Monitor110 Learnings: The Good, The Bad, and The Really Bad

The response to my Monitor110 Post Mortem was pretty shocking. I want to thank those who commented, sent emails, and simply took the time to read the post. If some of you are really able to take my experiences to heart and to avoid some of the mistakes made by myself and the team, that would be terrific. To that end, I am going to spend some more calories drilling down on key areas of note during my 3+ years working with the company.

The Good: Articulating an Idea and Raising Money

From the time Jeff Stewart and I decided to press forward with Monitor110, we were very thorough and systematic in our approach to raising money. First thing I did before formally deciding to invest was to go around to potential customers - principally hedge funds and Wall Street firms - and get their reaction. We were able to show them the v1.0 system (the one we trashed, remember?), screen shots of the next generation application and our vision for the future. The general response: if you guys can deliver what you say you can deliver, I'd be very interested in the product. Good answers; just the answers a potential investor (me in this case) would like to hear. Little did I know that what we said we could deliver we actually couldn't, and that it would take almost three years for the key constituencies (management, development, the Board) to figure this out. [The reason: buy-side investors wanted a system that would extract the nuggets of differentiated, unique information and present it to them in a form that was beyond clear, something so easy that they could look at it and literally make a trade. In short, readily actionable. Reality, unfortunately, did not line up with this expectation. The ultimate release was much more of a research application, not something that immediately generated actionable, monetizable data.]

Be that as it may, we didn't know the execution problems at the time and the vision we were articulating was very seductive, to clients, to investors, to recruits, to ourselves. From a variety of client meetings we honed our pitch, created a presentation deck that we iterated on several times, and set about pitching a variety of top angels and VCs in Silicon Alley, Silicon Valley and Route 128. We raised $1.25 million from a group of angels, most of whom we considered strategic due to their either working at hedge funds, bulge-bracket Wall Street firms or were independent traders. This gave us the runway to make key hires, begin building the next generation product and to systematically tap the venture capital community. The pitch deck was no more than 15 pages, had lots of pictures, a handful of focused, powerful words and concepts, and a clear explanation of how we intended to use the money. While I'm no Guy Kawasaki, I know a good pitch deck when I see it and can sell it. Especially since I believed so passionately in the company's mission and prospects. So my message to those seeking to raise funds is:

1. Believe deeply in the mission and vision of the company; otherwise, no one else will.
2. Use few words, many pictures and be brutally clear. If the audience doesn't get it within 60 seconds, it's tough sledding.
3. Think of lots and lots of use cases and be ready to share them at will. This isn't just for pitching; you'll need this to understand the market opportunity as well.
4. Pitch early and often. We learned so much from speaking to dozens of smart, insightful people. I think we would have failed faster and better and/or increased our chances of success if we had listened more.
5. Hone the pitch on lower-likelihood prospects early and ramp up to the real targets after polishing the presentation and the delivery. The first bunch of times you will suck. After sucking for 5-10 times you'll tend to get much, much better. There is no way to short-circuit the process; there is simply no substitute for experience.

The Bad and The Really Bad: Recruiting, Metrics, Lack of Focus and Cash Management

1. Great team, wrong team
2. Inadequate metrics
3. Resources spread too thin
4. Poor cash burn management

The Bad #1: Great Team, Wrong Team

I'd argue that Jeff and I were very good at recruiting. We hired great people. Smart. Passionate. Opinionated. Caring. Problem is, I think in retrospect that we hired many of the wrong people, not because they weren't good but because they didn't have the depth of experience necessary to solve the problems we need to solve. We took the approach of hiring "best athletes," on the theory that super smart people can figure hard stuff out. For example, a few years back one of the teams that competed and placed in the DARPA challenge wasn't from MIT, Stanford or CMU, but a team hacked together by a tech guy from an insurance company and a bunch of his buddies who said "We can do this." They drew parallels between the DARPA challenge requirements and the dynamics of video games, and devised a completely out-of-the-box approach to solving the problem. And they proved that it didn't take a bunch of rocket scientists to compete in a crazy robotics competition. This was our fantasy. We'd be these guys.

Unfortunately, our reality is that we were cracking monumental problems at the frontiers of natural language and statistical text processing, data harvesting (ripping and cleaning), entity extraction and real-time matching of terabytes of data. Instead of building a team that had experience in each of these areas and could attack the scale of our problems from the get-go, we staffed the company with bright people who had to learn the material first before attacking the problem. Because of this, it took much longer to understand the magnitude of our issues, time that could have been spent either solving the problems or taking a different approach. By the time we figured out the depth of our issues, we had burned lots of resources which left us precious little runway to get a salable product to market. Best of intentions. Worst of decisions.

