The Fourteenth Banker Blog

August 29, 2010

How the Rich get Richer

Filed under: Running Commentary — thefourteenthbanker @ 3:29 PM

Presented in its entirety is a blog post from Bronte Capital. I have been reading John Hempton at Bronte for some time. This post is particularly interesting in that it discusses financial regulation from the perspective on one who makes it his business, among other things, to search out frauds. Here he analyses the Marc Rich saga and finds that regulation played a role in creating opportunity for fraud or something close to it. Certainly obvious from this is that people of no conscience have an edge in a capitalist society if there is no mechanism for what I referred to in a previous post as prosocial sanctions.

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 inPop 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

The Marc Rich saga is about power. Powerful people will fill vacuums. They will take up the space for themselves. They will breathe all the oxygen. They will privatize gains and socialize losses. This is a large part of our problem.

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5 Comments »

  1. Has a Regulation or Law outside of the most simple and unique to a specific situation ever been written that has not had multiple understandings? The simple unique law is stop on red at a stoplight and so forth. My profession was largely involved with understanding regulations and the first rule is to freeze out their applicability if against your desires. The next rule is to use both Law and Regulations to your advantage to advance your desires. Always, unless the state minion ruling is absolute. Has their ever, ever been a Regulator empowered by law to regulate that does not always, as a condition of employment, interpret the Regulation as instructed by politically based superiors. What better examples , both ways, than FDR or GWB?

    All but a single elected pair of Federal Officials are elected to represent the citizens and state they are elected in. The entire Congress is profoundly local . The very essence of the Constitution was to remove as few local impediments as possible from local self determination after the failure of the Articles of Confederation. Under our system it is manifestly impossible impossible to be fair to all fifty states with their 2200 all important Counties. There is literally NO formal national representation in the Congress. When push comes to shove, every Member of the House or Senate is required politically and legally to represent those that elected him or her.

    Complexity breeds Law that must try and define every possible use. This problem gets ever more difficult to accomplish. Even with official Congressional explanations put out by staff, the problem gets ever more difficult and the product ever more defective.

    The problem is itself quite simply exposed. In our system, the legal assumption is that you may unless proscribed by statute and fully litigated Regulation. Simply, change the law to you may not unless the state approves in advance. That would end the constitutional arrangements we operate under because the ultimate spirit of the Constitution is that you may until the law says you may not. There are at least 50 interpretations of what you may do politically and Regulation is a profoundly political act.

    Might not the ultimate American political problem be that there are ever less principles that the nation commonly agrees as proper? Everyone seems to take the activist political assumption as being paramount to their personal existence. At some point diversity of opinion kills social interaction.

    Why would anyone interpret against themselves when there are always others, many others usually, construing against people or groups?

    Comment by Jerry J — August 29, 2010 @ 7:51 PM | Reply

    • Which I suppose makes Trust busting or the breakup of the Too Big to Fails (but it is too late this time) the most elegant solution?

      Comment by thefourteenthbanker — August 29, 2010 @ 9:19 PM | Reply

  2. Yes, their must be some intelligent breaking up. The complexity problem though can be illustrated by comparing the couple hundred page Internal Revenue Code of 1939 to the current Internal Revenue Code. Regulation relied on massive simplicities compared to now. Regulation tried to not over do it by oligarchic consensus. Then, problems then went unrecognized by acclamation among the oligarchs. Things like the Cuyahoga River catching fire. I really got in hot water once from being too vocal with a plant manager of a paper company in Neenah , Wisconsin in the sixties. I worked for the plant’s biggest customer and I was not the doorman. So, there were ignored problems all over the place to keep things on an even keel. Breaking up must be based on simplicities and not necessarily on silly ideas about introducing competition where just as little operative competition existed back in the forties, fifties and even the sixties as now. The West has always been elitest. The simplicities need to be geared to allowing problem solving.

    Seriously, what was more monolithic in nature than GM from 1930- 1970? GM’s greatest fear was being broken up so they made sure that the other big two did not lose too much market share. The market was losely allocated by leaks and default arrangements. Collusion always exists among more or less equals .

    Reintroduce assessable shares for starters. A multiple of a required stated value. It could be enforced by share reduction. Another very probable future result will be that depositary institutions and others in finance, as well, will be forced into a recapitalization when compromised. The creditors and non insured depositors lose their positions, in whole and in part, to recapitalize the bank to proper levels. The surrendered creditor value becomes Common Shares and the old Shareholders lose all or become Junior Common Shares. The emphasis here should be encouraging financing via permanent Preferred Shares. In that case, the recapitalization would convert Preferred to Common Shares along with creditor conversions.

    Some businesses should be forced back into the old general partnership mold or some compromise between a GP and Assessable Common Shares.

    But most of all, how about stopping program trading with a hefty penalty tax on program trading profits wherever derived when repatriated. Force provision for repatriation in financial statements. It worked for Personal Holding Companies and more marginally for Excessive Accumulated Earnings. How about enforced open outcry for all trades? Slow their speculative asses down.

    In the end, the US reverts to producing it’s own needs to the greatest extent practical and forces domestic labor or we die. How about an equalization tax on imports that gets distributed to voting citizen’s annually, pro rata from a pool. Similarly, if patents and copyrights can pay for using their talent, the citizens can assess another national pool tax for allowing the excercise of the patents and copyrights and softwares, in particular, on their turf. Again, distributed pro rata to voters in the preceding election or elections.

    Comment by Jerry J — August 29, 2010 @ 10:12 PM | Reply

  3. […] attention to an excellent blog on Bronte Capital posted over the weekend by John Hempton (hat tip 14). John reminds us how prohibitions like sanctions actually enable certain people to profiteer from […]

    Pingback by struggling with the regulatory ecology | theParetoCommons — August 30, 2010 @ 8:39 AM | Reply

  4. While we are in the area of How the Rich get Richer The Fourteenth Banker Blog, if applied correctly, it could be the only source of income you will ever need.

    Comment by think and grow rich — December 2, 2010 @ 3:25 PM | Reply


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