Streetwise Professor

September 23, 2016

With Friends Like the Saudis, America Needs No Enemies

Filed under: Military,Politics — The Professor @ 8:34 pm

Today Obama vetoed a bill that would permit families of those who perished on 911 to sue the Saudi Arabian government for supporting the hijacker/murderers. Earlier this week, the Senate defeated an effort led by Rand Paul to halt arms sales to the kingdom because of its ongoing war in Yemen.

The Saudis are feeling the pressure and are trying desperately to change the subject–to Iran. The gravamen of the Saudi case is that Iran is a major state sponsor of terrorism. There is, of course, something to this. Iran has indeed been a state sponsor of terrorism, and has directed its campaign against the United States and Israel for decades.

But it is more than a little disgusting to hear the Saudis cast aspersions about terrorism. The modalities of Iranian efforts differ from those of Saudi Arabia. But it is indisputable that Saudi Arabia is responsible for more terrorism that has killed more Americans than the Iranians have been.

Indeed, Iran’s methods are in many ways more conventional and less insidious than those emanating in Saudi Arabia. Iranian terrorism (and unconventional warfare) efforts are indeed carried out at the direction of state organs, and often work through quasi-state organizations (such as Hezbollah). In contrast, the archaic nature of the Saudi state, with its immense royal family with numerous wealthy members, means that the concept of “state support” is much more amorphous. Saudi Arabia is not a state in the western sense, or even in the Iranian sense. This makes Iran in some respects a much more conventional adversary than Saudi Arabia.

Furthermore, Saudi Arabia’s contribution to terrorism around the world has been demonstrably far greater than Iran’s. The funding of Wahhabi mosques and madrassas throughout the Middle East, Southwest Asia, the Balkans, Africa, and the Caucasus–and Europe and the United States–has inculcated the poisonous Islamist ideology that has created terror. Most of this money has not been spent to support explicitly terrorist groups or terrorist acts. But it has created the ideological and religious infrastructure that has been the catalyst for these groups and acts. However bad as Iran has been, objectively speaking Saudi Arabia and other oil tick states of the Gulf have been far worse. With allies like these, we need no enemies.

Furthermore, the diffuse and ideological nature of the Saudi support for terrorism makes it much more difficult to combat than Iran. Not to say that Iran is an easy adversary, but the very fact that it is a fairly conventional (if revolutionary) state makes it a more addressable foe than Saudi Arabia. The Saudi state may not support terrorism in the same way that the Iranian state does (though it might), but that actually greatly complicates the task of the terrorism that emanates from Saudi territory, Saudi citizens, and Saudi money.

One can sense that the Saudis feel that they are facing an existential crisis, fed in large part by Obama administration policy towards Iran. The Iranian nuclear deal and the lifting of sanctions has stoked these anxieties. The Saudis are deeply insecure, in part because there is a large and alienated Shia population in the major oil producing provinces. Iran is a larger and more educated country that has dominated its Arab neighbors for centuries. Low oil prices have gutted the Saudi economy and are placing tremendous budgetary strains on the country.

Fear of Iran drives the bloody–and (typically for an Arab army)–inept and indecisive war in Yemen, in which Saudi Arabia has succeeded in using American technology to kill large numbers of Yemenis (including numerous civilians) with no discernible strategic effect. It also drives the strong Saudi support for the opposition in Syria, because the Saudis view Assad as an Iranian vassal who is an important part of an “Shia crescent” that threatens the Sunni countries of the Middle East, of which Saudi Arabia considers itself the leader: it is clearly their paymaster. The Saudis being Saudis, they have no qualms in supporting extreme jihadist elements: indeed, that is their preference.

This demonstrates the drooling incoherence of Obama policy in the Middle East. Empowering Iran through the nuclear deal has fed Saudi fears that lead them to intensify their various proxy wars against Iran, and the administration has responded by supporting the Saudis in these wars, quite robustly in Yemen, more equivocally in Syria. If the Saudis succeed in Syria this will empower Salafist elements that are viciously anti-American. In essence, the Obama administration has succeeded in stoking both sides in the conflict, which helps explain its clear escalation in the past two years.

The Saudis have oil–the largest reserves in the world. That is the American–and world–interest in Saudi Arabia. But (a) the Saudis want to sell their oil, and (b) protecting the Saudi oil fields does not necessitate supporting or even acquiescing to Saudi Arabia’s support for Wahhabist radicalism that is spreading death and destruction from Southeast Asia to Central Africa and pretty much everywhere in between–and even to the shores of the United States.

Indeed, US policy should be aimed at finding how to contain Saudi influence, rather than enable it. But old mindsets and Saudi money have prevented that. In the 1970s and 1980s, the Saudis insinuated themselves as allies of the US, united with us against common enemies: Iran and the Soviet Union. I remember distinctly that in the aftermath of the Iranian Revolution, and during the Hostage Crisis, the Saudis portrayed themselves as the moderate Muslims, and the Iranians as the radicals. With Americans held in Tehran, and mobs in the streets shouting “Death to America,” that sounded plausible. Nigh on to 40 years of painful experience have shown, however, that Saudi Arabia is anything but the voice of moderate Islam: it is the wellspring of violent radicalism.

Furthermore, the Soviet Union is no more. Whatever geopolitical rationale there was for supporting Saudi funding of Muslim fighters in the 1980s, it has long past, and in retrospect, looks like the benefits that we gained were not worth the decades of terror that came in the bargain.

In sum, indulgence of Saudi radicalism was based on ignorance of their true character which we should now be well past, and on a strategic situation that no longer exists. The time for indulgence is therefore long over.

But Saudi money has bought influence. It has bought politicians, of both parties: it was nauseating, for example, to see Lindsey Graham’s impassioned defense of Saudi Arabia in his speech against the Paul bill, and of course the Saudis have lavished money on ex-presidents from both parties and potential future ones (namely Hillary). It has bought think tanks. It has deeply corrupted American politics. It is therefore highly doubtful that its influence can be easily purged.

That’s why it has been encouraging to see the the Paul bill go as far as it did, and to see the 911 victims bill pass. Yes, I understand that the concerns that the logic of the the bill could be turned against the US. But it should be a wake up call to DC that many Americans understand the nature of the Saudi regime and the threat that it poses far better than the foreign policy establishment. A wise administration would attempt to find an alternative that would address the sovereign immunity concerns but at the same time make Saudi Arabia pay a price for its multifaceted support for Islamic radicalism and Islamic terrorism around the world. Instead, Obama caves to the Saudis and vetoes the bill, and fights against the Paul bill, and enables Saudi efforts in Yemen and Syria.

Iran is a problem, but it is a nation that can be confronted and contained (if not easily tamed) using conventional American power. Saudi Arabia poses problems that we have yet to find a solution to. And our biggest problem is that we (or at least our “elite”) haven’t even fully acknowledged that it is a problem, in large part because Saudi money has suborned our politics.

