Streetwise Professor

The FT has an interesting article about the difficulties and uncertainties facing cap & trade schemes, even in Europe where they’ve been implemented.  A good part of the article focuses on the loss of intellectual coherence in climate policy in Europe, as regulations and taxes are being mooted to reduce CO2 emissions.  Such command and control bolt-ons are inconsistent with the basic concept of cap & trade, which is that by determining a price of carbon the market will induce efficient responses to reduce emissions on all relevant dimensions:

And the more the carbon market shrinks in its ambitions, the more it faces a broader threat: that of losing touch with its original objective. Credits could continue being traded in the old way. But if the main thrust of carbon reduction is tackled by other means, the market could face questions about its social utility.

But to me, the most interesting part of the article relates to the arcane area of offsets:

Nibble, nibble. Then we come to the aforesaid vexed question of offsets.

That is the system whereby EU companies build projects in developing countries – which are not subject to carbon caps – and thereby earn the right to emit more back home. The premise is that each project emits less than the existing version – or less than some notional alternative, which is not the same thing.

There is scope for abuse here. And, some claim, there is growing protest among locals who might not be too keen on a pulp mill or dam at all, let alone one built with foreign capital. Hence the curious sight reported by one environmentalist of thousands of Thais last year waving placards reading “Stop selling carbon credits”.

Since offset-based credits account for only a fifth of the total, the simplest solution might be to abandon offsets altogether. But that would be resisted by EU industry, since the whole job of meeting carbon targets would thereby fall on EU plants. It would also be a further reduction in the scope of the scheme.

For those not familiar with offsets, these are basically projects that absorb greenhouse gases or lead to reduced production of said gases by substituting low emissions technologies for high emissions ones.  Planting a forest that absorbs CO2 is an example of an offset.  The party planting the forest would receive CO2 credits based on the amount of carbon absorbed by the forest which could be sold.  The income from the sale of the permits can be used to recoup the costs of creating the offset, and earning a return on the capital committed.

As the article notes, Europe relies on offsets for about 20 percent of its CO2 reductions; the US ACES bill passed by the house depends even more heavily on offsets.

I teach (along with colleagues Victor Flatt and Praveen Kumar) what is likely the first university course in carbon trading offered in the US (and perhaps globally).  While teaching the course, prepping for it, and listening to my colleagues and student preparations, I have become convinced that although there is a strong conceptual case to be made for offsets (if it is cheaper to capture carbon somehow rather than reduce carbon output on other margins), the practical difficulties make it highly problematic to rely heavily on them.

The practical objection relates to transactions costs, notably what is sometimes called the measurement branch of transactions cost economics.

Every transaction involves some measurement.  Measurement is costly, and like all costs, it is desirable to economize on these expenses.  Measurement costs can be so large as to make some transactions prohibitively expensive.  Economizing on measurement costs can also affect the nature of transactions.  (As a prosaic example, to prevent excessive, wasteful measurement, it may be economical to package several pieces of fruit in sealed packages, rather than allowing consumers to pick over individual pieces.)

In my lectures in the carbon trading class, I discuss how commodity measurement issues have posed challenges in commodity markets, and how market participants have developed mechanisms to address these challenges.  Based on this history, and and an understanding of the unique issues associated with carbon and especially carbon offsets, I conclude that measurement problems are likely to be extremely knotty in this context.

The root problem is that incentives to monitor quality differ between transactions for “bads” like carbon, and transactions for goods, like wheat or oil. In transactions for private goods, the buyer has an incentive to monitor the quality of the good provided by the seller.  Moreover, the parties to the transaction have an incentive to develop ways to balance the costs and benefits of improved measurement.

In contrast, in a market for pollution, almost by definition the “consumer” in the transaction has no incentive to monitor.  Since the effects of the bad are extremely diffuse, the willingness and ability of those “consuming” it to monitor it are minimal.  Indeed, this is  one of the sources of transaction cost that must be invoked to justify the public regulation of CO2 emissions in the first place (in lieu of private Coasean bargaining, or reliance on torts).

So third parties must do the monitoring.  But this is likely to be very burdensome, for a variety of reasons.  At any point in time, it is a non-trivial problem to monitor the amount of carbon absorbed by any offset project.  Think of the challenges of measuring the amount of carbon absorbed by a forestation offset project.

