Streetwise Professor

I seldom comment on anything having to do with precious metals because, well, the subject tends to bring out, how to say it?, er, enthusiasts.  Monomaniacal enthusiasts.  But I feel somewhat compelled to do so, because Adrian Douglas, a board member of the Gold Anti-Trust Action Committee (GATA) structured his comments to the CFTC about metals position limits around one of my older writings on manipulation. (Douglas’s comments are all over the web–that’s just one link.)  (Douglas delivered some impromptu testimony at the CFTC hearings on the subject.)

Douglas starts out all nice and stuff:

I recently read some of the work of Craig Pirrong, a recognized expert on commodity markets and market manipulation.

But then says:

Despite Pirrong’s alleged [thanks!] expertise in commodity markets, he considers that manipulation is mainly instigated by the “long” market participants in what is colloquially called a “corner.” He writes:

“Other speculative activities sometimes called manipulative are far more ephemeral than corners, and are of dubious practical relevance. For example, farm interests and farm state legislators frequently assert that large short sales of futures contracts by speculators are manipulative, and cause prices to fall below their ‘true’ value.

“Such ‘bear raids’ are profitable for the raiders only under very restrictive conditions. In order to realize a profit, it is necessary to sell high and buy low — that is, the short seller must eventually buy back his positions at a price which is lower than the price at which he initially sold. Since the number of contracts sold is equal to the number of contracts subsequently bought, this can happen if, and only if, the futures price responds asymmetrically to the speculator’s purchases and sales. That is, the price decline caused by the speculator’s sales must exceed the price rise caused by his subsequent purchases.

“There is no credible evidence that such an asymmetry exists or has existed in futures markets. Moreover, it is even difficult to construct a theoretical model that exhibits this property. As a result, it is highly unlikely that short manipulations of the type that is criticized so vigorously by the opponents of futures markets are a practical concern. Indeed, futures industry experts have been nonplused by the allegations of widespread ‘downward’ manipulation as far back as 1921, when there was no regulation; most recognized the real danger of squeezes and corners, but were deeply skeptical of the possibility of short manipulations.

“Nonetheless, the primary impetus behind the regulation of futures markets in the early 1920s was the collapse in agricultural prices after the end of World War I. Despite the skepticism of the industry witnesses, the promoters of the legislation regulating futures markets, such as Senator Capper and Representative Tincher, both of Kansas, were convinced that short-selling speculators were largely responsible for this collapse. As a result, Congress was intent upon preventing manipulative short selling. However, since it could not distinguish legitimate short selling for hedging purposes, for instance, from illegitimate short selling, Congress simply proscribed ‘manipulation’ and passed the buck to exchanges by requiring them to prevent what Congress could not define — or face the closure of their markets.”

I find it astonishing that an alleged expert could make such a claim. In the futures market there has to always be a buyer and a seller for every contract; that is, a “long” for every “short.” This means that there are as many longs as shorts. Whatever model can be proposed for long-side manipulation must, by symmetry, be possible for the short side. If one can drive prices up by buying a large amount of contracts, one can also drive the market down by selling a lot of contracts.

The prejudice that manipulation cannot be effectively carried out on the short side is a fundamental barrier to any intelligent and productive discussion of manipulation of the precious metals markets.

What the right hand giveth, the left hand taketh away.  Although Douglas then goes on to use other things I wrote in that article to support his arguments for a crackdown on manipulation in the gold market, which suggests that I’m not all bad:)  (Some friendly advice, Adrian: citing me is probably not the best way to persuade Gary Gensler and Bart Chilton.  Just sayin’.)

Mr. Douglas needs to read a little further, and a little more carefully.  I was addressing one type of short manipulation that was commonly alleged in the 1870s-1930s; the “bear raid,” in which a manipulator drives down prices by selling large quantities of futures and then profits by  . . .

Well, that’s the problem.  It’s hard to see how this could be profitable, because the manipulator has to buy back the contracts.  If selling contracts drives down the price, why wouldn’t buying them back at the end of the manipulation drive up prices?  And given the frictions (bid-ask spread, etc.) wouldn’t transactions costs make this unprofitable?  That’s why I said that there has to be some (unexplained) source of asymmetry in price impact to make such a strategy profitable.

I would agree that if such a strategy is profitable for a short, then the mirror image strategy would be profitable too.  The problem is, I don’t see either strategy being profitable, as I don’t see reliable evidence of the necessary asymmetry.

