Streetwise Professor

Not like they would, but anyways . . .  

The Treasury Department today released a letter on “Regulatory Reform Over-The-Counter (OTC) Derivatives” [sic–“in”? “for”? “of”?].  There are a few good ideas in it, but on balance the bad far outweighs the good.  

The centerpiece of the proposal (which has received a warm welcome from Congressional powers like Barney Frank and Collin Peterson) is to mandate clearing for “all standardized OTC derivatives.”  “Standardized” is not defined, but the letter suggests how this will be determined: If a clearinghouse offers to clear it, it’s standardized: “For example, if an OTC derivative is accepted for clearing by one or more regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared.”  

On Tuesday, I gave a presentation at the Atlanta Fed conference where I reiterated my argument–which debuted here on SWP–that mandating clearing is a bad idea.  Even for standardized products (my argument nowhere depends on standardization, except to the extent that there is some correlation between standardization and the magnitude of information asymmetries), it is quite possible that information costs are higher in cleared markets than in bilateral markets.  For particular transactions, involving particular transactors, it is possible that information costs are lower in a bilateral trade.  These lower information costs can make it efficient NOT to clear such deals; for other trades, in the same or similar instruments, clearing may be more efficient.  

In a nutshell, there is no basis for the presumption that the costs of clearing are lower than the costs of bilateral trades.  Moreover, I have not seen a credible argument showing that the social benefits of clearing exceed the social costs, but the private benefits are smaller than the private costs; such a showing would be necessary to justify a mandate  for clearing.  At the Atlanta Fed conference, Ed Kane of Boston College (the moderator of my session) argued that the safety net arising from deposit insurance and the implicit promise to bail out too big to fail banks could lead to such a circumstance.  I do not see the economic basis for this conclusion.  Moreover, there have been cases in the past–namely at the CBOT in the 1920s and the LME in the aftermath of the Tin Crisis–where exchanges resisted government pressure to adopt clearing even though there was no safety net that could have caused a divergence between private and social costs/benefits.  

As I said at the Atlanta Conference, my issue is not with clearing per se.  It is with who decides what gets cleared.  Chuck Vice from ICE (no, I did not make that up;-) had chided me after my talk where I cast doubt on the virtues of clearing for some products and participants by saying “I thought you were my friend, Craig.”  I replied: “I am your friend, Chuck.  If you (i.e., ICE) build a clearing system, and market participants come–as happened in energy–more power to you.  That’s great.  What I’m worried about is the ‘We’re from the government and here to help you’ problem.”   By substituting its judgment–an ill-informed judgment IMHO–for the judgment of market participants who (a) have better information on the costs and benefits, and (b) have skin in the game, and hence an incentive to make the right decisions (though since information and incentives are imperfect, they will some times make decisions that an omniscient agent would not), the Treasury risks reducing efficiency. This is a serious risk, in my view.

I have yet to hear any indication from the Treasury, Congress, or the Fed that the issues relating to information costs, and the implications thereof for the benefits of clearing have been acknowledged, let alone addressed.  Since information costs are an essential determinant of the efficiency of any risk transfer mechanism–which is what clearing is–this is a serious omission that undermines any presumption that the proposal is based on a thorough consideration of the relevant considerations.  

Some other issues.  First, the Treasury letter is framed in a very dishonest way.  It starts by saying “[a]s the AIG situation has made clear, massive risks in derivatives markets have gone undetected . . . even if those risks had been better known, regulators lacked the proper authority to mount an effective policy response.”  As its first proposed policy response, it recommends mandatory clearing of standardized products.  But the AIG products were highly non-standardized, and it is extremely unlikely that these products would ever be clearable.  But by linking clearing with AIG, the letter suggests that the former would have prevented the latter.  Nothing in any of the proposals would have had any effect on any of the AIG deals.  This linkage is dishonest, in my view; a classic bait-and-switch.  If a firm did something like that in a securities prospectus, the SEC would nail it.  Similarly, if somebody did something similar in an infomercial, FTC would be all over them.  

Second, the standardization issue will raise no end of difficulties.  It will create an incentive for parties who recognize that the costs of clearing exceed the benefits to enter into non-standard transactions.  The letter says somebody must “ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP.”  The subject of the sentence is “CCPs.”  So, are we to believe that CCPs are to investigate bilateral transactions, and make a judgment on the motives for such deals?  There is a real conflict of interest here, as the CCP has the incentive to force business its way, and look at all non-standardized deals with suspicion.  (I should also note that if the dominant CCP is a member-owned entity dominated by banks, they may influence things in the other direction.)  More likely, the regulator will be required to make such judgments.  So, CFTC (or whomever ends up being the regulator) is supposed to put itself in the heads of transactors, and decide what their motives are for a particular trade?  This is a recipe for litigation, conflict, and most importantly, legal uncertainty.  

This will raise all of the issues that created problems under the Grain Futures Act and the CEA.  Those laws required “futures” to be traded on exchange, but allowed cash market contracts to be traded bilaterally.  So, what is a future?  What is a cash market contract?  Who knows?  In part, the answer depended on the economic purposes of the transactions.  Same now with the “standardized” vs. “non-standardized” distinction.  Such distinctions are recipes for dispute, and invitations for financial engineering to circumvent the clearing requirement.  The possible implications for legal certainty are particularly disturbing.  

Third, the letter emphasizes the role for “robust margin requirements.”  There is no recognition that margining can actually contribute to systemic risks, and that the rigid types of margining that CCPs perform may be particularly susceptible to this problem.  Margin calls can induce liquidations that move prices away from equilibrium values, and set off positive feedback mechanisms that destabilize the market.  Similar problems can arise in OTC markets, but the greater flexibility in these sort of arrangements, including the ability to utilize a broader range of collateral, can mitigate the problem there.  It is by no means clear that rigid CCP-style margining reduces systemic risk; it can increase it in some circumstances.  

On the issue of margins, I was interested to hear Chuck Vice (of ICE–I just like saying/writing that;-) say that ICE Trust took an “agnostic view” of the credit risk of member firms in setting margins, and therefore would charge everyone the same margin level that would be sufficient to cover the likely loss on a particular position during an extreme market move.  Bug or feature?  Chuck thinks feature.  I think bug.  Different members pose different default risks (just look at disparities in CDS spreads among the members of ICE Trust), and this would suggest the optimality of different margins–that is done in the OTC market.  One size fits all doesn’t fit everybody when people are of different sizes.  In the OTC market, parties can customize collateral levels to reflect risks, and this has virtues.  

