Streetwise Professor

Russian manufacturing expanded at the most rapid rate in the last two years, with the April PMI registering 52.1 (with anything over 50 indicating growth).  Yes, better than a sharp stick in the eye, but nobody should get too excited: Russia is still a manufacturing underperformer.  The Global PMI was 57.8, the second highest level recorded in history.  The US PMI came in at a robust 60.4.  Germany’s even better, at 61.5.  China’s 55.7.  India’s 57.2.   Brazil was a comparative laggard, at 53.8, as was Japan at 53.5, both of which still lapped Russia.

Russia suffered one of the sharpest declines in manufacturing activity.  It is also experiencing one of the weakest recoveries.  Not exactly an “L”, but definitely not a “V”.  More like a very shallow “U”.

A good deal of this is the result of one of the myriad consequences of the resource curse.  Relatively strong oil prices have bolstered the ruble, and this has hampered the Russian manufacturing recovery.

Russia has been very aggressive at cutting interest rates to try to counter the ruble appreciation and force feed credit to businesses.  Even with this stimulus, however, the manufacturing performance has been lackluster.

The worst appears to be over (unless, as is not outside of the realm of possibility, the metastasizing European fiscal crisis causes another global shock), mais les bons temps ne roule pas en la Russie.

When he first became president, Putin compared Russia’s standard of living with Portugal’s, and promised that Russia would catch up to the small Iberian country by 2015.  Not going to happen.  Unless, that is, the convergence is from above, with Portugal crashing to earth with the other once flying PIIGS, rather than from below, with Russia growing at a much faster rate.

Oliver Wendell Holmes famously observed that FDR had a “second rate intellect but a first rate personality.”  If only Obama were FDR.  His vaunted intelligence has proved pedestrian.  On a good day.  And that cool demeanor that millions swooned over has been shown to be a sham as well.  People are awakening to the fact that he is, in fact, like that really cool guy in high school that you found out was just a condescending, stuck up, a@@h*le who couldn’t give a rat’s rump about you when you got to know him.

Even the Washington Post notices.  Yes, the Washington Post fer crissakes:

Breaking with presidential punch line tradition for the second consecutive year, Obama dropped zinger after zinger on his opponents and allies alike at the annual White House Correspondents’ Association dinner. Obama went all Don Rickles on a broad range of topics and individuals: Vice President Biden and Secretary of State Hillary Clinton, presidential advisers David Axelrod and Rahm Emanuel, the news media, Jay Leno, and Republicans Michael Steele, Scott Brown, John McCain and  Sarah Palin.

Except for a mild joke pegged to his falling approval ratings, Obama mostly spared Obama during his 14-minute stand-up routine.

Take a minute to absorb that: “Obama went all Don Rickles.”  How presidential.  It is true, as the WSJ editorialized, that  Obama relishes being his own Spiro Agnew.

What makes this even more amazing is that this insult humor routine was delivered within hours of his delivering at the University of Michigan graduation a homily on bipartisanship and the necessity of elevating our civil discourse.  No, seriously.   He did.  Really.  I wouldn’t lie about something like that.

FDR was a SOB in private, but a charmer in public.  Obama is an SOB in public.  And people are noticing.

But Obama doesn’t.  Jennifer Rubin hits the nail square and true:

Frankly, this gets back to a lack of self-awareness. This is a president who derides political opponents, fails to engage them on the merits, and has perfected the straw-man and ad hominem attacks. It was his White House that declared war on Fox News. So it is the height of hypocrisy for him to now tell the rest of us to up the tolerance and intellectual diversity quotient in our lives. It’s sort of like Tom Friedman telling us to consume less and reduce our carbon footprint. [A Twofer!  Slamming Obama and Tom Tool Time Friedman in the same paragraph.  Way to go, Jennifer.]

