What Are Derivatives Anyway, And How Did They Screw Up Our Country?

I always liked Calculus for some reason. Not really sure why, but I felt like it was a very abstract method of thinking that was kind of cool. I even ended up tutoring Calculus while in college - it was quite a hoot. However, this experience didn't really prepare me for figuring out the financial mess we are now in and how we got there.

One of the first things you learn in Calculus is how to calculate a derivative. This calculation takes a line or curve and determines what the slope of a line tangent would be at any given point. There is evidently some reason you would want to make this calculation that may be of some benefit to somebody somewhere, but regardless, the value of the derivative is, in fact derived from the value of the original curve.

I just saw a tee-shirt advertised bearing the words, "I wish I were a derivative so I could lie tangent to your curves." I'll have to get that one.

This is similarly the case in the lovely world of finance where some sharp witted banker will occasionally take the bold approach of selling a security that is of no real value itself, but it's value is derived from the value of something else. Got it? Now give me all your money, I'll print up some notes derived from the value of my car loan and we'll be on our merry way. I'll call you in a few months with your pay-out.

I'm not sure why, but I spent some significant time trying to learn what a derivative was and how they screwed up our country. And through several hours of reading "derivatives for dummies" websites, I still don't really know, but I will do my best to give a somewhat coherent explanation.

A derivative is a security whose value is derived from the value of something else. They are often used as a method of shifting risk of a volatile item. When you buy the futures of a commodity, the value of that note is derived from the price of the commodity. It's kind of like a bet on where the value of the commodity is going to go.

I was trying to think of an analogy and the best I could come up with was this: suppose I placed a bet that Tiger Woods would shoot under 75 in the first round of the 2010 Master's golf tournament. I somehow roped somebody into giving me ten to one odds that Tiger would not shoot less than 75. So since I was nearly certain that Tiger would shoot less than 75 (he always does), my bet was very valuable in my mind. However I was little nervous. I asked some guy at the bar if I could give him twenty bucks to pay off my $100 bet should Tiger shoot over 75. This guy gladly took the bet because Tiger never shoots over 75.

Or maybe I should sell the value of my bet and then pay the bet and the guy I sold the security to should Tiger shoot over 75. I honestly don't know - this stuff is really confusing.

Not convinced? How about this one. When I worked for the steel company, we would have to bid a job well before we actually bought the steel from the mill. There is some significant risk here because the price of steel will fluctuate significantly. We would buy an insurance policy that locked in the price of the steel at the price it was during our bid. Now, that insurance policy would become very valuable if the price of steel skyrocketed, however, it would be pretty much worthless if the price dropped. So if I were to start trading on the value of that insurance policy, it's value would be derived from the price of steel. I think that's a little closer.

I know those examples kind of suck, so here's a little bit better description that may help.

The confusing nature of derivatives actually works to the advantage of the investment banks because they can falsely report the value of these derivatives to accountants or prospective buyers and nobody will be able to prove them wrong. They probably don't even know what they are worth themselves!

I think Warren Buffet had a funny feeling that we may be headed down the wrong path when in 2002 he said, "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." I'll say.

So now that we know (or in my case, don't know), what derivatives are, we can accurately ascertain how they caused the financial and economic mess we are in. Uhhh, I can't quite nail down that one either. I presume that since the majority of the derivatives sold were tied to mortgages that defaulted, banks started to lose some serious money not only from the defaulted mortgages, but also the lack of value from their derivatives. Once the the cards started to collapse and the banks started failing, people started pulling their money closer and now banks are too scared to loan money which stifles any kind of economic growth.

Anyway, the real sad thing about this was that there were some of the smartest engineers and scientists in this country who were stuffed in cubes calculating derivatives instead of working in a truly productive setting of engineering, construction, or manufacturing. And why were they working for investment banks instead of engineering firms? It's because engineering firms don't pay shit compared to investment banks. So instead of our smartest people actually adding value to our country they were a bunch of crooked thieves stealing money. It's funny how really smart people do really dumb things.

What Are Derivatives Anyway, And How Did They Screw Up Our Country?

What is all this Six Sigma stuff and can it really be applied to construction?

I'm sure most have heard about the Six Sigma method of quality management, but I doubt many know exactly what it is or how it can be implemented. I didn't know either until I did some minor research and my memory of what I studied in school was refreshed, so without making a statistical analysis too boring, I'll attempt to give a brief, but thought provoking explanation of what Six Sigma is and how (if) it can be implemented in a construction setting.

