Friday, January 29, 2010

Raising Interest Rates on Reserves and a Jobs Bill at the same time?

Prompted by a column by Allan Meltzer:
Firstly, Mr. Meltzer's opinion on the Phillips curve is very interesting. He claims that the Phillips curve doesn't work, citing history. Paying high interest rates on reserves worsens inflation because you're actually adding more capital to the economy, just later.
I'd like to see a better argument for why the Phillips curve doesn't work than simply "it didn't work in the 70s". One of the big problems in the 70s was that we were heavily oil-constrained, and so even if there was excess labor or capital capacity, one of our critical inputs limited growth so that extra money put into the economy worsened inflation. Had the money gone towards non-oil-intensive parts of the economy, I wonder if we wouldn't have avoided stagflation. Additionally, from what I understand, Volcker's willingness to have high interest rates was what ended the inflation portion, and then from that recession, he lowered rates to get the economy going again. Thus, I'm still unsure about whether Mr. Meltzer's claims are accurate.
It is ridiculous and incredibly counterproductive, by the way, to come out with an $80 billion jobs bill AND increase interest rates on reserves. Those two policies will counterbalance each other on employment, and worsen inflation by increasing government spending without stimulating any demand at all. I don't hate some parts of the jobs (read: second stimulus) bill, but I'm not such a big fan of the "raising interest rates on reserves" policy - I'd rather see the Fed sell more government securities, although maturity mismatch is an underreported issue right now.

why banks aren't lending (the FDIC lottery for assets), making healthcare cheaper and some incredible links on behavior

I've added a new blog to my "read every day no matter what" list (currently at 5 - mankiw, cowen, pettis, krugman (usually to disagree), and now Eric Barker, as well as a number of newspapers), and he has a LOT of cool news and links! Most of these are hat tipped to Eric Barker, although some are my own discoveries.
I haven't done a links post in a while, and I've come across some biggies in the interim.
Just like taxes cause people to work less, fear of malpractice lawsuits are an expected cost that prompt doctors to work less. Since we're already crushingly short of most types of doctors, and especially competent ones, this gives more to the idea that tort reform would be a very intelligent step in bringing down costs. Not only would there be less "excess testing" but also more supply of doctor time, which would be very valuable in driving down medical costs.
The other problem with overregulation, populism and punishment: it creates uncertainty that can cripple the investment decisions of an economy.
"Highly trustworthy individuals think others are like them and tend to form beliefs that are too optimistic, causing them to assume too much social risk, to be cheated more often and ultimately perform less well than those who happen to have a trustworthiness level close to the mean of the population.  On the other hand, the low-trustworthiness types form beliefs that are too conservative and thereby avoid being cheated, but give up profitable opportunities too often and, consequently, underperform.  Our [empirical] estimates imply that the cost of either excessive or too little trust is comparable to the income lost by foregoing college."
The effect is unsurprising, but the magnitude is stunning.
Experts make the best decisions not when they overconsider, and not in a split second, but when they spend time not consciously thinking about their decisions. It's a good idea to sleep on a problem, etc.
betting on fun things makes them less fun.  (I'd bet you, however, that betting on non-fun things makes them more fun)
Incentives provide yet another reason why banks aren't lending. If having excess capital means you get the deposits of a failed bank for free, why would you lend? The only lenders are going to be those who are about to fail, would never be given deposits and need the interest income.

Monday, January 25, 2010

Subtle Media Mistakes: The Economist

The Economist tends to be better at economics than other media outlets, because it's their focus.
However, that doesn't exempt them from mistakes in trying to find a story.
They try and refute three signals of a bubble - asset prices too high, investment too high (leading to inefficient projects) and bank lending too high. Their mistakes are subtle, but they're there...
They cite the "reasonable" Shanghai A share P/E of 28. Paragraphs later, they mention that China is not very levered.  The problem with this is that leverage typically inflates P/Es in the short term, meaning that a 28 P/E in an unlevered environment is actually really high. There are three reasons for this.
Firstly, if I have a company that has 100 in EBIT (earnings before interest and taxes - basically, the money a company makes before paying debtholders, equityholders and the government), and no debt (assume a 0% tax rate), then all 100 flows to the equityholders. The earnings are 100. 5% revenue growth translates to 5% earnings growth.
If, instead, you have 100 in EBIT and 90 in debt, then only 10 flows through to equityholders... but if EBIT goes to 105, then all 5 of the new EBIT flows through to equityholders, because you dont have to pay more interest on debt just cuz your revenue goes up. Thus, it's much easier to see higher equity earnings growth in a levered economy - in this example, 5% revenue growth leads to 50% equity growth! A 28 P/E for a low-leverage country means that growth expectations are off the charts. If the country misses, then the stock market is in trouble.
The second problem is that if the expected return on invested capital exceeds only the interest payments required on debt capital (it doesn't even actually have to, just needs to be expected to), then any expectation of further leverage in the future would mean very, very fast growth, and the P/Es are high. Thus, that P/E of 28 may factor in expectations of colossal further leverage. The banks, however, are seriously overexerted (see below), so that leverage may not come for a long time. That's another recipe for an equity collapse.
The final problem is that most Chinese companies are asset-heavy - manufacturing plants, natural resource mines, etc. They're also much more bureaucratic than most US companies. If this means that there are lots of fixed costs, then the companies there have operating leverage - similar to the EBIT example above, except instead of the 90 going to debtholders, its going to servicing fixed costs. That means that any slowdown at all can crush asset values.
Thus, it's pretty likely that a 28 P/E is very high. Home prices are probably the same way.
They cite that home prices relative to average incomes has fallen in the past decade, and if you look at the pool of Chinese homebuyers, they're not average - the ratio of home prices to average homebuyer income is the same as the home prices to average income in developed countries. The problem with this analysis is that you have to do the same thing to developed countries - including poor people in the developed country number and excluding poor people from China's number is not apples to apples. In this case, the developed country number probably drops well below 4 or 5, so China's number is still high. China is also continually building MORE houses, while they're not increasing the number of rich people that fast. Thus, housing prices can collapse very, very quickly. This is exacerbated by the fact that occupancy rates are already low in the biggest cities.
Finally, China's property boom being financed by saving, not bank lending, helps to not decelerate the property market so much, but the banks are still wayyyy overlevered - it's a product of deficient banking resources, not reasonable banks. If the banks there collapse, perhaps the bailout measures there will be smaller than in the US but they'll still have to be substantial. Meanwhile, China is more unequal than the US, and has less mobility, so even if a small number of people or builders start defaulting, it's unlikely that there will be buyers to pick up the slack, as there would be with an equivalent sized banking crisis here. In other words, if the price elasticity of demand is higher in China due to greater economic inequality, home prices can still collapse.
On capital investment, there are a number of problems as well. The first problem is that GDP numbers seem to be getting more and more inflated, but let's put that aside because the evidence is anecdotal, not statistical. The author looks at ICOR and TFP as measures of the efficiency of Chinese investment. This, too, has problems. ICOR doesn't acknowledge that a huge percentage of their capital investment has gone into infrastructure and buildings. Construction itself is a tremendous contributor to GDP in China, and it counts no matter how efficient it is to build the building or infrastructure, so if China is accelerating construction and construction is a big piece of GDP (as it is in China - 40+%), you expect ICOR to stay stable. It only dips when you stop accelerating construction. (disclaimer: I haven't worked with ICOR that much, so if I'm misinterpreting it, please let me know, but I don't think so...)
TFP is a) dubious in its year to year relevance, b) strongly affected by what happens in other countries, and c) far less relevant when large portions of your GDP are in commodities production and commodities have increased so much in price over the last few years. That has the ability to mask declines in incremental capital efficiency.
Finally, the author does concede that bank lending is in trouble and the gvt will have to stomach a lot of those losses. He also ignores the fact that credit to GDP is less important than credit to bank deposits (and I don't know what those have been). He cites that the credit growth:gdp growth has been less than most developed countries since 2004, ignoring that the rest of the world had a massive credit bubble since 2004.
Overall, while I understand that people who think China will go the way of Japan (crash, and never recover) are probably overstating the case, it is probably naive to look at China and pretend it's not in a bubble. Maybe I overrate the size of the bubble - that is certainly possible - but most of what we see in China right now seems very, very bubbly. 

Saturday, January 23, 2010

Reconciliation and the Healthcare Bill

The fact that the House is considering passing the Senate bill and then adjusting it through reconciliation is absolutely absurd.

