Streetwise Professor

September 22, 2008

Russian Banking

Filed under: Economics,Politics,Russia — The Professor @ 7:19 pm

The Russian equity market has stabilized, the ruble has strengthened slightly against the dollar, (though it has fallen against the Euro), and the signs of acute stress in the Russian banking system seem to have eased due to the settling of the markets in the US, the prospects for a bailout, and the Russian government’s intervention into the market.

The Russian banking system is the key element here. I present a couple of takes on this from people with some expertise in the matter.

Anders Aslund is highly pessimistic/skeptical:

Putin continues to deny that Russia’s financial problems were caused by his war in Georgia, and it took the Central Bank more than a month to provide substantial liquidity injections. But it was already too late, as the liquidity problem had become a matter of solidity. Overtly, Russian stock valuations look attractive, but by heaping abuse on foreigners, Putin has scared the foreigners away, while Russian investors have no money at hand. With every statement, Putin erodes Russia’s political risk profile.

As is customary, many Russian businessmen pledged their shares to borrow money for stock purchases. As the stock market dives, they receive margin calls and are being forced to sell their shares at ever-lower prices, causing the stock market’s downward spiral to accelerate. In Soviet fashion, the Moscow stock exchanges closed for four days in a row in the week of September 15, because stocks plunged too fast. By denying the problem, the authorities have aggravated the lack of confidence.

On international financial markets, the war in Georgia has rendered Russian debt and bonds toxic. Interest rates on Russia’s bonds have risen by 2-3 percentage points, and many Russian creditors no longer have access to international capital markets.

Russia is just about to enter the third act of this tragedy: a banking crisis. Numerous medium-sized banks, and some large ones, are set to go under in the stock-market turmoil. Too many big investors can no longer meet their margin calls, while borrowing costs have risen sharply. The recent appreciation of the dollar adds to their hardship.

In the fourth act, the real estate bubble will burst. A reasonable guess would be that Moscow’s astronomic real-estate prices will fall by at least two-thirds. That will exacerbate the banking crisis.

In the fifth act, investment will seize up. Why continue building when you can neither finance your investment nor sell real estate? Russian consumers are already scared and will cut their consumption, causing aggregate demand to contract.

Richard Hainsworth is more sanguine. I met Richard in August, 2005, in Moscow at the European Finance Association Meetings. He has been in Moscow since 1982, and has followed the banking system since 1992, so he has been closely studying the system throughout its ups-and-downs. He is CEO of Rus Rating, a well-known bank credit rating firm in Moscow. His take:

The Russian banking system is so much stronger than it was ten years ago. Not just reforms in the system, but a wholesale change in the way the Central Bank operates, and the quality of the professionals in decision-making positions.

Even though banking is fundamentally a relationship business, and trust is the main factor in whether a bank can survive, the banking system in Russia will survive the current crisis. The quality of the mortgage assets, the complete absence of derivatives are major differences between the situation in Europe and the US, and the situation in Russia.

It is possible some banks, particularly those with large exposures to securities, may fail. But Russian banks as a whole will remain liquid, and the Central Bank will ensure the system survives.

Who’s right? Dunno. Certainly things are better than 10 years ago. The central bank does appear more professional (which wouldn’t be hard.) However, the political pressure could become intense if many oligarchs, and, more to the point, siloviki, face financial pressure from margin calls, constraints on credit, etc. So my take is that Richard’s view is probably right, but that there is an appreciable risk of the meltdown that Aslund envisions.

Does Orwell’s Ghost Ghost Putin’s Speeches?

Filed under: Uncategorized — The Professor @ 6:58 pm

From the Washington Post:

Mikhail Berger, a professor at the Higher School of Economics, said two factions in the Kremlin are competing to set economic policy, one interested in further market reforms and integration in the world economy, and the other favoring greater state control and a more isolationist line against the West.

Putin appeared to lean toward the latter group in the aftermath of the war in Georgia, repeatedly declaring that Russia’s economy could continue to thrive without the United States or Europe. But since the stock market crash, he has adopted a softer tone and courted foreign investment.

“We are becoming more dependent on each other through mutual investments,” he said Friday, adding that Russia was “banking on private initiative, entrepreneurial freedom, openness and rational integration with the global economy.”

Private initiative? Entrepreneurial freedom?   Openness?   Rational Integration?   Orwellian doublespeak, all of it, including “on” and “the.”   If you wanted an accurate description of Putinism, collect the antonyms of each of these terms: government control; pervasive state restrictions and favoritism of large enterprises; a closed, opaque system; integration on parasitic, opportunistic, and asymmetric terms.

Only fools will take such tripe seriously.   Unfortunately, when investment in Russia is considered, past experience tends to support P.T. Barnum’s judgment about the demography of fools.

September 18, 2008

Clearing Up the Mess

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 11:10 pm

It is apparent that the decisive factor that drove the Treasury to intervene with AIG is the insurer’s immense position in credit derivatives, notably credit derivatives tied to various mortgage securities. Whereas it seems that in the case of Lehman’s slow motion implosion, market participants had the opportunity to move positions and thereby limit the potential for a cascade of knock-on defaults on derivatives arising from a Lehman default, AIG’s much more rapid plunge permitted no such luxury. Fearing that AIG defaults would trigger defaults or bankruptcies by its counterparties (either because they held offsetting positions with others, or because the loss of the insurance contracts would blow holes in balance sheets large enough to force bankruptcy), the government decided to step in and effectively guarantee AIG’s performance on all its obligations.

