Streetwise Professor

October 24, 2015

Creeping Recognition that Regulation Has Created a Liquidity Death Star

Reason number one (by far) that I believe that clearing and collateral mandates increase systemic risk is that they transform credit risk into liquidity risk. Large price moves during stressed market situations require those with losing positions to make large variation margin payments in a very tight frame. These payments need to be funded, and funded immediately. Thus, variation margining causes spikes in the demand for liquidity. Furthermore, clearing in particular creates tight coupling because failures-or even delays-in making VM payments can put the clearinghouse into default, or force it to liquidate collateral in an illiquid market. The consequences of that, you should shudder to contemplate.

To be somewhat hyperbolic, clearing mandates create a sort of liquidity death star.

Recognition of how dangerous spikes in liquidity demand precisely when liquidity supply evaporates creates a major systemic risk is sadly insufficiently widespread, particularly among many regulators who still sing paeans to the glories of clearing. But perhaps awareness is spreading, albeit slowly. At least I hope that this Economist article indicates a greater appreciation of the collateral issue, although it fails to draw the connection to central clearing, and how clearing mandates can dramatically exacerbate collateral shortages:

WHEN the financial system teetered on the brink of collapse in 2008, the biggest problem was a lack of liquidity. Banks were unable to refinance themselves in the short-term debt markets. Central banks had to step in on a massive scale to offer support. Calm was eventually restored, but not without enormous economic damage.

But has the underlying problem of liquidity gone away? A research note from Michael Howell of Crossborder Capital argues that, in the modern financial system, central banks are no longer the only, or even the main, providers of liquidity. Instead, the system looks a lot like that of the Victorian era, with banks dependent on the wholesale markets for funding. Back then, the trade bill was the key asset for bank financing; now it is the mysteriously named “repo” market.

. . . .

Bigger haircuts mean that borrowers need more collateral than before in order to fund themselves. “When market volatility jumps, funding capacity drops in tandem and often substantially,” writes Mr Howell. The result, a liquidity squeeze at the worst possible moment, is a template of how the next crisis may occur (although regulators are trying to reduce banks’ reliance on short-term funding).

And again, it is at these times when the need to fund VM payments will kick in, exacerbating the liquidity squeeze. Moreover, clearing also ties up a lot of the assets (e.g., Treasuries, or cash) that firms could normally borrow against to raise cash. Perversely, that collateral can be accessed only if a clearing member defaults on a variation margin payment.

Just what the liquidity supply mechanism will be in the next crisis in the new cleared world is not quite, well, clear. As the Economist article (and the Crossborder Capital note upon which it is based) demonstrate, central banks lend against collateral, and the collateral constraint will already be binding in stress situation. Presumably central banks will have to be much more expansive in their definition of what constitutes “good” collateral (a la Bagehot).

It still astounds me that even though every major financial crisis in history has been at root a liquidity crisis, in their infinite wisdom the betters who presume to govern us thought they were solving systemic risk problems by imposing a mechanism that will sharply increase liquidity demand and restrict liquidity supply during periods of market stress. That should work out really, really swell.

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October 17, 2015

An Innocent Abroad: Fred Hof and the Intellectual Failure of American Foreign Policy

Filed under: History,Military,Politics — The Professor @ 10:05 am

Fred Hof, former “special advisor for transition in Syria at the U.S. Department of State,” has written a self-flaggelating flagellating piece about his-and the United States’-failure in Syria. It is part damning indictment of himself and the State Department, and part damning indictment of Obama.

A recurrent theme-implicit, not explicit-is Hof’s incredible naiveté. He was repeatedly fooled by the man he was supposedly working with-Bashir al-Assad-and the man he was working for-Barack Obama. He was fooled because he romantically projected his own beliefs on them, and because he engaged in wishful thinking, when he would have been better served to live by Lily Tomlin’s credo: “We try to be cynical, but it’s hard to keep up.”

Hof was-and remains-genuinely shocked that Assad reacted brutally to the first outbreak of opposition to his regime:

I did not think it inevitable that Assad—a computer-savvy individual who knew mass murder could not remain hidden from view in the 21st century—would react to peaceful protest as violently as he did, with no accompanying political outreach.

. . . .

By firing on peaceful demonstrators protesting police brutality in the southern Syrian city of Deraa, gunmen of the Syrian security services shredded any claim Assad had to governing legitimately. Indeed, Assad himself—as president of the Syrian Arab Republic and commander in chief of the armed forces—was fully responsible for the shoot-to-kill atrocities.

Hof actually believed that computer savviness was some marker for civilized values? He believed that Assad would actually care if his crimes were witnessed by the world? Cringemaking.

Look. Dictum 1 of the Dictator’s Handbook says, in bold, italicized type: “Every dictator who has attempted ‘political outreach’ to opponents has ended up at the end of a rope or bleeding in the dirt. Crush all dissent mercilessly.”

