’s Treasury, in particular, must demonstrate that it is still a “responsible shepherd of other countries’ savings”.

 

The notion of a “new normal” is convincing, even if you do not agree with every particular. But some forecasters now harbour higher expectations. They think the economy will bounce back to its old self, almost as if nothing had happened. They draw inspiration from the work of the late Milton Friedman, who showed that in America deep recessions are generally followed by strong recoveries. He likened the economy to a piece of string stretched taut on a board. The more forcefully the string is plucked, the more sharply it snaps back.

 

Friedman’s piece of string represents the demand side of the economy: the sum of spending by households, firms, foreigners and the government. The rigid board symbolises the supply side. When spending is strong enough, the economy’s resources are fully employed, allowing it to realise its full potential. As the workforce grows, capital accumulates and technology advances, this limit expands over time.

 

 

 

String theory

In a recession demand falls short of supply, leaving a sorry trail of unemployed workers, shuttered factories and unexploited innovations. But when the recovery arrives, Friedman suggested, it is all the more forceful because these resources have been lying idle, waiting to be brought back into production. The economy can grow faster than normal for a period until it reaches the point where it would have been without the crisis, when it reaches its full potential again (see chart 1, scenario 1).

 

 

 

 

 

 

Friedman’s story is heartening, but it can come unstuck in two ways. If the shortfall in demand persists it can do lasting damage to supply, reducing the level of potential output (scenario 2) or even its rate of growth (scenario 3). If so, the economy will never recoup its losses, even after spending picks up again.

 

Why should a swing in spending do such lasting harm? In a recession firms shed labour and mothball capital. If workers are left on the shelf too long, their skills will atrophy and their ties to the world of work will weaken. When spending revives, the recovery will leave them behind. Output per worker may get back to normal, but the rate of employment will not.

 

Something similar can happen to the economy’s assembly lines, computer terminals and office blocks. If demand remains weak, firms will stop adding to this stock of capital and may scrap some of it. Capital will shrink to fit a lower level of activity. Moreover, if the financial system remains in disrepair, savings will flow haltingly to companies and the cost of capital will rise. Firms will therefore use less of it per unit of output.

 

The result is a lower ceiling on production. In the IMF’s latest World Economic Outlook, its researchers count the cost of 88 banking crises over the past four decades. They find that, on average, seven years after a bust an economy’s level of output was almost 10% below where it would have been without the crisis.

 

This is an alarming gap. If replicated in the years to come, it would blight the lives of the unemployed, diminish the fortunes of those in work and make the public debt harder to sustain. But even worse scenarios are possible. A financial breakdown could do lasting damage to the growth in potential output as well as to its level. Even when the economy begins to expand, it may not regain the same pace as before.

 

Financial crises can pose such a threat to national incomes because of the way they erode national wealth. From the start of 2008 to the spring of this year the crisis knocked $30 trillion off the value of global shares and $11 trillion off the value of homes, according to Goldman Sachs, an investment bank. At their worst, these losses amounted to about 75% of world GDP. But despite their enormous scale, it is not immediately obvious why these losses should cause a lasting decline in economic activity. Natural disasters also wipe out wealth by destroying buildings, possessions and infrastructure, but the economy rarely slows in their aftermath. On the contrary, output often picks up during a period of reconstruction. Why should a financial disaster be any different?

 

The answer lies on the other side of the balance-sheet. Before the crisis the overpriced assets held by banks and households were accompanied by vast debts. After the crisis their assets were shattered but their liabilities remained standing. As Irving Fisher, a scholar of the Depression, pointed out, “overinvestment and overspeculation…would have far less serious results were they not conducted with borrowed money.”

 

Japan found this out to its cost in the 1990s after the bursting of a spectacular bubble in property and stock prices. For a “lost decade” from 1992 the economy stagnated, never recovering the growth rates posted in the 1980s. Richard Koo of the Nomura Research Institute in Tokyo calls Japan’s ordeal a “balance-sheet recession”.

 

The typical post-war recession begins when the flow of spending in the economy puts a strain on its resources, forcing prices upwards. Central banks raise interest rates to slow spending to a more sustainable pace. Once inflation has subsided, the authorities are free to turn the taps back on.

 

But in a “balance-sheet recession”, what must be corrected is not a flow but a stock. After the bubble burst, Japan’s companies were left with liabilities that far exceeded their assets. Rather than file for bankruptcy, they set about paying down their stock of debt to a manageable level. This was a protracted slog which, by Mr Koo’s reckoning, did not finish until 2005. In the meantime Japan’s economy stagnated. By 2002 its output was almost 23% below its pre-crisis trajectory.

 

Since Pimco’s forum concluded in May, the world economy has palpably improved. In many ways the new normal is beginning to look a lot like the old, vindicating Friedman’s plucking model. China is outpacing expectations. Goldman Sachs is making hay. The premium banks must pay to borrow overnight from each other is now below 0.25%, the level Alan Greenspan, a former chairman of the Federal Reserve, once described as “normal”. Companies in Europe and America are selling bonds at a furious pace. A few months ago financial newspapers were debating the future of capitalism. Now they are merely discussing the future of capital requirements. Shock has given way to relief.

 

 

 

The persistence of debt

But the relief is likely to be short-lived. Just over a year ago, the day Lehman Brothers filed for bankruptcy, the world economy fell off a precipice. When you are falling, you do not look up. Only when you hit bottom can you stop and contemplate the cliff you must now climb.

 

This special report will argue that although a “new normal” for the world economy is now in sight, it will be different from the old normal in a number of ways. Demand in rich countries will remain weak and emerging economies will not be able to compensate. The report will explain why many governments will have to keep their stimulus packages going for longer than expected, or face entrenched unemployment that will permanently lower their economic potential. Public debt will rise so that private debt can fall. The banks, the report will show, will remain cautious about lending again, which will slow up the recovery but also make companies more careful about their investment; and the securitisation markets that became so fashionable during the boom will recede, though not disappear altogether.

 

A persistent shortfall in demand will weigh on supply. By the time this crisis is over, as many as 25m people may have lost their jobs in the 30 rich countries that belong to the Organisation for Economic Co-operation and Development (OECD). The danger is that several million may never regain them. The mobilisation of capital will be fitful as the financial system copes with past mistakes and impending regulation. The travails of finance, in turn, may prevent the recovering economy from backing and exploiting innovations.

 

Like Japan’s bubble years, the years that led to the global financial crisis have left a heavy legacy of debt on the balance-sheets of banks and households, especially in Britain and America. It is this legacy that allows past losses to depress future gains. Fisher, again, put it best: “I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.” There is no better example of that than American consumers.

Stimulus and Psychology

Richard Posner picks up on Daniel Indiviglio’s post on stimulus and psychology. The stimulus made people feel better they say.

 

 

The [stimulus] program may, however, still have had an important positive effect on business and consumer psychology. Economists both left and right systematically neglect the psychological dimensions of a depression, properly emphasized by Keynes.

 

An exception, however is Daniel Indiviglio, who is not an academic economist, . . .

 

 

Maybe. I am not sure exactly what Posner means by psychology. I have never been optimistic about feelings as an economics model. Perhaps people spend more when they feel better but how do we get a consistent measure of feelings and even more to the point how does policy consistently affect them?

 

What I do think makes a difference is expectations. And, it’s pretty clear how the stimulus could have affected expectations. Most families got a slight reduction in taxes. If the administration nailed it just right then most of those families have simply incorporated that increase in disposable income into their expectations. Thus, they have altered their buying behavior in a very mild but lasting way.

 

More importantly, Wal-Mart (WMT) knows that these consumers have more money. When it lays out its plans for the coming year it’s assuming a mild boost in consumer spending. This affects Wal-Marts choices, which it turn affects Wal-Mart’s suppliers” choices.

 

These private expectations should be changing the evolution of the economy.

 

Vastly more important, however, are public expectations. I watch the brutal process by which the state of North Carolina incorporated the expectations of stimulus spending into its state budget. Expectations means a lot in state budgeting because by law the state has to expect to break even.

 

Expectations of future stimulus checks meant less draconian budget cuts, fewer layoffs and milder tax increases.

 

That is, sans-stimulus things on the state government front were about to get much, much, much worse. Now they are only getting much worse. State budget implosions were the dog that didn’t bark as a result of stimulus. Virtually all states were headed for cataclysmic shortfalls that would have resulting in skyrocketing layoffs and much higher taxes.

 

If Barro or anyone else believes that tax hikes would have worsened this recession then they must believe that the stimulus lessened it.