Manipulation can work by driving down prices in one market can enhance the profitability of other contracts with prices tied to that price.  (Again, the same thing can work in reverse.)  But that’s different than what I describe in what Douglas quotes.

Moreover, both large longs and shorts can sometimes manipulate by exercising market power in the “delivery end game.”  A long manipulation of that type–a corner–is what I focus on in the article Douglas quotes, and what is undoubtedly the most empirically important kind of manipulation.

And contrary to what Douglas claims, I did show in my 1993 J. of Business piece (and in a related chapter in my manipulation book) there IS asymmetry in market power manipulation.  The conditions that make long market power manipulation profitable (inelastic supply and elastic demand of the deliverable commodity) tend to make short manipulation unprofitable (and vice versa).  Therefore, one kind of manipulation should predominate in a particular market.  Short market power manipulation is usually found in perishable commodities, such as potatoes and onions.  Perishability makes the demand for these commodities very inelastic in the short run, which makes driving down the price relatively easy.  (Historical aside: frequent short manipulations led to a federal ban of trading futures on onions, the only commodity so honored.  There’s the answer to your question, Renee:)

Since gold (and, to a lesser degree silver) are held as stores of value (investments), their demand should be relatively elastic, making short market power manipulation very difficult and unprofitable.

Ironically, in the testimony before the CFTC, the main scare story the gold bugs told related to long manipulation.  Noting that the open interest in gold derivatives exceeds the physical gold available for delivery, they said that there would be extreme price disruptions if there was demand for delivery on a large number of contracts.  But this would be a long market power manipulation that drives prices UP, not a short manipulation that drives prices down, and which GATA claims has happened for years.

And that’s another problem.  GATA alleges that central banks, in cahoots with bullion dealers, have manipulated gold prices down for years.  But most manipulations are very short term affairs that have relatively short-lived effects on prices.

The GATA story of how manipulation works also doesn’t make much sense.  GATA was most exercised in the 1990s and early-2000s, when gold producer hedging was quite common.  Producers would short gold forward to bullion dealers.  The dealers would cover this long position by borrowing gold from central banks, and then selling it.  GATA interpreted the gold sales as an additional flow of gold onto the market that depressed prices.

This is mistaken on many levels.  The stock of gold remained unchanged by these transactions, and the price of gold is determined by the size of the stock, and the demand for the stock.*  Moreover, just mechanically, a gold loan is a simultaneous sale and future repurchase, not an outright sale; the sale and subsequent repurchase are essentially a wash.

If anything, the gold loan mechanism, and the resulting possibility that a single firm can accumulate a long position that exceeds readily deliverable supplies, can make long market power manipulations possible.  There is some evidence in gold lease rate data that such long manipulations have occurred in recent years.  (This is analogous to the repo squeezes that occur in the Treasury market, and which were rife in the mid-2000s.)  But these have the opposite effect on prices than GATA alleges, and these effects tend to be temporary.

If gold hedging affects prices, it does so indirectly, and in a non-manipulative way.  By permitting producers to manage risks more effectively, hedging presumably allows them to increase output (e.g., it permits them to obtain financing on better terms to expand mines.)  This would tend to reduce prices, by increasing the rate of growth in gold stocks.  But this is not manipulative.  It represents a socially beneficial reduction in the costs associated with financial frictions.  This cost reduction is welfare enhancing, whereas true manipulation is welfare reducing.

So, the GATA story doesn’t wash with me.  It is just a repeat of the same allegations that have been directed at commodity derivatives markets for years, and suffers from the same fundamental misunderstandings of the ways these markets work.  The GATA allegations are made more lurid by the involvement of central banks, and the secrecy with which these institutions operate.  But at the end of the day, there’s nothing to see here folks, so just move along.  Not that the gold bugs ever will.  But I hope that having written this, I can.

* GATA and other gold bugs have chronic difficulties distinguishing between stocks and flows.  They point to the fact that the volume of trades in gold exceeds actual gold stocks.  The aptly-named (since it is high variance) ZeroHedge breathlessly repeats such things, claiming that this is evidence of a Ponzi scheme.  Did these guys just fall of the turnip truck?:  this is true for virtually every major commodity market.  For a variety of reasons, the number of transactions, and frequently the open interest, is a multiple of the underlying deliverable supply.  Douglas states that this has developed slowly over many years:

The futures markets were conceived to allow commodity producers to reduce risk by being able to contract to sell their yet-to-be-produced commodity at some time in the future. By the same token, it allowed commodity users to reduce risk by being able to contract to buy a yet-to-be-produced commodity in the future. The futures markets also served to perform the function of price discovery by matching future demand with future supply at a market-clearing price.

