Streetwise Professor

August 26, 2015

Donald Trump Can Only Aspire to Match Obama’s Economic Ignorance

Filed under: Climate Change,Economics,Energy,Politics,Regulation — The Professor @ 8:00 pm

Yesterday I said Trump and O’Reilly were in a cage match to determine the world champion of economic ignorance. There is another contender of course, the current occupant of the office to which Trump aspires. Actually, I would say that Obama is the undefeated reigning world champ, and that the O’Reilly-Trump set-to was merely to see who might contend for the title in the future.

Obama’s gobsmacking ignorance-served up with a heaping side of superciliousness-was on full display at the “Clean Energy Summit” in Las Vegas on Monday. Time is finite, and my energy is only intermittently renewable, so I can’t possibly deconstruct these vaporings in detail. So I will limit myself to a few high-level comments:

  1. Obama’s claims that his policies on renewable energy and carbon will make a meaningful impact on climate is a massive fraud that would land you or me in jail. Obama’s own EPA acknowledges that the policy will reduce global mean temperatures by an imperceptible and irrelevant .02 degrees by 2100. Farenheit? Celsius? Who cares? It matters not. It is rounding error on any scale.
  2. Obama’s mantra is all about the jobs that his renewables policies are creating and will create. Jobs are costs, not benefits.
  3. Further, Obama is clueless about the seen vs. unseen. To the extent that these policies raise the cost of electricity, they will have adverse consequences on wealth and income in consuming sectors, and in sectors that could produce electricity more efficiently, but for the subsidized competition from renewables.
  4. And yes, these policies will increase costs. Renewables are intermittent and diffuse and therefore require backup resources to ensure reliability; there is often a long distance between renewable sources and demand, meaning that new investments in icky transmission are required; and there is often a negative correlation between renewable production and electricity demand (e.g., the wind usually stops blowing when it’s really hot). Just look to Germany, with its Energiewende fiasco if you have any doubts. There is a strong correlation between electricity costs and fraction of electricity from renewables, and although this could be due in part to an endogeneity issue (those with more costly electricity sources utilize more renewables), this does not explain the entire effect.
  5. Obama and other boosters of renewables boast about falling costs of solar. Wind is conspicuously absent from this discussion, even though it represents the bulk of renewables generation. Further. Fine! When these inexorable efficiency gains make solar economical as a large-scale source of electricity, it will be able to compete without subsidy. This is no reason to subsidize now. This technical progress in solar argument is a non sequitur of the first magnitude.
  6. Obama and other boosters rave about capacity additions attributable to renewables. Well, due to the intermittence issue, capacity utilization is very low. It takes a lot more than 1MW of renewable capacity to replace 1MW of thermal or nuclear capacity. Indeed, if the wind ain’t blowing, all the windmills in the world can’t replace one conventional plant.
  7. Obama’s ignorance is on full display when he claims that conventional electricity generation was not characterized by “a lot of innovation.” This is just a crock. Compare heat rates of plants 20 years ago to those of today: in California, for instance, thermal efficiency has improved by 17 percent over the last 13 years. Heard of combined cycle, Barry? There has been considerable innovation in electricity generation. Well, not at the light switch plate, which is probably the extent of Barry’s familiarity with the electricity value chain.
  8. Obama mistakes opposing subsidies with being anti-free market. Welcome to bizarro world. And, as is his wont, he did so in an Alinskyite fashion, demonizing his opponents (the always handy Koch Brothers) in a very personal way.

I could go on, but that would be an S&M exhibition, and this is (usually!) a SFW site.

Suffice it to say that in Las Vegas Obama gave a demonstration that proves that when it comes to economic illiteracy, Trump can only aspire to fill Obama’s shows.

And yeah. Take a moment to absorb just what that means.

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August 3, 2015

Adding to Atlas’s Burden: The EPA’s CO2 Rule

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — The Professor @ 6:41 pm

Acting under the aegis of its most malign agency, the EPA, in its unbending effort to hamstring the US economy, the Obama administration today released its long dreaded CO2 rule. The Rule mandates a 32 percent decrease in CO2 emissions by 2030. This outcome will be achieved by a dramatic reduction in the use of coal powered generation, and its replacement by renewables.

The administration touts its generosity by pointing out that compliance with the Rule has been extended by 2 years.

Great. We get screwed in 7 years, instead of just 5. Gee. Thanks. How thoughtful. You really shouldn’t have.

The Rule is tarted up with a cost-benefit analysis which purports to show massive benefits and modest costs. The benefit is in the form of improved health, in particular through the reduction in respiratory ailments.

But every step of this analysis is literally incredible. Consider the steps. First is an estimate of how the regulation affects climate. The second is an estimate of how climate affects health. The third is an estimate of the value of these health benefits. None of these calculations is remotely plausible, or even is it plausible that they can be made realistically, given the incredible complexity of climate and health.

