Streetwise Professor

Several months ago, during a raging debate on the consequences of the world economic crisis for Russia, a commentator whom I’ll call BFC excoriated me for my pessimism.  He pointedly asked if things were so bad, why were reputable organizations, such as the World Bank, making much sunnier (though hardly great) forecasts for the 2009-2010 Russian economy.  

All good things come to those that wait, B.  The World Bank has released its Russian Economic Report 18.  (Links to report and a powerpoint presentation are to the right on the linked page.  You can read the entire report, but its main results are summarized in the ppt presentation.)

It’s full of I-told-you-so material for SWP.  Key sentences:

With a much worse global financial outlook and oil prices in the USD 45 a barrel range, Russia’s economy is likely to  contract by 4.5 percent in 2009, with further downside risks. This represents a major downward adjustment from our  forecast in November 2008, which saw growth at 3 percent, based on growth of the world economy and oil prices around  USD 75 a barrel. (Emphasis added.)

In other words, the WB was unduly optimistic last year, when the debate was raging here on SWP.  

The report makes frightening reading (not that there is a single economy out there for which 2009-2010 looks good).  I would direct attention to a chart on p. 12 of the World Bank report, in Box 2.1, which plots growth rate deceleration (vertical axis) against fiscal stimulus (horizontal axis).  Look at the point way down at the bottom.  The one labeled “Russia.”  It means that the WB forecasts that the growth rate for Russia will decelerate more than for any other G-20 economy.  I repeat.  The growth rate for Russia will decelerate more than for any other G-20 economy.  In other words, by one measure, the WB validates my assertion, contested so vigorously by BFC and a couple of others, that the world crisis would hit Russia harder than the US and most other industrialized economies.  

This measure is related to one I’ve mentioned in a couple of recent posts, namely the growth gap: the difference between growth potential and actual performance.  The combination of the facts that (a) Russia was growing fairly rapidly 2006-1H 2008, and (b) has contracted more than other G-20 economies, means that (c) the growth gap in Russia is very large indeed.  This is reflected in the rapid deceleration in Russian growth.

Another particularly interesting and revealing chart is Figure 1.1.  Compare the performance of Russia not so much to the developed economies, but its developing peers.  Note how much Russia has underperformed these nations in the crisis.  

The rest of the report is chock full of interesting details.  I’ll call out a couple.  First, investment in Russia (never high when compared to other rapidly growing economies, e.g., the “Asian Tigers”) has plummeted, down in the fourth quarter by 1.1 percent, down in the first two months of the year by almost 15 percent.T  This bodes ill for long term growth.  Second, consumption has also declined after dramatic growth in previous years.  Third, construction is down 18 percent.  Fourth, unemployment forecast to be 12 percent. Fifth, disposable income down sharply.  I could go on.

The adjectives in the report are also quite illuminating.  Phrases like “rapidly decelerating” and “collapsing domestic demand” are sprinkled throughout.  

The report pays special emphasis to how the crisis has seriously eroded the laudable progress made against poverty in the last several years.  The poverty, unemployment, disposable income, and consumption numbers all point to potential sources of popular discontent.  

Furthermore, the report repeatedly emphasizes that Russia’s policymakers face serious constraints that severely limit their choices.  Sound familiar?

And if you think the World Bank is gloomy, it is a starry-eyed optimist compared to the OECD.  The OECD’s report on the Russian economy forecasts a 5.6 percent decline of GDP in 2009, as compared to the World Bank forecast of -4.5 percent.  The OECD report notes that the Russian recovery is highly dependent on exogenous factors, especially the price of oil (another point BFC disputed vigorously).  

So, BFC, you asked for it . . . you got it.  

It should be noted that big organizations like WB, IMF, and OECD are frequently lagging indicators.  Prudence, and the fact that they are political bodies, dictate that they be very cautious in their assessments.  In contrast, mere bloggers can be more aggressive and opinionated.    

Oh, I have to mention just one other thing before closing this post.  It speaks volumes: “Russia Seeks to Carve Out Role in Crisis-Hit World Economy“:

“I think in general they see this crisis as a way to show the world that they have some answers and they’ve moved on,” said Tim Ash, head of CEEMEA research at RBS in London.

“It is a great opportunity for them to re-jig the global financial architecture and put themselves in a central place.”

Arguably Russia’s closest allies are the other BRIC nations, emerging market powerhouses Brazil, China and India. All have sizeable foreign currency reserves and are vulnerable to the global slowdown as they rely on exports.

This month the BRICs released their first communique at a G20 finance ministers’ meeting and joined the Financial Stability Forum, signaling a growing world role.

The communique reflected some of Russia’s campaigns, calling for “major reserve issuing economies…to ensure that the macroeconomic policy is more balanced” and for a reshuffle of country representation at the International Monetary Fund (IMF).

Russia followed that up with its own proposals for Thursday’s meeting of G20 leaders. Its suggestion to replace the dollar with a new international reserve currency quickly found support from China and sparked international debate.

Now, the first quote is the view of a certain Mr. Tim Ash, but if it is at all a reflection of Russian official thinking–and there is independent information that would tend to support that view–then they are delusional.  They have answers?  They have a Plan to Save the World?  

As the World Bank and OECD note, they have huge problems at home, and limited policy tools to deal with them.  They have more than enough on their hands at home even to think about saving the world.  Their reserves, shrunken as they are, are doubtfully sufficient to address their own pressing issues, let alone provide a meaningful prop to the world economy.  Their policy ideas are primarily aimed at weakening the US, rather than contributing to a meaningful improvement in the world financial system.  (When I read their proposals, or hear Lavrov or Medvedev speak of them, I am reminded of the punchline of the old joke about the Russian given a wish by a genie: “I wish that my neighbor’s cow dies.”)    

The entire world is hurting economically.  I stand by my previous forecast that due to the very structure of its economy and institutions, Russia is hurting, and continue to hurt, worse than most others.  The World Bank and OECD are coming around to that view.

The WSJ has a long article based on an exclusive interview with your fave and mine, Igor Sechin.  It is full of the usual his-lips-are-moving whoppers, but this one stunned even me, even as predisposed as I am to snort at pretty much anything old Eyegore has to say:

And he was quick to point out that Russia became a major oil exporter in the 1970s in response to demand in the West amid the Arab oil embargo. “Now they tell us, ‘You have Dutch disease, you’re a resource economy.’ But you yourselves asked us to be that way,” he said.

Sorry, but WTF is he talking about?  Yeah, the USSR was just eager to please the US and the West in the early-to-mid 1970s.  We said “jump”, and Brezhnev said “how high, boss?”  

Please.  The Soviets exported oil because (a) there was money in it, (b) they needed a lot of money, given that the rest of the economy was going to hell (especially the agricultural sector, which couldn’t feed the country), and (c) they had absolutely nothing else to sell that anybody wanted.  

What is it about Russians that they are responsible for absolutely nothing?  It’s always “The Devil (i.e., America) made me do it!”  They are wanna be Masters of the Universe, but everything is out of their control.  Sheesh.

Here’s another one from Putin’s Pinnochio:

Mr. Sechin is Moscow’s point man for warming relations with the Organization of Petroleum Exporting Countries. But he said Russia, the largest oil producer outside the cartel, isn’t ready to accept membership in the group, despite its pleas.

“It would be irresponsible for Russia to join OPEC because we can’t directly regulate the activity of our companies,” he said, as nearly all are privately owned.  (Emphasis added.)

Spare me.  

First, Russia taxes oil exports.  It is perfectly feasible for Russia to regulate the activities of its companies indirectly through the oil export duty mechanism.  Russia can achieve any level of exports it wants by adjusting the duty.  And it has been adjusting it–downwards, thereby encouraging oil exports.  (Maybe Sechin was quite deliberate in including the word “directly” in his answer, knowing quite well that this is an irrelevance, given the ability of the government to control exports via the tax mechanism, without directing companies to do anything.)  

Second, “nearly all are privately owned”–except the one that is by far the biggest, Sechin’s own Rosneft.  And, does he really expect us to believe, with Khodorkovsky in the dock, Mechel’s CEO Igor Zyuzin contemplating what Putin meant about “sending a doctor” (and given Russian healthcare, that is a frightening prospect), BP-TNK’s Dudley fleeing the country, etc., that if Putin or Medvedev told the owners/managers of these “privately owned” companies to cut exports, that they wouldn’t salute and ask “how much?”  