However, gradualism has resulted in the futures markets morphing into giant casinos where less than 5 percent of contracts get settled with a physical commodity delivery. The futures markets are now totally divorced from their intended function. The futures markets have become such a farce that the delivery of physical commodities has become an inconvenience that hinders speculation and market manipulation.

Uhm, not exactly.  The facts that the volume of trades, and open interest, exceed deliverable supply, and that very few contracts are settled by delivery, have characterized commodity markets since the birth of futures markets in the late-1860s.  They have been the subject of comment and frequent criticism since that time.  This is not, contrary to what Douglas says, a new thing: the “morphing” took place about, oh, 1867.

We seek him (her?) here, we seek him (her?) there
Those Russkies seek him (her?) everywhere!
Is he (she?) in heaven? Where is he (she?) by Jove?
That demmed Elusive Russophobe?

The mild-mannered James, webmaster at Robert Amsterdam, has been accused by a commentor of being “behind the La Russophobe hate blog.”  James is rather nonplussed about the accusation.

Just further proof of how LR drives some people around the bend.

SWP PSA: I am not LaRussophobe, nor have I ever been LaRussophobe, nor do I have the faintest clue of who LaRussophobe is, nor do I really care.  Hell, I’m not even A Russophobe, no matter what some of you lot think.

One of the libertarian arguments against conscription is that it is a tax levied exclusively on the young (and young men particularly, back in the day).  The government uses its coercive powers to force the young to supply labor at below market rates.  This tax was rationalized using all sorts of high-sounding rhetoric.

The just passed health care legislation bears considerable similarity to conscription.  Here, the government uses its coercive powers to force the young to consume a service at an above market rate (in order to subsidize consumption by others).  We again hear the high-sounding rhetoric to cover this outright theft from one cohort of the population.  (One difference with conscription is that this tax hits young women harder than young men.  So much for the feminism of those who are among the law’s most fervent advocates.)  The indirect effects will also affect the young disproportionately; the inevitable tax burden will slow economic growth, dramatically reducing the lifetime incomes of those just entering the labor force.

When can we expect teens and twenty somethings to start burning their insurance cards?  Ironic, no, that this legislation was produced primarily by boomers who cut their political teeth on opposition to the draft?  What’s that old expression?  Never trust anybody over 30?  Methinks that saying might gain new currency once the implications of this law begin to be understood, especially by those who will pay the highest price.

In the immediate aftermath of the passage of health care legislation, several companies have announced nine and ten figure charges against earnings due to the effects of the legislation.  This sent many Congressmen into a rage, most notably Henry Waxman and Bart Stupak, who have summoned the CEOs of the companies to testify about their decisions.

Let me see if I get this.  In Waxman-Stupak land:

1. Corporations are greedy profit maximizers who often lie on their financial statements to exaggerate their performance;
2. The health care law will reduce corporate health care costs, thereby increasing profits, but;
3. Corporations oppose the health care law because they are greedy, and are lying in order to torpedo it.

Huh?  If these corporations really wanted to torpedo the law, they would have been much more outspoken BEFORE it was passed.  Now the horse has pretty much left the barn, you know?

More importantly, if the law truly will reduce costs, what possible motive would companies have to oppose it, and lie to make it look like a bad deal?  Under this hypothetical, wouldn’t this be against their own interests, the interests which Waxman, Stupak, et al believe companies will do anything fair or foul to advance?  Wouldn’t they be praising it to the heavens, and showering campaign contributions and travel junkets on those responsible for its passage to demonstrate their gratitude at being liberated from exploding health care costs?

Even on the Waxman-Stupak Scale*, this is cosmically stupid.  No, the true crime of these companies is to (a) follow the law requiring them to make public disclosures about events that will have a material impact on reported financial results, and (b) in so doing, make it clear that the health care legislation will have seriously detrimental effects on large swathes of the public.  Yes, the public, not just the corporations; because the announced charges relate to retiree benefits, which will almost certainly prove to be unsupportably expensive going forward.  And these announcements are just the harbingers of future unpleasant surprises to come.

Again: no man’s life, liberty, or property are safe while the legislature is in session.  Especially with this lot.

