Streetwise Professor

November 13, 2008

Don’t Look at Me–I Didn’t Say It.

Filed under: Military,Politics,Russia — The Professor @ 1:59 pm

But I do agree. From Strategy Page:

Meanwhile, Russians have this inferiority complex which is often expressed by aggressive behavior. It’s nothing new. During the communist period, the bad behavior was hidden by a façade of communist revolutionary rhetoric. But now we’re back to where we were a century ago, when the czar was in charge. Go read some of old newspaper stories from back in the day, and you’ll find that the Russians are picking up where they left off. The communists came and went, but Russian paranoia and threats prevail.

November 12, 2008

SWP a la Russe

Filed under: Economics,Politics,Russia — The Professor @ 10:03 pm

Paul Goble reports on some Russian voices that sound suspiciously like the SWP:

Vienna, November 12 – After first trying to deny that there was a crisis in Russia and then blaming it all on events in the West, the Russian government has taken measures that are exacerbating the situation in ways that threaten to create a revolutionary situation, according to an increasing number of Russian commentators.

And while some of these suggestions reflect the apocalypticism characteristic of much Russian political discourse, the arguments they offer and the evidence they provide in support of their views merits attention particularly as that country faces more problems ahead given rising anger among both key elites and the population as a whole about what is going on.

One of the most thorough and thoughtful analyses of just how serious the situation may be becoming is offered by Dmitry Tayevsky, an analyst who writes for the portal. He argues that the foundation of the current crisis in Russia reflects “not economic problems but serious administrative miscalculations” (

By attempting to deny that there is a crisis in Russia, he says, Moscow simply created a situation that gave birth to rumors that are having a more negative impact on that country than the truth would have. And then by trying to blame everything on the international financial crisis, the regime acted in ways that may help in the West but that makes the situation in Russia worse.

“The massive supply of money to enterprises belonging to those close to the Kremlin was like fighting fire with gasoline,” Tayevsky continues. “Such actions hardly will save the economy,” but they are already generating “massive dissatisfaction among others” who are not receiving such funds and thus are condemned “to economic and some to political death.”

Moscow has relied on oil and gas industries to provide it with super profits, but the operators of the companies involved have not invested money in finding new deposits and now, with oil and gas prices dropping, they are no longer profitable. And, the Irkutsk analyst continues, they are beginning to “eat themselves alive.”

One way that Moscow might have gotten out of this situation was to go “along the path of banana republics,” by allowing Western firms to build what Russians were not. But because the Russian marketplace was never attractive – Russian power holders have made sure of that – few in the West were willing to invest.

Some smaller reprocessing and manufacturing companies have emerged but with the banking crisis, they no longer have the liquidity to operate at earlier levels, forcing many of them to stop paying their employees or even letting many or in few cases all of them go – or, still worse from the point of view of social stability, hiring guest workers at even lower wages.

“In Russia,” Tayevsky notes, “the Jews and the United States are always the guilty parties,” at least according to the media and the popular mentality. But “in this case,” the guilty are to be found in the government – and “not the government of Chubais and Gaydar … but in the existing Putin-Medvedev regime.”

Among their mistakes are “ineffective investment of money the country has received from the sale of raw materials abroad,” the intentional disregard of the development of manufacturing, the corruption of society, and the continuing denial of the existence of problems everyone can see.

What should be done? Individual Russians should certainly avoid panic, but there is clearly a need for extraordinary measures, including the possible formation of a provisional crisis government that could address the current problems rather than continue to engage in public relations stunts.

But that is not going to be easy or without risks, Tayevsky concludes with regret, noting that “of course there will not be a crisis in Russia. There will be something immeasurably worse. But decent words for what it will be have not yet been devised at least in the Russian language.”

It would be a big mistake to ignore his argument. Others are making a similar case. An article on the site yesterday says that “the most important thing for the country is to avoid a social explosion,” something that it suggests is becoming ever more difficult as more and more people find themselves at risk (

Other analysts are pointing to rising tensions among various social and ethnic groups ( And perhaps most immediately seriously of all, ever more people are reporting rising tensions between the government and the military, the force on which the regime would have to rely (

The list of such baleful commentaries could be extended almost at will, and one, intended to highlight how much the Russian people and the Russian state have gained since the August 1998 default perhaps unintentionally highlights just how dangerous the situation is or may soon become.

In an essay posted online today, Valery Tishkov, the head of the Moscow Institute of Ethnology and a member of the Social Chamber, describes the last ten years as “the intercrisis decade,” a term that suggests the frightening past that many Russians hoped to escape may be replaced now by something even worse.

And he begs people to remember that over this period, there has been “a real improvement in the conditions of the lives of people even if emotionally and psychologically, the people of Russia continue to live in the paradigm of crisis and the rhetoric of complaint” (

Tayevksy’s comment is of particular interest:

By attempting to deny that there is a crisis in Russia, he says, Moscow simply created a situation that gave birth to rumors that are having a more negative impact on that country than the truth would have. And then by trying to blame everything on the international financial crisis, the regime acted in ways that may help in the West but that makes the situation in Russia worse.

Sounds familiar. As does this remark:

“The massive supply of money to enterprises belonging to those close to the Kremlin was like fighting fire with gasoline,” Tayevsky continues. “Such actions hardly will save the economy,” but they are already generating “massive dissatisfaction among others” who are not receiving such funds and thus are condemned “to economic and some to political death.”

In other words, went the rents go away, the glue holding everything together dissolves, and the situation threatens a war of all-against-all, for what’s to lose when you’ve been “condemned ‘to economic [or] political death”?

