Streetwise Professor

November 23, 2009

Is it THAT Jim Chanos?

Filed under: Derivatives,Financial crisis,Politics — The Professor @ 7:14 pm

Several sites on the web (EG) have linked to my  recent post on the AIG bailout, and included a hattip to Jim Chanos.  Just curious if that is the “noted short seller” (and billionaire)  Jim Chanos (a hedge fund manager noted for his very prescient call on Enron).  If so, it would be a hoot.

The sites mentioned have quoted the part of the post which notes that unlike the other banks that received payments via the Maiden Lane III SPV, Goldman had sold protection on CDOs to its customers, and thus was potentially exposed to collateral calls from them.  This means that with no cash flows from AIG (or Uncle Sugar), Goldman would have needed to find a few spare billion lying around to meet its obligations–at a time of a market meltdown.  (Think of how the market would have responded had Goldman not met the calls, or been observed scrambling around to do so.)

There is an indirect, oblique, and very understated confirmation that this cash flow mismatch issue was a real one for Goldman in its reply to (“Wretched”) Gretchen Moregenson’s most recent article on the AIG bailout:

Did we benefit from Maiden Lane III then? In one sense, yes – there a was a timing benefit in terms of money received sooner than might otherwise have been the case.

“Timing benefit in terms of money received sooner.”  How benign it seems, worded that way.  But in the chaotic conditions of mid-September, 2008, when cash was not king–because it was God–that timing benefit could have been the difference between life and death for Goldman.

As I said in the original post, the story is incomplete, and questions remain.  For instance: why go through the subterfuge of providing a cash injection to Goldman via a bailout of AIG rather than providing support directly to GS?  I can think of at least one reason: in those panicked days, even the suggestion that Goldman needed government support would have unleashed Armageddon.  Or at least, it was reasonable for Paulson, Bernanke, and Geithner to fear that it would have unleashed Armageddon.  But we–I–don’t know based on the record whether that was a decisive consideration.

I would say, though, that based on the same record we can’t say that it wasn’t.  I would say further that additional inquiries on this issue are likely to be far more probative than continued flogging of the “the Fed should have forced the banks to take a haircut” angle.

Despite the efforts of Goldman and its defenders to say “move along, nothing to see here,” there are still loose ends.  The most notable of which is the one that distinguished Goldman from the other banks that received Maiden Lane funds–the fact that it was in the middle of a contractual chain.

Anyways, it would be interesting to know if Jim Chanos has been touting SWP.  Just between us, Jim :)

November 22, 2009

A Pragmatic Take on Terrorist Trials

Filed under: Military,Politics — The Professor @ 9:57 pm

For a thoughtful discussion of why terrorists like Khalid Sheikh Mohammed should not be tried in civilian courts, I recommend ch. 7 of Judge Richard Posner’s Countering Terrorism.  It contrasts starkly with Attorney General Eric Holder’s babbling incoherence on the subject, and Obama’s deafening silence.  (Funny, he seems to have time to yak about pretty much every other subject, including, as in an ad I saw this evening, how it’s a really good idea for fathers to take interest in what their kids do.  Who knew?  Thanks for telling me!  I had never figured that out before.)

Pages 174-176 are quite persuasive, as is this summary on p. 185:

Criminal law enforcement is no more likely to win the “war on terrorism” than it is to win “the war on drugs.”  It is maladapted to both struggles.  We should be deemphasizing the efforts to prevent terrorism by criminal prosecutions, especially but not only in the regular courts,  which are not designed for the trial of people who pose a serious threat to national security.  Our counterterrorism efforts would be more effective, and at the same time the dilemma of defeating terrorism while respecting civil liberties minimized, if we downplayed the judicial role in counterterrorism.

Although a jurist, Posner understands the strengths and weaknesses of his profession (the legal profession generally, and the judging sub-profession particularly).  He persuasively counsels against the (Anglo-American) tendency to try to jam everything into conceptual boxes defined by historical precedent.  Since terrorism is sui generis, he says, it is advisable to devise similarly specialized means to combat it rather than to rely upon existing institutions designed for completely different tasks.

He is, interestingly, not a fan of military commissions, viewing them as essentially legal and judicial tools almost as ill-adapted to combatting terrorism as civilian courts.

Posner’s book, I might add, was published in 2006.  He also wrote another book that speaks to this subject, titled Not a Suicide Pact, also in 2006.

I wonder if Holder has read either.

Actually, I don’t.

Faulkner Goes to Russia

Filed under: Politics,Russia — The Professor @ 8:37 pm

Jonathan Brent is the editor of the Yale University Press who succeeded in opening Stalin’s archives (or portions thereof, anyway) for publication in the West after the collapse of the USSR.  He has written an interesting memoir on the experience, which includes an exploration of the reasons for Stalin’s continued popularity in Russia.  I’m about half-way through that, but did finish his essay on the subject in the most recent issue of The New Criterion.

