Streetwise Professor

March 13, 2010

A Dog That Didn’t Bark

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 9:34 pm

The Valukas report on Lehman makes for interesting reading.  One of the most interesting things in the report is what isn’t in it: specifically, OTC derivatives.  Given the hyperventilating over the role of OTC derivatives in the financial crisis, this is quite important news.

Yes, OTC derivatives are mentioned, but in only the most perfunctory way.  Valukus concludes that Lehman’s methods for valuing its OTC derivatives was sound, and that alternative valuation methods gave very similar estimates of the value of Lehman’s positions.  Moreover, he notes that Lehman’s OTC derivatives positions were in the money to the tune of $21 billion, which represented only about 3.3 percent of the firm’s assets.  And that’s about it.

It is clear that the OTC derivatives were not the problem with Lehman.  Indeed, they were arguably the only thing that WASN’T a problem with the firm.  The huge losses were in residential real estate-related positions, commercial real estate, private equity, and leveraged loans.

Even the collateral and contagion issues were associated with other activities, notably repo funding.  In this regard, its interesting to note that, unsurprisingly, the mechanism that is often held out as the way of protecting the safety of the system—collateral—is actually what fed the death spiral.

The report also should open some eyes about the other supposed magic bullet—clearing.  Valukas concludes that there is a colorable case against the CME to claw back losses that resulted from the sale at a deep discount of Lehman’s house positions with the CME clearinghouse.  Valukas states, however, that preemption under the Commodity Exchange Act, the immunity of self-regulatory organizations, and the safe harbor provisions of federal bankruptcy law may shield the exchange from these claims.  I don’t know much about the first two things, but based on my knowledge/experience it is very plausible that the safe harbor provisions would apply here.

But that’s not the main thing of interest here.  It is evident that the Lehman bankruptcy posed risks to the CME clearinghouse, and hence its members.  After finding out about the impending bankruptcy, the CME ordered Lehman to trade for liquidation only, but the firm added to its positions over the next couple of days.  Moreover, the exchange failed in its initial attempt to get members to buy Lehman’s positions in bulk; it decided on this approach after concluding that liquidating the positions on the open market would have been extremely disruptive, given their size and the chaotic conditions in the market.  Several days later the positions were auctioned in bulk, but only at a steep discount.  Resolution of the problem clearly stressed the CME.  (There’s nothing in the report about what happened with SwapClear.  It would be interesting to know more about that.)

Note that the CME clearinghouse was at risk while these positions were still held at Lehman.  The risk posed by these positions didn’t magically disappear.  Moreover, note that what sparked the crisis was Lehman’s balance sheet risk, not the risk of its cleared positions.  This is the kind of risk that clearinghouses have little ability to measure, manage, or price.

In the end, the CME worked through the problems, though there were doubtless some sleepless nights.   Yes, the clearing process worked, but so did the OTC market.  The point is that the failure of a big member posed a big risk to the clearinghouse—and hence its members.  Clearing doesn’t make risk go away, or eliminate systemic risk.

In brief, the Valukas report on Lehman does not comport with the received narrative of the crisis, in which OTC derivatives play a central, and malign, role, and in which clearing is the panacea.  The narrative is so entrenched, however, I doubt that the facts will make any difference.  It will be interesting to see whether the Usual Suspects acknowledge this reality.  I am not holding my breath.

March 12, 2010

Woodrow Obama

Filed under: Politics — The Professor @ 11:04 pm

The analogy is not exact—historical analogies never are—but there is more than a passing similarity between Obama’s health care battle and Woodrow Wilson’s campaign for the League of Nations; there are also striking similarities between the men themselves.  Obama should mark well the lesson—but I doubt he will.

Like Wilson, Obama is a self-styled progressive who is deeply skeptical of the Founders’ creation.  Like Wilson, Obama is firmly convinced of his own rectitude and his moral superiority over his political foes.  As with Wilson, this makes Obama firmly opposed to compromise with these foes; he views compromise as betrayal of a fundamental belief, and as Wilson did, he views his opponents as morally defective.  Obama, like Wilson, is a Nobel Peace Price winner (although Wilson actually did something to merit it).

When faced with a political battle over a deeply divisive issue about which he self-righteously believed himself on the side of the angels, and his opponents allied with the devil, Wilson refused to compromise with Republicans on the League of Nations.  Before this, Wilson had refused to include prominent Republicans in the American peace delegation to Versailles, making it a purely Wilsonian creation in which the opposition party had no stake, and hence could readily oppose.  Wilson assumed that since the League was a righteous thing, Americans would support it; he did not take seriously the misgivings of many Americans, considering them either ill-willed or uninformed. Faced with the prospect of defeat of his cherished goal in the Senate, Wilson embarked on a whirlwind speaking tour in attempt to rally support.  He failed.  The public was not swayed.  The initiative failed in the Senate.  And Wilson’s health was broken in the attempt, leaving him an invalid for the remainder of his term in office.

Does this sound eerily familiar?  Republicans were effectively excluded from the entire process of drafting a health care bill.  When his initiative ran into trouble, Obama refused even to contemplate compromise with those he deems to be morally deficient.  Obama also fails to take the widespread unpopularity of his pet initiative seriously, dismissing the widespread popular opposition as ignorant or malicious.  As the battle is reaching its climax, Obama has embarked on a Wilson-esque national speaking campaign in a last ditch effort to prevail.  God willing, the effort will not cost him his health, but the Wilsonian parallels are clear.