As Goble says, the arguments border on the apocalyptic, but in the current circumstances, the apocalyptic is not absurd.

Suspicious Minds

Filed under: Commodities,Economics,Politics,Russia — The Professor @ 9:53 pm

I find it somewhat curious that the Russian government would bail out the oligarchs by giving them state funds to pay off their debts to Western banks. If the ultimate objective of Putin, Sechin, and other siloviki is to reverse loans-for-shares, and effectively re-nationalize large corporations, there is a much more cost effective way to do so.

The shares of Deripaska, Fridman, and the others are held as collateral against their FX borrowings from Western banks. The fact that these oligarchs are facing collateral calls in the aftermath of plummeting stock prices means that the amounts due on the loans exceeds the value of the shares, and almost certainly by a lot. Giving state funds to meet the collateral calls means that the state is effectively keeping the shares out of the bankers’ hands by paying the higher prices that prevailed at the time the loans were taken. If the oligarchs default on the loans from the state, sure, the shares will fall into the mitts of Sechin, etc., but a lot of cash will have gone out the door to achieve that end.

So, why not let the oligarchs twist in the wind, default on their loans, and deliver up the share collateral to the banks? I doubt the banks have the slightest interest in holding large positions in these companies on their books. They’ll want to sell. Then use the state funds to swoop in and buy the stock at the current, depressed prices.

That’s a lot more cost effective than effectively paying the high prices at which the oligarchs margined the shares.

To summarize: Loan to the oligarchs, oligarchs default–the state gets the shares and pays the high price at which the shares were margined. Let the oligarchs default to the banks, buy back the shares at the current low prices. Result: Russian government gets the shares under either scenario, but pays a lot less to get them in the second one.

Doesn’t seem like a hard call.

Which suggests something else is going on.

One surmise: if Western banks get a large position in these companies for even a short period of time, they’ll want to do due diligence before selling their positions. That would involve pesky accountants turning over rocks, investigating contracts, examining subsidiaries, and in general, finding out where the cash comes in and most importantly where the cash goes out. Sure, Russian courts would attempt to stymie the process, but there’s no doubt that said accountants would discover some very, very interesting things. And we can’t have that, can we?

So, this suspicious mind hypothesizes that the ulterior motive for keeping the oligarchs’ shares out of Western hands at any price is that by failing to do so, Putin, Sechin, et al would run a serious risk of having some major tunneling schemes laid bare. And any guesses as to where those tunnels lead?

As for the argument that these companies are Russia’s “crown jewels”–please. I would be embarrassed to admit such a thing. RusAl is an aluminum company, for crissakes. Is Alcoa an Ameican crown jewel? If that’s the kind of company that is Russia’s hope for the future, things are worse than even I thought. Norilsk Nickel? Well, that’s a little better than aluminum, but not much. Steel companies? Come on, this is 2008, not 1938 or even 1958.

It is always suspicious when somebody seems anxious to pay more for something than they have to. That’s what the Russian government is doing by bailing out the oligarchs. The only thing the bailout seems to accomplish is keep prying eyes away from the books and operations of the oligarchs’ companies. I have a very difficult time of thinking of any benign reason why anybody would pay such a high price to do that.

Worser and Worser

Filed under: Economics,Energy,Russia — The Professor @ 8:27 pm

From America’s financial problems, to Russia’s. Hard as it is to believe, given the depth of our miseries, that is not an improvement. To the contrary.

Where to begin?

How about the Ruble. It is widely recognized that Ignatyev’s waffling on the Ruble was a blunder. Not that statements that Russia was preparing to defend the Ruble to the last ditch would have been credible, but the attempt to be a little bit pregnant won’t have any effect on the course of the currency, and calls into serious question the competence of the central bank, and the government. Hopes that the currency will decline gradually are pipe dreams. If speculators are convinced that (a) Russia will not put its reserves behind a defense of the Ruble, and (b) the government is reconciled to a decline in the Ruble in the future, they will make the future now and mount an attack on the Ruble. If the central bank tries to stem a speculative attack and slow the rate of decline by selling dollars and euros and buying Rubles, it will burn through reserves, and for nothing–because sooner or later the fundamentals of capital flight and a current account deficit will prevail and drive the currency lower.

What’s more, if those dollars and euros are spent attempting to slow–but not stop–a Ruble decline, that’s fewer dollars available to pay back dollar and euro denominated debt. Now this is primarily private debt secured by equity in Russian firms, but as has been discussed often on SWP by me and Michel, Putin et al are loath to let the collateral fall into Western hands. But if the reserves are frittered away in a futile attempt to defend the currency against registering the reality of bad fundamentals, they won’t have a choice, and there will be widespread defaults. One can only imagine the extralegal means and judicial legendermain that the oligarchs and the government will use to keep their paws on the collateral. This would turn into a diplomatic and political catastrophe, rather than merely an economic one. And who knows what hard, desperate men will do when their backs are against the wall?

The market is sending signals that the worsening situation has substantially increased the prospect of default by the government and big corporations. From Bloomberg (article linked above):

Credit-default swaps on Russian government bonds jumped to 7.82 percent of the amount insured from 6.14 percent yesterday, according to CMA Datavision prices. The yield on its 30-year dollar bonds increased to 10.47 percent from 9.1 percent, according to Bloomberg prices.

. . . .

The cost of protecting against a default by OAO Sberbank, Russia’s largest lender, surged to 8 percent from 5.65 percent, while credit-default swaps on OAO Gazprom, the largest company, increased to 11.5 percent from 9 percent.

Credit-default swaps, conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. An increase indicates deterioration in the perception of credit quality.

