If you watched a single World Cup match, you likely saw several advertisements for Electronic Arts (Nasdaq: ERTS) accompanying video game. Apparently, the exposure paid off.

The video game sector is one of the hottest spots for investing. And one of the hottest events in the space is the E3 annual conference. This is the place for gaming companies to build hype for their biggest blockbuster games or hardware of the year.

I caught up with Wedbush Morgan analyst Michael Pachter to get his veteran perspective on what he is expecting from E3 2010. In addition to a sneak peek at where the video game sector is headed, Pachter gives us an inside look at some of the companies we should be watching closely …

E3 2010 Preview with Michael Pachter

Prefer to read? Here’s the transcript of the podcast above:

Damien: Good afternoon, everybody, and welcome to the Wall Street Cheat Sheet podcast. This week we have an exciting guest, Michael Pachter, Analyst at Wedbush Morgan who covers the videogame in interactive entertainment space. Michael’s going to be talking to us today about a very exciting conference coming up very shortly called the E3 Conference. It’s out in California. And this is one of the premier events of the year for the interactive entertainment industry where all the exciting new developments are released for videogame fans. And today, Michael’s going to talk with us a little bit about some of the things he expects to see at E3 and how some of these developments and what he’s hearing will be affecting some of the stocks and companies that he covers at Wedbush. Welcome, Michael, and thank you very much for joining us today.

Michael: Thanks, Damien. I’m glad to be here.

Damien: So, Michael, E3 is, you know, one of the exciting events. And I know all my friends and my gamer friends are just absolutely pumped to see what’s going to come out at the event this year. Since you probably get a preview glimpse of some of the stuff or at least hear some chatter, can you maybe share with our listeners some of the things that you expect to be the more exciting developments in this year’s conference?

Michael: Yeah. It appears to me that this year is more of a hardware show than any we’ve had in the last, you know, probably eight or nine years. You know, we had a lot of buzz back in 2001 when the GameCube (NTDOY) and the Xbox (Nasdaq: MSFT) were unveiled. And we had a lot of buzz back in ’06 with the PS3 (NYSE: SNE) and the Wii. But – because, you know, the other console needs of those cycles was launched the year prior, so you know, PS2 back in 2000 and Xbox 360 back in 2005.

So, we haven’t had a show where all of the hardware manufacturers introduced something at the same time. And this year, we have each of the manufacturers introducing some new variation on the hardware. Sony preempted the spectacle by showing us the Move which is their motion controller at the Game Developer’s conference back in March. But they’re going to now show us a whole host of software that takes advantage of the Move. And they’re going to allow the masses to get their hands on the controller – control mechanism for the first time. So, I think that will be very, very well received.

Microsoft is launching something called Natal which is rumored to have a different street name. I saw something that leaked that called it the WAVE. Today is the first week of June. I’m actually going up there this week to preview it. And I have to sign a non-disclosure, so I won’t be able to [0:02:42] tell you. But I will learn the name this week. It’s going to be called something other than Natal. But Microsoft is a controller less motion control scheme, so you don’t use anything but your body to control the characters on the screen or the screen itself. And I think people, you know, we all saw it last year, but few of us – I was one – got to actually try it hands on. They’re going to let a lot of people see it. And my understanding is a software right after that thing is just really deep. I know somebody who has some software for it who has to wait until February for a release because he was told that the launch release Window is too crowded. There are too many games coming out for it. So, people would be excited about that. And then…

Damien: Michael, real quick, since that’s a pretty interesting topic. Do you think that this is the – an evolutionary step beyond the Wii? Is this going to be the first step into virtual reality?

Michael: Well, I think – I think that’s, you know, certainly, Microsoft’s intention is to evolve game play beyond, you know, what Nintendo did. And if you look at, you know, the Nintendo Wiimote and the controller mechanism, it’s a controller with an infrared light and an accelerometer built into it. You point it at a status bar that sits in front of your TV, so that you can calibrate it. Sony actually copied that exactly with the Move. It’s just that instead of using a status bar that’s an infrared sensor, it uses a camera, but it absolutely works the same way. And the only difference is that Sony’s camera will allow you to put your character, your actual physical presence into the game if you’d need to, if there’s a reason to do that.

But Microsoft went in a different direction, so there is no control or there’s no accelerometer. And again, it’s using hand motions and voice activation. And they really downplayed the voice activation a year ago. I think that’s going to be the big surprise of the show that you can talk to the screen and you can actually make things happen. And those of us who are, you know, far less creative than most, which is me, all I can think of is, you know, Xbox on or Xbox off. But clearly, you can, you know, theoretically, you could talk to your, you know, other players, you can play a multi-player game, coordinate action. That’s pretty obvious. If you could actually bark at your character and say, “Duck,” and he did, that would be kind of cool. I’m not sure what they’re going to do, but I think we’re going to see some games to take advantage of the voice activation as well. And…

Damien: And since this has been a development for so long, do you think that we should expect it to work flawlessly and not have a massive amount of, you know – speaking from the stock and business side – having a massive amount of problems or glitches that are going to cause refunds or returns?

Michael: Well, I think you just spoke in extremes, flawless, unlikely, and massive flaws, unlikely, so somewhere in between.

Damien: Okay.

Michael: I’d say modestly flawed. I mean, they’ve been testing this thing. You know the thing that I saw back in – I saw it in May of ’09 – worked very well. And they really haven’t shown it since, I mean, they demoed it at the first week of June, it’d be three year ago. No one had seen it since. So, they’ve kept it so close with us because they wanted to make sure it was as near flawless as they could make it. And the trip I’m taking, you know, this first week of June, I was scheduled to take the thing back in February and they cancelled on me because they said they weren’t happy with the way it was working. And they wanted the experience to be as close to flawless as possible. And they’re now very excited to having this up. So, I have a hunch it works pretty damn well, but I’ll know more in a week.

But my guess is yeah, there’ll be things. The gamers are hyper critical bunch. I mean, they tend to think that everything needs to work flawlessly and that everything should be free. So, you know, well, truthfully, everybody – you know, I’m sure that you can come up with great examples outside of the gaming world, but in my experience, I’ve never seen the degree of entitlement among any consumer group that you see among gamers. They want more and more and more for less money every year. It’s amazing. And, you know, I think the poster chapter of that is Call of Duty Modern Warfare (Nasdaq: ATVI) online play, you know, the idea that 1.75 billion hours are spent on an Xbox LIVE for the first five months. It means that roughly 8.5 million people play 10 hours a week for 20 weeks.