And note the bait and switch here. The Rule is touted as a solution to the Phenomenon Once Known As Global Warming. But the Rule itself admits that the effect on temperature will be point zero one eight degrees centigrade by 2100. This is effectively zero, meaning that the “Climate Change” benefit of the Rule is zero.

The health benefits come from reductions in particulates from coal generating plants. So why not regulate particulates specifically?

This all points out that cost benefit analysis for large federal rules is basically Kabuki theater. Some laws require this analysis, but since courts give so much deference (under Chevron) to agencies, that this analysis is not subject to any serious scrutiny. Consequently, the process is ritual, not a serious check on agency discretion.

The Rule is grotesquely inefficient even if you believe this Making Shit Up And Calling it Science!® “cost-benefit analysis.” An efficient rule would achieve its results at lowest cost. But the command-and-control EPA rule does not do this.

Originally, the Rule was expected to lead to a substitution of natural gas for coal. But we can’t have that, can we, given that natural gas is a fossil fuel (even if Nancy Pelosi doesn’t think so)? So the current rule encourages the use of renewables.

The economics of renewables (especially wind) are atrocious. They are intermittent and diffuse. Intermittency strains reliability, and requires maintaining backup generation. Germany (and other countries, including Spain) have gone all in on renewables, and it has been a disaster. Energiewende has saddled Germany with high costs and lower quality power that has imposed great costs on German manufacturing. (Fluctuations in wind and sunlight induce fluctuations in frequency that wreak havoc with precision manufacturing processes.) California is already on the verge of reliability problems when the sun sets during winter months due to a sudden drop in solar generation (aka the swan problem) that requires a sudden ramp up of conventional generation: but the supply of solar during daylight hours undermines the economics of conventional generation. Wind power in Texas is leading to frequent bouts of negative prices which reduce the profitability of conventional generation necessary to maintain reliability.

The Rule acknowledges reliability issues, but the response is totally inadequate:

[T]he rule requires states to address reliability in their state plans. The final rule also provides a “reliability safety valve” to address any reliability challenges that arise on a case-by-case basis.

That’s just great. EPA says: “Yeah, we know renewables create reliability issues. Not our problem! You figure it out, states.” Note that this is problematic because the electrical grid is interconnected, meaning that retiring a coal plant in one state can have serious effects on reliability in numerous other states. So how do individual state plans efficiently address these inherently interstate issues? And as for the “safety valve”, the case-by-case analysis is likely to be cumbersome and costly.

Let’s get down to cases. By its own calculations, the proposed Rule will have a risible effect on global temperature. Therefore, there is no cost benefit justification for the control of CO2 per se, the ostensible purpose of the rule. If there are substantial benefits from reducing particulate emissions, then tax these emissions at a rate commensurate with these costs and let utilities and others find the most economical way of complying.

But that’s not the point, is it? Obama and the EPA don’t want efficiency. They have an intense ideological animus against fossil fuels, and a romantic attachment to renewables: many of the Democrats’ largest donors are have a strong investment in renewables. Pigouvian approaches would likely result in the failure to litter the landscape with bird blending windmills and massive solar panels, so they prefer command and control approaches instead.

And did I mention that Obama insinuated that if you oppose the Rule you are racist?

This new Rule is a piece with the last 6 plus years of grotesquely inefficient legislation and regulations. Frankendodd. Obamacare. Net Neutrality. Each of these add huge amounts of new weight that the Atlas of the American economy must bear. An economy subjected to such burdens will survive, but it will not thrive. The EPA’s new Rule will provide no meaningful benefit, and any benefits that it does generate will be gained at excessive cost. But that is the Obama way. That is the leftist way.


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July 21, 2015

The Fifth Year of the Frankendodd Life Sentence

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 7:52 pm

Today is Frankendodd’s fifth birthday. Hardly time for celebration. It is probably more appropriate to say that this is the fifth year in the Frankendodd life sentence.

So where do we stand?

The clearing mandate is in force, and a large fraction of derivatives, especially interest rate and credit index derivatives are cleared. This was intended to reduce systemic risk, and as I’ve written since before the law was passed and signed, this was a chimerical goal. Indeed, in my view the systemic risk effects of the mandate are at best a push (merely shifting around the source of systemic risk), and at worse the net effects of the mandate are negative.

Belatedly regulators are coming around to the recognition of the risks posed by CCPs. They understand that CCPs have concentrated risk, and hence the failure of one of these entities would be catastrophic. So there is a frenzy of activity to try to make CCPs less likely to fail, and to ensure their rapid recovery in the event of problems. Janet Yellen has spoken on the subject, as has the head of the Office of Financial Research, Robert Dudley of the NY Fed, and numerous European regulators. Efforts are underway in the US, Europe, and Asia to increase CCP resources, and craft recovery and resolution procedures.

This is an improvement, I guess, over the KoolAid quaffing enthusiasm for the curative effects of CCPs that virtually all regulators indulged in post-crisis. But it distinctly reminds me of people madly sewing parachutes after the rather dodgy plane has taken off.

