Monday, April 26, 2010

The Fine Line between Regulation and Manipulation

Thesis: Tools designed to regulate the economy can be used to manipulate the economy.

DeepCapture is critical of Paulson and Goldman Sachs. The lead in to the story states:

The Goldman CDO scandal and other evidence suggests that the U.S. economy was set up for a fall by market manipulating hedge funds.

The gas price chart at the the bottom of this post (from shows a huge increase in gas prices in 2008 followed by a crash ... a sign of manipulation.

For several years, DeepCapture has documented odd stock behavior involving naked short selling. I began following short interest on several stocks and agree that the short selling complicates the process of assessing stock prices on corporate performance.

With these observations in mind, I thought I would parse the difference between regulation and manipulation.

This is not an easy task as the term "regulation" appears to have many meanings. In one sense, it means making things regular. For example, electrical sockets are regular. Because they have a standard design (are regular) we can plug a variety of appliances into any given socket. The electrical socket for my computer predates the PC revolution.

Some people use regulation as a synonym for law.

In the financial world, the word takes on a many different meanings. For example, insurance is used to regulate risk. One pays a regular premium each month to cover irregular health expenses.

Insurance companies are primary investors in our economy. They've applied their thinking about risk to other equities and devised a large number of tools to regulate risk in their investments.

For example, the Mortgage Back Securities that collapsed in the financial meltdown were designed to regulate exposure to individual mortgages. A bank will lend money on a mortgage. The repayment of the loan with interest is a nice regular source of money. If an individual defaults on a loan, the bank has to take a huge charge and lose the regular income. They often have to take this loss in a single quarter.

The system of mortgage backed securities, run by Freddie Mac and Fannie Mae, allow banks to bundle up mortgages into pools. This helps regulate the risk of individual loan defaults.

Credit Default Swaps and the Government Backed Re-insurance were designed to further regulate exposure to risks.

Short selling is often justified with claims that short selling provides liquidity for stores.

The whole Federal Reserve system was designed to help regulate the economy with tools that increased and decreased the money supply.

As I look at this complex set of tools used to regulate finances and the economy, I realized that the same tools can be used to manipulate the economy.

When the tools designed to "regulate" the economy get in the wrong hands, they can as easily be used to create financial destruction.

One might even go as far as to define "regulation" as "manipulation of the economy with the public good in mind."

For example, short selling, which can provide liquidity when a stock is hot, can also be used to destroy liquidity when the stock is in trouble.

Insurance, which regulates risk in normal times, can be used to temporarily hide underlying faults within a market...creating a systemic fault in the economy.

Now, what appears to have happened during the Bush Administration is that the financial world kept all the tools designed to regulate the economy going full bore. These tools generated false profits for financial firms but created a systemic risk for the world economy.

DeepCapture makes a great argument that a large number of the regulatory tools were captured and used by ne'er-do-wells who intentionally created false market signals for economic and political gain.

Unfortunately, as America is caught in a culture war with people clashing over the thesis/antithesis of regulation v. deregulation. We appear to have lost the ability to engage in the serious debate that would lead to a better mix of regulations.

Creating a better mix of tools is not simply the matter of adding a new layer of bureaucracy. Creating a good mix of tools requires the elimination of past regulations that proved problematic. Any new regulations should be carefully measured so as not to create adverse interaction with existing regulations.

Unfortunately, I fear our politically driven legislative process will do little more than to place political operatives in positions where they can, and will, do wrong in the future.

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