People want to use more and more of YOUR money to make riskier bets. When people use their own money, things don’t get out of whack. The more the risk/reward equation is manipulated to allow shots at high risk returns by laying the risk off on others, the more bad behavior affects us all.
The best and brightest in our society are used to invent deal structures where risk/rewards are bent and stretched all out of shape, instead of building products and services that we could all use. This is a structural deficiency, I think.
Those of us in the oil and gas business are intimately aware of risk/reward and how to play with the equations. Hell, screwin' bankers ('scroon sum bankers') is the first thing we learn in the business.
The first and most famous promote structure was a 1/3rd for a ¼, where an investor paid 1/3rd of the cost for ¼ of the project, and the originator got a “carried quarter”. Most buyers learned over time to require the promoter hold on to at least some sort of risk position… ie, wanted to see them have some skin in the game, not just a free quarter. This was an indication that the promoter believed in the project enough to keep some money in it. It gave everyone comfort.
Geologists would sell their projects for cash an overriding royalty interest… a cost-free percentage of the gross dollars produced. You learned quickly that you didn’t want THAT geologist making completion decisions. It cost them nothing to make expensive and high risk casing decision, but they had all the upside. Like going to Vegas and getting 20% if all winnings generated on hitting an inside straight without having to put a bet up yourself. This change in the rules results in too many hits on inside straights instead of folding or building on a pair. These would be characterized systematically as “Bad Decisions”, because they don’t maximize overall return. They are, in fact, destructive to capital overall. And it is caused by stupid rules.
Our good ol’ oil business drove a major set of bank failures… failures like Oklahoma's Penn Square Bank and their associates when they broke fertile new ground in wildcat drilling funding by offering non-recourse bank debt. Those were a glorious and heady days for those of us fighting to jam through the front door of the bank, while being jostled by our jowly be-booted brethren like Walmart shoppers on a Thannksgiving midnight. We thought someone had slipped acid into the coffee that morining. See, loaning money to drill wildcats is, in reality, a 1/3rd for a 1/30th deal.
Very nice, heh heh, but alas, unsustainable as a business model. Why would a banker do this? I mean, the data clearly tells you that you are going to get barbequed as a lender under these terms, So why do it? Fees and Bonuses. Banks paid them every year. In this case, the bankers learned that if you are paid to generate loans, not on how well they perform, you are going to push to get loans approved, regardless of how they perform. In other words, “You get what you pay for”.
Bad Behavior Poster Boy Enron, which at one time was a real midstream company with real assets and a real upstream sub, decided, via its McKenzie alum COO Jeff Skilling, that it could do anything in the world and it could somehow similalry de-risk everything it did.
Essentially, this company would enter into all sorts of businesses, and, like all other businesses, it would write business plans for the businesses it entered. Unlike all other businesses, it lobbied the Federal Government to allow it to essentially take the profits it anticipated making from their business plan spreadsheets and recognizing them immediately AS profits! If they didn’t come true, they would take a charge off on them later.
This brilliant breakthrough virtualized every business on Earth, because it magically made an idea tangibly worth whatever you wrote down you thought it might be able to generate in the future, all because the SEC, a regulatory agency, said so! Essentially, every idea is worth whatever you could model on a spreadsheet! A billion dollars! More! Except, of course, in reality, when they are not, which is 99.999% of the time.
Venture Capital firms, all other companies, and house cats already knew that ideas per se weren’t all that valuable. They all must have forgotten to tell Skilling and Lay, and the Enron Board must not have known any house cats. They relied on Attorneys and Accountants to tell them it was "alright". An appeals court, and later the US Supreme Court held that the Attorneys and Accountants couldn't be held liable for this blatant misjudgement, since, essentially, they weren't Enron. Some might fine lawyering went into THAT decision, because it defies all common sense.
Enron would book their future earnings every quarter as real, and manage their earnings by just having more ideas if the earnings were looking a bit weak, like when they didn't generate revenue in spite of the brilliant business plans being passed around.
Like all financial shenanigans, there was just one little problem. It’s called cash flow. They still had to make a payroll for all those folks having brilliant billion dollar ideas, and those pesky “non-idea” businesses with actual equipment and inventory they had the misfortune to still be in.
They initially decided to borrow money off their earnings by way of long term bonds. When that dried up, and the brilliant ideas still weren’t generating any cash, they jumped into what we call “fraud”. Yep. Up until this point, what they were doing was perfectly legal, although patently ridiculous. Their need for cash, the ony real fuel for the funhouse, drove them into creating their “special purpose vehicles” they called Raptors. Essentially, to generate cash, they sold iffy assets at high prices, guaranteeing them with corporate stock that they would buy them back again at a profit. Very nice, EXCEPT that it doesn’t meet the legal or commonsense description of “selling assets”. Imagine you had a cool picture of a 1966 Mustang Convertible. Your wife wanted you to sell it, so you sold it to your neighbor at Blue Book for a REAL Mustang, not a picture, BUT you promised to buy it back for twice what you sold it to him for in 2 years, because your neighbor is not an idiot. And you secured it with a note to your house, because, again, your neighbor isn't an idiot. Problem is, my wife would not say I SOLD the painting.
