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Monday, May 31, 2010

A guest contribution

In 2003, when Bill Strauss and I started our campaign against the excessive compensation paid the managers of the Harvard Endowment, Michael Lewis was among the chorus who criticized our naive failure to understand the workings of the modern financial system. To his credit, he has since had a few eureka moments, and although he hasn't apologized, I suspect that he would if given a chance. (If anyone who reads this knows him, please pass it on.) Anyway, this rather brilliant contribution to the subject of financial reform appeared in the New York Times just the other day.

May 28, 2010
Shorting Reform

To: Wall Street chief executives

From: Your man in Washington

Re: Embracing the status quo

Our earnings are robust, our compensation has returned to its naturally high levels and, as a result, we have very nearly regained our grip on the imaginations of the most ambitious students at the finest universities — and from that single fact many desirable outcomes follow.

Thus, we have almost fully recovered from what we have agreed to call The Great Misfortune. In the next few weeks, however, ill-informed senators will meet with ill-paid representatives to reconcile their ill-conceived financial reform bills. This process cannot and should not be stopped. The American people require at least the illusion of change. But it can be rendered harmless to our interests.

To this point, we have succeeded in keeping the public focused on the single issue that will have very little effect on how we do business: the quest to prevent taxpayer money from ever again being used to (as they put it) “bail out Wall Street.”

As we know, we never needed their money in the first place, and by the time we need it again, we’ll be long gone. If we can keep the public, and its putative representatives, fixated on the question of whether their bill does, or does not, ensure there will be no more bailouts, we may entirely avoid a discussion of our relationship to the broader society.

Working together as a team we have already suppressed debate on many dangerous ideas: that those of us deemed too big to fail are too big and should be broken up, for instance, or that credit default swaps and collateralized debt obligations and other financial inventions should simply be banned. We are now at leisure to address the few remaining threats to our way of life. To wit:

1. Washington will attempt to limit our ability to exploit the idiocy of institutional investors a k a our “customers.” The Senate appears intent on forcing our most lucrative derivatives business onto open exchanges, where investors can, for the first time, observe the prices we give them. This measure — which I’ve come to call the “Making the World Safe for Germans With Money Act” — will prove difficult to defeat. Our public strategy here, as elsewhere, must be to complicate the issue.

To the mere mention of open, public exchanges for derivatives, you should always respond, “That will destroy liquidity in these fragile and complex markets.” Most people don’t even know what “liquidity” means, or what causes it or why they actually need to have more rather than less of it — or what, even, the point is of a market that requires privacy to operate. They will assume that you must understand it better than they do. For that reason alone it is useful.

The other point you should make to our elected officials (privately, please) is that our profits function as a fixed point in an uncertain universe. If they curtail our ability to shaft German investors in one way, we will simply find some other way to do it.

Shockingly, the Senate version of the bill more or less would require us to cease to trade derivatives entirely. This unpleasant idea was introduced by Senator Blanche Lincoln of Arkansas, and it leads me to a point that is worth underscoring: We do not have a problem with the American people, we have a problem with American women. Elizabeth Warren, our TARP supervisor, continues to ask questions about what we did with our government money; Mary Schapiro has used her authority at the S.E.C. to sue Goldman Sachs. Of the four Republican senators who crossed over to vote with the Democrats, two were women — and one of the guys posed naked for Cosmopolitan magazine.

Going forward, we should discourage women from seeking higher office — or indeed, any position in which they might exert influence over our activities. More immediately, in your private conversations with Larry Summers, Tim Geithner and male Republican senators, you should simply refer to Blanche Lincoln as “unhinged.” They’ll get it.

2. Our slow cousins at Moody’s and Standard & Poor’s are likely to suffer a blow to their already lowly status. They are virtually certain to be stripped of their designation as Nationally Recognized Statistical Ratings Organizations. Whatever that means, it presents no threat to our way of life. Just the reverse: the more miserable it is to work at Moody’s, the less capable (and more manipulable) Moody’s employees will be.

The lone remaining risk to the status quo is the Franken amendment — introduced by Senator Al Franken of Minnesota — which would prevent us from personally selecting the ratings agencies that offer opinions on our offerings. It creates a board inside the Securities and Exchange Commission to assign ratings agencies, thereby removing the direct incentive the raters have to please us. (Of course, it preserves their indirect incentive: that is, that we might one day offer them jobs.)

The Franken amendment thus gums up what has been heretofore a very cleanly rigged system. In addition to encouraging public references to Stuart Smalley and Mr. Franken’s other theatrical embarrassments, we should remind our friends on Capitol Hill and in the press that “the Franken amendment will give the federal government the same control over finance it has seized in health care.”

3. There is a slight, but real, risk that public opinion will yank us in some unexpected direction. Over the past few months, a curious pattern has emerged: the more open the debate, the more radical the outcome.

In private, reasonable discussions we were able to persuade our friends in the Senate to prevent votes on amendments hostile to our interests — the worst of which, I might add, was dreamed up by yet another female senator. But the minute a vote was held, and senators sensed the cameras watching, even our friends abandoned us to the mob. All of these people are continually engaged in the same mental calculation: are the votes I might gain with this remark or this idea or this position greater than the votes I can buy with the money given to me by Wall Street firms? With each uptick in the level of public scrutiny — with every minute of televised debate — our money means less.

In the short term, we must do whatever we can to dissuade Representative Barney Frank from allowing any part of these discussions between senators and representatives to be televised. In the longer term we must return to the shadows. Do your work in private; allow your money to speak for you; and remember, the only way we’ll get the financial reform we need is if we pay for it. No one else can afford it

Saturday, May 29, 2010

American anger

The other day, on another forum, I encountered a piece from the Financial Times written by my old friend and one-time colleague, Simon Schama. Tagged as "the historian of his generation" by his British mentor when he was in his twenties, Simon wrote two outstanding, large works of political history, one on Holland in the late eighteenth and early nineteenth centuries, and the second on the French Revolution. Since then he has cultivated his interest in art, and enjoyed the new emblem of success in the historical profession, his own television miniseries, produced in Britain. This article identifies the crisis through which the western world is passing (you have to register to read it, but it's free), but uses a different analogy than the ones I've been favoring from the 1930s and the 1860s. Simon goes back to 1789, and finds a dangerously similar mood of inchoate rage, fueled by a sense of unfairness, all around the western world. The elite, here and in Europe, believes business as usual will solve any problem; masses of people do not. Here in the US anger is taking many dangerous forms, and very few people have the courage to stand up against it.