* The Waxman-Stupak Stupidity Scale is analogous to the Kelvin temperature scale, with zero indicating absolute lack of any mental activity.

Today’s terror bombing in Moscow reveals, yet again, that Islamic terrorism remains a world-wide threat.  Yes, the Chechen terror in Russia has its unique history and causes, but it shares ideological and operational similarities to and connections with the broader international Islamic terror movement.  The targeting of innocent civilians is brutal and wrong, and my sympathies are with those killed, those maimed, and those terrorized.

The Economist’s story expresses concerns–and they are not the first to do so–that this episode will be used to justify an expansion of state repression:

Big terrorist attacks have in the past been used by the Kremlin to justify tightening its grip on power and curbing the opposition. The second war in Chechnya, in 2000, which helped to propel Mr Putin into his presidency, was accompanied by a move to bring Russian television under Kremlin control. In 2004, after the school siege in Beslan, in North Ossetia, Mr Putin scrapped regional elections. It would be unfortunate if the Kremlin, rather than overhauling its security agencies and reviewing its north Caucasus policy, opts to act in similar fashion now.

This is no doubt possible.  Indeed, according to Oleg Kozlovsky, two narratives have dominated the immediate aftermath, one of which goes far beyond the Economist’s concerns:

It is too early to say who organized this terrorist attack. Russian bloggers discuss mainly two versions: Chechen rebels and the state security services. However weird it may sound, the latter version is at least as popular as the former one. In any case, the police and FSB were so corrupted and so busy fighting the opposition that they didn’t find time for the terrorists. By the way, chief of Moscow police was going to spend this day in Moscow City Duma promoting a bill introducing imprisonment for participants of banned peaceful rallies. He must have considered them the biggest danger for Moscow citizens. No surprise terrorists feel less restricted in Moscow than human rights activists.

Whoever organized this attack, the government will surely try to use this tragedy to further “tighten the screws” and secure their own power–the way they did after Beslan hostage crisis in 2004. The only question is what exactly they are going to do.
My thoughts run in a slightly different direction: will the inability of the current government ever lead to more widespread discontent with the competence of the government?; a reduction in the willingness to acquiesce to a strangulation of civil liberties in part justified as a necessary component of a war against terror emanating from the Caucasus that appears to be failing on its own term?  This is just the latest in a series of spectacular Chechen attacks on Putin’s watch (Nord Ost, Beslan, the recent bombing of the Moscow-St. Petersburg train, and now the Moscow Metro).  One part of the alleged bargain between Putin and the populace is that the former surrender their political voice and civil rights, and the former protects them.  When does the tipping point come when people decide that Putin has not lived up to his end of the deal?

Another part of the alleged bargain is that Putin provides prosperity.  I noted in my post last week that Putin’s tone in his screed directed against the United States in Hillary!’s presence betrayed a certain degree of panic over the economic situation. This article from Reuters provides further color that reinforces this perception:

Now leading the nation as its prime minister after completing the maximum two terms as president, Putin often plays a far more visible role than President Dmitry Medvedev in telling Russia’s business leaders what they are expected to contribute to the economy.

“I’m asking you for a third time, when are you going to sign this contract, do you not hear me?” Putin lashed out at deputy chief of gas monopoly Gazprom (GAZP.MM) Alexander Ananenkov, an elderly man wearing a hearing aid, at a meeting last December.  [What a guy!  Browbeating old deaf men.  How’s that for alpha male chimp behavior, S/O?]

. . . .

Another of Putin’s projects is the diversification of Russia’s energy export supply routes which, apart from their geopolitical role, will also swell the investment plans of state monopolies such as Gazprom and Transneft.

The multi-billion projects serve as growth drivers as they translate into orders of pipes, turbines and other equipment.

“I was recently at a (Russian) electrical transformers factory. A remarkable enterprise, new, very beautiful, modern. So why are you importing 70 percent of all transformers?” Putin asked the head of the Federal Grid Company, Oleg Budargin.

HEAT ECONOMY UP

Most of Putin’s foreign visits are related either to energy diplomacy or the lobbying of deals on behalf of Russian defense or nuclear power firms.

During his March visit to India, Putin signed deals worth $10 billion including to build up to 16 nuclear reactors, saying Russia wants to control a quarter of the global nuclear power market.

Putin is also keen to support construction which achieved double-digit growth during the oil boom years and where asset price bubbles had formed before the crisis hit.

