Nostradoofus

What is transparency?  Even the most dogmatic laissez-faire advocates acknowledge it is necessary to efficient markets, but rarely define it. The usual definition is simply to make more information publicly available.  But this misses a fundamental observation: complexity diminishes transparency.

To appreciate this, consider an example we have all experienced.

In the past year, you have probably clicked through dozens of license agreements in various software programs and Web pages.  For example, on a Mac you clicked through more than a dozen agreements last year simply to run system software upgrades.

These are binding contracts.  But have you read all of them?  Any of them?

Of course not. There isn’t time. It could take 100 hours a year — about two weeks of work time — just to read your clickthrough agreements.  So you don’t.  Now you have a somewhat opaque business relationship with your software and Web service vendors, because the aggregate complexity of all such agreements exceeds your real-world capacity to absorb their meaning.

Similar examples include credit cards and insurance policies.  The typical homeowner has a half dozen of each, each with a binding agreement of 10,000 words or more, which is typically modified one or more times per year.  No one reads them, because no one can.

It turns out that the end buyers of mortgage-backed securities were in a similar position, but with a difference: they typically had a fiduciary duty to understand what they were signing.  Faced with the real-world impossibility of understanding the wildly complex MBS agreements — some of which are more than a thousand pages — they could have chosen not to buy.  Instead, they laid off the fiduciary responsibility to the rating agencies, simply assuming that AAA meant “safe,” as it had for the century prior to about 2004.

One could argue it was reasonable to believe the ratings, and that rating agencies blew it.  Or, one could claim (as rating agencies now do) that rating agencies were faced with the same problem:  the instruments are too complex to rate with confidence, and thus the buyer should fend for themselves.  But either way, the central problem is that the instruments themselves are so hard to understand that even professionals don’t get it.

This illustrates the complexity vs. transparency issue vividly.  By the traditional definition, MBS are utterly transparent, because you can obtain and read the entire agreement before buying.  But by any practical definition, they are opaque, because real-world buyers — even fiduciaries like bank investment managers — don’t have enough hours in the day, and possibly not enough theoretical background, to evaluate them.  Moreover, there is the well-documented psychological problem that almost everyone overestimates their understanding of complex things.

Caveat emptor?  The laissez-faire dogmatist might argue that those who don’t understand should simply not buy.  Again, true in theory, but again with a real-world, practical problem:  as MBS are currently prepared, if everyone who didn’t understand them didn’t buy, there would be no MBS industry.

“Well, maybe there should be no MBS, then!” some will say.  This is like saying, “fire is always bad because it burned me once.”  Fire is so useful that we tolerate occasional catastrophes.  Similarly, a stable MBS industry has such enormous benefits, from a capital efficiency standpoint, that we have an interest in seeing them presented simply enough to permit real-world transparency, and thus reliable ratings and comprehending buyers.  Tame the fire;  don’t extinguish it.

I conclude from this that federal regulation may want to focus on a “reasonable man” standard for simplicity in the presentation of financial instruments to certain types of buyer.  Not because careless buyers deserve it, but as a way to make complex instruments usable in the real world.

—

The widely reported “imminent economic recovery” results mainly from:

1. Record high credit card default rates
2. Record high prime mortgage default rates
3. 70-year low US factory capacity utilization
4. 35-year high unemployment, still rising
5. 65-year high fiscal deficit, accelerating
6. Doubling of oil prices in 3 months
7. Magical thinking

There is essentially no evidence of recovery.  Even a single quarter of positive GDP growth, or employment growth, or income growth.  Anything.  The market is up 35% on sheer hope.  Beware.

Nostradoofus prediction for 2010:  Web retail is increasingly offshored.

To see why, pay a quick visit to the World’s Scariest E-commerce Site.  Savor the broken English, salted with nonsequitur French and Italian.  Admire the ragged formatting and non-matching fonts.

The site claims its location is “Alabama,” but they ask 20 business days for delivery, and the domain is registered in Shenzen, China.  Er, Alabama is far from California, but not that far.

If you actually buy something at that site, as I did, you’re greeted with the chilling purchase completion message, “Dummy string.  Actual purchase completion message goes here.” You then experience two weeks of deafening silence from “customer service” before your order arrives. But it does arrive.

What?  You’re not running out to buy from this site?  Before deciding, consider this:  on my first $100 purchase there, I saved 70% off the price of an equivalent item from a US site.  Including shipping costs.

So don’t look at the site itself, but rather what this site is trying to do.  Where is that $70 being saved?  They are cutting out the entire wholesale-retail chain, and shipping directly to your door from factories in Shenzen.  This is quite interesting.

