States, Innovate in IT or Else

California and other states lumber along with antiquated, expensive IT systems, leaving them on the outside of innovation 

While Grandma can flip through photo albums on a state-of-the-art laptop or, before long, an Apple (AAPL) iPad, many government agencies and corporations are still entrusting critical tasks to antiquated computer systems that cost a fortune to operate and maintain.

The probtlem is particularly acute at the state level. Each U.S. state has its own unique computer systems to process the same types of information and provide the same services as every other state. Worse, even within states, each division or agency has its own IT department and maintains its own computer systems. We're talking about hundreds of billions of dollars of IT spending every year—on clunky old infrastructure.

Consider California. The most populous U.S. state is more advanced than most, though it faces big IT challenges. It has roughly 130 agencies and departments, each with its own IT staff and computer systems. Each collects its own information and maintains its own databases. The systems of one department are not usually integrated with the systems of another. When they do share data, it is usually through the computer equivalent of Excel spreadsheets. The state has more than 40 separate computer applications to collect the same personal and demographic information about citizens. So, for example, when a business has to update an address, it typically has to inform multiple agencies.

Keeping up with regulatory changes is also a huge burden for the state's IT staff. Simple changes cost tens of millions of dollars and can take years. When President Obama signed legislation extending benefits for unemployed workers in November, out-of-work Californians had to wait as long as two months because the systems couldn't be updated.

New Technologies

Today's PCs and the Web are often more robust, secure, and fast than the massive enterprise systems used by governments and some businesses. A modern laptop has greater processing power than the mainframes for which many enterprise systems were designed.

A social networking site like Facebook or Twitter processes more transactions (in the form of messages) in a day than many financial companies and states process in a month. Sophisticated computer applications that used to take years to build can be built in months. And the newer applications are usually far easier to use and much more scalable.

So why isn't there a massive move to new technologies? If anything, the chasm between the old and new has grown wider. This was made plain to me after I posted a blog to the tech Web site TechCrunch. I wrote about California's IT challenges and encouraged Silicon Valley entrepreneurs to come to the rescue. I cited an example of one system for which the state has budgeted $50 million over several years, which I believed could be rebuilt for less than $5 million in less than a year. I received several credible offers.

Yet the idea appears to be very threatening to a handful of large system administrators that have built enormous businesses on antiquated state systems. I was challenged by a senior vice-president at CA Inc. (CA) who called me naive and chided me for knocking something I "know absolutely squat about." Her argument was that standards, processes, and people had to change first. Otherwise disaster would happen and "set California back even further." Others wrote to argue that government procurement processes can't be changed and that big government contractors with political connections would always hold back progress.

Out-of-Touch Opponents

I believe these critics are simply out of touch with the new reality. Security breaches of large government IT systems are common due to the ongoing cyberwars taking place between nations. Amazon.com (AMZN) is just as juicy a target, but has a far better history of IT security than most big government agencies. As for my lack of understanding of the problem: In my tech days, I developed several large enterprise systems, and I started two companies that marketed systems development and legacy systems reengineering software.

So I know there is a problem and a relatively simple solution. I also realize the challenges for governments to allocate contracts in a fair and equitable manner. But the disaster I see is if we continue the way we are. And it's a failure beyond the bloated costs, entrenched mainframe systems integrators, and dated computer 
languages. The greater danger is that, by trapping the public-sector IT architecture in this tired old wrapper, we miss out on huge chances not only to improve system performance but also to reinvent government. The public sector is effectively walled off from the innovation that has made Web 2.0 a rich, contextually relevant environment. In this context, there will be no Netflix (NFLX) Prize, no Google (GOOG) voice-automated transcription engine, and virtually no other true technology innovation.

Many people realize this. Web founder Sir Tim Berners-Lee has just launched a venture for the U.K.government to make public data available online so that entrepreneurs can build technologies to harness this information.Federal Chief Technology Officer Aneesh Chopra also launched an initiative to make federal government data available.And in the wake of my earlier posting, California Chief Technology Officer P.K.Agarwal has launched a crowd-sourcing Web site where he's asking the public to weigh in on how the state might improve its tech strategy.

So there is progress. More states need to make similar moves. We need to open the bidding to new players, loosen opaque requirements written under the false guise of security and compatibility, and retool our way of thinking about IT for the public sector. In the cloud computing era, big government IT doesn't have to be so big. The rest of America has done more with fewer IT dollars for over a decade now. It's time for Uncle Sam and his state and local brothers and sisters to join the parade.

By Wadhwa, who is senior research associate at the Labor & Worklife Program at Harvard Law School and executive in residence at Duke University. He is an entrepreneur who founded two technology companies. His research can be found at www.globalizationresearch.com. Follow him on Twitter "@vwadhwa".

