Streetwise Professor

December 16, 2008

Balkan Smashmouth, Revisted

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 10:27 pm

Exactly 11 months ago I wrote a post about Russia’s use of “vaporware” and threats to seize control of Serbia’s national oil company NIS at a bargain basement price:

To make the deal look a little less like an abject surrender, Gazprom has also dangled the prospect of giving Serbia a stake in a future gas venture. Word of advice, guys-DON’T BELIEVE IT, and DON’T TAKE IT. Gazprom is the master of what Bob Amsterdam calls “premature contractualization.” That is, announcing deals just in time to forestall projects that are adverse to Gazprom’s interest, and then fading the deal when the threatening competing projects are shelved in response to the Gazprom announcement. Gazprom will whisper sweet promises in anybody’s ear to get what they want, and then renege when it suits them. (Nigeria-you should take note of this, as Gazprom has been wooing you too.)

Gazprom’s stratagem is analogous to a common ploy in the software business. In the 80s and 90s “vaporware” was a commonly employed competitive strategy. A software company would announce a new, improved software product in order to forestall entry by a competitor. Once the potential entrant was scared away, the new software would just fade away into the mists, never to be seen. Gazprom is essentially following this playbook-constantly announcing vaporpipelines, vaporwells, vaporinvestments, vaporstorage, vapor-you-name-it whenever a threatening project is mooted.

So, what Gazprom is offering Serbia is: a pittance in cash plus a pig in a poke in exchange for hard assets right now. Given Gazprom’s record of delivering on its big talk, the Serbs would be well advised to take cash on the barrelhead and take the promises for what they are worth-a little more than nothing.

“A little more than nothing” seems to be a gross overvaluation, based on this piece from Eurasia Daily Monitor:

Serbia’s coalition government has removed Economics Minister Mladan Dinkic from his concurrent assignment as head of the negotiating team on energy agreements with Russia. The impending oil and gas deals involve essentially a Russian takeover of Serbia’s energy sector. Dinkic and his colleagues who were also ousted from the team—State Secretary Nebojsa Ciric and Privatization Agency Chief Branislav Zec—stand accused of holding “unconstructive positions in the negotiations” (Radio B-92 cited by Interfax, December 11; RTS Radio Belgrade, December 12). The government’s Russophile elements have prevailed without apparent difficulty on their pro-European colleagues to precipitate the energy deals on Russian-imposed terms.

One major contentious issue is Gazprom’s promise to build a section of the South Stream pipeline through Serbia. The Russian side is avoiding a clear commitment to a construction schedule and gas supply volumes and is even stalling for time on submission of a feasibility study. This evasive attitude can only reinforce the growing international doubts about South Stream’s plausibility.

Nevertheless, the agreements on oil and gas are now expected to be signed in Belgrade before Christmas by a high-level Russian delegation. Moscow is throwing in some sweeteners outside the energy sector. These would, however, only lead to greater Russian economic penetration of Serbia, correspondingly influencing its political system, and raising questions about Serbia’s European integration, the goal of President Boris Tadic and parts of the body politic.

. . . .

Now, however, Moscow suddenly insists that NIS be separated from the package. It wants to sign the NIS purchase contract immediately and postpone the signing for South Stream for a few years. Officially, Moscow claims that the oil deal and the gas deal remain packaged together, but that this does not preclude separating the time-frames for implementation of each. For Serbia, however, this means no guarantee and indeed no leverage to ensure that the South Stream pipeline and storage site would be built in Serbia. Thus, the disadvantageous handover of NIS to Russia as an incentive for South Stream would have been in vain and a total net economic loss to Serbia (BETA, December 11; RTS Radio Belgrade, December 12).

Vaporware, indeed.   Serbia originally–and grudgingly–acquiesced to the sale of NIJ in return for promises regarding South Stream.   Now, Gazprom/Russia is telling Serbia those promises are no longer operative.   Beware any deal that involves asynchronous performance.   Especially if the party promising to perform later is Gazprom.   You can take their promises to the bank–and be met with stares of disbelief for having been such a sucker.

This discarding of even the pretense of proceeding with part of the South Stream project also speaks to its viability, and the effect of the ongoing financial crisis on that viability.   And if there’s not the money for South Stream–what about Nord Stream?   And if neither is an immediate prospect, what does that say about European gas supplies, and the prospects for Nabucco?   (There’s also an interesting article in EDM about Hungary’s MOL and Nabucco, but that will have to wait for another post.)