Sechin repeated his call to segment and “gasify” the oil market:

Mr. Sechin called for a gradual but major overhaul of the international oil trade, adding tight regulation and longer-term supply contracts, eliminating “economically unjustified intermediaries” and reducing speculation. Russia is the world’s No. 2 crude exporter.

Russia doesn’t like open markets and price discovery.  It likes market segmentation and backroom deals.  

In the add insult to injury category, Sechin uttered these Orwellianisms:

Mr. Sechin hailed  BP  PLC’s TNK-BP Ltd. joint venture in Russia as a sign of Russia’s openness to foreign investment in the sector. But he singled out secretive Siberian giant OAO Surgutneftegaz as “Russia’s best private oil company.”

Investors have criticized Surgut for refusing to release international-standard financial accounts or details of its ownership structure.

Surely, from Sechin’s perspective, black hole Surgutneftegaz is indeed the ideal energy company.  And yes, the whole BP-TNK fiasco is just a shining illustration of how an Investor’s Paradise has risen from the ashes of the former Worker’s Paradise.  Orwellian, like I say.

I actually appreciate the fact that Sechin has become much more open.  By speaking publicly, he reveals his utter mendacity, and in so doing, provides a revealing glimpse at the equally mendacious regime in which he serves.

The Russians keep playing that pleasing music, complaining about the Ukraine-Europe gas deal.  There are several reasons for this.  One is that it undermines the need for Nordstream and South Stream.  

Another important reason is that Europe will buy gas at the Russian border (taking title there), and pay transport fees to Ukraine directly, whereas previously Russia owned the gas in transit in Ukraine and paid the transit fees to the Ukrainians.  

This would seem to be beneficial for Russia, because this ensures the Russians get paid for any gas destined for Europe.  If (a) the Ukrainians don’t pay the Russians for their gas, (b) the Russians cut shipments to Ukraine in response, and (c) the Ukrainians siphon gas paid for by the Europeans to meet their needs, then (d) the Russians are whole, having passed title for cash before the gas gets onto Ukrainian territory,  (e) there is no ambiguity that the Ukrainians are at fault, and (f) the Ukrainians would have problems with the Europeans.

But, this arrangement could also reduce Russian leverage in negotiations with Ukraine.  Until now, Russia paid Ukraine a transit fee, and the negotiations over that fee were inevitably tangled up with the negotiations over the gas price.  Russia could use its control over gas as leverage over the transit fee.  Now, Ukraine can negotiate that separately with the Europeans.  Moreover, every cent of higher transit charge reduces the European’s derived demand for Russian gas, and reduces the amount that the Russians can charge for gas.  The Europeans care about the all-in price (transport plus gas), and really don’t care how that is split between the Russians and Ukrainians.  But the Russians care a great deal, and the reduced leverage is likely to reduce their share of the total pie.

But I think that the main reasons for Russia’s over-the-top rage are two.  First, it dramatically reduces the probability that they will be able to seize control of Ukraine’s gas transport system, either de facto or de jure.  Such control is clearly a major component of Putin’s long term plan to control both the gas upstream and midstream on virtually the entire Eurasian landmass.  (He has ambitions downstream too.)  

Second, and perhaps most importantly, it likely gives nosy Europeans a far better view into the murky world of the Ukrainian gas market, and hence the Russian role in it.  Or, more to the point, the role of particular Russians in it.  This has the potential to hit Putin, Medvedev (a former Gazprom chairman), and their cronies where it hurts.  This would explain their outraged howls.  

Now, with Timoshenko, one can never be too sure that this isn’t just a tactical move in her ongoing Good-Bad-Ugly standoff with rival Ukrainian politicians/parties.  But, it does raise the prospect for some improvement in the deeply corrupt Ukrainian gas trade.  And to the extent that the deeply corrupt Ukrainian gas trade is inextricably mixed with the deeply corrupt Russian gas trade, that could provide Putin and Medvedev with some very uncomfortably moments indeed.

In It’s a Wonderful Life, facing financial ruin and scandal, banker George Bailey attempts suicide.  Rescued by his guardian angel Clarence, a still bitter George laments that he wishes he had never been born.  Clarence shows him that the world would have been a poorer place without him, and George regains his will to live.

Certainly the 21st century remake of the Frank Capra/Jimmy Stewart classic couldn’t feature an executive from AIG’s Financial Products unit, right?  More likely, in the 2009 version a crowd gathering at the bridge over an icy New England river outside of Greenwich would be shouting “Jump!” to the distraught exec standing on the rail–if they didn’t rush to throw him in bodily.  The modern-day Clarence would rescue him just to torment him with a demonstration that yes, the world WOULD have been better without him because then there would have been no financial crisis.

But not so fast.  It’s not so clear by any means that this morality play would be reality-based.  It is in fact quite possible that the world would have been a worse place without AIG; that the financial crisis would have been more severe; and that taxpayer bailouts would have been bigger.

AIG has been at the center of many of the debates over the financial crisis, and possible regulatory responses to it. In particular, the company’s fate has been used to justify the creation of a clearinghouse for credit derivatives, and indeed for all OTC derivatives. It is often argued that had there been a clearinghouse, the AIG debacle wouldn’t have happened. What’s more, it is often asserted that by taking on so much real estate price risk by writing protection on collateralized debt obligations backed up by subprime mortgage debt, that AIG triggered the financial crisis when these positions went south, requiring a massive taxpayer bailout.

In my view, both views are wrong.  Although AIG’s decisions were certainly a disaster for its shareholders, the systemic implications of AIG’s original plunge into CDOs, and the subsequent collapse of this strategy are vastly overstated.  AIG’s collapse was a symptom of the underlying systemic problem, not its cause.  The cause was the real estate bubble and the huge pyramid of structured finance built on top of it.  Although AIG arguably contributed to the size of that pyramid, its shareholders absorbed a good deal of the blow resulting from its collapse.  Without AIG, the major banks and investment banks–the Citis, the Goldmans, and the other firms that traded with AIG–would have suffered even worse losses, and required an even larger bailout.  A systemic event would have occurred if AIG didn’t exist, and that crisis likely would have been more severe.

So, maybe AIG isn’t George Bailey.  But it isn’t the financial devil incarnate either.  The obsessive focus on the company, and on legislative and regulatory remedies to prevent the recurrence of another AIG, are distracting attention from the true sources of the financial crisis, and the policy lessons to be drawn from it.

I’ll first focus on the clearing issue, because (a) Treasury Secretary Tim Geithner recommended the mandatory formation of a clearinghouse as a means for preventing future financial crises, and (b) it is a focus of my research interest.  A close examination of clearing also helps to bring into sharp focus the key forces driving the financial crisis, and AIG’s role in it.

This view that clearing could have prevented the AIG problem, and the necessity of spending amounts of huge taxpayer dollars in a bailout, is based on an incomplete understanding of how clearing actually works. A more complete analysis demonstrates that it is unlikely that clearing would have made a blow up less likely, and it would almost certainly have made things worse by concentrating the risk on fewer systemically important banks.

This conclusion is obviously completely contrary to the conventional wisdom, but I think it is the right one once one takes into account the way derivatives markets and clearing actually work. The situation is a complex one, so it takes a rather involved argument to make the point. I apologize in advance, but bear with me. Hopefully it will be worth it.

It is helpful to break the argument into three parts. The first part assumes that the adoption of clearing would not have affected the positions that AIG assumed. The second part considers whether clearing would have induced AIG to take on smaller positions. The third part examines whether things would have been all that different had AIG in fact reduced its positions in response to the adoption of clearing.

The conclusions, in brief:

• Holding AIG’s positions constant, clearing would have not substantially affected the allocation of losses among its trading parties, and if these losses required a bailout without a clearinghouse, they would have required them with a clearinghouse;
• if anything, the losses from an AIG default would have been concentrated at fewer banks (the members of the clearinghouse, a subset of AIG’s counterparties);
• although clearing would have presumably raised the costs that AIG incurred to hold positions (due to margining), it is very plausible that these costs would not have been so large to have induced AIG to reduce substantially its positions, given its estimation of how profitable they were;
• even if AIG had reduced its positions, since its counterparties were trading to hedge their exposures to structured products, these counterparties would have incurred larger losses on these positions, losses that would have likely .have required a government bailout of these firms; and
• only if clearing had led AIG to scale back its trading, AND if such a scaling back of AIG’s trading had led to a substantial reduction in the issuance and holding of the securities that AIG’s counterparties were hedging through the insurer, AND if this in turn had led to a substantial decline in the amount of subprime lending, would clearing have had a material effect on the financial crisis.

