What will it be: Feelings killing reason, or reason killing feelings? JP Morgran versus Bridgewater Associates

Today’s New York Times article (http://www.nytimes.com/2012/05/27/business/how-boaz-weinstein-and-hedge-funds-outsmarted-jpmorgan.html?pagewanted=2&emc=eta1) confirms our earlier interpretation of JP Morgan’s trading loss some two weeks ago. (http://learningfromexperiencelarryhirschhorn.blogspot.com/2012/05/what-happened-and-why-at-jp-morgan.html). There were hedge funds, most notably one called Saba, founded by Boaz Weinstein, who were on the other side of JP Morgan’s trade. JP Morgan was selling credit default insurance at prices the other hedge funds believed were too cheap. “Smelling blood,” they bought, anticipating correctly that the cost of insurance would have to rise. When Jamie Dimon learned how mispriced his firm’s position was, he shut down the unit selling the insurance. As we noted, it is as if an insurance company unwittingly sold cheap homeowner’s insurance to households on a floodplain. Its potential liability would be far higher than it had anticipated

What is most interesting is how the New York Times, in several reports, has emphasized the emotionality surrounding this trade. While Jamie Dimon might have been surprised by his firm’s losing position, there was considerable conflict between the London office, which oversaw the trade, and its New York City counterpart. As the New York Times reporter writes, “The head of the London office, Achilles Macris, gained more latitude to build and expand trades from his desk in London — including the wagers that ultimately went so wrong for the bank. But, “Althea Duersten, who was Mr. Macris’s counterpart in New York and oversaw North American trading, raised objections to Mr. Macris’s outsized bet, but was routinely shouted down by Mr. Macris during conference calls between London and New York, former traders said. What’s more, the brewing tension between Mr. Macris and Ms. Duersten left traders feeling whipsawed, said one trader in New York…. At one point, Ms. Duersten called one trader into her office at the New York headquarters and told him that he would report to her, instead of to Mr. Macris, the trader said. “Achilles hit the roof” upon hearing of the meeting, the trader said, adding that he “didn’t know who to listen to.”

Interestingly, in describing Boaz Weinstein they paint a picture of a “conquistador” eager for the big fight and the bit bet. “Those who have traded against Mr. Weinstein describe him as an aggressive trader who bets big and moves fast. He values a deal more than old-fashioned etiquette. Traders tell tales of losing money to him because of split-second price differences he picked up faster than they did. While that kind of behavior doesn’t win a lot of friends on Wall Street, these traders concede that Mr. Weinstein is too big and powerful to ignore.” The article notes that Weinstein is an avid poker and blackjack player. But the article also reports that he lost $1.8 billion for Deutsche Bank in 2008, trading in, of all things, credit default swaps!

It was not supposed to be this way. One presumptive benefit of quantitative finance is that reason and caution should rule, and where necessary, rule out, emotion. There should be no place for impulses and no recourse to unexamined intuition. Indeed, JP Morgan had “value at risk” economic models, which in 2011 pegged the London unit's exposure at only $1 million less than for the firm’s much larger investment banking business. The unit’s loss of what might now be as much as $3 billion suggests that this quantitative model failed to constrain Macris’ trading impulses. But then again, Deutsche Bank failed to constrain Weinstein’s.

I have recently completed a study, based on limited but publicly available information, of another hedge fund star, Ray Dalio, and his trading style. He is the head of Bridgewater Associates one of the largest hedge funds in the word, which had assets under management of $38 billion in 2011. He has written a remarkable manifesto about his principals for living and managing. The manifesto’s central theme is, “Drive out all emotions.” The financial results are undoubtedly superb. Dalio does not try to hit home runs, he is obsessive in his search for correlations among a wide array of financial instruments, he is cautious and disciplined, and he meditates every day as a way to gain control over his feelings. He believes that markets are unforgiving and that the world is a machine.