The Arizona immigration law is one manifestation. We now have two parallel economies, one legitimate, one in the shadows, and the latter has been growing while the former may even have been shrinking. Illegal immigration apparently dominates the meat-packing industry and, in much of the country, the construction industry. Illegal spheres of activity, like organized crime, always breed more illegality since their nature does not allow their employees to appeal to the law. White Americans probably do not want the jobs the illegals are doing, but they resent them anyway. This problem had been taken off the national agenda before the Depression struck during our last crisis, since the 1924 immigration act had pretty much halted large-scale immigration from just about anywhere. Today this is not an option. George W. Bush, to his credit, tried to pass immigration law, although he did so in such an undemocratic manner, dispensing with Congressional hearings altogether, that it was almost certain to fail, and so it did. We shall not see immigration reform this year.

The anti-abortion movement, which has entered a new phase, is another such manifestation. Pro-life groups have been using terrorism--defined as emotional intimidation, with or without violence, and occasionally including the murder of medical personal--to reduce the number of abortions for decades. Now several red states are passing laws forcing women seeking abortions to get ultrasounds, and Oklahoma has gone so far as to require that the women look at them. (The law has been stayed by a federal judge.)

Meanwhile the loss of faith in government continues apace, fueled by the new oil spill. It is ludicrous, of course, to blame it upon the current Administration--it reflects policies put in place over decades, as well as the erosion of any real regulatory authority in Washington. But Barack Obama now finds himself the prisoner of technological failures. In the same way that no one in authority worried about subprime mortgages, no one has taken the time or spent the money to devise a relatively quick, safe way to cap an offshore well, at least in the United States. (I cannot remember a serious spill ever occurring in the North Sea, where British and Norwegian firms have been drilling in much harsher conditions for decades. There might be a story in that.) The other night Rachel Maddow ran a remarkable feature detailing the course of a similar spill off the Mexican Coast 31 years ago. Every single tactic employed in the Gulf failed there, too, until, after three months, the company drilled relief wells. And that well was in much shallower water than this one.

A crisis, or fourth turning, generally involves an explosion of anger, and the challenge leadership faces is, on the one hand, to moderate it to the maximum extent possible (as Lincoln so wisely did), and on the other, to channel it productively, which was FDR's great gift. But fourth turnings are difficult times for outsiders and every one has witnessed acts of cruelty, often legal cruelty, against them. In 1940, a relatively liberal Supreme Court ruled 8-1 against a family of Jehovah's witnesses from West Virginia who refused to let their children salute the flag, claiming it was a violation of the Ten Commandments to do so. The decision was very unpopular, and three years later, while the country was engaged against real enemies of civilization, the court overruled itself in a very similar case. The same pattern repeated itself in the 1950s in several cases involving McCarthyism and the rights of Communists. Just last week, as I mentioned, the New York Times told the story of a courageous federal judge who has been willing to stand up for the rights of some the most despised members of our society. It struck a chord with me because I was already quite familiar with the abuse in question.

The sexual abuse of children is a terrible, inexcusable crime--even though I feel quite sure that the vast majority of abusers were abused themselves in their own childhood. People who commit such crimes against children need to be punished, and one can certainly defend the requirement that they register as offenders when released. But most Americans, I think, do not realize that federal law now provides for mandatory prison sentences for people who simply buy child pornography on the Internet to look at their computer. I have been aware indirectly of two such cases myself--I did not know the men in question, but I knew some one who did, very well. In the first case the offender escaped without jail. In the second case, about which I know a great deal more, he did not--he was sentenced to more than three years in federal prison, and served more than half of them. He was lucky--the average federal sentence in such cases is now 81 months.

Now child pornography does, of course, involve the abuse of the children who are photographed to create it, and those who make those pictures deserve severe punishment. I do not understand the appeal of such pictures at all and I certainly feel that people who want to look at them are disturbed. I understand the argument that anyone who buys them is subsidizing the industry, and would certainly support a heavy fine, and if possible, the imposition of some Internet lock. But I certainly am not convinced that there is a high correlation between looking at such pictures and actually abusing a child. I remember that when Denmark became the first country to legalize pornography many years ago, sex crimes immediately declined. And in the case in which I am most familiar, the defendant has never been accused or suspected by anyone--including those closest to him--of actually abusing a child or anyone else. Yet he served more than two years of prison time before being paroled and he will be marked for life as a sex offender. Such punishment does not seem to fit the crime, yet we all have a natural inhibition against standing up for the rights of people who purchase child pornography. To be quite frank, I have thought about addressing this question before, but I didn't have the guts.

Judge Jack Weinstein got over those inhibitions some time ago. After hearing such cases in his New York Court--most notably one involving a married father of five--he concluded that ruining people's lives for looking at pictures made no sense. When this man was convicted, he polled the jury to ask them if they would still have voted to convict had they known that the defendant would face a significant prison term under federal sentencing guidelines. When five of them opposed a prison sentence and two said they would have changed their votes, he threw out the conviction and ordered a new trial. When an appeals court overruled his decision, he found other grounds to ask for one. Child pornography collectors, he said, need treatment and supervision, not jail. He is not alone--other judges around the country, the Times reports, are also fighting rear-guard actions against these sentences--but most, of course, are not.

What generation, you may be wondering, is Judge Weinstein? He is a GI, now 88 years old. Ironically, because they spent so much of their youth in large institutions, GIs, in my opinion, had an acute sense of the need of those institutions to be fair. Most Boomers, on the other hand, simply want to make sure that the right people, from their point of view, are running the show, so that they can act at will. There can't be many GIs left on the federal bench and it won't be long before there are none.