Further, these efforts miss a very major point. The main source of systemic risk from the clearing mandate derives from the huge liquidity strains that clearing (notably variation margin on a rigid time schedule) will create when the market is stressed. There has been some attention to ensuring CCPs have access to liquidity in the event of a default, but that’s not the real issue either. The real issue is funding large margin calls during a crisis.

Moreover, as I’ve also discussed, efforts to make CCPs more resilient can increase pressures elsewhere in the financial system (the “levee effect.”) Relatedly, regulators have not fully come to grips with the redistributive aspects of clearing–including in particular how netting, which they adore, can just relocate systemic risks.

I therefore stand by my prediction that a regulation-inflated clearing system will the source of the next systemic crisis.

Moving on, I called the SEF mandate the worst of Dodd-Frank. In the US, the majority of swap trades are done on SEFs, though mainly through RFQs rather than the central limit order books that Barney and Co. dreamed about in 2010.

There was never a remotely plausible systemic risk reducing rationale for the SEF mandate. Hence, if SEFs are inefficient ways to execute transactions, the mandate is all pain, no gain. As an indication of that this is indeed the case, note that virtually all European banks and end users stopped trading Euro-denominated swaps with US counterparties exactly when the mandate kicked in. The swaps mandate was too onerous, and anyone who could escape it did.

In a piece in Risk, I referred to the Made Available to Trade part of the SEF mandate the worst of the worst of Dodd-Frank. It made no sense to force all market participants to trade a particular kind of swap on SEFs just because one SEF decided to list it. Apparently that realization is slowly sinking in. The CFTC recently held a meeting on the MAT issue, and it seems as if there is a good chance that the CFTC will eventually determine what has to be traded on SEFs.

It is an indication of my loathing for MAT as it currently exists that I consider that an improvement.

Still moving on, Frankendodd was intended to reduce concentration and interconnectedness in the financial system. The actual result cannot really be called a mere unintended consequence: it was the exact opposite of the intended effect. Completely predictably (and predicted) the huge regulatory overhead increased concentration rather than reduced it. This is particularly true with respect to clearing. Gary Gensler’s dream of letting a thousand clearing firms bloom has turned into a nightmare, in which the clearing business is concentrated in a handful of big financial institutions, exacerbating too big to fail problems. And clearing has turned out to be the Mother of All Interconnections, because every big financial institution is connected to all big CCPs, and because pretty much everyone has to funnel the bulk of their derivatives trades through clearinghouses.

I could go on. Let me just re-iterate another risk of Frankendodd: standardization–the regulators’ fetish–is  a major source of systemic risk. Monocultures are particularly vulnerable to catastrophic failure, and the international regulatory standardization that was birthed in Pittsburg in 2009, and enacted in Frankendodd and MiFID and Emir, has created a regulatory monoculture. Some are grasping the implications of this. But too few, and not the right people.

I’ve focused here on the sins of commission. But there are also the sins of omission. Frankendodd did nothing about the Fannie and Freddie monster, which is coming back from the dead. F&F was a real systemic risk, but the same political dynamic that fed it in the 1990s and pre-2008 is at work again. Get ready for a repeat.

Frankendodd should have just focused on raising capital requirements for banks and other financial institutions with liquidity and maturity mismatches, and driven a stake through Fannie and Freddie. Instead, it sought to impose a detailed engineered solution on an emergent order. This inevitably ends badly.

So maybe it would be more accurate to say that we’re in our fifth year on death row. Someday the warden will come knocking.

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July 18, 2015

Nothing Says Panic Quite Like Three TARPs

Filed under: China,Economics,Energy,Politics,Regulation — The Professor @ 3:41 pm

The invaluable Christopher Balding has been tracking closely the massive financial support the Chinese government has been injecting into the banking system, the shadow banking system, local governments, and the stock market. In a blog post earlier this week, he estimated that this support totaled at least $692 billion, rising to $933 billion if the Reserve Ratio cut is counted as a subsidy to the banking system.

These funds went to the local government bond program I wrote about in June, an  investment in pension funds, PBOC 6 month loans to banks, and PBOC loans to the Chinese Securities Financing Corporation, which in turn will lend these funds to buy stock on margin.

But it’s hard to keep up! Christopher kindly shared with me his most recent calculation, which shows that the Chinese government keeps pumping in the money, most notably an additional $200 billion in loans to intermediaries who will use these funds for margin lending, and a rumored (but not yet confirmed) $160 billion in additional support for provincial municipal bonds. This brings the total to $1.3 trillion.

In RMB, that totals over 8 trillion (with a “t”, boys and girls). To Sinofy Evertt Dirksen: A trillion here and a trillion there, and pretty soon you are talking real money.

Another metric: $1.3 trillion is approximately three TARPs. Maybe we should start using that as a new unit of measurement, as in, “Chinese authorities intervened in the market and banking system today, providing an additional .5 TARPs in state funding.”