Sberbank bonds plunged, sending the yield on five-year notes due 2013 up 210 basis points to 16.69 percent, Bloomberg prices show.

Sberbank’s stock fell 8.5 percent on the RTS today, and closed at $.92–not at its recent low, but damned close. And remember Sberbank is one of the banks that the government has favored, and pumped full of money. Another favored bank, VTB, was down over 22 percent.

The only other tool available to fight the Ruble decline is a sharp rise in interest rates. And the central bank pulled that tool out of the shed today. The problem is that it is a very costly tool to use. It will make it costlier for Russian firms and individuals to borrow, and cause a slowdown in the economy.

The stock market continued its slide, with the RTS down 13 percent today, 15 percent on the week. It was worse on the RIOB index of Russian stocks in London (which is not affected by the now-we’re-open-now-we’re-not shenanigans of the Moscow markets). This index was down 17.5 percent today, and 36.51 percent since 11/6/08.

And oil? Urals Med was down to $51.28/bbl. Kudrin is reconciled to oil $60/bbl or below for 2009-2011 ($50/bbl for 2009, $55/bbl for 2010, $60 for 2011.) That prospect, of course, is a major driver of all of the bleak news discussed earlier.

Whichever way Medvedev or Putin or Kudrin or Ignatyev turn, they face stark choices. Protect the Ruble–burn through the reserves or throw an already wobbly economy into a tailspin by jacking interest rates. Let the Ruble fall–serious potential for political unrest and the almost certain destruction of Putin’s credibility and reputation as the man who restored Russia from its last default. Bail out the oligarchs–say goodbye to dollars and euros. Let the oligarchs default–say goodbye to Russian control over the “crown jewels” of Russian industry, or keep control of them by repudiating foreign commitments and forget about foreign capital for a long time to come.

I think that the likely outcome is that Russia will not try to fight fundamentals, and will let the currency drop. Even if it drops like a stone. That would be the smart thing to do. As painful as the devaluation of 1998 was, it was a necessary condition for the economy to recover, and it did so in the 2000s.

But this will put tremendous domestic pressure on Putin and Medvedev. It will make them liars in the eyes of Russians across 11 time zones. But the problem they face is that attempting to defend the currency will only delay the day of reckoning, and leave them in a weaker position to deal with the fury.

And that is the danger of demanding and obtaining near absolute power, and depriving the citizenry of any meaningful political safety valve. When things go bad, everybody knows exactly whom to blame. That’s what makes a political system brittle.   And that is why there is a much greater potential for a political explosion in Russia than in the US or Europe.

Died of a Theory

Filed under: Derivatives,Economics,Politics — The Professor @ 7:39 pm

Hate to say I told you so, but . . .

Today Treasury Secretary Henry Paulson confirmed what pretty much everybody had figured out: The Treasury will not buy troubled assets under the TARP program. TARP monies have gone primarily to buying equity stakes in banks.

Paulson said “[o]ur assessment at this time that [the purchase of troubled assets] is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role, relative to other uses of TARP resources, in helping to strengthen our financial system and support lending.” In other words, don’ t hold your breath.

Back in September I expressed extreme skepticism at the theory underlying the TARP program, and questioned many of the proposed implementation schemes. I was not alone. Paulson just validated these judgments.

With TARP funds running low, Paulson is now resorting to investment banker-speak to plead for private capital infusions to complement TARP investments in banks: “We are carefully evaluating programs which would further leverage the impact of TARP investments by attracting private capital through matching investments.” “Leverage the impact.” Yuck. English, please.

This communicates an air of desperation. It’s no surprise that the market was down about 5 percent today in the aftermath of Paulson’s remarks.

This whole fiasco reveals that government recapitalization of banks is a necessary, but not a sufficient condition, to restore stability to the financial system. It is also imperative to clean up banks’ balance sheets by addressing the toxic asset problem. Laurence Kotlikoff, Perry Merhling, and Alistair Milne made a similar point on an FT blog last month but I do not believe that their plan for the government to insure the “AAA” rated CDO tranches on banks’ books goes nearly far enough. This will restore the value of some collateral, but not all of it. Moreover, it will not kickstart the price discovery and revaluation process that is necessary throughout the entire system. It also represents a substantial additional taxpayer funding commitment.

So. . . I keep coming back to Humpty Dumpty. Go ahead. Call me obsessive. I can handle it. I know it’s radical, but nothing else on offer gets to the heart of the matter. That dark heart is the complex optionality in all of the stuff churned out by Frankensteinian financial engineers. If that complexity is not undone, these assets will continue to contaminate balance sheets from sea to shining sea–and beyond.

I ran the idea by someone in a position to do something about it. I was forthright about the pitfalls of the idea–the difficulties in valuation and the extraordinary powers involved. He basically patted me on the head, and told me to go back to the ivory tower, saying that these problems made the plan a non-starter. Fair enough. I understand that response.

But that was October 18th. Four weeks have past. TARP is in a shambles. The Treasury has committed billions, and is running out of ammunition. The AIG bailout has been bailed out. The line of mendicants asking for handouts is stretching as far as the eye can see. Although certain indications from the inter-bank market suggest that the extreme panic has subsided, the renewed swoon in the stock market, led by crashing bank stocks, makes it painfully clear that the situation is still fraught with danger, and that the direct government injections of cash has not solved the crisis. Something more is needed, and soon.