That is, any effect of clearing on the financial crisis insofar as it relates to AIG would have been extremely indirect. Moreover, it is very difficult to evaluate just how extensive these indirect effects might have been.  Indeed, in my view, there were so many powerful economic forces contributing to the real estate bubble and the explosion in structured finance, that it is likely that both would have assumed almost the same proportions, and imploded with the same effects even if AIG had never been born.

Several themes recur through the analysis, and given that it can become complicated at times, it is worthwhile highlighting those at the outset.

The first theme is that there is a very limited cast of characters here: AIG and the major banks that AIG traded with. The major banks bore AIG’s counterparty risk as OTC counterparties. But crucially, these same banks would almost certainly have been the members of a clearinghouse, and hence would have borne the counterparty risk even in a cleared market! Indeed, due to the way clearing works, these banks might have had a greater exposure to AIG counterparty risk in a cleared market than in a bilateral one.

The second theme is that these very same banks were trading with AIG to hedge the risk on various products (e.g., CDOs) that they carried on their balance sheets. Had AIG not been around, or had traded less, they would have suffered losses on these products. In the event, AIG bore the losses. That is, AIG’s equity absorbed losses that otherwise would have fallen on the equity of these very same banks. They would have been in even worse shape than they are now! So, if it was necessary to bail out AIG to ensure these banks didn’t fail, without AIG it would have been necessary to have bailed out the banks directly, and paid more money to do it.

Only if the absence of an AIG to absorb risk had induced the banks not to buy these risky securities in the first place, and this led to a reduced scale of issuance of these securities, would things have played out differently in a good way. That outcome is highly conjectural. Therefore, any assertion that clearing, or any other regulatory or institutional change that constrained AIG’s risk taking is equally conjectural.

Let’s now get to the details of the argument, and compare how counterparty risk is allocated in a clearinghouse and a bilateral market. This comparison has immediate implications for the effects clearing would have had on the allocation of this risk, and the ultimate effects of the real estate collapse on the health of large financial institutions.

A clearinghouse (central counterparty, “CCP”) has member firms. These members are usually large financial institutions. A credit derivatives clearinghouse would almost certainly be dominated by large banks. The clearinghouse only has a relationship with its members. Customers do not have a direct relationship with the clearinghouse. They must trade through members.

I’ll assume that AIG would have not been a member of the clearinghouse (a similar argument would obtain if it were.) Therefore, it would have traded through member firms—major banks. AIG would have had accounts at one or more clearing members. Given its size, it would likely have had accounts at several members.

The important thing to recognize is that these members are the first line of defense against a default by a customer. That is, if a customer defaults, the firm(s) it clears through must make good the loss. Only if these default losses in turn force one of the clearing members into default do losses get passed to the clearinghouse. But then, the losses are shared among the other members of the clearinghouse. If (a) the capital of the clearinghouse, including any guaranty fund, cannot cover the default losses, and (b) the obligations of solvent clearing members to cover any remaining loss are smaller than that loss, then (c) those with positions on the opposite side of the market to the defaulter would absorb losses.

So, who bears the losses of a default?: (a) the other members of the clearinghouse, and (b) perhaps other customers (if the default loss is so large as to break the clearinghouse).

To get an idea of who the members of a clearinghouse likely would have been, let’s look at the current list of members of ICE Trust, the first CDS clearinghouse to get up and running:

• Bank of America Corp.
• Barclays Capital
• Citigroup
• Credit Suisse
• Deutsche Bank
• Goldman Sachs
• JP Morgan Chase & Co.
• Merrill Lynch & Co.
• Morgan Stanley
• UBS

Now let’s look at the list of the major counterparties of AIG who received money from the bailout:

• Société Générale (France)
• Goldman Sachs
• Merrill Lynch International
• Deutsche Bank
• Calyon, Crédit Agricole (France)
• UBS
• Barclays
• Coral Purchasing, DZ Bank
• Bank of Montreal
• Rabobank
• Royal Bank of Scotland
• Bank of America
• Wachovia
• HSBC
• Barclays Global Investors
• Here’s a link that breaks out the amount owed to each counterparty.  The original document has disappeared from an AIG website.

Note that there is a lot of overlap there. Moreover, if AIG’s default had been so huge as to break the clearinghouse, the very same counterparties in the list would have borne some loss.

That is, given AIG’s positions, clearing would have had NO EFFECT on the size of AIG’s loss. Moreover, it would have had little effect on who bore those risks. Indeed, it would have almost certainly INCREASED the loss borne by the banks that would have been members of the clearinghouse.

Why? Well, exactly because the overlap between counterparties and CCP members is incomplete.  The counterparty firms receiving bailouts  not in the list of CCP members (plus other firms that traded with AIG but which didn’t receive bailouts, e.g., some hedge funds) had taken positions on the opposite side of the market from AIG. These firms would have made money when AIG lost money. In a cleared market, in the event of an AIG default, the clearing firms would have been obligated to pay these firms what AIG owed them, but could not pay. In contrast, in a bilateral market, the banks in the list would have had no such obligation. Thus, the clearing member banks’ share of the loss arising from an AIG default would have been larger with clearing, than they were in a bilateral market.

So, if AIG’s failure necessitated a bailout to save these banks without clearing, its failure would have required a bigger bailout of the CCP member banks with clearing!  That is, Goldman, Citi, Merrill, BofA, etc., would have needed more support.  Moreover, the total would have likely exceeded the amount actually distributed to all the counterparties, because (a) presumably not all of AIG’s counterparties received bailout money, just those deemed systemically important, and (b) in a cleared market, the clearing members would be on the hook to all those owed money, not just those favored by the government.

In a nutshell: given the size of AIG’s positions, the total loss from its would be the same with clearing or without.  All clearing would have done is affected the allocation of those losses among counterparties.  The most likely outcome is that clearing would have concentrated the loss on a smaller number of systemically important banks–the very same banks that the government decided could not go under, and who had to be bailed out by funneling money through AIG.

This means that a necessary condition for clearing to have made things better is that it would have induced AIG to hold smaller positions. This raises two questions: (a) is it plausible that this would have happened?; and (b) even if clearing had induced AIG to hold smaller positions, would it really have made things better (i.e., would smaller positions have been sufficient to ensure that the financial crisis would have been less severe)? I believe the answers to both questions are “no!” At the very least, they are not obviously “yes.”

First consider whether clearing would have induced AIG to hold smaller positions.

Due to its high credit rating, AIG’s counterparties did not demand that it post collateral when it created its positions (though they did include “credit triggers” in the deals allowing them to demand collateral in the event of an AIG downgrade).  A CCP would have established minimum initial collateral levels for customers, and implemented a system of margin calls based on changes in mark-to-market values of AIG’s positions as a customer.

Margins/collateral are costly.  They typically must be posted in cash or near-cash instruments, thereby requiring firms to hold more of their assets in these low yielding instruments than they would prefer.  Thus, it is possible that by increasing the amount of collateral that AIG would have had to post that a CCP would have raised the costs AIG incurred to hold its positions, thereby inducing it to cut back on them.

But I doubt they would have cut back that much.  AIG loaded the boat on the CDSs on CDOs because it believed that these instruments would be very profitable.  Yes, higher collateral would have cut into those margins, but given how big AIG’s FP unit thought the margins were, it is unlikely that they would have cut back all that much.

Moreover, based on its modeling, AIG perceived that the risk on these positions was extremely low, in large part due to its belief (based on analysis of mountains of data by Gary Gorton) that the correlations between the risks of the assets underlying the CDOs were very low.  It is almost certainly the case that a CCP, given information available at the time, and no doubt influenced by AIG’s efforts to press its views and research, would have arrived at the exact same conclusion.  The rating agencies did.  Monoline insurers did.  Why would a clearinghouse been have been any different?