Understatement of the Century

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 9:42 pm

Today’s WSJ ran an extensive article on BP’s misadventures in Russia over BP-TNK.   It is titled “Misreading the Kremlin.”   Yes, truly an understatement.

This quote stands out:

“The mistake was believing that there was consensus among all the guys that make these decisions,” said one person close to BP.

Repeat that quote to yourself a few times.   Then ask yourself: who in their right mind could possibly think that there was consensus “among all the guys that make these decisions”?   Anyone who follows this at all knows–knows–that there are battling clans in Russia, and that the most prominent and the most powerful and the most adversarial center on Rosneft and Gazprom.   There is never consensus among these guys.   At best there is a truce, like that between the Five Families of the New York mafia.   Putin’s main job is to balance these factions and keep things from breaking into outright warfare.     There is an uneasy peace, and one faction is not going to do anything to help the other.   Indeed, each will try to torpedo the other whenever possible.

Anyone following Russian energy also knows that Igor Sechin is the godfather of the Rosneft clan.   So what does BP do?   It goes to Sechin–the engine of Yukos’s destruction–to talk about its plans to cooperate with Gazprom:

In April, Mr. Hayward visited Igor Sechin, a powerful Putin confidant. According to people familiar with the meeting, Mr. Hayward laid out BP’s efforts to reach a deal with Gazprom.


This is a runner-up in the understatement derby:

Mr. Sechin was in an interesting position: He also serves as chairman of state oil company Rosneft, and is generally opposed to further expansion of Gazprom, especially into the oil business, say several people who’ve discussed these issues with him.

“Generally opposed to further expansion of Gazprom.”   You don’t say.

I can only imagine the derisive laughter echoing off the walls of Sechin’s office after Hayward left the room.

In other words, if this article is to be believed, BP was unaware of the most basic contours of the Russian political landscape.   It assumed that “the Kremlin” was a monolithic body at odds with the AAR oligarchs.   Certainly the oligarchs were in a tenuous position, but their very survival was–and is–almost certainly attributable to the fact that the “Kremlin” is anything but monolithic.   The balance of power between the Rosneft-Sechin and Gazprom factions would have been disrupted by ousting the oligarchs, and putting one of the factions in control of BP-TNK.   Hence, these oligarchs survived.

Given the history of Yukos, it should have been readily apparent if the powers that be wanted to destroy these oligarchs, they would have already been destroyed–and BP would not have been the beneficiary.   Their very existence should have raised questions in the mind of BP CEO Tony Hayward.   No doubt Gazprom was feeding Hayward and other BP people a line that “the Kremlin” was looking to boot the oligarchs.   But one must take any representation from Gazprom with all the grains of salt from all the mines in Siberia.   And one must also base all strategies on an understanding of the fundamental Gazprom-Rosneft rift, and an analysis of how one’s proposed moves would play into that battle.

Any strategy involving the Russian energy business must start from a recognition that   there is bitter division and intense rivalry within the Russian hierarchy, especially in anything involving energy.   Basing a strategy on an assumption of “consensus” was a blunder of the first order.   Dealing with Sechin to advance a transaction that would benefit Gazprom is an even worse blunder.

In short, this article makes Tony Hayward and the rest of BP’s upper management look like complete incompetents.   This quote pretty much sums it up:

“There’s a group of people who know what’s going on and know what to expect,” said one person close to BP. “And then there’s the London office.”

Well put.

This is not to say that there is any right way to navigate the Russian energy labyrinth.   Or, to mix classical metaphors, in attempting to do business in Russian energy one must steer between Scylla and Charybdis–a virtually impossible task.   But blundering along as if these dangers do not exist is inexcusable.

December 13, 2008


Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 9:50 pm

Oil rallied this week (but still finished well below $50/bbl) primarily on reports that Russia would cooperate on output cuts with OPEC.   Dmitri Medvedev has hinted that Russia might actually join the organization.

There are several reasons for skepticism.   First, Russia has dramatically reduced its oil export duty, and is contemplating a further cut:

Russia cut oil export duties to $287 per tonne from November 1, from $372.2 in October, in response to calls by producers who feared making losses on overseas shipments. Russia’s senior energy official, Deputy Prime Minister Igor Sechin, had lobbied for an even lower November tariff of $195.20.

