Streetwise Professor

September 28, 2008

The Market’s Initial Take

Filed under: Uncategorized — The Professor @ 6:04 pm

Trading is open on CME GLOBEX.   Equity indices up slightly–S&P emini up 1.75, Dow up 20, NASDAQ up 4.25.   Dollar stronger across the board, including decent gains against the pound and the Euro.   Perhaps most importantly, Eurodollar futures up 2.5 (meaning a 2.5 basis point decline in forward 3 month LIBOR) and Fed Fund futures are down (meaning a 3 basis point increase in the Fed Funds forward rate), meaning that the credit spread has narrowed a bit–about 5.5 basis points.   Treasuries are also down.

Seems like a cautious, tentative endorsement of what’s going on.

Could Be Worse

Filed under: Derivatives,Economics,Politics — The Professor @ 1:50 pm

Could be raining.

That (apologies to Marty Feldman) is my take on the current iteration of the bailout process.

Actually, it could be a lot worse. The egregious “affordable housing” (AKA let’s dump huge amounts of money in the same ratholes that helped get us into this mess) component of the Democrat proposal is gone. (This is the part that was pushed most aggressively by the usual suspects, Frank & Dodd. What’s next? Willie Sutton to negotiate federal sentencing guidelines for bank robbery? Al Capone to bargain over liquor distribution laws?)

But that is damning with faint praise. As for what’s actually in the proposal? Color me less than enthusiastic.

Everybody involved made a big hullabaloo over the inclusion of warrants in the deal. Hello, finance 101 calling. Those selling troubled assets to the government will take into account the value of the warrants when calculating the price in dollars they will accept for the assets they want to sell. Every dollar increase in their estimate of the value of the warrants they must give up will reduce the reservation price for the cash component of the sale.

But it’s actually worse than that. The warrant component increases the government’s exposure to adverse selection/winner’s curse/lemons problems. The warrant is a claim on the assets (and liabilities) of the pieces of the firm that aren’t sold to the government outright through the auction or whatever process the government uses to buy assets. Indeed, equity, and especially a levered claim on equity like a warrant, is the most information sensitive component of a firm’s capital structure. The seller of the troubled asset has much better information than the government about the value of the unsold portion of the business (which includes not only the value of the assets and liabilities on the balance sheet, but the values of other pieces of the business, such as the franchise value of a retail banking operation.) Thus, if the winner’s curse is bad for the troubled assets, it will be much worse for the warrants.

The CEO of Bankrupt Bank (Motto: “Insolvent? Who? Us?”) will be glad to give Uncle Sucker all the warrants he wants. You want warrants? We got ‘em!

Moreover, the inclusion of warrants will greatly complicate the purchase process. In an auction for a particular MBS or CDO, the government will receive cash bids, and will demand warrants. The cash components of the bids are readily compared, but the warrant components will be extremely difficult to value. (Maybe the government will have to hire investment bankers to do this. Maybe that’s the real point.) This will add an element of arbitrariness and uncertainty to the determination of the winner.

It also strikes at the root of the theory underlying the buy-the-bad-assets-plan. The bids submitted to, and therefore the prices determined in, the auctions will not reflect only the value of the assets qua assets, but they will reflect the value of the warrants. This last component adds noise to the auction prices (and bids) as measures of the true value of the assets. Since the main defensible rationale of the buy the assets approach is that it will increase liquidity in the market for troubled mortgages by generating information about their value and thereby mitigating informational asymmetries, this additional noise impedes the ability of the asset purchases to achieve the stated objective.

UPDATE: My analysis of the warrant feature of the proposal was based on (a) the statement from Pelosi’s office that it “[g]ives taxpayers an ownership stake and profit-making opportunities with participating companies.” My interpretation of this, based on earlier descriptions of this feature, was that any company that sold assets to the Treasury would have to provide warrants. Tapscott’s summary of the “final bill” gives a very different impression: “Mandatory equity interests in total takeover scenario. Proportional equity interest based on percentage of assets sold if deemed appropriate Secretary.”

This is quite different. It means that, absent discretionary intervention by the Treasury secretary, the government will obtain equity only when it takes over an institution. Thus, the auctions for the assets will be clean, and not present the problem of multiple and potentially difficult to value sources of consideration paid for each asset purchase. This isn’t quite so problematic.

Also, the Tapscott summary states that the final bill has no bankruptcy “cramdown” provision as originally proposed. More good news.