If as I surmise the CCP had determined that the risk of these instruments was low, it would have set low initial margins.  Again, given AIG’s perception of the risk-reward profile of these deals, it is highly likely that it would have been willing to pay these margins, and continue to load the boat.  Perhaps not all the way to the gunwales as it did, but put it pretty deep in the water nonetheless.

Furthermore, it should be noted that by allowing it to trade without collateral, AIG’s counterparties effectively extended credit to the firm. They presumably would have been more than willing to extend credit to AIG as clearing members too, thereby allowing the firm to borrow to meet its margin requirements.  Now this borrowing would have been on balance sheet, and could have constrained the firm’s financing in other ways, whereas the implicit credit in the OTC deals did not.  Nonetheless, given AIG’s stellar credit rating (as farcical as that seems in retrospect), it could have readily funded massive CDO CDS positions; and given its appetite for this risk, likely would have done so.

In sum, although clearing, and the margining it entails, would have increased AIG’s costs of trading derivatives, I seriously doubt that it would have caused the firm to reduce its positions substantially.

But, if I am wrong, and collateralization via a clearinghouse would have caused AIG to cut back dramatically on its positions: would things have been better? Not likely.

Note that those trading with AIG were typically doing so to hedge—to lay off—the risk on positions in structured products they held on their books. And remember, who were these firms that were trading with AIG? The very same banks considered to be so essential to the survival of the financial system.

Assume for a moment that these firms’ holding of these structured products built on subprime loans would have remained unchanged even if they had not laid off the risk on AIG. Then, if AIG had taken smaller positions, these firms would have borne more risk. When real estate prices tanked, and took the value of these securities along with them, these firms would have taken a bigger loss than they did in actual fact because in the event AIG absorbed some of the losses on these positions. What this means is that the big banks the government has felt necessary to bail out indirectly through AIG would have required a bigger direct bailout because they would have suffered larger losses on their CDO portfolios.

Given the size of the CDO positions, the amount of loss would have been the same regardless of how many CDSs AIG bought.  The only thing that AIG’s trading did was affect the allocation of those losses; the losses were shifted from the banks that held the CDOs to AIG.  Recall that Treasury and the Fed deemed that the losses these banks would have suffered after AIG had absorbed a huge portion of the loss would have jeopardized the financial health of these firms.  Their health would have been in a more parlous state had AIG Financial Products never been born, as they would have had to absorb all the loss, rather than share some of it with AIG’s shareholders. Sure, an AIG bailout wouldn’t have been necessary without AIG, but an equally large, or larger, bailout of the banks holding the (unhedged) CDOs would have been required.  In effect, AIG’s shareholders bailed out the banks holding the CDOs, but didn’t have enough capital to do the job itself.  Uncle Sam kicked in the rest.

Now we’re approaching the end of the argument.  Holding AIG positions constant, clearing wouldn’t have reduced the size of the bailout, and likely would have increased it.  Even if clearing would have reduced the size of the firm’s positions, or even if AIG FP had never been born, holding constant the size of the underlying CDO positions that banks hedged through AIG, the size of the bailout would not have been decreased, and likely increased.

So, this means that AIG’s existence, or the scale of its activity, would have affected the severity of the financial crisis  only if they  had affected the amount of CDOs outstanding, and ultimately the amount of subprime debt issued.

Is this realistic?  It is certainly plausible that if AIG had traded less, or not traded at all, that (a) the cost of hedging CDO risk would have increased, (b) hence, banks would have held smaller CDO positions, (c) this would have reduced the demand for subprime debt, leading to (d) a less severe financial crisis.  But the magnitude of the impact of AIG’s actions on the size of the CDO and subprime markets was arguably not very large.  Myriad economic and political forces were behind the housing bubble and the growth of subprime and the associated explosion of structured finance.  Lax monetary policy, massive savings by China and Japan, tax subsidies for housing, policy initiatives to boost home ownership among those who could not afford it via conventional financing methods, the implicit government guarantee of Fannie and Freddie, pervasive belief that subprime finance and the associated structured finance were not risky, among other things,  all contributed to the boom and subsequent bust.  Disentangling AIG’s effect from all those other factors is difficult.  But it is likely that the AIG effect by itself, against the background of all these other factors, was small.  This is especially true when one considers that given the widespread beliefs at the time, that if AIG hadn’t done it, somebody else would have.

So, contrary to Time Magazine (surprise, surprise), AIG was not the real WMD.  It was, in effect, the particular channel through which the financial flood traveled.  The underlying causes of the flood lie elsewhere.  AIG is a symptom, not primary cause.

Indeed, given the underlying causes, the damage likely would have been worse for other financial institutions, and for taxpayers, had AIG FP never been born.  Moreover, the “solutions” du jour, namely clearing, would have probably made things worse by concentrating the impact on a smaller number of systemically important financial institutions.

AIG is insolvent.  That is not a good thing.  But consider this analogy.  A flood far more extensive than anyone believed possible occurs.  Believing the risk of a massive flood to be small, many people had built homes and businesses in an attractive area that they believed to be safe, only to have them inundated by the historic deluge.  A company had insured these houses, also believing the risk to be low.  The losses were so large, that the company was wiped out.  It had enough capital to cover some of the losses suffered by those it insured, but not all.  The government stepped in, and bailed out (financially) the homeowners, covering the losses the insurer could not.

So the questions: Would the world have been better had the insurance company not existed?  Would the taxpayers pay more, or less, had the insurer not existed?

The answers to these questions seem, to me, to be “No.”  Only to the extent that the existence of the insurance company encouraged building that, in retrospect, was imprudent would the answers be different.  And, if belief in the impossibility of such a flood was widespread, it is highly unlikely that the absence of the one insurance company that drowned in it would have had a significant impact on the number of houses built, and the economic damage suffered.

I think that the analogy is a good one.  AIG is the “seen” effect of the financial crisis.  It is the tangible evidence of its existence.  It is a conduit by which the crisis spread.  But it is not the cause.  The unseen, or the difficult to see (because of the complexity of the reality), is the true cause.

There are several meta-lessons here.  One relates to the role of derivatives.  Derivatives are, first and foremost, means of allocating risk.  They do not create it.  They shift it.  Now, the existence of a risk shifting tool, by reducing the costs of bearing risk, may lead people to make different economic decisions than they would in its absence, and this effect could influence the size of losses that occur.  But, for the most part, derivatives merely transfer the burden of economic losses, rather than affecting the magnitude of these losses.  Indeed, this shifting of risk typically reduces the cost of bearing it.  Even if a company, like AIG, fails spectacularly because of the losses it incurred in the derivatives market, that does not mean that the derivatives are bad.  That, again, is the seen.  The unseen is who would have lost, and how much more damaging that loss would have been, if some of it had not been shifted to the company that failed.  If the company had not born the loss, who would have?  Would they have been better able to bear it? The balance of the argument, to my mind, weighs strongly on the side that says the effects of the loss would have been more severe had AIG not existed.  The unseen alternative not chosen would have been worse than the seen.

There is a related meta-lesson.  I often say that one of the great lessons of the Great Depression is that people learned the wrong lessons from the Great Depression.  We are in the process of repeating that experience today.  By focusing on the observed spectacular failure of one company, pundits, and more importantly policymakers, are devising regulatory and legislative responses that do not address the true causes of the ongoing crisis, may make future crises worse, and which are likely to reduce the efficiency of markets going forward.  Mandatory clearing is just one example of that.  Geithner’s and Bernanke’s demand for sweeping discretionary powers over non-bank financial firms is another.  AIG is the poster child for these efforts.  But the focus on AIG distracts attention from the real issues.  As a result, as in the 1930s, we are likely to create a vast regulatory structure that will not make our financial system any safer, but which will impede the ability of markets to work effectively and efficiently.

I distinctly remember sitting in Sherwin Rosen’s Economics 301 Price Theory course at Chicago (in Winter ’82 quarter, I think), listening to him lecture about the informational role of the price system.  He was talking about relative prices, and all of sudden the volume of his voice rose startlingly, and he almost shouted: “And that’s why inflation is bad.  It F*CKS UP relative prices!”  (Sherwin is truly missed, by me in particular.)  And, if you screw up relative prices, Sherwin continued, you cause the misallocation of resources.  These inefficiencies can be very costly.  (Bertrand Russell once said that “efficiency is the highest form of altruism.”  Thus, screwing up relative prices is a profoundly un-altruistic act.)  