. . . .

RIA Novosti reported that Russia could reduce oil export duty to USD 117 per tonne to USD 119 per tonne from the current USD 192.1.

Mr Alexander Sakovich deputy head of the customs payments department at the ministry said the average price for Urals crude on world markets in the monitoring period from November 15 to December 9 inclusive was USD 44.5 per barrel. He said the price could continue to change until December 15 given high volatility on the market.

Mr Sakovich said duty on light petroleum products could be cut to $91-$93 per ton against the current USD 141.8 and on heavy petroleum products to USD 49 per tonne to USD 50 per tonne from the current USD 76.4.

The Russian government decided to set export duties on oil and oil products on a monthly basis from December 1st and abandon the previously accepted bimonthly practice.

The most effective way for Russia to curtail oil exports (which is the only way it would have an impact on world prices) is to keep its export tax relatively high.   Lowering the export tax encourages exports, and is contrary to statements that it will cut output.   Sechin’s support for lower duties is especially important in this regard.

It is possible to both cut export duties and cut exports, but this would require the imposition of export quotas.   Just keeping the taxes higher would be a more sensible and straightforward approach.   Although higher export taxes would hurt Russian oil exporting companies–most importantly, Sechin’s Rosneft–this effect could be mitigated by some sort of compensation to these firms.   (To work, though, this would require that the compensation not be linked to current exports or output in any way, as that would just offset the effect of the tax.)

The fundamental inconsistency between promising to cut output/exports in collaboration with OPEC on the one hand, and cutting oil export duties on the other makes me question the credibility of Russia’s statements.     Moreover, formal monitoring and enforcement of members’ adherence to quotas within OPEC are doubtful enough, and informal promises from Moscow with no prospect of enforcement seem a very weak reed to lean on.   Indeed, if I were OPEC I would be very leery of Russia’s representations.   Russia has every incentive to encourage an OPEC output cut–and then to produce as much as possible to exploit the higher prices.   If Medvedev and Putin think that attending the OPEC meeting and promising cooperation make it more likely that OPEC will indeed cut, they’ll do those things.   The intent to adhere to those promises is highly doubtful, however.

Liam Denning expresses different reasons for skepticism in the WSJ:

Look at an atlas, and you will see that all of the members of OPEC sit within or very close to the Tropics.

That Siberia lies far to the north is one reason why Russian President Dmitry Medvedev’s hints about joining the oil group amount to mere posturing. The Organization of Petroleum Exporting Countries’ primary lever for influencing oil prices is raising or lowering members’ output — sometimes several times a year.

Try doing that when the Siberian winter freezes dormant wells closed, meaning they have to be drilled again. Meanwhile, summer thaws churn up the ground, bogging down maintenance equipment. In Russia, once you drill a well, it pays to keep it pumping.

In theory, the Kremlin could stockpile reserves to adjust export volumes. But this would take time and incur big costs in an economic crisis.

It also isn’t clear why Saudi Arabia, OPEC’s de facto leader, would want Russia to join the quota system. In 2007, the Saudis exported 7.9 million barrels a day, according to the U.S. Energy Information Administration. Russia exported seven million barrels. Saudi Arabia would risk seriously diluting its influence in an already fractious group. And for what? Does anyone think Moscow would abide by OPEC policies if it didn’t suit it?

In reality, Mr. Medvedev is dressing up Russia’s inevitable output decline — largely resulting from the state’s tightened grip on the energy sector — as a planned move co-ordinated with OPEC. Second, with the economy still a leveraged play on energy prices, and a possibly destabilizing ruble devaluation on the horizon, he is trying to talk up the oil market.

Far from hinting at increased Russian influence, the president’s words carry more than a hint of desperation.

Denning’s point about the inherently less flexible nature of Russian oil production is of great interest.   It means that actual Russian cuts in the short run are more credible in the longer run than cuts in, say, Kuwait. Kuwait can cut today, and increase output relatively easily in the near future.   If Russia cuts today, it is effectively committing itself to cut for a considerably longer period.   Knowing this, it is less likely that Russia will choose to cut.   It would be in a real jam if it cut in conjunction with OPEC, only to have the latter’s members (predictably) renege on their commitments weeks later.   In that case, Russia would have the worst of all worlds–lower output and low prices.