The Bad #2: Inadequate Metrics

It took us a long time to build the next generation product. And during the development process, we didn't do a good enough job creating metrics to measure our progress and the efficacy of the components of the system. And by the time we got around to measuring stuff (hard release cycles, data precision and recall, speed of throughput, processes around source expansion and quality, etc.) we were very, very late in the game. In retrospect, we should have placed a much greater emphasis on the creation and use of key metrics, and building greater accountability into the culture. It would have forced us to face into our issues early on, potentially enabling us to change direction before wasting scads of precious capital. Our lack of a metrics-driven culture let the science project live on - and on and on. We discussed the importance of measurement dozens of times but got derailed by the many technical problems we encountered. We completely lost the forest for the trees. This was no excuse. We screwed up on this front, big time.

The Really Bad #1: Resources Spread Too Thin

We initially had a vision of a single product: a dashboard. The entire company was executing against this vision. Problem was, the market was telling us that a dashboard was not necessarily what it wanted. It wanted a research product using the data underlying the dashboard. It also wanted the ability to access our data via a feed or API. Therefore, our laser focus on a single offering split into three. While we were trying to listen to the market, we only ensured that we would do nothing particularly well. And as mentioned in my earlier post mortem, the Board was never really supportive of the research business and didn't really understand the opportunity posed by the feed business. What would have happened if we had only focused on one of the products? We either would have increased our chances of success or failed faster, both of which are superior outcomes to what eventually went down - a slow, painful death.

The Really Bad #2: Poor Cash Burn Management

Monitor110 wasn't some biotech company conducting research and using money to get through clinical trials. It was a technology company trying to sell a service to a very defined universe. Our cash burn got way, way ahead of where it should have been given our revenues. Because, as we thought, the ultimate salable release was right around the corner. But it wasn't. I can't count how many corners that product was around, but it was more than five and less than ten. Yes, we were working to solve a complex problem. But before we went "all in," we should have had much stronger signals from the market that it was prepared to buy what we were selling and at approximately the price point at which we intended to sell it. But because we were so concerned with disappointing our customers in light of the unexpected PR we had received, we really hadn't gotten much market input since early in the development cycle. We were so convinced that the demand would be there once we got the product out that we just kept building - and building, and building. And when we finealy stopped building and said "Here it is," they said, "That's nice. Kind of. And that price? Too, too high." Not happy words to ears that were poised to hear something materially different. And because of the burn level, it made staying in the game long enough to get the penetration needed to succeed virtually impossible. Moral of the story: test the market. Think. Design. Execute. Go back to the market. Repeat. Stop when the market says "I'll take it." And then start the cycle again.

Sure, there's more. But this will have to do for now.

Merrill's Restructuring: On the Right Track, But...

Well, Merrill just provided the market with a great example of what a bank has to do to achieve the results of a good bank/bad bank split:

1. Take a massive write-down of its illiquid asset portfolio;
2. Fulfill a colossal make-whole agreement on prior financing rounds by rolling down the prices of earlier offerings; and
3. Issuing billions in fresh capital at sharply depressed prices.

Net net, rather than doing a classic good bank/bad bank bifurcated structure, it bit the bullet and did the whole thing internally. $40 billion in write-downs in the past year. Additional payments to financing sources that were massively underwater, except for the fact that their paper contained reset options in the event that fresh equity was sold at lower prices within a prescribed time period. And oh boy, were the prices ever lower and did it ever happen within the prescribed time frame!

My question is: after all this, is there even more to come? As reported by the Wall Street Journal, Merrill's CEO said the following:

Chief Executive John Thain said the securities represented the "substantial majority" of Merrill's collateralized debt obligation, or CDO, positions, calling the sale "a significant milestone in our risk reduction efforts."

Can anyone out there tell me what a "substantial majority" is? If you are going to go through the pain and suffering of such a restructuring, don't you think it would make sense to either write it all down or to provide transparent disclosure of what was written down, what remains and what management thinks the realization on the remaining pieces will be? I just don't get it. If we believed bank CEOs every time they said "The worst is behind us" we'd all be in the poor house.

Come on, John. Better disclosure, my man. You have the chance to take the leadership on best practices in this area. Because without it, you and your banking buddies are still leaving investors with a murky outlook, and your share prices will continue to reflect this lack of confidence.

Update: Here is a more detailed article from the WSJ.

Banking Sector Band-aids Just Won't do It

We all know by now that the U.S. banking sector is badly broken. The real question is what to do about it. I think a few core principles need to be followed when devising a plan for healing the banking sector:

1. The plight of equity-holders should be ignored;
2. Long-standing rules governing bank ownership shouldn't be compromised in a panic; and
3. Bank balance sheets won't heal unless deep pain is felt, and preferably as quickly as possible.