And it gets better with scale. Once they are receiving 50 or 100 orders a day, they can ship them all in one box to the US, then break them up to trans-ship domestically.  Inventory? All in China, almost free to store.  Website?  Maintained in China, nearly free.

Perhaps most interesting is that, by locating near the factories, the retailer can eliminate inventory entirely, simply buying as needed directly from the factory.  This, in turn, permits the retailer to list a vastly larger catalog, since need not actually stock anything, but has immediate access to everything.

In the most extreme manifestation, the end buyer becomes the endpoint of a just-in-time delivery system, in which retail orders directly trigger production runs in China.

Yes, there are site quality issues. For now. But I would not bet against the ability of the industrial titans of Guangdong to solve that problem.  Web vendors of imported durable goods should be squirming, because this system is inherently and vastly more efficient.

—

Ed Colligan today is officially out as CEO of Palm, ostensibly due to the fizzled Palm Pre product launch.  Perfect example of Warren Buffett’s aphorism that when a good manager runs a bad business, only the reputation of the business survives.

We routinely confuse great businesses with great leaders. For example, eBay, an unregulated natural monopoly, enjoys network effects so large that, after 1998, it would have wildly succeeded with a chimpanzee at the helm. Form that mental picture before voting in Ms. Whitman as governor.  Not to say she’s bad — maybe she’s great. But we have no evidence either way, because eBay’s strategic advantage renders good leadership almost immaterial.

As regards Palm, my opinion (as head of a top-5 Palm software developer during the peak of Palm’s popularity) is that Palm’s window of opportunity had already closed before Ed took command.

Colligan will do great in private equity.  It runs in the family:  his older brother Bud, also sharp, is a GP at  hoary VC firm Accel Partners. All longtime Palm folks who know Ed expect his best work is still ahead, now unencumbered by Palm’s limitations.

So now it’s Rubinstein’s turn to be tarred and/or feathered by Palm’s decline.  Judging from his Apple career, he is a brilliant product guy (caveat:  he’s the first Palm CEO that I’ve never met).  And Rubinstein’s own reasoning is obvious — no one can rise above VP at Apple. But Palm has none of Apple’s advantages: scale, the network effect of iTunes, retail distribution control, and the Apple brand.

Palm’s only realistic window was far earlier, ending in perhaps 2003.  At that point they had most of what Apple has now and a few things Apple doesn’t:  leading share in smartphones, multiple carrier relationships, and a huge, experienced software developer base, many times larger than that of any competitor.

That’s all gone now, and Palm is trying to scale a smooth teflon wall with its bare hands.  Maybe Rubinstein will find a career later in private equity.  It’s more forgiving, and intelligence is more predictably rewarded.

The calculus of joining a declining Palm

Palm’s executive headhunter approached me around 2004 as a potential VP of product marketing. Terrible fit, for a number of reasons on both sides. Two facets of that dialog are relevant here.

1.  Palm’s strategic options are hamstrung by its misplaced consumer ambitions

Our talks ended immediately after I proposed a product strategy:  abandon the hopeless quest for scale in consumer phones, and focus instead on ”enterprise” phones:  ruggedized, WiFi, barcode reader, high-resolution camera, and deep software API.  Acquire Symbol Technologies, the largest industrial PalmOS hardware vendor. Own the market for insurance claims adjusters, inventory clerks, security guards, etc.  Leverage Palm’s only hard-to-copy advantage — the world’s largest base of mobile software developers — with a more sophisticated OS and radically simplified software installation and update system.  (Apple did all of this a couple of years later.)

My position, then as now, was that Palm was already doomed as a consumer play, for lack of scale. Any ephemeral market share gain would be pyrrhic, because mass market consumer phones have very low margins. Motolora’s travails illustrate the problem.  Even for Apple, many times larger, with a strong brand and distribution advantages, success with the iPhone was by no means assured, and even now enjoys high margins mainly because of the network effect of iTunes.

2.  Promotion to First Officer — of the Titanic

From a career perspective, would it have been worthwhile for me to become VP of a public company in terminal decline (if offered, which it wasn’t)? Probably yes, but not at all clear.  So I can really appreciate Rubinstein’s calculus in joining and remaining at Palm.

Who knows?  Had I gone there, I might by now be settling into a comfortable semi-retirement in private equity…

—

I know of a company whose main customer service problem is the occasional angry customer who claims he or she has already left several messages, though the company has actually received none.  The compay’s setup:

1. Only one phone line.
2. Only one person answers it and picks up VM.
3. Same complaint has occurred with 3 different VM services.
4. Company uses Google VM, which keeps a record of every call.

Thus, the customer’s claim seems as if it cannot possibly be true.