Back to the Treasury letter . . .  

Another pernicious proposal is that the CEA be amended “to authorize the CFTC and SEC to impose . . . . The movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems.”

Again, this is the GFA/CEA redux–like those laws, this proposes to force a subset of all trades onto centralized exchanges, or electronic trade execution systems that are very exchange-like.  The reason for such a mandate is not stated.  Nor do I think it exists.  What externality is being internalized?  At what cost?  What is the basis for substituting the government’s judgment as to how trades should take place for the judgment of the transactors themselves?  

This is certainly a boon for the CME, and arguably ICE.  And shazaam, their stock prices took off after the release of the letter.  Who would have thought?  

Again, as under pre-CFMA CEA/GFA, the on-exchange/off-exchange distinction will lead to dispute, litigation, and legal risk.  

One could argue that exchanges are more transparent, and that transparency is a benefit.  However, other parts of the letter–namely, the requirement that all trades (including non-standard ones) be reported to a trade repository made available to regulators, and the development of a price reporting system–address the transparency issue.  Indeed, these are better ways to address transparency concerns than either clearing or forced exchange trading.  I said just that in my FRB Atlanta presentation, and in my academic writings on the subject.  Exchange trading may be sufficient to produce price transparency, but it is not necessary.

The transparency proposals are something I support.  Indeed, I view those as something of a vindication, as I was advocating such measures in energy markets in the 2003-2004 period.  The Data Hub lives!  

One issue with post-trade price and position transparency is the effect it will have on liquidity.  JP Morgan’s Eric Beinstein raised such concerns in his talk at the Fed conference.  This was a big deal with London dealers in the stock market, who feared that premature disclosure of trades would make it more difficult for them to lay off positions that they took on from customers.  Therefore, it may be advisable that some reporting delay be permitted.  

The letter also addresses market manipulation, fraud, and other abuses: “The CEA and securities laws should be amended to ensure that the CFTC and the SEC have . . . . Clear and unimpeded authority . . . to police fraud, market manipulation, and other market abuses.”  This is a red herring.  Relatedly the letter says that “under current law [OTC markets] are largely excluded from or exempted from regulation.”  This is wrong if it is meant to refer to exemptions from the manipulation or fraud provisions of the CEA.

CFTC already has authority to police manipulation of “any commodity traded in interstate commerce” and this clearly would extend to OTC swap markets as currently constituted.  Even the much (and wrongly, in my view) maligned CFMA did not exempt any market from the anti-manipulation or anti-fraud provisions of the CEA.  So, why is this language in the proposal?  Ignorance?  

More unfortunately, the letter recommends giving regulators the ability to set position limits on OTC market positions.  As I’ve written  in my book on manipulation, and often on SWP, position limits are an inefficient way to combat manipulation and fraud.  Ex post action is a better way.   CFTC should be better able to do this with better information about positions, so position limits are not advisable.

The problem, though, is not with CFTC’s powers or information.  It is with its willingness and ability to use them.  CFTC’s record in anti-manipulation litigation is hardly glorious.  Moreover, the legal precedents–especially CFTC decisions like in re Indiana Farm Bureau and in re Cox & Frey–have seriously undermined the deterrent force of government and private ex post litigation.  Treasury and Congress would do much more to improve deterrence by writing legislation to clarify manipulation law to undo the pernicious effects of these decisions.  Without doing that, Treasury is fooling itself when it says (in Geithner’s letter to Harry Reid, linked at the bottom of the link above) that  “With CCPs, trade repositories, and other market participants providing the CFTC and SEC with a complete picture of activity in the OTC derivatives markets, they should be able to detect and deter all such market abuses [emphasis added].”

As if.

Information is NOT the binding constraint.  When a manipulation is suspected, the subpoena power is sufficient to obtain the requisite information–and it is usually the efficient way.

I repeat: The binding constraints are (a) the intellectual confusion inherent in existing manipulation precedents; (b) the intellectual confusion at CFTC and other regulatory agencies when it comes to manipulation; and (c) the vague language defining manipulation in the relevant statute, which is ultimately the source of intellectual confusions (a) and (b), and which stemmed quite clearly from Congress’s own intellectual confusion.  I have been saying this since 1994.  So, don’t listen to me.  I’m used to it.  But don’t fool yourselves into believing that you will reduce manipulation efficiently through position limits and the collection of more information that is mis-used because of a failure to understand the economics of manipulation.

The letter also recommends actions to ensure that derivatives are not marketed to unsophisticated parties.  I have not analyzed this issue in detail, but it is my sense that this is another area in which ex post litigation, including private actions (including class actions) would be a preferable way to handle the problem.  Trying to write rules to determine ex ante who is, and who isn’t, sufficiently knowledgeable to enter into derivatives trades is extremely problematic.  I also worry about the incentive this provides for people to take risks, and then attempt to back out of losing contracts by claiming that they were duped.  Maybe they were, but I think there should be a pretty high standard of proof required to support such a finding.

In sum: There are a few good ideas in the Treasury proposal.  Very few.  The biggest, most important proposals are wholly misguided, in my view.  They reflect, again in my view, (a) a shockingly incomplete analysis of the relevant economics, (b) an unjustified and unsupported presumption that regulators’ and legislators’ judgments are superior to those of private transactors, and (c) a failure to identify market failures that the proposed regulatory changes would fix.

John Taylor of Stanford gave a very nice keynote speech at the FRB Atlanta Conference on Financial Crises & Innovation.   It was a very different speech than Bernanke’s, and much more critical of government as a cause of the crisis, and a potential source of systemic risk in the future.   Indeed, Taylor listed three major sources of systemic risk going forward that have been featured prominently on SWP as well:

·           Massive expansion of US government indebtedness.  Interestingly, Taylor said that “[t]here is certainly no  stimulus effect from such deficits, and they put a very heavy burden on the not so distant future.”  

·           A dramatic expansion of the Fed balance sheet, and serious questions about the credibility of any Fed promise to withdraw liquidity from the system, thereby leading to a substantial threat of inflation.

·           An undermining of the rule of law, primarily illustrated by the administration’s heavy-handed efforts to subvert bankruptcy law and debt contracts in the Chrysler case, as well as actions on executive compensation and forcing out CEOs.

