Long Now

The Long Now Foundation "was established in 01996 to creatively foster long-term thinking and responsibility in the framework of the next 10,000 years." It has three main projects - "to construct a timepiece that will operate with minimum human intervention for 10,000 years... to preserve all languages that have a high likelihood of extinction over the period from 2000 to 2100... and to propose and keep track of bets on long-term events and stimulate discussion about the future."

The foundation also conducts "Seminars About Long-term Thinking". In fact, there's a Long Now "Meet-up" in London tonight, and Chris Skinner of the Financial Services Club recently compiled a great collection of blog posts, SIBOS discussions and comments in a document called "Introducing Long Finance".

It's quite liberating to think in terms of a 10,000 year framework, though one could get bogged down in the best way to go about it. I'm not sure it matters whether one thinks about how the world will be in the year 10,000 or 12,010 and what we might do today to ensure there actually is one, or whether you roll forward 10,000 years only to look back at what might then be considered to have been the big problems of today. In any case, it's at least a very different perspective on human existence to the one I was taught.

Of course, we already tend to this sort of analysis when we talk about landing our grandchildren with financial and environmental problems, but that's not very far in the future, and most of our institutions seem pressured for one reason or another to focus on the very short term.

For what they're worth, my own thoughts - partly reflected in earlier posts and partly in response to "Introducing Long Finance" (ILF) - are these:

1. It is critical to bear in mind that almost all significant events in history are Black Swans - surprise events that have a huge impact and which we rationalise by hindsight. As a result we should maximise our exposure to the upside of such events, and minimise our exposure to the downside (see The Black Swan).
2. We should focus on the total cost of our activities, rather than merely their immediate market 'price' - i.e. not only the retail price of petrol at the pump or the spread between savings and lending rates, but the cost of subsidies and cross-subsidies paid to each of participants in the supply chain.
3. It doesn't seem worthwhile to get too caught up in debating the rate at which certain energy sources are 'running out', when it seems likely that it will come as a surprise that they have, in fact, run out or at least become unaffordable (see above). Given the implications of running out of energy on a mass scale, any degree of scarcity is reason enough to create viable, sustainable alternative energy sources now. Otherwise we are exposing ourselves to the massive downside associated with a surprise event. This is the sort of thinking that led the Dutch government to spend €450 million building the Maeslant barrier, for example (page 6, ILF).
4. Education and health are more critical to our survival - and therefore of greater social importance - than the accumulation of wealth. But we have a tendency to let the accumulation of wealth dominate our activities from time to time. And then we get burned, either by military conflict or economic hardship (read in The Ascent of Money). We should therefore incentivise the pursuit of knowledge and good health above the accumulation of wealth. The process of accumulation of wealth should also be harnessed in favour of education and public health.
5. Migration will remain a very significant source of conflict, since population imbalances - whether caused by social policies like China's one-child policy or declining population - must result in significant relocation of people, whether peacefully or by conquest.
6. I agree that "commodities, capabilities, processes and capital" are key drivers of international tension (page 20, "Introducing Long Finance"). But I don't believe the long term issue is one of which nation will be the next global superpower. In fact, the trend may be towards the devolution of national power into regional and local power (see comment on page 26, ILF), Scotland and Wales being examples close to home, and commodities etc are not evenly distributed within most countries. So the economic challenge becomes one of matching regional/local strengths, weaknesses, opportunities and threats in terms of commodities, capabilities, processes and capital (labour included). Hans Rosling's analysis of regional human development, the rise of the "Cheetah Generation" in sub-Saharan Africa and the aid-investment dichotomy illustrated by China's involvement in that region are illustrative of this trend. Issues of fairness, inequality (page 32, ILF) and the total cost of our activities (#2 above) arise to be resolved in this context. The ideas of Bernard Lietaer and the Japanese currency of ‘fureai kippu’, that enables families to exchange time and duties in support of each others' parents and grandparents (pp 37-40, ILF) are also attractive here.
7. A focus on the eradication of "poverty" (see page 30, ILF) seems a futile as an end in itself. It should be a bi-product of prioritising education and public health over the accumulation of wealth, as well as meeting the challenges arising out of regional/local economics and migration, as discussed above.
8. Industries naturally concentrate and fragment, while customer dissatisfaction and the competitive activities of players normally considered to be in other markets play a role. This dynamic has played out in the past decade via the Web 2.0 or 'social media' phenomenon in the retail, travel and entertainment industries, for example. I've covered this in the consumer finance context already. And there are signs the markets for audit services and credit risk ratings will be next. So I disagree with Chris's contention that banks have a future as "safe keepers of information", in the way that "Apple’s iTunes, Amazon’s Superstore (it’s no longer books) and Google are all data businesses who use the rich analysis of data as their key resource" (page 46, ILF). I disagree partly because that would buck the social media trend generally, and partly for the very reason that those social media based businesses developed their rich data capability first, and are implicitly more competent in this respect than retail banks (who actually have little such readily accessible data or relevant skills and resources). Instead, the functions associated with retail and commercial 'banking' today are likely to be subsumed and concentrated into other types of businesses more closely aligned with end-to-end retail and commercial processes. Those businesses are in turn likely to fragment to create new types of service provider aligned with the regional/local economic developments, new currency models, shifts in population and so on, discussed above.

