Saturday, August 28, 2010

A deregulation conundrum

I have just read Daniel Amman’s excellent biography of Marc Rich - the oil trader notoriously pardoned by Bill Clinton.  I don’t want to get into the politics and ethics of the pardon other than to note that few things in it are black-and-white when you finished reading the book.

But the way Marc Rich made his money is fascinating and says a lot about the current re-regulation debate.

Marc Rich exploited price fixing/import/export controls to make simply unbelievable profits trading oil.  Marc Rich & Co (the Swiss vehicle) was started with just over $1 million in capital and a couple of years later was making in excess of $200 million in profit.  This level of profitability exceeds - by far - any other trading operation I have ever seen - and was probably the most profitable trading operation in history.  Marc Rich & Co (since renamed Glencore) is possibly the most valuable business in Switzerland within the lifetime of its founder.

A typical Marc Rich & Co trade involved Iran (under the Shah), Israel, Communist Albania and Fascist Spain.  The Shah needed a path to export oil probably produced in excess of OPEC quotas and one which was unaudited and hence could be skimmed to support the Shah’s personal fortune.  Israel - a pariah state in the Middle East - wanted oil.  Spain had rising oil demand and limited foreign currency but was happy to buy oil (slightly) on the cheap.  Spain however did not recognise Israel and hence would not buy oil from Israel - so it needed to be washed through a third country.  Albania openly traded with both Israel and Spain.  Oh, and there is an old oil pipeline which goes from Iran through Israel to the sea.  

So what is the deal?  The Shah sells his non-quota oil down the pipeline through Israel and skims his take of the proceeds.  Israel skim their take of the oil.  Someone doing lading and unlading in Albania gets their take and hence make it - from the Spanish perspective - Albanian, not Israeli oil.  The Spanish ask few questions.  The margins are mouth-watering - and they all come from giving people what they really want rather than what they say they want.  We know what the Shah wanted (folding stuff).  We know what Israel wanted (oil).  We know what Spain wanted (cheap oil).  Who cares that Spain was publicly spouting anti-Israel rhetoric.  [Similar trades allowed South Africa to break the anti-Apartheid trade embargoes.]

It also helped that Marc Rich & Co was a (highly) multilingual firm.  Rich is fluent in Spanish (it is the language he talks to his children in).  He speaks English, German, Yiddish and presumably Hebrew.  His business partner (Pincus Green - pardoned the same day as Rich) speaks Farsi amongst many other languages.  They could do this deal because they could negotiate it and - deep in their heart they hold the Ayn Rand view that trade is a moral virtue and hence they do not need to be concerned with other morality.  [The only line that matters is the law - and then it might not be the law of his adopted country - Switzerland - rather than the United States where he was resident.]

And when the Shah fell?  Oh well - Pincus Green - an American Jewish businessman - gets on the plane to Iran and does a similar deal with the Mullahs - who - despite their rhetoric will sell oil down a pipeline through Israel - and will allow Israel to skim their take.  Trading through the American embargo - well that is just another instance of getting around restrictions and profiting (very) handsomely.  [Rich would argue that the trades were done by the Swiss company which was not subject to the American restrictions.]

The regulatory regime for domestic American oil was also perverse.  Old oil (meaning wells drilled before the first oil crisis) received one price.  New oil (wells drilled after the crisis) received a higher price.  Squeeze oil (oil that was extracted from wells that ran less than 10 barrels per day) received a higher price still.  The oil could be chemically identical and the price difference over $20 per barrel.  Obviously a trader with a method (any method) of changing the oil source could make a fortune.  Again I am not commenting on legality or morality.  That was just plain fact.  Ayn Rand applies - you give a value and you receive a value.

What all this regulation did was that it allowed people to make simply grotesque profits by thwarting regulation.  The regulation thus worked less well and it was socially unfair.  Pincus Green was good at negotiating in Farsi.  He was astoundingly brave going to Iran immediately after the Shah fell.  He was good at organising shipping.  He worked really hard - but he did not invent something that changed the world and he wound up a billionaire.   Traders make money by intermediating real business solutions - but these were real business solutions to problems made by legislation.  Bad regulation, moral indignation about “trading with the enemy” or “trading with Israel” or with racists in South Africa made people with Ayn Rand morals exceedingly wealthy because you could arbitrage your way around any of these regulations.  

If you read the Marc Rich book you will understand why lots of people who were generally left-of-center became ardent deregulation advocates.  Plenty written by Krugman look like it advocates deregulation. (Not convinced: see his review of Laura Tyson’s book on trade theory in Pop Internationalism.  Indeed see most of Pop Internationalism as favorably reviewed by - of all people - the Cato institute.)