UPDATED UPDATE.   Seems Tapscott got it wrong.   The actual draft bill requires the Treasury to obtain warrants on non-voting common stock (from companies with listed equity) or senior debt (from those without) from any financial institution selling a troubled asset to the Treasury.   There is no language limiting the provision to institutions the government takes over.   It is unclear from reading the language whether the warrant is required for each transaction in which an institution participates, or whether the warrant is a one-time pay to play provision.   Although the act sets out the purpose the warrant provision is intended to achieve, it establishes no specific guidelines.     All in all, the warrant provision is impossibly vague, and will no doubt need the Treasury to specify detailed guidelines before it is operative.   These specifics could either neuter the provision, or create the problems suggested in my original post.   I’ve only scanned the rest of the bill, and “vague” seems the operative word.   There are numerous gaps that will have to be filled going forward.


Another problematic feature of the proposal is the inclusion of pension funds and politically favored financial institutions (e.g., community banks) to sell assets to the government. As I have argued before, one problem with the purchase the assets plan is that it doesn’t necessarily direct liquidity (cash in exchange for illiquid assets) to the institutions that most need it. The expansion of the set of participants only exacerbates this problem, as many of the new participants (a) likely don’t need the liquidity, or (b) don’t pose a systemic risk even if they do.

The only argument I can see for their inclusion is to increase the competitiveness of the auction process. Any such competitive benefit is conjectural at best. I wonder whether these firms would really want to participate in the auctions, knowing that they are likely relatively uninformed. If they don’t participate, though, they won’t get any money, which would alleviate my first concern.

All in all, my verdict on this iteration, as on all the others, is that it seems to put great faith in an untested theoretical conjecture; that the government purchases of some troubled assets will improve liquidity in the market for all troubled assets, thereby increasing their value and facilitating the recapitalization of the institutions that hold them. $700 billion–or whatever–is a helluva lot to pay for an experiment.

As a result, I fear that the epitaph for the bailout may be the same as the one Jefferson Davis penned for the Confederacy: “Died of a Theory.”

September 27, 2008

Brief Thoughts on the Bailout

Filed under: Derivatives,Economics,Politics — The Professor @ 11:42 pm

A couple of quick, semi-random thoughts.

First. Many of the difficult to value assets in bank portfolios are tranched claims on payments from mortgages. The securitizers took pools of mortgages, and created securities that had different priority claims on the cash flows. The more senior tranches have first priority on cash flows, and lowest exposure to a default by the borrowers; the less senior tranches have lower priority, and the highest exposure to borrower default.

These complicated structures have option-like characteristics, and complicated relations between default rates and timing on the one hand and security cash flows on the other. This makes each piece more difficult to value than the underlying pool of the loans. Put differently, even if you have a good idea on the default risk of the underlying pool of loans, it is more difficult to determine how this default behavior will affect the cash flows on the different tranches. Therefore, it is harder to value the individual tranches than the pool of loans underlying them.

One way to facilitate the valuation of these securities, and hence the liquidity of the market, would be to reverse the tranching process and create vanilla MBSs. Equivalently, if the bailout plan proceeds, and the government starts bidding for assets, it could solicit offers only for bundles of the tranches collateralized by a given pool of loans, where each bundle would be equivalent to a vanilla MBS on the underlying pool.

Operationally this might be a challenge because, by design different tranches were typically marketed to different clienteles. But it is worth considering as part of the strategy, as pools of whole loans should be easier to value than the sliced and diced CDO tranches created from them.

Second, the WaMu bailout seems to be preferable to the buy assets approach of the Paulson plan. It is targeted at an institution that needs help, and utilizes the existing powers of the government. Indeed, other than the monoline insurers and the investment banks (notably Goldman and Morgan Stanley), most of the financial institutions that warrant concern are banks subject to FDIC regulation, and therefore standard FDIC approaches can be relied upon rather than taking a wholly new approach that doesn’t necessarily address the problems of the institutions posing systemic risk.

Third (I guess this is a bonus, as I set out promising only “a couple” of comments). The essential intellectual underpinning of the Paulson plan to buy assets is that the auction process–or whatever process that the government will use to buy assets–will improve market transparency. That is, the prices “discovered” in the auctions/market purchases will reflect private information about the value of the assets, and other market participants can use this information to mitigate asymmetric information problems that seriously impair market liquidity for problem assets. Even though sellers will receive an information rent (i.e., the government will overpay due to its information disadvantage), the creation of information is a public good that improves efficiency that is an offsetting benefit.

Perhaps. I am skeptical that the auction prices will be all that informative, given the heterogeneity of the underlying assets and the (related) lack of competition that is likely to characterize the auctions. Discovery of a noisy price in a not-very-competitive auction for a particular CDO is unlikely to improve the precision in the valuation of another CDO that is not bought in the auction.