Print Friendly

September 16, 2016

Trump’s Political Jujitsu Creates Outrage and Schadenfreude

Filed under: Politics — The Professor @ 6:54 pm

If there is a more conceited, self-important group of twits than the national news media I am not aware of it. Its members view themselves as the arbiters of American politics. They make the rules, and enforce them. And woe betide anyone who dares defy them. Especially after they broke Nixon, they believe they can even get presidents to bend to their will. Presidents come and go, after all. The media is there forever.

Today they thought they were going to break Trump. After Trump announced an event at his hotel in DC, and intimated that he would make a statement on the Obama birther issue, the press let its imagination run wild. They believed–get this–that Trump would hold an event at his own hotel where his name and image are everywhere (including on the bottles of water in the fridges!) and abase himself before them, confessing his sins about insinuating that Obama had not been born in the US and subjecting himself to a barrage of their gotcha questions.

This tells you just how far up their own colons they live. It also tells you how clueless they are. Trump has shown time and again that he does not play by the conventional rules of DC, the rules that the national media presumes to enforce, and that he has zero deference for the media: he uses them, rather than the other way around. He has shown time and again that he makes his own rules. And so he did today. He did not just puncture the media’s presumptions. He stomped, crushed, mangled, spindled and mutilated them. Then emptied his bladder on them for good measure.

As it played out in reality, as opposed to the imaginations of the national media, his event was mainly rah-rah about his new real estate project. Further he trotted out dozens of retired flag officers and war heroes to provide backdrop. Then, after promoting his project, at the very end of his appearance, he said:

Hillary Clinton and her campaign in 2008 started the birther controversy. I finished it. You know what I mean. President Barack Obama was born in the United States, period. Now we all want to get back to making America strong and great again.

So not only did he not don (no pun intended!) sackcloth and ashes and beg forgiveness for being a birther he said he ended birtherism and that Hillary started it. Political jujitsu of the first order.

The noise you heard this afternoon was thousands of media heads exploding. Just Google something like “Trump birther press conference” and you’ll see outraged article after outraged article. “We were played. We were Rick Rolled.” And on and on and on.

The press pool stamped their little feet and held their breath, and not only vowed not to show the pool footage of the event, but to erase it. That’ll learn him!

Er, another indication of the media’s failure to recognize that the world has changed. They are no longer the gatekeepers. They cannot decide who sees what. There are other recordings of the event. There are numerous other channels–YouTube, Twitter, etc.–through which those recordings can spread. Their outraged articles and on-air rants will only intensify the Banned in Boston/Streisand Effect and will ensure that the attempt to censor will only make more people want to see it. It will go viral.

Yet another indication of the media’s obliviousness: they actually believe that people will care that Trump has affronted their amour propre. As if. Rather than sympathizing with the media for being tricked by Trump, far more people will indulge in schadenfreude. The media are heartily disliked by vast swathes of Americans, who will enjoy nothing more than witnessing them getting their comeuppance precisely at the moment that they thought they would demonstrate their dominance.

This episode is another illustration of (a) elite failure, and (b) the dramatic change in political norms. The elite establishment is offended that Trump does not obey their rules. But to a very large number of Americans–whom Hillary slurred as “deplorables,” an epithet that many have now embraced with pride–this is precisely Trump’s appeal. They think the rules are rigged against them. They don’t want no water: they want somebody to burn the motherf*cker down.  These people believe the elite has failed them, and what’s more, the elite has failed to recognize it: a double failure, and perhaps a fatal one.  They revel in the humiliation of the elite.

The pre-Brexit dynamic was very similar, and we saw what happened there. The old verities are cracking. The old rules are being flouted. The old rulers are despised. And they just don’t get it, and don’t know how to handle it.

This is an ominous moment for the media. Not only were they frustrated by Trumps failure to bend to their rules, his in-your-face demonstration that you can break the rules and survive will encourage others to do the same. In large part, the media’s power is predicated on the deference of politicians. Lose that deference, and the power is lost. So this is not just about the 2016 election. It is about elections after that. Perhaps Trump is a one-off. But success breeds imitators. Trump has successfully broken the rules, and that could lead to their demise.

Print Friendly

De Minimis Logic

CFTC Chair Timothy Massad has come out in support of a one year delay of the lowering of the de minimis swap dealer exemption notional amount from $8 billion to $3 billion. I recall Coase  (or maybe it was Stigler) writing somewhere that an economist could pay for his lifetime compensation by delaying implementation of an inefficient law by even a day. By that reckoning, by delaying the step down of the threshold for a year Mr. Massad has paid for the lifetime compensation of his progeny for generations to come, for the de minimis threshold is a classic analysis of an inefficient law. Mr. Massad (and his successors) could create huge amounts of wealth by delaying its implementation until the day after forever.

There are at least two major flaws with the threshold. The first is that there is a large fixed cost to become a swap dealer. Small to medium-sized swap traders who avoid the obligation of becoming swap dealers under the $8 billion threshold will not avoid it under the lower threshold. Rather than incur the fixed cost, many of those who would be caught with the lower threshold will decide to exit the business. This will reduce competition and increase concentration in the swap market. This is perversely ironic, given that one ostensible purpose of Frankendodd (which was trumpeted repeatedly by its backers) was to increase competition and reduce concentration.

The second major flaw is that the rationale for the swap dealer designation, and the associated obligations, is to reduce risk. Big swap dealers mean big risk, and to reduce that risk, they are obligated to clear, to margin non-cleared swaps, and hold more capital. But notional amount is a truly awful measure of risk. $X billion of vanilla interest rate swaps differ in risk from $X billion of CDS index swaps which differ in risk from $X billion of single name CDS which differ in risk from $X billion of oil swaps. Hell, $X billion of 10 year interest rate swaps differ in risk from $X billion of 2 year interest rate swaps. And let’s not even talk about the variation across diversified portfolios of swaps with the same notional values. So notional does not match up with risk in a discriminating way.  Further, turnover doesn’t measure risk very well either.

But hey! We can measure notional! So notional it is! Yet another example of the regulatory drunk looking for his keys under the lamppost because that’s where the light is.

So bully for Chairman Massad. He has delayed implementation of a regulation that will do the opposite of some of the things it is intended to do, and merely fails to do other things it is supposed to do. Other than that, it’s great!

Print Friendly

September 12, 2016

The New Deal With Chinese Characteristics

Filed under: China,Commodities,Economics,History,Politics,Regulation — The Professor @ 1:03 pm

When I was in Singapore last week I spoke at the FT Asia Commodities Summit. Regardless of whether the subject was ags or energy or metals, China played an outsized role in the discussion. In particular, participants focused on China’s newish “supply side” policy.

There is little doubt that the policy–which focuses on reducing capacity, or at least output in steel, coal, and other primary industries–has had an impact on prices. Consider coking coal:

Coking coal, the material used by steelmakers to fire their blast furnaces, has become the best performing commodity of 2016 after surging more than 80 per cent over the past month on the back of production curbs and flooding in China.