Bank Equity Holders: Out of Luck

Investors in junior securities, be they common shares, preferred stocks or subordinated debt, enjoy premium returns in the good times and bear disproportionate risks in the bad. They should not have a seat at the table in a bail-out scenario. When considering the plans put forth for rescuing the GSEs - Fannie Mae and Freddie Mac - I do not want to see Treasury Secretary Paulson spending my tax dollars propping up existing equity holders. This is money that should go to restoring liquidity and order to the mortgage market and enabling debt holders to get their money back. Equity holders - they should be wiped out. GSE equity holders have long enjoyed the benefit of a guarantee off the backs of the U.S. taxpayer; now the tables are turned and it's payback time. If you want the potential returns to equity, then you need to shoulder the risks to equity. And those risks have been borne out. And you are busted.

Now, this is an issue separate from fraud. If it turns out the disclosures were improper and that equity holders did not have the information necessary to make an informed investment decision, then by all means file a class-action lawsuit and seek appropriate remedies. But this is also part and parcel of being an equity holder. Bad things can and do happen. It's high time that equity investors understood this. And I'm not the only one to have this view: consider the words of David Einhorn, manager of the widely-respected hedge fund Greenlight Capital, from his book Fooling Some of the People All of the Time:

The truth is that investors in corporate securities are risk takers managing investments of risk capital. One risk is fraud. The best way to discourage fraud is to actually enforce the penalties for fraud. If investors believe that companies making false and misleading statements will be punished, they will be more sensitive to what is said. And, because their money is at stake, investors will allocate their capital more carefully.

Exactly.

Don't Play Games With the BHCA

2. The thought that bank ownership rules should be relaxed because of the need to attract liquidity into the sector is deeply misguided. While there are plenty of rules and regulations with which I disagree, but the long-standing Bank Holding Company Act rules make a lot of sense to me. Banks play a special role in the fabric of our economy, from money creation and credit to safety and access to liquidity. These are not areas to be trifled with. Further, I think proposed rule changes really cloud the issue. If the sector needs more capital, then the question needs to be asked; what can be done within the existing rules and regulations?

We have the example of TPG/WaMu, which, I'm afraid, is not a template for bringing capital into the sector. This was a deal done behind closed doors, at terms that frankly illustrate why the sector is so badly damaged. TPG wanted lots of cushion in order to do a deal, because of a high degree of uncertainty surrounding the investment portfolio. It presumably took large deal fees. The structure was also massively dilutive to current shareholders, and further provided anti-dilution protection against subsequent capital raises at prices lower than its deal price for 18 months. I'd be willing to wager that this is one anti-dilution feature that will surely end up in-the-money. Not bad, TPG. But to be fair, if I was TPG I'd have pushed for the same deal. Why? Because almost every large financial institution in the U.S. is made up of two institutions; a good bank and a bad bank.

Good Bank/Bad Bank as a Way to Move Forward

The good bank is a bank we can understand, analyze and readily price. The bad bank, well, is bad for a reason. It contains a large number of very complex, hard-to-value instruments. Mortgages. Illiquid derivatives. Leveraged loans and loan commitments. So an investor in such a combined good bank/bad bank entity is likely to pay a sharply discounted value for the good bank because the bad bank is so bad, or at least it's potential losses are so unclear.

What I believe we really need is a good bank/bad bank approach to the current banking sector woes, causing all banks to shrink by offloading their bad bank instruments into either a bank-specific vehicle (like Citi taking its bad assets and selling them into a "Citi Bad Bank") or a series of pools organized by asset type (similar to the Super SIV idea, except separate vehicles for mortgages, derivatives, leveraged loans and unfunded commitments). The instruments to be marked-to-market upon transfer and funded by private capital, which will now demand a return in line with the risk without placing unnecessary downward pressure on the valuation of the good banks that remain. And if private capital wishes to fund the good banks who now have clean balance sheets and are ready to expand but are short on capital, they will receive a return commensurate with healthy, good bank growth capital. This approach does not require a change to the Bank Holding Company Act, but it does require bank managements to take big hits to equity - now -  in order to lay a strong foundation for future growth.

Note to Bank Managements: Take the Medicine - Now

3. Bank management's steps towards fixing their balance sheets has been a slow, painful process, which is likely to be played out over even longer periods of time. This, in my opinion, is a huge mistake. It is both costly to their firms and for the economy, as the pervasive lack of confidence in our financial institutions will remain until the problems are cleaned up. But healing can only happen if investors have greater transparency into the future of these firms, which means really understanding the risks embedded in their asset books. And as it stands today, there are still way too many unknowns to make financial commitments to the sector. Those who did so early got smoked, and others, like TPG, received deals that ultimately hurt the bank and its shareholders and don't address the issues of transparency. Mr. Paulson should devote more calories to this issue and less to bailing out the GSE's and protecting their common stockholders. Yes, the GSEs are hugely important, don't get me wrong. But the larger banking sector needs fixing, and it appears that a little prodding is in order.