I realize some readers may be offended by this post, but I will never give up the idea that principles like the presumption of innocence and the need to prove specific offenses by facts are rights that everyone enjoys. Society has no right to take out its fear and anger on people who have not directly harmed anyone else. Crises and the early stages of the Highs that follow them (like the McCarthyite early 1950s) are historically the periods when witch hunts occur. No one can listen to half an hour of talk radio without realizing that the raw material for another one is plentiful in America. I'm glad to be a citizen of a country where Judge Weinstein sits on the bench.

Saturday, May 22, 2010

Diogenes's quest

Increasingly the theme of these weekly posts involves, on the one hand, the collapse of our institutions, and the emergence of selected brave souls who have been willing to challenge them and speak up and tell the truth. Exhibit A last week was Harry Markopolos, who stalked Bernie Madoff for nine years. Exhibits B and C this week are the Telius foundation, a non-profit headquartered on Arlington Street in Boston, Massachusetts, and a surviving, active member of the GI generation, a New York federal judge named Judge Jack B. Weinstein, who has stood up against what is in my opinion a disgraceful federal statute even though his stance is bound to be unpopular among almost everyone. And both these exhibits involve subjects which I have given quite a bit of thought to myself.

In 2003 I was in the midst of one of my frequent phone conversations with my friend Bill Strauss, the co-author of Generations and The Fourth Turning, who since about 1995 had become a dear friend. He told me that he had heard that various managers of the Harvard Endowment were about to receive annual bonuses totaling tens of millions of dollars. Bill was a social conservative but an economic egalitarian, and he was appalled. So was I. We both belonged to the Harvard class of 1969, although we hadn't known each other then, and I recruited five or six other members to write a letter protesting these payments. That and subsequent letters generated considerable publicity.

Our original objection was based on morality and equity. First, we did not believe that anyone working for a non-profit should make that kind of money. Secondly, we didn't see how these payments could be reconciled with annual tuition increases several percentage points above inflation, resulting in a price for a Harvard education that was more than triple what we had paid (adjusted for inflation) by the mid 2000s. We were gratified when the University eventually did expand financial aid to make itself more affordable to well-to-do students but we were still troubled by the payments. I personally was troubled for another reason. Studying the limited financial data which the University would release, I could not see that its actual annual income from the endowment was rising nearly as quickly as the endowment itself was. I had also been told by a retired financial analyst that the bonuses were based on beating benchmarks which were notoriously easy to beat.

Well, the other shoe finally dropped, of course, in 2007-9, when the commodities and securities markets collapsed and Harvard lost 1/3 of its endowment. Since the managers had been allowed to put virtually all the school's ready cash into high-return, high-risk investments, the school found itself obligated to borrow short-term cash just to keep operations going. Ambitious construction projects had to be halted. It was not difficult for me to convince my surviving co-conspirators (Bill, sadly, had died late in 2007) to go further, and to suggest that the University adopt a new, more conservative investment strategy aimed at securing more modest but reliable growth in its operating income. The University never replied to us with anything but boilerplate, although the manager of the endowment has recently announced, reportedly, that some aspects of the investment stratregy has changed. The university also refused to tell us how much bonus money had been "clawed back," that is, how many deferred payments had been cancelled, as a result of the 33% loss.

The Telius Institute of the Center for Social Philanthropy has now produced a report on endowment management at six leading schools, including Harvard. Although this will make this quite a long post, I am going to reproduce the entire summary of their conclusions.

Executive Summary
Educational Endowments and the Financial Crisis:
Social Costs and Systemic Risks in
A Study of Six New England Schools
the Shadow Banking System
Over the last two decades, wealthy colleges and universities placed an increasing share of their endowments into high-risk, high-return, largely illiquid investments. During the boom times, this socalled “Endowment Model of Investing” generated impressive financial returns. Then came the financial crisis, and in the space of a year, investment losses destroyed tens of billions in endowed wealth at
colleges and universities, up to 30 percent of endowment value at some of the wealthiest schools.Mounting endowment losses have been used by college administrations to justify some of the severest austerity measures in a quarter-century: deep budget cuts, diminished endowment payouts, staff layoffs, and other substantial reductions in force and benefits. The hardship caused by these measures has rippled out in the form of lasting job loss, stalled construction projects, and local business downturns in college communities that used to be secure havens of regional employment and economic resilience.

How did universities, once careful stewards of endowment income, get caught up in the Wall Street-driven financial meltdown? Did our higher education institutions, like America’s big banks and financial companies, take ill-advised risks chasing speculative returns? Educational Endowments and the Financial Crisis: Social Costs and Systemic Risks in the Shadow Banking System looks at what happens—and who suffers—when universities embrace high-risk investing.

This report examines six privately endowed New England colleges and universities—Boston College, Boston University, Brandeis University, Dartmouth College, Harvard University and the Massachusetts Institute of Technology—as case studies for exploring deeper connections between educational endowments and their impact on our institutions, our communities, and our economy. Even after the crisis, these six schools control nearly $40 billion in endowment assets, more than 12 percent of
the roughly $310 billion held in college and university endowments nationwide at the end of FY 2009.
They are among the largest employers in their communities in the Boston metropolitan region and the Upper Valley of western New Hampshire and eastern Vermont.
Based on this sample and a review of trends in endowment management, the study’s main
findings include the following:
The risks of the Endowment Model of Investing have been greatly underestimated.
 Investment risk-taking has jeopardized the security of endowment income.
For the past two centuries, endowment management has centered on protecting the principal of endowed gifts and generating reliable income. Investments were traditionally made in relatively transparent, liquid securities such as publicly traded equities, bonds, and money-market instruments.

But in the last 25 years, many universities have followed the path of schools such as Harvard and Yale and embraced a new model of investing that relies on radical diversification of endowment*portfolios into illiquid, riskier asset classes: private equity and venture capital, hedge funds, and various “real assets,” such as oil, gas, and other commodities, private real estate and timberland.

By taking on higher financial risk, endowment managers generated high returns for a time—but at the cost of intensifying colleges’ exposure to the rampant volatility of the global capital markets. Resulting investment losses, endowment declines, and liquidity squeezes have jeopardized the very security of income that has traditionally defined what an endowment is.