And just the hint that Activision would never charge for that has people open arms, you know, it’s like, it’s crazy. People think that “Hey, I bought a game for 60 bucks. I should be able to play it, you know, 40 hours a week for the rest of my life.” Well, if it’s got that much value, it’s not going to be 60 bucks anymore. And I think that that’s kind of the case with Move and Natal, people want it to be, you know, free and all games just instantly work flawlessly. And Microsoft spent a lot of money on this thing. And Sony spent a lot of money on theirs and they’re going to charge for it. And the games are going to have features in them we haven’t seen before. And, you know, I think that if they don’t work well, well, that’s probably – you’ll get good enough for what you pay.

Again, I think that Natal, we’ve seen rumors that it’s going to be 149. I think that would be a mistake. But the idea that Microsoft actually potentially believes its worth that much, suggest that they’re very confident that it works. So, you know, we’ll find out. I mean, I would be personally shock if the thing didn’t work. I mean, I have a feeling people are going to be blown away by it. So, the third guy in – of the console manufacturers is Nintendo. And obviously, they already have the motion control scheme. And the other two guys are trying to take a lot of the wind out of the Wii sales by saying we’re just as good.

So, Nintendo’s going in a completely different direction as they always do by introducing the – what they’re currently calling the 3DS. It’s a three dimensional handheld gaming device. And no one seen it, so nobody knows exactly what they’re going to do and there’s a lot of excitement I think building around that. I’ve seen – I’m sorry, screwed up – I’ve seen photo cameras that are currently only sold in Japan. I’ve only seen two of them, but I know they exist. We have a 3D screen built in, so that require glasses. The screen is a thick piece of some kind of crystal that, you know, that allows for multiple layers of display. And the cameras have two lenses in them, so they take, you know, the proper depth to display in 3D. They look pretty sleek. And again, you have to look at them pretty much straight on. You can’t angle it too much or you’ll see the image split into two. But it’s a very, very nice-looking, you know, three dimensional image. It’s much like wearing those, what they call those little view graph glasses. Remember those little things used to click the button and the circular slideshow we display in 3D. We all have those when we were kids. I can’t remember what it’s called.

Damien: The old school.

Michael: Yeah. But it does look like that. I mean it’s got that kind of two-eyed thing and the lens is really full view into seeing a 3D image. I’m pretty confident that’s what Nintendo’s doing. And I think that’ll be really well received. And since our focus is on the consoles, you know, for – from Microsoft and Sony, I think Nintendo is actually very smart to be taking the different direction of D3. So, I expect a lot of excitement about the three hardware reveals. And then we’ll see what kind of software is there to support them.

But all of that is pretty additive to what we normally get out of D3 which is just a giant lineup of new games that people haven’t seen. And, you know the ones – there are some big names everybody’s excited about, you know, the Halo Reach. And I’m not sure we’re going to study StarCraft and D3 other than the Activision of that. I don’t think they’re going to have it on the floor.

Damien: Do you think – is the new Halo going to be – and I saw – I followed it up with – on the – I followed it a little on the beta launch that they were having. Is the new Halo something that enlist or anticipating to be maybe one of the biggest blockbuster videogames of all time again?

Michael: Well, I think certainly it will sell, you know, as many units as anything that comes out this year. I mean, the, you know, the crazy thing is that two of the biggest games of the year are single platform games. So, Super Mario Galaxy which just came out a week ago or 10 days ago, and Halo Reach are each console exclusives and though each sell, you know, quite easily 8 to 10 million units with a bias that Mario could do more.

The bigger games out there, if there are any, you know, maybe the Call of Duty: Black Ops game which will probably sell about the same 10 million or 11 million multi-platform. So, we at Halo, certainly one of the top two or three games of the year and possibly the number one game, you know. It’s funny how, again, the freaking, you know, gamer community, they’re bitching about Halo Reach because Master Chief is not in it, you know. So it’s like, to me, the same game but their beloved Master Chief who like – it’s no, just – it’s still so funny that they, you know, how people are. But yeah, maybe, you know, maybe that was one of the selling points.

And I think Microsoft really is delivering something pretty meaningful. You know, we’ll see Gears of War 3 which is another big-selling console exclusive. That will get people excited. I’m sure that Sony has a couple of games that we haven’t heard about coming out. There could be another inFAMOUS, some of these games like that. Nintendo’s going to very likely show us Zelda, coming out in just a couple of months so they’ll show that. So, there’s a lot of new content that people haven’t seen. Electronic Arts is going to focus on Medal of Honor (Nasdaq: EA), I think that’ll make a good showing. We’ll probably see the Star Wars MMO.

And, you know, the Ubisoft is showing Driver which I think will get people excited. There really are a lot of games, so we’re going to see a lot of footage out of, you know, Activision is going to focus on Call of Duty: Black Ops. So and then Take-Two (Nasdaq: TTWO) who probably has the most anticipated game of any with Grand Theft Auto Next probably won’t show it because they’ll show it when the Rockstar guys decide it’s time to show it. But they’re fortunate because they currently have one of the bestselling games of the year in Redemption, you know, in the market place. So, it’s out, so they can’t talk about it, you know, can’t show anything that will surprise us. But I think that the buzz from that game helps the stuff they have coming out later in the fall, Max Payne 3, Mafia II, and possibly L.A. Wars. They should show some of those games because they are close to being out.

Damien: So, can you share a little bit into how this affects these companies in so far as, you know, for investors to consider, is Take-Two something that you like here going forward with their fall lineup and with their currently high selling game? And how do you feel about some of the other companies in the sector?

Michael: You know I like Take-Two a lot as a trade because I think that Take-Two will – the shares will go up when they announce the Grand Theft Auto. And I think that’s fair. I mean, Grand Theft Auto throws up just an enormous amount of profit. And I think that Take-Two has a potential of going up if their large minority shareholder makes any noise about how they need to do things differently in the company.

My long term view on the stock is, you know, I’m officially neutral. And my bias is, my only negative at this price. I mean, I have a $10 price target stocks at $11.60, so it’s not like I think it’s, you know, sell them to zero. I think it’s slightly over valued. And my $10 target, you know, we’re not trying to get too scientific about it, is just a commentary on the fact that they’ve lost $3 in fiscal ’06, ’07, ’08 and ’09 combined and there’s a full Grand Theft Auto in there. So, net, they lost $3 a share and yes, I think the next Grand Theft Auto is worth a lot and I’d say it’s probably worth about $1 to $2 of share.

So, in the next four years, they’ll lose $1 if they’re lucky. And that’s just not a great investment. I mean, the way that it’ll become a great investment is to turn that dollar of lose into something that, you know, some profit. And clearly, when their baseball contract rolls off, they’re more profitable by something, you know, in the order of 50 cents a share per year. So, the negative one, if the, you know, pie in the sky number could be positive one, if they do things right. But what do you pay for a company that makes a dollar every four years? You don’t pay $11.50 or $15. The way to get that number up to a dollar or $2 a share sustainable every year is to get their games out more frequently.