Without the health of our banking sector, I do not see a foundation for recovery. The Treasury, the Federal Reserve and bank managements need to wake up. An incremental approach to rebuilding financial strength, trust and confidence is a fool's game. Get to it.

Monitor110: A Post Mortem

Turning Failure into Learning

Writing a post mortem is hard, particularly when the result is failure: a failed deal; a failed investment; a failed concept. That said, without a post mortem, without deep reflection, honesty and introspection, how can we get better and do better the next time? Quite simply, we can't. My involvement with Monitor110, as an investor, Board member and leader, was one of the most interesting and informative experiences of my life. I learned about areas I never dreamed of. I worked with a terrific group of young, exceptionally bright people who believed in the vision. Ultimately, we failed. But why did we fail, and what could we have done differently?  Some of the stuff is pure 20:20 hindsight. These observations aren't worth much. But the interpersonal dynamics, the issues of organizational structure, the need to change strategy in light of new information, the relationship with key investors, all of these are very instructive. I will endeavor to be as honest and candid as possible.

Let me say that I deeply respect everybody involved with Monitor110 from the original founder, Jeff Stewart, to our investors, employees and customers. Everyone tried very hard to make things work, and this post is not an indictment of anyone. There are no "bad actors" in this story. But a confluence of factors made success an uphill struggle.

The Seven Deadly Sins

While we certainly made more than seven mistakes during the nearly four-year life of Monitor110, I think these top the list.

1. The lack of a single, "the buck stops here" leader until too late in the game
2. No separation between the technology organization and the product organization
3. Too much PR, too early
4. Too much money
5. Not close enough to the customer
6. Slow to adapt to market reality
7. Disagreement on strategy both within the Company and with the Board

A Little Background

I was initially approached in early 2005 by Jeff Stewart, who had the original idea for Monitor110. It was a compelling idea. The thesis: more and better information is being put out on the Internet every day, information that can be valuable to Institutional investors who are constantly looking for an edge. And these investors were not very sophisticated about how to best access this information; Monitor110 would use technology to help them get that edge. Jeff and a few guys had hacked together a version 1.0 of the system, which was based on a boolean matching engine with rules corresponding to each company and investment theme. It was fast. It worked ok. We spent some time working with PubSub, who had built a scalable matching engine but was not focused on the financial services industry.

By mid-2005 the system worked, but spam was becoming more prevalent and caused the matching results to deteriorate, e.g., too much junk clogging the output. Around the same time we started to dig into natural language processing and the statistical processing of text, thinking that this might be a better way to address the spam issue and to get more targeted, relevant results. This prompted us to not push version 1.0, instead wanting to see if we could come up with a more powerful release using NLP to mark the kick-off. In retrospect, this was a big mistake. Mistake #5, to be precise. We should have gotten it out there, been kicked in the head by tough customers, and iterated like crazy to address their needs. Woulda, shoulda, coulda. Didn't.

An Unusual Leadership Structure

The idea was that Jeff was the technology guy and I was the business guy. Jeff focused on technology and product and I focused on fund raising, HR, controls and client access (given my Wall Street and hedge fund rolodex). On paper, made sense. Jeff was a successful three-time entrepreneur, I was an experienced senior Wall Street executive. The problem was, however, that when it came time to make hard decisions the two-headed structure really didn't work. It was a technology company working to solve a complex problem, and ultimately technology dominated the discussion. Ultimately, we ended up building something that the business side was not happy with, which made selling it difficult. An indication of Mistake #2. Neither Jeff nor I had the power, real or perceived, to simply change direction. The Board was supportive of this management structure. This was also a mistake. Mistake #1.

A Real Product versus a Science Project

We talked about "release early/release often," but were scared of looking like idiots in front of major Wall Street and hedge fund clients. Is it better to wait a bit before releasing to have a more compelling product or to begin getting feedback on a less impressive offering? We chose #1; in retrospect I think we should have chosen #2. By choosing to wait we lost our intimacy with the customer (Mistake #5 again), falling into the classic (as a "green" entrepreneur I didn't know this, but as a seasoned four-year venture investor I know this now) trap of pursuing a "science project," not building a commercially salable product. Dumb. Another problem: technology and product management were effectively bundled together, with the same decision-makers for both. This was another crucial error, #2 again. Instead of having product management as the advocate for the customer and the product evangelist, we had technology running the show in a vacuum. Huge mistake. This allowed us to perpetuate the science project for much, much longer than we should have. There were no checks-and-balances built into the system. This was a recipe for failure. I intuitively knew it then but as an inexperienced entrepreneur didn't feel empowered to act. Really, really stupid. After 20 years of making consistently good business decisions why didn't I throw a fit and and be more assertive in communicating my concerns? No good answer here.

