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An Interview with Frank Partnoy

Deregulation, Derivatives, and Moral Hazard

San Diego, California

Frank Partnoy in his office at the University of San Diego. Photos by Nic Paget-Clarke.
Frank Partnoy in his office at the University of San Diego. Photos by Nic Paget-Clarke.

Frank Partnoy in his office at the University of San Diego. Photos by Nic Paget-Clarke.

Frank Partnoy is a law and finance professor at the University of San Diego. He is also the author of F.I.A.S.C.O.: Blood in the Water on Wall Street, Infectious Greed, The Match King, and WAIT: The Art and Science of Delay. This interview was conducted (and later edited) by Nic Paget-Clarke for In Motion Magazine on September 30, 2013 at the University of San Diego, in San Diego, California.

In Motion Magazine: Please tell me a little bit about yourself.

Frank Partnoy: I was born and raised in the Midwest, Kansas. I grew up in Overland Park, Kansas. Went to public schools through college. Attended the University of Kansas. I’m still a proud Jayhawk. And then went to law school at Yale. Graduated from law school. Clerked for Judge Michael Mukasey in the Southern district of New York, federal courts in New York, for one year and then went straight to work on Wall Street.

I worked at First Boston and Morgan Stanley, mostly in New York, for a couple of years and learned a lot, and wrote a book, FIASCO, about my experiences there. Then, I worked as a lawyer at a firm in Washington D.C. called Covington & Burling for two years. I got married and moved to San Diego in 1997 and have been teaching at the University of San Diego ever since.

Also, I founded a Center for Corporate and Securities Law. It’s a more eclectic, kind of alternate vision of a center for the study of business law and policy issues. The idea is to fill some of the gaps that other centers of study might not be covering. It’s a relatively small, fledgling upstart center but we have great ambitions and are hoping to study many of the world’s business problems.

Financial innovation and deregulation / bad regulation

In Motion Magazine: Going back in time to the ideas of Milton Friedman and his advocacy of privatization, deregulation, and cutting government social programs, are derivatives a product of deregulation? And why?

Frank Partnoy: To some extent derivatives are a product of deregulation, but they are also, somewhat ironically, a product of regulation. The best way to explain that is there have been two forces moving in the financial markets over the last several decades. One has been this wave of financial innovation where people have been developing all kinds of new products, new technologies. Everything from ATM teller machines that enables us to get cash, to easy wire transfers -- traditional banking functions -- to more esoteric financial instruments like credit default swaps and collateralized debt obligations (CDOs) that were the center of the recent financial crisis.

This has been one major shift, this increase in financial innovation. And Milton Friedman and others, including financial economists like Merton Miller, a Nobel laureate (so many of whom were at the University of Chicago) advocated this financial innovation as being an un-alloyed good. That this is a development that was important and beneficial and would make the world a better place.

The second change over the last few decades has been in regulation. As opposed to just the core innovation on the business side, there have been dramatic changes in law. And this requires a distinction between a wave of deregulation that freed up the markets to engage in this financial innovation I described, and then also a wave of regulation, a radical increase in rules and attempts and by regulators to specify the kind of things that people could do -- in advance. I’ll just give you one example of this.

In the 1970s, regulators began to use credit ratings, triple A (AAA), double A (AA), single A ratings of bonds in financial regulation. They would say, for example, if you are a broker/dealer who sells stock and bonds that the amount of capital you have to have is a function of the credit ratings of your assets. If you have a lot of AAA that is good. If you have a lot of lower-rated assets that is not so good.

Well, this idea of regulators passing rules that depended on ratings spread like wild fire throughout the markets and throughout our laws so that by the time the Financial Crisis happened there was an intricate web of all types of legal rules that depended on credit ratings. And one of the things that this does is that when you match this regulation with the financial innovation that I described earlier, you get very perverse effects.

For example, highly-regulated banks and pensions funds that face rules requiring them to buy AAA securities will reach and stretch and be open to buying things that are rated AAA but in fact are not remotely related to what a normal human being would think of as being AAA. Much of what got sold and bought during the years leading up to the Financial Crisis were financial instruments that appeared to be low risk, because they were rated AAA, but in fact were very risky.

So, these two kinds of tectonic plates that have been moving over the last thirty years have been colliding in ways that are fundamentally unhealthy and problematic. I think the collision is more complicated than just saying the markets were deregulated. Actually, I think it’s a combination of financial innovation and both deregulation and bad regulation.