But the culture he has created appears to be unnatural. As he reports, and as employees and ex employees report anonymously on a job board, everyone is vulnerable to being “probed” (his word) in order to ferret out their emotional responses. When a reporter from the New Yorker magazine visited Bridgewater to do a profile, Dalio readily berated an employee, called Peter, in front of colleagues for letting emotions get the better of him the day before the reporter’s visit. When, as the reporter writes, Peter protested that he felt that his integrity had been attacked that day, Dalio walked up to a white board and wrote down the word, “Felt”. The anonymous employees writing on the job board confirm that everyone is potentially vulnerable to an inquisition through which probes extract and eliminate feelings. Moreover, one employee writes that everyone is being watched with video cameras, even in areas where there are supposed to be none!

I think we can safely say that this culture stimulates paranoia. Humans are feeling creatures. The prospect of being probed to identify unwanted emotions must lead to mistrust and wariness. Paranoia may be a useful adjunct to trading; after all other traders are trying to increase their wealth at your expense. But should paranoia be all consuming, and should feelings be the identified enemy?

This split between excessive emotionality on the one side, and its ruthless suppression on the other, raises important questions about the psychological climate that trading and investing stimulates. What will it be: Feelings killing reason, or reason killing feelings?

The firing of Scott Thompson at Yahoo

The board removed Scott Thompson, the CEO of Yahoo, after it was revealed that he lied on his resume. He claimed to have a computer-engineering degree from Stonehill College in Massachusetts, which did not even have a computer- engineering major at the time of his graduation. An investor, Daniel Loeb, representing discontented shareholders who sought seats on Yahoo’s board, uncovered the discrepancy and forwarded the information to the Yahoo board. The New York Times reports that Thompson was evasive and unforthcoming throughout the process of the board’s investigation. For example, he sought pledges of support from some board members without responding to the allegations. He asked a senior executive to support him, and when the latter declined, he asked that the executive not reveal their conversation to board members. On a radio interview he elided the distinction between doing a major in computer engineering, and having a background in computer engineering by saying; “That’s really the background that I have, and it started back in my college days, and I think that’s really the wonderful part of being an engineer is you think that way.” In addressing Yahoo employees, he blamed a search firm for the discrepancy on his resume, which the search firm promptly denied. The New Times reporter, who has followed the story, wondered, “How and why Mr. Thompson’s résumé came to reflect the false claim that he had a degree in computer science remains a mystery. If the company wants to solve it, Yahoo may need to add a psychologist to its investigative team.”

Perhaps the answer to the psychological puzzle lies in Thompson's response to the revelation of the discrepancy. He appears to rely on evasion to cope with difficulty and stress. The practical gains to being evasive are readily apparent. One can create a good impression without quite lying. Hence he references his “background” rather than his major on the radio interview. One can also gain advantage without quite challenging people who control resources.  So he sought support from a senior executive but did not want board members to learn of his politicking.  

If a person learns to use evasion successfully, he is at risk of developing a certain obtuseness, a lacking in emotional intelligence. This is because he becomes comfortable getting what we wants without realistically assessing the obstacles he faces. He evades the obstacles by telling lies, white or not, and so never learns to actually negotiate his way through reality. Over time what is real and what is not take a back seat to how situations appear.  The New York Times article suggests that had Thompson been completely honest from the beginning, and had offered his resignation, the board may have refused it, if only because they had just recently fired another CEO.

One question is; what are the roots of an evasive style of acting? Since an evader is not a sociopath – he has a conscience, and can be burdened by the distinction between right and wrong --it is likely that he evades because he feels that he deserves the opportunity or the resource he wants.  But this belief, that he is deserving, is not based on a sense of his accomplishment, else why would he lie, but rather on the conviction that he has been held back, or unfairly deprived.  In other words, the evader feels entitled.  For example he "surely" could have been a computer engineer had he been offered the opportunity or had gone to a different college or had received proper guidance from adults.   This means that his “small lies” are actually righting a wrong by conferring an advantage that had been unjustly withheld. Ironically, he is correcting a moral imbalance by lying!

One question, which is of always of interest, is how do character flaws affect an executive’s performance. One answer is that sometimes these flaws may create an advantage. For example, the narcissistic executive may exude self-confidence, and the paranoid one may be detect threats sooner than others. Perhaps the evasive person succeeds, at least initially, because the politics of competition and cooperation among executives merits some evasiveness. Power is distributed ambiguously and coalitions of executives who support a strategy are not always stable. It may sometimes help to keep one’s friends, as well one's enemies, off balance. But it is often the case that as you get to the top, or to more powerful positions, Thompson was head of PayPal, reporting into the CEO of E-bay, before he became the CEO of Yahoo, these flaws  catch up with an executive, undermining or destroying his career.