There are two problems. Firstly, the Senate bill would never have even been approved without the blatantly corrupt appointment of Kirk to Kennedy's seat. For those of you who don't follow Massachusetts politics too closely, When John Kerry was running for president, Democrats in the MA legislature didn't want Mitt Romney, the governor at the time, to appoint a Republican senator, so they changed the rules of gubernatorial appointment to the Senate to state that the governor cannot appoint a senator to a vacant seat. Instead, a special election must be held posthaste.

When Ted Kennedy was terminal, the MA legislature, recognizing that Deval Patrick, the governor, is a Democrat, went back and changed the rules to what they were beforehand.

Adjusting procedure on the basis of who is in power is extremely shady... with any sense of fairness or dignity, Kirk would not have been in the Senate, which would have meant the Senate bill would have not passed. The fact that nobody is making a big deal out of this is unbelievable.

The other problem is that reconciliation is inherently designed to combat BUDGETARY issues, and budgetary issues only. The 2003 Bush Tax Cuts mentioned in the politico article were a classic use of reconciliation, because tax cuts are budgetary. Would it have been better if they had been designed to be bipartisan? Absolutely. However, the use of reconciliation was not absurd.

Even the "budgetary" parts of the health bill are not really budgetary issues by themselves , they're part of a healthcare overhaul which was not intended for reconciliation. To use that would be to abuse the procedures of the Senate.

In November 2008, it was hard not to vote for Democrats across the board. Just a year later, it's becoming hard not to vote for Republicans across the board. As long as Huckabee and Palin aren't the nominees, it's a real thought.

Btw, for the first time since the beginning of the Obama presidency, a poll has shown that Huckabee would narrowly defeat Obama in a presidential election if it were held today. We're not talking Romney, a moderate Republican, here. We're talking about a former MINISTER. That should be a wakeup call, but everyone is ignoring it...

Friday, January 22, 2010

Supreme Court Campaign Finance Decision: A Dangerous Precedent and a Dumb Decision

I strongly disagree with the recent Supreme Court decision declaring it unconstitutional to limit corporate and union spending on advertising for candidates in elections.
The stated rationale generally revolved around the idea that such restrictions violate the organizations' first amendment rights, and amount to censorship. (I don't know if the Supreme Court is using the first amendment argument - much of the media is - but it definitely used the censorship argument).
I'll take the first amendment issue first, and then deal with the censorship issue.
First Amendment argument:
The first amendment argument is complete and utter nonsense, because corporations and unions do not have first amendment rights. Every individual in this country, as a human being, is covered by the first amendment. Organizations in general, however, are not individuals.
Additionally, corporations are most intrinsically a tax entity, and a mechanism for distributing the profits of a business endeavor among the people responsible for the labor and debt/equity capital that spawned the endeavor. Corporations fundamentally represent their employees, debtholders and equityholders. Thus, corporate spending is actually involuntary spending by the employees and capital stakeholders of a company. Involuntary pronouncements can hardly be called 'free speech'. Thus, a corporation cannot have an opinion.
What about management, you say? Management is composed of people, and those people are allowed to have opinions and are allowed to state them. One could even argue that by contracting with a company as an employee or capital stakeholder, you are empowering them to use your money to distribute their opinions if doing so will be beneficial to the organization you're contracting with, and you, by extension. However, there are two points. Firstly, nowhere in the definition of a corporation or in any sort of corporate law is this stated - it's a philosophical case that has no bearing in a courtroom - which means that the message of a corporation must be treated as being from the corporation, not the individual, if the corporation pays for it. This is an entirely reasonable default case - whoever pays for a message is the one responsible for it. Secondly, this is a dangerous argument in application, because it is very difficult to determine what messages by corporations are actually profit maximizing observations by executives and what messages are the opinion of management, distributed at the expense of labor and capital stakeholders.
Unions, similarly, are intrinsically a negotiating unit. They, too, have no constitutional rights, they are merely a way for labor to bargain for better working conditions. Thus, they can be viewed in a similar light to corporations.
Censorship argument:
The censorship issue is slightly more nuanced, but still wrong. Censorship is the act of one group or individual forbidding another set of individuals from seeing certain material or making certain material available to be seen. Active distribution is not part of censorship. Forbidding a corporation or union from spending on advertising for a candidate is not forbidding anybody in the organization from having an opinion and doesn't forbid anyone from making it freely available. It doesn't even forbid the organization as an entity from having an opinion or from making it available. It merely forbids them from trying to force it upon others via active distribution. The same applies for telemarketers - the only rights involved with censorship are that a telemarketer must be allowed to make the information available if I want it, and I must be allowed to see the information a telemarketer makes available. They don't have the constitutional right to force me to take that information. Maybe it's legal to advertise and maybe it's not, in which case they should follow the law, but if Congress decided to pass a law forbidding telemarketing, it wouldn't be unconstitutional. McCain-Feingold earlier this decade did exactly this for campaign finance, and thus it should not be unconstitutional either.
In other words, censorship is the act of forbidding the consumption of information, or the act of forbidding information from being made available for consumption. The key is that the right to transact in information is mutually-agreed-upon, and the act of getting the information comes from the consumer side. The consumer has the right to demand available information and the informer has the right to make information available to consumers who demand it. This doesn't work in pseudoreverse, where the informer has the right to force information upon a consumer if the informer wishes to supply it, whether or not the consumer demands it.
For example, if I'm a company and I put a letter from the chairman on my website, or a video advertisement on my website, that is now available for consumption to anyone, and nobody should be forbidden from seeing it. Arguing that the corporation should be able to spend a million dollars for a list of email addresses to send their material to is absolutely no longer in the area of free speech and squarely in the area of active corporate advertising. Thus, it should be treated as such and the constitutional grounds for the ruling don't apply.
To be clear, I'm talking about whether forbidding advertising constitutes censorship, not actively arguing that advertising should be forbidden. I'm not in favor of forbidding organizational advertising - organizational advertising is societally helpful in many cases. How else would I know about the sale going on at Macy's, or the new flavor of Coke, or a new medicine that can help a condition I have? However, arguing that all organizations have the right to advertise anything they want doesn't hold true - if some forms of advertising are deemed to be harmful, then they can and should be prevented. Campaign spending is a form of advertising that has the potential for significant adverse effects on the impartiality of Congress and the fairness of our elections. Thus, it can be prevented without being "censorship", as long as the corporation is allowed to make its information available to anyone who wants to see it.

Thursday, January 21, 2010

Prop trading?

I post Cowen's posts here because they have a very intelligent response.

Firstly, I'll say that I have no problem restricting prop trading by commercial banks. There aren't significant synergies, and as long as the banks are able to spin off or sell their prop trading divisions, it's not a negative to the banks or to the economy. It may actually make bank incentives more inline with treating customers well. (The net effect is that prop trading can't prop up commercial lending or vice versa when one is in trouble, so you probably see more frequent credit issues, but they can never bring each other down no matter how big they are, so they're less severe. Given the structural dislocation in this severe shock, that's probably neutral to slightly positive).  [EDIT: I have written more on this since then, and I have started leaning against prop trading restrictions... it raises the cost of capital substantially by making counterparties harder to find]

The problem I have is the "too big to fail" component. Firstly, I've chronicled my objection to "too big to fail" many times before:

There are problems. A cap on the size of bank assets means that banks can treat customers badly, because they don't need to attract them (Cowen's point). Worse, it means high-profile banks (especially those with extensive ATM networks) can extort from their customers - lower interest rates, ridiculous fees, low security, etc - because they know that if the customers go anywhere, others will just pop up, and the ATM network and brand mean they'll never have trouble attracting them. Another question is of fairness - if you prioritize people who already have accounts, then low-income and young people who don't have accounts will find it very hard to find a decent bank, discouraging banking (which is a very bad thing, as I've noted before, because it makes money less secure, and thus more likely to be spent quickly - often on wasteful things. Estimates have as much of 20% of income in poor countries spent on prostitutes, drugs and alcohol).

Does this mean we will have many more ATMs as banks try to compete for who can charge fees? And will banks split into "inaccessible banks with low fees where people keep the bulk of their savings" and "accessible banks with high fees where people keep only what they need imminently"? Will banks in the former category continually try to move to the more-profitable latter, causing massive account churn (and high fee generation) as customers switch accounts?

The other problem is what it doesn't do - the legislation doesn't do any of the somewhat necessary things that I've chronicled many times recently:

Any of these could be addressed with further reform bills... incremental is not a bad thing! It's also possible they haven't been announced as part of the bill here.