I couldn’t agree more, obviously.   I think these are all major threats.   The first in particular is becoming greater by the day.   The second will become more acute as the Fed proceeds with various initiatives to acquire securities, thereby ballooning its already bloated balance sheet into the trillions, and as political pressures to avoid doing anything that could abort a recovery bias the Fed towards ease even if and when inflationary pressures become manifest.   The last is a new development, and it bears attention to see whether the government takes any further steps along this path.

Taylor’s overall theme was that massive government failure is a real possibility, and that government is a major source of systemic risk.   Agreed.   This is a message that bears repeating over and over again as regulatory and legislative nostrums are pushed in the coming months.

At today’s session, AEI’s Vincent Reinhart made a point that I’ve also emphasized on SWP.   I’ve said that the biggest lesson of the Great Depression is that people learned the wrong lessons from the Great Depression, and passed useless or counterproductive legislation as a result.   Reinhart said, in a similar vein, that the most important thing going on today is the battle over the narrative as to what caused the financial crisis, because that narrative will determine what policies are adopted going forward.   He stated that the narrative of the Great Depression was wrong, and that as a result the regulatory and legislative response was wrong too.   He fears that the emerging dominant narrative is similarly misguided, and will lead to similarly damaging results.

Taylor’s talk was an attempt to counter the conventional wisdom narrative, and advance a counter-narrative.   Sadly, I think that this is an uphill battle indeed.   But, as Reinhart says, it is a battle that needs to be fought.

As I was getting on the plane to come back home, a reporter sent me an advanced copy of a letter that Geithner has sent to Congress outlining plans for regulation of the OTC derivatives market.  That letter embodies a particular narrative that I believe is particularly, and perniciously, in error.  This illustrates the relevance of Reinhart’s point.  I will deconstruct that letter in detail tomorrow, time permitting.  

When Ben Bernanke started to speak last night, it began to thunder and lightning.  Could be just a coincidence, but . . .

I am participating in the Atlanta Fed’s conference on Financial Crises and Innovation in Jekyll Island, GA.  The keynote speaker tonite (the first evening of the conference) was Ben Bernanke, Chairman of the Fed.  

Bernanke’s speech was about the stress tests.  I thought he did a good job in explaining and defending the tests.  He clarified a few things in my mind.  Which is not to say he persuaded me that all is well.  In other words, I’m not ready to help revive Tinker Bell just yet.

Three things he said about the stress tests gave me some disquiet.

First.  He emphasized that they were a “confidence building exercise.”  That seems like assuming the conclusion.  I would like a fact finding exercise, with a clear statement of the findings, good or bad.  Stating that the objective is to build confidence suggests a pre-ordained result–Kabuki Theater.  It’s like saying that something is needed to build “self-esteem.”  Success builds self-esteem, not the other way around.  Similarly, success builds confidence; confidence building does not ensure success.

Second, he argued that the stress tests were based on models calibrated to extensive historical experience.  Well, we are in uncharted territory here, which raises doubts about the probative value of historical experience.  I can think of some ways to massage historical data that could be useful.  But one of the problems I see is that the characteristics–the quality–of loans issued in the 2005-2007 period differed substantially from the quality of loans issued in prior years even holding measurable characteristics constant.  What’s more, the unemployment and growth scenarios used in the stress tests differ substantially from anything in the historical data likely to have been employed.  Thus, there are at least two reasons to believe that historical experience may be misleading.  

Third, Bernanke stated something that I had conjectured in my previous post Tinkerbell Goes to Wall Street.  Namely, that the stress tests are not intended to estimate the market value of bank assets under alternative scenarios, and are not intended to be solvency tests.  Instead, they are based on a view that market prices are deeply discounted from fundamental values due to liquidity effects, and that as long term investors funded by deposits, banks can hold assets to maturity.  As a result, when evaluating the capital banks need, expected losses (in the “physical measure” if you will) are the relevant measure, not mark-to-market losses.  

This last is a view that Bernanke has maintained since early in the crisis; he testified to this effect in the days immediately following Lehman.  Maybe.  But this is essentially speculation.  Indeed, although Bernanke cited one of the papers presented earlier in the day to support his view, the other paper (by Michael Brennan) supports a contrary view.  Specifically, that by focusing on expected losses alone one ignores the states of the world in which the losses occur, and the systematic risk of those losses.  Losses that occur in very bad economic times are discounted more heavily.  The disparity between valuations based purely on expected losses and market prices may be due to liquidity effects, but it may be due to fundamental risk pricing issues–the shift from the physical to the pricing measure.  By ignoring this possibility, the stress tests could seriously underestimate the amount of capital banks really need.

In sum, Bernanke took a particular view on why many asset prices are so heavily discounted.  It is a liquidity driven story, not a fundamentals-based, or market price of risk/systematic risk-based story.  If he is right, there is some justification for the stress test estimates of capital needs and the capital position of banks.  If he is wrong . . .

Bernanke took questions afterwards.  In response to his statement that the Fed was committed to price stability, I asked: “How does the Fed make its commitment to price stability credible in light of the extraordinary measures it has taken in the past year?”

Bernanke gave a very long answer–I’d guess it took 3-4 minutes.  He looked me in the eye the entire time.  His answer was, it seemed to me, well practiced.  But it was not entirely reassuring.  He said (and I paraphrase, obviously): we’re doing two things.  First of all, all of the members of the Board of Governors and the Fed Open Market Committee are making public our views on what the “right” amount of inflation is–about 2 percent.  Second, we are making clear that we have the tools–charging interest on reserves, reverse repos–to withdraw liquidity from the system without selling assets.  That’s fine, to a point.  I have no doubt he knows that inflation is costly and has the tools to fight it; the question, though, is whether he can credibly commit to use these tools.

He went on to say that he understands clearly the nature of the problem, and is getting heat from both sides–those that fear inflation if he doesn’t respond to a rebounding economy by withdrawing liquidity, and those who fear a prolonged recession/deflation if he withdraws liquidity too quickly.  He suggested that this is nothing new–he said a couple of times that this is the kind of problem central bankers always face when an economy is at a turning point.  

Fair enough.  But as with my reservations about the use of historical data in the stress test, here I believe that we are in uncharted waters, and that although this problem may be of a kind that central bankers are quite familiar with, it is of a scale that none (at least none living) have had to navigate.  The amount of liquidity overhang is so large; the severity of the recession is so much greater than any of recent memory, and as a result the political reaction to a “double dip” recession would be commensurately greater; the banking system is so much more fragile than during previous downturns; and the independence of the Fed has been called into question as a result of its extraordinary actions more than ever before.  All of these factors make the Fed’s job of steering between the Scylla of deflation and the Charybdis of inflation very daunting indeed.  And although Bernanke certainly was personally impressive and appealing, I still believe that there is a very serious inflationary risk going forward.