Reading these two posts from Think  Markets  brings Sherwin’s outburst oh-so-long ago to mind.  Mario Rizzo notes how the Fed’s extremely aggressive monetary policy (which bears a major risk of massive inflation) is distorting relative prices.  In particular, it is attempting to inflate housing prices (relative to the prices of other goods and services) by reducing other prices (interest rates).  Worse, it is doing so deliberately, in an effort to influence the allocation of resources in the economy:

On the other hand, demand is being stimulated by Fed purchases of MBS.    As of March 18, 2009 the Fed had $236 billion in such securities  on its balance sheet. In addition, a $8,000 tax credit for first-time home-buyers was included in the stimulus law. More purchases of MBS are forthcoming. This should cause mortgage rates to fall further (although some of that fall is already being seen). And who knows what is coming after that?

(The tax credit will expire in December; that will reduce demand. I doubt this will be a big factor either on the upside or the downside.)

So whatever equilibrium the market is tending toward, it is not a long-run sustainable one. This is because real interest rates will rise in the few years due either to inflation or the Fed’s  sales  of MBS to prevent inflation.

If the first is the mechanism, then we shall probably see another housing bubble bursting. This is because the Fed will not begin selling securities until it sees sign of overall inflation (and not simply price rises in particular markets). This will be too late to prevent a new housing boom.

If the second is the mechanism, then the Fed will have simply succeeded in slowing down movement to the eventual lower-price equilibrium.

Overall, it is good news that housing prices are falling and sales rising. Yet the Fed will manage to turn this good news into bad:    just the opposite of the “Keynesian miracle” –  bread into stones.

This is to take a very Olympian view of the operation of the economy, with the Fed in the role of the All Seeing, All Knowing, All Powerful Zeus.  But, as Mario notes, these interventions are impeding the movement of the economy to a sustainable equilibrium; perpetuating the distortions that materially contributed to the current problems in the first place; and thus laying the groundwork for a future crash (one, by the way, that will wash over an already weakened banking system.)  

In other words, this is an exercise in what I termed NeoSoviet Economics; an attempt to dictate market outcomes in order to sustain an unsustainable status quo.  This is unlikely to turn out well.  

We need resources to flow out of bloated sectors (real estate and construction first among them, but autos and many parts of the financial sector as well).  This is never an easy process.  Indeed, it is inevitably painful.  But it is necessary to compare that pain, to the pain of alternatives.  Distorting relative prices and impeding the flow of resources to higher value uses will only make things worse.  

The Fed could use some of the wisdom of Canute, who knew better than to think that he could command the tides.  The Fed’s efforts to control the Fundy-like economic tides we are currently encountering are likely to be worse than futile; they will instead be destructive, and exacerbate and perpetuate economic dislocations rather than alleviate them.

News reports state that Geithner supports mandatory central clearing of OTC derivatives transactions.   His testimony is not quite so blunt, but could be interpreted that way:

Fourth, we should establish a comprehensive framework of oversight, protections and disclosure for the OTC derivatives market, moving the standardized parts of those markets to central clearinghouse, and encouraging further use of exchange-traded instruments.

I have argued against such a mandate here (“skinny” version), and here (“supersized” version).   Geithner is not specific about the organization of a clearinghouse, and in particular about the scope of products each would clear, but Darrell Duffie has argued that a specialized CDS clearinghouse would increase risk.   I’ve also laid out many of my arguments (that eventually showed up in the papers linked above) here on SWP–just type in “clearing” on the search bar if you’d like to find them.

Given the barrage of words I’ve already hurled at the subject, I’ll limit myself here to a bullet point list of the problematic issues:

• Risk pricing.   Dealers are likely to have better information about counterparty risks arising from the nature of the specific instruments, and especially from the balance sheet risks of counterparties.
• Netting is not necessarily a social benefit.   It redistributes wealth (in the event of a default) to clearinghouse members and from the other creditors of a defaulter, e.g., buyers of the defaulter’s commercial paper, its securities lending counterparties.   It is not immediately obvious that this allocation of counterparty risk is welfare improving.
• Clearing concentrates counterparty risk and redistributes it among the members.
• This concentration is especially problematic since derivatives counterparties have recourse to a dealer’s entire balance sheet in the event of a default.   In a CCP, recourse is limited to the capital of the CCP, plus any additional “good to the last drop” obligations of members to contribute additional capital in the event that the CCP funds are exhausted.   These funds appear small to the potential loss in the event of a major default.   As an example, CME clearinghouse can tap into $6 billion of capital if margins don’t cover a default loss.   (This includes CME stock deposited by clearinghouse members, valued at its current price too, which would likely fall in the event of a major default.)   The size of ICE Trust’s Guaranty Fund (the backstop monies that would be available in the event that margins don’t cover a defaulter’s obligations) is not publicly known (at least I have not been able to track down that number).   ICE has committed $10 million, with a commitment to raise it to $100 million.   I think members are obligated to kick in $20 million to the fund, but that could be scaled as position sizes increase.   I have not seen any indication that there will be “Maxwell House” (H/T Lucio) features in ICE Trust.   Anyways, we’re talking less than $1 billion here.
• CCPs have a more rigid, mechanical collateralization mechanism.   This could be a feature, but it could also be a major bug in times of systemic stress.   CCPs require posting of collateral in cash or close substitutes, sometimes intraday, and no later that the opening of business of the next day.   Dealers can be more flexible with collateralization, extending credit, or accepting a wider range of collateral.   Large market moves create large demands for cash in a CCP structure.   This can contribute to a liquidity crisis.   Note in October, 1987, many banks were unwilling to extend credit to fund margin calls.   Fed action alleviated a collapse of CME and CBT clearinghouses, but the margin induced demand for liquidity nearly led to a systemic collapse.   (Bernanke actually wrote a paper on this in the 1991 RFS).

I have seen no evidence that any of these points have been given serious vetting by the powers that be.

Bernanke and Geithner testified before Congress yesterday, and advocated the creation of vast new Federal powers to intervene in financial markets.   These powers (soothingly called “resolution procedures”) would include the ability to seize “systemically important nonbank financial firms.”   In particular, the government would be empowered to place such a firm “into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate” (Bernanke) and “to sell or transfer the assets or liabilities of the institution in question, renegotiate or repudiate the institution’s contracts (including with its employees), and prevent certain financial contracts with the institution from being terminated on account of the conservatorship or receivership” (Geithner).

This would represent a breathtaking expansion of government authority.   Such power can be used for ill by venal, unscrupulous, vindictive, or power mad politicians.   Think of this authority in the hands of an Elliot Spitzer-type, or an Andrew Cuomo-type.   Hell, think of what Harry Truman could have done with it during his battle with steel companies in the Korean War.   Moreover, merely rational politicians may respond to populist pressures, or to interest group pressure, to utilize these powers in a way that helps the politician, but not the broader interests.   These powers can also be used for ill by well-meaning, but incompetent officeholders.   The performances of Henry “Trust me, I stayed at a Holiday Inn Express Last Night” Paulson or Geithner or Bernanke hardly inspire confidence that such powers will be wielded wisely.

Bernanke briefly genuflected to bankruptcy law, but then dismissed its relevance, arguing that it was too cumbersome to deal with fast-breaking crises like that that engulfed AIG.

In essence, Bernanke and Geithner are pressing for what the property rights economics literature calls state contingent control rights.   Private contracts and the law (e.g., bankruptcy law) also have mechanisms to allocate control rights on a state contingent basis.   For instance, when certain events occur (e.g., a corporate debtor cannot make a payment), rights of control over assets are shifted.   Efficiency considerations provide incentives for parties to design transfer mechanisms that respect information asymmetries and costs, and other transactions costs.   Moreover, these mechanisms also provide protections against opportunistic actions that impair efficiency, but allow one party (or parties) to extract wealth from others.