The housing market meltdown was driven similarly. Politicians like to give things away in return for donations and for being well kept in political hog slop, so what better than promising Homes for Everyone? The problem? People don’t like to loan money they know won’t be paid back.
Essentially, the banks learned from their earlier mistakes, because, Penn Square, being NOT Too Big To Fail, failed. The fellows running similar operations thought “I sure like my cozy job and I sure don’t want to fail, so I am not gonna let anyone talk me into makin’ stupid loans on wildcats”. So what to do? Being an entrepreneurial banker, and still liking the flavor of bonus, the best and brightest we diverted from engineering and such, decide that maybe they can sucker… er, talk politicians into taking the risk part of the whole equation for the “good of the voter… er, people”. Why not let the Federal Government take all the risk via Fannie Mae and Freddy Mac? Think of the ungodly fees we will make if we aren't on the hook for the loans to these people that clearly cannot pay them back? Praise the Lord! Hell, its only taxpayers on the line, and they are less than 50% of the voting public today, and all we have to do is get whore politicians on board, so why the Hell not? Easy money for those that can’t afford it! Yehaw! Plus, it sounds good on the stump. A Chicken in Every Pot! We are doing this for the poor people!
In the end, we are merely talking about two things… debt and the ability to become indebted, and fraud. Is debt a good thing? You bet. It allows us to live very well and to invest for the future. Should poor people be excluded from accessing debt? Hell no. As long as someone, NOT taxpayers in general, are willing to gamble on someone’s ability and propensity to pay back what they own, why get in their way? If a lender is stupid enough to NOT require documentation, so be it. If the borrower is stupid enough to buy something that is guranteed to be taken away from them in the future, so be it. The failure is that either one of these folks expect US, the taxpayer, to make them whole for their very bad decisions.
Free Markets can only be Free if they are transparent and fair. Thus, appropriate government regulations. If you lie to me, you are defrauding me. Lying and fraud are no more an endemic component to free markets or capitalism than robbing a bank is endemic to banking. Both are wrong, and both are illegal. The reason transparency is so important to Free Markets is that it allows capital flows into lots and lots of bets, but not too much or for too long for bad bets. It is a self correcting system. If the bet works, you feed more into it. If it doesn’t, you quit feeding it. Bad bets thus don't burn huge amounts of capital. You need fraud or bad government regulations to waste on epic scales.
Enron and Bernie Maddoff lied about their results. Had Enron said “we are booking all our profits before we realize them, and borrowing money to take care of cash flow until we know whether they do or don’t work”, it wouldn’t have been the hot stock to own. Similarly, had Maddoff said “we really don’t invest anything, we use money coming in to pay the earlier investors a return”, no one would have invested. Easy Peasy.
Our regulatory system didn’t require this level of disclosure, nor did they check to make sure the companies were as represented. Class Action attorneys did a much better job, although they tended to overreach at times, as compared to the regulatory agencies. I find myself in the uncomfortable position of supporting and applauding the plaintiff bar over regulatory agencies, but why am I not surprised? Plaintiff attorneys are part of the free market and respond to free market forces, while regulatory agencies are not. Oh well. Irony abounds, it seems.
“Plaintiff attorneys are part of the free market and respond to free market forces, while regulatory agencies are not” hmmm…I am not sure where you get your “rules” for a fair and free market, but one can take the position a plaintiff lawyer’s role is to become involved after the damage is done. A regulators role is to prevent the damage from occurring in the first place.
If your thinking holds true, we could also do away with the health department and let the plaintiff lawyers sue the restaurants that spread disease, and so on.
One problem we have in America today is defining what constitutes fraud. A case in point is the Goldman Timber Wolf issue, which was securitized mortgage assets that Goldman knew were bad, and then sold them as a “priority’ while shorting the security at the same time to the tune of 10 Billion Dollars. Goldman did not disclose the conflict to the saps that bought Timber Wolf. The mullets lost everything and call it fraud. Goldman calls it “free market” at work. The SEC looks the other way. Now come the plaintiff lawyers, but so much collateral damage has been done. Sub contractors ruined, jobs lost..etc. The financial services sector is out of control. I submit to you that it is not an either / or situation of plaintiff lawyers or regulation. Both are needed in large portions.
Here is a short story on point.
http://www.rollingstone.com/politics/news/the-people-vs-goldman-sachs-20110511
Posted by: Royal Enfield | June 20, 2011 at 09:07 AM
Royal, I think I am going to surprise you and agree. If the goods you buy at the grocery store need to be labeled with what is in them and if they can kill you, complex financial derivatives deserve no less. Your comment on a priori and a postori (or al pastori, my personal favorite) WRT plaintiff attorneys and regulators are good observations as well.
Posted by: Open Choke | June 20, 2011 at 09:50 AM
This day will go down in History!!
Posted by: Royal Enfield | June 20, 2011 at 10:23 AM
Dang.
Posted by: Hondo Lane | June 21, 2011 at 12:03 PM
Scott, I mirror Hondo's thought. Agreement between you and Choke? Dang.
Posted by: Rely on the Prize | June 22, 2011 at 12:18 PM