Tuesday, June 03, 2008

Lamenting Smoke and MIrrors

The talk of the town today regards the apparent rueing by hedge funds over the imminent loss or curtailment of "vital tools" or "important weapons" in their arsenal that allow them to employ derivatives and swaps to obfuscate what they are doing in the marketplace by circumventing existing laws and regulations that require reporting, limit position size in addition to avoiding tax and other sundry benefits.

Of course it is not merely hedge funds that use them. In Japan, as I've detailed in the past, large long-only investors (like Fidelity) take advantage of OTC option structures with executing brokers to delay the disclosure of position changes until AFTER the majority of the position has been bought or sold. But recent squabbles, particularly those involving activists, have illuminated (surprise! surprise!) the more-than-widespread contrapreneurial use of option-combos, equity swaps, etc. to help Peltz, Icahn, TCI, and other other raiders/activists accumulate positions without the hindrance of fatuous details like reporting or compliance inflicted upon mere mortals. And everyone knows the ubiquitious use of equity swaps to wash dividends for offshore funds thus avoiding withholding and other tax-treaty requirements, as well as transmute ordinary income into whatever tax-preferenced delicacy is desired or required. Needless to say, those broker-dealers, and banks, already reeling from their loss of income derived from all manner of securitisation and all its milk-teats, leveraged deal-flow, Prime Brokerage, and quant hedge-fund washouts, are moaning and wailing now as they stand to lose yet another dubious source of income, the "greyness" and envelope-pushing smoke-and-mirrors which would make even the great David Blaine blush with embarrassment.

There may, indeed are, some legitimate arguments to the case suggesting that in general OTC derivatives markets contribute to better and more efficient financial intermediation. However, in the main, they are if not primarily, then very nearly, mere cynical loophole enabling, tax-avoiding, spirit-of-the-law bending, super-leverage enhancing, regulatory-busting, guideline-circumventing, gray-area-exploiting, piles of pooh that make worthless all of mankinds collective efforts to attempt to set investment, tax, and transparency, guidelines, regulations, laws, restrictions ostensibly for the benefit and protection of respective jurisdictional public interests, in general, and those of markets in particular.

Some may suggest the problem lies in regulation itself. Liberate all from the confines of restriction. Let everyone do as every one chooses, let chaos ensure and information will eventually flow freely. Like drug laws, that themselves allow criminal organized elements to profit, and not the state, so too, they would argue does financial regulation allow the banks and brokers to concoct yet another scheme to intermediate where none is actually required. Yes this demagoguery is seductive, but I don't buy it. For at the heart of capitalism lies two important concepts: reasonable market efficiency and reasonable fairness. The former requires that collusion, monopoly, and oligopoly be tamed, while the latter is essential for working people to arise in the morning and NOT do a smash-'n'-grab on the bosses house, wife, and warehouses or factories. Revolutions while perhaps conjured by fanatics, are nurtured and ultimately fed by unfairness, whether real or imagined.

I think the problem is inherently American - the result of excessive calculating legalistic rent-seeking, an unbridled feeling of financial exceptionalism by the "best and brightest" trained to and capable of exploiting the system, and a State that at once, has been made impotent by a biased demagogic philosophy that says "The Best Public Interest is No Public Interest" thereby not only allowing but encouraging the organs of the State to be invaded and run by the parasites themselves. It starts with a legal approach that gives primacy to the letter of the law rather than the spirit. This immediately places the burden of proof upon The State, allowing Genie, Genie & Genie Esq. out of the bottle and encourages yet more of our brightest minds to waste their lives and intellect conjuring loopholes and exceptions from the finite drafting of regulators with the full understanding that The State cannot possibly marshal the resources to draft every law, regulation and directive to include each and every possibility combination and permutation. Were the spirit pursued and enforced rather than letter, the house of litigious cards falls down. The operative word here are both spirit and "enforced" because the spirit, in itself, as England has shown is insufficient, as they've sold their souls to capture the wealth of intermediation by predating other financial centres. Indeed one could argue, London is not "better", nor climatically or culturally more desirable, just more practiced (and determined!) at looking the other way.

Australia, Germany and France have perhaps the correct approach: Combine the spirit with enforcement. This is precisely why the Russians, despite their historic affinity for things French, are living in Chelsea and NOT Parc Monceau or the XVIth, and why the Chinese are stashing their collected bribes in Singapore (or heaven forbid Dubai) and not Sydney. For if it looks like fish, and it smells like fish, and its in the water, it probably IS a fish. No amount of attempted transmutation or air-freshener can change the fact that its a fish. The SEC, CFTC, IRS, even ERISA have hand-wrung, kvetched, and gone down rat-holes to point of looking up their arses - everything except to do the obvious, which is to say that transactions doing XYZ where the spirit and purpose of XYZ has been set-forth in spirit will not hold up under scrutiny, and that violators will be forced to pay make whole what they've attempted to transmute in full with hindsight, ALL public enforcement costs, and pecuniary and not-so-pecuniary fines appropriate for the severity of the attempted transgression. The authorities should also speak with one voice, and to avoid misunderstanding by, as indeed Inland Revenue has been known to do, vetting schemes BEFORE employment.

This may not solve the problems of the markets and the world completely, but it will wholeheartedly make The People think the system is, at the very least, attempting to be Fair, and that we are not running a parallel universe - one for ordinary citizens, and one for the eagle-eyed opportunists who can buy and manufacture loop-holes at will to serve their parochial financial interests.


James said...

