Wanna Build a Business? Go After a Poorly-Served Market

Seems pretty obvious, duh? Now, I know I said I wouldn't write about the iPhone again - and I'm not - but iPhone is the case study laid out by my friend Paul Kedrosky that most clearly illustrates the point I am going to make. Paul's smart piece in yesterday's Wall Street Journal titled The Jesus Phone puts its finger on the most elemental but oft-forgotten explanation of the iPhone's almost cult-like status and the ultimate opportunity for new business-builders: that the market will enthusiastically respond to a product that addresses a core need that is currently being poorly served. And in the case of the iPhone, it is addressing the complete disgust by many if not most of the people toting around mobile devices used for both communicating with others and surfing the Internet:

I'll tell you. First, people hate their cell phones. Other than making phone calls -- a downright dreary bit of business -- using phones for Internet, entertainment and pretty much anything else has been abysmal. Cell phones are best characterized as crippled, paternalistic devices best suited for people who think straitjackets are comfortable evening wear. They have horrible Web browsers, crummy screens, and obscure-to-the point-of-opacity interfaces. (After all, some of the iPhone's most hyped features, like maps, are on traditional cell phones as well. You just can't find the feature.)

But in addition to hating their phones, people hate their cell phone carriers. Hate, hate, hate, hate. The major cellular providers -- with their ham-handed "support" and fascist control of software that can run on phones directly -- are right up there with the IRS in terms of inspiring your average mobile phone user's disgust and loathing.

Right on. Cutting through all the noise (Steve Jobs' skills as a marketer, techies' love for anything Apple, etc.), this is, in fact, the bottom line. And it is not hard to analogize to other products that have erupted due to this same phenomenon, when a customer need is being met but being met in an inadequate manner:

• The rise of the Japanese auto industry by producing high quality, fuel-efficient vehicles (the need: moving from point A to point B. The problem: lousy cars that guzzle gas).

• The emergence of Google (the need: to quickly find relevant information on the Internet. The problem: too time consuming to find what it is you are looking for)

• The growth of Apple in personal computers (the need: to easily access and use a variety of applications in an intuitive way. The problem: non-intuitive operating system and user interface on DOS-based machines)

I could go on but you get the point. It is kind of Paul to knock us in the head to bring us back to what is most basic: if you build a better mousetrap they will come. If you invent a mousetrap, great, but how do you know that people actually want a mousetrap? In the case of Apple, it is irrefutable that people want fun, powerful, easy-to-use mobile devices for both communication and Web access. The fundamental risk of market need has already been borne by the mobile phone industry over the past 20 years. What they are doing is bringing the market a better version of something that already exists; a particularly low-risk, high return strategy if implemented well. And early indications are that it will be. The mobile phone industry left the door wide open for Apple, and they are simply walking through it. Makes sense, right? It does to me.

 

Hola and Bonjour - The Trip

Yes, I'm back - sniff, sniff (reaching for my hankie right now). After my longest break from blogging since becoming a blogger almost a year ago. And you'll be happy to know that traveling in Europe with my wife and boys was terrific. No, it was priceless. My wife Carin did an amazing job planning the gig, which was, essentially, a road trip across France anchored by an initial stay in Barcelona and a final stay in Paris. Different cultures. Different languages. Different sleeping/eating/partying patterns. It was good - all good. My little intrepid travelers Andrew and Ethan walked, ran, hiked, laughed, danced and whistled in and out of caves, museums, restaurants, chateaux, markets and other places too numerous to mention. And I am happy to say that we didn't step into a cab, take a bus or take a metro in either Barcelona or Paris - ever. We walked. Everywhere. Which is really the only way to get close to a city. I just couldn't believe that my boys, ages 10 and 7, could make this happen all the way. But they did, and they did it with style. Fueled by fine bread, croissant, pain au chocolate, and other treats, of course. But they did it. And I'm terribly proud of them. The only problem with our trip is that it wasn't longer. But we have a long list of stuff to do when we next hit Europe, which makes the anticipation all the more fun. Writing this will certainly bring me back, which will feel so, so good.

