My intellectual influences part 4: Freddie Mac

I learned a bit of economics at Freddie Mac, I learned a lot about business and about information systems.

The economics that I learned there was about the options embedded in the 30-year, fixed-rate mortgage: the option to prepay; and the option to default. Bob Van Order was the main intellectual evangelist for the option-theoretic approach. I was the one who put together a team of economists and computer programmers to implement the simulation models to calculate option values.

Also, Bob promoted an idea formulated by Mike Lea, who had preceded Bob as Freddie Mac’s Chief Economist. This was the idea of the “dueling guarantee,” which said that the Savings and Loans had their liabilities guaranteed by Federal deposit insurance, while Freddie and Fannie had their liabilities guaranteed by the implicit support of the government. Shareholders in a firm with a government guarantee should want the firm to pursue high-risk strategies, because the gains go the shareholders and losses go to the taxpayers. Offsetting this consideration is “franchise value,” in that if you do go under and the government takes over, that eliminates future profit opportunities. Also offsetting the moral hazard was a sense of obligation to protect taxpayers. Bob helped nudge the company toward adopting a strict capital standard, but that discipline had eroded by the time of the financial crisis.

I was at Freddie as it was undergoing a major growth spurt. When I joined Freddie Mac in December of 1986, it had a very loose culture. Although it was 15 years old and a financial institution, it was managed very casually. It was just making the transition from sub-Dunbar to super-Dunbar, and certain key people made decisions informally by consulting with one another–or not, as the case might be. My first project was to go back and trace what had gone wrong with some multifamily security “hedges” in which a trader in Corporate Finance at his own discretion decided when to “hedge” and when not to “hedge,” based on his predictions for where interest rates were headed. In other words, he was speculating. He was fired by the time I finished the project.

A lot of people were fired over the next few years. Freddie Mac needed to make the transition to a tighter organizational culture with more formal lines of communication and more formal decision processes, and a lot of middle managers could not handle that transition.

I learned a lot about business from training courses. My guess is that taking relevant courses while you are working, where you apply what you have learned right away, is more efficient than going to business school. Some of what I learned:

1. the Myers-Briggs personality typing. Academic psychometricians do not consider this a reliable personality classifier, but I find it useful. At a meeting, you could just see the “P” types wincing while decisions were rattled off, and you could see the “J” types grimacing at having a decision revisited.

2. W. Edwards Deming’s management theories. He was a “quality control” guru. One of his most powerful ideas is that the earlier you intervene in a process, the more leverage you have. Waiting to inspect your widgets as they roll off the assembly line is inefficient. Making the assembly line more reliable is better. Designing the widget so that it is easy to assemble is better still. You can apply that principle broadly. If you want to improve health outcomes, make the environment less toxic, improve nutrition (particularly for the young), etc., rather than wait to treat the illnesses that result from ignoring these areas. If you want to improve educational outcomes, your best hope is in the first few years of life, not in college.

Deming also disliked “tampering” with a process, meaning making changes without thinking in experimental terms of tracking results and comparing to a baseline. Again, this has wide application. Schools are constantly tampering with curriculum, and rarely to they attempt a rigorous evaluation of whether the new curriculum achieves better results. With the virus crisis this year, we saw constant tampering by officials with different lockdown mechanisms, different advice on social distancing, etc. It drove me crazy that nobody had Deming’s scientific mindset.

3. Concerning information systems, Freddie briefly brought in an executive named Chuck Sheridan, who had a lot of wisdom. He was a fan of what was called information engineering. He offered the theory that in a business setting, the data are the most stable construct, the business logic is the next most stable, and the people involved are the least stable. I found this persuasive and helpful, particularly later with my Internet business. I became a fan of data modeling as a way to keep track of a complex information system.

Chuck also had a “law” that said, “The person who designed this system that I have to maintain was an idiot.” I think that the reason that this law holds is that when you first design a system, there is a lot of trial and error involved, and requirements change as you go. When you have a working version, you (a) want to stop, because Thank God Its Working, but (b) you know if you had it to do over again you would to it differently. So even when it’s your own system, you think that the person who designed it was an idiot. I developed a very strong bias in favor of re-writing systems often, in order to keep them legible, efficient, and flexible.

