Streetwise Professor

Timmy! Geithner is joining the pitchfork-and-torches crowd.   First, he blasts financial executive pay, and demands immediate changes:

“It is very important that we change the way these executives are paid, the form of compensation, this year,” Geithner said in an interview yesterday for Bloomberg Television’s “Political Capital with Al Hunt,” which is being aired throughout the weekend. “We have to end that era of irresponsibly high bonuses.”

Then he disputes Goldman’s contention that it didn’t need assistance at the height of the crisis:

Tim Geithner on Friday rejected Goldman Sachs‘ claim that it could have withstood the financial crisis without government intervention, adding that all banks were at risk of being wiped out.

“None of them would have survived a situation in which we had let that fire try to burn itself out,” the US Treasury secretary said on Friday in an interview with Bloomberg Television.

The Bloomberg article has more from Timmy!:

“None of them would have survived” had the government stood aside and let the crisis run its course, he said. “The entire U.S. financial system and all the major firms in the country, and even small banks across the country, were at that moment at the middle of a classic run, a classic bank run.”

Why, oh why, won’t anyone ask Geithner how he can, out of one side of his mouth, speak in such apocalyptic tones about the state of the financial system during the time of the AIG and Lehman collapses, and out of the other side of his mouth, tell the SIGTARP that the financial condition of AIG’s counterparties was not a relevant consideration in the decision to proceed with the AIG bailout?   How is it possible for these two things to be true?   I’ll answer my own question: It’s not.   He’s lying.

But this all raises the question of why, now, does Geithner feel compelled to go all populist?   My surmise: the left wants his head, and this is his attempt to save it.

This thought popped into my head last night reading the FT piece, and lo and behold, this morning I read the latest Taibbi screech in Rolling Stone*:

Not only are the mop-headed weenie of a Treasury secretary’s fingerprints on virtually all the gross giveaways in the new reform legislation, he’s a living symbol of the Rubinite gangrene crawling up the leg of this administration.   Putting Geithner against the wall and replacing him with an actual human being not recently employed by a Wall Street megabank would do a lot to prove that Obama was listenting this past election day.   And while there are some who think Geither is about to go–“he almost has to,” says one Democratic strategist–at the moment the president is still letting Wall Street do the talking.

And you thought I was cruel to Timmy!

Taibbi and I come at this from different universes.   Taibbi sees Geithner as a Wall Street stooge whose legislative proposals are a big fat wet kiss to the big banks.   I see these same proposals as dangerously interventionist and inefficient (especially as related to derivatives), although I do believe that many of the policies Geithner has implemented and proposed do play into the banks’ hands and exacerbate moral hazard problems.   Taibbi and I agree, I would imagine though, on Geithner the man as utterly untrustworthy.

The Taibbis of the world and his ilk are much more dangerous to Geithner’s future than classical liberal/libertarian types like me.   Hence his sudden populist turn, and his turning on Goldman in particular.

I doubt, however, that will be sufficient to save him and his job.   The only thing that can do that is a fairly strong improvement in the American economy.   As the administration’s top economic policymaker, he is acutely vulnerable if the recovery stalls, or another major financial problem hits, or the stock market takes a hit.   And we all know that Obama has no compunctions about heaving people over the side when they become liabilities: he is the anti-Bush in all things, including in the loyalty department.

Thus, yesterday’s unemployment number (widely misinterpreted though it was), did far more for Geithner’s job prospects than bashing Goldman.   With JP Morgan’s Jamie Dimon actively campaigning for his job, the left howling for his head, and Barack “what do you mean we?” Obama having his back, Geithner is a hostage to the nation’s economic fate.

* I have no clue why I get Rolling Stone delivered to me.   I didn’t subscribe. My kids swear they didn’t.   I can find no record of having paid for it.   Fan mail?   Practical joke? Got me.