Humpty has numerous virtues which, in my view, more than outweigh its defects. To repeat:

  • It does not require a commitment of taxpayer funds, and does not subject the taxpayers to adverse selection.
  • It will facilitate the restructuring of mortgages.
  • It will improve the liquidity of troubled assets by destroying the complex optionality that saps liquidity. This will increase asset prices, and thereby increase bank capital.
  • It will improve the transparency of bank balance sheets by replacing heterogeneous, impossible to value securities with a homogeneous claim that will almost certainly trade much more easily and efficiently than the existing troubled assets. This improved transparency will reduce the difficulties that private lenders and investors face in valuing banks, which will in turn reduce frictions in the inter-bank market and facilitate the re-capitalization of banks. It will also help the government identify which banks are in greatest trouble, and respond accordingly.

If Paulson wants to attract private capital to banks to complement government investments, it is imperative that potential investors know what they are investing in. This requires a quantum improvement in the accuracy of the valuations of the assets on bank balance sheets. He has just admitted that TARP as originally conceived won’t do that. Humpty has the best shot to do so. Without aggressive action to attack the troubled asset problem, Paulson’s call for additional private capital will be a pitiful plea that falls on deaf ears.

Yes, Humpty Dumpty poses serious challenges. But in my view it is, to paraphrase Churchill, the worst way to deal with troubled assets, except for all others that have been tried or proposed from time to time.

November 11, 2008

More on the Nerpa

Filed under: Military,Russia — The Professor @ 9:50 pm

Stratfor has some interesting material on the incident aboard the Nerpa:

The incident reportedly took place in the bow of what Stratfor and most other sources believe to be the Akula I-class Nerpa (K-152), where the torpedo tubes are located. [I doubt it was in the bow. The bow in modern subs is devoted almost exclusively to sonar equipment. Torpedo tubes are amidships. SWP] The Russian navy insists that the casualties resulted from a malfunction or the inadvertent activation of the sub’s fire-suppression system, specifically citing crew exposure to freon.

In 2000, it was an incident involving the leak of the flammable hydrogen-peroxide fuel of a training torpedo that resulted in an explosion that sank the Russian Oscar-II class submarine Kursk (K-141) and killed nearly 120 Russian sailors. Given the hydrogen-peroxide propellant and high-explosive warheads of the torpedoes stored in the bow of any Russian submarine, a fire originating there could quickly endanger the entire ship. In the case of the Kursk, the time from the ignition of the leaking hydrogen-peroxide fuel to the catastrophic explosions that destroyed the bow (and consequently sank the entire submarine) is thought to have been less than a minute.

Though the Russian navy is reportedly removing the specific type of torpedo involved in the Kursk incident from service, hydrogen-peroxide fuel is still used by many navies, including Russia’s. Were a fire to have broken out in this case, the commander — mindful of the lessons of the Kursk — would have likely felt compelled to act aggressively to quell the blaze, even if personnel could not evacuate the compartment completely.

Aggressive fire suppression is an essential tool of the submariner’s trade. Modern submarines include fire-suppression systems that use chemical compounds to extinguish fires. The U.S. Navy, for instance, uses halon to suppress fires. Though excellent at fire suppression and comparatively safe, these systems are expensive. More affordable systems can use freon compounds, which displace oxygen and carry a greater risk of suffocation.

. . . .

Should the Russian navy be functioning at some level of proficiency and competence, then the “malfunction” would likely had to have been more than just an accidental bump or nudge of a dial. But ultimately, while the Russian navy’s official story could be plausible under the right circumstances with the right chemical compounds in play, we cannot help but think that — with more than 200 people aboard — something more was going on.

Lot of guessing here, especially regarding the possibility of a torpedo fire, which I highly doubt. Interesting claims: 8 plus years after the Kursk disaster, the Russian Navy is still in the process of removing H202 fueled torpedoes from service, and the use of freon as opposed to halon as a cost saving measure. (Though I should note that after a little googling, I found that “Freon 13B1 is also known as Halon 1301.” Also, Halon is being phased out in many US defense applications.)

So, the issue comes down to whether the fire suppression system was triggered to fight an actual fire on the Nerpa, or whether there was an accidental discharge, either during testing or due to a faulty system or operator error. Any way it happened–it shouldn’t have.

I’ve been harsh about Russian shipbuilding capabilities in some past posts. I should note that American naval construction is also facing serious problems. The recent problems with the supposedly state-of-the-art USS San Antonio (LPD-17) are inexcusable and shocking. Similarly, the litany of cost overruns and construction errors in other shipbuilding programs (e.g., the Littoral Combat Ship) are a disgrace.

Thanks, Natasha Dahlink*

Filed under: Derivatives,Economics,Exchanges,Politics — The Professor @ 9:26 pm

I truly admire Natasha de Teran’s reporting on derivatives markets. Her work is head and shoulders above everybody else’s. If you are interested in these markets you should read her in efinancialnews (registration required).

Yesterday Natasha gave some very nice coverage to my work on clearing. She does a very good job at condensing the avalanche of words I’ve written on the subject on SWP into a concise, accurate, and readable summary. Moreover, she adds a couple of very illuminating stories that provide excellent real world (and near real time) illustrations of some of the pitfalls I’ve been writing about.

Thanks again, N. Hopefully this will increase the visibility of some of the concerns I’ve raised as the CDS clearing express train roars down the tracks. (Matt Leising of Bloomberg tells me that there is an MOU in place to give the Federal Reserve primary regulatory authority over a CDS clearinghouse, and that President Bush will announce this at as part of a plan to be announced at a gathering of world leaders to discuss the financial crisis later in the week.) Rushing ahead without giving adequate considerations to these issues could lay the groundwork for greater problems in the future.

