Streetwise Professor

September 15, 2014

Russia to OPEC: Stop Me If You’ve Heard This One Before. OPEC: Believe Me, We Have

Filed under: Economics,Energy,Politics,Russia — The Professor @ 3:00 pm

This is so amusing, because it is so typical:

Russian Energy Minister Alexander Novak will meet OPEC officials on Tuesday in Vienna, his spokeswoman said, as oil’s price fall piled pressure on Moscow’s budget.

The annual meeting had been planned long before oil fell below the $100 per barrel level critical for Russia’s oil sales which account for 40 percent of state budget revenues.

Russia suffered from a decline of oil production and prices this year and has cut its outlook for oil output as core western Siberian fields become more depleted.

The spokeswoman said that Novak and the officials from the Organization of the Petroleum Exporting Countries had not planned to discuss the prices of oil, which hit 26-month low for Brent crude on Monday.

However, a government source said the measures to prop up the prices have long been discussed at the ministry.

“The talk of closer cooperation with OPEC on prices have long been there,” he said.

So far, Russia, the world’s top producer of conventional oil, has ruled out coordinated action with OPEC to halt the price decline.

Yeah. Novak is scurrying to Vienna, but he’s not going to talk prices. Sure. Tell me another one, but not so funny as I just busted a gut reading that and can’t take too much more.

Putin, Inc. is no doubt in a mild-to-moderate panic at present because Brent has breached $100, and Urals is below that, in the low $90s. Russia needs Urals in the $104 range to meet budget targets, and that’s not counting Crimea or especially a war that doesn’t officially exist but which costs real money to fight.

So off Novak runs to Vienna, in an attempt to get OPEC to prop up the price. Not that Russia will do anything to help, mind you. It’s MO has long been to demand, beg, cajole OPEC to cut output to support prices, while Russia produces to capacity. That’s what Russia did in 2009 when prices cratered into the $30s. OPEC was not amused then, and they won’t be amused now.

If anything, geopolitical considerations, namely Russia’s support of Assad and cooperation with Iran, will make the Saudis in particular even less generously inclined towards Russia.

Meaning that Novak’s mission to Vienna will accomplish nothing, except to provide an entertaining example of Russian all take, no give negotiating style.

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Even Jacksonians Pick Their Battles

Filed under: History,Military,Politics,Russia — The Professor @ 5:07 am

I am, if you haven’t noticed, an instinctual Jacksonian (in the sense of Walter Russell Mead’s quadripartite characterization of American foreign policy types). My first reaction is to hit hard at those who confront the US or threaten American interests. ISIS is therefore a natural candidate for a good drubbing.

But more sober reflection (figuratively and literally!) leads me to conclude that a full-blooded response to ISIS is unwise, especially in Syria. For many reasons, the commitment that would be required to fully extirpate the organization is not worth the cost, and it’s better not to fight at all than to fight a half-assed or quarter-assed battle.

Our options now are extremely limited due to past choices, by  Bush yes but primarily by Obama. ISIS was contained in Iraq before Obama declared victory and withdrew prematurely from any presence in Iraq. An early intervention in Syria might have achieved some result before Islamists came to dominate the opposition, which occurred in part as the result of Assad’s decision to unleash Islamists, including ISIS, to create an N-way war in Syria: it is not really correct to call most of the Islamists oppositionists, because they effectively served as Assad’s allies in the battle against the FSA and other opposition groups. (I suspect that Obama’s withdrawal from Iraq, which basically left the place an Iranian satellite, and his demurring from attacking Assad, already an Iranian satellite, were driven in part by his pipe dream of a grand bargain with the ayatollahs.) Since 2011 we have suffered years of the locust, and last time I checked God isn’t promising to repay.

Now ISIS and other Islamist forces are well entrenched in Syria in Iraq. Rooting them out would require a robust ground campaign. We have no reliable allies in the region, and those who would have an interest in fighting ISIS-namely, the Iranians and Assad (who is in effect Iran’s main Arab ally/proxy) and Hezbollah-are really our foes in virtually every other way. Empowering them does not advance American interests,  and would actually inflame the already fraught Sunni-Shia conflict. Obama’s statement that healing the Sunni-Shia rift is part of his strategy is utterly delusional. By comparison, perfecting cold fusion and inventing a practical warp drive are child’s play.

All this means that, with some local exceptions, we cannot depend on local proxies to provide the necessary ground forces.  An American commitment would be expensive, extensive, and logistically challenging, especially given the unwillingness of Turkey to throw in. We would also face a tremendous challenge of knowing exactly who to fight, and we would no doubt be fighting not just ISIS and other Islamist groups, but Iran and Iranian proxies who would find this a great opportunity to take a few whacks at the Great Satan (just as happened in Iraq) and tie him down in a grueling war of attrition.

Which all means that perhaps the best that can be hoped for is a reversal of ISIS’s gains in 2014 in Iraq. This is probably achievable using a combination of American airpower and special forces in combination with Kurdish forces and Iraqi regulars, although rooting them out of Fallujah, Tikrit, and Ramadi and maybe Mosul is probably beyond the capability of the Iraqis. Air power can offset myriad weaknesses, but it can’t work miracles.

Once that is accomplished, a reduced but persistent presence can contain ISIS in Iraq, while Syria remains embroiled in an N-way standoff. (I say N-way because the non-Assad forces are fissiparous, to say the least. There are literally hundreds of groups.) A defeat of Assad would lead to something like Libya, most likely. Syria, in other words, is beyond human help: it’s fate is a choice among horrors.