This lack of self-awareness is disturbing.  His preternatural (and largely unwarranted) cockiness became even more pronounced after the health care vote, even though George W. Bush had far more to do with getting health care “reform” foist upon us than Obama; in fact, the health care vote was deeply damaging politically to Obama and especially his party.  The disconnect between self-image and reality bodes for yet more conflict.  The Era of Bad Feelings has only just begun.

The debate over “rules vs. discretion” was a centerpiece of disputes over monetary policy during the 1960s-1980s.  One of the most important contributions to this debate was by John Taylor, who devised an eponymous rule for monetary policy.  A rule that Greenspan and Bernanke flouted, and in so doing, contributed mightily to the financial crisis.

Taylor has an article about rules vs. discretion in today’s WSJ.  It is not about monetary policy, but rules vs. discretion in the resolution of large financial institutions that have failed, or are teetering on the brink of failure.   Taylor comes down firmly on the side of rules:

You do not prevent bailouts by giving the government more power to intervene in a discretionary manner. You prevent bailouts by requiring adequate capital based on simple, enforceable rules and by making it possible for failing firms to go through bankruptcy without causing disruption to the financial system and the economy.

Taylor’s argument is that the capriciousness of a system that gives regulators tremendous discretion gives rise to destabilizing uncertainty.  A rule-based system is more predictable, and more stable.

I too have argued for limiting discretion, though on somewhat different grounds.  My concern is that discretion, especially when there is a possibility that that discretion can be used to commit government funds (or even funds eventually contributed by other financial firms) in order to bail out creditors creates moral hazard.  Political economy considerations will almost certainly favor bail outs; concentrated, politically connected creditors will exert greater influence than diffuse taxpayers.  The prospect for bailouts reduces the cost of credit, which encourages excessive leverage, excessive risk taking, and  insufficient monitoring.  Which, in turn, makes failure more likely.

Although Taylor’s argument and mine on discretion are different, they are complementary.  I have not seen an even mildly persuasive argument in favor of discretion.  Thus, whereas the Chapter 11F bankruptcy option that Taylor advocates (as does George Schultz, one of the only US Treasury Secretaries I wouldn’t swap for Kudrin) is languishing, the discretion-heavy Dodd bill advances apace.

A constant theme here at SWP, in my public speaking, and in my academic work has been the lack of serious thought underlying the financial bills currently slouching through Congress.  These markets are complex (in the usual sense of the word, and the more technical meaning of complex systems characterized by emergent orders and rich feedbacks).  Any major changes will have effects that are almost impossible to predict: and it is quite likely that the legislative effects will be quite different from those intended by its framers.  Or, as I put it in a policy paper for Cato that I just finished (first draft, anyways):

There is a “fire, ready, aim!” feel to many of the policy proposals emanating from Capitol Hill and the administration.  Prescription precedes understanding.  To evaluate the costs and benefits of clearing mandates, this order must be reversed.

The implicit judgment underlying the regulation is that the received structure is fundamentally defective, but there is no explanation as to why that is so.  There is no stepping back to ask: “Could there be an economic rationale for the arrangements that have emerged from the decisions of myriad economic agents?”  There is no grappling with the Coase question: no serious attempt to identify the source of transactions costs that could lead to the massive “market failure” that the advocates of major changes believe exists.

As I’ve said before: fools rush in where angels fear to tread.  Without understanding what is broke, and what isn’t, how can you fix it?

I am reminded of the time I was helping my grandfather fix a tractor.  I had the wrenches out and was ready to just start unbolting stuff.  He said: “Wait just a God damn minute.  Why don’t we try to figure out why it isn’t working first?  If you just take the damned thing apart it will be well and truly broken.”

Is it too much to ask the denizens of the 202 area code to wait a God damn minute and figure out what in the financial system didn’t work and why, before they well and truly break it in ill-considered efforts to “fix” it?

Well at least I have some company in my misery.  Today’s New York Times, of all things, has an article that highlights the foreboding of several other finance scholars:

Others simply argue that it is premature to pass sweeping legislation while so much about the crisis remains unclear and so many inquiries are in progress.

