Function and Purpose as it relates to Securities and Disclosure

30 Apr

In trying to explain myself on Kid Dynamites blog (link later…) regarding my explanation of material disclosure, I made the following argument (Going to edit it a bit when I have some time):

I’ll try one last way. A much more philosophical construction. Function versus purpose.

Function is the properties of an item as it relates to what it does and is.

What are the functions of a ferrari?

If you press down on a gas pedal the wheels spin. It is constructed from metal. Turn the steering wheel left and the tires turn left. It is red. It can go from 0-60 in 3 seconds…

Each property above is quantifiable/verifiable by any party. These functions are the same and as true for you, for me, or even a cow you might run into on the road. Function is absolute and the same in all frames of reference. It describes who, what, where, when and how.

The purpose of something on the other hand is the narrative applied to items in the world. It is an entirely human construct.

What is the purpose of a shoe?

For most people a shoe protects your feet while you walk. For others a shoe is a fashion accessory or a collectors item. For a dog it’s a chew toy. For the bacteria living in the sole, the shoe is home.

Purpose is relative. It is frame of reference dependent. It is different for everyone. The purpose of an item describes Why it is. That we’re having this discussion illustrates that why as it applies to the item is impossible to define. Purpose does not exist without the person. Statements of purpose dont describe the item, they describe the person using the item.

Look at the difference in sentence construction between the ones under function vs the ones under purpose. In “function” the subject in the sentences is the item. The sentences tell the story of the car. In “purpose” the subject in the sentence is not the item. The item is the object here. As statements of fact these sentences describe you, me, the dog, and the bacteria.

The argument that KD, I and others are making is that since function is absolute, it can and must be the only way we evaluate materiality. The subject of disclosure is the item.

Setting the standards of disclosure as an item’s purpose is to make it relative, making the subject all the people using it and therefore impossible to accomplish. Even if the great majority of the population shares the same why. Purpose is never a shared statement of fact.

The functions of a security, what a security is, is a representation of assets. So long as the disclosures are a truthful representation of the assets, then materiality and the responsibility of an underwriter is fulfilled. While Paulson thinks the assets will go down is a fact, it is a fact about paulson and not the assets nor its representative security.

I understand why this discussion is so difficult. Humans have a propensity for applying narratives and purpose to everything. We then believe that these purposes are elements of the world, rather than elements of us. We are interested in the human aspect and perspective of the world. While we may find it of little import, these perspectives still never change what the world is.

Thousands of years ago, humans built a large ring of giant stones was built in Northern Ireland. This is stonehenge. In the absense of its builders everyone can still understand what was built. To this day no one really understands why it was built. We debate, and research and study ancient relics not because we want to know about the relics. Stone henge is and forever will be a pile of rocks. We pursue these studies to understand the people. It is the interest in other humans.
Knowing why stonehenge was built doesnt tell us about stonehenge, it tells us something about the people who built it.

This is probably worth at least some decent grade in a Ivy league philsophy course.

GS… Fiduciary Duty,Materiality, Price vs Value vs Quality, Social Value, Markets

29 Apr

I’ve recently spent sometime reading and commenting on a number of financial blogs, discussing the current firestorm surrounding Goldman Sachs. Between the SEC suit and the senate hearings Tuesday the two major roles of GS are at the heart of these discussions.

The primary issue and the one that the SEC’s suit involves is the failure to disclose material information regarding the ABACUS synthetic CDO transaction/deal/offering. This is a legal matter on what defines something being material.

The second issue that has arisen and which gets mixed into the discussion is that Goldman as a market maker / seller of securities will often have an opposing and adversarial interest with the clients to/from which they buy and sell securities. This has thus far not been a legal matter but rather a question of ethics, as well as a topic in the regulatory/reform debate.

Lastly the entire question about the social value of financial firms and trading activity is brought up, asking what exactly does all this trading do for society?