Crank forward to the current crisis: what we see are the problems of deregulation and complexity.  We see traders and investment bankers who get rich - not as rich as Marc Rich and Pincus Green - but still frighteningly rich.  And they get there by taking risks that are ultimately absorbed by taxpayers or mutual fund holders (particularly taxpayers).  We see agency problems everywhere - where management enrich themselves at the expense of others - and they do so by capturing upside but (in part) socializing the downside.  Regulation in this case is about controlling agency problems - about stopping people privatizing the profit and socializing the losses.  

A plea

As a plea then I want a debate about the right form of regulation - a regulation that controls agency problems but does not allow arbitrage opportunities to people with “Ayn Rand morals”.  

We are not going to get that from the current Tea Party Republicans.  They simply argue that regulation (they say but do not mean all regulation) impinges on “freedom” (something that is clearly a good but hard to define).  However many of the same people want planning regulations to ban a mosque in downtown New York because it is an insult to the victims of 9/11 (and banning mosques is not a restriction on “freedom”).  

If that is the level of debate we are not going to get good re-regulation - we are just going to get pandering to whichever lobby group manages to garner most support.  And that is a real risk because we will leave agency problems in place (they benefit the rich and powerful) and we will introduce the same sort of (dumb) regulation that made Marc Rich and Pincus Green astoundingly wealthy.  That sort of regulation also benefits the rich and powerful - especially those with “Ayn Rand morals”.  [The rich and powerful - if you have not noticed - are good lobbyists.  Unless we are careful many amongst them will get their way.]

I don’t know how to do this well - but I thought I would state the obvious.  The most obvious things that need regulation are things with a government guarantee (implicit or explicit).  If you have an implicit guarantee (as we now know almost all large financial institutions have) then regulation really matters.  If there are large agency problems (small shareholders, large management) then regulation should be deliberately biased to put power in the hands of shareholders not managers (eg banning staggered board elections).  

Likewise other agency problems should be strongly policed and the regulation should be of the form that allows that policing.  When Elliot Spitzer found that Marsh - a large insurance broker - was participating in bid rigging against schools buying insurance that was shocking - and is precisely the sort of thing in financial markets that should be policed strongly.  But it took Elliot considerable effort to find and prove his case.  The rules should be established so that sort of behaviour is really difficult to hide.  

And I do not think that I need to explain to anyone how much mortgage brokers contributed to the crisis by (a) deliberately misleading borrowers about conditions on their mortgage and (b) participating in the faking of borrowers income/assets/education level when they on-sold the loans to Wall Street.  Agency problems were at the core of the crisis.

On the other side if there is no agency problem then deregulation should remain the order of the day.  Trade restrictions create arbitrageurs - and the arbitrageurs ensure the trade restrictions don’t work anyway.

There are obviously going to be extensions to this rough rule - and this post is really to garner discussion.  But for a start I expect agents who benefit from their agency (and the abuse of their agency) to join the Tea Party.  

It is difficult to get policy right.  And when and if the policy is got right we are in for a very long fight to implement it.  

 

 

John

31 comments:

Anonymous said...

The Rich&Co factors haven't been possible in a very long time, yet set a new standard in fancy. Maybe skim is a slightly rough word to use when those 30 years ago slow was the word in markets. A little 'liquid reciprocity' quickly became sacred to a deal; speeds things up, brings conviction, and in most circles better with good spirits and not too much froth. What we know too little about requires some empathy because there's a bit of that in many of these old deals merely in order to get them done. In this day and age, we're dealing with packages not each other. And all that is tough intricate rule-making that will takes many years I think.

狂猪 said...

The use of regulation in pursuit of a particular social outcome is inherently fragile within a complex environment.

Regulations can work very well for simple problems and work very efficiently too. However, for complex issues, the success of the regulation depends on the intelligence of the regulator. Furthermore, while the regulations tend to be static (rules on pieces of paper), the environment is dynamic (the world is always changing). For example, the regulation for mortgage finance has been largely the same for the last 30 years. However, the environment (various preconditions) for the subprime mess only came together in ~2004 to bring about the current crisis. The smart regulations can turn into dumb regulation when the rules of the game are changed.

Stepping back, I do believe governments should use their resources to promote certain social outcome. However, framing the problem in terms of finding "better regulation" for complex issues is ultimately counter productive.

Perhaps we should frame the problem in terms of finding "better incentive".

epicaricacy said...