And for the record.  I’m damn glad I don’t have his job.

Other than the price, that is.  The excellent Izabella Kaminska continues her fascinating coverage of the relation between oil prices and fundamentals at FTAlphaville. Izabella provides additional data on the continuing accumulation of oil and product inventories in the face of rising prices, and links to a Goldman Sachs analysis thereof.  

A positive co-movement between inventories and prices is an anomaly in the standard theory of storage model.  In that model, an negative demand shock (or a positive supply shock) leads to (a) a decline in price, and (b) an increase in inventories.  

I have devised a model (the ideas for which I first explored on SWP) in which you can get a positive covariation between prices and inventories due to stochastic fundamental volatility.  The basic idea is that when fundamental uncertainty goes up, people increase precautionary inventory holdings.  The only way to do this is to bid up price in order to reduce consumption and increase production.  

Although I think that this model can explain some market behavior (such as in the post-hurricane period 2005-2006), it doesn’t seem to fit the current episode.  If anything, fundamental uncertainty is declining of late.  Stock prices have been rallying.  The volatility indices (e.g., the VIX) have been declining.  

Here’s an alternative explanation.  Traditional models posit Markovian processes for (net) demand shocks.  This means that current demand shocks imply a distribution of future demand.  Moreover, the models are typically stationary, meaning that a given current demand shock leads to a smaller change (in the same direction) in expected future demand.  In these models, the distribution of future demand changes only if current demand changes.  

An alternative model (which is hard to implement formally) incorporates “future” shocks that are distinct from current shocks.  (A Fama-French JF paper on metals prices from 1988–if I recall the year–explores this idea.)  That is, information may arrive today that has no implications for current demand or supply, but does has implications for future demand or supply.  So, for example, if new information arrives that suggests the economy will be better in 6 months than than had been previously anticipated, a rational economic response is to add more to inventory in anticipation of higher future demand.  Expected future prices rise due to the bullish future information, and in conditions of full inventory, the cost-of-carry relationship causes current prices to rise too.  (Indeed, holding current demand constant, the higher price induces lower consumption and higher production, which allows the accumulation of additional inventory.)  

This is pretty close to the Goldman-Sachs story.  Goldman also argues that if oil storage facilities fill up, the connection between future prices and spot prices will break down.  In the context of the model, if the marginal cost of storage becomes very steep, the increase in future demand leads to a rise in the future price, but a much smaller rise in the spot price; it is too costly to accommodate the future demand shock by adding even more to inventory due to the very high and rapidly rising cost of storage.  Thus, current inventory (and hence current consumption) do not respond to the future demand shock; since consumption doesn’t respond, spot prices don’t change either.  

Note that the nature of the “future shock” (to steal the name of an old book) is not specified here.  It could be a real shock or a nominal one.  That is, it could be that information arrives that suggests that real demand will increase in the future, or that only nominal (money) demand will increase.  That is, inflation is expected to increase.  This could lead to increases in nominal spot and futures prices, even in the face of stagnant or declining real demand.  

One piece of evidence that could bolster this interpretation is that nominal Treasury yields are beginning to rise.  The 30 year auction yesterday was something of a disaster, and 10 and 30 year yields are rising. Indeed, over the past week when oil prices have been rising, the breakeven rate (the difference between 10 year nominal T-note rates and the corresponding TIPS yield) has increased from about 1.41 percent to 1.58 percent.  Not a big deal, but the direction is interesting.  

So, the oil market could be a “green shoot” signaling an impending recovery of demand.  One not quite here yet, but on the horizon.  Or, it could be a “green” shoot in the sense that (a) money is green, and (b) per Milton Friedman, inflation is always and everywhere a monetary phenomenon.

Banking stocks have experienced a big rally, given impetus by the anticipation, realized in the event, that the “stress tests” would show that big financial institutions were solvent, and would require only modest additional amounts of capital.   Indeed, the conventional wisdom now appears to be that the banks can earn their way out of the hole in relatively short order.

I have my doubts about this Alfred E. Neuman “What, Me Worry?” rally.   Indeed, the entire stress test exercise resembles Kabuki Theater, and the market response seems to be more appropriate to a matinee presentation of Peter Pan (“We believe, Tinker Bell!”)

Here’s one thing that feeds my doubts.   A bank is insolvent if its liabilities exceed its assets.   This would be easy to determine if the assets in particular were easy to value.   But many are not, so we cannot get a snapshot of the current solvency of banks.

But, apparently the whole idea of the stress test is to estimate bank solvency under alternative scenarios of future unemployment, economic growth, interest rates, housing prices, etc.  

So, apparently we are to understand that it is impossible to determine bank solvency at the current moment because we cannot value the assets, but we can estimate their future value under various future economic contingencies.

Just how is that possible?

Or maybe there is another interpretation.   Maybe one can interpret the stress tests as an attempt to determine the current value of these assets by estimating a distribution of future cash flows under alternative economic scenarios, taking an expected value across them, and discounting back to the present.     This interpretation would suggest that the operating assumption of the analysis is that current market prices (to the extent that they exist) do not reflect the true value of the assets, due perhaps to steep liquidity discounts.   This is the line the Fed, the banks, and Treasury have been pushing since the beginning of the crisis.  

But, if it were that easy to determine the “true” value of these assets, why is it that they are so illiquid, 7 months post-Lehman, and after the Fed has created unprecedented amounts of liquidity?     How could there be such a big disconnect between “true” asset values and market prices?   Are these just rating agency models writ large?   What assumptions underlay the modeled relations between asset cash flows and economic outcomes?   How do the stress tests capture how defaults and recoveries on various kinds of loans (commercial real estate, residential real estate, credit cards, etc.) will vary depending on economic conditions?   Given that we are going into unexplored economic territory, skepticism is almost mandatory.     History may provide little guidance.   Defaults and recoveries on debts incurred during a period in which it was widely believed that a severe economic contraction was highly unlikely will be quite different from those experienced in severe recessions in the increasingly distant past.   How much will they differ?   Who knows?  

I would suggest that there is an acid test for such beliefs.   If the banks are really solvent and don’t require much additional capital because their assets are really worth pretty close to the values banks have currently assigned to them, then both banks as sellers and numerous investors as buyers would be willing to participate in the PPIPs program.   Investors would be willing to buy the assets at close to the prices implicit in the stress test results, because the government is supplying on very generous terms the liquidity necessary to carry these assets.   Banks could sell assets firm in the knowledge that these prices investors are willing to pay would not be so low as to prove to the world that the banks are insolvent.  

