Streetwise Professor

August 31, 2010

There Are NO Panaceas

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 10:18 am

I saw the headline of this Matt Leising article, “Lehman Derivatives Records a Mess,” and reflexively thought it would be about its OTC trades (of which there were, if memory serves, over 900,000 if memory serves).

I was wrong.  It was about its exchange traded–and cleared–positions:

Barclays PLC had no idea how big Lehman Brothers Holdings Inc.’s futures-and-options trading business was when it considered taking over the defunct bank’s derivatives trades at exchanges in 2008, a Barclays executive said.

“Lehman’s books were in such a mess that I don’t think they knew where they were,” Elizabeth James, a director of Barclays’s futures business, testified today in U.S. Bankruptcy Court in Manhattan. James worked on Barclays’s purchase of Lehman’s brokerage during the 2008 financial crisis.

She said she received an e-mail from former Barclays trading executive Stephen King saying Lehman had “absolutely no idea” if it had sold $2 billion more options than it had bought, or whether it owned $4 billion more than it had sold.

. . . .

Transferring margin together with trading positions “is normal practice in the ETD business,” she told U.S. Bankruptcy Judge James Peck, referring to Lehman’s exchange-traded derivatives. “You’d be crazy if you didn’t.”

She said Lehman’s lack of records initially prevented her from performing “due diligence” to discover what Lehman’s and its customers’ positions were, where Lehman kept its bank accounts, and who its brokers were.

James said she had seen a tabulation of Lehman’s positions at the Options Clearing Corp. showing that the daily margin requirements for its trades had varied by as much as $1 billion within a few days in September 2008.

Moral of the story: moving more trading to exchanges, exchange-like systems, and clearing will not necessarily lead to greater clarity about the positions that big entities like Lehman hold.  One of the arguments for clearing has been that it will improve regulatory transparency, and help regulators figure out where the risk is and who is exposed to whom.  Even overlooking the basic fact that it is possible to have centralized trade reporting without mutualizing credit risk through clearing, the Lehman story shows that this alleged advantage has been vastly oversold.

Big complicated firms have big, complicated, and dynamic positions that are hard to keep track of, regardless of where and how they are traded.  There is a long, long, long way to go before even approaching the ideal of “mapping” risk in the financial system.  More centralized collection of information is a necessary, but by no means sufficient, condition to achieve this goal.

The Lehman story should be a cautionary tale to all those who naively believe that waving a legislative wand and casting a spell that drives trading to exchanges will magically eliminate all of the huge operational difficulties associated with measuring and managing risk.

August 30, 2010

When the Head of the Chinese Central Bank Makes An Airport Trade

Filed under: Economics,Financial crisis,Politics — The Professor @ 8:17 pm


An airport trade is when somebody puts on a trade far bigger than he can afford.  He then heads to the airport with a one way ticket to a foreign nation, preferably one without an extradition treaty.  If the trade is a winner, the guy enjoys a blowout vacation then returns as the conquering hero.  If the trade is a loser–well, welcome to Margaritaville.

There are rumors ricocheting around the internet and news that Chinese Central Bank Chairman Zhou Xiaochuan has defected to the United States.  The original version of the rumor, according to Stratfor, related to a huge loss on Chinese investments in US securities:

The rumors appear to have started following reports on Aug. 28 which cited Ming Pao, a Hong Kong-based news agency, saying that because of an approximately $430 billion loss on U.S. Treasury bonds, the Chinese government may punish some individuals within the PBC, including Zhou.

Uhm, no.  Completely implausible.  US Treasury data show that in mid-2009, China owned about $760 billion in Treasuries, and about $450 billion in agency securities.  There is no way that it could have lost $430 billion on these positions, obviously.  Especially since Treasuries have been up recently.  Indeed, people are speaking of a Treasury bubble.

To lose huge money on Treasuries in this market you’d have to be short.  Friend and frequent commentor Charles does a quick back of the envelope calculation, and figures that somebody would have to be short about $4.5 trillion in Treasuries.  Zero Hedge calculates $3.5 trillion.  Either way, no way.  Like anybody could put on such a position with nobody knowing.

But Zhou hasn’t been seen.  Internet searches on his name have been blocked in China, as have websites carrying the rumor.  The rumors of  defection are flying fast and furious.  Chinese repo rates spiked.  There’s smoke, so what’s the fire?

One story is that this is all part of a power struggle in the leadup to a transfer of power in 2012.  Given the opaque nature of Chinese politics, this is plausible.

But here’s another, more ominous possibility.   Helicopter Zhou has overseen massive injections of liquidity into the Chinese market to fight the financial crisis.  There are widespread worries about a housing bubble, and the cracking thereof, with disastrous consequences for banks.  Similarly, there are myriad reports about massive quantities of bad loans, including huge amounts to local governments.  The recent bank “recapitalization” plan, which seems to have more in common with a three card monte game than a real recapitalization, only adds to concerns.

Put all this together, and it is plausible that Zhou has realized that the whole structure is on the verge of collapse, and that he is the natural fall guy.  So, he’s getting out while the getting is good.  The biggest airport trade, ever.