The wreck of AIG hard on the heels of the collapse of Lehman hard on the heels of the disappearance of Bear has led to repeated calls for the establishment of a clearinghouse–a central counterparty (“CCP”)–for OTC derivatives, including credit derivatives. In this post I will attempt to discuss some of the issues this possibility raise. Bottom line: a CCP could help a lot, but it is not a panacea. Moreover, the benefits of a CCP depend crucially on the answer to the question: Why hasn’t the market already created a CCP?

What does a CCP do? It insures default/performance risk by mutualization, i.e., sharing of these risks across market participants. Note that in the days (or should I say day) before the AIG collapse, the Treasury essentially tried to create such a mutualization mechanism on the fly when it attempted to coax/coerce banks into lending to AIG. Not surprisingly, this effort failed, and in the event, the government stepped in as the ultimate insurer–meaning that taxpayers are essentially bearing the risk.

One way a CCP would have definitely helped is through the netting of offsetting exposures. In the OTC market, as currently constituted, when A sells a contract to B who sells to C who sells to D, (a) B and C have no market risk exposure (because they have offsetting positions), but (b) there are four sources of performance risk; default by A, B, C, or D is a possibility. For instance, B could suffer a loss on another position that impaired its ability to perform on its contract with either A or C. With clearing, or with some sort of mandatory netting (“ringout”) arrangement, B and C would be taken out of the chain of contracts, and only A and D would pose and face performance risk. B and C could blowup and neither A nor D would care.

In brief, central clearing reduces overall credit and performance risk by reducing the overall magnitude of performance risk exposure. Without netting, performance risk is roughly related to gross positions in the market, whereas with netting, performance risk is reduced to the net exposure.

The CCP also centralizes position information, making it easier for somebody (e.g., the Fed, Treasury) to figure out market exposures. I can only imagine the nightmare that regulators lived trying to figure out who traded how much with whom, and then assembling the jigsaw puzzle to visualize the potential for systemic problems. This is especially true given the dodgy nature of documentation in the credit derivatives market. Although participants have supposedly made progress cleaning up back office problems, these problems haven’t disappeared. This would represent another benefit of a CCP–it would force a rationalization of the confirmation process.

Now let’s figure out how things would have worked out in the AIG case had a CCP been in place. I presume that AIG had a big net position (as otherwise it wouldn’t have been facing multi-billion mark-to-market losses.) So, to the extent its positions weren’t fully collateralized (and I return to the collateral issue below), AIG would have failed to the clearinghouse. These losses would have been covered, to the extent possible, by funds precommited by CCP members in the form of a default fund or its equivalent. In addition, most CCPs have credit lines with banks. If the default fund was inadequate to cover the value of the AIG’s defaulted positions, the CCP would have been able to call on these credit lines, which would have become liabilities of the remaining, solvent members of the CCP. Through this mechanism, or through the CCP’s ability to require members to make additional capital contributions, the losses would have been shared by the other CCP members. A member’s share would be, to a first approximation, an increasing function of the size of the participant and its positions.

Thus, the effects of the CCP would be to diffuse the risk of a single default among all of the members of the CCP. It is likely–though I doubt it can be proven mathematically–that this would reduce the likelihood of the default causing a cascade of knock on defaults. Under the current, non-cleared system, the exposure to an AIG default is related to the direct and indirect gross exposures of each trader in the market to AIG. A firm with a big direct, or even indirect, exposure to AIG, would suffer a big loss from the latter’s default. That big loser would be more likely to be unable to perform on its other obligations than an otherwise identical firm with a smaller gross exposure to AIG. Under a CCP, there would be less dispersion across firms in the exposure to AIG. Thus, under most circumstances it appears less likely that one firm would experience a disproportionate loss from an AIG default.

Here’s a simple example that may capture some of what I am trying to convey. A and B are sellers of CDO insurance. C and D are buyers. C and D have portfolios of CDOs that they have financed with debt and equity. To normalize things, let’s assume that each insurance buyer’s debt is 90 and equity is 10. To make it simple, to emphasize the concentration effect, assume that C buys only from A, and D buys from B. A defaults. This occurs when B has suffered a big loss on his CDO position–let’s say that the CDOs have fallen in value to 50, and instead of paying the 50 it owes, A only pays 20. B no longer has insurance over its entire position. It now a CDO worth 50, and a payment of 20 from A–it thus can only pay 70 of its debt of 90. It defaults on the loan. There is a knockon effect.

Now lets say that the default of 30 is shared among B, C, and D in equal proportions. (NB: In reality, sharing rules are much more complicated.) Let’s say too that B is sufficiently capitalized to be able to cover its insurance obligation and its 1/3 share of the 30 default. Here, C and D receive (on net) 40 of the 50 that they are owed, leaving them with assets of 90 and liabilities of 90. They don’t default. Under the CCP, B and D bear some of the loss that C bears alone with no clearing. This reduces the probability that C will default.

Now, of course exposures are endogenous. In my example, C is a fool for having put all his eggs in one basket. Therefore, you would expect traders to consciously attempt to trade with more counterparties and limit their concentration in the absence of a CCP. Nonetheless, various considerations related to asymmetric information–something I will discuss more below–may in fact induce concentration.

It should also be noted that clearing economizes on collateral. Collateral is related to gross positions in the absence of clearing; with clearing they are related to net positions. This can reduce demands for liquidity during periods of systemic stress. Firms will face smaller collateral calls, and thus have less need for credit or to liquidate assets during periods of market stress.

So if clearing is so great, why hasn’t it happened already? On the answer to that question turns the policy recommendation.