Yet another metric: $1.3 trillion is almost exactly $1000 per Chinese citizen. TARP was about $1500 per American. But China’s per capita GDP is (depending on whether you use exchange rates or PPP) about 1/5th or 1/7th of US GDP per capita. Thus, a low middle income country is spending roughly 3 to 5 times more per person as a percentage of per capita income than the high income US did. (Given that Chinese GDP is likely overstated-another issue that Christopher has analyzed in detail-the true multiples are even higher.)

Such massive spending-arguably the most gargantuan stimulus package ever-is not the sign of a confident leadership. It is a clear sign of panic.

Remember the extreme panic in DC and Wall Street in the post-Lehman period that culminated with TARP? Even in that hysterical environment, people questioned the need for and advisability of TARP. But in the end panic won out. That is the only reason TARP passed: people were scared stiff at what would happen if it didn’t.

Now think of how panicked the Chinese must be to implement measures that dwarf TARP. That’s what economists call revealed preference. Or, in this instance, revealed panic.

This gives the lie to official statistics, which showed a (patently unbelievable even absent this massive stimulus) .1 percentage point decline in the growth rate. Also giving the lie to the official statistics is the collapse in China-driven commodity prices, notably iron ore and coal, and oil as well. The slowdown in commodity economies further discredits the official Chinese data.

The Chinese stock market is getting most of the attention. This is the drunk-looking-under-the-streetlamp-for-his-keys phenomenon. The stock market is visible, and people can relate to it: this is why the government is using massive carrots (notably the support for margin lending) and even bigger sticks to try to arrest the decline. This would suppress the most visible manifestation of crisis. But the real dangers are lurking out of sight, in the leveraged sector (most notably the rats’ nest of non-bank lenders, but the banks are concealing a lot too), SOEs, and a real economy whose performance is masked by dodgy official statistics.

I’ve long referred to China as the Michael Jackson Economy, kept going by intense dosages of economic/financial drugs, cosmetic surgeries, and stimulants. The Chinese authorities are now administering the biggest dosages ever. This is an indication that the patient is doing quite badly. Further, although such actions may delay the inevitable, they make the end all the more horrific.

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July 15, 2015

The Joint Report on the Treasury Spike: Unanswered Questions, and You Can’t Stand in the Same River Twice

Filed under: Derivatives,Economics,HFT,Regulation — The Professor @ 11:39 am

The Treasury, Fed (Board of Governors and NYFed), SEC, and CFTC released a joint report on the short-lived spike in Treasury prices on 15 October, 2014. The report does a credible job laying out what happened, based on a deep dive into the high frequency data. But it does not answer the most interesting questions.

One thing of note, which shouldn’t really need mentioning, but does, is the report’s documentation of the diversity of algorithmic/high frequency trading carried out by what the report refers to as PTFs, or proprietary trading firms. This diversity is illustrated by the fact that these firms were both the largest passive suppliers of liquidity and the largest aggressive takers of liquidity during the October “event.” Indeed, the report documents the diversity within individual PTFs: there was considerable “self-trading,” whereby a particular PTF was on both sides of a trade. Meaning presumably that these PTFs had both aggressive and passive algos working simultaneously. So talking about “HFT” as some single, homogeneous thing is radically oversimplistic and misleading.

But let’s cut to the chase: Whodunnit? The report’s answer?: It’s complicated. The report says there was no single cause (e.g., a fat finger problem or whale trader).

This should not be surprising. In emergent orders, which financial markets are, large changes can occur in response to small (and indeed, very small) shocks: these systems can go non-linear. Complex feedbacks make attribution of cause impossible.  Although there is much chin-pulling (both in the report, and more generally) about the impact of technology and changes in market structure, the fundamental sources of feedback, and the types of participants in the ecosystem, are largely independent of technology.

Insofar as the events of 15 October are concerned, the report documents a substantial decline in market depth on both the futures market, and the main cash Treasury platforms (BrokerTec and eSpeed) in the hour following the release of the retail sales report. The decline in depth was due to PTFs reducing the size (but not the price) of their limit orders, and banks/dealers widening their quotes. Then, starting about 0930, there was a substantial order imbalance to the buy side on the futures: this initial order imbalance was driven primarily by banks/dealers. About 3 minutes later, aggressive PTFs kicked in on the buy side on both futures and the cash platforms.  Buying pressure peaked around 0939, and then both aggressive PTFs and the banks/dealers switched to the sell side. Prices rose when aggressors bought, and fell when they sold.

None of this is particularly surprising, but the report begs the most important questions. In particular, what caused the acute decline in depth in the hour leading up to the big price movement, and what triggered the surge in buy orders?

The first conjecture that comes to mind is related to informed trading and adverse selection. For some reason, PTFs (or more accurately, their algos) in particular apparently detected an increase in the toxicity of order flow, or observed some other information that implied that adverse selection risk was increasing, and they reduced their quote sizes to reduce the risk of being picked off.