From a purely geopolitical perspective, this would serve American interests. Iraq would not fall under the thrall of Sunni head choppers. Iran would not be further empowered. The Gulf states would be less threatened, though they will continue their duplicitous, perfidious ways (Qatar especially). The ISIS terror threat to the US and the West more broadly can be addressed through the same means we have used to combat Al Qaeda for the past 13 years.

Not a they lived happily ever after outcome, by any means, but better than some of the choices on the menu.

I also shudder at the prospect of the Anti-Jackson commander in chief leading a campaign. An extended military action of the type the Pentagon would consider necessary is antithetical to every fiber in his being. It is obvious that he has no appetite for the fight, and has a predilection for limited measures (drone strikes aimed at killing terrorist leaders, the odd special forces raid) that have no strategic purpose or effect. War under such unwilling and uncertain leadership would be a pointless expenditure of American lives and treasure.

Partial rollback and containment of ISIS is good enough, and does not tie down the US in a costly and divisive struggle that is peripheral to its core interests. Russia and China are far more pressing long-term problems, and another war of attrition in the Arabian snake pit is a distraction from dealing with those problems.

Alas, Obama is disinterested in those issues as well. He basically threw the Ukrainians to the Russian wolves  last week:

Expressing confidence that the United States was on “the right side of history” in this battle, Mr. Obama said the nation would also resist Russia’s incursions in Ukraine, even though he noted that the United States has very little trade with Ukraine and “geopolitically, what happens in Ukraine doesn’t pose a great threat to us.”

Again with the hands-off reliance on some impersonal historical force to make things right. Mentioning trade first is rather bizarre, and the cluelessness of the last statement is mind boggling. You’d think that a challenge to both the entire post-Cold War settlement in Europe and to the principles of the post-WWII settlement (not to mention the entire post-Westphalian principles) like that which Putin is posing in Ukraine would be a matter of some geopolitical importance. It has implications far beyond Donbas-the Chinese are watching with great interest, for example. But the return of the 1930s doesn’t bother our Barry.

The Poles and Balts and Nordics are probably losing their water right now after having read Obama’s “what, me worry” approach to Ukraine and Putin, especially given the jarring contrast with Obama’s remarks in Tallinn before the Nato summit in Wales: Obama’s credibility is already shot, and the contrast between his indifference to the broader implications of Putin’s actions in Ukraine and his pledge to defend all Nato countries will only pump in another couple of bullets. Putin will no doubt take this as an invitation to push things even more.

Obama has company in selling out Ukraine. Explicitly deferring to Putin’s anger about its effects on the Russian economy,  EU put the Association Agreement with Ukraine on hold. Don’t want to provoke the old boy, you know.

But as is always the case, immediately after the capitulation, fighting swelled in Donetsk in spite of the cease-fire. Putin pockets every concession, then escalates. He doesn’t need external provocations. He is self-provoking, especially when he sees that his actions will meet no serious resistance.

The anti-Jacksonian approach of Obama and the Europeans, which eschews force and bleats about “no military solutions” and the need to rely on diplomacy alone is responsible for the myriad messes that now confront us. But bullheaded Jacksonian pugnacity isn’t warranted either. A prudent choice of battles, and the means to fight those battles, is needed. Use enough force to beat back and contain ISIS in Iraq. Turn attention to the true strategic challenges in eastern Europe and Asia, starting with arming Ukraine and supporting it economically and politically, deploying more robust Nato forces east of the Elbe, and committing to long-term undermining of Russian military capabilities through sanctions and other economic measures (e.g., releases from the SPR) that weaken the economic props for its ambitious rearmament program. And for God’s sake don’t advertise weakness and appeasement to people like Putin.

Is that too much to ask? Alas, the answer is probably yes. So things will likely get worse  before they get better, and even when they get better they won’t be as good as they were in 2013.

Update: The Kagans bravely try to craft a strategy to deal with ISIS, in Syria as well as Iraq. It seems like a poker strategy based on repeatedly drawing inside straights. Not impossible, but not bloody likely. I think the diagnosis of the current situation is pretty on target, and aligns with my years of the locust take. But getting Sunnis who don’t trust us to bear the brunt of fighting other Sunnis which necessitates simultaneously sidelining Shias (which is required to get the Sunnis to work with us) seems beyond the ability of any American administration, especially this one, due to its demonstrated lack of competence, the fact that Sunnis in Iraq believe it betrayed them after their previous efforts in the Anbar Awakening by abandoning them to a Shia government in Baghdad, and the fact that it is widely suspected, with considerable justice, of harboring an intense desire of doing a deal with Iran.

The Underwear Gnome business strategy has a better chance of working than this.

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September 10, 2014

SEFs: The Damn Dogs Won’t Eat It!

Filed under: Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 8:37 pm

There’s an old joke about a pet food manufacturer that mounts an all out marketing campaign for its new brand of dog food. It pulls out all the stops. Celebrity endorsements. Super Bowl Ad. You name it. But sales tank. The CEO calls the head of marketing onto the carpet and demands an explanation for the appalling sales. The marketing guy  answers: “It’s those damn dogs. They just won’t eat the stuff.”

