Mindles Dreck is the Dreck of my dreams

I’d like to reproduce chunks of his old yet prescient post (or go here and scroll down to 22 January):

Pundits continue to link the Enron debacle to a need for increased regulation,
especially of derivatives. What most of these people…don’t appreciate is that regulation and/or accounting rules are the
most fertile breeding ground for derivatives and synthetic or packaged
securities. Regulations and accounting rule-inspired transactions
describe the bulk of the well known derivative-related blow-ups of the
last two decades. Proscriptive regulation and the derivative trade have
a symbiotic relationship.

Investors and operating companies buy derivatives for two basic
purposes: speculation and risk transfer. A derivative, (a financial
contract based on the price of another commodity, security, contract or
index) either eliminates an exposure, creates an exposure, or
substitutes exposures. That last one, substituting exposures, is
important to heavily regulated investors.

For example, insurance companies were a goldmine for derivatives
salespeople in the last two decades, only slowing down in the late
1990s. The fundamental reason for this is not because insurance
executives were stupid, but because they manage their investments in a
thicket of proscriptive regulation. Insurance companies have to respond
to their national regulatory organization (the NAIC), their home state
insurance department and the insurance departments of states in which
they sell or write business. They file enormous statutory reports every
quarter using special regulatory pricing, and calculate complex
risk-based capital reports and "IRIS" ratios regularly.

Even though the insurance industry has been heavily regulated
throughout the entire post-war era, the incidents of fraud and
financial mismanagement have been numerous and spectacular.  Remember Marty Frankel?
Mutual Benefit Life? For each of these cases that are in the news,
there are many smaller ones you don’t hear about. Some of that may be
the nature of the industry, but it doesn’t make a prima facie case for more regulation…

Insurance companies often need the yield of less creditworthy
obligations. So derivative salesmen see an opportunity to engineer
around the regulations. They package securities that substitute price
volatility for the proscribed credit risk. Then the investor can be
compensated for taking some additional risk, and the banker can be
compensated for creating the opportunity. A simple example of this is
the Collateralized Bond Obligation (CBO). A CBO is created by buying a
bunch of bonds, usually of lower credit quality, putting them in a
"special purpose vehicle" (SPV) and then issuing two or more debt
instruments from the SPV. The more senior instruments can obtain an
investment grade rating based on the "cushion" created by the junior
debt tranche. The junior bond absorbs, for example, the first 10% of
losses in the entire portfolio and only when losses exceed that amount
will the senior obligations be impaired. The junior instruments, known
as "Z-Tranches" become "toxic waste", suitable only for speculators and
trading desks with strange risks to lay off (or, in a famous 1995 case,
the Orange County California Treasurer).

A CBO is just one example of a credit rating-driven transaction, but most of them achieve the same thing – they decrease frequency of loss but increase the severity.
So they blow up infrequently, but when they do it’s often a big mess.
Ratings-packaged instruments are less risky than the pool of securities
they represent but often riskier and less liquid than the investment
grade securities for which they are being substituted. As a result,
they pay a yield or return premium (even net of high investment banking
fees). That premium may or may not be enough to pay for their risk. But
they pass the all-important credit rating process and are therefore
sometimes the only choice for ratings-restricted portfolios reaching
for yield.

…[Frank] Partnoy is a former derivatives salesperson, and he clearly suggests
that regulation is often the derivative salesman’s best friend.
Complicated rules encourage complex transactions that seek to conceal
or re-shape their true nature. Regulated entities create demand for
complex derivatives that substitute proscribed risks for admitted
risks. If a new risk is identified and prohibited, the market starts
inventing instruments that get around it. There is no end to this
process. Regulators have always had this perversely symbiotic
relationship with Wall Street. And the same can be said for the
ridiculously complicated federal taxation rules and increasingly
byzantine Financial Accounting Standards, both of which have inspired
massive derivative activity as the engineers find their way around the
code maze.

Dreck, in case you don’t know, used to blog with Megan McArdle over at Asymmetric Information.  Here is what happens when you enter "Star Dreck" into YouTube.


Well done. This will be one of my new examples I use my first day of class when I teach my Ten Pillars of Economic Wisdom and get to Pillar #6 on unintended consequences.

"403 Sorry, you aren't allowed here!"


These are stimulating remarks, Tyler, taken from the Dreck commentary. Thank you. Still, they leave a worried observer with some questions:

1) If the main problem with the speculative bubble that has been bursting around us for the last year or so --- not just in derivatives and similar fancy financial instruments of a dubious sort --- is due to various governmental regulations and recent accounting rules --- then how is it that ever since the industrial revolution in the late 18th century, there have been regular waves of speculative bubbles long, long before these recent US regulatory and accounting regulations.

For instance, Clement Juglar 7-year business-cycle waves, which that prescient French economist first observed in the early-mid 19th century, which seem to follow a regular pattern: new breakthroughs in productivity, increased consumer confidence (and borrowing), rises in aggregate demand, and price fluctuations, all leading to a speculative bubble that bursts asunder . . . as at the end of 7 to 8 years in the 1980s, or a similar length of time in the 1990s, and again (only worse, with these new-fangled financial instruments) in this decade again . . . and yes, once more, in 7 years or so.

