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Wednesday, March 7, 2018

Comments On "Skin In The Game"


Skin in the Game: Hidden Asymmetries in Daily Life is the latest instalment of Nassim Nicholas Taleb's Incerto series, which is "a combination of a) practical discussions b) philosoophical tales, and c) scientific and analytical commentary on the problems of randomness, and how to live, eat, sleep, argue, fight, befriend, work, have fun, and make decisions under uncertainty" (description from the Introduction). This article is a limited review of some of the aspects of the discussion of the book that relates to economics and finance. My beat is bond market economics, I am not here to offer advice on how to live, eat, sleep, etc. As a result, my discussion here is not really enough information to decide whether to buy the book or not, instead, I am just discussing a few points that intersect with the subjects I normally discuss.

Book Description


Skin in the Game was published in February 2018, by Random House, and the hardback edition is 304 pages (I read the Kindle edition, so I do not have page numbers to reference). It follows on previous highly successful books, including The Black Swan and Antifragile.

The book is largely non-technical, although there is a technical appendix with some theorems on probability. Reading those equations was painful in the Kindle edition, which is a typical problem. The only way to get readable equations on a screen is to use the equivalent of the PDF format, but that limits the devices that can be used to read the book.

As a disclaimer, I did not read the entire Incerto series. To say that Nassim Taleb has a strong personality is an understatement, and it shows up in his books. His style is obviously popular, but his earlier books were not my cup of tea. However, I enjoyed reading Skin in the Game more than the previous instalments, but I cannot explain what I found different in the writing style.

To be clear, I agreed with a lot of the discussion in the book. I am just highlighting a few sections where I had some disagreements.

He refers quite often to "bull***t detectors," I would have preferred the Mad Magazine styling: "bull%$#* detectors."

Basic Thesis

The basic idea behind the concept of "skin in the game" is well known; Taleb therefore explains the concept relatively quickly, then moves on to the broader implications of the idea. I would summarise it as follows: society needs to ensure that decision makers share in the negative consequences of bad decisions. If people make too many bad decisions, they will then be effectively eliminated. For example, if the people making the decisions to launch a war fight on the front lines (as did the Roman emperors), they will not be able to lose more than one badly thought-out campaign. The key is to have evolutionary pressure on institutions; they need to survive. Furthermore, anything that survives obviously has some merits to deal with uncertainty, no matter how silly it may appear to rationalist outsiders.

He underlines that "skin in the game" is not "incentives" as they came to be defined by economists and corporate behaviour theorists. The top of the corporate hierarchy makes out like bandits if things succeed, and face very few penalties if things go wrong (as Taleb points out, they will now scream "Black Swan!"). The incentives are asymmetrical; they have no skin in the game.

Taleb spends a good portion of the book skewering targets who do not have skin in the game. Academics, economists, and American foreign policy "experts" are popular targets. He even names the strategy of getting highly visible benefits (and highly rewarded) while burying the risks (which when materialise offer no downside) the "Bob Rubin Trade." The list of targets is impressive, although perhaps too large. In Table 2 in the "Appendix: Asymmetries in Life and Things" he lists "Copy Editors" as having no skin in the game. A copy editor does what most people call "proofreading,"* and to do the job properly, they need to be aloof to the text they are examining. I used to act as a "technical copy editor" for other publications, and so I am familiar with the procedure. (I was not the person to worry about grammar, rather make sure that the technical jargon was correct.) One trick was to read paragraphs backwards, so you focus on whether each sentence is grammatically correct. If the copy editor is swept up in excitement with the narrative, they miss the typos. In fact, I spotted at least one glaring typo in Skin in the Game, so perhaps the copy editor got some revenge.

Taleb's philosophy leads to a small business oriented libertarianism: entrepreneurial firms are led by owners who will be punished by the consequences of failure. Federalism is preferred, as it prevents meddling by centralised bureaucrats. I am a Canadian prairie populist, and end up with a similar bias. Although socialists were an important part of prairie populism, the broader movement favoured small western businesses and farmers (versus large eastern firms), and the Federal government was viewed with suspicion (since it was dominated by easterners). As a result, I am generally on Taleb's side versus his targets, but this may not be the case for other readers. (For example, fans of Hillary Clinton might object to his referring to her as "Hillary Monsanto-Malmaison.")