The callers all have one thing in common:  they are forgetful.  How do we know this?  Because when finally reached, they have all called for the same reason:  they do not recognize the company’s charge on their credit card bill.  The company reminds the customer, who says, “Ohhhh yeahhhh.”  Every time, at least so far.

Since these customers are forgetful about what charges they have committed to, perhaps they also forget that they have not left 4 messages?  My theory is that they may have called 4 times, but never actually left a message before.  Thus no contact was made, yet the customer has a vague feeling the company was unresponsive.

Suggestions invited from this blog’s massive readership.

—

Early adopter behavior speaks volumes about the brand positions of Google and Microsoft.

With Google, the response to a new release is, “I will sign up for Google Wave immediately, lest I miss a developing trend.”  The response to a Microsoft release is, “I will delay trying Bing until proven, lest I waste time on yet another failed initiative.”

The Microsoft image develops in response to a series of failed or incoherent releases. Palm suffered the same image problem among its developers after a series of failed attempts to update its operating system after 2002.  Apple suffered the same problem during the 1990s, after repeated false claims of innovation.

The requirements for a positive brand image among early adopters are surprise and utility.  The new offering must not only work well and do something useful, but also must innovate in a direction unexpected even to industry enthusiasts.

So, for example, a product like Microsoft AdCenter is not only unsuccessful as a business, but also hurts the Microsoft brand among early adopters, because it is utterly derivative, does not work well (slow, poor browser compatibility, basic bugs in the site’s business logic), and is not useful (doesn’t generate enough traffic to be worth the hassle).

By contrast, Google develops its brand by innovating in unexpected, but useful, directions: big Javascript apps;  open APIs;  super-effective collaborative spam filtering.  Enthusiasts themselves can no doubt come up with more and better examples.

Underlying all this is the idea that early adopter branding is product-driven.  You actually have to have a good product.  You can’t promote your way to a brand in this arena.

—

Even as the industry collapses around them, some newspapers seem not to fully understand their own business.

Traditional newspapers consist of reporters (gather content), editors (judge and shape content), ad sales staff, a printing facility and distribution trucks.  Reporters and editors provide the value to end users, and the ad sales pay for it all.

Newspapers were able to charge money largely because printing and distribution costs created barriers to entry for other newspapers.  You can’t afford to buy a printing plant and fleet of delivery trucks if you don’t have circulation, but you can’t get circulation without a printing plant and fleet of delivery trucks.  That’s a big barrier.  As a result, the city paper was the only way to reach a consumer in print on a daily basis.  Local monopoly.  They charged a lot for that, and this is why Warren Buffett loved to own newspapers.

Printing and distribution costs are now zero, thanks to the Web.  This lowers entry barriers, while pushing price down to marginal cost:  zero.  That’s why Web news is mostly free, and Web ads are nearly free.  Oddly, ten years into the collapse, news industry pundits still sometimes ask, “Why are we giving away content?”  They simply don’t understand that free-ness is a microeconomic certainty, given the conditions. Google internally describes the situation very simply:  ”information wants to be free.”  That was always true, but distribution costs created the opportunity for distribution control, which pushed up prices.  Until now.

So that whole industry is the walking dead, excepting a few very strongly branded papers.  What might replace the other 500 papers that disappear?

Go back to the second paragraph and look at the list of functions performed by newspapers.  Note how only two pieces of this puzzle are useful to the reader:  reporters and editors.  The rest, from the end user perspective, was just an unavoidable cost of getting the content.

So the real question in news is how to pay for information gathering and editing.  And we already have a partial answer to the editing problem:  bloggers.

Not all blogs are collections of random ruminations (as this one is).  There is a small but growing handful of blogs that act as meta-editors for the news.

For example, Calculated Risk and Naked Capitalism, two respected finance blogs, are increasingly quoted by traditional media.  They are written by industry professionals with over a decade each of experience in their respective specialties (mortgage and investment banking).

From the reader’s perspective, these two blogs do what the city newspaper editor used to do:  edit the news.  They read everything publicly available on a given story, condense it, and tell a pithy and interesting story.  

They also have a business model.  Each has a wide readership, which lets them sell ads.  Though each author could, so far, probably make more money doing something else, there are certainly cases where bloggers are already making a living by acting as meta-editors.

In short, the editing function may be a solved problem.  Each successful news blogger becomes a sort of one-person brand.  That brand sustains a readership, which in turn sustains an ad base.  

This leaves a harder problem:  news gathering.  Currently nearly all news bloggers are parasitical on newspaper reporting.  They don’t actually fly to Geneva to talk to a banker, but instead judge the comments the banker made to a NY Times reporter. Obviously this will fail when the newspapers go under.  What will pay for content gathering?