And I think what everybody misses on Take-Two is that as good as Red Dead Redemption is, and it is a great game, it took six years to make. And nobody takes six years to make games. And when I say nobody, I mean you really cannot name a game franchise that comes out every six years, but Take-Two has six of them. That’s the problem. The Mafia is a six-year development cycle. Max Payne is a six-year development cycle. L.A. War was announced five years ago, so, you know, at least a five-year cycle. And they just have too many of their good games that take too long. And, you know, I think that the problem of the company is that the developers always believe if we take an extra two or three years, we can take the game score from an 85 to a 95. And I actually think Red Dead Redemption is, you know, reveals the flaw in the way the companies run because they allowed the developers to take the extra few years. They did it. The game got a great review and everybody’s patting themselves in the back on how well it’s doing. But that creates unacceptable risk because if Max Payne hasn’t reviewed that highly and doesn’t sell that many units, they’re going to lose money on it. And, you know, investors don’t want to buy a company that loses money on its big franchise. So, I’m not a huge fan until they start getting games out on the two or three-year cycle. They can do that, then I will really, really like them. Again, great quality games just don’t come up frequently enough.

Damien: And is there – are there any other companies in the space that you think are doing well? You know, Activision, obviously, has been a huge focus for the average investor to play the videogame space. Do you think Activision can still maintain its sort of leadership in the space? Or is it one of those deals where it’s better to pick some of the other up and coming companies now that it’s just established itself as a leader, there’s not as much growth opportunity there.

Michael: You know, I think that’s really a fair question. And this industry is constantly surprising us. I mean, years – you know if we were talking five years ago, we would have said, “EA is the one to own because they’re dominant.” And Activision, you know, was kind of just afterthought. And in fact, in fall of ’05 Activision has a terrible, terrible holiday and the stock hit, you know, probably five-year in row and has gone up a ton since.

So, you know, the bet, you know, five would have been ignore the industry leader and play the up and comer. And that would have been the right thing to do. I tend to actually really like Activision right now because I think the industry is evolving into, you know, where the winner is going to win based upon having the biggest franchises with the largest recurring revenue streams. And Activision, without question, has that in World of Warcraft. It looks to me like they have something real with the Call of Duty franchise. And, you know, I’m hopeful that they don’t mess it up the way they messed up Guitar Hero. And again, in fairness to them, I’m not sure Guitar Hero really had, you know, kind of a 10-year staying power. I think that it was quite a bit faddish game. You know its fun, but once you have your, you know, two or three versions of it and you have your 150 songs, how many do you really need?

So, I’m not sure that’s got the same kind of recurring revenues. But I do see the online game play of Call of Duty is presenting a real opportunity for Activision. The idea of that on Xbox LIVE, my number 8.5 million people played 10 hours a week for the first 20 weeks, that’s incredible. And if Activision could figure out a way to charge for that, it doesn’t really matter if only two million of those people pay. Activision’s going to make a lot more money. So, I think that’s coming. And I think that where investors are going to decide they really love Activision the next two or three years is when they have a Call of Duty online multiplayer subscription business, and a Bungee online multiplayer subscription business and a StarCraft online multiplayer subscription business. And we add it all up, you’re going to see that, you know, Activision’s generating two thirds or three quarters of profits from recurring subscription revenue. And that makes the stock worth a lot. That makes – that takes multiple up.

So, my bias is they’re in the midst of a transition, not necessarily a way from package goods, but supplementing package goods by introducing online monthly subscriptions. And I don’t think it takes very many people. It takes two or three million people for each of the services paying somewhere between $5 or $15 a month to throw off crazy amount of profits. Now, that won’t make the, you know – I said 8.5 million on Xbox LIVE, so probably 12 or 13 million between Xbox 360 and PS3 that are playing online. If only 2 million of them get, you know, can afford to pay for the subscription, 10 million of them are going to be angry.

But what are they going to do? You know, I don’t think they’re going to just go over to EA and play Battlefield or Medal of Honor for free because if Activision can demonstrate that 2 or 3 million people will pay 10 bucks a month, EA is not going to give away Battlefield and Medal of Honor for free. They’ll charge 10 bucks a month, too. I just think that’s just reality. And as we see, the publishers come up with models to monetize online game play. I am confident that the stocks are going to go up. Consumers may not be happy because, back to the sense of entitlement, they think everything should be for free in perpetuity.

The fact is that either they’re going to stop playing games and go spend their money on something else or they’re going to grudgingly spend their money, you know, to continue to do what they like to do. My bias is that there will be a pricing model that strikes a balance between what consumers are willing to pay and what the publishers are willing to charge and I think everybody wins. So, then consumers are going to spend more money, but they’re going to get a lot more game play for that money. And I think the publishers that benefit are led by Activision, followed by EA because I think they have the content, EA with Stars Wars MMO and Battlefield and Medal of Honor, they have the content that people probably are willing to pay for. And EA is going to probably do the same thing on the sports side.

So, subscription multiplayer I think is the way – the wave of the future. And I think that EA and Activision are positioned best to capitalize on that, followed by Ubisoft. I don’t think THQ (Nasdaq: THQI) and Take-Two yet have a line up of games that are really great multiplayer experiences. GTA multiplayer pretty much fell on its face. I mean it’s a single player game. We’ll see how Red Dead Redemption multiplayer does, but I just don’t see why I want to be in a game with cowboys shooting, you know, six shooters and other cowboys. So, ultimately, you know, I really think because of the military theme, shooters win. And Activision with its Bungee deal, you’re going to get some kind of a Halo-like space shooter out of it. EA with its production M&A deal probably the same thing. So, these guys are very much focused on that online multiplayer market. They haven’t announced plan to charge on subscriptions, but its coming.

Damien: Well, Michael, this has been extremely interesting and exciting especially if someone who – I, myself, a casual gamer and also have invested very heavily in the videogame sector for probably the past decade. And I know a lot of our listeners are very interested. I want to thank you very much for taking the time today to give us a little bit of a preview on E3. And I really hope that you and I can catch up again after the conference, maybe a week after or something. And you can maybe, once again, for our audience, give them a little bit of a thought process on what you liked about the conference and what you see going on going into the end of the summer and the fall.

Michael: Happy to do that and nice to be here. Thanks for having me, Damien.

Damien: Thanks so much, Michael. I really appreciate it. And thanks, everybody, for listening. This has been the Wall Street Cheat Sheet podcast. You can hear more and read more at wallstreetcheatsheet.com and we’ll see you soon.

Be heard! Click here to nominate someone for a Medal of Honor.

