Tuesday, June 30, 2015

Why neither free markets or regulation solve everything

Several years ago, the NHL instituted a salary cap that limited how much a team is able to spend for their team payroll. Prior to this arrangement, you had teams with a lot of money to spend, who frequently did so in order to lure the better players and create super teams that the rest of the league could not really compete with. In essence, if you had deep pockets and were willing to spend that money, you could create a team that few in the league could truly compete with. In an effort to create some true parity and genuine competition across the entire league, the NHL created a minimum and maximum level that teams could spend. However, this was quickly circumvented.

A "flaw" in the cap agreement was that you could divide the total money of the contract by the total number of years to get your cap hit value. Suppose you want to pay your player 50 million total in order to them to come to your team. You don't want to pay that in one year of course, because the league says you can't do that. So, you make an agreement with the player that he will sign a ten year contract at 5 million a year. However, you will pay him 8 million for the first five years, and then 2 million a year for the remaining 5 years with the expectation that you really don't expect him to still be playing in the NHL by year ten. Though this honors the letter of the law, it truly circumvents the intention of the law. My team did it, as did several others. This clause has subsequently been fixed, although a new circumvention technique has been created that I won't go into.

This example, is a small example that I believe fits the macro world we live in. Prior to the institution of the salary cap, team could and did spend whatever they wanted. Spending a ton of money on players was not a guarantee that you would win, and in fact, because there are quite a few batshit GM's, that scenario created a plethora of very bad contracts that ultimately drove up the contracts of players who really weren't very good. As for the teams that were both very shrewd and also had very good management, they simply dominated. At present, the NHL remains a fourth tier sport in America, but because of the cap and attempts to grow the sport, the league is far far more profitable and is larger than it had been under previous arrangements. This, of course, is not all because of a salary cap, and even at that, my team and the LA Kings possess 5 of the last 6 championships. Still, with the exception of a relatively small number of poorly run teams, the parity and competition level on a nightly basis is a lot closer than it had been when I was growing up and the league was full of ape sized goons whose only skill was their ability to pummel someone. I do not like everything the salary cap has brought, because on some level, it is a forced parity that punishes teams who put a lot of hard work into drafting and developing their talent just to have some rich idiot GM come along and poach them because they know the team that developed them cannot afford to keep them under the salary cap. Still, the league has never been stronger and may even expand here to Las Vegas.

On the macro level, I feel like the period between 2000-2010 provided a mirror image to what I described above. In the banking world, we undid a host of regulations that kept a lid on speculation, and we allowed massive banks on Wall Street to simply buy up just about every single independent bank across the country. Predictably, consumers got worse, rather than better attention, and the mega banks were allowed to do basically whatever they wanted to make money. Ninja loans, and subsequent creation of toxic mortgages is just one example. While a very select few bankers made a shit ton of money (just like a select few NHL players previously did) what was left behind was giant size pile of crap for the rest of us to pay for. Free markets work up until a particular participant grows so big they can stifle competition from smaller players. Regulations that limit unfair advantage and keep all players in a state of true competition also work until they become so onerous that they stifle creativity and limit reward. I believe a good balanced can be reached, and I see a difference between regulating to keep competition and creating regulation for the sake of central planning.


  1. Apples and oranges I am afraid. The NHL and all of the other sports leagues only exist in a world of no competition, where their business plan must include rules that keep teams within a reasonable amount of competitiveness. No real innovation exists in one ‘franchise’ without it being shared and adopted by all teams. This is no different than a chain like McDonalds not allowing a franchise close to another one without demographic study that shows they can both prosper and thus make McDonalds Corporation more profitable. If they were allow two to directly compete in an area that would not support them… they could both fail and maintaining high standards with struggling profits would be difficult.

    With respect to the bank, the one big thing that happened or didn’t happen was that no one went to jail. The committed fraud, forgery, collusion and any number of other crimes but no one went to jail. Now for a system of law to work… you must enforce the law. People want to wring their hands and say “but if we did that… the world would have a depression”. Two points to that… yes, the depression would have been deeper but as it stands, we are still a fragile world economy and none of the underlying graft has been cleared and secondly William Black successfully restructured the S&L crisis… The tools and knowledge were available. I am pretty will convinced that most of the higher level lawlessness and gambling took place with a relative certainty that the government would fold. Why would it fold… well, for one, the financial aspects and personnel are so entwined with private sector corporations that the fox was in the hen house and secondly and most important is our willingness to let congress farm out responsibility for our nation’s currency rather than us electing people capable of understanding basic finance.

    In the aftermath of Enron and Worldcom we already had regulation in place that make corporate principles responsible for what their companies did… yet no one was even indicted… Something is amiss here because and to my way of thinking it can really only be one of two things… 1) we do not really have an accountable government and it is a proxy for much larger interests or 2) we have a government that is so corrupt and in bed with the banking and multinational businesses to do its job.

