Streetwise Professor

June 21, 2009

There’s So Damn Much of It

Filed under: Military — The Professor @ 3:08 pm

History, that is.  And especially in Italy.  My trip there is winding down.  In a 24 hour period, I saw amazing Greek ruins c. 500BC in Paestum (where the “new” stuff dates from 273 BC, and the “really new” stuff is from the time of Augustus, 1st century AD); the ruins of the castle in Roccasecca where Thomas Aquinas was born (the castle was that of the Aquino family); and the areas of the battles around Monte Cassino (including San Pietro, the scene of John Huston’s moving film).  Too much to get one’s head around, really.  So much to see in the world, so little time.

San Pietro was especially haunting.  Many villagers were killed during the battle, and the returning survivors rebuilt the town further down the hill, leaving the battered ruins of the old town as a monument to their townsmen, and the Americans who died capturing it.  There is a monument to the 36th “Texas” Division there as well.  Also visited the site of the 36th’s attack on the Gari River (often misnamed the “Battle of the Rapido”).  Also very sad.  It was a forlorn hope.  To the Germans, the sites of the river crossings were like shooting galleries.  

Quite a powerful experience.  

Our luck was in on the trip.  We left Sorrento a day early (never to return again–what a nightmare).  Today, when we were supposed to leave, the area was struck by a freak hailstorm that buried some cars under masses of huge hailstones.  If we had left on schedule, no doubt our rental car would have been heavily damaged, and we wouldn’t have been able to see Cassino.

June 20, 2009

Reality Rears Its Ugly Head

Filed under: Financial crisis,Military,Politics,Russia — The Professor @ 12:23 am

From Gazeta, Russia has realized that its plans to develop 6-7 carrier groups was a pipe dream:

Development of 6-7 carrier task groups in 2012 the Navy  Commander Vladimir Vysotsky announced a year ago is postponed.  Deputy Defense Minister (for Armaments) Vladimir Popovkin said  yesterday that their development would be premature at this point.  “Before going to the trouble, let us first decide what we need  carrier task groups for. What strategic interests far from home do we have? There is more to a carrier task group than the aircraft-
carrier alone. Aircraft-carriers need escorts. And the Russian  Navy only includes four fleets nowadays,” Popovkin said.

Last July, Vysotsky said that carrier task groups centered  around nuclear-powered aircraft carriers and capable of supporting  strategic nuclear submarines would be developed for the Northern  Fleet and Pacific Fleet. He promised that work on the colossal  project would begin in 2012.

Ruslan Pukhov of the Center for Analysis of Strategies and  Techniques appraised postponement of carrier task force  development as abandonment of global military aspirations by  Russia. “Everything we see plainly shows that Russia has focused  attention on conflicts in nearby foreign countries… like the one  in South Ossetia,” Pukhov said. “You don’t need aircraft-carriers  unless you plan to attack someone.”

Pukhov said as well that the plans to build aircraft-carriers  had appeared in the period of financial prosperity owed to high  oil prices.

According to the expert, even should the Defense Minister  change its mind again and concentrate on the aircraft-carrier  construction program, the Navy cannot expect the first of them  before 2020. “We only have two shipyards capable of construction  of so colossal and technologically complicated a ship. They are  the Northern Shipyards and the Baltic Factory, both in  St.Petersburg,” Pukhov said. “Considering that both are located in  the very center of St. Petersburg and allowing for shallow depths  of the Baltic Sea, we really have only one facility for the  project, namely Sevmash in Severodvinsk. Before putting aircraft-  carriers into its lap, however, we’d better wait and see how it  fares with the Admiral Gorshkov.” (Repairs of this heavy aircraft-  carrying cruiser have been under way this last decade, pending
completion of the negotiations with India.)

What is it about 2020 anyways?  Just near enough to seem possible, just far enough away that by then people will forget the visions proffered in 2009.

And, if the experience with the Gorshkov is the litmus test, 3020 is probably a more realistic date.

I wrote at the time that this plan was announced that it was a complete fantasy.  It was strategically idiotic, and practically unattainable given the state of Russian shipbuilding.  Interesting to see that even Putin et al can’t fight reality forever.

Doubling Down

Filed under: Economics,Energy,Politics,Russia — The Professor @ 12:14 am

Russia has decided not to enter the WTO, announcing its intentions to join the organization as part of a customs union with Kazakhstan and Belarus.   According to Stephen Blank, there is room to doubt whether the announcement was coordinated or not with the other two CIS members.   As Blank also notes, Russia was no doubt unwilling to agree to conditionssuch as opening its meat and dairy sectorsand realistic in recognizing that Georgias veto would make joining the organization an unlikely prospect in any event.   But Blanks most important conclusion echoes my reply to commentor Howard Roarke in response to the latter’s query regarding my opinion on the subject:

Naturally, such economic policies are also connected with the growing efforts of Putin’s entourage to rely exclusively on energy prices going up to extricate Russia from the current crisis, and their efforts to extend ever more state (i.e., their personal) control over ever more sectors of their own and other states’ economies. Closed markets and trade blocs generally accompany closed political systems and neo-imperial policies that can only end in conflict. Georgia may have been the first as we saw last year, but as Belarus shows, it probably will not be the last such example

Blanks diagnosis could have been written by the theorists of the Natural State, North, Wallis, and Weingast.   NWW emphasize the connection between closed economic systems that do not permit free entry and open competition even when they possess the simulacra of a capitalist system (e.g., corporations and some freedom to contract) on the one hand, and closed political systems that do not permit free entry and open competition in political life even though they possess the simulacra of a democratic system (e.g., elections and parties).  