One reason is that there is a coordination or externality problem that means that although it is collectively rational to form a CCP, it is individually irrational, or that the costs of coordinating the creation of a risk sharing arrangement are too high.

For instance, I have argued that some market participants (especially big, highly creditworthy players–like AIG before its collapse’-) may oppose the formation of a clearinghouse because a CCP levels the credit playing field. The biggest, most creditworthy firms have a competitive advantage in a non-cleared OTC market, and a CCP might undermine this advantage. The big guys may therefore not want to participate. And if they don’t play, the clearinghouse will never get off the ground.

Moreover, to the extent that a systemic event caused by a chain of defaults has costs that affect parties other than the intermediaries–a plausible hypothesis–the contracting parties do not internalize all of the costs of their decisions. They therefore do not fully internalize the benefits of the formation of a CCP–and hence may not agree to its creation.

These arguments suggest that the mandatory creation of a CCP would be welfare improving.

There are arguments, however, that suggest that there are substantial costs to the formation of a CCP. In particular, asymmetric information makes it costly to share risks. To the extent that participants in a CCP have private information about their own creditworthiness and the riskiness of the positions they clear, moral hazard and adverse selection problems will occur. These are real costs of risk sharing. The greater these costs, the smaller the benefit of forming a risk sharing arrangement.

As I have argued in a working paper, these costs are greater, the more difficult it is to value the instruments being cleared. Valuation is relatively easy in instruments that are standardized and traded on transparent markets with nearly continuously available, competitively determined prices. Valuation is much more difficult for idiosyncratic instruments that are infrequently traded, and/or which are traded in opaque markets.

The former conditions describe centralized exchange markets for liquid instruments, like T-bond futures. The latter, alas, describes many OTC derivatives, especially credit derivatives, and especially credit derivatives on CDO structures. Hence, it may well be the case that the reluctance to move to a CCP system for more complex instruments is due to the fact that the costs of sharing default risk are higher for these instruments.

Of course, these explanations–coordination/externality vs. high cost–are not mutually exclusive. If I had to make a gut call, I would say that the coordination/externality problems are sufficiently acute that some regulatory effort may be warranted to require the formation of a CCP system. At the same time, any such regulation should take into account the moral hazard and adverse selection problems that are inherent in more complicated instruments, and therefore recognize that risks cannot be shared as extensively for such instruments as is the case for vanilla products traded in transparent markets. This regulation should also recognize that pricing information, transparency, and valuation expertise are required to mitigate the costs of risk sharing for more complex instruments. Therefore, the creation of a clearinghouse might also require measures to improve price transparency and share valuation expertise. This raises other possible sources of resistance. Individual traders profit from private information on prices, and hence are reluctant to share this information. Thus, formation of clearing may require the mandating of disclosure of transaction pricing information. Good luck with that.

In brief, the AIG mess would probably haven’t been as messy if a CCP had been in place. Moreover, it is possible that the absence of a CCP is due to a market failure. However, it should also be recognized that clearing of the kind of stuff that got AIG into trouble ain’t easy–it ain’t like clearing T-notes or even OTC vanilla swaps. It is almost certainly the case that it is uneconomic to share performance risks as widely and extensively in more exotic credit and mortgage products as is the case for vanilla, exchange traded stuff.

I should note that this post was written more hastily than I usually like, but I feel that the issue is sufficiently important and timely to justify a more hurried take. If, upon further consideration, I decide that this analysis is incomplete or incorrect, I’ll make the necessary changes.

Chronologies V

Filed under: Uncategorized — The Professor @ 3:44 am

The New York Times published an article that provides further detail–and concrete intelligence–relating to the sequence of events leading to the Russo-Georgian War. Cellphone intercepts of South Ossetian calls provided by Georgian intelligence indicate that Russian armor was moving through the Roki Tunnel well before the 2330 commencement of the Georgian bombardment of Tskhinvali. Indeed, according to the intercepts, Russian AFVs were moving through the tunnel almost 20 hours earlier, at 0341 on 7 August.

The reports appear credible. They are consistent with other reports–from Russian sources–and with Matt Bryza’s contemporaneous account of what the Georgians told him. Moreover, the reports contain key details, most notably the mention of a Colonel Kazachenko, known to be an officer in the 135th Motorized Rifle Regiment which was the van of the Russian advance into Ossetia.

But the strongest evidence for their credibility is that the Russians have not denied them. Moreover, their attempts to explain the movement are risible. Gen. Lt. Nikola Uvarov, a Defense Ministry spokesman lamely states that “military hardware regularly moved in and out of South Ossetia, supplying the Russian peacekeeping contingent there. ‘Since we had a battalion, they need fuel, they need products; naturally you have a movement of troops. . . But not combat troops sent there to fight.”

Riiigghht. It was a fuel shipment. At 330 in the morning. That’s the ticket. What’s more, there is no mention in the intercepts of “fuel trucks”–just armor. Moreover, the Ossetian guards were apparently taken by surprise by the movement–this is hardly consistent with routine resupply.

It should also be noted that in the extremely tense conditions prevailing in early August, a resupply operation under cover of night accompanied by armor was incredibly stupid, risking the possibility of misinterpretation. Moreover, this points out the absurdity of having an interested party–and Russia has clearly asserted its interest in South Ossetia before and after the crisis–serve as a “peacekeeping” force. The ambiguity inherent in such an arrangement is an invitation to confusion, confusion that can lead to conflict.

Certain aspects of the story support the hypotheses that I have advanced; namely, that the Georgian attack was a response to a Russian incursion. I also acknowledge that that incursion itself could have been made in anticipation of a Georgian move.