For people in the world of statistics, one of their most inspiring discoveries is that of the bell curve and how it applies to the world in which we live. Basically, everything on earth, and possibly in the universe falls, statistically, into some version of a bell curve. For example, if I were to plot a histogram of my golf scores over the past five years, there would be a mean of the scores which would be the highest number (top of the bell) and then two tails of higher and lower scores.

So everything from the number of cups of coffee you drink each day to the variance of IQ scores will fall into some distribution of a bell curve. Itwould be safe to assume that quality items or as they are called, defects, will also follow this same distribution either in manufacturing or construction.

So what Six Sigma intends to do is take the number of defects in a particular process down to six standard deviations away from the mean (middle of the curve). Basically, this amounts to 3.4 defects per million opportunities (DPMO).

*Note: Six standard deviations from the mean would actually be about two hundred times less than 3.4 DPMO, but there is some theoretical shift of 1.5 sigma that occurs in the calculation that may or may not be legitimate and I don't really understand it. In either case, 3.4 or 0.015 DPMO is pretty damn good for a construction project so for all intents and purposes the difference is negligible.

So this is a nice little goal to set for yourself, but how might one go about reaching this pinnacle of quality? Six Sigma projects follow two project methodologies comprising five phases each with the acronyms DMAIC and DMADV.

DMAIC is used for projects aimed at improving an existing business process.
DMADV is used for projects aimed at creating new product or process design.

The DMAIC project methodology has five phases:
Define high-level project goals and the current process.
Measure key aspects of the current process and collect relevant data.
Analyze the data to verify cause-and-effect relationships. Improve or optimize the process based upon data analysis. Control to ensure that any deviations from target are corrected before they result in defects.

DMADV
Define design goals that are consistent with customer demands and the enterprise strategy.
Measure and identify CTQs (characteristics that are Critical To Quality), product capabilities, production process capability, and risks.
Analyze to develop and design alternatives, create a high-level design and evaluate design capability to select the best design.
Design details, optimize the design, and plan for design verification.
Verify the design, set up pilot runs, implement the production process and hand it over to the process owners.

My keen intuition tells me that construction projects will fall into the DMADV because every construction project is different. Which brings us to the main obstacle of implementing Six Sigma on a construction project: Construction is not manufacturing!

Six Sigma was developed by Motorola to improve quality. Companies like Motorola have the luxury of having design and manufacturing all in house and not to mention the fact that they are building the same thing over and over. Imagine trying to put an automobile together when it is not only a unique design, but every part of the car is installed by a different company! And then implement a quality management system for every unique installation that came down the line.

Construction isn't quite that difficult because you are working on a much bigger scale but we have to realize that implementing manufacturing principles into construction is just not that easy. Plus the whole Six Sigma black belt certification process is a little cheesy. However, a six sigma level of quality is nothing short of a fantastic accomplishment.

What is all this Six Sigma stuff and can it really be applied to construction?

More tough times for Constructonomics

After attending a pre-bid meeting for a door replacement job for the City of Philadalphia, I was all set to deliver a bid for the project after ironing out some minor details with the minority requirements and union politics. However, last week I received a call from someone in the City of Philadelphia procurement office. The woman asked for my fax number so she could send me a letter. Well, I don't have a fax machine, so this was a little difficult.

I should probably get a fax machine even though they are rather pointless these days. It's just as easy to scan a document in and send it over email. Plus you have an instant electronic copy of the correspondence.

So I told her that I didn't have a fax and I asked if she could scan the letter and send it over email. I was kind of surprised that she was actually willing to do this because the City of Philadelphia isn't typically the most accommodating to contractors who are trying to bid on their work. Anyway, I received the email and attached was a letter stating that I was disqualified from the bid on Stenton Manor Door Replacement. The reasons for the disqualification were as follows:

1. Late submission of the Supplemental Prequalification Questionnaire

2. The questionnaire does not reflect that the bidder has successfully completed contracts of equivalent scope and comparative magnitude

3. The bidder did not demonstrate sufficient financial resources to complete the project.

Just for the record, I had my pre-qual questionnaire in on time, and I didn't get the supplement until the day it was supposedly due. They were never clear about whether the supplement was due on the same day or not. So if this was the reason for my disqualification, why did they go into further explanation about experience and financial resources, both of which could be substantially argued?

I decided to give the Philadelphia procurement commissioner, Hugh Ortman, a call to discuss this bit further.

Surprisingly, I actually got Mr. Ortman on the phone on my first try and he was very polite in listening to my side of the story and giving some further explanation. I explained that while my company is new, I have eight years of construction industry experience and this would serve as more than enough to do a small door replacement job. Mr. Ortman explained that my personal experience is all well and good, but it's the experience of the company that is looked at in determining qualified bidders.