Fundsmith: Low Cost, Diversified and Contrarian?

We didn't need Terry Smith to tell us that the fund management industry is 'broken', but at least he's put his money where his mouth is. His new Fundsmith Equity Fund will have no initial charge (where typical charges are around 5%), a 1% annual management fee, no performance fees, and he says it will try to keep stock trading/turnover low to prevent dealing costs eating into investors' funds.

All well and good, but Terry gives an interesting response to a query on diversification:

"All of the research shows the standard deviation on an individual stock is approximately 49%, the market is at 19%. On 20 stocks, the standard deviation is 20%. So if you buy 20 stocks, you get 19/20ths of the diversification benefit of being in the market, so you do not need to own 100, 200 or 300 stocks to get the market diversification benefit. But the great thing about 20 is that you know what they are doing. I know there is no chance that I would be able to, in significant detail, follow the details of 100 or 200 companies."

This sounds dangerously like Terry expects that the fund's returns will be normally distributed, when surely he doesn't believe that - even if he still clings to the efficient markets hypothesis. Holding at least 20 stocks might be a start, but one would need to know a lot more about the size of the holdings, distribution by industry, geography, correlation and where the herd is in relation to each stock/sector and so on to judge whether Fundsmith fully complies with John Kay's edict to "pay less, diversify more and be contrarian."

It would be more interesting to see Terry Smith turn his hand to a fund of Exchange Traded Funds, since they offer an opportunity to pay less, diversify more and be contrarian, yet retail investors need help figuring out and adjusting to how correlated the various sectors are from time to time, and what's in or out of favour.

Of Creative Destruction, Auditors and Ratings Agencies

Among the lessons to be learned from the financial crisis, so far we've rightly heard a lot about self-restraint and more effective financial regulation. But we've not heard much about how the market for external audit services and credit ratings will change to help protect taxpayers from footing the bill for future bail-outs.

There have been many significant accounting scandals in the decade since the the Dot-com bubble burst on 10 March 2000. Enron died in 2001, eventually taking accounting giant Arthur Anderson with it. WorldCom filed for Chapter 11 in 2002, the same year the Tyco scandal broke - among many others. In 2003, the Ahold and the Parmalat scandals broke. In 2004, it was AIG under investigation, which duly restated its net worth as being 3.3% lower. Madoff's activities went on unchecked until 2008. Meanwhile investment banks packaged the riskiest types of mortgages into allegedly low-risk bonds as due diligence methodologies became outpaced by the sheer scale of debt issuance, seriously undermining confidence in the standards set by ratings agencies.

More scandals and surprise losses are on the way. Only yesterday, internal auditors at 75 major UK corporations recently confessed in a survey conducted by a major accounting firm that they are failing to stem the rising tide of fraud, and are increasingly vulnerable to it:

"The three most common types of fraud were misappropriation of assets, suffered by 31 per cent of companies, improper expenditures (22 per cent) and procurement fraud at 16 per cent. Poor financial controls and collusion between employees and third parties were seen as important drivers of fraud."