 Far from being innocent victims of the financial crisis, endowments helped enable it. Much attention is rightly being paid to the role of for-profit financial institutions in the weakly regulated “shadow banking system” in provoking the recent financial crisis. But the role of nonprofit institutional investors in heightening risk in the capital markets requires much closer scrutiny as well. Given the scale of capital under their control and the academic credibility they lend to high-risk investment strategies, the influence of college endowments on financial markets extends far beyond the ivory tower.
By engaging in speculative trading tactics, using exotic derivatives, deploying leverage, and investing in opaque, illiquid, over-crowded asset classes such as commodities, hedge funds and private equity, endowments played a role in magnifying certain systemic risks in the capital markets. Illiquidity in particular forced endowments to sell what few liquid holdings they had into tumbling
markets, magnifying volatile price declines even further. The widespread use of borrowed money amplified endowment losses just as it had magnified gains in the past.
The seeming success and sophistication of the Endowment Model also encouraged other
institutional investors and their advisers—smaller endowments, pension funds, foundations, investment consultants, and asset managers—to imitate these high-risk strategies and place more assets into the shadow banking system.

Wall Street’s influence has undermined endowment stewardship.
 Conflicts of interest on governing boards weaken independent oversight of investments. College governing boards have failed to guarantee strong oversight of the Endowment Model by relying heavily upon trustees and committee members drawn from business and financial services, many from the alternative investment industry. The report begins to document the predominance of business and finance professionals on college boards and the numerous potential conflicts of interest that arise when the investment firms of trustees from the finance industry provide investment
management services to the very institutions on whose boards they serve.
To take only one example, Dartmouth’s board has included more than half a dozen trustees whose firms have managed a total of well over $100 million in investments for the endowment, over the last five years. Even when there are not potential conflicts of interest, the oversight abilities of many trustees and investment committee members seem to have diminished because of their professional connections to the shadow banking system or their corporate directorships. By working
in bailout banks, venture capital, hedge funds, private equity, and other alternative asset management firms, many trustees may be de-sensitized to the risks associated with exotic, illiquid investments that they deem “normal” business activities.

 The rise of the CIO has ratified a culture of risk-taking and excessive compensation.

The complexity of investments under the Endowment Model has spawned a new class of
highly compensated investment officers on campus. Whereas a decade ago, only one of the schools in our study had a chief investment officer (CIO), today five out of six do. CIOs and investment officers from investment banks and consulting firms are now wooed by colleges with some of the highest compensation packages in the nonprofit sector. The increasingly intertwined worlds of higher education and high finance reflect how the culture of stewardship in nonprofit endowment management has been eroded by a Wall Street culture focused on profitable investment returns as if
they were central to colleges’ institutional missions.iii
The full costs of the Endowment Model of Investing are much greater than the short-term value of endowment declines. Although they had little responsibility for endowment management or oversight, students, faculty, staff, alumni, and local communities are bearing the brunt of the Endowment Model’s consequences:
from widening pay inequity to demoralizing layoffs, hours and benefits cuts, and hiring and pay freezes; from program cuts to reduced student services; from construction delays and stalled economic development to forgone tax revenues. Because these six schools are among the very largest employers in their communities, the widening pay gap between over-compensated senior administrators and more
modestly compensated staff not only distorts pay structures on campus but also deepens social inequality within surrounding communities.

 Layoffs and reductions in force have wider negative economic impacts.
Layoffs and reductions in force as a result of endowment declines serve to magnify growing income gaps in disproportionate ways, contributing to regional unemployment and scarring communities economically in ways that are difficult to quantify. Nevertheless, the report provides conservative preliminary estimates of the regional economic impacts due to announced layoffs and positions eliminated:

o nearly $135 million in lost annual economic activity in the Boston metropolitan region
o more than $30 million in lost annual economic activity in the Upper Valley

 Program cutbacks and stalled project plans negatively affect communities.
The sudden postponement of planned construction projects, most notably Harvard’s ambitious Allston Initiative, translates into lost jobs, broken promises, and diminished opportunities for community economic development. Based solely on potential earnings from the anticipated jobs that fail to materialize from the Allston delays, the report conservatively estimates that more than $860
million in expected economic activity will be lost over the next three years. Longer delays will deepen community economic losses. Proposals to cut back educational programs and to close institutions such as the Rose Art Museum at Brandeis University have weakened community cultural development in less readily quantifiable, but no less important ways.
 Tax-exemption is costly to communities.
The public pays for colleges’ tax-exempt status in multiple ways, supposedly in exchange for the public benefits that colleges provide. The tax revenue that cities, states and the federal government have forgone because of tax-exemption has allowed college endowments to accumulate considerable wealth.
o PILOTs and Forgone Property Tax Revenue
As major property holders in their communities, the six schools in our study own taxexempt real estate worth more than $10.6 billion, yet collectively they made negotiated payments in lieu of taxes (PILOTs) totaling less than 5% of the $235 million in taxes they would owe if they did not have the privilege of their tax-exempt status. Some schools make no PILOTs whatsoever.

o Tax-Deductible Endowment Gifts and Gains
Gifts to endowment are tax-deductible to donors, and investment gains and income that
endowments generate are tax-exempt. Endowment managers can therefore rapidly trade without considering the potential tax consequences of their investment decisions.

o Indirect Arbitrage Using Tax-Exempt Debt
Tax-exempt bonds have allowed colleges to borrow at low interest rates while keeping
their endowment assets fully invested in high-risk, high-return investments. Endowments pocket the difference in yields tax free, while investors in tax-exempt bonds also receive favorable tax treatment on income. Congressional leaders and the Congressional Budget Office are exploring how colleges benefit from this indirect tax arbitrage when they use tax-exempt bond proceeds for operating expenses in order to use other investments to chase higher rates of return. Because of the excessive levels of illiquidity in their investment portfolios, colleges have increasingly turned to the bond markets for cash.

