Mapping Strategy

Forecasting Their Way to Durable Profits

From the front page of today's Wall Street Journal [emphasis added]:

...a little-known tool of the insurance world: Computerized catastrophe modeling. Crafted by several independent firms and used by most insurers, so-called cat models rely on complex data to estimate probable losses from hurricanes.

But regulators and other critics contend that the latest cat models -- which include assumptions about various climate changes -- are triggering higher insurance rates.

Starting in the early 1990s, cat models began to replace the industry's older tools. Previously, insurers based their rates and underwriting policies largely on historical records of past claims.

Never mind if the forecasts are accurate or not. They work. To increase profits. That's not a pejorative statement as far as the insurance companies are concerned. It's their fiduciary responsibility to maximize return for their shareholders by any legal means available. It does however, set up an interesting, albeit very long-term test of the credulity and patience of their customers. I.e., should the forecasts prove inaccurate. More from the WSJ piece [emphasis added]:

Underlying the newer cat models are scientific theories that rising sea temperatures will result in more intense, and possibly more frequent, hurricanes. The hypotheses suggest that catastrophic hurricanes like 2005's Rita, Wilma and Katrina weren't an aberration, but rather the shape of things to come.

Large reinsurance companies... were early converts to theories of global warming and cite warming of the earth's oceans when predicting massive damages from future storms.

Well of course they were! Think about it for a second.

You're the CEO of a big reinsurance company. Two scientists walk into your office. One says he's got a new computer model that predicts big future costs due to storms.

"Of course I may be wrong," says scientists number one, "After all, I'm a scientist. We deal in hypotheses. You're the executive. You need to make the call on what to do with this."

"So let me get this straight", says the CEO. "If your models are right, we get to raise our rates because our competitors, customers, regulators and the general public are all looking at the same stuff, convinced that your predictions are true? Is that what you're saying?"

Hmm, she thinks to herself (the CEO). This is pretty good. If this guy is wrong, we get to pocket the difference for decades. It would take that long for anyone to prove this guy wrong. Even better, it's not that hard a sell to the general public. We've got cover. If he's right, well... we'll keep him on retainer. Keep his firm in good shape. Drop them some plum projects to keep 'em happy... maybe even kick this over to mar-com to manage. Under that scenario, we've at least got a decent business until I retire -- no better or worse than before. All upside. No downside. Suhweet!

The CEO smiles. She turns to scientist number two. "And what do you have to say for yourself?" she asks.

"Um...", stammers scientist number two (a geologist by training), "...the fossil record over several million years, and agricultural evidence over several millennia would tend to suggest that storm activity actually decreases during warmer climatic periods. And we're just getting this new data in from deep ocean probes suggesting that 80-90% of the ocean volume is staying the same temperature or maybe getting colder. It would be a bit hasty, in my opinion, for you to raise your rates based on a set of theories and prospective models that claim precise predictability when what we're really dealing with here is massive uncertainty. If you just sign the proposal we put on your desk to study this a little further, we can refine the numbers..."

"Thanks for your advice", asks the CEO. "I'll look into it. Have a nice day."

That's a fantasy dialogue, obviously. Read the WSJ article and draw your own conclusions [emphasis added]:

Perhaps the most prominent critic to surface is Karen Clark, an economist who founded one of the first cat-modeling firms two decades ago. Today, she warns about the programs' misapplication...

Companies that rely too heavily on cat-model data "are subjecting their businesses and their customers to the volatility of computer models," says Ms. Clark, who now runs a Boston cat-model consulting business. "The models are being used as if they produce definitive answers rather than uncertain estimates." Ms. Clark says she advises clients to use them in conjunction with other factors, such as broad historical data.

To be sure, insurers themselves are facing higher rates from the reinsurance companies that backstop their claims. The reinsurers, and the financial ratings agencies that assess the health of carriers, are also using the controversial newer models.

