Streetwise Professor

November 25, 2008

The Financial Crisis in Russia Begins to Bite

Filed under: Economics,Energy,Politics,Russia — The Professor @ 10:09 pm

I haven’t written anything on Russia lately, being absorbed (obsessed?) with all things clearing, so I need to do something to stir up the natives in SWP-land;-)

There has been little concrete news to write about.   The odd constitutional amendment Kabuki dance continues, but there’s little more to say about it.     The Russian central bank has loosened the ruble band a bit further, but is evidently still defending the ruble–effectively giving speculators a free put that will pay off when the bank cries uncle, as it inevitably must.   This is a foolish economic policy dictated by political considerations; if rapidly deteriorating fundamentals justify a drop in the ruble, let it drop rather than throw away (I cleaned that up) hard won reserves in an ultimately futile defense of an overvalued currency.   The only conceivable reason for engaging in this policy is that Putin has staked his reputation on the ruble and avoiding another 1998-esque collapse, and that relatedly, a rapid drop would give the lie to Putin’s and Medvedev’s public expressions of confidence.   Timothy Post and Da Russophile are sanguine that the Russian people will not turn on the government out of anger over the economic situation, but its actions suggest that Putin and Medvedev are not quite so confident.

Speaking of deteriorating fundamentals, oil sold off sharply today after a nice rally yesterday.   Urals Med was quoted at $45.86 in European trading today.   Brent has sold off some since that price was quoted, so the current price of Urals is probably south of that number.   $45.86 ain’t $40, but it’s a long way from where the price needs to be to stabilize the Russian economy.

The most interesting news is this Reuters report that the government has decided to “delay” electricity pricing reform.   A long article in the Moscow Times last week suggested that such a move was in the offing.   Russia had spun off its electricity generators from state monopoly UES, but prices are still regulated at very low levels that make it completely uneconomical to make desperately needed investments.   The next step of the restructuring plan would have raised these prices to allow grid operators to earn a rate of return sufficient to attract new capital.   Allowing generators to sell at higher prices was essential to attracting desperately needed investment in new capacity.

The suspension of the pricing reform will likely be viewed as the government reneging on a commitment.   This will make it even more difficult to attact the massive amounts of capital necessary to improve Russia’s decrepit power grid.   (Though it should be noted that the financial crisis itself, and the problems in the real economy that will result from it, would undermine the investment case without the government’s piling on.   But the reputational effect of changing the rules will exacerbate the difficulties in attracting capital, and will have effects well after the financial crisis abates.)

The decision making process was typically opaque, but it appears that major industrial interests, especially the big energy and mining companies pressured the government to keep prices low in order to support their suddenly struggling operations.     This will further discourage investors, not just in electricity, but in all sectors, as it provides additional evidence (as if any was needed) that political calculations, rather than economics, drive key policy decisions.   (And, in a pre-emptive exercise of “whataboutism,”   I concur completely that this is going on the US and Europe too.   Any bailout of the auto companies would be similarly egregious.)

The whole affair also shines a light on Russia’s vast investment needs.   Electricity, roads, rails, health care, to name just the largest, are all in need of massive investments.   The politicized capital allocation mechanism was not directing the oil windfall to where it was needed when energy prices were high, and now tens, and perhaps hundreds, of billions prudently accumulated when oil prices were high are being frittered away bailing out oligarchs to keep the stock they have pledged in collateral out of the hands of western banks, and propping up an overvalued ruble.   This will have deleterious effects on Russia’s long term growth prospects.

Due to the closed nature of Russian governance, the silovikis‘ hands are invisible, but that’s not what Adam Smith had in mind.   The hidden hand of the siloviki distorts the allocation of capital and discourages badly needed investment.   Russia will not make the transition beyond Nigeria with snow and missiles until their malign influence is eliminated.

SWP on Reuters

Filed under: Derivatives,Economics,Exchanges,Politics — The Professor @ 9:16 pm

I am quoted extensively in this Reuters article on CDS clearing.   No surprises here: I’m just blowing another raspberry at proposals that the government force clearing, or the trading of all derivatives on exchanges.

If It’s So Great, Continued

Filed under: Derivatives,Economics,Exchanges,Politics — The Professor @ 9:12 pm

The FT reports that major banks are reluctantly supporting the formation of a CDS clearinghouse, if only to stave off something worse–the Harkin proposal to force all trading of everything onto exchanges:

The world’s biggest investment banks are throwing their weight behind a proposal for mandatory central clearing of the $54,000bn over-the-counter credit derivatives market, according to a memo obtained by the Financial Times.

The initiative suggests that dealer banks are stepping up their campaign in Washington to head off proposals for a radical overhaul of the sector, including attempts to force the entire industry to move trading in contracts such as credit default swaps (CDS) on to an exchange. (Emphasis added.)