Bernanke and Geithner pointed to Federal powers to force banks into receivership as a precedent for their request to obtain similar powers over other institutions.   It is important to note, though, that there is a crucial difference.   Government, via deposit insurance, is effectively a direct claimant against an insured bank.   An insolvent bank has incentives to act in ways that is detrimental to the interests of this claimant, and others as well.   Just as bankruptcy law serves to protect creditors against the inefficient actions of shareholders and managers, the ability of the government to intervene protects the government and taxpayers as creditors against the inefficient actions of insolvent banks and their managers.   Note that most of the banks seized in this fashion are small and not systematically important.   This illustrates that this mechanism serves less as a mechanism of systemic protection, but as a means of protecting one class of creditors.

I would also emphasize the breathtaking hypocrisy in this proposal.   Systemically important banks are at the heart of the current financial crisis.   Sure, AIG is a big deal, but so are Citi, BofA, etc.   The government already has considerable power over these banks.   Arguably, it should be using it to control systemic risk, not to mention to limit the exposure of the FDIC as deposit insurer.   But it seems that every action of the Treasury and Fed is consciously intended to avoid taking forceful action.

In their testimonies, neither Geithner or Bernanke specified the kinds of safeguards that would be in place to protect the intertests of affected parties in the event of a government intervention.   Given that government especially is often first and foremost a mechanism for rent seeking, it is imperative that such mechanisms exist.

AIG was the poster child for the Bernanke-Geithner arguments.   One interpretation of their remarks is that the government lacked the authority to impose haircuts on creditors and counterparties, and hence were forced to use government funds to make these firms (e.g., Goldman) whole.   That seems a real stretch.   It seems more likely that the AIG outcome reflected the influence of some firms and interests, and the lack of influence of others.   From this perspective, it is quite likely that the outcome would be the same even if the government had the power to impose a haircut on Goldman or not.   I think that if Paulson and Bernanke had wanted to get AIG derivatives counterparties to share the pain, they could have found the way.   The fact that they didn’t was, in this view, a conscious choice, rather than the result of a lack of the ability to make a different choice.

The power to impose unilaterally contractual adjustments that will influence the allocation of tens of billions of dollars is an awesome one.   It needs serious ringfencing to protect the interests of the myriad claimants of these “systemically important” firms.   Thus, rather than delegating vast powers to the Executive Branch, or the Fed, it would be worthwhile to see how bankruptcy law can be modified to permit more timely intervention while respecting the interests of affected parties against the potentially malign or incompetent actions of the government.   Moreover, an established procedure could reduce uncertainty, which is an important benefit during times of systemic stress.

There’s another thing to be considered.   What will be the equilibrium consequences of such a massive shift in control rights?     Given such a shift in the contracting environment, private parties will adjust their contracts.   They may try to contract around the restrictions in ways that could have serious implications both during a systemic event, but also in “ordinary” times.   How will granting these conditional control rights to the government affect private contracting decisions relating to capital structures?   Employment contracts?   Compensation structures?   How will it affect the sizes of firms?   Their horizontal and vertical scopes?   (I can see, for instance, this leading to an increase in vertical integration, as arms length contracts face additional risks under the Bernanke-Geithner proposal.)   How will it affect other kinds of financial contracting, e.g., collateralization, the use of derivatives, the use of clearinghouses?

I don’t know the answers to these questions.   Many are likely unanswerable ex ante.   But it must be recognized that the unintended effects of this expansion of power are likely to be huge, and deserve consideration ahead of time.   Marry in haste, repent at leisure is not a wise course to follow.   Many of the proposals for regulatory and legislative changes, these included, seem predicated on the view that nothing else will change in response to these changes.   We know that is wrong.   We also know that many of the equilibrium responses of private parties will be individually rational, but reduce efficiency.   The Bernanke-Geithner proposals will not only affect what happens during a systemic event, but what happens every day after they are implemented.   The cumulative impact of these seemingly small changes in individual contracting decisions could be greater than the impact arising from the effect of the proposed regulations on the problem at hand–controlling systemic risk.   I would hope that some serious thought is given to this issue before we put the current crisis to use to vastly expand the government’s power in the next one.

Numerous commentators, including Willem Buiter, have emphasized the potential for adverse selection in the Geithner plan auctions of troubled assets.   Join the party, dudes.   This was the graveman of my skepticism of the original TARP auction scheme.

But, I think that moral hazard is the key problem with the Treasury plan.   That is, the plan defers Judgment Day for the banks.   We need to separate the Saved from the Damned, but instead Geithner lets dodgy banks continue to operate.   They have the option as to whether to participate in the sale of troubled assets, and will exercise that option to maximize their value.   Unfortunately, maximizing this option value means that the banks will do what it takes to defer Judgment Day, and in so doing, they have very perverse incentives.   Moreover, inasmuch as there is arguably an externality from the continued operation of insolvent banks (as it calls into question the solvency of the entire banking system, and poses the ongoing risk of another systemic event), deferring Judgment could be very costly indeed.

This is not to say that adverse selection is important.     It is, but in a way different from what Buiter and others have emphasized.   In particular, adverse selection arising from the fact that sellers of the toxic assets are likely to have better information about their value than buyers means that, to protect against the “winner’s curse”, potential buyers will low-ball their bids.   That is, their bids will be at a discount (on average) from the true value of the assets.

This represents a further deterrent to banks to participate.   Indeed, if the information asymmetry is sufficiently severe, trading activity in this market may be de minimus.   Thus, low ball bids will represent an even further disincentive for truly bad banks to participate in the sale of toxic assets.   And they will be able to make a credible case that these prices do not reflect true values.

This problem is a reason why, in the Fall, I proposed Humpty Dumpty.   By aggregating bad assets, and selling equity claims on the pool of these assets, asymmetric information/adverse selection problems are mitigated.   Substantially.   This selling stuff a piece at a time is just nuts, and maximizes the potential for adverse selection.

Like Casey Stengel once said: “Doesn’t anybody know how to play this game?”

One interesting thing in the news today. New media darling Sheila Bair supposedly recognizes that bad banks have little incentive to participate in the sales of toxic assets, and is reported to be planning to exert pressure on the banks to sell.   Moreover, the government will supposedly use the results of stress tests (remember them?–funny how Geithner didn’t mention them in his most recent announcement)   push the banks to sell.

I guess that’s an improvement, inasmuch as it at least indicates that there is a glimmer of understanding of the problem at the root of the Treasury plan.   But why do so in such an opaque, indirect, and potentially ad hoc and arbitrary way that could be undermined by influence activities?   (Who decides who gets pressured, and how much?   How is compliance going to be measured and monitored?   How will political pressure and lobbying affect the process?)   Why not do it in a straightforward, public, mandatory, non-discretionary, non-arbitrary way?   This is, after all, allegedly the era of transparency in finance.   Why is the government being so un-transparent in its handling of this?   Could it be that they don’t have   the political will to do things openly and honestly, or that they are skeptical that such an approach will work?   Could it be that they prefer such ill defined and imprecise approaches because it maximizes their residual control rights?

So, Sheila, I say: If you think that the moral hazard involved in allowing banks to choose their degree of participation in the sale of toxic assets is a bad thing, come up with a credible, public statement of a way to address that problem.   Delphic utterances and leaks that create uncertainty are not what we need right now.   We need to resolve uncertainty, not layer it on.

Vlad is POd.  Seriously POd.  At the Ukrainians and the Euros, for having the audacity to modernize Ukraine’s shambolic gas pipelines without consulting HIM.  Can you imagine, the nerve.  Like Ukraine must think it is a sovereign country or something.

Here’s a glimpse at little Vlad’s foot stamping, hold-his-breath tantrum:

“It seems to me the document about which we are talking is, at a minimum, ill-considered and unprofessional because to discuss such issues without the basic supplier is simply not serious,” Putin said in the Black Sea resort of Sochi.

Just how the “basic supplier” would be harmed by measures that would improve the reliability and capacity of a major route linking its supplies to the ultimate consumer, Vlad didn’t say.

He’s so cute when he’s mad, dontcha think?  All I can say is, when he goes off like this, I know there is something right with the world.  For a change.

Loyal Putin creature Sergei Shmatko, the Energy Minister, chimed in:

Shmatko said the joint declaration touched on more sensitive issues than just gas and might damage EU energy security.

“It goes far beyond modernization of the Ukraine transit system and talks of the integration of Ukraine into the legal sphere of the European system as far as energy is concerned,” he told reporters.