Unintended–But Totally Predictable–Adverse Consequences

Filed under: Derivatives,Economics,Politics — The Professor @ 11:13 pm

The SEC’s short sale witch hunt has burned some innocent victims–convertible bonds and options. Short selling of stocks is an essential hedging tool for these instruments, and the short sale restrictions have therefore undermined widely used hedging strategies, thereby driving the investors that rely on them from the market.

Brilliant move. The effect on convertible bonds is particularly unfortunate. Just when financial institutions are looking to recapitalize, throw a monkey wrench in a part of the capital market many banks have tapped to strengthen their balance sheets.

This is a perfect illustration of the dangers of regulators taking a cartoon view of the world, where evil villains are responsible for all the chaos in fair Gotham. In their monomaniacal focus on the manipulative potential of short selling, Cox and his his minions have completely overlooked its benefits, and implemented policies that have inflicted substantial collateral damage on other portions of the financial market, including parts of the market that could facilitate fixing problems at the institutions allegedly protected by the regulations–banks. This is particularly tragic given that the rationale for the policy is based on anecdote–to put it as charitably as possible. Remember what George Stigler said: The plural of “anecdote” is not “data.”

The collateral damage inflicted by a policy with a threadbare rationale (or should I say it is nakedly short of a rationale?) provides a chilling reminder of how regulation can make things far worse, rather than better. Apparently Chris Cox wants to regulate the financial markets in the worst way, and has succeeded.

September 25, 2008

Russian Military Fraud

Filed under: Uncategorized — The Professor @ 8:20 am

Paul Goble has an excellent story describing the pervasive fraud in Russian military spending–fraud that will only increase with planned increases in expenditure. Whenever attempting to explain Russian policy, in my experience the best working hypothesis is that the policy is designed to facilitate siloviki tunneling of state cash flows and assets, rather than to achieve the publicly stated objective.

Regulate This Too

Filed under: Derivatives,Economics,Politics — The Professor @ 7:37 am

From the solons of Time’s Curious Capitalist blog, an assertion that Chris Cox is “An American Hero” because he opposed the Commodity Futures Modernization Act of 2000. Apparently, blogger Justin Fox believes that OTC derivatives are somehow responsible for the current financial mess. Just how, exactly, Justin doesn’t feel obliged to tell us. The logic seems to be: (a) The Act was passed in 2000 in a hurry in the dark of night, (b) OTC derivatives are waaayyy complicated and unregulated and really scary financial instruments, (c) we’re experiencing a financial crisis 8 years after the Act was passed, and (d) Phil Gramm had his hand in it. Or something. There isn’t even a semblance of an attempt to make a connection between a change (a clarification really) of the rules for OTC derivatives and the current financial crisis.

That’s probably a smart move on Justin’s part, because it is very hard to see any such connection. The main problems with the financial system stem from exposure to real estate markets that financial institutions incurred due to their purchase of mortgage SECURITIES regulated by the SEC. This includes massive purchases by securities firms regulated by the SEC.   Moreover, the ratings firms that provided credit ratings for these securities are already SEC regulated.

The closest immediate connections of big, bad “unregulated” OTC derivatives to the current crisis are (a) the collapse of AIG, due to its huge net position in credit derivatives tied to mortgage securities, and (b) the systemic risks posed by the interconnections of parties who engaged in derivatives transactions.

Even here, though, the case is not altogether clear. Consider AIG (and monoline insurers that also sold protection on various credit risky instruments.) AIG was a big seller of protection against the decline in the values of mortgage securities. But the derivatives market is a zero sum game. If AIG lost zillions, somebody made zillions. Who? Some might have been hedge funds or others taking a speculative position opposite AIG. Others, however, were purchasing protection as a hedge of positions held in their portfolios. Absent AIG’s sale of protection to them, they would have suffered unhedged losses on their underlying positions in the securities. Absent this protection, some–perhaps many of them–would have gone bust. AIG’s failure is big, ugly–and noticeable. The failures avoided could well have been bigger (because the protection buyers were even less well-capitalized than AIG, a difference which created the gains from the risk transfer in the first place) and uglier, but as they didn’t happen, they aren’t noticeable.

Put differently, the existence of derivatives affected the distribution of wealth resulting from changes in the prices of the underlying securities. It did not affect total wealth–somebody’s loss was somebody else’s gain, penny for penny. The whole motivation for derivatives is that changes in the distribution of wealth contingent on the state of the world leads to a more efficient allocation of risk, making the transacting parties better off ex ante. AIG put its capital at risk insuring (it is an insurance company, after all) contingencies that others didn’t want to bear. In the event, AIG suffered huge losses, but in many cases, absent the existence of a credit insurance market its losses would have been borne by firms less-well capitalized to bear them.