Premium hard Australian coking coal delivered to China hit $180.9 a tonne on Friday, this highest level since price reporting agency Steel Index began publishing assessments in 2013. It has risen 131 per cent since the start of the year, outpacing gold, silver, iron ore and zinc — other top performing commodities.

The main driver of the rally — which has also roiled thermal coal — is Beijing’s decision to restrict the number of working days at domestic mines to 276 days per year from 330 previously.

This policy is aimed at the improving the profitability of producers so they can repay loans to local banks. But it has reduced output and forced traders and steel mills to buy imported material from what is known as the seaborne market.

80 percent. In a month.

Or thermal coal:

Newcastle thermal coal is heading for the first annual gain in six years as China seeks to cut overcapacity and curb pollution. While the timing of the output adjustment is unavailable, it may start in September or October after recent price gains, Citigroup said in the report dated Sept. 8. Bohai-Rim is 26 percent higher from a year ago, when it was 409 yuan, while Newcastle has climbed as much as 40 percent this year.

The phrase “supply side reform” actually fits rather awkwardly here, at least to a Western ear. That phrase connotes the reduction of regulatory and tax burdens as a means of promoting economic growth. But Supply Side Reform With Chinese Characteristics means increasing the government’s role in managing the economy.

A better description would be that this is The New Deal With Chinese Characteristics. FDR’s New Deal was largely a set of measures to cartelize major US industries, in an effort to raise prices. The economic “thinking” behind this was completely wrongheaded, and motivated by the idea that there was “ruinous competition” in product and labor markets that required government intervention to fix. Apparently the higher prices and wages were supposed to increase aggregate demand. Or something. But although the New Deal foundered on Constitutional shoals only a few years after its passage, in its brief existence it had proven to be an economic nightmare rent by contradictions. For instance, if you increase prices in an upstream industry, that is detrimental to the downstream sector for which the upstream industry’s outputs are inputs. According to scholarship dating back to Milton Friedman and Anna Schwartz, and continuing through recent work by Cole and Ohanian,  interference in the price mechanism and forced cartelization slowed the US’s recovery from the monetary shock that caused the Great Depression.

The motivation for the Chinese policy is apparently not so much to facilitate the rationalization of capacity in sectors with too much of it, but to increase revenue of firms in these sectors in order to permit them to pay back debt to banks and the holders of wealth management products (which often turn out to be banks too). Further, the policy is also driven by a need to sustain employment in these industries. Thus, the policies are intended to prop up the financially weakest and least efficient companies, rather than cull them.

So step back for a minute and contemplate what this means. Through a variety of policies, including most notably financial repression (that made capital artificially cheap) and credit stimulus, China encouraged massive investment in the commodities and primary goods sectors. These policies succeeded too well: they encouraged massive over-investment. So to offset that, and to mitigate the financial consequences for lenders, local governments, and workers, China is intervening to restrict output to raise prices. Rather than encouraging the correction of past errors, the new policy is perpetuating them, and creating new ones.

Remind me again how China’s government got the reputation as master economic managers, because I’m not seeing it. This is an example of a wasteful response to wasteful over-investment: waste coming and going. Further, it involves an increase in government intervention, which obviously has those in favor a more liberal (in the Smithian sense) free market policy rather distraught, and which foreshadows even more waste in the future.

The policy is also obviously fraught with tensions, because it pits those consuming primary and intermediate goods against those producing them–and against the banks who are now more likely to get their money back. That is, it is a backdoor bank (and WMP) bailout, the costs of which will be borne by the consumers of the goods produced by industries that were supersized by past government profligacy.

Ironically, the policy also stokes something that the government purports to hate: speculation. Policy volatility encourages speculation on the goods and industries affected by these policies. The large movements in prices in the coal and iron-steel sectors in response to policy changes provide a strong incentive to speculate on future policy changes.

Further, it creates the potential for moral hazard in the future. Future lenders (and purchasers of WMP) will look back on this policy and conclude that the government may well undertake backdoor bailouts if the companies they have lent to run into difficulties. This is hardly conducive to prudent lending and investment.

This is not foresighted policy. It is extemporizing to fix near-term problems, most of which were created by past measures to fix near-term problems. There is a Three Stooges aspect to the entire endeavor.

Of course, it’s an ill wind that blows no one any good. Glencore is no doubt very grateful for Chairman Xi’s heavy-handed policy intervention. It has probably played a larger role in bringing the company back from the brink than did the company’s prudent efforts to cut debt. But it is probably too late, alas, for Peabody Coal, and Arch Coal, and all those “coal people” whom former empathizer in chief Bill Clinton mocked last week. The ingrates!

The bottom line is that China is the 800 pound gorilla of the commodity markets, and shifts in its policies can lead to huge moves in commodity prices. Given that these policy shifts are driven by the crisis du jour (e.g., commodity producer shakiness threatening to make banks and local governments shaky) rather than good economics, and that these policy shifts are difficult to predict given the opacity and centralization of Chinese decision making, they add to substantial additional volatility in commodity prices and commodity markets: who can read the gorilla’s mind (which he changes often)?, and woe to those who read it wrong.

Print Friendly

September 9, 2016

Wasn’t it the WaPo Who Once Instructed Us That It’s Not the Crime, But the Coverup?

Filed under: Politics — The Professor @ 6:36 pm

The Washington Post has had just quite enough of this Hillary email stuff, thank you, and has sent out the Official Narrative, in the form of an editorial:

JUDGING BY the amount of time NBC’s Matt Lauer spent pressing Hillary Clinton on her emails during Wednesday’s national security presidential forum, one would think that her homebrew server was one of the most important issues facing the country this election. It is not. There are a thousand other substantive issues — from China’s aggressive moves in the South China Sea to National Security Agency intelligence-gathering to military spending — that would have revealed more about what the candidates know and how they would govern. Instead, these did not even get mentioned in the first of 5½ precious prime-time hours the two candidates will share before Election Day, while emails took up a third of Ms. Clinton’s time.

. . . .

Ms. Clinton is hardly blameless. She treated the public’s interest in sound record-keeping cavalierly. A small amount of classified material also moved across her private server. [Not so much rat in it!] But it was not obviously marked as such [er, so?, and is she so stupid that she needs a BIG BOLD LETTERS TO TELL HER WHAT IS CLASSIFIED?], and there is still no evidence that national security was harmed. Ms. Clinton has also admitted that using the personal server was a mistake. The story has vastly exceeded the boundaries of the facts.

It is beyond ironic that the Washington Post, of Watergate fame, has forgotten the main lesson of that scandal–a lesson it first drew and has pushed repeatedly over the years: it’s not the crime, it’s the coverup. Watergate was a “two bit burglary” that blew up into a presidency-ending national crisis because of Nixon’s efforts to conceal. That Nixon was capable of such conduct was widely believed even before it was proved precisely because of his longstanding reputation for dishonesty and trickery.