Furthermore, Hof’s optimistic view was completely oblivious to Syria’s history. In the 1970s and early-1980s, Assad’s father faced an extreme threat from the Muslim Brotherhood. The Brotherhood came close to assassinating him, and he responded by extirpating the organization in Syria, most infamously by attacking Hama with armor, artillery, and air power, resulting in the deaths of thousands (which Brotherhood propaganda has succeeded in inflating to 40-50,000). Assad no doubt had intelligence about the resurgence of the MB within Syria, and throughout the Middle East generally. He no doubt understood that the “Arab Spring” was largely the Muslim Brotherhood Spring-something that those in the West generally and the US in particular still fail to grasp. Even if he didn’t know these things, he certainly feared them, and was not going to take any chances that the protests in Deraa were fronting for, or would be exploited by, the Brotherhood.

In other words, the chances he would not have responded to any protest with extreme force were somewhere between zero and none.

But the US, and this administration in particular, not only seems oblivious to the Muslim Brotherhood’s malignity, it actually thinks that it is a progressive force in the Middle East.

Hof also took at face value Assad’s representation that he would sever all ties with Hezbollah in exchange for a return of the Golan heights. This was wishful thinking in the extreme. Just how far did Hof think that the Iranians would let Assad proceed down this path? Iran’s interest in Syria is primarily because it is their vital bridge to Hezbollah. Iran is dedicated to Israel’s destruction. If he had tried to sell out Hezbollah to achieve a deal with Israel, the Iranians would have been in a race with the Brotherhood to kill him.

Indeed, Hof understood this at some level, but chose to ignore it:

Fully complicit in the Assad regime’s impressive portfolio of war crimes and crimes against humanity, Iran relies on its client to secure its overland reach into Lebanon.

As for the man he worked for, Hof reminds me of Flounder in Animal House: “You fucked up! You trusted us!“:

My failure to predict the extent of Syria’s fall was, in large measure, a failure to understand the home team. In August 2011, Barack Obama said Assad should step aside. Believing the president’s words guaranteed decisive follow-up, I told a congressional committee in December 2011 that the regime was a dead man walking. When the president issued his red-line warning, I fearlessly predicted (as a newly private citizen) that crossing the line would bring the Assad regime a debilitating body blow. I still do not understand how such a gap between word and deed could have been permitted. It is an error that transcends Syria.

“Such a gap between word and deed” is the essence of the Obama way. And please. Obama ran in 2008 on disengaging militarily from the Middle East. He ran on the view that US military intervention was inevitably counterproductive. He ran in 2012 bragging about ending the war in Iraq, and took the opportunity to remind the world yet again of his belief of the futility of American military engagement in the Middle East.

You see, there are some words that Obama utters that conform to his deeds almost exactly. The key is understanding which words he means, and which ones he doesn’t. Hof again let his magical thinking delude him into believing that Obama meant the things he said that Hof agreed with, instead of realizing that these words contradicted Obama’s core beliefs, and were uttered for the sole purpose of meeting “a communications challenge: getting Obama on “the right side of history” in terms of his public pronouncements.”

Hof deserves credit for admitting his failures so openly, and I can sympathize on a human level. What is disturbing is that his failure is symptomatic of deeper institutional failures in the United States foreign policy establishment. The examples are many, but Syria alone provides some particularly damning ones. How long has the US been chasing the Assad chimera? Remember Warren Christopher panting after Assad père during the Clinton administration? Nancy Pelosi meeting with and gushing over the Chinless Ophthalmologist in 2007? John Kerry chasing after Assad for years, finally dining with him and his wife in Damascus, then saying this?:

“I have been a believer for some period of time that we could make progress in that relationship,” he said. “And I’m going to continue to work for it and push it.”

In the same year, when he once again wanted to go to Syria, his visit was blocked by the Obama administration.

“President Assad has been very generous with me in terms of the discussions we have had,” he said after his March speech. “And when I last went to – the last several trips to Syria – I asked President Assad to do certain things to build the relationship with the United States and sort of show the good faith that would help us to move the process forward.”

He mentioned some of the requests, including the purchase of land for the US Embassy in Damascus, the opening of an American cultural centre, non-interference in Lebanon’s election and the improvement of ties with Iraq and Bahrain, and said Mr Assad had met each one.

“So my judgment is that Syria will move; Syria will change, as it embraces a legitimate relationship with the United States and the West and economic opportunity that comes with it and the participation that comes with it.”

A few years later, of course, Kerry was comparing Assad to Hitler and pressing for air strikes- a call that Obama spurned. A perfect demonstration of Kerry’s lack of judgment, discernment, and just plain seriousness.

No. Fred Hof is not the problem. Fred Hof is a symptom of a bigger problem: the intellectual failings of American foreign policy.

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October 12, 2015

From the Ridiculous to the Absurd Is But A Single Step: A New Rebel Group Magically Appears in Syria

Filed under: History,Military,Politics,Russia — The Professor @ 6:23 pm

If there’s been a bigger debacle for the US military since St. Clair’s Defeat in 1791 than the fiasco of arming the “moderate” Syrian resistance, I would be hard pressed to name it.

First, there was the fact that the pitifully small number of recruits that we managed to scrape together were either killed or captures no sooner than they had set foot into Syrian territory. Then, other groups turned over arms and equipment to al Nusra to secure safe passage. Then the Russians bombed the snot out of our (CIA-trained) forces while Kerry mewled in protest.

So it was announced that the Pentagon-run train and equip program was being terminated. But check that! The mission has not been ended. Train no: equip yes. We will just give arms to “leaders” we’ve vetted and let them hand them out to . . . whomever.