For those who care, here is what we did, in a nutshell:

Days 1-3: Barcelona

Stayed at the Hotel Palace on Gran Via de les Cortes. Nice. Great location for walking all over creation. Spent lots of time with family who live in Tarragona. Aside from the eating, Rambla-ing, selective museum-ing and Gaudi housing (La Predriera, Casa Batllo), we went to a cool amusement park on the top of a hill with panoramic views of the city called Tibidabo. Multi-tiered, beautiful perches for sightseeing and nice rides for kids. Also had a traditional Catalan meal at relatives of our relatives who took us in and treated us like royalty. Totally amazing. It was hard to leave Barcelona, not just because of its beauty and grandeur but because of our family. They have three kids who are ages 13, 12 and 7 and adored by my sons. It made for a very special beginning to our trip.

Days 4-6: Figures, Perpignan, Dordogne Valley

On the way to spending the night in Perpignan at La Villa Duflot, we stopped in Figures to see the Dali Museum. What a trip! The museum was perfect for the kids. Dali's whimsical architecture couples with his whimsical (and bizzare) art kept the kids (and the adults) interested and excited. We were sorry to not have more time to spend at the Dali but it was great to hit it on the way out of Spain. And La Villa Duflot was a nice place to kick it and unwind, have a great meal and catch some key sleep. It's all about truffles and foie gras in this region, and let's just say that I didn't get cheated! We also visited this amazing medieval city built into a cliff called Rocamadour, which we hiked up and enjoyed the panoramic view. Oh, and yes, I felt compelled to check my email:

I know, I know, I'm a clown. Bug off, ok? It's a disease. So, after this we stayed in this beautiful old town called Sarlat at a nice hotel called Clos la Boetie. Sarlat was home to amazing plazas and markets at which I bought fresh produce, foie gras, truffles and local wine to bring home. It was all good. Here is a picture of Andrew, Ethan and I all cleaned up and ready to chow after a day of hiking all over creation:

Saw reproductions of the cave paintings at Lascaux II in Montignac, checked out the Grand Roc cavern in Les Eyzies, and stepped back about 40,000 years in time. Great, great stuff for kids and adults alike.

Days 7-8: Rochecorbon in Loire Valley

We then drove from caves to chateaux. Amboise, Chenonceau, Chaumont, etc. Ethan ran down the bridge over the river at Chenonceau whistling "Take Me Out to the Ballgame" - not sure other visitors really understood what he was doing. Oh, well, a little slice of Americana brought directly to the Loire by my boy. Good stuff. We stayed at this interesting hotel literally built into the bluffs overlooking the Loire River called Les Haute Roches. It is a cool place in a great location but in need of a facelift. It served as a good launching pad for our various Loire excursions.

Days 9-11: Paris

Ah, Paris. We stayed on the Rive Gauche in the Hotel Lutetia, which we absolutely loved. It was the perfect place to serve as our Parisian hub for our mega foot-based excursions. I think we must have traversed 10-12 arrondisment during our stay; it was that crazy. From the Jardin de Luxembourg to the Tuileries, from the Lourve to the Pompidou, from the Musee Rodin to the Tour de Eiffel, it was a beautiful thing. We had the best hot chocolate and the most amazing sweet ever (called the Mont Blanc) at Cafe Angelina, took in a great meal at the Pied du Couchon, picked up the most amazing elephant ear and tarte tatin and munched it walking down the street from one of the thousands of sublime boulangeries in Paris, not to mention more than a few crepes purchased from street vendors who should be sainted. Ah, a nutella crepe. I could use one right now! Also, Paris's parks are great for kids. Climbing and swinging toys that brought home that point that their litigation environment must be very different than ours; you'd never see those toys in a U.S. playground for fear of lawsuits. What a bunch of bs. Anyway... Check out this picture at the Jardin de Luxembourg:

These were good times, friends. No, great times. If you have the opportunity to do the road trip Carin, Ethan, Andrew and I took in, I highly recommend it. A truly enriching life experience.