    1. Objectively, fraud is hard to prove in a court of law. It is very easy to connect the dots and logically conclude that if originators of ninja loans are selling their paper to wall street, it is inevitable that subsequent securitization of those loans are bound to have failures. So to me, it seems clear people would know they would fail, but I don't think they really intended to scam investors. They simply cashed out and hoped they could get far enough away from it before it all blew up. As for the ratings agencies, these are full of the guys who weren't good enough to land wall street trading gigs. You can say they weren't too bright, but it's hard to say they fraudulently rated used toilette paper as triple A. Of course, there simply was no politcal will to investigate Wall Street like a Benghazi cover up.

      "No real innovation exists in one ‘franchise’ without it being shared and adopted by all teams."

      I see no difference between this and the real world. Why invest in innovation if you can continue to squeeze profit out of an existing idea? At one time, S&Ls were an isolated entity that served a very specific need, and then we removed the regulations that put them into a whole new arena of competition they did not belong in. Hence, S&L operators got fleeced, and we got the bill. Then we repealed Glass/Steagall and did it all over again. Across the country, Wall Street banks simply bought market share rather than opened their own small branches to compete for the business of smaller banks. They just bought those banks and told the customers that if they didn't like it, they could just leave and go elsewhere.

      Going back to sports, in some ways, it is an isolated market, but the mechanics really aren't that different. If the NHL removed the rules that force competition, the rich teams would drive up salaries so far that small market teams could not compete and they would go bankrupt. Hockey would then be a sport that survives and operates only in rich cities. Certainly there are still a couple of teams that suck pretty bad and probably should close their doors. Still, the league as a whole is strong and is able to provide a team for 30 fanbases that generates quite a bit money. In our economy, we have the opposite. Monopolies exist, competition is stifled and quite a few people are locked out of participating in splitting the profit in an equitable way. It's not so apples and oranges to me.

    2. Think about it.
      So think of yourself as a potential chief financial officer three years ago. You know that this stuff has been called toxic waste. You know that
      you're in the midst of what's going to be the largest bubble in the history of the world, financial bubble, which is the U.S. real estate bubble. You know how badly this is going to end.

      But what happens if you don't invest in subprime and Alt-A and your competitors do? During the bubble phase, there are very few defaults on subprime because you simply refinance it. There are much higher fees and somewhat higher interest rates. So the people that do lots of subprime and Alt-A report that they have the highest earnings. Their bosses earn the biggest bonuses. Their stock appreciates. Their
      options become more valuable, et cetera, et cetera, et cetera.

      If you as a CFO refuse to do that – the average CFO in America lasts less than three years. Think of the incentive for the short-time approach. If you don't do it, not only do you not get your bonus because you don't hit the high target figures, but your boss, the CEO, doesn't get his full bonus. And all of your peers don't get their bonus.

      What were the odds?
      The odds were only about 1 in 10,000 that a bond will go from the highest grade, AAA, to the low-quality CCC level during a calendar year. Imagine investors' surprise on Aug. 21 when, in a single day, S&P slashed its ratings on two sets of AAA bonds backed by residential mortgage securities to CCC+ and CCC, instantly changing their status from top quality to pure junk.

      As to Worldcom and Enron.

      Bernie Ebbers is still in jail. The CEO of Enron dead before he could hit jail, Jeff Skilling jail. On occasion there is justice.
      On the flip side, no one in government that passed laws enabling the crisis was held responsible. The Federal Reserve, free and clear. Appraisers who did false appraisal, free and clear. The realtors who lied, free and clear. The people buying houses the knew the could not afford, free and clear.
      And the list continues of all the people who had a hand in creating the crisis yet it's dumped solely on the banking industry.

    3. An excellent post Lou, and intentionally or not, you kind of support my point back to TS that copy catting and beating a dead horse are ingrained in free markets. Your third para there really drives it home. At that level, I have no doubt the Fuld's and Daimon's of Wall Street knew quite well what was going to happen. At the least, I believe they certainly knew they were in the midst of a ridiculous bubble. But, they simply let it go in order to keep pulling in ridiculous fees. This will happen though in any industry, IMO. No one is going to go in a different direction when there is easy money to be made without doing so.

      As to your last para, I tend to look at the Ebbers and Skilling situations this way, they were crooks, but they were not banking crooks. When a firm like Enron or World Com makes analysts look stupid, there is a price to be paid. Also, these occurred outside of a bigger bubble blowing up. I agree with you on the Rogues list, but I don't think the average person who was outside of the industry really understands the connections. I could write for days on little things I saw happen here and there across a ten year period in the credit markets that were obvious steps to a blowup. It couldn't have happened without the Fed, but then again, there was not a peep of protest from the banks on wall street when they decided to make money rather than do their jobs.