Purchase some aspect of government power

In Motion Magazine: So, on the subject of regulation, on the relationship of the banks to the government, it seems that without the government: 1) changing the rules -- such as undoing Glass-Steagall; 2) advocating for derivatives through Alan Greenspan (editor: Chairman of the Federal Reserve of the United States from 1987 to 2006) and others, 3) not seriously enforcing what few regulations there are -- the weak Securities and Exchange Commission (SEC); and 4) bailing out the banks and large corporations when there are problems -- derivatives such as they are wouldn’t exist. What is your understanding of this power relationship?

Frank Partnoy: I think the relationship between bankers and government is a tight one, and is becoming tighter and tighter over time. And it is not a coincidence.

There is literature called public choice theory, which basically says that whenever private parties have a concentrated economic interest they will want to lobby and takeover the governmental apparatus that is most relevant to them. Also, that they will have more of an incentive to do that for their own benefit than the rest of society collectively will have an incentive to counter-balance them for their benefit.

In the race between Wall Street and Main Street, we would predict that Wall Street would have the incentives to win, and in fact would win. That Wall Street would be able to, in a sense, purchase some aspect of government power. I think one of the things that we have observed over the last few decades is the increasing influence of Wall Street, just as this theory would predict.

It is particularly true in the areas of complex finance and financial innovation that the major banks have developed very sophisticated lobbying organizations. That they have become major contributors to political campaigns. That they have undertaken considerable expenditures in elections. And this is really without regard to political party. One of the interesting things that the banks did was to dramatically increase contributions to the Democratic Party during the 1990s, and with great success.

Bailout private sector gambling

The dismantling of Glass-Steagall and the separation between commercial and investment banking was eviscerated during the 1990s. The deregulation of derivatives was cemented during the eleventh hour of the Clinton administration in 2000. The story is of Wall Street having concentrated interests and being involved in the regulatory apparatus.

Most recently and pointedly this is illustrated with the bailout of the banks post the Financial Crisis. Only the much-despised and maligned Lehman Brothers didn’t manage to obtain government support in the aftermath of the crisis. And, subsequently, the banks have continued to do quite well in lobbying for the financial regulation that became Dodd-Frank (Wall Street Reform and Consumer Protection Act) to exclude the most onerous provisions that would hurt the banks’ business.

(Similarly), in arguing that the Federal Reserve should continue to keep interest rates artificially low so that the banks can effectively borrow money from the U.S. government at close to zero percent and then lend that money to the U.S government for a longer term at, say 3%, and pocket the difference. This trade is known on Wall Street as the “carry trade” and has been generating huge profits for the banks since the Financial Crisis.

I think anyone looking at the history of the last few decades would see that banks and governments have gotten into bed together and have become progressively more intimate over the last few years. This has had serious consequences, not just in the United States but outside of the United States, as well. One of the things that it has done is to create what economists call moral hazard. The idea of moral hazard is that we will all take on extra risk if we know that we are insured, if you know that there is no down side. If you could gamble your firm’s money and know that if you made money for the firm that you would get paid a $10 million bonus, but that if you lost money nothing really bad would happen and that you wouldn’t have to pay for the losses, you would have an incentive to gamble.

That kind of incentive has spread throughout the world as governments have been willing to bail out private sector gambling. A lot of what we have seen, the spread of risk-taking not just in the United States but elsewhere in emerging markets, in Greece, in Argentina, has been a massive increase in the willingness to take on risk by individuals who believe that they won’t suffer as a result.

The U.S. Securities and Exchange Commission

I think you pointing to the Securities and Exchange Commission in the United States is another illustration of the problem.

We, for historic reasons, have separated civil enforcement from criminal enforcement. Civil enforcement means that the government can go after you but the most they can do is make you pay a fine or maybe prevent you from working in the industry. Criminal enforcement means you go to jail. We’ve decided to separate those two functions in the financial markets so that the Securities and Exchange Commission has the ability to civilly enforce the laws but can’t throw anyone in jail. Only the Department of Justice and the United States Attorneys’ offices on the federal level have the capacity to prosecute. The result of that has been to have largely toothless enforcement of criminal sanctions at the highest levels on Wall Street. This has created a lot of anger among the public who would like to see senior executives prosecuted for their misdeeds.