Using Stock Options as Currency: The Perils of Success

I'll admit it: I've been pretty critical of mainstream media on occasion. But Kevin Delaney of the Wall Street Journal penned an excellent piece today on the challenge Google is facing attracting and retaining talent given its scale and stock price. This is not a particularly new theme; I've written about this concept in the context of creative destruction several times over the past year. But Mr. Delaney provides many concrete and highly relevant examples of how Google is become a victim of its own success, something about which senior management is aware but has fewer levers to pull given its $500+ stock price and sexy pre-IPO companies like Facebook:

As Google Inc. exploded into a company of more than 12,000 employees, attracting a million resumes a year, the Internet giant rarely lost staff to start-ups or had prospective workers turn down job offers. Now, though, Google's magnetic pull on top Silicon Valley talent is showing signs of weakening.

Take Justin Rosenstein, 24 years old, a Google employee since March 2004 who invented its Web-site-building service, Page Creator. He joined social-networking start-up Facebook Inc. last month as a senior software engineer, and says Google's past success in hiring entrepreneurial people helps explain why it's seeing some of those people leave as it becomes larger: "That same caliber of people is naturally going to consider carefully whether it's at Google or somewhere else that they have the most potential to do big things and do them quickly."

Now, to be clear, Google's recruiting and HR department may well be the best on the planet. They have fostered a culture that is very enveloping, very supportive and very flexible for its brilliant, high-performance, creative workforce. And this is not an inconsequential lever in the face important quality-of-life issues.

It's unclear whether the latest departures will have any impact on Google's performance down the line. But the company acknowledges that creative and entrepreneurial people are the core of its success -- that's one reason Google lavishes them with extravagant free food and other perks. "If we do not succeed in attracting excellent personnel or retaining or motivating existing personnel, we may be unable to grow effectively," Google has acknowledged in regulatory filings.

But still, by having among the best, brighest, most ambitious and sought-after people in the technology world on your payroll, it inevitably comes down to the bottom line: money and a direct relationship between what you do and the payoff you get. This is very hard to achieve in a firm with 12k people and a $160 billion market cap:

Facebook, Mr. Rosenstein's new employer, is one company that professes having an easier time competing with Google for staff. Co-founder and engineering vice president Dustin Moskovitz says the 250-person start-up has managed to hire 10 out of the roughly 11 engineers who had rival job offers from Google since the beginning of the year, an improvement on the past.

"There are lot of people [at Google] who are talking about leaving now and what they want to do next," says Mr. Moskovitz.

Mr. Rosenstein says he still loves Google, but was attracted enough by the "huge potential upside" at Facebook and other factors to leave "a lot of value on the table" in stock options that had yet to vest when he jumped. After leaving, he posted a note online for friends describing Facebook as "the Google of yesterday, the Microsoft of long ago."

You know what this sounds like? Wall Street and the evolution of where money is made across the broker/dealer community. It used to be that you could mint money in the cash business. It was great! Then it got big and competitive, spreads came in, machines started doing the work of people, and the people-driven cash platforms began to wither. And then derivatives blossomed. First spreads were wide, it was the "wild west," then counterparties got more comfortable and transactions got more standardized, capital rushed in, the fun ran out of vanilla derivatives and ran into the structured end of the derivatives business. Then proprietary trading became hot. And on and on.

As capital flows into to attactive opportunities, be they companies, technologies or business lines, returns naturally compress and those opportunities need to be re-invented in order to continue their growth and prosperity. Or, as is frequently the case, the best and brightest that identified and extracted value from the opportunity in the first place move on to greener, more exciting pastures, where the direct relationship between work done and rewards received are immutable. As in entrepreneurial Wall Street groups. Or in pre-IPO, entrepreneurial companies. We're starting to see this happen with Google, which is simply a function of its overwhelming success. Will they be able to stem the tide and avoid the fate of Microsoft and Yahoo!? Maybe for a while, sure. But the inevitable weight of success will hamper them more and more over time. It is just the nature of things. And, as the old saying goes, "You Can't Fight Mother Nature."