The entire trajectory of Russian politics and economics post-crisis is further illustration of the Natural State character of Russia.   Some within Russia, including some elements associated with Medvedev, have expressed hopes that the crisis would spark a transformation in the economy, leading to a decreasing reliance on energy and resource rents.   These hopes have proved chimericalas the Natural State theory would suggest.     The natural state is highly vulnerable to the destabilizing effects of economic and political competition, especially Schumpeterian destructive competition.”   Economic competition upsets the distribution of rentseconomic goodiesthat holds together the coalition of factions in the Russian state.       As a result, when the state is weakened and threatened, the immediate response is to move even more aggressively to limit competition.   Sure, the crisis provides strong evidence that to benefit Russia, it needs to diversify.   But benefitting Russia and benefitting the factions in a rentier state are two very, very different things.  

And, truth be told, it is quite possible that an attempt to move beyond the natural state would be so destabilizing that the result would be chaos.   Thats why Ive called Putinism purgatory economics.   Its not hell, and it’s sure not heaven.   But, attempting to leave purgatory is more likely to result in taking up residence in hell than in heavenas centuries of Russian history, most notably the last, demonstrate.  

The WTO announcement, along with numerous other recent developments, is a manifestation of this fundamental tendency to respond to crisis by suppressing competitive forces, rather than strengthening them.   International trade erodes rents, reducing the power of some and increasing the power of others.   Upsetting the balance of rentsand hence the balance of poweris a dangerous thing in the natural state.   Moreover, WTO is rule based.   Natural states also rely heavily on the ability of a relatively unconstrained state, often embodied in a highly personalized style of rule (Blank also mentions the highly personalized Putin style) to adjudicate between rival factions in order to maintain balance.   Rules impede the ability to do this.  

The other developments include: Medvedevs announcements that attempts to spur innovation in the Russian economy would be focused in state corporations, rather than left to market processes; Putins statement that he would create a vertically integrated state-controlled body to oversee oil and gas exploration in Russia; and Putins personal intervention in Pikalevo.  

And, if further illustration were needed that Russia lacks the institutional infrastructure to support a transition, today the Bailiffs’  Service announced its intention to sell Telenors stake in Vimpelcom.   Add that to the Khodorkovsky trial, and the new legal travesty involving Heritage and HSBC, and you will understand that there is no check on the discretion of the state, least of all from the court system.  

The logic of the Russian state is that the prospect of negotiating a transformation from a competition-suppressing rent-based natural state to a competitive economic and political system is so daunting that it is unlikely to be attempted.   Anything that limits the flexibility of the center to shuffle around money and power is not to be tolerated.    The response will be to double down on the existing system, not to move away from it.  Indeed, all forces tend to work against the movement to an impersonal, competitive system: and will continue to do so until the pressure of crisis abates, or the system collapses.    As Wellington said of Waterloo, which alternative is realized in Russia will be a close run thing.   It could go either way.


June 13, 2009

Mandatory Clearing: The Doubts Mount

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 3:12 pm

John Dizard wrote an interesting piece on mandatory CDS clearing in the FT:

There’s a new series of disaster scenarios being talked out, most publicly in Congressional hearings on financial system reform. The two parties, buyside and sellside, are assembling their coalitions.

As is usually the case, the sellside, which is to say the big New York dealers, have so far been fastest off the mark. However, too many people on the buyside are watching this time to allow the sellside an easy win judged by friendly officials.

The CDS dealers now have their ICE Trust clearing platform up and running, have somewhat rationalised the documentation and terms, and have substantially reduced the volume of outstanding CDS contracts. They call the ICE Trust a “central clearinghouse”, by the way, which I would not. A real clearinghouse, of the sort that is used by commodities futures exchanges, is heavily, independently, capitalised, and can call on the resources of its clearing members to meet any shortfalls in capital caused by a failure. It also has clear margining requirements that are substantial in relation to the risks, which must be satisfied daily with cash on pain of liquidation.

The ICE Trust platform, in contrast, is a limited liability company. So no mandatory capital calls. The margining is modest in relation to value of the positions, and is more flexible and forgiving than that on public exchanges. The ICE Trust is a thinly capitalised bank, owned by other banks, and deals only through banks. Even well capitalised non-banks have to go through the likes of Tarp recipients. The security of the CDS clearing is based on trust and the taxpayers who underwrite the security of the banking system.

I share Dizard’s concerns about the capitalization of ICE Trust, although I believe he is wrong about “no mandatory capital calls.”  Chuck Vice, President of ICE, told me that ICETrust members can be required to contribute an amount equal to their original contribution to the guaranty fund in the event of a default that exhausts that fund.  The problem is, even with that feature, the clearinghouse may be less than adequately capitalized.  Moreover, I don’t think that the issue is that ICE margining is more modest and relaxed than at other clearinghouses.  My concern is that ICE doesn’t have the information to set the margins as effectively as bilateral OTC market dealers.  

Dizard also notes something that I mentioned some months back: the reluctance of some Chicago clearing member firms to embrace CDS clearing:

The Chicago traders, who had resented the New York dealers’ monopoly on CDS clearing, gradually realised that clearing CDS on single names (companies or countries) was a poisoned chalice. A Lehman or AIG-like failure could decapitalise all their other markets.

The FT has more information on exchange jitters on an OTC clearing mandate:

The word “standardised” sounds innocuous enough. But its use in a US policy document on the future of over-the-counter derivatives has set alarm bells ringing at derivatives exchanges.

Tim Geithner, US Treasury secretary, has said that to contain systemic risks he wants US laws to be changed to require clearing of “all standardised OTC derivatives through regulated central counterparties [CCPs]”.

This marks a sweeping change to the way OTC derivatives are handled, implying a shift away from the dealers at banks who brokered such contracts to the formal exchanges that have long jealously eyed the huge OTC markets.

But what does “standardised” mean? How much of the OTC markets can and should be shifted on-exchange, whether cleared or – as Mr Geithner also wants – traded?

Nobody has a clear answer, since OTC derivatives come in many shapes and sizes, ranging from straightforward interest rate swaps to more tailored products such as “average price options” used by grain processors to hedge against movements in crop prices.

Exchanges, many of which own their own clearing houses, might be expected wholeheartedly to welcome the Geithner proposals. But they are warning against a strict definition of “standardisation”.