What makes the email controversy so damaging to Hillary is not so much the emails themselves (though I take issue with the WaPo’s attempt to sanitize and minimize their import), but the barrage of lies that she has unleashed in an attempt to explain her conduct. The lies are transparently such to those who have an even passing familiarity with the facts. Further, Hillary is such a bad liar that her deceit is likely obvious to many who don’t.  Adding to this is the fact that Hillary’s shiftiness on the email issue reinforces her longstanding Nixonesque reputation as a power-hungry liar. Hence, the longer the email controversy drags on, the lower Hillary’s trustworthiness ratings (never high to begin with) plunge.

Furthermore, that Hillary feels compelled to lie indicates to many that there must be something to hide. Meaning that the lies give the lie to the WaPo’s claim that there is nothing to see here, and we should all move on.

This is why the WaPo and the NYT and a phalanx of establishment journalists savage Matt Lauer and anyone else who asks her about the emails, and why they are so frantic to rule the issue over, done, irrelevant, and out-of-bounds. Every question about the subject obligates her to tell another lie–or lies, plural–further cementing her pantsuit-on-fire image. So the questions must stop! Now!

This may succeed in getting Matt Lauer’s mind right, and the minds of others who want to remain accepted members of the tribe. But this reveals yet another problem with the WaPo’s editorial: it reads like yet another diktat from the Better Thans to the Lesser Thans, instructing them on what to think. Once upon a time that might have worked. But truth be told (though not by Hillary!) these days the Lesser Thans have a very low opinion of the Better Thans, and are more likely to bridle at such attempted instruction, rather than knuckle under. The Brit Better Thans tried to do the same thing, and were rewarded with a stinging Brexit rebuke.

In other words, in the face of populist unrest, presumptuous patrician instruction is likely to have the opposite of the intended effect.

But what else have they got? They go with what they know. And the pronouncements to “pay no attention to the server behind the curtain” betray more than a little establishment panic. The media and political elites are clearly more than a little unnerved by the fact that Hillary has had no more success shaking off Trump than she has had shaking off that racking cough.

In addition to playing defense (“no more email questions!”) the media and the Democratic establishment are playing offense against Trump. Bizarrely, their main weapon in this attack is Putin. I see no evidence that these increasingly frenzied assaults are having the slightest effect. Part of the reason for that is post-Cold War, the vast majority of Americans don’t give a damn about Russia, and couldn’t care less what Putin does to his own country, or even to countries on his borders. But there is another reason as well: the sudden emergence of Putin as a Democratic bogeyman seems more than a little insincere.

Well, it seems outrageously insincere, actually, to anyone with a memory that stretches back four years, or seven. Go back seven years, and you come across the image of  a buffoonishly grinning Hillary pressing the reset button with Lavrov, and announcing a new age of Russia-US relations. Go back a mere four years, and you see the same people screeching about Putin now ridiculing Romney for suggesting that Russia and Putin are a threat. Go back four years, and you see these people seeing nothing amiss in Obama whispering a Message to Vladimir to Dmitri Medvedev:

President Obama: On all these issues, but particularly missile defense, this, this can be solved but it’s important for him [Putin!] to give me space.

President Medvedev: Yeah, I understand. I understand your message about space. Space for you…

President Obama: This is my last election. After my election I have more flexibility.

President Medvedev: I understand. I will transmit this information to Vladimir.

So, in 2012 the people now claiming Putin is the evil puppet master who will jerk Trump’s strings were totally fine with Obama canoodling with selfsame Putin, and snarked at Romney “the 80s called and want their [Cold War] foreign policy back” when he claimed that Putin was a threat.

So were they clueless in 2012? If so, will they man up and admit it? Or are they opportunistic now? (Personally, I’m going with “both.”)

Hillary is still the likely winner, but it is far too close for comfort for the elite media and the political establishment (primarily on the Dem side, but not exclusively so). So the drones are swarming to defend the queen. But I seriously doubt that their Putin sting is all that venomous, and if I am right Hillary may well be frustrated in her ambition. If that happens, no head in throwing distance of a lamp will be safe.

 

Print Friendly

September 3, 2016

The Smartest Woman in the World Doesn’t Know Her A-B-Cs

Filed under: Politics — The Professor @ 12:45 am

When it comes to condemning Hillary Clinton’s mendacity, I take second place to no one. But even I am stunned by the revelations in the holiday Friday FBI dump. The audacity of her mendacity is staggering.

Where even to begin? There is so much.

  • The woman who was the primary classifying officer of the State Department claims ignorance as to the meaning of (C) (designating “confidential”)  at the beginning of paragraphs in various documents she reviewed, and which had passed through her server. During her interview with the FBI, she averred that it just was an alpha order designation. Which would make total sense, except these documents had no paragraphs designated (A), (B), (D), (E), etc., and had multiple (C)s. Maybe Hillary didn’t learn the A-B-C song as a child. The chutzpah required to say something so risible with a straight face is beyond measure.
  • Said same classifying officer claimed she had no knowledge that the designation NOFORN meant not for distribution to foreigners.
  • She claimed lack of memory for many details relating to her email, classified documents, etc., because of the concussion suffered in 2012. But if you dare question her health, you are a raving conspiracy loon. In a typically Clintonian fashion, she wants things both ways. She’s brain damaged when it helps her, she’s the smartest woman in the world when it helps her.
  • She (again remembering that “she” was the designated classifying officer) said she trusted that her subordinates not to send her any classified information. She also claims she never sent any classified information. So we are to believe that the Secretary of State never had any communications that were relevant to the national security of the US, and would damage said security if released.
  • Her original story was that she wanted a private server so she only had to deal with one device, e.g,. Blackberry. Turns out she had 8(!) at one time or another. Oh, and 5 fricking iPads. None of the devices have been recovered, and 2 of the iPads are AWOL. Supposedly at least two of the Blackberries were destroyed. With a hammer. By one of her flunkies. “If I had a hammer, I’d hammer my Blackberry in the morning, I’d hammer it in the evening, all over this land.” The other Blackberries? Who knows? Check eBay or DealDash.
  • The movement of her material from the home server to the new bathroom server at Platte River Networks was a complete FUBAR. The material could not be moved remotely (as if that was secure). So a computer containing the email archive was shipped from NY to Colorado, but even then the transfer was not easy due to an Apple Mail-Microsoft Exchange incompatibility. So it was uploaded to Gmail, and then downloaded onto the PRN server. Totes secure. And some 900 of the messages remained on Gmail.
  • But it gets better! The PRN drone shipped the laptop and a thumb drive containing the archive back to a Hillary staffer via UPS or USPS (he can’t remember which). They were never received. I should say allegedly never received, because you can never believe anything this lot says, especially when the disappearance is oh so convenient. Maybe they will reappear on a White House table in  5 years, like Rose Law Firm billing records.
  • Late in 2014 Clinton consiglieri Cheryl Mills informed PRN that the email retention policy had changed (how convenient!). PRN was instructed to irrevocably delete all messages on the PRN server over 60 days old (which would include everything relevant from her time at State) using BleachBit. The drone at PRN did delete the email, but neglected to BleachBit them.
  • After the NYT broke the story about the private server, and after the House had subpoenaed her emails, the PRN drone had a conversation with Clinton staffers. After realizing that he had deleted but not wiped the emails from the PRN server, he said “oh shit” (his words) and then merrily proceeded to BleachBit them. In full knowledge that they were under subpoena. The Clinton crowd will no doubt attempt to pin this all on him, but his come to Satan moment occurred after he had a conference call with Clinton staff. The inference is immediate.