 

Blackstone and iPhone? I'm Sick of Both

You know when you've reached the ISP - the Information Saturation Point? I've reached it with both Blackstone and iPhone. If I read one more article rehashing the same old stuff, or seeking to make some "insightful" point that has already been made 345 times I might barf. Truly. I can't bear to see another picture of Steve Schwartzman; I just can't. Or commentary around his stupid 60th birthday bash. And the iPhone? Yeah, Steve is great, the idea is great, the features seem cool, blah, blah, blah. It's just that I'm getting ill with every "new" story I read. PC Magazine ran a great article on this today titled Shut Up About the iPhone, Already, and I couldn't agree more:

Anyway, I digress from my point, which is that this week is going to be pathetic. Articles like the "insanely easy" analysis or the "it factor" piece are going to be coming out daily. Wake me when it's over. I've even told all my writers on the Dvorak blog that this topic is dead and verboten until the friggin' phone actually comes out! Sheesh.

Indeed. It's getting old, friends. Are we all really that bored that we seem compelled to read this crap? And what about Blackstone? Are they not in the paper every-single-day? Of course they are. And I'm getting ill. Aside from my "I told you so" piece on the BX post-IPO price reaction, I'm done. Enough is enough. I am drawing a line in the sand. Just say no. No more Blackstone. No more iPhone. For the good of our civilization and our collective sanity.

The Blackstone Post-IPO Plunge? Duh.

Friends, fellow denizens of the investment world, you could have predicted this, right? Right? Frenzy, rapidly pushing up stock price, followed by fear, generating a painful decline in stock price. This has nothing to do with the quality of Blackstone as a firm, of course. BX is great as I've written many times. However, it's valuation and price move out of the blocks was in cloud cuckoo land, putting the stock in a position where there was only one direction in which it could go - down. Why didn't market participants see this coming? We all saw how Fortress traded, and that wasn't a surprise, either. We saw how Blackstone rushed to get the deal out the door given the risk of changing tax legislation relating to carried interest. This was all in the public domain. And finally, you had my post on Blackstone from March 18th titled Blackstone Going Public? Watch Your Wallet, Brothas, where I laid this all out pretty clearly:

I have just a few things to say:

• That this (the Blackstone IPO) was coming was obvious, obviously;
• The offering will go out at and get bid up to a stupid valuation, just like Fortress (e.g., let the flurry of excitement subside, let the stock settle down to a reasonable valuation, and buy then. For proof see FIG, IPO and aftermath);
• This has 99% to do with monetizing Steven and Pete's stakes and perilously little to do with succession planning, creating "institutional permanance," or any of the other excuses commonly given for listing (and I think they were more valid in the case of Fortress, to be honest);
• Blackstone is a great business, likely a better and more diversified business than Fortress;
• Blackstone should, and will, trade at a higher PE than Fortress;
• As usual, Blackstone is a step ahead, letting someone absorb the IPO risk (Fortress) while quickly jumping ahead of other potential issuers (see Carlyle, KKR, Apollo, Citadel, etc.); and
• This is not a terribly good sign for either the private or public markets.

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But really, what does this mean? Mostly that Steve is calling the top. Not an absolute market top, but a valuation top for his firm. Why?

• PE is just getting so big. Too big. Too much liquidity. At some point in the not-too-distant future returns will degrade. He knows this. He is sitting the catbird's seat. He's smart. We're dumb. He's the deci-billionaire, remember?
• "The real and perceived growth of the Blackstone business will slow, so let's monetize it while we can extract the momentum from the market (read: dummies like us), right? And besides, guys, it's mostly my money, anyway."
• The public scrutiny of PE returns, its place in the market, and its adverse PR will only intensify. There is a real issue with the tax treatment of management fees - logic and reason implies that this may well change. Why not monetize these on a capital gains-tax rather than a ordinary income-tax basis? This is worth billions of capitalized market value.
• That whole issue of Steve's saying for the last 20 years "Being public sucks because of costs, complexity, scrutiny, etc." applies to everybody but him because, hey, now we're talking about his money and he wants it - now.

Am I cynical? No. Just realistic. God bless Steve, Pete and the rest of the gang. They've created an amazing amount of wealth for their investors. Now it's payback time. Let's just make sure that we dummies don't give them more than their due, because if it's up to them and their bankers, we will. Much to the chagrin of our wallets and our pride.

Well guys, you did EXACTLY what I told you not to do. And now it's time for the tears. Except for Steve, Pete, Tony, Tom et al, where it is Champagne all around.

 

Populist Regulatory Rhetoric? Ugh.