No doubt the recent decision of Permanent Court of Arbitration in The Hague intensified Putin’s Pavlovian response to a question about Khodorkovsky.   The court ruled that Yukos shareholders could sue Russia for violating the Energy Charter by seizing Yukos assets.

The likelihood of collection in the event of a favorable verdict is probably small.   Indeed, given the murky and political nature of the case, a favorable verdict is not a foregone conclusion.   But Putin has reason for fear nonetheless, because regardless of the verdict, a trial would be huge problem.   The kinds of information that would be revealed would be extremely damaging.   The ongoing SOVCOMFLOT trial in London, and other London cases involving Russian litigants, demonstrates just how such proceedings can bring to light all sorts of shady practices.   And those cases pale in comparison to the blockbuster potential that any litigation involving Yukos would have.   No wonder Putin goes ballistic under these circumstances when somebody rings the Khodorkovsky bell.

A couple of other things about Putin’s virtual audience with the great unwashed amused me.   First, his whining about the WTO, and supposed American opposition to Russia’s accession.   All nations, the US included, are hypocrites on trade policy, but Russia is a leader in this area.   The economic crisis has exacerbated Russian protectionist tendencies, and these are likely to get worse, not better, if the oil price remains relatively high and takes the ruble with it. Whereas world manufacturing is recovering, albeit unevenly, Russia’s is contracting further.   This will only encourage Russian protectionist tendencies.

Second, Putin continued his on-the-one-hand-but-on-the-other-hand evaluation of Stalin.   The amusing part, though, was Putin’s explicit mention of the cult of personality: indeed, in the critical portions of his remarks, he mentioned the personality cult before,   you know, the millions of deaths: “At the time (of Stalin’s rule) we had to deal not only with a cult of personality, but with massive crimes against our own people.”   Pretty bizarre coming from a man who is actively creating is own personality cult.

One last Russian, but not Putin-related note.   The Hong Kong Stock Exchange has again delayed a decision on a Rusal (Deripaska) public listing.   The bankers who are into Rusal for billions are desperate for an IPO so they can get some of their money back.   HKSE gives the impression, though, of somebody who figures that if they just ignore an embarrassing person in their company, he’ll just go away.   Given Rusal’s desperation–and that of its bankers–that’s not likely to happen. Meaning that HKSE will have to fish or cut bait.

It would be foolish to permit the listing.   Rusal, and anything dealing with Deripaska, is a scandal waiting to happen.   Or, more accurately, a scandal that’s already happened, and ongoing, just waiting to be revealed.

Putin gave his annual call-in-arama yesterday.  Most of it was same-old-same-old.  The only thing of interest was his response to a question about when Khodorkovsky would be freed.

Putin’s typical reaction to the mere mention of Khordokovsky’s name can only be described as Pavlovian.  It appears to reflect a mixture of hatred and fear.  Putin hates Saakashvili, but seems more to disdain him than hate him.  Not so with Khodorkovsky.  I get the sense that the thing that Putin fears most is for Khordorkovsky to walk free .

Putin’s reaction during the call-in was no different.  Completely ignoring the actual crimes for which Khordokovsky has been convicted and charged, Putin asserted that Khodorkovsky was guilty of five murders because the former Yukos head’s chief of security was convicted of murder of Yukos foes.  Khodorkovsky has not been charged in connection with, let alone convicted of, these crimes.

Setting aside the dubious nature of any conviction in a politically charged case in Russia (note the forced resignations from the Constitutional Court, and their implications for the Russian justice system), Putin may not want to be subjected to the same standard of “proof” as he applies to Khodorkovsky.  After all, if benefiting from the murders of opponents carried out by security personnel under one’s command is sufficient to make one guilty of murder, just think of how many murders can be laid at Putin’s feet?