China Plans Lowest Increase in Defense Spending in a Decade

March 4 (Bloomberg) -- China plans to boost defense spending by 7.5 percent, the slowest pace of expansion in a decade, as the government seeks to allay concerns about the country’s growing military might.

The increase to 532.1 billion yuan ($78 billion) compares with a 14.9 percent rise in 2009. China’s defense budget had been expanding by at least 10 percent a year for the past 10 years.

“The Chinese government has always paid attention to controlling the size of our defense spending,” National People’s Congress spokesman Li Zhaoxing, a former foreign minister, told reporters in Beijing today. “China is committed to a policy of peaceful development.”

China’s military spending is second only to the U.S., which aims to spend $636.3 billion this year, and is more than double India’s budget of $32.1 billion.

“While this year’s increase is down a bit, we are still talking about an increase that is much bigger than Western nations and one that allows for a significant military build-up to continue,” Andrew Davies, director of Operation and Capability at Canberra-based Australian Strategic Policy Institute, said in a telephone interview.

The country’s sustained military buildup comes as other governments in the region have either cut or held expenditure steady, raising concerns that a power imbalance was building. China has territorial disputes with neighbors including Japan, India and Vietnam, and regards Taiwan as a renegade province that will be reunited by force if necessary.

Relative Growth

“Their capability is increasing relative to others, and countries in the region are worried about that,” Phillip C. Saunders, a distinguished research fellow at the National Defense University’s Institute for National Strategic Studies in Washington, said by telephone. “A lot of people think China wants to be a dominant military power in the region.”

China’s military is starting to have a presence far from its shores. Last year Chinese navy ships protected sea lanes from Somali pirates in the Middle East.

“This was unprecedented strategically,” David Finkelstein, the director of China Studies at the Center for Naval Analyses in Alexandria, Virginia, said in a telephone interview. “This is the first time Chinese navy vessels operated outside of Asia.”

The country is also considering sending combat troops abroad for United Nations peacekeeping efforts, retired Chinese Navy Rear Admiral Yin Zhuo told reporters on March 3.

Taiwan Tension

China’s defense budget comes amid tensions with the U.S. over its plans to sell $6.4 billion of missiles, helicopters and ships to Taiwan. After the sale was announced in January, China said it was suspending military-to-military contacts and would sanction U.S. companies whose weapons were sold to Taiwan.

Saunders said this year’s actual spending could be as much as two and a half times the official budget, which does not include items including purchases of foreign weapon systems and pensions.

The U.S. says that China’s actual military spending may be more than twice the published budgets because it omits many items. In 2008 actual spending may have exceeded $140 billion compared with the stated budget of $58.8 billion, according to the Pentagon’s annual report to Congress on China’s Military Power, published last March.

“Although academic experts and outside analysts may disagree about the exact amount of military expenditure in China, almost all arrive at the same conclusion: Beijing significantly under-reports its military expenditures,” the Pentagon said in the report.

Economic Expansion

Chinese defense experts say the rise in spending is only natural given the country’s expanding economy and isn’t meant to threaten its neighbors.

“China does not seek to be a military superpower,” Yin said. China only wants a military “commensurate with our national interests and strength.”

That strength includes development of a new generation of long-range nuclear Intercontinental Ballistic Missiles capable of reaching the U.S., Saunders said.

The next big development for military watchers is whether China will build its own aircraft carrier, he said.

--Michael Forsythe. Frederik Balfour. With reporting by Chua Kong Ho in Beijing. Editors: Ben Richardson.

Buffett Casts a Wary Eye on Bankers

“Don’t ask the barber whether you need a haircut.”

That little nugget was buried in Warren E. Buffett’s annual letter to Berkshire Hathaway shareholders published over the weekend. It was his thinly veiled dig at Wall Street bankers and the perverse incentive system for corporate “advice” on mergers and acquisitions — namely that bankers are paid only if a deal is completed. (Bankers typically earn nothing if a deal is abandoned or collapses, giving them little reason to recommend against pursuing a transaction.)

It was a timely note from Mr. Buffett — Monday ushered in more than $50 billion worth of merger announcements — and it resurrected an age-old debate on Wall Street about how bankers are compensated for their counsel to corporate boards.

And it’s an issue that resonates far beyond Wall Street. Just think of all the other parts of life where people offer only encouraging words — “You should do this!” — because that’s the only way they get paid (real estate agents, stock brokers, the list goes on).

And Mr. Buffett has trained his sociologist’s eye on this phenomenon more broadly, too. In his 1989 letter to shareholders, he famously wrote about the “institutional imperative,” which describes, among other things, how an entire organization can rise up to help a boss justify some deal he’s inclined to do, regardless of its merit.