Another article in Transitions Online, however, suggests that at least the Georgian soldiers at the pointy end did not understand their role to be a desperate lunge to stop a Russian incursion:

Georgian soldiers who fought in South Ossetia told EurasiaNet that they thought their initial mission in the breakaway region was to stop separatist attacks on Georgian villages in the area. On the morning of 8 August, the Georgian government cited shelling on two Georgian villages as the reason for its decision to move on Tskhinvali.

“Our goal was to put an end to fighting in the area and take control,” said one senior lieutenant from Georgia’s 3,500-strong 4th Brigade, a unit that bore the brunt of the fighting on 8 August. “Nobody in the army expected a war with Russia.”

The realization that Georgian forces were not up against South Ossetian militia, but an opponent who could vastly outnumber the Georgian army in numbers and firepower came as a shock, sources say. “The main thing is that the scope of the threat was underestimated, while our own combat capabilities were overestimated,” commented one defense ministry source, who asked not to be named. . . .

After nearly encircling the city, Georgian troops then tried to establish control over a key road to the north that led to South Ossetia’s border crossing with Russia, one mid-ranking commander said. A 300-strong South Ossetian garrison near the village of Tbeti was defending the road.

As Georgian troops battled the garrison, the first convoy of Russian tanks appeared, the commander recounted. The showdown occurred in a relatively narrow field of battle. “We destroyed one tank after another, but they kept coming,” the commander said, speaking on condition of anonymity.

The tanks were traveling from the southern mouth of the Roki tunnel, a border passage that provided the conduit for Russian forces and materiel. The Georgians’ failure to seal off the tunnel has been repeatedly cited as a critical strategic error. Georgian officers were aware of the tunnel’s significance, but they lacked the force to seal it. “Had we had a chance to destroy the Roki tunnel we would’ve done it,” said Deputy Defense Minister Kutelia. “The tunnel is tucked under a rock and it is very hard to destroy or block it unless you get really close.”

This account states that the South Ossetians, not an advancing Russian force, were the Georgian’s objective. It is possible to reconcile this with the Georgian government’s assertion that the Russian advance triggered the actual attack; the Georgian troops were deployed initially to attack the Ossetian artillery, but were hurled into action only when Saakashvili heard of the Russian advance. But this information could also support the Russian position that the Georgians attacked on their own initiative. That is, the causal connection between the by now well documented Russian advance into Roki before the commencement of the Georgian attack and Saakashvili’s decision to attack is ambiguous. Some evidence suggests that the final decision to attack was driven by the intelligence of a Russian advance; other evidence suggests that the attack was proceeding for reasons other than the Russian advance, but that the Russian advance (triggered by what?) upset Saakashivili’s plans.

The NYT article also puts to the fore questions about the intelligence capabilities of each side. It provides a glimpse on Georgian sigint and elint capabilities. We know that Georgian UAV reconnaissance capabilities were the subject of a concerted Russian campaign, so it is unclear as to whether Georgia had access to UAV information. It is also intriguing to ponder whether the US was sharing any intelligence with Georgia.

It is also interesting to ponder the sources of information available to the Russians that allowed them to anticipate the Georgian move (and I think the vast preponderance of the evidence shows that they did anticipate the move and actually entered Ossetia before the Georgian bombardment began). This Moscow Times piece damns Russian intelligence capabilities. Russia had virtually no UAV capability, and was forced to use TU-22 bombers to perform recon operations for which they were unsuited. It is also well understood that Russian satellite intelligence capabilities are substantially degraded from Soviet days. Presumably due to geographic proximity Russia had good elint and sigint capabilities, but arguably it was highly reliant on reports from Russian “peacekeeping” forces, and even more, from South Ossetian forces with eyes on the battlefield. This last is particularly troubling because the Ossetians would have had an incentive to color intelligence reports so as to get the Russians to act on their behalf.

This would not be the first time that two sides blundered into war based on faulty information, and perhaps distorted information supplied by interested parties.

I think it’s also worth pointing out that even when one can establish the chronology of a battle with some precision, that is not always sufficient to establish the motives for commanders’ decisions.

You Can’t Handle The Truth!

Filed under: Energy,Exchanges,Politics — The Professor @ 2:41 am

Last week I was invited to testify about energy speculation in front of a Senate subcommittee on energy.   I had to decline due to the uncertainty surrounding Ike, but another academic who has also expressed skepticism about the Master’s view of the financial universe accepted–only to be uninvited the day before the hearing.

Draw your own conclusions.

Cocaine Blues, Revisited

Filed under: Economics,Energy,Politics,Russia — The Professor @ 2:39 am

About a year ago, in “Cocaine [Oil] Blues,” I wrote:

The thing about cocaine is that what goes up, comes down with crash. After that shot, you feel invincible, but the comedown is brutal and depressing. That’s what happened to Willy Lee, and what’s likely to happen to Putin-or his successor, if there is one-when oil prices come down, as they inevitably will.

That day may have arrived. Even though oil prices are still higher than they were at the time I wrote that piece, they are well off their historical highs. Moreover, developments in the world financial markets have combined with the decline in the oil price (and exacerbated the decline) to shake the Russian financial system to its foundations. The equity market is in freefall–indeed, trading was halted today in a typically shortsighted attempt to kill the messenger. But the equity market, and the capital market more generally, is not the cornerstone of the Russian financial system. Russian finance is bank-centric. Those banks have always been shaky, and they are showing signs of acute strain in the midst of capital outflows and a flight to liquidity. Major Russian corporations are also highly leveraged, and tap external markets for credit. The credit crisis will constrain their ability to continue to finance their operations.