What happened and why at JP Morgan

The news is filled with reports and articles on JP Morgan’s loss of $2 billion dollars on a poorly executed trade. The question people are asking is how this could happen at a bank with a very good reputation for controlling risk. In this blog entry I want to explain what happened, and provide a psychological explanation for why it happened. At its core, the story is about a game of poker between JP Morgan and hedge funds, as the former doubled down on a bad bet, hoping that the hedge funds would "fold."  JP Morgan's loss is still on paper, but as it unwinds its positions,  paper losses could turn into real money.

The story begins when the bank’s office in London, part of its Chief investment office (CIO), was buying insurance on corporate bonds that the bank owned. This insurance, called “credit default swaps,” would compensate the bank for losses, should the companies that sold these bonds go bankrupt and not be able to pay its creditors. It was a perfectly sensible hedge. It is the same as protecting the value of your house by buying fire insurance. You pay the premiums, but your house is insured.

At some point however, this investment strategy changed, and the CIO began selling rather than buying insurance. It seems that the traders in the CIO now believed that the finances of companies backing the original bonds would be improving. JP Morgan could make money by selling insurance at rates that would be very favorable to them, once it became clear that the original corporate bonds were safer than once thought. In other words, buyers would wind up paying too much in premiums. It is as if a company selling fire insurance knew that a new fire retardant was about to be introduced, so that the risk of a house burning down was going to fall substantially. If homeowners did not know this, they would wind up paying more than they had to for their fire insurance policies. Should it choose to do so, the insurance company that owned these policies could then sell them to other insurance companies, at favorable prices. While the risk of fires had gone down, the earlier, higher, insurance rates were locked in.

But when JP Morgan switched from buying to selling insurance, its previous hedge changed to what is called a “directional bet.” JP Morgan was now betting that the finances of the companies that stood behind the bonds would improve. This was a pure bet as opposed to a hedge, since it presumed an outcome that was uncertain.

How did this bet fare? Not well. JP Morgan was selling insurance on a composite of bonds, called an index. Hedge fund traders soon realized that the cost of buying the insurance with the index was cheaper than the cost of buying insurance on each bond in the index. This is called a "mispricing." It is as if the price of a bundle of groceries is substantially less than the sum of the prices of each item in the bundle. So to make money all the hedge funds had to do was to buy the insurance, lock in the lower price, and wait for prices to rise. As one trader at Merrill Lynch said, “Fast money has smelled blood.”

But prices did not rise, because the CIO traders continued to sell the insurance, effectively keeping the premiums -- the cost of insurance -- down. They were willing to throw good money after bad, effectively "doubling down" on their bet,  because they had what Jamie Dimon, JP Morgan’s CEO, once called, the bank's "fortress balance sheet" behind them. In effect, the CIO traders were like the poker player with lots of chips, who ups the ante on a bet, so that his opponents, scared by the size of his bet, will fold -- in this case, sell rather than hold onto the index.

The hedge fund owners were pissed. From their point of view JP Morgan was trading like someone who “corners a market,” and so controls the price and quantity. But since this is an unregulated, over-the-counter market, they could only complain to journalists rather than federal officials. This was how Jamie Dimon and his leadership team first got wind of the trade and shut it down. In other words, Dimon first learned of this trade and its mispricing from the newspapers.

It is tempting to think of the professionals in the CIO as rogue traders. But the office's reputation was solid. It had put on successful hedges many times before, and had even made money for the bank from some of its directional bets.  Diamond trusted the executive Ina Drew, who oversaw the unit, which is one reason that he and his top team did not monitor the trade closely. Upon realizing the extent of the mispricing, Drew did the honorable thing and offered to resign, several times in fact, until Dimon accepted her resignation. The trader directly involved in the transaction, Bruno Iksill, was skilled and talented and had a good reputation in the close knit world of Credit Default Swap traders.