This bears watching.  If the rumors are true, and his defection/departure has anything–anything–to do with a deteriorating financial and economic situation in China, we are all in for a hell of a ride.  What exactly?  Who knows?  Commodity prices would likely crash.  But beyond that, given the opacity of the Chinese economy, financial system, and political system, it’s difficult to know how they would react and what the effects of their actions would be, either in China or the larger world.

Keep your eye on this one.

August 28, 2010

Basel Faulty

Filed under: Economics,Financial crisis,Politics — The Professor @ 9:54 pm

It is flattering to know that the always insightful (and knowledgeable) David at Deus ex Macchiato found insightful my observation that capital requirements can result in crowded trades–and hence systemic risk.  I think the idea is pretty straightforward.  It’s all about incentives.

Risk-based capital requirements are like a regime of price controls, in this instance, risk price controls.  If some risks are mispriced, and particular, priced too low, all affected institutions face the same incentives to take on those particular risks.  The more institutions that fall under the capital regime, the more institutions that will take on these underpriced risks.  That’s why I am very leery of global capital regimes, a la Basel.  If they screw up the prices–and screw them up they will, with metaphysical certainty–the effect of the perverse incentives will be global.

David suggests the need for regulators to set up capital arbitrage groups to address this problem.  The foregoing suggests that these groups should look for the stuff that everybody is doing–those are the risks that are likely to be mispriced.

The problem is that because everybody is doing it, if the regulators try to crack down, the political pushback will be intense.  For evidence of this, see this dispiriting paper about how those who went into the subprime craze succeeded in getting Congress to add fuel to the craze, rather than crack down on it.  Moral of the story: subsidies (underpricing) tend to create constituencies that favor the continuation of the subsidies.  (Cf. the American sugar program, or farm programs generally.)  As a result, I think that cap arb groups inside regulators will be about as effective as the war on drugs.

Not everybody is so impressed with my argument.  Synthetic Assets, for example:

Craig Pirrong and David at Deus ex Macchiato are worried that the minimum capital requirements set by Basel III will face the same problems as those created by earlier versions of Basel:  As banks seek to minimize their capital positions they are all pushed by the regulations into the same trades, this leads to the growth of unregulated financial sectors and crowded trades.

The question I have for proponents of this view is:  Why would a bank seek to minimize its capital position, when the purpose of capital is to protect the firm against unpredicted — or even unpredictable — losses?  There’s a reason Jamie Dimon has been feted for his “fortress balance sheet” approach to the crisis that everyone — including Chuck Prince — could see coming.

Whenever minimum capital requirements are the determinants of bank behavior, that’s a good indicator of a deep structural problem with the financial system, because it means that you have a financial system populated by banks that are more concerned with maintaining profitability in the short-run than with ensuring that the bank is a viable entity in the long-run.  In short, when banks are maintaining only minimal levels of capital, you have pretty clear evidence that repeated bailouts have resulted in the complete perversion of financial system incentives.

SA–with all due respect, you miss the point.  Neither I nor David (if I can speak for him) anywhere claim that banks set capital levels at the absolute minimum.  It is evident though, that they do economize on costly capital (their shareholders demand it), and make asset allocation decisions strategically in response to the incentives inherent in capital rules.  There is no way to explain what transpired in the lead up to the crisis without understanding the crucial role of capital requirements, most notably the extremely favorable capital treatment accorded to AAA rated CDOs, SIVs, etc.  You’d have an easier time explaining Hamlet and leaving out a certain prince from your telling.

Yes, banks held more than the minimum in capital.  But that was extremely misleading about the true risks in the system, because the capital requirements were fatally distorted.  The capital required against certain instruments (government debt being another example) was too small relative to the true risks of those instruments.  So too many banks loaded up on them. (This exacerbated the underpricing problem because the capital requirements didn’t take into account how the correlation in trading activity across entities increased the risks of their portfolios.)  JPM was the decided exception that proves the dreary rule.

This is a story about relative prices.  In a risk based capital regime, some risks are mispriced relative to others.  Banks load up on those mispriced risks.  Since all face the same distorted pricing signal, they tend to trade the same way.  They held more capital than they were required to, but that provided a false sense of security because the required levels of capital did not accurately reflect the risks.

There is, in fact, dysfunction in the financial system.  That dysfunction, in the first instance, is the result of the deadly combination of implicit and explicit guarantees that stoke moral hazard, and woefully inadequate and scarily expansive capital requirements that are intended to make it difficult for banks to exploit that moral hazard, but fail to do so.

That’s why I find it chilling that regulators around the world are touting capital requirements as the panacea that will prevent the next crisis, when in fact universal or near-universal requirements are more likely to be the cause of the next crisis.  It is inevitable that any requirements will misprice some risks.  Banks, motivated in part by the explicit or implicit safety net that means that they do not internalize risks, will methodically seek out those underpriced risks.  With identical, or even highly similar, capital requirements across jurisdictions, their portfolios will be overweighted towards those underpriced risks.  Everything will look just fine because the banks will say–“look, we have so much more capital than the minimum, so no need to worry.”  But the minimum is way too small.  And when those overweighted investments get hit by an adverse shock, it is a correlated shock, meaning that there is a substantial risk that the death spiral will begin, as everybody tries to get out of crowded trades.