Excellent Post. One point. There's a problem with giving shareholders that much say over operations. Well not as much a problem, as it doesn't necessarily represent a solution. In 2007, which management team would face shareholder wrath, those booking the record profits which were ruinous on a risk-reward basis ex post, or the management team showing 10% lower than peer ROAs because management feels uneasy "dancing as long as the music is playing"?

Wisely Managed said...

Very interesting post; I think I'll have to read that book.

However, in stating the obvious, you seem to have missed the even-more-obvious:

"The most obvious things that need regulation are things with a government guarantee (implicit or explicit)."

The obvious solution is to remove the government guarantee.

Agency problems are at the core of every government, every corporation, and our entire financial system. Exposing people to the risks of their own decisions is the only real solution, and it happens to be the simple one. Government guarantees on deposits, home loans, student loans, small business loans, and farm loans were bad enough, but now we have even more precedence for guarantees on poorly run banks and corporations and unrealistic, vote-buying promises to labor groups. To your point, government guarantees on things naturally lead to those things being highly (mis)regulated (think healthcare). Of course, the regulation will fail, so more regulation will result. It will also fail. Altruistic regulators (if you are naïve enough to actually believe that regulators and government employees are in it for “the good of people”) are just as fallible as profiteers and rent seekers and rarely suffer any consequences for their poor decisions. Anointing bureaucrats with power and expecting them to figure out how to solve agency problems (while ignoring the agency problem caused by the mere existence of their job) is what got us where we are today.

The only conundrum is why anyone expected the outcome to be different.

John Hempton said...

Well maybe removing the government guarantee is "more obvious" but removing implicit government guarantees is easier said than done.

Moreover - and this is one of those I am a liberal moments - I don't want to do it for everything.

At the base level I think we can agree on a government guarantee of availability and some quality in primary school education...

Where we draw the line (my line quite a long way into the liberal camp) then becomes a matter for debate...

J

John Haskell said...

About this Iran to Israel pipeline ... did it run through any other countries? I kind of wonder if say the Iraqis or Jordanians or Lebanese started wondering why the pipeline (assuming it actually ever existed, which I find extremely doubtful) all of a sudden needed to be used?

Presumably the Iranians asked them to turn their pumping stations back on and they just acceded without asking any questions. Also I wonder if the outbreak of the Iran-Iraq war posed some kind of slight obstacle?

MattJ said...

I don't understand your antipathy to the Tea Party relative to the Democrats and Republicans. What should be abundantly clear at this point is that the agency profiteers you reference effectively own both the Democrat and Republican parties. There is little to no chance of any useful regulation coming from either of those parties at this time. What I would hope would happen is that those like yourself who see the problems on the horizon would realize the futility of dealing with them through the current parties and would attempt to use the emerging Tea Party to move things forward.

You call them Tea Party Republicans, but that is only true to the extent that the Democrats have made no attempt at all to win their votes. I think the next two election cycles in the US are the last chance for Republicans to hold onto them. If the Republicans win power and then are as useless as I expect them to be, the field will be wide open for a new party to emerge. I hope there will be sensible people at that time in a position to lead that movement, but if they all have the same attitude that you show, I fear there won't be.

Anonymous said...

John,

sorry, this may be completely irrelevant but I just wanted to clarify.
You said "many of the same people want planning regulations to ban a mosque in downtown New York ".
I obviously did not trace what every single and possibly even prominint Tea Party member said but I usually saw a slightly different kind of statement, namely
people asking those who try to build the mosque to stop and think about the potential insult to others. Have I missed something obvious?
Joseph

minka said...

I read an article recently, wish I could remember where, that the fundamental problem is that taxation of the rich has to soar, back to say 70%, as before Reagan. That removes the incentives to subvert regulation, which was in fact much lower when upper income taxes were (much) higher. If the rich make much less from such legerdemain, they are less likely to engage in it.

John Hempton said...

Disincentives on the rich are generally overstated. I never noticed the seroiusly motivated being less seroiusly motivated when their marginal tax rate was 45 versus say 37.

--

But more to the point - it that was what would work it is the dumbest idea I have read in a while.

Raising taxes to the point they kill all incentives including the incentives for legerderain - would - politely - seem counterproductive.

J

Anonymous said...

Having a proposed mosque move a few blocks from the epicenter of where two hijacked planes were crashed into World Trade centers filled with people, taking out a whole zip code, has nothing to do with whether one is a Tea Party person or not.

How close to Mecca, Medina, Damascus, Mount Sinai Egypt, Mashhad Iran can one propose to build a Jewish Temple. A Christian Church? A Catholic Church. A Buddhist Temple?