Fiduciary Duty

Fiduciary duty deals with the question of ethics as applied to the second issue.

A large part of the Senate hearings dealt with the following: How can Goldman sell securities to clients that it thinks are poor and/or has positions against? (We will ignore offerings for now and concentrate on pure market making activities.) The confusion here lies in the belief that a market maker / broker has a fiduciary duty the same way a lawyer or investment advisor would. The fiduciary relationship rests upon the idea that one party, acting on behalf of the client will work to maximize the clients interests. As a market maker this cannot possibly be true. For one the incentives of both parties in a buyer / seller relationship are by nature adversarial, anyone selling a product invariable benefits from a higher price while the buyer benefits from a lower price. There is always going to be a conflict of interest and thus impossible to ever believe a principal trading market maker is your fiduciary.
What GS ‘sells’ as a market maker is the ability to transact, to find a price someone will buy at, and a price someone will sell at.

Consider even the instance of agency trading. Where a desk at Goldman has no positions of it’s own but merely matches orders. Many times in the day an agency trader will receive buy and sell orders on the same security from different parties. If we assume his role is fiduciary in nature, how can he accomplish this to the best interests of his clients? If the sell order is large the sales at the beginning of the order will likely come at the beginning of the day will come at a higher price than those at the end. Knowing this, if the agent performs to the best interests of the buyer, he should wait until the end of day to purchase securities at the lowest price. This however contradicts his duty to get the best prices for his seller as his holding of the buyers orders lowers demand and makes price drop quicker. One may argue that he could try to balance out their interests, but that also means that he’s sacrificing the interests of one party to maintain his relationship with the other. In fiduciary terms, this is an inherent conflict of duties, which makes being a fiduciary impossible.

In it’s very nature acting on behalf of multiple parties which may be diametrically opposed makes being a fiduciary impossible. It is impossible for a trader/agent/broker to run a successful business representing only 1 client. It is therefore impossible to ever assume that anyone executing a trade, principal or agent could ever have a fiduciary duty.

Materiality and Price vs Value vs Quality

We must make a distinction between the price of an item, the value of an item and it’s quality. Price is a number, it is what you need to pay to buy a service of product. The value of an item is not. Value is completely dependent upon the perspective of the buyer of any good, service of security. What an individual chooses to buy is ultimately determined by if the perceived value of the item intersects and exceeds the price required. Some people buy a $1000 Prada purse because they believe its value is greater than or equal that price. For many others of us, we would think this a ridiculous price to pay because we find little value in a purse. Now what is of concern when we make our decision about a purchase is it’s qualities. Quality as used here defined as: it’s inherent and distinguishing characteristics and properties. What an item IS. This too is absolute. Our concern when making this decision is that what the item as advertised in this case the designer bag, is actually a real Prada bag. The material information when it comes to buying a bag are the veracity of its qualities.

The same is true regarding securities. Too often people confuse the value of a security with its price, this is not true. We buy securities we believe have value exceeding it’s asking price, and sell securities that have prices exceeding its value. How we determine may depend upon a number of theoretical models / opinions (dividends, expected appreciation etc.). Because of uncertainty in the future, the value is something unknown and is completely dependent upon the perspective of the individual. (The value of a stock of DISNEY may simply be having a piece of a company someone loves) The qualities of a security are the assets and properties that define what it IS. This may be the company a stock represents, the cash flows / loss divisions in a CDO, the payoff and reference security on an option. The job of a banker/underwriter in an offering is to assure investors about these properties, verifying the numbers and the facts. While someone’s opinion (short of having material non-public information) may change our perceived value of these assets, it never changes what the assets represent.