Did order flow become more toxic in the roughly hour-long period following the release of the retail number? The report does not investigate that issue, which is unfortunate. Since liquidity declines were also marked in the minutes before the Flash Crash, it is imperative to have a better understanding of what drives these declines. There are metrics of toxicity (i.e., order flow informativeness). Liquidity suppliers (including HFT) monitor it in real time.  Understanding these events requires an analysis of whether variations in toxicity drive variations in liquidity, and in particular marked declines in depth.

Private information could also explain a surge in order imbalances. Those with private information would be the aggressors on the side of the net imbalance. In this case, the first indication of an imbalance is in the futures, and comes from the banks and asset managers. PTF net buying kicks in a few minutes later, suggesting they were extracting information from the banks’ and asset managers’ trading.

This raises the question: what was the private information, and what was the source of that information?

One problem with the asymmetric information story is the rapid reversal of the price movement. Informed trades have persistent effects. I’ve even seen in the data from some episodes that arguably manipulative (and hence uninformed) trades that could not be identified as such had persistent price impacts. So did new information arrive that led the buyers to start selling?

A potentially more problematic explanation of events (and I am just throwing out a hypothesis here) is that increased order flow toxicity due to informed trading eroded liquidity, and this created the conditions in which pernicious algorithms could thrive. For instance, momentum triggering (and momentum following) algorithms could have a bigger impact when the market lacks depth, as then smallish imbalances can move prices substantially, which then triggers trend following. When prices get sufficiently out of line, these algos might turn off or switch directions, or other contrarian algorithms might kick in.

These questions cannot be answered without knowing the algorithms, on both the passive and aggressive sides. What information did they have, and how did they react to it? Right now, we are just seeing their shadows. To understand the full chronology here–the decline in depth/liquidity, the surge in order imbalances from banks/dealers around 0930, the following surge in aggressive PTF buying, and the reversal in signed net order flow–it is necessary to understand in detail the entire algo ecosystem. We obviously don’t understand it, and likely never will.

Even if it was possible to go back and get a granular understanding of the algorithms and their interactions, this would be of limited utility going forward because the emergent ecosystem evolves continuously and rapidly. Indeed, no doubt the PTFs and banks carried out their own forensic analyses of the events of 15 October, and changed their algorithms accordingly. This means that even if we knew the  causal connections and feedbacks that produced the abrupt movement and reversal in Treasury prices, that knowledge will not really permit anticipation of future episodes, as the event itself will have changed the system, its connections, and its feedbacks. Further, independent of the effect of 15 October, the system will have evolved in the past 9 months. Given the dependence of the behavior of such systems on their very fine details, the system will behave differently today than it did then.

In sum, the joint report provides some useful information on what happened on 15 October, 2014, but it leaves the most important questions unanswered. What’s more, the answers regarding this one event would likely be only modestly informative going forward because that very event likely caused the system to change. Pace Heraclitus, when it comes to financial markets, “You cannot step twice into the same river; for other waters are continually flowing in.”




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July 12, 2015

The Chinese SEC, as in, Securities Execution Commission

Filed under: China,Economics,Politics,Regulation — The Professor @ 7:45 pm

Trying to staunch the bleeding in the stock market, China is unleashing the full power of a police state. A Securities Execution Commission, if you will:

China’s police ministry is teaming up with the securities regulator to probe short selling, as the government works to stem a stock plunge that has erased $3.9 trillion in market value.

The Ministry of Public Security said it will help the China Securities Regulatory Commission investigate evidence of “malicious” short selling of stocks and indexes, according to a statement on its website Thursday. Vice Public Security Minister Meng Qingfeng visited the regulator’s offices in Beijing on Thursday, the official Xinhua News Agency said earlier on its microblog.

The move comes after the securities regulator pledged to “strictly” punish market manipulation and China’s state-run media blamed short selling, rumor-mongering and foreign meddling for fueling the stock slide. The ruling Communist Party has announced an unprecedented series of measures to boost shares, including banningmajor shareholders, executives and directors from selling stakes.

Whenever a police ministry “teams up” with securities regulators, watch out. You can bet-and it wouldn’t be speculation!-that some poor schmoes are going to do hard time for manipulative short selling. And China being China, it is not beyond the realm of possibility that some really unlucky bastards will wind up in front of a firing squad or inside a mobile execution van.

And isn’t it always the way? Stock price declines are always blamed on short sellers. Always. And with stocks, manipulation accusations are thrown about on the way down, but never on the way up.

If the Chinese authorities want to find a market manipulator, they need to look no further than the nearest mirror.  Which is precisely why they are so intent on finding someone else to blame.

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July 8, 2015

Monkeys Fly in China

Filed under: China,Economics,Exchanges,Regulation — The Professor @ 5:56 pm

In the very early days of this blog, I told the story about what Chief Economic Advisor Beryl Sprinkel said on Black Monday, 1987, when a panicked Treasury Secretary James Baker wanted to close the stock market: “We’ll close these markets when monkeys fly out of my ass.” No monkeys flew, and the markets stayed open, eventually stabilized, and then recovered.