Wednesday, January 20, 2010

National Referendum, or was Coakley a bad candidate?
I disagree with Nate Silver's assessment. He claims that the difference between Coakley's high water mark and her end result is the fault of her as a candidate, when a LOT changed on the national scene between those numbers (people had more time to digest healthcare, which was the key differentiator in statistics for who voted for and against Coakley).
Also, he claims Coakley was a terrible candidate. However, Scott Brown isn't exactly the next Reagan or Republican Obama. Very few people ever mention "wow, I'm inspired by Scott Brown!". Secondly, Coakley won a primary with three other strong candidates - one of whom has already been elected to the US House of Representatives by Mass residents (Capuano), one with a tremendous private sector record that would be useful in dealing with banks (Pagliuca, whose mistake was not making this apparent), and the founder of the most successful nonprofit in the country (Khazei). This was the most attention I can remember ever being given to any Democratic or Republican primary in this state (including for governor, where the primaries have actually been competitive). Maybe that's cuz it was Kennedy's seat, but it doesn't matter.
Maybe she ran a weak campaign - never has anyone seemed so arrogantly self-assured in her chances at victory - but she was not an inherently weak candidate. Not every candidate we elect has Obama's charisma, and that has never stopped those Democratic candidates in the past (seriously... have you ever listened to Barney Frank?). This wasn't MA getting deluded by personality over issues (as Krugman wants to believe), this wasn't an issue of an inherently weak candidate (third time this excuse has been used - VA and NJ also), this was a national referendum, largely on healthcare, spending and taxes. Watching Krugman, Silver, etc. rationalize what happened in defense of more of what we've been seeing in the last year (or even more liberal policy) has been almost comical in terms of its delusion.
More evidence for the fact that this was a national referendum can be seen in NJ and VA's results. Three's a trend, and when you have the uninspiring likes of Bob McDonnell, Chris Christie and Scott Brown engineering massive voting turnarounds by campaigning against a Democrat-controlled legislature with approval ratings in the 20s.... that is a national referendum. Brown didn't run against Coakley - he never said anything negative about Coakley - he ran against Pelosi and Reid.  When New Jersey and Massachusetts (very, very blue states) elect Republicans within two months of each other, coincident with those terrible approval ratings, there is something going on other than a strong candidate.
Would Brown have won if Coakley ran a better campaign? Probably not. Would the turnaround still have been huge? Yes... this was a THIRTY ONE POINT TURNAROUND. If you figure about 50% of people have their mind made up on the party they're voting for, regardless of the candidate and the environment, that means that 62% of voters who actually look at issues and candidates changed their mind. Independents have swung 3 to 1 against the Dems in all three states. A quarter of registered Democrats crossed party lines this time, largely listing healthcare as their concern, and again, that doesn't happen in races featuring similar pairs of candidates in MA.
Fortunately, even if the far left doesn't acknowledge the message, you have to believe anyone with a vulnerable congressional seat (not named Harry Reid) has heard the message loud and clear: if they don't govern from the center, they're going to be governing from the sofa. If only we see a rebellion like that in a red state, and actually get some bipartisan government going, we may be in for a better finish to the decade than the start has been.

Instead of the Bank Tax, why not an Accelerating Bailout-Outstanding Tax?

So, I'll go on record here and say that I think Obama's proposed "financial transactions tax" and "bank tax" are poorly designed.
I've already outlined what I think a better alternative to the financial transactions tax would be: a turnover tax. An explanation of how it would work, and links to why it's solving a problem that people overlook, is here:
I write here about a better version of the "bank tax".
The current bank tax targets all bank assets, ignoring insurance companies, auto companies and other recipients of the bailout.
The problem with this is it actually encourages everyone to seek bailouts in the future. Non-core companies (autos and insurers, here) can seek bailouts knowing they won't be punished for it. If banks will be forced to "pay to recoup bailouts" in the future whether or not they accept bailouts, they are likely to accept more cheap capital from the government in order to facilitate expansion, knowing they'll pay the tax on it later no matter whether they take it or not. Even with moderately high interest rates, if asset prices are very depressed and the bailout is the only source of credit, that credit is worth it to pick up bargain basement assets.

You don't want banks treating the government as a normal source of financing, albeit a countercyclical and highly unsophisticated one. Banks receiving bailouts should NEED it. Taxing banks that didn't need bailouts creates a bizarro moral hazard by which banks seek bailouts even when they DON'T need it. That's a real handout to the financial sector, and a completely unwarranted one.
The logical response is then that the government should enact a bailout tax. Any companies that received bailouts need to pay for it in the long run. Companies that don't take government money, don't need to pay.
There are nuances with this. Firstly, the banks functionally already pay a tax on their bailout money - all have to pay significant interest and equity on the bailouts they take. If the gvt were a private sector company, the fact that they're not recouping the cost means that the government didn't charge interest high enough. Of course, if the gvt were a private company, then they'd be pricing in defaults, which the government could not allow because it's a massive adverse selection problem - nobody takes bailouts because the interest rates are too high, so the only ones who take it are the ones who are very unlikely to be able to pay it back anyway, and the government needs to avoid defaults because they can bring the system down. Thus, allowing overall higher interest rates to account for default becomes de facto nationalization of weak banks and nobody else takes anything, even if they need it. The system still isn't stable.
So if the government can't just raise interest rates (functionally the same as a regular bailout tax), what does this mean? It means that you want variable interest terms for each bailout recipient. However, you can't do that during the bailout because it'd just sink the weak companies, both because they can't pay the interest immediately and also because a perception of weakness can drive their equity balance downward, forcing more capital calls. You also are relying on the government to accurately assess the strength of each company individually, under crisis pressure.
Two more practical problems: firstly, the government forced all banks, healthy or not, to accept a bailout so that the weaker ones don't look too weak. Secondly, here is the list of companies that the government has committed the most money to as of today (source:
AIG, Fannie Mae, Freddie Mac, General Motors, Citigroup, GMAC, Chrysler, BofA+Countrywide, PNC Financial Services, JP Morgan and SunTrust.
With the exception of JP Morgan, this is a pretty representative list of the companies on which the government is set to lose the bulk of the money.
Do those companies (other than JPM) look like companies that are currently capable of paying a tax on their portion of the bailout? One day, they SHOULD pay it all back, and for any notion of moral hazard, they're the ones you're concerned about (everyone ELSE paid back with interest, indicating they should have had lower rates to begin with), but they're very weak today.
So how do you achieve variable interest rates for different credit quality companies, only tax companies that sincerely took bailouts (as opposed to taking them from public pressure), and still not sink your weak companies in a fragile environment?
The answer to me seems to be accelerating interest rates (which could also be done retrospectively as a growing tax on the actual amount of bailout dollars outstanding).
If you had a situation where bailout dollars has no tax and reasonable (but nontrivial) interest rates in the first year (as actually happened), and then accelerated the interest rates over time, then you'd be in a situation where you don't sap crappy companies of even more money while they're weak, but eventually they are forced to pay everything back with interest. For some companies, the bonds could even be "bunny bonds" for the first few years of payments (bonds where instead of paying cash interest, the recipient just adds the interest to the principal of the debt until they can pay it all off)
This has a fairness about it (the companies you're doing it to would have taken all the exact same money anyway, cuz they're the ones who needed it most), and the companies who can pay back quickly with interest and who didnt get themselves into the mess in the first place aren't hit too hard. The companies that really screw up pay for it.
This also has the benefit of not promoting zombie companies that persist forever in a weak state. At some point, the truly weakest companies, the ones that will never return to effectiveness, are going to default because interest rates rise. However, the default is delayed and the major remaining creditor is the government. At that point, the bank can go through the US's usual swift (and often severe) bankruptcy process, removing a "zombie" from the field and leaving real competitors, with a competitive pool that is much stronger than it was during the crisis (and thus may be better able to absorb a bankruptcy).
Thus, an accelerating "outstanding bailout" tax has the feature of avoiding zombie socialism much more than a straight bank tax would (a bank tax may even cause zombies to persist longer, as all the banks are weakened but the non-accelerating part means they're rarely weakened to the point of dissolution, and if they are, it's slow).
True acceleration of the interest rates also means that companies are less likely to use the government as a source of cheap capital for expansion, because of the potential risk of not being able to pay it all back.
It's a system that's both fairer and more aligned with proper incentives than a comprehensive bank tax.