Brent argues that post-Krushchev, the Soviets attempted to retain the essence of the Soviet system, but jettison the cult of personality.  After the collapse, he concludes, Russia is attempting to distance itself from the essence of the Soviet system (a proposition that is debatable, given the move to a one party authoritarian state), but restore the cult of personality.

His explanation for the fascination with Stalin is quite interesting:

The question of why the image of Stalin, rather than a symbol of the Soviet system minus Stalin, has returned to daily Russian life, which is what [Russian historian Alexander] Chubaryan and Krushchev before him advocated, can be answered only by recognizing that the Soviet system has no other visible symbols of success.  Lenin’s short reign did not represent Soviet success so much as the triumph of Marxist thought.  It was Stalin who fought the great battles against Trotsky, the Nazis, and the sneering West.  In the eyes of many today, Stalin vindicated the Soviet system, by transforming it into a great world power. No more “obsequiousness or groveling” before the West, or, as Stalin wrote in a letter to Gorky, “no more beggarly Russia.”  In the end, the revival of Stalin has less to do with the image of Stalin than with the image of Stalin than with the self-image of the Russian people, their powerful need to look into the mirror and see not themselves but their deepest aspirations reflected back. [Emphasis in original.]

In brief: the worship of Stalin is a form of self-worship, an exercise in self-esteem building.  If Brent is right, his theory has an implication: the intensity of the Stalin personality cult should vary inversely with Russia’s fortunes.  The worse the present reality, the greater the need to retreat into an idealized past.

[It is interesting to note that Gorbachev, who is widely reviled in today’s Russia, was an ardent admirer of Lenin.  This provides another data point in support of Brent’s view of the relative appeal of Lenin and Stalin to the Russian people, and the reasons for it.]

In Stalin’s time, the cult of personality had one god.  Now, it arguably has two, with Putin joining Stalin in the pantheon.

According to Edward Lucas, this bodes ill, for Russia’s neighbors, but for Russia most of all.  From a description of his upcoming talk:

Seen from the Kremlin, history is simple: the Soviet Union, with extraordinary sacrifice, liberated Europe from fascism and  Europe  should be grateful. Anyone who disagrees is a fascist. Stalin may have been bad in some ways, but he was an effective leader in difficult times. The  Soviet Union  had its flaws, but so do other countries. Criticism reflects double standards and jealousy of  Russia’s recovery.

This simplistic and triumphalist version of 20th-century history is the central plank in  Russia’s new ideology. Edward Lucas, a journalist and author who has been covering the region for more than 20 years, will show why it is not just mistaken but pernicious. The revival of Stalinist history is a threat to the countries of Eastern Europe–and a dreadful dead end for Russia.

To me, Putinism is all about dead ends.  Economic dead ends.  Political dead ends.  Diplomatic dead ends.   It is all part of the necessity of maintaining stasis in order to avoid destablizing the natural state.

In this regard, Medvedev’s sounding an admittedly uncertain trumpet of condemnation of Stalin (and importantly, of how Russians idealize him) has some significance.  Russia’s future has a great deal to do with how it relates to its past (there is definitely correlation here, and perhaps causation).  As Faulkner said of the South, in Russia, the past Is never dead. It’s not even past.  Or, if you want to have some idea of where Russia is going, look at how it relates to where it’s been.

Further My Last (On Clearing)

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 10:23 am

My previous post on the Acharya et al (AEFLS) assertion of the purported externality in bilateral OTC markets focused on whether there was actually an unpriced “bad.”  I judged otherwise based on the fact that credit and counterparty risks are repriced repeatedly (and ruthlessly).

There is another reason to reject their analysis.  It should be incumbent on one who justifies the existence of an externality to justify a particular policy to (a) identify the transactions costs that preclude internalization of this externality, and (b) demonstrate that their policy would create a net benefit, by, for instance, reducing transactions costs.  AEFLS don’t even try to do this (another symptom of the Nirvana fallacy).  And when one examines the particulars, it is highly doubtful that the costs of the purported externality are as large as AEFLS insinuate that they are.

The AEFLS story is that contracts between two counterparties to an OTC derivatives deal impose costs on other market participants, notably, the firms’ other counterparties to earlier derivatives deals, and the counterparties’ counterparties, and on and on.  OTC market participants don’t take these costs into account, trade too much, and create too much risk.

Which raises the Coase Question: if these costs are so large, why don’t the affected parties craft a solution that mitigates them?  If, as AEFLS argue, a central counterparty would reduce these costs, why don’t the affected parties create one to internalize the externality and enhance their welfare?