Until investors and banks put their money and assets where their mouths are, and start buying and selling these assets at prices close to the values at which banks currently value them on their books, I will be deeply suspicious of the stress tests, and any other bank or government assurances that the toxic asset problem is modest and containable.

Here’s a more skeptical—indeed, cynical—explanation of what’s going on.   There is a confluence of interests between the banks, the Treasury, and the Fed.   The banks, of course, want to have the option to earn, not to say gamble, their way of their current predicament.   The Treasury and the Fed realize that there is no Congressional support for additional funds for troubled banks.   They further realize that the operational and legal challenges involved in resolving huge bank holding companies are incredibly daunting.   So, all concerned have an incentive to kick the can down the road.   To defer action in the hope that a turnaround in the economy or some stroke of luck—or a burst of inflation—will eliminate the necessity of winding up insolvent institutions.  

Hence, the Kabuki Theater of the stress tests.   Each side plays its part in a very stylized way.   The banks even put up enough of a stink to make it seem like something is being forced on them.   Professional wrestling looks authentic by comparison.

Viewed in this way, the rally in bank stocks is understandable too.   Of course, part of it can be “we believe” optimism that the economy is recovering, and that bank earnings will similarly rebound, or that the stress tests show that previous pessimism about the severity of the toxic asset problem was overdone.   But, it also makes sense to the extent that it is now quite clear that the banks will be allowed to continue to operate with little risk of resolution, bankruptcy, or nationalization.   To the extent that bank equity is effectively an option, the revelation that this option will not be terminated any time soon is extremely bullish news.   Moreover, since debt of insolvent banks is also effectively equity, and hence effectively an option, extending the option to gamble one’s way out of ruin also enhances the value of bank debt.   Immediate resolution would probably lead to the immediate loss of a good part of the value of unsecured bank debt, but survival could permit recovery of a good fraction of that value. This can explain the tightening of CDS spreads on banks—an indication that the value of their debt is rising.

Viewed in this way, the rally in bank securities is explained by the market’s estimation that the stress tests, and the apparent willingness of the government to eschew any efforts to restructure big banks, extends the life of the gamble to survive option.

But, if this view is correct somebody has the short position in that option.   Normally, an increase in the value of the gamble to survive option would benefit equity at the expense of debt.   But given the potential for a bailout that may provide some support for creditors in the event the gambles do not pay off, it is possible that extending the life of this option could help both bank debt and equity.    

Under this interpretation, that somebody holding the short position would be taxpayers, or the holders of dollar denominated claims who will pay an inflation tax.   Heads, the bank shareholders and bondholders win.   Tails, the taxpayers pick up the tab.  

Although there is no direct market in these things, Treasury securities prices do provide something of a signal.   Greater debt or greater inflation put upward pressure on Treasury yields, and we are beginning to see evidence of that.

So, I am highly skeptical about the stress tests, and their interpretation.   Given the very gloomy prognostications of the IMF and others about the total unrealized losses on toxic assets, the stress test results and the way they are being spun seem too good to be true.   Maybe we are in Neverland.   But maybe the banks, Treasury and the Fed have their own reasons to double down and hope for the best, and the stress tests are providing the cover to do that.   The artificiality of the stress tests, and the weird nature of the entire exercise (i.e., how can you value what banks will be worth tomorrow if you can’t value what they’re worth today?), make me suspect that the latter is a very real possibility.    

Today is the 110th of Hayek’s birth.  Reading a couple of items in the FT brought to mind one of Hayek’s most trenchant observations.  Specifically, Hayek was extremely suspicious of the use of the word “social” as a modifier.  He viewed it a a meaningless appendage at best, a means of undermining (or intimidating the exercise of) independent thought at its worst.  Hayek believed that the positive connotations of the word “social” were used to justify profoundly illiberal, and at times oppressive, actions and policies.

The s-word is cropping up a lot in discussions of the Chrysler bankruptcy, and the administrations attempts to strongarm those standing on their contractual rights.  One example:

“The financial interests of investors may conflict with what the government is trying to do from a social perspective,” says Steve Persky, managing director of Dalton Investors, a Los Angeles-based hedge fund that specialises in distressed debt.

And another:

The message that all the constituencies involved in Chrysler must share in the pain originated in the White House. “The government played a very strong hand,” says the person representing one agent bank. “All the senior lenders got the short end.

“The government had one eye on the social element and one eye on not abrogating contracts, but can you reconcile these two goals?”

Translation: “social perspective” and “social element” mean policies intended to benefit one group of individuals at the expense of another, but that the beneficiaries are called “society” and the victims of the redistributive policy are by implication “anti-social.”  I can’t think of a better example of Hayek’s warnings about the use of “social.”

No, the 60,000 Chrysler workers are not “society.”  They are a politically favored group.  And no, the senior creditors are not “anti-social.”  They are individuals and firms whose contractual rights are being threatened.

Indeed, the insinuation that the deprivation of a small number of individuals’ contractual rights is somehow necessary to achieve larger benefits for “society” turns reality on its head.  By undermining the security of contract to benefit a small, politically favored interest group, these actions will reduce the wealth of Americans–and indeed people around the world–by a far larger amount than it will increase the wealth of the Chrysler workers and retirees.  It will raise capital costs and transactions costs throughout the entire economy, making most of us far poorer (except, perhaps, for lawyers and lobbyists).   The rule of law and contractual rights are essential to the production of wealth, and to economic growth.  Undermine these, and less wealth will be generated, today and in the future.  

And, to provide some perspective on how the word “social” is used to rationalize robbery, here’s a wonderful quote from Obama’s Book Club buddy, Hugo Chavez, rationalizing the expropriation of oil services firms who actually had the temerity to demand payment for services rendered (can you believe?):

“Tomorrow we’ll start recovering the goods and assets that will now belong to the state — social property as it always should have been,” Mr. Chávez said in a televised speech Thursday. “Mr. Man on the moon, cover your ears because the cries of anguish from the bourgeoisie will reach all the way to the moon.”

We’re not Venezuela or Russia yet, by any means, when it comes to undermining property rights.  We still have independent courts.  But the administration’s (and Congress’s) disregard for property rights, and its willingness to run roughshod over them to benefit certain political constituencies promoted to the rank of “society” is an ominous precedent.