Sitting here in the US one can hardly crow about the state of the banking system, but as bad as things are here in the US, they are marginally worse in Europe, and substantially worse in Russia.

As oil prices skyrocketed, and billions flowed into Kremlin coffers, and the economy recovered from its 1990s disasters, Putin et all–and the Russian public–wildly exaggerated the nation’s economic strength and economic independence from the rest of the world. Like Willie Lee after his shot of cocaine, Putin (and Russians generally) felt invincible.

But the strength was extremely dependent on a factor largely beyond Kremlin control–the world price of oil. And that factor was–and is–extremely dependent on world economic activity. What’s more, Russia is dependent on external capital flows. The credit crisis strikes at both sources of dependence. Hence, when New York or London feels a chill, Russia gets pneumonia.

This dependence has been, as I have written, exacerbated by self-inflicted wounds–Mechel, BP-TNK, and, most importantly, Georgia. Russia therefore faces a perfect storm of internal and external factors that will seriously challenge Putin’s grandiose ambitions.

The question becomes–Can Putinism withstand the strain?

Recall that the Putinist economy is a “natural state” that uses resource-based rents to buy peace (or, perhaps, merely peaceful coexistence) among rival factions of siloviki. The sustainability of this system is questionable if these rents decline substantially. Moreover, using the cartel analogy I have advanced in the past, systemic crises can raise the discount rates of the rival clans, which can also undermine their incentives to maintain the uneasy cooperative equilibrium, and instead grab while the grabbing is good. Thus, at the level of the “elites” (a polite expression that in this context refers to Chekists who exercise control over the state’s coercive powers), the financial crisis corrodes the monetary glue that binds rival gangs in an uneasy peace. The crisis therefore dramatically increases the odds of an outbreak of conflict among rival clans.

But the problem is not limited to the prospect of interclan warfare alone. One of Putin’s accomplishments has been to reverse the despond of the 90s, and replace it with extremely high social and popular expectations of a prosperous future. In part, this is due to the fact that by comparison to the 90s, anything looks great. In part, it is due to the fact that the economy has without a doubt improved–in large part due to external factors for which Putin et al have been more than willing to claim credit. In part, it is due to the drumbeat of propaganda emanating from the government and its media lackeys. But whatever their source, these very expectations pose a great threat to Putin. If they are disappointed–and the credit crisis and the knock-on effects on Russia’s banking and capital markets dramatically raises the risks of disappointment–Putin’s (and Medvedev’s) popular support is at risk. Bank failures, or difficulties in obtaining credit on now accustomed terms, or a spike in inflation resulting from (a) a decline in the ruble, and (b) massive injections of liquidity in an attempt to prop up the banking sector, could all bring back memories of the 90s, thereby striking at the very rationale for Putinism.

Thus, economic weakening poses both elite and popular challenges to Putinism. Internal and external events over the last months have increased substantially the likelihood of such a weakening.

It may be premature to posit that Russia’s “Black Tuesday” and associated events represent an existential crisis for Putinism. But maybe not. Putin has essentially entered into a Hobbesian bargain with the Russian people. In exchange for a restoration of public order, and ending a war of all-against-all (as many people view the 90s), Putin demanded unchallenged authority and the perquisites of power. A struggle among the elites to protect their own shares of a shrinking pie would give the lie to the image of order that is essential to the maintenance of the system. Indeed, it could well spark a return to actual violence, either among the clans, or directed at any manifestation of popular unrest, that would call into question the viability of the Hobbesian bargain.

As I have written before, the Putinist system is extremely brittle. If it breaks, it will shatter. In a largely non-idealogical system held together by rents and a promise of order and improved living standards, financial shocks are the primary thing that can cause the structure to collapse.

What might transpire in the coming days and months? There is a distinct risk of greater instability. I definitely expect a pronounced ramping up of anti-Western, and anti-American, vitriol–as hard as that is to imagine given the rhetoric already emanating from Russia. But Putin et al have clearly made attacks against the West a major part of their political defense at home. I also anticipate an intensification of domestic oppression, and a clampdown on the few remaining independent outlets for public opinion–including especially the internet. Atomizing the domestic opposition and uniting the country against a common enemy are tried-and-true tools of control in Putin’s Russia.

There is also an air of unreality, and denial, surrounding the Russian leadership today. Medvedev gives anodyne “there’s nothing to worry about” pronouncements; Putin announces large increases in defense spending (at the same time the resources to fund such increases are declining and are likely to decline further.)

Even if Russia muddles through the current situation, there are still reasons to doubt the benefits of Putinism. For those whose horizons are defined by the Soviet period or the 1990s, Russian economic accomplishments of the Putin era do indeed seem nearly miraculous. Those, however, are very low standards indeed. What Putin has essentially created is an economic and social purgatory–certainly an improvement on hell, but hardly the best outcome that can be envisioned, and one that it is difficult to escape for something better. The prospects for moving beyond the purgatory of the natural state to something more dynamic, modern, and self-sustaining are poor.

To use a financial metaphor (which seems appropriate under the circumstances), to me Russia is like a short options position. Limited upside. Large–and potentially unlimited–downside. As North et al point out, the natural state is self-limiting; it must be so to survive, as it cannot withstand the uncontrolled development of competing sources of power and wealth. But, at the same time, it is vulnerable to collapse in the face of increased uncertainty or declines in the rents that hold the system together. We may stand at the cusp of the latter outcome.