This suggests that the big banks are not sold on the idea of CDS clearing.   This doesn’t surprise me, given the problematic aspects of a CDS CCP that I’ve discussed in gruesome detail in numerous posts.   I’ve read that dealers bought Clearing Corp earlier this year with the thought that the time would be right for CDS clearing in 2011 or 2012, but that intense political pressure has accelerated that time schedule.

Harkin’s legislative grenade is of course not the only source of government pressure to create a clearinghouse; the NY Fed (under the leadership of Treasury Secretary nominee Timothy Geithner) has been leading the charge.   But there is no doubt that Harkin’s initiative has put the fear of God into the banks, and has overwhelmed any reservations that they have harbored.   Geithner, the Fed, the Treasury, could pressure the banks and make their lives uncomfortable; Harkin’s bill could put them out of the CDS market making business altogether.   Given this selection of poisons on offer, it’s pretty easy to understand why the banks have chosen the one they did.

This has historical precedents.   For instance, exchanges fought the first attempts to regulate futures in the 1920s.   The prospect of legislation that would have essentially put them out of business made them willing to accept unpalatable regulations that nonetheless permitted them to continue to operate.

This just illustrates that a bill needn’t be passed to have pernicious effects.   Very bad proposals can lead to the adoption of less bad, but still undesirable policies.   It would be somewhat comforting if the banks had their Come to Jesus moment because events and sober analysis had convinced them that clearing of CDSs was in their benefit, and would improve market efficiency.   Their shouts of Hallelulah under the threat of severe compulsion are hardly credible professions of their faith in the revealed truth of clearing.   Given that there are strong reasons to believe that CDS clearing is not a panacea, and may well impair market efficiency and increase systemic risk, their pragmatic protestations of belief make me even more skeptical that this is the right thing to do.

The Morgan Stanley Cascade

Filed under: Derivatives,Economics,Exchanges,Politics — The Professor @ 8:47 pm

Yesterday the WSJ published a long article about Morgan Stanley’s near death experience in September.   Although the byline reads Susan Pulliam, Liz Rappaport, Aaron Lucchetti, Jenny Strasburg, and Tom McGinty, it reads like it was ghosted by Chris Cox because it raises the specter of evil speculators ganging up to destroy Morgan by buying credit protection against the bank, and short selling its stock:

Trading records reviewed by The Wall Street Journal now provide a partial answer. It turns out that some of the biggest names on Wall Street — Merrill Lynch & Co., Citigroup Inc., Deutsche Bank and UBS AG — were placing large bets against Morgan Stanley, the records indicate. They did so using complicated financial instruments called credit-default swaps, a form of insurance against losses on loans and bonds.

A close examination by the Journal of that trading also reveals that the swaps played a critical role in magnifying bearish sentiment about Morgan Stanley, in turn prompting traders to bet against the firm’s stock by selling it short. The interplay between swaps trading and short selling accelerated the firm’s downward spiral.

. . . .

Pressure also mounted on another front. There was a surge in “short sales” — bets against the price of Morgan Stanley’s stock — by large hedge funds including Third Point LLC. By day’s end, Morgan Stanley’s shares were down 24%, fanning fears among regulators that predatory investors were targeting investment banks.

. . . .

New York Attorney General Andrew Cuomo, the U.S. Attorney’s office in Manhattan and the Securities and Exchange Commission are looking into whether traders manipulated markets by intentionally disseminating false rumors in order to profit on their bets. The investigations also are examining whether traders bought swaps at high prices to spark fear about Morgan Stanley’s stability in order to profit on other trading positions, and whether trading involved bogus price quotes and sham trades, people familiar with the probes say.No evidence has emerged publicly that any firm trading in Morgan Stanley stock or credit-default swaps did anything wrong. Most of the firms say they purchased the credit-default swaps simply to protect themselves against potential losses on various types of business they were doing with Morgan Stanley. Some say their swap wagers were small, relative to all such trading that was done that day.

. . . .

But swaps were also a good way to speculate for traders who didn’t own the debt. Swap values rise on the fear of default. So traders who believed that fears about Morgan Stanley were likely to intensify could use swaps to try to turn a fast profit.

Note the use of the word “bet” (three times) in the first three quoted paragraphs.   The article also throws about terms like “financial Frankenstein” to describe credit default swaps.

I agree with Felix Salmon’s verdict:

In fact it tells a much simpler tale: Morgan Stanley’s counterparties were forced to buy CDS protection to hedge their exposure to the bank, and Morgan Stanley’s hedge-fund clients withdrew a lot of money, not in a bear-raid attempt to kill it off, but because prudence demanded that they do so, and also because they were understandably upset about John Mack’s role in getting the short-selling ban put in place. That ban devastated many hedge-fund relative-value and convertible-arbitrage strategies and caused a lot of anger in the hedge-fund community.

. . . .

So yes, it’s possible that those demonic short-sellers were responsible for the fall not only in Morgan Stanley’s share price, but also in Citi’s at the end of last week. But it’s also possible that it was just old-fashioned sellers, who weren’t selling short but were rather selling down their existing long positions. And it’s also possible that it wasn’t selling at all, but simply a lack of buyers willing to place bets on a fragile institution with a possible leadership vacuum. We simply don’t know — which is why it’s silly to assume that short-sellers were to blame.