Uhm, and what business is of yours, Sergei?  Ukraine and Europe have a perfect right to enter into such relations, even if it does involve some legal integration.  The concept is called “sovereignty.”  I’m sure you’ve heard about it.  After all, you and your cronies never tire of telling the rest of the world to f*ck off, and leave your “sovereign democracy” alone.  Goes both ways, dude.

Putin, gansta that he is and wants to be, sounds like one.  “Hey, Ukraine, you MY b*tch!  How dare you go out with somebody else.  Don’t make come over there and slap you around like I did that Georgia b*tch!”

This is all particularly rich in light of some of the things that Putin said during January’s gas war.  (Seems like years, not months, ago.)  At the time, Putin repeatedly denigrated the condition of Ukraine’s gas transport system, and called its reliability into question.  This was, in large part, an effort to pump up the prospects for Nordstream and South Stream, both of which would bypass Ukraine.

And that’s the real reason for Vlad’s pique.  He doesn’t want a reliable Ukrainian transportation network.  It undermines his goals, geopolitical and economic.

So, I say to Ukraine–You Go.  And to the EUnuchs–you surprise me, and in a good way.  (Though perhaps they didn’t foresee how Vlad would react.  It will be interesting to see whether they hang tough after Vlad’s outburst, and the inevitable follow on efforts to intimidate, and to play divide and conquer in an attempt to undermine this deal.  I’m sure that Schroeder will soon slouch to Moscow to get his orders to attempt to derail this deal.)

In other Russia news, Economy Minister Nabiullina has announced that the Russian economy contracted 8 percent year-on-year in February, and will likely contract 7 percent YOY for the first quarter. To put things in perspective, this collapse began in August, when GDP was probably on the order of 3-4 percent above its level as of February, 2008.  Thus, in 6 months, GDP has declined about 10-11 percent, a 20+ percent annual rate.

Economists often evaluate performance relative to growth potential.  Given a growth potential in Russia of 6-7 percent annualized, GDP should have been 7 percent higher, rather than 7 percent lower, than February 2008 as of the end of 2009.  This output gap of 14 percent compares with an approximate 8 percent gap in the US.

This is consistent with my view that the economic crisis has hit Russia harder than the US and Europe.  As is the fact that Russian economic indicators (e.g., the stock market, the ruble) have done better than their counterparts as of late.  The US market has turned around in recent weeks.  As I’ve noted, Russia is effectively a strongly procyclical economy (it’s “beta” to the world economy is greater than one) due to its dependence on highly procyclical energy and mineral industries.  With oil rallying 25 percent plus in recent weeks, in part due to the Fed’s apparent willingness to tolerate a lot of inflation to turn around the economy, and other commodity prices (e.g., copper) rallying too, Russia has benefited.

Though not so much as to justify this heady optimism by Deputy Prime Minister Igor Shuvalov (H/T R):

In comments to foreign media, First Deputy Prime Minister Igor Shuvalov said the government was increasingly upbeat about the Russian economy and hoped it would start growing again by the end of this year if the global economy doesn’t sharply deteriorate. As oil prices have risen above $50 a barrel, the ruble has steadied against the dollar and the Kremlin says there are tentative grounds for optimism, sounding an increasingly confident note about its handling of the financial downturn.

“The first phase is over,” said Mr. Shuvalov. “Most businesses have already adapted and the budget is not playing out according to the worse scenario.” Mr. Shuvalov confirmed that the Kremlin was no longer willing to offer large-scale bailouts to distressed corporations, something it did during the first stage of the crisis, but said that the government would help strategically important firms that had a genuine need. He stressed that commercial banks were now awash with cash, however, and could cover many of the lending requirements.

It is way too early to make such giddy pronouncements.  Russia is still highly dependent on the state of the world economy, which is anything but strong.  Kudrin is certainly not so ebullient.  He recently warned of a new wave of bad debts hitting Russian banks.

And Russia still faces its own home-grown curse: its legal nihilism, personified by Igor Sechin (will Marty Feldman play him in the movie?).  Sechin sent a letter to Norilsk Nickel, raising questions about some transactions, and in shades of the Mechel episode, Norilsk’s stock tanked immediately:

Norilsk slumped as much as 12 percent after the country’s biggest mining company said it received a letter from Deputy Prime Minister  Igor Sechin‘s office seeking information on transactions that were carried out last year.

. . . .

Norilsk sank 11 percent to 2,203.90 rubles on the Micex Stock Exchange, the biggest drop in a month. Sechin is seeking details on 86 billion rubles ($2.6 billion) of spending on share buybacks and asset purchases, and information on the sale of mining permits to a company owned by former Chief Executive Officer Mikhail Prokhorov, company spokeswoman  Erzhena Mintasova  said today.

Norilsk Nickel has complied with Russian law and the company’s own charter for all its transactions, Mintasova said.

Sechin, as chairman of  Rosneft, oversaw the state oil company’s acquisition of bigger rival  Yukos Oil Co.‘s largest assets at bankruptcy auctions after an investigation that led to the imprisonment of Yukos founder  Mikhail Khodorkovsky, once Russia’s richest man.

Meanwhile, the Telenor/Vimplecom farce continues:

Telenor said a Russian court rejected a motion to stay a ruling that found the Nordic region’s largest phone company liable for $1.7 billion in damages related to a dispute among OAO VimpelCom shareholders. VimpelCom sank as much as 11 percent in New York trading.

Wise words, these:

“The Norilsk and Telenor cases serve well to remind investors that Russia risk is a real phenomenon, which is the last thing Russia needs in this new, tighter-liquidity global market,” said  James Beadle, chief investment strategist at Moscow-based Pilgrim Asset Management.

The dispute is “an open demonstration of Russia’s aggressive business culture,” and is the same story as  OAO TNK- BP Holding, Beadle said.

So, in other words, la plus ca change.

The political uncertainty also continues.  A couple of interesting articles today, one by Pavel Baev in EDM, which noted:

Both Medvedev and Putin tried to perform as wise statesman meeting with Kissinger, but in reality for them global issues are just a public relations campaign of little importance compared with their real priorities of re-distributing money and property among servile but disloyal oligarchs (Grani.ru, March 20). This role of two-headed godfather is central for the regime’s survival in times of falling oil revenues when doubts in the irritated elites grow and spread under the surface of total obedience. Firing governors is apparently not enough to exterminate these mutinous doubts, so the second trial of Mikhail Khodorkovsky and Platon Lebedev is rolling towards the “guilty-as-charged” sentence (Novaya gazeta, March 18).

There is no way around the simple premise that in order to achieve a new positive start in U.S. relations, Russia has to begin a meaningful reformatting of its corrupt quasi-democratic regime. The Obama administration refrains from advocating any conditions of this sort, but Medvedev seems to be aware of the need to modernize the rigid system of “Putinism.” He remains reluctant, however, to deviate from the course set by his senior partner, who believes that the crisis hurts the U.S. more than Russia and will diminish its leadership, scorned as “uni-polarity.” Putin relies on the “fear factor” to keep the disgruntled elites under control and expects that demonstrative generosity towards pensioners and other “have-nots” would prevent an escalation of protest activity. His new anti-crisis plan unveiled last week does not envisage any new grants to struggling oligarchs, but gives first priority to social protection; it could, however, be overtaken by the unfolding disaster – as was the previous plan adopted last November (Kommersant, March 19). Such an emergency would require different kinds of measures, and forceful mobilization against an external threat is Putin’s fall-back option of choice; anti-Americanism, therefore, remains an important political resource – perhaps the very last refuge for a pair of scoundrels.

I particularly agree with Baev’s statement that the Khodorkovsky/Lebedev trial is intended to squelch “mutinous doubts.”

I found this paragraph entertaining:

Medvedev has personally explained to bankers that it would not be “fair” to demand money from the insolvent Rusal and its owner Oleg Deripaska; he also maintains that the International Monetary Fund should be governed by a board with a “fair” representation of contributors. Deputy Prime Minister Igor Sechin suggested at the recent OPEC meeting to establish a more “fair” system of regulating oil prices, which the gang of seasoned quota-fixers found only slightly amusing (Kommersant, March 16). This concern about “fairness” is not always driven by pragmatic calculations but betrays a grudge about the lost prosperity and stability that were perfectly on track until the U.S. made their economic problems everybody’s headache by provoking the global crisis.