Josh Rosner is the inaugural recipient of our first annual Medal of Honor for Excellent Service Award. Like a Navy Seal who does the most elite work yet receives the least public spotlight, Rosner has for years consistently been one of the best analysts on Wall Street. Most importantly, while other false prophets had undeservedly taken credit for nailing the crisis (for the wrong reasons), Rosner and a small handful of other hard working analysts saw and called everything for the right reasons in real-time.

For this reason, Rosner deserves to be treated like a Rock Star. If you had invested money based on Rosner’s calls, you’d surely feel like one. So, while the circus freaks and high-powered public relations people garner all the attention, Wall St. Cheat Sheet is going to bring you the gentlemen who invaded enemy territory in the dark of night and emerged with the Truth.

I had the great honor of sitting down with Josh to discuss his career, the bias of traditional Wall Street analysts, the current state of the financial system, Goldman Sachs et al, the lost spirit of capitalism, and the good guys on Wall Street …

Damien Hoffman: Josh, tell me how your career on Wall Street started.

Joshua Rosner

Josh: Totally circumstance. To make a long story very short, I started on Wall Street in the depths of the ’89-’90 recession. I couldn’t find a job except on Wall Street. I came from a legal family. Wall Street was the last industry I ever intended or thought I’d work in. I thought I was going to go into foreign service. I expected to work for or hoped to work in the government — ideally, in foreign service or international affairs.

Damien: So you thought you’d travel the world and now you’re stuck on a 9-mile long island?

Josh: I didn’t want to travel the world as much as I wanted to be a productive part of policy formation.

Damien: How did you stumble upon your first job Wall Street job?

Josh: A friend made a suggestion to talk with her brother who then was at Lehman Brothers. I interviewed there and they hired me as an associate. That was it!

Damien: Since then you’ve worked your way towards becoming an independent analyst. Can you tell us about that journey?

Josh: I was at Lehman for about 3 years. Then I left and went to Oppenheimer — which was bought by CIBC. I was there for almost a decade. The second half of it was focused almost entirely on financial service industry research. I got tired of the quality of research I was watching come out of the sell-side and the increase in conflicts of interest that were becoming more apparent in the dot-com period.

I think all of us are born either growth or value guys. I was born a value guy. So, the dot-com thing never made much sense to me. Some like-minded colleagues, both buy-side and sell-side, and I left to start an independent research firm. We did that until shortly after 9/11 when circumstance changed.

At that point, we offered KBW our research product until they got back on their feet after 9/11. Keefe’s response was, “We really appreciate it, but we can’t source from somewhere else. Why don’t you folks all you come over?” They wanted me to follow New York or New England thrifts and GSEs. I wasn’t very comfortable going back to the traditional sales side. My partners and I had differing views. We still remain very good friends. I simply wanted to keep going down the path of an independent financial research boutique. They did too, but they thought there was an opportunity to do that within Keefe. So, we went different ways.

It became very difficult for me to do it by myself and I was hired away to a firm called Medley Global Advisors. They asked me to run their financial services practice and focus on advising institutional investors on regulatory, legislative, and policy issues.

I was there from the beginning of 2003 through the middle of 2006. Management started heading down a different path than I. So, I continued to do my thing at Graham-Fisher. That brings us to today.

Damien: What exactly has you diverging toward the independent analyst route?

Josh: One is the most obvious potential conflicts of interest between investment banking clients and research — right where perhaps analysts puts a more favorable spin on the securities of companies they’ve got a banking relationship with. Furthermore, the willingness to be pressured by large institutional clients who want you to consider stocks or securities that they’ve got heavy exposure to.

It seems to me that the independence of your view is really paramount. In the largest and most complex financial institutions, the institutions themselves do not offer levels of disclosure and transparency that make them truly analyzable.

Damien: Is it hard to get access because you don’t play the game?

Josh: I have to rely solely on the cold hard facts of their filings and public disclosures coupled with my macro-economic analysis. Wall Street is so soiled it becomes hard for an analyst at a traditional Wall Street firm to actually have an economic outlook. The guy who’s covering the mortgage bankers is not covering the mortgage insurers. The guy who’s covering the mortgage insurers is not covering the GSEs. The guy who’s covering the GSEs is not covering the thrifts. However, changes within a sector occur where all of these sub-sectors meet. So, the traditional sell-side analyst is stuck relying much more heavily on management to give them macro guidance and highlight structural changes in the industry. Consequently, their independence ends up jeopardized.

Damien: Speaking of macro views, we all know one of the prongs for a sustained recovery is fixing the banking system. Can you update us on which inning we’re in and what you think the banks have done well so well so far?

Josh: In terms of fixing the banking system, there’s a couple ways of answering the question. That question also needs to be asked as the banking system distinct from the real economy, and the banking system distinct from the credit markets. There are really three different things related to each other with interplay, but they’re separate.

Damien: I was thinking specifically about the banks because they went through the process of giving out loans to people who couldn’t pay them back and it’s been the heart of the problem. But when you delineate it that way, the credit markets have also been in disarray and need to be healed as well.

Josh: Our large banks have taken some level of government support. They’ve raised some level of capital. I think it has bought them time. I don’t think they fundamentally dealt with a lot of the troubled assets they continue to hold. That’ll have to be dealt with. We still have a significant number of smaller banks that are going to fail. Depending on how you define ‘fail’, we probably have north of 600 and potentially as high as 1100 failed banks. More realistically, I think 600-800 banks are going to fail. But let’s not look at the issue in terms of banks. We should look at it in terms of assets.

Part of the problem is the banks are still by and large undercapitalized to perform the financial intermediation that bankers are expected to perform. In 1989, banks and savings institutions were responsible for providing 65% of consumer revolving credit. Since 2000, they’ve only been responsible for 30-40% of that consumer revolving credit. However, securitized pools as a percentage of total revolving consumer credit were 6% in 1989. Since 2000, they’ve been somewhere close to 50% — declining only since the beginning of the crisis.

Damien: So, there’s been a swap of providing credit?

Josh: Right. Commercial and savings institutions were 54% of total non-revolving consumer debt in 1989, and then only provided 30-34% since 2002. I bring it up because even if we make our banks whole, even if we plug the wholes in their balance sheets, provide them capital or force them to raise capital, create new demand for borrowings, and create a steep yield curve, the reality is we’ve lost the system by which we funded a trillion dollars of collateral in this economy in 2007. And that’s 2007 alone.

What have we done to fix the issue? We haven’t fixed either the banks nor have we fixed the credit markets. Fixing would actually be a fundamental repair — not a patch like we have now. We’ve put up scaffolding to make sure when bricks fall off the buildings they do not hit people below. In our case, the scaffolding has names like Commercial Paper Program, TALF, PPIP, the TGLP, and quantitative easing.

