Sámal Joensen Mikines, Reykjavík Art Museum/IcelandReview.com – Pilot Whale Killing, ©1944.
FireRescue1.com, Controlled Burns Set Off Massive Wildfire, 9 Feb 2006.

Henry Blodget, the former securities analyst, now edits Silicon Alley Insider and contributes to several magazines.

His December 2008 Atlantic piece, Why Wall Street Always Blows It, is a nuanced account of his fall from internet grace and subsequent ill-timed real estate investments.  He describes the institutional and human factors contributing to his own errors as well as the current financial crisis.  You should read his story.

I will briefly review it with a focus on his description of the current crisis.  Then I will describe the similarities between Blodget’s account and my selective history of whaling and forest fire management. 

BLODGET’S BUNGLES

Blodget buys a home in the spring of 2007 with almost no money down.  By the fall of 2008, he is ‘upside down’ on his mortgage, and his ARM reset looms.  He verbally rounds up and enumerates the usual suspects contributing to his predicament.  But in an unusual twist, he can NOT find fault with any of the real estate enablers – agents, bankers, or regulators.  Instead, he suggests his situation reflects the human interaction of uncertainty, self-interest, and reliance upon recent experience, and no one can be individually blamed.

Blodget suggests that the same holds true for the current financial crisis, for the following reasons:

1. Boom-bust cycles are at least 30 years long, and exceed the normal business lifetime of most investment bankers;
2. Every home buyer, real estate agent, securitizer, legislator, and regulator were doing what they could to keep the American Dream alive;
3. Wall Street firms took risks (that in retrospect brought them down) because they were judged by investors and themselves relative to their peers, who were taking similar risks;
4. It seemed that things really were “different this time” (it always does), in an age featuring low interest rates, wonderful technology, and the apparent banishment of the business cycle; and
5. Wall Street’s replacement of their partnership structure with public ownership allowed investment bankers to take risks with their shareholders’ capital, rather than their own personal capital.

I believe that Blodget’s account stresses two things. 

First, there are natural impediments that prevent people and institutions from learning that things are NOT different this time, and these were exacerbated by an extended and benign economic environment.

Second, the general abandonment of Wall Street’s partnership system encouraged speculative risk-taking.  Blodget emphasizes this last key point with the following:

• When your fiduciary duty is to manage the firm for the benefit of your shareholders, you can easily persuade yourself that you’re just balancing risk and reward-when what you’re really doing is betting the firm.

WHALE WATCH

Whaling is about scale and distance.  Of creatures so huge and rich that men would band together, sail to the ends of the earth, and hunt them to their death. 

If we look for pearls by the sea, we’ll find that:

• Whaling expeditions organized as closely held partnerships were successful; and
• Otherwise similar corporate whaling ventures were NOT.

Professor Eric Hilt of Wellesley College examined performance differences between whaling expeditions organized as partnerships, and otherwise similar expeditions organized as corporations in his NBER Working Paper – Incentives In Corporations: Evidence From The American Whaling Industry. 

Typically, an agent or managing partner would “purchase supplies and hire a captain and crew, and plan the voyage on behalf of the investors.”  The vessel would then leave its home port for a voyage that might cover “tens of thousands of miles” and last more than three years.  Once the voyage was underway, it would be impossible for investors to observe the performance or progress of the captain or crew.

As a result, whaling enterprises tended to be very closely held, with the agent holding a significant stake in the venture to ensure that his interests were aligned with other investors.

In the 1830’s the whaling industry attempted to adopt the corporate structure spreading throughout America – with a board of directors, executive committee, and diffuse ownership.  But even as the whaling industry expanded through the 1840’s, the corporate ventures uniformly failed – “none survived.”

Professor Hilt suggests that the corporate structure:

• provided little advantage over the partnerships;
• was used simply to attract investments from a large number of small investors; and
• limited the incentives and the profit for the managing partner, or agent.   

Since agents arranged for numerous whaling voyages (each a separate “business,” using both partnership and corporate structures), Professor Hilt statistically examined the performance and productivity of each voyage.

The analysis compared the productivity of whaling voyages sponsored by the same managers a) within corporations, and b) as unincorporated partnerships.  Professor Hilt found that the corporate managers’ voyages were less productive. After conducting a series of statistical tests, Professor Hilt finds that the corporate failures:

• [Were] … not due to … the lack of talent or experience of the manager. The diffuse ownership structure of the corporations, and the reduced stakes held by their managers, likely diminished the incentives for the managers to perform their roles diligently…
• These corporations were diffusely owned, and were run by agents whose role began to resemble that of professional managers. Whaling was a business where consistent success was very difficult to achieve, and the weaker incentives produced by these corporations at least contributed to their poor performance.   © 2004 Eric Hilt

FLAME ON…AND OFF…AND ON

Wildfire prevention is about time and destruction.  Of the gradual development of the humility and wisdom needed to accept that smaller fires can delay the destruction of uncontrolled infernos.