Tuesday, January 19, 2010

I cannot stop laughing... "Obama-Mia"

Political commentary on the Obama presidency aside, this is hilarious:
"Hope—The Obama Musical Story" premiered here Sunday evening. One is tempted to end the review right there. Seriously, isn't the oeuvre's title and premature timing commentary enough? Sure, the U.S. president has been (favorably) compared to God but even Jesus Christ had to wait nearly 2,000 years before he became a Superstar.
With polls showing that most Americans now realize they are being (mis)led by a mere mortal, it is no coincidence that this production had its debut in Germany. Here the president's messiah status (remember the 200,000 worshipers at his 2008 Berlin speech?) is still accepted dogma and helped fill the Jahrhunderthalle, a 2,000-seat venue.

"In no way does Hope show Obama as a saint," the musical's organizers say on their Web site. And truly, as the mostly American cast tells, through song and dance, the story of Mr. Obama's rise from a Chicago community organizer to the White House, we learn of the president's human imperfections—or at least one: "He's an idealist," the Mrs. Obama character says with a hint of disapproval. Despite this serious character flaw, the ensemble sings upon his election: "Celebrate! Celebrate! Around the world every nation celebrate."

Sen. Harry Reid will probably be pleased to learn that the actor playing Mr. Obama is sufficiently "light skinned" to portray the president and did not sing with any discernable "Negro accent." And, always a plus for an actor as well as a president, he was able to perform without a teleprompter. He got to sing numbers like "Yes We Can," and "Look Without Hands," which I first thought was a commentary on the president's foreign and economic policies but turned out to be a eulogy to his grandmother.

Much of the material was taken from stump speeches, but there was also a lot of "original" writing. Take the romantic highlight of the show, when Barack woos Michelle in a love duet. "I think we fit together like a hand inside a glove—I know this is no ordinary kind of love." One would HOPE that even Mr. Obama's speech writers could have rhymed better than this.

In one cliffhanger, Michelle is stricken by self-doubt—I guess that's what they mean by "artistic freedom." Without spoiling too much of the plot, Michelle's mother manages to reassure her that she has what it takes to be a First Lady. "You were chosen for this time . . . walk in your glory. Think like a queen, for you are royalty."

Of course no story is complete with just a hero, even if he is of the über variety. And so enter the villains: drug dealers in Mr. Obama's community organizing days and, in more recent times—you've guessed it—Republicans. In his solo, Sen. John McCain challenges Mr. Obama with lines like: "See you in November, and I'm the Great Defender." Personally, I prefer the real maverick's performance, Sen. McCain's unforgettable rendition of that old Beach Boy song, "Bomb Iran."

Strangely, Mr. McCain was played by a German, hence his introduction of Sarah Palin as his "Runny mate." Mrs. Palin, by the way, whose solo was bizarrely accompanied by scantily clad dancers in gothic outfits, was played by the same actress also standing in as Hillary Clinton—a subtle hint to the president, perhaps, not to trust his secretary of state.

In what the writer probably thought was a clever plot construction, a parallel story line centers on the residents of a "typical" Chicago neighborhood hit by unemployment, foreclosures and the war. The pre-Obama era is "Chaos!" as the first song reminds us. Among the assorted stereotypes is the unemployed Ricardo, sporting one of the worst Puerto Rican accents in the history of show business; the Obama-supporting African-American Johnson family; and your archetypical Republican: an elderly woman of German background who doesn't think much of "colored" people. But, with the Obama spirit already healing the planet, the German bigot and Mr. Johnson declare in a heart-warming duet after the elections: "We can be friends." Yes, we can.

When the Johnsons learn that their son has gone missing in Iraq, they are consoled by none other than Rev. Jeremiah Wright. Perhaps the news about the good Reverend's tragic accident with the campaign bus didn't make it to Germany. Thankfully, neither did any of his anti-American sermons. Instead, the Wright character gets to sing a couple of soaring gospels, promising "Everything will be all right, all right, he'll make it all right."

And so He did. No sooner has Mr. Obama been elected than the Johnsons learn their missing son is alive and that the war will probably soon be over. Call it the inauguration miracle...

The musical's American composer and lyricist, Randall Hutchins, who lives in Germany, says his show is not "political." Right, but only in the sense that Leni Riefenstahl's "Triumph of the Will" was just a documentary. The audience's standing ovation at the end was probably as ideologically overdetermined as my trashing of this hagiography."

Friday, January 15, 2010

My favorite financial reform perspective, infrastucture bank, not losing your luggage on planes, and the best time to do things

I've promised links posts would be rare, and have now made three in three days. I apologize... this won't continue! However, the Pettis link was too good to give up, and the rest of it was interesting and unusual as well.

Michael Pettis is probably my favorite blogger, edging out Mankiw and Cowen. He's a Chinese economics expert, and is second to none in his deep understanding of Chinese financial economics and macroeconomics. Here, he talks about currency pressure, the potential for trade hostility and US demand for goods. He's worth spending time on. (Hat tip to Paul for the recommendation). I quote liberally below, only because I agree with it so strongly:

"If we were to see a break in the [Chinese] housing bubble, there are broadly speaking two ways to address the problem.  The so-called "Anglo-Saxon" model would involve a rapid liquidation of loans, the seizing and selling of collateral, and bankruptcies.  The advantage of this model is that assets are quickly re-priced and allocated to their most profitable or efficient uses.  

Assets that are non-viable at their original costs, in other words, are marked down and returned to the economy, and very often the new users engage in rapid innovation and the creation of new industries.  One obvious example is the massive railroad bankruptcies that occurred in the US after 1873.  The railroads were liquidated and purchased by new investors at steep discounts, allowing them to cut freight costs sharply, thereby spurring a whole series of new industries, most famously, I think, the mail-order retail business.  More recently the collapse of the broadband suppliers and the subsequent drop in internet costs permitted the existence of, Ebay, Google and a host of other new technology companies.

But there is a cost.  Liquidation can be brutal – businesses close down, land and assets are seized, workers lose jobs, families are forced to leave their homes, and so on.  Americans, for whatever reason, have been more tolerant than many other societies of these kinds of disruptions, perhaps because of a combination of innate optimism and a robust political framework that absorbs some of the costs and anger.  Other societies are less so.

The second way, broadly speaking, that the break in the housing bubble might occur, and without the brutal social adjustments, is what has sometimes been called the "Japanese" model.  Rather than force bankruptcies and rapid liquidation, borrowers would be permitted easily to roll over their loans, financing costs would be kept low (at savers' expense of course), and excess inventory taken off the market.  The disadvantage of this kind of process is that assets are very slowly reallocated – sometimes after many years – to more efficient uses, and those assets taken off the market become a pure dead-weight to the economy.  In addition the need to keep financing costs low, so as to delay recognition of the losses, hampers future growth by encouraging continued misallocation of capital and slowing the development of domestic consumption by forcing households to bear most of the cost of the adjustment via low interest rates on their savings.  The advantage, of course, is that it much less socially disruptive and painful...

...Financial crises are usually the way a distorted system rebalances, and although they are often necessary in the long run, they can obviously be painful in the short.   Needless to say there is nothing like a financial crisis to bring out calls for the reform of the financial system, but I think we should be very cautious about what kinds of reform we ask for.  The recent financial crisis, which seemed most to affect "Anglo-Saxon" financial systems, have brought out, predictably enough, fervent warnings about the riskiness of deregulated and fragmented financial systems, along with a pride of proposals for reform, many of which aim to prod and force financial systems into more rigid and constrained forms.

But we risk, as always, drawing the wrong lessons from the crisis, and confusing the triggers with the underlying causes of the crisis.  Every major financial financial crisis in history was preceded by a massive liquidity build-up. which the financial sector was forced to accommodate, as it always does, by taking on too much risk.  Hyman Minsky, and his disciples like Charles Kindleberg, describe this process vividly, with banks and other entities taking on too much risk as a function of excess liquidity and excessively low costs of capital.  It doesn't matter if the system is highly fragmented and deregulated or highly regulated and monolithic.  After all a large part of the prestige of the "Anglo-Saxon" model derives from the spectacular collapse of its antithesis, the Japanese model of the 1980s, which seemed — mistakenly again — to prove the superiority of deregulated systems, with their breakneck innovation, over highly regulated and very rigid systems.

