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The Baseline Scenario
Entrepreneurs and Risk
Posted: 15 Jan 2010 06:50 AM PST
I planned to write about Malcolm Gladwell in this post a couple of days ago, but I had rambled on long enough, so I deferred it until later. Well, Felix Salmon beat me to the punch, which is all for the best anyway, since the connection was going to be John Paulson, and Felix knows much more about hedge funds than I do.
The topic is Gladwell’s still-subscription-only article, “The Sure Thing: How Entrepreneurs Really Succeed,” in which Paulson plays a starring role. The sub-sub-head in the table of contents says, “The myth of the daredevil entrepreneur,” so even though I expected Gladwell to be annoyingly contrarian again, for once I expected to agree with him. The conventional wisdom, in this case, is that successful entrepreneurs get that way by taking big risks.
I’m inclined against the conventional wisdom because I co-founded a company, it’s done pretty well, and I’m about the most risk-averse person I know. (Want proof? I even worked at McKinsey, the world’s epicenter of risk aversion; two of the other founders were also former management consultants.) In my opinion, based on limited experience, to start a successful company you need to have a solid plan, a realistic assessment of your chances, the willingness to take on a modest amount of financial risk (starting a company is rarely the best way to maximize your expected aggregate income, and never the best way after adjusting for risk), and the belief that the non-monetary satisfaction you get along the way will more than compensate for the financial disadvantages.
Gladwell, however, wants to say something much more provocative, and in the process says something much more confused. To begin with, as Salmon points out, his definition of “successful entrepreneur” is unusual–looking at his examples, it seems to mean “anyone who makes a large amount of money as head of any kind of company, even if he made the money in the act of acquiring that company at a lowball price.” (The implied definition of “entrepreneur” is “anyone who heads any kind of company,” which includes, say, Chuck Prince. While Prince may be a failed CEO, calling him a failed entrepreneur seems silly.) Although hedge fund managers do technically head their own companies, they fit with almost no one’s conventional definition of an entrepreneur; they are investing other people’s money, and they don’t create anything except new trades.
Much of the conceptual substance of Gladwell’s article comes from “From Predators to Icons,” a study by Michel Villette and Catherine Vuillermot (which I haven’t read and won’t read, so I’m counting on Gladwell’s summary).* According to them (this is a direct quote), “The businessman looks for partners to a transaction who do not have the same definition as he of the value of the goods exchanged, that is, who undervalue what they sell to him or overvalue what they sell to him or overvalue what they buy from him in comparison to his own evaluation.” Gladwell adds, “He repeats the good deal over and over again . . . his focus throughout that sequence is on hedging his bets and minimizing his chances of failure.” This is certainly a smart thing to do, and a good way to make money if you can do it, but it’s an awfully narrow definition of what it means to be an entrepreneur; it’s a better definition of a successful investor–Warren Buffett, for example. But how does it apply to, say, the founders of Apple, Google, Amazon, or Microsoft? In the case of Google, for example, everyone knew Internet search would be big; Page and Brin simply built a better mousetrap.
Also note that Gladwell’s added sentence is a poor description of John Paulson’s behavior: “But if he was genuinely going to make a trade of the lifetime, he needed more. Like a cocksure Las Vegas card-counter, he was eager to split his winning blackjack hand, again and again.” [Greg Zuckerman, The Greatest Trade Ever, p. 177 in free pre-publication version.] And his short position got to the point where it simply count not be hedged. “Now that the ABX had tumbled from 100 to 60, Paulson had a lot more to lose–the index easily could snap back to 100. If the mortgage investments recovered in price, Paulson would be known as the investor who let the trade of the year slip through his fingers.” His colleague Paolo Pellegrini tried to get Paulson to lock in more of his winnings, but he refused [p. 198]. And how can a real entrepreneur–Page and Brin, Gates and Allen, etc.–possibly hedge his position? When you have years of your life’s work tied up in one project, it can’t be hedged. You only have one life.
Gladwell wants to use his theory of “entrepreneurialism” and “risk-taking” to take a shot at stock-based compensation for corporate executives, arguing that we actually don’t want CEOs taking risks. But the point of stock-based compensation isn’t to encourage risk; it’s to align the interests of CEOs and shareholders, because otherwise CEOs have the incentive to sit on their cushy jobs and cushy salaries and avoid mistakes that will get them fired. I don’t think the problem with CEO compensation is stock per se. It’s stock options, which give CEOs asymmetrical payoffs; in particular, it’s stock options that get reset when things go badly,** so CEOs make money no matter what happens; and it’s stock-based compensation that can be cashed in too early (as opposed to, say, three years after the CEO retires), creating short-term incentives to pump up the stock price.