“We need to heat up this sector a little bit, although I am not talking about overheating,” Putin said of the construction industry, where he plans to introduce a government-backed mortgage scheme with subsidised interest rates for home buyers.

So, apparently Goldilocks is going bald: Putin doesn’t want housing too hot or not hot enough; he wants it JUST right.  Good luck with that.

Putin’s frenetic activity, his browbeating of some executives, and his pleading before foreigners on the behalf of others, does not exactly scream confidence in Russia’s economic prospects.  In fact, it suggests quite the opposite, and Putin is responding in the only way that a former Soviet appartchik knows how: to issue a blizzard of commands.  The fact that these commands will almost certainly not lead to a substantial economic improvement, and are likely in fact to prove counterproductive, will eventually reveal that Putin is rather impotent.  That is poison to an authoritarian leader.

The economy and domestic safety are two of the fundamental plinths of the Putinist bargain.  Both look increasingly shaky, although Putin’s popularity has not yet exhibited any dramatic weakening.  My question is: how long can that last when he does not deliver on his side of the bargain?  My conjecture is that fear of the answer to that question will lead to even more rigorous efforts to atomize society and control public expression (including over the internet) to prevent the formation of a critical mass of people saying that the emperor has no clothes.

* I was interested to see that the Obama administration issued a statement on the bombing that used the term “terror” or “terrorism” more than once.  Does that mean that the phrase “man caused disaster” (in Janet Napolitano’s artless prose) is no longer operative?  That there is actually such a thing as terrorism?

Work demands (go figure!) and some recent travel (some work-related, some not) have put a crimp on the blogging, and the reading to feed the blogging.  So, I only have time for a few quick hits on Russia.

First, the substance of Putin’s put down of Hillary, rather than just the atmospherics, is intriguing.  For one thing, Putin used an official forum with the cabinet member of the United States to make a special pleading for individual Russian oligarchs.  Tame ones, of course, who do Putin’s bidding.  (And, perhaps more.  Which makes me wonder whether it was a special pleading for . . . Vladimir Putin.)  So much for Putin, scourge of the oligarchs.  (No Ivan IV he, in this regard.)  For another thing, the whinge about the collapse in trade betrayed a certain desperation, as did the lament about the low level of direct US investment in Russia.  A leader convinced that his nation was in the midst of a robust recovery, particularly a prickly, nationalist one like Putin, would not be likely to engage in such a public whine.  But one who has deep concerns about the economic future, and who is known for his tendencies to blame his and his country’s miseries on anybody else, especially anybody else with the initials USA, would be.  Not exactly a “Russia off its knees” moment.  Intriguing indeed to wonder why.

And Vladimir, if you wonder about the plummeting of foreign direct investment in Russia, and you want somebody to blame: look in the mirror, and curse the vaunted power vertical.  Consider, too, this story about Conoco’s divestiture of half its stake in the Russian oil firm Lukoil:

But its apparent decision could reflect the shift in dominance of Russia’s energy sector towards state-backed companies such as Rosneft and Gazpromneft, the oil arm of Gazprom, the state-controlled gas group.

This has left Lukoil by the wayside since Conoco first bought into it in 2004, analysts said.

Chris Weafer, chief strategist at Uralsib investment bank in Moscow says: “When they bought into Lukoil it was a time when it was positioned as Russia’s premier oil company.

“At the time they expected they would be able to use that relationship to expand further into Russia.

“But today the rules of the oil game have changed in Russia; today you are not in it unless you are partnered with a state company”.

“The catalyst for the sale comes from their debt position but the reason they are selling is because the competitive position they had with this company when they acquired it no longer exists.”

Rosneft emerged as Russia’s foremost oil producer from the state break-up of Mikhail Khodorkovsky’s Yukos, the target of earlier failed efforts by Exxon Mobil and Chevron of the US to gain entry into Russia’s oil sector via tie-ups with a local company.

Rosneft, Gazpromneft and Kremlin-friendly Surgutneftegaz are now seen as frontrunners for new licences to develop big new fields, while companies with foreign participation are treated with suspicion by the government, analysts said. [You don’t say.  “Suspicion” would be a good day.  Some companies throw parties when they are get promoted to suspicion.]

And, relatedly, TNK-BP, where the “blatant” expropriation is apparently  that the company walks away with nothing, whereas the kinder, gentler, non-blatant Sechin appropriation is that the company gets its initial investment back.  Which is better than nothing, but is still theft because a good deal of the value of such a property is the value of the option to invest optimally in the future.  Look, Vladimir, when the upside is always at political risk, don’t be surprised if FDI lags.