Damien: Is this perpetual scaffolding or is there hope that while the scaffolding is there the building will be remodeled?

Josh: That is the issue. We’re starting to talk about already pulling away the scaffolding, but we really haven’t done anything meaningful in terms of repairing the building. To extend the metaphor, we have not even fully surveyed the building.

Damien: Then are we going to experience some sort of lost decade like Japan if we have all this fixing and surveying left to do?

Josh: I warned about that in July of 2007 in a very important paper. I think that’s a very real risk. I think it’s actually tied to the third piece of this puzzle. We’ve discussed the credit markets and banking system, but we haven’t touched on the real economy. The real economy was a different crisis. Typically, we think of this as ‘the crisis.’  There are actually two different crises: first, the credit market crisis or capital market crisis, which includes ‘too big to fail’ institutions, the blow out of credit spreads, and the problems in the structured securities and derivatives markets; and second, we have the real economy component, which I view as a separate crisis.

This second crisis contextually began in the ’60s when the relationship between real wages and asset prices changed. At that time we saw further distortion in the real economy with an aging population — meaning the baby boomer generation — moving past their peak earning years and the democratization of consumer credit.

We’ve drained quite a lot of equity out of our homes. What used to be the single largest retirement asset for the average American family has actually been in many cases completely gutted at a time when the largest population we have ever had in this country moves toward retirement. There will be a huge impact and burden those people will have on the social safety net — meaning Medicare, Medicaid, Social Security. Those are real economy problems.

Damien: I discussed this with John Mauldin during our interview. What do you say to those people between the ages of 18 and 45? Will they simply work through their peak earning years to pay the debts of the elders?

Josh: That’s part of the reason Obama was elected. People hoped we would have a visionary take us down a new path and address some of these imbalances through technological innovation, educational advances, etc. We certainly haven’t seen that full vision anywhere, but I think that was the hope.

At the end of the day, we have to make significant changes to our continuing education. We need to have real changes in terms of immigration policy. We need to attract a highly skilled workforce in numbers. If we do so, then we’ll replenish the pool and things will be okay. We have an aging population. But it’s not aging as quickly as other places, and there are still a lot of people who would like to be here. That’s one of the positives.

I would suspect that for a while those trillion dollars will get bigger. No matter what we want, the government will become a bigger component for a retiring population. On the flip side, government is going to have to support economic achievements such as retraining and retooling. Government is going to have to support the creation of a post-industrialized economy.

This is not terribly different than the transformation that we’ve seen before in this country. However, a lot of people seem to forget at the end of the 1800s we had a depression — at the end of the 1800s! That was a transformative depression driven by the shift from an agrarian society towards an industrialized society. The excesses of that initial transformation were partially what we felt in the ’20s and the disastrous depression. We are moving toward a post-industrialized economy in which we don’t need the same urban centers or physical infrastructure. Inventory management has had huge advances over the past decade and all of those positive productivity changes are starting to trickle through into the real economy. They create displacement and problems, but we have to absorb those changes. It will take a while.

Damien: Do you think we will have a quicker turnaround now because we have the internet and the ability to start businesses and transfer ideas quickly?

Josh: No, because we’ve got international flows of capital as well which makes it a very difficult challenge for us. We’ve got a population that has among the highest wages in the world, and that puts us at a competitive disadvantage unless we were moving to an isolationist environment. That is not attractive or tenable to anyone at this point.

I think we’re going to go through a period when some of those productivity gains will be passed through as income losses or a loss of some degree of purchasing power.

I would point out that unlike the recovery in the early 1980′s in which we had two unprecedented secular tail-winds supporting our recovery, those same winds are blowing as head-winds. Namely, in the early 1980′s we were still at the very front end of the democratization of consumer revolving credit. Most families purchased based on savings and limited lines of credit — mostly in the form of installment or charge cards. Today, we have over-lent and the opportunities to exploit consumer credit for economic growth is again tied to quaint concepts like wages.

The second difference acting against a quick and sustainable turnaround is the baby boom generation. The largest generation in U.S. history was at the front end of prime earning years in the early 1980′s. Today those same boomers are nearing the end of their earning years. That has real implications.  Just think about the implications for housing and healthcare.

The other risk is that 50% of total employment and 44% of total payroll are tied to companies with less than 500 employees. These businesses are seeing some withdrawal of credit availability, mostly from smaller banks. If that trend accelerates we will see another leg down in employment, another leg up in consumer bankruptcies and defaults, and another risk to asset values in real estate.

Damien: Are we already seeing some of that with wages stagnating for all these years as India and China sucked up a lot of the labor force?

Josh: Yes. There has always been this great notion that globalization will help all ships rise. However, in a closed system that is an unsupportable argument.

Damien: Do you buy the assertion that Americans are going to get frugal and increase savings on a permanent level? Or, is it in our culture blood to inevitably swipe the plastic and inflate our standard of living as soon as things get good again?

Josh: It depends where we are. There will be a necessary increase in frugality. The savings rates are going higher. For many, the lessons we’ve learned are very serious lessons. It took almost three decades for our nation to begin to lose the effect the depression culture and ethos. That said, we didn’t have consumer revolving debt at that point. We didn’t have international trade flows and capital flows. It was a different world.

Do I think we are going to have some increase in consumer savings rates over the longer term? Absolutely. Do I think that our cultural values are shifting back towards traditional American values of frugality? We often forget the whole Protestant ethic and spirit of capitalism included frugality.

Damien: The Calvinists.

Josh: Exactly. Thrift is a real part of capitalism’s spirit, and we’ve forgotten that. I think we’re going to start remembering that. But we’re also going to recognize capitalism in its “purest” form is a non-workable option — but that’s a whole other discussion.

Damien: Moving on to a domestic issue, do you think Goldman Sachs played the three-card monte and passed the taxpayers money to AIG so they could get paid on their default swaps? Or, is that kookie conspiracy theory stuff?

Josh: The most despicable lesson — and I wouldn’t relate it to Goldman as much as I would to 5 or 6 institutions — was in a time of national crisis we had institutions that were unwilling to put aside their lobbying, put aside their will to power, and recognize they had a greater obligation to the country. This is part of why I said capitalism in its purest form doesn’t work because they would assert their primary duty is their fiduciary obligation to their investors. However, I would say part of fulfilling your fiduciary obligation to your investors is to make sure there is a playing field on which to bring your ball and bat every week.

Do I think they tried to maximize their returns in this crisis and minimize the losses they would have to recognize? Absolutely, no question. Is that wrong? I’m not an ethicist, so this is one man’s opinion: Yeah, I think in some sense it is wrong. How do we square that circle? That’s for the government to determine. But I do question whether our Founding Fathers intended for corporations to have the same rights as citizens.