In some cases, e.g., the classical one of a factory that spews pollution that harms myriad individuals, it is plausible that coordination costs (arising from, inter alia, free rider problems) preclude private collective action, and that legislation/regulation mitigates these costs.  But that hardly seems the case here.  The very fact–often cited by the advocates of new, invasive financial regulations–that there are a relatively small number of large institutions that dominate this market means that large numbers-driven coordination problems preclude effective collective action.  Indeed, the institutions that account for virtually all of the activity in the OTC market are already members of a formal organization, the International Swaps and Derivatives Association (ISDA).  ISDA has long served as a mechanism for coordination among, and providing collective goods to, its members.  For instance, ISDA facilitated the standardization of the terms of OTC deals through its standard master agreement.

In brief, the parties that bear the primary burden of this putative externality are relatively small in number; know who each other are; regularly cooperate on a variety of issues of common interest; anticipate interacting with one another well into the future; and have a formal organization to facilitate this coordination.  These conditions would tend to favor private collective action to internalize an externality, especially one allegedly as costly as the one asserted by AEFLS.

But they haven’t done so.  This is like the dog that didn’t bark.  If the danger was there it would have barked.  It didn’t, so . . .

Could there be transactions costs that prevent cooperation?  Just because the canonical sources of such costs appear absent in this instance doesn’t mean they are altogether absent.  One possibility is the kind of problem that Libecap and Wiggins identified in their work on oil field unitization (and that Libecap addressed more generally in his Contracting for Property Rights).  Specifically, that it can be prohibitively costly to negotiate agreements that would (but for these transactions costs) enhance wealth when said agreements have profound distributive effects, and there is private information about these effects.

The complete alteration of risk sharing arrangements would certainly have distributive effects (as I’ve noted in work dating back to the ’90s), especially when the affected parties are heterogeneous (as was almost certainly the case before the crisis, and likely even more so today).  Consequently, one can’t rule out this possibility.

However, it is also plausibly the case that the adoption of clearing would be wealth reducing.  In some sense, then, the heterogeneity-driven coordination cost externality story and the no externality story are observationally equivalent: both predict that market participants would not voluntarily cooperate to create a central counterparty.

To try to untangle the correct explanation of an incontestable fact–that clearing was not adopted voluntarily for the bulk of OTC derivatives transactions–it is necessary to undertake a fact- and context-intensive analysis, rather than play the superficial Pigouvian “I spy an externality” game and stop there, as AEFLS do.  And sad to say, by even getting to this point they are miles ahead of most of the advocates of a radical reshaping of financial market institutions, most notably those in the administration and Congress.

Be Afraid. Be Very Afraid.

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 9:30 am

Via SeekingAlpha:

“One of the huge lessons of our work over the last few years has been how shockingly stupid incredibly smart people can be,” said Davidson, who with Blumberg has been reporting on the crisis for nearly two years as part of  National Public Radio’s  “Planet Money” team. “That includes bankers, regulators  and investors.”

OK, that’s a given. Lesser known is this: Our elected officials in Congress — the ones trying to reform our financial services industry as we speak — don’t really understand the issues at hand.

“We spent a day with the Financial Services Committee — Barney Frank’s committee — and it was an amazing experience,” Davidson said. “We talked to 13 congresspeople, 12 of whom admitted that they don’t understand this  at all. And the guy who thought he did really didn’t.”

It’s interesting, then, that these are among the folks calling for investor protections and significant financial reforms. And by “interesting,” I mean “anxiety-inducing.” I’m willing to give them the benefit of the doubt; their intentions are good, after all. But you know what they say about the road to hell.

NB: the directly quoted material in this excerpt is from two NPR reporters.  N. P. R.  Hardly the hotbed of libertarian firebrands.

Personally, I am far less forgiving than the authors of this piece (who are directors of the Maryland Association of CPAs). Anyone who, in full knowledge of their ignorance, nonetheless feels entirely justified in completely restructuring complex markets involving trillions of dollars at risk is a public menace.  A public enemy, in fact, all the worse because they presume to be performing “public service.”

Don’t do me any favors.  The greatest public service these people could perform would be to put away their wands, and stop playing Sorcerer’s Apprentice (or, more accurately, stop playing junior apprentices to Sorcerer’s Apprentice Barney Frank.)

November 21, 2009

Barbara Hits the Nail on the Head

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 7:53 pm

In his megalomaniacal effort to use the financial crisis as a Trojan horse to advance his campaign “on every front to increase the role of government,” Barney Frank is hellbent on fixing things that demonstrably didn’t break.   Even under the extreme stresses of the crisis.   Case in point: he wants to require clearing of foreign exchange derivatives transactions:

If it didn’t break, why fix it?

That is the question being asked by foreign exchange bankers after Barney Frank, chairman of the House Financial Services committee, announced currency derivatives would not, after all, get an exemption from proposed US rules that would require all derivatives trades to be processed through a centralised clearing system.

