Streetwise Professor

October 8, 2015

Why Don’t Journalists Scrutinize the Oracle of Syria?

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

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

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

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

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

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

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

Print Friendly

October 7, 2015

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


Print Friendly

October 3, 2015

People. Get. A. Grip: Glencore Is Not the Next Lehman

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,History,Regulation — The Professor @ 6:53 pm

There is a lot of hysterical chatter out there about Glencore being the next Lehman, and its failure being the next Lehman Moment that plunges the financial system into chaos. Please. Get. A. Grip.

Comparing the firms shows there’s no comparison.

Let’s first talk size, since this is often framed as an issue of “too big to fail.” In November, 2007, Lehman’s total assets were $691 billion. As of August, Glencore’s were $148 billion. Lehman was about 4.5 times bigger. Moreover, Glencore’s assets include a lot of short term assets (inventories and the like) that are relatively liquid. Looking at Glencore as a $100 billion firm is more realistic. Lehman was much bigger.

Then let’s talk leverage. Lehman had 3 percent equity, 97 percent debt. Glencore about one third-two thirds. Stripping out the short term debt and short term assets, it’s about 50-50.

Then let’s talk off-balance sheet. Lehman was a derivatives dealer with huge OTC derivatives exposures both long and short. Glencore’s derivatives book is much smaller, more directional, and much in listed derivatives.

Lehman had derivatives liabilities of about $30 billion after netting and collateral were taken into account, and $66 billion if not (which matters if netting is not honored in bankruptcy). Glencore has $2 billion and $20 billion, respectively.

Lets talk about funding. Lehman was funding long term assets with short term debt (e.g., overnight repos, corporate paper). It had a fragile capital structure. Glencore’s short term debt is funding short term assets, and its longer term assets are funded by longer term debt. A much less fragile capital structure.  Lower leverage and less fragile capital means that Glencore is much less susceptible to a run that can ruin a company that is actually solvent. That also means less likelihood that creditors are going to take a big loss due to a run (as was the case with Lehman).

As a major dealer, Lehman was also more interconnected with every major systemically important financial institution. That made contagion more likely.

But I don’t think these firm-specific characteristics are the most important factors. Market conditions today are significantly different, and that makes a huge difference.

It wasn’t the case that Lehman failed out of a clear blue sky and this brought down the entire financial system through a counterparty or informational channel. Lehman was one of a series of casualties of a financial crisis that had been underway for more than a year. The crisis began in earnest in August, 2007. Every market indicator was flashing red for the next 12 months. The OIS-Libor spread blew out. The TED spread blew out. Financial institution CDS spreads widened dramatically. Asset backed security prices were plummeting. Auction rate securities were failing. SPVs holding structured products were having difficulty issuing corporate paper to fund them. Bear Sterns failed. Fannie and Freddie were put into receivership. Everyone knew AIG was coughing up blood.

Lehman’s failure was the culmination of this process: it was more a symptom of the failure of the financial system, than a major cause. It is still an open question why its failure catalyzed an intensified panic and near collapse of the world system. One explanation is that people inferred that the failure of the Fed to bail it out meant that it wouldn’t be bailing out anyone else, and this set off the panic as people ran on firms that they had thought were working with a net, the existence of which they now doubted. Another explanation is that there was information contagion: people inferred that other institutions with similar portfolios to Lehman’s might be in worse shape than previously believed and hence ran on them (e.g., Goldman, Morgan Stanley, Citi) when Lehman went down. The counterparty contagion channel has not received widespread support.

In contrast, Glencore’s problems are occurring at a time of relative quiescence in the financial markets. Yes commodity markets are down hard, and equities have had spasms of volatility lately, but the warning signs of liquidity problems or massive credit problems in the banking sector are notably absent. TED and OIS-Libor spreads have ticked up mildly in recent months, but are still at low levels. A lot of energy debt is distressed, but that does not appear to have impaired financial institutions’ balance sheets the same way that the distress in the mortgage market did in 2007-2008.

Furthermore, there is not even a remote possibility of an implicit bailout put for Glencore, whereas it was plausible for Lehman (and hence the failure of the put to materialize plausibly caused such havoc). There are few signs of information contagion. Other mining firms stocks have fallen, but that reflects fundamentals: Glencore has fallen more because it is more leveraged.