The best encouragements to productive risk-taking are measures that limit the cost of failure for people who are actually creating something new, and this is one reason why Silicon Valley has been so successful. The financial risks of starting a company aren’t that big, for most people. High-tech companies are typically started by people who could pull in low-six-figure salaries working for other companies, so they’re giving up a couple of hundred thousand dollars in opportunity cost; the rest is typically angel investor or venture capital money. More importantly, there is (historically, at least), little stigma attached to failure, so there’s little reputational downside to a failed startup. In a world full of risk-averse people, that’s very important.
Anyway, Gladwell is right about the myth of the daredevil entrepreneur , but this is the wrong article to prove the point.
* According to Gladwell, the study is based on case histories of successful entrepreneurs, which sounds an awful lot like selecting on the dependent variable. Again, I haven’t read it, so he may well be wrong–but if that’s what Gladwell thinks the study is based on, he should have steered clear.
** Typically by exchanging old options at a high strike price for new options at a low strike price.
By James Kwak

Design or Incompetence?
Posted: 15 Jan 2010 03:30 AM PST
Or both?
In late summer or early fall, Citibank was running a promotion: if you opened a new account or moved a certain amount of money to your bank account, you would get a $200 bonus within three months. Someone I know took advantage of this promotion, but as of Monday he still hadn’t gotten the $200 bonus, so he visited a branch.
“I was given the ridiculous explanation that I didn’t surrender the promotion letter and that the promotion code NP55 was not linked (?) in the application. I told them that: (1) the letter is not a coupon to be surrendered, (2) I should not have to tell the customer service rep how to process the promotion, (3) there was no requirement that the letter even be presented (just go to a financial center, it states), and (4) the code only needed to be mentioned if applying by phone. They called me back in the afternoon and asked me to come back this morning. They first offered me some ‘thank you’ points, but I stood my ground. After calling several places they finally reached a Texas office that would further research my problem. “
Eventually, he got a letter saying that Citibank would give him the $200 credit.
I’ve often wondered about situations like this: Is this just garden-variety incompetence, where the marketing folks think of a promotion and the computer guys program the systems wrong? Or is it a sinister design, in which the company decides to pull a bait-and-switch, and will only make you whole if you complain? (This goes far beyond banking. Think about any situation where you were overbilled, and after spending hours complaining you only ended up where you should have been in the first place. I’ve always thought there should be a treble-damages rule or something like it for overbilling, because otherwise companies have an incentive to overbill everyone all the time, especially if they are near-monopolists like the cable company.)
I’ve generally leaned toward incompetence, because I think if a company actually did have such a sinister plan, it would leak (because lots of people would have to know about it). But maybe it’s something in between.
Paul Kiel of ProPublica has uncovered multiple cases where homeowners are not getting their trial loan modifications made permanent. That’s not news. What is news is that the reasons the banks are giving for not making the modifications permanent are complete bogus! One person had his modification rejected by JPMorgan Chase because he made a statement that he expects his income to eventually recover; another was required by Wells Fargo to update his documentation during the trial period and then put into a second trial period because his income went up by $80 per month. (If you’re wondering why this matters, the big reason is that this way a bank can string you along making you think you’ll get a modification before finally rejecting you; if they rejected you up front, you could have walked away and saved yourself the payments in the interim.) In both of these cases, this violated Treasury Department guidelines for the loan modification program.
Here’s the thing. Jamie Dimon and John Stumpf are not reviewing documents and rejecting people’s modifications. These decisions are being made by first- and second-line servicing center employees, who are following instructions they got from . . . somewhere. What’s more remarkable, official spokespeople for both banks are cheerily giving bogus reasons for failing to make modifications permanent, unaware (until busted by ProPublica) that they are violating the Treasury Department’s rules!
So someone is taking the trouble to create inaccurate instructions for the servicing centers and give inaccurate talking points to the PR department. It could be pure incompetence, I guess. But it could be something in between–incompetence through conscious inattention. The bank’s senior executives make the decision to participate in the loan modification program, but then they don’t try very hard to make sure they are following the rules. They know that if they have a messed-up process, they can save on internal costs, and they can also drag out the trial modification periods, which means (a) more payments they wouldn’t have gotten if they rejected people on schedule and (b) longer before they have to write down the loans in question on their balance sheet. So they aren’t consciously giving orders to break Treasury’s rules, they’re just not trying hard to follow the rules, staff their servicing centers properly, train their people sufficiently, and test their computer systems thoroughly. And that way there’s never a smoking gun; instead, they can just say their servicing centers are swamped and they’re having trouble implementing new processes fast enough. (Wait! That’s what they’ve been saying about this very program for months!)
There doesn’t even need to be intent here (although there could be). Companies focus on the things they think are important. During the financial crisis, all the banks were focusing on their cash levels every day, and I’m sure they did a very good job at it. They don’t focus on things they think aren’t important. It seems like JPMorgan Chase and Wells Fargo are not focusing on their loan modification programs, and Citibank is not focusing on delivering on its promotions, just on using those promotions to suck cheap deposits onto their balance sheet. If that ends up helping their bottom line, then so much the better for them.
By James Kwak