As is the other news in the second FT article quoted above.  Namely, the use of big banks dependent on the government to serve as the enforcers of the government’s will:

But whatever the final ruling, the talks last week illustrated that four banks, led by JPMorgan, which acted as agent for the loan, were acting to advance the government’s agenda, according to people familiar with the talks. The core lenders, which also included  Morgan Stanley,  Goldman Sachs  and  Citigroup, have all taken taxpayers’ money through the troubled assets relief programme.

The efforts of Mr Lee at JPMorgan, which originally had $2.7bn of Chrysler debt, were supported by the three other agent banks, Citi, with about $900m in face value of loans, Morgan Stanley and Goldman Sachs with well under $600m each. Mr Lee declined to comment.

The four banks divided up the work of contacting other creditors, with each calling those with whom they had the strongest relationships, the people familiar said.

In some cases, the large banks were lenders to smaller Chrysler creditors, in others, they had sold them the Chrysler debt. “There was a lot of high drama stuff,” recalls one creditor. “There was a lot of we will never do business with you again kind of talk.”

That can be standard in the tough negotiations over the fate of troubled borrowers. But in this case, there was another element. In an illustration of how dramatically the financial world has changed during the financial crisis, bankers from the agent banks say they felt under pressure from the US government.

This is the kind of abuse of effective government control over large financial institutions that has led me to oppose nationalization as a means of addressing bank insolvencies.  We again seem to have the worst of both worlds: the government gives every impression of being captured by the major banks when it comes to dealing with insolvency (I hope to write about the stress tests in a bit), but exerts pressure on them to divert resources to its favored constituents.  And perhaps this is the disturbing quid pro quo: the banks get the opportunity to gamble themselves out of trouble, and in exchange, assist the government in undermining contracts so as to benefit its favored interests.

Like I’ve said.  These things don’t average out: being too nice to the banks on some things and leaning on them in others is to commit two errors that compound, rather than offset.  (Like the old lawyer joke: “I’ve won cases I should have lost.  I’ve lost cases I should have won.  Therefore, on average, justice has been served.”  No.  It’s been dis-served twice.)

To close the circle, this quote from an article about science prizes illustrates perfectly Hayek’s warnings about the low and dishonest rhetorical use of the word “social”:

“I hate these inducement prizes and their language of social benefit,” says University of Pennsylvania prize scholar James F. English, author of “The Economy of Prestige: Prizes, Awards and The Circulation of Cultural Value.” “It’s a cover for what they are really about, which is getting attention. I don’t think that kind of small-scale frantic prize-chasing investment is the best way for us to solve big problems.”

Different context, to be sure.  But a wonderful illustration of Hayek’s point that when you hear the word “social” being used, be very, very careful.  There is a very good chance you’re either being played–or intimidated into silence.

Sorry about the light posting, but I have been in DC for 4 days, including 3 days of deposition testimony in a manipulation case before the Federal Energy Regulatory Commission.  A good time was had by all.  Well, maybe not all.  I had some fun, though.  

It seems that things have carried on without me, with the comment sections of some earlier posts going nuts. (Choice of words quite intentional;-)

But, it’s time to weigh in with some new material. Several Russian things have caught my eye.  

First, in Georgia on My Mind I speculated about the possibility of a renewal of fighting between Russia and Georgia.  Tensions have ramped up further in the 11 days since.  Russian criticism of NATO maneuvers–staff exercises, really–in Georgia has grown only more shrill as the exercise began:

The expulsions came as Moscow fiercely criticised the start of  Nato military exercises  in Georgia, another source of tension in relations between Russia and the 28-member alliance.

Dmitry Rogozin, Russia’s envoy to Nato, said that the alliance would be better off holding the manoeuvres “in a madhouse” than in a country where troops were “rioting against their own president”, a reference to this week’s alleged  army mutiny in Georgia.

. . . .

“It’s still not clear how Russia is reading both the Obama administration and the security relationship with Nato,” said a senior British official this week.

“The messages coming out of Moscow are still unclear. Russia is still hugely sensitive about anything that affects its near-abroad.”

The development of a functioning Nato-Russia relationship is seen as important by security analysts, who believe that Moscow has a role to play in helping the allied effort in Afghanistan and combating piracy off the coast of Somalia.

But earlier this week, Mr Lavrov cancelled plans to attend a meeting later this month of the Nato-Russia Council, a body that brings together the governments of the western alliance and Moscow.

And what, exactly, is “unclear” about the Russian responses?  

The aforementioned mutiny of the Georgian tank battalion, and the ongoing standoff between Saakashvili and the opposition; the Russian assumption of the responsibility of guarding “independent” South Ossetia’s and Abkhazia’s  borders with Georgia; related allegations that Russia is positioning troops (including Grad rocket launchers which Russia excoriated the Georgians for using) in these areas, within 40 clicks of Tblisi, in violation of the cease fire; Russian allegations of the massing of Georgian troops; the spy expulsions (choosing the Canadians as the tat in the game of tit for tat is interesting–thoughts, Michel?); the sortieing of the entire Russian Black Sea Fleet.  It is plausible, though not proven, that the demonstrations and the mutiny had Russian support, even if they also draw upon domestic dissatisfaction with Saakashvili.  If a strategy of subversion doesn’t work. . . what next?  Maybe the repositioning, the fleet movements, etc., are just muscle flexing and an effort to voice extreme displeasure with NATO, but maybe there is something more.  

Another interesting tidbit: Russia fired the head of its airborne units.  Presumably another casualty of the war to reform the Russian military, joining ousted GRU commander  General Valentin Korabelnikov.  

Here is an interesting article by a Finnish expert on Russia that echoes a favorite SWP theme: the brittleness of the Russian system, especially in hard economic times under an anomalous diarchic leadership:

It would be inadvisable, however, to hold your breath while waiting for Russian reforms: there are serious structural constraints that are preventing Russian from making significant changes. Thus, anyone who is optimistic that Russia will soon change its ways seems bound to get caught up in the cycle of disillusionment.

In the post-Soviet age, Russia has never had anything more than a tepid interest in integrating with Europe. A set of deep-seated historical, cultural, economic and social factors instead have encouraged Vladimir Putin’s Kremlin to pursue its own course. Accordingly, Russia has developed a peculiar socio-economic system that Putin aptly dubbed “managed democracy.” The evolution of this awkward system of government now makes Russia’s integration into the associations of democratic states impossible for the foreseeable future. It also makes the enlargement of Euro-Atlantic institutions seem like a threat to what the Kremlin claims to be Russia’s national interests.