So which is it that can best prevent crisis and the associated economic costs — the very open systems or the very rigid systems?  Neither, it turns out.  All of them react more or less the same way to excessive liquidity and too-cheap capital — by taking on too much risk, whether in the form of complex derivatives and securitizations, in the case of the former, or in the form of very old fashioned collateralized loans, in the case of the latter.

So is there no room for financial sector reform?  Of course there is, but the purpose of reform should not be to allow us to turn from the crisis and proclaim "Never again!"  That is silly.  It will happen again and again and again.  Instead, the purpose of regulation should be to ensure that the financial system does a better job of allocating capital during "normal" periods.  A financial system designed to minimize the risks of crisis is probably a waste of time.  It should be designed to create the best mix of risk capital and safety consistent with a rapidly growing economy over the long run.   Periodic financial crises are a necessary evil, and there is little we can do about them except try to create automatic structures (counter-cyclical in national balance sheets, as Mnsky argued) that minimize their transmissions into the real economy.   So in China's case, contrary to breathless advice by press and experts, the US financial crisis teaches almost nothing about how to manage financial sector risk.  It neither proves nor disproves the usefulness of a highly deregulated and innovative financial system.  China´s financial sector issues are different.   China´s systematic misallocation of capital is its biggest financial problem.  China needs serious governance reform and interest rate liberalization so that capital can flow to the most dynamic parts of the economy and be made available to risk-taking entrepreneurs in a way the fosters productivity growth.  It needs capital to be correctly valued so that it is not wasted on creating overcapacity, asset market bubbles, and trophy projects, all of which detract from future consumption growth."


On a related note, this is written by advocates of creating an "infrastructure bank" - a bank, run by the government, that would supplement private credit for building out bandwidth, roads, electrical distribution, etc. This would be a massive, massive improvement over congressional appropriations, because nothing gets built that doesn't find a private backer willing to take on credit risk, filtering out pork and resulting in much more effective short and long run stimulus.
How to guarantee your luggage won't be lost or stolen: pack a starter pistol

Best time to have surgery: Morning (4x less likely to have complications in the morning than between 3-4PM)

Best time to get a human being on the phone when calling a company's customer service line: As early as possible (lowest call volume)

Best day of the week to eat dinner out: Tuesday (freshest food, no crowds)

Best day to fly: Saturday (fewer flights means fewer delays, shorter lines, less stress)

Best time to fly: Noon (varies but pilots say airport rush hours coincide with workday rush hours)

Best time to exercise: 6-8PM (body temp highest, peak time for strength and flexibility)

Best time to have sex: 10PM-1AM (skin sensitivity is highest in late evening)



How Asset Bubbles and Rational Casino Investing relate to Financial Reform

One of the things I find interesting is that so many theoretical
economists and media talking heads think that an asset bubble is a
sign of highly irrational and greedy financial professionals. However,
many of these folks have never managed money or dealt with clients,
which means they are largely missing some important pieces of

Many, possibly most, professionals who look at securities in a bubble
understand that a bubble is one explanation for the price rise; maybe
they'll underestimate it, maybe they'll even dismiss it, but they
understand it. A great many participants will understand perfectly
that a bubble is happening.

However, there's an agency problem. One senior official in a financial
firm once told me (referring to one particular asset bubble), "we all
knew it was happening, but if you get out too early, you underperform
as it approaches its heights. We participate because our clients won't
tolerate underperformance for any period of time. If we didn't
participate, we'd be fired."

I never wish to use personal anecdote as a source of evidence, but I
happen to have been actively investing and doing research for another
large financial firm, partly on energy, during the energy bubble. I
claim no skill, just luck, in getting out unscathed. I took a risk I
shouldn't have - a lesson I've taken to heart as I look at the Chinese
asset bubble and the effects on securities around the globe. But my
choice to take a risk is not a choice for others.

While there certainly were legitimate questions about how high oil and
other energy prices could go based on growth trajectories in emerging
markets, a substantial fraction of us knew that oil was in a bubble
and would have to come back down. I remember considering both sides
and realizing that the marginal cost of producing a barrel of oil from
the most expensive conventional fields was about $90 or $95 a barrel,
and that while capacity was constrained in the short run, there was
potential for expansion at that level of marginal cost. Meanwhile, I
owned a number of energy stocks, including a very sizable position in
a company that built refineries (and whose earnings was thus
intricately tied to the price of oil, as long as credit was

When I bought in, oil was in the high $70s. When oil cleared 90, I
started wondering if it was a bubble, and when it hit 110, I became
convinced and was worried about when it would pop. I could have
certainly sold out right then, but the aim when selling a stock is
(obviously) to sell at the best price possible - you don't get extra
credit for recognizing and selling early (in fact, you lose if you
don't have a strong alternative security to own lined up, which I
didn't at the time). I started gauging sentiment (something I've
always hated doing), and didn't get spooked til oil hit 135. Oil
eventually got to 147 before collapsing, and the credit bubble popped,
and the rest is history.

Despite what everyone likes to say about all sorts of money management
incentives, the ultimate incentives of a money manager are to a)
manage as much money as possible and b) have the money you manage go
up as much as possible. Both of these are only achieved via
outperformance. They face the same incentives I did - maximize
outperformance while minimizing risks - except if they fail at either,
they lose their jobs. I became aware of the possibility of an oil
bubble when oil was in the high 80s/low 90s, became convinced of one
when oil was at 110/115, but because I wasn't convinced that everyone
ELSE was convinced of one, I stayed in. It's not a game I like to
play, and as I've learned more about alternate types of securities, I
avoid those situations more and more (I've removed all exposure from
China, for example). However, participating in the energy bubble
wasn't blind, it wasn't schizophrenic, it was calculated and in my
extremely lucky case, paid off. I'm not unique in this regard - some
people really did think oil was headed straight to 200, 300 and even
500**, but a lot of people played the casino game despite
understanding what was happening.

Which brings me to the point. Just as this credit crisis was
originally caused by consumers being so shortsighted that they bought
houses they could not afford (mortgage lenders like Countrywide were
certainly complicit in this), asset bubbles in general can partly spur
from a shortsightedness (or perhaps a lack of financial education) on
the part of people who are choosing financial advisers. Every
manager, no matter how good, underperforms periodically - Warren
Buffett, the best investor ever, has underperformed in 7 of his last
22 years (that's almost 1/3 of the time!) and has some years where he
is CRUSHED - in 2009 he underperformed by over 20%, and in 1999 he
underperformed by 40%. Warren Buffett is lucky and smart in that he
has set himself up in a position where he cannot be fired based on one
bad year, so he uses his tremendous intelligence and foresight to
compile an impressive record despite blips.

Most of the rest of finance isn't so well-positioned. When one bad
year by a manager leads to a mass exodus of capital, a firm has almost
no choice but to fire that manager in order to preserve the fund.
Managers who prioritize not getting fired then make sure they never
underperform too drastically in one year, which means that most of
them have to participate in bubbles.

Just as a public that understood how to live within its means could
not have caused a credit crisis with mortgages or anything else, a
more longsighted, patient public, who doesn't abandon a manager at the
first sign of underperformance, would be the single biggest factor in
preventing asset bubbles - more than anything you could do with
financial reform.

How do we achieve that? Fortunately, we don't need a patient public to
make the public act patient.

One possibility would be the introduction of back-end loads to mutual
and hedge funds in exchange for a reduction in annual fees, thus
strongly rewarding longer term investors. Less effective but
functionally similar would be a (voluntary or involuntary) "lockup"
period with withdrawal penalty in exchange for lower fees (this stops
working after the lockup period is done, however, while an end load
works forever). Another would be be better investor education, if
that's possible (we can't even teach reading consistently, though, so
that's going to be tough).

Far less effective would be the idiotically populist transactions tax
that Obama has proposed, because it cannot get large enough to stifle
that sort of activity without crippling our capital markets. Somewhat
effective would be a turnover tax, which I have outlined in a prior
post, found here:
A turnover tax wouldn't prevent fundamental investors from
participating in bubbles, but it would prevent high-frequency traders
from speeding up the ascent and descent of equity and standardized
credit bubbles, which they do by a factor of 2 or 3 in both directions
(best estimate, based on volume of HFT transactions). Speed
exacerbates bubbles significantly because participants don't have time
to react before becoming insolvent, and the Fed doesn't have time to
react with appropriate monetary policy. Removing high frequency
traders could reduce the impact of bubbles, even if it couldn't easily
eliminate them.

