Felix Salmon

Regulators should play to their strengths

Felix Salmon
Aug 23, 2009 20:29 UTC

The first thing that regulators do isn’t regulate: the first thing that regulators do is try to maximize their own power. Then, and only then, do they even think about using that power. Item:

The Securities and Exchange Commission says it is taking a close look at flash quotes, high-frequency trading and other dark corners of the stock markets.

But by many accounts, the agency is outmatched by the traders and market venues with technology that is remaking the trading world.

The agency lacks its own traders with knowledge about cutting-edge strategies and how the markets operate. It long ago ceded the daily surveillance of trading to self-regulatory organizations, like NYSE Regulation and the Financial Industry Regulatory Authority. And it takes a lawyerly approach to regulation and rule making that rarely employs deep analyses of real trading data.

The SEC has enough of a mountain to climb just trying to be effective at the stuff it already does: this kind of mission creep helps no one. It makes a certain amount of conceptual sense that the SEC should be regulating trading strategies, but it doesn’t make practical sense — not unless and until the SEC has proven that it’s more competent than this.

In the mean time, who best to keep an eye on high-frequency trading and the suchlike? Well, the CFTC might be one place to start, especially since in an ideal world the SEC and CFTC would be merged into one entity, and also since at least as much high-frequency trading goes on in commodities and derivatives markets as goes on in stock and bond markets. A bit more cooperation between the two would do no one any harm.


Foreclosure properties are in high demand as the lenders are in troble and there are many tax foreclosure properties available

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The Flaw of Averages

Felix Salmon
Aug 23, 2009 04:11 UTC

I’m not generally a fan of management books, maybe because I’m not a manager. So it’s probably just as well that I didn’t realize that The Flaw of Averages, by Sam Savage, was a management book before I started reading it. The highest praise I can give it is that I finished reading it — all the way through — which is something I don’t think I’ve ever done with a management book. Savage is a clear and gifted writer, which helps, and I’m interested in the subject matter, which also helps.

But there was something else which kept me reading: I was waiting for the other shoe to drop, and it never did. The basic thesis of The Flaw of Averages is not only true but mathematically provable: when you’re dealing with probability distributions rather than certainties, you can find yourself making all manner of horrible and costly errors if you try to boil those probability distributions down to a single number like an average. Instead, contemporary software, much of it based on Savage’s own research and development, allows you to create and manipulate those distributions directly, with much more useful results.

Savage advocates that companies create a new position, the Chief Probability Officer, charged with coordinating the institutional knowledge about probability distributions. He writes, in what might be the nub of the whole book:

Managers at many levels are just bursting with probabilistic knowledge, which if properly channeled can be put to good use.

Of course, the question of how to put the knowledge of lower-level managers to good use is not a question confined to probability distributions: really, it’s the central question of all management theory. But substantially all of this book deals with the question of how best to deal with probability distributions; there’s nothing at all on how to smell them to see if they make any sense, or how to judge how accurate they are.

Most startlingly of all, there’s no discussion of what probability is. One of my favorite parts of Riccardo Rebonato’s magnificent book Plight of the Fortune Tellers is chapter 3, “thinking about probabilities”. He makes the hugely important distinction: on the one hand there’s frequentist probability, where you can run the same experiment thousands of times to see what different results occur. On the other hand there’s subjective probability: if I ask what the probability is that oil will hit $100 per barrel in the next five years, you can’t do that.

Many people, Savage included, love to run Monte Carlo simulations in order to try to reduce subjective probability to frequentist probability, but there’s a category error going on whenever that happens, which is one reason that financial instruments designed by running Monte Carlo simulations blew up so spectacularly during this financial crisis. Monte Carlo simulations are very bad at showing the risk of something unprecedented happening, but as Nassim Taleb loves to point out, it’s the unprecedented events — the black swans — which tend to be crucially important.

On page 291 of his book, Savage prints an admittedly hypothetical distribution of future sea levels. He then goes on to explain why the distribution is oversimplified, and why we can’t trust it in its initial oversimplified form. But the fact is that his base-case scenario, the place where he starts his analysis, is a thin-tailed normal distribution, with the chance of sea levels rising in future being exactly the same as the chance that they will fall.