Meanwhile, in a 60 Minutes interview Obama said that he had been skeptical of arming the opposition from the get-go. (This is no doubt true: remember his dismissive remarks from last year about the futility of arming pharmacists and farmers and expecting them to beat an organized army?)

This immediately raises the questions: (a) then why did you, as commander of chief, permit the program to proceed? (b) if you were going to let it proceed, why didn’t you demand changes to give it a reasonable chance of achieving some success?

What’s more, despite Obama’s alleged skepticism, he is permitting yet another effort. This one would make Rube Goldberg proud. This is so bizarre that you might think I’m playing some sort of joke on you, but I swear, I’m just passing along what’s been reported.

Lo and behold, last night, almost at the exact same time Obama was heaping scorn on the idea of supporting armed opposition groups, a new Syrian resistance group magically appeared: The Democratic Forces of Syria.

It’s sort of the Rainbow Coalition of Syria. Kurds. Arabs. Assyrian Christians. So you should feel all warm and fuzzy about the inclusiveness of the new group.

If you believe the formation this group, and its allegedly ecumenical nature, was spontaneous and indigenous, I have some oceanfront property in Wyoming to sell you.

Bolstered by American arms, the mission of the new group is to advance on Raqqa, and drive ISIS from its Syrian capital. The Kurdish YPG has gained some success against ISIS, and would obviously be the core of any new force.

But we aren’t arming the Kurds! Because that would infuriate Erdogan and Turkey, and he could very well back out of his agreement to allow the US access to Incirlik, and do other nefarious things to kneecap the American efforts (such as they are) against ISIS. So we’re doing this instead:

Officials emphasized that U.S. military aid will go directly to the Arabs, not the Kurds, but the Kurdish fighters stand to benefit from the decision. To date, Washington has hesitated to hand equipment directly to the Kurds. Instead, they send materiel through the central government of Iraq. The new aid will be transported directly to Syria, where Arab groups are expected to launch a new offensive in and around Raqqa, the de facto Islamic State capital, while the Kurds continue to hold border areas where together they have succeeded in routing the militants.

The Kurds are the most effective military force in the region, and the Arabs have been completely unheard from in this sector, so we arm the latter and let the former cool their heels.

From the ridiculous to the absurd is but a single step.

To quote Casey Stengel: Can’t anybody here play this game?

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October 10, 2015

Igor Gensler Helps the Wicked Witch of the West Wing Create Son of Frankendodd

Hillary Clinton has announced her program to reform Wall Street. Again.

The actual author of the plan is said to be my old buddy, GiGi: Gary Gensler.

Gensler, if you will recall, was the Igor to Dr. Frankendodd, the loyal assistant who did the hard work to bring the monster to life. Now he is teaming with the Wicked Witch of the West Wing to create Son of Frankendodd.

There are a few reasonable things in the proposal. A risk charge on bigger, more complex institutions makes sense, although the details are devilish.

But for the most part, it is ill-conceived, as one would expect from Gensler.

For instance, it proposes regulating haircuts on repo loans. As I said frequently in the 2009-2010 period, attempting to impose these sorts of requirements on heterogeneous transactions is a form of price control that will lead some risks to be underpriced and some risks to be overpriced. This will create distorted incentives that are likely to increase risks and misallocations, rather than reduce them.

A tax on HFT has received the most attention:

The growth of high-frequency trading (HFT) has unnecessarily burdened our markets and enabled unfair and abusive trading strategies that often capitalize on a “two-tiered” market structure with obsolete rules. That’s why Clinton would impose a tax targeted specifically at harmful HFT. In particular, the tax would hit HFT strategies involving excessive levels of order cancellations, which make our markets less stable and less fair.

This is completely wrongheaded. HFT has not “burdened” our markets. It has been a form of creative destruction that has made traditional intermediaries obsolete, and in so doing has dramatically reduced trading costs. Yes, a baroque market structure in equities has created opportunities for rent seeking by HFT firms, but that was created by regulations, RegNMS in particular. So why not fix the rules (which in Hillary and Gensler acknowledge are problematic) rather than kneecap those who are responding to the incentives the rules create?

Furthermore, the particular remedy proposed here is completely idiotic. “Excessive levels of order cancellations.” Just who is capable of determining what is “excessive”? Furthermore, the ability to cancel orders rapidly is exactly what allows HFT to supply liquidity cheaply, because it limits their vulnerability to adverse selection. High rates of order cancellation are a feature, not a bug, in market making.

It is particularly ironic that Hillary pitches this as a matter of protecting “everyday investors.” FFS, “everyday investors” trading in small quantities are the ones who have gained most from the HFT-caused narrowing of bid-ask spreads.

Hillary also targets dark pools, another target of popular ignorance. Dark pools reduce trading costs for institutional investors, many of whom are investing the money of “everyday” people.

The proposal also gives Gensler an opportunity to ride one of his hobby horses, the Swaps Pushout Rule. This is another inane idea that is completely at odds with its purported purpose. It breaks netting sets and if anything makes the financial system more complex, and certainly makes financial institutions more complex. It also discriminates against commodities and increases the costs of managing commodity price risk.

The most bizarre part of the proposal would require financial institutions to demonstrate to regulators that they can be managed effectively.