And these bad behaviors were reinforced by an unplanned event that sharply impacted our psyche: being on the front page of the Financial Times. It is hard to call it a mistake since we didn't seek to get such exposure, but I put it down as Mistake #3. To be honest, this single fact was a very meaningful factor in our failure. It raised the level of expectations so high that it made us reluctant to release anything that wasn't earth-shattering. It was also catalyst for us raising our last and largest round of capital. So the net effect was that it enabled to raise all this money that kept us far from the customer. Truth be told, we were probably afraid of customers at this point because we didn't want to disappoint them or look bad. Oh, we'd build something they'd love. We just wouldn't show it to them until it was done. Ugh. Just so stupid.

Too Much Money

Too much money is like too much time; work expands to fill the time allotted, and ways to spend money multiply when abundant financial resources are available. By being simply too good at raising money, it enabled us to perpetuate poor organizational structure and suboptimal strategic decisions. Mistake #4. We weren't forced early on to be scrappy and revenue focused. We wanted to build something that was so good from the get-go that the market would simply eat it up. Problem was, with all that money we hid from the market while we were building, almost ensuring that we would come up with something that the market wouldn't accept. And then there were technology issues that came up along the way, very substantive issues, that because of so much money we simply didn't face into nearly fast enough. And this drove a wedge in the company between those that were more plugged into the market (and felt we weren't building the right thing or addressing the data issues the right way) and those who were building the product (and felt very convinced that what they were building was responsive to the market). I would almost argue that too much money enabled the other six mistakes to be made again and again and again. Seems counter-intuitive, right? It's not. And believe me, I am super sensitive to this issue now as an investor. If a company wants to raise significantly more money than I think they need to get to revenue, I push back. Hard.

Investor Expectations versus Market Reality

We raised money based on a vision of a scalable web portal, a tool that would eventually be the web-enabled side of Bloomberg. We never believed we'd replace Bloomberg, Reuters or Thomson for market data and mainstream news, but that we'd eventually become a necessary part of the Institutional investor research mosaic. We were positioned as a technology company, not as an alternative research provider or a services business. And it was the deep belief in Monitor110 as a pure technology company that created a rift between the business side of the company and powerful members of the Board. Mistakes #6 and #7, as you'll soon see.

We did an angel round in the latter part of 2005 followed by an institutional round early in 2006, enough money, we thought, to help us build the new version 1.0 of the product. We then did another institutional round in Q3 2006 to further execute against this vision, because the money was offered to us on a pre-emptive basis and around six months earlier than we were planning to do a raise. The new release would be whizzy, fast, comprehensive and use all that neat technology to analyze unstructured data in real time, and to score each data element by reputation and relevance. Easy to filter, discover and analyze. Super cool, right? Sure. Problem was, we started out trying to analyze most of the dynamic web (probably up to 100 million sources by now) in real-time, and using technology (NLP, pattern matching, etc.) to do the filtering, indexing and categorization. This was no mean engineering feat. We had a very, very large and complex back-end. And even with this, the quality of the data coming through to the end-user was just not that good. Too much spam, still. Duplicate posts. Sometimes mis-categorized. Difficulty applying our reputation algorithms. Not good.

Those closer to the customer wanted to effectively chuck this approach and to build up a high-value corpus of data from the bottom up, using our deep knowledge of the source universe to assemble a body of data from publishers of high reputation. Really more akin to a "Bloomberg for the Web" than the original product, as the sources would be of high-quality and indexed correctly. They also wanted to build a research capability, where a desk could generate customized reports for clients leveraging our technology and data. But making this fundamental change to our approach towards data and the business model resulted in a fight. Almost a jihad, where certain parts of the company were vehemently in favor of changing our approach while others said "improvement to the current system is right around the corner." This could only happen because of Mistakes #1 and #2, where nobody could pound the table and say "this is the way we're going to do it and here's why," nor could the business side simply say "this is what our clients want. This is why we should do it." We were one big, passionate, driven, dysfunctional family. This argument played out over months and months, and cost us an enormous amount of money. Eventually we did change our approach to data, but it was a fight that spiritually damaged the company and morale and had a financial impact that substantially depleted our coffers.

And in Conclusion

The good news for me personally is that I now invest in a way that actively seeks to avoid the seven deadly sins listed above, and the performance of my portfolio companies bears this out. But I simply wasn't smart enough or experienced enough to see all of these mistakes or to feel empowered to do something about them until it was too late. I would like to thank all of our investors for having the confidence in us to pursue the Monitor110 vision, and I'm sorry that we weren't financially successful. I'd also like to thank the people with whom I worked during my tenure at Monitor110. Not a bad apple in the lot. Smart, hard-working, highly motivated professionals. They will invariably do extremely well in their post-Monitor110 lives.

