Archive for the 'valuation' Category

Filthy lucre

[by JSC5]

I’m amazed how common it is to believe that people who’s job it is to help others shouldn’t benefit too much in the process. Here’s the latest installment, from the New York times, quoting politicians and professional worry-worts:

“A nearly $1 million salary and benefit package for a nonprofit executive is not only questionable on its face but also raises questions about how the organization manages its finances in other areas,” said Senator Tom Coburn, Republican of Oklahoma. …

“Many donors feel that paying the leader of a charity a six-figure salary is outrageous,” said Ken Berger, [president of the website Charity Navigator]. … “I’m not advocating poverty wages,” he said. “But arguing that those working for the benefit of the neediest people in our society should make millions and multimillions like corporate leaders defies common sense.”

A world in which it “defies common sense” to compensate people highly when they provide goods and services on a charity basis that are undersupplied by a market economy is a world in which lots of people believe that money is dirty. The outcome of such a belief – low pay in the NGO sector – ensures that only the children of the ruch can afford to do things like conduct research into development interventions abroad, or run an organization connecting at-risk youth with older adults.

The world I prefer to live in is a world in which we encourage the provision of charitable goods and services by making sure that salaries at all levels are sufficient to encourage bright people with new ideas to get into the field and improve efficiency. And if someone happens to live well by doing good, then more power to ’em!

Now, of course, there is some sort of tradeoff here. High salaries in the non-profit sector could attract good people, or they could be a waste of resources that could have otherwise gone to additional provision of charity goods and services. Clearly both happen, to a certain extent. Just like with faux-scandals over corporate pay, the answer in the NGO world is to strengthen the transparency of the donor market, strengthen board oversight of NGO management, and increase competition among providers of charity goods and services so that more efficient and successful organizations can prosper, while lurking behemoths fall.

Those damn kids and their high G.P.A.’s

It seems like every year, some segment of the old geezer intelligentsia gets worked up about ‘grade inflation’. This cycle, it’s the TimesEconomix blog that kicks off the hand-wringing, with a new dig at private schools:

G.P.A.’s have risen from a national average of 2.52 in the 1950s to about 3.11 by the middle of the last decade. For the first half of the 20th century, grading at private schools and public schools rose more or less in tandem. But starting in the 1950s,  grading at public and private schools began to diverge. Students at private schools started receiving significantly higher grades than those received by their equally-qualified peers — based on SAT scores and other measures — at public schools.

My hunch is that grade inflation hawks have more in common with old men in rocking chairs yelling at ‘kids these days’ to get off their lawns than they do with, say, actual education policy experts. We’ll start by debunking the traditional inflation argument, and then take a look at the public-private disparity. First, the argument against traditional inflation hawkery:

1. There is nothing metaphysical about grading. Just as there is no inherent, metaphysical value of a dollar, there is no platonic ideal of an ‘A’ or an ‘F’ floating out there in the ether that we here on Earth should be compelled to perceive and imitate. Hence, we should all be very wary of arguments based on average GPAs across varying time periods, as if this information on its own were enough to win the argument. That’s because …

2. The real purpose of grading is to provide useful information. First, grading exists to help tell the student how s/he is doing during the class, so that the student can adjust his/her own study habits, effort, and expectations. Second, grading exists to help others objectively evaluate a student’s mastery of the subject matter, usually in the context of a competitive application for a job, internship, faculty position, or what-have-you. That’s it. If rising GPA’s hinder these two functions, then grade inflation really is a serious problem. If not, then there’s very little reason to take the grumpy old inflation hawks seriously — outside of the camp value of listening to how things were back in the day. And as it turns out …

3. Our current system of grading does, in fact, provide useful information. You can rank people just as easily on a 4-point GPA scale normed at 3.11 as you can on a 4-point GPA scale normed at 2.52. Now, a rising mean GPA certainly could threaten to compress the highest performers on the upper end and inhibit oridnal ranking, but I don’t see much evidence that this is actually happening. There isn’t really any good data on this, but my own experience in college indicated that GPAs even at elite private universities are concentrated heavily around the mean, with plenty of room left over on either end for the high and low performers to distinguish themselves.

4. Finally, you say ‘inflation’, I say ‘attainment’. It’s a big, bad world out there — bigger and badder than the world was in the comparatively sleepy 1950s. There’s a lot more to learn now than there was then, and the tempo of discovery and invention is only accelerating. As a result, we’ve done a lot of what my mother disparagingly refers to as ‘curricular cram-down’, but what I prefer to think of as ‘learning more’ — especially among top-tier students. It’s now expected that our top-flight students learn intro calculus and stats in high school, along with a hard science and history. What used to be considered ‘college-level’ courses (the AP program) are now seen as prerequisites for admission at the best universities. And it just keeps on going. What used to count as a graduate level seminar in comparative Latin American government is now given to juniors and seniors. It ought to surprise no one, then, that average educational attainment in college may have grown from 2.5 to 3.1 in the last 50 years. Just compare the standard mathematics classes taken by kids at MIT in 1950 and 2010. What some call ‘inflation’ could just as easily be seen as ‘appreciation’.

“That’s all well and good”, you might say, “But what about the disparity in mean GPA between private and public universities? Doesn’t that put the lie to your cute little story, JSC5?”