From Systemic Risk to Sustainability
The Endowment Model of Investing is broken. Whatever long-term gains it may have produced for colleges and universities in the past must now be weighed more fully against its costs—to campuses, to communities, and to the wider financial system that has come under such severe stress. The financial crisis has revealed that the risks of the Endowment Model of Investing—of volatility and illiquidity—are
much higher than previously understood, particularly when amplified by the use of leverage. This report analyzes those risks but also insists that a full understanding of the costs and consequences of the Endowment Model must go beyond narrow discussions of risks and returns merely at the level of the
portfolio. As long-term investors, colleges and universities have an important stake in the sustainability of both the wider financial system and the broader economies in which they participate. Rather than contributing to systemic risk, endowments should therefore embrace their role as nonprofit stewards of sustainability. Rather than helping to finance the shadow banking system, endowments should provide
models for transparency, accountability and investor responsibility.

The aftermath of the financial crisis clearly calls for a transformation of the Endowment Model of Investing—not simply a return to a more “conservative” investment strategy. Instead, a more sustainable endowment model of investing is needed. Endowments need to foster greater resilience in times of crisis by investing in assets with greater liquidity and lower volatility, and a portion of excess returns generated during good times needs to be set aside in rainy-day funds for the bad. But more fundamentally, endowments need to pursue “responsible returns” that remain true to their public purpose and nonprofit mission as tax-exempt institutions of higher learning. By integrating sustainability factors into investment decisions and becoming more active owners of their assets, endowments can begin to seize the
opportunities of long-term responsible stewardship.

College and university endowments were among the first institutional investors to take their rights and responsibilities as corporate shareowners seriously. In the early 1970s, Harvard and Yale developed the first campus committees on investor responsibility, which developed some of the earliest ethical investment policies for endowments. Since then, they have made recommendations for how endowments should vote their proxies on shareholder resolutions related to social issues and provided
models for similar governance structures at dozens of other schools. However, with the rise of the Endowment Model of Investing, its diversification into new asset classes beyond domestic public equities, and the increasing use of external investment managers, committees of investor responsibility designed for an earlier era have watched their relevance erode. Given the social costs of the Endowment
Model of Investing, which this report only begins to document, it is high time for colleges and universities not only to reassess risk but also to reclaim this legacy of responsible institutional investment

Now it is my belief that anyone who received a rigorous liberal arts education--as I was lucky enough to do 45 years ago--and who has continued to exercise his critical faculties, can quite easily see through the kind of professional claptrap that has infected almost every profession today. Indeed I think that belief is critical to any real faith in bureaucracy. That was why Bill Strauss (who certainly felt the same way) and I and our classmates weren't afraid to challenge these practices before their consequences became evident. Yet to be vindicated in this way by impartial analysts who obviously know the subject much better than any of us did is obviously a source of satisfaction, as well as of sorrow.

Judge Weinstein's story is equally interesting, but I have given you all more than enough to think about for one day. I shall try to post it at a later time.

Saturday, May 15, 2010

Freedom is the freedom to say that two plus two equals four

Harry Markopolos, I am proud to note, is a Boomer, born in 1956. He spends a good deal of his book on his pursuit of Bernie Madoff, No One Would Listen, trying to figure out (as I have myself) exactly what made him so different. To begin with, he credits his parents with instilling in him a strong sense of right and wrong. Secondly, in his adolescence he helped his father manage some chain restaurants, and figured out how to identify employees were stealing. Thirdly, he spent 20 years as an officer in the Army Reserves, which he joined at a pretty unusual time, the late 1970s, because he had an ROTC scholarship But lastly, he always loved math, partly, at least, because figures did not lie. That, I suppose, was the part with which I identified the most, even though I've never been quite as focused on math as he was. Everyone argued about everything in my family when I was growing up, but perhaps because I was the only one who spent a lot of time reading, I had the keenest awareness of a reality out there, beyond the confines of our house, which offered answers to questions. I had only limited success getting other families to acknowledge particular parts of that reality, but trying to rely on the facts became a lifetime habit.

In the late 1990s Markopolous was working for a Boston financial firm which had learned about the mysterious broker and (in effect) hedge fund manager, Bernie Madoff, who claimed to be running a very exclusive investment service that guaranteed a return of 12% a year. His boss wanted him to look into it because, revealingly, he wanted him to emulate his strategy, secure comparable returns, and secure some of the business that was going to Madoff. Markopolos quickly concluded that he couldn't--and that Madoff had to be running some kind of a fraud. To begin with, it was simply impossible for anyone to generate returns that were not only that high, but that consistent, regardless of the ups and downs of the market. Secondly, the split-strike strategy upon which Madoff claimed to be relying--a strategy of buying a basket of representative stocks, selling call options for them that would have to be redeemed if the stock rose and buying put options that would protect Madoff if they fell--was designed to moderate gains and losses, which was not what Madoff was claiming to do at all. The more Markopolos (and three friends and colleagues whom he enlisted in the chase) learned about Madoff's purported operation the more specific he got. He began to realize that if Madoff was managing billions--eventually, tens of billions--of dollars. If he were telling the truth, he would be executing a huge percentage of the options trades carried on in the world's markets--but he couldn't find any evidence of those trades at all. Curioser and curioser, as Lewis Carroll would say.

Now let me digress for a moment and bring up the example from my own life which parallels this one: the career of the baseball player Barry Bonds, who broke into the majors in Pittsburgh, where I was living, in 1986, when he was 22. (I apologize to readers who are not baseball fans.) Bonds established himself as a great player within a few years, but from 1986 through 1999 his performance followed the normal pattern of a baseball player. It took him about four years to reach an MVP-level of performance, including substantial, but not absolutely top-quality power. In his first 7 years he hit 16, 25, 24, 19, 33, 25, and home runs, never leading the league. Then, at the ages of 27, 28 and 29, when most players are (or, up until the last decade, were) at their peak, he hit 34, 46, and 37 home runs. The 37 came in strike-shortened 1994, when he might easily have reached 50 if the season had played out. During this period, his slugging averages--the measure of his overall power--ranged from .416 as a rookie to .624, .627 and .647 in those three peak years. Then, once again reflecting normal patterns, his home runs and slugging began to fall off as he entered his early thirties. From 1995 through 1999 (when he missed more than a third of the year) he hit 33, 42, 40, 37, and 34 home runs, and his slugging fell back slightly to about .600. The figure of 34 for 1999 when he played in only 102 games, is rather interesting, especially since that was the year after Mark McGwire hit 70 home runs. As 2000 began Bonds was 35, an age at which nearly all players are into the decline phase of their careers.