I just can’t believe that that kind of normal distribution is ever a useful place to start when thinking about something like climate change — the subject of the chapter at hand. The chances of sea levels falling from their current level are tiny — much lower than 50%. And the histogram going out is very bumpy indeed: to a first approximation, either Greenland and the west Antarctic ice sheet melt into the sea, or they don’t. Tails don’t get much fatter than this one.

But this whole book reads as though it was written in what Taleb calls “mediocristan” as opposed to the real world of “extremistan”. Tails are thin; Black and Scholes and Merton and Markowitz are heroes; probability distributions can be modeled and tamed and understood on a seat-of-the-pants level.

It’s true that the world of The Flaw of Averages is better than the world we’re just emerging from, where things like value-at-risk and correlation were disastrously boiled down to single numbers. But I’m still not sure I want to live in Savage’s world: it seems to me to be lacking a healthy dose of fear of the unknown. Quite the opposite, in fact: large chunks of the book are devoted to the riches that can be struck by identifying “real options” and buying them on the cheap from people who, looking only at averages, might overlook a lot of option value.

My fear is that if Savage’s souped-up Excel spreadsheets catch on, the corporate world will fall into the overconfidence trap which did for the financial world during the Great Moderation. Savage’s statistical distributions are extremely powerful tools, both in terms of identifying profitable opportunities and in terms of avoiding massive potential downside. But if companies become particularly adept at avoiding crashes, then that’s a recipe for yet another Minsky bubble. The fewer corporate disasters we see, the more risk and leverage that companies will feel comfortable taking on, and the more likely it is that another system-wide crash will occur.

Savage’s techniques are very good at discovering existing correlations which might not be immediately visible to senior management. But they’re useless at discovering correlations which were never significant in the past but which suddenly and terrifyingly go to 1 in the future when a Black Swan arrives.

If we all take Savage’s advice, we’ll weather most storms much better than we do right now. But I fear we’ll fare even worse in the event that a hurricane hits.

Update: Savage responds:

I believe in Black Swan thinking whole heartedly, but have been amazed to discover that most of my students (both university and executive) don’t even grasp the concept of a distribution in the first place. I also agree that any technology can lull people into a sense of security, but distributions of any kind are not as bad in this regard as single numbers. And my hope is that shaking the ladder in any manner will encourage people to stop fixating on the right answer, and start thinking about the right question, which is the proper defense against the black swan.

Actually one of my favorite interactive simulation demonstrations is black swanish, and sharply contrasts the Right Answer and Right Question schools. I didn’t think I could do it convincingly in the book because it is like writing about what it feels like to ride a bicycle, but I will try here. It involves picking a portfolio of petroleum prospects (like the Shell model), where one of the projects (site A) is a very attractive natural gas field, but is in a politically unstable part of the world, and there is a chance it could blow up politically.

Right Answer approach for dealing with the board of directors:

Ladies and gentlemen, we need to estimate the probability of an overthrow at our favorite site A, so we can chose an optimal portfolio that protects us in this event.

A committee is formed and after months of discussion it arrives at a 15% probability. Yes, there is a reasonable chance the place will blow up (lets call it a grey swan), but It is ridiculous to think you could estimate the probability with the accuracy implied by “15%” This analysis would rightfully deserve the wrath of Taleb.

“Right Question” approach:

We plug probabilities of overthrow ranging from 0 to 100% into an interactive simulation. As soon as a probability is plugged in, one thousand trials are run for each of 100 potential portfolios, nearly instantaneously. As we do this we observe the shape of the galaxy of portfolios in risk return space being deformed by probabilistic forces. We also notice that for all probabilities ranging between 3% and 97% that a few portfolios stay on the efficient frontier. These portfolios all contain both site A, and a less attractive site B, which is an alternate supply to the same market. Thus if A blows up, the price of gas goes up and B becomes a gold mine. This leads to the right question for the board of directors.

Ladies and gentlemen, do we hedge site A with site B? We are having an up or down vote in five minutes.

Well now you can see why I didn’t write about it, but if you ever have time for a webex, I find the demonstration dramatic, because I had no idea that the hedge of A with B would be optimal for such a huge range of probabilities.


Sam Savage’s book is great. I work with a bunch of very intelligent, highly educated people in a very quantitative field (investment management) – and yet, for all the sophisticated analysis we apply – the flaw of averages lurks everywhere and crops up in the most seemingly benign fashion and impacts decision-making all the time. Fixating on ‘black swans’ is all the rage these days, but let’s not forget to tie our shoe-laces.