These are some of the same problems I have with the concept of loan modifications on the mortgage side. It’s an issue legislators have to be bold enough to address. If you’re on the government’s dole, should you be able to lobby them? I would say no. If, on the other side, you are a mortgage company that is modifying a mortgage, and you know damn well there’s a 50% or 60% chance the mortgage is going to re-default, are you actually helping the borrower? I would argue, “No.” You’re actually taking two years of incremental cash flow from him or her before he or she re-defaults. That is predatory lending. However, our government is now sanctioning and trying to force that type of predatory lending. Is that appropriate? Well, I would say, “No.” If there is an “acceptable” level of redefault, that social policy decision needs to be decided by legislators rather than the executive branch.

We need Congress, our elected officials, to be grown ups and meet their responsibilities. They need to stand up and say, “That’s a policy issue.” So, the question is, “What is the socially acceptable level of re-defaults?” That hasn’t been defined. So, how could we have an effective modification program if we haven’t even defined what is socially acceptable? The entire root of this crisis boils down to a breakdown of the social contract. So, to get back to your question, was Goldman a part of that breakdown in social contract? Absolutely.

Damien: Do you think it was a pre-meditated strategy that was imposed by some of these financial firms to take on issues and get involved in markets they knew eventually would bring down the whole system?

Josh: Do I think it was pre-meditated? Do I think they understood the risks? Well, if they didn’t, they should be out of business for poor risk measurement and poor risk practices. So in that sense, I do think they understood the risks they had in front of them and chose to ignore them for the longer term. No question. Do I think they pointed the moral hazard gun at our heads intentionally? Yes, a couple did.

Damien: Moving on to a personal issue, what does the future hold for Josh Rosner?

Josh: I love what I do. There’s really nothing I’d rather do at this point. I’d like to believe that in some sense I’m helping the financial and economic literacy of both policy makers and market participants. I’d like to believe that I’m tempering some of the self-promoting or lobbying by market participants. I’d like to hopefully have a greater impact on helping to be a productive part of finally coming around and recognizing the fixes that need to be put in place for the banking system and the credit markets.

Damien: Josh, if your son came to you and said he was inspired to follow in your footsteps, what advice would you give him?

Josh: I would want my son to pursue his own world in his own way. The reason that I did not go into law like my father was I never wanted to find myself at some point in my career wondering whether my achievements were the result of my father’s excellent reputation or help.

However, I can’t say I did it all by myself. Meaning, there are some phenomenal people on Wall Street who take care of other people they think are doing the right things for the right reasons. For example, in my case, I was helped a lot by the two men who used to run Oppenheimer and General Counsel Bob Kleinberg at Oppenheimer. There were some phenomenal people at Oppenheimer. The sense of family, purpose, and social importance was really culturally something I picked up at home — but it was also reinterpreted with the Wall Street meaning for me at Oppenheimer. It was a rare place.

So, I would tell my son to find the good people on Wall Street. Figure out a way to help them help you understand how to do your job in the most ethical and positive way. After 9/11 I really questioned the value of what we do on Wall Street and, after much reflection, accepted that if we do our jobs we will drive capital in the most productive direction for society first and foremost.

On Wall Street there really are two types of people: those who rise solely because they are shrewd, and those who rise because they have earned the respect of their peers. I would encourage my son to figure out a way to be in the latter group.

Damien: That’s great advice! Well, Josh, this has been a very intellectually stimulating conversation for me. Congrats on all your great work and achievements. I hope you can help our policy makers set things straight sooner than later.

Josh: I appreciate that very much. Thank you, Damien.

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This may sound like common sense to investors and traders, but most people — including policy makers — do not readily accept the flawed nature of economic models.

Thank goodness we have professor David Colander testifying to Congress in order to enlighten an otherwise dim room. Colander’s work at Middlebury College focuses on the incentives and work-product of economists. His work has become increasingly more important as economists have heavily influenced policy making in recent years.

In addition to exposing a few absurd underlying economic presuppositions such as “individuals behave with rational self-interest,” Colander is helping shift incentives for professional economists away from publishing toward engaging in more useful studies. Based on these noble efforts to save us all from flawed economic models screwing up our daily lives, we are proud to award David Colander our third Medal of Honor for Excellent Service in addition to Josh Rosner and Chris Whalen …

“Most people assume economists are searching for truth.  In reality, economists are searching to achieve certain institutional goals like getting tenure, publishing articles, or doing a whole variety of things which may be related to truth.”

David Colander

Damien Hoffman: David, what type of economics do you research and teach?

David: I’m called the “Court Jester of economics.”  I’m the person who says what everybody knows, but appropriate people know better than to say.

I’m an economist watcher.  I look at the incentives economists face, then understand and interpret economics through those incentives.  So, I look at the economics of economics of economists [laughs].

Most people assume economists are searching for truth.  In reality, economists are searching to achieve certain institutional goals like getting tenure, publishing articles, or doing a whole variety of things which may be related to truth.  Therefore, there’s all kinds of incentive compatibility problems.  What’s happened in pure macro theory I have considered a travesty for a long time and have written about it for the last 20 years.

Damien: How did this travesty arise?

David: The models are useful and were useful at some point, but they quickly lost their usefulness.  In order to make them manageable they had to use so many assumptions that they deviated so far from reality and ultimately stopped shedding light on reality.

Over time, we should have considered much more complicated non-linear dynamic models and a whole variety of new models — but economists didn’t do that.  They kept dotting I’s and crossing T’s on a very restrictive equilibrium model which assumed away many of the most important elements that cause fluctuations and lead to the interesting effects that we see in the real macro economy.

Damien: How did this all lead to you testifying to Congress?

David: The Congressional Committee heard of that work and invited me for that reason.

Damien: When you testified and said the models are too rigid in the face of unpredictable human behavior constantly changing in real time, was that too scary for legislators whose role in society is to increase order and reduce chaos?

David: I hope not because that’s reality.  If reality is too scary, maybe some people think we have to hide it.  I don’t consider that especially scary at all.  It’s just a statement of common sense and the reality of what we know.

As opposed to moving on after discovering problems with the models, economists continued looking at the same model. Perhaps they did so to avoid the scary dimensions that would have all kinds of results happening.

Joseph Schumpeter once said when talking about these models that, “Most of the non-linear dynamic models that I favor have multiple equilibrium.” And, he said, “You have to assume away all these multiple equilibria if economics is going to have any chance of being a science.” I consider that absolutely wrong.  You have to deal with the fact that there are multiple equilibria if economics is going to have any chance of being a science.