If we search for a glimmer of bright on Western dry land, we’ll find that federal file control policy has struggled for more than a century to achieve a balance between efforts that:

• Reduce the immediate short-term costs and losses from uncontained fires; and
• Promote the gradual build-up of forest debris that generates catastrophic fires.

Professor Robert B. Keiter of the University of Utah describes how wildfire prevention efforts  can produce catastrophic fires in his The Law of Fire: Reshaping Public Land Policy in an Era of Ecology and Litigation.  

Fires naturally occurred in pre-colonial North America – typically due to lightning or Native American hunting/military initiatives.  As Americans moved West during the 1800’s, they regularly faced wildfires. 

In the late 1800’s Congress created both the national forest reserves and Forest Service.  The latter had: 

• no duty more important than protecting the reserves from forest fires…  They were … [to] extinguish any such fires before they are well under way …   Congress … established a unique open funding process that essentially gave the agency a blank check for its firefighting efforts. © 2006 Robert B. Keiter

In the early 1900’s, lightning fires left “over 3 million acres charred, 85 people dead, and several towns in ashes.”  In response, the  “Forest Service embraced a blanket fire suppression policy… that treated every fire… as a threat and subject to extinguishment.” 

Policy enforcement gradually became more effective, expanding after WW II, and so that it “successfully” reduced annual burns by more than half.

By the mid 20th Century, just “… as the federal government seemed on the verge of conquering fire, scientists … question[ed the] wisdom of the all-out suppression policy… [observing] that fire played an … irreplaceable role in shaping the landscape and … reducing wildfire intensity…  [Also,] … the high costs associated with the total suppression policy were hard to justify…”

While suppression policies had worked well for decades, they produced an accumulation of debris that would have been consumed in low-intensity fires. To reduce fire control costs, fire suppression efforts were curtailed by the late 1970’s, and natural fires were allowed to burn. 

In the “summer of 1988, the Yellowstone fires … rampaged across more than 1.5 million acres of … forest lands, sparking national headline coverage as well as …investigations and recriminations” and more aggressive fire control efforts resumed.  Unconsumed fuel accumulated until “the calamitous 1994 fire season that ravaged nearly 5 million acres in the … West, claiming 34 lives, … [and] costing the federal treasury $965 million.”

Fire losses and policy debates continued until the “passing the Healthy Forests Restoration Act of 2003…”  This  legislation reflects “congressional judgment that a century of fire suppression has left the public forest lands overgrown and thus susceptible to catastrophic fires… and … authorizes hazardous fuel [debris] reduction  projects…”

One century after federal fire control efforts unsuccessfully attempted to halt fires with “all out suppression” policies, forest management policy has shifted by 180 degrees.  The current focus is on controlled debris reduction based on the acceptance of limited natural burns.

CONCLUSION

More than 160 years ago, corporate whaling ventures failed while closely held partnerships thrived.  More than 50 years ago, forest scientists realized that aggressive fire control temporarily limits fires’ destruction, but catastrophic infernos follow.

Today we wrestle with the destruction engendered by investment banks that had relinquished partnerships for a corporate structure.  We struggle with the fallout caused by our own greed, hubris, and confidence that we had largely vanquished the business cycle.

On Monday (Dec 15) the FOMC’s next scheduled two-day meeting commences, to be followed six weeks later by an end-of-January conclave. Might we request or insist that FOMC participation be expanded to include historians and forest scientists, as well as the customary gaggle of economists?
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I used to work with numbers for a living, but now I know that these tough times are no fluke. They’re largely the result of half-baked policies. Looking for my next job or at least an idea.  Till next time.

REFERENCES

 
Henry Blodget, The Atlantic – Why Wall Street Always Blows It, Dec 2008. 

Eric Hilt, Wellesley College, NBER Working Paper #10403 – Incentives In Corporations: Evidence From The American Whaling Industry, © 2004. 

Robert B. Keiter, University of Utah S.J. Quinney College Of Law, Research Paper No. 06-02 – The Law of Fire: Reshaping Public Land Policy in an Era of Ecology and Litigation, © 2006.