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Those underperforming bond funds

Felix Salmon
Aug 22, 2009 19:04 UTC

Most investors have a significant exposure to bond funds. But according to S&P’s latest SPIVA report — by far the best comparison of fund performance to underlying indices — nearly all of those bond funds have underperformed their indices:


In case you can’t see this clearly, it says, among other things, that over the five-year period ending June 2009, 92% of investment-grade long funds have underperformed the index, 98% of mortgage-bond funds have underperformed the index, and 94% of general muni funds have underperformed the index. If you bought a California or New York muni fund, you had a 100% chance of underperforming the index.

Sam Mamudi, reporting on these results for the WSJ, puts them in the context of “the debate over passive versus active mutual-fund investing” — but he leaves out a crucial piece of information: passive investing in bonds is non-trivial. If you look at the performance of equity funds against the S&P 500, say, you can do so in the knowledge that it’s pretty trivial to buy an index fund or an ETF which will give you something very, very close to the performance of the index. With these bond indices, however, that’s not the case.

There are some bond ETFs: iShares, for instance, has a pretty broad suite of them. Most of them are pretty young, having been launched in 2007 or later, but there are a couple of older ones, such as the 20+ year Treasury bond fund (TLT). If you look at the information iShares provides, however, it’s really hard to tell how good the fund is at replicating the return of the index. We know that on June 30 its net asset value stood at 94.62, up from 83.41 five years previously; we can also find out that over that time the fund paid out 20.435 in dividends. You don’t want dividends, or you find them expensive to reinvest? Tough luck. We also know that the benchmark index increased from 237.77 to 388.29 over that time.

The index, then, increased over the course of those five years by an annualized 10.3%. If you just add the dividends onto the net asset value for the fund, you get an increase from 83.41 to 115, or 6.6% annualized. That’s pretty much in line with the 6.94% weighted average annualized return for long government bond funds generally.

What happens if you run the same exercise for IVV, iShares’ S&P 500 index fund? The index went from 1661.53 to 1498.94. The fund, meanwhile, went from 113.26 to 92.24 with 12.3185 in dividends. The index’s annualized return was -2%, while adding the dividends to the NAV of the fund gives an annualized return of -1.6%. The index fund outperformed the index, on this methodology, partly because you weren’t reinvesting dividends in a falling asset, but also because dividends are lower on stocks than on bonds, even government bonds.

But all of that is just doodling, really. The important thing to remember when it comes to bond funds is that realistically you should only be comparing managed bond funds to index bond funds, rather than to indices directly. After all, your choice isn’t between investing in a managed bond fund and investing in an index, it’s between investing in a managed bond fund and investing in an index bond fund. So while it’s true that a startlingly high percentage of managed bond funds underperform their index, it’s not necessarily true that the same percentage of those funds underperforms an index fund linked to the same benchmark.

Update: Wcw, in the comments, points me to this document, in which iShares says that the five-year return to end-June 2009 of the TLT fund was 7.25%, while the index return was 7.32%. The return on IVV was -2.28%, while the return on the S&P 500 was -2.24%. Even the TIPS bond fund, which Pimco disparages so, returned 4.80% to the index’s 4.94%. I would assume, of course, that these returns assume no commissions or bid-offer spreads when buying or selling the funds, or reinvesting dividends.


If high frequency trading programs are front-running big bond funds, and they doubtless are since this is a massive market to exploit, then this would help explain their across-the-board below-index performance.

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Friday links are significant

Felix Salmon
Aug 21, 2009 21:00 UTC

Bad idea du jour: Murdoch hiring bloggers, putting them behind a paywall

Koons’s personal collection: “Poussin, Dali, Picasso, Magritte, Picabia. Egyptian antiquities. And Manet’s last significant nude.”

“The NYT believes that people can be made sober, even rich ones, by smashing into a wall. It is a testable hypothesis

The limits of arbitrage

Moulton’s Recession Red: “A wine to remember in a year to forget”

Usain Bolt will be world record holder for a generation

China’s impossible inflation forecast

Jayson Blair, life coach

What your tattoo locations say about you

Why $800 billion over 10 years isn’t the same thing as $80 billion a year

Are you in LA at the end of this month? If so, go to the bicycle film festival!