It’s nice to think some things can change, but the deal incentive for bankers probably isn’t one of them.
“You shouldn’t earn a lot less by keeping your client from doing something stupid, but that’s the way it is,” Felix Rohatyn, the financier and elder statesman of Wall Street, told me. “The majority of fees are conditional.”

Mr. Buffett’s letter made a bold suggestion that isn’t sitting well with the establishment.

“When stock is the currency being contemplated in an acquisition and when directors are hearing from an advisor, it appears to me that there is only one way to get a rational and balanced discussion,” he wrote. “Directors should hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not going through.”

Of course, acquirers often hire more than one banker to advise a board, to act as a check on the other. But all too often, both banks are given the incentive to recommend the deal.

Since 2008 in the United States, in 131 of the 230 deals that were worth over $1 billion, the acquirer hired more than one bank, and in some cases more than five. Those banks were paid an estimated $3.3 billion for advisory services, according to Thomson Reuters and Freeman Consulting.

The problem, as Mr. Buffett explained when I called him on Monday, is that the system is skewed. Companies are willing to pay advisers a supersize fee when they do a deal because then it is merely a rounding error, a tip on a lavish, celebratory meal.

It would be hard to justify a big payment if there were no deal, so the system has evolved into an all-or-nothing game. Banks are willing to play it, because the rewards are so high, and they are not shy about offering attaboys and go-get-em’s to help make it happen.

When Berkshire recently acquired Burlington Northern, Goldman Sachs and Evercore Partners — which advised Burlington — were paid almost $50 million for what equated to only a couple of weeks of work.

Mr. Buffett, of course, did not use an investment banker.

“If we need advice for a deal, we probably shouldn’t be doing it,” he said with his trademark chuckle. He told a story about how First Boston (now Credit Suisse) tried to gin up interest in the mid-1980s for Scott Fetzer, a hodgepodge of small businesses based in Cleveland. It called on 30 firms to help make a sale, but failed to find a buyer.

Mr. Buffett then called Scott Fetzer’s chief executive himself and negotiated the deal face to face. Just as they were about to sign the deal, a banker for First Boston said that the bank was still entitled to a $2 million fee. The banker asked Mr. Buffett’s partner, Charlie Munger, whether he’d like to read the firm’s analysis of Scott Fetzer. Mr. Munger replied, “I’ll pay $2 million not to read it.”

That’s not to say that Mr. Buffett won’t ever pay investment bankers. “If someone brings me a deal, I’m more than willing to pay them,” he said, referring to his favorite banker, Byron Trott, a former managing director at Goldman Sachs, who helped broker deals including Berkshire’s investment in the $23 billion Mars-Wrigley merger and its acquisition of Marmon Holdings. However, Mr. Buffett insists that typically, “I don’t think we’ve ever paid for advice.”

Mr. Buffett’s biggest gripe is not just that bankers are given improper incentives, but he thinks their advice is suspect, especially when valuing stock-for-stock deals.

He had some experience this past year with such deals when Berkshire bought Burlington (he issued 80,932 Class A shares and 20 million B shares). He was also uncharacteristically vocal with his criticism of Kraft for paying $19.6 billion for Cadbury, much of it in stock (he’s a big Kraft shareholder).

He thinks that too much attention is paid to the value of the company that may be acquired, and not enough attention is focused on the value of the stock that the acquirer is shelling out.

“In more than 50 years of board memberships, however, never have I heard the investment bankers (or management!) discuss the true value of what is being given,” he wrote in his letter.

“Charlie and I enjoy issuing Berkshire stock about as much as we relish prepping for a colonoscopy. The reason for our distaste is simple. If we wouldn’t dream of selling Berkshire in its entirety at the current market price, why in the world should we ‘sell’ a significant part of the company at that same inadequate price by issuing our stock in a merger?”

Despite hearing from some of Wall Street’s biggest names about Mr. Buffett’s critique of their profession on Monday, most were circumspect in their reply.

“As usual, Mr. Buffett has an interesting point,” said Joseph Perella, one of the deans of the deal business and the co-founder of Perella Weinberg. He said he was happy to report that some clients had begun paying flat quarterly fees for advice, regardless of whether his firm recommended for or against a deal. However, he acknowledged, “most clients aren’t doing that.”

When I invited Mr. Rohatyn to critique Mr. Buffett’s view of his profession, he replied, as so many in the business did: “Warren is Warren,” is all he would say.
•
I will once again be in Omaha for Berkshire Hathaway’s annual meeting on May 1 asking questions of Mr. Buffett and Mr. Munger. If you have questions for either gentleman, please send them to arsorkin@nytimes.com. (Let me know if I can identify you by name if I ask your question. Also, please tell me if you’re a Berkshire shareholder.)
By ANDREW ROSS SORKIN

---

 8 Comments