The market for alternative information and tools is very, very challenging, and the current market environment isn't making it any easier. But there are clear needs out there that should and will be addressed. I will write a post on the alternative information market at a later time. Thanks for listening.

Monitor110: Closing a Chapter

Some of my friends and readers have already heard the news, that the Board of Monitor110 has decided to cease operations. It was a hard decision and certainly a sad one at that. Monitor110 was one of my first early-stage investments, and one which I spent a lot of time trying to make work. Mistakes abound, mistakes that I wouldn't make today having become a much more experienced investor and entrepreneur since my original investment and involvement. To say that I learned a lot from the experience is the understatement of the century, and I will write a series of posts outlining my learnings, the good, the bad and the ugly, from every facet of the company's conception, rise and fall.

My life changed dramatically through Monitor110, due to the people I met (employees, investors, customers, advisors, other entrepreneurs and vendors), the things I did (raise money, structure deals, recruit, do business development deals) and the lessons I learned (too numerous to detail here). It also was an engine to get me even more involved in early-stage investing and advising, an activity that has become my principal vocation over the past three years. It also spurred me on to blogging, enriching my life as an outlet for self-expression, idea sharing and as tool for meeting amazing people, seeing deals and building community. As disappointing as failure feels, my life is permanently changed for the better due to my involvement with the company and its constituencies. I am a better investor, a better adviser and perhaps better in touch with my own strengths and weaknesses as a result.

More later. And thanks to all those who have sent me kind notes of support. I really appreciate it.

An Open Letter to the Next U.S. President

Dear Mr. President:

It has been my view for quite some time that the U.S. is in pretty bad shape. From the deteriorating economy to the questionable integrity of our financial institutions, from the faulty regulatory frameworks to the dumbing down of American culture, from our bankrupt policy towards the U.S. dollar to a deepening malaise from Wall Street to Main Street, things are looking quite bleak. But all is not lost; we are Americans. We are innovative and entrepreneurial. We can be tough (if pushed). We can come together (if compelled). And now is the time for us to be tough and to come together in order to rebuild our country, a country whose promise is far greater than the one I see today.

I think the most important thing you can do as President is to help us feel better about ourselves, and to help the world feel better about us. And I believe these two goals are pretty closely related.

What is hurting us now? Fear of inflation, stagnant economic output and joblessness. Nobody wants a replay of the 1970s. Or the 1930s, for the matter. One area that has gotten little press that threatens the future of our country and its prosperity is our crumbling infrastructure. A recent story in the Economist provided some startling and scary statistics: "In 2005 the American Society of Civil Engineers estimated that $1.6 trillion was needed over five years to bring just the existing infrastructure into good repair. This does not account for future needs. By 2020 freight volumes are projected to be 70% greater than in 1998. By 2050 America’s population is expected to reach 420m, 50% more than in 2000. Much of this growth will take place in metropolitan areas, where the infrastructure is already run down." And the picture just gets worse over time. This is kind of like Social Security, in which our leaders have chosen to defer pain to future generations, without thought of how it might effect our children and grandchildren. The issue with investing in infrastructure is that it is an investment in the future, yet with benefits that can and will be enjoyed today. A massive program to rebuild roads, bridges and subway systems, to upgrade and expand airports, ports and waterways, would provide hundreds of thousands of good-paying jobs and drive local economies across the country. Such a program would have massive ripple effects on the retail sector, putting money in people's pockets that is not driven by home equity loans but real, productive jobs. Further, such a program would lay a solid foundation for future growth, growth that if it were to happen in the absence of these infrastructure investments would put us on track to have conditions akin to a third-world country. These jobs would be a mix of manufacturing and service jobs, supporting our still-significant heavy industries with real work. Needed work.

Now all this investment takes money, and as you know, we are already burdened with a staggering external debt. This debt is particularly unpleasant because of the sharply falling dollar, which makes our creditors less likely to continue extending credit. But you know what - I bet that you could raise the money to do these investments without even batting an eye. Why? Because all of these investments make the U.S. a better - not a worse - credit risk, as it immediately stokes the engines of growth and further lays the foundation for continued healthy growth in the future. Invest today, get a lot more back tomorrow. But for this to fly, you need to keep your wits about you and keep taxes low, encourage capital investment. resist any protectionist tendencies and to foster good relationships with our trading partners. Any backsliding in this area and the whole thing will backfire on you. You can easily sell this to both Congress and the American people. And selling the bonds to finance such an endeavor won't be much more difficult to our well-heeled, cash flush trading partners. Well, maybe a little more difficult, unless...