I just love this last bit:

...some models now attempt to estimate future losses over a shorter period of time. In doing so, they may also use selective historical data. One model, for example, was reprogrammed to give greater weight to years in which ocean temperatures were particularly warm and hurricane rates were high, such as the period from 1930 to 1945 [prior to broad industrialization and CO2 increases]. That particular model resulted in higher loss estimates for the near-term.

...and therefore higher rates. The logic is circular.

David Einhorn on the Financial Crisis, Government Complicity and Why Rating Agencies Aren't Much Better Than USAToday

Working deep inside Wall Street these past eight months or so, I've had a privileged vantage point from which to observe some of the most tumultuous quakes in the industry in a generation -- and arguably in a century. (Given the near-catastrophic, and still potentially catastrophic nature of those changes, one might legitimately argue with whether 'privileged' or 'punitive' would be the right word to describe my seat in the proverbial bleachers on this one. Since I'm still being paid -- for now -- I'll stick with the former, if only because it has been quite an education.)

Readers without a direct interest in the inner workings and accounting arcana of the financial services industry though, should take a gander at David Einhorn's ten-page pdf/speech: "Private Profits and Socialized Risk". [emphases added in the excerpts below] H/T: Bob Weber.

On the credit-rating agencies:

The market perceives the rating agencies to be doing much more than they actually do. The agencies themselves don't directly misinform the market, but they don't disabuse the market of misperceptions -- often spread by the rated entities -- that the agencies do more than they actually do. This creates a false sense of security and in times of stress this actually makes the problem worse...

It is hard for me to see how the rating agencies survive this debacle with their franchises intact.

On the failure of Bear Stearns and how the SEC has enabled the entire mess:

Rather than looking at its own rules which permitted increased leverage, lower liquidity, greater concentrations of credit risk and holdings of no ready market securities, the SEC is conducting an investigation to see if any short-sellers caused the demise of Bear by spreading rumors.

Of course, Bear didn't fail because of market rumors. It fell because it was too levered and had too many illiquid assets of questionable value and at the same time depended on short-term funding.

On how none of us are really spectators in this

...before Bear Stearns failed... I [had] planned to speculate that regulators believe all of these [major investment banks] are too big to fail and would bail them out, if necessary. The owners, employees and creditors of these institutions are rewarded when they succeed, but it is all of us, the taxpayers, who are left on the hook if they fail. This is called private profits and socialized risk. Heads, I win. Tails, you lose. It is a reverse-Robin Hood system...

As night follows day, it is certain that in the absence of tremendous government regulation, this bailout [of Bear] will lead to a new and potentially bigger round of excessive risk-taking...

On the counter-party credit system

In effect, [with Bear] the government appears to have guaranteed virtually the entire counter-party system. The message is that if you are dealing with a major player -- anyone in the "too big to fail" group -- you don't have to worry about that player's creditworthiness. In effect, your risk is with the U.S. Treasury...

...regulators should consider dismantling the counter-party system... require the posting of all derivative trades, clearing them through a central system and regulating margin requirements...

Sobering stuff, with a few funny bits (check out his water-vs-Coke analogy), along with some interesting long- and short- stock picks near the end. I urge you to read it all. The reason I post it here (a scenario- and big-picture-oriented blog) is that it will eventually touch pretty much everything in the global economy. Ignore it at your peril. Understand it and you'll at least be able to tell the difference between a two-by-four and a rock when it hits you (and all of us) in the back of the head.

From Risk to Uncertainty

I don't agree with everything in this piece by Thomas Homer-Dixon that appeared last week in the Toronto Globe and Mail, but this quote is an absolute gem (emphasis added):

Our global financial system has become so staggeringly complex and opaque that we’ve moved from a world of risk to a world of uncertainty. In a world of risk, we can judge dangers and opportunities by using the best evidence at hand to estimate the probability of a particular outcome. But in a world of uncertainty, we can’t estimate probabilities, because we don’t have any clear basis for making such a judgment. In fact, we might not even know what the possible outcomes are. Surprises keep coming out of the blue, because we’re fundamentally ignorant of our own ignorance. We’re surrounded by unknown unknowns.