I’m glad you asked. In a word, no. There are two possible explanations for higher private school GPAs, neither of which should worry us that the sky is falling:

1. Poor study design. The study compares the GPAs of what it calls “equally qualified peers” in public and private universities  based on SAT scores alone. The problem here is that grades in college are awarded based on performance in college classes, while SAT scores come from a test taken in 12th grade that covers information normally covered by upper-track students by the end of 8th grade.  The study’s assumption seems to be that if 2 students scored equally on the SAT, then they should probably score equally in any given class in college. For this to be true, however, we’d have to assume that the SAT truly does measure scholastic aptitude instead of high speed recall and use of 8th grade knowledge. We would also have to assume that there is no difference between the quality of the education at public and private universities that may lead to higher educational attainment among private school students. We’d also have to assume that there are no confounding variables that might legitimately distinguish the student who opted for the private university from the one who went public. All of these assumptions strike me as problematic.

2. Actual grade inflation. But maybe private schools really do inflate GPAs above comparable public school students’ GPAs. Is this the smoking gun that inflation hawks might think? No. Remember that 1) grading is not metaphysical, and 2) grades are supposed to convey information. Let’s drop the issue of resentment for a second and look at practical effects. Everyone knows that grading at different schools is different. Without a rigid national rubric, it has to be. That’s why college admissions committees look at population averages and distributions of grades from different high schools to help them interpret the individual GPA of any given applicant in light of their educational background. Graduate schools do the same when interpreting college GPA. The goal of having grades providing useful information to help construct ordinal rankings can still be met even if some institutions have higher average grades than others. That’s why you employ recruitment professionals with this kind of industry knowledge, and it’s why you do population norming. Certainly private university GPA inflation, if it existed, would make ranking more difficult, but certainly not impossible.

The take-home lesson is that grade inflation is not the slam-dunk case most grade inflation hawks seem to think it is. It’s hard not to conclude that persistent grade inflation hawks are really just angry that kids these days have a higher GPA than they themselves did back in the day.

Spare the rod, spoil the child

I’m a little late commenting on it, but the official, court-ordered bankruptcy examiner’s report on Lehman Brothers came out last week. The report is extremely detailed (9 volumes!), and most commentators have focused on the shady Repo 105 deals that artificially hid Lehman’s real liabilities while boosting its assets.

I just want to take a minute to talk about basic incompetence, however. When a large proportion of Harvard’s graduating class goes into investment banking each year, what they’re mostly going into is ‘valuation’. It’s not a terribly difficult thing, but it is very time-consuming and requires attention to detail. You employ a standard set of models and theories to derive present value of various companies, assets, commodities, etc. Then you see if present-day prices are less than your calculated value. Buy low, sell high, and all that. One of the most basic concepts in valuation is the intertemporal discount rate. Having a dollar of income today is generally better than having that same dollar of income tomorrow, because with that dollar today I can invest and have more than a dollar tomorrow. So to calculate the net present value of an asset, an investment banker will discount future earnings by a given discount rate. This is Valuation 101, and the bread and butter of an investment banker’s job. If investment bankers ‘deserve’ their ridiculous compensation, then it’s most likely for their skill at valuation.

So it might surprise you to learn that Lehman Brothers was doing an absolutely terrible job of valuation. Frank Partnoy has a great summary of the bankruptcy examiner’s report’s section on valuation, where he finds this nugget in the report (page 556):

The discount rates used by Lehman’s Product Controllers were significantly understated. As stated, swap rates were used for the discount rate on the Ceago subordinate tranches. However, the resulting rates (approximately 3% to 4%) were significantly lower than the approximately 9% discount rate used to value the more senior S tranche. It is inappropriate to use a discount rate on a subordinate tranche that is lower than the rate used on a senior tranche. [emphasis added]

That last sentence is a study in understatement. The ‘tranches’ they’re talking about are the way you slice and dice a pool of mortgages, with the “more senior S tranche” being a less risky pool of mortgages, and the “Ceago subordinate tranches” being a significantly more risky group of mortgages. Lehman’s quality control group operating above the trading desks created valuation models that get valuation completely wrong. When something is more risky, you use a larger discount rate to reflect net present value. The examiner’s report says, moderately, “It is inappropriate to use a discount rate on a subordinate tranche that is lower than the rate used on a senior tranche.” Perhaps a more accurate reading would be, “It is completely fucking boneheaded and a breach of the most basic standards of professaionalism to use a discount rate on a subordinate tranche that is lower than the rate used on a senior tranche.” This isn’t even an issue of the products being too complicated to value properly (though they were); it’s an issue of getting even the most basic parts of the model right.

Which leads me to the title of today’s post: “spare the rod, spoil the child.” We’ve all heard this from certain strict Christian parents who think that a child won’t learn unless you beat them senseless. I don’t personally sign up for that brand of parenting, but at some point there really do have to be consequences for misbehavior. I’m not advocating the US adopt the practice, but it is noteworthy that the North Korean government tried its lead financial and economic planner for incompetence and then executed him by firing squad a couple days ago. Sure, Kim is a dictatorial dickhead, and the poor schmuck was just a fall guy for Kim’s own policies. But say what you will about the DPRK, they don’t spare the rod.

Maybe we don’t need to go that far. Maybe all we need to do is limit the insane, unearned profitability of the financial sector so that incompetent i-bankers don’t get take-home pay that would make a Gilded Age tycoon blush.

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This is a group blog. JSC5 currently writes from the US. JSC7 writes from behind the Great Firewall of China.

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