But from 2000 through 2004, Bonds hit 49, 73, 46, 45 and 45 home runs. His slugging averages established new all-time records, previously held by Babe Ruth: .688, .863, .799, .749, and .812. He also broke the all-time single season walk records by tremendous margins, walking 117, 177, 198, 148, and 232 times in those years. As I saw it at the time (and as I argued repeatedly on a baseball researcher email list), this simply could not have been done without performance-enhancing drugs. Not only were these totally unprecedented performances, but Bonds turned them in when other players, without exception, were declining, or at best staying even. (Henry Aaron, as some of my correspondents liked to point out, did increase his home-run production in his late thirties, but that was because he had moved from a pitcher's park in Milwaukee to a hitters' park in Atlanta, and because offense in general rose after 1968, just as it did in the 1990s.) And several players, like Ted Williams in 1957 (when he hit .388 with 38 home runs) had turned in single extraordinary seasons late in their careers--but not all through their late thirties. Yet those who agreed with me on the list (and there were many) generally preferred to keep their mouth shut, while others raised all sorts of absurd suggestions as to how Bonds could have done this without chemical help. Eventually the proof that I was right emerged after Bonds's drug suppliers were raided.

Now Markopolos at the same moment--the late 1990s--decided to try to expose Madoff, partly because he was drawing off so much business, and wrote the first of repeated submissions to the SEC arguing with overwhelming logic that Madoff had to be running some kind of scam. Either he was indulging in a well-known form of insider trading called front-running, taking advantage of the trades he knew his brokerage customers were about to make to get ahead of the market, or, more likely, it was simply a Ponzi scheme. Drawing on his military training, Markopolos planned his campaign carefully and tried to identify both SEC staffers and journalists who might be sympathetic. He did get some suggestive journalistic coverage in the Wall Street Journal, but he got nowhere with the SEC, despite eventually making about half a dozen submissions. The reasons for all this are fascinating. Madoff, surely one of history's most brilliant sociopaths, had created a structure that was largely self-perpetuating.

When the Madoff story finally broke at the end of 2008, attention focused on individual and institutional investors, many of them Jewish, who had entrusted him with their life's savings. Many of those stories were tragic, but they were a relatively minor part of his operation. Madoff's main source of funds were hedge funds. Hedge funds have become a huge, almost totally unregulated financial industry, and it was only from this book that I began to get some idea of what they do. Their real function, as far as I can tell, is not to find clever bets to make on stocks and other assets, but to diversify. And they do a great deal of their diversification with each other. Since they are not regulated and evidently don't have to report much of what they do, it's very hard to tell how much of the money they have generated comes from brilliant decisions and how much simply reflects the expanding market. But everyone seems to want to put money in lots of hedge funds so as not to miss out on some edge that some one may have developed. Madoff, of course, seemed to have developed the best one of all.

That was not all. Madoff also made it enormously profitable for fund managers to associate with him. When a fund brought him money, he paid it 4% of the 12% annually that he claimed to be realizing on that money, and paid 8% to the investors. Fund managers usually take 1-2% of the money invested with them, so this was an irresistible deal. And as soon as fund managers had substantial amounts of money with Madoff, they had a huge financial and emotional incentive to believe that the gains were real. Many of them clearly did not think that they were honest--they thought Madoff was "front-running", as described above, or taking advantage of other kinds of inside information. But as along as they were getting their annual 4%, they didn't care. Madoff also became a favored manager for people with money they wanted to hide, especially from Europe, where his clients included several royal families. (Prince Charles has denied he was an investor; Markopolos doesn't seem to be fully convinced of that.) But interestingly enough, there were others who, although they were not trying to blow the whistle, realized the truth. None of the big banks ever placed any money with Madoff. Neither, as far as I know, did the mangers of the Harvard Endowment.

There were many reasons, including Markopolos's somewhat abrasive personality, why he could not get the SEC to listen to him. The biggest, he came to believe, was that the SEC, which was created in a much simpler time, simply did not understand new financial instruments like options and derivatives. Secondly, he makes clear, the SEC is not in the habit of taking on major market players--it contents itself with levying small fines on smaller players. After Madoff fell, the SEC inspector general did a massive report on what had gone wrong, one that I hope to read at some point myself. Markopolos makes many suggestions for reforming the agency but I didn't have a great feeling of confidence that any of them would work. The new system is too deeply entrenched, and I'm increasingly persuaded that it is rotten to the core. That, however, will have to await another post--this one is already long enough.

Markopolos did not bring Madoff down--the mad optimism of the financial community, of which he was only one part, did. In late 2008, with markets collapsing around the world, his investors had to have their money back, and he didn't have it. Markopolos has speculated that Madoff essentially turned himself in because he had taken money from Russian mobsters and South American drug lords, who might have taken out their frustrations in other ways had Madoff not found security inside the federal prison system. Meanwhile, Markopolos has become a full-time fraud investigator, and claims to have many cases pending. We shall see how many see the light of day.

I could not help thinking as I read this book of parallels between Markopolos's profession and my own. In the last forty years academia in general and history in particular have largely abandoned the values upon which they were originally based, with disastrous results. Like the transactions of hedge fund managers, the writing done by most professional academics is useless to anyone but themselves. It pays off not in money--no one has ever made a dime writing postmodernist history--but in positions and prestige. Like the fund managers who had to buy subprime bonds because everyone else was doing it, younger historians realize they can't afford to write about politics and government because to do so will cost them their jobs. The new academia is also self-sustaining. I felt better because the collapse of academia has certainly been less serious for American than the collapse of our financial system--but I felt worse because academia lacks any self-correcting mechanism. Perhaps, a friend of mine has suggested, the crash in academia will come when young men and women and their families will start to refuse to pay the inflated price of a university education of very dubious value. I wonder.