I feared this day would come. And it's here. No, not just the sabre-rattling and moaning about how hedge fund and private equity-types are too rich, how hedge funds are increasing investor risks and debt buyers are accepting overly-liberal terms fueling the private equity juggernaut and the like. But a newly-energized Democratic Congress starting the process of shaping the SEC dialogue around these and a host of other issues to flex their muscles. I'm trying to wake up and enjoy my coffee (jet lag, you know) and I have to click on a Wall Street Journal story titled (Entire) SEC Makes House Call - not the way to start a day:

WASHINGTON -- In the latest sign Congress is turning a skeptical eye toward Wall Street, an influential House committee is set to hear testimony from all five commissioners of the Securities and Exchange Commission today -- the first time that has happened in at least 10 years.

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With the Democrats in control of both houses of Congress, it is an opportunity for Democratic lawmakers to frame such issues as the rise of hedge funds, chief-executive pay and shareholder rights through their own prism and to sharpen the debate heading into the 2008 election.

"It's signaling power," said James Angel, associate professor of finance at Georgetown University's McDonough School of Business in Washington, of the invitation to all five commissioners.

Among the topics to be discussed at today's hearing of the House Financial Services Committee: corporate governance, the SEC's enforcement policy, shareholder lawsuits, hedge funds and a provision of the Sarbanes-Oxley Act dealing with reporting corporate earnings, according to an internal committee memo.

Congress is focusing on areas that have "populist appeal as we go into the 2008 election cycle," Mr. Angel said. He added that when populist lawmakers are looking to win votes, "when all else fails, blame the rich." One House Democratic aide said the committee will likely conduct many more examinations of the financial sector.

The last thing in the world the U.S. economy - or global economies, for that matter - need at this juncture is a bunch of politically-driven, vote-gathering rhetoric impacting investment decisions and global capital flows. One sure way to hurt the stock markets (which, by the way, impact the hot populist topics of public pensions and middle class wealth) - go after the hedge fund and private equity industries. As readers know, I am not an anti-regulation guy; I am an intelligent regulation guy. If the market is willing to reward a certain segment of society for generating a certain kind of value which benefits them, is that really a bad thing? I don't think so. But it sure makes for great political posturing. And if those in power lose sight of the unintended consequences of their actions (say, like damaging the climate for investment and innovation), that would be a bad, bad thing. And I hope this won't happen. But today's WSJ story and the upcoming SEC testimony does not give me great comfort that the next twelve months won't be full of politically-driven rhetoric at the expense of economic growth and vitality. Ugh.

Illiquid Assets: Dimensions of Risk

Exploding spreads in structured mortgage products, which have driven sharp drops in asset values and collateral calls have shined a bright light on the risks posed by illiquid assets. Bear Stearns is now being held up as the latest victim of flying too close to the Sun, loading leverage on top of complex, illiquid assets that, in fact, had values far lower than those reflected on its books in the wake of a liquidation. Today's article in the Wall Street Journal made some good points that plainly chronicle some of the issues facing those investing in illiquid assets:

Figuring out the risk profile of illiquid assets -- and funds that invest in them -- can be tricky. Typical methods for assessing risk rely on measuring volatility -- the choppier returns are, the riskier the investment. But because illiquid assets don't trade regularly, marking to market -- or using recent sales prices to determine an asset's value -- may not be possible. In these cases, a fund manager may instead use a mathematical model to value an asset, a practice called marking to model.

Such models tend to smooth returns, making an asset look much less risky, says Massachusetts Institute of Technology finance professor Andrew Lo, who is also a principal in AlphaSimplex Group LLC, an asset-management company that runs a hedge fund.

Using broker-dealer quotes for illiquid assets can also damp volatility because they are often based on an average of bid and offer prices rather than actual sales prices. What's more, price quotes can vary widely from one dealer to the next.

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Mr. Lo has found that returns for illiquid assets and funds that invest in them tend to have little variation from one month to the next. Paradoxically, it is this smoothness of returns that show how illiquid, and risky, a position might be.