That is, it was individually rational for the Merrills, Citigroups, Deutsche Banks, UBSs, etc., to hedge their counterparty risk.   This was especially true in the immediate aftermath of the Lehman collapse, which had demonstrated that (a) a big investment bank could collapse with stunning swiftness, and (b) there was no guarantee that the government would intervene to prevent the collapse.   Put differently, one can explain what went on without positing that malign speculators were making these trades with the specific intent of destroying the firm.

There is still an issue that deserves thought, but which is likely impossible to resolve.   That is whether this individually rational behavior was economically efficient–or collectively rational.

For instance, the activities of those hedging against (or betting on) a Morgan Stanley collapse could be consistent with an informational cascade.   The individual banks had information on Morgan Stanley’s creditworthiness, but were also drawing inferences from the actions of other potentially informed parties.   A given bank, observing others buying protection or short selling MS stock, would infer that these parties had received adverse information about Morgan’s creditworthiness.   Even if a given bank’s own information wasn’t that bearish, the inference drawn from the behavior of others could be sufficient to convince it that the firm was on the brink of failure, leading it to buy protection against an MS default.   And the next bank, seeing what that bank had just done, would likely make the same inference.   And the next bank, and the next one.   Such a “cascade” can become self-sustaining, leading everyone, regardless of their information, to join the wave of those “betting” against MS’s survival.

The literature on cascades demonstrates that these cascades can lead to the “wrong” outcome.   Specifically, if the first couple of traders act on signals that present an overly pessimistic view of Morgan’s condition, an unjustifiably bearish cascade can occur.   In such a cascade, even those with more optimistic signals will make bearish trades. Thus, the ultimate outcome of the cascade may not aggregate information accurately.   A healthy firm can be brought to its knees by a cascade.

So it is possible that Morgan Stanley’s agonies were the result of an inefficient informational cascade in which everybody was individually rational, but the result was inefficient and collectively irrational.

This raises the question: What can be done to stop such inefficient cascades?

The literature on cascades suggests that cascades are very fragile.   They can be stopped quickly by the release of accurate, credible information.   It is hard to imagine this occurring in the frenzied conditions of the market on those September days.   Who could have provided this credible, accurate information in real time?   Morgan Stanley itself was hardly a credible source of information.   Given the opaque nature of the firm’s balance sheet, moreover, it is hard to imagine that there was any credible source of information.

Perhaps some sort of circuit breaker–or, perhaps, “cascade breaker”–would have done the trick.   Stopping trading would have stemmed the cascade’s momentum.   This stoppage would have had to have been coordinated across several markets, including the CDS, stock, and options markets, in the US and abroad.   Moreover, how would the breaker be triggered?   Would it be some non-discretionary trigger based on observable market prices, e.g., a fall in a company’s stock price of X percent?   Or a discretionary action?   If discretionary, who would exercise it?   A government regulator?   There are obvious pitfalls with any of these alternatives.   (Look at the chaos in the Russian stock market in recent weeks, with myriad market closures.)

This “cascade breaker” could provide an intellectually respectable justification for a restriction on short sales.   (Not that the opponents of short sales have made such a justification, preferring instead to portray short sellers as financial Snidely Whiplashes.)

But not so fast.   Although it seems that bank runs–and what happened to Morgan Stanley is analogous to a bank run–are inherently bad, and that stopping them would be good public policy, the banking literature does not support this conclusion.   As Diamond and Rajan and others have shown, bank runs can be a valuable disciplining advice.   Absent the threat of runs, financial institutions that supply liquidity can act opportunistically towards their creditors.   This opportunistic behavior can be costlier than a run.

Thus, there is no immediately obvious policy response to the events described in the WSJ article.   The cartoonish demonization of short sellers and credit protection buyers is certainly not a reasonable basis for intervention into the markets.   The details presented in the article do not prove that speculators intent on driving Morgan Stanley out of business were responsible for the short sales and the CDS purchases; individually rational hedging behavior could have produced the same behavior.   Individual rationality does not imply efficiency because of the possibility of inefficient information cascades, but even then, the optimal policy response is not obvious.     Unless policy makers can reliably distinguish between inefficient and efficient runs/cascades, intervening to prevent all cascades through the imposition of a circuit breaker can eliminate a valuable disciplining mechanism that reduces the costs of contracting.

In the end, I imagine that one’s priors about the likelihood of inefficient cascades determines one’s policy recommendation.   Since information cascades are the result of myriad individual decisions, and the optimality of these decisions depends on private information unobservable to any investigator, it is impossible to determine ex post (let alone in real time) whether a particular run/cascade was efficient or inefficient.   Thus, there is inevitably a paucity of evidence that people can use to revise their priors.   Moreover, any policy action is likely to have large, and virtually impossible to quantify, costs.   (How does one quantify the costs arising from less efficient contracting when the elimination of disciplining runs rules out the “best” contracts?)   Thus, cascade breakers, or any policy response, are little more than shots in the dark, based on quasi-religious views about the efficiency of markets.

