Root causes are hard to solve, whether drugs or CDS

Stratfor (one of the best geopolitical intelligence companies in the world – and that published a great global intelligence report weekly on their website) recently published a report on the drug trade.

One key takeaway is how flexible the drug supply chain/logistical operations are. When the US and its South American partners started achieving success in thwarting the transfer of drugs (primarily cocaine) from Colombia and Peru to the US by ship and air, they switched to overland routes through Mexico. This is one of the reasons for the tremendous growth in the Mexican drug cartels and the shrinkage of the Colombia cartels. If you have been watching the news lately, you can’t avoid seeing story after story about the Mexican cartels. Because Mexico has a much bigger economy than Colombia or Peru, and it has such a porous border with the US to bring in money and guns, it was easier for the Mexican cartels to branch out into other industries than it would have been for the South American cartels. The “war on drugs” may have been a critical tipping point in creating the problem.

Now that the US is turning to the Mexican cartel problem, there is emerging evidence that the logistics chain is shifting more volume back to air and sea. It’s still going through Mexico, but that could change as well if the US and Mexico have success against the cartels.

So what do we learn from this? Solving problems is a lot more complicated than finding a proximate cause and mitigating it. The root cause is always much deeper. Whether it’s addressing demand in the US as stated by Hillary Clinton in her recent speech or legalizing marijuana as requested by the posters to Obama’s Town Hall meeting, what we do know is that the supply chain is not the problem.

Also, this should give us pause as we re-regulate the banking industry. When the G-20 meets this week, that is #1 on the agenda. But if they focus on the proximate cause(s) like the CDO market or AIG, it will all be a waste of time and we will just be setting the world economy up for another crash in the next decade.

The problem wasn’t specific investment types or specific regulations. The problem, as it has been for millennia, is that almost every transaction has asymmetric information. The seller usually knows more about what he/she is selling than the buyer can possibly know. And the buyer knows more about what he/she is paying with than the seller. Capitalism is based on mutual gain through trade. But what looks like a great deal (7% annualized return on mortgage-backed securities backed by the US government through Fannie Mae and insured through an AIG credit default swap) may not be so tasty when you unpeel the fruit.

But regulating MBS and CDS will just shift the financial industry to start dressing up some other investment type. I think that the proposal to require all financial institutions that create derivatives to keep at least 20% of the derivative in house would be a good start. Whatever they dress up, at least they eat 20% of the losses.

The next challenge is the personal incentives. When an investment banker (or anyone else) can get their money out before the market realizes the true worth of what they created, even the requirement I just described won’t work. It would be easy for someone to convince themselves that their newly invented derivative is a great product (not that anyone would do this on purpose), get their millions in annual bonus, and then watch while Rome burns from the comfort of their estate in the Hamptons. This requires moving incentives from short term to long term, perhaps matched to the duration of the securities they work with. If you sell 6-month bonds, you can get 6-month incentives. I’m not sure how to make this work for 30-year bonds, but you get the idea.

I know that if we are true free marketers, this should be done by the banks, not by the feds (or the G-20). But since the banks are run by people getting these same incentives, I think that at least for now, we may need it to be enforced at the government level.