Craig Donohue, chief executive of CME Group, the largest US futures exchange, which owns a clearing house, says: “Standardised is not the right way to do it.”

He and others are concerned that lawmakers in the US Congress may come up with a strict definition that would force a shift of OTC contracts into clearing houses that are ill-equipped for the task.

They warn that such a move could expose clearing houses to unnecessary risks that could even damage the financial system at a time when regulators are looking at ways to protect it against future crises.

Kim Taylor, president of CME clearing, says: “There is a danger in having regulatory mandates that are too broad, that would require clearing of products that clearing houses don’t feel comfortable risk managing.”

Declan Ward, executive director at NYSE Liffe in charge of clearing, says the danger is that certain OTC products with unique specifications negotiated to deal with particular risks are relatively illiquid. Coupled with lack of transparency in pricing “you are adding risk to a CCP”.

These are important points.  “Standardization” is not the only issue.  Certainly, more complex, non-standardized derivatives are problematic to clear.  Illiquidity and lack of reliable pricing information for seldom-traded instruments–standardized or not–can also raise major problems for clearing, as Declan Ward and Kim Taylor suggest: and as I’ve written in my academic work going back to 1997.  

CME’s Craig Donohue favors letting the market sort out what is, and what’s not, appropriate for clearing:

Mr Donohue says: “I worry that those kinds of definitions wouldn’t have all that much durability given the level of innovation.” Like other exchange heads, he argues that the market must have a role in deciding which OTC products should be cleared. A recent jump in the number of OTC energy derivatives being cleared through the CME’s Clearport clearer has been driven purely by market demand, he points out.

MarketWatch provides additional evidence of skepticism, including from a regulator (Britain’s FSA) and the DTCC:

Broad proposals for tighter regulation of the over-the-counter derivatives market have already been put forward in the U.S. and Europe authorities are widely expected to follow suit.

Alexander Justham, director of markets at Britain’s Financial Services Authority, said the derivatives market has grown without transparency.

The natural response is the “vanilla-ization” of contracts, by standardizing the terms so they can be traded on an exchange or cleared through a so-called central counterparty (CCP), which acts as an intermediary and absorbs the loss if one party defaults, Justham said.

“But not everything can be put on an exchange and not everything can be cleared,” he cautioned at a recent Mondo Visione conference in London.

Other commentators agreed, saying clearing houses would struggle to handle some of the more complex derivatives.

“The danger is that too much reliance will be placed on CCP clearing,” said Diana Chan, CEO of clearing house EuroCCP, which is a unit of the U.S.-based Depository Trust & Clearing Corp.

In order to be suitable for clearing, a derivative contract must be relatively easy to price, so the CCP can collect the right amount of margin, and trading must be sufficiently liquid for positions to be closed quickly, Chan said.

AIG’s downfall

Credit-default swaps have been at the center of the argument over derivatives because of their role in the near collapse of American International Group Inc.

CDS are similar to an insurance contract and pay out if a company defaults on its debts.

But volumes soared in the lead up to the credit crisis, and the opaque nature of the market meant it was almost impossible to track where the exposure to these derivatives lay.

Justham said a straight-forward CDS on, say, supermarket chain Tesco, might be suitable for trading on an exchange. But more complex contracts, such as bespoke agreements linked to several different credit events, wouldn’t work.

Even liquid contracts such as simple credit-default swap can pose problems, because when the underlying debt gets close to default, that liquidity can dry up very quickly, said Roger Liddell, CEO of LCH.Clearnet, a clearer mostly held by its users.

Glad to have company, folks.

Mandatory clearing, and the associated greater rigidity in margining, could also dramatically reduce the utility of the derivatives markets as hedging vehicles.  Rigid, daily mark-to-market payable in cash, subjects hedgers to cash flow risks.  Even if a derivatives position and an underlying position have mark-to-market values that are almost perfectly correlated, cash margining with daily mark-to-market generates cash flow changes on the derivatives hedge position that may not be matched by offsetting cash flows on the position being hedged.  This mismatch can greatly reduce the utility of hedging, and lead firms to do less of it–and hence result in them bearing more price risk.  That’s a highly undesirable outcome, and a cost that advocates of mandatory clearing do not address.  OTC markets permit more flexibility in managing these cash flow considerations, which is one reason why hedgers often prefer OTC markets to cleared exchange markets.

(As an aside, it’s also one reason why the LME fought introducing clearing even in the aftermath of the tin crisis, and even when forced to do so, implemented a clearing system that permitted more flexibility and use of credit.  This was intended specifically to meet the needs of metal hedgers, who would often have a gain on a hedged metal position, but since this gain did not generate a cash inflow, would be required to stump up additional cash to pay the MTM loss on the hedge under standard futures margining practice.)  

In sum, there are a lot of reasons to have a variety of methods for trading derivatives, and for allocating the default/performance risks associated with them.  These go a long way to explaining just why such a variety of methods exist, side-by-side.  As I’ve said before, the advocates of a mandate have not even attempted to provide a credible explanation as to why market participants would avail themselves of a variety of different mechanisms, if one is decidedly superior.  In contrast, there are numerous, well-articulated (if I do say so myself;-) arguments as to why they do so, and why it is best to let them do so.  As the foregoing articles suggest, moreover, numerous market participants–including those, such as exchanges and the DTCC, who might otherwise seem to have an interest in supporting a mandate because it would send business their way–also recognize that these considerations are quite important.  One hopes that they are sufficiently persuasive to convince Congressmen, regulators, and our Secretary of the Treasury, all enamored with clearing, that it is not a good idea to try to pound a square peg into a round hole.