On a second note John Hempton, and speaking of fascist Spain, it was no coincidence that the proposed name of this mosque was Cordoba House.


anon,
Robert Dobb

Anonymous said...

Laffer's Curve is as valid as ever.

As are growth inducing, supply side economic policies.

Keep your eye out for them in Presidnet Obama's second half of his term... Especially if he truly cares to be reelected.

-R. Dobb

Sir G said...

John

surely, one aspect of good regulation must be that it is written with regulation-busting in mind: any regulation which contains strong incentives to circumvent it *and which leaves substantial loopholes within it is, i would argue, a bad regulation to start with;

i don't understand your reference to Ayn rand morals; what is that? surely, the persistence with which governments make bad laws has to make clear that "morality" and "law abiding" cannot possibly be one and the same thing: no offense, but only someone whose life experience is limited to dealing with a relatively benign government regimes could confuse the two;

you should get out more :)

kim.rampling said...

Had the pleasure of having the original Marc Rich & Co A.G, Zug as a client way back when they were into just about every commodity deal in the the book.

Their great rivals in Zug, Phillip Bros (of Philbro Solomon fame) where always runners up. And they span off so many of commodity traders in that small Swiss town that it become synonymous with that business.

Regulation by it's very nature produces arbitrage opportunities - just look at the asset backed securities market. No regulation can ever be perfect as there are too many diverse interests to pander to that lead's to more regulation and...

...arbitrage opportunities.

Peter Rickwood said...

Taxing transactions seems pretty obvious as arbitrage relies on low cost transactions, right? Killing off some of the arbitrage trade might mean we give up a little efficient allocation of resources. But on the other hand, we might gain something from having all the uber-smart arbitragers actually doing something directly productive....

Anonymous said...

As to this Cordoba House mosque at ground zero, would it be any different or insensitive if some group built a gun store next to Columbine High?

I don't recall any group proposing a Buddhist or Shinto temple anywhere close to The Arizona Memorial.

Anonymous said...

The problem with transaction taxes is the create even more arbitrage opportunities unless all countries agree to along. Thus the political establishment of a country like Canada which faces very little domestic political pressure on financial reform can gain its own arbitrage rewards by acting as a spoiler within the G8/G20 financial reform councils. As a corrillary I suspect if Kevin Rudd had acted more like a bad ass spoiler on bank taxes and global bank reform like Canada's Stephen Harper I suspect Rudd might still be Prime Minister today. That's largely because a lot of electorate in small countries like Australia and Canada like political leaders ala Trudeau and Whitlam who do things to annoy, frustrate, make difficult for, etc the leaders of larger countires such as the UK and the US.

Marc Rich Rocks said...

Marc Rich was unjustly persecuted by Rudy Giuliani, perhaps the most corrupt and self-serving US Attorney the over hyped SDNY ever had or will have.

Pincus was a little lazy. Didn't want to work on Friday nights or Saturdays. Perhaps some day Hashem will forgive him.

Hashem loves Marc Rich, the mensch.

Anonymous said...

Is the Ground Zero Mosque a joke?
While everyone has chased after Imam Feisal Abdul Rauf and his wife, Daisy, I have been reading up on Sharif El-Gamal, the actual developer of the mosque/community center/tourist attraction/whatever he says it is today.

Who else si not impressed.

Land near Ground Zero was pretty cheap before 9/11 and the prices have not gone up.

So what’s he up to with buying and obtaining rights to land there?

He has a project. But not a lot of money.

Yet.

Maybe the Saudis or the Iranians pony up money. But he might just borrow it.

From Reuters: “The Muslim center planned near the site of the World Trade Center attack could qualify for tax-free financing, a spokesman for City Comptroller John Liu said on Friday, and Liu is willing to consider approving the public subsidy.”

We’re seeing hat. Not cattle.

Now the New York Post reported: “Sharif El-Gamal, the leading organizer behind the mosque and community center near Ground Zero, owes $224,270.77 in back property tax on the site, city records show. El-Gamal’s company, 45 Park Place Partners, failed to pay its half-yearly bills in January and July, according to the city Finance Department. The delinquency is a possible violation of El-Gamal’s lease with Con Edison, which owns half of the proposed building site on Park Place. El-Gamal owns the other half but must pay taxes on the entire parcel.”

Amid all the hoopla, something else is going on. If someone can explain it, I’m all ears.

Maybe these guys are just the imen of arbitrage. And Cordoba House is just some random, no meaning pulled out of the air name.

Anonymous said...