But many monkeys are flying out of many asses in China. Although the authorities have not closed the stock markets, individual companies have halted trading in their stocks: trading in more than one-half of the listings in China is currently suspended.

Halting trading more than for a short interval in order to resolve information asymmetries and permit the flow of liquidity to stocks that have just experienced an information event (as during a temporary stock halt in the US) is in general a bad idea. (Post-87, Greenwald and Stein wrote a paper published in the JOB laying out this argument.) An uncoordinated and extended halt of many stocks is a really horrible idea, because of the negative externalities. That is, uncoordinated flying monkeys wreak even more havoc than coordinated ones.

Halting trading in a large number of stocks increases selling pressure on stocks that are still trading. This happens for at least a couple of reasons. First, individuals who need to raise cash (e.g., to meet margin calls) are forced to concentrate their sales in the stocks that keep trading. This tends to concentrate selling pressure, rather than diffuse it. Second, individuals who want to rebalance their portfolios away from equity into cash or bonds have to concentrate their sales in the stocks that continue to trade. Again, this concentrates selling pressure.

This creates a vicious feedback loop. A number of companies halt trading, which forces selling pressure to spill over with greater force on other stocks, which leads some of these companies to halt trading, which intensifies selling pressure on other companies, and so on. The ultimate likely outcome is a protracted lockdown of the entire market. Protracted because who is going to be the firm to restart trading first, and risk having everyone sell the hell out of them?

The vaunted Chinese economic managers (ha!) have well and truly bungled this one. They should have prevented open-ended trading halts, or had a coordinated stoppage and restarting of trading. The coordination failure at work now is manifest.

Again, I believe that the sharp selloff is more of a symptom of a deeper economic problem than a potential direct cause of such a problem. The main adverse spillover that the stock selloff could cause is through the margin debt channel. Margin calls could lead to fire sales of illiquid assets. Again, the more stocks that are not trading, the more severe these fire sales in non-equity assets will be: this is another adverse consequence of uncoordinated monkey launches. Moreover, failures to meet margin calls will saddle the lenders (themselves often highly leveraged) with losses. Both of these channels could have adverse consequences in the brokerage, banking and shadow banking sectors. Their balance sheets are not that hale and hearty to begin with, and this kind of shock could spark broader financial distress throughout the sector.*

In other words, the stock market decline is less of a crisis in itself, than a potential catalyst to a crisis via informational and fire sale channels. And perversely, uncoordinated trading halts in the stock market are more likely to intensify than mitigate any such catalytic effect.

But the Mandarins know everything, so I’m sure it will turn out swell.

In the meantime, the Mandarins have a message for all investors in China. Good luck with that!

* Perhaps one could argue, as Michael Brennan did when trying to explain price limits in futures markets in the JFE in 1986, that halting trading could ease pressure on margin credit. I am skeptical though. Even if stocks stop trading, margin lenders are likely to demand additional security in current conditions. Indeed, trading halts that reduce the informational content of stock prices create a source of uncertainty to margin lenders which they are likely to compensate for by demanding additional margin based on their estimate of the stock price once trading recommences, plus a premium to compensate for the uncertainty.

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June 15, 2015

Always Follow the Price Signals. I Did on Brent-WTI.

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 8:18 pm

As a blogger, I am long the option to point out when I call one right. Of course, I am short the option for you all to point out when I call one wrong, but I can’t help it if that option is usually so far out of the money (or if you don’t exercise it when it is in) 😉

I will exercise my option today, after reading this article by Greg Meyer in the FT:

West Texas Intermediate crude, once derided as a broken oil benchmark, is enjoying a comeback.

Volumes of futures tracking the yardstick have averaged 1m contracts a day this year through May, up more than 45 per cent from the same period of 2014, exchange data show. WTI has also sped ahead of volumes in rival Brent crude, less than two years after Brent unseated WTI as the most heavily traded oil futures market.

. . . .

WTI has also regained a more stable connection with global oil prices after suffering glaring discounts because of transport constraints at its delivery point of Cushing, Oklahoma. The gap led some to question WTI as a useful gauge of oil prices.

“I guess the death of the WTI contract was greatly exaggerated,” said Andy Lipow of consultancy Lipow Oil Associates.

But in the past two years, new pipeline capacity of more than 1m barrels a day has relinked Cushing to the US Gulf of Mexico coast, narrowing the discount between Brent and WTI to less than $4 a barrel.

Mark Vonderheide, managing partner of Geneva Energy Markets, a New York trading firm, said: “With WTI once again well connected to the global market, there is renewed interest from hedgers outside the US to trade it. When the spread between WTI and Brent was more than $20 and moving fast, WTI was much more difficult to trade.”