In the case of ABACUS the argument is that Paulson’s view is material because it would change someones perceived value of a security. It moves the standard from the qualities of a security, to how information may effect its perceived value. While an opinion may change the price and even the associated value it changes none of the basic properties of a security, its long term performance nor what it represents. For every investor there are a different set of perfectly reasonable opinions and factors which would change the perceived value of a security. This is the problem with such a standard. After all an investor could want to know what the underwriter or manager thought the likelihood of default was, their view of the economy or any other pieces of information useful in our financial decision making. All these would clearly impact our value perception. A crazier investor may want to know if managers wore blue underwear, because he felt it was lucky. Where do you draw the line? No disclosure would ever be adequate. This is why material information has to be constrained to a securities qualities. (Management knowing that they lose a large contract effects what the security represents and therefore why it is material)

Social Value

The last question, how does trading securities add any social value. After all when you trade on the stock market, trade derivatives, you’re certainly no longer providing capital to companies that need it. So how does this activity create value for anyone.

The answer is liquidity.

When an investor puts capital into a company the expectation is that he will earn something from this investment eventually. This may come in the form of dividends or selling the shares off to someone for more than you invested. The markets provide the necessary function of helping someone sell off their existing investment. If it’s harder to find buyers for your shares and therefore exit your investment you will demand a higher return for committing your money. This means that businesses that the cost of capital for a business is significantly higher and makes growth harder. The markets create liquidity, helping to ensure that someone who puts capital into a business can find a flexible way to exit and be rewarded for their investment. Obviously this in turn relies on the principle that the new buyer of the shares can themselves exit their position. In essence the ability to transfer risk lowers the cost of investing and growing business. Derivatives, bonds, CDOS etc are all instruments used to spread and transfer risk between parties and increase liquidity.

TV, The Internet and the Future of Video(Part 1)

15 Apr

Recently I began consulting at a media/cable/advertising firm trying to introduce new technology into the way we consume traditional TV and TV ads. In my discussions with friends I’ve realized that most people don’t understand many of the business or technological constraints revolving around video. I’ve decided that I would explore some of the basic ideas here and look at what i believe will change in the future.

The Basic Economics

In Cable TV there are four essential parties in a business relationship with one another that allows you to get your weekly allowance of Lost or Gossip Girl. The advertiser (Ford/Coca Cola) , the programming network (Cable:TNT, TBS Broadcast Networks: ABC), the cable operator (Comcast, Cox , Time Warner) and the Consumer (You).

The advertiser buys time during the TV shows you watch in the hopes that any ads seen by viewers will make them buy more of their products, or pay more for their products. Generally the price they pay the networks is related to the number of people the ad will be seen by as well as the type of audience. Younger is generally better than old, and higher income better than low. For any company TV’s appeal is the ability to reach a mass audience. There are approximately 114million TV households in the United States. Few other mediums have the opportunity to reach nearly the entire population of the country.

The programming networks are the guys responsible for creating all the shows us consumers spend their evenings in front of the screen watching. They’re responsible for the reality shows, the dramas and even broadcasting sporting events. Programmers make money in two ways, the first as stated above is by selling advertising. The more popular (I’m not sure popular shows are always better shows), the more they can charge for all the 30 second ads shown during. The second are through something called affiliate fees which is what your local cable operator must pay the network to be allowed to broadcast it. (Sometimes if you pull up the financials of a public programming company, this will fall under ‘distribution revenue’) Networks generally charge some dollar amount per subscriber to the cable operator. The programmers with more popular content generally get away with charging more per person. More on this later.

Cable Operators are in the business of delivering video and nowadays data. After spending millions if not billions of dollars to put wire and fiber into the ground in your neighborhood, Time Warner sells you access to their networks so you can enjoy your TV.  Their primary concerns are the number of subscribers as well as how much each subscriber pays (ARPU: Average Revenue Per User). The more services you sign up for the more the cable company makes. And since a huge amount of the costs were part of actually building the system rather that to pay for operating the service, they’re hoping you max out as much as possible.

The Consumer: If you’re like me you’re just hoping theres something good on TV. You pay the local cable guys a monthly fee so you can watch the shows, maybe see an ad for a car you’re going to buy and if you’re really splurging pay for a cable modem so you have broadband access.

