- Repost: Mentally Challenged Derivatives Regulation

Thanks to the government regulators and their media enablers completely misrepresenting the issue, most people don’t understand where exotic derivatives come from, so let me explain it to you. When the government makes a rule which violates the economic realities of the free market, the incentive to create a new kind of derivative is born.

Free market economics has internal rules which if left alone, will moderate virtually all of its own potential excesses. These rules are so basic that most people wouldn’t think of them as economics at all. They are things like “the law of supply and demand” or “the law of diminishing returns”. These are the internal moderations of the free market. Like the rules of nature, they are all independently self correcting. There is no point where the law of supply and demand forms a bubble or the law of diminishing returns provides a perverse incentive to throw money around needlessly.

But the problem in the real world is that the free market hasn’t been left alone. Instead, governments have decided that rather than coping with the real world as it is, they would rather mess with the market until it gives them a result that they want for political reasons. As an example, unions represent voting blocks, so they’re given enormous legal advantages by elected officials who also write such rules. Ordinarily labor cost is determined in broad terms by the economic value added of the job. But when the union gets it's legal advantages it begins to distort things. It artificially causes the price of labor to rise without any other justification. This makes things more expensive for the company and in turn makes it more like that they move their manufacturing overseas. Now the union staffers are unemployed.

The same sort of thing is true in finance.

It’s a little arcane to offer an example for derivatives in this format and it wouldn’t read nearly as well. I can provide specifics if pressed. But if you can take my word for it then I assure you, every single derivative that’s been developed in the last 40 years – from interest rate swaps on down – has been created in response to an arbitrary change in the legal, regulatory or tax codes. The instinct to make the world bend to political will is what has created the derivatives marketplace, not greed. (Which is what the people who are trying to bend the world would have you believe.)

People in government believe in control. They believe they can make a decision and the world will change to conform to their view of how things should be rather than how they really are. It’s never been true, but since the advent of computers in finance, that idea has gone from tragic to farce. There has, in my opinion, never been so great a gap between the people writing the rules (the dim and misguided) and the people trying to get around them (the clever and motivated). Imagine how things would look at NASA if when he created it, Lyndon Johnson had decided to put ladybird’s cousin with downs syndrome in charge of the whole thing. That’s how the financial markets look to many people today.

Moon shots would still get done, and shuttles and satellites would be launched, but much of the time it would be in contradiction to, and over the specific objections of the ‘person in charge’. The interest of that person won’t have anything to do with space exploration much of the time anyway. Rules would come down from management like ‘On Tuesday everyone must wear a ‘blue shirt’, or “We all have to smile when we say hello.” In response to all this, the PhD’s and engineers would all nod and smile at each other, then get on with the actual business at hand.

The culture that would develop would be one where the people who are the most respected and the most rewarded would be those who can best find the blind spots of ‘management’, and succeed in getting things accomplished in spite of the rules. In effect it would be a culture where the ‘gray’ area becomes the most important. If you don’t work on Wall Street you’re probably aghast at reading that characterization, but if you do work here, then you’re probably nodding knowingly right now like one of those PhDs.

I figure that right now someone out there is trying to come up with an analogy between Apollo 13 and the financial crisis, but the analogy doesn’t hold. The incentives that created the crisis of 08 were in place long before the actual event, and the bail out was long implied. but for Fannie and freddie and the pressure to increase home ownership rates, the whole thing would have never happened.

And if we had followed the rules of the free market afterward, all the banks would have been folded up for repurchase by smaller banks that hadn’t been caught in the asset bubble. The new management would fire the people responsible (rather than holding witch hunt congressional committee meetings with the people who weren’t) and life would have gone on as before. the main difference would have been that without the people in charge promising to punish the winners and help the losers, the markets could have had the confidence to come roaring back instead of trickling as they have. Unemployment by now would have been lower and the economy would have been better. But instead we got more ‘control’ from the top.

But I'm not saying that markets don't need rules; of course they do. But they need rules like language need rules. They should be rules designed to better reveal the truth rather than try to ‘control’ or obscure it. In fact, if the regulators simply make the data which facilitates short selling more transparent, the very idea of an asset ‘bubble’ may be ended for good.* But in this political climate, that’s the last thing we’ll see. Instead we’ll get more attempts from our mentally challenged rulers to ‘control’ the markets, and the market will respond to them by going further to get around those rules. We on Wall Street will continue to manage risk and to provide products and services that make economic and financial sense, no matter how convoluted the rules get. Ban activity and you simply drive it offshore or obscure it behind the next class of ‘exotic instruments’.

Over the long term, Government can’t control the markets any more than they can control nature. The best shot they have at control is to set all we snarling greedy wolves in opposition to each other like the checks and balances of old. It’s the only kind of control the markets will ever really respect. The sooner we get that idea through to the mentally challenged people in government, the better off we’ll all be. But if recent demonstrations of their intellect are any indication, they probably wouldn’t understand it anyway.



* The term 'financial bubble' is widely misused, and I do the same here. Information cascades (their technical name) will always exist at high frequency but making short selling easier will keep them from expanding to a size where anyone cares.


Please see The Original post for Mark's cogent comment.