But the primary regulator of the financial markets, the Securities and Exchange Commission, simply does not have that capacity and the Justice Department, at least so far, has been unwilling to bring those cases. There’s a tremendous frustration about that in addition.

In general, the relationship between Wall Street and government has been a kind of partnership, working together, and that’s good if you work on Wall Street. But, as we’ve seen, it is less good if you don’t.

Economic efficiency and a-legality

In Motion Magazine: Particularly in Infectious Greed, you write about the culture of doing what is economically sensible as well as mentioning several times economic efficiency. Likewise, at one point you say that people in finance are acting in an a-legal way. Later, you express hope that some changes to financial regulations, which you suggest, might actually lead to fostering honesty. Are these cultural problems perhaps a result of basing our social relations on economics, instead of perhaps solidarity and reciprocity?

Frank Partnoy: (Your question) is actually about the tension between economic efficiency and morality or fairness. Economic efficiency is a ruthless concept, but an important one. If we all just were lying around on sofas all day long, and not engaging in productive activity, we couldn’t generate the wealth and products and intelligence in technology that make all of our lives better off. There’s a certain way of thinking that economics dictates that is helpful in increasing productivity. But it also in some ways is massively dysfunctional.

If you only think about the financial costs and benefits of activities, then, particularly if you work in banking, you will find yourself in situations where the thing that is economically right to do, that will generate the most profit for you and your firm, can be deeply problematic and unethical.

One of the challenges of this collision of financial innovation and regulation is that often the law doesn’t provide people with much guidance in a way it might in other areas. We believe as a society that it is wrong to murder someone and so we have laws that unequivocally say that it is illegal to murder someone, with certain exceptions for self-defense and so forth. There’s a law on the books that comports with people’s morality and behavior in a general sense.

But, in financial markets that is often not the case. Instead, the legal rules are convoluted, complicated, and lack any moral or ethical underpinning. They simply tell you that you will benefit from behaving in a certain way.

A frequent problem with respect to legal rules in business is that instead of telling you you should drive safely or drive carefully, they tell you to turn left here, or take two right turns here. They reward or penalize conduct without regard for any sense of whether it is right or wrong. “We are going to tax this kind of transaction but not that one.” “We are going to let your firm avoid reporting a liability when you do a swap but not when you trade a bond.” These rules don’t have moral force for the people in the market who are subject to them.

So, for example, I wrote in Infectious Greed about Enron. Many people regarded Enron as evil and regarded the people who worked at Enron as immoral. But, I actually think the story is more subtle and complicated than that. By and large, the people who are working at financial institutions, or complex economic institutions like Enron, who are engaging in conduct that turns out to be deeply problematic, not only don’t believe that they are doing something wrong, they have a strong argument that what they doing is not prohibited.

This is the distinction between something being legal or illegal that we normally confront in our lives, but that distinction doesn’t necessarily exist in a lot of business transactions. Instead, transactions occupy a kind of gray area, a kind of nether land between illegal and legal, and so I use the term a-legal to describe something where we simply don’t know whether it is legal or illegal. We can’t tell from the specifications of legal rules. Is using a swap wrong in some way? It is not really wrong. It might be wrong in certain uses, but it falls into this kind of gray area of alegality. We end up with people, human beings, who are engaging in activities without a moral compass.

It is not that they are necessarily evil. If you told them that it is wrong to behave in this way, and you will be punished for it if you behave in this way, they probably would change their behavior. But, because of the way financial regulations have spread, we have areas where we simply don’t have clear standards of conduct for people and their behavior. It’s almost like instead of having a principle that says you should not commit murder, we have specific rules that say: you should not commit murder with a knife, you should not commit murder with a gun, you should not commit murder with a noose, and that’s it. We leave all these gray areas, and if someone comes up with the idea of committing murder by smothering someone with a pillow and it’s not prescribed conduct, they rationalize murder as falling into this gray area.

One of the interesting things is people have recognized how foolish it would be to prohibit murder in that very rules-focused way, but we haven’t recognized how foolish it is to regulate the financial markets in a heavily rules-based way. As a result, we’ve got massive amounts of dysfunctional behavior we would normally call unethical or immoral that falls into this gap.