That joke came to mind when reading about the CFTC’s frustration at the failure of SEFs to get traction. Most market  participants avoid using central limit order books (CLOBs), and prefer to trade by voice or Requests for Quotes (RFQs):

“The biggest surprise for me is the lack of interest from the buyside for [central limit order books or CLOB],” Michael O’Brien, director of global trading at Eaton Vance, said at the International Swaps and Derivatives Association conference in New York. “The best way to break up the dual market structure and boost transparency is through using a CLOB and I’m surprised at how slow progress has been.”

About two dozen Sefs have been established in the past year, but already some of these venues are struggling to register a presence. Instead, incumbent market players who have always dominated the swaps market are winning under the new regulatory regime, with the bulk of trading being done through Bloomberg, Tradeweb and interdealer brokers including IcapBGC and Tradition.

“It’s still very early,” Mr Massad told the FT. “The fact that we’re getting a decent volume of trading is encouraging but we are also looking at various issues to see how we can facilitate more trading and transparency.”

Regulators are less concerned about having a specific numbers of Sefs since the market is still sorting out which firms can serve their clients the best under the new regulatory system. What officials are watching closely is the continued use of RFQ systems rather than the transparent central order booking structure.

Not to say I told you so, but I told you so. I knew the dogs, and I knew they wouldn’t like the food.

This is why I labeled the SEF mandate as The Worst of Dodd Frank. It was a solution in search of a non-existent problem. It took a one-sized fits all approach, predicated on the view that centralized order driven markets are the best way to execute all transactions. It obsessed on pre-trade and post-trade price transparency, and totally overlooked the importance of counterparty transparency.

There is a diversity of trading mechanisms in virtually every financial market. Some types of trades and traders are economically executed in anonymous, centralized auction markets with pre- and post-trade price transparency. Other types of trades and traders-namely, big wholesale trades involving those trading to hedge or to rebalance portfolios, rather than to take advantage of information advantages-are most efficiently negotiated and executed face-to-face, with little (or delayed) post-trade price disclosure. This is why upstairs block markets always existed in stocks, and why dark pools exist now. It is one reason why OTC derivatives markets operated side-by-side with futures markets offering similar products.

As I noted at the time, sophisticated buy siders in derivatives markets had the opportunity to trade in futures markets but chose to trade OTC. Moreover, the buy side was very resistant to the SEF mandate despite the fact that they were the supposed beneficiaries of a more transparent (in some dimensions!) and more competitive (allegedly) trading mechanism. The Frankendodd crowd argued that SEFs would break a cabal of dealers that exploited their customers and profited from the opacity of the market.

But the customers weren’t buying it. So you had to believe that either they knew what they were talking about, or were the victims of Stockholm Syndrome leaping to the defense of the dealers that held them captive.

My mantra was a diversity of mechanisms for a diversity of trades and traders.  Frankendodd attempts to create a monoculture and impose a standardized market structure for all participants. It says to the buy side: here’s your dinner, and you’ll like it, dammit! It’s good for you!

But the buy side knows what it likes, and is pushing away the bowl.

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Family Feud: Lifting the Oil Export Ban

Filed under: Commodities,Energy,Politics,Regulation — The Professor @ 7:42 pm

Larry Summers has called for an end to the crude oil export ban in the US. This is pretty much a no-brainer for even a pedestrian economist, let alone one of Summers’s intelligence, not to say one as intelligent as Summers thinks he is.

No-brainer or not, eliminating the ban (which isn’t a total ban, in any event) will have only modest effects. This is because although crude cannot be exported freely, refined products can be. Lifting the ban will mainly entail a substitution of crude exports for product exports, which will result in modest impacts on final product prices.

Here’s a crude outline of how opening up exports will play out (pun intended).

  1. The price of crude in the US will rise, and the price in Europe (notably Brent) will fall, until the price differential is approximately equal to transport costs of a buck or two, in contrast to the current differential of approximately $6.50. This isn’t immaterial, but it’s not a huge change either, given current prices in the $90s.
  2. The amount of crude refined in the US will decline, and the amount of crude refined overseas will rise. Refining margins in Europe will rise and those in the US will fall. The differentials in product prices will remain about the same, because products will be exported after the ban is lifted just as they are now, though export volumes will decline. Prices will differ by transportation costs post-lifting, just as they do now.
  3. The effect on product prices in the US (e.g., the price of gasoline) is a priori impossible to sign, because there are offsetting effects. US refiner input prices will rise, but margins will fall. The net price effect of higher costs and lower margins can’t be determined a priori.
  4. One factor will definitely lead to lower product prices. Post-free trade in crude, there will be a better match between crude slates and refineries. US refineries are more complex, and optimized to process heavier crudes from Mexico and Venezuela. Most are not optimized to process the large quantities of very light crudes that are flowing from Eagle Ford and the Bakken. In contrast, European refineries are better able to process lighter crudes. This better match of refineries to crude will reduce costs and increase productivity, which tends to reduce product prices.
  5. The main factor that will determine whether product prices rise or fall will be the effect of the lifting of the ban on the total output of crude: if more crude is produced, more products will be produced, and prices will decline. The lifting of the ban will reduce Brent prices, which will reduce North Sea output (and Nigerian output too). The lifting of the ban will increase US prices, which will cause US output to rise. The net effect on total crude output depends on the relative elasticities of supply. If, for instance, Brent supply is very elastic and US supply is very inelastic, total crude output could well fall, which would tend to increase gasoline and distillate prices in the US. If the elasticities are reversed, total supply would likely rise leading to lower product prices.
  6. If I had to guess, I would say that given that the product price changes will be negative but small, and hard to detect in the normal fluctuations of prices. The combined price effect shared between the US and non-US markets for light crudes is relatively small (on the order of 5 percent of price) and the offsetting effect on foreign and domestic output leaves a net effect on output (and hence prices) that will be relatively small.
  7. Tom Friedman supports lifting the ban, which makes me think twice. Friedman also says that lifting the ban will cause crude prices to drop by $25/bbl and thereby crush Putin and Iran and ISIS, thereby saving Ukraine and the MIddle East. Tom Friedman is an idiot. Pay no attention.