It's something I've said for a long time:

It's tempting to think that all things are predictable given enough information, enough minds, enough time and enough computing power. It's just not true. (Which is not to say that some things are not predictable... and with incredible precision... a phenomenon that leads to overestimating the scope of problems and questions that lend themselves to such methods.)

Telling which is which is the trick...

I would go even further to say that really smart people who, by life experience know that some things are fundamentally unpredictable still draw an unvoiced sense of emotional comfort in their business life from the idea that some wise expert somewhere has been to the future (for all intents and purposes) and if we could just find him or her things would be OK... and/or that a really sophisticated computer model or prediction market (the 'collective mind') can provide crystal ball-level insights.

Sometimes yes. Often, no.

I liken Mr. Homer-Dixon's observations to those tragically massive car pile-ups that happen a few times of year in fog-prone areas like the Central Valley of California. Everyone is driving along at a reasonable speed, with reasonable spacing between vehicles. People are sipping coffee, tuning radios, maybe talking on cell phones. Slightly distracted, but mostly responsible. All is normal.

Then the first guy hits a fog bank and can't see squat. He taps his brakes. The second guy sees red lights and fog coming up fast and taps his brakes just a little bit harder, and so on. In just a few seconds, hundreds of cars end up in a tangled heap and people die. All because the guy in front was convinced by every one of his senses and not without justification based on experience that the visibility on the next 100 yards of road would be the same as on the last 100 yards of road.

One of the Benefits of Working in "Cube Land"

Your choice of seating at work may affect much more than your sensory pleasure at knowing when someone is eating tuna fish or onions versus citrus fruit or chocolate. Google has discovered that it's the most important factor in your being in the loop: in particular, whether you win or lose based on your close colleagues' prediction market trading.

(See 'heat map' at right: successful traders are depicted in green; losing traders in red).

(H/T: Jeffrey Henning)

'Real' traders take note! (Pick your desk-mates carefully.)

Random thought: this adds a whole new dimension to the elaborate strategies seasoned business travelers use to get primo seating on airplanes. Exit row? No thanks. Just give me the seat next to Warren Buffett.

Scenarios as Vehicles for Fear-Mongering

When we develop scenarios with clients, we emphatically avoid the kind Frank Furedi (rightly) decries here [emphasis added]:

From global warming to obesity, bird flu to terrorism: 2007 was the year when the threat of an apocalypse became an everyday, even banal public issue... The fear market in apocalyptic scenarios continued to flourish in 2007. Almost every week we were told that ‘the situation’ is far worse than we originally thought... Public figures appear to have lost the capacity to reassure or lead people. Instead, they frequently opt for evoking frightening futuristic scenarios where the line between fiction and reality become unclear.

One consequence of Western societies’ obsessive preoccupation with the apocalypse-to-come is that less and less creative energy is devoted to confronting the all too important problems that exist in the here and now. Take the global credit crunch unleashed by the sub-prime home loan crisis this year for instance.

In terms of its material impact, this was arguably the most significant event of the year. After more than a decade of economic stability, the world economy faces the threat of a major recession with important implications for people’s lives. This threat may not make an exciting plot for a sci-fi movie, but it has a direct bearing on the quality of life of millions of people. It also raises important questions about an economic system that is so heavily reliant on using fictitious capital to reproduce itself.

Events over the past 12 months suggest that what we think and how we think influences how we experience our reality.

Some rules and questions we use to avoid these traps and test whether scenarios are useful include:

Are scenarios sufficiently orthogonal to and distinct from one another? Does each embody both 'good' and 'bad' elements? Real world developments are seldom all good or all bad at the same time and from the same perspective. If participants in a scenario workshop find it trivial to line up the scenarios in the same way from "good/easy for us" to "bad/frightening for us", we haven't done our job of representing real-world nuance in hypothetical future stories.