Nothing new? I’ve already read these significant links.

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Loans aren’t better than securities

Felix Salmon
Aug 21, 2009 19:33 UTC

A bad asset is a bad asset, whether it’s a loan or a security. And the distinction between the two isn’t particularly helpful, as is evidenced by equal-and-opposite newspaper stories today.

On the one hand, there’s Floyd Norris in the NYT:

Banks are now losing money and going broke the old-fashioned way: They made loans that will never be repaid.

As the number of banks closed by the Federal Deposit Insurance Corporation has grown rapidly this year, it has become clear that most of them had nothing to do with the strange financial products that seemed to dominate the news when the big banks were nearing collapse and being bailed out by the government.

There were no C.D.O’s, or S.I.V.’s or AAA-rated “supersenior tranches” that turned out to have little value. Certainly there were no “C.D.O.-squareds.”

Staying away from strange securities has not made things better.

On the other hand, there’s Robin Sidel in the WSJ:

U.S. banks have been dying at the fastest rate since 1992, mainly because of bad loans they made. Now the banking crisis is entering a new stage, as lenders succumb to large amounts of toxic loans and securities they bought from other banks.

Federal officials on Thursday were poised to seize Guaranty Financial Group Inc., in what would be the 10th-largest bank failure in U.S. history, and broker a sale of the Texas bank to Banco Bilbao Vizcaya Argentaria SA of Spain. Guaranty’s woes were caused by its investment portfolio, stuffed with deteriorating securities created from pools of mortgages originated by some of the nation’s worst lenders.

Guaranty owns roughly $3.5 billion of securities backed by adjustable-rate mortgages, with two-thirds of the loans in foreclosure-wracked California, Florida and Arizona, according to the company’s latest report. Delinquency rates on the holdings have soared as high as 40%, forcing write-downs last month that consumed all of the bank’s capital.

Guaranty is one of thousands of banks that invested in such securities, which were often highly rated but ultimately hinged on the health of the mortgage industry and financial institutions.

So, which is it? Was Phase 1 of the crisis based on securities while Phase 2 is based on loans, or was Phase 1 the souring loans and now Phase 2 is the securities? Frankly, it’s neither. Banks’ assets soured, and they failed. Some of those assets were loans, and others were securities. Some banks trusted the structured-finance wizards more than they trusted their own underwriters, and loaded up on highly-rated CDOs. Others trusted their own underwriting more than the structured-finance wizards, and lent out billions of dollars in housing loans which will never be repaid. Both were doomed: the only way to win was not to play.


I’m looking forward to the day when you call for the “disaggregation” of The Economist.

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Disaggregating Zero Hedge

Felix Salmon
Aug 21, 2009 16:23 UTC

I first heard the name Daniel Ivandjiiski associated with Zero Hedge in March of this year, before the blog really took off. I do believe that he’s just one of many contributors who use the pseudonym “Tyler Durden”, but he’s the only one I’ve ever heard identified, and I think he’s been there for quite a while. He has reportedly said that he’s just a contributor, not a founder, but I’m not sure that distinction really means very much.

Does it matter that Ivandjiiski was barred from the securities industry for insider trading? In most cases, no, but in some cases, yes.

In any case, it’s now time that “Tyler Durden” disaggregate himself, so that it’s more transparent which blog entries were written by the same person. I used to pay more attention to Zero Hedge than I do now, because I found a few posts which I considered to be so wild that I felt I could no longer trust much of what I read there. If it were clearer which “Tyler Durden” wrote those particular posts, I’d pay much more attention to the other “Tyler Durden” posts. And that’s good for everyone.


Shaen Bernhardt von Bernhardi

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Where Rubin went wrong

Felix Salmon
Aug 21, 2009 15:37 UTC

Charlie Gasparino is right:

If there’s one certainty of the past decade of Wall Street greed and government mismanagement of the economy, it’s that Citigroup was a grossly mismanaged institution. Eventually, the federal government was forced to prevent what would have been the largest bank failure in U.S. history by pumping some $50 billion in capital into the bank, and guaranteeing hundreds of millions in toxic assets.