There will be one major effect, which Summers alludes to, and which I have emphasized when I teach about the export restriction in my Energy Policy course for EMBAs: the main effect of the change in policy will be to redistribute rents within the domestic oil industry. It will reduce the profitability of US refiners, especially some independents who are feasting on the abundant supply of light crude. It will increase the profitability of domestic crude producers.

In other words, contrary to a lot of the rhetoric, this isn’t about “big oil” vs. main street. It’s about Downstream Medium Oil vs. Upstream  Medium Oil. The big integrated majors basically see money shifted from one pocket to the other: since the lifting of the ban will increase total surplus in the energy market, the integrated majors will benefit, but the benefit will be smallish. The independent refiners will be losers, and pure upstream companies will be winners.

This is, in other words, a sort of family feud. A battle between different branches of the US energy sector family. But as any cop called to the scene of a domestic dispute will tell you, these can be pretty intense.

In sum, ending the ban would make the pizza slightly bigger, but you won’t notice it much at the pump, if you notice it at all. The main effect would be to change the size of the slices. But since conflicts over how the pizza is divided drive politics, the export ban will generate  political battles of an intensity out of proportion to its modest effects  on overall wealth and welfare.

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September 9, 2014

The Euros Get Tough on Google, But Run and Hide From Gazprom

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 8:09 pm

The European Commission’s competition commissioner has scuppered a proposed settlement with Google. The Commission has already taken many pounds of flesh from Microsoft and Intel over the past year, so now it is looking to add some Google cuts to the meat locker.

What about the EU’s case against Gazprom, you ask? <Crickets.>

I’m not a big Google or Microsoft fan, but the accusations leveled against them (and Intel) are highly speculative. Gazprom’s exercise of market power, and its protection of that market power, is almost textbook. The egregious price discrimination, and its use of contractual terms (no re-sale) to support that discrimination, is a blatant example. So on the merits, the Gazprom case should proceed and the Google case should be settled, and on anything but onerous terms.

But the craven Euros quake before Gazprom. Indeed, they seem to be even less willing to confront the company now that Putin is on the war path.

They have a better case against Gazprom, and that case could be a political lever in what is an existential battle over European security: Putin and the Russians have ranted and raved about the case when the Euros did press it some, which indicates that it hits the company, and hence Russia, where it hurts.  But rather than hitting this pressure point, the Euros bury the case and go kick Google instead.

Don’t think that Putin doesn’t notice. And know that it is exactly this kind of cowardice that emboldens him.

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Igor Might Cash In, But Only Because the Future Is Bleak

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 7:44 pm

It looks like Igor may get his money:

Allocation of over $40 billion from Russia’s National Welfare Foundation for Rosneft oil giantcould be reasonable, as the investment will be repaid, Russian Prime Minister Dmitry Medvedev said in an interview to the Vedomosti newspaper, released Monday.

“This number only seems so impressive, but this is not [supposed to be repaid] within a year,” Medvedev said, answering a reporter’s question on whether Rosneft’s request for $40 billion is feasible.

“The company needs to keep up production, since Rosneft is a major contributor to the budget. In this regard, we have to help them by maintaining the investment level,” Medvedev explained, adding that the government is considering specific ways of aiding Rosneft.

Now, this is Medvedev speaking, so take it for what it’s worth. But it’s my impression that lately Dmitri’s designated role is ventriloquist’s dummy, and if you looked closely you can probably see Putin’s lips moving. This is at least a trial balloon, and perhaps it is laying the groundwork for an official announcement. It is sufficiently controversial within the Russian government that Putin probably does not want to act precipitously and is putting Medvedev out there to see if the proposal attracts too much fire.

This statement likely reflects a couple of realities. First, Sechin’s influence with Putin. The second is the effect of sanctions. Although the EU and US sanctions have not been as draconian as they might be, the FUD factor has worked. Western capital markets and banks are largely shut to Russian companies, especially those subject to sanctions (like Rosneft). Rosneft has maturing debt to refinance, and as Medvedev says, it needs to invest to maintain production.

Output dropped 1.3 percent in August, as the productivity of western Siberian fields continues to drop as they age.

In another indication of the stress that it is facing, Rosneft (and thus Putin/Russia) actually agreed to let China invest in Russian oil fields on terms never extended to a western firm. The Chinese can bring capital, but not the expertise and technology that Rosneft needs to develop the challenging resources on which has staked its future. And the Chinese usually drive a hard bargain. So even with state money, Rosneft will struggle to achieve anything like the lofty ambitions that Sechin has laid out.

The state money will buy some time for Rosneft. Presumably Putin and Sechin are hoping that the state money will get them through the sanctions, which they likely anticipate will fade away in the near-to-medium term. But the FUD factor will continue to limit Rosneft’s access to western capital and western technology. Yes, energy firms and banks will come back if and when sanctions go away, but on terms that will be far less favorable than had been available pre-Ukraine. Putin’s unpredictability has dramatically raised the political risks of investing in Russia, especially in the energy sector.  Future capital will come with strings, and will be reluctant to invest in long term projects that could fall victim to Putin’s next adventure.