So, I concur with Denning’s basic argument that Medvedev is just talking his book (as traders say), and that he is trying to get some price action in exchange for cheap talk.

Rather than listening to Medvedev, or Putin for that matter, I would pay attention to the export duty.   That is the primary lever that Russia can pull to affect exports and hence world prices.   If Russia raises the duty, it means it is serious about cutting output.   If it keeps the tax low, or cuts it further as the Novosti article suggests, all the talk about cutting output in conjunction with OPEC is just that–talk.

December 12, 2008

Convertibles, The Short Sale Ban, and the Near Toppling of Citadel

Filed under: Derivatives,Economics,Politics — The Professor @ 12:02 am

More detail on the havoc wreaked by that Mr. Magoo of American finance, SEC Chair Christopher Cox, and his short-sighted short sales ban:

The panic that swept through the capital markets after Lehman declared bankruptcy was one form of human frailty that Citadel’s sophisticated mathematical models could never have anticipated. The second and perhaps more devastating one occurred on Wednesday, Sept. 17, when news broke that the Securities and Exchange Commission was considering a temporary ban on short-selling 900 stocks – 799 of them financial stocks.

The proposed ban was good news for the banks and brokers. It meant that Morgan Stanley (MS, Fortune 500), Citigroup (C, Fortune 500), and others didn’t need to worry that hedge funds could drive them to the brink.

Yet the news was horrifying for hedge funds like Citadel. Scores of Citadel’s positions – particularly in convertible arbitrage, which requires shorting – would simply blow up if the ban went into effect.

According to sources, Griffin phoned Christopher Cox, the SEC’s chairman. Griffin pleaded with Cox, telling him the ban could mean certain death to many hedge funds – including Citadel. Cox, according to these sources, was unmoved and merely responded with the party line about how the country was going through a national financial crisis and the SEC needed to do what it had to.

There was nothing Griffin could do or say to sway him, and on Friday, Sept. 19, the ban was made official. (The SEC declined to comment for this story.)

Citadel was now hemorrhaging money. Over the weekend and throughout the following week, Griffin talked with his portfolio managers and told them to dump the dogs and keep the racehorses, meaning preserve the positions that they believed had long-term upside as they engaged in a selloff.

By the end of September, Citadel’s funds were down 20%. In early October, Griffin sent a letter to investors stating that September had been the “single worst month, by far, in the firm’s history. Our performance reflected extraordinary market conditions that I did not fully anticipate, combined with regulatory changes driven more by populism than policy.”

“The SEC needed to do what it had to.”   I sure hope that is nothing even close to a direct quote of what Cox told Griffin, for if that’s what counts as reasoned policy, we’re in even deeper trouble than I thought–and I thought we were in major trouble.

I guess it could have been worse.   He could have said “A man’s gotta do what a man’s gotta do.”

December 11, 2008

Miscellaneous Clearing News

Filed under: Derivatives,Economics,Exchanges — The Professor @ 11:32 pm

In a moment of clear thinking (pun intended), Britain’s antitrust authority, the Office of Fair Trading, has decided not to pursue further analysis of exchange ownership of clearinghouses:

The OFT has decided not to undertake any work in the market for derivatives clearing, after inviting views earlier this year.

The OFT called for submissions on the broader issue of competition in this market in May after it concluded that ICE Clear Europe’s regulatory provisions did not have a significantly adverse effect on competition.

In reaching its decision, the OFT considered both the submissions it received from interested parties, and recent developments in the market. It concluded that, whilst some potential concerns about the competition effects of vertical integration between derivatives exchanges and clearing the transactions on them were raised, no specific action is required at present because:

  • Regulatory initiatives from both the US and EU suggest that now would not be an appropriate time for the OFT to take further action other than to monitor developments closely.
  • The industry is characterised by rapidly changing market developments and product and technological innovation which further indicate action at this time is not appropriate.
  • Consumers in derivatives trading in the majority are large, globally active companies which have demonstrated that they are able to react to market developments.

Whilst it has decided not to prioritise work in this area at present, the OFT will continue to monitor market developments closely.