One major difference is that Wilson fought his League battle politically weakened after Republican electoral triumphs in the 1918 midterm elections, which Wilson himself had nationalized as a referendum on his presidency.  Obama and his party face a rout in the 2010 vote in similarly nationalized elections that will be a referendum too, but this presents different challenges than Wilson faced.

Wilson’s failure to compromise on the League—a failure rooted in his progressivism, overweening self-confidence, and belief in his moral superiority to his political opponents—is considered one of the greatest failures by an American president.  Obama may well succeed (though I pray he does not) in the narrow sense of seeing his initiative passed into law, but regardless of whether he does or not, he and his party will reap a political whirlwind.  Wilson’s political misjudgment cost America, and the world, in the balance of the 20th century.  Obama’s political misjudgment is likely to be very expensive for America in the balance of the 21st.

It would be wise for Obama to learn from Wilson’s example.  But his Wilsonian personality makes it almost inevitable that he will not.  He will pay a price, but the rest of us will pay a much greater one.

Marx said that history repeats itself, first as tragedy, then as farce.  We are at risk of repeating history, and we would be lucky indeed if farce is the worst that comes of Obama’s imitation of the Wilsonian precedent.

March 11, 2010

How Do You Define “Blatant”?

Filed under: Economics,Financial crisis,Politics,Russia — The Professor @ 9:58 pm

Igor Sechin says that any decision to take TNK-BP’s license for Kovytka would be “fair.” “‘There’s no talk of any blatant expropriation. I think we will find a solution to this issue,'” Deputy Prime Minister Igor Sechin told reporters.”

Yes, I am sure there will be a fig leaf.  I am sure that TNK-BP will be browbeaten behind the scenes to convince them to smile and play nice and do a deal and say “thank you sir may I have another?” in public.  But at the end of the day, any deal will take place under the threat of expropriation, and will not be a truly voluntary transaction.  Just another day in the life of the natural state.

Meanwhile, Sechin and Kudrin are taking it to the mattresses over the issue of tax breaks for Siberian oil:

A feud between Russian Prime Minister Vladimir Putin’s deputies over how to plug the budget gap may end up curbing growth in oil output, the biggest source of state revenue, and limiting flows to Asia, analysts said.

Finance Minister Alexei Kudrin wants to claw back some of the Siberian tax breaks granted to oil companies led by OAO Rosneft and increase taxes on gas producers such as OAO Gazprom. Rosneft Chairman Igor Sechin, Kudrin’s fellow deputy prime minister, wants to prolong oil export tax exemptions to fund output increases. Gazprom and Rosneft are both state-run.

“The Pandora’s box has been reopened,” Yaroslav Lissovolik, chief strategist of Deutsche Bank AG in Moscow, said in an interview. “The tug of war between the ministries is starting.”

. . . .

Kudrin wants to boost gas taxes either at the extraction or export stage, a government official said last week. Gazprom, the world’s largest gas producer, defeated a similar proposal last year. Russia hasn’t increased extraction taxes for gas suppliers since 2006.

Kudrin is under pressure.  Sechin/Rosneft and Gazprom want to keep the rents flowing.  To add to his travails, Putin is trying his old gambit of pacifying discontent at the first signs of its appearance by playing Santa Claus.  Most recently, he ordered a 6.3 percent increase in pensions against Kudrin’s protest:

The government will increase pensions by 6.3 percent next month despite warnings from Finance MinisterAlexei Kudrin on Thursday that the budget cannot afford it.

“We have the means, and I think the decision to increase pensions will not affect the macroeconomic conditions,” Prime Minister Vladimir Putin said at a Cabinet meeting. The increase signifies “carrying out our responsibilities before our citizens,” Putin added.

The pension fund may see a deficit of up to 170 billion rubles ($5.71 billion) if any increases not indicated in the legislation are made, Kudrin said. By law, pensions can be increased if the Pension Fund makes a profit or if inflation is especially high. The fund’s profits did not increase, nor will they increase in the current year, and inflation is expected at clock in at 5.6 percent to 7.5 percent in 2010. Therefore, the law does not allow for a pension increase, Kudrin said, RIA-Novosti reported.

“We have the money,” Putin replied. “Our ability to lower inflation last year … indicates that we can maintain macroeconomic conditions as planned,” he said.

Putin says it, so it must be true!

Russia’s economy has bottomed out, but its rebound has been less robust than elsewhere in the world.  The service sector is barely growing.  Foreign direct investment is still in the dumper. Manufacturing eked out a extremely small gain: the most recent PMI came in at 50.2, with anything above 50 indicating growth.  In contrast, the Eurozone PMI was 54.2 and the US  was 56.5.  So Russia is a definite laggard.

The recent rise in oil prices to over $80/bbl is a mixed blessing.  It bolsters Russia’s budget, but also causes the ruble to strengthen, which hurts manufacturing in particular.  So while the rest of the world is recovering with some vigor, Russia is languishing.

So Kudrin is caught between the rent seekers and Putin doing his populist turn.  (What about Medvedev you ask?  Don’t make me laugh.)  He has done a remarkable job over the years at steering a very respectable macroeconomic course for Russia: the country’s problems lie with its institutions and microfoundations.  But it is a thankless job, and there is no guarantee that he will be able to hold off indefinitely those baying after state funds.