Put differently, the financial system was more fragile then, and Lehman was clearly more systemically important, because of its interconnections and the information it conveyed about the health of other financial institutions and government/central bank policy towards them. The system is more able to handle a big failure now, and a smaller Glencore is not nearly as salient as Lehman was.

In sum, Glencore vs. Lehman: Smaller. Less leveraged. Less fragile balance sheet. Less interconnected. And crucially, running into difficulties largely by itself, due to its own idiosyncratic issues, in a time of relative health in the financial system, as opposed to being representative of an entire financial system that was acutely distressed.

With so many profound differences, it’s hard to imagine Glencore’s failure would lead to the same consequences as Lehman. It wouldn’t be fun for its creditors, but they would survive, and the damage would largely be contained to them.

So if you need something to keep you up at night, unless you are a Glencore creditor or shareholder, you’ll need to find something else. It ain’t gonna be Lehman, Part Deux. But I guess financial journos need something to write about.

Print Friendly

September 30, 2015

Let Putin Find Out the Hard Way

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

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

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

This is not that complicated:

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

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

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

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

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

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

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

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

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

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

Let Putin find out the hard way.

Print Friendly

September 28, 2015

Regulation Confronts Reality In the Commodity Markets. Reality Is Losing.

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Financial crisis,Regulation — The Professor @ 6:36 pm

Following the commodities markets today was like drinking from a fire hose. Many big stories, with “up” and “down” being the operative words. Alcoa split up. Shell announcing that it was giving up on its Arctic plans after its controversial test well failed to find commercially viable reserves. Oil price down around 3 percent, etc.

But the biggest news items were Glencore’s continuing downward spiral, and ESMA’s release of its technical recommendations for application of MiFID to non-financial firms, including commodity firms.

Glencore’s stock was down hard at the open, and at one point was down 31 percent. It’s CDS are now trading up-front (always a bad sign), and the spread widened from an already big 550 bp to 757 bp. At conventional recovery rates, this gives a (risk neutralized) probability of default of better than 50 percent. The Biggest Loser was Glencore’s CEO, Ivan Glasenberg, AKA, Ex-Glencore Billionaire.

The CDS are now trading wider than when Glencore had it s last near-death experience at the height of the financial crisis. Arguably the firm’s situation is worse now. It cannot attribute its woes to stressed financial market conditions generally, in which pretty much everyone saw spreads blow out to one degree or another. This is unique to it and the mining sector. It is a verdict on the firm/sector.

Moreover, in 2008 the firm was private, and Glasenberg and the other owners were able to stanch the bleeding by injecting additional capital into the firm. The ominous thing for Ivan et al now is that they tried that again a couple of weeks ago (along with announcing other measures to reduce debt and conserve cash) and it only bought a temporary respite before the blood started gushing again.

Moreover-and this is crucial-Glencore 2015 is a very different creature than Glencore 2008. It was more of a pure trader then: it is a mining firm with a big trading arm now. This means that its exposure to flat prices (of coal and copper in particular) is much bigger now. In fact, most commodity firms saw little drop off in profits in 2008-2009, and several saw profits increase. The fundamentals facing trading firms in 2008-2009 were not nearly as bad as the fundamentals facing mining firms today. That’s because their flat price exposures weren’t large, and margins and volumes (which drive trading profits) are not as sensitive to macro conditions as flat prices. Given the lack of any prospects for a rebound in flat prices, Glencore’s prospects for a recovery are muted.

Some tout Glasenberg et al’s trading acumen. But it is one thing to be able to sniff out arbs/relative mispricings and structure clever trades to exploit them. (Or to hold one’s nose while doing deals with dodgy regimes around the world.) It is something altogether different to predict where prices are going to go. Glencore made a bet on China, and now that bet is not looking good. At all.

In a nutshell, this is pretty much out of Glencore’s hands. It is along for the ride.

The irony here is that Glasenberg sold the Xstrata merger and the new business model as a way of using the less cyclical profitability of the trading venture as a way of dampening the cyclicality of the mining operation. As it is developing, an extremely adverse cyclical downturn in the mining operation is impairing the viability of the trading operation. How the trading operation can flourish within a financially distressed corporation is an open question. Maybe the company will have to pull an Alcoa, and separate the trading from the mining operations, to keep the latter from dragging down the former.

A key takeaway here relates to the other story I mentioned: ESMA’s release of its recommendations regarding the application of MiFID to non-financials. The objective is to mitigate systemic risk. I was always skeptical that commodity traders posed any such risk (and have been making that argument for 3+ years), and so far the Glencore meltdown is supporting that skepticism. There has been no evidence of spillovers/contagion from Glencore to financial institutions, or to the broader market, a la Lehman.