There are measures an agency can take, but they're more limited than
the government realizes, and are better at dealing with credit crises
than asset bubbles (related but different). Standardizing the products
that can be standardized and placing them on exchanges is a great idea
because it limits the web of counterparty risk that characterized this
recession, reducing the need for bailouts. Coming up with ways to
quickly, fairly, efficiently and consistently break apart illiquid
financial institutions to satisfy creditors would reduce the panic and
liquidity effects from a failure like Lehman's. Working with financial
institutions to implement the end load/lower fee plan or a turnover
tax would be helpful. Insulating the Fed from political pressure would
be useful, and investor education on accounting, economics and
financial markets will always be helpful. Creating mandatory processes
for evaluating the creditworthiness of consumers would be a
possibility- you don't want to limit who can be lent to, but you do
want to force lenders to go through a reasonable series of steps to
ensure that they are lending to people or firms who are representing
their assets and income truthfully, so that lenders can't advertise
"immediate credit" as a sales pitch and make mistakes when they do it.

The other issues - regulating bank bonuses, instituting bank taxes,
etc - will be highly counterproductive (I've listed a great deal of
why here:
and are mostly likely to result in costs to shareholders and customers
than they are to mitigate risky behavior. Trust me - no regulator can
keep up with the sophisticated products and processes that are in
finance. Regulators don't draw enough talented people, they're
perpetually understaffed and they face political pressure. It's better
to regulate and align the incentives of clients with a safe system
than the incentives of banks with a safe system because clients change
less and they're more fundamentally at the root of the problem
(financial firms wouldn't do it if their clients didn't require it).

**(I posted that report on the wall of my office because it was so
funny - oil was at 140, I'd just sold out after watching oil almost
triple already, and people were projecting $500 oil?)

Thursday, January 14, 2010

Trevor's Guide to Case Interviews for Finance and Consulting

This is the original version of Trevor's Guide to Case Interviews. Please do not print or copy-paste this information anywhere, including into email. You are welcome to link or bookmark the original page. Copyright 2009 to me, Trevor F. Updated 1/26/10.

Please note that this is an ad-supported blog. If you are interested in the product displayed in the ads, please click! Anyone more savvy with blogger is more than welcome to help me spruce this up - please let me know. If I've made any errors, feel free to note them in the comments. Special thanks to Jason P, Gillian L, Graham F and Rowan F.

This is a guide to how to prepare for case interviews for Finance and Consulting.

FOUR KINDS OF QUESTIONS (Each firm prefers different types)
1. Logic / Arithmetic (usually, but not always, in finance)
“What’s 42 x 37?”
“You have a 5L jug and a 3L jug. Measure out 4L in as few steps as possible.”

2. Market Sizing
“How many lightbulbs were sold in Australia last year?” (Approximate)

3. Strategy (Consulting. Sometimes finance)
“You’ve been brought in to a small pharmaceutical company to help them assess whether to proceed with a drug development project. Ask any questions you like.”

4. Mathematics / Statistics (Quant)
“There’s a jar with 1000 coins. 999 have heads and tails. One has two heads. You pull out one coin randomly and flip it 10 times, getting 10 heads in a row. What is the probability you pulled out the coin with 2 heads?”
Usually not regular consulting or banking – usually a more quantitative job, i.e., hedge fund.

I will go through each of them, one at a time.

Can’t help you with this much.

If it helps you, break logic questions into math.

For straight arithmetic it can be helpful to split into 10’s and ones.

e.g. 42 x 37 = (40 + 2) x (30 + 7) = (40 x 20) + (2 x 30) + (7 x 40) + (2 x 7)

Relax, and take your time.

It’s better to get the right answer slowly than the wrong answer fast.

Basically dimensional analysis (remember middle school science?)

Oranges consumed in Europe = Oranges consumed per person x people in Europe

Sprinklers sold in the US =

Sprinklers sold to golf courses + Sprinklers sold to professional gardening services + Sprinklers sold to individuals

It's easy to make this too complicated, and you can get bogged down.

Amount of gas consumed in the US =


1. Break the Problem Down

Number of Beetles in the Congo -> ???
Beetles/Tree x Trees/Mile x Miles of Forest/Congo -> You can roughly estimate these

2. Orders of Magnitude, Not Real Numbers

1 million vs. 2 million doesn’t matter
1 million vs. 10 billion does

3. Simplify!

Define the scope of the problem, don’t tackle everything.
Gas in North America -> ???
Gas used in trucks in North America for shipping things -> EASIER

Skip this for one second

If you’re asked and have no idea, get a piece of paper + pen and slowly work through it logically.

If you get it wrong, don’t give up hope. If you were logical but just got stuck, or made an arithmetic error, it doesn’t rule you out.

Stay calm and confident. Take your time.

To start: Ensure you are focusing on the correct question. The first key to this is listening to the interviewer. You can verify what you're working on by asking - "So, in summary, I'm looking at both the revenue and cost sides of operations for a hard drive manufacturer, and coming up with a plan for them to increase their profitability. Is that correct?"

Additionally, feel free to ask any followup questions. As long as it's not something stupid ("how would you do it?"), it can provide helpful information ("What sort of parts go into a hard drive?" would be one possibility, for example). If they don't want to tell you, they'll tell you.

Because these things are inherently logical, it will be useful for clarity and for ensuring that you hit everything for you to state the framework on which you're operating. So, if I were doing this (and you'll see this all below), I'd say "I'm going to first look at the industry, then I'm going to go down the income statement, starting with revenues, then variable costs, then fixed costs, and I'll conclude by going over to the balance sheet and looking at working capital". If industry analysis is relevant, I'd start with that. Having laid all of this out at the beginning, it'll help you pace yourself and stay on topic, and give them the chance to pace you and keep you on the right track.

So - onto the actual framework itself. I like using financial statements because businesses are measured with their financial statements. Working on things that affect financial statements is a guaranteed way to talk about things that matter. If done correctly, they also have the advantage of not being way overused, like Porter's Five Forces (mentioned below because its still useful, especially for entering new industries) or some other BCG and McKinsey strategies that I won't go into here.

2 Big Statements to Think About:
Income Statement
The set of revenues, profits and costs that came in and out in the period
Flow. It's the in- and outflows for the period

Balance Sheet
The set of assets and liabilities you have
Snapshot. It's the list of stuff you have at a given time.

An analogy is that the Income Statement is your salary, and the Balance Sheet is your bank account and mortgage.

Here is where blogger's formatting hurts, so I'll try to keep this simple.

Price * Volume
(Price per chicken * Chickens you sold)

Variable costs (costs that fluctuate with the number of things you sell)
(Chickens * Chicken Feed/Chicken, Chickens * Hours of Labor/Chicken)


- SG+A
Short for Sales, General and Administrative Costs
Fixed costs (costs that don't directly fluctuate with the number of things you sell)
(Chicken coop maintenance costs. CEO Salary. Salespeople salaries)


- Interest, Taxes, and other stuff you can safely ignore for interviews

Total Profit for the Company, to be split up among owners of the company


Some definitions:

Assets: Stuff that will eventually result in money for you
Liabilities: Stuff that will result in you paying money
Equity: The residual value (Assets - Liabilities)
Money you get - Money you give = What it's worth

By definition, A - L = E.
This is usually written A = L + E, because it's easier to set up the balance sheet that way.

It is vitally important to note that this is recorded at original cost, and then lowered ("depreciated" or "amortized", depending on the asset) over time as it loses value. Thus, if I bought a building in 1920 for $300, it will be no more than $300 on the Balance Sheet.
Thus, equity on a balance sheet is only a rough estimate of the actual value. It's a better estimate of the money that has been put into the company to build it. Don't worry about this too much, but understand it.

Typical Balance Sheet:
Cash + Marketable Securities



Hard Assets (buildings,
vehicles, property, etc)

Acquired Intangible Assets
(patents, acquired brands,
customer lists, "goodwill",
etc. These can only be added
to a balance sheet when you
buy them, not when you
make them. This is because BS
measures what you've put into
the business, and if you make them,
they've already been reflected through
expenses that hit the equity account)



Other Stuff
Don't sweat the equity account too much - just know that profits get added here each year, and payouts (dividends and buybacks) get subtracted.
I don't know how to do it on Blogger, but this is typically arranged like you're looking at the pages of an open book. On the left page are assets, at the top of the right page are liabilities, and underneath liabilities are equity. (Thus, why A = L + E is the right format - it's all additive, you don't have to worry about which section to subtract, so the right page all added together equals the left page). Some companies do put them sequentially like I have, but that's beyond the scope of this presentation.