For a very long time the relationships between these four parties were pretty good. Recently however the family of four is finding itself more unhappy with one another. We’ll take a look at why.

The Book of Three. Past, Present and Future

1 Jan

The other day while looking for a gift for a friend of mine, I was browsing through the local Barnes and Nobles. I decided on a series of books I read many many years ago and thought it would be a fun gift for my friend. The series The Chronicles of Prydian by Lloyd Alexander.

I first read these books over 20 years ago now. It was during the annual book fair at my elementary school that I happened upon this yellow paper back with a cartoon drawing on the front cover. The Black Cauldron the title read. “Also a motion picture by Walt Disney Pictures.”  At the age of seven anything with a cartoon on its cover drew your eye.A cartoon with an elf and a sword is simply irresistable. Upon buying the book at the fair our school librarian let me know that this was in fact the second book in a series. I would have to read the series’ first book, The Book of Three. Luckily the school library had all the other books. One of them had even won the Newbury award, the yellow medal that is sometimes affixed to childrens books!  Soon after I was discovering tales about Taran, Eilonwy, Hen Wen the pig and the Book of Three a tome about the past, present and future. Over the next two weeks I had read through all five books in the series. Paging through these books was everything that reading should be to children. It provided a foundation for the imagination, characters to connect with and even lessons in morality valuable at any age. It was the first time I can ever remember reading something and becoming incredibly sad. I can trace many of my current interets including my love for role playing games and science fiction to the moment when I by chance glanced upon that cover. Many other authors owe Alexander thanks for the money I poured into books since then. The novels were for me what I would assume Harry Potter is to many other children. They were the perfect gift for an adult who could still channel her imagination.

As I took the 5 books out from the shelves they stood on, a young asian boy came walking by. He was the same age I was when I first picked up the paperback give or take a year. With his mom following behind he looked up at the empty space left by the books I had just picked up and saw the cover for one of the remaining copies of The Book of Three.  Immediately he reached up and grabbed the book and holding it in his hand stared at it and exclaimed “COOOOOOOOL.” As handed his new found interest to his mother I could not help but smile a little, hoping that this small treasure would give him as much joy as it did me. I wonder in 20 years whether he’ll be able to trace any of the influences in his life to the green book standing in the shelves left by the man in the childrens section of Barnes and Noble.

#24, Poker and Geeks.

18 Dec

Anyone that knows me understands that I’m a huge basketball fan. They also know I’m a fan of Kobe Bryant.  My other big personal interest is poker. What do these two things have in common? The way the best people in each field approach their craft.

The stories that have always fascinated me about Kobe Bryant have been the strange quirky ones about how he approaches basketball. In a recent column between Malcolm Gladwell (author of Tipping Point and Outliers) and Bill Simmons of ESPN fame Simmons recounted the following story:

“When I visited Nike last month, we toured the development building (in which they customize sneakers for specific athletes), and the guy who ran it told us that Kobe was their favorite client. Why? Because he kept pushing them and pushing them to make the right shoes for him, even flying there for days at a time just to put himself through grueling workouts with sensors all over his body. This past summer, he pushed them to create a special low-top sneaker that also would prevent him from rolling his ankles — which seems incongruous on paper — yet they feel as if they pulled it off. And only because he kept pushing them.”

Think about this for a moment. For all the marketing done on behalf of sneakers giving them the pretense of making you like Michael Jordan how many people actually believe or care if the shoes actually do much to improve your abilities. My initial guess is that most people outside of Nike would give this little thought. I doubt the basketball players themselves even care very much outside of the marketing dollars involved. How else can you explain the lead weighted atrocities that they call baksetball sneakers. In another anecdote there was a NYTimes article probably one of the most interesting pieces about basketball statistics discussing how the Houston Rockets use data to help Shane Battier defend opposing players. In one specific example, how to tackle Kobe Bryant. In many circles people found the article incredibly enlightening about how the new Moneyball mentality can be applied to basketball. For the most part NBA players themselves didn’t find the piece interesting but in the beginning of this season the NYTimes reported:

“And after a New York Times Magazine article last February depicted the Houston Rockets’ Shane Battier’s use of analytical data to guard Bryant, he went to Grover’s assistant, Mike Procopio, and requested the same type of report on the Rockets’ tendencies.”