I could go on (and on and on), but you get the idea. The sewer of lies, coverups, willful destruction of documents, and egregious breaches of national security is bottomless.

In a way, I am less livid at Hillary, Cheryl Mills, and that entire crowd. They are mendacious by nature. Slugs gonna do what slugs gonna do.

No, the objects of my greatest scorn are James Comey, the FBI, and the DOJ. They were obviously just going through the motions with this investigation. What the FBI grudgingly released only under pressure from the House reveals a pattern of conduct extending over years that would warrant indictment under either the statutory negligence standard, or even the fictitious intent standard that Comey invented to rationalize recommending no charges against her. The circumstantial evidence of intent screams out, from the day that the private server was first considered, to the day that it was wiped clean, to the day she told barefaced lie after barefaced lie to the FBI.

When someone destroys documents, the law is that the finder of fact should draw a negative inference about the content of those documents. One doesn’t destroy what makes one look good, so the logical inference is that the documents make one look bad. And here the inference is that Hillary intentionally flouted the law in order to shield her communications from any public scrutiny or oversight, in order to escape accountability for her actions.

But the FBI and the DOJ ignored all of this, and gave Clinton a pass. In so doing, they are accessories to and enablers of her mendacity and corruption. In so doing, they demonstrate that the system has been deeply corrupted. Perhaps irredeemably so. The powerful and protected get a pass. The rule of law has gaping exceptions that exempt the privileged. Accountability is an alien concept.

DC is an Augean Stables that would give pause to Hercules, if there was a Hercules in sight. But there’s not. So the shit just gets deeper by the day.

Print Friendly

August 31, 2016

Sechin Makes His Bashneft Bid

Filed under: Energy,Politics,Russia — The Professor @ 9:13 am

In my most recent post on the Bashneft saga, I surmised that there might be a quid pro quo: Rosneft would be allowed to buy the smaller producer in exchange for a promise to proceed with its long delayed privatization. It appears that something along those lines is what is going on, although whereas I conjectured that Putin made this offer to Sechin, Bloomberg reports that Sechin is pitching the idea to Putin:

Rosneft PJSC chief Igor Sechin, not taking no for an answer, has come up with a proposal to expand his energy empire while helping critics in the Russian government meet their goal of reducing the widest budget deficit in six years.

Sechin, a longtime ally of President Vladimir Putin, has asked the government to let state-run Rosneft buy its controlling stake in smaller oil producer Bashneft PJSC for $5 billion in cash, a premium to the market, according to two senior officials. Russia could then earn another $11 billion by proceeding with its delayed sale of 19.5 percent of Rosneft itself, generating a $16 billion windfall that would cut this year’s projected deficit in half, they said.

Sechin is also proposing to sell off small pieces of Rosneft to multiple investment funds and trading firms, rather than a big chunk to the Chinese or Indians.

This illustrates the transactional nature of Putinism. Presumably other interested parties have submitted their proposals to Putin, who will decide based on a mixture of efficiency, fiscal, and political considerations. The political considerations will focus on the distribution of rents among his retainers in exchange for political support and other services that those favored can provide Putin. Putin is in essence holding an auction, and the technocratic opposition to a Rosneft acquisition (at least before it privatizes) essentially forces Sechin to bid more aggressively.

One interesting aspect of this is the sequencing. If Putin bestows Bashneft on Rosneft in exchange for a promise of a future privatization, would Sechin dare to stall or delay once Bashneft is in hand, resorting to his usual arguments that due to this, that, or the other, the price isn’t right? If Rosneft sells off a stake in exchange for Putin’s promise that it can then acquire Bashneft, might Putin say at a later date: “Things have changed, so I’ve changed my mind”?  Making commitments credible in a personalized, natural state is not an easy thing. And these things get harder, the older Putin gets, as the end game problem looms larger by the day. The ability to evade future performance depends on  the political balance and economic conditions at the time performance is required, and those can shift dramatically.

So this is Sechin’s bid. It will be interesting to see whether Putin accepts it, and the conditions that he imposes in an attempt to make sure that Sechin lives up to his half of the bargain. Those conditions will reveal a good deal about not just Sechin’s current position within the hierarchy, but the degree of trust between the major players in the regime.

 

Print Friendly

August 23, 2016

Carl Icahn Rails Against the Evils of RIN City

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — The Professor @ 12:15 pm

Biofuel Renewable Identification Numbers–“RINs”–are back in the news because of a price spike in June and July (which has abated somewhat). This has led refiners to intensify their complaints about the system. The focus of their efforts at present is to shift the compliance obligation from refiners to blenders. Carl Icahn has been quite outspoken on this. Icahn blames everyone, pretty much, including speculators:

“The RIN market is the quintessential example of a ‘rigged’ market where large gas station chains, big oil companies and large speculators are assured to make windfall profits at the expense of small and midsized independent refineries which have been designated the ‘obligated parties’ to deliver RINs,” Icahn wrote.

“As a result, the RIN market has become ‘the mother of all short squeezes,”‘ he added. “It is not too late to fix this problem if the EPA acts quickly.”

Refiners are indeed hurt by renewable fuel mandates, because it reduces the derived demand for the gasoline they produce. The fact that the compliance burden falls on them is largely irrelevant, however. This is analogous to tax-incidence analysis: the total burden of a tax, and the distribution of a tax, doesn’t depend on who formally pays it. In the case of RINs, the total burden of the biofuels mandate and the distribution of that burden through the marketing chain doesn’t depend crucially on whether the compliance obligation falls on refiners, blenders, or your Aunt Sally.

Warning: There will be math!

A few basic equations describing the equilibrium in the gasoline, ethanol, biodiesel and RINs markets will hopefully help structure the analysis*. First consider the case in which the refiners must acquire RINs:

Screen Shot 2016-08-23 at 10.20.03 AM

Equation (1) is the equilibrium in the retail gasoline market. The retail price of gasoline, at the quantity of gasoline consumed, must equal the cost of blendstock (“BOB”) plus the price of the ethanol blended with it. The R superscript on the BOB price reflects that this is the price when refiners must buy a RIN. This equation assumes that one gallon of fuel at the pump is 90 percent BOB, and 10 percent ethanol. (I’m essentially assuming away blending costs and transportation costs, and a competitive blending industry.) The price of a RIN does not appear here because either the blender buys ethanol ex-RIN, or buys it with a RIN and then sells that to a refiner.