Combined with the resignations from the Constitutional Court and the Magnitsky death and on and on Putin’s outburst lays bare the political nature of “justice” in Russia, and the subordination of the judiciary to the power structures.  (I was going to say “executive,” but Putin really isn’t the de jure executive, though he is almost sure such de facto.)  Putin had no business even answering the question.  The appropriate answer would have been that Khodorkovsky’s fate is not his concern: it is a legal matter to be handled by the proper authorities.  That would be a joke, of course, but Putin quite often engages in such “humor.”   But when Khodorkovsky is involved,  Putin cannot help himself.  He cannot keep his hatred and fear in check.  His responses are reflexive, conditioned, uncontrolled.  It is an amazing thing to witness.

I’ve had several calls from reporters asking my opinion on the Lynch Amendment to Barney Frank’s derivatives regulation bill.  For some reason, Forrest Gump pops into my head every time that question is asked.  You know, the part where he says “stupid is as stupid does.”

As I am sure you all know, the amendment introduced by New Jersey Massachusetts representative Stephen Lynch, imposes restrictions on the ownership and control of the clearinghouses that the Frank bill will require the vast bulk of derivatives to be traded through.  The amendment imposes similar restrictions on ownership of exchanges and swap execution facilities.

Specifically, the amendment defines a class of “restricted owners” that includes swap dealers and major swap participants, and limits the amount of a clearinghouse (or execution facility or exchange) that these restricted owners can own or control collectively to 20 percent.  The justification for this limitation is to reduce conflicts of interest, the specific nature of which are not identified.

This represents yet another example of Congressional micromanagement of the organization and governance of financial institutions.  In my view, it is incredibly wrong-headed.

Let’s focus on clearing organizations.  Remember what they do.  They are a mechanism for pricing (via collateral) and sharing counterparty risk.  Any financial institution that agrees to participate in the sharing arrangement will reasonably expect to have control rights in the organization that oversees this sharing mechanism.  No sane financial institution is going to agree to share in a large fraction of the risk borne by a clearinghouse if it is restricted to having a small share in control.

This means that restricting ownership and control rights will inevitably exert a decisive influence on the allocation of counterparty risk through a clearinghouse.  If the swap dealers and other major swap market participants are limited in the amount of control they can exercise, they will limit the amount of risk they are willing to bear.  So who will bear it?

The traditional clearing firm has been effectively a mutual/cooperative.  Several intermediaries agree to share and manage counterparty risk.  These intermediaries offer various trading services, including brokerage and market making.  Counterparty risk is created as a result of the deals that they intermediate, and they find it in their mutual interest to price and share this risk collectively.

This mutual model has survival value.  Even the exchange clearinghouses that Frank et al apparently consider the ideal to be imposed on everybody are effectively mutuals governed by the major intermediaries.  (Once upon a time, the Board of Trade Clearing Corporation permitted every CBOT member to become a member of the clearinghouse, and adopted a one-member, one-vote voting structure.  However, over time, the organization evolved and became dominated de facto and de jure by the largest futures commission merchants.)  Nor is this an anachronism reflecting merely path dependence and hysteresis.  Indeed, one of the largest clearinghouses, LCH.Clearnet, has recently become a more focused mutual-type organization with increased control by large financial intermediaries; in a major reorganization completed weeks ago, LCH fended off a take-over effort launched by major market users by buying out smaller members and giving the big intermediaries a bigger stake in the organization.

This makes sense if the large intermediaries are the efficient bearers of counterparty risk.  If they are the efficient bearers, they should bear it.  And if they bear it, they will certainly condition their willingness to do so on their ability to control the organization.

Moreover, major market users have another reason to want to control the clearinghouse.  “Trading services” is a bundle of a variety of different services, of which clearing is merely one.  These services are consumed in close to fixed proportions.  Moreover, there is likely to be market power in the provision of several of these services, and clearing in particular has natural monopoly characteristics.  An independent clearing organization could exploit its scale economies, and exercise market power and extract rents from major intermediaries that use its services.  Moreover, to the extent that there is market power in one or more parts of the trading services business, this could exacerbate double marginalization problems, leading to other pricing efficiencies.