* Apologies to the Rocky and Bullwinkle Show. And Natasha de Teran has nothing in common with Natasha Fatale. Especially the accent;-)

Given the difficulties that some folks have had getting access to the article, here it is:

OTC clearing as a cure-all could be OTT
Natasha de Terán
10 Nov 2008

The promotion of clearing as a cure-all, tax on and apology for the over-the-counter derivatives industry is a neat one – but history demonstrates it may not act effectively as any of those things, and specialists worry it could do far worse.Regulators, when caught on the back foot, habitually rush to put out directives and convince lawmakers to rubber-stamp them at the double. Frequently such measures are ill-thought-out, delivering little more than a short-term injection of credibility and a longer-term expansion of their authority.

The participants, in this case the banks, will counter that their markets are self-correcting and that alternatives of their own devising will better assuage any regulatory concerns. Often their principal concerns are to protect their vested interests and preserve the status quo.

And when, between these poles, merchandisers – in this case the exchanges – spring up claiming to have devised tools to resolve this conundrum and boasting that their particular version is superior to those of their rivals, it is the profit motive that is generally their paramount concern.

As a result, and although all of the above groups’ claims about OTC clearing have some weight, they should be seasoned with healthy doses of scepticism. For when an experienced academic, with acknowledged expertise and no skin in the game, weighs in with serious concerns about the proposed rules, the participants’ interpretation of them and the suitability of the apparatus on offer, it is time to sit up and pay attention.

Craig Pirrong, a finance professor and director of the energy institute at the University of Houston, has spent his career studying derivatives markets, exchanges and clearing houses. Recently he has been giving a lot of thought to the issue of over-the-counter derivatives clearing – and he is far from convinced that rushing to clear OTC business is going to help anything. Worse, he worries that it could cause serious problems.

At the risk of being too simplistic, his principal concerns could be boiled down to one issue: that of information asymmetries.

First, he worries that clearing members could have better information about the price of OTC risks than a central counterparty that clears them. When the CCP’s insurance of OTC risk is underpriced, they will avail themselves of it, and when it is overpriced they will not.

This will result not only in an incomplete insurance of OTC risk, but – in the extreme – it will make the risk-sharing device altogether inefficient.

Second he worries that clearing members might have better information about the balance sheet risks of other OTC players and be able to react more quickly to any real or perceived deterioration in their balance sheet strength than CCPs.

This is because the broad spread of members’ business activity with each other should afford them greater insight into their relative balance sheet strengths than a CCP would have. Also, CCPs do not typically charge for balance sheet risks. Instead, they determine criteria for membership based on capital levels, and then set thresholds for collateral postings based on the risks of the instruments the members hold in the CCP. That means that any two given members with the same portfolio, but potentially vastly different balance sheets, will post the same amount of collateral.

On the rare occasions when CCPs do attempt to address this balance sheet issue, they cannot use the soft and hard information mix that OTC counterparts rely on. Instead they must use transparent rule-based mechanisms, typically requiring members with lower credit ratings to post more initial margin than those with higher ratings. If this crisis has shown anything, it is that those ratings are nothing better than rudimentary laggard indicators of balance sheet risks.

Given the above, it is worth considering two things: where exchanges get their information from to price risks and what a counterparty active in both cleared and uncleared OTC markets might do about the perceived deterioration of another’s balance sheet strength.

First, pricing information. Clearing houses manage price risks by looking to liquid, transparent datapoints. In futures and options markets, they can do this easily by looking to the prices on listed markets. In the case of interest rate swap risk, such as that managed by LCH.Clearnet’s SwapClear, the pricing is based on a large number of liquid, observable prices that can be derived from multiple data points.

But when CCPs start clearing OTC credit derivatives risks, they will have much more limited data: they will have to base their assumptions on a smaller number of less liquid, less transparent variables and derive their pricing from just a few sources. In stressed scenarios they might not be able to mark to market at all. Instead they will be marking to model.

Second, what might a clearing house member do in the event they suspect that the balance sheet of other OTC counterpart and clearing house members is being unduly stretched? They could cease trading with that counterpart, they could require that the counterpart post surplus collateral to cover this risk, or they might continue trading with the counterpart but require all the OTC trades be novated to the CCP.

In doing so, they would be parking the unsavoury risk at the clearing house and buying “cheap” insurance from it.

Unlikely? Consider this. In the last few days before the Lehman Brothers collapse, two different behaviours were evidenced in the cleared OTC marketplace.

In the repurchase agreement market, a large dealer refused to take Lehman’s name even though the trade was going to be novated to LCH.Clearnet’s repoclear facility. The trader’s decision was predicated on the belief that Lehman’s counterparty risk was too bad to take.

Not only did he therefore not want to carry it himself, but also he didn’t believe that he should oblige others to share it with him.

In the swap market, another dealer is meanwhile alleged to have attempted to offload to LCH.Clearnet’s Swapclear facility a legacy portfolio of interest rate swap trades that he had on with Lehman. At that time LCH.Clearnet would have been more than aware of Lehman’s risks and would have been able to make an informed decision about whether the assumption of new risks reduced or added to the sum of Lehman’s risks.

In the event, the swap issue proved immaterial since the swap portfolio was not novated to the CCP, but this second incident clearly demonstrates the difficulties that might arise from information assymetries and the potential for abuse of risk-sharing mechanisms. Worse is this: if the actions of the swap trader were known to the repo trader, the latter’s incentive to behave prudently and shun the profit motive in favour of the co-operative’s greater good would have been eliminated.