I know that’s not a very palatable diagnosis, but there it is.   We are ignorant, and the ignorance cannot be remedied.

November 22, 2008

If It’s So Great . . .

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics — The Professor @ 5:03 pm

Those who have read SWP regularly will have deduced that I have a historical bent.   Although historians and economists (and other social scientists) tend to think and analyze problems in very different ways, I think that history is quite often a useful source of material on which to test theories and conjectures, and a source of inspiration and ideas useful in the generation of new theories and models.   It also frequently proves quite useful in debunking assertions about the necessity or sufficiency of a certain factor causing some outcome.

Today’s historical excursion examines a couple of episodes in the past relating to clearing.   Specifically, two occasions in which important exchanges, the London Metal Exchange and the Chicago Board of Trade, adopted central clearing under government pressure only after a long period of resistance.   In each case, the memberships and/or leaderships of these exchanges steadfastly refused to introduce clearing until forced to do so by regulators.   In each of these cases, the regulators’ rationales were tangential, at best, to the actual economic purpose and effects of a clearinghouse.   It seems that as various government entities are pushing a clearing solution for the CDS market that we are in the process of repeating history.

A central counterparty/clearinghouse was first adopted in the US in 1891 in Minneapolis.   From time to time in the following years, some members of the Chicago Board of Trade proposed that the exchange adopt the “Minneapolis Model.”   Each time, either the membership or the board of directors rejected these proposals.

All of the merits of central clearing were pretty well understood.   In particular, CBT members understood that clearing would reduce the amount of money that would be tied up in margins–although some considered this a bug, not a feature.

The standoff between the advocates and opponents of clearing continued literally for decades.   The impetus for the move that actually resulted in the creation of the Board of Trade Clearing Corporation originated in the passage of the Grain Futures Act of 1922.   This Act gave the Secretary of Agriculture considerable power over grain exchanges.   The Secretary could put an exchange out of business by revoking its designation as a contract market.

In 1925, William Jardine was Calvin Coolidge’s Agriculture Secretary.   He was convinced that large speculators were manipulating the grain markets, to the detriment of farmers, and wanted to do something to stop it.   In another foreshadowing of current events, Jardine was convinced that identifying who held large positions would facilitate deterrence.     He further thought that a clearinghouse would achieve this objective because it would require the registration of all positions in order to perform its work.

Of course, it would have been possible to register positions without creating a central counterparty.   Indeed, such a change to clearing procedures had been proposed, but not adopted, in 1911.

The directors of the CBT continued to balk at creating a clearinghouse, until two influential members of the exchange, L.F. Gates and J.C. Murray, who served on the exchange’s Grain Exchange Legislative Committee, wrote a letter warning of dire consequences if the exchange failed to act.   Gates and Murray said that failure to implement the clearinghouse plan could lead to a revocation of contract market status.   Stung into action by their warning, the directors approved the creation of a clearinghouse (and a Business Conduct Committee to police the exchange’s members.)

Jim Moser argues that Jardine’s pressure was not what caused the CBT to adopt the central counterparty.   He notes that the exchange could have satisfied Jardine’s demands for transparency by registering every trade, but not providing a central guarantee.   He concludes that the directors’ reluctance to adopt the CCP was based on privacy concerns that Jardine alleviated.   From this he infers that the directors’ objection to the clearinghouse was not the risk sharing aspect of its operation, but the possibility that its operation could result in disclosure of position information.

Perhaps.   But it seems that if there was a strong demand for risk sharing via a CCP, the exchange could have found away to address the privacy concerns.     Thus, another, and in my view more straightforward, interpretation of events is that there was not a uniform desire for a CCP, and there was strong opposition to the concept; and that Jardine’s threat to shut down the exchange compelled the directors to pacify him by adopting a method that he had endorsed–the Minneapolis Method.

That’s one of the problems with history–it seldom permits definitive answers as to cause and effect.   But regardless of the interpretation, the extreme reluctance of the Board to adopt a CCP suggests that the concept is not nearly as beneficial as its advocates suggest.   To be sure, there were legal and privacy objections, but (a) where there’s a will, there’s a way, and (b) it is often the case that explicit objections camouflage the true reasons for opposition.     And to me, the most straightforward interpretation of the facts is that the CBT adopted a central counterparty not because of its inherent economic benefits, but only as result of government pressure motivated by considerations completely unrelated to the costs and benefits of sharing default risks. The failure of the CBT to adopt a central counterparty voluntarily is consistent with the view that this method of allocating default risk has costs that exceed the benefits.