User control of the clearing function can prevent such exercise of market power.  The mutual/cooperative form allows the major users to obtain clearing services at cost.  If the major users of clearinghouse services cannot control the clearinghouse, those who do control it have an incentive to extract rents from the major users by charging inefficiently high prices.

Thus, from risk bearing and pricing perspectives, user dominance of clearinghouses makes economic sense.  Maybe, just maybe, that’s why users have dominated clearinghouses nearly everywhere and at all times.  Could it be?  What do you think about that, Rep. Lynch?  Barney?  (Barney is a big backer of Lynch’s amendment.)  Or do you guys just know better?  (We are not worthy!)

To me, what Lynch views with suspicion as a conflict of interest is actually an alignment of interest.  It aligns the control rights with risk exposures.  It similarly aligns the interests of those pricing the service with those who consume it.

If implemented, the Lynch amendment would make the mutual model unworkable.  As a rough estimate, if big users are limited to a 20 percent stake, 80 percent of the risk would have to be borne by somebody else.  Which would be who, exactly?  Equity investors?  Why would they provide capital?  Presumably to get a return.  Which would likely require the clearinghouse to be established as a for profit venture.  A venture that would have an incentive to charge supercompetitive prices for its services to extract rents from big users.  And mightn’t such equity investors have an incentive to take risks, given the asymmetric nature of equity returns arising from limited liability?  Isn’t that directly contrary to the whole reason for mandating clearing in the first place?

Also, does it make sense to weaken the ability and incentive of those with specialized expertise in evaluating counterparty risk to monitor and control the specialized organization established to manage this risk?

This is all so perverse.  Why do Lynch and Frank want to impose a constraint that almost certainly will reduce the efficiency of the organization that they have seized on as the way to improve the operation of the derivatives markets?  Or is this just a backdoor way of throttling the derivatives markets increasing the costs of using them through idiotic restrictions on the way they are organized, owned, and governed?  (Make firms who trade derivatives clear them.  Make clearing more expensive by preventing the implementation of efficient ownership and control structures.  Voila!  Fewer derivatives trades!)

There is one potentially real inefficiency that can arise through user-dominated clearing organizations.  Due to the economies of scale in clearing, it is likely that only a single clearinghouse will survive in equilibrium.  As I’ve shown in my work on exchanges, a cooperative organization supplying a natural monopoly service can generate rents for its members by restricting membership.  It lets in just enough members so that no competing organization can survive, but due to the entry limitations reduces output and raises prices to the ultimate consumers of these services.  “Non-profit” exchanges did that for a long time.

Mandating that a clearing organization permit open access would eliminate this problem, but create another.  In particular, to maintain the financial stability of the clearing organization, it is likely desirable to prevent financially weak firms from joining.  The hard thing is to write rules that would be sufficiently discriminating to prevent the clearing organization from using financial requirements for membership as an excuse for excluding potential members in order to enhance market power rents.

That is a real concern, but the Lynch amendment is an incredibly crude way of dealing with it.  Drafts of the various derivatives regulation bills mandate that no clearing organization should implement anti-competitive policies. It would be better to leave it at that, and delegate enforcement of this provision to the anti-trust authorities than attempt to handle the entry barrier problem with restrictions on organization, ownership and governance that impede efficient risk bearing and monitoring, and encourage other ways of exercising market power.

So sayeth Lord Fisher, or Lord Macauley (attributions differ).  Whoever said it, it is damned close to the truth.  And whoever said it, I’m damned sure Obama never read it.

His speech tonite clearly indicates that he certainly doesn’t understand this home truth.  For he has proposed a “moderate” course in Afghanistan that promises only to get more Americans killed for virtually no prospect of gain.  When I blogged (ranted, some would say) about Obama’s Hamlet routine over Afghanistan in the fall, I opined that there were two real options: go large or go home, and that by far the worst choice would be a halfway measure.  True to form, Obama has chosen door number three.