In the second item, contrary to a SWP prediction, ELX has chosen the Options Clearing Corporation to clear its futures business.   Since there was a large overlap between the ELX founders, and the group of firms that invested in the Clearing Corporation Formerly Known as BOTCC, I had predicted that ELX would choose the ClearingCorp.   My conjecture is that the purchase of the CCorp by ICE scuppered those plans.   Getting clearing services from a potential competitor, ICE, was probably not that appealing a prospect.   The whole CDS clearing issue was not on anybody’s radar screen when ELX was first mooted, and the banks invested in CCorp.   The CDS clearing thing took on a life of its own, and the ICE initiative made sense, and pushed the ELX to the back burner.

Beware, Emoticon Users!

Filed under: Russia — The Professor @ 11:18 pm

Russian adman Oleg Teterin has trademarked 😉

Companies will be sent legal warnings if they use the symbol without his permission, he said.

“Legal use will be possible after buying an annual license from us,” he was quoted by Kommersant as saying. “It won’t cost that much — tens of thousands of dollars.”

To Mr. Teterin, I say: 😉 😉 😉 😉 😉 😉 😉 😉 😉 😉 😉 😉 😉 😉 😉 😉

So sue me.

Crisis, What Crisis?

Filed under: Economics,Politics,Russia — The Professor @ 12:16 am

This article from Business Week requires little SWP comment:

On 9 December, Russia’s State Statistics Service revealed the GDP growth figures for the third quarter. And – lo and behold – they are “surprisingly bad”, “much worse than expected”, “below market expectations”, etc. (Read the reports in The Moscow Times, Bloomberg and Reuters).

You might think that by now economists would no longer be surprised by the stream of dire economic news. For anyone who has been closely following what has been happening in Russia’s economy over recent weeks, it’s increasingly obvious that it has essentially stepped off a cliff. As Danske Bank economist Lars T. Rasmussen writes in a research note: “The question is whether there will be any economic growth at all in Russia next year.”

“But surely 6.2% growth in the third quarter isn’t so bad?” I hear you say. Think again. That figure is the year-on-year change, not the quarterly change. In other words, it includes the rapid growth that took place in the first half of this year and the fourth quarter of 2007, when Russia’s GDP was still growing by 8%. The month-on-month trends show that output is already contracting. Russia’s GDP fell by 0.4% in October, according to government officials.

Now, the signs are that production in Russia is not simply stagnating: It is in fact plummeting like a stone. Industrial output, generally an early indicator of GDP trends, has been falling for months – by a cumulative 5% between July and October. And the output decline appears to have accelerated dramatically in November and December. According to the latest government figures, cited in the Moscow Times article, manufacturing production will have plummeted by an additional 10% by the end of the year.

The latest business surveys also confirm the dramatic speed and scale of the economic deterioration. These show that the situation facing Russia’s service industries (not recorded in the industrial output figures), is even more dire than in manufacturing. <

The gloomy official figures only confirm what has been apparent from anecdotal evidence for weeks. In sector after sector, Russian companies are reporting sharply declining orders and massive lay-offs. Construction, banking, metallurgy and the automotive industry are all in deep and obvious crisis. Russian railways has reported a 20% decline in freight volumes, reflecting the nationwide slump in industrial production. As for the oil industry: that was reporting declining output and insufficient funds months ago, long before the financial crisis escalated and the oil price plunged.

The risk of a GDP contraction has already been highlighted by longtime Russia watcher Anders Aslund, perhaps the first economist to warn of the current Russian economic slump. In October Aslund suggested that Russia’s GDP could fall by 5% next year.

Now those views, which once appeared heretical and extreme, are becoming mainstream. Barclays Capital now predicts “acute declines in output in the first months of the year”.

Nouriel Roubini, a US economist who became famous for accurately predicting the global credit crunch, is also weighing in on Russia’s economy. He writes that the current global outlook “signals a sharp recession in advanced economies, and a very likely recession in Russia too”.

Meanwhile Bloomberg cites Alexander Lebedev, one of Russia’s top businessmen, saying that the economy would “definitely” go into recession next year, and that it is “quite possible” that it will contract by as much as 10%.

Even the dreaded “D” word is now beginning to be heard. In comments cited in The Moscow Times, leading Russian economist Evgeny Gavrilenkov warns that if the latest government figures are accurate, they mean that Russia is now heading into a “severe depression”.