The LME was another exchange that adopted central clearing only when its very existence was threatened by government action.   The LME had suffered a major crisis in 1985-1986 with the collapse of the International Tin Council’s price support program.   Tin prices collapsed, contracts were breached, and many LME members suffered huge losses, with some closing their doors.   Prior to the Tin Crisis, the LME had been strictly a principals’ market, with all dealings done on a bilateral basis just as is the case in OTC markets today.   The LME clearinghouse was merely a mechanism for netting payments and deliveries, similar to a bank clearinghouse.   It was not a CCP.   Indeed, the LME had consciously resisted creation of a CCP for years after this practice had become standard in both American and British commodity markets.

Remarkably, the LME’s resistence to the idea continued after the Tin Crisis.   Thus, even a major series of dealer defaults was not sufficient to convince the membership that a central counterparty was a superior method of sharing default risks.   The LME adopted a CCP only after the newly formed U.K. Securities and Investment Board (SIB) made it clear that it would deny the LME its license to operate unless it introduced an independent CCP.

Most of the benefits attributed to CCPs are private benefits that accrue to their members–lower collateral, more efficient sharing of default risk, prioritization of derivatives counterparties over other creditors.   If this was all there was to the story, derivatives markets participants should adopt a CCP without fail.   But, as these historical episodes demonstrate, they don’t.   Indeed, they demonstrate that the resistance to the idea can be so strong that only intense government pressure can overcome it.   Thus, there must be more to the story.   There must be some costs sufficiently large to overwhelm the private benefits commonly attributed to a CCP.   These costs, unfortunately, are seldom–if ever–the subject of serious analysis.   They should be.   A reasoned judgment about the efficiency of a CCP must be predicated on a judicious weighing of both costs and benefits. Presumably 1920s grain traders and 1980s metals traders whose livelihoods depended on the efficient operation of their markets made such a judicious appraisal, and decided that the costs outweighed the benefits.   That should give advocates of CCPs pause, and spark a more thoughtful consideration of their full effects.

Throughout the period of explosive growth in OTC derivatives, market participants have arrived at a similar judgment.   The concept of clearing is well known.   The subject has been mooted–and rejected (for the most part).   That judgment should not be overridden without excellent justification.

Heretofore, that justification has been totally lacking, but government pressure to adopt a CCP for credit derivatives, and perhaps eventually other derivatives, is unrelenting.   There are repeated invocations of   “systemic risk” and the bandying about of scary (and often mixed) metaphors–“weapons of mass destruction,” “time bombs,” etc.   But the concept of systemic risk is never precisely defined, nor do the advocates of clearing of OTC derivatives present any serious argument as to how a CCP would reduce that which is scary (but undefined.)

Typically, the argument stops at “a CCP would net which would reduce replacement costs in the event of a default, thereby lowering the costs that other dealers pay when one dealer defaults.”   That argument is incomplete, not generally true, and arguably false.   It fails to recognize that netting just redistributes default costs from derivatives counterparties to other creditors, some of whom may be systemically important; it does not consider that the formation of a CCP may increase the sizes of positions that traders hold, thereby increasing the potential for default losses; it ignores the effects of a change in risk allocation on asymmetric information and the incentives to monitor counterparty risk; it overlooks the fact that a CCP, by effectively guaranteeing customer positions, requires dealers that are members of a clearinghouse to bear the costs of a defaulter’s entire net position (including trades done with non-member customers), rather than merely their direct trades with the defaulting member.

If systemic risks are an increasing function of the default losses that dealers incur, it is a straightforward exercise to create examples in which such losses (and hence systemic risks) are higher, rather than lower, with a CCP.   This is true even if one ignores the effects of asymmetric information.   The monomoniacal focus on netting obscures the myriad effects of the mutualization of default risk, and leads to a wild overestimate of the efficacy of clearing in reducing systemic risks.

The government forcing grain traders or metals traders to adopt an inefficient method of allocating default risks is bad enough, but the social costs of these actions were likely bearable because these markets were small in the scheme of things.   Forcing the adoption of clearing in the massive OTC financial derivatives markets is another thing altogether.   Here the costs of a mistake could be huge.   The incomplete and faulty analysis that is being used to justify the creation of a CDS CCP greatly increases the odds that its adoption would in fact be such a mistake.

The seeming compulsion to “do something” in the face of a burgeoning credit crisis threatens to hasten the implementation of an ill-considered plan with major systemic consequences.   Let’s hope that that compulsion is replaced by contemplation and measured action before it is too late.

November 21, 2008

Just as I Suspected

Filed under: Derivatives,Economics,Exchanges,Politics — The Professor @ 3:45 pm

My post yesterday on Senator Harkin’s derivatives bill was based on the WSJ report. Michael Giberson at Knowledge Problem kindly provides a link to Harkin’s full statement (and even more kindly links to SWP.) And wouldn’t you know, as I suspected, Harkin indeed quoted the Sage of Omaha’s “Weapons of Financial Mass Destruction” yadda yadda, and adds some hyperventilating of his very own:

My bill will end the unregulated ‘casino capitalism’ that has turned the swaps industry into a ticking timebomb. And it will bring these transactions out into the sunlight where they can be monitored and appropriately regulated.