Back to the Future: Naked Short Edition

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 6:54 am

Recent legislative proposals would outlaw short selling of credit default swaps, i.e., only bond owners can buy protection.  (Remarkably, such a provision is included in the Waxman-Markey climate change bill.)  As if to prove that there is little new under the sun, Larry Neal of the University of Illinois presented a paper at the Manufacturing Markets Workshop in Florence, which closes with the following:

The most enduring, and ultimately most controversial, piece of legislation to arise in the eighteenth century was Barnard’s Act (7 Geo. II, cap 8).  Parliament passed the act originally in 1733 for a period of three years to see what effect it might have and then made it permanent in 1736 after it appeared that the limited number of securities available had not suffered any adverse effect s of the act. . . . The act was intended to eliminate time bargains in public securities altogether by requiring the seller of government stock for a forward contract have possession of the stock at the time of the contract, essentially eliminating options business on forward contracts or the settlement of forward contracts by paying the cash difference between the forward price agreed and the spot price at the time agreed for the completion of the contract.  Sir John Barnard thought that this would eliminate sudden movements in the prices of various forms of government debt by eliminating the pernicious business of stock-jobbing.

After his presentation, Larry noted to me that the primary effect of the Act was to drive forward trading from London to Holland.

I’ve been critical of current legislators and the Administration for seizing on a regulatory framework mandating exchange trading first established in 1921-1922 to serve as the model for current regulatory proposals.  Perhaps I was too critical: an early-20th century precedent appears progressive indeed, as compared to the early-18th century precedent of the short sale ban.  

In a nutshell: these various “new” regulatory proposals are not new at all.  They have been tried before.  And found wanting.  They are simplistic, based on a misdiagnosis of the operation of the market, and are nostrums that will at best will not make things worse, although it is more likely that they will dramatically reduce the efficiency of the market and may well increase systemic risk.  Another example of “learned nothing, forgotten nothing.”

June 12, 2009

Russian Bits

Filed under: Commodities,Economics,Financial crisis,Military,Politics,Russia — The Professor @ 11:26 am

A few scattered comments on Russia.

First item: John Wallis spoke at the Manufacturing Markets Workshop this morning, and I had a chance to speak with him a bit after his session.  In his talk he had mentioned the role of innovation in undermining natural states, and sustaining open order ones.  This brought to mind a dilemma that the Russian elite is clearly dealing with.  Medvedev in particular and those associated with him have lamented the rent-based nature of the Russian economy, and have expressed a desire to encourage innovation.  But they want to do it in a way that maintains the natural state.  Rather than encouraging the development of an uncontrolled, open access, Schumpeterian creative destruction technology sector, the Russian elite–even those who recognize that a rentier state is a dead end–want to foster innovation in state firms.  

State firms present less of a challenge to the existing order.  There is no chance of a massively successful entrepreneur upsetting the political equilibrium, creating an alternative center of power.  No high-tech Khodorkovsky, in other words.  

I predict that this system will half succeed.  It will succeed in sharply reducing the risk of the rise of challengers to the existing political order.  It will fail miserably in fostering innovation.  Bureaucratic state firms are death to innovation.   Innovation thrives because the very people that the elite fear–the risk taking, the entrepreneurial, the unconventional–have free rein.  But that can’t be allowed because it threatens the existing order.  Medvedev and others want their cake, and eat it too, but they can’t.  They can’t have a vibrant innovation culture without challenging the political status quo.  As Wallis said in his talk, political dynamism and economic dynamism are highly complementary.  In the end, Russia is likely to choose political stability, which per this argument requires foregoing economic dynamism.  

Second item: Missile defense.  The New York Times has an interesting article on the negative Russia response to a clever US initiative to position some missile defense assets in Russia.  According to the article, the Russian response is a categorical нет as long as there are also missile defense facilities in the Czech Republic and Poland.  Very revealing.  

The article says:

For Russia, any reconfiguration that preserves sites in Poland and the Czech Republic “is just window dressing,” said Dmitri V. Trenin, a political analyst.

“I’m not sure everyone in the U.S. understands how much is at stake as far as the Russians are concerned,” said Mr. Trenin, director of the Carnegie Moscow Center. “The issue for the Russians is, what are the U.S.’s long-term intentions vis-à-vis Russia? And they are looking at missile defense for the answer to that question.”

An unwillingness to scrap the Eastern European facilities would be seen by hawks in Moscow as evidence that “the hidden agenda is to contain and destroy Russia,” he said.

Given the realities of the proposed installation, such attitudes are best explained as paranoid, and immune to reasoned argument and diplomacy.  

Item three:  Russian GDP declined at a 9.8 percent annualized rate in the first quarter:

Russia’s economy contracted the most in 15 years in the first quarter after industrial production plunged and the government’s 3 trillion rubles ($97 billion) in stimulus spending failed to boost companies and banks.

. . . .

The world’s biggest energy supplier is falling into its first recession in a decade after the global slowdown sapped demand for its commodities and companies struggled to find funds. The government’s stimulus package has failed to spur bank lending, even as the central bank cut its main interest rates three times since April.

“Aggressive cuts in official interest rates over the past six months have not fed through to lower borrowing costs,”  Neil Shearing, a London-based analyst at Capital Economics, wrote in a report last week. “A sustained recovery is unlikely much before the second half of next year.”

Manufacturing fell 23.5 percent in the first quarter, compared with a revised 6.6 percent expansion in the same period last year. GDP may slump as much as 8 percent in 2009, Economy Minister  Elvira Nabiullina  said last month, after growth of 5.6 percent in 2008 and 8.1 percent the year before

. . . .

The  deficit, Russia’s first in a decade, may reach 10 percent of GDP this year, according to the Finance Ministry. The Reserve Fund may be exhausted by the end of next year, Finance Minster  Alexei Kudrin  said.

The 10 percent budget deficit projection is 25 percent more than the 8 percent projection that Kudrin had said was the maximum possible allowable.  

Rising oil prices will help the budgetary situation, but not the overall economy:

The recovery in oil prices is unlikely to bolster Russia’s economic performance,  Rory MacFarquhar, a Moscow-based economist at Goldman Sachs Group Inc., said in a report last week.