Thus it is easy to see how the use of a CCP could encourage a wholesale adoption of this worst practice kind of behaviour – taken to the extreme, why would OTC market counterparts ever need to bother who they deal with if someone else is managing it and others insuring it?

Pirrong is a great advocate of clearing and he is also a supporter of derivatives, but his concerns about mixing the two into a ready-made soup are considerable. More OTC clearing could include the potential for excessive and irresponsible risk taking, the mispricing of risk and the exploitative use of information asymmetries.

Natasha tells me that the editor did some fine surgery with a chainsaw (my characterization), lopping off the last 400 words, hence the rather abrupt ending. But you all should get the drift.

Putin Plays King Canute, and Faces Hobson’s Choice

Filed under: Commodities,Economics,Politics,Russia — The Professor @ 9:01 pm

Vladimir Putin has sharply criticized businesses and individuals that have taken capital out of Russia. Central Bank head Sergei Ignatyev seconds that emotion.

Central Bank Chairman Sergei Ignatyev backed Prime Minister Vladimir Putin’s call for stricter banking oversight by government, law-enforcement and financial authorities amid capital outflow.

“When there is a significant capital outflow, a more effective, tighter oversight of the situation is needed,” Ignatyev said Monday in comments broadcast on Vesti-24. Net private capital outflow reached $50 billion in October, he said, citing preliminary estimates.

Lenders that have received government funds meant to boost liquidity in Russian markets are increasingly transferring money abroad, Putin said during a government meeting Monday, according to Vesti’s web site.

He also on Monday warned against “corporate egoism,” saying that emergency funding must work “within Russia, as intended,” he said, Interfax reported.

Putin and Medvedev clearly desire to step capital flight, and various ideas have been mooted to achieve that objective in the aftermath of the $50 billion outflow in October. All of these ideas involve the employment of state power in one way or another.

Rather than attempting to stop the flow through capital controls, or by exerting pressure on Russian businesses and banks, Putin, Medvedev, and Ignatyev would be better served by stepping back and asking: “Why is capital fleeing the country at such a rapid clip?” But then again, they probably wouldn’t like the answer. It is a vote of no confidence in the security of capital from the predations of the state, in the the government’s policies, and the country’s investment prospects.

After a week of relative quiescence in both Russia and the West, economic tremors are being felt again. We are not through the woods yet. In this environment, the relative vulnerability of Russia to investor yips and the resulting capital flight are pronounced. Putin can attempt to command the capital to stop, but it won’t. Indeed, the more he attempts to impose additional controls, the more he will frighten investors about the security of capital, and the more desperate and creative they will become in their efforts to get their money out. Putin will have no more success in stemming capital flight than King Canute did in commanding the tides to cease. (And I am aware that there are alternative interpretations of the Canute myth, one being that he issued his famous command to rebuke flattering courtiers. That’s definitely not Putin’s motivation.)

In other, related news, Ignatyev also conceded that the Ruble is likely to fall:

“I do not rule out more flexibility in the ruble exchange rate with some tendency toward a weakening of the ruble against some foreign currencies in the current conditions,” Ignatyev said.

That’s central banker-speak for “Going Down!” And the market reacted, right on cue, with the Ruble selling off almost 4 percent (for December delivery) on the CME, and the Ruble spot down about 1.8 percent.

Here’s my interpretation, FWIW. The currency is the most visible indicator of economic conditions and confidence in the Russian economy and the government’s management thereof. Regardless of what Russians see on TV, they will know things are not going well if the Ruble continues to depreciate. From an internal political management perspective, I doubt the government wants to see a substantial decline in the Ruble. Such a decline would alert people to the severity of the economic situation, give the lie to the soothing “it’s not our problem” rhetoric coming from the Kremlin, and represent a repudiation of the government’s management of the economy.

But macroeconomic considerations, capital flight, and especially the decline in the price of oil will make it extremely difficult to defend the Ruble. The fundamentals are not auspicious. Moreover, Russian corporations and oligarchs, including those near and dear to the Kremlin and the White House (on the Moskva, not the Potomac) owe substantial amounts–in hard currency–to Western banks. Margin calls and debt repayments will force Russia to choose between dipping into hard currency reserves to pay off the debt, or letting the companies fall into foreign hands.

Russia has large currency reserves compared to 1998, but the demands on those reserves are much greater too; state debts are much more modest, but private and corporate debt is massively greater, and is secured by assets that the Kremlin is loath to lose control of. I see the willingness to let the Ruble decline despite the political dangers this entails as an admission the $500+ billion in reserves is insufficient to defend the currency and pay off foreign creditors, especially in the face of a likely extended slump in oil prices. Given this Hobson’s choice, Putin and Medvedev have chosen to keep Russian companies in Russian hands, and to let the currency take care of itself; the political fallout will be managed by, uhhmmm, other means, most likely.

As I said some time back, the financial crisis is showing that “$570 billion can evaporate in a trice.” It may not evaporate in Russia, but it will decline steadily and perhaps precipitously in the coming weeks and months. And it is coming pretty clear that it will go primarily to Western banks to keep them from obtaining big stakes in Russian corporations, rather than to defending the currency. Ordinary Russians will pay a price, in terms of higher prices for imported consumption goods, and domestic substitutes.

November 9, 2008

A Sadly Familiar Tale

Filed under: Military,Russia — The Professor @ 10:29 pm

Russia, and before it the USSR, have suffered several very serious incidents involving their submarines. The most noteworthy of these was the sinking of the Kursk in August, 2000. Yesterday, another Russian submarine suffered a fatal accident, though the ship survived. While on a shakedown cruise, the Akula class boat Nerpa suffered a malfunction apparently involving a fire suppression system. There was reportedly a release of Freon gas into sealed compartments, resulting in the loss of 20 individuals. The dead were apparently civilian shipyard personnel on board to observe the operation of the boat during its cruise, and make necessary repairs.