“Casino capitalism.” “Ticking timebomb.” “Bring these transactions out into the sunlight.” How trite: that scores very low on the originality scale, senator. Like a zero.

How about a serious comparative analysis of the costs and benefits of alternative trading mechanisms for different instruments? How about at least a moment of silence to ponder the questions: “Why have these markets evolved in this fashion, with a diversity of trading methods for a variety of different products?” and “What makes me so much smarter than the market?” and “What specific market failure (externality, collective action problem, etc.) is at work here, and how does forcing everything onto an exchange fix it?” and “Gee, we tried this before, and it created all sorts of problems, so why should we expect it to work any better now?” How about a recognition that market participants with very high powered incentives in fact spend a great deal of effort and money to monitor counterparty risks?

The issues here are very, very, very complicated. There are myriad moving pieces. I certainly disclaim any divine insights as to what the best way to organize derivatives markets. But I can make a plausible case based on a comparative analysis grounded in an understanding of basic economic considerations that there are very good reasons for trading some things on exchanges subject to centralized clearing, and to trade other things on bilateral OTC markets without clearing. A debate over the appropriate regulatory framework should focus on these kinds of considerations. Maybe such a debate will lead me–and others–to conclude that there are remediable problems in the way that markets are organized, and to identify the most efficient fixes. One thing for sure, however, is that cheap, lazy, hackneyed, grandstanding, and fact-free bloviations about “casinos” and “timebombs” are hardly the basis for re-engineering markets involving billions and perhaps trillions of dollars.

Well, Well, Well

Filed under: Derivatives,Economics — The Professor @ 3:08 pm

Yesterday I made a snarky comment about Warren Buffet, and the fact that CDS spreads on Berkshire-Hathaway have blown out. The stock price of B-H has also tanked too.

Buffet, of course, turned the phrase that every lazy derivatives critic has used to make cheap points: “Weapons of financial mass destruction.” Buffet made this comment after one of his companies suffered big losses on derivatives trades.

The cynic in me (or should I say, “me, the cynic”–paging Lily Tomlin again) has always harbored a suspicion that Buffet’s reasoning was “I’m really smart, and of course it can’t be my fault that these derivatives were a bad bet–so it must be the derivatives’ fault, not mine.”

Well, apparently Buffet doesn’t believe his own diagnosis: Berkshire-Hathaway has lost large sums by shorting equity index puts. Whoops. Actually, double whoops. Sure, B-H collected the premium, but it was all downhill from there as (a) the decline in stock prices, and (b) the big spike in volatility both drove up the value of index puts–and hence caused the seller (B-H) to lose money. There are now some murky issues relating to collateral and Goldman Sachs that are raising doubts about B-H.

This is the financial equivalent of Jimmy Swaggert or Elmer Gantry–the moralistic crusader revealed to have committed the sins against which he had famously railed.

Not that I consider selling puts a sin–as a consenting adult, you pays your money, you takes your chances just like anybody else. Just don’t come whinging to me or the world or the regulators or whomever when it doesn’t break your way. In other words, take it like a man, Warren.

B-H is an insurance company, and by selling puts it allowed others to insure against stock price declines and volatility increases. That’s a good thing. Sometimes insurance companies collect premia, and pay off much more than they expected–that’s the nature of the business.

The key difference here is that the typical insurance model is to manage diversifiable risks (e.g., fires, car accidents) through pooling. But stock indexes are not diversifiable risks; they are systematic ones, almost by definition. They don’t go away by pooling. AIG essentially made the same mistake; its huge CDS position on CDOs imposed substantial systematic risk on the firm. Thus, both B-H’s and AIG’s strategies diverged from the insurance model.

It will be interesting to see Buffet’s explanation for this strategic choice.

Who You Gonna Call?

Filed under: Commodities,Economics — The Professor @ 1:35 pm

Whenever oil prices move a lot, I field a lot of calls from reporters. Oil prices plummeted yesterday, so I was interviewed by NPR (Morning Edition) and for local Houston TV news. So for today’s listening and/or viewing pleasure (and I use that term advisedly):

Here’s the link to the NPR piece. Here’s the Houston Channel 2 10PM News piece (there’s a video link to the right.)

The Houston reporter mis-spelled my name as “Perron.” Hey, lose an “r” and marry a scheming blonde, and maybe I can become dictator of Argentina!

Another funny thing about the Houston interview. We did it in front of my place at around 615 PM, so it was dark. I was staring into a bright light, making me feel like I was being given the third degree in an old film noire. A neighbor drove by, and seeing the TV truck and presumably thinking that local news was covering a murder or something, shouted to the reporter (Daniella Guzman)–“What happened? Anything the matter?” Daniella responded: “Just interviewing your neighbor, who is an expert on oil prices.” To which I added–“Well, I play one on TV.” Always wanted to use that line.