Mr Frank’s move came as policymakers are debating the detail of legislative proposals designed to increase transparency and reduce risk in the vast over-the-counter derivatives market. While the proposals are not final, the U-turn on his previous stance has stunned the FX market.

Get used to it, guys.   Barney’s all about the u-turns, pace his volte face on clearing and exchange trading in his obviously thoughtfully considered OTC regulation bill.

The FX folks are point out some things I mentioned months ago, such as the fact that clearinghouses can concentrate risk, and therefore exacerbate systemic risks:

Bankers have also warned that clearing in FX could create new concentration dangers which they fear could create fresh systemic risk, given the size and significance of the FX market. The market is already concentrated among a handful of top international banks.

But it is Barbara Matthews that brings out the key point:

Barbara Matthews, managing director of BCM International Regulatory Analytics, believes there is a general issue to be considered about concentrating so many markets on to clearing platforms. She warned that policymakers must be aware that clearing houses could create new “choke points” in the system – not unlike the risk created now by any large bank – which must be considered carefully. “Its perfectly natural in a time of uncertainty to look towards some kind of central arrangement,” she said. “But I’m hearing people say it eliminates risk and that’s not true – it just transforms it. If the idea is that risk will be gone, then some people are in for a nasty surprise.”

That last bit bears repeating: “But I’m hearing people say it eliminates risk and that’s not true – it just transforms it. If the idea is that risk will be gone, then some people are in for a nasty surprise.”

Exactly right.   Those who have advocated clearing mandates–Geithner, Gensler, and Frank most prominently–commonly assert that clearing eliminates counterparty risk.

Wrong.   It doesn’t.   It reallocates it.

The only question is whether they know better and are lying, or are ignorant.   Either way, they selling a bill of goods, and as Barbara Matthews says, are laying the groundwork for the next nasty financial surprise.

Who You Gonna Believe, Putin or Your Lyin’ Eyes?

Filed under: Economics,Politics,Russia — The Professor @ 6:40 pm

Bloomberg reports the grim news on foreign direct investment in Russia:

Russia’s foreign direct investment plummeted an annual 48.1 percent, the most on record, to $10 billion in the first nine months of the year after the economy slid into its worst crisis in a decade.

Overall foreign investment, including credits and flows into the securities markets, was $54.7 billion, 27.8 percent less compared with the same period a year earlier, the Moscow- based Federal Statistics Service said in an e-mailed statement today. The office started collecting the data in 1999.

Gross domestic product of the world’s biggest energy producer eased its decline to 8.9 percent last quarter from a record 10.9 percent in the three months through June. Energy products make up about 70 percent of export revenue, with this year’s 82 percent increase in Urals crude driving Russia’s recovery. The government has said Russia is relying on investment to sustain its recovery as some of the world’s biggest brands reduce their presence in the country.

KBC Groep NV, Belgium’s biggest bank and insurer by market value, said this week that it intends to sell its banking unit in Russia as it revises plans for regional expansion. Wal-Mart Stores Inc., the world’s biggest retailer, has yet to open a single store in Russia since it started to look into entering the market more than a year ago.

Carrefour SA, Europe’s biggest retailer, announced last month that it will sell its business in Russia, several months after opening its first store in the country. The decision was prompted by the “absence of sufficient organic growth prospects and acquisition opportunities,” the company said

Foreign investment in stocks and bonds tumbled 65.8 percent to $348 million in the first nine months compared with the same period last year, the Statistics Service said.

The decline in foreign investment has been one of the primary contributors to Russia’s 2008-2009 economic decline, which was one of the world’s steepest, particularly when compared to pre-crash growth.   The unwillingness of foreign investors to pursue opportunities in Russia–opportunities that looked so promising, especially for retailers, before the crash–is an ill-omen for the future.

It is no surprise then, that Putin is putting on a charm offensive, trying to attract foreigners back to Russia.   He has suggested that they would be permitted to participate in future privatizations.   He says risible things like “Russia will remain a liberal market economy,” all in an effort to lure the foreigners who have fled in the past year.

All these honeyed words, however, pale by comparison with the headlines about the travails of foreign investors in Russia.   Telenor.   BP.   Shell.

When evaluating the risks and rewards of investing in Russia, which should carry greater weight?   Putin’s soothing phrases, or the fate of Sergei Magnitski?   The former are pie crust promises, easily made, and easily (and I daresay, inevitably) broken.   The latter is a cold, hard, immutable fact.   Putin will gladly take back what he sold, but nobody can give back Magnitski’s life.

In such an environment of lawlessness and brutality, and relentless nationalist propaganda, a foreigner must be very brave, or very foolhardy, to risk investing in Russia.   Don’t look, therefore, for foreign investment to bounce back anytime soon.