Cash: Cash. $ in the bank

Marketable Securities: Stocks, bonds, Bank CDs, etc, that can be easily sold

Inventory: The cost of making the goods you have to sell but haven't sold yet. Want this to be just high enough to sell what you need, and no higher

Receivables: What people owe you

Payables: What you owe people (think credit cards you pay at the end of the month)

"Goodwill": A measure of the additional amount you paid for an acquisition that isn't reflected in their other assets. Just remember - this is designed to measure how much has been put into the business, so paying up for "intangible awesomeness" counts.

1. Increase Revenues -> price per unit * units sold
2. Reduce Fixed Costs
3. Reduce Variable Costs
4. Balance Sheet Efficiency

Less inventory is good because there's less spoilage, and less money invested in stuff that
just sits there.

Less receivables per unit of revenue is good because you're getting your $ faster, and you
don't have to wait for it (and there's less risk they won't pay)

More payables per unit of COGS is usually good because you can wait longer til actually
paying and do something else productive with the money in the interim

FOCUS ON #1, then #3, then #2, then if you get it, #4. #4 is (usually) less important in interviews.



The probability-weighted amount something is worth
EV(project) = (amount you make in scenario A x probability scenario A happens) +(amt you make in scenario B x probability scenario B happens)... across all scenarios

A pirate is deciding whether to hunt for buried treasure. If he finds it, he'll get 1000 doubloons. If he doesn't find it, he gets nothing. The expedition will cost 250 doubloons. The chance of finding treasure is 30%. Should he undertake the endeavor?

(1000-250)x(30%) + (0-250)x(70%) = 50.

The expected value of the search is 50, which is greater than 0. The expectation is that he makes money, so he should do it.

This concept is how casinos and lotteries make money... all of your bets are expected value negative for you and positive for the casino, even if some outcomes are positive for you and negative for the casino.

The amount of profit you make on money you invest.

Different to costs.

If I buy $10 of wood and make a chair out of it and sell it, the wood is gone and the money I put into buying it is gone - it's a COST.

If I spend $1000 on opening a store, or researching a patent, and then use that store or patent to sell things, I can sell and still own the store or the patent -

Individual projects have a return on invested capital (ROIC):

I open a store for $1000
I make $200 a year profit from the store
My ROIC is 200/1000 = 20%.

This works for expected values, too:
I open a store for $50
My expected value profit is $5 from the store
My expected value ROIC is 5/50 = 10%.

Putting it in context:
You want your ROIC to be more than the "cost of capital" - If you have to borrow money at 10% interest to invest in a project that returns 8%, you're losing money.

This is why it's such a bad idea to invest in the stock market when you have credit card debt - the amount you're paying by having credit card debt is so much higher than any reasonable stock market return, that your "cost of capital" exceeds your expected ROIC and it's a bad investment, even if your stocks go up.

Thus, profits going up is not necessarily a good thing if you could have done better things with that money.

Thus, be careful if you're presented with profits that quadruple! If it required a lot of capital to achieve, it's not that impressive.

What a "good" ROIC is depends on how risky the project is. If it's over 15% it's likely a good ROIC. If it's under 10% and it's risky, it's more likely to be bad. If it's truly risk-free, it can be a very low ROIC and still be ok.

Whole companies have ROICs, also. Their invested capital consists of equity and debt. (Think about it - if you're running a business and you need money, you can either borrow it - debt - or give someone a share of the profits in exchange for money - equity. Then, you pay off debtholders first, and whatever is left is divided between the equityholders. This is similar in concept but different in specifics to the equity on the balance sheet.)

Generally, average ROIC for whole companies is somewhere between 11 and 13%.

Investment = the equity capital and debt capital that went in
Return = net income out

ROIC = Net Income / (Debt + Equity)

Whole company ROIC is far more important for finance than consulting. Its use is nuanced, look it up if you're curious.

One more note on equity as invested capital. If a company issues equity to raise capital (a cut of the future profits in exchange for money), the people who already owned equity lose money because they're now getting a smaller percentage of the profits. The "profits" attributable to each share is called earnings per share (EPS), and it can be calculated for public companies for a given year by Net Income / Shares Outstanding. You can actually have net income go up and EPS go down if shares outstanding rises too fast (and stock price is usually judged by EPS). These profits aren't all paid out immediately - some of them will be used by the company to grow. The part that is paid out is called a dividend. Some companies buy back shares instead of paying dividends to increase future EPS for the rest of their owners. This is mathematically identical to paying dividends, but they're taxed differently.

Everyone and their mother has a preferred way of analyzing firms and industries. While many of these are useful in other contexts, I think they have the ability to send you down irrelevant or less central paths in interviews. If you can remember everything and keep it straight, that's great, but if you're time-constrained, some of them are more useful than others. One of the best, because its founded in actual economic principle, is Porter's Five Forces. It's particularly useful for analyzing the ongoing competitive strength of a company or industry, which is really nice when you're looking at questions like "Should I enter this industry?" or "Should I develop this new product?/What product should I develop?". (Michael Porter is a very famous HBS professor).

According to Porter, the strength of a company in general can be measured with five large assessments:

1. Threat of substitution. How easy would it be for customers to switch to other products or services instead of buying yours? This can be affected by many things - brand loyalty and product differentiation, importance of the product, advantage of the product over competitors' products, relative prices, switching costs, quality, etc.

2. Barriers to entry. If the market is profitable, others will want to participate, increasing competition and decreasing profitability. How easy is this? Think of patents, contracts, brand, economies of scale, switching or sunk costs, capital requirements, learning curves in manufacturing, government policy, industry profitability, distribution, etc.

3. Competition by incumbents. Innovation, advertising and product differentiation are important here. This is also where things like collusion, cooperation, price wars, etc. come in.

4. Customer power. How much can customers dictate your prices and your product features? If a customer has a lot of power, they can force you to spend more on your product and take less money for it. Anyone who sells to Wal-Mart or the Department of Defense would face this. Indications of customer power include number and size of important customers, fixed/sunk vs variable cost balance (customers can be forced to pay variable cost but not fixed or sunk costs), relative switching costs (Wal-Mart can switch easily, you can't), substitute products or distribution mechanisms on either side, buyer price sensitivity, product differentiation.

5. Supplier power. Similar to customer power, but instead, it's the people you're buying from, not selling to. Same considerations apply.

Economics - You can probably skip this if you're really pressed for time and understand extremely basic supply and demand, but this can be very useful.
Supply and demand are extremely important. Generally, as supply goes up, quantity supplied goes up and price goes down. As demand goes up, quantity supplied goes up and price goes up.

 For example, if you're buying wheat, then if twice the number of people show up to your same farm to buy wheat than did yesterday, the price is going to go up because demand has increased - the demand curve has shifted. However, if the same number of people as yesterday come back tomorrow, then the price will revert to its original level - you're moving along a stable supply curve with a shifting demand curve.

If, however, there is so much rain this summer that supplying the same amount of grain costs far less, then the supply curve has shifted, so more people show up and pay less for their grain.

The percentage by which quantity changes relative to the percentage by which price changes is called elasticity. There's a price elasticity of demand and a price elasticity of supply.

Examples of elasticity:
elastic supply: High tech (expensive) deep sea oil wells.  If price a supplier can get for their good drops even a little bit, they produce a lot less cuz its no longer profitable.
inelastic supply: Software or Movies. Once you've put in the development cost, the marginal cost is almost nothing, so price can drop a TON and the company will still be willing to sell lots of copies.
elastic demand: Newspapers in 2010, Cars, TV dinners, books, beef, many commodities. As price goes up even a little bit, they become a lot less attractive relative to alternatives, so you consume a lot less.
inelastic demand: Medical care, cigarettes, newspapers in 1950. Price can go up a ton and everyone will still buy.

 If you want to know more, take an intro economics class, or read the rest of my blog at, because elasticity something I talk about with reasonable frequency (esp vis a vis China, housing, and sometimes healthcare or carbon emissions).

Be able to draw a supply and demand graph. Supply goes up, and demand goes down, with quantity on the x axis and price on the y axis.

Also be able to "think on the margin". The price of a good isn't set by what everyone is willing to pay for it, it's set by what an incremental customer is willing to pay for it. In fact, most decisions need to think "on the margin". Think of it this way:

You have no job and have so much free time that you're bored. Someone offers you work for an hour a day at $7 an hour. Should you take it?

You have a job for 7 hours a day at $7 an hour. Someone offers you an additional hour of work per day at $7 an hour. Should you take it?