Derivatives: options and forwards

In Motion Magazine: Going through your books, it seems the idea of derivatives has been continuously developing. It seems defining them is either quite simple or extremely complex. The simple version seems to be: a derivative is an off-the-books agreement in which the underlying process terminates with a capital exchange whose quantity is derived from the gambled-upon result of that underlying process. Though oftentimes it’s just a front for trickery. Can you give me a definition and perhaps a brief overview of the stages of development of derivatives?

Frank Partnoy: The basic definition of derivative hasn’t changed over time. It might not be particularly useful, but here it is: a derivative is a financial instrument whose value is based on or derived from something else. Now, that’s a very broad definition, so what is it that we mean when we say derivative? The problem is that we can mean lots of different things.

There are really, at the core, two classes of derivatives: options and forwards. An option is a derivative because its value is derived from some underlying thing. For example a call option on stock gives you the right to buy stock at a specified time and price, and the value of that call option is derived from the value of the stock.

Likewise, a forward transaction might involve a farmer and a baker agreeing to exchange wheat in one year. The farmer is going to have a crop coming to harvest and the baker is going to need wheat and so they agree that in a year the farmer will sell a bushel of wheat to the baker. That’s a derivative because the value of that forward contract, or agreement, is derived from the underlying price of the wheat.

The relationships can be quite complex but they share this common characteristic: no one worries too much about basic options and basic forwards. Those are categories of derivatives that have existed for thousands of years, that are widely used, that have important functions. They permit people to hedge risks and can be very useful. The definition of a derivative at its core includes products that are not especially problematic and even potentially helpful and part of what we would want a well-functioning economy to include. So, why have derivatives gotten a bad name? What has happened to the market for these relatively simple options and forwards that has changed so much? There are a couple of things.

Swaps: regulatory arbitrage incentives

One is the proliferation of what are called swaps. A swap is essentially a series of forward transactions where one party agrees to pay another party over time based on changes in some financial variable. The most basic one is an interest rate swap where I might agree to pay you a fixed rate and you’ll pay me a floating rate over time based on a million dollars, or some amount of money.

These instruments also are potentially very useful. In fact, when they were first developed in the 1970s and 1980s, they were used for all kinds of hedging purposes. But one of the things that happened was this unholy combination of deregulation and regulation created incentives to use derivatives in two very problematic ways.

One was for something I call “regulatory arbitrage,” which is a term for avoiding the cost of legal rules by entering into a transaction that is economically equivalent to something else but avoids its costs. You can either buy “A” or “B”. “A” is regulated and you might have to pay a tax, or disclose it, or treat other people fairly if you do “A”. But “B” is not regulated, or, differently regulated. It’s economically the same. It will get you the same payoff, the same results, but it won’t be taxed, or you won’t have to disclose it, or you won’t have to treat people fairly.

So, one of the things that happened with derivatives was there were changes in regulation that created lots of “A”s and “B”s out there, where “A”s were securities that were regulated, or financial instruments that were regulated, and the “B”s were derivatives that were un-regulated, or differently regulated. (Well), parties started using the “B” form, or derivative, in all kinds of dysfunctional ways: off the books, off balance sheet, borrowing huge amounts of money without recording it.

And this continues today. Derivatives are used for these kinds of regulatory arbitrage transactions, in the trillions and trillions of dollars. If you look at any bank today, even a bank that you regard as safe, it will have massive contingent liabilities that are not recorded on the books -- that are off the books.

One of the amazing things about this first category of regulatory arbitrage is that it’s become almost uncontroversial in the markets and in government. People just assume this is what derivatives are used for. Yes, it results in hiding things, enabling companies to avoid taxes, and all this dysfunctional unfair behavior, but that’s just the way it is. We accept it.

Swaps and information asymmetry

There’s a second way that derivatives are used and that’s maybe even more problematic. Again the label is a fancy term, “information asymmetry.” What does that mean? That’s a professor’s term for there being a sophistication, or information gap where one person knows what he or she is selling, the details of what he or she is selling, and the other person doesn’t.

This kind of thing happens all the time in the markets. If you go to buy a car, you go to buy any sort of product in the store, there is an information asymmetry between the company that makes your laundry detergent, or a car you want to buy, and you.

We have in most areas lots of legal rules that attempt to level the playing field so that the marketplace will work. If you always thought that people would be trying to poison you, or trying to take advantage of you, ripping you off, then you might not even be willing to go to that store and buy products. The markets wouldn’t be able to function well, and often they don’t function well.