Moreover, offset projects are supposed to be permanent.  Think of the forest example again.  If the forest burns down, the carbon captured–which has resulted in the distribution of valuable CO2 permits to the developer–is released.  Conceptually, you could provide the appropriate incentives by requiring the developer to acquire and retire an amount of carbon emission permits equal to the amount of CO2 released by the fire.  But here we face a stock-flow problem: the developer may be on the hook for say, 50 years worth of permits.  The developer has every incentive to retain very little capital, and just declare bankruptcy in the event.  So, to give the appropriate incentives to trade-off the benefits and costs of risk of loss of permanence, it may be necessary to require the purchase of insurance; or bonding requirements; or capital requirements.  But how do you price the insurance?  How do you determine the bond or capital that gives the right incentive?  Offset projects differ in permanence loss risks; who measures that risk (which will vary by project and by the efforts of the operator of the offset to control the risk of release) and prices it so that developers have the incentive to create the right mix of offsets?

Presumably we will see the creation of offset rating agencies to address some of these issues.  In light of the financial crisis, enough said?

And here’s another thought apropos the financial crisis.  I predict that if offset projects are created, financial instruments will be created to distribute (“slice and dice”) the risks of loss of permanence, and the risks of underperformance.  Specifically, I predict the creation of CDOs–carbon derivative obligations–that will create offset tranches from portfolios of offset projects.  The lower rated tranches will bear the first risk of loss of performance, the mezzanine tranches the second risk of loss, and the AAA pieces will only fail to pay out completely if the offset portfolio’s performance is so poor that the less senior tranches are wiped out.

After all, failure to produce the anticipated/promised amount of carbon offset is almost exactly analogous to a default, which is just the failure to produce a promised cash flow.  It is therefore to be expected that the risks will be managed, sliced, and diced in very similar ways.

But permanence isn’t the only issue.  Offsets are also supposed to be “additional,” meaning that a particular offset project wouldn’t have been created even without the prospect of receiving valuable carbon credits.  For instance, if the ability to sell natural gas or power makes a project to capture methane viable even absent the inducement of carbon credits, providing such credits provides an excessive incentive to create such projects.

And just how does one measure additionality, exactly?  It requires a detailed understanding of the economics of a particular project.  (The issues here are very complex.  Think of a wind power project.  Wind power is erratic, and typically requires backup from fossil fuel units to maintain reliability.  It’s not trivial to model what the actual amount of fossil fuel consumption that is eliminated by a wind project.)   Moreover, and even more problematically, since these projects are durable, it requires an understanding of the but for equilibrium; what does the equilibrium long term supply curve for these projects look like in the absence of a subsidy (via the provision of credits)?; what alternative technologies are being displaced?  Any measurement of these quantities is highly, highly subjective, and built on layer after layer of assumptions.

These problems would be pretty daunting even if enforcers/measurers had good incentives, and were not subject to influence.  But how does one incentivize those making the evaluations?  How does one economize on influence costs, which are likely to be quite substantial?  Again, all of the problems with rating agencies that culminated during the financial crisis occur in spades here.  And when one considers that offsets are to be created internationally, corruption and enforcement problems may be particularly acute in some jurisdictions.

In other words, offsets sound great in theory, but are likely to be extremely expensive in reality, especially if they are introduced on large scale.  These expenses need to be taken into consideration when evaluating the costs and benefits of cap & trade generally, or of specific cap & trade plans.  Moreover, these costs may prove so prohibitive that it would be better to eschew offsets altogether, or sharply circumscribe their use.  But this will mean that the cost of carbon will be that much higher as the burden of adjustment to caps will be forced onto other margins subject to diminishing returns.

From my perusal of various sources, it doesn’t seem that the measurement issue has been adequately analyzed, or measurement costs adequately quantified.  As a result, it is likely that the costs of a cap & trade system will be far greater than have been estimated.  That is a sobering thought.

In light of Obama’s populist pivot, last week in the WSJ Michael Barone had an interesting analysis of the history of American populism.  Barone is spot on drawing the distinction between leftist “soak the rich” populism and libertarian populism.  The best part of the analysis focuses on Jacksonian populism, which is of the latter strain:

Ask anyone reasonably well versed in American history to name our most populist-minded president, and you’ll likely hear the name of Andrew Jackson. He was the son of Scots-Irish immigrants, raised on the frontier, and he ran the first democratic (and Democratic) campaign. A gang of Jackson’s roughneck supporters, so the legend goes, rushed to the White House after his inauguration and tore the place apart.

But Jackson was not a “spread the wealth” populist. On the contrary, he opposed the American System of John Quincy Adams and Henry Clay to have the government build roads and canals and other public works. He killed the central bank and paid off the national debt.