You have a job for 14 hours a day at $7 an hour. Someone offers you an additional hour of work per day at $7 an hour. Should you take it?

You have a job for 14 hours a day at $25 an hour. Someone offers you an additional hour of work per day at $7 an hour. Should you take it?

The answer to all of these questions is very different, because you don't look at the value of your time on average, you need to think "what is the value of one ADDITIONAL hour of work vs free time for me, given the amount of time I work and the amount of money I have?"

This also goes for goods. If you are in the desert with no water, how much would you pay for a cup of water? If you are in your living room with a case of water that you could open now or later, how much would you pay for a cup of water? If you were drowning in the Poland Springs bottling plant, how much would you pay for a cup of water?

Again, water doesn't have an inherent value - its value is how much you'd pay for one more of it (which would certainly be positive and large in the first case, positive and small in the second case, and negative and large in the last case).

An example of where this is important is tax policy. If you tax corporate profits if the supply curve has a positive slope (like most normal ones do after a point), then producing that last widget isn't worth it, so the company makes less widgets. If you tax income, then working that last hour isn't worth it, so the worker works fewer hours.

This also applies to cost shocks - if your input costs go up and you can't raise prices, then you'll produce less because that last unit you're making is no longer profitable.


You've been brought in to advise a local clothing store on how to grow profits. It's a high-end women's fancy clothing maker, and they currently have 5 stores in NYC, Boston, LA and Chicago.

Think of:

What are the company's sources of revenue?

What are trends in these revenue sources?

What are the variable costs associated with the revenue?

What are the fixed costs associated with the revenue?

Trends in variable costs (material):

Trends in fixed costs (storefronts):

Competitors and how strong they are/how you can beat them (price? product differentiation?)

Substitutes for the company's product/how you can beat them (price? product differentiation?)

Then create:
Some suggestions to boost revenue (not right or wrong, just some ideas)
expanding to high-end men's goods
opening new stores
expanding existing stores
improving store locations - where should they be?
opening a partner brand for lower-end clothing
loyalty program
Some suggestions to lower variable costs:
Install a better inventory system so it takes salespeople less time to sell
Some suggestions to lower fixed costs:
Geographically consolidate
Improve distribution centers
Finding cheaper, "nichey" store locations
Some suggestions for balance sheet efficiency:
Install an inventory-tracking system (could be a loyalty program) so you can reduce inventory w/o affecting sales
this reduces a) inventory hours by salespeople
b) the amount of money you have tied up in clothes sitting in a backroom - the $ can be used elsewhere!
as a note, Wal-Mart is a GENIUS at this, and it's one major reason they've succeeded


You've been brought in by a company that makes airplanes to help them cut costs. Where would you look?

You've been brought in by a pharmaceutical company to evaluate whether the company should try and develop a cure for ingrown toenails. Create a framework to help them make this decision.

You've been brought in by a movie theater to help boost overall profits. How would you approach the problem?

A tractor-maker has invented a technology that lets their tractors hover. They don't know what to do with it. Help them figure out how to offer it to the marketplace.

Your client needs help deciding whether to buy a chain of upscale, trendy grocery stores (think Whole Foods) that's been struggling lately. What can they do to turn it around, and how should they decide whether to buy?

Other Recommended Reading:
Case in Point (check it out on Amazon)
summarized here:

Cap and Trade and global warming

 Everyone I know is too biased in one direction or another to give me a straight answer on what the actual data is that seems to suggest global cooling.
I've chronicled this on my blog a lot, but I'll restate it here: I believe in global warming, where we have no idea what the severity will be, but I'd also like to see accurate data and I'm skeptical of the massive government-driven taxes on the economy to try and deal with it (as opposed to funding science or implementing intelligent allocations of carbon credits that can't be done by a US government entity). This doesn't imply lack of preparation and intelligent, efficient anti-carbon measures - they are important - but it does imply that we should be careful about implementing them properly.
It's no different to nuclear war - nuclear war has a probability p (severity is a little clearer with nukes, while probability is a little less clear, but it's the same principle), so we take measures to avoid it. We don't institute authoritarian rule or remake the entire country/economy to avoid it, because that would be counterproductive... instead, we do our best to identify the threats and opportunities for improvement and deal with them as best we can, as rapidly as we can. Downsides? Done right, not many... we're more secure in other ways as well, even if we overestimate the possibility of nukes. (It's amazing to me that Democrats consistently seem to discount the possibility of a nuclear exchange when arguing against foreign intervention in places like Iran, while Republicans seem to discount the possibility of a climate bomb, where both are intrinsically identical types of problem).
Similarly, getting us off of foreign oil would lower the trade deficit (a good thing as long as government spending can come down with it to reduce inflation), make us more energy secure and independent and spur all sorts of unknowable innovation in the transport, distribution and manufacturing industries. It's a no-lose, done right. It's a big lose under a lot of other proposals - a lot of people assume the "trade" part of cap and trade would be frictionless and cause no deadweight loss, but that assumes a) perfect information, b) infinite management attention and c) most importantly, actors equally able to afford to buy or sell carbon credits. Misallocating the credits would be a very bad thing, and with our lobbyist congressional culture, they would be misallocated. This would have big implications for economic growth and R+D; going on a bad cap-and-trade program could significantly delay an actual workable scientific solution if it strips us of talent and money. Thus, I'm skeptical that cap-and-trade can ever work in the US as a piece of congressional legislation.
Again, ideally, you'd want the credits allocated more towards industries that can't easily switch from carbon-producing methods and have no lower-carbon substitutes (a lot of fertilizers and chemicals fall into this category, for example), so that industries with easy substitutable methods of production or industries that produce goods with lower-carbon substitutes are forced to have a lower carbon footprint with minimal economic impact. Each year, each carbon credit deflates (a right to produce 1 ton of carbon next year turns into a right to produce .98 tons of carbon, for example), so that all industries have an accelerating incentive to get off carbon as fast as they can develop good substitutes for current processes. The government could at any point increase the deflation of carbon credits to ensure that carbon prices never drop below some publicly announced and anticipated X (we'd need to prevent congress from re-inflating carbon credits, because it'd be too tempting in times of war or recession).
In this way, the lowest hanging fruit (patching up leaks in natural gas pipelines, or fixing leaky windows) gets attacked first, and it proceeds reasonably linearly towards more difficult carbon to eliminate. As each industry figures out an improvement,  it can sell its excess credits to industries who haven't found solutions yet but have deflating credits. This may require adjusting utilities rates for particularly persistent emitters who have no alternative, but that's something that hopefully states can deal with over time. This is one of a few simple cap and trade mechanisms.
However, the initial allocation is more critical than most theoretical economists would have you believe, and our lobbyist, highly partisan congress is probably incapable of dealing with it. A bad allocation strongly risks a situation where we reduce our carbon emissions not by improving our processes, but by simply raising the price and lowering supply of desirable goods made by weak producers who can't afford to deal with it - in effect, lowering consumption and prolonging recession in a big way. There also needs to be a credible way not to have wildly fluctuating carbon expectations as legislatures decide to relax or tighten emissions restrictions. It's a hard battle.

Gay marriage and state-by-state divorce rates: spurious correlation

Nate Silver devotes an entire article to the fact that states that ban gay marriage have higher divorce rates, and says he thinks it's interesting.

Some possibilities I thought of:

-States with high divorce rates tend to be poorer (because poor couples are more likely to divorce, either because of the money issue or because they tend to marry younger), which corresponds with more religious regions of the country, either by coincidence or cause (I suspect cause but I have little evidence, so I'll accept either explanation).

-Getting married as a gay person is harder, so those who do it are more committed and more likely to stay together (small contributor at best)

-People in unhappy marriages are less happy in general, and are stronger in their religion (thus banning gay marriage) or simply becoming bitter (and hating those who are different, like gay people)

I tend towards the [edit: FIRST] explanation. [I changed the order].

Another possibility, of course, is that it's a coincidence the same as the link between number of pirates in the world and global warming. As the number of pirates have gone down over the past few centuries, the earth has gotten warmer! (and if the world has in fact gotten a bit cooler in the past few years (due to a megacycle or a temporary fluctuation), the temperature has dropped as Somali pirates have risen in number!)

If Nate Silver were to be reading this post, I'd caution against thinking that statistical relations imply anything even remotely interesting without some sort of counterintuitive explanation for it. This is going to be intrinsically related to religion, with no surprising results.