The touching concern of Medvedev, Sechin et al for fairness brings to mind a spoiled child screaming “No FAIR!” when he doesn’t get what he wants.  Not that he earned it.

The other interesting article is from Goble’s WindowOnEurasia:

Even in other countries, he suggests, the notion that people are ready to sacrifice their rights to the state in exchange for economic well-being and will revolt if the government fails to provide it is overstated. Even in today’s severe economic crisis, the Moscow commentator says, “there are no signs in Europe of an 1848 or even of a 1968.”

In most cases, he argues, “the chief stabilizer is open political activity within a legal framework.” But in Russia, “our system is completely different, although it employs (for conspiracy!) the very same words,” an arrangement which includes the kaleidoscopic assertion that with Russians everything is exactly the same and at the same time entirely different.
This pattern has deep roots in Russian history and reflects a decision on the part of all those not intensely involved in political issues to focus on “their personal affairs and only on them” and to view politics as something alien to and apart from them and yet to see leaders as “symbiotically” involved in the survival of the state.

To this arrangement, Radzikhovsky says, a European would react with surprise: “They are DEPRIVING you (the people) of the rights to judge and decide and you (the people) nonetheless are still willing to support this arrangement!” But a Russian, he suggests, would understand the situation instantly, seeing it was being “a question of words.”

For the Russian it is not about deprivation, it is about “RELIEVING” the individual and society “of responsibility … and of the work involved in judging and deciding.” And as an example, to Radzikhovsky quotes Saltykov-Shchedrin’s observation that “the energy of the actions of fools opposes the energy of inaction.”

“The energy of societal inaction is the foundation of [the Russian] State,” he continues. “Therefore firmly or shakily, we stand by it.” Indeed, he says, “individualism (in individual affairs) plus humble fatalism (in common affairs) equals the ethnic Russian or better civic Russia (everyone in Russia, regardless of nationality acts that way) social-political SYSTEM.”
Given that set of attitudes – and Radzikhovsky insists that they can be called “sobornost,” “collectivism,” “apoliticalness,” or “alienation” – the relationship of those in power and everyone else is fundamentally different. Those in power have “a DIFFERENT function” and serve as “a shepherd” to the society.

Such a system, of course, has a dangerous tendency: the absolute power of the state in such circumstances tends to “corrupt absolutely, “both those who rule and those who are ruled.” But there is “a still more dangerous alternative: the absolute lack of rights on the part of the government and the absence of power [which can also] corrupt the people absolutely.”
The way out of this vicious circle would be a government with “LIMITED POWER,” but in Russia that has never been known and is not unknown now. “And with that is connected the completely SPECIAL role of the government in Russia,” one that is reflected in the very different attitude people have toward criticizing the government.

In most countries, Radzikhovsky continues, government is viewed as “only a superstructure’ over society” and thus as something from whose change the society does not think will change society. Consequently, any criticism of the powers that be for [such a] society is secure.”
But for Russians, “as is well known to all,” the picture is “different.” That is because criticism raises the question of leadership change, and “in the course of all Russian history up through today the main political question has not been resolved.” That is the question of the creation of mechanisms for a peaceful, regular and lawful change of the highest levels of power.”
Those in power, of course, “exploit this: destroy the powers that be and you will destroy Russia! This is a big EXAGGERATION. But it is only an EXAGGERATION” because the problematic situation it reflects is not invented but quite real. Russia has not succeeded in dividing “the powers that be” and “the country” just as it has not split power and property.

Consequently, the deference the population shows to the rulers is not so much “a slavish instinct” as an instinct for national SELF-PRESERVATION,” Radzikhovsky suggests, arguing that it rests on the notion that the powers and the population are linked together in “a biological symbiosis” whose violation by either side could lead to the death of the whole.
Thus “the real social compact [in Russia] is much more serious. It is not a trade off of independent sides,” and it is not about well-being “but about survival.” In this situation, the population will remain far more willing to defer to those in power because “the people DO NOT WANT” to do anything but “to AVOID being the opposite of humble.”

Understood in this way, Radzikhovsky concludes, the social compact in Russia has not yet been violated sufficiently to cause a revolt, especially given how great fears remain of “chaos.” And he reminds his readers that “one cannot free people externally more than they are ready for that internally.”

This is a very interesting commentary on the apathy of Russians.  It points out the fundamental lack of a civil society in Russia, the alienation between state and people (in spite of the allegedly organic relatonship between them) and reinforces a point that I made in my summer post On Russophobia, namely, that classical liberal limited government is an anathema in Russia.  (This, ironically, gave rise to charges that I was in fact a Russophobe projecting pejorative images of The Other.  But, as I noted at the time, this is considered a feature not a bug by many Russians, and many Russians like Radzikhovsky who think it is a bug acknowledge its existence nonetheless.  They have met The Other and it is Them.)

This is why, although I don’t discount the possibility of popular unrest, I believe that the main threat to the system comes from within, due to the “doubts in the irritated elites . . . spread under the surface of total obedience” (in Baev’s words).

The most important sentences in the Geithner Toxic Asset plan are:

To start the process, banks will decide which assets – usually a pool of loans – they would like to sell.  

To start  the process, banks will identify to the FDIC the assets, typically a pool of loans, that they wish to  sell.

The bank would then decide whether to accept the offer price.

In other words, the Geithner plan gives valuable options to the banks holding toxic assets.  They have to the option to choose to participate.  They have the option to choose the assets to sell.  They have the option to accept, or not, what independent buyers bid for the asset.  

Banks, of course, will exercise these options to maximize the value to their shareholders and managers.  Period.  Let me repeat: banks  will exercise these options to maximize the value to their shareholders and managers.  

But it is well known that insolvent banks, or banks teetering on the brink of insolvency, face extremely perverse incentives.  Shareholder and manager maximization for such institutions is often at odds with efficiency, and wealth maximization.  This is true because managers and shareholders of troubled financial institutions have incentives to take unwarranted risks and invest in projects that dissipate wealth.  That is, zombie banks (or more accurately, their owners and managers) are living, breathing moral hazard problems.  Maximization for them means minimization for us.  

Options in the hands of people facing perverse incentives are usually very, very bad things.  Sort of like matches, gasoline, and tinder in the hands of pyromaniacs in a lumberyard.  

In the present instance, giving potentially insolvent or near insolvent banks options can be expected to exacerbate, rather than mitigate, the current financial crisis, and the ultimate cost to us as taxpayers and economic agents could be huge–and, in my view, is likely to be so.  

So why is Treasury going down this path?  Were the pyromaniacs very persuasive?  In the virtually vacant Treasury department is there nobody of sufficient stature, without deep and longstanding connections to troubled financial institutions, who is willing to challenge the advisability of giving fragile financial institutions options to engage in morally hazardous behavior?  Nobody willing to call Bulls*it on Citi, BofA, Goldman, etc.?  

Maybe this reflects a mindset at Treasury that this is a liquidity problem, not a solvency problem.  After all, Geithner has said the banks have enough capital.  (Really? Evidence, please?)  And options in the hands of solvent but illiquid banks are not as dangerous as in the hands of insolvent ones.  So, the decision to give banks the options is consistent with thinking that they are really solvent.

I would offer two points in rebuttal.

First, the liquidity story is less and less plausible in the aftermath of the Fed unleashing a tsunami of liquidity on the US financial system.  You’ve all seen the chart with the spike of reserves being held at banks.  And the Fed just announced that it was going to unleash a second tsunami in the coming weeks.  So, the Fed has addressed the liquidity issue, meaning that there’s no need for the new Treasury program.

Second, maybe I’m wrong that this is a solvency problem–but maybe the Treasury is wrong that it isn’t (and if that’s not their belief then the plan is particularly foolish as it ignores the incentive effects of that insolvency).  There is certainly a high likelihood that many banks are insolvent.  Myriad knowledgeable commentators believe they are (appeal to authority, I know. . . ).  I would certainly be very reluctant to declare definitively that there is not a large possibility that many major banks are insolvent.  I would be doubly, trebly, reluctant to base a policy involving potentially trillions of dollars on such a belief.  

Given that this may well be a solvency crisis, those three little sentences could lead to disaster, the S&L crisis on steroids, meth, and angel dust.  All at once.