Require firms that are too large and too risky to be managed effectively to reorganize, downsize, or break apart. The complexity and scope of many of the largest financial institutions can create risks for our economy by increasing both the likelihood that firms will fail and the economic damage that such failures can cause.[xiv] That’s why, as President, Clinton would pursue legislation that enhances regulators’ authorities under Dodd-Frank to ensure that no financial institution is too large and too risky to manage. Large financial firms would need to demonstrate to regulators that they can be managed effectively, with appropriate accountability across all of their activities. If firms can’t be managed effectively, regulators would have the explicit statutory authorization to require that they reorganize, downsize, or break apart. And Clinton would appoint regulators who would use both these new authorities and the substantial authorities they already have to hold firms accountable.

Just how would you demonstrate this? What would be the criteria? Why should we believe that regulators have the knowledge or expertise to make these judgments?

I have a Modest Proposal of my own. How about a rule that requires legislators and regulators to demonstrate that they have the competence to manage entire sectors of the economy, and in particular, have the competence to understand, let alone manage, an extraordinarily complex emergent order like the financial system? If some firms are too complex to manage, isn’t an ecosystem consisting of many such firms interacting in highly non-linear ways exponentially more complex to control, especially through the cumbersome process of legislation and regulation? Shouldn’t regulators demonstrate they are up to the task?

But of course Gensler and his ilk believe that they are somehow superior to those who manage financial firms. They are oblivious to the Knowledge Problem, and can see the speck in every banker’s eye, but don’t notice the log in their own.

People like Gensler and Hillary, who are so hubristic to presume that they can design and regulate the complex financial system, are by far the biggest systemic risk. Frankendodd was bad enough, but Son of Frankendodd looks to be an even worse horror show, and is almost guaranteed to be so if Gensler is the one in charge, as he clearly aims to be.

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October 8, 2015

Why Don’t Journalists Scrutinize the Oracle of Syria?

Filed under: Military,Politics — The Professor @ 5:04 pm

One of the most irritating things about coverage of the war in Syria is that virtually every story relies on a single source, the Syrian Observatory for Human Rights, for the bulk of its (alleged) in-country information. This story from Reuters is an example.

The problem is that the Observatory isn’t in country at all. It’s a one man operation run by Rami Abdulrahman from his flat in London,where he’s lived for 15 years.

Despite the distance, and the fog of war, Rami provides exceptionally detailed reports on military operations by all sides in real time. Not a sparrow falls in Syria without Rami’s knowledge. Particularly suspicious are his precise casualty counts. It’s never “around 20 were reported killed.” It’s always “22 were killed” or “27 were killed.” There is seldom that precision in mass casualty reports even in the US, sometimes for days after the event occurs.

Rami’s distance, the extremely fragmented nature of the contestants (the opposition groups number in the dozens), the inherent uncertainties of first person accounts, the incentive of those on the ground to lie, his inability to verify information, and on and on and on should raise serious doubts about his accuracy, even if you don’t wonder about his potential interest. His background strongly suggests a Muslim Brotherhood connection. (The MB was the heart of the anti-Assad opposition for years before the war broke out. That’s who Assad père was trying to wipe out in Hama in 1982.)

Yet I have yet to see one serious journalist inquire about him or his operation, or question his/its reliability. Instead, he is universally treated like some sort of oracle, all knowing and all seeing. Is it just because it’s too hard to report from Syria, and just too easy to pretend that the guy in London knows everything there is to know?

Since the vast bulk of stories rely on this single, doubtful source, it all must be questioned. And he must be questioned, not least by those who rely on him as their primary source. And you must question any article that relies heavily on him. Which means, you must question pretty much every article about Syria.

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October 7, 2015

We Need to Choose Our Battles, and Syria Isn’t It

Filed under: History,Military,Politics,Russia — The Professor @ 11:04 pm

The hysteria over Russian actions in Syria continues. The Russians are making token strikes-at most-against ISIS, and are focusing their firepower on other anti-regime forces in the west of the country.

Well, of course they are. Putin’s objective is to save Assad’s regime. Its core area in the west. The greatest threat is in the west. So that’s where the bulk of the blows will fall.

Today’s cruise missile attack, launched from the Caspian is partly showing off (especially showing off the fact that Iran and Iraq had to concur), but it also makes military sense as part of a preparatory bombardment supporting a counterattack by regime forces, which is apparently in progress. This demonstrates that the Russian air campaign is part of a coherent military operation which integrates air and ground elements. This presents a stark contrast to the air-only US campaign against ISIS, which cannot achieve any decisive result whatsoever. (It remains to be seen whether Russian air support is sufficient to overcome the extreme shakiness of the Syrian army, which wasn’t much to start with and which has been relentlessly ground down by four years of brutal war.) (In contrast to the coherent Russian effort, the US attacks in Syria yesterday involved destroying two “crude oil collection facilities.” Really. No excavators were available?)

There is also hysteria about Russian lying about what they are doing.  This is like attacking a cobra for striking. It’s what they do.

Most of the frenzy focuses on the Russians’ targeting of “our” rebels in the Free Syrian Army. Yes, this is quite deliberate, and a strike at the US for having the temerity of supporting the anti-Assad effort. Putin views this as a part of a broader struggle against the US.