In other words, if Putin indeed permits Rosneft to dip deeply into the National Welfare Fund, it will be an acknowledgement that Russia has burned its bridges with western finance and technology.

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September 8, 2014

Cleaning Up After the Dodd, Frank & Gensler Circus

A lot of CFTC news lately. Much of it involves the agency, under new chairman Timothy Massad, dealing with the consequences of Frankendodd and the overzealous efforts of his predecessor Gary Gensler to implement it.

One of Massad’s priorities relates to clearinghouses (CCPs):

CFTC Chairman Timothy Massad said in a Sept. 5 interview that his agency will bolster examinations of clearinghouses, which process trillions of dollars in transactions and are potentially vulnerable to market shocks or cyber attacks. The agency is working with the Federal Reserve on the effort, he said.

New rules requiring banks and other firms to use clearinghouses owned by LCH.Clearnet Group Ltd., CME Group Inc. (CME) and Intercontinental Exchange Inc. (ICE) have been “a great thing” and have helped regulators “monitor and mitigate risks, but it doesn’t eliminate risk,” according to Massad.

“We’ve got to be very focused on the health of clearinghouses,” he said.

It’s nice to see that the CFTC, as well as prudential regulators, recognize that CCPs are of vital systemic importance. But as I’ve said many times, on four continents: In a complex, interconnected financial system, making CCPs less likely to default  does not necessarily increase the safety of the financial system. Making one part of the system safer does not make the system safer. It can prevent one Armageddon scenario, but increase the likelihood of others.

Gensler babbled repeatedly about the clearing mandate reducing the interconnectedness of the financial system. In fact, it just reconfigures the interconnections. The very measures that are intended to ensure CCPs get paid what they are owed even in periods of crisis can redirect crushing stresses to other vulnerable parts of the financial system. CCPs may end up standing, surrounded by the rubble of the rest of the financial system.

CCPs are deeply enmeshed in a complex web of credit and payment relationships. Mechanisms intended to reduce CCP credit exposure-multilateral netting, high initial margins, rigorous variation margining-feed back into other parts of that web.

There are so many interconnected parts. Today Risk ran an article about how LCH relies heavily on two settlement banks, JPM and Citi. Although LCH will not confirm it, it appears that these two banks process  about 85 percent of the payments between clearing members and LCH. This process involves the extension of intraday credit. This creates exposures for these two big SIFIs, and makes the LCH’s viability dependent on the health of these two banks: if one of them went down, this could cause extreme difficulties for LCH and for the clearing members. That is, OTC derivatives clearing adds a new way in which the financial system’s health and stability depend on the health of big banks, and creates new risks that can jeopardize the health of the big banks.

So much for eliminating interconnectedness, Gary. It’s just been moved around, and not necessarily in a good way.

Again, mitigating systemic risk requires taking a systemic perspective. The fallacy of composition is a major danger, and a very alluring one. The idea that the system gets safer when you make a major part of it safer is just plain wrong. The system is more than just the sum of its parts. Moreover, it can actually be the case that making one part of the system stronger, but more rigid, as clearing arguably does, makes the system more vulnerable to catastrophic failure. Or at least creates new ways that it can fail.

Another issue on Massad’s plate is addressing the conflict between his agency and Europe on giving regulatory approval to each other’s CCPs. It looks like this issue will not get resolved by the drop dead date in December. This will result in substantially higher costs (primarily in the form of higher capital requirements and higher margins), the fragmentation of OTC derivatives markets, and greater counterparty concentration (as US firms avoid European CCPs and vice versa).

The CFTC is also trying to fix its fundamentally flawed position limit proposal, and particularly the defective, overly restrictive, and at times clueless hedging exemptions. Mencken defined Puritanism as “The haunting fear that someone, somewhere, may be happy.” The CFTC’s hedging exemption, as currently constituted, reflects a sort of financial Puritanism: “The haunting fear that someone, somewhere, may be speculating.” To avoid this dread possibility, the exemptions are so narrow that they eliminate some very reasonable risk management strategies, such as using gas forwards to hedge electricity price exposures.

This has caused an uproar among end users, including firms like Cargill that have been hedging since the end of the freaking Civil War. Perhaps their survival suggests they might know something about the subject.

In the “be careful what you ask for” category, the CFTC is wrestling with a very predictable consequence of one of its decisions. In an attempt to wall off the US from major shocks originating overseas, the Gensler CFTC adopted rules that would have subjected foreign firms dealing with foreign affiliates of US banks to US regulations if the parents provided guarantees for those affiliates. Foreign firms definitely didn’t want to be subjected to the tender mercies of the CFTC and Frankendodd regs. So to maintain this business, the parents stripped away the guarantees.

Problem solved, right? The elimination of the guarantee would eliminate a major potential channel of contagion between the dodgy furriners and the US financial system, right? That was the point, right?

Apparently not. The CFTC has major agida over this:

Timothy Massad, the new CFTC chairman, said in an interview he is concerned aboutrecent moves by several large Wall Street firms to sidestep CFTC oversight by changing the terms of some swap agreements made by foreign affiliates.

“The concern has always been that activity that takes place abroad can result in the importation of risk into the U.S.,” Mr. Massad said. He said there is a concern that a U.S. bank’s foreign losses would ultimately find their way to U.S. shores, infecting the parent company in possibly destabilizing ways.