Damien: Over the past 20 years, economists have slowly altered their image as more of a hard science when in fact it’s a social science.  How do we return to understanding an economist’s role in providing information instead of elevating them to a high priest of finance?

David: There are many different roles for economists.  There’s some roles for highly mathematical economists who analyze and study systems.  There’s some roles for people who understand the institutions.  The problem is that economics has forgotten those advantages and gives people incentives to work only on fairly esoteric problems rather than practical problems.  That has to do with the nature of incentives in academia.

Damien: How did you suggest Congress deal with these incentive issues?

David: The only way to change anything within the system is to change the incentive structure of the people who are operating there.  That’s a basic economic insight. The way to achieve progress isn’t through regulation and telling people what to do.  The way to do it is to change the incentives they face so their incentives match what you want them to do.  Currently, the incentives in academia are for publishing articles written for other economists.  And all economists compete in the same dimension.

My emphasis has been there should be multiple dimensions of competition — multiple types of outlets for economic research.  And, they should be equally rewarded.  Economists need more cross-disciplinary input from outside.  I suggest having a variety of people on the reviewing committee such as physicists, mathematicians, politicians, and business people.

My second suggestion was we need a lot more people with expertise in interpreting models — people who can understand the reasons for the modeling, why it was done, and the mathematics behind it. Then, those interpreters will spend time in asking, “Is this particular model going to be useful for a particular problem?” Currently, there’s no incentive for economists to ask these critical questions.

Damien: If economists are not focused on the efficacy of their models, what role should economists be playing as policy makers?

David: It depends on the particular economist.  The training that economists get in graduate school does not prepare them to be policy makers.  Instead, it prepares them to be article writers.  Policy makers require a much broader sense and understanding.  They need to know institutions.  They need to know politics.  They need to know a whole variety of issues.  Some economists have that ability.  Other economists don’t.

A lot of economists don’t have those skills because they’re not trained in them.  They have to learn them on their own.  So, whether they should be policy makers or not depends upon the particular characteristics of the individual economist.

Damien: How has the Federal Reserve dealt with this problem?

David: I don’t think the Fed can be condemned for causing the problem or praised for avoiding it.  They’re part of the whole overall system.  However, they’ve told me in order to recruit the top economists, they’ve had to change their incentive structure. The only thing the young people want to do is continue publishing.

I get scared when the Fed gets more worried about publications rather than policy.  In the past, the people at the Fed were promoted because they wrote good policy memos and provided good advice.  Currently, Fed employees are being promoted in the research division by how much they publish.

Damien: David, thank you very much for all your hard work.  We wish you the best in your efforts.

David: Thank you very much, Damien. I am honored you considered me for this award.

Check our David Colander’s acclaimed book The Making of an Economist, Redux

Want more Medal of Honor? Try these posts:

Medal of Honor: Banking Analyst Chris Whalen is the Best at Breaking Down Banks

Medal of Honor: Top Analyst Josh Rosner Nailed the Crisis

Economic Policy

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One of Superman’s greatest powers is his x-ray vision. Independent banking analyst Chris Whalen has similar skills when it comes to seeing through banks’ vaults and financial books.

You can hardly find anyone as well respected on Wall Street as Chris Whalen — and Chris has earned that reputation.  In addition to his accurate and incredibly thorough analysis, Whalen follows Groucho Marx’s valuable advice “Before I speak, I have something important to say.”

Therefore, you won’t see or hear Whalen babbling crap or echoing the lemmings as they follow one another over a cliff.

I had the pleasure of catching up with Chris to talk about his adventurous career in finance, the folly of Wall Street’s over-simplified ratings systems, why covering banks is like calculating the location of a particle in physics, and how a Groucho Marx quote guides his rigor.

Sit back, relax, and learn why Chris Whalen is our second Medal of Honor recipient in Wall St. Cheat Sheet history …

Chris Whalen

Damien Hoffman: Chris, you’ve had a very adventurous career in finance. Tell me about your adventure.

Chris: I was brought up in a different household from most because my father, Richard Whalen, was a journalist.  My mother corrected his spelling.  He worked at Time Inc.  and briefly at the Wall St. Journal with a guy named Robert Novack — who we just lost.  So I had the good fortune of following his career.  That included moving to Washington DC and writing speeches for Richard Nixon.

I grew up in D.C., so my world was national politics and the Fed.  People like Paul Volker, Alan Greenspan, and Arthur Burns would be at our house drinking bourbon, dining, and talking — doing what people did in the 60s and 70s.  So that was my context.

I came out of Villanova in 1981 and worked on Capital Hill.  Then I worked for the Heritage Foundation and Jack Kemp on the Hill — the Republican Conference Committee. That’s where I started to learn how write for two great editors, Karl Pflock and Terri Hauser, who both also were hardcore libertarian conservatives.

Then I got a chance to go up to New York and work at the Federal Reserve in the management training program.  That was my jumping point from DC to Wall St.  After that program I went to work for Bear Stearns as a sales trader.  I had a lot of fun there.

After Bear I worked with my father’s consulting firm, WIRES Ltd., that focused on trade and investments.  We had a lot of big clients in the Far East.  Then I started doing my own thing down under in Mexico because we were working on things related to NAFTA and Free Trade.  Among other things, I published a newsletter called the Mexico Report until ’97.

In ’97 I moved from DC back to New York and did tech-industrial banking at Bear Stearns.  I focused mostly on the financial buyer private equity community, but also got to try to make some big picture ideas work with Alan Schwartz, who is a tremendous banker. He didn’t deserve the way he got treated at the end of the Bear Stearns mess.  I’m very hopeful that he’s going to come back.  He can work as a banker in half a dozen industries and it’s really a talent to have that kind of flexibility.

Skipping ahead a bit, in 2003 I got a phone call from my current partner Dennis Santiago, who I met as a banker at PruVolpe.  He’s a great technologist and has built half a dozen major platforms on Wall Street for analyzing and displaying data.  He had bended my ear about his latest project called Audit Integrity.  I took a look at it – actually worked as a consultant on it for a few months.  It was a good methodology but, unfortunately, you can’t boil down a fundamentals-based analysis because it’s going to be wrong very often.  You’re going to have many false positives that will make the tool ineffective.

For example, when the flag is raised in the system, the question is, “What does the flag mean?”  If you go through that iteration, which is what we go through for things such as our Bank Monitor sample, we are able to then approximate a score — but it’s still a very complex score.  It is not a “yes/no” which is what Wall Street wants.

Damien: There are too many conditional variables to come up with one number in a snapshot and say, “This is it.”

Chris: That’s right.  On the other hand, having the ability to crunch tons of variables in the platform is great.  We get some interesting preliminary results.