So should the US respond to the challenge frontally, in Syria?  No. And it’s not even a close call.

First, what is the strategic objective to be gained? I find it hard to see an important security interest in Syria. And overthrowing Assad because he’s a monster could be justified, except that monsters-and arguably worse monsters than Assad-will take over. An Assad rout would likely result in a bacchanal of sectarian violence which would result in the extirpation of non-Sunni communities in Syria. There has not been one Middle East war that has ended in anything closely resembling peace, and the circumstances in Syria are even less favorable to such an outcome than in Iraq and Libya.

Second, the idea that the there is a serious “moderate” opposition in Syria is not true today, and arguably never was true. The FSA’s day passed years ago, and our track record of identifying moderate, secular forces in this region is appallingly bad.

Those that are pushing this fantasy include John McCain, who is detached from reality on this issue. Others include journalists Michael Weiss and Hassan Hassan, who have been flogging this narrative for four years, and are frantically doing so now: the more implausible the narrative becomes, the more frenzied they become. One should note that Hassan is tightly connected with UAE, which has been the main supporter of the anti-Assad opposition from the beginning, and Weiss’s connections are murky, and his pom-pomming for a Syrian opposition that is lousy with Islamists raises questions.

(And by the way: I thought the CIA program to arm the opposition was supposed to be covert. Why are we blabbing about it?)

Third, what can be done? The idée du jour supported by left (Hillary Clinton) and right (several GOP candidates, including Rubio, Fiorina, and Christie), is a no fly zone. This is superficially appealing because it relies purely on American airpower, and thus does not require a ground commitment. This virtue is in fact a measure of the non-seriousness of the idea.  It would not have been militarily decisive before the Russians arrived because Assad’s air force played only a marginal role in the conflict. Now it would require a confrontation with the Russians, because it is the Russians that are flying. Why engage in a confrontation that could lead to unpredictable developments elsewhere, and which (per the above) would not result in any material strategic gainer the US?

Rubio goes further, plumping for a “safe zone” that somehow will magically be radical Islamist-free. How this would work outside of some Harry Potter-esque fantasy is beyond me. Further, note the “safe zone” idea is a favorite of Erdogan. Who has been a major supporter of the Islamist groups in Syria. It appears for all the world that Rubio has bought a bill of goods from the GCC and the Turks about the Syrian opposition.

If you look at the correlation of forces (as the Soviets put it), and the strategic stakes, deeper US involvement in Syria makes no sense. The odds of prevailing are low, and the gains from winning are trivial, and likely non-existent.

Russia’s aggressiveness is indeed a concern, and someone with Putin’s mindset will be emboldened if he believes that he will meet no resistance. But an asymmetric response, an indirect approach, is more advisable. Russia’s vulnerabilities are economic and financial, and its greatest sensitivities are on in the Baltics, Poland, and Ukraine.

One last thing. The sputtering denunciations of Putin, notably again by McCain and others, are profoundly counterproductive. They only contribute to Putin’s image as some sort of colossus, which only encourages more aggressiveness and more admiration for him. At the other extreme, the administration’s mewling protests that the Syrian intervention is a testament to Putin’s weakness is just plain pathetic, especially since it is not accompanied by any countermoves anywhere.

Unfortunately, this administration is has neither the intestinal fortitude nor the strategic dexterity to respond effectively, or even coherently. We will have to wait another 15 months at least for a reach change. Unfortunately, there’s not much to look forward to on that front, as none of the Republican candidates have impressed in the least. Rubio particularly disappointed not just because of the safe zone inanity, but because of his clueless remark that Syria is a battle for the future of Sunni Islam: (a) this is not our battle, and (b) it it mimics Saudi and Qatar Sunni chauvinism, and their interests are not ours, in the slightest. (How often has our anger at Iran blinded us to the fact that the Saudis are a deeply malign force too? I actually have a grudging respect for the Iranians. At least they are quite open about their hatred for us.)

We need to pick our battles, and Syria isn’t it. The obsession with it is distracting from the true objective, which should be to construct a coherent strategic response to Putin that exploits our comparative advantages, rather than confronting him where he can exploit his.


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September 30, 2015

Let Putin Find Out the Hard Way

Filed under: Military,Politics,Russia — The Professor @ 1:13 pm

I have no need to demonstrate my anti-Putin bona fides, but I just roll my eyes at the hysterical response to his intervention in Syria, and today’s launch of Russian bombing operations.  There is much shrieking about the fact that the Russians say they are bombing Isis, but in fact launched a raid on Homs where Isis was not present.

The Russian response is, basically: “Hey, they all look alike to us.” There is much truth to that.

This is not that complicated:

  1. Russia is intervening to save Assad from imminent defeat, and to protect its ports in Syria.
  2. Isis is not the most immediate threat to either Assad or the Russian facilities.
  3. Therefore, Russia will focus on non-Isis targets, while claiming to be fighting Isis.

This is really not that much different than the Turks using Isis as a pretext to attack their real enemy, the PKK.