Andrew Lo is a smart guy. He has done seminal work in the area of analyzing the properties of hedge fund returns. His statements are both accurate and logical and, not surprisingly, mirror those of someone who has written about the risks of running an illiquid asset book - me. From Broadening the Multi-Strategy Mandate 07/21/2006:

For instance, if you can't arrive at a fair value for an asset, a "thumb in the air" method is used like book value minus an illiquidity haircut. This approach dear friends, is not very scientific and is extremely prone to error. Beyond error, once an approach is used for a particular asset that approach tends to be used again and again and again. This has two potentially adverse effects upon disclosure and compensation: (1) compensation may be overstated because NAV might be much lower that the level reflected in the NAV calculation; and (2) volatility of returns will be understated since this asset, whose value invariably is moving up and down but whose value is difficult to measure, is being valued in the same way quarter after quarter after quarter. This is called autocorrelation. This skews the analysis of fund returns and makes a fair comparision across different firms and different strategies nearly impossible. Does any of this sound good?

Bottom line: if you are running an illiquid asset book, especially one that is leveraged, you'd better have some of the following working for you:

1. Immense liquidity to support margin calls in an eroding market;
2. A diversified portfolio so this one book doesn't drag down your entire firm (a la Amaranth);
3. Valid, conservative market data points on the bid side to back up "mark to model" valuations; and
4. A long time horizon.

And you don't need to be running a complex, leveraged mortgage derivatives book for this to be the case, which is why I kind of chuckle when all this emphasis is being placed on Bear Stearns. Risks of this sort abound across a wide array of portfolios, many of which are anything but exotic. How about the following:

1. A large short position where the borrow is tight and the market is rallying;
2. A large long position in an thinly-traded stock;
3. A highly concentrated portfolio of small- and mid-cap stocks;
4. A leveraged book of correlated large-cap longs in a declining market.

Are these "exotic" risks? No. Can they be marked-to-market and not just marked-to-model? Yes. Can you get competitive dealer bids? Yes. Is leverage the killer in each situation? No. Is illiquidity the killer in each situation? No. The nature of the risk differs based upon the situation. Sometimes it is liquidity-based. Other times it is leverage-based. Sometimes it is both. So let's not throw stones at Bear Stearns and make like they are another LTCM. Because they're not. Funds take risks. Stuff happens. Disclosure of these risks needs to be extremely clear, accurate and detailed. Investors need to know what they're getting, and valuations need to be done in a rigorous, transparent manner. If this is done and the s**t hits the fan, so be it. It is the by-product of playing the game. Hedge fund returns, as Mr. Lo and others have discovered, are generally negatively skewed, e.g., akin to selling options, collecting premium, generating superior returns for a period and then BANG - getting hit hard, and sometimes getting carried out. Hedge fund investment is not a business for the meek and certainly not one for the stupid. If investors thought they were getting a free lunch by investing in leveraged "high quality" paper and collecting juicy returns, shame on them. Because in the markets, you seldom get something for nothing.   

I'm Back

Big deal, right? It has been quite some time. I didn't think I could take a break from blogging for this long but I guess I was wrong. My family trip through Spain and France was terrific; almost magical, in fact. I'll write about that later. I just wanted to say hi and communicate that I'll try and get back into the swing of things, toute suite. I am a little discombobulated trying to fully re-engage after 11 days out of the country traveling with Carin and the boys. I had my blackberry and did email, yes, but that is a far cry from being back in the saddle in NYC and bombarded with the usual array of stuff I get bombarded with on a daily basis. Anyway, I hope the last two weeks have treated you well and that the sub-prime mortgage demons have stayed far, far away. May the force be with you and we'll be speaking soon.

School's Out!

Friends, I am going dark for a bit. My kids just finished school and we're taking them on a little European excursion. Actually, we're road tripping from Barcelona to Paris, visiting some family in Tarragona, driving across the Pyrenees and hitting several cool points of interest in between. Wending our way through the Dordogne Valley, checking out the cave paintings, chowing down on some truffles, foie gras and walnuts in the Perigord region and all that jazz. No time for Bordeaux, unfortunately. And the kids are only interested in the 1984 and 1997 vintages which, I'm sorry, you need to be at least 10 years of age to consume. Not the most restful of holidays but full of fun and culture - and I'm certain to gain 5 pounds in the process!