NYSE: Financial Next Step

Goizueta NYSE Euronext Panel Explores Financial Next Steps Published: September 30, 2009 in Knowledge@Emory

A year has passed since the worst economic crisis since the 1930s crashed the global financial markets. Nearly everyone is speculating when things will settle down and get back to the new normal. On September 2, Larry Benveniste, dean of Emory University’s Goizueta Business School, and Duncan L. Niederauer, CEO of the New York Stock Exchange Inc., teamed up to host a panel discussion on lessons learned and contemplate the question, “Where Do We Go From Here?” Moderated by Susan Lisovicz, CNN’s primary correspondent on the stock market, the live, web-streamed discussion included Frank Blake, CEO, The Home Depot Inc.; U.S. Sen. Saxby Chambliss (R-Ga.); Daniel Amos, CEO, Aflac Inc.; and Atlanta Federal Reserve Bank CEO Dennis Lockhart. (See video) In his welcome remarks to the packed house at Emory University’s Schwartz Center for Performing Arts, Benveniste called this period in history “a leadership moment,” and Niederauer added there were “a lot of lessons to learn. The question is, ‘are we going to learn them?’” Amos likened the shock of last year’s economic undoing to suffering a sports injury. “At first,” he said, “You’re stunned and worried about using it again.” While the panelists believe the economy is showing signs of recovery—albeit a subdued one—they’re not looking at consumer spending to spur economic growth going forward. “The consumer is traumatized by the last two years and is very cautious,” noted Lockhart. Consumer caution poses a problem in terms of jump-starting a sputtering economy, but Lockhart believes that the long-term effects of consumers choosing to save versus purchase goods via credit is a “virtue” that will lead to a more balanced economy. Additionally, a return to more conservative lending practices will make it more difficult for consumers to access credit. The Home Depot’s sales are closely tied to the housing market, one of the industries most affected by the sour economy. The Home Depot CEO Blake described the current economy as “less bad” than it was a year ago, and noted that the home improvement retailer felt a slowdown as far back as 2006. Blake does not think consumer confidence will rebound until the housing market stabilizes. Sen. Chambliss recalled the chaos that ensued after Congress was asked to “give [the President] $700 billion by Friday, and it needs to be in the form of a blank check,” he said of the early days of the financial crisis. “I had people daring me to vote for it.” It won’t be long before the effects of the government stimulus package wind down, as the panelists wondered: if consumer spending won’t drive the U.S. economy as it has in the recent past, what will? Benveniste, who in addition to his academic achievements was a staff economist for the Board of Governors of the Federal Reserve System in Washington, D.C., believes increased demand from outside the U.S. could play a big rolGoizueta NYSE Euronext Panel Explores Financial Next Steps Published: September 30, 2009 in Knowledge@Emory A year has passed since the worst economic crisis since the 1930s crashed the global financial markets. Nearly everyone is speculating when things will settle down and get back to the new normal. On September 2, Larry Benveniste, dean of Emory University’s Goizueta Business School, and Duncan L. Niederauer, CEO of the New York Stock Exchange Inc., teamed up to host a panel discussion on lessons learned and contemplate the question, “Where Do We Go From Here?” Moderated by Susan Lisovicz, CNN’s primary correspondent on the stock market, the live, web-streamed discussion included Frank Blake, CEO, The Home Depot Inc.; U.S. Sen. Saxby Chambliss (R-Ga.); Daniel Amos, CEO, Aflac Inc.; and Atlanta Federal Reserve Bank CEO Dennis Lockhart. (See video) In his welcome remarks to the packed house at Emory University’s Schwartz Center for Performing Arts, Benveniste called this period in history “a leadership moment,” and Niederauer added there were “a lot of lessons to learn. The question is, ‘are we going to learn them?’” Amos likened the shock of last year’s economic undoing to suffering a sports injury. “At first,” he said, “You’re stunned and worried about using it again.” While the panelists believe the economy is showing signs of recovery—albeit a subdued one—they’re not looking at consumer spending to spur economic growth going forward. “The consumer is traumatized by the last two years and is very cautious,” noted Lockhart. Consumer caution poses a problem in terms of jump-starting a sputtering economy, but Lockhart believes that the long-term effects of consumers choosing to save versus purchase goods via credit is a “virtue” that will lead to a more balanced economy. Additionally, a return to more conservative lending practices will make it more difficult for consumers to access credit. The Home Depot’s sales are closely tied to the housing market, one of the industries most affected by the sour economy. The Home Depot CEO Blake described the current economy as “less bad” than it was a year ago, and noted that the home improvement retailer felt a slowdown as far back as 2006. Blake does not think consumer confidence will rebound until the housing market stabilizes. Sen. Chambliss recalled the chaos that ensued after Congress was asked to “give [the President] $700 billion by Friday, and it needs to be in the form of a blank check,” he said of the early days of the financial crisis. “I had people daring me to vote for it.” It won’t be long before the effects of the government stimulus package wind down, as the panelists wondered: if consumer spending won’t drive the U.S. economy as it has in the recent past, what will? Benveniste, who in addition to his academic achievements was a staff economist for the Board of Governors of the Federal Reserve System in Washington, D.C., believes increased demand from outside the U.S. could play a big role. “If we’re smart, we’ll embrace that,” he said. The panelists expect the debate over regulation and transparency in the financial markets to continue. They advised against any new regulation that goes overboard. Sen. Chambliss discussed Congress’s role in helping create the environment that allowed for an abundance of risk-taking. In 2000, he was one of 155 members of Congress who voted for the Commodity Futures Modernization Act, a law that amended existing legislation and allowed for broadening the scope of trading mechanisms, essentially deregulating the financial system. While it accomplished its goal, it also set the stage for the financial derivatives market by barring states from regulating credit default swaps—a move that turned out to be disastrous. Sen. Chambliss admitted, “We’ve got to do a better job looking into the future,” but cautioned against a regulatory “knee jerk reaction.” Too much regulation, he added, would stifle innovation and potentially chase investors overseas, thereby reducing the competitiveness of U.S. markets. Niederauer, who sees increased regulation as “inevitable,” expressed concern that regulation be, he said, “Smarter. Not just more.” He advised lawmakers to view future regulation from a systemic risk perspective. He also pointed out the public relations effect of regulation. If regulation does “right by people,” explained Niederauer, it will work to close the chasm that the near collapse of the country’s financial markets created between Main Street and Wall Street. Lisovicz asked the panel about the possibility of replacing the numerous regulatory entities that currently watch over the financial markets with a “super-regulator.” None of the panelists thought it was a real possibility—or a good idea. Benveniste explained he would be fearful of an all-powerful regulator that existed without the checks and balances of the current system. Regardless of beefed up regulations, several of the panelists noted that those determined to disregard rules and abuse the system will find a way. The key is to ensure that others feel confident enough, and have avenues available, to question events and particular business practices rather than ignore their misgivings. “It’s the willingness of a person to ask a stupid question,” explained Blake. Toward the end of the event, Lisovicz asked the panelists, “A year from now, where will we be?” Niederauer contended that the financial and credit markets will still be licking their wounds, and that unemployment will still be, he said, “frustratingly high.” By this time next year he also expects to see some new regulation in place. Blake believes consumers are going to have a hard time feeling “good about things” until housing prices stabilize, and Sen. Chambliss added that until the inventory of foreclosed homes is “off the marketplace,” there won’t be stability in the housing market. “Secondly, we’ve got to get government spending under control,” Sen. Chambliss added. As the effects of the government stimulus and of the Federal Reserve Bank’s ramped up intervention come to an end, Benveniste believes we will experience “a nervous time.” He reemphasized his point that emerging markets are key to boosting economic demand long term, adding that it’s a “mistake not to think globally.” While Amos believes things will be better by this time next year, he doesn’t think the economic backdrop will have changed much, describing any rebound as “slow moving back the other way.” But he is hopeful for the long term. Calling himself “entrepreneurial in spirit,” Amos believes that “young people and young ideas” will drive the economy going forward. The audience, the majority of whom were students, nodded in agreement. e. “If we’re smart, we’ll embrace that,” he said. The panelists expect the debate over regulation and transparency in the financial markets to continue. They advised against any new regulation that goes overboard. Sen. Chambliss discussed Congress’s role in helping create the environment that allowed for an abundance of risk-taking. In 2000, he was one of 155 members of Congress who voted for the Commodity Futures Modernization Act, a law that amended existing legislation and allowed for broadening the scope of trading mechanisms, essentially deregulating the financial system. While it accomplished its goal, it also set the stage for the financial derivatives market by barring states from regulating credit default swaps—a move that turned out to be disastrous. Sen. Chambliss admitted, “We’ve got to do a better job looking into the future,” but cautioned against a regulatory “knee jerk reaction.” Too much regulation, he added, would stifle innovation and potentially chase investors overseas, thereby reducing the competitiveness of U.S. markets. Niederauer, who sees increased regulation as “inevitable,” expressed concern that regulation be, he said, “Smarter. Not just more.” He advised lawmakers to view future regulation from a systemic risk perspective. He also pointed out the public relations effect of regulation. If regulation does “right by people,” explained Niederauer, it will work to close the chasm that the near collapse of the country’s financial markets created between Main Street and Wall Street. Lisovicz asked the panel about the possibility of replacing the numerous regulatory entities that currently watch over the financial markets with a “super-regulator.” None of the panelists thought it was a real possibility—or a good idea. Benveniste explained he would be fearful of an all-powerful regulator that existed without the checks and balances of the current system. Regardless of beefed up regulations, several of the panelists noted that those determined to disregard rules and abuse the system will find a way. The key is to ensure that others feel confident enough, and have avenues available, to question events and particular business practices rather than ignore their misgivings. “It’s the willingness of a person to ask a stupid question,” explained Blake. Toward the end of the event, Lisovicz asked the panelists, “A year from now, where will we be?” Niederauer contended that the financial and credit markets will still be licking their wounds, and that unemployment will still be, he said, “frustratingly high.” By this time next year he also expects to see some new regulation in place. Blake believes consumers are going to have a hard time feeling “good about things” until housing prices stabilize, and Sen. Chambliss added that until the inventory of foreclosed homes is “off the marketplace,” there won’t be stability in the housing market. “Secondly, we’ve got to get government spending under control,” Sen. Chambliss added. As the effects of the government stimulus and of the Federal Reserve Bank’s ramped up intervention come to an end, Benveniste believes we will experience “a nervous time.” He reemphasized his point that emerging markets are key to boosting economic demand long term, adding that it’s a “mistake not to think globally.” While Amos believes things will be better by this time next year, he doesn’t think the economic backdrop will have changed much, describing any rebound as “slow moving back the other way.” But he is hopeful for the long term. Calling himself “entrepreneurial in spirit,” Amos believes that “young people and young ideas” will drive the economy going forward. The audience, the majority of whom were students, nodded in agreement.