Equation (2) is the equilibrium in (an assumed competitive) ethanol market. The price an ethanol producer receives is the price of ethanol plus the price of a RIN (because the buyer of ethanol gets a RIN that it can sell, and hence is willing to pay more than the energy value of ethanol to obtain it). In equilibrium, this price equals the the marginal cost of producing ethanol. Crucially, with a binding biofuels mandate, the quantity of ethanol produced is determined by the blendwall, which is 10 percent of the total quantity sold at the pump.

Equation (3) is equilibrium in the biodiesel market. When the blendwall binds, the mandate is met by meeting the shortfall between mandate and the blendwall by purchasing RINs generated from the production of biodiesel. Thus, the RIN price is driven to the difference between the cost of producing the marginal gallon of biodiesel, and the price of biodiesel necessary to induce consumption of sufficient biodiesel to sop up the excess production stimulated by the need to obtain RINs. In essence, the price of biodiesel plus the cost of a RIN generated by production of biodiesel must equal the marginal cost of producing it. The amount of biodiesel needed is given by the difference between the mandate quantity and the quantity of ethanol consumed at the blendwall. The parameter a is the amount of biofuel per unit of fuel consumed required by the Renewable Fuel Standard.

Equation (4) is equilibrium in the market for blendstock–this is the price refiners get. The price of BOB equals the marginal cost of producing it, plus the cost of obtaining RINs necessary to meet the compliance obligation. The marginal cost of production depends on the quantity of gasoline produced for domestic consumption (which is 90 percent of the retail quantity of fuel purchased, given a 10 percent blendwall). The price of a RIN is multiplied by a because that is the number of RINs refiners must buy per gallon of BOB they sell.

Equation (5) just says that the value of ethanol qua ethanol is driven by the relative octane values between it and BOB.

The exogenous variables here are the demand curve for retail gasoline; the marginal cost of producing ethanol; the marginal cost of producing BOB (which depends on the price of crude, among other things); the marginal cost of biodiesel production; the demand for biodiesel; and the mandated quantity of RINs (and also the location of the blendwall). Given these variables, prices of BOB, ethanol, RINs, and biodiesel will adjust to determine retail consumption and exports.

Now consider the case when the blender pays for the RINs:

Screen Shot 2016-08-23 at 10.20.25 AM

Equation (6) says that the retail price of fuel is the sum of the value of the BOB and ethanol blended to create it, plus the cost of RINs required to meet the standard. The blender must pay for the RINs, and must be compensated by the price of the fuel. Note that the BOB price has a “B” superscript, which indicates that the BOB price may differ when the blender pays for the RIN from the case where the refiner does.

Without exports, retail consumption, ethanol production, biodiesel production, and BOB production will be the same regardless of where the compliance burden falls. Note that all relevant prices are determined by the equilibrium retail quantity. It is straightforward to show that the same retail quantity will clear the market in both situations, as long as:

Screen Shot 2016-08-23 at 10.20.35 AM

That is, when the refiner pays for the RIN, the BOB price will be higher than when the blender does by the cost of the RINs required to meet the mandate.

Intuitively, if the burden is placed on refiners, in equilibrium they will charge a higher price for BOB in order to cover the cost of complying with the mandate. If the burden is placed on blenders, refiners can sell the same quantity at a lower BOB price (because they don’t have to cover the cost of RINs), but blenders have to mark up the fuel by the cost of the RINs to cover their cost of acquiring them. here the analogy with tax incidence analysis is complete, because in essence the RFS is a tax on the consumption of fossil fuel, and the amount of the tax is the cost of a RIN.

This means that retail prices, consumption, production of ethanol, biodiesel and BOB, refiner margins and blender margins are the same regardless of who has the compliance obligation.

The blenders are complete ciphers here. If refiners have the compliance burden, blenders effectively buy RINs from ethanol producers and sell them to refiners. If the blenders have the burden, they buy RINs from ethanol producers and sell them to consumers. Either way, they break even. The marketing chain is just a little more complicated, and there are additional transactions in the RINs market, when refiners shoulder the compliance obligation.

Under either scenario, the producer surplus (profit, crudely speaking) of the refiners is driven by their marginal cost curves and the quantity of gasoline they produce. In the absence of exports, these things will remain the same regardless of where the burden is placed. Thus, Icahn’s rant is totally off-point.

So what explains the intense opposition of refiners to bearing the compliance obligation? One reason may be fixed administrative costs. If there is a fixed cost of compliance, that will not affect any of the prices or quantities, but will reduce the profit of the party with the obligation by the full amount of the fixed cost. This is likely a relevant concern, but the refiners don’t make it centerpiece of their argument, probably because shifting the fixed cost around has no efficiency effects, but purely distributive ones, and purely distributive arguments aren’t politically persuasive. (Redistributive motives are major drivers of attempts to change regulations, but naked cost shifting arguments look self-serving, so rent seekers attempt to dress up their efforts in efficiency arguments: this is one reason why political arguments over regulations are typically so dishonest.) So refiners may feel obliged to come up with some alternative story to justify shifting the administrative cost burden to others.

There may also be differences in variable administrative costs. Fixed administrative costs won’t affect prices or output (unless they are so burdensome as to cause exit), but variable administrative costs will. Further, placing the compliance obligation on those with higher variable administrative costs will lead to a deadweight loss: consumers will pay more, and refiners will get less.

Another reason may be the seen-unseen effect. When refiners bear the compliance burden, the cost of buying RINs is a line item in their income statement. They see directly the cost of the biofuels mandate, and from an accounting perspective they bear that cost, even though from an economic perspective the sharing of the burden between consumers, refiners, and blenders doesn’t depend on where the obligation falls. What they don’t see–in accounting statements anyways–is that the price for their product is higher when the obligation is theirs. If the obligation is shifted to blenders, they won’t see their bottom line rise by the amount they currently spend on RINS, because their top line will fall by the same amount.

My guess is that Icahn looks at the income statements, and mistakes accounting for economics.

Regardless of the true motive for refiners’ discontent, the current compliance setup is not a nefarious conspiracy of integrated producers, blenders, and speculators to screw poor independent refiners. With the exception of administrative cost burdens (which speculators could care less about, since it will not fall on them regardless), shifting the compliance burden will not affect the market prices of RINs or the net of RINs price that refiners get for their output.

With respect to speculation, as I wrote some time ago, the main stimulus to speculation is not where the compliance burden falls (because again, this doesn’t affect anything relevant to those speculating on RINs prices). Instead, one main stimulus is uncertainty about EPA policy–which as I’ve written, can lead to some weird and potentially destabilizing feedback effects. The simple model sheds light on other drivers of speculation–the exogenous variables mentioned above. To consider one example, a fall in crude oil prices reduces the marginal cost of BOB production. All else equal, this encourages retail consumption, which increases the need for RINs generated from biodiesel, which increases the RINs price.