 Chris Ballard in his recent book called Kobe the equivalent of a Star Wars Geek at Basketball.  It’s this mindset, this geeky aspect that is compelling. To him figuring out Dwyane Wades two step to the rim is like knowing what alien race Yoda is (It’s “Unknown” for those that care) Every little thing matters.

The same exists in poker. As a member of a few poker training sites I’ve gained invaluable knowledge from the videos. Many times however you’ll see players wanting to know the “proper actions” to take in various situations like a how-to guide to play poker. What many people miss as they constantly seek this step by step manual is that this isn’t what’s most importan.  What is most valuable from these videos is listening to the thought process of  how an advanced poker players come to decide which action to take. Learning to bet-bet-overbet bluff is like learning Kobe’s jab-step, one dribble, spin back, pump-fake, step through jumpshot. Sure it’s a useful tool to have in your repertoire but learning that one move isn’t going to make you a very good or great player. In a recent video series I watched two poker pros discuss at length different spots and their thoughts on how to play their hands. For some hands they can spend 10 minutes discussing the merits of the different options and what factors they accounted for. This is the real value in these videos. The thinking, the mindset and the approach these pros have towards their craft is what others should take away. It’s not learning someone elses playbook, but discovering how we go about writing our own playbook. If you ever listen to a poker pro discuss/watch two other high class players in a match you’ll quickly notice how different their appreciation for the game is. You’ll realize that for the most parts these guys are poker geeks. They get excited by the things other players are doing. Sometimes they’ll mention some little detail that at the surface may seem insigificant, a bet size or timing but to them it’s another thing that matters. It matters the same way the sneakers matter to Kobe Bryant.

It’s no different in basketball, poker or any other field. It’s not good enough to be told or shown what to do. In order to have the chance to be the best at anything you have to think every little thing matters. You have to learn the right approach. You have to learn to be a geek.

First Person Shooters have tunnel vision and no spine.

24 Nov

With the release of Call of Duty: Modern Warfare 2 millions of gamer are back online playing mock soldier.

These games are also a constant reminder of the shortcomings of the genre when used as a model for real life experience.  One of the most glaring is the lack of peripheral vision. Stare straight ahead and then put your hand up somewhere to the immediate right of your head. You’ll notice how wide your eyes true visual range is in being able to see things that are nearly parallel to your body. The second aspect of the human eye is that it is extremely sensitive to movement.  In a hostile environment the ability to react to movement in our periphery has inevitably saved countless lives from prehistoric times to wars in the modern age.

In FPS games like COD:MW2 however players have a cone of vision that is designed to be much narrower and what you’ll immediately realize is that players are extremely vulnerable from the sides. Walk into a room in Call of Duty and you’ll notice that u cant see much to your side. In games like this you are much more likely to be shot in the side of the head simply because of the limited way in which vision is modeled.  To design peripheral vision into games would require programmers to remodel the way the environment is perceived by the player. I believe that in doing so however would tremendously improve the player experience in first person games.

One other aspect of FPS games pertains more specifically to the way targeting works in consoles. One of the major differences in the way the Xbox/PS3 controller differs from the mouse is that by pressing down on the joystick you tell the game to turn in a direction at a certain rate. To turn 90 degrees to the left then requires a player to press down on the joystick , wait for the visual confirmation that we have achieved our goal then release the joystick. Compare this to the way in which the mouse operates. If you want to turn 90 degrees to the left you simply move the mouse the distance that would require to make that change.  Which is closer to the way in which our body really operates? Imagine pointing a gun forward and needing to aim at something 90 degrees to your left. We certainly don’t tell ourselves to spin counterclockwise at a rate of 3 rotations a minute and then stop once we’re pointing the right way. Instead like using the mouse we tell our body where we would like it to point and how fast we would like it to do so. How can this be solved on the console?