John,

which book are you referring to? The Fountainhead, Atlas Shrugged, or one of the less famous volumes?

I don't know that the repeated reference to Ayn Rand strengthens your argument.

John Hempton said...

Marc Rich is the closest real-life example I have to an Ayn Rand hero. Either of those books would do...

Just google the expression ayn rand marc rich.

The references are legion.

Laban said...

"On the other side if there is no agency problem then deregulation should remain the order of the day. Trade restrictions create arbitrageurs - and the arbitrageurs ensure the trade restrictions don’t work anyway."

Does that include the trade restrictions on weaponry and explosives, drugs and prostitution, all of which seem to have 'arbitrageurs'?

John Hempton said...

I was careful to note that there would obviously need to be extensions to these rules...

But if you ask my personal position - prostitution should be legal. Illegal and it becomes a mechanism for making crime pay.

I am a little less liberal on drugs - but my inclination there would also be to say that prohibition has not worked any better than the alternatives.

Drugs however is generally a crime between consenting adults - and the story is harm minimization. (Yes - at heart I am a bleeding heart liberal.)

I have however a real problem whent it comes to activity not involving consenting adults. Child prostitution should remain illegal - period - no exceptions etc... introducing drugs to minors...

Again there will be arbitrageurs as you would call them... in that case I might call them something else...

I set this up as a subject for discussion as I do not know the answers - and far smarter people than me have deliberated for a long long time on these issues.

J

Anonymous said...

"proposed mosque move a few blocks from the epicenter of ..."

Dobb, I believe the proposed site is already a few blocks from said epicenter. That's not to say it isn't in less than perfect taste, but they are not exactly taking down the U.S. flag from ground zero, and raising the crescent moon.

Anonymous said...

John,

The only regulation that ever works is the RSP one (rock-scissors-paper) - i.e. setting few sides against each other, and making them about equal to start with. Ideally so that either side winning even a bit means the other side loosing quite a bit (but not necessarily vice versa).
I know, it's easy to say but pretty damn hard to figure out how to do it. My problem is that no-one even looks at it from this perspective, and the regulation we get is not really a regulation as such but one of the extremes you describe.

I'm sure game theorists have other uses than doing auctions, and when it came to them gov'ts were pretty happy to use them to maximize the revenues. Why is it that no gov't I know of talks to them about how to write regulation?

Anonymous said...

anon,

Good point, but how do you even get the powers that be to heel enough to play RPS when they all have large scale automatic weapons? Bigger weapons?

Anonymous said...

Falls short of identifying the probable real issue: concentration of wealth and power.

If regulatory capture is easiest when ruling elites control regulators (and most everything else, economically), statements like "regulation matters when institutions are too big to fail" are trivial.

Now you could say these people will get some ethics and start to give up wealth and power by behaving honorably... but come on, these people LOVE MONEY and are not likely to change.

It may be that a depression that destroys massive amounts of wealth across all classes is what Nature requires to bring people to their senses.

Anonymous said...

@previous anon: Indeed, but at least trying would help.
At least in theory executive/legislative/judical arms are RSP. Of course, in practice it gets a bit more complicated, but I still believe it's better than the regulatory stuff we have now

Karen said...

I don't think it is that hard to think up good regulations and weed out the bad - IF you really want to do the right thing.

What has me in despair is my perception that "the right thing" is the LAST thing Congress or the Obama Administration wants to do.

Our most powerful political leaders seem to want the campaign-donation spigots and the revolving door to stay open for them, in preference to doing what's morally right and what will enhance our nation's strength for the future.

And what has me truly worried is my perception that ordinary Americans' sense of right and wrong has also been deadened to the point where if there is a revolt against the status quo it will only make things worse.

Anonymous said...

Great article. I agree with your analysis fully. I wish there was some easy way to get laws and/or regulators to stop the type of things you mention. In a 'democracy' of self-interested individuals, i don't think there is much hope. The only two solutions i can think of are to have a culture of people who stand-up firmly against this type of stuff at the first instance, whistle-blow and then massive action is taken. The US is not a country that has this type of culture right now. It might be possible in Austria, or the Netherlands, or Sweden. The other solution is to have a state with extremely punitive powers for actions like this. This punitive powers (say death by torture for white collar crimes) will avert alot of this nonsense before it even gets started.

Anonymous said...

John

the problem is not our unfamiliarity with Ayn rand (a writer who is greatly overestimated as both writer and thinker, imho), but the inexplicable manner in which you conflate observance of government-made regulation with morality of any sort, whether ayn rand or otherwise

cheers

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.