“Until we understand what the causes were, we may be implementing ineffective and even counterproductive reforms,” said Andrew W. Lo, a finance professor at the Massachusetts Institute of Technology. “I understand the need for action. I understand the need for something to be done. But what I expect from political leaders is for them to demonstrate leadership in telling the public that we need to proceed about this in a much more deliberate and rational and thoughtful way.”

. . . .

The most basic critique comes from Professor Lo and others who say that Congress is moving too quickly. The origins of the crisis remain a subject of intense controversy. Investigations continue to unearth surprising information. The Financial Crisis Inquiry Commission, a bipartisan panel created by Congress, is not scheduled to report until December. Why not wait, they ask, until the targets are clearer?

Exactly.  The article quotes others, including Lawrence White of NYU who almost sputters with indignation at the failure of any of the bills to address Fannie Mae and Freddie Mac at all.  But what would you expect from Barney Mae and Chrissy Mac?  Or is it Fannie Frank and Freddie Dodd?  Regardless, addressing that issue would raise the most embarrassing questions, like: WTF are the people who bear tremendous personal responsibility for one of the most costly aspects of the crisis–and what is arguably a key underlying cause of the crisis–doing in charge of “fixing” the system instead of donning sackcloth and squatting on a pile of ashes, begging abjectly for forgiveness?

In another misery-loves-company moment, from a truly unexpected source, Sheila Bair and the FDIC have come out against the derivatives spinoff provision of the Lincoln bill:

Federal Deposit Insurance Corp. Chairman Sheila Bair is opposing a Senate measure that could cut off privileges to banks like Goldman Sachs Group Inc. and JPMorgan Chase & Co.that don’t segregate swaps trading units.

Bair, in an April 30 letter to Senate Banking Chairman Christopher Dodd and Agriculture Committee Chairman Blanche Lincoln, said the proposal championed by Lincoln would create “weakened, not strengthened, protection of the insured bank.”

“If all derivatives market-making activities were moved outside of bank holding companies, most of the activity would no doubt continue, but in less-regulated and more highly leveraged venues,” Bair wrote. “Even pushing the activity into a bank holding company affiliate would reduce the amount and quality of capital required to be held against this activity.”

Not that Bair has gone the SWP full monty: she still favors the Volcker rule and mandatory clearing.  But at least she recognizes the completely insane and ill-considered, unlike Shapiro and Gensler.

But will any of these Cassandra-esque warnings, from Bair or from academics, make a difference?  Sadly, almost certainly not.  This whole endeavor is operating on a strictly political timetable, and is driven by a strictly political considerations.  It is the centerpiece of the Democrats’ attempt to salvage something from the upcoming elections.  And as such, thoughts about the economic rationale or consequences are irrelevancies.

It has been reported that Federal prosecutors are considering the possibility of a criminal indictment of Goldman Sachs.  It is early yet, but it’s worthwhile to contemplate what the consequences of this action would be.

In 1988, Drexel Burnham Lambert faced the prospect of RICO charges arising from the Milken issues that would have effectively destroyed the firm.  The company plead nolo to avoid that death sentence, but it was mortally wounded and imploded months later, with moderately unpleasant consequences for the financial markets (including the derivatives markets).  The mere prospect of a Treasury Department ban on its participation in Treasury auctions due to one of its traders having squeezed the T-note markets (arguably a less severe sanction than anything associated with criminal charges) caused a run on Salomon Brothers that almost destroyed the firm; only Buffett’s frantic efforts saved the firm.  (That article is an interesting read.  I smiled at the part where Buffett was talking on a payphone.  Was it that long ago?)

Goldman’s stock was down hard on the news, and its CDS spread widened.