Outside of finance, we have a well-established set of rules that tries to combine capitalism with consumer protection. In the financial markets we don’t really have that any more. It’s more of a “caveat emptor”, buyer beware, free-for-all market, particularly in the case of complex derivatives.

If you are a wealthy individual or an institutional investor, even if you are not very sophisticated, you don’t have the same kinds of protections that people have in other markets. The banks aren’t necessarily under any obligation to disclose the risks of a complicated product, or to tell you about the worst-case scenarios of what might happen with the product. The result is it’s quite a profitable business for the banks to sell complex products that people don’t understand. There has been a tremendous compression in the profits for banks from selling simple things, like stock and bonds, and that has driven the banks to sell more complicated products where the margins are much higher.

So, where you are thinking about derivatives, it’s not just a simple definition, it is how they are used that really matters. When you create these two incentives, this regulatory arbitrage incentive and this information asymmetry / information gap incentive, what you do is incentivize the financial institutions to engage in increasing degrees of complexity in order to make money at the expense either of the law or of their clients and counter-parties. This is where derivatives have gotten a bad name and have really deserved a bad name.

Incomprehensible and risky

In the 1990s, there were lots of derivatives that were sold to municipalities or pension funds, where municipalities and pension funds took on massive risks and didn’t understand them and lost huge amounts of money. Then, similarly, in the Financial Crisis lots of investors took on massive risks linked to subprime mortgages and didn’t understand them. One of the most amazing things about the use of derivatives leading up to the Financial Crisis was that it wasn’t only the less sophisticated municipalities or pension funds that lost money, it was the banks themselves.

One of the things that has happened with derivatives is that they have become so complicated that even the parties who create and trade them lack the capacity to assess and monitor them. We have these massive banks that have become not just black boxes but black boxes with risk managers who don’t understand what black boxes are. It’s true even at the most conservative banks.

Earlier this year, I did an investigation of Wells Fargo with Jesse Eisinger, a Pulitzer Prize-winning reporter for The New York Times and ProPublica, and what we found was that even a respected conservative institution like Wells Fargo is still engaging in massive amounts of derivatives transactions that are incomprehensible and risky.

We have this term derivative which on its face has a relatively simple innocuous meaning, but what has happened over the last few decades is that these potentially simple products have become infinitely more complicated and are used in ways that are infinitely more troubling.

And, all this happened while we’ve had regulators doing this two-step I described before, the combination of deregulation and highly specific rules. And the reason that is an un-holy combination, when you add derivatives to the mix, is that the deregulation allows parties to do whatever they like, and the regulation of highly specific rules are always out of date. It is regulation looking in the rear-view mirror. The regulation creates even more dysfunctional behavior because the banks see these rules and say, “OK, let’s transact around the rules.” “Let’s get around the rules.” This is where the amorality creeps in, as well.

From hot potato to boomerang

In Motion Magazine: In Infectious Greed you write about how after Enron, and after and Global Crossing, the banks didn’t lose much money because they had Credit Default Swaps and Collateralized Debt Obligations which saved them and made it so that someone else paid them back the money they lost. If that was so, then why didn’t that work for the banks in 2008? Something had changed?

Frank Partnoy: Infectious Greed was published in 2003, and I describe these risks as a hot potato, the idea or metaphor being that the banks would get the risks, realize they were hot, and then pass them off to someone else. One of the things that we learned in 2008 was in the build-up to the Financial Crisis there was some extent to which the hot potato metaphor still held, that the banks were originating subprime loans and then securitizing them, bundling them together and selling them to other people, but the metaphor had changed from a hot potato to a boomerang.

Essentially what the banks were doing was originating these mortgages, taking on the risks, selling them off to someone else, and then entering into even more complicated versions of these Credit Default Swaps and Collateralized Debt Obligations, in which they took the risks back onto their institutions, like a boomerang. Tossing it away and then it comes back and slices their heads off.

What is remarkable about the Financial Crisis was that they didn’t appear to understand that they were taking these risks on. And that’s a very complicated story about what are called Super Senior Tranches of Synthetic Collateralized Debt Obligations.