We do need to make some cuts to help finance this historic rebuilding initiative, to show our creditors that we can make tough decisions when necessary. What we don't need is to cut spending on education, science and math programs, early-child support and core programs in the arts that help keep us rounded as human beings. We also need a cogent policy on supporting intelligent investment in alternative energy. What we do need is to cut military spending - dramatically. Not because we don't need a strong military, but because we don't need to be and shouldn't attempt to be the moral compass for the entire planet. The previous administration drove a stake through the heart of our military, leaving an overextended, demoralized, undermanned, disorganized and fractured institution in its wake. Our massive overseas troop deployments and ongoing presence in Iraq is costing us hundreds of billions of dollars a year, dollars much better spent at home supporting the programs I outlined above. Are we really better off because of such policies, especially in a newly multi-lateral world?  I think you'd be well advised to consider a different mission for our military, one that puts it in the role of protector of U.S. interests, narrowly defined. We can't turn back the clock on China - they have a role to play as a global force and will not be denied. Then you have Russia, India, the Middle Eastern economic powers and others wanting their seat at the table. We need to become a leader of, but also a true part of the global community. This requires a level of humility, poise and perspective we haven't seen in a long, long time. This means sharply scaling back legacy military involvements that have their roots in World War II, and bringing lots of our fine men and women in uniform home. It also means rebuilding the command structure and morale of our troops, who have spent too much time fighting questionable battles that have left our proud nation poorer, weaker and more isolated than it has in generations. Our nation and our military deserves better.

I believe these policies will play well with the rest of the world, Mr. President. Not because it shows us in a position of weakness, but because it shows that we can take care of business at home, business that is key for the economic and political functioning of the world. We've been off the rails, and our enemies and allies alike have been acutely aware of this. It is time to reverse this perception, because the status quo is simply not sustainable. I do not wish to live through a slow, grinding decline of the U.S. as a superpower, both economically and militarily. You alone are in a position to stop this from happening.

I know this will be hard to pull off, Mr. President. Let's face it; no matter what, you are leaving office with a trillion-dollar deficit and a global stage still in flux. The real question is how you are preparing our nation for the future. You will either be remembered as someone who had an historic opportunity in a rapidly changing world but chose to do nothing with it, or to make the hard decisions, stare fear and uncertainty in the eye and say "I am embracing the future. Not everybody will be happy today but subsequent generations will benefit from my bold actions." I sincerely hope you choose the latter, Mr. President.

Best regards,

A Proud but Concerned American

Straight-talk on FAS 157: Blackstone and their Banker Buddies Have it Wrong

There have been some rumblings over the past several months about accounting rules being a key contributor to the banking sector meltdown, and I've let it slide. But now that  Steve Schwartzman and Tony James of Blackstone have publicly stated their views that FAS 157 - or Fair Value Measurement rules in normal-speak - is perhaps even dangerous, I have to put my blogging hiatus to the side. Because this view is so myopic, slanted and not acknowledging of the complexity of the issue that some additional (and more detailed) perspective is warranted.

I've always felt that primary responsibility of bank leadership was to maximize return while managing risk to an acceptable level, and in a financial firm this really comes down to the concept of gap management (the difference between the duration of assets and liabilities, or the net interest rate sensitivity of the firm). Before the rates thrifts could pay for deposits was de-regulated, they had a wonderful business of lending long at comparatively high rates (principally in residential mortgages) and borrowing at comparatively low rates (via core deposits). Because rates were undifferentiated core deposits were very "sticky," as there wasn't a price motive to switch from one thrift to another. Therefore, the implied duration of its loan book was long while the implied duration of its core deposit base was long as well, giving them a matched book and a steady stream of earnings. Now this is a simplified view of things but you get the point. When this came to a screeching halt in 1982 and thrifts needed to compete more aggressively for both mortgage assets and deposits, that nicely managed gap widened dramatically. Assets were still long-dated, but lower yielding than before due to competition. Liabilities were now more expensive and of a much shorter duration, causing a massive funding mismatch that contributed to the S&L crisis of the late 1980's.

Why my little walk down memory lane? Because my thesis is that we are pretty much experiencing the same phenomenon today. Assets whose duration have unexpectedly lengthened due to lack of liquidity, while most banks have funded themselves in a seemingly opportunistic but highly risky way through repurchase agreements, asset-backed commercial paper and other short-term financing instruments. And when the music stops and investors stop wanting to lending short? The predictable cash crunch ensues. This is a classic failure of gap management, the key building block of running a successful financial firm. Some may throw up smoke and say "Well, the trading risks of investment banks are much more complicated than the simple mortgage loans of the 1980's. This is totally different."