The U.S. government is now Citigroup’s largest single shareholder. The firm is currently on its third CEO (and some regulators are pressing for yet another change at the top); it has gone through almost a half dozen CFOs, numerous management changes during its sordid history, and endless regulatory turmoil.

Throughout the good times and bad, there’s been one constant—Bob Rubin. And consider the following: Citigroup was technically illegal when it was founded by Sandy Weill and John Reed back in 1998 because it combined both commercial and investment banking, but with the help of Rubin as Treasury secretary, the law that would have prevented the supermarket model from working—The Glass-Steagall Act— was dismantled. Citigroup survived, and Rubin was rewarded with his dream job: Lots of money and little if any management responsibility.

Now you know why Bob Rubin’s reputation won’t be repaired anytime soon.

There’s a typo: the government guarantees are for hundreds of billions in toxic assets, not hundreds of millions.

What interests me is that although Gasparino concedes that Rubin’s actions as Treasury secretary were instrumental in creating the monster that was Citigroup, he still says that Rubin “served this country well while in government”.

My view of Rubin is harsher: that from the very beginning of his career he amassed vast stores of both fiscal and reputational capital by making huge bets that things would go right. And so long as things went right, Rubin became ever richer and more powerful. When things went wrong, however, he was blindsided with enormous force. Rubin was so used to things going his way that he lost sight of the possibility that there was any other potential outcome:

[Rubin] has been speaking to former government officials, regulators and friends on Wall Street to determine if they saw the financial crisis coming because he sure didn’t until it was too late. Most admit they didn’t either, and that makes Rubin feel better.

Of course as any former Goldman employee should know, this isn’t a simple binary question — did you see the crisis coming or didn’t you. It’s a question of risk management: did you see the possibility that the crisis might come, and did you protect your balance sheet against that possibility. In Rubin’s case, clearly, the answer is no. While many senior officials were very worried about the possibility that the Great Moderation was really just an old-fashioned credit bubble, Rubin wasn’t. As a result, Chuck Prince kept dancing, fatally, until the music stopped.


On a quick/dirty recall…I think it’s ~ $320 billion on a total book of assets ~ $1.75 trillion. Call it a range from 1/6 to 1/5…of total assets.

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Should banks extend and pretend?

Felix Salmon
Aug 21, 2009 13:57 UTC

There was a nice little debate among the Reuters commentary group this morning about an increasingly-common way of dealing with dodgy loans: what some are calling “extend and pretend” and others refer to as “delay and pray”. Basically, you just roll over bad-but-performing loans as they come due, rather than take any losses associated with the borrower’s inability to make a big principal repayment. Rolfe Winkler, for one, thinks it’s a very bad idea:

Banks argue that loans should not be marked down if they’re still “performing.” As long as borrowers are meeting their contractual obligations, there’s no reason to take a writedown. The problem is, this gives banks an excuse to extend, amend and pretend. They can make concessions on loan terms or delay foreclosure notices, if only to maintain the fiction that borrowers will make good…

As the Japanese can tell you, this is just a recipe for stagnation. Thanks to a debt bubble that authorities refused to deal with decisively, that country is now entering its third consecutive lost decade.

This is true — especially if, like Rolfe, you think that the collateral underlying these loans is going to continue to decline in value. Very few upside-down loans are worth more than the property they’re secured against, and if you’ve lent money against a declining asset, then the sooner you can take your losses and move on, the better.

On the other hand, the person you’re selling that collateral to doesn’t think it’s going to fall in value. And really what we’re faced with here is a distribution of possible future states.

The calculation which needs to be done is pretty complex, and involves the future path of three uncertain variables. First there’s the lender’s own cost of funds: at the moment it’s low, but there is a chance it could rise substantially by the time the extended loan matures. Secondly there’s the income stream from the loan: while most of these loans are performing right now, and making their interest payments on time, there’s a significant chance of future default on many of them. And thirdly there’s the future course of property prices, or other assets securing the loans.

The last two, of course, are highly (but not perfectly) correlated: if the value of collateral declines, then the chances of the borrower defaulting on the loan increase. But in an efficient world, every lender, on a case-by-case basis, would work out the expected profit or loss from extending the loan, taking into account the amount of volatility we’ve seen in all three variables, and then compare that to the known loss they’d need to take if they just foreclosed tomorrow. If the expected loss from extending is lower than the loss that would need to be taken today, then they extend.