Basically, what it means is that the banks had bet that the reasons that people default on their mortgages wouldn’t change very much. That people default on their mortgages because they lose a job, or lose a loved one, or have a health issue -- and that those were predictable over time. What the banks didn’t predict was that the correlation of defaults would increase dramatically if you originated large numbers of subprime loans to people who only had a sliver of equity in their houses. That enabled bets on just those people, as opposed to the traditional borrower. So that the reasons why people would default had changed from divorce, losing a spouse, losing a job, to being highly contingent on housing prices.

Synthetic collateralized debt obligation

What happened was derivatives enabled the banks and others to place huge bets that were focused on packages of subprime mortgages only. In other words, they could bet on a subprime mortgage a hundred times. They could bet on it repeatedly. It isn’t just that they buy an interest in the mortgage loan. Through derivatives, they could gamble on the same loan over and over again. And, if you have a concentrated pool of bets on subprime mortgage loans, and then housing prices decline by twenty percent, then one of the things that happens is that everyone defaults on their mortgages.

Whereas in the past you might have said, “Oh, the correlation of defaults is never going to be that high.” If you had a pool of a hundred mortgages, you would almost never see more than say ten of them default because not every one is going to lose their job. Not everyone is going to get a divorce. Not everyone is going to have a loved one die. The difference is when you shift to investments that are focused on pools of subprime mortgages only, without very much equity in them, if housing prices decline by twenty percent or thirty percent, the incentives for every single person in that pool are such that every single one of them should default. They’d be crazy not to default, really, given how underwater all of them were in their mortgages.

These bets that the banks have made, you can think of them as sort of being like buying flood insurance on the top ten floors of a twenty story building. The CDOs have layers to them and the super-senior part is like the top ten floors. In the past, the floods that had occurred were never very high and that’s because the assumptions had always been, and this in fact had been true, that the waters would not rise to a high level. But, what the banks started doing was locating these buildings in areas where if in fact there was a flood the flood would be twenty stories high. So, when housing prices declined by thirty percent, that was a flood. All of the mathematical models that the banks had used were proved wrong and the entire twenty stories were hit.

The banks thought that they had off-loaded this risk but in fact by taking on the risk through these super senior-positions on synthetic collateralized debt obligations, synthetic meaning that you have bets on the underlying mortgage as opposed to owning the mortgages themselves, because of those the derivatives ended up behaving like a boomerang.

That was how they were able to both off-load the risk and end up taking on the risk as well.

Markets become manic

In Motion Magazine: Ok. But why did it drop the thirty percent which started the flood?

Frank Partnoy: There are various explanations as to why it dropped. Some are macroeconomic, in focus, ...

In Motion Magazine: The underlying problems of the economy?

Frank Partnoy: Exactly. ... and some are about the cyclical nature of markets. This is what happens. Housing prices don’t always stay the same, or slightly go up. They go up and then they crash. They go up and then they crash again. This happens in stock markets in the U.S. and all around the world. Sometimes it’s the case that markets become manic.

Charles Kindleburger has a classic book called Manias, Panics and Crashes, which is a book about finance but it really is a book about psychology. It talks about how markets will enter periods of mania, like the 1920s in the stock market, or like 2005-2006 in the subprime mortgage market. Ultimately, people will realize that these loans or investments have become unmoored from reality and it’s unsustainable and that’s when they panic. And, when they panic there is a crash and the market suddenly declines.

But it’s a heated debate about why it is that housing markets declined by thirty percent. There are lots of factors.

Counterproductive and destructive

In Motion Magazine: Historical sociologist Giovanni Arrighi talks in his books about four stages of capitalism. He refers to them as the Iberian/Genoan stage, the Dutch stage, the British stage, and the U.S. stage. He says that in each of these periods there’s a time of material expansion and then one of financial expansion. Finance supersedes material and lays the basis for the following phase. Well, it seems like today we are in a period of financial expansion. Our crises are certainly about finance. And I bring this up in particular because of something you mention at the end of the Enron chapter of Infectious Greed when you refer to Nobel Prize-winning economist Ronald Coase and his question about which will dominate, corporations or markets. Markets superseding companies. What does that mean exactly? Is this Milton Friedman’s dream come to fruition? Something else?