Yes, this campaign will help Assad, and Assad is an evil bastard. But the Islamists that are dominating the anti-Assad forces are evil bastards too. Many are Al Qaeda offshoots, and others are indistinguishable from Al Qaeda in their ideology and agenda. Or from Isis, for that matter. They are Sunni supremacist Islamists. And wouldn’t you know, we are fighting Sunni supremacist Islamists around the world, and have been for going on 15 years.

There are no good guys in Syria. Stop pretending there are: there is considerable reason to doubt there ever were. And any differences between Isis and the non-Isis Islamists the Russians are bombing are trivial. They do all pretty much look (and act) alike. And what’s more, pretty much everyone in the West looks the same to them: they all think your head would look just splendid mounted on a spike in the front yard.

And yes, Assad’s forces will slaughter his foes if they win. But Assad’s foes will slaughter Assad’s supporters if they win. Syria is a charnel house being fought over by demons.  There is a symmetry of evil.

It is particularly rich that those who are shrieking about Russian involvement say that it will radicalize Sunnis.

Um, where are these people been? Since like 700AD, let alone since 2001 or 2011? Radicalization is a done deal, and the most that the Russians can do is gild that lily.

Moreover, I actually find myself agreeing with some in the administration here. If you truly believe that Syria is a pointless slaughter that we should avoid at all costs (and I believe that is the case today), why would you oppose Putin jumping in? The administration believes (rightly) that we have no current military options that would generate results that even remotely justify the costs: the military realities are exactly the same for Putin. Yes, he will likely secure a rump Syria with its shambolic Russian port facilities (which is more than we could gain). But his airpower is going to be no more decisive than ours, and he is putting himself at risk of getting sucked in more deeply in ways that will cost him blood and treasure that he can’t afford.

As I said before: don’t interrupt an enemy while he is making a mistake.

As for the US, Russian involvement is leading some to advocate getting more heavily involved ourselves. Another military adage is: don’t reinforce failure. Failure is the charitable way of describing US policy in Syria. Don’t reinforce it. Let it go. It’s past our ability to save, or even palliate. It’s done. Both sides.

Let Putin find out the hard way.

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September 26, 2015

Capital My Boy, Capital: Or, the Day of the MiFIDs

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Politics,Regulation — The Professor @ 6:42 pm

As the EU’s Markets in Financial Instruments Directive II (“MiFID II”) slouches towards its destiny in Brussels, one of the last items on the agenda is capital requirements for commodity traders. It appears that the entity responsible for providing technical advice to the European Commission, European Securities and Markets Authority (“ESMA”–my God when it comes to acronyms the US military has nothing on the EU) is like the proverbial poor carpenter who owns only a hammer, so that everything looks like a nail. Or in ESMA’s case, that every firm that intermediates looks like a bank, and must be regulated accordingly, including through capital requirements. Thus, firms that serve as intermediaries in physical commodities are likely to be subject to the same type of capital requirements as firms that engage in financial intermediation, like banks, and be forced to hold a higher proportion of equity in their capital structures than they currently do.

This raises the question: what “market failure” (to use a shorthand that I dislike but which gets at the basic idea) justifies the regulation of the capital structures of firms?

One can make the case for banks and some other financial intermediaries. Banks have fragile capital structures because they engage in liquidity and maturity transformations that make them vulnerable to runs. Runs on a particular institution can impose costs on other institutions, and the resulting financial crises can have devastating effects on the broader economy. The effects on the broader economy occur because financially impaired banks cannot produce their most valuable output, credit, and contractions of credit can cause a broad downturn. Banks don’t internalize these effects, and thus may choose capital structures that are too fragile. Capital requirements can ameliorate this externality.

Commodity trading firms intermediate, but they are totally different than banks. I set out the reasons in detail in this white paper (sponsored by Trafigura*-with bonus video!). A few of the key points. Commodity trading firms (“CTFs”-hey, I can play the acronym game too!) aren’t too big to fail because they aren’t that big, by comparison to banks in particular. More importantly, they don’t have fragile capital structures because although CTFs transform commodities in space, time, and form, they don’t engage in financial transformations in maturity or liquidity like banks do. They aren’t even that highly leveraged, in comparison to European banks in particular. Further, whereas a bank can’t produce its main product (credit) if it is financially distressed, the human and physical assets of a commodity trading firm can continue to transform commodities even if the firm is financially distressed: it can operate under insolvency protection or its assets can be spun off to another firm.

This is not to say commodity trading firms can’t go bust. They can: we might see that in a big way if Glencore’s travails worsen. It is to say the fallout will be limited to their creditors and shareholders, and will not be the catalyst for a financial crisis.

Consequently, there is no justification for regulating the capital structures of these entities. But Europe, in its wisdom, apparently thinks otherwise.

The numbers are big. Based on public data from 2010-2012 for five big European energy companies with trading arms alone, I estimate that the additional equity required is in the vicinity of $120 billion with a “b”. Smaller entities will take smaller hits, but it will add up and probably put the final number in the $150 billion-$200 billion range. Some Swiss entities won’t be hit directly on their main trading businesses, but they have derivatives affiliates in the UK that will be. They might decide that the weather is better elsewhere.

The big driver in the number is the Operational Risk category, which is based off 15 percent of revenues averaged over the last three years. This number is big for commodity traders because they buy and sell a lot, which generates revenues that typically dwarf their incomes (because margins are on the order of 1-2 percent).