Seemingly unperturbed by the dramatic disconnect between Russia’s and the West’s values and interests, the Kremlin pursued two geopolitical goals in recent years. Buoyed by an unprecedented windfall from energy exports, Russia tried to position itself as an independent great power unconstrained by any alignments. It also sought to fashion itself as an alternative values center – a norm-maker in its own right, on par, say, with the European Union or the United States.

The global economic slump ended up exposing severe flaws in the Russian system, in particular a glaring lack of checks on executive authority. The excessive concentration of power in the hands of a few now seems to be hampering the country’s ability to come to grips with a spreading economic crisis. A more open system, one that encouraged the promotion of the best and the brightest, as opposed to those who best curry favor with Putin, would stand a far better chance of guiding Russia out of its present economic mess.

During the “fat years,” the abundance of energy-export revenue meant that the Kremlin leadership didn’t have to worry about its brittle and arcane management structure. But now, with surpluses giving way to ballooning deficits, Russia’s rulers have ample reason to be worried about their futures.

It seems that at least some of the Kremlin’s leading men are aware of their plight, and are interested in finding a way out. Thus, some appear to be ready to reengage the West following the breakdown in relations last year, stemming from Russia’s blitz into Georgia. [For background see the Eurasia Insight archive]. This forward-thinking faction also seems to be tentatively probing for ways to reinvigorate the Kremlin management team, with the aim of making it more flexible.

But the real question is whether Russia’s paramount leader – Putin – is ready to admit that the system he built has turned out to be dysfunctional. Until an answer manifests itself, Russia will find itself stuck. Putin’s dependence on managed democracy has left the government ill-equipped to handle the economic crisis, as it can neither opt for thorough democratization, nor can it effectively follow the path of authoritarian adaptation.

. . . .

The thing is that the Medvedev-Putin “tandemocracy” is neither a democratic division of power, nor is it an efficiently functioning duumvirate. Under conditions where dwindling resources are fostering competition among various elites, Russia’s peculiar power arrangement stands to become a factor of instability [here, here, sayeth SWP].

When Putin anointed Medvedev as his successor he made sure that Russia’s next president would be politically and institutionally weak and dependent on him. As a result, Medvedev is essentially an impotent leader: he cannot sack Putin, his prime minister, make him responsible for all Russia’s current woes (as many Russian autocratic rulers did to their predecessors in the past) and then attempt to introduce certain changes “from above.” For his part, Putin also appears to be stuck with Medvedev as his presidential pick. What follows is a virtual political stalemate with Moscow being unable to come up with a semblance of a coherent policy.

As Russia’s political system remains largely unreformed (and seemingly unreformable), its foreign policy is likely to be more of the same. For the Russian leadership, the notion of the country’s great power status will stay unchanged. Russia, therefore, is likely to become increasingly prickly in its dealings with the United States and European Union due to its own inherent internal weakness.  

The last paragraph suggests the tie between the three stories: increasing Russia bellicosity in Georgia, and versus NATO generally, the sacking of another commander of an elite service branch, and tensions within the regime.  A regime under tension, especially one with Great Power pretensions and bathed in paranoia, could find another adventure in Georgia to be very useful.  Indeed, note the mention in the above article about some of the “liberal” elements in the government desiring to reach a rapprochement with the West after the Georgian rupture.  This would not serve the interests of the hardline siloviki, which would give them further incentive to stoke tensions with the West–and we see tensions in Georgia, the Baltics, and elsewhere.  Military men disgruntled over the proposed reforms are a danger to the government, and in the current economic and political situation could represent a very grave danger–so some of the most prominent are being replaced.  

In brief, all the aggressive talk and action emanating from Russia make perfect sense when one considers the extremely unsettled economic conditions; the brittle nature of the political system; the cross-currents between Putin and Medvedev, and the various factions that look to each.  There is a real possibility–not a probability of one, but an appreciable one–that these forces could erupt into something serious.  Although domestic tumult is possible, I think a foreign adventure is more likely.  And the most likely place for that to happen is Georgia.

And speaking of Georgia, I will be heading there Friday.  No, not that Georgia.  Our Georgia, to speak at the Atlanta Fed’s conference on the financial crisis, to be held on Jekyll Island, GA.  So the posting may again turn light.

The Obama administration–and President Obama personally–have inserted themselves where they do not belong, in the midst of the Chrysler bankruptcy. Obama and his administration have clearly engaged in strongarming secured creditors in order to serve the interest of an unsecured creditor, the UAW, which just happens to be the Democrat Party’s Siamese twin:

Chrysler LLC filed for Chapter 11 bankruptcy protection in New York on Thursday, saying that it would sell its core assets including its Chrysler, Jeep and Dodge brands into a new company that would be owned by the U.S. government, Fiat SpA (FIA.MI) and the company’s workers.

The plan, however, depends on U.S. Bankruptcy Court approval of the sale, and this group of lenders feels the current plan to sell those assets within 30 to 60 days may infringe on their legal rights.

“We’re just standing on the law,” said Tom Lauria, a bankruptcy attorney at White & Case, representing a group of about 20 Chrysler first lien senior secured lenders.

“They (Chrysler) say they are going to allocate out and distribute the proceeds of the sale in a way that they couldn’t do if they were going to do it under a Chapter 11 plan,” he added.

The group of lenders Lauria represents includes Oppenheimer Funds, Stairway Capital and other secured lenders who have their own group of investors, including teachers’ credit unions, pension funds, retiree plans, college endowments, and retirement funds.

He said the group understands the need for Chrysler to sell itself and for the industry to restructure, but owes a fiduciary duty to its investors and objects to the way Chrysler is trying to divy up the proceeds of the bankruptcy sale without putting it to a creditor vote.

“This is not an objection to rescuing Chrysler, Lauria said.

Rather, Lauria said, Chrysler’s proposed plan “inverts” the classic priority scheme written into the bankruptcy code, where senior secured creditors are paid in full first, followed by junior lenders, administrative claims, unsecured lenders and equity holders.

“The sale is an attempt to end-run the procedural protections that are provided to stakeholders by Chapter 11,” he said.

“What’s happening is the senior secured creditors are going to get 29 cents on the dollar and the unsecured creditors are going to get $10 billion dollars.”