And that’s why I think Basel–I, II, III. . . or IV, or XXIV–has been faulty, and will be faulty.  The fault is inherent in any global system to set risk prices.  The knowledge problem will kill you, every damn time.

Under Pressure

Filed under: Climate Change,Politics — The Professor @ 8:58 pm

This is, in a way, a woulda, coulda, shoulda post.  Back in July I was going to write about the Russian heatwave by referring to a book on climatology that (a) seemed to provide a cogent explanation of the process by which a brutal heat wave could be created, and (b) strenuously argued that this process had nothing to do with anthropogenic global warming.  But other stuff happened, the post didn’t get written–and now the National Oceanic and Atmospheric Administration (NOAA) has released a report validating this explanation of the heat wave.  Thus, I could have said I told you so.  But I didn’t.  So you can take me at my word that I indeed could have said so, or not, depending on your predisposition.

Anyways, during the height of the Russian heat wave, I immediately thought of the book “Global Warming: Myth or Reality?  The Erring Ways of Climatology” by the late Marcel Leroux, a well-known (and iconoclastic) French climatologist.  (I read the book in the fall of 2006.  I’ve mentioned it on the blog before.)  Leroux emphasized the decisive influence of “mobile polar highs”–high pressure cells originating at the poles, then moving towards the equator–in determining weather and climate.  With respect to heat waves in particular, Leroux argued that “anticyclonic agglutinations”–combinations of a sequence of MPHs–were to blame.  When an unusually strong series of MPHs combine, and then stall over a particular region, during periods of high insolation (i.e., the summer) that area will experience a heat wave.  Describing the infamous French heat wave of 2003, Leroux wrote:

In 2003, from June onwards, the meteorological situation was dominated . . . by th epresence of a vast area of high pressure. . . . The great stability brought about by the anticyclonic conditions–calm air, or very slight breezes, and the absence of upward air movements–encouraged the warming of air in the lower layers.  The conduction of heat, and infrared absorption, are in fact enhanced when pressures are high and the air cannot rise; the layers nearest to the ground become (for the same amount of solar energy received) relatively very much warmer.  The heating leads to a considerable diminution of relative humidity (i.e., the air becomes much drier).  . . . Now that the moisture content is absent, maximum insolation occurs, and the cumulative heating effect gradually assumes the proportions of a ‘heatwave’, especially in urban areas, which are less ‘ventilated’, and become warmer, drier, and more polluted (pp. 278-279).

When re-reading Leroux in July, that sounded to me exactly like what happened in central Russia, down to the last jot.

Recently NOAA, hardly a hotbed of climate change skepticism, has stated that the Russian heatwave fits the Leroux template exactly:

The extreme surface warmth over western Russia during July and early August is mostly a product of the strong and persistent blocking high. Surface temperatures have soared as a result of the combination of clear skies, sinking motion within the environment of the high pressure causing compressional heating of air, the lack of any temporary relief owing to the blocking of the typical cold fronts that cool the region intermittently in summer. Add to this scenario the cumulative effect of drought that began in early summer which has caused soils to dry and plants to desiccate to wilting point , thereby causing additional surface warming via land feedbacks as the blocking condition persisted. These are all well-known and studied physical processes that have accompanied summertime blocking and heat waves in the past.

Much of the intensity of the current heat wave, and also the pattern of surface temperature conditions across Eurasia during July 2010, can be recreated from the atmospheric blocking event itself. The diagnostic procedure involves standard methods applied to the historical record of analyzed 500 mb heights and surface temperatures during the prior period of 1900-2008. The method of statistical regression is used to understand how surface temperature changes during a typical blocking occurrence over Russia during July, and is a method that can be used to infer causal relationships.

The temperature pattern accompanying a “garden variety” block consists of a localized +1 to +2°C warming over western Russia, with somewhat weaker coolness toward the Urals. July 2010 was not a garden variety block, but was instead the most extreme block in the post-1900 period. While there is no analogue from which to draw an assessment of the expected impact on temperatures form such a block, one can nonetheless use the historical regression relation in order to infer the impact of this extreme July 2010 block. The process involves multiplying the regression pattern by the standardized departure of the height index observed for July 2010. The calculation offers a meaningful evaluation of the surface temperature response to the extent that the height-temperature relation is linear. The results indicate a surface warming in excess of +5°C is expected over western Russia in response to the July 2010 blocking high, accompanied by a downstream pattern of about -3°C coolness over the Urals and warmth of +2°C to +3*C over northern China, Mongolia, and northeastern Russia.