Which makes me think: maybe we should offer Kudrin a job over here, as, say, Treasury secretary.  He has just the skills we need.  The ability to craft and implement sensible macro and budget policies in the face of intense political pressure.

So how’s this for reset: we trade Timmy! for Kudrin, straight up.  Now that would be the steal of the century, sort of like Brock for Broglio.

“The point, yet again, is that Simon Johnson has absolutely no clue what he’s talking about”

Filed under: Uncategorized — The Professor @ 9:13 pm

Economics of Contempt says so, so I don’t have to.

March 10, 2010

Gary Gensler’s Plan to Take Over the World

Filed under: Commodities,Derivatives,Economics,Politics — The Professor @ 10:39 pm

Gary “Jeremiah” Gensler continued his assault against CDS, this time from deep in enemy territory, at Markit’s Outlook for OTC Derivatives Markets Conference.  If it were up to Gensler, the OTC Outlook would be terminal.

In the speech, Gensler repeats several of his constant themes, and also adds some more, drafting off the cynical European outrage over sovereign CDS.  All of the tired standbys are here, including arguendo ad AIG (don’t leave home without it!)  but he also uses the shameless “derivatives used to mask Greece’s budget chicanery” argument.

I see.  We’re supposed to trust governments to regulate instruments that governments use to escape commitments they’ve undertaken.  What’s next?  Robert Downey Jr. for Drug Czar?

Gensler calls for regulation of derivatives dealers including capital and collateral requirements.  But siloed regulation of specific instruments makes little sense when these are just one element in the portfolios of complex financial institutions that engage in a wide range of risk taking activities.  A holistic approach by banking regulators is called for to ensure that risks are priced properly and consistently across all the instruments in bank portfolios.  But that wouldn’t give the CFTC a hand in the game, would it?

The CFTC chair also calls for transparency, arguing for something like the consolidated tape in equity markets.  I have no problems with that, having advocated a data hub for energy years ago, and suggesting it for OTC derivatives more broadly more recently.

But Gensler overstates the potential benefits.  He laments the fact that during the crisis there were “no reference prices for particular assets.”  Well, duh.  That’s because they didn’t trade.  And mandating that something trade on an exchange will not magically mean that it will trade at all.  Low volume instruments typically don’t trade on exchange because it’s not worth the cost of maintaining a market that is seldom used.  This isn’t Field of Dreams: just because you build a trading facility, doesn’t mean that people will come to trade everything on it.  Even with an exchange mandate and/or post-trade transparency, many instruments will still lack reference prices on a timely basis because there is no underlying demand to trade them with any frequency.

Which undermines Gensler’s next demand: that derivatives be cleared.  Sufficient trading activity is a necessary condition for clearing to be the best way of allocating default risk (though not a sufficient condition).  In addition, I note, wearily, that Gensler again invokes clearing as a deus ex machina that “guarantees obligations of both parties” and “takes trades off the books of financial institutions.”  Pray tell, where does the risk go?  Who provides the guarantee?  Is there a guarantee fairy?  Do leprechauns guarantee trades with a pot of gold at the end of a rainbow?  (Or is that needed for the Irish banks?)

In this speech, Gensler expands his criticism of CDS to take up the by now standard “no insurable interest argument” against holding “naked” CDS positions: who knew regulators were such prudes?  In a section titled “market manipulation” he regaled his audience with the story of how in the 18th century unscrupulous folk had taken out insurance on ships they didn’t own, which then seemed to have a bad habit of being lost.  This, and related schemes, led to the passage of statutes that required the purchaser of insurance to have an insurable interest.

There is an argument to be made for the efficiency of such rules in some contexts.  In particular, in the specific historical case Gensler discussed, the probability of detection was probably quite small, given the difficulty of proving that a particular vessel sank as a result of foul play (difficult if for no other reason that it was lying at the bottom of the ocean, perhaps with the bodies of its crew).  This meant that ex post deterrence of this conduct was likely very ineffective.  Moreover, there is no compelling benefit of A buying insurance on B’s property or life.

The question is whether this analogy is apt for CDS.  I think not.

First, there are potentially beneficial reasons for naked CDS.  Speculation of this sort can provide valuable information: markets that restrict short sales are typically less informationally efficient than those that don’t, and experimental evidence suggests that short sale restrictions encourage bubbles.  Moreover, market makers may sometimes take naked positions in CDS pursuant to their vital role of providing liquidity.  In addition, holding naked CDS against related positions (e.g., equity positions in the same firm, CDS positions in other firms in the same industry) can be sensible spread trading strategies that ensure that financial instruments are priced appropriately relative to one another.

Second, it is interesting that Gensler cannot point to any particular example in CDS analogous to what apparently happened to ships in the 18th century. He resorts to the “some say” dodge, stating that “some observers . . . contend” that CDS swap protection buyers “may have engaged in market activity to help undermine an underlying company’s prospects.”

Be a man Gary.  If you have evidence of this, let’s hear it.  If not, some say you should shut the hell up.  I would also note that Gensler’s argument can be applied to pretty much any financial instrument.  Owners of puts on a company have an incentive to do thing to undermine that company’s prospects.  What makes CDS special?