Jackson argued that government interference in the economy would inevitably favor the well-entrenched and well-connected. It would take money away from the little people and give it to the elites.

That view seems to be shared today in what I have called the Jacksonian belt, the broad swath of America settled by the Scots-Irish from the Appalachian chains in Virginia southwest to Texas. The Obama administration argues that Democratic big government and health-care programs will help the little guys. Jacksonians today, as in the 1830s, don’t agree. [Emphasis added.]

Redistributionist populism of the variety that Obama is now appealing to is quite different in its attitude towards government power.  There are some points of intersection–both Jacksonians and left-populists detest banks–but for the most part the two populisms are diametrically opposed on most economic issues.  And don’t even start on issues relating to the military, terrorism, and foreign policy.

The current political situation in the United States is, in essence, a conflict between Jacksonian-libertarian populists who are deeply suspicious of government power (in large part because of their belief that the government serves specific economic interests) and progressives using populist rhetoric to advance an agenda that would lead to a massive increase in the reach of government power.  This will lead to considerable rhetorical confusion as both sides will employ populist tropes to advance their respective causes.  It’s therefore quite important to keep the distinction in mind, and Barone’s article is an excellent primer on the subject.

In a burning ring of fire?  One can hope.  I refer to the price of Rusal stock, which has tanked even further since its inauspicious reverse pop immediately after the IPO:

United Co. Rusal Ltd., the world’s largest aluminum producer, fell for a third day in Hong Kong trading, extending its drop since last month’s initial public offering to 20 percent.

The shares slumped 4.5 percent to close at HK$8.66 ($1.11) on the Hong Kong Stock Exchange. They cost HK$10.80 each in the IPO. Today marked the eighth slide in nine sessions for Rusal, controlled by billionaire Oleg Deripaska, since trading began.

“Hedge funds that participated have been disappointed with the dynamics of the IPO and are closing the trade and taking the loss,” said Joseph Dayan, head of international sales and trading at Otkritie Securities Ltd. in London. “The fact that liquidity is drying up is another negative.”

Now, part of this decline can be laid to the decline in world markets and the related news regarding the increasingly bleak prospects for the world economy in the past couple of weeks.  But it also arguably reflects that the Rusal IPO had more than a little pump and dump aspect to it.

Speaking of Rusal, Oleg Kozlovsky and I discussed Deripaska during our conversation.  Oleg said that it was widely perceived that Deripaska is willing to abase himself any way Putin desires in order to maintain his position, and that most of the public interactions between the two (e.g., Pikalyovo) are only so much theater.

The massive snowstorm that buried DC had one favorable outcome: it gave me an opportunity for me to meet courageous Russian civil society advocate and opposition figure Oleg Kozlovsky.  Oleg had spoken at Principia College across the Mississippi from St. Louis in its Lectures in Moral Courage series.  He was scheduled to fly back to Moscow via DC, but his flights were cancelled due to the storm.  I found out about this via Facebook, and messaged Oleg that I would be in St. Louis for the weekend, so we were able to get together for breakfast this morning.

Oleg is a very polite, unassuming, and articulate young man.  He has demonstrated his moral courage many times on the streets of his home country, but his is not the courage of bravado or confrontation.  He is dedicated to non-violence; he spent a good deal of his time while waiting out the delay in St. Louis in bookstores looking for books on non-violent protest.

We had a wide-ranging conversation about all sorts of matters, from Putin, to the controversy over his passport, to energy, to Europe and energy, to Kaliningrad, to the effects of the economic crisis, to the militia and OMON, to the military and the effects of the reforms, to Khodorkovsky.  After a while, he smiled and said that he didn’t want to sound so negative, so I suggested that we talk about politics and economics in the US instead–which ended with me apologizing for negativity.

I then took Oleg on a brief tour of some of the sites in St. Louis, notably Forest Park.  Hopefully he’s now boarding his flight back home.

All in all, an enjoyable morning.  One amusing moment came when he asked me about how my blog came to be named “Streetwise Professor.”  I told him that it derived from a combination of (a) the fact that “the Street” refers to the financial markets that I had originally intended to blog about exclusively, (b) the fact that I’m a professor, and (c) my punk rock inclinations.  He smiled and said that he liked the title because it makes him think of street protests.

It was a privilege to meet Oleg, and I wish him Godspeed.  I look forward to seeing him again soon, perhaps in Texas this spring.