Operational risk is a catch-all category that encompasses things other than price and credit risks, such as rogue trader risk (of which there was an example just this week), a systems failure that results in a loss, etc. Yes bigger firms with bigger revenues are likely to have bigger operational losses, but these risks don’t scale with commodity firm revenues.

I have been told that there is whispering in Brussels against these numbers, because they are based on revenues derived when oil was north of $100/bbl. At lower prices, the operational risk charge will be smaller.

Thanks for proving my point, you whisperers! Please speak up, so everyone can hear!

Operational risks are more related to the scale of the physical business (e.g., the number of barrels traded)  which is much more stable than the price of oil. So a revenue-based operational risk charge expands and contracts like an accordion with the price of commodities, but the operational risk that the charge is supposed to absorb doesn’t fluctuate nearly so much. Given the costs of increasing equity, it is likely that firms will hold equity based on high commodity price-based revenues, leading to equity capitalization that is excessive in most environments. (Well, since the regulation generates no meaningful benefits, any requirement is excessive, but it will be extremely excessive given the way it is set up.)

You might say: “Who cares?” After all, in a Modigliani-Miller world, capital structure is irrelevant. Requiring firms to issue more equity and less debt doesn’t impose costs.

Yes. In a Modigliani-Miller world, which, like the Coase world, points out the things that must be true for the irrelevance result to hold. A theoretical world, in other words, not the real world we live in.

Firms care about capital structure because in a world with economic frictions capital structure can generate or destroy value. Imposing a capital structure that firms would not freely choose therefore imposes costs.

Firms affected by the new regs will adjust on many margins. Some will decamp from Europe, for other locales like Singapore. Others who cannot be so footloose will restructure their businesses to mitigate the impact. For instance, they might try to restructure to ring fence the trading activities that are subject to MiFID. Their ability to do so will depend on whether the Commission makes physical forwards subject to the regulation. Again, since these firms did not choose these locations or structures in the absence of the regulation, these changes will involve an increase in cost and a destruction in value, with no corresponding benefit that offsets this cost even  in part.

Privately held firms may face the biggest conundrum. There is a good reason for private ownership: it aligns the incentives of owners and managers because the managers are the owners. This is a more feasible option for commodity firms than large entities in other industries because commodity price risks can be laid off to the broader financial market using derivatives hedges. The downside of private ownership is that it limits access to public capital markets for equity funding. Clever financing policies (e.g., the issuance of very long term debt that provides long term funding without a loss of control) can finesse this problem, but requiring a big boost in equity would likely force firms either to contract their balance sheets and reduce their size (again, creating an economic cost because these firms will be artificially small), or go public, and incur increased agency costs (because of a poorer alignment of incentives).

In brief, application of bank-like capital requirements on commodity traders would be all pain, no gain. The efficiency of commodity intermediation would decline. This will harm producers (who get lower prices) and consumers (who pay higher prices) because middlemen’s margins must rise to cover the higher costs caused by the burdensome regulation of their capital structures. This will not be offset by any reduction in systemic risk.

There’s an early post-WWII SciFi novel titled Day of the Triffids, in which a plague of blindness leads to the rise of an aggressive species of plant. Well, MiFID rhymes with triffid, and Day of the MiFID would be a candidate for a sequel. Why? Because blindness about the realities of commodity trading is allowing an aggressive variety of plant (Brussels bureaucrats-believe me, the metaphor fits!) to wreak havoc on the poor folk who trade, produce, and consume commodities.

Well played, Europe! Well played!

* For those whose intellect cannot conceive of any other reason than personal gain to explain an individual’s opinion, do remember that I arrived at most of the conclusions contained in the white paper when I was retained to analyze the systemic risk of commodity traders by a bank trade association that very much wanted me to conclude the opposite, and who therefore spiked the study. But the truth gets out eventually.

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September 25, 2015

Dying of a Theory, Socialcon Edition

Filed under: Politics — The Professor @ 6:25 pm

This should be a very winnable year for the Republicans. Hillary has more baggage than the hold of the Titanic, and her campaign is careening towards many icebergs to boot: the email fiasco in particular metastasizes daily, with her spokes-drones daily cast in the role of Nixon’s Ron Ziegler, intoning that one previous explanation after another is no longer operative. Waiting in the wings are a socialist loon, Bernie Sanders, and a hair-plugged political lifer loon, Slow Joe Biden. Nominating a non-insane person would result in a near shoeshoo-in for the Republicans.

But that would be too easy. There is a group of single issue ideologues, mainly social conservatives, whose insistence on ideological purity could doom us to further years of a Democrat in the White House. The glee of these people at the resignation of John Boehner as Speaker of the House illustrates the mindset, and the problem. These are people the Republicans can’t win without (because they tend to stay at home with their panties in a bunch if they don’t get their way) but can’t win with (because they alienate people who might be inclined to favor Republicans on other issues, such as fiscal matters, defense, taxes, immigration, and Obamacare).

I am hardly a Boehner enthusiast (or a McConnell one either). He has been uninspiring, and Obama has outmaneuvered him time and again. But I recognize that Boehner is in a difficult position, especially given the media imbalance between Democrats (and the Obama administration especially) and Republicans. But that too is symptomatic of the baleful effects of social conservatives: they provide an unending stream of bulletin board material for the media. If those who have rebelled against Boehner get their wish, and have one of their own supplant him in the leadership, the media-and Obama, and Hillary-will get their wish too.