But information engineering did not take hold at Freddie Mac. The company was still too loose as a business. It was at that time that I formulated the aphorism that every organization gets the systems it deserves. Tight organizations, like the Fed and like the operations division of Freddie Mac that processed security payments, had very solid information systems. Loose organizations, like Freddie Mac’s marketing department that negotiated contracts with mortgage lenders, had information systems that were fragmented, with information buried in odd places.

4. I learned the importance of project management. In large organizations, projects don’t just happen. You need a project manager to keep everything on track. You need a project executive to whom the project manager can appeal when decisions are needed or people are being uncooperative. I picture the Obamacare web site fiasco as a case of not having a high-level project executive and/or a competent project manager. Ultimately, I blame the lack of business experience among Obama’s top aides.

5. We also had some “new age” management training. Things like Steven Covey’s Seven Habits. Some consultants coached our top executives to develop a set of “operating principles,” which they rolled out in the organization. For example, “practice open, honest, and timely communication.” The most interesting operating principle was “Assume positive motivation.” Often, there is conflict in an organization, and it is easy to assume that the people on the other side are just being selfish or narrow-minded. “Assume positive motivation” meant that you tried to empathize with them, rather than dismiss them. It was an attempt to resist falling into what I have since learned is called the illusion of asymmetric insight, where you believe you understand your opponent’s true motivations, and they are bad. You might say that “assume positive motivation” is the essential lesson of my book The Three Languages of Politics.

A woman I hired as a project manager, Susan Snyder, also gave me some “new age” tapes, including “Who are You?” by Ram Dass (formerly Richard Alpert). I listened to that tape many times during my commute to and from Freddie Mac. One key lesson from that tape is that when you are wrestling with an either/or choice, if you pick (A) you will have to live with the part of you that wanted (B), and vice-versa.

She also showed that when a project is floundering, you need to hold a gripe session in order for the participants to air the frustrations. Then you try to steer them constructively by putting on a white board the “current state” of the project and the “desired future state” of the project.

This was related to another idea from management training, which was to be “at cause” rather than “at effect.” If you are “at effect,” you see yourself as a helpless victim of your situation. It is easy for a mid-level of low-level employee to feel this way. If you are “at cause,” you look for the best possible way to cope with the problem. Simply being in that frame of mind is a better, happier way to live. In general, not just in business.

I learned to avoid hiring anyone who talked in very negative terms about their previous job. If they were “at effect” working for someone else, they would likely be “at effect” working for me, and this would hurt morale for my whole team. So if I were hiring today, I would stay away from social justice warriors. Not to discriminate against their politics, but to avoid the “at effect” type that is so demoralizing.

For me, and I think for many other people as well, the most difficult part of being “at cause” is dealing with difficult interpersonal conflict. One of the best people at Freddie Mac at doing that was Mary Cadagin (the article is from after she left Freddie and went to Fannie Mae). When she saw that an executive needed a set of facts in order to be comfortable, she produced a fact pack, even though her own style was more intuitive. When she saw that someone (like me) was raising criticisms that demoralized a meeting, she would end the meeting and just talk to the individual one-on-one to find out what the person’s issues were and get the person to come to terms with them. Mary was the opposite of “passive/aggressive.”

6. I learned that there is no perfect organization chart. No matter how you structure it, some decisions will cut across organizational lines. The solution at Freddie Mac was to create committees. Because mortgage credit policy affected many areas, there was a “credit policy committee.” Re-organizations do not necessarily make a company better structured. They are often used to remove or lower the status of some executives and to raise the status of others. Usually, this is what the CEO is after, because it can be easier to effect these changes through a re-org than through formal demotions and promotions. Sometimes, a re-org can just be a power play by a mid-level executive.

7. In textbook descriptions of a firm, managers have all of the information that they need in order to optimize. In the real world, what managers know is dwarfed by what they don’t know. You certainly don’t observe demand curves or cost curves in an actual business.

Somewhat related: David Andrukonis said that the way to make yourself unhappy was to notice the people making more money than you and working less hard. Instead, better to make the effort to notice the people who are making less than you and working harder. He eventually was forced to resign when as Chief Risk Officer he told the CEO that the risky mortgages that Freddie was getting into were bad for borrowers, bad for Freddie Mac, and bad for the country.