No, not me–although I am sure that a few of you would disagree.  No, I refer to Senator Maria Cantwell (D-WA) and her confreres, who clearly have some deep seated neuroses and phobias when it comes to anything involving derivatives and speculation.

Cantwell actually earns a twofer today.

First, she is the co-sponsor of a new cap & trade bill.  Although cap & trade isn’t dead, it is coughing up blood; even Obama has recognized that it has no chance of passing soon.  Along with Senator Collins (R, sorta-ME), Cantwell has introduced a bill that would institute a cap & trade regime.  It is, blessedly, much simpler than the grotesquely bloated, complicated, and convoluted ACES bill that passed the House in 2009; apparently Cantwell and Collins believe that ACES is doomed, and that a simpler bill may be the only hope.  Conservation of paper is, alas, its main redeeming feature.

It isn’t really a cap & trade bill.  It’s better described as cap, definitely, trade, not so much.  And the latter feature is what lays bare Cantwell’s phobias.  To read what she and Collins have proposed is to enter bizarro world.  They impose onerous restrictions on the trade of emissions rights and derivatives on them, apparently out of a belief that (a) speculation is evil, and (b) derivatives can only be used for speculation.

There are two completely non-sensical provisions in the bill that relate to trading emissions rights, and derivatives on them.

First, the bill permits only emitters to own certificates, and to purchase them at (an annual) auction.  This means, specifically, that financial institutions cannot buy or trade certificates.  Presumably, this is intended to bar the market to those malign speculators.  But its actual effects will be to make the market extremely illiquid, and to make it unnecessarily costly for those who have more permits than they need to trade them with people who have fewer than they need; financial institutions would be the natural market makers and liquidity suppliers, and baring their participation would starve the market of liquidity.  This will hamper the efficiency of the market, and make it costlier to achieve the emissions reductions imposed by the cap feature of the bill.  Moreover, it is likely that absent such a restriction, certificates could be used as collateral and facilitate end user financing, an alternative that would be precluded under the bill, making it more costly for emitters to finance their purchases of certificates.

Second, and even more bizarrely, the bill prohibits those very end users from trading any derivative contract on emissions.

Let me repeat: the bill prohibits those very end users from trading any derivative contract on emissions.

Huh?

Under a cap and trade scheme (and I mean scheme), end users are exposed to carbon price risk, and over very long time horizons.  They are natural hedgers who need derivatives to manage that risk exposure, but the Cantwell-Collins bill would preclude them from doing that.  The bill creates risk by pricing carbon, but at the same time denies those affected by this risk the ability to manage it.  That borders on cruel and unusual, and just makes it unnecessarily costly to achieve carbon reductions.  Pain with no gain.

But note the bill doesn’t ban derivatives outright, so Cantwell and Collins are apparently perfectly willing to contemplate a carbon casino where only speculators can play (though not in the certificates themselves).  But the speculators will not be allowed to provide valuable risk bearing services to hedgers.  No, it doesn’t make sense to me either.

Seldom have I seen anything so inane coming out of Congress, and that is saying something.

Separately, Cantwell came out with a call for increased regulation of commodity derivatives generally:

The US commodities market should be freed from “reckless speculation” and abusive trading practices, a leading US senator has urged, as she attempts to stop the price of everyday items like petrol and food from being impacted by financial traders.

Senator Maria Cantwell, who is separately trying to revive the Glass-Steagall reforms of the 1930s which would prevent retail and investment banks from operating under the same roof, yesterday called for increased regulation of the commodities and derivatives market.

The Democrat politician is attempting to push regulation of the commodities markets – a hot topic in the summer of 2008 when oil prices topped $140 a barrel – back to the top of the political agenda.

She is calling for stronger powers for the Commodities Futures Trading Commission (CFTC), including the potential to police the unregulated over-the-counter derivatives market, which has worth $25 trillion at the end of June 2009.

And how, pray tell, does the Senator support her case?  By calling on the vaunted expertise of megatool Michael Masters:

Backed by hedge fund manager Michael Masters, of Masters Capital Management, she called for the proposed reforms to take their place alongside wider financial regulatory reforms currently being discussed by the US Congress.

Mr Masters believes that there is a strong correlation between the credit crisis and volatile commodity costs, which have seen a rise not only in oil prices but in basic food staples in recent years.

Correlation, causation.  Whatever.