With the advent of the two joystick controller players can now control their characters along two simultaneous motions. Move forward,back, left and right. Pivot the field of view up down left and right. What is interesting though is that while looking up and down does not change the way your character is oriented (it acts like our head would in real life) turning left and right requires the entire character to pivot. It is designed this way because joysticks have a limited range of motion. It would be like if a persons spine were fused and we could not turn from the hip up. Similarly it is impossible to run one direction while facing another. (Strafing exists but is dramatically different due to the speed at which players move)  What does this have to do with the targeting problem above?

Developers should create a secondary movement/targeting system that resembles the way our body turns and pivots from the waist up. It could simply be done by utilizing a button (i.e. left trigger) to act as a SHIFT key. Holding this button down would change the way the right joystick operates. Instead of pivoting the whole body it would simply pivot the game version of our upper torso. Since the range of motion of the upper body is limited we can then map the range of activity to particular amplitudes in the joystick and have it act exactly as we would a mouse. Centering the joystick would place our field of vision and target straight ahead, while pushing the joystick to the upper left would immediately have our character look to the upper left most range. Similarly everything in between would be mapped accordingly and players could train their muscle memory the same way they would if they were holding a real gun.

Many games already do this second target system, but it is used most often in a game that is trying to simulate some kind of turret system. The Mechwarrior genre of video games was one which used this “upper torso” action as their primary method of targeting. By improving the current Console movement system with the upper torso action we can create a better simulation of how the human body works and improve the game mechanics as well.

Fourth and 2

16 Nov

Last night at the end of the Patriots-Colts game, leading by 6 with a little more than 2 minutes to play Bill Belichick decided to go for a first down at their own 34 yard line. Conversion fails, Colts Score, Sports commentating mayhem ensues.

Let us at least look at the basic problem being proposed in this case. The simplest way to look at this is the following equation:  You go for it if  x + (1-x)*y >  z

x: probability of Patriots converting the 4th down.

y: probability of Colts failing to score a TD from 34 yards.

z: probability of Colds failing to score a TD from the 70-80 yards.

If the Patriot’s chances of converting combined with their chances of stopping the colts when they fail to is greater than the chances of the colts scoring from further then they should go for it. For various values of x,y,z that are very realistic going for it proves to be a good decision.

We can complicate it by asking what x,y,z really represent. What’s we’re implicitly weighing is the efficacy of the (Patriots Offense vs Colts Defense)  against the (Colts Offense vs Patriots Defense)  The better both teams are performing offensively the better the result for going for it versus punting. Another factor that arises in this question of going for it is the the value/penalty of having to go an extra 40-50 yards.  y is essentially the Touchdown function at 34 yards. Whereas z is the Touchdown function at 70 yards. (y= f(34) , y=f(70) ) Yards to end-zone have a diminishing return. Going from the 5 yard line to the 10 yard line is a much greater penalty than going from the 45-50. For better offensive teams the penalty for each incremental yard is less than it would be for poor offensive teams. (In the extreme scenario the Colts + Raiders both have a HIGH likelihood of scoring from 1 yard out, but the Colts have a significantly greater likelihood from scoring 50 yards out than the Raiders would)

I don’t propose to have an answer as to which is actually the correct decision but simply ask that people analyze and consider the different factors and solutions in this scenario. It drives me crazy that  most of the sporting world refuses to do any analysis but instead exclaim “Play the percentages and punt.” Exactly what percentages are people referring to here. Surely there must be a study that the coaches, sports writers and radio talk show hosts have all studied. My guess is that they simply relied on conventional practices and based on history believe them to be best.