I suppose this makes sense from a management standpoint, but in my case the City lost an opportunity to get some very cheap labor on a job that was far less complicated than other's I have worked on. I was advised to come back in a year or two when I get some jobs under my belt. It feels like a chicken and egg scenario.

At first I was curious if I just didn't slip the right person a twenty or something, but I guess I'll try again down the road, but that time any "financial resources" I have may be a thing of the past.

More tough times for Constructonomics

To Union or Not to Union

I worked for a steel fabricator and erector for about a year (before I was politely asked to leave for reasons of which I am still unsure) who does the majority of their work in Philadelphia, New York City, and Atlantic City - all union towns. I once asked one of the old-timers at the company what would happen if we started erecting steel in one of these towns with non-union iron-workers. He looked at me like I just asked what would happen if the sun burnt out tomorrow. He replied, "You would not build a job non-union in Philadelphia."

I wonder if some thug named Joey would track you down and kill you? I'm certainly not going to find out. However, I am in a little bit of a quandary about a job in Philadelphia that I am bidding. The job is small so there is a chance that I could fly under the radar of the union, and honestly the chances of getting "taken care of" by the union is pretty slim. However, since this is a publicly advertised job, the chances of getting at least some picketers or something is relatively high given the number of union workers that are "on the bench". I've been advised to, "not worry about it".....gulp.

The other option of course is to hire a union contractor to do the job, which honestly isn't that bad of an idea, since the city has prevailing wages that must be paid to worker regardless of their union status. This is to ensure the competitiveness of the union. The union iron-workers that erected steel for me during my brief but eventful stint with the steel erector were good and certainly in the same league as any non-union iron-workers I've worked with.

The problem is that as a new company, subcontractors aren't jumping out of their chair in hopes of bidding one of my jobs. This is the disadvantage of not having a strong network of contacts in the area when starting a business. However, I must play the hand I am dealt.

I'm actually in favor of unions. Perhaps they push too hard at times, but if they were not there everything would be built by illegal immigrants whose bodies are disposed of in the nearest river after the job. This is a shame that human beings would do this just to make money, but it is unfortunately the case. A union provides a worker some security from fluctuations in the construction market that inevitably come along. If they are not working at the moment, they are still paid (I'm not sure if it is 100% or not) and they are given health and vacation benefits through the union instead of leaving it up to some stingy business owner that will probably just hire them on a temporary basis.

Unions absolutely give workers some security in their life so they can focus more on the task at hand and less about whether or not they will have a job tomorrow. As a construction manager I was constantly concerned about what was going to happen when we were finished the job I was working on and this absolutely affected my performance. I would ask where I'm going to go after this job, and they would skirt the question or make up a lie. This made me angry and anxious and it certainly didn't make me want to work harder for the organization. I eventually quit this company because they couldn't give me a straight answer on where my next job was going to be when we were nearly finished the one I was on. I decided to take one in the hand rather than something that may or may not be in the bush. Maybe I'll start a construction manager and project engineer union.

So for this small job I'm bidding, I'm hoping that I can find a union contractor, and if I can't, I may have to do some smooth talking to a picketer, but regardless, unions have their place and I've got no problem with them.

To Union or Not to Union

Construction Financial Leaders Unveil Third CONFINDEX of 2009; Industry Construction Conditions Show Modest Stabilization

Princeton, N. J. — The Construction Financial Management Association (CFMA) has just released its latest CONFINDEX reading, for the third quarter 2009. In its latest reading, CONFINDEX showed a modest improvement, a slim uptick since the June 2009 reading, from 89 to 91. CONFINDEX remains in negative territory since the fourth quarter 2008.

Noteworthy to this latest quarterly reading, the Financial Conditions and Current Confidence sub indices are projecting 2010 expectations to be positive. These indices include General Business condition, Availability of Bank Credit, Bonding Credit and Total Backlog.

“The responses to all these issues were well into positive territory for 2010,” said Jim Bartsch, Director of Research and Analysis for CFMA.

CONFINDEX was launched last year as a proprietary construction industry assessment by 200 randomly chosen CFOs in the commercial construction sector. Released quarterly, it’s comprised of eight elements used to calculate a net score of confidence, including the state of construction industry conditions and total backlog, and availability of bank credit, bonding credit and working capital. It is also made up of four sub-indices, such as business conditions, financial conditions, current confidence and outlook for the next year.

CONFINDEX next reading is scheduled for release in December 2009.