The comparison of the above reqression map with the observed temperature anomaly map for July 2010 clarifies the cause for this heat wave. The strong agreement between the July 2010 observed pattern of Eurasian surface temperatures and that pattern attributable to the impact of upper tropospheric blocking provides key evidence that the block is the immediate cause for the heat wave (and related temperature conditions over adjacent countries). Blocking events are typically of 1-2 week duration, and by contrast the 2010 situation is highly unusual in that blocking has existed over western Russia on virtually every day form the beginning of July until the middle of August. The cumulative impact of such prolonged blocking has led to the extreme nature of the surface impacts on temperature, soil conditions, and rainfall.

The near universal response to the Russian heat wave has been–I’m sure you’re surprised–to attribute it to global warming, or climate change, or whatever the nom de jour might be.  This continues even after NOAA weighed in, with drivel like this in the FT.

To attribute this to a secular global temperature rise, it would be necessary to show how such a rise would affect the likelihood and severity of such “blocking events” (anticyclonic agglutinations in Leroux’s terms).  Leroux said it could not be done, generally, and indeed was nonsensical: if a rise in temperatures (forced by GHGs) was the underlying mechanism, pressures should drop (p. 279) because, duh, hot air rises–unless the rise is blocked by a high pressure wave resulting from some other process.  (Other climate skeptics, notably Richard Lindzen, postulate that the rising hot air results in a negative feedback mechanism that substantially reduces the temperature increase resulting from a given increase in GHGs.)

Moreover, NOAA refuses to attribute the blocking events to a secular climate change process:

Despite this strong evidence for a warming planet, greenhouse gas forcing fails to explain the 2010 heat wave over western Russia. The natural process of atmospheric blocking, and the climate impacts induced by such blocking, are the principal cause for this heat wave. It is not known whether, or to what exent, greenhouse gas emissions may affect the frequency or intensity of blocking during summer. It is important to note that observations reveal no trend in a daily frequency of July blocking over the period since 1948, nor is there an appreciable trend in the absolute values of upper tropospheric summertime heights over western Russia for the period since 1900.

The indications are that the current blocking event is intrinsic to the natural variability of summer climate in this region, a region which has a climatological vulnerability to blocking and associated heat waves (e.g., 1960, 1972, 1988). A high index value for blocking days is not a necessary condition for high July surface temperature over western Russia—the warm summers of 1981, 1999, 2001, and 2002 did not experience an unusual number of blocking days.

It should also be noted that the warming was extremely localized, that the Southern Hemisphere actually experienced substantial cooling, and the pattern observed in 2010 was less “global” than the pattern during the comparable event in Russia during the summer of 1936.

The contrasting patterns in parts of the Northern and Southern Hemispheres suggests to me that one of the various periodicities in climate may be at work, but that’s just a wild guess on my part.

The temptation to use weather events to flog pet theories about climate is dishonest an annoying in the extreme–regardless of who does it, be they skeptics jumping up and down about a cold winter or alarmists howling about a hot summer.  The Jeremiah-esque ideologue and proselytizer James Hanson got the global warming hysteria ball rolling by saying that the US heatwave and drought of 1988 was a harbinger of doom–when it was most likely something quite similar to what happened in Russia this summer.  Their cause flagging politically, the alarmists are trying to do the same with the Russian heat wave.  It is not honest to do so–and it is not science.

It is possible that there are complex interactions and mechanisms by which temperature trends forced by GHGs can lead to increased frequencies and intensities of heatwaves and droughts.  But none have been described or tested.  The initial empirical evidence, per NOAA, that there appears to be no trend in the frequency of blocking events is inconsistent with this.  Moreover, as Leroux notes, atmospheric pressure and the frequency of MPHs both began to trend up well before GHGs did.  So what caused that pressure trend?  GHGs couldn’t have.

Thus, the Russian heatwave should be a reason to acknowledge that we do not fully understand–or even remotely understand–the drivers of temperature extremes in particular, or climate generally.  It should be a spur to inquiry and research, not an opportunity to advance predetermined agendas.

NOAA is to be commended for taking an objective approach to the subject.  Sadly, too few others–including far too many scientists–have not.  Rather than a centerpiece of a morality play about global warming, events like the Russian heat wave should be viewed as things that are anomalies (or at least, lacunae) in the received climate models.  Such anomalies/lacunae should lead to questioning the received models, and the posing and testing of others.  That’s how science should work.  Whether today’s politicized climate science will work that way is, sad to say, highly doubtful.

August 27, 2010

Mosque-ow on the Hudson

Filed under: Politics — The Professor @ 10:01 pm

At first blush, the full throated defense of Islam generally, and the Ground Zero Mosque specifically, by the progressive left is passing strange.  Given that the battle over the GZ Mosque is centered in New York, the leftist precincts of that city, notably the Upper West Side, hard by the Hudson, are particularly strident in their attacks on the mosque’s critics.

The progressive argument is couched in terms of religious tolerance, opposition to religious bigotry, and the importance of property rights.  But the progressive left has long been extremely antagonistic to the believers of other religions, especially evangelical Christians, traditional Catholics and Jews, and Mormons.  The antagonism often clearly degenerates into outright bigotry, which seldom brings a peep of protest from other progressives.  Ridicule, mockery, and insult are routine.