      This last piece, is really what I base a lot of my gripes about pure free markets on. Ayn Rand essayed at length about "the trader" being the ideal man who only gives value for value. Originators of loans could care less, they were simply middle men. At the bank level, however, you have a bunch of exceptionally bright people who did know better, but did nothing about it. Like the CFO you described, they all basically said, "Well, everyone else is doing it, why fight the insanity if we can make money on it." They didn't have to buy ninja paper. but it became "hot" like tech stocks and junk bonds. The government doesn't have to tell a bank what it can and cannot trade, but it can and should put limits on leverage and it should punish ratings agencies when a triple A rated security goes belly up in a relatively short period of time. The banks, however, have made it clear they do not want this scrutiny. Hence, we are already releveraged back to the hilt

    4. How do you punish banking crooks when the government via legislation enabled the fraud to occur?
      The Fed Reserve.
      Real Estate agents.
      Fannie, Freddie.
      AIG, insuring when they knew there were problems.
      Buyers via buying what they could not afford and damaging homes in anger.

      The Fed Reserve provided the fuel for the bubble. Without cheap credit, no housing crisis.

      Many had responsibility or contributed to the crisis. Yet not 1 person in government said we made mistakes.

      As far as the people [putting together the paper, sure they knew there was risk. Sure they knew that the bonds included sub prime and short term loans. AIG the insurer certainly knew it a and insured them at the best loan rate. No one from AIG was tagged.

      The banks not the government want the scrutiny. The government is every bit as culpable as the banks. Happens that way when the government is leading the charge. As they said in 2006, everyone has the right to own a home.

    5. Believe me, I am no fan of what the Fed has done and is doing. They are very much a part of the wealth redistribution that has crushed the middle class. Much as I see fraud, I also have to admit that Michael Lewis provided an excellent over view of what happened in his book, The Big Short. The fed and big banks, IMO, are at the very top of the chain and should shoulder most of the blame. You can't convict anyone if you don't even try, and that is what we were faced with. The funny thing, the loans that were actually label as sub prime, or Alt A were not the worst performing. To some degree, those were priced properly. As for AIG, you had a bunch of traders who assumed what they were giving insurance for was AAA. They didn't question it. I don't believe banks really want scrutiny. If they had to mark to market every day, they would not carry so many illiquid securities. There is much that could be done to put limits on leverage, and even this simple thing will not be done. Greenspan once talked about irrational exuberance and markets went into full panic thinking that judgement day had come and the the Fed was going to start reiging things in. They never did of course.

  2. Twenty twenty hindsight. What I'd love you analysts to tell me is what happens when the fed actually begins to move the needle up from zero. Is the move higher already baked into world markets? What happens to the national debt when historical rates are put back in place? Does the shoe drop before or after the next election? Will the monetary central planners crush Obama after propping him up for almost seven years?

    If the masters of the universe all saw the last bubble busting why didn't they all short and get rich? Some did but most bore the brunt of this never ending (great) recession we are mired in.

    Do tell oh great swami. Do tell.

    1. The masters of the universe did not fight it because there is an adage in the trading world, "Don't fight the Fed". Bill Gross, certainly a master of the Universe for some time, openly asked this question a long time ago, and well before the market blew up. They didn't short it, IMO, because there was a ton of money to be made helping to keep pumping up the bubble before it popped. With the exception of Lehman Brothers, none of the banks really paid any price.

      A problem with comments like yours William is that they are so fucking blind. Your hatred of Obama and anything Democrat except for Corey Booker handcuffs you to making everything about Obama, Clinton, or Benghazi. This run up started well before even W coming into office, and much of it can be traced to Reagan appointee and Ayn Rand ass kisser, Alan Greenspan.

      In seriousness, however, I think that what the Fed is basically hoping for is that we eventually have an economy wherein we have a broader base of economic participation, IE a rebuilding of the middle class. If that happens, the tax base will widen, and we will inflate our way out of it. I don't like this plan, but if you are really trying to come up with a way to survive moving the needle off zero, I think this is what needs to happen.

    2. Rebuild the middle class.

      An interesting concept.

      How do you do that when we embrace a global economy where cheaper labor wins? We get cheap junk, they get manufacturing jobs to produce the jobs.

      The upside, it stabilizes a 3rd world countries, brings prosperity to their countries. A foreign relations success.

      The downside it destabilizes the US workforce, the most affected the middle class.

      How do you build a middle class when we have a nation where we encourage open borders cheap labor at home, export middle class jobs?