Things have played out exactly as I forecast in August, 2011:

One of the leading crude oil futures contracts–CME Group’s WTI–has been the subject of a drumbeat of criticism for months due to the divergence of WTI prices in Cushing from prices at the Gulf, and from the price of the other main oil benchmark–Brent.  But whereas WTI’s problem is one of logistics that is in the process of being addressed, Brent’s issues are more fundamental ones related to adequate supply, and less amenable to correction.

Indeed, WTI’s “problem” is actually the kind an exchange would like to have.  The divergence between WTI prices in the Midcontinent and waterborne crude prices reflects a surge of production in Canada and North Dakota.  Pipelines are currently lacking to ship this crude to the Gulf of Mexico, and Midcon refineries are running close to full capacity, meaning that the additional supply is backing up in Cushing and depressing prices.

But the yawning gap between the Cushing price at prices at the Gulf is sending a signal that more transportation capacity is needed, and the market is responding with alacrity.  If only the regulators were similarly speedy.

. . . .

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.  But the Brent contract will be an inverted paper pyramid, resting on a thinner and thinner point of crude production.  There will be gains from trade–large ones–from redesigning the contract, but the difficulties of negotiating an agreement among numerous big players will prove nigh on to impossible to surmount.  Moreover, there will be no single regulator in a single jurisdiction that can bang heads together (for yes, that is needed sometimes) and cajole the parties toward agreement.

So Brent boosters, enjoy your laugh while it lasts.  It won’t last long, and remember, he who laughs last laughs best.

This really wasn’t that hard a call to make. The price signals were obvious, and its always safe to bet on market participants responding to price signals. That’s exactly what happened. The only surprising thing is that so few publicly employed this logic to predict that the disconnection between WTI and ocean borne crude prices would be self-correcting.

Speaking of not enjoying the laugh, the exchange where Brent is traded-ICE-issued a rather churlish statement:

Atlanta-based ICE blamed the shift on “increased volatility in WTI crude oil prices relative to Brent crude oil prices, which drove more trading by non-commercial firms in WTI, as well as increased financial incentive schemes offered by competitors”.

The first part of this statement is rather incomprehensible. Re-linking WTI improved the contract’s effectiveness as a hedge for crude outside the Mid-continent (PADD 2), which allowed hedgers to take advantage of the WTI liquidity pool, which in turn attracted more speculative interest.

Right now the only potential source of disconnect is the export ban. That is, markets corrected the infrastructure bottleneck, but politics has failed to correct the regulatory bottleneck. When that will happen, I am not so foolish to predict.




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June 13, 2015

Definitive Proof That The New York Times’ David Kocieniewski Is A Total Moron*

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 6:06 pm

Not that further proof is needed, but still.

You may recall that NYT “reporter” (and by “reporter,” I mean “hack”) David Kocieniewski slimed me on the front page of the NYT on 31 December, 2013. In a nutshell, Kocieniewski accused me of being in the pocket of oil traders, and that this had led me to skew my research and policy positions. Specifically, he insinuated that I opposed position limits and defended speculation in energy markets because I had been suborned by oil traders who profited from high prices, like those that occurred in 2008 (before the crash). Kocieniewski’s main piece of “evidence” was that I had written a white paper sponsored by Trafigura. According to Kocieniewski, as an oil trader, Trafigura benefited from high prices.

At the time I pointed out that this demonstrates Kocieniewski’s appalling ignorance, as Trafigura is not a speculator, and is typically short futures (and other derivatives) to hedge its inventories of oil (and other commodities). Companies like Trafigura have no real interest in the direction of oil prices directly. They make money on margins and volumes. The relationship between these variables and the level of flat prices depends on what makes flat prices high or low.  I further said that if anything, commodity traders are likely to prefer a low price environment because (1) low prices reduce working capital needs, which can be punishing when prices are high, and (2) low price environments often create trading opportunities, in particular storage/contango plays that can be very profitable for those with access to storage assets.

Well, imagine my surprise (not!) when I saw this headline and article:

Crude slide bolsters Trafigura’s profits and trading margins

Trafigura has posted record half-year profits and a doubling of trading margins, illustrating how one of the world’s largest commodity trading houses has been a big beneficiary of the collapse in oil prices.

Profits at the group rose almost 40 per cent in the six months to 31 March, reaching $654m, while margins hit 3.1 per cent, as the Switzerland-based company used its global network of traders and storage facilities to buy cheap crude and take advantage of dislocations in the oil market.

. . . .
It was not the only company to benefit. Other trading groups including Vitol, the largest independent oil trader, and Gunvor have posted strong results for this period. Even ShellBP and Total managed better-than-expected first quarter results thanks to the performance of muscular trading operations.

Wow. In Kocieniewskiworld, “Crude slide bolsters Trafigura’s profits” would be a metaphysical impossibility. Here on earth, that’s an eminently predictable event. Which I predicted. Not that that makes me a genius, just more knowledgeable about commodity markets than David Kocieniewski (which is a very low bar).