And progressives are stalwart defenders of property rights?  Who knew?

Moreover, many of the beliefs and behaviors shared by large numbers of Muslims, especially about women and homosexuality, are antithetical to strong progressive views.  Indeed, many progressive attacks against the adherents of non-Muslim denominations emphasize their benighted views on women and gays, even though those views are benign compared to those common in the Muslim world.

In this regard, it is particularly illuminating to note that the Reagan administration made common cause with Saudi Arabia and other reactionary Muslim states to oppose United Nations initiatives on reproductive matters (read: abortion) and women’s and gay rights that were the pet causes of the transnational progressive left.  Progressives were scathing in their criticism of Reagan for this alliance.

So any intellectually consistent and honest progressive would have to admit that the strange new respect for Islam is contradictory, and indeed, hypocritical.

What explains it then?  I think the answer is straightforward.  The progressive left is defined in the United States by its opposition to the beliefs of the majority of other Americans.  The progressive left detests the idea of American exceptionalism.  Most Americans are American exceptionalists.  Funny thing, that.  The progressive left believes that the United States is a deformed and malign nation, an oppressor.  (Don’t believe they believe that?  Read Howard Zin sometime, or the encomiums to him.  Or the recent cringe-making State Department report to the UN Human Rights Counsel.)  Most Americans admit to the nation’s flaws, but believe that it is truly the last, best hope of mankind, whose contributions to human freedom and dignity–and yes, progress–far outstrip its failings.  Most progressives identify themselves as elite who are intellectually and morally superior to the great unwashed, especially those living away from the coasts.

So, if the vast majority of those whom the progressive left loathes are offended by the thought of a mosque headed by an imam of troublingly ambiguous views being located so close to Ground Zero, as surely as night follows day, the progressives will rise in defense of the mosque and the imam.  All the more because said imam has expressed critiques of American policy and actions that sound eerily like those that are staples of the left’s bill of indictment against the US.  And American exceptionalism is an anathema to Islam as well.  The endless Muslim complaints–whines, really–about the transgressions of the West generally, and the US in particular, resonate loudly with progressives.  In this regard, progressives and Muslims–even the most reactionary of them–have a meeting of the minds.

In brief, the left’s alliance with Islam on the matter of the GZM and other matters, is purely an opportunistic one, and completely unprincipled.*  They share a common opponent.  A common enemy.  And it is us.  On virtually every other issue, they have nothing in common, and indeed hold completely contrary views.  But progressives have no problem putting those differences aside in order to use the mosque issue as another front in their continuing war against a mainstream American that remains stubbornly wedded to the belief that America is a pretty good country, damn it.

And I say go for it!  The left is wallowing in its self-righteousness, self-anointed moral superiority, and disdain for vast swathes of the American public: if you doubt that, just take a gander at Bloomberg’s speech (but only if you have a very strong stomach).  Hardly the recipe for political success in a country where such views are held by a decided minority.  What’s more, this particular issue stirs such intense passions among so many people.  Indeed, there are few other issues on which progressive lectures are likely to engender such an intense backlash.

So go right ahead.  Keep poking the big dog with a stick.  You all and Imam Rauf can have one big pity party when the big dog wakes up and does what big dogs do, when poked with a stick.

* And don’t even get me started on the sudden solicitude on the left for General Petraeus and the troops in Afghanistan and Iraq.   As if the Taliban and Al Qaeda et al don’t have more than enough things that they hate about us that one more will make a difference.  After all, depriving them of “reasons to fight us” would require adoption of shariah and submission to the caliphate.  Is that what Bloomberg and Frank Rich and others that have raised this argument are proposing?; it is certainly the logical implication of their argument.  What a strategy!   Win a war by acceding to the enemy’s demands.  And where were these people when many of their political allies (and funders) were calling Patraeus “General Betray-us”?

August 25, 2010

Thick as a BRIC

Filed under: Economics,Energy,Financial crisis,Politics,Russia — The Professor @ 8:39 pm

FT Alphaville summarizes the Troika Dialog argument touting Russia as the BRIC to bet on.  According to TD:

Russia has more raw materials, a more educated and middle-class population, a strong macroeconomic framework, a better track record, more resilience to global warming, and is cheaper. Moreover, it has unique commodity assets and a clear and successful European path to follow.

Color me extremely unimpressed.  If this is the best case, Russia’s future is bleaker than I thought.

1. Raw materials are a curse to growth and long term economic prospects, not a benefit.  That has been particularly true in Russia’s case, but it is difficult to find raw material intensive economies that have been stalwart growth performers.  It’s a lot easier to find such economies that are basket cases.

2. Yes, Russia has a more educated populace than other BRICs.  But that is already reflected in the higher per capita income of Russia compared the other BRICs (another attribute that TD touts).  Moreover, as is true of much of Russian capital, the educational prowess–the human capital–of the Russian population is pretty much a Soviet legacy that is depreciating rapidly.  The current Russian educational system is pretty much a disaster, and a shadow of the Soviet system.  Corruption is rife: today, Russian educators put the cheat in ???????.  The future of Russian education is hardly encouraging.