Earthquakes and hurricanes put some insurance companies out of business because the resulting claims exceed their capital. Does that mean we should ban insurance against such natural disasters? If we did, you bet–no insurance company would fail! But millions of homeowners would bear greater losses. It is better to have an insurance market where insurers sometimes fail, than to have no insurance market at all. The fact that insurance companies fail just means that risks are not fully insured. The policyholders of the failed company don’t get all their claims covered to the extent that they are contractually entitled. But they usually get some coverage. This leads to a better allocation of risk than would occur with no insurance market at all.

The real root of the current crisis is securities that have plummeted in value. This decline in value represents a decline in wealth, not, as in the case of derivatives, a zero sum change in the allocation of wealth. The CFMA had nothing whatsoever to do with the plunge in the value of these instruments, and the concomitant loss of wealth. Indeed, there is a strong case to be made that the liberalization of the OTC derivatives market and the subsequent growth of the credit derivatives market actually mitigated the adverse impact of this decline in the value of these securities.

For his part, however, Chris Cox stills sees the derivatives boogey man under his bed. To wit, from Market Movers, Cox’s testimony on the need to regulate credit derivatives:

There is another similar regulatory hole that must be immediately addressed to avoid similar consequences. The $58 trillion notional market in credit default swaps — double the amount outstanding in 2006 — is regulated by no one. Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market.

This is an area that our Enforcement Division is focused on using our antifraud authority, even though swaps are not defined as securities, because of concerns that CDS offer outsized incentives to market participants to see an issuer referenced in a CDS default or experience another credit event.
Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS. Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instrument upon which a CDS contract is based. This means CDS buyers can “naked short” the debt of companies without restriction. This potential for unfettered naked shorting and the lack of regulation in this market are cause for great concern. As the Congress considers fundamental reform of the financial system, I urge you to provide in statute the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets.

In other words, show Chris Cox a derivative, and he just sees an evil manipulative tool. (Or maybe he just has some sort of Puritanical hang up with nakedness. One can almost sense the frisson every time he utters the words “naked short.”)

I have already taken Cox to task for his dim understanding of the economic functions of financial markets, but since he won’t go away, I guess I shall have to taunt him a second time. First, shorting is not per se bad. It can make markets more efficient, and indeed, markets where shorting is not possible are more vulnerable to bubbles than those where it is. We WANT markets to reflect bad news too–we want prices that reflect all information, not just happy talk. Second, buying CDSs is often a risk reducing transaction–those long the underlying credit hedge their exposure (as discussed above). Third, although it is possible that someone long a CDS would profit if the price of the underlying instrument declines, or experiences a credit event, and thus may be tempted to do something to cause such a price decline or credit event, if Chris Cox has a particular example in mind, he should share it with the class. Better yet, he should bring an enforcement action. Even if the CDS is not regulated itself, the underlying security would be subject to SEC regulation, and any attempt to manipulate its price would be actionable. (This also shows that the “loophole” is a figment of Cox’s fervid imagination. A manipulation than enhances the profit of the CDS position would necessarily distort the price of the underlying security. This would involve some sort of fraud or manipulation that would fall under SEC jurisdiction. I should also note that creation of large long CDS positions is actually more likely to increase the risk of a squeeze that artificially inflates debt prices during credit events. Well, go figure–I said that 2.5 years ago.)

Chris Cox, American hero? Hardly. The title to this Green Day CD fits far better.

Make Them an Offer They Can’t Refuse

Filed under: Derivatives,Economics,Politics — The Professor @ 5:53 am

I have deep reservations about the Paulson-Bernanke bailout proposal. In a nutshell, they propose to buy “illiquid” assets from struggling financial institutions. This raises the question: Why are these assets illiquid? When you answer that question, the entire case for the bailout becomes dicey at best.

Illiquidity is first and foremost the result of asymmetric information–a lemons problem. If the owner of an asset has better information about its value than potential buyers, the buyers are very reluctant to make bids for them. They realize they face a winner’s curse: if the owner accepts the bid, it is because the bid is above the owner’s estimate of value. Now, in current circumstances, owners desperate for cash to survive may be willing to sell assets for less than their (relatively well informed) estimate of value. Thus, the lemons problem/winners curse may not cause a complete market failure with zero trading volume (as would be the case if there were no non-informational reasons to trade.) But severe information asymmetry drastically reduces the liquidity of the market for these assets.