Masters and I participated in a workshop on oil markets sponsored by the Energy Information Agency back in November.   I can state categorically that he doesn’t understand the economic function of derivative markets, or of the functions that financial intermediaries play in these markets.  He says things like (I quote from memory, but this is almost verbatim) “financial markets are for allocating resources over time, but commodity markets are to get goods from producers to consumers.”  Well, yeah, but commodity markets are also crucially about allocating resources over time, because the time patterns of consumption and production don’t necessary always match exactly.  In fact, they almost never do.  (Think about a seasonal commodity, like corn or natural gas.)

So even beyond risk shifting, you need futures and forward markets to encourage the efficient allocation of commodities over time; getting stuff from producers to consumers inevitably involves intertemporal trade.  What’s more, financial intermediaries are frequently the best able to perform the function of storing and financing commodities.  After all, what they do is facilitate intertemporal resource allocation, and commodity storage and financing is just a specific example of that.  But not in Mastersworld, evidently.

Talk about the blind leading the blind–or is it the phobic leading the phobic?  Maybe group therapy is available at a discount.

After Masters made this statement at the EIA workshop, I replied along the above lines.  Only less politely.  I started by saying something like: “I can’t believe you said that.  It’s one of the dumbest things I’ve ever heard.  Commodity markets are all about allocating resources over time.”  Always trying to win friends and influence people.

I doubt either of these measures is going anywhere.  Fortunately.  But they reveal a disturbing mindset that is all too common on Capitol Hill, and among the pilot fish that swim symbiotically with the senatorial sharks.

Russia announced with great fanfare the maiden flight of its 5th generation aircraft, the T-50.  This is allegedly Russia’s answer to the F-22 Raptor.  But as Alexander Golts writes, one can never be too sure:

On Friday, we were told that the state-run Sukhoi aircraft manufacturer successfully ran a test flight of a fifth-generation fighter jet in the far eastern city of Komsomolsk-on-Amur. The fighter jet did, in fact, make it up into the air, but it flew in such a dense cloud of lies that nobody can be sure exactly what they saw.

Does the T-50 PAK FA fighter— which journalists have incorrectly called the Russian Stealth — possess fifth-generation aircraft capabilities such as a constant flying speed of more than 2,000 kilometers per hour, a flight range of more than 5,000 kilometers, a low radar profile, radiolocation of distant enemy objects and long-range guided missiles? None of that is clear. Some sources claim that the onboard radio-detection system is still going through bench tests, and nothing whatsoever is known about its weapons systems.

Nor is there any information regarding the engine that is purported to propel the T-50 at greater speeds than its primary rival, the U.S. F-22 Raptor. Several firms engaged in backroom intrigues for years, repeatedly failing to put forward a reliable tender for the engine’s construction. In the end, NPO Saturn won the contract. And the first thing that the firm’s directors did was start telling bald-faced lies about the engine’s capabilities.

Both Prime Minister Vladimir Putin and Deputy Prime Minister Sergei Ivanov have acknowledged that problems with the aircraft’s engine will take a long time to resolve. But on the day of the T-50’s maiden flight, the managing director of NPO Saturn’s Unified Engine-Building Corporation, Ilya Fyodorov, made a sensational announcement. He said the jet is outfitted with “the very newest engine and not an improved version of the Su-35 engine as reported by some media and several specialists. It fulfills all the requirements presented to us by the Sukhoi company.”

Strategy Page is similarly skeptical, reporting that the T-50 is merely a “pimped out” Sukhoi Su-35 or Su-37.  SP also suggests that Fyodorov is blowing smoke about the engines: “The 47 minute test flight was done without the new engines designed for the T-50. Russia has always had problems with high performance jet engines, and those woes continue.”

Like Golts says, 5th generation involves supercruise, speed, and especially stealth.  None of which can be verified from a short test flight.

A variety of factors create doubts.  As Golts writes, promising a spiffy new aircraft is a way of attracting funding.  Moreover, the repeated embarrassments over Bulava make Putin and the military desperate for a success.  And the Russian public also eats up military prowess in a way most Americans don’t (at least nowdays).

So, maybe this is the real deal, but quite possibly not.  And even if a test flight gets off the ground, and the aircraft has the advertised capabilities, it’s another thing altogether to manufacture it in numbers, especially given the decrepitude of Russia’s military-industrial base and the stringency of its budgetary situation.  This is far more likely show than go.

The unsavory reputations of Russian “investors” continue to impede their ability to make deals outside their own commercial cesspools (H/T MJ):

The U.S. Government participated in stopping General Motors from selling Saab to a Dutch automaker in December due to possible involvement in the deal by the Russian Mafia, a Swedish media outlet is reporting.