Basically, bloggers will eventually have to pay the Associated Press, or a lightweight Web-only equivalent of AP, for stories.  This will probably work once blogs completely replace news, but we are headed for a chasm, during which newspapers and AP have laid off all their reporters, but blogs (or their proxies) have not yet hired any back.

More hypothetically, there is probably a way to crowdsource some kinds of reporting.  If 100 people send “earthquake in Karachi” over Twitter, you know there is something going on.  This solves event reporting, but not the higher-end stuff like interviewing experts.

Whatever happens, there will be a transition period in which there is very little news gathering for print.  Reporting in that period will likely be done by non-newspaper sources:  government data, subsidized reporting (BBC, CS Monitor), television, and magazine investigative pieces.  The transition period might last years.

—

The Republican Party has, for the first time in 40 years, an opportunity to remake itself.

In the 1960s, Nixon made a Faustian bargain, essentially exploiting racist frustration in the Deep South over the Civil Rights Act to lure southern Democrats to change sides. Thus began an uncomfortable but enduring coalition between laissez-faire businesspeople and relatively poor, uneducated, conservative magical-thinkers that might euphemistically be called “social issue populists.”

One could argue the Reagan Revolution was no revolution, but an incremental extensions of that same basic alliance to include one more group of social issue populists: Southern Baptists.  Again, it worked, in the short run.

This coalition won elections, but was essentially unholy, combining two completely different political philosophies into one party.  This could not last forever, so it didn’t. The laissez-faire business elite were increasingly outnumbered in their own party by populist ideologues with no interest in government, big or small.  

In the past several years, as Bush Jr.’s GOP turned shrill and spendy, it was itself abandoned by its centrist, non-ideological leaders, leaving behind mostly know-nothings.  Centrist, non-ideological Republican voters naturally followed them out the door, leaving the impotent, free-falling GOP we see today.

But there is an obvious strategic path to their salvation. One type of small government — specifically, high-ROI government, in which economical regulation enforces property rights, growth in median income per work hour, and a level competitive playing field — is still the right answer.  This position constitutes the under-represented center of American politics.  In coming years, there will probably come an opportunity to exploit frustration with a new status quo of high inflation and low ROI on spending.  The question is how long it will take for reason again to take root in GOP leadership, which is currently bush league (no pun intended), after the death or departure of most of the wiser heads.

I say this with all due respect, as a laissez-faire fiscal conservative currently without representation in either party.  Here’s hoping.

—

I usually write about bigger themes, but FYI, an identity theft method popular for years in east Asia has recently hit US shores.  

It’s very clever.  Gangsters affix their own card reader over the card slot on your bank’s ATM machine.  When you insert your card, it passes through the gang’s reader and into the ATM.  You make your withdrawal as usual, and your card comes back.  Unbeknownst to you, the gang’s reader now has your card number, so they can create a duplicate of your ATM card.

But they still need your PIN, right?  Right.  That’s why they have a video camera installed across the street, with a telephoto lens aimed at the keypad.  They simply watch you type in your PIN.  Now they have a duplicate ATM card and your PIN.  Cha-ching.

This scam has been spotted recently in Orange County, California.  Fruits of globalization, I guess.  If you see something like it, do us all a favor and call the police.  Since the scam requires so much equipment, police have an excellent chance of catching the bad guys if they know where the equipment is.

—

Proposed analytical framework for redesigning economic policy.  Common sense, but apparently not discussed anywhere else.

1.   Acknowledge history.  Current policy was essentially all forged in the 1930s. Forget deck-chair-rearranging debates about later initiatives:  the core assumptions — consumer-centrism, social safety net, regulatory structure, tax structure — were mostly crafted in the 30s.  

2.  Acknowledge changed circumstances.  In the 1930s, the United States was the lowest-cost producer of manufactured goods, the largest exporter, the largest creditor, had one of the highest savings rates, the best education system, and imported no energy.  Moreover, little was known about how to extend human life through medical technology or behavior.  All of these conditions have changed.

3.  Identify mismatched policies.  We went to a consumer-centric orientation in the 1930s in an effort to reverse deflation by unlocking America’s vast savings. Today, there are no savings to unlock, so consumer-centrism has nothing to unlock.  Securities regulation was designed around all securities that existed in the 1930s.  Many securities have been invented since then, so the old policy is unnecessarily narrow.  Medical insurance was developed piecemeal, in an era when there was very little that medicine could do.

4.  Choose one metric to optimize for.  I prefer median output per work hour, because it is simple, yet captures economic advancement and social equality at the same time.  Median productive life span might be a nice-to-have as well.

5.  Design new policies based on the above.

This leaves out some details, such as getting rid of policies that are bad under all circumstances (e.g. promoting consumer debt through tax subsidy), but the exercise will let almost anyone — even politicians — make smarter choices.