3. TD vastly understates Russia’s crippling economic defects:

Apart from oil price dependency, which is an aspect of macroeconomic fragility, Russia’s weaknesses are poor corporate governance, which restricts the returns to minority shareholders, and regulation, which restricts ROE levels (e.g. utilities). We reject the fashionable view that other issues like weak population growth, poor infrastructure, or poor government are necessarily damaging to ROE levels.

Poor corporate governance is the understatement of the century.  FTAlphaville has a more complete list:

It ranks worst for corruption, corporate governance, and most institutions in international rankings. In financial services – such as investor protection, ethical behaviour of companies, strength of auditing, and market sophistication – again it fall short of the other Brics, according to the World Economic Forum. And it ranks second worst on the business cost of terrorism (behind India), and both violent crime and organised crime (to Brazil).

But even that list is seriously incomplete.  A more complete list would include: the absence of reliable property rights, the lack of contract enforceability, the corruption of the legal system and the absence of the rule of law, the constant threat of expropriation, the arbitrariness of government.  I could go on.

In brief, the TD analysts are being pretty thick.

Timothy Garten Ash had a more reasonable assessment a couple of months back, but it still focuses on traditional macro and structural issues and underemphasizes Russia’s fundamental problem: its institutional deficit.

These are all issues that primarily speak to Russia’s long term prospects.  Its second quarter growth numbers came out, and they show things aren’t doing all that well in the short run either.  Russian GDP grew 2.5 percent year-on-year from July, 2009 to July, 2010.  The economy actually declined month-on-month.  Although the fires certainly contributed to this decline, it is not a a favorable sign.

This is anemic even by comparison to the US.  From trough (2Q 2009) to the present (hopefully not the peak, though it might be a local one given the real prospects for a double dip), the United States grew 3.1 percent.  This was after a 4.2 percent decline from the peak in 4Q 2007 to the bottom in 2Q 2009.

In comparison, the Russian economy declined 7.9 percent in 2009, about twice the US decline.  Twice the decline and a smaller rebound is hardly stellar performance, especially since the standard of comparison–the US–has not been a stellar performer itself.

Things are even worse if evaluated on an output gap basis.  Given that Russia was growing at 5+ percent into mid-2008, the output gap is now about 15.5 percent.  Since the US was growing at about 2.5 percent, the gap her is around 5.5 percent.

The sluggish growth in Russian GDP is particularly underwhelming given that oil prices have more than doubled off their crisis lows.  This should have given Russia a favorable jolt, while serving as drag on the US.

The Finance Ministry is sticking by its forecast of 4 percent growth in 2010.  Highly unlikely, especially given the effects of the drought; the fires; and the serious prospect for a global slowdown in the last third of the year.

Short run or long run: neither looks too hot.

August 24, 2010

Sorry Don’t Feed the Bulldog

Filed under: Economics,Financial crisis,Politics — The Professor @ 8:35 pm

Barney Frank has admitted it.  He was wrong about Fannie and Freddie:

“I hope by next year we’ll have abolished Fannie and Freddie,” he said. Remarkable. And he went on to say that “it was a great mistake to push lower-income people into housing they couldn’t afford and couldn’t really handle once they had it.” He then added, “I had been too sanguine about Fannie and Freddie.”

When I asked Frank about a long-term phase-out plan that would shrink Fannie and Freddie portfolios and mortgage-purchase limits, and merge the agencies into the Federal Housing Administration (FHA) for a separate low-income program that would get government out of middle-income housing subsidies, he replied: “Larry, that, I think, is exactly what we should be doing.”

Well, I guess several hundred billion dollars of losses is enough to convince even Barney.  (No similar mea culpa from Chris Dodd.  Putz.)

That’s fine as far as it goes, but one would have hoped that this recognition that his judgment in matters financial was fundamentally flawed would have led Frank to  show a little more humility in his recent legislative doings.  But one would have hoped in vain, for Frank and his partner in slime Dodd were the creators of the monster that is Frank-n-Dodd.  So what I wrote in September, 2008 holds:

And that’s where the real moral hazard lies. At root, moral hazard exists when a decision maker is not accountable for his actions, when he is able to reap the benefits but somebody else pays the costs. Due to the arcane nature of the GSEs, the ability of Congress to deflect attention, the advantages of incumbency, and myriad other factors, Barney Frank and Chris Dodd and the others in Congress who have protected Fannie and Freddie at every turn will never, ever, pay a political cost for their actions. They have reaped the political benefits, in the form of campaign contributions and the channeling of Fannie and Freddie funds to their pet political causes in housing, but you and me and every other taxpayer will have to pay to clean up the mess. Few people who matter–the constituents of Frank and Dodd et al–will understand the connection between their actions and the F & F blowup, and what’s more, the costs are spread broadly among all taxpayers, the vast majority of whom would be unable to exact a punishment on the perps even if they had the information and incentive to do so.