“We have long argued that oil prices do not have a direct impact on activity, since they are almost entirely taxed away by the state,” he wrote. “In the past, high oil prices were accompanied by strong credit inflows, which do have a stimulative impact. But we do not expect a rebound in credit under current circumstances, given the damage already suffered by both domestic and foreign lenders.”

Goldman predicts a contraction of 7.5 percent in GDP this year, while theInternational Monetary Fund  on June 1 said it expected the economy to shrink 6.5 percent.  Alfa Bank, Russia’s largest privately owned bank, expects the economy to contract 5.7 percent.

That is, the continuing weak worldwide economic situation, with weak investment, weak banks, and weak finance, translates into poor prospects for Russia in 2009 and 2010, higher oil prices or no.  Although some in Russia (particularly in the Putin and Sechin circles) apparently believe that the rebound in oil prices alleviates the need for any structural changes in the economy, this may well be a false hope.  And, as noted in item 1, Russia’s way of groping towards structural change is likely to be unsuccessful in any event.  

This is particularly true in light of:

Item four: Vimplecom and Telenor. Russian bailiffs are edging towards selling off Telenor’s shares in the company pursuant to a Russian kangaroo court verdict in a suit filed by Alfa Group stalking horse Farimex:

Russian bailiffs said they are ready to sell shares in OAO VimpelCom held by Norway’s  Telenor ASA  that were frozen by a court in March.

All documents needed to proceed with the sale of 15.34 million  VimpelCom  shares have been completed and the stock will be offered on the open market “in the near future,” Russia’s Federal Bailiff’s Service said in a  statement  on its Web site today. Bailiffs seized Telenor’s shares in VimpelCom, Russia’s second-largest mobile-phone company, representing a 29.9 percent stake, after the levying of a $1.7 billion fine.

Farimex Products Inc., the Russian owner of a 0.002 percent VimpelCom stake, brought a case against Telenor in Siberia that found the Norwegian company liable for damages for delaying VimpelCom’s expansion in Ukraine, leading to the fine. Telenor says Farimex is a front for billionaire  Mikhail Fridman‘s Alfa Group, which owns 44 percent of VimpelCom. Altimo, Alfa’s telecommunications unit, has denied any link to Farimex.

If Telenor’s shares in VimpelCom are sold, “we are likely to see an escalating political conflict,” said  Konstantin Chernyshev, an analyst at Uralsib Financial Corp. in Moscow. “Telenor is a state-owned company and it’s unlikely it’s going to give up without fighting in the courts.”

As noted above, foreign investment has largely deserted Russia, contributing to its economic implosion (which is stark compared to its supposed BRIC peers).  Things like this are hardly the way to encourage its return, which will make its recovery all the more difficult.  This is also an illustration of the highly personalized nature of justice in Russia, where a favored oligarch gets preferential treatment in the legal system.  

Lastly, just a quick remark on Putin’s performance in monotown Pikalevo:

Mr Putin, who is a master at dispensing ritual humiliation, likened Oleg Deripaska to a cockroach and forced him to accompany him on a tour of Pikalevo, a factory town that has witnessed the most serious social unrest Russia has seen since the start of the global economic crisis.

Last week Pikalevo’s residents vented their anger over job losses and unpaid wages at one of the oligarch’s local factories by blocking a major road and causing a 250-mile traffic jam. The unprecedented protest reportedly worried the Kremlin, which has long been afraid that Russia’s imploding economy could cause serious political unrest.

Anxious to ensure that the Pikalevo problem remained an isolated one, Mr Putin sought to cast himself as the town’s saviour – and Mr Deripaska as its villain.

The prime minister rounded on the hapless tycoon as they toured a cement plant.

“Why has your factory been so neglected?” he demanded, as Mr Deripaska hung his head in apparent shame. “They’ve turned it into a rubbish dump.Why was everyone running around like cockroaches before my arrival? Why was no one capable of taking decisions?”

He then ordered the tycoon to pay all outstanding wages – £830,000 – before the day was out. Mr Deripaska was Russia’s richest man until last year. He has suffered a dramatic reversal of fortune as mounting debt has seen his assets shrink from £17 billion to about £2 billion today.

This is a perfect illustration of the a-institutional, personalized style of the Russian polity.  As Wallis emphasized in his talk, personalization, and the absence of impersonal institutions, are the hallmark of the natural state.  Wallis says that natural states are good things–compared to the alternative of a Hobbesian war of all against all.  And perhaps such a conflict is the only realistic alternative to the existing system; it is quite plausible that an open order with impersonal rules is not a realistic alternative for Russia anytime soon.  But all of these seemingly unrelated items make it very clear that the natural state is deeply embedded in Russia, and that the price to be paid in terms of lack of economic dynamism is likely to be high indeed.


June 10, 2009

Surprise, Surprise

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 2:37 pm

I was somewhat surprised to see both CME and ICE come out in opposition to mandatory OTC derivatives clearing:

Top managers from two major financial exchange groups on Monday warned the U.S. government not to go too far in forcing central clearing of over-the-counter derivatives, a troubled, multi-trillion-dollar market whose future is central to both companies.

Terrence Duffy, executive chairman of CME Group Inc <CME.O>, said in prepared remarks to be delivered on Tuesday to a congressional panel that government-mandated clearing of all over-the-counter derivatives could drive business overseas.

. . . .

ICE’s Sprecher said in prepared remarks that forcing illiquid, unstandardized derivatives contracts into a clearinghouse could actually increase market risk.

“While ICE certainly supports clearing as much standardized product as possible, there will always be products which are either non-standard, not sufficiently liquid, or that do not have enough interest in them for clearing to be practical, economic or necessary,” he said.

“While the illiquid and unstandardized contracts should not be forced to be cleared, firms dealing in these derivatives should report them to regulators, so regulators have a clear and total view of the markets.”

Jeff Sprecher has it exactly right.  You can get the transparency without going to the full risk sharing inherent in clearing.  What’s more, mandatory clearing can actually increase risks.  