Frank Partnoy: It’s a really an interesting question. Clearly there’s been an increase in financialization so that we are in the second half of this stage, if you believe in those stages. The financial segments of the market are much larger than you would anticipate they would be if they were simply matching people who have capital with people who need capital, which is the basic function of the financial market. So, they are doing much more than that and much of it is counter-productive and destructive.

How does it end? I don’t know. It does have a kind of cyclical feel to it. I don’t know if this is what Milton Friedman and Mert Miller and the other Chicago economists hoped for when they applauded the rise of financial innovation and deregulation, but I sort of doubt it.

Corporations or markets

In Motion Magazine: And what does it mean to transcend companies into markets?

Frank Partnoy: Ronald Coase had this idea that there was a borderline between the firm and the market. If it were more costly to engage in transactions within a firm versus a market, that you would see movement away from firms to markets and vice versa. That essentially the firm and the market are alternative ways of providing the goods and services that are the backbone of an economy. You can do it within an organized structure or you can do it with no organization at all, in a pure market setting.

You can imagine walking down the streets of Mumbai with individuals selling any kind of product you can imagine and no organizational setting at all, on the one hand. (And on the other hand) the massive multinational companies that we see in the developed world that are selling products. (Within India, the Tata Group is an exemplar of the organizational setting.) And one of the interesting things about finance is we have these behemoth banks now, these massive organizations, but it is very costly to do these transactions within a firm. This means that you get all kinds of shenanigans and you don’t understand what is happening.

So, which one is better? I don’t have a clear answer to the question but I think what we are seeing is a re-engagement of what Coase was talking about. This kind of bipolar distinction between how transactions could find a home. I think it is a legitimate question to ask whether the people who have favored deregulation have actually ended up with the opposite of what they intended. They ended up with these massive highly-regulated organizations that are much more dysfunctional than even a market would be.

Betting on collapse

In Motion Magazine: When you were writing, for example, about the 1997 Asia Financial Crisis you pointed out that as soon as investors sensed that there was a crisis in Southeast Asia, a lot of investors reversed their bets and in essence bet on their being a crash so that they could make money on the crash. If you step back one more step, you can almost see all of these crises, taken together, as a giant bet against the whole economic set-up. This is perhaps emphasized by the fact that the crises and the reactions are getting more and more frantic. I know this is a speculative question, but what do you think of the idea that perhaps the very nature of Credit Default Swaps, of CDOs, of the sovereign defaults spreading through Ireland, Greece, Spain, Slovenia, Cyprus et cetera are a process of reversing a bet on the ability of the economic system to survive?

Frank Partnoy: One thing I think you put your finger on is very sophisticated people typically end up making lots of money on not just the run-up but the collapse. That was true in Asia. It was true in the Subprime Crisis and it will be true in the next crisis. And there are lots of people betting now on collapse. They might be right and they might not be right. I don’t know.

The measures of volatility in the markets are quite low but the markets are behaving as if there won’t be a collapse. The received wisdom widely held is that there won’t be a collapse anytime soon and there are some smart investors who regard that as the time to bet on collapse. It’s cheap now to bet on a collapse. If you wanted to buy put options, which are basically insurance policies against disaster, they are as cheap as they have been in a long, long time.

I think, one of the interesting questions is what function these people are playing in the world. It used to be the case that people would say, “Oh, these naysayers are destructive.” The banks in 2008 complained about short sellers driving the prices of their securities.

People like to vilify folks who bet against the markets, but in many ways I think we should actually be celebrating them and thanking them. That they are heroes, in a way. What they are doing is showing us how irrationally optimistic we have become about certain aspects of the markets and then punishing us when we do become too optimistic.

It is fascinating that they end up getting rich off of that as well. There is a business out there of betting on and profiting from the destruction of others that actually has an arguably positive and stabilizing effect on the markets. It’s a really radical idea, but an intriguing one that I find in a bizarre way sort of comforting.

Published in In Motion Magazine December 15, 2013

An Additional Note from Frank Partnoy -- "I want to thank Nicholas Paget-Clarke for preparing so thoroughly for this interview, and for asking such thoughtful questions. Interview subjects sometimes try to influence, or edit, transcriptions of their interviews. Sometimes such editing is necessary, depending on the quality of the interviewer's work. But the credibility and authenticity of the interview can suffer as a result of editing. I want the reader to know that, out of respect for Mr. Paget-Clarke, I didn't edit anything. He transcribed the interview, and I read it. But I didn't change a word."

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