Bernake seems to reinforce the policy of "there are no rules". Im the world doesnt want to go where I think it should go, then I'll keep manipulating.

"Cassandra" said...

At this point, Bernanke is like a single fire-fighter standing before a vast raging forest fire. He can scratch the dirt, knock few trees down, spray some water on a house to to prevent a spark from torching it, but it's essentially out of his control.

Whatever he does, he can't really make it much worse, and with the exception of blowing the damn up valley which will result in an argameddon of sorts., there's most much he can do to put it out. Only tighter fiscal policy, an end mercantile diddling of exchange rates, and a rip-roaring recession will squelch the flames, all of which are painful. Letting it burn just keeps the anxiety heightened.

This may nihilistic, but unless all the firefighters work together, and the arsonists are rounded up, the first will rage until it burns it self out. I think the FRB is contrary to popular belief, NOT the arsonist, but culpable of not stopping the arsonists when they had the chance, and maybe even trading guns for liquor with them.

James said...

I suspect the fed became WAY too overconfident after the successful reflation of the tech bubble. The success probably played right into an academic economists hands. Lets see if something happens I apply x + y which equals z. Poof everything is perfect.

etc said...


Don't worry about lack of tax and regulation bite. If you look at levels of enforcement by the IRS, SEC, CFTC, Fed, OCC, and so on, as well as legislation and regulations, they're all pretty lite by historic levels. But things are starting to swing back. There's some populists in the Senate like Grassley that are starting to push against special breaks.

Of course, careful what you wish for. Some left-ish might like a reaction like increasing taxes on the wealthy to fund various social programs. However, some of those same lefties might not like populist proposals on trade or immigration.

trillion dollar meltdown said...

looks like lehman is the next to collapse.

poetic justice :)

superduperdave said...

Cassandra, maybe the Russians are all in London because the food is closer to their native cuisine than French. But aren't there are straightforward income tax reasons why millionaires would prefer the UK over just about anywhere else?

Mencius Moldbug said...

Not to pick nits, but if revolutions are "fed by unfairness, whether real or imagined," presumably one could appease all the real grievances, and there would still be an infinite number of imaginary ones to redress.

In my comprehensive & highly scientific study of history, the data tells me that revolutions are fed by people who encourage others to think that revolution is (a) justified, (b) will improve their lot, and (c) is likely to succeed.

(a) is a Humean ought. (b) does not have the best track record. (c) has a pretty good track record, but one wonders where it would be without (a) and (b).

As the Duke of Wellington liked to put it: "Pour la canaille, la mitraille." Indeed in China they saw that an ounce of grapeshot is worth a pound of concessions. Just as Victorian stability and prosperity was founded on Peterloo, the PBoC's dollar hoard is founded on Tiananmen. The mob, like most bullies, is a great coward.

The Kennedys used to parade around Latin America claiming that "peaceful revolution is the only alternative to violent revolution." I wonder how that sounded to the folks who were to be revolved - if I can supply the verb with a rather indirect object. Someone always does have to be revolved, you know.

Also, have you met any American working people lately? They may be bitter (tm), but I'd be pretty surprised if you find one with the revolutionary energy to snatch a donut from a Wal-Mart greeter. When it comes to proletarian violence, it's all on the lumpenproletariat these days. One can call these folks many things, but "working people" is not really accurate...

As for legal complexity, who cannot deplore it? But at some point, we must look at the whole ball of band-aids with the eye of the engineer. As St. Exupery put it: "the machine is complete not when there is nothing left to add, but when there is nothing left to take away." Of course, if you take away the wrong thing, the machine just crashes to the ground in a pile of smoking ball bearings. But that's why engineering is an art.

As for the "spirit of the law," it is quite true that if you vest unchallenged executive power in the hands of capable and responsible people, the results tend to be good - whether your executives are judges, regulators or army officers. I'm afraid I have to admit that given the choice, I would choose the last, but I suppose that's what makes me a reactionary.

The US legal profession, in particular, has been tasting the fruits of executive power for quite some time now. As a result it has acquired some interesting views of the world that are very much in accordance with that taste. Google "legal realism," then "critical legal studies..."

The nice thing about bringing in the military is that it has no experience at all in civilian politics or government, so its mind is not full of this kind of "scholarship." I'd love to see what the USMC would make of monetary policy, for example...

Mencius Moldbug said...

And besides, if you think I'm a reactionary, there's always good old Pobedonostsev. A bit mystical in spots, true, but can ya blame him? The chapters on democracy and the Press are simply balls to the wall. Reportedly Poby was Dostoyevsky's favorite Russian statesman, and you can see why. If only he'd lived another century.

Anonymous said...

Mencius - " I'd love to see what the USMC would make of monetary policy, for example..."

You mean like the Blackwatch folks?

Mencius Moldbug said...

I believe you're referring to Blackwater - but since the motto of the Black Watch is nemo me impune lacessit, you might have stumbled on something.

I mean, imagine if Dr. Ben released one of his little statements, testimonies to Congress, etc, and all it said was that. "Nemo me impune lacessit."

Anonymous said...

Cassandra, this is off topic a hair, but I do really enjoy your blog. Your writing is fiercely dense, defying any notion that one ought'nt jam pack a sentence with meaning but rather respect the limitations of the least able of ones fellows and write Lite.

Adrem said...

A fine essay plus some very pertinent comments. But but by golly it does get arduous - chasing round for a French and a Latin dictionary, looking up Wiki on some obscure Russian politician, and rummaging thru Google for "legal realism".