Markopolos does not seriously address the fascinating question of what made Bernie Madoff tick. I was more interested, clearly, in what made Markopolos tick. Is he a hero? Yes--but not, perhaps, in the way most people might think. Thirty years ago, writing about citizens of totalitarian regimes, the Swiss psychoanalyst Alice Miller argued that those who resist do not really do so out of extraordinary courage--they do so because they simply are not capable of doing anything else. That seemed to fit Markopolos to a T. Mathematical proof, he points out in one moving moment in the book, is much more powerful than legal proof, which depends ultimately on a jury of emotional human beings. He was one of those who simply could not disregard the numbers. There are others like him in other fields, but it seems they will always be exceptions.

Friday, May 07, 2010

Real terrorism threats

The arrest of Faisal Shahzad, who tried to set a huge car bomb off in the middle of Times Square, was another highly revealing incident in the struggle against terror, as well as a lucky break for the United States. Americans of all political stripes, as I learn from my War College students year after year, are essentially idealistic when it comes to revolution. They nearly always think that violent revolutionaries are poor, hungry, and oppressed--in other words, that the act at least partly out of legitimate grievances for which remedies must be found. (Among the military this comes, I suspect, from the frequent invocation of Masloff's hierarchy of human needs, beginning with food, warmth, and shelter.) We also tend to believe that we are threatened by the most dedicated, radical adherents of Islam, and the Bush Administration actually launched a campaign to change conservative Muslim societies in order to make them more friendly. None of that, it turns out, is true.

I don't have the time to review the data on the 9/11 hijackers, but most of them were at least solidly middle class, and quite a few of them, critically, had already lived in the West. The same pattern has repeated itself here: Shahzad's father is a Pakistani general, and he had lived long enough in the US to become a naturalized citizen. The case of the Nigerian airplane bomber Umar Farouk Abdulmutallab was strikingly similar: his father is a Nigerian banker and he had lived here as well. Nidal Hassan, the Jordanian-American doctor who opened fire at Fort Hood, was also an American doctor. Emotionally, it seems, the most dangerous terrorists are men who have experienced modernization first hand. The harder we push modernization, one could speculate, the more of them there might be. It is interesting, too, that both Nigeria and Pakistan were once British colonies and still include many English speakers.

There is another reason why the real danger to the west comes from isolated immigrants. If one takes the trouble to read the 9/11 report, some of which I went through a few years back, one thing stands out: even before 9/11, it was extremely difficult for Al Queda to get its people into the United States, and since then it seems to have become almost impossible. And even if they could get here, buying a van, propane tanks, chemical fertilizer, and other necessary equipment requires a certain familiarity with American society and some skill as an actor. And to actually bring off a terrorist attack successfully requires considerable training and mechanical skill.

That is where we have been lucky during the last six months--neither Abdulmutallab nor Shahzad had enough training to build a successful explosive device. (The same was true, incidentally, of Eric Harris and Dylan Klebold, the Columbine killers, who would have murdered hundreds of students if their improvised bombs had gone off.) Shahzad could certainly have wreaked havoc in Times Square with an assault rifle, but he, unlike Nidal Hassan, evidently hoped to get away. A successful terrorist has to be sufficiently westernized to move among us easily, sufficiently crazy to want to kill dozens of people (and probably sacrifice his own life as well), and sufficiently skilled to make it happen. That combination remains very rare.

It is sad to note that some legal surveillance of Muslim-American and Muslim European communities seems to be necessary to look out for potential trouble, but no other conclusion seems possible. The European-American working class produced terrorists who killed a President and set off a huge explosion in Wall Street during the early decades of the twentieth century, but America survived. It does seem likely that Nidal Hassan will not be the last succcessful Islamic terrorist in the United States, and I think the President would do well simply to say so. We are not immune to small terrorist attacks, at least, any more than we are from oil spills. But it is not clear that the way in which Afghanistan governs itself has much to do with the safety of Americans now. There are far more Pakistanis and Pakistani-Americans furious about our drone strikes in Pakistan than there are Afghans likely to do any harm to the United States.

I originally posted this Friday evening. Today, to my amazement, the New York Times led with a long article on Anwar Al-Alwaki, a Muslim cleric whose jihadist cds and videos have apparnetly helped inspire all three of these terrorists. He fits the profile better than any of them: he was born in the United States in 1971 and educated in Colorado, and he led several mosques in the United States before leaving for Yemen, where he was detained for two years and is now in hiding. As the article shows, some evidence strongly suggests that he knew about 9/11 in advance, since two of the hijackers living in San Diego attended his mosque. He preached Muslim reconciliation with America after 9/11 but eventually changed his tune. Today he is apparently the only American whom US military and intelligence forces are authorized to assassinate--something which strikes me as utterly unconstitutional under the treason clause of the Constitution. In any event, his life further confirms that the threat comes from the intersection of the two cultures, not from deep within the Muslim world.

I've been reading an extraordinary and most disturbing book this week, No One Would Listen, by Harry Markopolos, the Boston-based financial analyst who tried for about nine years to bring Bernie Madoff's Ponzi scheme to the attention of the authorities. Next week it will probably be the subject of a lengthy post. I identify with Markopolos: he has a strong sense of right and wrong (and has had to wonder where it came from), and he is convinced that data does not lie. In the early 2000s I had a series of arguments on an email list of baseball researchers about Barry Bonds. No one had ever increased their home run production so spectacularly for a sustained period of years so late in their careers, I pointed out--no one, ever. Bonds simply had to be taking performance enhancers--but most of the people who posted on the topic violently disagreed with me and clung to the belief that he had simply improved his skills. In the same way Markopolos realized Madoff must be a crook, and probably the purveyor of a Ponzi scheme, as soon as he discovered that Madoff had been claiming an annual 12% return, year in and year out, in good times and bad--because no one had ever done anything like that. Yet it took nine years for the truth to emerge. How that could happen tells us, alas, a great deal about our financial community and our society, and I must finish the book and think it over. Stay tuned.