According to the Dagens Industri newspaper, the Swedish government asked its security force, the Sapo, to investigate the financial affairs of the Convers Group, a Russian investment group owned by the family of billionaire Alexander Antonov that was one of the major shareholders of Spyker when the Dutch automaker made the offer to buy Saab in December. That investigation reportedly turned up a “strong suspicion” of ties between the Antonovs and organized crime, information that was passed on to the FBI. The report goes on to say the the board of General Motors was then contacted by the U.S. Government and told to stop the sale.

Supposedly, the workaround was for Spyker’s founder to “assume ownership” of the Antonov/Convers stake.  It was originally reported that GM’s reluctance related to IP issues (as was ostensibly the case with Opel).  But, apparently IP is code for “infamous persons” rather than “intellectual property.”

A Spyker spokesman issued a hissy-fit denial, but GM’s Planning VP lent credence to the story: “as part of finding a sustainable solution for Saab, we are happy with the structures of the company that [founder] Victor Muller has put in place for Saab Spyker and I’ll just leave it at that.”  If you can’t say anything nice . . .

More rampant Russophobia, no doubt.  Wonder why that is?

I think this calls for a little Joan Jett, don’t you?  And Marky & Dee Dee Ramone & Joan Jett too.

If Economics of Contempt and Yves Smith see something the same way I did, there’s probably something to it, as we seldom see eye-to-eye on much.  That something is the Volcker plan, and Paul Volcker’s defense of it in today’s New York Times.  The essence of the critique is that the plan’s focus on deposit taking institutions is overly narrow, and Volcker’s assumption (as set out in his oped) that non-bank “capital market” institutions don’t pose a systemic risk is just wrong.  As I noted in “Don’t Bank on It” and the follow up post, investment banks and hedge funds and foreign banks not subject to the plan’s constraints will take advantage of the profit opportunities foreclosed to banks by the plan.  These institutions will grow large and leveraged, and even though they are not beneficiaries of deposit insurance, they will be so enmeshed in the financial system that in the post-Lehman environment it is unlikely that governments would forego a bailout were they to run into trouble.  Knowing that, lenders will be willing to finance them at rates that do not reflect their actual risks, and they will grow to large and risky.

Here’s the way Smith puts it:

The consequence of this system of “market based credit” is that those markets have significant scale economies (network effects, high minimum scale required to be competitive, etc.). The result is a comparatively small number of firms have made themselves crucial. The Bank of England in its April 2007 Financial Stability report noted the importance of certain firms it called “large complex financial institutions” and deemed them to be important not simply due to their size, but also their crucial position in certain markets. Its list then was:

ABN Amro, Bank of America, Barclays, BNP Paribas, Citi, Credit Suisse, Deutsche Bank, Goldman, HSBC, JP Morgan Chase, Lehman, Merrill, Morgan Stanley, RBS, Societe Generale, and UBS

Of course, that list is somewhat shorter now, but a bigger issue remains: if you tried breaking the capital markets operations of these dominant firms up, those businesses would tend to evolve back into a concentrated format. And it is these origination and trading operations that make them too indispensable to fail.

In reading Volcker’s op-ed, he completely ignores the 800 pound gorilla in the room, that this crisis extended a safety net under these global trading operations. More important, the industry recognizes full well how it is now situated. These origination and market-making operations will not be allowed to seize up. Before, they merely played with other people’s money. Now they play with other people’s money and a guarantee. Having the officialdom say it ain’t so or pretend it is working towards a solution when it does not yet have one does not fool anyone who understands the real issues.

Put differently, governments’ inability to commit credibly not to intervene to save big, interconnected firms is a huge gravitational pull that encourages the coalescence of such massive entities.  Deposit insurance is not the key problem.  Indeed, deposit insurance can encourage the formation of a lot of small, risky institutions that may pose a systemic risk collectively (see the S&L crisis); it is the inability to precommit not to save the big but failing that encourages the evolution of too big institutions.  And saying that deposit taking banks cannot engage in a certain type of potentially risky activity will primarily foster the development of big firms that don’t take deposits, but engage in this risky activity.

I think that Volcker’s main problem is that he has an anachronistic, and perhaps nostalgic, view of the financial system.  Putting aside the point of whether it is desirable to restore the financial system of the days of Leave it to Beaver, it is clearly impossible to do so.

Maybe all this is moot.  If this FT piece is to be believed, the Volcker plan is DOA in the Senate:

A proposal by former Federal Reserve Chairman Paul Volcker to limit bank’s proprietary trading will be either be dropped or significantly modified in the Senate, lawmakers and staffers told dealReporter.