Criminal charges against the firm raises a significant risk of a run (specifically, a withdrawal of short term credit) that could threaten the firm.  Goldman is well-capitalized, and in a decent liquidity situation, but not so soundly financed that it is inconceivable that it could fail. Similarly, Buffett’s connection to the firm provides an economic cushion, and perhaps just as importantly, a political one.

It must be remembered that these situations are highly non-linear, due to the substantial feedback and the existence of multiple equilibria.  Runs can be self-fulling.  If enough creditors believe the rest will run, they will run, which will cause others to run, etc.  That is, ironically given that firms like Goldman have been accused of commencing speculative attacks against whole countries, such firms are actually acutely vulnerable themselves to such attacks.

Again, Buffet’s presence here may be crucial: if lenders believe that he will inject additional capital into the firm, they will be less likely to run.

Bottom line: even a criminal charge against the firm is unlikely to be fatal, but the risk of a non-linear, unstable, destructive response is not out of the question.

And given the centrality of Goldman to the financial system, it going non-linear could cause a destabilizing, non-linear response in the broader markets.  If Goldman defaults on derivatives, the scramble to replace the positions would have large price, volatility, and correlation effects that can set off their own non-linear feedbacks.  Similarly, the effects on the credit markets would not be pretty to watch.  The world financial system is still very fragile.  It is not recovered from the 2008 cataclysm, and it is under considerable stress from the European mess.  In this environment, feedbacks can be particularly destabilizing and destructive.

Which raises interesting political issues.  Are the Treasury and the Fed engaged in contingency planning to deal with the potential for Goldman distress arising from criminal charges?  I am sure this is a particularly delicate issue: is Justice in contact with Treasury and the Fed about these issues, either to keep the financial authorities aware so they are not caught by surprise, or for consultations about the substance of the charges?  If they are in contact, is it two way, or is it just a matter of Justice briefing Treasury or the Fed?

This is particularly delicate given the political toxicity of banks in general, and Goldman in particular.  Anything that smacks of giving Goldman a pass will cause a non-linear political effect.  But actions (or lack of actions) that contribute to or do not mitigate a shock to the financial system could be devastating both economically and politically.

These are not palatable choices, and that makes it very difficult to assess what course will be followed.  This uncertainty is exacerbated because “the government” is not a unitary thing.  Multiple independent decision makers have the power to take actions that would have serious effects.  Even a mis-statement by a press spokesman can have cataclysmic consequences.  (Remember the incautious statement by a spokesman for the East German government that set off the train of events that caused that government to collapse?)  All of this uncertainty contributes to the risk of destabilizing responses.

On a more philosophical level, this issue creates some interesting dilemmas.  Recall the intense reaction to the Supreme Court’s decision in the Citizens United case?  Many commentators, especially on the left, were outraged at the Court’s treatment of corporations as “persons” for certain purposes.  My intuition here is that the same folks would likely be outraged if the government did not pursue criminal charges against Goldman.  Would they experience any cognitive dissonance at their denial of the personhood of corporations as a matter of principle, and their insistence that the corporation be prosecuted as a criminal–criminality a behavior undertaken by individual persons?

Of course, you might ask whether I would feel any cognitive dissonance about not prosecuting Goldman.  To which I reply: legal personhood encompasses a bundle of characteristics, rights, and obligations.  Considerations of efficiency and justice suggest that is desirable to endow corporations with some of the individual pieces of this bundle, but not others.  There are trade-offs involved, and its is wise to eschew categorical, all-or-nothing choices, and instead make a pragmatic judgment about the legal rights and protections of corporations.  Yes, corporations are like persons in some respect, but not necessarily in all respects.  The problem is that lawyers tend to think in categories, not trade-offs, and this leads to difficulties.

Insofar as the specifics are concerned, the key issue is the incentive effects that charging the firm criminally would have.  The prospect of the large losses that could result from criminal charges would certainly provide a greater incentive for upper management to monitor and discipline the actions of their subordinates; that’s the whole idea behind vicarious liability.  But this effect could also be achieved by prosecuting the individual managers responsible for oversight of underlings that engage in criminal acts.