Some reporters have speculated that the CIO traders were tempted by the prospect of making money for the bank, and perhaps for themselves, assuming they were paid for their performance. But the incentive system at JP Morgan was much more nuanced than this, and traders were assessed on how they managed risk, not simply on how much money they made for the bank.

I want to suggest instead that CIO traders were induced into the “game” of trading, which despite all the quantitative controls and models that evaluate risk, can feel quite personal, just as if you are playing poker face-to-face with known opponents. Derivatives trading, as opposed to trading on the stock market is a “zero sum game.” For every winner there is a loser. By contrast, on the stock market, all investors can experience an increase in the value of a share. The zero sum nature of derivatives trading makes trading feel personal since you are causing someone else considerable pain to extract personal gain. This is why the Merrill Lynch trader used the metaphor “smelling blood” to describe the contest between JP Morgan and the hedge funds. When trading switches from a discipline informed by quantitative models, to a personal contest, people are vulnerable to taking outsized risks. The markets become a game, albeit one with big stakes and personal reputations to defend. This is especially true when the number of players is small.

This hypothesis is strengthened when we consider the character of Achilles Macris, who was in charge of the London desk of the CIO, and oversaw Bruno Iksil’s trading. While this is speculative, he appears to be the kind of person who would relish a game. He once told the Financial News that he kept his personal art collection on his office walls because, "The idea is to be part of an organization that is forward looking, intellectually curious and keen to reflect passion for new ideas and creativity. We want the work environment to reflect who we are." This is not the voice of a bureaucrat or a risk modeler, but of someone who takes pleasure in putting his personal stamp on a setting. 

It is probably true that the “quants,” the quantitative modelers, are taking over Wall Street. But as long as trading is experienced as a game, the human element--with its dares, contests, reputations, winners and losers -- will persist.  

CNN in a polarized culture

The New York Times carried an article on the struggles CNN is having sustaining its television ratings. “In April 2011,” the article notes, “CNN had an average of 451,000 viewers at any given time, more than the cable news channel MSNBC’s 428,000. The month included the much-watched royal wedding in Britain. But this April, an unusually quiet month in the news business, CNN had an average of 357,000 viewers, its lowest monthly average since August 2001. MSNBC held steady with 425,000.”  Employees who are proud of the CNN brand are disturbed by the channel’s inability to beat the competition. One employee is quoted as asking, “Who is the strong leader that’s going to get us out of this thing?”

In pre-internet days, CNN was the radical upstart showing how very busy people -- think of the business traveler returning to his or her hotel room after a hard day’s work --could get the news-of-the-day every hour. This was a revolution. Moreover, during the Gulf war CNN proved that it was the go-to station for national emergencies. It had depth and presence throughout the world to provide comprehensive and immediate coverage. But this was all pre-internet. Today, people who want to stay tuned can access a wide array of websites any time and any place. CNN still shines when emergencies break, but by definition these events are few and far between.  By contrast, “the news” today is largely a backdrop for the projection of personalities such as Bill Riley, or Rachel Madow. This is why news has converged with entertainment. This is also one reason why John Stewart has been able to secure a niche for, “The Daily Show,” his wonderful blend of comedy and news.

If we think of the strategic space within which CNN operates, it appears to have two choices; make “the news the star” or make the “star the news.” The internet rules out the first, news is a commodity, and the polarization of political opinion rules out the second—left and right are already occupied by competitors. This may be one reason why CNN cannot create stars out of Anderson Cooper, Wolf Blitzer or Piers Morgan, while in contrast, Rachel Madow, of MSNBC, has become the star of the left.

But it was not always so. For those of us old enough to remember, Walter Cronkite, the famed newscaster for CBS from the 50’s through the 70’s, represented probity and cultural authority in presenting the news of the day. He ended every newscast with the phrase, “And that’s the way it is,” as if to emphasize that our collective experience, as he had just described it, had been accurately and faithfully rendered. But just as he represented the news, he was also a star. When in 1968 he turned against President Lyndon Johnson’s Vietnam War strategy, Johnson is reported to have said, "If I've lost Cronkite, I've lost Middle America.”  So in his case, the news was the star and the star was the news.