One of the interesting sub-themes is the book is his description of how "intolerant" minorities can push their preferences on majorities. One example is the question of kosher (or hallal) certification of food. Those who do not follow kosher dietary rules generally do not have objections to eating kosher food, and so it often easier to satisfy everyone by getting the kosher certification. He argues that this effect will eventually do in GMO food (he apparently has had a running battle with GMO supporters). I am sympathetic to that view, but the cost differentials between "organic" versus industrial agriculture still appears to be a barrier.

The Problem of Large Corporations

Taleb is critical of large firms. He recognises that most employees do have skin in the game: the cost of failure is losing their job, possibly making them unemployable. He describes how firms trap workers in the expat category by paying them too much and offering benefits that are not available at home (described in "A Curious Form of Slave Ownership"). This makes their entire life revolve around pleasing the firm, since the loss of those benefits would be too painful to bear.

Therefore, the problem is not "skin in the game," rather it is the ability to make decisions. He writes in "Do not Rock Bureacratistan":
People whose survival depends on qualitative "job assessments" by someone higher of higher rank in an organization cannot be trusted for critical decisions. 
In summary, the criteria for judging success are no longer aligned with the true economic interests of the firm. Smaller firms do not allow such organisational drift (or else they fail).

My concern with this is that the corporate structure is inherently far more efficient than small firms. This efficiency can cover up a lot of incompetence, as argued by Scott Adams. Although one can wax nostalgic about mom and pop stores and restaurants, they are being steamrolled by big chains. Sure, there are areas where small firms may have an edge (for example, hedge funds, more on which below), but dominance by multinationals in many segments is unlikely to be reversed. Complaining that these firms are fragile does not really matter; if they fail, they just are replaced by a less incompetent large competitor.

Economics and Forecasting

Taleb is not happy with economists and strategists who do not put their money where their mouth is. From the Introduction:
Don't tell me what you "think," just tell me what's in your portfolio.
I do not give forecasts or investment advice -- for legal reasons. The legal framework developed countries have evolved towards make sense, and it has arguably survived for good reasons. So I do not feel particularly constrained by them.

In any event, I took the opposite view from Taleb when I was working as an analyst. I could care less what strategists thought about markets; what mattered was the opinions of the people on internal investment committees. I was not looking to replicate some guru's portfolio; I was being paid to pretend to be a guru myself. (To be honest, I presumably was not viewed as such.) What I wanted was good reasoning for both sides of a trade, so that I could recycle what I needed. Someone who is just talking their book in a repetitive fashion was practically useless.  As a result, the format in way investment advice is usually given was perfectly suited for my use.

Finance

Taleb worked at a bank, then moved to set up a hedge fund. He discusses at length the differences between bureaucratic banks (with their "Bob Rubin Trades") and hedge funds. Since hedge fund founders commonly have 50% of their assets invested in their own funds, they have skin in the game.

Like many commentators, he dumps all of the lines of business of a modern bank under the single rubric "banking." In particular, he is mainly complaining about the setup of the capital markets divisions of universal banks, as well as investment banks. However, there is no reason why banks have to incorporate a capital markets division; in fact, this was prohibited as late as the early 1980s in Canada (less sure about the timing for other countries).** Instead, the financial system was segregated into distinct "pillars" -- with the objective that capital markets distress would not spill out into the wider banking system. This segregation was eliminated by libertarian-leaning economists who argued that this regulation was hampering growth. All of the problems that Taleb identifies were predicted by the people who opposed financial market deregulation.

Furthermore, investment banks generally morphed into public corporations from being partnerships. Partners very much had skin in the game, and acted to keep risk within limits. However, public firms have an advantage for raising capital, so there is no way of turning the clock back -- other than intrusive regulations.

The following passage in the section "The Bob Rubin Trade" is curious:
The good news is that in spite of the efforts of a complicit Obama administration that wanted to protect the game and the rent-seeking bankers, the risk-taking business started [emphasis mine - BR] moving toward small independent structures known as hedge funds.
Started? A reader new to finance might interpret that passage as saying that hedge funds were somehow an innovation that developed after the Financial Crisis. In fact, they have been a major player since the early 1990s (albeit the first firms started much earlier), and the 1998 crisis revolved around a very large hedge fund - Long Term Capital Management.

