Wednesday, March 25th, 2009
unmanageable proportions

In January, B. Ramalinga Raju came clean on the accounting fraud that he had orchestrated at Satyam Computer Services Ltd.  A few words in his resignation letter summarized the story:

What started as a marginal gap between actual operating profit and the one reflected in the books of accounts continued to grow over the years.  It has attained unmanageable proportions as the size of company operations grew significantly . . .Wall Street Journal | A faxed copy of the letter may be found here.

We have seen many things we thought were manageable become unmanageable.  There seems no end to the schemes that are being uncovered; as “the tide went out”the research puzzle | That was the name of my posting when the Madoff affair first came to light. all sorts of falsehoods and foolishness were revealed.

Finding “manageable proportions” is the order of the day.  Businesses, public and private, are groping to find the right size and shape for what they do.  Conditioned by metrics that moved in comfortable ranges, business leaders thought of their guesswork as something more predictable than it was.  (Those who reinforced that façade of predictability by accounting legerdemain also have lost their bags of conjuring tricks, although we can be assured they are working on some new ones.)  Decisions are untethered from the structures to which they were tied.  While some bold souls will bet big in response (and time will determine whether they subsequently carry adjectives of “inspired” or “reckless”), most will hunker down and play their chips carefully, realizing that they are in a different game and that it might make sense to learn what it is about before getting too crazy.

Investors are going through a parallel process.  Just as businesses got comfortable with unwise exposures because the wind was at their backs, so too did investors, and a reconnoitering is afoot.  Figuring out the changing market attributes before others do pays off in any environment and it should do so “in spades” in this one, but success will hinge on a reasonable alignment between market observation, confidence levels, and money management rules.  (We will revisit those dynamics in a future posting.)

Many investors were lured by the equity culture at just the wrong time and held too much in risky assets for the return profiles that were likely to be generated.  Many traders were seduced by low levels of volatility that made some strategies appear to be alchemy.  Many investment firms structured their products and investment philosophies by looking backward, which any amateur can do, instead of forward.

And it resulted in beliefs and exposures of unmanageable proportions.

Retrenching and reducing the bets is a natural approach for those who have been burned.  The investors cut their equity allocations, the traders play on the edges instead of being “all in,” and the investment firms slash payrolls.  Sometimes those moves are necessary and sometimes they are just “get me out” reactions, desperately seeking sustainability without rethinking the fundamental processes and structures of decision making.  It was the fissures in those that led to the errors; the new playbook needs to be focused not on what was done but how and why.