All this has been going on for over two centuries, long, long before libertarians could blame the recent financial crises on excessive governmental intervention, yes?


2) Aren't financial institutions, starting with banks, supposed to carry out credit(worthiness)-analysis before lending to a agent . . .whether that agent is a home-buyer, a small business person, a big corporation (Enron?), a hedge-fund, or the like?

Instead, we have had asset-based underwriting, haven't we? In which . . . to hell with credit-worthiness and risk-management. As long as we have an underlying asset somewhere, rising in value (like housing prices), get the damn loan out and pass the risk down the line to other financial institutions, however the risk has been sliced, diced, and repackaged?

Of course, as with the earlier 7-year financial balloons and busts, the underlying financial assets will crash sooner or later in value . . . with the burdensome costs passed on to --- well, this time, it seems, average taxpayers. And of course, with promises by John McCain now to prolong the tax-cuts of the Bush administration that, of course, had nothing to do with the speculative bubble that emerged in this decade. (When the top 24 hedge-fund heads earn more annually than the 500 CEOs of the Fortune 500 Companies, aren't we in . . . well, let us say, a strange economic world? With, of course, government once again to blame for that strange world not operating as certain economists insist it would if only we could get government back to where it was, maybe, in the Andrew Jackson era of the 1830s?


3) There are, of course, other postulated business-cycle periods and duration . . . such as the Kondratieff 45-60 year cycles, adopted with skill by Joseph Schumpeter and linked to clustered waves of revolutionary technological breakthroughs. These roughly correlate with the big recessions or deep depressions since the 1770s . . . as they do now, assuming that the new information-age technologies emerged around 1970 or so.

The most interesting recent work in these long-wave theories relates the speculative financial booms-and-busts to, among other things, new demands for energy and big fluctuations in energy prices, along with increasing global imbalances in excessive footloose capital of the sort that have fallen into the hands of utterly corrupt gangster-regimes in oil-rich countries like Russia, Iran, the Saudi Wahhabi zealots, Venezuela's Chavez-regime, Persian-Gulf sheiks, and the like . . . none of which countries have the capacity for absorbing the trillions of dollars they've amassed since the mid-1970s, except to direct them into countries that do. And presumably the same observation would apply to the huge trade-imbalances of neo-mercantilist countries like China.


4) But then, to repeat, what has any of this to do with the obvious culprit behind all these problems? Namely, government in solid democratic countries like the US, plus (in the minds of many) Alan Greenspan . . . a devoted follower of Ayn Rand.

The latter adulation itself food for thought, no? . . . leaving you wondering if suddenly the posters at Marginal Revolution are rushing out to the Salvation Army or other charities with their huge collections of Ms. Rand's works as now almost as toxic as the financial paper worth, undoubtedly, well more than the $800 billion of bad debt US taxpayers --- who knows? maybe even some of the 24 hedge-fund billionaire-heads --- will be paying for?

For some reason, the link only works if you go there from the Assemetrical website: it's from Jan. 22, 2002

I love libertarian Manichean dualism: life is so simple when all good comes from the market and all evil from government! (***sarcasm***)

The obvious question is: why do you need government regulation for a financial market to create fraud and hot-potato investments that will collapse later? If attempts at regulation force the unscrupulous and the credulous to make more contorted frauds, the problem still is due to markets not the regulators.


Let's pretend I'm the boss in that situation. Should I say "I want to reward the criminal employees by firing the honest guy who tried to rein them in"? Or should I say "fire those crooked a**holes, and have my loyal manager revise the rule to make it tougher for their successors"?

Who's the real bad guy here? Figure it out: it's easy.

I agree with Peter Jackson (though I'm still a little mad about his 3-hour King Kong movie).

Mike, I think the problem here isn't that the government is some white knight who failed to reign in nasty business and therefore needs more power (that's how I read your solution, anyhow). In this regard, I don't see Matt's example as all that helpful either.

The problem was that the gov't here WAS powerful enough to change people's incentives, causing resources to be invested into things that weren't actually stable. The problem wasn't that people didn't do what the government wanted them to do, the problem was that they DID, and it wasn't a good idea for them to be doing it in the first place, a fact that regulators (and indeed most people) were ignorant of ex ante. The way I see it, It wasn't a good manager, bad employees, and a good rule: all three were bad.

I've been practicing finance law for 30 years. I wrote some of the first swaps. I did some of the first CDOs. I've structured billions (maybe trillions) in tax and accounting leases, structured financial products and derivatives.

Here's an iron law of finance:

All finance more complicated than straight equity or debt is designed to avoid regulation or exploit its rigidity. (Not "virtually all". All.) The insurance company example is right on target.

One little anecdote:

In the mid-80s, I was on the investment committee of a charitable organization with a USD 50 million endowment. One of the restrictions (adopted before my time) was that all debt investments had to be rated A or better. (There were no restrictions on the riskiness of equity investments.)

Our debt portfolio manager was delighted to report to us that it was outperforming debt benchmarks by a healthy margin. Having studied portfolio theory, I found this interesting. I checked the portfolio listing, expecting to find some securities that didn't meet our restrictions.

The portfolio was indeed all rated A or better. But it was virtually all in i/o strips! No credit risk, but stratospheric volatility risk.

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