Rise of the Machine: Bliss or Blast

Tech.view

Machines in control

Aug 28th 2009
From Economist.com

How real is the threat of autonomous technology?

HOLLYWOOD has made at least half a dozen films based on Mary Shelley’s gothic masterpiece—mindless travesties all of them, even the Kenneth Branagh version released in 1994. That is a pity because the parable of the Genevan protagonist, Victor Frankenstein, deserves wider appreciation, especially among those concerned about technology getting out of control.

In the actual story, there is no crazed assistant, no criminal brain stolen from a grave, no violent rampage, and no angry mob hunting down and killing the monster. Instead, the rejected creation pleads to be accepted, and cared for, by its creator and tries hard to fit in with society. Yes, there is violence and revenge—it wouldn’t be a gothic novel without them. In the end, however, the autonomous being departs to commit suicide after its creator dies of disease.

Getty Images

Out of control?

What makes the tale such an enduring classic are the moral questions it raises about creation, responsibility and unintended consequences. The lessons are as relevant in today’s world of autonomous technology—whether driverless vehicles or surgical robots—as they were in 1818 when the melodrama first scared the daylights out of Georgian England.

Whether consciously or not, the Royal Academy of Engineering in Britain seems lately to have taken Shelley’s fable to heart. In a report published last week, the academy urges opinion-formers to start thinking seriously about the implications of autonomous technology—machinery that can act independently by replicating human behaviour. The intention is to have such machines do the sort of jobs people find dull, dirty or dangerous. Many such systems either already exist or are closer to reality than is generally realised. And right now, the ethical, let alone the legal, framework for dealing with any untoward consequences of their actions simply does not exist.

The academy looked at two areas of the technology that are expanding fast: autonomous transport and automated help around the home for the elderly. Within ten years, driverless vehicles that use lasers and radars to sense their surroundings will be able to thread their way through traffic. They are already widespread in controlled environments such as warehouses, airports and mines. Whether they will be seen on the public highways is not a technological issue, but a political and legal matter.

With their digital controllers programmed to obey the highway code, driverless trucks will be far safer and more predictable than human-operated vehicles. They won’t suddenly pull out in front of you, or refuse to give way when they should. But if a mechanical failure or software glitch should ever cause a driverless truck to collide with a car, who would be legally responsible—the truck company, the manufacturer, the systems engineer? (Under today’s product-liability law, the motorist would doubtless get off scot-free, even if the accident was his fault.)

There are similar concerns about automatons designed to watch over the elderly. Systems exist to check when people are awake, whether they have taken their medication, and what their vital signs are. Privacy issues aside, such aids are to be welcomed for their greater good.

But once sensor data can be used to tell people with dementia what to do and what not to do, the potential for abuse can become real. The benefits of such patient-monitoring in the home may be that the individual wanders around less, suffers less incontinence and sleeps better. But can even the most responsible of families and carers be trusted to supervise such technology day in and day out for years on end, to stop accidents happening? The answer may be not more technology, but better social engineering. For sure, people have barely begun to think about such issues.

In 2006, a survey by Elon University and the Pew Internet Project in America asked some 742 technology experts and social critics whether autonomous machines would leave humans out of the loop. Slightly over half thought people would not lose control, but not all that many fewer felt they might.

Respondents were invited to give their views. A recurring theme was that “technology beyond our control” was rather alarmist. The history of applying automation to human tasks (telephone operators, for instance) had not left people unduly at the mercy of autonomous contraptions. Defying Shelley’s prognostication, many respondents felt few technologies live beyond the control of their creators: everything has a “choke point” of one sort or another—built in, often subconsciously, for reasons of convenience, safety or mistake.

That was three years ago, when few were probably aware of how quickly a technology known as “evolvable hardware” was emerging from the shadows. Like the “brute-force” methods standard in code-cracking and computer chess, evolvable machines try billions of different possibilities. But the difference is that they continually crop and refine their trial-and-error solutions—mimicking the way natural selection works in the wild.

How soon before evolvable machines become cleverer than people? Little over a decade is the current consensus. One such machine has already been awarded a patent for something it quietly invented on its own.

The temptation to surrender control to machines that are smarter, more vigilant and less prone to boredom, irritation and emotional outbursts than people will be overwhelming. People will do so for reasons of comfort, convenience, safety and cost. So, what happens when a one-in-a-billion bug causes the software to crash, or the safety valves are not operated properly?

That is what happened at Three Mile Island in 1979. Though the nuclear power station was not an autonomous system, it was running automatically with its human controllers outside the loop. When things went horribly wrong, inexperienced operators tried desperately to take command, only to make one compounding mistake after another—turning a control system with good negative feedback into a positive, runaway disaster.

Though now dated, Langdon Winner’s oft-cited book “Autonomous Technology” (MIT Press, 1977) was one of the first to call attention to the way the complexity of big systems can lead to loss of control and disaster. That was two years before the explosion at Three Mile Island.

Dr Winner was also one of the first to note that Frankenstein’s invention represented a giant leap in the capability of a certain kind of technology. Yet, it was sent it out into the world with no concern for how best to include it in the community. When the creature returned as an autonomous force with demands that it insisted were met, its creator was unable to find a way to repair the damage done by his imperfect invention. Shelley’s story may have been the first to show how good intentions behind technological inventions can go awry. It surely won’t be the last.

Wharton: Do Not Try to Cure the Incurable

Peter Linneman on Real Estate: The Storm Is Over, the Wreckage Remains Published : August 19, 2009 in Knowledge@Wharton

Although some upbeat economic news in recent weeks might indicate the beginning of the end of the recession, there’s still plenty of “wreckage” to deal with, says Wharton real estate professor Peter D. Linneman. Nowhere is this more apparent than in the housing and commercial property sectors, which have taken one of their worst beatings ever. Linneman refutes the argument that the U. S. government should do more to prop up the weakest parts of the economy, like the troubled real estate industry. In an interview with Knowledge@Wharton, he also draws on policy missteps of the past to caution the Obama administration to tread carefully and avoid “trying to cure things they can’t cure,” while contending that the U. S. might have more in common with countries like Venezuela, Russia and Japan than most observers think.

An edited transcript of the conversation follows.

Knowledge@Wharton: Could we start by taking stock of the real estate market — both housing and commercial. What does it look like to you today and for the rest of the year?

Peter D. Linneman: Let’s take housing first. Single-family housing starts have bottomed and will slowly pick up…. For the last four months, single-family housing prices at multiple listing services — namely what real people are selling their homes at instead of foreclosure sales — have been up in almost every market except Las Vegas. So that part is positive, absent further economic collapse driven by Washington.

The multi-family side has fallen off a cliff. Multi-family starts are about a quarter of their historic norm. They’re down 75% in about seven months as a run rate and they’ll stay down because of the shortage of available construction capital. It’s not such a horrible thing because there’s a fair amount of vacancy. What’s happened is that as the economy has lost jobs, people have doubled up. Young graduates stay with their parents; immigrants stay with their cousins and brothers. That will continue until the economy improves, which probably won’t be until late this year and into next — again, if Washington can just keep calm. Therefore, the lack of construction going on is a good thing in the sense that it means you can eat up excess inventory. It’s not good if you’re in the construction business, but as a general matter it’s good. The multi-family [sector] won’t pick back up until next year, based on my analysis.

If you ask, is the storm over? The storm is over. What’s left is cleaning up the wreckage from the storm. People have a hard time distinguishing the storm and the wreckage. [There is a] big difference though. When that hurricane is still hitting you, it’s still creating more damage. Now what you’re dealing with on the housing side is all of these people who bought speculative homes. They thought prices would only go up. They thought they’d flip them in six months. There was nobody to flip them to, so of course, they foreclosed. They had no money in it. They didn’t lose anything. That’s probably over half a million homes.

So the wreckage is still being dealt with — [by] the people who were speculators, the people who bought 97%-loan homes even if they were living in them and [the people in] greater Ohio. Greater Ohio is, say, Ohio and 50 miles [just outside] of the Ohio border. That’s in a real recession. It’s been in a real recession for seven years. That’s a different issue than the rest of the country faces.

Unfortunately, the government is trying to cure things it can’t cure. The government is trying to [give] what is not theirs to give. Salvation is not theirs to give, but they’re trying to give salvation. If you had no money in your home, and you thought you would flip it in six months for 100% profit — and then prices fell 20% — salvation [for that business decision] is not the government’s to give. They shouldn’t do it. And the more they try to do it, the more harm than good they’re doing.

Knowledge@Wharton: When you say the storm is over and what’s left is the cleanup, is that just in the U.S. or do you see the same thing internationally?

Linneman: That’s fairly true everywhere. The difference is on the commercial side. It’s true everywhere with the minor exception of China and Brazil, and the very minor exception of India. And when I say that [I mean conditions are] good for Brazil, China and possibly India.

Knowledge@Wharton: How do you see the differences between the way the financial crisis affected the housing market and the commercial market?

Linneman: In one sense, it’s totally different; in another, it’s not. The way [the commercial market] is different [is that] it wasn’t subprime. The Fed kept interest rates at effectively 1% for four years while inflation was running at 2.5%. It guaranteed that anybody who put their money short and safe, lost money for four years. Well, people aren’t going to sit around and lose money for four years. People piled into long and risky.

The common element is what was long and risky. Subprime was long and risky. Certain types of commercial real estate were long and risky. Condominium developments were long and risky, not just in the U.S. Developments in [India] were long and risky. Leveraged buyouts of operating companies were long and risky. The common element was long and risky [assets], not real estate.