Senate Banking Committee ranking member Richard Shelby (R-AL) said he opposes the so-called Volcker rule and the Obama administration’s call to levy a USD 90bn tax on banks. His comments come as House Financial Services Committee Chairman Barney Frank (D-MA) predicted the proposals outlined by President Obama could be law within six months.

Speaking to this news service on Thursday, Shelby said if Democrats push forward with the proposals they risk unravelling much of the bipartisan support already reached regarding the passage of financial regulatory reform in the Senate. Shelby said that the Obama administration risks losing Republican support for the bill if they begin to “politicise” the issue.

However, Shelby said he expects to hold a meeting with Banking Committee Chairman Chris Dodd (D-CT) regarding the way forward on regulatory reform in two weeks time. A Democratic banking committee staffer confirmed that the meeting between Dodd and Shelby will be critical as Dodd needs to determine the level of bipartisan agreement and the timing of bringing the bill through committee and on the Senate floor.

With the election of Republican Scott Brown to the Senate, the Democrats no longer have the necessary 60 votes to force through a Regulatory Reform package, and any bill will need at least some Republican support to pass. A Dodd staffer said the senator is likely to quietly drop or modify many of the recommendations in the Volcker rule to ensure Republican support for regulatory reform.

“Chris is retiring so he wants to end his career with an important regulatory reform bill and he wants to make the bill bipartisan,” the staffer said. “He is not going to risk bipartisan support to make the White House happy.”

. . . .

Senator Mark Warner, a Democrat on the banking committee from Virginia, also said he has concerns regarding elements of the Volcker rule, many of which are already being dealt with by the committee. He said that one of the problems is in the definition of what constitutes proprietary trading and that regulators should be more proactive in determining what constitutes excessive risk taking by financial players.

Warner also said that the prospective Senate version of the Kanjorski amendment passed by the House also includes using capital adequacy standards to reign in excessive risk taking by financial institutions and that such an approach gives regulators greater flexibility. [Pet peeve alert: it's rein in dammit, not "reign in."  It's pretty bad when the editors of one of the world's largest newspapers, and a British one no less, doesn't know the difference.]

But apparently JP Morgan Chase isn’t taking any chances about the Volcker rule (as Surya first noted in the comments over the weekend):

J.P. Morgan Chase & Co. is reconsidering its interest in acquiring the North American operations of RBS Sempra Commodities but remains in talks to buy the firm’s European metals and energy trading operations, people familiar with the situation said Monday.

The change in sentiment is tied to J.P. Morgan’s concerns about new proposals by President Barack Obama that could put a kink into any acquisition, as well as the notion that the North American natural gas- and energy-trading business overlaps with some of the bank’s existing operations.

The new proposals from the Obama administration, issued last week, could force a large commercial bank like J.P. Morgan to exit any proprietary-trading businesses like those up for sale.

A good illustration of the effects of policy uncertainty.

Henry Paulson’s new book alleges that Russia attempted to convince China to join it in selling large quantities of Fannie Mae and Freddie Mac (government supported entity, or GSE) bonds in order to force the US government to prop up the GSEs:

Russian officials had made a top-level approach to the Chinese, suggesting that together they might sell big chunks of their GSE holdings to force the US to use its emergency authorities to prop up these companies,” he said.

. . . .

“The Chinese had declined to go along with the disruptive scheme, but the report was deeply troubling,” he said. A senior Russian official told the Financial Times that he could not comment on the allegation.

Bloomberg has more:

Paulson learned of the “disruptive scheme” while attending the Beijing Summer Olympics, according to his memoir, “On The Brink.”

The Russians made a “top-level approach” to the Chinese “that together they might sell big chunks of their GSE holdings to force the U.S. to use its emergency authorities to prop up these companies,” Paulson said, referring to the acronym for government sponsored entities. The Chinese declined, he said.

Russia’s five-day war with U.S. ally Georgia started on Aug. 8, the same day as the opening ceremonies of the Beijing Games. Prime Minister Vladimir Putin told U.S. President George W. Bush during those ceremonies that “war has started,” according to Dmitry Peskov, Putin’s spokesman.

“The report was deeply troubling — heavy selling could create a sudden loss of confidence in the GSEs and shake the capital markets,” Paulson wrote. “I waited till I was back home and in a secure environment to inform the president.”