Under the bailout proposal, the government will become the buyer of the assets. Regardless of the design of the mechanism for purchasing the assets, it is likely that the sellers will have a substantial information advantage over the government. Thus, the government is likely to suffer from a substantial winner’s curse problem, and end up overpaying for the assets it does buy.

This is not to say that current holders of mortgages and mortgage CDO’s have a very accurate estimate of the true value of these things. It is just likely that they have a better estimate than the government, or most potential buyers. The current owners have had an opportunity to do research on the underlying pools of mortgages. They have also observed the payment experience on what they have in their portfolios. As a result, they have some idea of which of their holdings are (relatively) good; which are bad; and which are truly ugly. The one eyed man is king in the land of the blind. The owners of these assets may have only one dodgy eye, but the government is likely to be nearly blind–so bet on dodgy cyclops.

Substantial competition between participants in an auction can mitigate the adverse impacts of asymmetric information. I am skeptical, however, that there will be a lot of competition here. The assets are so heterogeneous that the competition in the auction for any particular security (and that’s what matters) is likely to be subdued.

Another matter of concern is that although the objective of the auction is to facilitate the recapitalization of financial institutions, there are doubts as to whether the proceeds from auction sales will flow to the institutions that face the most daunting obstacles in recapitalizing in the market through sales of equity or subordinated debt. It is likely true that more desperate institutions are more likely to want to participate, and may accept lower prices for their assets. This would mean that such firms would be the most likely sellers, which would in turn mean that they would be disproportionately represented among the auction winners. Nonetheless, a good portion of the auction proceeds will likely flow to canny asset owners that could probably survive (or recapitalize) without these proceeds. Thus, the government may end up overpaying for assets, and the overpayment may do little to restore the balance sheets of the institutions that really need the help.

So, the bailout aid may not go to where it delivers the most bang for the buck. Paulson and Bernanke appear to be hoping that the bailout will inject liquidity into the market for heretofore illiquid mortgage securities. From the best I can gather, they think that these assets are selling at deep discounts to their actual value due to their illiquidity. Make the market more liquid, asset prices go up, and everybody’s happy.

I really don’t see how this will work. If the illiquidity is due to adverse selection/lemons problems, private buyers will still be very reluctant to purchase those assets the government doesn’t buy. So, in the end, the likely outcome is that (a) the government will overpay for a lot of assets due to the “winner’s curse”, (b) some of the overpayment will go to institutions that really need the capital, but some will go to to those that don’t, or who could raise it on the market, and (c) the market for problem assets will remain illiquid, with the government being the only buyer. That doesn’t seem to be the wisest way to spend $700 plus billion.

The lemons problem arises because of asymmetric information, but also because the seller has the ability to say no to the buyer’s offer. The seller says “yes” when the bidder overpays, and says “no” when the buyer underbids. The only real way to avoid this problem is to deprive the seller of the discretion to refuse offers. That is, Don Corleone (“I’m gonna make him an offer he can’t refuse”) is less subject to the winner’s curse than buyers who employ less coercive means. So, the best way that the government has to avoid the lemons problem is to approach financial institutions and say: we’re paying you X for Y. Your options are “Yes” and “I agree.”

That, of course, presents a whole slew of legal, constitutional and ethical issues. Moreover, there is still the question of to whom the government should extend these tender offers. Presumably, institutions more vulnerable to failure, and whose failure would impose more stress on the system.

But that’s in essence what the government did in the case of AIG. It decided to intervene with AIG because of its central position in the nexus of credit derivatives contracts, and because of its impending failure. It gave AIG a near ultimatum.

That seems a much better approach than playing Uncle Sucker willing to buy anything somebody’s willing to sell them. The seller is likely to have information advantages, and the payments made to winning sellers may not go to where its effect on the stability of the system would be greatest. Moreover, I am skeptical that the government’s purchase of bad assets will suddenly improve the liquidity of the private market for these assets. Instead, focusing on particular companies that are most important to the stability of the system, and which are having the greatest difficulty in financing themselves via the market, and sharply limiting the discretion of those companies to accept the terms offered, is a better way to target government assistance and to avoid the winner’s curse.

How could this restore market confidence today? If it is perceived to be a credible policy. How to make it credible? One thing that would enhance credibility would be for Congress to approve legislation and funding for such a program. This should include, of course, oversight and accountability provisions.

As ugly as they were, the Fannie, Freddie and AIG interventions make more sense than trying to create liquidity in the market for low quality mortgages through the mechanism of a government bailout. If illiquidity reflects the fundamental nature of these assets, and the distribution of private information regarding their value, the purchase program will not restore liquidity in a cost effective way.