If you look across the world, anything that was long and risky has been crushed because the government went from forcing people artificially to demand long and risky to quite the opposite. It forced them to demand short and safe. Demand changed dramatically, from being artificially high to [becoming] artificially low. The government also encouraged [buyers] with low interest rates … [making it enticing to borrow] short and float.

People are looking at the symptoms rather than the cause. The cause was low interest rates forcing people to go long and risky. Better to lose money later with a risk than for sure now. It turns out now is the settling up for when you went long and risky.

There’s no similarity between a home [loan] and a commercial real estate [loan]. Commercial real estate has a cash flow behind it. It has tenants behind it, everybody from the U.S. government to a venture capital firm. [Residential] homes have you and me [asking], do we want to stay here? [There is] no cash flow. By the way, the leverage was much higher on the single-family side at the margin. People forget that 20% of all homeowners have no mortgage — no mortgage — in the United States…. Only 5% of all Americans are not current with a mortgage, 33% of Americans rent, 20% have no mortgage and 5% aren’t paying [their mortgage].

Knowledge@Wharton: Coming back to the role of the government, you said earlier that it shouldn’t try to do what it can’t do. What is the right strategy for the government now?

Linneman: My view is that [what] government [officials] should have done but didn’t [was to] admit that they are also human beings. Milton Friedman was a professor of mine and he used to say that when you listen to people talk about the government, if you change the word government to omnipotent deity, the meaning of most sentences would be unchanged. You hear people say the government should help delinquent borrowers. What they really are saying is an omnipotent deity should come in and save them. They’re just human beings. They have no more information than we do. They have no more expertise than we do. They have powers of mandatory behavior, which are dangerous because I make mistakes everyday at my job. For all we know, this tape is not working. Well, if this tape is not working and it’s just us, it affects two of us. If we’ve committed a similar mistake and we’re in charge of the government, it affects 300 million people.

What they [the government] need to do is admit they’re human, and that they do not have answers. The phrase I’ve used throughout all this is, first, do no harm. We’ve had a government that for the last year has — under both the Bush administration with Paulson and the Obama administration with Geithner — leaped, then looked. They leap to grand solutions, whether it’s TARP or TALF … then two days later they say, “Well, we’re not going to do it that way and by the way we’re changing.” All [I see that] they’ve done is obliterate rules.

The thing that distinguishes us from Zimbabwe, Russia and Venezuela, is that prior to September 1, 2008, you had a fair idea that if a company couldn’t pay its debts, it would go into bankruptcy and the process would work out. You had a fair idea that if a bank couldn’t collect its loans, it would be taken over by the FDIC and liquidated…. Now they’re talking about oil. Will we regulate oil prices? On and on, so that you have no certainty at all.

What was the best way to raise money prior to September 1 last year? You went to Wall Street. You made a pitch to investors and you tried to convince them. What’s the best way to make money today? Lose a lot of money and then go to Washington with your political power and try to raise money. That can’t be good because I don’t know who is politically powerful enough. So they’ve ruined the playing field. People do not play games if they don’t know the rules. That’s why Zimbabwe, Venezuela and Russia have weaker economies — nobody knows the rules. I don’t even have to like the rules. You and I play games all the time that we think have stupid rules. But as long as we know the rules, we’ll play.

We changed from the most predictable rules in the world to [a] Russia-Venezuela [approach]. If you don’t believe it, suppose I told you the Duma in Russia conducted hearings for two weeks on whether to subsidize, to the tune of tens of billions of dollars, a couple of companies? After two weeks they said no. The next day Putin said yes. You’d say, “Well, that’s Russia. And that’s why I don’t invest in Russia.”

That’s literally what happened in November to the auto industry. Congress conducted hearings. They said no. Twelve hours later, the Secretary of the Treasury said, “We’ll do it anyway.”

I’m not picking on Democrats or Republicans. Unfortunately, this has crossed party lines. What they really need to do is — less. Unfortunately, that is not what they’re good at.

Knowledge@Wharton: Let’s look back about 20 years [when] the savings and loan debacle happened. The government agency called in the Resolution Trust Corporation, or RTC, to solve, at that time, what looked like a big mess, and Wall Street, securitization and real estate investment trusts [REITS] emerged as a solution. As this scenario plays out with real estate finance, and housing and commercial real estate, where do you see the sources of capital [coming from] and what will the landscape look like?

Linneman: There is a great similarity between what happened then and [what is] happening now…. One, human nature. Human nature then said things only go up and we believed our own [lies]. One of the things that happens at the end of every cycle, by the way, is that human nature takes over, so it’s not the first time human nature has taken over….  You’re not going to regulate human nature out of existence. Madoff is not the first guy to steal. Wars have been going on since the dawn of man. Murder has been going on. And so have economic ups and downs because of the hubris of people.

The difference was the government then said, “We are going to live by the rules. If you’re not solvent, we’re going to shut you down.” Did they make some mistakes in hindsight of shutting down a few people who were solvent? Yes. And the courts later resolved that. There were so many of them that were insolvent, they had to liquidate them and set up a special agency.

Instead of doing that this time, the government has said, “We can decide how to keep people alive.” Instead of shutting down the insolvent, they’ve kept the insolvent [institutions] alive and pumped in billions of dollars. Think about it. There’s only so much money and capital in the system. If you give money to insolvent people, all you’re guaranteeing is that the solvent aren’t getting the money. There’s only so much. My analogy is that if you give blood transfusions to the dead, they’re not only not going to get up and dance the jig, but there won’t be any blood to give to those who are still alive and could benefit from it. That was the big mistake we made this time.

You mentioned securitization. Securitization came to the rescue of Latin American debt if you think about it. Back with the Brady bonds, it came to the rescue of the S&L crisis — namely, we’ll package stuff up both in terms of debt and equity. The equity side has proven pretty successful. Yes, the stock prices fell. Hey, stock prices of everything fell. REITS stock prices fell more than the prices of other stocks for one simple reason — that in normal times, they have a beta of about 0.5. They aren’t perfectly correlated. Therefore, people are willing to pay a premium for something that’s not perfectly correlated. When people rush for the fire escape, everything is perfectly correlated. Not only does it go down as much as everything else, no longer are you getting a premium for the fact it doesn’t. It actually has to fall more. The flip side is going to be … it will go back up more until the next time we rush to the fire escape. And we will rush to the fire escape again within the next 10 years because we’re human.

How will capital sources come? They will be equity, not debt. It will, in the near term, be a massive debt-for-equity swap. People say we’re over-levered…. At the face value of the debt we are, but not at the current market valuation. It’s a little like saying I put $100 million into my stocks. Of course, they’re worth $20 million today and you’re still saying, “No, they’re worth $100 million.” No they aren’t. They’re worth $20 million. In the same sense, if you look at the market value of the debt, whether you trace it through the banks, through what’s traded or through [commercial mortgage-backed securities or residential mortgage-backed securities], we’re not over-levered.

What we are is over-face valued, which means — because debt is a contract — you’ve got a lot of contracts that have to be worked out. Whereas equity says no workouts; it’s just down. It’s great for lawyers, bad for everybody else. Where will the money come from? It will come from public capital markets first. The REITS are in the best position to take advantage of this because they’re around, they’re loaded, they’re low leverage, they’re transparent and they’re name brands. The private equity funds will take advantage of it. It’s more difficult because they’ve told investors that they are going to get 20% to 25% returns. It’s very hard to make a pro forma show of 20% to 25% return on a cash stream — any cash stream — without a lot of leverage. So the absence of leverage means you can get 12%, 15%, 18% on paper, but not [in the 20% range]. And that’s a challenge for private equity.

… You’ll probably see some private equity funds go public, for example, [and] use that money to pay down debt … and restructure in that way….

You are going to see banks sell assets. It’s going to go a lot slower than people think because this time the U.S. government is acting much more like Japan did in the early 1990s, which was very slow to shut down the insolvent [Japanese banks]. We are giving blood to the dead, rather than giving blood to the living. If we do that, they have less incentive to [sell] assets, create a market and move on.

Knowledge@Wharton: What will real estate look like and what should it look like in the future?

Linneman: What it will look like in the future is pretty obvious — ups and downs, with more up than down. Probably 60% to 70% up and 30% down — but the downs occurring right when you think they’re impossible to occur and the ups occurring just when you think they’ll never occur. As I was saying to some friends at a gathering that I host of major real estate people, if you go back to 1997, before the Russian ruble crisis, nobody saw the extent of the collapse…. At the height of the dot-com, nobody saw that two years later you’d be in the depths of 9/11. You may have seen a down, but not the depths. In the depths of post 9/11, nobody saw 2005 being as strong as it was. As you sat in 2005, nobody saw the first quarter of 2007 being as frothy as it was. In the first quarter of 2007, no one saw the depths we’re in now.

Why do you believe any of us when we sit here and say anything, because even those of us who have been pretty good at predicting, have only predicted direction and generally missed magnitude. I predicted a recession five years ago and every quarter thereafter for 2009. So great, I was right. I predicted flat GDP and a 1.5 million job losses. I was only off by 4.5 million jobs and I was only off by 6% of GDP. Other than that, I was a genius, right? The point being, even those of us who got directions right, missed magnitude.

We need to have some humility and understanding. We’re going to be very wrong about the next two years. The next two years are going to see a lot of asset price appreciation, particularly related to real estate. You’re going to see better economic performance than people are foreseeing. If you look at past recessions, that’s always turned out to be the case.