In hindsight we can see the conditions that sustained Cronkite as a cultural authority figure. There were only three major networks, they were quasi-monopolies, and along with major newspapers, there were no alternative sources of news. By contrast, market competition often drives out the company that occupies the “middle” space, so that for example, retailing is split increasingly between low-cost providers such as Wal-Mart, and high-end sellers such as Nordstrom. Should a competitor choose to situate itself between them, Wal-Mart will offer better prices and Nordstrom higher quality and better service. This is one reason Sears has had difficulty sustaining its brand.  Similarly, should CNN chose to be somewhat left, MSNBC will out perform it, and should it choose to be somewhat right, Fox will beat it.

But I also want to highlight another feature of Cronkite’s persona. As I suggested, he played the role of arbiter and representative of the truth. One of the features of a polarized political climate is that opinion displaces truth, or to put it another way, the very idea of truth is suspect. Instead, we believe that behind any purported statement of fact there is a hidden interest, and we can no longer be assured that “that’s the way it is. “

It is useful then to ask, what is the source of polarization?  It is easy to see how in an era of audience fragmentation- one consequence of the new technologies –symbols of cultural authority and national consensus, like Walter Cronkite, fade. But why the polarization?

There are of course many explanations for the latter, but I want to focus on a psychological one here.  In one way of thinking, we join up with the world around us by internalizing it. For example, we are not simply attached to our parents; we are attached to the internal representations of our parents. That is why it is said that siblings always grow up in different families. Each internalizes the same parents in a different way. So our experience of what lies outside of us is linked inextricably to the representations inside of us.

So one question is, how do we internalize a fragmented society?  One possibility is that it shows up as an internal experience of disorder or even chaos. We don’t know where we belong. That may be why Robert Putnam famously argued that today we “bowl alone,” --clubs and groups are disappearing --and Sherry Turkle suggests that our life online leads us to be “alone together.” This is speculative to be sure, but it may help explain why political discourse sounds increasingly apocalyptic. The apocalypse lies on the other side of chaos.

Seen in this perspective, joining a camp in a polarized battle helps us compensate for this experience of fragmentation. But since the experience of fragmentation is in some degree toxic, we bring to the battle the angry feelings that fragmentation induces. It is not unlike the ways in which fans of a soccer club can become a mob after a game, particularly if its team wins.  

This may shed some light on the CNN employee who wished for the “strong leader.” CNN “sits in the middle of one of the world’s most labyrinthine enterprises, ever buffeted by changing bureaucratic fortunes.” Fox, by contrast is the vision of a single man, Roger Ailes. As one reporter suggests, even Rupert Murdoch cannot interfere in Ailes’ decisions.  In a fragmented world we may hunger after strong leaders, call this the authoritarian seduction. As it positions itself as the source objective news, CNN would like to draw on the authority of a national consensus about what is true, But if this consensus is gone, do its employees instead need to subordinate to the vision of a single leader and his or her authority. And if it does this, will it then be forced to join the battle of camps in a polarized culture?

Why brands grow stale. The case of The Gap

The New York Times carried a recent report on the struggles The Gap, the clothing retailer, is facing in trying to refresh its brand. It stock price fell from $53 dollars in February of 2000, to $9.50 in November of 2008. It is now at $28, half its peak price. While it once dominated retailing by creating a clothing style that made informal dress look fashionable, it seems to have lost its sweet spot. Interestingly, a study of Gap stores, by students in a design oriented MBA program, found that they were uninspiring physically, and that the sales clerks seemed bored and disinterested. Contrasting Gap stores with competitors such as Abercrombie+Fitch, Anthropologie and American Apparel, the report suggested that employees on the front line lacked passion for the product. (http://www.nreliu.com/content/work/docs/HLiu_Gap_Proposal.pdf)

It is interesting to ask how a brand goes stale and what we can learn more broadly from this kind of experience. A beginning can be a foretelling. The Gap was founded in 1969 and was called “The Gap” because, by dressing young people in denims and jeans, it was emphasizing the generation gap. In this sense The Gap both rode and interpreted, through fashion, a major cultural movement. As the "generation gap" term suggests, this movement was expressed through the reworking of authority relationships, stimulated by the declining social and psychological distance between parents and children, bosses and workers, and leaders and followers.