Mr. Gavrilenkov may want to keep an eye on his six, saying stuff like that.

If this article is accurate, and the economic difficulties are that acute, a media management strategy (to put it euphemistically) of denying the severity of the situation, and threatening those that speak the truth, will only make things far worse. For things this severe cannot be camouflaged. When it is clear that the emperor has no clothes, the government will lose its credibility, and the prospect for civil unrest will rise dramatically, for economic hardship combined with the realization that you’ve been lied to is a volatile combination.

I know Timothy, and DR, and others will take issue with this, but I find it hard to believe that a severe economic downturn and a the revelation of a deception campaign orchestrated at the highest levels will not lead to political unrest. Even among famously fatalistic, not to say passive, Russians.

And here, from Time, is perhaps a harbinger (complete with an appearance from Michel’s pensioners’-):

In the Siberian city of Barnaul, pensioners, angry with rapidly declining living standards and rapidly rising bills, last week stormed and occupied the Regional Administration Building, demanding more money. Russian sociologists are expecting a massive wave of similar protests and strikes to roll throughout Russia, not unlike those that shook the country in the 1990s, with angry coal miners blocking railways in Siberia and unpaid workers striking in the cities. Now some enterprises are again failing to pay their workers, while others simply go out of business. But disruptive protests would contravene a new labor code passed under Putin in 2001, which sets tight restrictions on the forms of protest available to trade unions. But a Russian state that narrows the options of legal protest available to its people during a major national crisis may be courting serious trouble — it’s certainly a principle that Czar Nicholas II failed to understand.

And that’s Time, for crissakes.

The volcano is rumbling.   Sometimes the rumbles of volcanoes do not presage an eruption–now.   But they often do.

December 10, 2008

I Knew There Was Leverage in There Somewhere

Filed under: Economics,Russia — The Professor @ 11:47 pm

Business Week has a very interesting article regarding a topic that generated a good deal of debate back in October–the Russian real estate market.   There are a variety of interesting contentions in the article.   One is that it is widely expected in Russia that big city real estate prices, especially in Moscow, will crash.   And I mean crash, big time:

It couldn’t last, and it hasn’t. Now that the global economic crisis has hit Russia with full force, real estate prices are finally tumbling. And if recent trends are any guide, the mother of all crashes may be in the offing. “The property market in Russia is on the brink of collapse,” says Vasily Koltashov, head of economic research at the Institute for Globalization & Social Movements, a Moscow think tank. “Property prices are very severely inflated, and demand is obviously slumping.”

Down 10% in Two Months

According to the widely cited IRN Index, the value of residential property in Moscow fell by 2% in the first week of December alone. That compares with a decline of 2.3% for the whole of November, and just 0.9% in October. Oleg Repchenko, IRN’s head of research, says that real estate prices in Russia have fallen on average by around 10% in the last two months. He estimates they’ll fall by a further 30% before next summer.

Others go further. Peter Aven, president of Alfa Bank, one of Russia’s leading commercial banks, has predicted that Moscow property values will fall “several times over.” In an October conference presentation, Aven pointed out that the value of Moscow property prices is some five times the European average. When it comes to choice property in the center of Moscow, the cost for a 100 square meter apartment is 155 times the income of the typical Russian. That compares with a multiple of just 5.9 in Germany.

Little wonder that Moscow property prices are now sinking rapidly. Indeed, some analysts say that the real market situation is way worse than the headline figures suggest. According to Inkom-Nedvizhimost, a Moscow real estate consultancy, the city’s major development companies sold an average of five new apartments in the city in November. That compares with around 40 to 50 apartments per month in the summer, and 90 to 100 in the first half of the year. The collapse in demand means that many developers are already offering deep discounts on new apartments, typically ranging between 25% and 40%. <

Nor is it just residential property, the most overheated segment of the Russian market, that is now crashing. Commercial property also has taken a dramatic hit. Irina Florova, an analyst at real estate consultancy CB Richard Ellis (CBG) in Moscow, says that average office rents have fallen by 20% since October and are expected to decline by 25% more by early next year. The take-up of new office space has fallen by 50% since a year ago, while the volume of vacant office space has doubled. “Now it’s a tenant’s market,” says Florova. “Landlords were used to increasing prices, and now they are faced with a completely different situation. For them it was a bad surprise, which happened in the space of two or three weeks.”