8. In investigating artificial intelligence for mortgage underwriting, I stumbled on the “Big Data” approach. The rule-based systems that companies were trying to develop were just inferior, expensive versions of human underwriting. Credit scoring companies, on the other hand, used the masses of data assembled by credit bureaus to come up with better predictors of default risk. For example, the utilization ratio, which is the ratio of the amount you owe on your credit cards to the total amount of credit available to you on those cards, is a powerful indicator, but one that human mortgage underwriters overlooked entirely.

If this has been the longest post in my “influences” series, that is no surprise. Business was far and away the best “school” of my life.

12 thoughts on “My intellectual influences part 4: Freddie Mac

  1. Arnold,
    I wish I could have read this post forty years ago. It would have saved me a great deal of time and anguish. Then again I wouldn’t have believed you if I had. Most of what you said is something you have to learn for yourself.

  2. Most of my work experience has been in not-for-profit organizations (college, university). What you learned at Freddie Mac (a share-holder owned company, operating under a government charter) would be hard to glean from higher ed.

    1. Personality typing. This does apply, but not-for-profit orgs probably attract, hire, and promote personality types somewhat different from business.

    2. Upstream quality control vs tampering. Almost everyone in not-for-profit orgs fears rigorous evaluation, so it’s rarely attempted and almost never completed. An exception that proves the rule is Swarthmore’s honors program, which uses external evaluators. For example, a simple, affordable external check might be to use a relevant GRE as an exit exam for students in a Major, but no colleges require it.

    3. Information systems. I can’t speak to IT operations, but it’s plain that many (most?) universities have websites that resemble archeological digs, rather than tight, efficient information channels.

    4. Project management. Projects usually get distorted by org politics.

    5. “New Age” management principles. In higher ed, such principles are thwarted by an empirical law of inverse relationship between rhetoric and substance: The more an org talks “transparency” (or “community” or “shared governance”), the less there is.

    6. Organization chart. In higher ed, ad hoc committees shift power to “the administration,” but faculty mostly go along to get along.

    7. Optimization. This is the crux of the matter. In higher ed there isn’t a clear org goal (maximand, objective function, whatever). The “mission statement” promises grand, vague outcomes (usually something about “transform” etc) that can’t be evaluated for performance.

    8. Big data. A striking, paradoxical fact is that most colleges and universities (i.e., academic, research institutions) rarely use (or even seek) the best, current academic research (empirical economics or psychology) to inform policies, decisions, methods.

    Why, then are American colleges and universities nonetheless the envy of the world? Miguel Urquiola argues that competition (e.g., rankings) is the key.

  3. Mary Cadagin eventually became the Chief Information Officer and Head of the NY Office for the Open Society Foundations. I wonder how she would compare her time in business with that in the non-profit sector.

  4. Kling: “With the virus crisis this year, we saw constant tampering by officials with different lockdown mechanisms, different advice on social distancing, etc. It drove me crazy that nobody had Deming’s scientific mindset.”

    We didn’t need the Deming scientific mindset for either lockdowns or mask wearing since both had long been established by the WHO and the CDC along with many other health organizations around that world as ineffective.

    Sweden’s former top government epidemiologist, Johan Giesecke, got it right when he said in April: “All countries will have exit strategies where they will loosen one restriction, look at the numbers as say: “Ooo… the numbers are going up, so we’ll have to try another strategy and then say: “Ooo! That worked!”

    https://unherd.com/thepost/coming-up-epidemiologist-prof-johan-giesecke-shares-lessons-from-sweden/

  5. Remember well when Demming was making a splash in the federal bureaucracy. Did the training. Unfortunately on the non-business side. Wound up being operationalized in statute as the Government Performance & Results Act, as worthless a paperwork drill as you could ever hope to find. Spent a lot of time tracking (from the outside looking in) two multi-decadal software acquisition failures that cost hundreds of millions. No amount of program management seemed to help. The program management offices were endlessly reorganized and the management rotated constantly. Finally concluded that contracting out as much as possible and hoping the contract manager would draft substantive deliverables was about all that would work. No amount of internal program evaluation, inspector general analysis, GAO reports, or congressional hearings would ever amount to anything. Just a waste of resources.

    The only way out the mess that is the federal bureaucracy is substantive constitutional reform. Specifically adapting a parliamentary system. Parliamentary systems are widely recognized as superior to presidential systems on all sorts of dimensions. Given the clamor for abolition of the electoral college, why not go all the way and adopt a parliamentary system given that the USA is fundamentally incapable of conducting a free and fair national election? Nice high level discussion here: https://nationalinterest.org/feature/america-needs-parliament-17220

    • Parliamentary systems are widely recognized as superior to presidential systems on all sorts of dimensions.