Bull. Trading risk becomes liquidity risk when you can't trade. If you can't finance a book to take into account the vagaries of different market (read: liquidity) scenarios, then nothing else matters. Just ask Bear Stearns. So, if you are a prudent gap manager and operating in a FAS 157 world, what would you do? Do real stress-testing of liquidity scenarios and construct a capital structure that address much of the liquidity risk posed by non-standard assets. Because in an adverse scenario where liquidity dries up, there is a flight to quality and spreads blow out, the bank will experience a large mark-to-market gain on its liabilities, both avoiding a huge hit to equity and mitigating the need to run out and secure costly financing under highly adverse circumstances (like Citigroup, Merrill Lynch, Lehman, Washington Mutual and the rest of them). This could have prevented a lot of pain to a lot of shareholders. Sure, they might not have ridden as high during the up-market, but they would been more than compensated with downside protection. It's called volatility reduction. Or prudent gap management.

By way of background, let me share some of the Financial Accounting Standards Board's summary of what FAS 157 is intended to do:

The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability.

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This Statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability.

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This Statement clarifies that market participant assumptions include assumptions about risk, for example, the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. A fair value measurement should include an adjustment for risk if market participants would include one in pricing the related asset or liability, even if the adjustment is difficult to determine.

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This Statement clarifies that a fair value measurement for a liability reflects its nonperformance risk (the risk that the obligation will not be fulfilled). Because nonperformance risk includes the reporting entity’s credit risk, the reporting entity should consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value under other accounting pronouncements...

I think this stuff is pretty straightforward and reasonable but hey, that's just me. Messrs. Schwartzman and James, however, feel quite differently. From today's New York Times:

But Mr. Schwarzman is convinced that the rule — known as FAS 157 — is forcing bookkeepers to overstate the problems at the nation’s largest banks.

“From the C.E.O.’s I talk with,” Mr. Schwarzman said during an interview on Monday morning, “the rule is accentuating and amplifying potential losses. It’s a significant contributing factor.”

Some of his bigwig pals in finance believe that Wall Street is in much better shape than the balance sheets suggest, Mr. Schwarzman said. The president of Blackstone, Hamilton E. James, goes even further. FAS 157, he said, is not just misleading: “It’s dangerous.”

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The idea seems noble enough. The rule forces banks to mark to market, rather to some theoretical price calculated by a computer — a system often derided as “mark to make-believe.” (Occasionally, for certain types of assets, the rule allows for using a model — and yes, the potential for manipulation too.)

But here’s the problem: Sometimes, there is no market — not for toxic investments like collateralized debt obligations, or C.D.O.’s, filled with subprime mortgages. No one will touch this stuff. And if there is no market, FAS 157 says, a bank must mark the investment’s value down, possibly all the way to zero.

That partly explains why big banks had to write down countless billions in C.D.O. exposure. The losses are, at least in part, theoretical. Nonetheless, the banks, in response, are bringing down their leverage levels and running to the desert to raise additional capital, often at shareholders’ expense.

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Of course, Mr. Schwarzman’s theory only holds up if the underlying assets are really worth much more than anyone currently expects. And if they are so mispriced, why isn’t some vulture investor — or Mr. Schwarzman — buying up C.D.O.’s en masse?

For Mr. Schwartzman’s part, he says that the banks haven’t been willing to unload the investments at the distressed prices. Besides, the diligence required for most buyers is almost too complicated.

I think Steve and Tony are only looking at half the problem. In a mark-to-market world, you can't only look at the asset side, you need to look at the liability side as well. And, oh yes, there is also that niggling issue of liquidity. As Mr. Schwartzman says, "...the banks haven't been willing to unload (the) investments at distressed prices..." Well, a firm earns that right by having a capital structure and funding plan that can support a long-term hold strategy. Otherwise, they should suffer the vagaries of the market. But this is an issue simply not addressed by the bright men of Blackstone or their Wall Street buddies.

So why do risk managers and bank managements' so consistently make bad decisions? Probably because there is an over-reliance on measures that are seemingly quantifiable. They can measure delta. They can measure vega. They can measure theta. They can measure gamma (or at least they think they can). They can estimate credit loss ratios. But what about liquidity? When you are quantifying factor exposures, how exactly do you model liquidity as other risk factors change? It is a very, very hard question. Sometimes risk management requires judgment beyond computers, which is hopefully one of the biggest take-aways from the current credit melt-down. My sense is that there is currently a fear to manage without a machine telling you what to do. It is kind of like the drunk looking for his lost keys by the streetlight, simply because this is where he can see. But the likelihood of his keys being within the illumination of the streetlight is very, very low. Some of the best risk managers, guys like Gus Levy of Goldman Sachs and Ace Greenberg of Bear Stearns, didn't rely on computers but relied on instinct, savvy and experience. We need more of this. It's called leadership. Let's not cloud the issue. It's not about FAS 157 or any other accounting rule. It has been and always will be about management.