But ESMA has proposed Technical Standards that would impose the full panoply of CRD-IV capital requirements on commodity traders (and other non-financial firms) that cannot avail themselves of an exemption (on which I will say more momentarily).

  1. If firms cannot make use of an exemption under MiFID II, capital requirements under the new banking regulatory framework will apply to them. This new framework consists of Regulation EU No 575/2013 (CRR) and Directive 2013/36/EU (CRD IV), repealing Directives 2006/48/EC and 2006/49/EC. While CRD IV is addressed to CAs and includes, inter alia, qualitative provisions on the Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP), the new CRR imposes quantitative requirements and disclosure obligations pursuant to Basel III recommendations on credit institutions and investment firms, including own funds definition, minimum own funds requirements and liquidity requirements. However, under Article 498(1) of CRR, some commodity dealers falling within the scope of MiFID are transitionally exempt from the CRR’s provisions on own funds requirements until 31 December 2017 at the latest, if their main business consists exclusively of providing investment services or activities relating to commodity derivatives.
  2. Moreover, firms falling within the scope of MiFID II will be considered to be financial counterparties rather than non-financial counterparties under Article 2(8) of EMIR. Therefore, they will not be able to benefit from the clearing thresholds or the hedging exemption available to the latter under Article 10 of EMIR. An additional consequence of being classified as a financial counterparty will be that the trading obligation (i.e. the obligation to trade derivatives which are subject to the clearing obligation and sufficiently liquid on trading venues only, cf. Article 28 of MiFIR) would apply in full without being subject to a threshold.

So, even if you aren’t a bank, you will be treated like a bank, unless you can get the exemption. Apropos what I said the other day about impoverished carpenters, hammers, nails, etc.

To get an exemption, a firm’s non-hedging derivatives business must fall below a particular threshold amount, e.g., 3 percent of the oil market, 4 percent of the metals market. ESMA recommends that hedges be determined using EMIR criteria. The big problem with this is that only months ago ESMA itself recognized that the EMIR framework is unworkable:

  1. It appears that the complex mechanism introduced by EMIR for the NFC+ [Non-Financial Company Plus] classification has so far led to significant difficulties in the identification, monitoring and, as a consequence, possible supervision of these entities by their competent authorities.
  2. As a result, in the context of the revision of EMIR, ESMA would see some merit in the simplification of the current framework for the determination of NFC+.
  3. One route that the Commission may wish to explore is to move from the current two-step process (Hedging/Non Hedging and clearing threshold) to a one-step process, where counterparties would qualify as NFC+ when their outstanding positions exceeds certain thresholds per asset class, irrespective of the qualification of the trades as hedging or non-hedging. This idea is further developed in Section 4.2 which addresses the way in which NFCs qualify their transactions as hedging and non-hedging.

In other words, ESMA judged that it is impossible for regulators to distinguish firms’ hedging derivatives from its speculative ones. Given these difficulties, just a few months ago ESMA recommended jettisoning the entire mechanism that it now proposes to use to determine whether commodity firms are exempt from MiFID, and the associated capital and clearing requirements.

Makes perfect sense. In some universe.*

At the very least the ESMA plan will impose a huge compliance burden on firms who will have to justify their categorizations of derivatives positions as hedges or no. Given the complexities of risk management (e.g., managing risk on a portfolio basis means that saying what trade is a hedge is difficult, if not impossible, the rapid and frequent adjustments of positions inherent in most trading operations, etc.) this will be a nightmare.

So the good news is: You can get an exemption from capital and clearing requirments! Yay!

The bad news is: The entity proposing the exemption says that the process for getting the exemption is unworkable, and you’ll have not just a compliance headache, but a compliance migraine.

So at the very same time that the financial travails of a big commodity firm cast serious doubt on the systemic riskiness of these firms, European regulators advance regulations intended to fix this (non-existent) problem, and are doing so in a way that they themselves have cast serious doubt on.

Put differently: regulation is confronting reality in the commodity markets at this very moment, and reality is coming off second best.