Do scenarios incorporate "here and now" events and choices? (We usually embody these in what we call 'events', a component of modular scenarios). Scenarios entirely about some far-off, visionary 'place' with no explicit ties to current issues are seldom useful beyond the fiction stacks.

Are scenarios directly comparable to current conventional wisdom? (I.e., as Furedi puts it, "how we think... [and] experience our [present] reality"). Without a concrete "you are here dot" scenario that represents what constituents are thinking and assuming, it's impossible to describe how "far away" hypothetical future scenarios really are, or what change they imply. If I'm contemplating a trip to Miami, it helps to know (in terms of budgeting, preparation and mode of transport whether I'm currently in Juneau, Ft. Lauderdale or Tiera del Fuego.

China's GDP Changes Hands Every Day...

Well, almost. In my business it has become habit to scoop up watershed factoids like this and--along with other bits and pieces--make sense of them in a larger context of multiple future scenarios.

...the Bank for International Settlements in Basel, Switzerland... [tracks] the size of foreign-exchange markets. In April, daily turnover in currency markets rose to $3.2 trillion, the bank said yesterday.

That's more in value than the annual economic output of Germany or China, changing hands in currency markets every day around the world. It's also up 71% from the BIS's last survey in 2004, the largest jump in volume since the institution began conducting its benchmark survey in 1989.

Fallacies of Telecom Network Resilience: Lessons From the Taiwan Earthquake

Picking up from my post on the same topic earlier this week, more is becoming clear about Internet and telecoms network failures to and within Asia as a result of Tuesday's major earthquake(s) in and around Taiwan.

• Boats are in place and the fix is already underway, contrary to earlier reports indicating that the cables wouldn't even be touched until after the turn of the new year.


• Laws designed to keep fishing vessels from dragging undersea cables carry fines pitifully out of proportion to the potential damage (roughly a million-to-one). It's not clear why, in a nation (China) not shy about capital-punishment, someone has not lost their head over previous cable cuts (e.g., April 6, 2004).


• The capacity of land-lines from Europe to Asia is tiny in comparison with those from the U.S. to Asia and the U.S. to Europe. This global asymmetry  raises a host of issues ranging from economic development to politics to outsourcing to culture.


• Satellites are expensive and have only limited capacity. The illusion that they offer backup to undersea cables is just that--little better than thinking that carrier pigeons will fill the gap.

With that and other emerging news, it's also becoming clear that lessons learned after 9-11 haven't 'stuck'.

Within the IT-savvy portion of the New York financial community at least (and, I would have imagined, well beyond it) a great deal was learned, publicly documented and put into practice to address the fragility of such networks. The cost was not small, however the there was unanimous agreement that the alternative was worse. The direct and indirect costs of closed markets (four days in the case of 9-11) were understood to be vastly larger--something that many in Asia are rediscovering to their collective chagrin.

The lessons of 9-11 (from a business resilience perspective anyway) are not particular to New York, to the U.S.,  or even to a cause. I'll rephrase and repeat that last bit, because without justification, thinking about business resilience is too often segmented by what went bump in the night rather than what happened as a result of it.

The business resilience lessons of 9-11 apply as well to natural as to man-made disasters; as well to widespread as to 'point' impacts; and as well to protracted as to short-duration events.

The lessons are immutable--essential principles for building and maintaining resilient networks and organizations. Two biggies are:

Understand layer one. Don't assume that a carrier's logical architecture (much less it's marketing architecture) showing a ring, double ring, or even mesh network has anything to do with physical reality. Both 9-11 and the Taiwan earthquake illustrate how economic pressures and crowd dynamics drive networks towards similar if not identical paths-of-least-resistance. (I suspect that carrier assurances in articles like this are not really about physical routes.) This is no more the fault of a particular company or person than is Interstate 80 through the California Sierras, the Golden Gate Bridge across the mouth of San Francisco Bay or the majority of the U.S. financial community on one tiny island (Manhattan). Those were simply the most logical  and least costly places to put those things. So it is under the ocean... 