CFTC anti-manipulation standards require a finding that a manipulator had the ability to cause distorted prices, took actions that had the effect of causing such a distortion, and acted with the specific intent to do so.  Is Gensler arguing for a different standard for CDS?  Does he have any evidence that most CDS holders, naked or otherwise, have the ability to cause the distortions that Gensler conjectures?  Can he cite specific examples of where this ability to cause was actually exercised to cause the mayhem he describes?  Most importantly, does he seriously believe that such an action could be undertaken without being detected?   This seems an area in which ex post deterrence through enforcement action or private action is best suited, which is quite different from the shipping example that Gensler discusses.  Blanket bans against naked CDS don’t make sense in this context, as they preclude potentially valuable uses of this strategy, while (so far only hypothetically) misuses can be deterred efficiently ex post.

Gensler also trots out the empty creditor problem.  As I argued here and here, the conventional analysis of this issue (advanced most prominently by Henry Hu, and which Gensler essentially repeats) is seriously incomplete because it fails to address the latent Coase Question of what transactions costs preclude voluntary trades resulting in optimal allocation of rights.  Insofar as remedies are concerned, Gensler and I actually agree: he recommends position disclosure and voting in bankruptcy based on economic interest, just as I did last April in the first of the two posts linked above.

The CFTC chair also criticizes the Basel capital rules insofar as they apply to CDS.  I yield to no man in my disdain for these rules, and think that they were a major contributor to the financial crisis (to the extent that they incentivized banks to undertake the same trading strategy of holding large positions in AAA CDOs).  But I think that Gensler, in his Ahab-like obsession with CDS, focuses on a side issue.  Specifically, he criticizes the component of the rules that give capital relief to those who hold CDS as a hedge against other risk exposures.  He wants more restrictive capital treatment of CDS -hedged positions.  He pejoratively states that this treatment means that “a bank can essentially rent another institution’s credit rating to reduce its required capital.”

Well, yeah.  That’s what hedging is all about; an institution is laying off the risk to somebody who bears it at a lower cost. This can be done by selling the underlying instrument, or entering into a hedging transaction utilizing a related instrument.  Sometimes–a lot of the time–the latter is more efficient.   Economically, it makes perfect sense to require less capital against hedged positions.  It would be perverse indeed to do otherwise.

As to specific restrictions, Gensler suggests that “only CDS subject to collateral requirements could be allowed to provide capital relief.”  Perhaps he hasn’t read the most recent ISDA Collateral Market Review (released on March 1), which states that 97 percent of CDS positions are collateralized.

And by-the-way: AIG’s CDS contracts were subject to collateral agreements.

So, Gensler’s specific recommendations are red herrings, even in the context of arguendo ad AIG.

Would it that CDS and OTC derivatives were the only object of Gensler’s control fetish, and desire to swell the authority of the CFTC.  But no.  Not only are there position limits, but Gensler has also set his sights on the market for power firm transmission rights, setting off a turf war with FERC.

Gensler is attempting to put Rahm Emanuel’s “let no good crisis go to waste” dictum into action, exploiting the financial crisis–and importantly, more than twice told tales about the financial crisis–to advance a regulatory agenda that would concentrate tremendous power in his agency.  This agenda is built on fundamentally flawed analysis.  What’s more, the agency that he heads quite clearly has not demonstrated that it has the capability, resources, or expertise to exercise those powers effectively and judiciously.  And I am being very charitable in saying that.  (If you have any doubts, take some time and look through the reports the GAO has written about the CFTC over the years.  It does not make for happy reading.)

I have some novel suggestions, Chairman Gensler.  First, do no harm.  Second, be circumspect about anyone’s abilities–including yours–to micromanage huge, complex markets.

March 8, 2010

The Worst of All Worlds

Filed under: Politics — The Professor @ 9:43 pm

Retiring Congressman Eric Massa is a Naval Academy classmate of mine.  I did not know him at Navy, so I have no direct personal knowledge about him.

I can say, though, that if what is stated here is true, Massa would be a predator.  I couldn’t give a damn about his sexual orientation, but a predator is beyond the pale, regardless of whether the prey is of the same gender or not.

In his defense, Massa claims that these stories are slanders intended to drive him from politics because of his opposition to Obamacare.

But, of course, these stories are not mutually exclusive.  Massa could be a predator whose inclinations and behavior were not a secret, and which were revealed by hatchetmen for purely partisan reasons.  That had he not crossed the wrong people politically, his sick secret would have remained such.  Had he not crossed the Chicago mafia, perhaps he would not be watching his life, and his family’s life, go down in flames.

The sad thing is that if I had to bet, that’s where I’d put my money.  After all, there are many no votes, any one of which would be equally useful for Emmanuel, Pelosi, and Obama to flip or eliminate.  Why Massa?  Most likely because he was vulnerable, because what is being said about him is close enough to the truth that he cannot stand and fight.  I’m sorry to say it, but that’s the most likely explanation.

That doesn’t make it right, even if it is true.  Have we sunk so low that the fate of the health care of hundreds of millions of Americans, and trillions of dollars, hinges on the perversions, alleged or real, of a single congressman, and the willingness of a ruthless and shameless set of opportunists to exploit them, ignoring in the process the vehement opposition of a solid majority of Americans?  Is our polity so decadent that the most solemn offices are held by people who are vulnerable to blackmail, and those who are willing to engage in it?

