October 15, 2008: It was pouring rain, a deluge even by Vancouver standards. That summer, I had taken out a loan to finance a gig. The gig had gone away, but the obligation remained, and the cash had just dried up. So much for a
sure thing.My soon-to-be-ex-girlfriend's mother was visiting, in our tiny studio apartment, and they were bickering. In a bid to ignore them, I looked at my screen, and there was the news: the economy was officially in the toilet.
It was then I had my Scarlett O'Hara moment: never again.
Never again was I going to get caught in a position where far-off people making narrowly self-interested decisions could bend me over a barrel. So I set out to understand all that financial crap even if it killed me. What I discovered was that when you boil down the arcana and punditry, finance isn't really about money at all. Money is assumed. Instead, it's about risk. Or rather, tinkering with the shape of risk, so that your upside is way bigger than your downside, so you're more likely to win, and so your time spent exposed is shorter. And for the people that play that game, implicitly, leaving some sucker holding the bag. Having just had a major life lesson on being on the bad side of risk, I got to thinking.
The instrument widely held to cause the most destruction of wealth and economic activity is the credit default swap. These behave like insurance policies, wherein the policy-holder would pay the issuer on a regular schedule up to a certain maturity date. If the thing being insured—in this case, debt—blew up, the issuer agreed to pay the full value of the bond. Perfectly legitimate everyday activity in Finance-World, or the rest of the world: You own something, and you endeavour to protect it. But what if you didn't have to own it? And what if you could game the system by insuring bonds you knew would fail? Which is exactly what people did. Tiny downside, enormous upside. Peanuts if you lose, windfall if you win. And winning was almost certain.
Now, I'm infamous for taking interest in atrocities, because whatever happened to cause them worked. If it didn't, there'd be no hugely conspicuous atrocity for everybody to gawp at. So I wanted to see if I could come up with an analogous model in my newfound armchair financier knowledge for what I actually do for a living. I came up with this:
A bond is a fixed-income instrument. You cut an enormous cheque to get a piece of paper that says at some point in the future, you will get that enormous cheque back, plus a little bit of extra money. The principal of the bond is analogous to the project's budget, the maturity date is analogous to the deadline, and the interest is analogous to the project's ROI forecast. Now, what can we say about this structure?
Fixed downside, fixed upside, where the downside is way bigger than the upside. A lot to lose and not a lot to gain. And they do. Software projects are notorious for being late and going over budget, or failing completely with a humiliating whimper, just like a loan that goes into default. Even with recent advances in development tactics on the ground, this conceptualization of the project on the finance side means it's constantly battling to perform according to plan, against all odds. So it isn't just like buying a bond, it's like buying a junk bond.
For a credit default swap, you pay a fixed number of nominal premia on regular intervals, in the anticipation of a credit event during that period. If one happens, you get reimbursed some huge value in relation to your outlay. ROI isn't measured in percent, or even multiples. It's measured in exponents.
Here, the premium would be analogous to a regular flat fee to the people working on the project. The maturity date would be analogous to some arbitrary date set for deciding if you want to continue the arrangement. The credit event is analogous to the overwhelming likelihood that some valuable new knowledge or capability will be discovered and implemented during that period, and the reimbursement is analogous to the arbitrary value of that event.
Now, there are some differences: First, a CDS is a derivative, which means it's zero-sum. In order to win, somebody has to lose. Not so with this arrangement, because we're talking about the development of new operational knowledge and capability, so you don't have to feel dirty about it. Second, the value of the upside on the discovery events is arbitrary, and there will be more than one. You don't know what they're going to be worth. Could be a little, could be a lot. But they will be something, and they will be frequent. Such is the nature of the medium. Third, the discovery events compound in value, as the results of earlier events combine with later ones.
The trick is not to focus on specific outcomes but rather on value. Negotiate a premium that you can live with spending, with the understanding of the overwhelming probability you're going to get something worth more than what you spend, and that you will occasionally hit a jackpot.
So the question to the CFO when evaluating this conceptual model for the development of new capability is: how much do you wanna bet?