Get a cross-carrier view. Don't assume that because you have signed up with three carriers that your data (or voice) traffic is moving via three distinct networks, much less three physically dispersed paths. Inter-carrier 'grooming' agreements can spring up without any legal requirement for end customers to be notified.  This is what happened on 9-11. In a similar vein, don't assume that the Internet itself is resilient because it was designed to withstand a nuclear attack. See point one: physical routes matter.

I'll address other laws of business resilience in subsequent posts.

Exchanges (Finally) Go Global

It's unfortunate that the WSJ chose to run this fact-packed, big-picture story (subscription required) on the Saturday of Memorial Day weekend. Being the strategy geeks that we are however, we were all over it. The story charts the recent sea-change from human-driven, city-centric, product-specific, cooperatively owned stock exchanges to global electronic powerhouses trading in a wide range of securities and derivatives.

[U.S.] exchanges find themselves motivated by a new phenomenon: Big overseas companies no longer see the U.S. as a place where they must list their shares to raise capital. Tougher U.S. regulation of companies and the ease with which capital can flow around the world have made it attractive for companies to list closer to home. Next week, the Bank of China is preparing a nearly $10 billion offering that will take place on the Hong Kong Stock Exchange... In 2000, nine of every 10 dollars raised by non-U.S. companies outside their domestic markets was through U.S. exchanges... By last year, only one in 10 such dollars was raised in New York. [emphasis added]

As the WSJ notes, that's a truly radical change. Some of it is no doubt driven by exchange rates, but only some. Another major factor has been increased regulatory oversight in the U.S., (e.g., Sarbanes-Oxley), providing a sobering lesson in the unintended consequences of well-meaning legislation in a fluid, free-market global economy.

Massive, permanent structural shifts like this are what we refer to when we talk about "discontinuous change" and the need for creative scenario thinking in order to survive it. Linear forecasting and trend-spotting does little good. One day the world looks much like it always has and business-as-usual works just fine... and then one day it doesn't. Credit the NYSE's post-Grasso leadership with seeing and responding to these changes as best they can.

In early 2004, when John Thain arrived to take the helm, he quickly discovered that the NYSE had serious competitive issues. Specializing in stocks, it was less electronic than its peers. Visits to Chicago and Europe showed how the New York exchange had fallen behind innovative rivals such as the CME, Euronext and Deutsche Börse. Mr. Thain invited one NYSE staffer to his office a few months after he arrived and told him that the exchange had to go public, build a derivatives business and go overseas... [emphasis added]

Better late than never. The other thing they've been needing to do, which the article also notes, has been to marginalize and ultimately eliminate a byzantine human-dependent floor-trading system that by preserving antiquated pre-computer trading methods only lines the pockets of seat-holders and specialists. Other Mapping Strategy posts on NYSE doings can be found here, here, here, here, here, and especially here ("Competition and Terrorism in the Securities Industry").

Executives, Prediction Markets, and Wall Street

Prediction market fans can chalk up yet another story in a mainstream publication likely to catch the attention of C-level executives: 'Betting the Ranch on Your Company' in the CFO Magazine issue dated March 6th. It's a reasonably thorough and intelligent treatment (save for a quibble about true versus perceived probability), however the examples will be largely familiar to those who've been following this space for more than the last few months. The author is unfortunately over-reliant on a single source with an agenda (albeit a very well-informed one who happens - in our opinion - to be right): Mike Knesevitch of Intrade's parent Trade Exchange Network.