Lauria said his clients had viewed the quality of their collateral as secure and took correspondingly low interest rates on their loans to Chrysler because the loans were “seemingly secure.” But now the lenders find themselves effectively subsidizing more junior creditors, in a way that would not typically occur under the bankruptcy code, Lauria said.

. . . .

“Based on the pressure the administration has put on a number of my clients who have received no TARP funds in the last 24 hours, I cannot imagine the pressure that it brought to bear on the lenders in our group who received TARP funding,” Lauria said.

“I’ve never seen the President of the United States personally thrust himself into a bankruptcy case. The executive branch is going to be present in the court and it will really put pressure on the court to demonstrate to the people of this country that it’s watching what’s going on in an independent and unbiased way.”

In a televised appearance from the White House, Obama termed the dissenting Chrysler debtholders “speculators” who had endangered the automaker’s future by holding out.

“I don’t stand with those who held out when everybody else is making sacrifices. That’s why I’m supporting Chrysler’s plan to use our bankruptcy laws to clear away its remaining obligations,” Obama said.

The part about “us[ing] the bankruptcy laws” is particularly rich, as the aggrieved creditors are clearly standing on the bankruptcy laws, and numerous precedents thereunder, while the UAW and the administration are just as clearly doing everything possible to subvert those laws and precedents.  

Selective intervention of this sort has consequences.  Any potential lender or investor to any politically sensitive firm will certainly raise his/her estimate of the likelihood that their investment will be expropriated if it serves the interests of this administration, or some future one.  The cost of finance, both debt and equity, will rise accordingly.  

The main saving grace here is that there is a possibility that an independent court will slap down this usurpation.  That is what–so far, anyways–has kept this country sliding down too far on the path towards an unconstrained executive, and away from a rule based system in which personal liberties–including property rights–are protected from the awesome power of the state.  The Supreme Court did so when overturning the NRA in the poultry case, and in ruling in the Youngstown case against Truman’s seizure of the steel industry during the Korean War.    

We’ve seen what happens when the power of the government favors organized labor in the airline industry, and the railroad industry before that.  It was not pretty.  In the case of the airlines, it is still pretty ugly.  

So, where will the effect be biggest?  Right now, I’d say Ford.  The company has been relatively fortunate, but it will definitely face higher capital costs going forward.

 Another industry worth watching is the banking industry.  You know, the one that needs massive recapitalization.  Maybe in the 12-13 figure range.  No big deal.  Sure you’ve read about it.  

In banking, the schizophrenia is manifest.  On the one hand, the government is reluctant to permit the operation of existing processes and precedents that would impose losses on bank creditors, thereby permitting undercapitalized banks to continue to operate without necessary restructuring.  On the other, in the auto industry it is taking actions that undermine the ability of banks to attract new capital by undermining the law’s protections to creditors.  That is, it is taking actions that run roughshod over the operation of rules governing the disposition of firms in financial distress, in one instance protecting creditors, in the other screwing them.  But it is protecting from the effects of the law those who don’t deserve protection, and attempting to deny its protections from those who do.  

And no.  These things don’t average out.  

This greatly increases the uncertainty and unpredictability in the capital markets.  It means that we are transitioning from a largely rule-driven system, albeit an imperfect one, into a discretionary, political-driven system.  As ugly as the bankruptcy process is, at least it is a process, and one that offers some protections.  Executive extemporization based on political calculations is the antithesis of process.  The resulting increase in the risk/uncertainty will have huge effects on contracting going forward, and will tend to impede investment and growth.  

Some pooh-pooh these problems.  Felix Salmon, for one:

Oh come  on. When Detroit raised debt capital in the past, its lenders weren’t operating on the assumption that they would be paid off in full before the UAW got a penny — and if they were, they were being foolish in the extreme. The UAW, after all, is necessary for the continued existence of the company: they’re doing the equivalent of putting new money in to the operation, in the form of their labor going forwards. I don’t see the creditors offering to put up any new capital.

Sure, the creditors might have a point about seniority if the firms were to be liquidated with the loss of all jobs. But let’s not forget that a huge part of the reason why they lent their money in the first case was that the US auto industry is systemically important, and that the government would never allow it to be liquidated. They were making a moral hazard play, and believed the car companies when they said that bankruptcy would be disastrous, and so they assumed that the government would keep the car companies out of bankruptcy.

Where to begin?  Time is at a premium, so I will just make a couple of comments.

Re “[w]hen Detroit raised debt capital in the past, its lenders weren’t operating on the assumption that they would be paid off in full before the UAW got a penny”: “paid off in full” is a straw man (very Obama-esque of Salmon, BTW, for Obama is the master of the straw man gambit).  No doubt they were operating under the assumption that in any renegotiation or bankruptcy procedure, the normal horsetrading would mean that unsecured creditors would receive something, and that they secured creditors would take a haircut.  But no doubt they were also not operating under the assumption that the government would attempt to undermine completely their contractual and legal protections, and exert tremendous pressure to force bondholders to subsidize the UAW to this extent.  

Re “[t]he UAW, after all, is necessary for the continued existence of the company: they’re doing the equivalent of putting new money in to the operation, in the form of their labor going forwards [sic]. I don’t see the creditors offering to put up any new capital.”  Uhm, I’m pretty sure they are going to get paid for their labor going forward.  Any concessions re wages and benefits?   Apparently not.  This is about the priority of an unsecured claim that the UAW willingly agreed to in the past, and whether that priority should be honored going forward.  (And, insofar as the UAW’s necessity for the company’s continued existence is concerned:  It is largely responsible for its current predicament, and its increased dominance will hamper the company even more going forward.)  

Re “moral hazard play” and “liquidation”: Another straw man.  Pretty Olympian of Salmon to put himself in the minds of myriad bond investors.  Moreover, he suggests that seniority matters only in liquidation.  But, first, neither ex ante or ex post would anybody consider full liquidation a likely outcome.  Second, seniority affects bargain power, and hence payoffs, in restructuring outside of bankruptcy, and within bankruptcy.  An unexpected, ex post attack on seniority therefore transfers wealth from one group to another even outside of liquidation.  

The key word here is “unexpected.”  If this heavy handed intervention was unexpected–and it seems pretty clear that it was–after observing it rational investors will revise their estimates of likely outcomes involving future politically connected, financially distressed companies.  In particular, they will revise their expected payoffs downwards.   They will revise upwards their estimates of transactions costs and risk.  All of these effects will inevitably lead to higher capital costs for this kind of firm.

Salmon calls this argument a “groaner.”  Sadly, he’s the one who deserves the groans.