The Renewable Fuels Association has also raised a stink about speculation and the volatility of RINs prices in a recent letter to the CFTC and the EPA. The RFA (acronyms are running wild!) claims that the price rise that began in May cannot be explained by fundamentals, and therefore must have been caused by speculation or manipulation. No theory of manipulation is advanced (corner/squeeze? trade-based? fraud?), making the RFA letter another example of the Clayton Definition of Manipulation: “any practice that doesn’t suit the person speaking at the moment.” Regarding speculation, the RFA notes that supplies of RINs have been increasing. However, as has been shown in academic research (some by me, some by people like Brian Wright)  that inventories of a storable commodity (which a RIN is) can rise along with prices in a variety of circumstances, including a rise in volatility, or an increase in anticipated future demand. (As an example of the latter case, consider what happened in the corn market when the RFS was passed. Corn prices shot up, and inventories increased too, as consumption of corn was deferred to the future to meet the increased future demand for ethanol. The only way of shifting consumption was to reduce current consumption, which required higher prices.)

In a market like RINs, where there is considerable policy uncertainty, and also (as I’ve noted in past posts) complicated two-way feedbacks between prices and policy, the first potential cause is plausible. Further, since a good deal of the uncertainty relates to future policy, the second cause likely operates too, and indeed, these two causes can reinforce one another.

Unlike in the 2013 episode, there have been no breathless (and clueless) NYT articles about Morgan or Goldman or other banks making bank on RIN speculation. Even if they have, that’s not proof of anything nefarious, just an indication that they are better at plumbing the mysteries of EPA policy.

In sum, the recent screeching from Carl Icahn and others about the recent ramp-up in RIN prices is economically inane, and/or unsupported by evidence. Icahn is particularly misguided: RINs are a tax, and the burden of the tax depends not at all on who formally pays the tax. The costs of the tax are passed upstream to consumers and downstream to producers, regardless of whether consumers pay the tax, producers pay the tax, or someone in the middle pays the tax. As for speculation in RINs it is the product of government policy. Obviously, there wouldn’t be speculation in RINs if there aren’t RINs in the first place. But on a deeper level, speculation is rooted in a mandate that does not correspond with the realities of the vast stock of existing internal combustion engines; the EPA’s erratic attempt to reconcile those irreconcilable things; the details of the RFS system (e.g., the ability to meet the ethanol mandate using biodiesel credits); and the normal vicissitudes of the energy supply and demand.  Speculation is largely a creation of government regulation, ironically, so to complain to the government about it (the EPA in particular) is somewhat perverse. But that’s the world we live in now.

* I highly recommend the various analyses of the RINs and ethanol markets in the University of Illinois’ Farm Doc Daily. Here’s one of their posts on the subject, but there are others that can be found by searching the website. Kudos to Scott Irwin and his colleagues.

Print Friendly

August 21, 2016

The Price of Politics in Putin’s Natural State

Filed under: Energy,Politics,Russia — The Professor @ 10:20 am

After months of watching Rosneft, Lukoil, Gazpromneft, and others shout “Bashneft is mine!” “NO! It’s mine!”, Putin has apparently lost patience and said “None of you will get it!” Last week Medvedev announced that the sale of the company (seized from oligarch Vladimir Evtushenkov’s Sistema in 2014) would be delayed indefinitely.* Rustem Khamitov, president of Russian Republic of Bashkortostan (where Bashneft is located), suggested that the sale be delayed five years. Meaning never.

Yes, Medvedev made the announcement, but a decision like this is obviously Putin’s. Medvedev’s job is to announce controversial decisions or release bad news that Putin doesn’t want to be questioned about. Coming as it does in the midst of the surprise defenestration of Putin’s chief-of-staff Sergei Ivanov and other high-level reshuffling, this has set off considerable speculation about the real reason for the decision.

The main subject of speculation is what this means for Igor Sechin, head of Rosneft. Sechin wanted Bashneft badly, but the technocrats in the government, led by another Igor–Deputy PM Shuvalov–were fighting this tooth and nail. Perhaps Putin just got tired of the fighting, and pace my introduction, decided to end it by putting the company on the shelf.

Or maybe there is something more to it. The official reason given for the delay of the Bashneft is that the company is that the government wants to prioritize the sale of a piece of Rosneft:

Deputy Prime Minister Igor Shuvalov on Wednesday said Russia would consider selling Bashneft stake after it has completed the privatization of Rosneft,

“A sale of a stake in Rosneft is on the forefront now. We should focus on that. After selling the Rosneft stake, [the government] will return to selling Bashneft as we have a Presidential order to privatize this company,” Interfax news agency quoted Mr. Shuvalov as saying.

One interpretation of this is that is a big defeat for Sechin. Sechin has fought “privatization” for years. When the oil price has been high, Sechin has said that it would be stupid to sell because the company was undervalued; when the oil price has been low, Sechin has said that it would be stupid to sell when the stock price is commensurately low. In Sechin’s view, the market undervalues Rosneft 100 percent of the time, and the price is never right. The real reason is that nosey outside investors would cramp Igor’s style.

If this signals Putin’s resolve to push the sale of Rosneft, it would be a stinging defeat for Sechin. This would fit with the firing of Ivanov, as it would represent a further winnowing of the old guard.

A more charitable interpretation is that this is Putin’s way of cutting the baby. Shuvalov and others had objected to Rosneft’s participation in the Bashneft auction because purchase of the company by a state company would not be a proper privatization, and would violate Russian law. Perhaps Putin promised Bashneft to Sechin, but only after a sale of the stake in the company (which would still remain majority state owned).

What is clear is that the decision is not purely an economic one, but is driven by regime politics. Politics will drive the ultimate disposition of the company (and Rosneft), and will provide some information about who’s up and who’s down within the elite.

The episode provides a demonstration of the importance of rent seeking within a natural state like Russia. The delay is driven by a battle over rents, and the delay is quite costly. The Russian government needs quite badly the money (a material $5 billion or so) that a sale would generate. Oil in the $40-$50 range and sanctions have put a serious dent in Russia’s fiscal situation, and it has blown through a good fraction of its rainy day funds. Further, the stock price of Bashneft fell 8 percent on the day of Medvedev’s announcement. This is a measure of the value destroyed by state ownership.

This is real money, particularly for Russia right now. That Putin is willing to leave it on the table is a measure of the price of politics in Putin’s natural state.

* Evtushenkov’s fate is a perfect illustration of the parlous nature of an oligarch’s existence. Those attempting to draw inferences from past connections (such as they were) between Trump and Russians really need to keep that in mind, but never do. Hell, if figures like Yakunin, Victor and Sergei Ivanov, and perhaps now Igor Sechin can fall from favor, past connections with far lesser figures are less than meaningless.