Cutting Off One’s Nose to Spite One’s Face

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 5:24 pm

Greece desperately needs people to buy its bonds.  So what does it do?  It excludes potential buyers, specifically hedge funds:

Greece ordered its bankers to exclude hedge funds from a bond offering this week in an effort to punish the speculators it blames for destabilising its debt markets.

The decision came amid growing anger among European leaders over what they see as the role speculators played in undermining the Greek debt market and driving the country towards a possible default.

. . . .

According to people familiar with this week’s €5bn (£4.5bn) Greek bond issue authorities in Athens told banks handling the sale to make sure they did not allocate any bonds to hedge funds or any bodies that might be a proxy, or front, for them.

Uhm, those hedge funds that want to buy are going to result in lower interest rates for Greece.  Excluding them from the primary market can only make things costlier for Greece.  (Although since these folks can buy in the secondary market, the effect of excluding them from an auction might not be that large.)   You don’t punish bearish hedge funds (not that they deserve punishment in any event–see below) by taking a smack at bullish ones.  How assinine.

The Queen of this Greek drama, Prime minister Papandreou is absolutely over the top with his anti-speculative rants:

Greek Prime Minister George Papandreou, drawing parallels with the 1947 fight to contain communism in Europe, called for trans-Atlantic cooperation to combat “unprincipled speculators” who threaten to bring a new global financial crisis.

“Europe and America must say ‘enough is enough’ to those speculators who only place value on immediate returns, with utter disregard for the consequences on the larger economic system,” he said in a speech today in Washington. “An ongoing euro crisis could cause a domino effect, driving up borrowing costs for other countries with large deficits and causing volatility in bond and currency rates across the world.”

Papandreou and other leaders such as German Chancellor Angela Merkel have blamed much of the surge in Greek financing costs on market speculation, rather than its inability to tame the region’s biggest budget deficit. Germany and France are pushing for curbs on “speculators” using derivatives to bet against Greek debt, which will be ready in June, officials in Berlin and Brussels said today.

Papandreou called the market for credit-default swaps a “scourge” that “haunts Greece and all of us.” U.S. and European regulators need to bolster regulations to curtain such activities, he said, or “a small problem could be the tipping point in an already volatile system.”

Puh-lease.  I mean seriously.  What should haunt you, Mr. Prime Minister, is years of profligacy only partially concealed by financial chicanery (enabled, true enough, by some of the very banks against whom you rail today).  If you are facing some sort of financial  Armageddon, it’s the fault of your government and its predecessors, dating back years.  I would say that it was the governments of Greece–and other countries, the US included–that acted with “utter disregard for the consequences on the larger economic system.”

And which are acting with such utter disregard today.  Only more so.

But the shoot-the-messenger histrionics don’t end with Papandreou.  All of Europe’s government leaders are closing ranks to blame everybody but those who actually spent the money they didn’t have and couldn’t pay back.  Here’s Sarkozy:

“If Greece needs them (the measures), we’ll be there,” he said. “Speculators … must know that ‘solidarity’ means something.”

France, Germany and Greece will take a common initiative to fight speculation, and the euro zone’s two biggest economic powers “have decided to do what’s necessary so that Greece is not isolated,” Sarkozy said.

And Merkel:

German Chancellor Angela Merkel said that Greece doesn’t need financial aid, as she turned her focus to restricting the use of derivatives to halt “speculators” from exploiting countries’ budget deficits.

“Credit-default swaps, where you insure your neighbor’s house just to destroy it and make money from it, that’s exactly what we have to curb,” Merkel said at a joint press conference in Berlin yesterday with Greek Prime Minister George Papandreou.

. . . .

“We must succeed at putting a stop to the speculators’ game with sovereign states,” Merkel said. “We can’t allow speculators to be the profiteers of Greece’s difficult situation.”

So the Merkel story is, effectively, that the Greek financial house was all in order, nice white stucco and all, until one day, out of a clear blue Aegean sky, some malicious speculators decided to burn that house down.

What a crock.

It would be more accurate to say that the Greek financial house was used to store gasoline, while the family was busy puffing away on cigarettes (the Greeks being among the greatest smokers in Europe, BTW) and throwing their butts and matches around with abandon.  Some people noticed this, figured out something bad was almost inevitable, and put their money where their eyes were.  Yes, they probably made a few bucks for themselves, but also did the service of accelerating the inevitable fiscal reckoning, not just in Greece, but in Europe as a whole.

Oh, and even Merkel’s own German financial regulator, BaFin, denies that speculation caused the Greek crisis:

German market regulator BaFin said Monday that so far, it doesn’t see any sign of massive speculation in credit default swaps against Greek government bonds, despite some recent press reports suggesting this.

A significant reason behind widening CDS spreads is the increasing demand for insurance against Greek risk, BaFin said in a statement, adding that it closely watches the government bond and credit derivatives markets for selected euro-zone countries.

. . . .

BaFin said data published by the U.S. Depository Trust & Clearing Corporation don’t signal an increase in new open positions and don’t indicate massive speculation. It is true, however, that the gross volume of outstanding CDS contracts for Greek government bonds amount to around $83 billion as of Feb. 12, according to DTCC, more than twice the $41.1 billion a year earlier.