An issue that I discussed in some detail related to the leverage in the Russian real estate market. In response to the original posts, some commentors noted that mortgage finance was unimportant in Russia. I concurred with that assessment, but expressed doubt that such pricey properties could be purchased without leverage. Moreover, given that wealthy Russians apparently found it quite advantageous to lever up their other investments, it strains credulity that they wouldn’t lever their housing assets.

The BW article repeats the point about the infancy of the Russian mortgage market, and is silent about the leverage in the residential real estate market. It does state, however, that banks have a major, major exposure to commercial real estate:

Spare a thought, too, for Russia’s construction and development companies, many of which now face ruin. Over recent years they have collectively plowed tens of billions of dollars into new construction projects, typically financed with the help of short-term loans. But even before property prices began tumbling, the sector was in a crisis brought on by a complete halt in financing. In comments to the RIA-Novosti news agency in November, Vladimir Ponomarev, vice-president of the Association of Russian Builders, described the situation facing the industry as “practically a catastrophe.”

As a result of the financial crunch, investment in the construction sector has already ground to a virtual standstill, with knock-on effects for other sectors of the Russian economy. “Of course, changes on the real estate market can significantly affect the rate of investment in the economy,” says Evgeny Nadorshin, chief economist at Trust Bank in Moscow.

The real estate crunch also will affect the wider economy through its impact on the banking sector. When it comes to the banks’ balance sheets, the fledgling mortgage market represents just the tip of iceberg. Alfa Bank’s Orlova estimates that around 14% of corporate loans are to construction companies, while an additional 30% of loans use some form of real estate as collateral. That means that the volume of bad loans—already estimated at around 10% of banks’ portfolios—is now set to rise sharply.

The article is somewhat ambiguous when it says “an additonal 30% of loans use some form of real estate as collateral.”   Does this refer only to corporate loans (as the first clause in the sentence suggests), or to all loans?   Either way, it suggests that the real estate exposure of banks is far higher than the mortgage lending numbers would suggest.

My interpretation is that the mortgage contract is relatively new and novel in Russia, so instead lenders primarily use recourse loans collateralized in part by real estate.   Mortgages are non-recourse loans, meaning that all the lender can do is seize the mortgaged property.   If you default on a recourse loan, the lender can seize the collateral and go after the rest of your assets.   If I am correct in this, if real estate indeed continues to collapse, the collateral will fall below loan value, banks will seize the collateral and start going after the borrowers’ other assets.   That could get ugly.   And the same kind of dynamic currently operating in the US would kick in in Russia–banks seize real estate collateral, dump it on the market, reducing housing values, leading to more defaults, etc.

Even for those who own property unencumbered by debt, the decline in property values will lead to a wealth effect that will depress consumption and economic activity–again, something that is happening in the US.     This is also bearish for the Russian economy.

There is little room for solace if the price bubble was concentrated in Moscow, St. Petersburg, and perhaps some other cities; the housing price bubble was highly concentrated in the US too, and mortgage defaults are highly concentrated, with most occurring in three relatively small areas (in CA, NV, and FL).   A concentrated collapse can have systemic consequences in a connected system.

(I also wonder how much of this debt is dollar or Euro denominated.   I know that a lot of Eastern Europeans borrowed in foreign currency.   I also know that Russian corporates also borrowed a lot in FX.   Given the rosy expectations about the ruble appreciating on the back of a spiraling oil price, I would not be surprised if a lot of the debt collateralized by real estate is also in dollars or euros.   If so, everything I said before goes double.   Or triple.   Or whatever.)

The BW article is not definitive (I’d like to see more data, less journalism) but it is suggestive, and does support my suspicion that there is a lot of debt tied directly or indirectly to real estate sitting on Russian bank balance sheets.   Since real estate prices have just begun their descent, and given the level that they had reached likely have a very long way to go down, the financial strains in Russia will only intensify in the coming months.   The effect on banks plus the wealth effect will test mightily the Russian economy, and make growth very hard to achieve.   To put it mildly.

Two Questions For Obama

Filed under: Politics,Uncategorized — The Professor @ 11:16 pm

“In your years in Chicago and Illinois politics, have you ever witnessed any corrupt acts?   If you have, what did you do about it?”