Next!  Russia’s military “reform” is now widely recognized as an abject failure:

Although the interview Gen. Nikolay Markov, the chief of the General Staff, gave to “Rossiiskaya gazeta” attracted fare more attention, the press conference Krivenko gave together with Soldiers Mothers Committee of Moscow chief Tatyana Kuznetsova and VTsIOM sociologist Konstantin Abramov provided many more details.

Speaking first, Krivenko explicitly stated that “the failure of military reform in the form in which it has been conducted up to now is recognized by the leadership of the country.” The planned shift to a largely professional force has failed, and the draft, given the reduced length of service the government has allowed, is not working either.

Plans for contract service have failed so far “not as a result of financial causes but as a result of the incompetent administrative decisions of the Defense Ministry,” Krivenko continued, but plans to try to rescue the situation by boosting the salaries of professionals still further would bust the budget, particularly if the relative number of less-well-paid draftees continues to fall.

But their numbers appear bound to fall, at least in the next few years, given the small size of the cohort born in the troubled 1990s. If the number of soldiers is to be kept at 700,000 and if draftees are to serve only one year, then the military would have to draft 700,000 young people each year, a number far exceeding the number in the prime draft age groups.

One could address that, he says, but forcing people who avoided service earlier and who are still under 35 years of age to serve, “but for this would be necessary another kind of state, and one can imagine just what it would be like.” Such “a draconian variant” is something no one is now seriously considering.

Krivenko stressed that “the president and the government understand this. And they understand that ahead is a dead end,” one from which the country can escape either by spending more money on the military, increasing the length of service for those who are drafted, or cutting the size of the services still further.

Increasing the length of service is the easiest in some ways: after all, Moscow did it in the 1990s, boosting the requirement from 18 months to two years. But Krivenko argued that there are two reasons Moscow might not want to go in that direction. First, “the difference between one year and two” “is qualitatively different” than the earlier much-smaller increase.

And two, such an increase could exacerbate social and political tensions, possibly having an impact, he explicitly suggests, on who will occupy the position of Russian president after the 2012 election. Consequently, decisions on force structure are likely to become more not less political in the coming months.

Guess they’ll just have to wait for that huge baby boom generation to grow up.  Yeah, right.

Lastly, the something for nothing gang strikes again.  Ukraine is seeking a deal to give up partial control over its pipeline system, in exchange for getting gas at a discount from European prices.  Russia’s response?  Yeah, we like the control thing, but fuggedibout any quid pro quo:

Russia’s OAO Gazprom does not view participation in a joint venture to manage Ukraine’s gas pipelines as sufficient grounds to lower the price Ukraine pays for imports of Russian natural gas, Kommersant reported, citing officials with the knowledge of the matter.

The dynamics of the Russian-Ukraine relationship will be quite interesting to watch.  I’m guessing Russia overplays its hand, either out of habit, overconfidence, desperation, or a confidence of all three.

I have a couple more items, but they’ll have to wait.

Economics of Contempt makes a point that I’ve advanced for well over ten years now (including fairly recently in a guest piece at FTAlphaville.) Namely, that clearing depends on price transparency and liquidity to work; it does not create these things.  Clearinghouses consume price transparency and liquidity–they don’t create them.

Moreover, trying to clear things for which price information is lacking due to a lack of trading can create systemic risks, rather than reduce them.  CCPs can’t price risks adequately for illiquid products.  Moreover, they have a very difficult time of managing the risks of any defaulted positions in illiquid products.  This means that taking on exposure to these products puts the CCP at risk, which, in turn, creates the potential for a clearinghouse failure, an eventuality that EoC “would rather not see . . . in [his] lifetime.”  Having stared it in the face (in 1987), I concur wholeheartedly.

EoC echoes another frequent SWP argument, namely the chronic misinterpretation of the AIG debacle.  He notes that contrary to what is commonly stated, AIG’s positions WERE collateralized, and indeed, it was the collateralization mechanism that was the proximate cause of the firm’s demise.  Those who flog the clearing solution really, really, really need to spell out how having AIG pay variation margin to a CCP, instead of Goldman and Deutsche Bank and French banks, would have made any substantial difference whatsoever.  (See the post “It’s a Wonderful Life: AIG Edition” for my statement of this argument.)  Indeed, it could have made things worse.