In these cases one might conclude that accounting, financial controllership, auditing and the assessment of credit risk all succumbed to the same illness. In fact, there are more similarities than differences between the activities of ratings agencies and audit firms, so they ought to share the criticism of the state of the market for those activities.

There have always been arguments about where the scope of external audit responsibility begins and ends, and whether firms who offer audit services should continue to be free to also offer accounting, regulatory and risk management advice - or, indeed, credit ratings - where they make most of their money. But the fundamental reality is that auditors and ratings agencies purport to offer to external stakeholders some verification of a corporations' activities, yet their fees are paid by the corporations they audit or rate. So there are inherent conflicts of interest to be managed right from the start. We've also now reached the awkward stage where only four firms audit most of our major corporations, including banks. And only three ratings agencies assess the risk of default on most of planet Earth's 'investment grade' securities. Worse still, in May 2010, two of the 'Big Four' major global audit firms said they were planning to launching ratings businesses.

Little wonder that the Financial Reporting Council's Professional Oversight Board believes that the Big Four accounting firms outweigh their regulatory constraints (hand-wringing we've seen before). And that the G20 leaders wish to reduce their reliance on ratings (see the October Basel Committee report), while global regulators are calling for an alternative to single-grade ratings by rating agencies (note the particular frustration of the SEC and the FSA on this front).

Worryingly, however, we are only seeing expressions of frustration from the bodies we rely upon to control the situation. Certainly, the European Commission's dithering over the stranglehold of the Big Four suggests we won't see a more robust approach in the EU any time soon.

Experience suggests that these sorts of issues are only resolved after a crisis has occurred - the process of creative destruction traced in The Ascent of Money. It is also said that industries naturally concentrate and fragment, although customer dissatisfaction and the competitive activities of players normally considered to be in other markets play a role - e.g. social finance models involve parceling loan amounts into tiny loans at inception, rather than introducing layers of securitisation.

So, eventually, life will get pretty rough for the auditors and the ratings agencies. And for the taxpayer. Again.

Slim comfort.

Image from Critter's Crap.

The Next Financial Crisis Starts Here

I laughed out loud when reading yesterday's FT article on plans for an investment fund to enable banks to "unlock" capital that would otherwise be tied up under Basel III rules. Surely a spoof?

"The CRC Capital Release Fund will work by entering into “bilateral synthetic securitisations” with banks, whereby the fund will effectively buy a small amount of exposure to the riskiest portion of a segregated pool of bank assets, cushioning the bank with a “first loss” position.
The potential capital unlocked could be large, fund documents said.
In one example, the fund could reduce money required to be set aside by a bank against a €3bn ($4.1bn) pool of enterprise loans by up to 85 per cent.
The fund is expected to make between seven and 15 deals with four to six European banks.
It is targeting an average annual return of 20 per cent over its lifespan."

Wait, don't tell me. The six European banks will all "put" a share of their interests in pretty much the same underlying risky assets into the fund, which in turn will be rated AAA by one of a few major ratings agencies adopting the same old approach to due diligence and 'audited' by one or more of the Big Four accountancy firms (which will also provide the accounting advice on how to structure the fund and how one or more of the six European banks can reduce the capital they need to hold under the Basel rules). Then a bunch of other banks - and maybe the lucky six banks themselves - will invest in the fund, directly or indirectly, attracted by the 20% "return".

And pretty soon, the same structure will be replicated throughout the whole banking sector...

Image from Globlogisation.

Social Impact Bonds: Enough Social Impact?

The "Social Investment Bank" is an interesting experiment that's taken more than three years to bring to pilot stage. Its vision is to leverage money in dormant bank accounts ("unclaimed assets") to help the non-profit sector (aka "the third sector") "to grow and meet its goal of supporting marginalised communities in a way that neither the state nor the private sector can." To leverage the unclaimed funds, the SIB will raise money from 'non-government' investors by issuing "social impact bonds" - each being "a contract between a public sector body and Social Impact Bond investors, in which the former commits to pay for an improved social outcome."