Print Friendly

August 20, 2016

On Net, This Paper Doesn’t Tell Us Much About What We Need to Know About the Effects of Clearing

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 4:26 pm

A recent Office of Financial Research paper by Samim Ghamami and Paul Glasserman asks “Does OTC Derivatives Reform Incentivize Central Clearing?” Their answer is, probably not.

My overarching comment is that the paper is a very precise and detailed answer to maybe not the wrong question, exactly, but very much a subsidiary one. The more pressing questions include: (i) Do we want to favor clearing vs. bilateral? Why? What metric tells us that is the right choice? (The paper takes the answer to this question as given, and given as “yes.”) (ii) How do the different mechanisms affect the allocation of risk, including the allocation of risk outside the K banks that are the sole concern in the paper? (iii) How will the rules affect the scale of derivatives trading (the paper takes positions as given) and the allocation across cleared and bilateral instruments? (iv) Following on (ii) and (iii) will the rules affect risk management by end-users and what is the implication of that for the allocation of risk in the economy?

Item (iv) has received too little attention in the debates over clearing and collateral mandates. To the extent that clearing and collateral mandates make it more expensive for end-users to manage risk, how will the end users respond? Will they adjust capital structures? Investment? The scale of their operations? How will this affect the allocation of risk in the broader economy? How will this affect output and growth?

The paper also largely ignores one of the biggest impediments to central clearing–the leverage ratio.  (This regulation receives on mention in passing.) The requirement that even segregated client margins be treated as assets for the purpose of calculating this ratio (even though the bank does not have a claim on these margins) greatly increases the capital costs associated with clearing, and is leading some banks to exit the clearing business or to charge fees that make it too expensive for some firms to trade cleared derivatives. This brings all the issues in (iv) to the fore, and demonstrates that certain aspects of the massive post-crisis regulatory scheme are not well thought out, and inconsistent.

Of course, the paper also focuses on credit risk, and does not address liquidity risk issues at all. Perhaps this is a push between bilateral vs. cleared in a world where variation margin is required for all derivatives transactions, but still. The main concern about clearing and collateral mandates (including variation margin) is that they can cause huge increases in the demand for liquidity precisely at times when liquidity dries up. Another concern is that collateral supply mechanisms that develop in response to the mandates create new interconnections and new sources of instability in the financial system.

The most disappointing part of the paper is that it focuses on netting economies as the driver of cost differences between bilateral and cleared trading, without recognizing that the effects of netting are distributive. To oversimplify only a little, the implication of the paper is that the choice between cleared and bilateral trading is driven by which alternative redistributes the most risk to those not included in the model.

Viewed from that perspective, things look quite different, don’t they? It doesn’t matter whether the answer to that question is “cleared” or “bilateral”–the result will be that if netting drives the answer, the answer will result in the biggest risk transfer to those not considered in the model (who can include, e.g., unsecured creditors and the taxpayers). This brings home hard the point that these types of analyses (including the predecessor of Ghamami-Glasserman, Zhu-Duffie) are profoundly non-systemic because they don’t identify where in the financial system the risk goes. If anything, they distract attention away from the questions about the systemic risks of clearing and collateral mandates. Recognizing that the choice between cleared and bilateral trading is driven by netting, and that netting redistributes risk, the question should be whether that redistribution is desirable or not. But that question is almost never asked, let alone answered.

One narrower, more technical aspect of the paper bothered me. G-G introduce the concept of a concentration ratio, which they define as the ratio of a firm’s contribution to the default fund to the firm’s value at risk used to determine the sizing of the default fund. They argue that the default fund under a cover two standard (in which the default fund can absorb the loss arising from the simultaneous defaults of the two members with the largest exposures) is undersized if the concentration ratio is less than one.

I can see their point, but its main effect is to show that the cover two standard is not joined up closely with the true determinants of the risk exposure of the default fund. Consider a CCP with N identical members, where N is large: in this case, the concentration ratio is small. Further, assume that member defaults are independent, and occur with probability p. The loss to the default fund conditional on the default of a given member is X. Then, the expected loss of the default fund is pNX, and under cover two, the size of the fund is 2X.  There will be some value of N such that for a larger number of members, the default fund will be inadequate. Since the concentration ratio varies inversely with N, this is consistent with the G-G argument.

But this is a straw man argument, as these assumptions are obviously extreme and unrealistic. The default fund’s exposure is driven by the extreme tail of the joint distribution of member losses. What really matters here is tail dependence, which is devilish hard to measure. Cover two essentially assumes a particular form of tail dependence: if the 1st (2nd) largest exposure defaults, so will the 2nd (1st) largest, but it ignores what happens to the remaining members. The assumption of perfect tail dependence between risks 1 and 2 is conservative: ignoring risks 3 through N is not. Where things come out on balance is impossible to determine. Pace G-G, when N is large ignoring 3-to-N is likely very problematic, but whether this results in an undersized default fund depends on whether this effect is more than offset by the extreme assumption of perfect tail dependence between risks 1 and 2.

Without knowing more about the tail dependence structure, it is impossible to play Goldilocks and say that this default fund is too large,  this default fund is too small, and this one is just right by looking at N (or the concentration ratio) alone. But if we could confidently model the tail dependence, we wouldn’t have to use cover two–and we could also determine individual members’ appropriate contributions more exactly than relying on a pro-rata rule (because we could calculate each member’s marginal contribution to the default fund’s risk).

So cover two is really a confession of our ignorance. A case of sizing the default fund based on what we can measure, rather than what we would like to measure, a la the drunk looking for his keys under the lamppost, because the light is better there. Similarly, the concentration ratio is something that can be measured, and does tell us something about whether the default fund is sized correctly, but it doesn’t tell us very much. It is not a sufficient statistic, and may not even be a very revealing one. And how revealing it is may differ substantially between CCPs, because the tail dependence structures of members may vary across them.

In sum, the G-G paper is very careful, and precisely identifies crucial factors that determine the relative private costs of cleared vs. bilateral trading, and how regulations (e.g., capital requirements) affect these costs. But this is only remotely related to the question that we would like to answer, which is what are the social costs of alternative arrangements? The implicit assumption is that the social costs of clearing are lower, and therefore a regulatory structure which favors bilateral trading is problematic. But this assumes facts not in evidence, and ones that are highly questionable. Further, the paper (inadvertently) points out a troubling reality that should have been more widely recognized long ago (as Mark Roe and I have been arguing for years now): the private benefits of cleared vs. bilateral trading are driven by which offers the greatest netting benefit, which also just so happens to generate the biggest risk transfer to those outside the model. This is a truly systemic effect, but is almost always ignored.

In these models that focus on a subset of the financial system, netting is always a feature. In the financial system at large, it can be a bug. Would that the OFR started to investigate that issue.

Print Friendly

Next Page »

Powered by WordPress