. . . .

The moves mean any liability for those swaps lies solely with the offshore operation, which the banks have said will protect the U.S. parent from contagion. Yet without that tie to the U.S. parent, the contracts won’t fall under U.S. jurisdiction and so won’t be subject to strict rules set by the 2010 Dodd-Frank financial-overhaul law, including requirements that contracts historically traded over the telephone be traded publicly on U.S. electronic platforms [i.e., the SEF mandate].

By de-guaranteeing, the US banks have eliminated the most direct channel of contagion from over there to over here. But apparently the CFTC is worried that unless its regulations are followed overseas, there will be other, albeit more indirect, backdoors into the US.

In essence, then, the CFTC believes its regulations are by far superior to those in Europe and elsewhere, and that unless its regulations are implemented everywhere, the US is at risk.

Not too arrogant, eh?

A few observations should make you question this arrogance, and in a  big way.

First, note that the most likely effect of the CFTC getting its way of exporting its regulations into any transaction and any entity involving any affiliate of a US financial institution is that foreign entities will just avoid dealing with any such affiliate. This will balkanize the global derivatives market: ‘mericans will deal with ‘mericans, and Euros with Euros, and never the twain shall meet. This will likely result in greater counterparty concentration. Such developments would create systemic vulnerabilities, and even though the direct counterparty credit channel could not bring that risk back to US banks, the myriad other connections between foreign banks and American ones would.

Second, note the last sentence of the quoted paragraph: “including requirements that contracts historically traded over the telephone be traded publicly on U.S. electronic platforms.” So apparently attempts to avoid the SEF mandate infuriate the CFTC. But the SEF mandate has nothing to do with systemic risk. For this reason, and others, I named this mandate “The Worst of Frankendodd.” But so intent is the CFTC on pursuing this systemically irrelevant unicorn that it is questioning moves by US banks that actually reduce their exposure to problems in foreign markets.

Timothy Massad has the unwelcome task of cleaning up after the elephant parade at the Dodd, Frank & Gensler Circus. Clearing mandates, coordinating with overseas regulators, position limits, and the elimination of affiliate guarantees are only some of the things that he has to clean up. I hope he’s got a big shovel and a lot of patience.

 

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September 5, 2014

Obama The Chess Playing Pigeon Struts Around the Board & Claims Victory Over Putin

Filed under: History,Military,Politics,Russia — The Professor @ 7:28 pm

Obama’s cultists often compare him to a chess master, playing the long game. There is another chess metaphor that is far more apt, however. Specifically, there is a story that has gained wide currency in which Vladimir Putin compares Obama to a chess playing pigeon. Putin supposedly said: ”Negotiating with Obama is like playing chess with a pigeon. The pigeon knocks over all the pieces, shits on the board and then struts around like it won the game.”

This story is almost certainly false. The chess playing pigeon meme dates to far before Obama’s time. But there is no person that the story fits better. The story has resonated precisely because it is so right. If Putin didn’t say it, he should have, and he would have been dead on.

For proof, one need go no further than Obama’s claim that he, and he alone, is responsible for the cease fire agreement (such as it is) in Ukraine:

“I want to point out, the only reason that we’re seeing the ceasefire at this moment is because of both the sanctions that have already been applied and the threat of further sanctions,” Obama saidfrom Wales where a NATO summit is taking place. [Emphasis added.]

The Reason article linked above points out several of the problems with Obama’s statement, but it misses the biggest one. The colossal one.

Obama effectively asserts that the ceasefire is a setback for Putin that he was forced to accept due to the pain of sanctions and the prospect of worse sanctions to come.

This is a total inversion of  reality. The reality is that this is a major victory for Putin. For crissakes, Putin and Lavrov have been demanding a ceasefire for weeks. Months even. Demanding. It’s what they’ve wanted all along, and has led their list of demands. It saves the Russian rebel puppets from defeat, and allows them to cement their position in Donbas. It forces Poroshenko to acknowledge the Russian puppet states as legitimate interlocutors. It creates a frozen conflict that makes Ukraine toxic for Europe and Nato. It creates a bleeding ulcer inside Ukraine that will sap the poor country of its vitality, and keep it on the precipice of becoming a failed state.

From Putin’s perspective, what’s not to like? To love, even, given his obsessive hatred for an independent Ukraine.

The timing is also telling. When did the ceasefire happen? In the immediate aftermath of a dramatic Russian escalation that inflicted a bloody, devastating defeat on Ukraine and turned the tide of battle. This forced Poroshenko to negotiate from a position of weakness, and allowed Putin to negotiate from a position of strength. This is exactly contrary to the impression that Obama attempts to convey, which is that Putin was forced into concessions.

There are two, and only two, possibilities here. It is hard to decide which one is more frightening.

The first one is that Obama is so clueless that he does not know that Putin has been demanding a ceasefire, and that a ceasefire achieves his main strategic objectives. So clueless that he does not know that this is exactly what Putin wants. Hell, he’s not even B’rer Rabbit, who had to use reverse psychology to get thrown into the b’rer patch where he was born and bred. Putin said that’s exactly where he wanted to go, and Obama doesn’t even understand.

The second is that Obama knows, but is so intent on shunting the Ukrainian crisis to the bottom of the pile that he shamelessly goes all Orwell, and declares down to be up, war to be peace, and defeat to be victory. That Obama wants to put the “Problem Managed” stamp on Ukraine, and walk away, perhaps to sneak a peek at his Nobel Peace Prize, and say “I’ve  earned it!-or at least I can pretend I did!”