November 20, 2008


Filed under: Economics,Energy,Russia — The Professor @ 10:01 pm

An interesting article in the Moscow Times states that ConocoPhillips and ExxonMobil are negotiating with Gazprom to help the latter in the Yamal LNG project.   I know what you are thinking–Time to short CP and Exxon!   Are they out of their minds?   Investing in Russia with Gazprom?   Don’t they remember Sakhalin II?   BP-TNK?   Yukos?

But read a little bit deeper, and take a look at an accompanying article,   and it makes a little more sense.   Gazprom chairman Alexander Medvedev said: “Recently, we had a meeting with top managers of Conoco and outlined potential areas of cooperation. One of these areas [involves] the Arctic, both in the United States and Russia. … They are very similar.”   The accompanying article states:

Gazprom said it might explore offshore Alaska with ConocoPhillips as the gas exporter seeks to expand its global reach.

CEO Alexei Miller and his counterpart from ConocoPhillips, Jim Mulva, held talks Monday in Moscow, Gazprom said in a statement.

Gazprom, which supplies one-quarter of Europe’s gas, is seeking access to new markets in North America, and a delegation visited Alaska last month. Miller and Mulva on Monday discussed joint projects on international markets, focusing on liquefied natural gas supplies, the statement said.

“The experience of Gazprom could be beneficial in developing gas projects in the U.S.,” Miller said in the statement.

Miller said in June that Gazprom had approached ConocoPhillips and BP on joining their Denali pipeline project, aimed at delivering Alaskan gas to the continental United States. Gazprom sent eight executives, including Miller, to Anchorage in October, where they met with ConocoPhillips representatives.

My interpretation of all this is that it involves a Williamsonian exchange of hostages.   Yes, maybe US majors will invest in Russia, but at the same time Gazprom will invest in the US.   If Russia expropriates the western firms, they will have a hostage that they can seize in return.

The critical thing will be to craft the agreement and contracts so that Gazprom’s investment can truly be seized if Russia/Gazprom attempts to steal the western firms’ investment in Russia.   Russia has already shown great creativity in finding ways to expropriate assets–even from its own.   Yukos–taxes.   Uralkali (perhaps)–safety investigation.   Mechel (perhaps)–antitrust.   Sakhalin II–environmental violations.   BP-TNK–immigration issues, license revocations.   It will be a challenge to write an agreement that defines expropriation sufficiently broadly so as to encompass all the various schemes that the Russian government–and the country’s pliant courts–could use   to effectively expropriate western investments in Yamal, or make the transaction so unpalatable that the western majors are forced into selling their stake at a distressed price.   (Perhaps one clever thing to do would be to preclude any Russian firm from buying the stake in the future.)   Even then, there is the challenge of dealing with the asymmetry between Russian and western courts.   Gazprom would almost certainly get a fairer hearing in any western jurisdiction than any western firm would get in Russia.

Perhaps no deal will get done.   But the I’ll-invest-in-yours-if-you-invest-in-mine approach is quite revealing.   It indicates that Putin’s and Gazprom’s past actions have affected the thinking of western firms.     They understand the nature of the expropriation risk, and are dealing with it by going medeival: that is, by exchanging hostages the way knights and dukes and kings did in the days of yore.

The discussions are revealing in another way.   They represent a dramatic turn away from Gazprom’s go it alone bravado of 2007 and earlier in 2008.   Their tune then: Western investors?   We don’t need no stinkin’ western investors.     Their tune now: come on over!   We could use the help.   This is indicative of (a) the effects of the financial crisis on Gazprom’s ability to finance these huge projects, and likely (b) Gazprom’s recognition of its technical capability to complete these challenging projects and its desperate need for new gas supplies to offset its declining production and large delivery commitments.

It’s amazing how rapidly things can change.   But CP and XOM and BP should recognize that things can change right backagain.   Therefore, I suggest that they craft their hostage agreements very, very, carefully.

Back to the Future, Futures Edition

Filed under: Commodities,Derivatives,Economics,Politics — The Professor @ 7:52 pm

Senator Thomas Harkin (D-for-don’t even need to ask, IA) has introduced legislation that would require all derivatives trading activity to take place on a futures exchange regulated by the CFTC.

That’s a really dumb idea, even from a senator.

The rationale for this move is somewhat inscrutable.   Harkin said:

The economic downturn in this country is forcing us to examine all contributing factors on our markets.   With the value of swaps at a high of some $531 trillion for the middle of this year — 8 1/2 times the world GDP [gross domestic product] of $62 trillion — it is long past time for accountability in the markets.

Can you say non sequitur?   I knew you could.

The Solon of the Sow Belt continued:

By regulating all futures contracts, the Derivatives Trading Integrity Act restores confidence in the markets and provides the soundness and integrity the financial system needs

And just how does it do that?   Does your assertion make it true, Senator?