The real estate industry [is] probably going to have a great four years for public companies, including companies that aren’t … [yet] public. You’re going to see a number of private equity funds struggle, some [just] to stay in existence [because of their debt]. Let’s face it. Anybody who used debt is caught up in that negotiation game. And if all your energies are caught in the negotiation, you’re not in the create-new-value game. You only have so much time and energy. Those who had low debt –a few families but mostly public companies — will have the opposite [experience].

Will securitization arise? Some version of it, yes. Do I know exactly what version? No….  What you’ll see is that securitization is not going to go away. People are saying, “We should do this regulation or we should not allow this or not allow that.” Trust me. If you read the literature that people — intelligent people doing thoughtful analysis — wrote as securitization was occurring, not just in real estate, it said, “Look at all the problems it’s solving. Yes, it does have a few drawbacks, but…” Well, as things gain momentum, the “buts” come to dominate the benefits. In the beginning, it’s easy to get the benefits to dominate the “buts. “As we push things and we start believing our own [public relations] and our hubris sets in, we push the margins….

There is a myth [that] securitization created this problem. It’s not true. What created the problem was bad risk analysis, whether it was bad risk analysis on the equity side or bad risk analysis on the debt side. A loan to somebody to flip an apartment when there are 50 apartments that [are ready to move into] and there are 500 [apartments] being delivered in a year — if you give 100% loan on that, that’s a bad loan because it was badly underwritten, whether it’s securitized or held as private loan, or even if it’s bought with 100% equity. It’s bad risk analysis. Fifty are needed. And 500 are being built. That’s ten years’ worth. If you’re pouring money into that, that’s bad….

Bad risk analysis generally goes with either the end of a cycle — when we start believing ourselves — or bad policy. The bad policy was the 1% interest rate, which made things look better than they should have as an alternative.

By the way, do I think the Fed will never make another monetary policy mistake? It was an honest mistake. It certainly wasn’t a dishonest mistake. Of course, they’re going to make more mistakes because they’re just human beings. So securitization isn’t what is wrong. Japan, in the 1980s, made the greatest number of insane loans with the worst risk analysis and the worst documentation in modern history. None of them were securitized. They were all held on balance sheets…. The packaging of it influences it at the margin. But bad decisions are bad decisions, no matter how you package them.

Knowledge@Wharton: The argument that some people might have is that with securitization you don’t have to hold the risk. You can move it to somebody else.

Linneman: The old joke was — this is in the old loan world when you didn’t securitize — I make the loan and then if it doesn’t work, I pretend it’s good until either I get promoted or retire. Right? That was it. So the institution in some sense held it. But when you get to where the rubber meets the road, it’s human beings. And human beings have the incentive to not take the responsibility for their own mistakes. We have the human being dimension to take all the responsibility for any success we’re remotely [close to], including success we have nothing to do with. Failure [has] no parents and success [has] a thousand fathers. These are old sayings for a reason. When [these loans] were held as whole loans, or when they were done as equity, dot-com had relatively little debt, was some of the worst risk analysis ever. Hundreds of billions of dollars [were] wasted on bad risk analysis.

By the way, if we had done it as debt rather than equity, would it have been any smarter if we’d have held them as whole loans rather than equity. Dumb is dumb as [far as] risk analysis [goes]. And the packaging can influence [the risk profile], but it’s secondary. The truth is, you saw relatively few people with 100% of their own money making really dumb decisions — in any of these. What you always see is a lot of people, with other people’s money [making bad decisions], and an incentive structure [to further encourage those decisions].

Because we’re human beings with flawed integrity and the ability to tell ourselves we’re doing the right things even when we’re not, one of our greatest abilities is deluding ourselves. I look in the mirror every morning and I see John Wayne at his best. It gets me through the day. You see the storybook here. We all delude [ourselves]. People are focusing on the package it [these loans] came in. I’ve got bad incentives whether I’m holding the loans on and I’m trying to get my bonus that year or I’m trying to sell them and get my bonus. It may be more transparent one way over the other.

Securitization made the problem visible about two years earlier than it did in Japan when it was private, and than it did in the S&Ls when it was behind closed doors. I shudder to think how big the mistakes would have grown to if they had have been behind closed doors instead of securitized.

Knowledge@Wharton: What are the main lessons that we should learn from this experience?

Linneman: Great lessons. One: Whenever there’s more money being offered to you than you can imagine, it will be followed by a period where nobody’s going to offer you money. Another lesson: Don’t match long assets with short liabilities. These aren’t rocket-science lessons, but they are lessons.

Third: Debt has risk. Normally, and too often, people only think debt has a price, but not a risk. A lot of people say, “Debt is cheaper than equity.” Do you understand how many people paid as the cost of their debt — not the interest rate — they paid all their equity. I put in 20% equity on a purchase. The interest rate was 4%. It ended up costing me one year of 4% interest and 20%. It cost me 100% of my equity…. The biggest risk of debt is not that the interest rate goes up. The biggest risk of debt has always been — I wrote this in my book years ago — [that] they don’t want to give you money when your debt is due…. This is not the first time it’s happened. It’s interesting. I’m 58 and in the last 31 years I counted five times when economic events that supposedly only happen once every 100 years have occurred. Must have been a good 31 years, you know? 

This stuff happens and it happens because we’re human. That’s the last lesson. We are human. We don’t need more regulations. We just need to enforce the regulations we have. We have regulations that date back to the 1930s that say no federally insured depository can exist unless it can demonstrate safety and soundness. And we pay regulators — we have paid regulators — to enforce that. I think they missed. I’m not even blaming them. Remember, the burden of proof is you don’t get a government insured deposit license unless you can demonstrate safety and soundness. It’s pretty obvious they weren’t safe and sound. Again, they are human beings on the regulating side as well.

It reminds me of the tragedies of gun control. Every time somebody walks into a McDonald’s, a post office or a school and kills … people with a handgun, you know that the next day there will be cries for more gun control. Every state in the country has probably 14 inches of gun control laws because every time [new legislators are voted into office], they pass an addition. What we need to do is to enforce the gun control laws, which say children, criminals and the mentally unstable should not have access to them. All those laws already exist. Forget more regulation. Just enforce the ones we already have. All that more regulation can do … is make it harder to enforce, because I am going to have to spend a year figuring out what they mean. Now instead of 14 inches, I have 28 inches of regulations and I can’t pay attention to all of them.

Madoff is not a matter of market failure. Madoff is a matter of regulatory failure — over four administrations. The guy was a thief. Do we need new laws against thieves? There have been laws against thieves as [long] as mankind [has had laws]. Yet there are always thieves. The issue is having the will to enforce what you have. It’s rare that we’re passing a law that is truly improving on the fundamentals of the Ten Commandments or the Koran or whatever. They figured it out then. Don’t lie. Don’t steal. Let’s just have it real simple. What we need is a dedicated enforcement effort that takes it seriously. That’s difficult to do because it takes a human will that’s generally not there. We’re not inventing anything new. We’re just reliving. One hundred years from now this will all just be history. It’s like reading about World War I. It happened over there, a whole bunch of people got hurt and some died. It was a great tragedy. But it will just be history. We’re living history and it’s just going to keep repeating itself in variations. At least that’s my vie

Wharton: Listen, Then Synthesize

Connecting the Dots at the World Economic Forum: ‘We Can No Longer Face Global Issues Alone’ Published : August 19, 2009 in Knowledge@Wharton

Economic progress, ethics and social entrepreneurship are three themes that have long had a place on the agenda of the World Economic Forum (WEF), even back in the 1970s when the Geneva-based nonprofit think tank first began bringing together business leaders, politicians, activists, religious leaders and, laterally, celebrities at its annual meetings held in Davos — that is, long before phrases like “subprime lending” had ever crossed the lips of bankers and Wall Street investors.

But how can these and other global topics remain relevant during today’s market turbulence? It’s a question getting urgent attention from leadership experts like Gilbert Probst, WEF managing director and dean of its Global Leadership Fellows program, a three-year master’s degree course run in partnership with various business schools, including Wharton.

To discuss what topics are likely to appear on future WEF agendas, Knowledge@Wharton spoke with Probst, along with Tiffany West, associate director and Global Leadership Fellow, Program Development team, and Ana Karinna Sepulveda, project manager for the WEF’s Global Education Initiative. Identifying risk, developing more effective leaders and ensuring sustainability are just a few of the subjects the WEF is likely to focus on in coming years, they say — in other words, much, much more than just the economic crisis.

An edited transcript of the conversation follows.

Knowledge@Wharton: As you know, the world economy today has been in a crisis for a while, and the World Economic Forum has had such a wonderful role to play in encouraging conversations among world leaders on the issues. Could you start by talking about the World Economic Forum, what you’re trying to accomplish at Davos and how some of this has changed as a result of the financial crisis?

Gilbert Probst: First of all, it’s difficult to say how much has really changed, but the role [of the forum] has become more important. If you look at what [the forum] is and was since [it began], it is to build up partnerships and shape the global, regional and industry agendas. And the role was always to say we are kind of entrepreneurs in a global public interest where we think of economic progress needs at the same time as social development [that is] sustainable….

Differently said, we always thought — and even more so now, of course, with the crisis — that our challenges cannot be solved or met by governments, business or civil society alone. There is a huge interdependence, and that [requires] collaborative efforts to deal with today’s issues. In that sense, it was always there, but it has accelerated. Tiffany can say something about Davos, our experience of the last years and what has changed in the way we organize the partnerships or people that we get together.

Tiffany West: If you look at the themes of our annual meeting over the past ten years, there has been a change in the way the dots are connected. How do we collaborate with each other? How do we come out of a crisis by working together? What we’ve done in our programs has been to try and highlight this notion that all the different sectors [and] different stakeholders must work together to address the global issues because, as Gilbert said, we can’t address these alone anymore. What we try to do is put in place a mechanism for top-level people to come together and start the dialogue, so that then those conversations can trickle down through their organizations [and] help shape what comes out a few months later.