The Construction Financial Management Association is the only non-profit organization dedicated to serving the financial professional in the construction industry. Established in 1981, it serves more than 7,000 members in 89 chapters across the United States, offering an award-winning business journal in addition to a variety of educational and professional development programs through its chapter network, at its Annual Conference & Exhibition, and via the Internet. Membership in CFMA provides construction financial professionals with unique opportunities for industry networking, career development, and personal growth.

Construction Financial Leaders Unveil Third CONFINDEX of 2009; Industry Construction Conditions Show Modest Stabilization

Instant Egomaniac: Just Add Promotion

What is it with promotions and workplace authority that makes people think they should be sitting at the right hand of God above. I think it has something to do with the emphasis we place on career success in this country. It would be interesting to study the behaviour of managers in countries with less career pressure to see how they differ from managers in this country. Good luck getting a grant for that one.

In construction, everybody is an egomaniac to begin with, so you can only imagine what happens when you promote someone who is already a legend in their own mind. You get a larger than life superhero who is going to shoulder this company and take them to the top of the mountain. It isn't too pretty.

The kind of ironic thing is that there is significant research and discussion about what makes a good manager and much of this discussion argues that the personality types that perform the best as managers are much more humble, empathetic, and caring than one may expect. These "soft" skill are quite contrary to hard skills that were probably required to get a promotion in the first place. This, in my opinion, is where truly talented people can adapt to the changing environment and perform well in a role quite different from the one they had become so comfortably successful. Education of managment technigues also helps. But there are also those(even with education), who cannot adapt properly and flap around like a sea bass that just jumped in the boat.

Jim Collins, the author of Good to Great, claims that this fascination with a larger than life, rock-star leader is detrimental to successful organizational performance and, through extensive research, has found that an appropriate model of leadership is directly responsible for strong organizational performance.

Bob Vanourek, developed a 7 dimension Core Leadership Model, and the number one dimension is that the leader must possess a "healthy personal core". Fist-pounding, tyrannt, egomaniacs, are certainly far from healthy.

Jeff Arnold recently posted an article called Leaders Look Bad on his Zen Leadership Blog. He talks about how strong leaders are not afraid of admitting fault, mistakes, or lack of knowledge even at the risk of looking incompetent to co-workers and subordinates.

Unfortunately, conventional wisdom and to some degree the working environment encourages us to inflate our egos slightly upon promotion. Perhaps our ego ain't our amigo and we should try keep it in check.

Instant Egomaniac: Just Add Promotion

Several Charged in NYC Construction Corruption

By JENNIFER PELTZ (AP) – 10/1/09 4pm

NEW YORK — Six former New York City building inspectors, two reputed Lucchese crime family leaders and more than two dozen other people and businesses were indicted Thursday in a sprawling racketeering case that ranges from construction bribes to gun trafficking.

The encyclopedic indictment grew out of a gambling investigation and ultimately spanned from a betting operation in Costa Rica to construction bribes in the Bronx, authorities said.

The charges are the latest in a string of recent cases targeting construction corruption. They include a July indictment accusing a concrete testing company of faking test results on dozens of high-profile projects and a case charging a top city crane inspector with taking bribes to fake inspection reports.

Aided by wiretaps and even a bug in a restaurant, Manhattan prosecutors charged some 29 people and four construction and real estate companies. Together, they engineered about $120,000 in bribes and more than $400 million in profits from gambling and other crimes, authorities said.

"The case mushroomed," said Patrick Dugan, chief of the Manhattan district attorney's investigative division. "We uncovered the corrupt arrangements between all these individuals."

Most of the defendants were due to be arraigned later Thursday on charges including enterprise corruption — New York state's version of racketeering. Authorities still are looking for two defendants.

Three members of the Lucchese organization actually worked at the city Department of Buildings as inspectors, two of them juggling their government jobs with drug and weapons trafficking, loan sharking and illegal gambling behind the scenes, prosecutors said. Three other ex-inspectors also are accused of taking bribes.

Together, they corruptly voided violations, lifted stop-work orders and sped up inspections at more than a dozen construction sites and buildings in Manhattan and the Bronx, prosecutors said. Police Commissioner Raymond Kelly said all the locations have been reinspected and are safe.

One building contractor paid $44,000 to ensure his inspection would come out well, District Attorney Robert Morgenthau said. A nightclub owner paid more than $29,000 to expedite and inspection and ward off violations, the DA said.

The six accused inspectors have resigned or been fired, prosecutors said.

The city Department of Buildings didn't immediately return a telephone call.

Several Charged in NYC Construction Corruption