November 20, 2009

Nirvana is Just a Band

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 9:02 pm

Last week I wrote about one justification for exchange trading and clearing mandates–the market power argument.  This week I’ll examine another argument, and render a similarly skeptical verdict.

In a chapter of Restoring Financial Stability, Viral Acharya, Rob Engle, Steve Figlewski, Anthony Lynch and Marti Subrahmanyam argue that bilateral transactions in OTC derivatives markets involve an externality.  Their argument is not stated that clearly, but FWIW here it is verbatim:

[A]ll OTC contracts . . . feature collateral or margin requirements, wherein counterparties post a deposit whose aim is to minimize counterparty risk.  The deposit is marked to market daily, based on fluctuations in the value of the underlying contract and the creditworthiness of the counterparties . . . . The difficulty, however, is that such collateral arrangements are negotiated on a bilateral basis.  Parties in each contract do not take full account of the fact that counterparty risk they are prepared to undertake in a contract also affects other players; indeed, they often cannot take account of this counterparty risk externality in an OTC setting, due to inadequate transparency about the counterparty’s positions and its interconnections with the rest of the market.  While bilateral collateral arrangements do respond to worsening credit risk of a counterparty, such response is often tied to agency ratings, which are sluggish in capturing credit risk information and potentially inaccurate.

An externality means that some cost or benefit is not priced.  By invoking the concept of externality Acharya et al (“AEFLS”) are asserting that something–a bad in this instance–isn’t priced.  They are a very vague on just what this is, but here’s my interpretation of what they mean.

A firm that has already entered into financial contracts affects the risk exposure of its existing counterparties when it enters into new deals.  A firm that has a large number of commitments outstanding can enter into additional contracts that substantially increase its riskiness, thereby harming the incumbent counterparties.  The cost imposed on these incumbent counterparties isn’t, in this telling, priced.

This is, in essence, an asset substitution argument.  And indeed, asset substitution is always a concern in any credit relationship, whether it is between a bank and a borrower, or derivatives counterparties.

But an understanding of the way these markets work suggests that the asset substitution problem is far less important than AEFLS suggest.  One way of controlling this problem in lending relationships is to rely on short term debt, allowing repricing of old debt frequently and thereby limiting the gains from asset substitution.

In OTC derivatives markets, similar mechanisms are at work.  The main dealers rely heavily on short term financing.  Thus, attempts to engage in this type of behavior can lead to substantial increased financing costs, and indeed, a loss of access to short term funding altogether–this is a death sentence to a financial institution, as Drexel found out in the 1980s, Salomon almost experienced in the 1990s, and Bear and Lehman suffered during the crisis.

In fact, Diamond and Rajan argue that the “fragile” capital structure of financial intermediaries–the vulnerability to runs or other mechanisms that result in the rapid withdrawal of access to funding–are intended precisely to  provide such discipline.  Thus the supposed bug–the vulnerability of a big liquidity supplier to failure–is, in some respects, a feature.  Without it, the opportunism that AEFLS worry about would be a greater concern.

OTC dealers also trade derivatives extensively with one another.  Thus, changing creditworthiness can affect their ability to deal in these markets, and the pricing of these deals.

There are, therefore, mechanisms by which financial institutions internalize the costs associated with the riskiness of their dealings.  Of course, these do not work perfectly.  Of course, information is imperfect.  But it is essential to note that myriad lenders and counterparties are continuously interacting with big OTC dealers in a variety of different markets.  They are doing their own credit appraisals.  They are voracious consumers of any bit of information about other players in the marketplace.  The markets for funding and derivatives can serve to aggregate this private information in the prices and credit terms of derivatives trades, and in the funding costs that the institutions pay, thereby pricing (albeit imperfectly) counterparty risks.

Moreover, as Peter Klein pointed out in an earlier post on O&M, it is necessary to make an explicitly comparative analysis when evaluating policy alternatives.  The identification of an imperfection of the OTC market is not sufficient to conclude that it should be replaced by some other alternative that is inevitably imperfect as well.

In this regard, a comparison of the OTC market with the particular alternative that AEFLS advocate–central clearing–demonstrates that OTC markets arguably dominate clearing even on dimensions emphasized by AEFLS.

Most notably, clearinghouses almost NEVER condition margin levels on the creditworthiness of the member firms.  If they do (as, for example, LCH.Clearnet does in limited circumstances) they rely soley on agency ratings.  This reflects a variety of factors, including a lack of information to make such judgments.  Moreover, it reflects the fact that it would be very difficult, in practice, for a clearinghouse to discriminate among its members.  Such discrimination–which could have serious competitive effects–would expose the clearinghouse to intense influence activities.  (Thus, clearinghouses are most likely to work effectively when the members are homogeneous, and heterogeneity can be an impediment to their formation.)  This means that clearinghouses do NOT price counterparty risk in a discriminating way.  In a cleared market, a major determinant of counterparty risk is in the public domain, and not priced.  This is not conducive to an efficient allocation of trades among firms, or in the scale of trading activity.