September 24, 2008

Regulate This

Filed under: Derivatives,Economics,Politics — The Professor @ 9:35 am

The emerging conventional wisdom about the ongoing financial crisis is that it was the result of too little regulation, and that additional regulation will be needed to prevent its recurrence. Just what regulatory lacunae caused the current crisis, and just what regulatory changes will save us from future scourges are almost always left unsaid. Instead the word “REGULATION” is wielded like some magic incantation, which by its very utterance will protect us.

Sorry. Not good enough. Details matter. Specifics matter. Talk to me when you have some of either. Until then, talk to the hand.

One accusation that I have seen is particularly risible. That is that the 1999 repeal of the Glass-Steagall Act (by the Gramm-Leach-Bliley Act) somehow caused the meltdown. Helllooo. This would be somewhat plausible if the securities underwriting affiliate of a commercial bank imploded, causing a bank failure that sparked a general banking panic. Nothing remotely like that happened. Indeed, the crisis erupted because the very institutions created by Glass-Steagall–stand alone investment banks–blew up. Indeed, the modern, post-’99 versions of universal banks, took hits, but survived. Moreover, the last big investment banks standing–Morgan Stanley and Goldman Sachs–are rushing to transform themselves into banks. Other investment banks have been sold off–or their corpses have been–to commercial banks. In other words, the market is throwing dirt on Glass-Steagall.

The single most important factors in the meltdown (as an oped by Calomiris and Wallis in today’s WSJ points out) were Fannie and Freddie. (Although I have long believed that Fannie & Freddie were disasters, I have not been convinced that their actions in the subprime market were essential to the proliferation of bad mortgage debt. The Caomiris-Wallis piece and other things I’ve read are persuading me that F&F were primus inter pares in causing the disaster.) Fannie and Freddie were not market failures. They were creatures of the government doing the bidding of a coalition of Congressmen. I agree wholeheartedly that they were not regulated properly or sufficiently. But you are truly delusional if you believe that’s what Congress or other bloviators mean when they call for “more regulation.” In fact, the very Congressmen that aided and abetted F&F are (a) doing their level best to perpetuate that scam as long as possible, and (b) using the financial fallout from the effects of F&F to justify the imposition of regulations on other financial institutions.

One of the great lessons of the Crash of ’29 and the Great Depression is that people learned the wrong lessons from the Crash of ’29 and the Great Depression, and created regulatory “fixes” to phantom problems. Glass-Steagall, the Securities Act, the Exchange Act, the Commodity Exchange Act, etc., were all responses to defective diagnoses of what caused the Crash and the subsequent depression. Each imposed substantial costs on the economy for decades afterwards, and didn’t address the real causes of the financial and economic tumult of the late-1920s and 1930s. I fear that history is in the process of repeating itself.

It’s Only Natural

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges — The Professor @ 8:18 am

More from Matt Leising at Bloomberg on yesterday’s oil squeeze:

“This sharp move reflected extreme tightness in the prompt physical market as participants that were short oil scrambled to find physical oil before expiration,” wrote the analysts, led by Jeffrey Currie. Record oil prices have made refiners rely on stocks of existing supply, the analysts wrote, creating “critically low” inventory levels.

Vulnerable to Spikes

“This tight inventory situation has left the oil market with very little cushion and therefore extremely vulnerable to price spikes,” the note said.

Trading was light on Nymex yesterday. About 41,000 crude contracts for October delivery changed hands, 85 percent less than the 15-day moving average volume of 280,000 contracts, according to Bloomberg data.

The traders who sold contracts short might have been betting on price declines due to less-than-expected damage to oil rigs and production from Hurricane Ike as it crossed the Gulf of Mexico.

“Ike did more damage than originally thought,” said Rick Mueller, director of oil markets at Energy Security Analysis Inc. in Wakefield, Massachusetts.

The most recent storm in the Gulf made landfall in Texas on Sept. 13, cutting off power and damaging some refineries. U.S. energy producers resumed output for about 23 percent of oil and 34 percent of natural-gas production in the Gulf after the storms, the Minerals Management Service said yesterday in a statement on its Web site.

This suggests that deliverable supplies were low due to Ike. Low deliverable supplies make the market more vulnerable to a squeeze. Put differently, somebody with a 10 million barrel futures position may not be able to squeeze the market profitably when deliverable supplies are 9 million, but may be able to do so when they are only 5 million or 4 million. Thus, Ike’s disruptions raised the likelihood of a squeeze.