For example, the pilot project "will prepare around 3,000 short term prisoners for their lives post-release [from Peterborough prison] and will work with them to prevent a return to a life of crime... If ... re-offending drops by more than 7.5 per cent within six years, investors receive a payment [from the Ministry of Justice] representing a proportion of the cost of re-offending. The payment will increase based on the reduction in re-offending with the total cost of the project capped at £8m. Social Finance [expects to raise £5m] from social investors that will be used to pay for the services in the prison and outside in the community."

There is a bit more complexity in the way it is explained here and in the Guardian, but perhaps you get the drift.

I'm not sure that I share the reported view of "sceptics" that this is "about city slickers making a fast buck," though the board and executives have some roots in the City and are offering "commercial investors, and high net worth individuals... greater financial return as the social return improves." This is "a risky business", as the Guardian article notes, so it's probably a bit hot for you and me anyway, even on such small numbers and moving at such a glacial pace. Public sector figures are notoriously, shall we say, inexact. And, by definition, we're talking about an area where the public sector body concerned doesn't have a good grip on the situation now, and obviously will be starved of funds to monitor closely in future (otherwise, there will be duplication in resources).

If I were a sceptic, however, I might prefer to consider this initiative as consistent with New Labour's reputation for public sector financial engineering, albeit gratefully endorsed by the Coalition as a "Big Society" initiative that might partially compensate for public funding cuts, at least in the justice budget. A sceptic might also consider that the focus on areas of apparent public policy failure begs certain questions that I'm sure have already been answered, or will be during the pilot:

1. Is it purely for lack of funds that the government doesn't grasp the nettle and reform the public policy areas in question? In other words: If the bonds don't sell, will no one implement the proposed fixes?
2. Does this proposal merely allow the public sector to outsource its accountability for difficult policy areas to a special purpose vehicle?
3. Does this proposal encourage public sector bodies to dump more of their work into the "too hard" basket and hope it will be picked up by taxpayers or private investors directly? Note the irony, for instance, in the quote from "Paddy Scriven, general secretary of the Prison Governors' Association, [who] has welcomed the scheme but warned those running it not to "cherry-pick" the least difficult offenders and leave the hardline cases to the prison and probation services." Isn't it his members' job to reduce recidivism?
4. If the bonds for one type of project perform well for investors, will the government ensure the policy lessons are learned and reap the savings, or allow repeat projects/returns?

Personally, I am left with two concerns, which are really two sides of the same coin, as it were:

1. The nature and scale of the risks to capital may be hugely under-estimated, giving rise to complaints and compensation awards that are underwritten by the taxpayer; and

2. The nature and scale of the risks to capital may be hugely over-estimated, giving rise to windfall gains to investors, again, underwritten by the taxpayer.

Yes, like all investment banks, this one comes with a taxpayer guarantee. Which means we're all on the hook for this in the end, whichever way it goes.

Don't get me wrong. It's fantastic that we are getting excited about making improvements and saving costs in these very difficult areas of public policy. And we should never lose sight of the root causes of apparently intractable social problems, nor cease in trying to resolve them. I just don't see the need for all the chicanery around getting the liability for fixing them off the public books when the liability sits there anyway.

Worse still, it distracts our great regulatory minds from the real challenge of how to finance growth in the 'real economy' while the government and our ailing banks attempt to rebuild their balance sheets. To that end, rather than tinkering with yet another public sector investment bank, surely the government will achieve greater lasting social impact by clearing the way for genuinely private, social funding initiatives aimed at creditworthy people and small businesses, as well as alternative energy and other socially productive projects.

It took about 6 months to actually plan and launch Zopa, for example, and it's members generated about £100 million in the time it's taken to get the SIB to pilot phase. There are at least a dozen other examples out there, which have either launched or are in development, some of whom are no doubt engaged in needless technical analysis - as Zopa was - because the authorities lack the time or other resources to publish helpful guidance on how such platforms ought to be structured.

Image from The Tool Factory blog.