In other words, Papandreou, Sarkozy, Merkel et al are saying: “Don’t bother me with the facts.”  They don’t want to face up to fiscal realities, so they are trying to direct blame elsewhere.

Politics as usual, in other words.  And it is politics as usual that put Europe in this positions in the first place, and politics as usual that will prevent any fundamental change.

March 7, 2010


Filed under: Uncategorized — The Professor @ 1:47 pm

Roseanne Rosannadanna has apparently weighed in on Russia’s highly touted policy to replace a 19th century-style mass conscription army with a volunteer force based on “contract” soldiers:

Roseanna Rosannadanna Nevermind

Specifically, Russian Chief of the General Staff Nikolai Makarov has announced that the army will continue to rely on conscripts rather than transition to a volunteer force (per EDM):

Controversy returned to the Russian Chief of the General Staff and First Deputy Defense Minister, Army-General Nikolai Makarov, following an interview on February 25, during which he seemed to signal a policy reversal on the issue of further developing contract personnel numbers (Kommersant, Russia Today, Interfax, February 25). Makarov pointedly asserted, “We are not going to switch to contract service. Too many mistakes have been made, while the task of building a professional army has not been fulfilled. So the decision was made that conscript service will remain in the armed forces,” adding that, “We are increasing conscription and cutting down the contract component. We have realized that contract servicemen must be trained using new methods.” Sensationalist interpretations of his comments were offered, among others, by, which claimed that he was in effect “tearing up contracts” (, February 26). Moreover, some critics suggested that his plans contradicted part of the new military doctrine signed by President Dimity Medvedev on February 5.

Nevertheless, Makarov was actually simply highlighting that for the time being the possibility of using kontraktniki as the basis of the armed forces is unrealistic. This reflects the awareness that the future backbone of the line units will be the new professional non-commissioned officers (NCO’s), trained in courses lasting two years and ten months at Ryazan, and these will not serve in units in any meaningful numbers until 2013-2015 at the earliest. Equally, had Makarov fallen into the trap of advocating professionalizing the force structure and abandoning conscription, his critics would have denounced him for promoting unaffordable plans.

Strategy Page has more:

It was thought that getting rid of conscripts would do the trick [of getting rid of ?????????; search on that term in Youtube if you want to see more videos of the practice–and if you can stand watching gratuitous brutality]. Not so. Although the volunteers were in for more than three years, rather than two (and now one) for conscripts, the lack of effective NCOs saw the bad habits persist. Thus the need to develop professional NCOs to keep things under control in the barracks.

Volunteers cost a lot more than conscripts, but there is not enough money to do away with conscription. Russia uses some volunteers, especially for combat duty in places like Chechnya. These troops get paid on a scale equal to, and, with combat pay, above civilian wages. Conscripts get a few dollars a month. The volunteers expected better living conditions, and often didn’t get it. So they left.

The hazing has been one of the basic causes of crimes in the Russian armed forces. The hazing accounts for 20 to 30 per cent of all soldier crimes. This has caused a suicide rate that is among the highest in the world. Poor working conditions in general also mean that Russian soldiers are nearly twice as likely to die from accidents, or suicide, than American soldiers.

With hazing, and the resulting poor morale and discipline, the military is also unable to keep many of its experienced and capable NCOs. Many of the best ones have been leaving the military, despite better pay and living conditions. All noted the problems, caused by hazing, as a major reason for getting out.

Conscription itself, and the prospect of being exposed to the hazing, has led to a massive increase in draft dodging. Bribes, and document fraud, are freely used. Few parents, or potential conscripts, consider this a crime. Avoiding the draft is seen as a form of self preservation.

The Russian lack of sergeants (praporshchiki) has been difficult to fix. Just promoting more troops to that rank, paying them some more, and telling them to take charge, has not done the job. So going back to look at how Western armies do it, the Russians noted that those foreign armies provided a lot of professional training for new NCOs, and more of it as the NCOs advanced in rank.

So the Russians opened an NCO Academy. It will eventually take 2,000 NCOs a year, and put them through a 34 month course in how to be a superior NCO. Much of the instructional material is being borrowed from the West, where similar NCO schools have been around for decades. None of these schools, however, keep their students for nearly three years. But the Russians know that they have to break a chain of tradition (hazing among troops, deferring all decisions to officers, and so on) that has crippled the Russian army for over half a century. Thus the long course, in an attempt to drill the bad old ways out of these carefully selected troops, and inculcate new methods borrowed from successful professional armies in the West. The graduates of these academies will become platoon and company sergeants (1st Sergeants) and sergeants major for battalions. They will, as in the West, have the respect and trust of the troops, and serve as an intermediary between the officers and the troops. As in the West, the new NCOs will look after the welfare of the troops, especially when the officers are not paying as much attention as they should. The new NCOs will be paid as much as a high ranking officers ($1,100 a month), which will help attract the most suitable candidates. [This pay compresssion will also serve to tick off the officers, and thereby create other kinds of morale and leadership problems.]

A three year training program is bizarre, and a testament to how bad the problem must be.  It essentially means that training of NCOs must be hermetically sealed from what transpires in the units and the barracks, for long periods of time, for fear that exposure to the prevailing unit/barrack culture will ruin the NCO.  But this will just create more problems.  In the US military, and the British and French and other capable forces, NCOs develop by coming up through the ranks and experiencing what the privates and lance corporals experience; learning by doing is the essence of becoming “an intermediary between the officers and the troops.” This informs their actions as NCOs.  Moreover, in addition to their shared experiences, the continued connection between NCOs and their charges is what builds trust and respect (for those who deserve it–and leads to trouble for those who don’t).  The grunts know that the sergeants know what it is like to be a grunt.  That’s unbelievably important.