In contrast, in the OTC market, dealers have a wide variety of sources of information about the creditworthiness of potential counterparties that they take into account when determining the terms on which they are willing to deal with these counterparties.  That is, although their information is imperfect, big dealers almost certainly have better information on the creditworthiness of other dealer firms than a clearinghouse would.  What’s more, the fact that any given firm is being evaluated by multiple counterparties and lenders means that (a) the private information aggregation mechanism noted before can work in the OTC market in a way impossible with a single evaluation by a clearinghouse, and (b) evaluation errors are somewhat diversified in the OTC setting, but with one monitor in a cleared market, if the clearinghouse gets it wrong the problem can be huge.

That is, counterparty information in OTC markets is imperfect, but almost certainly better than in a cleared market.  Moreover, there are a greater array of mechanisms available to price counterparty risk based on this information: not just in margins, but in the pricing of deals (many deals explicitly adjust prices to reflect credit terms), the pricing of the financing that dealers require to operate, and in the sizes of transactions.

I’ve argued extensively in some working papers that as a result of these information advantages, contrary to the claims of AEFLS, counterparty risks are likely to be priced MORE accurately in a bilateral market than a cleared one.  Clearing can offer some offsetting advantages, but the key point is that a trade-off is involved.  In my view, it is highly likely that this trade off frequently favors bilateral, OTC dealings rather than central clearing.

Like so many advocates of clearing, AEFLS fall victim to the Nirvana fallacy.  They point out imperfections in OTC markets, and do not carry out a comparative analysis of the relative imperfections of alternatives.  What’s more, their analysis of the supposed failings of the OTC market is incomplete because they do not fully explore how market participants structure their transactions to deal with the putative market failure they identify.

They’re miles ahead, though, of Barney and Chris and Timmy! and Gary and Mary and the gang.  At least AEFLS try to identify an alleged market failure.  Even though they fall into the classic Nirvana fallacy, at least they point out a potential inefficiency, thereby permitting an rigorous exploration and analysis of this possibility.  Which is way more than can be said for the Sorcerer’s Apprentices attempting to reorganize completely the largest and most complex financial markets in the world.

Cross posted on O&M.

Timmy!’s Testimony

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 3:28 pm

Krugman is bashing Timmy! Geithner for his role in the AIG bailout.   This poses something of a dilemma for yours truly.   My sentiments parallel those of Henry Kissinger during the Iran-Iraq War: too bad they both can’t lose.

All snark aside, the SIGTARP report that has put Timmy! (oh, that was snarky–sorry) on the hotseat raises some questions that have been totally ignored over the debate over whether the Fed should have sent Goldman et al to the barber shop to get a haircut on the valuations of their swaps with AIG.

The indisputable fact is that billions of cash went out the door to Goldman et al as a result of the Fed’s actions.   The Fed took ownership of the CDOs underlying the swaps that AIG had entered with the banks, and effectively paid the banks 100 cents on the dollar.   That is, they ensured that the CDO hedges were perfect (belying the old trader adage that the only perfect hedge is in a Japanese garden).

The question is, therefore, what were the alternatives?   The alternative that has garnered all the attention is that the Fed should have paid less than 100 cents on the dollar.

But that’s not the only alternative.   Hank Greenburg has suggested that the Fed should have simply guaranteed the swaps, thereby vitiating the need to provide any collateral payments.   (I made a similar suggestion in an earlier post on AIG).

The SIGTARP report states clearly (p. 14) that this alternative was considered, but dismissed.   The ostensible reasons for the rejection seem very dubious, indeed.

First, “FRBNY told SIGTARP that a perceived downside of this structure from FRBNY’s perspective was that it could involve FRBNY in long-term credit relationships with supervised institutions.”   Please.   The Fed has gone hog wild in extending credit (through repos, for instance) with supervised institutions.   It has taken all kinds of dodgy collateral at all kinds of dodgy valuations.   That certainly involves taking a long term credit exposure.   (Spare me any protests that there is no credit risk here because these repos are collateralized.   Given the quality of the collateral, and the counterparties, there is an appreciable probability that the Fed will suffer a credit loss on these deals.) And if the Fed’s actions were a response to an existential event, which is the gravamen of its defense of its actions, such prissiness over protocol appears decidedly inappropriate–making this explanation exceedingly implausible.

Further thought (added at around 1900 CT):  Given that the CDS were so far underwater to AIG, if the government had guaranteed them, the likelihood that the Fed would have become a creditor to the banks on the other sides of the deals was exceedingly remote.  That is, it was highly unlikely that the Fed would have been exposed to default losses on these deals, meaning that the “credit relationship” was a fiction.  (Besides, at the time, were most of the counterparties even under Fed supervision?   Most were foreign banks, and even the US counterparties, with the exception of Wachovia, were investment banks that I do not believe were under direct Fed supervision, except perhaps as Treasury primary dealers, rather than as banks.)