So Frank paid no price for the havoc he created.  “Whoops. Sorry!”  Doesn’t quite cut it now, and in light of what he now realizes, it is doubly reckless to be a primary architect of a wholesale reengineering of the financial markets.  So this holds true too:

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?

If Frank really means what he says about abolishing F&F, why didn’t he even make a start along that path in his most recent legislative “achievement”?

And the recent summit on housing finance policy makes it plain that the government is almost certain to continue to wreak havoc in the housing market, even if it doesn’t do it through F&F.  And the scope of the intervention looks ready to balloon:

The Federal Housing Administration (FHA) will offer financial institutions holding mortgages worth more than the value of the houses, so-called “underwater” mortgages, a guarantee on 90 percent of the mortgage value if the institution will write-off 10 percent of the mortgage. These risky mortgages have been bought up by Wall Street investment banks at may be 30, 40 or 50 cents on the dollar. The government now says that if the holder takes 10 percent off the mortgage, the government will guarantee 90 percent of the mortgage. So they may have bought a $400,000 mortgage for $200,000. If the mortgage holder agrees to write-off $40,000, the government will guarantee the mortgage for $360,000.

I presume that this is intended to be a political initiative intended to buy popular support prior to November’s elections.  If so, I think it is a grave political miscalculation, as well as an economic one.

Remember that the whole Tea Party movement grew out of a rant by Rick Santelli.  And what was Santelli ranting about?  He was ranting about “how many people want to pay for your neighbor’s mortgage?”  What does this FHA initiative do?  Have the government guarantee your neighbor’s mortgage, meaning that if s/he doesn’t pay–you will.  And given that many mortgages are far more than 10 percent underwater, pay you will.

Santelli Rant

There is already bailout fatigue in the country, and this will make it all the worse.  Especially given the fact that a disproportionate share of the dough will flow to people in a few counties in a few states.  If this happens, it will only stoke the anger.

When it comes to housing, the government just can’t leave well enough alone.  Barney Frank has that figured out.  Sort of.  Will he commit himself with ever fiber of his being to help others have a similar come to Jesus moment?  Given the havoc he caused, he owes nothing less.  Because sorry just ain’t enough.


Filed under: Commodities,Derivatives,Economics — The Professor @ 7:58 pm

Back in the Dark Ages, I wrote my PhD thesis on the ocean shipping industry.  Specifically, I applied core theory to explain the diversity of organization across different sectors of the shipping business, with collusion in the liner (container) business, and competition in the bulk sector.  Not long after going into academia, I realized that the core theory thing was a dead end professionally, so I remade myself into a derivatives scholar.

Well, reading the Economist this week, I had a peanut butter-chocolate Reese’s moment: the magazine ran an article about derivatives on container shipping rates:

Clarksons, the world’s biggest shipbroker, which pioneered derivatives for dry-bulk cargoes like iron ore and coal in the early 1990s, made its first container-derivative trade in January this year. Since then two other London-based brokers, ICAP and Freight Investor Services, have also started to offer derivatives settled against the Shanghai Containerised freight index, which is based on per-box rates on the world’s busiest container routes. Alex Gray of Clarksons admits that the market is tiny at the moment. But he reckons that container derivatives may be worth 5-10% of the physical market by the end of 2011.

One interesting sidelight in the article:

Half the container fleet runs like a bus network with regular sailings at set times. With these ships, prices are set under long-term contracts. But the spot market, where vessels are chartered for specific trips or time periods, is very unpredictable, particularly since regulators put a stop two years ago to an arrangement between shipping lines (the top 15 of which control 80% of the market) to manage overcapacity by co-operating on routes and rates.

If this is an accurate description of the business, it’s changed a lot since I studied it in any detail.  The most interesting feature is the statement about regulators.  My thesis argued that the cost and demand structures in liner shipping (cost indivisibilities and highly divisible demand) made competition unstable, and that collusion (shipping conferences–“an arrangement between shipping lines . . . to manage overcapacity by co-operating on routes and rates”) was an efficient response.  If collusion is no longer permitted, then some alternative, e.g., more long term contracting, should develop.  (I also showed that long term contracts can mitigate the inefficiencies that exist with spot contracting.)

Anyways, it’s interesting to see the convergence of the two seemingly divergent issues that have defined my professional career.  Maybe it’s time to take another look at the shipping business.  (Don’t worry: I’ll still have time for you, Gary and Bart.)

By Their Friends You Will Know Them

Filed under: Military,Politics — The Professor @ 1:39 pm

Two stories in the news illustrate the close nexus between the Russian government and criminality.  The  first story is that of Viktor Bout.  An infamous arms dealer, Bout is in custody in Thailand, awaiting extradition to the US.  Russia–at the highest levels of its government, including the Foreign Minister Sergei “The Trantula” Lavrov–has rallied to Bout’s defense:

“We regret this … unlawful, political decision,” Foreign Minister Sergei Lavrov said during a visit to Armenia. [Though I would defer to Lavrov’s expertise in the area of “unlawful, political decisions.”]