Knowledge@Wharton: I know you’re involved in developing content for the forums. How have the themes changed? Or do you find there’s more emphasis on the same themes?

West: The themes have changed and what we try to do is be very topical in terms of what [not only] our members, but also the [general public], are interested in learning about. One thing that has come up [a lot] in the last couple of years is [the need to explore], for instance, what the new values are. We have gone into a crisis situation that was mainly caused by a loss of sense of values. What are the new values that [will come out of this]?

Second, how do we identify and mitigate risks? Obviously, we did not do a very good job of that going into the crisis. We need to get much better at that.

Next, how do we build effective institutions? One of the things that we’re working on is the Global Redesign Initiative. That is, examining how we redesign institutions — not just Bretton Woods or U. N. institutions, but institutions that are more on the “soft” side as well.

The final thing that I would add is ensuring sustainability. That’s not a new topic, but every year it comes [closer] to the forefront of what our members [see] as one of their main responsibilities, and what the public hold our members accountable for.

Probst: But isn’t it also that [these] topics are not necessarily that new? … We realized with the financial crisis what globalization really means…and this increasingly interconnected world suddenly showed us what the impact [of that] is. We as professors have been saying for 20 years that the world is complex. It’s in every foreword that I’ve written in the last 20 years. But we now realize [that] the complexity asks us to be different in [the way we lead], in the way we collaborate [and] in the way we solve problems, and that a single leader, nation or organization can no longer face the global issues alone. The dynamics have completely changed.

What is interesting is that many of the issues we [discussed at Davos] in the last years are still there. And I even think it is important in the financial crisis that these issues like climate change, terrorism or water scarcity and distribution, etc. , are still on the agenda and are dealt with, and it is not only a financial crisis [that needs to be solved].

It would be interesting, Tiffany, to say what has changed — what was different in the last Davos meeting and what might be different in the next one.

West: Specifically on the global issues, the non-financial ones?

Probst: Yes. Or also [how] to keep all these issues on the agenda… because there’s also a risk, of course, that we now are focused on the financial crisis alone and think we just have… to solve the financial crisis. Well, that’s not true.

West: Exactly. That’s why when I mentioned sustainability, it’s definitely one of those key issues that cannot fall off the global agenda and we always make sure that we are not focusing too much on the economy. Yes, it’s the World Economic Forum, but all the other issues affect the economy as well. What is different now is how we address those issues. I don’t want to repeat what Gilbert has said, but it is how we must all work together.

Knowledge@Wharton: It’s not so much talking about the economy, but also how the state of the economy affects the ability of individuals and companies to respond to complexity. For example, globalization now will reveal itself not just in the way derivatives affect banks in one country and another, but also by the way in which pandemics spread. The way people respond will depend on what kind of economic climate we’re looking at.

In addition to the forum’s themes that have been mentioned, one evergreen theme is entrepreneurship, specifically in terms of wealth creation in emerging economies. Ana, I believe you’ve been focusing on that. Could you tell us about what you’ve been working on and how that fits in with the World Economic Forum’s program?

Ana Karinna Sepulveda: As you mentioned, the financial crisis has brought [on] a lot of anxiety and nervousness worldwide. But it has also showed us potential opportunities — not only for working together, but also reassessing priorities and establishing linkages. At the Global Education Initiative, we started looking in 2007 at the linkage between entrepreneurship, education and economic development. We created a new work stream in our initiative, which looks at how to create a new generation of entrepreneurs that will create jobs and help us through the recovery,while also being the ones who make an impact on society….

Perhaps I need to give an overview of what the Global Education Initiative is [before discussing] the details of the work on entrepreneurship education.

[Our annual meeting in] Davos is our flagship and probably what we’re known most for. But the ultimate mission of the World Economic Forum is to improve the state of the world and we do that, as Tiffany and Gilbert said, by bringing leaders together to discuss issues on global, regional and industry agendas. But [we] also shape those agendas by addressing issues in specific initiatives. Education is one, corruption is another, as are risk, health and water.

In the case of education, we started in 2003 at one of those magic moments that happens in Davos behind closed doors. A group of CEOs, mostly from IT and telecommunications, had the idea of doing something for education worldwide. That’s how this started six years ago. The initiative’s mission is to help governments create sustainable, relevant and scalable education through collaboration and partnerships, [while] engaging business and other stakeholders.

So far the initiative has mobilized $100 million of support and [has touched] over 1. 8 million students and teachers. It’s one of the initiatives that is very action-oriented, in particular in the Middle East — in Jordan, Egypt, Palestinian territories — the state of Rajasthan in India and last year Rwanda.

But to return to the linkage with entrepreneurship, in 2007 we started thinking about what the business case of education is. Why do we have to rethink the way we are educating people? And for what are we educating them? What is the ultimate purpose? And then we started this work stream.

On April 23^rd of this year, we launched a report called “Educating the Next Wave of Entrepreneurs. “… [And it asks,] what are the things you need to teach people when they are young to be entrepreneurial? Also, there’s a strong focus on higher education. The message we tried to convey is entrepreneurship should not be limited to business school-related careers. It has to be across all disciplines. [And it's about] how we reach out to socially excluded groups, like women and people in disadvantaged communities.

Probst: This is a good example of how the forum changes. The idea is that we need coordinated approaches, a lot more collaboration or, as Tiffany said, [we need to make sure] that all the stakeholders are involved. What becomes important here is that we not only have to build communities where the forum is [seen as] an expert in creating communities, maintaining communities — but also where you have a community of thought leaders, religious leaders, women leaders, media or industry. More and more, it’s a question of getting all the stakeholders involved…. The examples that Ana just mentioned are typical also — the creation of public-private partnerships [rather than isolated communities]….

Knowledge@Wharton: One thing the forum is very good at is bringing people together around common issues and themes and creating the partnerships and communities that you just mentioned. Especially in stressful times, this is not easy because people tend to focus on their own interests more than the common interests. How have you tried to get around this kind of barrier?

West: We are quite lucky in that our constituents, just by the fact that they are members of the World Economic Forum, are already convinced that they need to talk to all the different stakeholders. In terms of how we do that elsewhere, it is through the Global Education Initiative [and other initiatives] where we can go outside of the World Economic Forum, outside of our membership base and say, “Here is an example that is successful. “Whenever you can prove to a constituency that there are ways of working that are different than what they are used to or from the insular way of looking [at things], it helps break down the barriers.

Knowledge@Wharton: What would be some examples of the result of the collaboration that the World Economic Forum has brought about?

Sepulveda: [An example] is one of our early initiatives, the Jordan Education Initiative, [which brought] together the private and public sectors…. [Another example] for communities that were not yet members, and have not yet become members, of the forum, is what we’re doing right now in Rwanda. In Rwanda we [introduced] the public-private sector model as well as a donor community [to the country]….

These are just two examples within my work of how we reach out to different groups and bring them toward a common goal.

Probst: It is fascinating to observe how the communities we have are strong. I’m thinking [in particular about] the Young Global Leaders, leaders from all over the world [who are younger than] 40 who have a very strong community. Or the Social Entrepreneurs, which is a community… of leaders, [and] the young fellows in our program, by the way, are involved in that. But they get involved increasingly in the global discussions at Davos, and in the regional meetings.

[These people are involved in,] for instance, the Water Needs Initiative… [and] the Business Alliance Against Chronic Hunger Initiative [to name a few], so that communities are not isolated…. The Young Global Leaders [don't always agree with each other], but they are involved. Something that we started seeing more of at Davos in the last few years is that they are completely involved in meetings there. A lot of the Young Global Leaders [meetings] have a big number — way over a 100 — in Davos. The Social Entrepreneurs — they do not have their own meeting [but] they are in Davos; they [participate] in the Middle East meeting [and] the African meeting. This is really thinking across disciplines and that’s exactly what it needs. If you take the Business Alliance Against Chronic Hunger Initiative, it is a public-private partnership that [involves multiple stakeholders]….

West: It’s a good point: How we bring in different views of the Young Global Leaders to the Social Entrepreneurs, for instance. The way that plays out in Davos is that they become anchors for the community there in that the examples they provide are much more… accessible to the average person than some of the very large corporations. We like to get those examples in there to show that there are different ways of looking at the world and that business is not just big business.

Knowledge@Wharton: Clearly, though, there was a time when if you heard about the World Economic Forum, all that came to mind was Davos. As you all have said, it has gone in many new directions. If you were to think a few years into the future, where do you see these conversations going? What new challenges and partnerships will the World Economic Forum be looking at?

Probst: More important, rather than the next five to 10 years, is to create the new generation of leaders [today]. We need a new generation of leaders that has a different approach to dealing with complexity and know what complexity means. What it means is collaboration, because it’s easy to talk about public-private partnerships but we were not trained like this. We were not trained to have a stakeholder approach even if it has been in business books for the last 20 years. It was not something that we learned as leaders. That we act as a global community and we understand… our role in a global community and that we learn to have all stakeholders involved… in the issues. By the way, our internal Global Leadership Fellows program has this as a goal. If we get there, we should have different topics and different issues. But it is difficult to say what they will look like in five to 10 years. I just hope that we have better or different leadership at that point.

West: What I hope to see is that collaboration is the norm, that we no longer have to do the convincing. Right now we’re spending so much energy convincing people that this is the way of the future and the time would be better spent on addressing the issues themselves. That would be my big hope.

