In his note, This Is Water, Ben described the fourth pillar of the current zeitgeist. That pillar is financialization.
Financialization is squeezing more earnings from a dollar of sales without squeezing at all, but through tax arbitrage or balance sheet arbitrage.
Financialization is the zero-sum game aspect of capitalism, where profit margin growth is both pulled forward from future real growth and pulled away from current economic risk-taking.
Financialization is the smiley-face perversion of Smith’s invisible hand and Schumpeter’s creative destruction. It is a profoundly repressive political equilibrium that masks itself in the common knowledge of “Yay, capitalism!”.
This is a note about living and investing in the waters of
the current zeitgeist: the life aquatic.
The Life Aquatic also happens to be the title of a
2004 Wes Anderson movie, where a vaguely Jacques Cousteau-like character, Steve
Zissou (Bill Murray), attempts to exact revenge on the shark that ate his
Financialization is a kind of jaguar shark. Financialization
is all about using financial engineering techniques, either securitization or
borrowing, to transfer risk. More specifically, financialization is about the
systematic engineering of Heads I Win, Tails You Lose (HIWTYL) payoff
One of my new favorite writers, Ribbonfarm’s Venkatesh Rao, wrote at length about HIWTYL in his series, The Gervais Principle.
This is a simple and child-like example of the operation of a basic human instinct: the heads-I-win-tails-you-lose or HIWTYL (let’s pronounce that “hightail”) instinct. It is the tendency to grab more than your fair share of the rewards of success, and less than your fair share of the blame for failure.
In business, and especially in finance, we see this
playing out everywhere.
Debt-financed share buybacks? HIWTYL.
Highly-leveraged, dropdown yieldcos? HIWTYL.
Options strategies that systematically sell tail risk for
(shudder) “income”? HIWTYL.
(aside: corporate borrowing can be viewed as management
selling put options on a company’s assets. I’ll leave it to you to consider
what that might imply about government borrowing)
Management fee plus carry fee structures? HIWTYL.
Literally every legal doc ever written for a fund? HIWTYL.
There are two ways to effectively handle a counterparty that
has engineered a HIWTYL game: 1) refuse to play the game at all, 2) play the game
only if you have some ability to retaliate if your counterpaty screws you.
Legal action doesn’t count. The docs and disclosures are written to be HIWTYL,
You need to be in a position to hurt your counterparty for
You need to be in a position to hurt your counterparty economically.
Steve Zissou: Now if you’ll excuse me, I’m
going to go on an overnight drunk, and in 10 days I’m going to set out to find
the shark that ate my friend and destroy it. Anyone who wants to tag along is
more than welcome. […] I’m going to find it and I’m going to destroy it. I
don’t know how yet. Possibly with dynamite.
[a woman asks a question about the shark Zissou is
Festival Director: [translating] That’s an
endangered species at most. What would be the scientific purpose of killing it?
Steve Zissou: Revenge.
-The Life Aquatic (2004)
I’ll assume by now we’re all pretty familiar with the
prisoner’s dilemma—the simple game where the payoff structure incentivizes
“defection.” There’s also the iterated prisoner’s dilemma, where the
game is played more than once. What’s interesting is that in this version, the
“always defect” strategy that dominates the single-play version performs
Robert Axelrod analyzed the topic in depth in his 1984 book,
The Evolution of Cooperation, in the context of a tournament where
various strategies for the iterated prisoner’s dilemma competed for a high
score. The winner ended up being the simplest of the strategies, “tit for tat”.
Here’s how “tit for tat” worked.
On Turn 1, cooperate.
Thereafter, mirror your opponent’s decision.
It’s fine to swim in the waters of the zeitgeist, admiring the aquatic fauna. But should a jaguar shark suddenly emerge from the depths and devour your best friend, you’d best chase it down with dynamite and destroy it. Traders understand this principle deeply and intuitively. Particularly if they trade in an illiquid or opaque area of the markets.
In our highly-financialized world riddled with HIWTYL payoff
structures, we’re most likely to get screwed when we engage in one-off
transactions with counterparties we can’t effectively retaliate against.
Unfortunately, a lot of financial transactions fit
this profile. Particularly for small investors.
The best we can reasonably hope to do is mitigate the risk
of getting totally and irrevocably screwed. There are a couple ways to do this.
One is to stay liquid. Don’t get involved in fund structures or transactions
where you have no liquidity, or where someone is doing potentially illiquid
things in an optically liquid structure where they can in fact lock you in at
their discretion (*ahem* every hedge fund ever). Or, where someone else
will likely be in a position to squeeze you, if and when you want to sell (*ahem*
credit). You can still get screwed but you can also get out.
Frankly, however, that’s not ideal. Or even realistic.
A more flexible approach is to adopt a minimax regret
mindset when making investment and position sizing decisions. “Assuming this
all goes bad, how screwed am I going to be?” If you’ll be intolerably
screwed under any but the most draconian scenarios, adjust your risk posture.
There’s an important distinction to be made here between
risk mitigation and risk management.
Risk mitigation is about proactively reducing risk.
Risk management is about accepting risk, within
We confuse the two at our peril.
We tend to have more options when it comes to HIWTYL and tit
for tat in every day life. Particularly at the office. Watch carefully how
governance works. Watch how senior management makes and communicates decisions.
Watch how rewards are distributed and blame is assigned throughout the
organization. This is the thrust of the Ribbonfarm piece mentioned above.
[C]onsider the Golden Ticket example. It was a random idea that initially seemed good, then seemed to prove out bad, and then unexpectedly ended up as a win. Such are the uncertainties of life.
How would you attempt to bank such a success in predictable ways?
First you would cut a deal for a performance-linked bonus for a successful marketing campaign (but no penalty for failure of course).
Next, you would set up a committee and charter it to collect, vet and recommend ideas, perhaps with a promise of some nominal rewards, such as gift certificates, for successful ideas.
You would then drop hints and suggestions to create ideas, like the Golden Ticket scheme, that you personally favor.
And finally you would create the appropriate level of urgency in the work of the committee to achieve the risk-levels you want in the ideas produced.
If it works, you praise everybody generously, hand out a few gift certificates, keep your bonus to yourself, and move on. If it fails, you blame the people in charge of the work for failing to consider an “obvious” (with 20/20 hindsight) issue.
As usual, once you start looking for this stuff you will see it everywhere. So your homework is to take all this and apply it to politics. In the meantime, I’ll close with a final exchange from The Life Aquatic, between Steve Zissou and his financier, Oseary Drakoulias.
Oseary Drakoulias: The wire transfer came
straight through from Kentucky, and the bank has agreed to gap-finance the
rest. But there are a few hooks on it, so take a pew for a spell. Number One,
the bank wants a drug screen for everybody on the boat, before they’ll forward
Steve Zissou: A piss test?
Oseary Drakoulias: Yes, a piss test. Two, a
stooge from the bond company will be riding along during the whole shoot, to
keep you on budget.
Steve Zissou: Who’s the stooge?
Oseary Drakoulias: A chap by the name of
Bill Ubell, and there’s not a damn thing you can do about that, Steve. Three,
you must swear – legally swear – that you will not kill that shark, or whatever
it is, if it actually exists.
Steve Zissou: I’m going to fight it, but I’ll let it live. What about my dynamite?