Market participants and the instruments they trade are heterogeneous.   This heterogeneity can–and almost certainly does–make it efficient for multiple, differentiated trading platforms to exist side-by-side.   Heck, even the most homogeneous of financial instruments–the stock in a particular company–trade on different types of trading mechanisms in order to meet the diverse needs and preferences of investors with different information and preferences regarding the rapidity with which they want to trade.   Closely related instruments can trade on a variety of platforms.   For instance, cash Treasuries and Treasury futures trade using very different mechanisms.   In a nutshell, it is desirable to allow the development of a variety of different trading mechanisms (microstructures) to permit a discriminating match between the characteristics of the mechanism and the characteristics of the instruments and their traders.

Forcing a one-size-fits-all trading approach completely ignores this heterogeneity.     It will impose costs on market users, and may even serve to undermine their soundness and integrity.

I’ve argued repeatedly that with respect to clearing (i.e., default risk sharing) in particular, there is a strong case to be made that some instruments should be centrally cleared–but some should not.   Central clearing provides benefits, but it comes with costs due to asymmetric information.   Indeed, since market participants internalize most of the benefits from clearing, they have a strong incentive to adopt it unless there are even larger costs.

With respect to the soundness of the financial system, forcing central clearing can increase systemic risk.   Clearinghouses don’t price dealer balance sheet risk–dealer counterparties in bilateral OTC markets do.   Dealers typically have better information about the creditworthiness of their counterparties than a clearinghouse will.   Thus, they can price default risk more accurately.   Clearinghouses treat all members as if they are the same–even though they are not, having different balance sheet risks, for instance.   This equal treatment of the unequal tends to divert trading activity towards riskier firms more likely to default.   Reductions in collateralization reduce trading costs and encourage an expansion of trading activity.   At best, clearing redistributes the default losses, and this redistribution (away from derivatives counterparties to dealers’ other creditors) can exacerbate, rather than reduce systemic risks.

Market participants recognize all of these effects.   They imply that there are costs to central clearing, and the fact that OTC market participants have not adopted clearing for many derivative products is strong evidence that these costs exceed the benefits that clearing would provide them.   They certainly know more than a certain senator from Iowa.

There is a case to be made for creating a centralized database of derivatives trades.   This can be done, however, without forcing everything onto exchanges, or requiring clearing.

There is also zero evidence that the current financial problems were in any way caused by OTC derivatives trading.   Of all the implosions of financial firms, only AIG’s was directly attributable to derivatives trading.   Moreover, the much feared knock-on effects from the failure of a big derivatives dealer have yet to materialize, and won’t in my view.   The biggest problems in the financial system are attributable to securitization, and the collapse of real estate prices.   These, in turn, are traceable to a variety of sources (e.g., the Fed, lax banks)–none of which are the OTC derivatives market.   So, when bloviating about “contributing factors,” it would be worthwhile for the senator to take a serious look at what those contributing factors actually are, rather than reflexively blaming derivatives.   His criticism echoes the common descripton of derivatives as “financial weapons of mass destruction.”   (And, by the way, (a) if I hear or read that expression one more time as a QED-end-of-argument-substitute-for-analysis, I just may go postal, and (b) if Warren Buffet is so smart and has avoided taking undue risks, why has the CDS spread on Berkshire Hathaway blown out?)   The substitution of conventional wisdom for serious thought is intellectually lazy, and a recipe for policy failure.

The funny thing (in the laugh-to-keep-from-crying sense) about Harkin’s proposal is that it harkens (I’m so punny) back to Congress’s first regulations of derivatives markets in 1921-1922.   At that time, Congress required all grain futures to be traded on a “contract market”–i.e., an exchange–registered with and approved by the government (USDA at that time, later the CEA and still   later the CFTC.)   So, rather than come up with something new, Harkin resurrects an approach first trotted out when Ford was actually a vibrant concern–and Henry Ford I was running it.   I thought we were in the era of change–silly me.

That approach caused no end of problems as the pace of financial innovation picked up in the 1970s and 1980s, as it became increasingly clear that not everything SHOULD be traded on an exchange.   This led to a sequence of Rube Goldberg-esque attempts to reconcile the irreconcilable–the exchange trading requirement and the fact that not everything was most efficiently traded on exchanges. The passage of the much (and wrongly) maligned Commodity Futures Modernization Act eliminated the confusion and legal risk that the old approach had created.

In brief, forcing a one-size-fits-all approach is doomed to failure because it fails to take into account the heterogeneity of financial instruments and financial market participants.   We have the proof of experience that it is doomed to failure.   But nonetheless, Harkin is playing King Canute, trying to force markets to conform to his will.   Good luck with that.   All it will do is create opportunities for lawyers–and undermine the efficiency and arguably the soundness of our financial markets.

I am sure that it is just coincidence that Harkin is Chairman of the Senate Ag Committee, which has jurisdiction over the CFTC–which, under Harkin’s bill, would have regulatory authority over every derivative traded from sea to shining sea.   Think of the campaign contributions!   The thought never crossed his mind, I’m sure.

Like Lily Tomlin said, we try to be cynical, but it’s hard to keep up.

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