I was invited to testify at these hearings, but had to decline due to my prior commitment to a conference.  Hopefully I’ll have the opportunity to do so at a later date, and give it to them with the bark off, for it is evident that there is much ignorance on these issues in both the press and Congress:

First, the press:

Many OTC derivatives flew off the rails in 2007 when the housing bubble burst and credit tightened, leaving banks, such as the now defunct Lehman Brothers, with huge losses. Credit default swaps played a major role in the troubles at American International Group <AIG.N> that led to its government bailout.

The connections in the sentence about Lehman Borthers are completely incoherent.  This is just stringing together a bunch of things that happened and asserting a causal connection.  Lehman had OTC derivatives.  There were housing and credit crises.  Lehman had huge losses.  The OTC derivatives of the kind at issue in clearing were not Lehman’s main problem.  How about some real reporting, and some real forensics, about the connection between OTC derivatives, including CDS and interest rate swaps, and what happened to Lehman.  What I’ve quoted above is far to common, and is just lazy repackaging of somebody else’s lazy BS.  And for the billionth time, AIG is the reddest of herrings in the OTC derivatives debate.  Give it a rest.  Please.  

Now, Congress:

As lawmakers and the Obama administration move to crack down on OTC derivatives, the House Capital Markets Subcommittee is set to hold a hearing to “advance the discussion in Congress on … meaningful regulation of this dark corner of the financial services industry,” said Representative Paul Kanjorski, Democratic subcommittee chairman, in a statement.

Can we please give the “dark corner” and “dark market” metaphors a rest too?  Yesterday, maybe?  And WTF does “meaningful” mean?  Bad regulation can be meaningful.  Just what is the appropriate regulation, and how do the proposed regulations–especially mandatory clearing–make the markets more efficient?    

Don’t wait up for an answer.  These people don’t even know to ask the questions.  We just get bromides about dark markets.  

I know who’s in the dark.  And it ain’t the markets.

June 5, 2009

Shut Up, He Argued: Derivatives Edition

Filed under: Commodities,Derivatives,Economics,Financial crisis,Politics — The Professor @ 3:30 pm

In the aftermath of the financial crisis, CFTC head Gary Gensler believes that OTC derivatives markets need regulation in the worst way, and that he’s just the man to do it.  Gensler testified in front of Congress, and presented an outline of his ideas for regulation of the OTC markets.  It is now clear how Gensler was confirmed in his post, despite his involvement (salutary, in my view) in the (wrongly, in my view) widely excoriated Commodity Futures Modernization Act:  he agreed to push all the derivatives policy nostrums emanating from Capitol Hill.

There is enough here for several posts, and I’ll probably do just that, time and travel schedule permitting.  The Cliffs Note version is: I disagree with just about everything, and think that most of the arguments raised in the letter are wrong, when they’re not retarded.  (Can you say that anymore?)  Actually, that’s not quite right.  There are NO arguments in the letter to speak of.  Just a series of unfounded assertions on which Gensler erects a set of far-reaching policy proposals.  The Monty Python “Argument Sketch” goes to Washington.

Today I’ll focus on the issue that constitutes the most important part of Gensler’s letter: clearing.  It presents a cartoonish version of what clearing does, and grotesquely misstates the economic implications of clearing.  Gensler presents clearing as a panacea, a silver bullet, that will banish systemic risk.  Based on this distorted depiction of the costs (none) and benefits (incalculable) of clearing, Gensler recommends that virtually everything be cleared, and that non-cleared product be subjected to intense scrutiny.

Gee.  If it’s such a great idea, why didn’t anybody think of it before?  That’s the first clue–and it’s a big one–as to why Gensler’s advocacy (which, admittedly, just echoes Geithner’s and Congress’s) is almost certainly based on fantasy rather than fact.  

Gensler’s most grotesque distortion is to assert that bilateral markets are too interconnected, and that cleared markets would be less so:

One of the lessons that emerged from this recent crisis was that institutions were not  just “too big to fail,” but rather too interconnected as well.   By mandating the use of  central clearinghouses, institutions would become much less interconnected, mitigating  risk and increasing transparency.   Throughout this entire financial crisis, trades that  were carried out through regulated exchanges and clearinghouses continued to be  cleared and settled.  

Where do I start? First, clearinghouses CREATE interconnections, albeit different ones than in the OTC market; clearinghouses formalize a specific and extensive form of interconnection between systemically important market participants, and their customers. They are a means of SHARING default risks, and determining the allocation of losses from default. Sharing means a connection.  By definition.  The members of the clearinghouse share the risks of default. The clearinghouse members and their customers are therefore interconnected, and the failure of one has financial implications for the financial health of others. Moreover, the central clearing structure can actually lead to greater concentration of risk than occurs in the bilateral market, and result in less capital being available to absorb default losses.  That is, the particular interconnections in a cleared market can be more systemically threatening than those in a bilateral one.  It is false, misleading, and borders on the fraudulent for Gensler to claim that clearinghouses make markets “much less interconnected.” It is false, false, FALSE.  

Clearing changes the nature of the interconnection.  It is incumbent on advocates of the imposition of clearing to demonstrate that this change is an improvement.  Gensler doesn’t even begin to try to do so.  He just misleadingly asserts the issue out of existence.  Out of such sloppiness, bad policy is made.

The last sentence of the quoted paragraph is also misleading. First, other than the AIG trades (which I’ll get to in a minute), products OUTSIDE the regulated exchanges and clearinghouses also continued to be traded and settled. Lehman’s collapse did NOT lead to a cascade of failures, for instance. Second, the distribution of products traded on exchanges and in the OTC markets is not determined exogenously, so the comparison is not a fair one. Where things trade and the institutions of trading are endogenously determined by the actions of market participants. In my academic work, I argue that some products are suited for clearing, some not, and that trading patterns reasonably reflect those differences. Therefore, a comparison of the performance of cleared and non-cleared markets does hold everything equal. The stuff that is cleared is basically the easier stuff–hence you would expect fewer problems there.  