The reports of freon gas are somewhat odd. Freon is a refrigerant. My guess is that this has been mis-reported or mis-translated. Halon gas is widely used as a fire suppressant, and perhaps this was actually what caused the deaths. Halon releases in tanks and armored vehicles have caused deaths of American servicemen, I believe.

The Nerpa is actually something of a mystery ship. Laid down during the USSR’s dying days in 1991, it remained uncompleted for lack of funds until recently. It is rumored that it was to be leased for 10 years to the Indian Navy–rumors that Russia has hotly denied. (You can surely take the denials to the bank.)

The safety record of the Soviet and Russian sub fleets is pretty appalling. There is a depressing litany of sinkings, deaths, catastrophic radiation leaks, etc. Russia has made a considerable effort to rejuvenate its moribund surface and sub fleets, in order to be able to stake a claim as a global, rather than merely continental, player. It has announced grandiose plans to expand its navy, especially its submarine and carrier forces. The deadly shakedown cruise of the Nerpa suggests that those plans may founder on the shoals of shoddy construction and operational carelessness.

Has Anyone Made This Point Before?

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

I know there are very few new things under the sun . . . but although I’ve read a great deal about clearing, I don’t think that I’ve seen anyone point this out: The main benefit commonly attributed to a central counterparty (CCP)–netting–effectively gives derivatives counterparties a priority in bankruptcy that they would not otherwise possess. As a result of the effective change in priority, the initiation of clearing transfers wealth from CCP members’ other creditors to their derivatives counterparties (who include CCP members.) That is, in dollar terms, formation of a CCP is not a positive sum game (although it can be from the perspective of the CCP members), but a zero sum game. CCP members win at the expense of the other creditors of their members.

This has important implications. Advocates of centralized clearing argue that netting reduces systemic risk by reducing the cost of replacing defaulted derivatives positions. In a bilateral market, counterparties must replace all of the defaulter’s out-of-the money positions; with a CCP, they replace only the net positions. Since replacement is costly (as the counterparties lose in-the-money positions and replace them with new ones of zero value), netting reduces the losses counterparties incur, thereby reducing the likelihood that the counterparties will in turn default; that is, netting reduces the susceptibility of the market to a “daisy chain” of defaults.

Or does it? What about the other creditors? Netting eliminates an asset: the dealer’s in-the-money derivatives positions that are net against some or all of its losing positions. Without netting, both derivatives counterparties and other creditors would have a claim on this asset. With netting, the asset disappears, meaning that the other creditors cannot use it to satisfy their claims against the bankrupt dealer. Thus, netting favors derivatives counterparties at the expense of other creditors.

This means that holding the dealer’s position constant, netting engineers a transfer of default loss, not a reduction of total default loss. It only does so when one considers only derivatives counterparties, and ignores the defaulter’s other creditors.

This has implications for systemic risks. Perhaps netting reduces the possibility that a dealer’s default will cause derivatives counterparties to default, but it increases the likelihood that its other creditors will face financial distress, and perhaps bankruptcy. The defaulter’s other lenders may include banks, hedge funds, money market funds, commercial paper investors, and so on. These lenders may also be systemically important, in the sense that their financial distress can have ripple effects, or trigger a cascade of subsequent defaults.

It is therefore by no means obvious that the ultimate effect of the formation of a CCP is a reduction in systemic risk exposure. Netting redistributes the wealth effect of a default. Unless derivatives counterparties are uniquely systemically important, netting can actually worsen systemic risks.

These points can best be illustrated by an example. Large dealers typically buy and sell the same contract in large quantities. For instance, a dealer may buy 1000 contracts and sell 500 of the same contract to different counterparties. This dealer has a net exposure of 500 long contracts.

In a bilateral market, the offsetting 500 contracts are not eliminated by netting. This has several implications. First, a firm with offsetting positions often has to post collateral on the both the purchased and sold contracts, even though some of those contracts offset (thereby resulting in no market risk exposure.) Since collateral is costly (because it requires the dealer to hold liquid instruments with lower yields than alternative investments), the firm incurs a cost on the offsetting positions that could be avoided if these positions were netted out. Therefore, given the positions held by market participants, the formation of a CCP that nets positions economizes on collateral.

Second, as shown by Jackson and Manning (2006), the lack of netting increases the costs of replacing defaulted positions. Consider a dealer in a bilateral market who is long 1000 and short 500 contracts. Assume that the dealer defaults when the long positions are a liability to him, and the corresponding 1000 short contracts are an asset to his counterparties, and his 500 short positions are an asset to the dealer. The counterparties must replace the contracts at the prevailing market price (at which the short positions they enter have zero values, and hence are neither asset nor liability.) This is an economic loss to the victims of the default, which is reduced by whatever they realize from their claim on the assets of the defaulter, which will be less than what they are owed. It is important to recognize that these replacement costs are incurred on the entire gross position of 1000 contracts.

In contrast, in a cleared market, replacement costs are incurred only on the 500 net positions. Thus, clearing and netting reduces the losses that the defaulter’s counterparties incur to replace the defaulted positions because fewer positions (and sometimes no positions) must be replaced.