Moreover, the prospect of a non-linear response to the charges (let alone a conviction)  means that the cost of the criminal sanction is likely hugely disproportionate to the harm, and hence have an excessive deterrent effect.

Furthermore, many innocent individuals would be harmed by a crippling or destruction of Goldman–its innocent employees in the first instance, but myriad other individuals as well.

Finally, given that (a) these crimes, if they occurred, are economic in nature, (b) the cost of the harm can be approximated with some accuracy, and (c) Goldman is sufficiently wealthy as not to be judgment proof from the economic harm that resulted from its actions or lack of action, a strong case can be made that civil action, including third party actions by those injured, is more efficient than criminal prosecution.

Back in 2008 I wrote a few posts on the Porsche corner of VW stock.  The FT has posted the amended complaint in the securities fraud and manipulation lawsuit filed by VW shortsellers.  It makes for very interesting reading.

It is clear that if the basic facts in the complaint are correct, that this was a garden variety corner.  A very intense one, due to the nature of stock markets.  Whereas in commodities additional deliverable supplies are usually available at some price above the competitive level, the strictly finite supply of stock in a company makes the relevant supply curve effectively vertical, which means that the only thing that limits how how the price of the cornered instrument can go is the cost that shorts incur from defaulting on their obligations.  As I mentioned in one of the earlier posts, this event was like the great stock corners of the old days, most notably the 1901 Northern Pacific corner.  In this case the price shot up nearly five-fold, something that would be extremely unlikely in a commodity corner.

Porsche’s strategy was pretty straightforward.  It owned 50 percent of VW stock.  20 percent was in the hands of the German state of Lower Saxony, which was unlikely to sell.  Index funds (who could not sell their shares because of their need to match indices in which VW was a component) owned more than 5 percent.

Porsche stated publicly that it had no intent of gaining a controlling 75 percent stake in the company, but bought calls and sold puts on shares representing 25 percent of the company.  This long call-short put strategy created a synthetic forward contract on VW stock.  It did so knowing that if its long position equaled 75 percent, given index funds’ and Lower Saxony’s positions of greater than 25 percent, any short seller would not be able to obtain stock to make delivery, and would be cornered.

The sellers of the synthetic forward hedged their exposure by buying shares; they bought shares from short sellers who believed that the stock was overpriced, based in part on comparisons to the prices of other, related stocks.

Porsche concealed its efforts by engaging in the options transactions with a variety of different counterparties, making it difficult for anyone to understand what the company’s total position was.

According to the complaint, a decline in the price of VW stock caused by the financial crisis caused problems for Porsche; its puts moved into the money, imposing a substantial financial burden on the company.  So it decided to spring its trap, and the price of VW stock skyrocketed from about 200 Euros/share to nearly 1000.  For a brief time, VW had the world’s largest market cap.

All in all, a very straightforward and compelling story.

The complaint makes a big deal out of the fact that Porsche’s VW options were not, as some contemporary press reports claimed, cash-settled.  Instead, they required the call option seller to deliver shares upon exercise.

This isn’t that critical.  VW could have manipulated even if the options were cash settled.  Just the means of manipulation would have differed.

With delivery settled options, Porsche could effectively determine the price of VW stock by choosing the number of options to exercise, and hence the number of shares of stock to buy (X shares, say); this would have determined the number of shares that the shorts would have had to come up with at the time of exercise.   This, in turn, would have determined the demand for the stock and hence its price.  Porsche could have profited by selling the remaining options at a value reflecting the inflated stock price.

But if the options were cash settled, VW could have achieved the same result by buying stock in competition with the shorts scrambling to cover.  If they bought X shares on the open market (i.e., the same number of shares acquired by exercise of the physically settled options), shorts would have faced the same supply curve for shares, and would have driven up price to the same level.  Porsche would have profited by the cash settlement of its options at the same price.  Thus, VW could have achieved the same outcome regardless of whether the options were cash settled or not.  (One caveat: perhaps regulations constrained open market purchases differently than the exercise of options.)