* It also hardly inspires confidence that ESMA fails basic arithmetic. Note that the threshold in oil is 3 percent, then consider this from its Briefing on Non-Financial Topics: “If a firm’s speculative trading activity is less than 50% of its total trading, it may be MiFID II exempt providing its market share is less than 20% of each threshold in the market share test e.g. 0.8% for metals, 0.3% for oil etc.” Um, last time I checked .2 x 3%=0.6%, not 0.3%.


Print Friendly

September 26, 2015

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Well played, Europe! Well played!

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

Print Friendly

September 25, 2015

Dying of a Theory, Socialcon Edition

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

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

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

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

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

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

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

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

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

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

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

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

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

Print Friendly

September 21, 2015

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

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

I had an acid flashback moment when I read this:

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

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

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

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

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

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

Print Friendly

September 19, 2015

Putin Has Made His Sandbox. Let Him Play In It.

Filed under: History,Military,Politics,Russia — The Professor @ 3:04 pm

In my humble opinion, too many people are way overthinking what Putin is doing in Syria. It seems pretty straightforward. A long-time Soviet and Russian client was on the verge of collapse: the loss of Idlib earlier this month, after a long battle which ground inexorably against Assad, represented a major blow. Syria is Russia’s only outpost in the Middle East, and is also important to Iran, with which Russia cooperates because they share a common enemy: the US. Absent Russian intervention, Assad’s destruction appeared imminent.

Meaning that this is more of a rearguard action, defending the rump of the Syrian state, than an offensive thrust. And it is a reaction to events, not a part of some grand geopolitical strategy.

Some get this.

Donbas is a precedent. Direct Russian military intervention only occurred last August when it seemed that the Ukrainian army was on the verge of crushing the rebels. Once the situation stabilized, Putin seemed-and still seems-to be willing to accept a stalemate.

As for the military effect, the major resources committed appear to be aircraft, and ground units to protect them and their bases. The US campaign against ISIS shows that air power alone is unlikely to be decisive. The Russians have Assad’s army to work with, but it is battered and demoralized after four years of war, and even with air support is unlikely to be capable of sustained offensive action. It is probably on a par with the Iraqi army in terms of combat effectiveness (and may be worse), and past months have shown that even with US (and some Iraqi) air support, the Iraqi army can’t wage offensive warfare. I seriously doubt the Syrian army can either, even with additional Russian air support. Thus, the most likely outcome of the Russian intervention is to stave off Assad’s defeat and perpetuate the stalemate.

There is much gnashing of teeth and rending of garments in Washington and Europe, but since they haven’t done anything in the past four years and had no plans of doing anything serious going forward, this reaction is decidedly overwrought.

The administration persists in its pathetic insistence that Assad must go. Today Kerry repeated this demand, but said Assad’s departure doesn’t have to happen on day one or month one. What about century one? That seems feasible.

The US wants to negotiate Assad’s departure, and somehow thinks it can enlist Russia in this effort. That is utterly delusional, especially now that Russia has upped its commitment to Assad. It is also delusional because by making it clear that the US will not do anything serious to combat Assad (especially since that would anger its new BFF, Iran). Our negotiation leverage is therefore bupkis. Therefore, it is better for Kerry and Obama to keep quiet, and let the world think that they are neutered losers, rather than speak up and remove all doubt.

The biggest loser in this is Israel. Iran cares about Syria primarily because it is its bridge to Hezbollah. Israel has periodically launched air attacks in Syria to prevent the movement of advanced weapons (especially anti-aircraft missiles) to Hezbollah in Lebanon. The Russian presence complicates Israel’s problem greatly. But of course, this is probably a feature not a bug from Obama’s perspective.

The puzzle is Turkey. Turkey wants to see Assad’s destruction, and is perfectly fine with replacing him with Islamist radicals. Russian intervention reduces the odds of Assad’s defeat, and this is a defeat for Turkey. I have no idea how someone as erratic  as Erdogan will respond. One response will likely be greater covert support for the jihadists fighting Assad.

In sum, Putin’s actions in Syria will perpetuate a grim status quo, rather than cause a dramatic change in the strategic situation in the Middle East.  What happens going forward depends in large part on developments on the ground. If the current level of intervention is insufficient to slow the crumbling of the Assad regime, how much further will Putin be willing to go? His resources are constrained. As I wrote earlier, he faces daunting logistic difficulties in mounting a bigger intervention.

Regardless, we (in the US) are cast in the role of spectators: as Anthony Cordesman notes (perhaps stating the obvious), at present the US has no realistic military options in Syria. Obama made that choice four years ago, and reiterated his choice in 2013. Putin is now making his choice, and will have to live with the consequences: his options are no more palatable that the US’s (though he does have a coherent objective, which the US does not have and never had). We should leave him to it.