I hope some journalist has the guts and the independence (i.e., not scuba diving in the Obama tank) to ask these questions.   I am not holding my breath.

Given what is known–and has been known long before I was born–it would be completely incredible for Obama to answer “No” to the first question.   Corruption is endemic in Chicago, and in Illinois state government.   It is almost certain that the answer to the second question is: “Nothing.”   If he had done something, no doubt we would have heard about it.

So, here are the possibilities:

1. “No” to Q1=he’s a liar. No need to proceed to Q2.   (But, then again, he claims he never heard “Reverend” Wright make racist or anti-American statements, so apparently he can make incredible statements with no adverse consequence.)

2. “Yes” to Q1, “Nothing” to Q2=he’s honest (I guess), but complicit in corruption.

3. “Yes” to Q1, “Something.”   Seems like a set of measure zero.

Hardly seems like the qualifications for Savior.

And we should remember: Blagojevich was elected as a reformer offering change to clean up the corrupt (Republican) government of Illinois.   I kid you not.   The moral of that story: Beware of Illinois Democrats bearing the gift of honest government.     Unfortunately, I fear that just as the Trojans didn’t learn the lesson about Greeks bearing gifts until it was too late, so have we.

Some Things Just Don’t Mix

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 11:00 pm

There are two competing models in CDS clearing.   The CME model is to clear these products through its existing clearing structure, effectively “co-mingling” futures risks and CDS risks.   The alternative model, embraced by ICE and Eurex, will clear CDS and futures products seperately.

As I’ve mentioned on a few occasions, there is considerable tension among CME clearing members over the co-mingling idea.   This article from DJ News Wires details the competing claims and complaints over the various models:

CME argues that “co-mingling” futures and CDS contracts in its clearinghouse will avoid an additional capital call on banks and dealers.

The strategy has generated warnings from some of CME’s largest partners in the futures industry, who are concerned they will be exposed to CDS risk.

Patrice Blanc, chief executive of Paris-based Newedge, said co-mingling futures and CDS clearing is “dangerous,” and that it could “create huge systemic risk” for market participants.

Clearing CDS contracts is “a much more complex issue than it’s been made out to be,” Blanc said in a recent interview with Dow Jones Newswires.

Thomas Peterffy, CEO of electronic brokerage firm and CME clearing member Interactive Brokers, has also come out against mixing futures and CDS risk on CME’s platform.

Co-mingling of futures and CDS risk could threaten the integrity of a clearinghouse, says Roger Liddell, CEO of London-based clearinghouse LCH.Clearnet.

He also cautioned that clearing CDS trades may be more complicated than many believe.

“There is a risk in assuming that everyone can clear everything,” Liddell said at the Futures Industry Association’s 2008 Expo in Chicago last week.

I concur with the various cautions voiced by Liddell, Blanc, and Peterffy.   They are, in effect, in agreement with my assessment that CDS clearing presents acute balance sheet and product risks that are inherently more costly to share through a clearinghouse, due to asymmetric information problems.

Now, “co-mingling” is synonym for “diversification.”   In a world of complete information, the CME’s Kim Taylor would be exactly right:

Kim Taylor, president of the CME clearinghouse, has acknowledged the concerns. She argues that combining the risk of futures and CDS contracts in one clearinghouse provides diversification, lower overall risk and cutting trading costs.

Taylor, speaking on a panel at the FIA event, noted that risk management for the clearinghouse as a whole has become more efficient when CME has brought new product lines into its clearinghouse, notably the energy and metals contracts from the New York Mercantile Exchange.

In a world of complete information, with no information asymmetry, there are economies of scope in clearing.   Through the diversification effect, the riskiness of a combined CDS and futures portfolio would be lower than the sum of the risk of the stand alone CDS portfolio and the risk of the stand alone futures portfolio.   Moreover, clearing across products economizes on margins.   Again, due to the diversification effect, with a combined portfolio one can achieve the same default loss profile for a smaller margin than one can with seperate portfolios.

So, co-mingling sounds like a no brainer.   So why aren’t savvy market participants buying this?   I think the answer is pretty clear.   They understand that this is not a situation of complete information.   Due to information problems, moral hazard and adverse selection problems make it costly to clear CDS trades.   CME clearing members are quite right to be very leery of importing the product and balance sheet risks associated with credit default swaps into a futures clearing system that has worked very well.

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