I’ve heard this argument about how well futures and options clearinghouses worked during the crisis several times now.  Every time I’ve heard it, those advancing it have failed to consider the possibility that this comparison is superficial and incomplete, and it ignores the fact that despite all of the hyperventilating, bilateral markets continued to work too.  

And for those with short memories, I suggest a look at the near death experience of the CBT and CME clearinghouses on 20 October, 1987, and the problems with COMEX clearing on Silver Tuesday in March 1981 (when the Hunts imploded) and during the mid-80s, to get a better understanding of the potential frailties of cleared markets, and how they can actually create systemic risks.  

I would also submit that many of Gensler’s proposals actually would lead to increased interconnectedness. For instance:

Central counterparties should also be required to have fair and open access criteria that allow any firm that meets objective, prudent standards to participate regardless of whether it is dealer or a trading firm. Additionally, central clearinghouses should implement rules that allow indirect participation in central clearing.

Extending the membership of clearinghouses by government fiat means that more firms are members of the clearinghouse–and hence interconnected to the failure of any other member. So much for reducing interconnection.

I would also note that Gensler completely overlooks that mandating open access to clearing will increase the heterogeneity of the membership of these organizations, which will have important implications for their governance. In my work on exchanges I note how heterogeneity greatly complicates governance, tends to impede decision making, leads to divisive political infighting, and on and on. (The paper I am presenting in Florence focuses on the effects of heterogeneity of the membership of financial cooperatives like exchanges and clearinghouses affects their governance.)  

Now, I have also shown in my academic work that membership limitations can also be used to turn the clearinghouse into a cartel. But nonetheless, it is very dangerous to blithely dictate the membership policies of such systemically important institutions without even the slightest consideration of how these diktats will influence governance–and how governance might affect policies relating to margining, capital, risk management, and systemic risk. Governance matters, and the heterogeneity of membership that Gensler’s recommendations would create would inevitably affect the politics of exchange governance, and the efficiency of clearinghouse operations.  Not that Gensler–or anybody else flogging this policy–even acknowledges the governance implications.

(I would further note that the possibility that the members of a clearinghouse can effectively use this institution to operate a cartel undermines arguments that anti-competitive motivations underly dealers’ refusals heretofore to clear many products. This provides further support for my argument that there are other costs associated with clearing, namely costs relating to asymmetric information, that outweigh the private benefits that clearing can provide the members of the clearinghouse.)

Gensler brings up AIG to justify his arguments. This, in my view, is the modern financial equivalent of arguendo ad Hitlerum: invoking AIG to justify any policy without a full and fair discussion of just how that proposed policy would have affected AIG’s behavior or the market, is irresponsible and usually reflects a lack of thought. It, like arguments ad Hitlerum, is an appeal to emotion rather than fact and analysis.

Sadly, Genlser’s invocation fits that characterization:

By novating contracts to a central clearinghouse coupled with effective risk management practices,  the failure of a single trader, like AIG, would no longer jeopardize all of the counterparties to its trades.

Wrong again, Mr. Gensler. This seems to suggest that a clearinghouse makes default risk Disappear!, like some amazing magician. No. It does not. It redistributes the risk. As I showed in It’s a Wonderful Life: AIG Edition, (a) it is highly unlikely the products AIG traded would have been cleared in any event, and (b) if they had, it is unlikely that clearing would have materially mitigated the implications of an AIG collapse, and indeed could have made it worse.  This is related to the interconnection point.  Once AIG blew up, the members of the clearinghouse would have been on the hook just as its bank counterparties were.  And guess what?  The members of the clearinghouse would likely have been the same bank counterparties.  

There is no acknowledgement in Gensler’s prepared testimony of even the possibility that clearing may be inappropriate for some products, and that requiring clearing of these products may result in greater costs than benefits.  Indeed, the fact that clearing has not succeeded for numerous products, and has not even been attempted for some, raises quite clearly (no pun intended) the possibility that the costs indeed exceed the benefits.

Think of it this way.  By recommending a mandate, Gensler (and others like Geithner who have taken similar positions) is asserting implicitly the existence of a market failure.  The key word is “asserting.”  He is not specifically identifying what that market failure is, and how his proposal corrects it.  Why, if clearing is so socially beneficial, has it not been adopted?  What market failures, what transactions costs, are preventing the adoption of this socially optimal arrangement?  If it is not possible to present a coherent, plausible, and evidence-backed case for the existence of such a market failure, the presumption should be that the market knows better than Mr. Gensler, and that market participants have adopted one set of institutional arrangements for some products and another set for other ones because costs and benefits differ across products and users.  Mr. Gensler apparently believes one size fits all.  The market has been acting as if it believes something very different.  Why is the market wrong?  It may be–but it is incumbent on Gensler and others to make the case.

This implicit assertion of market failure pervades the Gensler letter.  His recommendations to dictate how instruments are traded, with a decided preference for exchange trading, represent another example.  We see invocations of transparency and other Motherhood-and-Apple-Pie virtues to justify dictating market structure, with no serious discussion as to why market participants have apparently chosen suboptimal arrangements.  I will hopefully return to this part of the proposal soon.    

The Gensler testimony also suggests–though it is somewhat ambiguous on this score–that the government will establish margin requirements on all derivatives trades.  One could also read the letter to mean that it will require clearinghouses to set prudent margin requirements.  Either alternative is problematic to the extent that the government and the clearinghouse–but especially the former–are unlikely to have better information for setting these requirements for some products than some private market participants.  This is problematic–as is the possibility that a government regulator or a clearinghouse may be subject to political pressures that lead it to set margin requirements based on rent seeking considerations, rather than prudential ones.