Think about that. Right now Obama and the rest of the Democrats are probably buying popcorn by the gross to munch while watching the Republicans commit ritual suicide. They probably can’t believe their luck in the draw of political enemies.

Politics is the art of the possible. Consider the example of Lincoln, much reviled in his time, and revealingly much reviled today by many of those who were baying for Boehner’s scalp. The radicals and the ultras were scathing in their criticism of Lincoln for his temporizing on the issues of slavery, and eventually Reconstruction. But if Lincoln had run on the Radical Republican platform in 1864, he would have not been re-elected, and the South would likely have prevailed in seceding, or negotiated a return to the Union on terms that preserved slavery: either way, the slavery that the Radicals so hated would have endured. If  he had run on an avowedly abolitionist platform in 1860, he would not have been elected, and again, the result would have been years of continued bondage.

Lincoln attempted to keep together a fractious coalition in a period of unequaled political stress. He made compromises that drove the radicals wild. But their preferred path was impossible. Indulging them would have driven the bulk of the country into the arms of the reactionaries. The abolitionist/radical nightmare would have continued unabated had they won the internecine Republican  civil war within  a Civil War.

That’s the way it is in a democracy, and in any political system, really. The electorate is a constraint. The tension of leadership is to lead-that is, not merely to capitulate to popular whims-while not getting so far out in front that the electorate rejects you.

The vast bulk of the electorate is not about to join the socialcons in a kamikaze charge, especially on social issues like abortion or even immigration. But by insisting on ideological purity on these issues, these people will empower the left, which will move the country further away from the socialcons’ desired state of affairs, not closer.

To invoke Lincoln’s Civil War antagonist, Jefferson Davis, who said that the Confederacy’s epitaph should be “Died of a Theory”: the ideological and theological theories being advanced by the Rigid Right will will kill any Republican chances at the presidency in 2016, and likely beyond.

The beyond part is realistic, and particularly disturbing. It is realistic because there are many examples of ideological purists putting their dominance of a party and forcing its adherence to their ideology over electoral success. You have to look no further for an example than the UK, where in the aftermath of a stunning electoral defeat, the Labour Party decided not to understand and accommodate the majority. Instead, it indulged its inner Bolshevik, and elected as leader a hardcore leftist (Jeremy Corbyn) who would have been extreme in the 20s, or the pre-Thatcher 70s. Those who are left can take smug comfort in their purity, and are indeed reveling in their intra-party triumph, but shouldn’t be planning on moving into 10 Downing Street anytime soon.

Those who are pushing Trump (though it is beyond me how any social conservative could seriously consider him a fellow traveler), or Cruz, or Huckabee, and who will sit out the election if a Rubio, Fiorina, or Bush are nominated better place a high value on making sure that their purity of theory and ideology is unsullied by compromise, for that’s all that they will have to console them. Politically and legally the country will move further away from them, not closer, because they will extend the Democrats’ hold on the White House.

The perfect is the enemy of the good, especially in politics. The problem is, some people are too self-righteous to figure that out.

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September 21, 2015

The Wicked Witch of the West Wing Brings on an SWP Acid Flashback Moment

Filed under: Economics,History,Politics — The Professor @ 2:23 pm

I had an acid flashback moment when I read this:

Biotechnology stocks took a sharp dive Monday after Hillary Clinton said she would propose a plan to counteract “price gouging” by drug makers.

Ms. Clinton, who is seeking the Democratic nomination for president, was responding to New York Times article published Sunday that told of a price increase for a drug used to treat a life-threatening parasitic infection. The cost of the drug was recently increase from $13.50 a tablet to $750, the story said.

Why? Because Hillary wreaked havoc on pharmaceutical stock prices 23 years ago, when Bill was running for President. Indeed, this is more than a matter of academic interest to me, because I played a role in the fallout from that. In 1993, I wrote a study, titled “Political Rhetoric and Stock Price Volatility,” that contributed to one of the early Clinton scandals. For you see, while blasting pharma companies, Hillary was also invested in a hedge fund that shorted health care stocks, and I documented using standard event study methodology that her speeches led to economically and statistically significant declines in pharmaceutical company stock prices.

In large part as a result of the study, Hillary was subjected to an official ethics inquiry. Her friend-and arguably more-Vince Foster was working on this and other nascent Hillary scandals when he put a bullet in his brain on the ramparts of Fort Marcy. On a more personal note, the study was the direct cause of the end of my employment at the University of Michigan Business School.

For details about the official fallout of this long-ago and long-forgotten study, see footnote 3 and the associated text in the Senate Whitewater Report. For how this played out for me, see this old SWP post. (As an aside, Sara Ellison and Wally Mullin expanded on my study in an article that was published in the JLE.)

As for Hillary, I think an inquiry into her investment holdings is warranted. Given the sleaze of the Clinton Foundation, and her disdain for the rules that little people follow as illustrated by the Home Brew Server, I would not be in the least surprised if the (once, and hopefully not future) Wicked Witch of the West Wing has been less than punctilious in the separation of her financial and political interests.

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