In contrast, Russian NCOs parachuting into units from their three year isolation will be viewed with suspicion, as out-of-touch outsiders.  Moreover, knowing the way that identifying anyone as “special” affects they way that they view others not so designated, and the way that the unspecial view them, the new NCOs will tend to look down on their subordinates, and their subordinates will resent them.  Their subordinates will also doubt whether their sergeants really know what it is like to be a Russian private.  Moreover, the pay compression is hardly calculated to make the officers all that fond of the NCOs either.

In brief, the Russian military, and the army in particular, seem stuck in a very bad equilibrium with no way out.  The current system has led virtually anybody but the most marginal and desperate to attempt to avoid conscription; Wellington’s description of his soldiery seems to fit Russia’s:

A French army is composed very differently from ours. The conscription calls out a share of every class — no matter whether your son or my son — all must march; but our friends — I may say it in this room — are the very scum of the earth. People talk of their enlisting from their fine military feeling — all stuff — no such thing. Some of our men enlist from having got bastard children — some for minor offences — many more for drink; but you can hardly conceive such a set brought together, and it really is wonderful that we should have made them the fine fellows they are.

The differences are that: (a) the Russian army is theoretically on the French model in which everyone serves, and has all the disadvantages thereof without any of the compensating benefits, and (b) it is highly doubtful that the Russian system has made its soldiers “fine fellows.”

But the alternative of creating a professional force with elan and morale is beyond reach, and the extreme measures intended to achieve it are unlikely to succeed.  What Russia needs is NCOs that are essentially the best of the men whom they command, only older and more experienced; a special caste of NCOs will come with its own special problems.

This makes the second part of the EDM article all the more amazing.  It states that Russia is attempting to move to network centric warfare, based in part on the less than stellar performance of the army in the Georgian War (which is pretty amazing since the units involved were among the best in the service).  But network centric warfare depends crucially on trained and motivated soldiers.  A conscript army is unlikely to cut it, even (especially?) if leavened with a number of NCOs created in isolation from the units they are supposed to lead.

I continue to believe that it is a very clear understanding of the debilitating dysfunctions of the Russian military that is a major source of the government’s paranoia about NATO.  Look, even if it wanted to, NATO couldn’t realistically invade Russia; the numbers are too small, and the logistical obstacles too daunting.  And it really, really, really, doesn’t want to.  But to Russian leaders already marinated in paranoia, the knowledge that their military is really an empty shell–at best–can only intensify that paranoia.

* Maybe it’s Nirvana instead of Roseanne Rosannadanna: Nirvana Nevermind

March 6, 2010

Hail, Columbia

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 10:00 pm

I’m just back in Houston from speaking at a conference at the Columbia Law School, titled “The Financial Crisis: Can We Prevent a Recurrence?”  It was probably the best conference I have ever attended.  It was a gathering of a truly talented group of academics (mainly legal scholars, but some economists), practicing lawyers, finance practitioners, central bankers (US and non-US), and government folks, all of whom offered excellent insights on various aspects of the crisis, and policy responses to it.  The organizers, Jeff Gordon of Columbia and Howell Jackson of Harvard Law School, are to be congratulated for putting on a phenomenal event.  It was a privilege to participate.

I spoke on clearing.  (Go figure.)  My remarks were well received, I think.  Robert Pozen of MFS Financial Management said in his remarks that he didn’t agree with a lot of what I had to say, but that any supporter of mandated clearing (which he is) had to take my critique seriously, and address the concerns I’d raised.  Which is quite fair.  I don’t claim to have all the answers, but I think I have good questions, and hope that posing them will contribute to the formulation of better policy.  (I started my talk with Hayek’s quote “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”  I think that some in policymaking circles think they know far more than they do about the systemic implications of clearing, and all I aim to do is what Hayek says economists should do.)

The conference finished up with a session on “Radical Solutions.”  Charlie Calomiris and Luigi Zingales gave very interesting talks that echoed two major SWP themes, namely that too big to fail is the result of governments’ inability to commit credibly not to bail out, and that the ultimate source of moral hazard and the excessive growth of financial institutions is that their creditors are convinced that they will be bailed out, and hence are willing to lend on terms that do not reflect risk.  They offered interesting proposals to address these problems.

One thing that struck me throughout the event is the widespread belief that financial reform efforts are dead in the water.  Some considered that unfortunate.  Others, including yours truly, were not so negative; not that I/we don’t believe that some sort of reform is needed, just that the alternatives on offer are likely to be counterproductive.

Today’s luncheon speaker was Henry Hu, a University of Texas law prof now heading up the SEC’s new Division of Risk, Strategy, and Financial Innovation.  I don’t always agree with Henry–I have criticized his analysis of the “empty creditor” problem, for instance–but he is obviously a thoughtful man who is bringing tremendous energy and enthusiasm to his DC job.  In his talk, he asked the audience to let him know whether they observed any new product or trading strategy that threatened to destabilize the financial system.  That’s fine, but I would also hope that he would be equally alert to regulations or legislation that could have deleterious effects; and be particularly alert to the creation of policies that could encourage the development of problematic strategies and products in direct response to such policies.