Clueless or mendacious. Pick one. There is no third choice.

Ukraine: you’re on your own. Which, methinks, is precisely why you entered into such a humiliating deal.

But don’t think Putin will rest on his laurels. To the contrary, he smells weakness. How else to explain that a mere two days after Obama stood in Tallinn, Estonia and delivered in stentorian tones a solemn promise to defend Estonia and other allies to the last, that the FSB launched an operation inside Estonia, and kidnapped a member of the country’s counterintelligence service?

This isn’t over, people. Not by a long shot. The fecklessness on display daily, including notably at today’s Nato summit in Wales, acts on Putin like an aphrodisiac. The escalations have just begun, and either President Pigeon doesn’t understand, or understands but doesn’t care enough to do anything about it.

 

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September 4, 2014

Three Dubious Pieces on Russia

Filed under: Economics,History,Military,Politics,Russia — The Professor @ 7:36 pm

The Ukraine situation continues to churn away. The situation on the ground is difficult to follow, but there is a consensus coalescing about Putin’s strategy. In a nutshell, the view is that he is aiming at a frozen conflict. He is telling Ukraine: “If I can’t have you, no one will.” He is pressuring Ukraine in the hope of forcing it to forego any connections, especially defense/security connections, with the West, and to give Russia de facto control over Ukraine’s foreign policy. And since this involves trade and energy policies, it also gives Russia de facto control over a considerable portion of Ukraine’s economy.

I’ve been of the view for some time that this is Putin’s goal.

Even though a consensus is coalescing, there is a raft of bad commentary out there. Among the worst is this piece by Simon Shuster. He argues that it is unwise for the West to provide weapons to Ukraine, because this would embolden Poroshenko to continue his attack on the separatists, rather than enter into negotiations.

Where to begin? The first major problem is the implicit assumption that it is appropriate for Ukraine to negotiate with rebels who are puppets of a foreign power over the control and governance of sovereign Ukrainian territory, especially given the precedent this would set for Putin. If this works in Donets, why not Kharkiv? Why not Odessa? And beyond Ukraine too: the Baltics most notably.

The “we need to get Ukraine to negotiate the terms of its surrender” is basically the Putin position.

The second major problem is Shuster’s claim that the weapons that the West would provide would be used to complete an offensive operation against the rebel puppets. But the arms that have been discussed include almost exclusively defensive weapons, notably anti-tank and anti-aircraft missiles, along with training that could be focused on executing defensive operations. Such weapons would dramatically raise the cost the Russians would incur to invade more deeply into Ukraine. This could deter Putin from continuing and expanding his offensive.

Expanding Ukraine’s offensive capabilities would require supplying them with tanks, artillery, helicopters, and combat aircraft. Even if they had more such equipment, it is doubtful that Ukraine has adequate manpower to increase substantially its offensive capability. Defense requires less manpower and less training than offense.

From both Ukraine’s and the West’s perspective, permitting Ukraine to defend its sovereignty unconditionally, rather than negotiate it away, is paramount. Providing defensive weaponry would advance this goal.

Another dubious piece of commentary, this one from a normally reliable writer, relates to France’s decision finally to do the right thing, and suspend (though not cancel) the sales of the Mistral class helo carriers to Russia. Bloomberg’s Leonid Bershidsky opposes the suspension, because Kremlin hawks (and hawkish buffoons, like Rogzin) have opposed the purchase of foreign vessels from the get go.

This argument is based on the premise that the purpose of canceling the sale is to punish Russia for its invasion of Ukraine. But that’s not the real reason to oppose the sale. The real reason is that the Mistrals would dramatically increase Russia’s power projection capabilities, and pose a severe threat to Ukraine, Georgia, and the Baltics.

Although one role of sanctions is to punish, another is to diminish capabilities. This second reason is the real reason why it is imperative to stop the sale. Russia with Mistrals is more dangerous than it is without them.

And don’t think that the Russian military doesn’t realize this. This gives me serious reason to doubt Bershidsky’s reasoning.

A third example doesn’t relate to Ukraine, but to the hack on JP Morgan computers. The hack has been traced back to Russia, but there is no definitive evidence of Russian government involvement. This Bloomberg piece notes the hesitancy to pin the hack on the Russian government:

JPMorgan’s security team continues to investigate the possibility that the hackers may have been aided or at least condoned by the Russian government, possibly as retaliation for U.S.-imposed sanctions, said a second person involved in the probe.

Others trying to piece together what happened, including outside specialists hired by the bank, say they have seen nothing to suggest the Russian government directed or aided the JPMorgan attack. Instead, they said that the hackers may have been opportunistic, expecting to be shielded because of the tensions between Russia and the U.S.

Some investigators speculated the cybercriminals were hired by the Russian government in the past and may have used malware and other tactics also shared with Russian government agents.

We live in the era of Little Green Men with no identifiable connection with the Russian government carrying out operations that advance the Russian government’s interests. The entire Russian operation in Ukraine, starting with Crimea, has been based on maskirovka and plausible deniability and using cutouts and proxies, or Russian personnel disguised as cutouts and proxies. Why should things be any different in the JPM hack? It’s not like the Russian government is going to advertise its involvement in such an activity. But the parallels are so close that the prudent inference is that this s a Russian government operation.