September 14, 2008

Tell Me What You See

Filed under: Politics — The Professor @ 10:21 pm

Commentor Timothy Post takes me to task (surprise) for my post on Sarah Palin, complete with a bonus, unsolicited repetition of the slur about Trig’s parentage. The ironic thing about this is that my post was addressing a very narrow issue–the insinuation by Tom Broke-jaw and David Gregory that Palin didn’t know the responsibilities of the Vice President–and did not address in any way Palin’s qualifications for office. But, I stand accused of drinking the Go Sarah Go Kool Aid nonetheless.

But Timothy’s Pavlovian response to anything not brutally critical of Palin is very revealing. It encapsulates the most important dynamic of this election, post-Palin: the intense, visceral, hatred that Sarah Palin triggers among liberals and Democrats, and the almost as intensely rapturous response she engenders from her supporters. In a phrase, Sarah Palin is a national Rorschach Test.

It all boils down to the fact that Sarah Palin is the most purely Jacksonian major party nominee since James K. Polk in 1844. (For an entertaining bio of Polk, skip Wikipedia, and check out this catchy biographical tune by They Might Be Giants.) And since the time of Old Hickory himself, Jacksonians have driven America’s political and social elites into apoplexy. In Jackson’s day, cultured New Englanders scorned Jackson and the his great mob of unwashed followers. Today’s Coastal Crowd takes a similarly dim view of anyone hailing from a background like Sarah Palin’s: evangelical Christian, rural, and traditionalist. (It is hard to imagine a latter-day Arthur Schlesinger sitting in Harvard Yard writing encomiums to Jackson.)

Indeed, “take a dim view” hardly captures the sputtering rage that Palin incites. I have never witnessed this intensity of invective–personal, hurtful–directed at any political figure (Bush and Clinton included). To me, it seems that this hatred–and that is not too strong a word for it–is not aimed at Palin herself so much as what she represents. The response to Palin is like that directed against someone who has broken a taboo. To the progressive “elite” in this country (and Europe), Palin is a transgressive figure who violates the well established boundaries of what is, and what is not, acceptable for a major political figure. As an embodiment of The Other, she is a challenge to the established order of things–and must be not merely stopped, but destroyed. If Sarah Palin can ascend the heights of political power anybody can do it–and we just can’t have that now can we? Just as Jackson was a challenge to the established order, so is Palin. Just as Jackson appealed to vast numbers of Americans outside the accepted power structures, so does Palin. As such, because of what she represents, she is a threat.

The irony of all this is that the more the self-defined elites attack her, the more sympathy and support she will generate. Palin, like Obama, embodies the aspirations of many previously marginalized in the political process. Many of those who identify with her take the attacks on her personally–as attacks on themselves. The attacks will therefore, most likely, boomerang against those making them. Rather than driving people away from Palin towards Obama, they will only increase the breadth and intensity of support for Palin–and McCain.

This matters because, as I have opined before, it is the Jacksonians in Pennsylvania, Ohio, Michigan, and Missouri that will decide this election. They make up the key swing constituency that will determine who is inaugurated on 20 January, 2009. Obama has always struggled with this group. Biden did–and does–nothing to offset that. McCain was already more naturally appealing to these folks, with his Scotch-Irish, military background, but years in Washington have attenuated that connection. Palin forges a bond with, if not a silent majority ignored by the coastal elites, a pivotal constituency essential to assemble a constitutional majority. And every attack, every insult, every slur, every condescending interview will only strengthen that bond. These assaults are triggering a tribal response to defend one’s own that lends an intensity to McCain’s support that he never could have engendered on his own. Moreover, Palin has united the heretofore fissiparous tribes of the Republican party, in essence overcoming fissures that John McCain himself largely created.

I am agnostic as to Palin’s qualifications and merits; her resume is thin (though not as thin as Obama’s), but she has done a lot in a short period of time as governor. I find the signs of an incipient Palin personality cult as creepy as I find Obama’s full-blown one.

But the point is that her qualifications are irrelevant. Her candidacy is as symbolic in its own way as Obama’s. Indeed, her symbolism is far more demotic than Obama’s, his appealing to a self-identified, highly self-conscious, and highly politicized elite, hers to a heretofore politically marginal and un-self-conscious constituency. And Timothy, every time you or one of your tribe attack her, slur her, condescend to her, you are cutting your own political throats. So, by all means, carry on.

[Aside: Palin is a Jacksonian, no doubt. But what are those who oppose her so viscerally? Certainly not Hamiltonians. Not Jeffersonians either. Wilsonian is the closest, but even that doesn’t quite match (especially on foreign policy questions, though Wilsonian Progressivism on domestic matters is an element of the coastal elite’s political thinking. ) No, I think that Palin clearly reveals a fault line between Jacksonians, and a European progressive mindset that is outside traditional American political categories, but which is firmly ensconced among the self-perceived elites on the coasts.]

More on Property Rights Insecurity and Short-Termism

Filed under: Commodities,Economics,Energy — The Professor @ 9:35 am

AP has an interesting article that complements my earlier analysis:

A debilitating dispute at Anglo-Russian joint venture TNK-BP, in large part resolved, has also stoked concerns. The company reassigned 148 technical specialists from the country earlier this year amid visa difficulties and litigation.

In July, chief operating officer Tim Summers said the Russian shareholders’ desire to cut capital expenditure by $900 million in 2008 could wipe up to 1 million tons to 5 million tons from the company’s output over the next 12 months.

Further evidence that the Russian partners in BP-TNK are highly desirous of getting cash out now.

The article also points out that the nearly confiscatory tax regime also depresses the incentive to invest.