In the real world, however, bankers are human, and they’re liable to fudge the figures so that extending the loan always makes sense: tweak a volatility assumption here, put in a favorable interest-rate assumption there, and it’s not hard to get the answer out that you wanted in the first place. They have a very strong incentive to do this, because much of the time if they take their losses now, they’ll become insolvent: everybody wants to survive, first and foremost.

So that’s where the regulators come in. At the moment, it’s far from clear that they have either the ability or the inclination to force banks to face reality — especially when they’re dealing with big banks. To the contrary, “extend and pretend” has obvious attractions for technocrats, too: it allows them to kick the hard decisions down the road, which is something nearly all politicians love to do. And when it comes to non-bank lenders, the regulators are pretty much out of the picture entirely.

Tthere’s definitely a part of me which is sympathetic to both borrowers and lenders who manage to come to a “one more chance” agreement. There are significant costs to default and foreclosure, and such agreements mean those costs don’t have to be taken — at least not in the immediate future. When hope becomes delusion, then regulators must step in and force write-downs. But the calculations you need to do in order to tell the difference are pretty complex.


Banks thrive on the future path of uncertain variables. Speculation rules across all the exchanges the world over. Isn’t monetary appreciation based on variables?

That banks could ever consider NOT EARNING INTEREST on loans, albeit at slower returns than anticipated, would be very suprising.

The tattooed MBA

Felix Salmon
Aug 20, 2009 20:03 UTC

The conversation in the comments to my tattoo post has become very interesting, and now Ryan Avent weighs in with his take:

Most people don’t tend to see things the way Mr Salmon does, but rather take outward signs at face value. Most jobseekers do dress up for interviews. Most young people seeking professional work do not get large, visible tattoos. Firms pay for fancy offices and hire college graduates, even though fancy offices and college graduates are expensive and shabby offices and a staff of non-graduates might signal that the firm is very good at what it does—so good that it doesn’t need to bother with the normal trappings.

In general, I think it tends to be much more costly to depart from convention than to keep to it, at least until a reputation has been established.

I’m reminded of this recent post by James Kwak, formerly of McKinsey & Co:

It’s not what you learn at business school that matters, it’s the screening function. Top business schools screen for the attributes that certain types of companies, including consulting firms and investment banks, value – above-average intelligence, ambition, presentability, ability to get along with others, willingness to follow orders, and a strong streak of conformism. McKinsey recruits people with Ph.D.s (and certain other advanced degrees) as well because the Ph.D. is an indicator of intelligence and (to some extent) ambition, but it is considerably harder to get a consulting job as a Ph.D. from a top school than as an MBA from a top school because of the other things that an MBA signals.

I think there’s a gap in the market here, for a new high-end management consultancy, and/or boutique investment bank, which only hires people with tattoos and which doesn’t employ a single MBA. Even if only a minority of potential clients see things the way I do, that could easily be enough people to build a strong and sustainable business.

Once upon a time, in fact, the City of London was full of “barrow boys” who had left school at 16 and made it rich as traders. In the US, shops like Bear Stearns and Salomon Brothers often took great pride in being staffed with hungry guys from the streets, people with the opinion that it’s making money which matters, not being respectable. Even now, certain corners of the market, like the inter-dealer brokers, have similar characteristics. But as an ever-growing proportion of smart kids goes first to a good college before even looking for a job, and as these firms become better established, it becomes very easy to fall back onto hoary conventions when it comes to staffing.

I’m dedicating this post to a certain heavily-tattooed bank flack who never went to university and who has suffered as a result — more for the lack of formal education than for the ink, it must be said. No one thinks that at this point in her career what she did or didn’t learn as an undergraduate would make the slightest bit of difference to her performance in the job, but somehow it’s always easier to promote someone else. It’s a sign of overcaution and laziness on the part of her managers. And in theory there’s no reason why that laziness and overcaution can’t be exploited by their rivals.


This is for Dave regarding his statement above.

Even though Bear Stearns had to be bailed out by JPM does not mean that it wasn’t a good shop. Excuse me if I’m wrong but the majority of businesses started in the US don’t even make it a year and Bear was around since 1923. I don’t know about you but I think an 85 year run is a pretty good one. There are only a select few large companies out there today that could boast of a longer existence.

Just figured I would point out pure ignorance.

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