Asymmetrical Information

From the desk of Mindles H. Dreck:

The Absence of Regulation is Not a Scandal

Thomas Nephew takes issue with my criticism of Bill Keller's New York Times piece below:

Briefly, it seems to me something went wrong at Enron, more oversight was needed, and Gramm had a hand in preventing that oversight once upon a time. That need not have been with "malice aforethought" to merit Keller's takedown.

Thomas and Ginger apparently are worried that I'm some sort of religious right type, so let me clarify my views on this.

I'm the sort of person who reacts negatively when people say "there ought to be a law". All things being equal, I'm in favor of fewer laws and maximum personal and commercial freedom. I think the idea that the presence of fraud (which is already a crime, folks) is no way prima facie evidence of the necessity of government oversight.

It's the idea that the absence of regulation is a scandal that gets my blood boiling. It reminds me a bit of the "absence of intervention" criticisms used by the Chomskies of the world to condemn the U.S. As a rabid free-marketer (and rabid individual rights proponent), I'm much more worked up about the stupid assumptions about the false panacea of regulation than the nastiness of the article. These guys had a lifetime in power, they can take it. And in two cases they deserve it anyway. I've gone that low a few times myself, and its here for all to see. (Of course, I was entirely justified....)

But I asked out loud as I read it, "is the failure to regulate any business that is not yet accused or proven guilty of fraud a scandal?"

In my book, refusal to regulate should be the norm. There are thousands of bankruptcies every year - in unregulated industries like textiles (Burlington Industries),and in regulated industries like telecommunications, insurance or finance. In fact, anecdotally, my impression is there is more fraud and failure in regulated industries than unregulated, at least on the financial side. Many of them, unfortunately, involve fraudulent accounting. I was a banker once upon a time, and I can tell you every business that is failing attempts to cook its books. Cooking the books actually has little to do with regulation, as practiced by those who might have regulated Enron.

The CFTC, which regulates trading in commodities, futures and options on futures, is there to keep a liquid market and protect investors. They regulate Futures Commissions Merchants (FCMs), the New York and Chicago-based futures and options exchanges (CME, CBOT, NY Mercantile etc.) and other organizations involved in these markets to make sure that customer funds are segregated and properly accounted for, and that sufficient capital is maintained to protect customers and counterparties. I hate to break it to all you fans of regulation, but FCMs fail from time to time. Despite regulation. Can you imagine that? Actually, the industry has its share of scandal, including the trade-allocation swindle that Hillary Clinton benefited from. I don't automatically look at the industry's record and think "can you imagine how much worse it would be without regulation?

Generally speaking, institutional over-the-counter trading is exempt from much of this regulation. There are exemptions for securities sold to sophisticated or institutional investors (hedge funds fall under this exemption usually). A firm does not have to register with the CFTC if it buys futures only for certain exempt classes of clients, such as foreign governments and certain corporations and pension funds. Generally speaking, Enron's derivative trading business was with institutions. They weren't selling energy derivatives to individual investors. By the way, your local heating oil company is, without regulation. They all are, in the form of fixed price or capped contracts, an innovation sparked by Enron and others wholesaling the risk. Perhaps your local heating oil company should have a visit from the CFTC. That would only take a million new examiners, at a cost of...oh forget it.

It was Citibank, JP Morgan and others that were the largest ($) counterparties to Enron. They lost hundreds of millions of dollars. Fooling JP Morgan/Chase may not be as hard as it should be, but its harder than fooling regulators. Morgan has their ears in the market, and they pay to hire smart people, not all of whom are normally blinded by potential corporate finance fees.

Finally, Enron's biggest losses were in affiliates that would have been unregulated anyway. Regulated companies tend to separate their regulated businesses into subsidiaries - hence bank and insurance holding companies. Enron wrote all sorts of fancy derivatives contracts that leveraged their own stock price through affiliates. It was leverage of their own inflated market valuation that turned around on them when the bubble popped. If they were regulated their regulated subsidiary might have been more insulated. Which would have saved a few jobs for a few months.

Keller's Op-Ed, in a nutshell, says "thank God these scuzzballs are out of the Congress. In fact, to use his words, he accuses them of being part of the "Taliban Wing of the Right" and "debasing" the Congress, and, later, being part of the right wing "Mafia."

As I said, a good crack at Helms and Thurmond is worth reading, and I would only note with amusement the "Ad Talibanum" fallacy in Keller's article (I do in the Bullpen every time I see one) but for the poor job he does on Gramm. Likening Gramm to the two of them on the basis of pork and the Enron accusation struck me as a stretch. Pork is not a distinguishing characteristic in Congress. Regulation doesn't prevent financial accounting fraud. The idea that refusing to regulate is responsible for managerial fraud is silly, and deserves cries of indignation.

The rest of my comment was just a shot at Keller for doing such a poor job of "takedown" relative to the warblogging community. That part of my comments was the "era of good feelings" to which Thomas makes reference in his post.

Posted by Mindles H. Dreck at January 12, 2002 11:45 PM | Technorati inbound links