It should also be emphasized that collateralization is often the positive feedback mechanism that creates systemic events; big collateral/margin calls in the aftermath of big market moves lead to liquidation of positions, which moves prices more, which weakens the financial position of those affected by the initial price moves more, etc. Geithner and Gensler and others suggest that more, and more rigid, collateralization (via a clearinghouse) unambiguously reduces systemic risk.  Not so.  It is more plausible to say that collateral can mitigate some moral hazards, and can be a way of pricing some risks, and can be a way of mitigating one-off, non-systematic defaults.  But it can also be the doomsday machine that accelerates the spread of financial distress.

Come si
Last week I wrote about how numerous Italian municipalities are regretting their decision to enter into interest rate swaps.  Today’s WSJ reports that many American cities, towns, and counties are experiencing similar regrets, and are talking about escaping their contractual obligations.

As reported in the WSJ, the facts seem pretty simple and straightforward.  On the basis of this reporting, the municipalities’ complaints are meritless.  Specifically, the WSJ states that the municipalities (a) borrowed at floating interest rates, and (b) swapped that floating rate into a fixed rate via a swap.  The terms of the swaps were such that the fixed rate in the swap were lower than the municipalities could have borrowed at fixed rates:

But municipalities also added swaps to the mix, promising to pay a fixed rate to banks, often 3% or more, while receiving payments from banks that vary with interest rates. On the swaps, the municipalities generally have been losers, as the interest that banks have to pay them have often fallen below 0.5%.

So, what the municipalities did is lock in an interest rate via a combination of floating rate borrowing and a swap.  They locked in a lower rate than they could have by borrowing at fixed rates.

Yes, if they hadn’t done that, their interest costs would have been lower due to the dramatic fall in rates–and if they’d borrowed at floating rates, rather than fixed ones.  But, by giving up the possibility of paying a lower floating rate, the municipalities protected themselves against the possibility of higher interest rates.

That’s what’s called hedging, people.  And you don’t evaluate hedges ex post, based on what did happen.  You evaluate hedges ex ante, by determining what transactions optimize your risk-return trade-off, based on what could happen.

You don’t evaluate hedges ex post because, lacking a crystal ball, you didn’t have that information available when you made the hedging decision.  If you can see the future you have no need to hedge.  If you can’t see the future, and want to avoid risk, you might want to hedge.  And if you do, roughly speaking, about half the time you will regret it ex post.  But woulda, coulda, shoulda is a bogus way to evaluate hedges.  You have to evaluate them based on the information you had when you made the decision, not based on what actually transpired in the unknowable future.

The municipalities seemed to have wanted to make one way bets: to protect themselves against rate increases, but profit from rate decreases.  You can do that, but you have to pay for the privilege–by buying options.  But even if they had done that, the municipalities would still have experienced ex post regret, and presumably would be whining about the wasted option premium spent buying caps that proved unnecessary after the fact.  (But, again, hedging decisions have to be made before the fact–they are decisions to reduce risk made in the presence of uncertainty about the future.)

So what the municipalities are claiming is that they should get FREE options that allow them to profit when rates are high but don’t impose any loss when rates are low.  Hey, I’d love to get free options too.  But good luck finding someone willing to give them to you. (Actually, Uncle Sugar does that with some regularity, through Too Big to Fail, or implicit guarantees of Fannie and Freddie.  There the taxpayers are the ones that end up paying for the options.)

The municipalities might have something to complain about if they could show that the swaps were priced off-market, or included various option features that were systematically mispriced in favor of their counterparty bank (as has been alleged in some Italian deals).  Even then, my sympathy would be limited because they could have and should have obtained independent valuation analysis to protect themselves against this sort of opportunism.  And I should note that the WSJ article doesn’t say a word about any mispricing or off-market pricing.

Absent evidence of deliberate mispricing (and perhaps not even then), the municipalities should get no legal relief from their contractual obligations.  There are attempts worldwide to escape transactions that were entered into voluntarily, but which were regretted afterwards because of the way the market moved.  In China, for example, energy consuming firms are exploiting government pressure to escape some of their obligations under various energy derivatives trades entered when prices were very high, and which went way underwater when prices plummeted.  Now the Italian and American municipalities.  (Notice how governments seem to think that contracts don’t apply to them when it’s inconvenient to perform?)  These efforts undermine the market, and have the perverse effect of making hedging more costly as counterparties have to price in the risk of not getting paid in full; indeed, they can make hedging impossible altogether as nobody is willing to enter a heads-I-lose, tails-the-municipality wins deal for no compensation.