I do not pay much attention to the hedge fund industry, but the internal consensus of the industry when I left in 2013 contained considerable skepticism. Hedge funds may have bounced back after the crisis, but that reflects the fact that the industry got annihilated during the crisis. They were dropping like flies, and that is what kept prices away from any sensible fair values for months.

My portfolio mainly holds index funds -- which are managed by boring, bureaucratic entities that do not make any claims about performance. Efficient index portfolio management is not trivial (I worked on index management tools), but it pretty much turns into a rules-based approach. The sad fact is that the average hedge fund did not perform any better than those index funds over the long haul after fees. In other words, having skin in the game is not a magic performance elixir.

Interestingly enough, I did not spot any reference to securitisation or collateralised debt obligations (CDO's) in the book. I first saw extensive reference to the phrase "skin in the game" in discussions of the failure of the securitisation/CDO "originate to distribute model." The argument was (and I agree) that lenders dumped the credit risk created by risky lending too easily onto the securitisation market. The argument was that the originator of loans has to retain some of the riskiest exposure to the loans (the equity of the CDO) in order to align its interests with the buyers of the senior tranches of the CDO. One may note that hedge funds were the main facilitator of the CDO market; the decentralised model of "two guys and a Bloomberg terminal" of quantitative credit hedge funds were the first wave of casualties of the Financial Crisis.

Very simply, commercial banking evolved over centuries to deal with the known problems of animal spirits and liquidity crises. Bailouts by a lender-of-last-resort is an inevitable feature of the system (as I discussed here). Obviously, if you own a lot of deep out-of-the-money put options on banking stocks, this is not to your advantage. However, society has a lot more interest in avoiding the collateral damage created by a financial meltdown than delivering profits to options buyers. The boring bureaucratic structure of banks -- and the avoidance of mark-to-market accounting (a heresy in hedge fund space) -- is what allows the system to generally survive. Yes, traditional banks can get overly exuberant, and we end up with a zombie banking system. However, the system can avoid the meltdowns associated with market-based short-term lending.

Concluding Remarks

Once again, I want to highlight that I am just responding to a few of the comments within Skin of the Game, I am not attempting to deal with the larger questions he raises within the book. I am not the person to come to for spiritual guidance. (My advice generally runs along the lines of "get off my lawn" or "get a haircut and get a real job.")

Footnotes:

* Technically, a proofreader compares a typewritten manuscript -- that was already examined by a copy editor -- to a printed proof that was laid out by hand. Since publishers now work with digital files, there is no manual transfer to set up printing, and "proof reading" is generally not required. (At most, the printed copy needs to be examined to see whether there was some technical issue in transmission, or if there are some technical defects that affect formatting.)

** Banks always needed a Treasury to trade position-making instruments, such as Treasury bills, as part of liquidity management.

(c) Brian Romanchuk 2018

5 comments:

  1. Hedge funds these days look a lot like AUM farmers to me making a very nice living off the fees and delivering lower returns than an equity index fund but with that lower volatility that the industry obsesses about. Is it really worth it though?

    ReplyDelete
    Replies
    1. To top it off, you need to have experts to do due diligence on the fund (unless you can get into a famous fund that’s been around fir decades). It’s easier to just run off with client’s money than it is to get a good performance. So paying your due diligence people also cuts into your returns.

      Delete
  2. I may be wrong, but I believe that the minimum capital requirements (minimum shareholder equity) is a way of guaranteeing that banks have at least some “skin in the game”. The higher the capital requirements are, the higher is the “skin in the game”.

    Actually, there are a lot of research material concluding that the higher the shareholder equity ratio (the more “skin in the game”), the lesser is the probability that the bank will go broke. Maybe bankers take extra care when their skin are in the game. Maybe they manage risks better when there is skin in the game.

    ReplyDelete
    Replies
    1. Sure, the *shareholders* have skin in the game, but the people who make the decisions don’t. At worst, they have locked-up shares or options that expire worthless. Sure, they’ve brought in rules in to claw back bonuses, which does address Taleb’s arguments.

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  3. Kinda sad to hear you read a book by this crank haha

    ReplyDelete

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