I could go on, but it’s late.  Suffice it to say that Gensler is predicating a massive change in the regulation of financial markets based on a set of implicit assertions.  He is implicitly asserting the existence of a plethora of market failures.  Not one of which does he demonstrate by thorough argument or evidence, beyond the ritual incantation of the Ghost of AIG.  He does not even identify what the market failures are.  This is the stuff that public policy disasters are made of.   If there are market failures that need fixing, it should be straightforward to identify what they are, and to show how the proposed policy will improve the allocation of resources by reducing the severity of these market failures.  

But Gensler doesn’t even try to do that.  That shouldn’t be sufficient, but given that Gensler is primarily serving as Charlie McCarthy to Congress’s Edgar Bergen, sadly it will be more than enough.

No Laughing Matter

Filed under: Economics,Energy,Financial crisis,Politics — The Professor @ 1:31 pm

Treasury Secretary Timothy Geithner’s trip to China drew guffaws—yes, laughter—when he tried to say with a straight face that the US was committed to a strong dollar policy.      (The Wall Street Journal tried to put a more favorable gloss on it, saying that the audience at Beijing University “tittered” at Geithner’s statement.   FT Alphaville (linked above) called it “loud laughter.”)     Guffaws are warranted.   The credibility of this statement is indeed risible, even though it is no laughing matter.   Every major policy initiative points in the exact opposite direction.  

Angela Merkel isn’t laughing.   She’s spitting mad, apparently sharing the same concern as Geithner’s China audience.   She delivered a broadside against the aggressive quantitative easing by the US Fed, the Bank of England, and (to a lesser degree) the European Central Bank.  

Even one of the authors of that policy, Ben Bernanke has suggested (in testimony before Congress) that American deficits are too large and could threaten price stability.

Commodity prices could well be the harbinger of an incipient inflation, and provide a money-where-your-mouth-is verdict on the credibility of Geithner’s pronouncement.   Fundamentals in the developed economies—the US, Europe, and Japan—remain horrid.   Yet copper has breached $5000 for the first time in months and oil neared $70 before selling off on 3 June on additional signs of fundamental weakness, a building of crude stocks of about 2 million barrels when a bigger than 1 million draw was widely forecast.  

So where is the demand coming from?   China is widely identified as the source.   Moreover, the rally in world equity markets in past weeks has been driven in part by a belief that the Chinese economy is strong and will experience decent growth for the remainder of the year.        Forecasts of 8 percent growth are widespread.

I am very skeptical about the realism of such forecasts, and similarly skeptical about the official statistics on the purported growth in Chinese manufacturing.   Here’s the reason for my skepticism.   Every major export-oriented economy is in deep trouble: Japan has experienced a double-digit decline in GDP; South Korea is sputtering; Germany is one of Europe’s weakest economies.   China is an export driven economy.   Domestic consumption accounts for only about 35 percent of Chinese GDP.   As the FT Alphaville post (by Izabella Kaminska) states: “trade has been a key engine for China’s rapid economic growth in the past few years, but a slump in global demand has caused a fall in Chinese exports since November of last year.             Exports in April fell 22.6 percent from a year earlier, compared with a fall of 17.1 percent in March and 25.7 percent in February.”   So, (a) China is a trade dominated economy, and its remarkable growth in recent years has been driven by exports; (b) its exports have declined dramatically; (c) other trade-oriented economies have experienced declines in GDP bigger than those experienced by less-export dependent economies; but (d) China is growing, or going to grow, far more than virtually any other economy in the world.   Huh?   How is that possible?   (Not to mention the other anecdotal evidence, such as the layoff of 20 million migrant workers, and the closure of numerous factories in the (former?) boom areas of coastal China.)   It all doesn’t add up.

What does make sense is that China is indeed buying commodities, but as an inflation/dollar hedge, rather than to feed a resurgent manufacturing sector.   Given its massive investments in dollar-denominated securities, dollar inflation is in fact no laughing matter to China, and it makes perfect sense to substitute out of such assets into commodities.   This makes sense not just for Chinese, but for others holding dollar-denominated assets, and the assets denominated in currencies of other countries/regions with central banks which are engaged in aggressive quantitative easing.  

I find it very hard, therefore, to credit the commodity rally to strengthening real fundamentals.   Other data support this.   The differential between nominal yields on Treasuries and yields on inflation protected Treasuries (TIPS) are widening, indicating increased inflation expectations.   But, importantly, TIPS yields themselves are not rising.   That is, real interest rates are not rising, as would be expected as the real economy strengthens.    This is important, and has gone largely unremarked.  Indeed, some advocates of quantitative easing and expansionary fiscal policies, such as Martin Wolf, actually view the decline in TIPS yields as a favorable sign.  Wolf says this means that government spending and borrowing is not crowding out private investment.  Another way of putting this is that there is little demand for private investment.  Hardly the sign of an impending recovery, that.  

Like James Hamilton, I believe that the main puzzle is why nominal yields haven’t risen  more relative to TIPS; the monetary expansion and the spurt in commodity prices both would suggest a bigger increase in inflationary expectations than the nominal-TIPS yield differential reflects.   Moribund commodity consumption (as indicated by continued high and at times rising stocks), flat-to-declining real interest rates, rising nominal rates, and spurting prices commodity prices say stagflation to me—not recovery.     And that’s not funny.  

June 2, 2009

The Natural City

Filed under: Economics,Politics — The Professor @ 2:05 pm

I will be traveling to Italy to present a paper at the University of Paris X conference on “Manufacturing Markets: Legal, Political and Economic Dynamics.”   One of the highlights of the event to be will be to hear John Wallis’s presentation on the Natural State, and to talk with him.  

I told my wife Terry about my enthusiasm and she (the art major) asked “What’s a natural state?”   I said, well, it is a form of political organization.   It is a highly personalized system where some people have privileged access to economic resources, and privileged access to judicial resources.   In a natural state, personal connections are everything; insiders prevail; and outsiders seldom get a fair shake, in court or out of it.

“Oh.”   She replied.   “Like Chicago.”

Exactly.   Like Chicago.

The political incubator of Barack Obama.

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