It seems that the municipalities are attempting to exploit–and feed–the hostility towards derivatives to escape the consequences of their own decisions.  Let’s hope that if it comes to legal action, judges take a very skeptical view of such claims, and make municipalities play by the same rules as grown up commercial parties.

Some weeks back I quoted from the jacket blurb of Steve Pincus’s 1688.  I remarked that Pincus’s description of James II’s attempt to create an authoritarian state in England (modeled on the absolute monarchy of Louis XIV) reminded me of Putin’s actions in Russia since 2000.  Reading the book has only convinced me of the aptness of the comparison.  What Putin has done parallels what James did almost exactly: splitting the opposition, cracking down on news media, establishing state control over all information sources, co-opting the courts, seizing control of local government; the list of similarities goes on and on.

But something else struck me while reading the book on a plane to Jacksonville this afternoon: parallels between James’s England and current America.

James ascended the throne with the good wishes of most of the English nation.  His anodyne statements about protecting freedom of conscience convinced most in England that a new era of tolerance was in store.  England, by a large margin, had great and positive expectations for James’s reign.

But it soon became clear that James had a strong ideological agenda that was at odds with the deeply held beliefs of most Englishmen of all political persuasions.  James’s rough actions belied his smooth words about tolerance.  He embarked on an aggressive campaign to remake England along continental lines, a campaign that attacked deeply held convictions in England about the relation between government and the governed.  Rather than being an empathetic man in touch with the sentiments of the country, as most had believed, he proved to be a haughty, headstrong, and stubborn one intent on bending the country to his will, and damn quickly.

In very short order–a little more than a year–James’s extraordinary actions had sparked intense opposition throughout England.  Protestant Dissenters, who had welcomed the King’s initiatives on religious tolerance, soon understood that his lip service for freedom of conscience was in fact a cover for a far-reaching plan to revolutionize the constitution of English government; a plan that threatened the liberties and property of all English people, Establishmentarians and Dissenters alike.

As a result, James went from being the hope of the nation to the subject of hatred and vilification.  Yet he plunged ahead with his plans, against strong and growing opposition from all classes of English citizens, of all faiths–including from many of James’s fellow Catholics.

I think that it is fair to say that Obama’s trajectory has been quite similar to James’s to this point.  Eerily similar.

I doubt that the path forward will be quite the same.  A mere 3 years after his ascension to the throne, James was a fugitive, overthrown in a Glorious Revolution.  Pincus makes a persuasive case that this was, contrary to conventional historiography, a true revolution that united broad swathes of the English public against a perceived tyrant.

There will be, I trust, no such resolution–or revolution–in the US.  But I do think that it is highly likely that there will be an intense popular reaction that will transform American politics for years to come.  The reaction is already manifest.  The question remains as to whether it will be sufficient to derail Obama’s headlong race to a statist future in 21st century America, as the Glorious Revolution derailed James’s race to an authoritarian, absolutist one in 17th century England.

And that is the key difference between the US and Russia.  Putin will succeed–and largely has succeeded–in his Jacobean plan because Russia is politically inert, lacks a vibrant civil society, and is so atomized that it cannot oppose the concerted efforts of the state; moreover, a history of idolatry of the state is a powerful ally for Putin.  In contrast, James’s England was politically active and contentious, jealous of its liberties, and convinced of its exceptionalism vis a vis continental rivals–most notably, France.  There are many in America who are similarly exceptionalist and adamant about their freedom.  As Toqueville noted in the 19th century, in America there is a tradition of civil action and civil society that was (and is) completely absent in Russia.

So Russia is likely to continue on its authoritarian trajectory, while America is about to enter a protracted political conflict over a statist future.  May America prove exceptional, yet again.

My new virtual bud, fellow Chicagoan, and long-time CME floor trader Jeff Carter has an excellent post about health care at his Points and Figures blog.  Two word summary: incentives matter.  Jeff’s story is an excellent illustration of the argument in my post from earlier today about how policy should be aimed at encouraging purchase of high deductible, catastrophic coverage plans.  These provide insurance against the kinds of risk people should insure against, while giving them the incentive to consume routine health care services wisely and frugally.  That’s what we should be aiming for, not the monstrosity currently slouching through the House.