      Every NFL football game these days includes the announcers telling us, always in the same words, who each team has nominated for “the Walter Payton Award considered the Leagues most prestigious honor”. It goes to someone who has done charity work, and the League promotes it relentlessly but most fans don’t care. For them it is a public relations honor, much less important than Most Valuable Player, Defensive Player of the Year, etc.

      Some people think parliamentary systems are inherently better. Some people don’t. Always look with skepticism on a passive voice construction.

      • It may be opinion in part , but opinion backed by data.

        “This article employs a global data set to test the relationship between a historical measure of parliamentary rule and 14 indicators ranging across three policy areas: political development, economic development, and human development. The study revealed a strong relationship between parliamentarism and good governance, particularly in the latter two policy areas. “

        https://journals.sagepub.com/doi/abs/10.1177/0010414008325573

        And the experience with presidential systems in South America and Africa speaks for itself.

        • I completely agree that “the experience with presidential systems in South America and Africa” has been pretty bad. But I think the cause is not “presidential systems” but “South America and Africa”. In other words, it is the underlying society, not the form of government.

          When the generals overthrow the president, is it still a “presidential system”? When the generals overthrow the prime minister, is it still a “parliamentary system”?

          And which is France?

    • I’m certain the US system is better for the US.

      Israel, with a Parliamentary System, is about to have its 4th election in 2 years.

      Haven’t read the data, but already don’t believe the conclusion.

  6. Arnold, I don’t have time now to elaborate on your reference to the “dueling guarantee”. The idea was well known and discussed in the late 1970s and early 1980s. Anyway, it still is critical to understand the fragility of most systems of financial intermediation and the risks assumed by some private enterprises and is related to my last comment on your Part 1 post and my comment on your Part 3 post.

  7. So much good stuff here and in the intellectual series. So similar to so many of my own lessons; tho most of which I sort of knew – perhaps seeing them was confirmation bias.

    On #7, managers without enough info, I was wondering if you would articulate my biggest Reporting lesson: Managers want to know the future but no info nor reporting system can get reliable future info. This is quite related to #8, big data can help a lot. It especially helps with decisions subject to the Law of Large Numbers, like most Sales decisions, somewhat contrary to Bayesian priors being updated. Not like building a factory, like Dell built one in Poland, or entering or exiting a market, or selling off a subsidiary like the Polish factory Dell sold to Foxconn, or IBM selling PC then server business to Lenovo.

    on #1, MB Personality, as an xNTP (introvert with extrovert skills), it was very helpful to understand my ENTJ friends and our yuuuuuge differences on many issues. Jordan Peterson and other psych pros like the Big 5 more, but it’s much harder to describe groups of people. I was wondering if Trump isn’t an ESTJ, where I describe iNtuitives as abstract, and Sensitives as concrete/ specific.
    https://careerassessmentsite.com/celebrity-personality-types/mbti-estp/
    Many call Trump a P (open-ended, as compared to my J closure focused).

    Thinking about Trump at a Fed meeting – would he be J making decisions, or P revisiting them? I think he’s one of those in the middle of this trait – often looking for closure / fast decisions / be done with it (J judging), but often changing his mind. Whether for good reasons or whimsy it’s not always clear, but changing (P perceptive).

    I also liked the book that explained it in more detail: https://www.goodreads.com/book/show/104191.Please_Understand_Me
    Bryan Caplan prefers Big 5; I often disagree with Bryan on stuff, tho.

    On #6, it seemed to me that too often the successful mid-level managers I dealt with were more involved with boot-licking rather than merely performance, but I left that early mgr fast track to become a consultant. Possibly too early. In the US.

    Much harder for a non-Slovak speaker to be a consultant in Slovakia, if not already with a big consulting company.

    The illusion of asymmetric insight is quite good – the tribalist group forming. Good in-group; bad out-group. I was a fine team contributor, but never enthusiastic for being much of an in-group guy in business – but as a Libertarian was looking for gov’t mistakes and constantly finding many.

    Also good read on Cadigin.
    Thanks again, Arnold, for fine thoughts.
    Briefly.

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