Regardless, this is about as classic an example of a corner as you will see in this day and age.  Which makes it all the more amazing that German financial regulator BaFin did a great Sergeant Schultz impersonation, and saw nuthink!  nuthink!, both during and (even more amazingly) afterward.  Another stellar moment in the regulation of market manipulation–and a clear demonstration of why private action by the victims of a manipulation is the most effective deterrent against this form of opportunistic behavior.

Russia’s economic anschluss in Ukraine is well underway.  First, Putin announced a proposal to merge the nuclear generating assets of the two countries.  Second, yesterday he proposed something even bolder: the merger of Gazprom and Ukrainian gas monopoly Naftogaz Ukrainy.

Gazprom’s Alexi Miller stated the proposal met with an “enthusiastic” response from Ukrainian government officials.  However, Ukrainian President Yakunovich’s spokesman denied that the deal had been discussed.

This would obviously be a major coup for Russia on the political and economic levels.  It would transform Ukraine into a Russian satrapy.  It would reduce the potential for holdups and conflicts like those that culminated in gas shutoffs to Europe in 2006 and 2009.  It would also reduce the need for South Stream in particular, thereby relieving Gazprom of the financial burden of paying for a system that makes sense only as a way of circumventing Ukraine and undermining Ukrainian bargaining power.

One wonders how the Europeans, distracted by Greece and the Greeces to come, will react to this.  One possible reaction is to conclude that this would be a good thing.  It would relieve them of any care about quarrels between far away people of whom they know little.  It would reduce the transactions costs and associated prospect for gas cutoffs inherent in a situation where ownership of highly complementary assets is divided.

But the Europeans should realize that Russian success in Ukraine will not sate its ambitions.  It will only move the scene of tension and potential conflict that much further west.  Insofar as gas is concerned, deal or no, the Europeans should get their act together and encourage development of alternative supplies, whether via new pipelines (a stretch), LNG, or domestic exploitation of shale gas.  (As an aside, isn’t the Russian concern for the impact of shale gas production on the European environment touching?  If only it were matched by a similar concern for Russia’s own environment.)

And yeah, I know saying “Europeans” and “getting their act together” in the same sentence is something of a joke.

In the early days of the blog I wrote a lot about how Putin is a man in a hurry.  In the present instance, he is clearly in a hurry on Ukraine.  It’s not hard to understand why.  He probably recognizes that there is only a short window of opportunity to achieve his ambitions.  Yanukovich’s power is at its apex, and the opposition is demoralized and divided.  But the near riot that accompanied the approval of the Kharkov agreement over the Sevastapol base is a reminder that a large swathe of the Ukrainian public opposes ceding its autonomy to Russia.  Putin no doubt reasonably concludes that it is necessary to move now while the opposition is still disorganized and inchoate.

But this move is so provocative that it could catalyze the revitalization of a more-or-less unified opposition.  If Yakunovich goes along with it, it could revivify Putin’s bogeyman–the Orangist opposition movement.  It clearly puts Yanukovich in a delicate spot, and gives Tymoshenko a powerful issue and a new lease on political life.  A merger would also have a profound effect on the shadowy interests that make obscene money in the dirty gas trade in Ukraine.  Given the influence of these forces (and their money) on Ukrainian politics, they could play a decisive role in the ultimate resolution.

One thing is certain.  The process will not be open, transparent, or clean.  A murky mix of power politics, nationalism, Ukrainian political dysfunction, and money will determine what happens next, and after that.  In these circumstances, it would be foolhardy to predict an outcome.  I do sense (and perhaps it is only wishful thinking) that there is an appreciable probability that this could blow up in Putin’s face as occurred during one of his previous attempts to meddle in Ukrainian politics–the 2004 presidential election.