I like to look at the context of the numbers, step back and say, “Where is this bank’s business model compared to the other banks?”  Take Hudson City Savings Bank (HCBK) for example.  They are very different than the other banks — even the banks in their peer group and size range.  They’re much less risky in a lot of ways that are very significant.

We said we’d stay positive on this name because they’re going to outperform everyone else. That’s the insight investors and risk managers want from analytics.  You want the analytics to help you get there, but it’s never going to give you a 100% black or white answer.  You have to understand what the numbers mean and the context.  But there is also a judgmental factor you can’t teach to a computer.  It’s moving.  It’s dynamic.  You can’t teach a computer that the last five years were crazy.  You can say, “Yes, these are all anomalies and now we’re going into some more anomalies in the opposite direction.”  But all the machine sees is the numbers and assesses them at face value.

So there is a judgmental part at interpreting all of these pretty analytics to try and finally come down to a judgement that offers something.  We have a range for retail products.  We have our index give a very objective view:  “How did you do this quarter?”  Basically, we look at five discreet factors that are all weighted equally.  Then we get more subjective as we try to synthesize a CAMEL Rating — the framework regulators use for evaluating banks.  We’ve got to decide which ones are important.  The bottom line is you’re going to be much better off so long as you can remember the difference between objectivity and subjectivity in analysis.

What we see a lot of on TV and the news is just a general movement of prices — it’s not evidence of rational behavior.  It is so funny when economists posit rational behavior in the financial market.  I think for 50 years we’ve been moving away from rationality in the markets because we don’t focus on cash flow and the fundamentals of values.  Instead, we look at stuff like, “To who can I sell this asset for more than I paid?”  So, by definition we live in a speculative environment.

When you try to use fundamental analysis, you’ve always got to be aware of that speculative context.  Look at financials.  From March of this year until now we’ve had a 100+ percent rally in financials.  Does that make any sense given the fundamentals?  Absolutely not.  You see this in other sectors as well.  The momentum factor in markets today is fascinating.  It’s much bigger than it’s ever been before.

Damien: Speaking about understanding the difference between types of analysis, does your diverse skill set play a role in keeping you cross-disciplinary in your approach?

Chris: A broader sampling of life’s experience is always a good thing.  For example, I wasn’t a particularly good banker when I went back to Bear Stearns.  I worked on fixed income and was also a bit older than most associates.  But, fortunately, they gave me good tips and I worked on several deals. I also did a few at PruVolpe. That’s how you learn:  the hands-on experience of diligence, talking to people, and researching financials. Those are all skills that take time to develop and to gain the confidence to use properly.

For example, if you’re an analyst, you learn how to tell little white lies if you can’t get access to the information you need.  Some people stretch things too far.  But working as an investigator in banking deals and as a channel researcher gave me forensic skills that I wouldn’t have learned about otherwise.

I’ve done a fair amount of work in consulting and litigation.  So. I’ve developed a niche of specialization with certain types of research, working with the public disclosure system, and tracking data that way.  It helps.

Now, include my partner Dennis.  He is a scientist and systems developer who knows how to query Edgar in amazing ways.  That skill allows us to harvest data kids coming out of school just don’t know how to do.  So there is a value to accumulating knowledge and skills you can’t get in formal settings.

It’s funny how people are skilled with technology when coming out of school, yet unskilled in the basics.  They can use all the tools and program in different languages, but if you sit them in front of a terminal with a command prompt and ask them to build something from scratch, they can’t do it.  Not all of them, but most.

Damien: As an researcher, how do you deal with barriers to disclosure?

Chris: Disclosure presents a lot of challenges outside the US because we are the only country in the world silly enough to believe in disclosure.  Disclosure is not a universal thing.  We can get hold of some data in some countries, but the quality level is iffy and the providence on the data is almost unknown.  So, we end up working with private vendors.  We have a friend in Vietnam of all places who gathers public and private company data throughout Asia.  It’s a private service bureau model.  There is no public mandate for disclosure in any of these countries.

Damien: How do your partners get the data if it isn’t mandated or disclosed?

Chris: Bilaterally with other banks.  If they have business relations with the bank, they will exchange data confidentially.

It doesn’t help the analyst or the investor.  As an analyst we are left with market price data.  It’s all anybody really has. Then we have the US economic data which is a horror show — but everybody pretends it’s biblical text. This is why the data industry has focused on tools driven by market data instead of fundamentals. Issuers have no interest in transparency, but rather selling stocks and bonds.

That’s what you’ve got in most of the world:  anecdotal news reporting. Y ou don’t have the rigger of disclosure you have in the US. Even in Europe.  Think about it:  where do you go for bank data in Europe?  There ain’t no place to go.  I’ve been told there’s a not-so-secret secret — a non-public source for all the regulators.  I’ve got to see if we can get them to give us some disclosure.

Damien: This leads to an interesting point. Your personal website has a very interesting quote from Groucho Marx, “Before I speak I have something important to say.” How do you know when you’ve done enough research to speak?

Chris: That’s a very good question. The first thing I do is assume the posture of the student. So long as you pay tribute to your sources and admit when you don’t know something, you’re all right.

I cringe when people describe me as an expert because it is very hard to be an expert in all of these banks — even the ones I actively cover. You can read everything, listen to all the calls, think deeply about them, and they can still surprise you!

I have to be qualified in my opinions. There’s no “absolute” anything. There isn’t an absolute distribution of possibilities  on which you can run Monte Carlo situations and be confident because your possibilities are variables floating through space. You don’t quite know what they are, but you sort of do.

It’s like a classic physics problem. Where is the particle in space? The answer is I don’t know, but I think I kind of know where it’s going and how fast it’s going there … but I don’t quite know where it is in space right now. We don’t want to get into a trap of generalizing — which we all do because we want to say all companies are like, for example, this one is better than that one. That’s a narrative comparison. That’s dangerous.

Working with Dennis I’ve learned to use statistics very broadly the first time I look at a bank. I compare the bank to all banks because I want to know where it falls into possible ranges of business models. But when you’re a sell-side analyst — or especially investment banking — you tend to group banking peers very closely. In other words, they don’t look at the entire industry. They look only at a few peers and comps. That analysis is prejudiced because they are looking at only part of the industry group. However, if you keep those sources of distinction in mind, you can keep out of trouble.

Damien: Chris, you’ve clearly done better than keep out of trouble with your excellent analysis leading up to and through the financial crisis. We are proud to give you our Medal of Honor for Excellent Service and look forward to your future work.

Chris: Thank you, Damien. I am flattered. I look forward to staying in touch.

Please click her to learn more about Chris and Dennis’s company Institutional Risk Analytics.

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Did you miss our first Medal of Honor? Read it now:

Medal of Honor: Analyst Josh Rosner Nailed the Crisis

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