Second, “there was a lack of statutory authority of the Federal Reserve to provide such a guarantee.”   Please, again.   There are a variety of structures that effectively create guarantees.   For instance, if the Fed could see its way clear to setting up and capitalizing a special purpose vehicle (SPV) to buy the CDOs, it could have set up and capitalized an SPV, and then novated the deals to the SPV.   If it was concerns about counterparty risk that made the banks so insistent on receiving collateral payments, this structure would have allayed their concerns–and required no cash to go out the door.

In this structure, the government’s risk exposure would have been the same as under Maiden Lane and its purchase of the underlying CDOs: it would have been long the CDOs.

In sum, the rationales given for not providing some sort of guarantee are completely unpersuasive.   Completely.   A guarantee would also not have required agreement on valuation with the counterparties.   They would have been assured of receiving their contractual payments, and that should have been that.

The transparently implausible rationale for eschewing the guarantee alternative tells me that the Fed’s–and Geithner’s–injured and adamant denial that “the financial condition in the counterparties was not a relevant factor” (p. 15) in deciding to pay 100 cents on the dollar is dishonest.   Geithner has said many other things that do not pass the honesty smell test, so it wouldn’t surprise me that if this was the case here as well.

Thus, it is highly likely in my view that this was a backdoor way of providing liquidity to systemically important institutions at a time that their financial condition was in serious question.

In this regard, it could well be that Goldman was the firm that was in greatest need of an injection of cash.   The SIGTARP report states that, unlike the other AIG counterparties, “Goldman Sachs did not hold the underlying CDOs but rather had sold equivalent credit protection to its clients who held those positions.”   Very interesting.   It is likely that these client counterparties were demanding collateral from Goldman.   If so, if Goldman didn’t receive cash from AIG–or the government–it would have needed to find additional cash to make these payments.

Yes, Goldman states that it was hedged by its purchase of credit protection on AIG.   But, (a) in prevailing conditions, there was considerable credit risk in those CDS, meaning that Goldman may not have been paid out 100 percent of what it was owed, and (b) even if the CDS paid out, there would almost certainly have been a cash flow date mismatch, with Goldman needing the cash to make margin calls to its clients immediately, and receiving any cash payments on CDS at some later date.   Given the state of the credit markets at the time, funding this gap would have been an expensive, and dicey, proposition.

Given the supposed First Commandment to Treat All Banks Equal (p. 29), the Fed could not have bought out Goldman and not the other banks.

Against that, if providing liquidity to Goldman alone was the objective, there should have been ways of doing that directly–unless the Fed was concerned that special treatment of Goldman would have commenced a destablizing run on it like the one that cratered Lehman.

I therefore can’t conclude for certain that the AIG bailout was really a Goldman rescue in drag.   One can tell that story, but there are alternative explanations.   However, given that the Fed’s explanation for not taking actions that would have required no cash payments is so weak, my conclusions are that the AIG bailout was an indirect of providing liquidity to systemically important institutions, and that one cannot exclude the possibility that this was an indirect way of providing liquidity to one institution in particular–Goldman.

(One question unanswered by the SIGTARP report: if Goldman didn’t own the CDOs that eventually wound up in Maiden Lane, how did they get there?   Did Goldman buy them from its clients in a mirror image deal that involved swap tearups, and then sell them to Maiden Lane?   It would seem that would be necessary to deal with Goldman’s own sales of protection. )

A couple of other points related to the SIGTARP report.   First, as I emphasized in “It’s a Wonderful Life: AIG Edition,” if AIG hadn’t been born and hence not around to sell protection, the owners of the CDOs would have taken a bath.   Thus, it is not credit default swaps per se that were the ultimate source of the problem; it was the underlying CDOs.   Only to the extent that the existence of AIG contributed to a larger CDO market could CDS have contributed to the financial crisis.   Indeed, the crisis–that is, the losses suffered by big banks–could have been worse if AIG hadn’t taken a $50 billion hit.

Second, one of the narratives has been that AIG didn’t have to post collateral, and hence took on bigger positions than it would have if it had been required to do so.   It indeed didn’t post any initial margin, but it is clear that the deals contemplated the posting of collateral even absent an AIG credit event.   AIG had posted at least $22 billion in collateral prior to its downgrade (Table 1).   Perhaps the necessity of posting initial margin would have reduced AIG’s appetite, but likely not, in my view.   First, by not requiring original margin, counterparties were extending AIG credit, and presumably charged for it; only to the extent that it would have been costlier to finance initial margin payments would the posting of such margin have made AIG reduce its positions.   Second, given that it lost huge sums on mortgage backed in its security lending program and other operations, it is clear that AIG viewed these as very attractively priced risks.   Sure, a slightly higher cost (due to the necessity of posting initial margin) might have induced it to cut back some, but likely not very much.

