Thursday, June 09, 2005

Finance Science

The Cost of The Absence of Money

I've often thought that the mismanagement of large sums of money is the worst crime. So much effort by so many people goes into the aggregation of wealth and so much suffering is induced by its absence that financial crimes can be among the cruelest. There are tipping points where the amount of money available can make a big difference in people's lives.


Say, for instance, that a certain hospital has a secure endowment. It has been in operation for a hundred years, has a distinguished history and a handful of specialties that keep its name in the literature. The hospital has a large inner city clientele, most of which can pay at least some of the bills. At some point, an auditor discovers that a lot of the old bequest accounts have been drained to pay the inflated salaries for an executive team that came aboard a few years ago and recently departed. Perhaps no laws have been broken, but it is apparent that the endowment is no longer able to generate the kind of cash flow necessary for basic maintenance.

So what happens? The new management cannot find enough of the kinds of efficiencies and service reductions that had kept the place going in the past. To make the best of a bad situation, they eliminate most of the staff, sell off most of the campus and dedicate the remaining funds to support a small clinic. With the original funding, they might have kept the big facility alive for another ten or even twenty years, but it’s the best they can do now.


The local impact is that hundreds of older patients will now have to travel, perhaps an hour, by city transit to another facility. The clinic handles emergencies and such, but chronic patients, diabetes patients with limb deterioration, dialysis patients, emphysema cases, may have to go elsewhere. A certain portion of these folks will give up and die. The other patients may well decide to get treatment less frequently. Some of the diabetes patients will lose limbs as a result. Dialysis patients will spend a lot more time feeling sick and can expect a shortened life span. Most of the staff will find jobs elsewhere. Some won’t. Some will have to leave behind relatives who will suffer to greater or lesser degrees from the lack of support. The man who sells hotdogs on the corner is making a lot less money. His wife is one of the diabetes patients. They don’t run the air conditioner any more so they can save some money. The man who sells papers in the street can’t quite get enough money together for a visit to the dentist. He’s grumpy all the time and won’t let the neighborhood kids help him anymore. Sometimes they hide his papers in the morning.


There are more examples of what happens when the CFO cheats or errs than I can enumerate. Let’s talk about the Orange County derivatives fiasco, the collapse of Enron, pension defaults, stock bubbles, real estate frenzies. I imagine you have your own relevant experiences. The common theme to these rolling catastrophes is that financial errors make people suffer and nobody calls FEMA.


Everybody has a different explanation for why these things happen. When I read anything related to finance, I could easily be convinced that it’s due to lack of intelligence. The Science of Finance has developed to a point where it reads like Quantum Mechanics. The incorporation of the Black-Scholes formula into hedge fund investing is the best example of this analytic surrealism. Nevertheless, I think most people would insist that these failures have something to do with human nature. An article from CFO Magazine, by Stephen Brown, (by way of Alan L. Nelson) seems to have found a piece of the puzzle. Apparently rogue traders have a tendency, possibly innate, to "double up" after they make a loss. That is, they increase the size of the next risk to cover the previous losses. His solution: keep a closer eye on these guys.

6/9/2005 4:41 PM

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At Friday, June 10, 2005 1:26:00 PM, Blogger mal said...

The problem with financial raiding I think is more cultural than structural. In Business schools you hear talk of the "voices of the company", community, employees, owners and customers. The reality is that management runs organizations for the seek of management. The voices are at best annoyances that need to be mollified. Hence the run up to the Enron fiasco, Kozlowki raiding Tycho the Lincoln Savings disaster. What I find especially worrisome is how many organizations interlock their directorships. What is the saw about back scratching? It also seems part of Business Machismo does not include anything resembling ethical behaviour

I do enjoy your posts. Please keep them coming


At Friday, June 10, 2005 1:26:00 PM, Blogger mal said...

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At Friday, June 10, 2005 10:16:00 PM, Blogger jj mollo said...

Thanks much Mallory. It's nice to have encouragement.

I think the business schools do try to instill ethical standards, but it's hard. The most successful ones are the least inhibited, the biggest risk takers. It's hard for boards to really hold the reins over a rock-star CEO. They're all great salesmen and often charismatic. The first thing they say is, "I have to have freedom to make decisions. I can't have anyone second guessing me every ten minutes."

Board selection is a whole other issue. I don't know much about it, but I've seen some sad cases.

At Sunday, June 12, 2005 6:49:00 PM, Blogger mal said...

You are correct that many business schools do discuss ethics in the curriculum. The one where I did my grad work did. Interestingly, the prestigous State run University across town did not. Go figure. I wonder about Harvard and some of the other "pressure cooker" schools. We must also consider the characters who drive to the top for those positions. Is trying to teach them ethics akin to planting corn on rock?

At Tuesday, June 14, 2005 10:35:00 AM, Blogger jj mollo said...

Maybe not on rock, but at least shallow soil. Consider the number of kids who cheat in school. The book "Freakonomics" makes a good case that even teachers cheat. We teach contradictory goals. Win at all costs, but do it honestly. When someone who is used to winning is confronted with a possible failure situation, it is unreasonable to expect honesty. I admire those unreasonable people who demand it, but you can't divert the stream with a few shiny rocks.

The thing I like about the Finance article is that it explains the real world of business, a certain part of business anyway, by using systems logic. A tendency to gamble using a particular methodology, will engender initial success, but eventual catastrophe.

The natural selection process of business is blind. It accepts specified results without regard to strategy. Knowing that fact gives us a way to change the filter. For society to use its money wisely, it needs to get smarter, and we start by asking honestly why things go wrong.

Just saying that people are crooks doesn't do the job. We have to ask why are they crooks and what kinds of crooks are causing the most damage.


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