Saturday, May 01, 2010

Liberty vs. authority

One of the great dramas of western history is playing out before our eyes--one which could conceivably compare, centuries hence, to the fall of the Roman Empire. For the second time in a century, the whole edifice of western civilization threatens to break apart. When nineteenth century civilization collapsed in large parts of Europe in the early twentieth century--first in the former Russian Empire, and then in Central Europe--totalitarian movements with contempt for human life filled the vacuum. The US intervention in the Second World War saved western Europe for a new and enhanced form of civilization, and the ravages of time eventually put an end to Communism. Europe, which had suffered so much from the cataclysm of 1914-45, responded by putting aside the national antagonisms of the previous three centuries, a process which reached its climax a little more than ten years ago with the creation of the Euro. Now a new economic crisis and the coming to power of European generations that have grown up in peace and affluence are threatening that achievement, while in the United States the whole idea of authority is coming under a new attack that threatens to tear parts of the country apart while making it impossible to cope with our own economic crisis.

My current research, as I have mentioned before, deals with the American response to the world crisis of 1940-1, and will focus largely on the almost unbelievable organizational effort that enabled us to win the war in Western Europe and the Pacific and create the world in which I have my whole life. Yesterday I had to lecture on the long-term impact of the Vietnam War, and pointed out that it turned out to mark the end of an entire era of warfare, and, in a sense, of civilization. It was the last major war fought with draftee armies and using massive, indiscriminate firepower, including bomb tonnages many times those of the Second World War. A new generation, it turned out, was unwilling either to submit to conscription or to tolerate destruction on that scale. In succeeding decades the American military, as a percentage of our (and the world's) population, has gradually shrunk until it is only marginally larger than it was in early 1940, when the US was effectively disarmed, at least on land. The military we have relies increasingly on precision weaponry, which, although it still kills innocent people, kills them by the dozens rather than by the thousands. And the United States in this respect has led the way. By the same measure of proportion of population, the armies of the world's other leading states, including China, India, Russia and the nations of Europe, are even smaller than ours. By historical standards the only remaining heavily militarized nations are the two Koreas, Israel, Syria, and Saudi Arabia. And for some time the United States has been the only nation to regard war as a normal instrument of national policy--and our recent wars have been designed to stabilize non-western states.

In the 1820s, when Clausewitz described a similar decline in the size of European armies and the role of warfare during the 19th century, he remarked, "All the world rejoiced at this development." In the same way, I still believe that we should rejoice at the one we have lived through. The dream of peace among industrial nations inspired millions in the early twentieth century, especially in the United States. It did much to bring about American entry into the First World War, and its evident failure after that war turned many Americans into non-interventionists when the Second World War broke out in Europe and Asia. After 1945, and for 45 years, Americans argued bitterly over whether peace with the Soviet Union and Communist China was possible, and prepared for the most destructive war of all, one that never came. But then, to paraphrase Pasternak, as suddenly as the appearance of the leaves in spring, the threat vanished in the 1990s. The terrible ethnic wars of the Balkans in the 1990s were, in a way, a measure of how far the industrial nations had come in 80 years. The outbreak of those wars represented a breakdown of law and civilization, but this time--unlike in 1914--the Russian, German, French and British governments saw no need to become involved in them themselves, with the single, brief exception of the Kosovo war in 1999, by the US.

It will be a great achievement if we can get through the next two decades without a major war, and I think it is quite possible that we could. I will be quite happy to die without ever seeing the world's richest nations once again mobilize their youth by the millions for another series of immensely costly conflicts, probably involving the use of nuclear weapons. But the ebbing of governmental power that has had other far less inspiring consequences as well, suggesting that we still face an enormous challenge of finding a workable balance between our enhanced liberty and the authority we need.

Here in the United States, an Administration that is simply trying to fix a few of our crumbling institutions--such as our financial markets and our health care system--faces a sustained, ferocious attack from about 45% of our population and the most vocal segments of the media. Meanwhile, deregulation has made certain corporate interests (including the big banks and health insurance companies) sufficiently powerful, it seems, make it very difficult, if not impossible, to institute effective reforms. Thirty-five years of endless anti-government rhetoric have made quite effectively discredited the idea that government can provide an essential counterweight to private power. The federal government has also failed to write laws reflecting the reality of immigration into the United States, creating both an underground economy and another source of popular resentment, one into which state and local politicians are beginning to tap, as the new law in Arizona shows. In much of the country basic public services are threatened by the combination of the anti-tax movement and the economic crisis.

Although Europe is also suffering severely from the economic crisis, its political crisis is nowhere near so far advanced as ours. That is because Western Europe took about a decade longer than the United States to emerge from the Second World War, put its new institutions on a secure footing, and start its generational cycle over again. (This is very clearly reflected in European birth rates. No baby boom occurred in Europe until the late 1950s, and even then it was much more modest than our own.) But postwar Prophets like Brown, Sarkozy and Angela Merkel now rule Europe, and it is not clear that they can keep their parents' institutional achievements alive. The Greek financial crisis has aroused voices in Germany arguing that the Euro was a mistake, since it made German economic health and financial stability hostage to the behavior of less responsible nations in other parts of Europe. Merkel herself, in a dreadful failure of leadership, allowed the situation to drift for weeks in hopes of getting through a key local election first, and thus has made it much worse. Britain is likely to elect a hung parliament for the first time in 87 years (interesting number, that!). The new democracies created in Eastern Europe in the 1990s have fared better than their counterparts from the 1920s had at this stage, but those created out of the former Soviet Union have not done well at all.

I have been reading about previous crises all my life, well before Strauss and Howe put them all in historical context. George Orwell despaired of the future of Britain and of the world in 1938, and Harold Nicholson documented his increasing despair during the winter of 1939-40, as well as his excitement when the catastrophe of France's fall drove Britain out of its funk. Solzhenitsyn spent the last twenty years of his life trying to document the collapse of his own country during the First World War, a tale without a happy ending. The financial collapse of 2008 was not enough, as it turned out, to overcome our inertia, or Europe's. But these are early days yet. Meanwhile, in six weeks, a new World Cup will begin in South Africa. I often wonder whether professional sport has provided a healthier outlet for the emotions that in earlier centuries fed enormous wars. Unless and until, as in 1940, the Olympics and the World Cup need to be adjourned for a dozen years, we will still be living in a period of relative peace.