One should not go the next step–as people often do–of concluding that Ike “caused” the price disruptions in the October contract. Just as a forest fire requires BOTH dry tinder AND a spark, a squeeze requires low deliverable supplies AND the affirmative action of a large long (or longs). A large long must demand excessive deliveries. The low deliverable supply only means that the long can get the same price effect–and a bigger profit–by demanding fewer deliveries and liquidating more contracts at an artificially high price. Put differently, the cost of manipulation is burying the corpse of deliveries. With low deliverable supplies, the corpse is small, and the manipulation is easier to carry out. To mix metaphors, and extend the forest fire example, the low deliverable supply is the dry timber, but the uneconomic demands for delivery by a large long or longs is the spark that is necessary for the fire to occur. Low deliverable supply is a precondition that makes the market vulnerable to a squeeze. But somebody has to do the squeezing. Smaller players can squeeze when deliverable supplies are small.

Since the FTC Report on the Grain Trade in 1920-1921, it has been common to label events like those of yesterday as “natural squeezes” because “natural” market conditions made the squeeze possible. The “natural” terminology has been used to excuse the opportunistic exercise of market power by those who exploit these conditions to distort prices. This “reasoning” is wrong, and highly injurious to the market. It essentially gives longs a manipulation option. Hold a large long position to expiration. If something happens to reduce deliverable supply–squeeze away, and make money. If nothing happens, just liquidate at the competitive price. When they come after you for squeezing, just say “Hey, it was a natural squeeze. And natural is good, right? That’s what they tell me at Whole Foods!” It’s worked. And it has undermined market efficiency. Regardless of whether exogenous events made a squeeze more profitable, a necessary condition for the squeeze to occur is for somebody to exercise market power opportunistically. These people should not be allowed to skate.

As commentor Scott Irwin noted, due to the fact the squeeze took place in a very short period of time, it is unlikely that it will have acute deadweight costs, although large amounts of money will change hands as a result. (The fact that the main price action took place in the last half-hour of trading that is used to determine settlement prices–and the final prices on swaps tied to NYMEX CL–suggests that somebody was long swaps as well as futures, and earned profits from the price distortion on a cash settled OTC swap position.)

The main deadweight cost is the effect that the episode will have on the speculation debate. People are already seizing on this as evidence that market manipulation is a serious problem that needs to be addressed by more draconian restrictions on market participants. My take is very different. The contrast between what happened on 9/22 and what happened in the last half of 2007 and the first 8 months or so of 2008 shows that the big price surge in oil that peaked in July was almost certainly NOT the result of manipulation.

Yesterday’s events bear all the hallmarks of a squeeze. It waddled like a squeeze, it quacked like a squeeze, it flew like a squeeze, and it swam like a squeeze, so . . . I would have a hard time arguing that what happened in the October CL price was normal and competitive.

So what yesterday shows is, yeah, manipulation can happen. What happened on 9/22 bears all the hallmarks of a manipulation—and look how different that was from what transpired over the first 7 or so months of 2008. The 9/22 event was intense, but limited to a very short period of time in a single market. It affected one price that moved a lot relative to other prices (e.g., the November price, the prices of heating oil and gasoline). It happened as the contract moved to expiration/delivery. That’s what happens during a squeeze, a manipulation.

In contrast, the runup in oil prices over 2007-July, 2008 was long, sustained, occurred in all markets, was not concentrated around contract expirations, and did not result in one price getting way out of line with all other prices.

Thus, in my view, by contrast, the squeeze of 9/22 shows that what happened in 2007 and the first 7 months of 2008 was NOT manipulative.

The events also showed that when a squeeze happens—people notice. Regulators notice. The subpoenas went out within hours of the event. People will sweat. People will pay. That’s the way to deal with it. By focusing on people who engage in demonstrable wrongdoing, and punishing them severely—not by clamping down on all speculative activity, virtually all of which is quite legitimate. Cut out the cancer—don’t shoot the patient in the head—a surefire cure, but not a very constructive one.

This episode also brings to mind a historical parallel. In May, 1921, the Senate was holding hearings on the regulation of futures trading. A representative of the Chicago Board of Trade, Julius Barnes, testified that there was no need to regulate futures trading because the exchange had the incentive and ability to prevent manipulation. The very moment he was speaking, a large grain trader named Field executed a huge squeeze of the expiring May wheat future. The price of May wheat rose $.17/bu–almost 10 percent–on the last day of trading, and the price of cash wheat fell $.20/bu the day after the contract expired. This spike and crash is symptomatic of a squeeze.