The time line tells it all.  Obama says that troops will begin to deploy in 2010.  (No sh*t, Sherlock: it’s now December, 2009).  And they will begin to withdraw in July, 2011.  Given the time for deployment, and preparation for withdrawal, this means a year, perhaps a little more, of campaigning.

I dare you to name a single counterinsurgency in history that was wrapped up in one year.

The numbers are also telling.  McChrystal asked for 40K troops: Obama has promised 30K.  So, restricted time, with fewer troops than McChrystal deemed necessary to achieve victory.

Given Obama’s spending profligacy, the poor mouthing rationalization doesn’t cut it.  Moreover, this is a false economy: committing resources, but too few to achieve anything lasting is a pure waste.

And look at the less-than-inspiring operational objective: “we will pursue a military strategy that will break the Taliban’s momentum.”  Uhm, breaking momentum is a first step, at best.  What is to prevent the Taliban from regaining the momentum when we leave–on a pre-announced schedule?  Indeed, this is almost certainly inevitable.  In any counterattack or counteroffensive, breaking the attacking enemy’s momentum is but the prelude to turning him back, and eventually crushing him.  But that part is conspicuously absent from Obama’s stated plan.

Think of all the great commanders in history.  Can you recall a single one whose clarion call to battle was: “Let’s break their momentum!”?

President Hamlet has turned into a parody of Henry V:

But we in it shall be remembered
We few, we happy few, we band of brothers
Fought them on St. Crispan’s Day to break their momentum
Then went home to save a few dollars

Moreover, the thought that the Afghan army and police force can be brought up to speed in 18 months is farcical.  Indeed, it is impossible to believe that Obama really thinks that this is possible, especially if he has as low opinion of the Afghan government as he and his minions have repeatedly expressed.  If Afghanistan’s government is as corrupt and ineffectual as the administration has stated, standing up of a robust Afghan army in 18 months would be a miracle rivaling the Immaculate Conception.

Rather than a full-blooded plan to achieve enduring military gains, Obama’s at best seems to be a spoiling attack meant to cover an eventual withdrawal.  It will likely achieve some short term gains–especially since the Taliban have every incentive to play rope-a-dope rather than fight, and bide their time until we leave–but offer virtually no prospect of any long term advantage.

Failure is so likely here that one can be excused for suspecting that’s the whole idea.  Give it a perfunctory try, and then when it predictably gets nowhere in 18 months, say “well, we tried.  It’s hopeless.  We have to get out.”  More charitably (though perhaps barely), it is designed to create a simulacrum of victory in 18 months that can be used to rationalize a withdrawal (“declare victory and go home”).  At which time the Taliban will expand into the vacuum thus created.

It’s pretty clear that Obama has no stomach for an extended commitment in Afghanistan.  It’s also clear that he doesn’t have the stomach–the intestinal fortitude–to follow his true desire and pull the plug now because of the political firestorm that would unleash  after all the posing during the campaign and his early Presidency about “wars of necessity”–a phrase conspicuously absent from his speech.    So he is choosing a course that will give him political cover against charges of cutting and running, but putting the US on a path to a rapid exit after a barely respectable interval.

To me, it’s a close call between go home and go large.  Indeed, if anything, I probably lean towards go home.  Absent the reputational and signaling implications of an immediate departure, I’d lean pretty strongly in that direction.

But the one thing that I adamantly oppose is what Obama has chosen.  I would have more respect for his judgment, courage, and character if he had grasped the nettle and followed his true inclinations.  But the course he has chosen seems crafted to triangulate his personal political course.  Such moderation is often the wisest, most pragmatic course in politics, but in war it is, as Fisher-Macauley noted, imbecility.

Who, in good conscience, can ask American soldiers, Marines, airmen, and sailors to die to “break an enemy’s momentum,” and then go home?