Sepulveda: [I would hope that one of the] development goals would be achieved by 2015…. Four years out of that date, we would be looking at [whether there are any gaps]. Whathas not been achieved? In terms of education, I concur with what Tiffany is saying. I wish that by 2020 we don’t have to [keep] convincing government, [individuals and so on] that education is important. It is a central part of economic and social development worldwide. We are planting the seeds [today] for those conversations to happen in 2020 with the Global Agenda Counsels, the groups that are shaping the issues. Education is one of those. That’s going to fit into what Tiffany was talking about — the Global Redesign Initiative. By 2020 the conversation is going be around the greater spread of technology and how technology has impacted education. What are the countries or parts of the world that are still left out? How can we leverage the spread of technology to learn about peace, coexistence, the shape of world teaching and again more collaborative approaches?

Knowledge@Wharton: Each of you spend a lot of time thinking about collaboration and leadership at the World Economic Forum. What is the one leadership lesson that you have learned at the Young Global Leaders that you use on a regular basis in your work?

Sapovida: One of the things that has been very important to me and that I learned in the last one-and-a-half years… from the Young Global Leaders and the Social Entrepreneurs is — as corny as it sounds — to believe in the idea that you have to work very hard. [And you must] believe strongly in that and don’t give up. The entrepreneurs have this quality that when they see a wall, they think, “How do I bring that wall down? “Other people say, “Oh, there is an obstacle” [and give up]. [Entrepreneurs]try to empower people around them to bring that wall down. So that for me has been a leadership skill or a leadership lesson.

Knowledge@Wharton: And if you don’t bring the wall down, you might climb over it or dig under it?

Sepulveda: Exactly.

Knowledge@Wharton: Entrepreneurs are good at that. Gilbert?

Probst: I have learned that I have to apply what I teach. It was probably the most difficult thing to learn because it’s easy to talk about what is in the books or what you observe…. To apply it, to allow people — I mean not just the fellows in the leadership program, but everybody works with me — to reflect on themselves as leaders. You’re only a good leader if you know yourself and if you are able to ask, “How do I communicate, how do people perceive my leadership role? “…. [and] understand your role in a community or in a global context. This needs reflection time and I try to give the people around me the reflection time [to ask], “What are we doing,where are we and where do we go? “…. I had to learn to take the reflective time for me to become a reflective practitioner, to become a reflective leader. And you have to force yourself to do it.

Knowledge@Wharton: Tiffany, you have the final word.

West: What’s been most important for me is learning how to listen and not just for the sake of listening, but really being able to synthesize what I hear and turn that into a coherent vision that motivates people around me. Without doing that, you’re dead in the water.

Knowledge@Wharton: Thank you all very much.

Wharton: Tell Them They are Idiots

Farhad Mohit: DotSpots and the Wisdom of Crowds Published : August 19, 2009 in Knowledge@Wharton

Entrepreneur Farhad Mohit is hardly resting on his laurels, although he could. In 1996, he launched BizRate, a consumer rating site, and then in 2004, Shopzilla, a shopping search engine. His latest venture is DotSpots, a service that lets people update the news in real-time with dots, or distributed objects of thought. These could include mini-blog posts containing text, videos, images, documents, perspectives from the blogosphere or eye-witness accounts from the scene. Mohit talked with Knowledge@Wharton about DotSpots, the publishing industry, the wisdom of crowds, what he learned from his previous successes and the importance of finding the right team, among other topics. 

An edited transcript of the conversation follows.

Knowledge@Wharton: Could you start out by telling us a little bit about DotSpots?

Farhad Mohit: Sure. DotSpots is a platform to allow ordinary people, or what we call the “wisdom of crowds,” to bring content that’s being created — “user generated content” we call it — and apply it to the mainstream news. So that’s its core essence. I can tell you why we’re doing that later, but that’s what it is.

Knowledge@Wharton: Can you give an example?

Mohit: Yes. The plane that landed in the Hudson River [on January 15, 2009]. I don’t know if you call it landing, but whatever, it landed in the Hudson River. The news was actually broken by Twitter. Flickr had tons of eyewitness videos. There are a billion and a half people with Internet access and a cell phone. So they are able to be everywhere and break the news. The problem is that the mainstream news doesn’t have a very good way of integrating that into their systems right now. They have to get reporters out to the scene and things like that. They don’t have the money to do it. They don’t have the time to do it. But it’s happening. So our idea is that we should let people just be able to attach their content right into the mainstream news, right as that story’s breaking, because the story kind of frames the issue. “Plane Landed in Hudson River” — then photographs can come right from the blogosphere and right from the Flickr and YouTube people loading the real videos. So you can immediately get multiple perspectives, eye witness videos right into the mainstream news as it is developing.

Knowledge@Wharton: Is there some way that those are organized?

Mohit: Yes, it’s the same way that Wikipedia is organized. That’s where the wisdom of crowds comes into play. You basically have people loading in a bunch of stuff. And then you have consumers of the information looking at it and saying, “Is this useful? Is it not useful?” This is my background from BizRate, one of these rating companies, so I’m pretty experienced in building systems that take a bunch of feedback and filter up what’s useful and filter out what’s junk, because yes, there will be a lot of junk as well.

Knowledge@Wharton: I understand your website uses something called the semantic annotation system. I presume that’s the system you use to filter out the junk. Could you explain that?

Mohit: Yes, it’s not actually the system we use…. The system we use for the junk is people’s votes. But the semantic nature of the business is the following: It’s that when the news gets created right now, a copy gets created. Usually, like I said, it’s a framing device. [News organizations] don’t do a lot of investigative reporting anymore. They don’t have a lot of live presence because they are running the news as a business and those are very expensive things to do, right? So they kind of frame it. And usually they frame it from an institutional point of view. So they say, “According to the White House,” and then whatever the White House has given them, they run that. And not only that, but then other places pick it up. The Associated Press, [for] example, syndicates to 1,500 outlets. And then other places start talking about that. So copies of the story get made, and then out of those copies pieces get made. 

Now [say] you want to talk about this quote [from] the President, and you have some information you want to add to it, a video that might disprove what he says or challenge it, or a blog [that might offer] a different perspective. What we need to do is … find all the relevant or semantically equivalent relevant copies out there so that you can attach [them] to your local news… The President said something, you attach it. We distribute it all over the place, to copy in China as well as to … The New York Times and Fox News…. So you, as one node on the net, now can attach something to your local copy, and we distribute it everywhere. But you have to find all the semantically equivalent pieces of text.

Knowledge@Wharton: So is this something that you think publishers should welcome or should they be afraid of this?

Mohit: I think that publishers should welcome it. The end result, if we’re able to build this platform out correctly, is that in almost real time, live eyewitness footage starts coming in, commentary from the blogosphere covering this from multiple angles and in depth [reports] scrutinizing the statements of our officials, etc. And we’re able to bubble up the high quality stuff. This becomes high quality user-generated editorial content that, for free, the publisher can add onto the frame that it has built for the story. So it makes their stories more engaging. The content appears in context, on the page, and so it keeps people on the pages longer and near the advertisements. And you know, at the end of the day, that’s why [publishers] are in business.

Knowledge@Wharton: Can publishers control this?

Mohit: Absolutely. We’re a publisher-friendly system. We gave a bunch of controls to the publishers so that they can control how [the content] will appear on the site. It’s very much a system in development, so we’re building the systems right now, but the first step for us is to go to publishers and say, “How can we make this useful to you? We know that you are hurting on the content side and on the cost side. We’re able to gather this stuff for free, and we want to put it into your system for free. But we know you’re also worried a little bit about the quality.” So we are going to build tools for them to be able to do that.

Knowledge@Wharton: So where does the balance of power lie, with the publisher or with the wisdom of the crowds?

Mohit: I think the natural thing that will come out of this is that the publisher is very much interested. I don’t think the publisher has an agenda per se. I heard that Fox News is always accused of being conservative. And I heard the guy speak. He’s like, “I’m a lifelong Democrat. I run a business for Mr. Murdoch. And the fact is, we have an audience and that audience is pretty loyal to us and we try to meet their needs and it makes us money, right, to do that.” And so I think if we can show that DotSpots brings more content, a variety of voices, engages customers, their users, and makes you more money, the publishers will embrace it. That’s the point of it.

Knowledge@Wharton: Is this focus mainly on breaking news, hard news or other kinds of events?

Mohit: Every kind. The breaking news is where the sensational things — like eyewitness videos — come in. So there’s an aspect of that when you’re adding multimedia; the currency of the information is much more important. But there are three functions that the press is supposed to perform. One of them is framing issues, the second one is a live presence, showing what’s happening, and the third one is investigative reporting — deep analysis, scrutiny from multiple angles of the corridors of power and asking questions, hard questions. That’s happening in the blogosphere. That’s more of the reflective stuff, the stuff that happens in the weeks after a story comes. A lot of times the blogosphere is responsible for [much] of the actual investigative reporting. It’s just not a very efficient mechanism right now. We should be doing the questioning; the people should be seeing the questioning and answering right as it’s happening, not weeks later.

Knowledge@Wharton: How are you making money from this?

Mohit: It’s an interesting question. The short answer is that we have a two-step process. First, you have to get ubiquity. There’s only three ways to make money on the Internet. One is sell subscriptions. We’re not selling subscriptions. Two is sell software. We’re not selling software. Three is some form of selling advertisements. Today we’re not selling advertisements. You know why? We don’t have anybody using the damn system. So if we never get anyone to use the system, it’s pointless for me to sit here and explain to you how we make money from it. If we have ubiquity, which is what our goal is right now, our social value is starting, it plays itself out, and then we can start to talk about it. It would be one form or another of either helping someone sell better ads or serving some types of ads ourselves. Nothing to worry about today.