To conclude: given the availability of another alternative to buying out the banks at 100 percent of par, that would not have required a cash payment, and the weak justifications for avoiding that option, make it highly likely that the AIG bailout was structured in part to provide liquidity to major banks (and perhaps, but not conclusively, one particular bank).   Which makes the Fed’s–and Geithner’s–denial that the financial health of these firms was an irrelevance highly dubious, not to say, a lie.

November 19, 2009

Not the Worst!

Filed under: Commodities,Economics,Energy,Financial crisis,Politics,Russia — The Professor @ 9:20 pm

Yes, Russia can breathe easy.  Even when it comes to corruption, it’s not the worst!  Bad–tied for 146th out of 180, according to an average of surveys assembled by Transparency International–but not the worst.  Indeed, not even the worst in the FSU–several ‘Stans are all well below Russia.

And I am sure that the “whatabout Ukraine” crowd is asking, well, “whatabout Ukraine.”  Well, amusingly, it is tied for 146th place, although since ties (based on rounding to 1/10th of a point) are arranged alphabetically, and the lowest and highest scores for Ukraine are both higher than Russia’s, my guess is that without rounding Ukraine edged out its former Gulag cellmate.

Speaking of ties, Zimbabwe joined Russia and Ukraine in 146th place.  Now that’s something to be proud of.

It should also be noted that Russia isn’t even close to being the least corrupt in the FSU. Indeed, one ‘Stan–Kazakhstan–came it at 120, and even Azerbaijan beat Russia’s 2.2 score (out of 10!) by a tenth of a point. The Baltic states aren’t even in sight, with Estonia at 27 and Lithuania and Latvia at 52 and 56, respectively.

But, according to accounting firm PWC, Russia IS the worst, when it comes to, er, agency problems:

Russia is the worst country in the world for companies in terms of employee theft and extortion by officials, a PricewaterhouseCoopers LLP survey showed.

Seventy-one percent of domestic and foreign companies in Russia were victims of fraud in the past year, double the rate reported in fellow BRIC countries Brazil, India and China, PwC said in a report released today. That’s a “shocking” increase of 12 percentage points from 2007, when the last survey was conducted, PwC said. In Japan, the figure is 9.6 percent.

Theft and bribery hit Russia’s financial, energy and mining industries the hardest, according to the survey of 3,000 executives from 55 countries, including 86 Russians. “The nature of these industries means that they are particularly exposed to both asset misappropriation and corruption, the two most prevalent types of economic crime,” PwC said.

. . . .

PwC said the prevalence of government graft in Russia is twice the global average, with 48 percent of all companies surveyed reporting an instance of bribery or corruption in the last 12 months.

The problem has been exacerbated by the country’s record economic contraction, which has lowered the “morale” of employees and made “asset misappropriation” more tempting, PwC said. The economy shrank 10.9 percent in the second quarter, the most on record, and 8.9 percent last quarter.

More people are feeling “real pressure to ‘cross the line’ or to look the other way,” PwC said.

The line about the special vulnerability of energy and mining is of particular interest.

One other Russia bit caught my eye today.  Russia’s industrial output contracted in October:

Russia’s  industrial slump deepened in October as companies failed to build up inventories and credit remained tight even after eight central bank interest rate cuts since April.

Output fell 11.2 percent from a year earlier after the decline eased to 9.5 percent in September, the  Federal Statistics Service in Moscow said via e-mail today. Production rose a non-seasonally adjusted 0.8 percent on the month. The medianestimate in a Bloomberg survey of 10 economists was for an annual decline of 8.1 percent.

. . . .

Manufacturing in October plummeted an annual 17.5 percent, the most since May, and dropped 4.3 percent compared with the previous month in the first monthly decline since August.

Output and generation of electricity, heat and water dropped 6 percent last month compared to the same period in 2008, the smallest annual decline since April.

Passenger car production in October plunged an annual 58 percent, while output of trucks declined 54 percent compared to last year, the statistics service said.

Wage arrears increased in October by 6.4 percent, to 5.4 billion rubles ($188.4 million) after declining 8.6 percent in September, the statistics service said in the report today.

This may be the case of every silver lining having its cloud.  The strengthening of commodity prices (thanks, Ben! thanks, China!) has bolstered the ruble, which adds another blow to an already devastated manufacturing sector.

The corruption news–with the energy and mineral industries at its heart–and the Dutch Disease effect, both demonstrate just how hard it will be to transform Russia’s economy.  The powerful won’t want to stop the gravy train, and as long as it is going it will be very difficult for non-resource industries to take hold.

Like I say.  Purgatory.

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