Filed under: Uncategorized — The Professor @ 9:30 am

Well, Ike has come and gone.   Here in College Station, a little wind, a lot of rain, but no big deal.   I’ll return to Houston tomorrow, but the main issue there seems to be power.   Could have been worse.

Stuck on Stupid

Filed under: Commodities,Derivatives,Economics,Energy,Politics — The Professor @ 2:10 am

During the aftermath of Hurricane Katrina, General Russel Honore castigated a reporter for being “stuck on stupid.”

For some reason, that phrase has come to mind repeatedly in the past hours. Perhaps it is due to the fact that I am sitting on the 9th floor of the Hilton in College Station, Texas, watching the rains and winds of Hurricane Ike. But more likely, it is that I am passing the time reading several of the latest “studies” purporting to lay the blame for the runup of commodity prices (especially energy prices) in 2007-2008 at the feet of speculators, and more particularly, commodity index traders.

The most widely disseminated of these is the Masters-White “Accidental Hunt Brothers” piece. Another is “The Commodities Market Bubble: Money Manager Capitalism and the Financialization of Commodity Markets” by University of Missouri-KC professor L. Randall Wray.

In a nutshell–same old, same old BS.

I could go on and on deconstructing this bilge, but even though the opportunity cost of my time is only slightly above zero, being marooned as I am, it is still positive. So I will limit myself to hitting the low-lights.

The most fundamental problem with these papers is their failure to identify any channel whereby side-bets on commodity price outcomes affect the supply and demand for physical commodities. Masters and White are particularly slippery in this regard, equating in a conclusory way the purchase of physical oil by China to the purchase of forward and futures contracts in similar notional quantities by index funds, and then asserting that the side bets contribute just as much to demand as the Chinese purchases of physical oil, and hence are just as responsible for any price increases. Similarly, Masters-White state that index traders are holding “stockpiles” of oil. Uhm, no, they don’t. They hold contractual claims on oil that they liquidate without converting them into actual, bona fide stockpiles of physical oil. The Masters-White argument is akin to saying that the bettors at race tracks own the outcomes of horse races. No, they own betting tickets–contingent claims that have payoffs that depend on the outcome of a horse race. Absent some other mechanism (e.g., bribing the jockeys), these contingent claims don’t influence the outcome of the race.

Put differently, moneys invested in indices don’t actually flow into the market for the physical commodities. Nobody uses these dollars to buy oil or corn. Instead, these funds are used to place collateralized bets on future movements in prices. The actual money invested in these strategies (if the index investor follows a fully collateralized strategy) is used to buy T-bills in dollar amounts equal to the notional value of the commodity index. The actual moolah doesn’t flow into the commodity markets, the way that it does when Sinopec or PetroChina buys a supertanker of Arabian crude.

Masters-White and Wray also fail to address the fact that index investors liquidate their positions before they become claims on physical commodities, and hence they are typically sellers at the time that spot prices are determined.

In terms of “evidence” these authors merely point to the fact that index fund investments have risen at the same time that commodity prices have risen. They do not appear to separate out the effect of increases in the amount of commodity index fund assets that was caused by the effect of rising prices on the value of existing positions from the increases attributable to the flows of new moneys into the funds. There is no effort to carry out rigorous statistical tests (e.g., cointegration tests, Granger Causality tests) to establish causation or an equilibrium relation. (It is possible that the visual relationship between two strongly trending series like an oil price and the size of index positions could be a spurious one. The authors of these studies make no attempt to explore this possibility.)

Masters-White make a big deal of the fact that all commodities in the various indices have gone up, and say that this would be extremely unlikely unless the index investment was driving all of them. But commodities not in funds, such as MGE wheat, iron ore, minor metals, have been skyrocketing in price too.

This line of reasoning does suggest one potentially rigorous test of the hypothesis. Namely, if the increasing importance of index money is injecting a common element into prices of all index commodities, overwhelming individual commodity-specific fundamentals, one should observe increasing correlations across commodities in indices, and stable or declining correlations between indexed and non-indexed commodities. This effect should be especially pronounced in high frequency data (daily, or intra-day) because the index investments are by construction made simultaneously or nearly simultaneously across commodities in the indices. Of course, Masters-White-Wray don’t even come close to identifying, let alone testing, such a refutable hypothesis.

In terms of “theory,” Masters-White and Wray put great stock in the cost-of-carry relationship between spot prices and futures prices, asserting that by buying futures, index investors drive up futures prices, which equal spot prices plus carrying costs, thereby forcing spot prices up too. But, for instance, in copper and oil, the price rises in 2007-2008 occurred simultaneously with movements from contango into backwardation.

Masters-White assert that order flow moves prices, so the predominately long order flow of index funds therefore must move prices up. There are two fundamental problems with this “reasoning.” First, when index funds roll, their order flow is on the sell side–so why don’t they move nearby prices down when they roll?

Second, and more importantly, they are very confused on the relationship between order flow and price discovery. Although Masters-White are correct that orders in futures markets are anonymous, they draw the wrong conclusion from this. The impact of any particular individual, anonymous order on prices depends on the average information content across orders. Holding the intensity of informed trading constant, increasing the intensity of index trading reduces the average informativeness of order flow. Thus, more orders are entered, but their individual impact is smaller, leading to little or no net impact on prices. (Index trades are likely to be deemed uninformative on average for reasons identified by current colleague Praveen Kumar and fellow Chicago GSB PhD classmate Duane Seppi. It is unlikely that a particular trader has private information on all components of an index, and if he has private index on any individual components, it is more effective to trade on that information in the markets for the individual components. This is why markets for index products, e.g., SP500 futures, are typically much more liquid than the markets for the individual components.) Moreover, informed traders adjust the intensity of their trading in response to changes in uninformed order flow, and generally trade to offset the effect of uninformed orders on prices. Thus, even if “dumb money” moves prices away from where they “should be,” this is an opportunity for smart money to trade against that, thereby forcing prices back towards the level justified by fundamentals.