Knowledge@Wharton: You have a track record with BizRate and Shopzilla. Are there any lessons for those experiences that could tie into how you could build this up to scale? But before you answer that, could you explain what BizRate and Shopzilla are?

Mohit: We started BizRate in 1996 out of Wharton as a class project. BizRate was a rating system that allowed customers to rate their experience with vendors and share it with other customers. So it’s a feedback system. It’s grown to be the 20th-25th biggest site in the world, or something like that right now. So it’s functioning and doing really well. Shopzilla was a natural extension of that idea, which is now we have all these people rating businesses, why don’t we have the prices of the products as well and do a full fledged search engine so you can buy products based on price and the attributes of the retailer. Would they deliver it on time, etc. That’s the 50th biggest site, I think, in the world. So they have both had some good success.

The lessons out of that for DotSpots: Well, you know, it was an 11-year process doing those two things. We made some decisions. For instance, we raised about $77 million of capital. I think that was, in hindsight, pretty stupid. We are doing it completely the opposite way. So at the end, we raised a lot of capital. We had a lot of high paying salaries on board. We brought a lot of people on that we didn’t need because we thought we needed to do that. We were high on the hog and everybody [had] good paychecks. But then when we sold the company in June of 2005, there were all these fat cat investors who were celebrating and pretending they were part of the team, and they shouldn’t have been. It should have been really the company and the employees.

So one of the things we’re doing with DotSpots that’s quite different is that we’re trying to keep our burn rate as low as possible, trying to keep the ownership in the hands of our employees. We basically are a fully distributed company as a result. Everybody works from home.

Knowledge@Wharton: I believe everybody works from home and the company pays a part of the mortgage, is that right?

Mohit: That’s right. It wasn’t that everybody works at home because we want to save money on offices. It’s because it’s a smarter way to get productivity out of our folks, and people love it. The idea of paying a part of the mortgage is more of a token, because at the end of the day what we say to our folks is, “Look, this is a business. What we’re trying to do is this. Keep your burn rate as low as possible, but be able to pay your bills so you’re not looking over your shoulder. From that point on, what we’d like to do is compensate you in stock, because if you want a higher salary, we can do that. But then we have to sell stock to do that. And so you can make that decision. But now is a bad time to be selling stock back to DotSpots. You want to keep your stock. So keep your pay low; you’re not going to get rich today. Right? Or maybe in the next three, four years, but we’re building towards a great product and a great company that whenever there is an exit or a liquidity event, the employees and the people who put their blood, sweat and tears into this thing are the ones who are celebrating, not a bunch of money people who tricked us into selling our stock too early.” Also known as venture capitalists.

Knowledge@Wharton: Spoken from experience.

Mohit: Yes.

Knowledge@Wharton: So you have a pretty small team right now, is that correct?

Mohit: Yes, we are seven people today, and we have four who are kind of in trial mode. One of the cool things about having a distributed company is that people can start pitching in from remotely even before they hit the payroll. You get to feel them out. They get to feel you out. It’s an efficient model for figuring out if somebody should come on board or not. No risk to them; they are on some other payroll and they are pitching in on their off time. So that’s another benefit of the model. But we’re still a small team, 11 people. 

Knowledge@Wharton: So the sort of financial meltdown that we’re in actually could be beneficial to you, to this idea?

Mohit: Everyone asks if it’s a good time to start a business. [My response is]: Are you curious about something? Are you interested in solving a problem? Do you have the drive to dedicate maybe five or 10 years of your life to this particular problem? If so, it’s a good time to start a business. If not, then you’re just looking for financial engineering or timing something or flipping something. That is not an entrepreneur to me. So I don’t care about the business climate. That’s somewhat irrelevant to what we’re trying to do. We’re trying to solve a problem. We have to figure out how to do that properly. There’s a lot of work to be done. It’s fun because we are passionate about the problem itself. And we have enough runway for a year. I can fund this thing forever. That’s the fortunate position that I am in. The general entrepreneur, if they have enough runway for a year, should just concentrate on running their business and then figuring out how to extend that runway, to always be about a year in front of them, right? So that is the way I look at it.

Knowledge@Wharton: I was thinking it might be beneficial because publishers would see this as a way to help them actually cut costs…

Mohit: Publishers have been in a financial decline for a long time. So I don’t think we needed this added boost. I’m worried that The New York Times is not going to be around when we launch our software. But overall I don’t think it’s that important of an issue. You know, if the business model works, it’ll work in any environment.

Knowledge@Wharton: Your site also says that companies that have figured out these issues have grown as big as Google and Wikipedia. Do you think that is somewhere in DotSpots’ future? If so, how?

Mohit: Yes, but to correct the quote and put it in context, I said that the wisdom of crowds concept and the large information kind of hub concepts are ones that do quite well on the Internet, right? Google and Wikipedia are two examples of such things. It’s way too early to say if DotSpots can make a scratch on that. So it’s quite presumptuous. On the website we’re allowed to be a little like that, but it would be stupid of me to say that to your audience. Let’s start with our first few people on board before we make too many big, grandiose claims.

Knowledge@Wharton: What’s your biggest fear about this venture, besides the obvious fear of failure…

Mohit: I think we have some significant challenges. [One is] the technology, the idea of matching these blocks of text properly so that when you attach content and we distribute it to 500 places, it doesn’t come up in an irrelevant place. The core technologies are a challenge…. Are we going to be able to present this content in a compelling enough way for people to be able to digest it? Is it going to be intrusive to them or not? So that’s one of the fears we have. And then finally, I think if today, people said, “Are you worried about spam?” I [would reply], “Today, where we’re sitting we’d be lucky — we’re not worthy of spam.” So but one day, if we’re successful and lots of people are using the service, then we have all sorts of issues around spam coming into the system. People trying to sell stuff. People trying to whatever. So that’s an issue — execution. All of it is execution. I mean the idea is a good one. If we don’t do it, someone else will. [The question is], can we execute on these hurdles and get to critical mass, which is what the main goal is.

Knowledge@Wharton: If people are evaluating new ideas for the Internet or some other space, what advice would you give them?

Mohit: On the internet in particular, there’s certain things to keep in mind that are important for an idea. I think information-based ideas are very good; the Internet is an information medium. Does it have an increasing-returns-to-scale type dynamic involved? That’s to say more begets more. So in our case, the more people load content into DotSpots, the more publishers will want this content and it will be useful to them. The more publishers start publishing the content, readers become exposed to it and then the activist bloggers and people who are on the content side will be more excited about putting it in. And then the next thing. So more begetting more is very good. And then the idea of erecting a barrier to entry as it goes. You know, the good businesses; as more begets more, there’s only one of them that’s necessary. So if you’re thinking about us as an annotation layer on the news, there’s not going to be 10 different annotation layers on the news. The content providers want one system. The publishers want one system. So being a first mover in something that has increasing returns to scale and is about information — those are very cool things. But that’s on the idea side.

Now if you want to go out and do something, the most important thing is some introspection to see what your skills are and what your core competencies are. And then putting together a team that complements you, not by saying, “You’re such a stud,” but by saying, “You’re an idiot.” [For example], a good tech partner was essential for me. The team that’s coming together for DotSpots is phenomenal. It’s unbelievable the kind of people who are joining. I think that with a decent idea that has these dynamics and with a good team, you’ll do wonders.

Knowledge@Wharton: Farhad, thanks so much for talking with us.

Worse Look at Emerging Economies

As I have written before, China is a relationship based system. The market is based on government pronouncements. The stimulus was caused by a wall of money from banks, which was misallocated, because it was assigned by the government through the banks to state owned businesses and local governments. Some went into the stock market and real estate markets. A lot was used to stockpile commodities. That is where Brazil comes in.

Brazil has had a higher percentage of exports of commodities to China and it has recently boosted its trade. Since we are far from high growth, the demand for commodities over the past few months has been driven by China. As China pulls back, so will the demand for Brazilian commodities.

Without the American consumer, the demand for consumption of Chinese goods will fall off and China will experience slower growth. Also look for massive dumping. And the complaints to the WTO are not coming from the US. The big filers are places like India and even Latin America.

I point out that all of my pronouncements have been correct. Look also for growing toxic assets within the Brazilian banking system. I have predicted this for months and the dominoes continue to fall. First Russia, then the Gulf, now Nigeria. The next will be China and Brazil. I can’t confirm it. I do know they are there. It is typical of a state dominated financial sector. In Russia the state owned Sberbank has just been hit by a $180 mm embezzlement scheme. In China it was $780 million for I believe CCB.

During booms all banks make bad decisions. As Buffett says, you get to see who is naked when the tide goes out. Brazil has been exceptionally lucky that the Chinese stimulus package kept commodities afloat while all other economies where collapsing. But as the Chinese economy deteriorates so will the economy of Brazil and with it bank loans.

It has to do with information. Information has value. It is disclosed only for money or because of a legal disincentive. The conflict of interest between the state as enforcer of the legal disincentive and the owner of the bank will be decided in favor of the bank. So the state will cover it up as long as possible. There aren’t any stress tests that I know of. Trust me. They are there.

The Chinese have put a $1.2 trillion loan band aid on the problem but it won’t stop the hemorrhaging because American buyers are not going to pick up the demand and the Chinese cannot change their legal environment fast enough to increase their own demand from 35%. So the growth in the US will be slow but steady, while the economies of many emerging markets (EMs) in East Asia and commodities producers (ex India) will flounder.

Eventually the US market will recover as capital is reallocated to more efficient firms. Without an efficient legal system in EMs that cannot happen. The banks will never get rid of their toxic assets. Toxic assets a can only go if there is a way to collect collateral through foreclosure or bankruptcy. These do not exist in many EMs.