So may the beginning of your summer be full of fun and happiness for you and yours and I look forward to re-engaging later in the month.

Waking up to Risk Redux: Is Nassim Taleb the Regulatory Rock Star?

Systemic risk. "Fat tails." Six-sigma events. I've written about this stuff quite a bit during my time as a blogger. I've made the point that the real risk regulators should be focused on is systemic risk, not fund-specific risk. All the hoopla around hedge fund registration is, from my perspecive, a red herring. The goal of regulation should be to protect the markets, not to protect a group of institutional investors who conduct poor due diligence by hampering the flexibility and money-making ability of all hedge funds. And I've seen the leading regulatory regimes across the globe evolve to the point where they, too, are focusing on systemic risk as opposed to single-fund risk. And this is a very happy development indeed.

This point was made most recently during Anthony Ryan's speech at the Managed Funds Association conference in Chicago. Mr. Ryan is currently Treasury Assistant Secretary for Financial Markets. It is also interesting to note that I touched on this very same topic in my post on New York City last night. I am including some key points from Mr. Ryan's address; please let me apologize in advance for its length but his talk was very, very good.

...I would like to focus on the issue of systemic risk. We will never eliminate the potential for systemic risk, but we can seek to reduce the probability of it occurring and its impact. My purpose today is to sensitize all of us as to how systemic risk operates and urge all stakeholders in our capital markets to take the necessary steps to implement policies, procedures and efforts to mitigate it.

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Systemic risk can be defined as the potential that a single event, such as a financial institution's loss or failure, may trigger broad dislocation or a series of defaults that impact the financial system so significantly that the real economy is adversely affected.

Some may posit that the increasing sophistication of risk management systems coupled with other developments and efforts has placed systemic risk on the endangered species list. For supportive proof they point to the lack of extensive ripple effects upon the financial markets following some relatively recent shocks.

I'd like to elaborate why, given market conditions, I believe that subscribing to this thesis is both potentially misleading and imprudent. Let's begin with answering the question: how could a systemic risk event manifest itself? Meteorologists describe atmospheric conditions conducive to producing a perfect storm. What are the atmospherics for a perfect financial storm? While there would be several, let me name a few: easy credit and leverage, highly correlated strategies, connected and concentrated lenders, inadequate information, and underdeveloped financial market infrastructure.

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Could our capital markets practices' better play have influenced the distribution of risk events such that the tails of the distribution have shortened? It is true that the dispersion of risk is greater. The presence of so many derivatives strategies and instruments do help to hedge risk, and markets have adjusted to "tremors." At the same time, we can also observe that the capital markets, with a few periodic exceptions, are not pricing risk and future volatility anywhere near close to long-term averages.

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So, the long tails of some distributions may also be a lot fatter than people frequently assume. Besides baseball salaries, there are many other data series where the distributions are anything but normally distributed. Look at "book sales per author…populations of cities…numbers of speakers per language, damage caused by earthquakes, deaths in war, deaths from terrorist incidents…or the sizes of companies."

Could the same be true of capital markets, commodity prices, inflation rates, and economic data? If so, what are the implications? What if such events occur with much more frequency than people recognize, and what are the consequences if we do a particularly poor job in preparing for them?

One student of such distributions is Nassim Taleb. He defines an occurrence such as a systemic risk event as follows: "First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable."

If we can not predict a systemic market event in advance, and we seek to reduce the impact of such an event, we must prepare.

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So the tails may be longer than people imagine, and the tails could also easily be fatter. We must therefore be humble enough to realize that a systemic event in the financial markets cannot be discounted and its impact will be significant.  Preparedness is therefore key and all stakeholders in the capital markets must contribute to the effort.

So there you have it. I believe Mr. Ryan's characterization of the challenges facing both regulators and market participants alike are spot on. And he and his colleagues are now internalizing the risks long understood by Mr. Taleb, risk managers and traders at every major financial institution: the risk of long-tail ruin is real and it occurs far more frequently than normally-distributed models would predict. Tails in the financial markets are fat - very fat - and the best we can do is to make sure the system can withstand significant and unpredicted shocks, because they will happen. And we have history as our witness.