Putin spokesman Peskov denies the allegation:

Russia never approached China about dumping U.S. bonds, Peskov said today. “This is not the case,” he said by phone.

Note that Peskov is quoted in Bloomberg as a source of information about Putin telling Bush that war had begun; he is not necessarily a definitive source about this other allegation.  Note further that the FT could not get official comment one way or the other.

This occurred about a month before the Feds seized the GSEs, and 5-6 weeks before it all hit the fan in mid-September.  Although there were clouds on the horizon in the late-summer of 2008, there was little to suggest the severity of the impending tempest.  Thus, the Russians should be congratulated for their perspicacity.  I wonder what information led them to this conclusion, and how they obtained it.  (Although, their foresight was not perfect.  Even though the Russian market had already begun to show serious cracks post-Mechel and with the onset of the Russo-Georgian War, the official attitude was that Russia was becoming an economic juggernaut that was immune from adverse economic shocks from abroad.  Not exactly, as events proved.)

Of course, there is a single source for this allegation–Paulson–and he doesn’t provide any real detail as to how he came to know of this gambit, or what information led him to this conclusion.

That said, it is eminently believable.  Combine mercenary motives with the Putinists’ raging complexes and resentments of the US, and their desire to knock America down a few pegs, and to that add the “I wish my neighbor’s cow would die” element of the Russian character, and you can easily see this happening.

If it did happen, it says a lot about the Russian M.O. Clearly, Russia had 65.6 billion reasons to be concerned about Fannie and Freddie.  Moreover, they were rightly anxious about the financial condition of the GSEs, and the potential for a substantial loss in the value of their investment.  But, if Paulson is right, rather than behaving in a constructive and forthright way, Russia instead acted the manipulative gangster, and attempted to play Machiavellian Great Games and score geopolitical points.

Such attitudes should be kept in mind when dreaming about resets, and negotiating arms control agreements, Afghanistan logistics arrangements, and actions against Iran.

I’m not a big fan of Zero Hedge; it’s very high variance.  (Which kinda makes sense, if they’re not hedged:)  But every once in awhile “Tyler Durden” hits the nail.  Apropos AIG, he asks the question I asked, and Hank Greenberg asked: why didn’t the Fed/Treasury simply guarantee AIG’s contracts?:

Why did the Fed not guarantee AIG’s assets ahead of the firm’s implosion. Surely, the realization, which as everyone trumpets these days, that AIG’s failure would have destroyed the world should have been known to at least one person in authority? And as all know, the collateral call toxic spiral commenced only once AIG was formally downgraded by the rating agencies. Well, had the AIG had the formal guarantee of the Federal Reserve, which is implicitly a guarantee by the U.S., then AIG would not have been downgraded in the first place, and no collateral calls would be forthcoming. Of course, Goldman would end up owning CDOs that as Janet Tavakoli points out, and contrary to what the Fed claims, are now worth at best pennies on the dollar. Furthermore, Goldman’s AIG CDS would immediately have become worthless, with Goldman unable to sell them in the open market for a profit of billions of dollars, yet the firm would continue extracting collateral as per its prior arrangement with AIG, in essence not impairing Goldman at all. And had AIG not started down the downgrade spiral, then numerous other adverse consequences of the nationalization of the insurance company would not have transpired. While it would not have saved America’s financial system, it would have made the descent more manageable. Yet with Goldman having benefited massively from the elimination of a vast swath of competitors, one wonders if the guarantee track may have been considered and subsequently denied, under the wise tutelage of 85 Broad advisors. We suggest Senator [sic] Issa and Neil Barofsky focus very closely on any email released as part of the disclosure process that highlight the Fed’s reasoning as to why AIG should not receive a guarantee, and what the nature of such reasoning may have been. [Emphasis added.]

I agree completely that this is the most important question.  The stuff about the disclosures is perhaps easier for the politicians and public to understand, but that’s a side issue, at best.

Timmy! Geithner basically blew off this issue.  Bernanke definitely blew it off.  Issa asked him about it, and in his response letter, Bernanke didn’t answer; he said only that that question had been answered by FRBNY General Counsel Thomas Baxter.  What, is Helicopter Ben averse to spending a few pixels to explain, in his own words, why this option wasn’t chosen?  Lawyering up always looks suspicious.

The refusal to answer this question is very telling.  That’s where the story really is.  Guarantee: no cash out the door, but no AIG implosion either, allowing time to manage the crisis.  There had to have been a compelling reason to eschew this option.  I haven’t heard it yet.  Like Z-H says, let’s see the paper trail.