The exact purpose of this operation cannot be discerned. Warning? Reconnaissance? An attack discovered before it could be fully executed? But especially in the current environment, it would be foolish in the extreme to conclude that it is anything but a hostile act directed by the Russian security forces, even if it was carried out through by shadowy figures not operating in an official capacity. That’s what the Russians do.

 

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September 1, 2014

Merkel: No Military Solution in Ukraine. Putin: Really? It’s Working for Me!

Filed under: History,Military,Politics,Russia — The Professor @ 10:57 am

As surely as day follows night, Putin followed the most recent EU meeting with an escalation in Donbas. As is their wont, the Euros expressed outrage at Russian actions in Ukraine and threatened increased sanctions, but their body English/German/French/Dutch, etc., screamed  a desire to avoid a confrontation at all costs. The delay of seven days in announcing sanctions was only the most visible manifestation of Europussilanimity. So Putin took his cue, and ratcheted up both the military tempo and his rhetoric.

Per usual, Merkel was the leader of the poodle pack. Even though Germany has agreed to send weapons to the pesh merga fighting ISIS (though Germany is unwilling to, and probably incapable of, assisting in military action in Iraq), Merkel stubbornly doubled down in her refusal to do the same for Ukraine (h/t Ivan):

Chancellor Angela Merkel of Germany, speaking early Sunday after the meeting broke up, said that Germany “will certainly not deliver weapons, as this would give the impression that this is a conflict that can be solved militarily.” But she said further sanctions were needed, as “the situation has deteriorated considerably in the last few days,” and would be imposed “if this situation continues.”

Apparently Putin didn’t understand Merkel’s pronouncement, despite his fluency in German, because he is clearly under the impression that the conflict in Donbas can be solved militarily.

Compare and contrast her stony refusal to arm the Ukrainians to her plaint on the need to arm the Kurds. With respect to the Kurds she said, ”the immense suffering of many people cries out and our own security interests are threatened.” First: there is immense suffering in Ukraine, even if it hasn’t devolved to head chopping quite yet. Second: Germany’s own security interests are far more threatened by Putin’s actions in Ukraine than ISIS’s actions in Iraq, as ominous as the latter are. I would say that Merkel is willing to arm the Kurds precisely because ISIS’s threat to Germany is far more distant than Putin’s is.

Merkel’s idiocy is beyond measure. The point of supplying weapons to Ukraine is to deter Russian aggression. The prospect of facing Ukrainian forces amply armed with anti-tank weapons could be just the ticket to get Putin to un-deteriorate the situation in Ukraine. Given Russia’s weak manpower situation, he cannot mount an even slightly extended campaign. His army is still highly dependent on conscripts, and with the one-year conscription cycle, units are deployable for only 4 to 6 months. Moreover, although some losses can be hidden from the Russian public for a period of time, large losses over an extended period cannot. Nations with very small cohorts of young men are especially sensitive to losing them.

Hence, it would not take much of a leap in Ukrainian military capacity to give Putin grave reservations about escalating the military confrontation even further. A liberal supply of selected weapons (as well as intelligence and communications and logistics support) would provide that capacity. But Germany-and the US administration-steadfastly withhold it. It borders on the criminal.

And here’s a puzzler. Germany now ranks as the second largest arms exporter in the world. Since heaven forfend Germany would sell weapons to countries that would use them for aggressive purposes, it must be that the German weapons are being sold to countries that want to be able to defend themselves against aggressors, and by purchasing arms they can deter such aggression. So by making large weapons sales, Germany must be relying on the argument that the deterrence effect of these arms reduces the likelihood that countries will try to solve disputes militarily. But it is unwilling to apply that argument to Ukraine.

Or maybe it’s just that Ukraine can’t pay, so screw ‘em.

Back in 2008-2009, I asked whether the situation was more like the 70s (the optimistic view, such as it was) or the 30s (the pessimistic one). I think the answer is now clear. We are in 30s mode, with a craven West cringing before emboldened autocrats in both Europe and Asia.

This provides a demonstration of why history cycles. The politicians who are elected in a time of (relative) peace and prosperity are usually the least fit to keep the peace and stability. They are focused on domestic issues, and take international tranquility for granted. They point to the absence of an imminent threat, and argue that militaries can be slashed. They are masters of projection, assuming that everyone is as pacific as they, and share their desire to focus on economic issues and domestic programs and spending.

But they fail to realize that threats are endogenous. When everyone is a lamb, there is an opportunity for wolves. Predators like Putin can succeed only because stronger nations and groups of nations become soft, let slip their vigilance, drop their guard. They are full of rationales for doing so, but in the end these  are just manifestations of their denial of the reality that not all people, politicians, and leaders think the same way and pursue the same ends.

So after a period of conflict, strife-weary countries turn to softer leaders who sing siren songs, who are temperamentally and constitutionally averse to conflict, who despise martial matters (and who are hence ignorant of them), and who are strategic naifs who think that every dispute can be negotiated. Appeasement is their first instinct, and their second, and their third. They believe in win-win, in give-and-take.

This creates a main chance for aggressive opportunists, especially those of a zero sum mindset. Opportunists who interpret every concession made to them as an invitation to demand more. These wolves upset the peaceful (apparent) equilibrium, ushering in a period of conflict and disorder that the lambs are utterly incapable of addressing. Populations are interrupted from their reveries, and turn to more steely leaders, and the cycle begins again.

In the meantime, however, there is much trouble, suffering, and too often, bloodshed. Ukraine is the first to suffer from this phase of the cycle. It is almost certainly not the last.

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