An exasperated Barnes wrote to his business partner: “nothing has embarrassed, in recent years, like the gyrations in Chicago May–the very day we were arguing before the Senate Committee that the governors of these exchanges were making some progress themselves in eliminating manipulation.” A month later, a chastened representative of the CBT, L.F. Gates, testified before the Senate that “The trade recognizes the manipulator as the enemy of the whole organization. We dislike him as much as any of you gentlemen do, and if we could find any way of shitting him out absolutely, we would do it. Maybe you can help us on some of these problems.” In other words, the CBT almost begged for regulation. The Congress obliged, passing the Futures Trading Act, the first major Federal regulation of the futures markets, and the progenitor of the Commodity Exchange Act that governs the markets to this day.

Thus, the actions of a squeezer–Mr. Field–on one day dramatically changed the political landscape, and forced a previously recalcitrant CBT to submit to Federal regulation. Sadly, whoever squeezed the October crude contract on 22 September, 2008 may have a similar legacy. Even though the October CL squeeze in no way validates the wild accusations leveled against oil speculators for causing the price runup to $147 in July, it may well become the “I rest my case” Perry Mason moment that will be used to justify wide ranging restrictions on energy trading. Restrictions that will do little if anything to prevent events like those that occurred on Monday; that will not prevent prices from rising to $147 or higher when fundamentals justify it; and that will impair the efficient operation of the market as a price discovery and risk management tool.

Thanks, buddy, WTF you are.

September 22, 2008

Send Lawyers, Guns and Money . . .

Filed under: Derivatives,Economics,Energy — The Professor @ 9:39 pm

Sheesh, how many fans are there out there, anyways? (If you get this, and the connection to the title, you’re a Warren Zevon aficionado. If not, google “zevon lyrics laywers guns money.”)

I am referring specifically to today’s events in the NYMEX crude market. From Bloomberg:

Sept. 22 (Bloomberg) — Crude oil climbed more than $25 a barrel, the biggest gain ever, as the dollar weakened the most against the euro since January 2001, boosting the appeal of commodities as a hedge.

The October contract, which expires today, rose almost $12 more than the contract for November delivery, as traders rushed to close positions. Oil, gold, corn and other commodities climbed as the dollar dropped on concern that a U.S. proposal to buy $700 billion of troubled assets from financial firms will deepen the budget deficit.

“This looks like a squeeze play,” said Phil Flynn, senior trader at Alaron Trading Corp. in Chicago. “All of the contracts are up, but nothing like October. This is the last day of trading and someone is scrambling to guarantee supply.”

Crude oil for October delivery rose $18.05, or 17 percent, to $122.60 a barrel at the 2:30 p.m. close of floor trading on the New York Mercantile Exchange. Futures climbed as much as $25.45 to $130 a barrel, the highest since July 22. The more- active November contract rose $6.11, or 6 percent, to $108.86 a barrel.

It sure does look like a squeeze, Phil. During a squeeze the nearby price (October, in this instance) increases relative to the deferred prices (November, and later months.) On Friday, October settled $1.80 over November. At some point today, October traded at least $19.55 over November. Based on settlement prices, October gained $9.45 on November. That last number is a huge move, given the normal volatility in calendar spreads, but the $17.75 move is mind-blowing.

A squeeze would work by somebody holding a large long position refusing to liquidate that entire position. On the last trading day, refusing to liquidate is equivalent to demanding delivery. If the shorts perceive that deliverable supplies are inadequate to meet the long’s implied demand for deliveries, they are willing to bid up the price in order to offset their positions and avoid the prospect of making inefficient deliveries.

I would therefore like to see how many contracts liquidated. WSJ data report open interest of 23,130 contracts–or 23 million barrels of oil. I am pretty sure that this figure is yesterday’s open interest. That’s substantially more than the likely delivery capacity in Cushing, OK over the coming month. If one long, or a couple, held the bulk of these positions, or a large futures long also has a big long position in deliverable crude, they would possess the market power to squeeze the shorts. To the extent that the large long was also long in OTC instruments settled against the last NYMEX settlement price, they could profit even more from the price spike.

In some respects, this is a stunning development. Anybody even remotely familiar with these markets is aware of the intense scrutiny they are currently subject to. Any large long has to know that subpoenas are incoming. Knowing that the world–the regulators, the Justice Department, Congress–is watching, you would think that large longs would go out of their way to avoid doing anything even remotely manipulative. The most plausible explanation of today’s move, however, is that somebody squeezed October crude. Dunno about the guns, but money and lawyers will certainly be in play very, very soon.

Update: Another piece of information consistent with the squeeze interpretation.   October Heating oil and RBOB gasoline were up less than 5 percent on the day.   OCT and NOV HO were about by about the same amount, and OCT RBOB actually rose less than NOV.   The sharp rise in the price of nearby crude relative to products (i.e., the sharp decline in the crack spread), and the lack of steepening backwardation in products are what you would expect to observe in a squeeze of the CLV.

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