Not that there was ever anything to it in the first place, but this pretty much blows to hell the entire premise of Dim Dave’s story. Proof yet again that if you read the NYT for economics stories, you’ll wind up dumber after reading than before.

* As well as an unethical slug who blatantly violated the NYT’s ethics guidelines. Not that his editor gave a damn, making him as much of an unethical slug as Kocieniewski.

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June 11, 2015

The Ethanol Mandate is Enough to Drive Me to Drink

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — The Professor @ 6:13 pm

About 19 months ago I wrote about RINsanity, i.e., the United States’ nutty ethanol (and other biofuel) program. RINsanity has long outlived the phenomenon (Lin-sanity) that inspired the neologism. A couple of weeks ago, the EPA announced the ethanol and biodiesel quotas . . . for 2014. Who said time travel is impossible? That Einstein. What an idiot!  (The EPA also announced quotas for 2015 and 2016.)

In a nutshell, despite protestations to the contrary, the EPA largely conceded to the reality of the E10 “blend wall” (the fact that the vast bulk of auto engines are incapable of burning fuel with more than 10 percent ethanol), and announced quotas that were (a) smaller than the market expected, and (b) smaller than the statutory amounts that Congress specified in its farseeing omniscience 10 years ago. At the same time, the EPA decreed larger quotas for biodiesel.

As a result, the market did the splits. The price of ethanol RIN credits that count towards the ethanol quota plunged, while the price of biodiesel RIN credits that count towards the biodiesel quota rose. Scott Irwin and Darrell Good have all the gory details here. (Those are the guys to follow on this issue, folks. I’m just kibitzing.)

As a result, pretty much everyone is upset. The nauseating biofuel lobby is screaming bloody murder because the ethanol quota is too small, and is threatening to go to court. Those holding ethanol credits are fuming due to the forty plus percent price decline.

This all points out the dysfunctional nature of environmental markets in which the supply is set by some opaque politicized bureaucratic process unhinged from economic reality. (The European CO2 credit market is another classic example.) The Congressional mandate set quotas (supplies) years in advance based on forecasts of future fuel demand that turned out to be wildly incorrect. So the EPA played Mr. Fixit, and through some unknown process, divined what Congress meant to do-really!-and announced some surprising numbers that caused prices to plummet.

The EPA’s reaction? It is shocked! Shocked! to find gambling going on at Rick’s (ethanol served here!):

The EPA didn’t intend for the program to create a speculative market, and an agency spokesperson declined to comment on RIN price movement.

“RINs are used to demonstrate compliance under the Renewable Fuel Standard program,” the EPA said. The agency manages an electronic system that tracks the RINs, but not their prices on the open market.

Earth to EPA! Earth to EPA! (And hey-aren’t you supposed to be earth’s stewards? So what are you doing orbiting Pluto?): if you create a scarce resource (ethanol credits) a market-and yes, one with speculation!-will appear. This is inevitable as the sun rising in the east. Another unintended but metaphysically certain event.

Indeed, the kind of speculation that these markets foster is particularly bizarre, because of the necessity of speculating on the feedback between the market and the EPA’s decisions on the amount of the scarce resource it creates. A big part of the RIN prices is market participants’ expectations about what the EPA will decide. If the EPA’s decision takes the market price into account, in some unknown (and almost certainly unarticulated) way, the reasoning chain becomes mind-numbingly complex very quickly. Mr. Market guesses what the EPA will do. That affects prices. The EPA takes the price, and guesses what this says about what the market knows about fundamentals . . . and what the market thinks about what the EPA is going to do. It adjusts its decision accordingly. Market participants have to make judgments about the feedback between the price and the EPA’s decision, which can affect the EPA’s decision, and on and on, ad infinitum. (This is analogous to Keynes’s beauty contest metaphor, and Soros’s theory of market “reflexivity.” Sign of the apocalypse alert: I gave Keynes and Soros a favorable mention in a single blog post.)

That’s no way to run a market, but the alternatives are  likely worse. One alternative would be to set quotas for years far into the future, and then not adjust them based on the evolution of other fundamentals that cannot be foreseen when the quotas are set.

It’s pretty clear that events like have just rocked the biofuel world are an inherent part of the system. Somewhat arbitrary, inherently difficult to predict (in part because they are politicized), and “reflexive” decisions are a major determinant of supply. These decisions are made at discrete times. It is extremely likely that there will be disconnections between the quantity the market thinks the EPA will select and what the EPA actually chooses. Given the inelasticity of demand for energy products, these supply surprises lead to big price impacts.

All of which goes to show that a better use of ethanol is imbibing it to cope with the craziness of a faux market.

Of course it’s not just that the market is crazy: it’s crazy that there is a market. Ethanol is an economic and environmental and humanitarian monstrosity. Yes, ethanol would play a role without subsidies or mandates. But a much smaller role. Forcing and inducing its use is costly, not environmentally beneficial, and raises the price of food, which hits the poorest the hardest. So this crazy market shouldn’t exist in the first place. I think I need another drink.




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