Friday’s dinner speaker was Simon Johnson.  I have an extremely mixed reaction.  I share his concern about too big to fail, and the potential for legislative and regulatory capture by the finance industry.  But given that I consider much of the proposed legislation to be counterproductive, unlike Johnson I don’t believe that it is axiomatic that bank opposition to this legislation is an outrage.  His is a very Manichean world view, with big finance as the epicenter of evil, and those who fight big finance as the avatars of goodness.  Not quite that simple, IMHO.

It was weird, to say the least, to hear someone channeling Andrew Jackson in a Brit accent.  He started out talking about TR taking on the trusts, and FDR taking on the banks, but I was thinking that his real hero should be Andy Jack.  Sure enough, a few minutes later he said that the true first opponent of financial oligarchy was Jackson.

Again, I have some sympathies; much of Jackson’s critique was correct, as is some of Johnson’s.  But much of Jackson’s criticism was misguided, and what’s more, the system that he advocated to replace the corrupt Second Bank of the US was plagued by chronic instability and crisis.  Johnson was less than candid about Jackson’s banking legacy: he would only admit that the post-Jackson banking system was “complex.”  But to admit that a previous populist response to concentrated financial power was hardly ideal would undermine Johnson’s populist jeremiad against today’s concentrated financial power.  That failure to confront the possibility that a populist reaction can be destructive undercuts Johnson’s credibility in my eyes.

Johnson’s tone was also extremely off-putting.  It was snide and arrogant.  He came off as a populist provocateur poseur.  Not particularly appealing.  But worth hearing nonetheless.

At the conference, there was a lot of agreement about the underlying causes of the crisis.  There was, however, less agreement about policy responses going forward.  That’s not surprising, but given the caliber of the people at the conference, it does suggest that we are in for a long debate over policy going forward.

And while I was at the Columbia conference, SWP daughter Renee was at a conference at Texas A&M, sitting 10 feet from George H. W. Bush and Barbara Bush.  And someone really important: Chuck Norris.  And she lived!  (He gave the death glare to one of her friends who was laughing too hard at something.)  Nobody quite that famous at Columbia, but it was worth the trip nonetheless.

March 3, 2010

You’re Never Too Old to Rock and Roll If You’re Too Young to Die

Filed under: Music — The Professor @ 12:52 pm

For a moment last night I had my doubts about that (Jethro Tull) wisdom, at least insofar as fairly hardcore punk is concerned.  After class my eldest and I headed a couple of miles cross town to The Warehouse to see the Dropkick Murphys.  The crowd was, uhm, interesting.  The Rancid/Rise Against crowd was mainly awkward kids.  Social D, aging X-ers.  Everclear, upscale fuddy duddies.  Murphys: mainly folks in their 20s, very high testosterone levels, and higher alcohol and controlled substance levels.  Haven’t seen that many wasted people in a very long time.  Maybe ever.  But then I’ve lived a pretty boring life.

There was a huge amount of pent up energy that was released in a frenetic explosion at the first chords from the Murphys.  A good part of the people in the crowd near us (about halfway to the stage) immediately began pumping both arms alternately in the air at high speed.  They looked like those punching nun puppets.  Then  the bodies started flying as several rather chunky guys began hurling themselves to-and-fro, looking to get pinballed by those around them.

Then the casualties started to stream out.  One girl came from near the stage with her nose pointed in a direction that God didn’t intend.  Then a guy with a gushing cut over his left eye.

A good time was had by all!

One guy next to me was way out of control, lurching wildly from side to side.  He banged into me once.  The second time I fended him off with a forearm to the left kidney.  The third time he came harder, and almost trampled Renee, so I sent him semi-sprawling with a two handed push.  The next time, I thought it was going to get ugly because he came at me squared up, with both arms in the air.  But all he did was give me an I-love-you-man hug, and then shouted in my face: “Murhpys! Yeeeeaaaaahhhhhhhhh!”  before his friends sort of dragged him away.  After catching his breath full force in the face, I don’t think I could pass a drug test today 🙂

After the first several songs and the associated release of energy, the crowd settled into a less excited state.  It was still rocking, but not frenetically crazed.

As for the Murphys, they were all that I expected.  Fast, loud, entertaining.  (Heh.  “Wild Rover” just came on my Pandora.)  Interesting mix of instruments.  Bagpipes, of course, but also banjo, mandolin, and accordion.  Not a lot of talk, just song piled on song, almost all fast.  The stage set was attractive, with several Celtic crosses on the speakers.  The backdrop for most of the show was a Celtic Church Gothic scene.  Later there was the obligatory punk rock band smiling skull (with an eyepatch), and lastly a dawn skyscape.

All in all, very much worth it, despite my initial reservations.  One weird thing.  Being there you got the impression that the show was very spontaneous and unscripted, but it started precisely at 10:30 and ended exactly at midnite.  Exactly.  So exactly, it couldn’t have been an accident; instead, a very tight, well-rehearsed, 90 minute set.  I wondered if the two huge tour bused parked outside were about to turn into pumpkins or something.

Bottom line?  I can’t reject the Tull hypothesis.  Not yet anyway; the Streetwise Professor lives.  So bring on the next show!

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