Masters-White also make a big deal out of the fact that many market participants quote spot prices basis a futures to conclude that futures prices are driving spot prices, and hence noise injected into futures prices by index trading must therefore contaminate spot prices. In other words, futures prices are the dog, spot prices are the tail.

This is to confuse mechanics with substance. The key point is still that when it comes to determining futures prices as the market moves to expiry, participants recognize that if they hold positions to term they must make or take delivery of physical product. Thus, futures prices at expiration reflect supply and demand fundamentals in the physical market. I will not take delivery of something at a price if I do not believe that I can sell it at that price or better. I cannot sell it at that price or better unless there is physical demand for the product at that price. Thus, even though it is common to price some physical trades basis a futures price, that basis is determined in the market. Moreover, it adjusts to reflect physical supply and demand fundamentals, just as the delivery mechanism connects fundamentals to futures prices.

Put differently, basis pricing does not mean that spot prices do not reflect physical market realities. The best illustration of this (discussed in a SWP post over the summer) is the heavy/sour crude basis, which widened dramatically over the summer. This reflected the high demand for low sulfur diesel, the low yield of such fuel from heavy crude, and disruptions in the markets for sweet crude (driven primarily by problems in Nigeria.) (All of these are nuances that Masters et al, and Michael Greenberger, miss completely–even though they are salient factors in understanding the summer’s market dynamics.) Physical crude traders did not mindlessly pass on increases in WTI prices to the prices of heavy crudes. Differentials adjusted to reflect physical market supply and demand realities.

This gets back to the fundamental problem with all these analyses, one that is highlighted by Masters’ and White’s choice of a title for their opus–“Accidental Hunt Brothers.” I have said it a zillion times, but maybe the zillionth-and-first repetition will make it sink into heretofore impervious skulls: PRICES SERVE TO ALLOCATE REAL RESOURCES. IF PRICES ARE SUBSTANTIALLY DISTORTED, THAT MUST MANIFEST ITSELF IN PRONOUNCED DISTORTIONS IN THE ALLOCATION OF REAL RESOURCES. In the case of the real Hunt brothers, to keep prices high, they had to accumulate huge quantities of physical silver–real physical inventories, not phantom paper inventories. When the government propped up the price of wheat and milk, it had to buy and hold (or destroy) huge quantities of physical wheat and milk. As another example, when a manipulation takes place, the manipulation causes manifest distortions in commodity flows. For instance, in 1910 famous (or infamous) speculator James A. Patten (benefactor of the Patten Gymnasium at Northwestern University as well as the Chicago Art Institute) cornered the New York cotton market. Prices became so distorted that English spinners shipped cotton back to the US to take advantage of the price distortions–the economic equivalent of water flowing up hill.

If speculators are distorting prices, that necessarily causes distortions in stocks or flows of physical commodities. If index investors, or other speculators, were Hunt brothers, accidental or otherwise, they would necessarily find themselves in the same circumstances–paying for, holding, and financing large positions in physical commodities. Positions so large–if the price distortions are as large as asserted–that could not escape notice. Neither Masters-White, Wray, nor any of the other critics of index investment have provided any evidence of such distortions. Indeed, they haven’t even tried to do so.

To his (mild) credit, Wray recognizes the problem, anyways. He notes that Krugman has argued that speculative distortion should lead to accumulations of large and growing inventories in the hands of speculators. He attempts to avoid confronting this implication by stating that Krugman’s argument presumes perfect competition, and that commodity markets are not perfectly competitive, therefore Krugman’s argument doesn’t hold.

It is Wray’s argument that doesn’t hold. Perfect competition is not the essential linchpin of the analysis. Even if there is some market power on the producer side of the market, sellers will respond to higher prices by increasing output. Similarly, consumers will respond by reducing consumption. If somebody–a speculator–injects additional demand for the real commodity into the market, and drives prices up, producers will increase output and consumers will reduce consumption. This is sustainable only if the speculators willing to pay the (putatively) artificially high price put their money where their mouths are, and hold inventories of the commodity. (Wray tries to finesse the analysis by stating that maybe large oil producers are keeping oil in the ground rather than producing it. Maybe. But that is something that cannot be laid at the feet of the speculators. Moreover, it is hard to reconcile with the movement of the market into backwardation.)

Wray makes some other basic economic errors. For instance, he notes: “Americans have responded to rising gasoline prices in the manner economists expect, with consumption falling sufficiently to offset China’s increased use of crude oil—yet crude prices barely responded.” Catch the freshman mistake? If the reduction of consumption is an equilibrium response to higher prices, you wouldn’t expect the drop in consumption to cause a fall in prices. The reduction in consumption is a movement along a demand curve, and absent any shift of the demand curve, holding all else equal, the price should not fall. Wray’s is essentially a yo yo theory of prices. Rising prices cause falling consumption cause falling prices cause rising consumption cause rising prices . . . Maybe Wray should get rich by inventing a perpetual motion machine.

In brief, there is nothing new here. Indeed, these papers–trumpeted to the skies by Senators Lieberman, Cantwell, and others–are just a repetition of the same blarney that’s been flying about for months now. Can we please get unstuck from stupid, and start having an intelligent debate on these issues, one that reflects at least a modicum of comprehension of basic economics? Alas, I seriously doubt it.

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