In wording that suggested Russia suspects the United States exerted undue influence to secure the ruling, Lavrov said Moscow had information it was made “under very strong external pressure.”

“I assure you we will continue to do everything necessary to secure his return to his homeland,” Lavrov said of Bout.

There is widespread discussion about the reasons for Russia’s incensed reaction to Bout’s impending extradition.  The most straightforward hypothesis is that the government, those in the government, or those closely related to the government, are implicated in Bout’s dealings.

The second story, from the New York Times, describes how hackers operate with impunity from inside Russia:

rrests in Russia for computer crimes are rare, even when hackers living in Russia have been publicly identified by outside groups, like Spamhaus, a nonprofit group in Geneva and in London that tracks sources of spam.The F.B.I. in 2002 resorted to luring a Russian suspect, Vasily Gorshkov, to the United States with a fake offer of a job interview (with a fictitious Internet company called Invita), rather than ask the Russian police for help. To obtain evidence in the case, F.B.I. computer experts had hacked into Mr. Gorshkov’s computer in Russia. When this was revealed, Russian authorities expressed anger that the F.B.I. had resorted to a cross-border tactic.

Online fraud is not a high priority for the Russian police, Mr. Zakharov said, because most of it is aimed at computer users in Europe or the United States. “This is a main reason why spammers are not arrested,” he said.

Politics may also play a role. Vladimir Sokolov, deputy director of the Institute of Information Security, a Russian research organization, said the United States and Russia were still at odds on basic issues of computer security, although the differences were narrowing.

The United States tends to view computer security as a law enforcement matter. Russia has pushed for an international treaty that would regulate the use of online weapons by military or espionage agencies. Last year the United States opened talks on a treaty, but it has continued to press for closer law enforcement cooperation, Mr. Sokolov said.

Computer security researchers have raised a more sinister prospect: that criminal spamming gangs have been co-opted by the intelligence agencies in Russia, which provide cover for their activities in exchange for the criminals’ expertise or for allowing their networks of virus-infected computers to be used for political purposes — to crash dissident Web sites, perhaps.

Again, the simplest explanation is that the “law enforcement” organs and/or the government benefit from the operations of these hackers.  The benefits may be pecuniary, or arise from the utility of having hackers available to perform dirty operations aimed at foreign “enemies” that include both governments and individuals.

It is pretty amazing to see a government lionizing somebody like Bout, or protecting criminal hackers.  It says quite a bit, and what it says isn’t flattering.

The Mafia Economy

Filed under: Commodities,Economics,Politics,Russia — The Professor @ 12:59 pm

In recent months, the owners of large pieces of Norilsk Nickel, Oleg Deripaska and Vladimir Potanin have gone to the mattresses for control of the company.  In response, Don Putin has felt compelled to fly to Norilsk in what is seen as part of a move to resolve the dispute. (And given what an ecological hellhole Norilsk is, you can be sure he isn’t going for the sights or the fresh air and waters.)

Although control contests are not unknown in the US or Europe, it is unheard of to see the head of government involved in resolving them.  That’s the role of the markets and the courts.

And it is the very absence of active markets and reliable courts that mean that Putin is needed to arbitrate and resolve these kinds of disputes.   Putin effectively recognizes this:

Commenting in 2008 on a shareholder conflict in the Russian subsidiary of the British oil major BP (BP.L) TNK-BP, where BP and a trio of Russian-born billionaires held 50 percent stakes, Putin said equal ownership did not work.

“I told them: ‘Don’t do it. Agree to one of you having a controlling stake,'” Putin said at the time.

In the absence of a controlling shareholder, in Russia business disputes resemble scenes from the Godfather or the Sopranos more than the kinds of business conflict you see here in the states.  And the institutional response in Russia is exactly analogous to the one that mafioso have evolved in Sicily and the US: to appoint a capo di tutti capi to knock heads when the capi fight over turf.  His job is essentially to ensure that rents and power are distributed in a way that mitigates the potential for conflict, and to crush those who threaten to destabilize the system.

This is part of the reason why Russia is doomed to economic stasis, at best.  This kind of system cannot readily deal with change that upsets the balance of rents and factions.  So dynamic forces have to be suppressed.  In a system like Russia’s, creative destruction is impossible.  There’s only destructive destruction.

And that’s the best case.  Worse cases are not improbable, and really bad.  In particular, if for any reason–death, incapacity, or just declining capacity–the capo di tutti capi can no longer function effectively, everyone goes to the mattresses in a war of all against all.  So stasis–Putin’s economic purgatory–is preferable to the most likely alternative.  Internecine warfare is the most likely alternative because the more civil, humane, and productive alternative–the creation of institutions that support markets and the constructive resolution of disputes–is devilishly hard, especially so since those who would have to lead (or at least consent to) the creation of these institutions would lose wealth and power as a result.  I think that the widespread recognition of these conditions also explains popular support for Putin, or at least a good deal of it.  If you take for granted that the system is essentially mafia-like, you want a good capo that can maintain equilibrium.  And whatever you might say about him, Putin plays the role quite well.

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