This process of reworking has taken decades, and we have not yet seen the end of it. This may help explain how The Gap was able to sustain its leadership and differentiation by for example, establishing Old Navy and buying the Banana Republic, while keeping The Gap brand fresh. It was offering a sustained interpretation, through fashion, of how the meaning of authority was changing. By the year 2000 The Gap was the largest pure apparel company in the world.

So why did The Gap brand grow stale, and what broader lessons can we draw from its experience? The Times article emphasizes the decisions taken by its current CEO, Glenn Murphy who was hired by the board in 2007. Murphy had a strong background in retail, but in a decidedly non-fashionable business-- drug stores. To improve The Gap’s fortunes he focused on cost cutting, efficiency, inventory control, and promotions to increase same-store sales. Indeed, one explanation for The Gap’s troubles is that cost cutting undermined quality. As one person quoted in the Times article notes, “Finishes, washes, all the things that gave a garment more character — trims, sweater yarns, were all switched to lower-cost options.” 

But I want to suggest a different explanation. Though Murphy increased The Gap’s efficiency as a retailer, he left the fashion side of the business alone. When asked why he had taken so long, some 4 years, to put a leadership team in place on the design side, he answered, “It’s in the company’s and my best interest to allow the creative team to do what they think is right.”

Perhaps his response reflects the practice of judiciously delegating the work experts have to do, to… the experts! After all, we don’t expect hospital administrators to be the best doctors, university presidents to be the best scholars, or orchestra CEOs to be the best musicians. On the other side, these enterprises are at their most vital when there is a strong symbiosis between the creative or scientific leaders, and the organizational leaders.

One is reminded here of the relationship between General Leslie Groves, the director of the Manhattan project- the project to build the first atomic bomb- and Robert Oppenheimer, its scientific director. Groves appointed Oppenheimer despite the fact that the latter had little administrative experience and was rumored to be a “fellow traveler” of the Communist Party. According to Robert Norris, he saw in Oppenheimer a man of genius but of thwarted ambition whose drive for recognition could be harnessed to Grove’s responsibility for building the bomb. “Part of Groves' genius was to entwine other people's ambitions with his own. Groves and Oppenheimer got on so well because each saw in the other the skills and intelligence necessary to fulfill their common goal, the successful use of the bomb in World War II.”  (http://www.atomicheritage.org/mediawiki/index.php/The_Unlikely_Pair:_General_Leslie_Groves_and_J._Robert_Oppenheime) My colleague, Tom Gilmore, describes this as a symbiotic relationship between “church and state.” One hypothesis is that Murphy’s comment reflects a wish or desire that he not be held accountable for building and sustaining such a relationship.

The fashion business may be particularly demanding on this score. At its best, fashion expresses a culture’s basic questions about authority, the differences between men and women, the meaning of the body, the salience of taboos and the tension between the sacred and the profane. When fashion is linked to these underlying issues, the resulting products reflect not only a designer’s talents, but also the synchronicity between the designer and his or her wider cultural milieu. It would seem that a CEO in the fashion business should take special care to tune in to this culture, seek out such designers, and build strong relationships to them.

There is a complementary issue that is important, and that is the distinction between the “primary task” of a business and the business of making money, a distinction my colleague Chatham Sullivan emphasizes. The former focuses on how the company creates value for its customers, the latter on how it makes money by creating this value. Facing economic difficulties, a CEO can lose sight of the first and focus only on the second. Creating value is risky, but making money is predictable within limits. For example, you just cut expenses. This approach could work for drug stores, but in the world of fashion this can be a self-defeating process. This may be one reason why The Gap stores became increasingly drab, why front line employees were demotivated, and ultimately why the clothing lost its luster. The Times quotes a former Gap designer reflecting on Murphy’s leadership, “If there were six things you used to do on a T-shirt, you’d do three or two.”

We might propose that all organizations lose their romance after a certain period of time. Perhaps they have extended honeymoon periods when founders first light upon an idea and implement it through a business or delivery system. But The Gap’s experience sheds some additional light on this process. It suggests that leaders will cast their businesses as routine and ordinary to defend themselves against the risk and work entailed in keeping a business concept alive, in linking church and state, and in staying connected to the wider culture. Making money becomes an end not a means.