Print Friendly

September 18, 2015

Skepticism is the Preeminent Scientific Virtue: Certitude is a Leading Scientific Sin

Filed under: Climate Change,Politics — The Professor @ 6:39 pm

One way to identify a scientific paradigm in crisis is an attempt by its adherents to crush those who dissent. These efforts become all the more frantic, the more advanced the crisis becomes.

We may be witnessing such a moment now. Jumping on a proposal made by Senator Sheldon Whitehorse (D-CO) in a WaPo oped, a group of noted climate scientists have signed a letter addressed to the Attorney General supporting a RICO investigation of those individuals and organizations who are climate change skeptics and deniers. Whitehorse compared those who dispute the climate change consensus to the tobacco scientists who disputed the cancer-smoking link, who were RICO targets in the early-2000s.

This is a perversion of science in the name of science. Certainty, faith, and conformity are the domain of religion: Skepticism and doubt are the domain of science. Skepticism is perhaps the preeminent scientific virtue: certitude is the leading scientific sin.

Indeed, the sociology of modern institutionalized science, with its dependence on government funding, tends to produce excessive consensus, and is rife with mechanisms that suppress challenge. Skepticism and doubt need defending and nurturing, not stigmatizing and outright repression.

The whole climate change debate is framed in a logically fallacious way because it is posed as a false choice: is anthropogenic climate change true or false? I believe that it is true, but that is a trivial answer to a trivial question. The more interesting questions involve the magnitude of the effect, and the costs of alternative means of mitigation or adjustment, and on these issues there is much room to be skeptical about the much vaunted consensus.

The consensus is based on models. Very large, complicated models of coupled, complex systems. I know enough about models to know that one should always be skeptical of them. One should be particularly skeptical of large models. And one should be especially skeptical of models of coupled complex systems (non-linear) with myriad feedbacks. By their very nature, such systems defy modeling, especially where computation is involved because computational tractability almost always involves linearizing the non-linear.

Climate models are all these things, so doubt and skepticism are more than warranted: they are mandatory. Climate is filled with poorly understood feedbacks and processes that are handled-if they are handled at all-by crude parameterizations (a polite way of saying SWAG: scientific wild assed guess). Furthermore, their empirical validity is doubtful, at best. The longstanding inability to predict the behavior of the tropical troposphere is one example, but even more tellingly, the failure to predict the recent temperature plateau is a massive empirical failure.

Alarm bells should also be triggered by the repeated fiddling with historical temperature data. Especially since that fiddling always seems to work in one direction: past temperatures are pushed downwards to increase the upward trend.

A confident science would relish the challenges of skeptics, secure in the knowledge that it will prevail because theory and evidence are on its side. A frightened and insecure science-especially one dominated by scientists fearing for their funding and their academic sinecures-responds by attempting to throttle those who criticize it. That’s what we are seeing now, with these efforts aided and abetted by politicians and journalists (e.g., jackholes like Jake Tapper-who would be a jakehole, I guess-and his performance in Wednesday’s GOP debate).

It is particularly risible to see scientists who dominate journals, dominate the peer review process, dominate the funding review process, dominate the universities and research departments, and who secure the lion’s share of government funding, whine about the dread threat posed by a few (and they emphasize that they are few) dissenters from the consensus. The constellation of organizations and funders that support the climate change consensus dwarfs that which the scientists and Whitehorse claim threatens science and truth. The letter reeks of projection by the signers. It’s very Russian.

Again, a confident science, a correct science, in control of all the commanding heights of the modern scientific establishment, should have nothing to fear. But we see the elephant quaking before the mouse, demanding that it be squashed.

But it is perhaps the fact that they have a lot to lose that explains the ferocity of the response to anyone who threatens them.

The endorsement by politicians of inquisitorial means is to be expected. That’s how they roll. The endorsement by scientists of inquisitorial means to be applied to other scientists is an abomination.

Update: When not applied to its original targets, the mafia, RICO is almost always a tool of government extortion and intimidation. I am reminded in particular of the Giuliani prosecutions of Michael Milken in the 1980s. Even in criminal cases it is almost always a perversion of justice. To invoke it in a scientific dispute is beyond outrageous.

Print Friendly

Next Page »

Powered by WordPress