It should be noted that this “benefit” from netting is in fact a transfer, rather than a true cost savings. In the absence of netting, the non-offset in the money positions (in the example, the dealer’s 500 short contracts) are an asset to the defaulting firm. This asset can be used to pay the defaulter’s creditors, including derivatives counterparties and others. Netting reduces assets and liabilities by an equal amount; netting reduces the claims against the defaulter’s assets, but reduces the assets by an identical amount. Thus, the total loss suffered by creditors does not change, although the allocation of the loss is likely to change.

In the context of the example, without netting shorts holding 1000 contracts must share with all the other creditors the defaulter’s remaining assets, including the defaulter’s 500 short positions. With netting, in contrast, shorts holding only 500 contracts must share with all the other creditors the defaulter’s remaining assets, which do not include the 500 netted short positions. Thus, in effect, netting gives derivatives counterparties a priority claim to one of the defaulter’s assets–his winning derivatives positions–assets that they would have to share with other creditors absent netting.

An extension of the example illustrates these points. Assume that in a default, the 1000 contracts cost the counterparties $1 billion to replace, and hence the defaulter’s 500 short contracts are worth $500 million to the defaulter in the absence of netting. The defaulter has other assets of $700 million, and other liabilities of $1 billion. In a bilateral setting, the defaulter has assets of $1.2 billion, and liabilities of $2 billion. If the defaulter’s assets are split pro rata among the derivatives counterparties and the other creditors, the victims of the default receive $600 million, and hence lose $400 million. Other creditors also receive $600 million and lose $400 million.

With netting, the derivatives counterparties have a claim of $500 million ($1million on each of the 500 contracts that do not net out), and the defaulter’s assets are $700 million because netting reduces both assets and liabilities by $500 million. Pro rata division of the defaulter’s assets results in a payment of $233.3 million to the derivatives counterparties, meaning they lose $266.7 million. The other creditors receive only $466.7 million and lose $533.3 million. Thus, although netting makes the derivatives counterparties better off, it makes the other creditors worse off by the exact same amount.

Thus, netting effectively transfers wealth in a default from a defaulter’s other creditors to its derivatives counterparties. In the example, netting redistributes $133.3 million from other creditors to the derivatives counterparties. Reductions in replacement costs therefore do not reduce social costs, unless some frictions, related perhaps to systemic risks, imply that giving one set of claimants priority enhances wealth. I discuss this issue further below.

In sum, netting by a CCP benefits its members by (a) reducing collateral, and (b) reducing replacement costs. The important part of that last sentence is “its members.” It is important for two reasons. First, this is a private benefit that these firms will presumably take into consideration when evaluating the net benefits to them of cooperating to create a CCP. Second, since one of the benefits to a CCP’s members is actually a transfer from other creditors, dealers may have an excessive incentive to form a clearinghouse. This makes the absence of a CCP all the more peculiar–and supports the possibility that other costs, such as those arising from asymmetric information, exceed the private benefits of netting received by CCP members.

Netting can also affect systemic risk by affecting the scale of dealer trading activities. To the extent that that the introduction of a CCP reduces the costs dealers incur at the margin to engage in derivatives trades, dealers will trade more. By accumulating bigger positions, they can pose a greater systemic risk.

Netting can affect marginal cost in at least two ways.

First, netting reduces costly collateral. Lower collateral costs induce greater trading activity. (In the 1920s, opponents of central clearing at the CBT argued that bilateral trading encouraged “conservatism”–i.e., less trading–because it imposed higher collateral costs which restrained trading activity.)

Second, reductions in replacement costs could have a similar effect. Here the analysis is more complicated, however. Holding the terms of the dealers’ other liabilities constant, a reduction in replacement costs due to netting encourages dealers to trade more. However, the dealer’s creditors will certainly respond to the implicit reduction in their seniority resulting from clearing by adjusting the terms on which they supply capital to the dealers. Increasing the scale of trading activity increases the default costs other creditors incur. If creditors price capital appropriately, and charge the firm an additional dollar for each additional dollar of default cost they absorb as a result of an expansion in dealers’ trading activity, the dealers will internalize the cost of the transfer, and reductions in replacement costs will not distort their incentives to trade. Given the complexity of dealer balance sheets and the difficulty in evaluating total derivatives exposure, however, it is possible that other creditors will not fully recognize the implications of an expansion of a dealer’s trading activity, and underprice capital as a result. This would encourage the dealer to expand trading activity excessively, as the costs of this expansion are borne by other creditors.

To the extent that lower collateral requirements and replacement costs encourage dealers to trade more, reductions in dealer default exposures that result from clearing will be smaller than one would estimate holding positions constant. Larger positions increase default losses, offsetting in part or in whole the effect of clearing on default losses per trade.

In sum, it is clear that the distributive effects of clearing have not been widely appreciated–if they have been recognized at all. Netting via clearing effectively gives derivatives counterparties a priority claim on some of a dealer’s assets–the portion of a dealer’s positions that are offset by other positions. In a bilateral market, all creditors, not just derivatives counterparties, would have a claim on that asset. This redistributes the burden of a default from derivatives counterparties to a defaulter’s other creditors. Netting is therefore effectively a zero sum game, not a positive sum game. Moreover, the losers may not be members of the clearinghouse, which could distort the incentives to create a CCP. Furthermore, the systemic effects of this redistribution are ambiguous. Imposing additional losses on other creditors could put them into financial distress, even while it eases financial distress from derivatives counterparties. Financial distress by these creditors could also pose a systemic risk.

Thus, the debate over the formation of a CCP should be framed very differently than it has been heretofore. The appropriate question is: Should derivatives counterparties receive a priority claim on a defaulter’s assets? That is, should derivatives counterparties receive priority over a defaulter’s other creditors? The answers to these questions are not immediately obvious.

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