...some contracts aren't as accurate as others—particularly those that hinge on court cases in which cameras aren't present... prediction markets might... provide a venue for useful corporate decision-making... the judgments of a group of bettors within a company itself can supply useful information on business operations that lack systematic ways of culling data... Wisdom gleaned from employees in such ways can temper executive decisions. [emphasis added]

...which is exactly why some executives fear and/or marginalize prediction markets and why despite the track record and the enormous number of potential applications of prediction markets in business decision-making, they've enjoyed only moderate, creeping success to date. One does not claw one's way up the corporate ladder and struggle to get one's face on the cover of Forbes only to have one's decisions 'tempered'... unless one is smart and forward-thinking and secure in knowing that the wisdom of the many will trump the wisdom of the very few more often than not (though not always).

Telling the difference is the tricky part.

What C-level executives choose to do with the information that keeps coming out about prediction markets in major publication is dependent to a large degree on things that have nothing whatsoever to do with the accuracy of the markets themselves, e.g.:

• how congruent is the organizational structure and decision-making process with the forces and yearnings that prediction markets inevitably unleash? (flat, fast and democratic? or hierarchical, slow and autocratic?)
• how secure do executives feel in their role(s) as facilitators and empowerers? (as opposed to being the smartest and best informed in every situation)
   
  
• how (and how well) does information flow through the organization today? (are cross-boundary exchanges encouraged? or are silos and secret-keeping behaviors implicitly rewarded?)
• how are heretics, truth-tellers, gadflies and other critics of conventional wisdom utilized (or 'dealt with') inside the confines of a particular corporate culture?

It should also be noted that the success of prediction markets in business has been restricted, for the most part, to a handful of truly enlightened companies known for management innovation and experimentation with second-generation knowledge management. Yet even there, we know of none that has yet adopted them wholesale. (One large client has told us they're explicitly laying the groundwork to make that possible but hasn't quite gotten there yet.) Whether the next few years are a time of true market-adoptive chasm-crossing for prediction markets, or a time of continued dribs and drabs of ad hoc experimentation (amidst wider and wider awareness) is anyone's guess.

One thing that is worth getting excited about is a potential correction that prediction markets might achieve to the longtime myth of securities analyst independence - something which could catapult them into the 'hot' bin (i.e., "do something about this now") of top executives at virtually every publicly traded company.

Intrade is also about to list a contract that depends on the likelihood of a downgrade, a restructuring, a technical default, or missing payments at one prominent, if wobbling, corporation.

The practice of mutual hand-washing among Wall Street traders, deal-makers and analysts whose paychecks all come from the same place has been barely band-aided over in recent years by conflict of interest regulations, changes to explicit bonus incentives, organizational firewalls and a trickle of independent competition. Barely. We've seen it from inside. The system was very ugly. It is slightly less ugly now. By contrast, the advent of public prediction markets to corporate financial analysis would be like a busload of supermodels storming into town - a shot of independent truth and beauty and information that could drive them into widespread corporate-internal applications almost overnight. Interesting times...

ADP Links SFTI to SWIFT

The implications of this development are bigger than they first appear:

ADP Brokerage Services Group, a division of Automatic Data Processing, Inc. (NYSE: ADP), announced today its capability to enable the Securities Industry Automation Corporation's (SIAC)(R) SFTI(R) user community to access SWIFT's global community via the ADP SWIFT Service Bureau offering.  SIAC's Secure Financial Transaction Infrastructure (SFTI)(R) is a high capacity infrastructure that improves the overall resilience of the financial industry's data communications connectivity. The ADP SWIFT Service Bureau offering provides a bi-directional bridge for message and file traffic between SFTI clients and SWIFT, and provides the financial community with seamless, cost effective and highly scalable access to robust and secure domestic and international networks.  It affords SFTI clients the ability to interface with the SWIFT network without incurring the cost of acquiring, operating and maintaining individual hardware, software and communications lines.

The significance of this includes:

1) Linking even more closely the two parts of the banking industry that were separated in the 1930's

2) Dramatically expanding SFTI's global presence; (the resilient network was conceived as a patch for New York metro-area data networking problems that emerged on 9-11), and

3) Opening up the NYSE's reach at a critical point in its competitive history as it merges with Arca, (the NYSE is majority owner of SIAC, which in turn runs SFTI.)