Streetwise Professor

And now on two fronts, as it were.

The battle over the “vertical silo” (i.e., vertically integrated in econspeak as opposed to bizspeak) approach to execution and clearing remains under assault in Europe:

European Union states want to extend a draft law curbing risk in privately negotiated derivatives to the whole sector, which could ultimately dent profitability of the world’s first mega bourse merger.

. . . .

But banks say the merged group should be opened up to clearing competition. Extending the law’s scope to regulating listed as well as OTC derivatives would achieve this goal.

It would make it easier for users to clear listed contracts transacted on Deutsche Boerse or Euronext’s LIFFE derivatives platform elsewhere and not be locked into the group’s clearers.

“The inclination among OTC derivatives fans like us is ‘why differentiate between one derivative and another?’,” said David Clark, chairman of the Wholesale Markets Brokers’ Association.

“The big deal in all this is the competition element with Deutsche Boerse. This move to extend the scope of the draft law has got politics written all over it,” Clark said.  [Politics?  Whoda thunk?]

. . . .

Exchanges sense integrated business models are under threat.

“Some are trying to weaken vertical structures by creating clearing links with other structures. That creates systemic risk and shifts focus away from the real issue of dealing with OTC derivatives,” an exchanges industry official said on condition of anonymity due to the sensitivity of the issue.

The battle between the “verticalists” and “horizontalists” in clearing is a decade old and has never resolved, with the same two countries pitted against each other today as back then.

“Verticalists” and “horizontalists”?  Sounds like something out of Swift.  Count me as a verticalist–or more accurately, a marketalist.  That is, that this is something best left to market processes rather than legislation and regulation.

Now a battle on vertical integration is evidently brewing in the US too.  At least in the eyes of some market analysts, ICE’s CEO Jeffrey Sprecher is worried that a horizontalist, non-marketalist US Department of Justice may condition acceptance of a NASDAQ-ICE-NYSE-EuronextLIFFE merger on opening up of the derivatives clearinghouse (from Bloomberg: no link yet):

IntercontinentalExchange Inc. may drop out of its joint bid for  NYSE Euronext if the U.S. Department of Justice raises concerns about the deal’s combined futures business, Sanford C. Bernstein & Co.’s Brad Hintz said.  ICE, the second-largest U.S. futures market, and Nasdaq OMX Group Inc. made an unsolicited offer for NYSE Euronext last week, valued at $11.3 billion, countering Deutsche Boerse AG’s February offer for $9.53 billion. In the proposal, Atlanta-based ICE would take NYSE’s Liffe futures-trading markets, expanding in Europe. New York-based Nasdaq OMX would take NYSE Euronext’s listings, equity and options units.

ICE and CME Group Inc., the world’s largest futures market, own their own clearinghouses, which may create barriers to entry and be anti-competitive, the U.S. Department of Justice said in 2008. Equity and options exchanges –such as those owned by NYSE Euronext and Nasdaq OMX–use centralized  clearinghouses like OCC that aren’t owned by any one market.

“The most important issue facing these competing offers is the possibility that the ICE/NYSE Liffe merger will resurrect DOJ concerns with vertical integration of futures execution and clearing,” Hintz, an analyst at Sanford C. Bernstein in New York, wrote in a e-mailed note today. “If this issue arises ICE will likely drop out of the bidding and the Deutsche Boerse deal moves  forward.”

Yes, be afraid.  Be very afraid.  I have the sense that the DOJ’s Antitrust Division is itching to attack vertical integration in derivatives, the economics be damned.

* This perhaps corny (perhaps?) title was inspired by my recollection that today is the 149th anniversary of the first day of the Battle of Shiloh.  Two of my great-grandmother’s brothers fought in the battle: Eli and John, who served in the 46th Ohio Volunteer Infantry.

Eli was something of what is called a “Jonah” in the Navy–a hardluck guy.  He was captured at Shiloh, and held in a prison camp in Montgomery, AL for a couple of months.  Exchanged, he returned to Ohio.  He claimed he was unable to return to his regiment because of dysentery contracted during his imprisonment.  His military record includes a note from his family doctor, believe it or not.

His efforts to stay home were unavailing, and he was ordered to report to his unit.  He returned to the 46th shortly before the Battle of Chattanooga.  He proceeded to lose his belt and cartridge box, for which he was dunned $10 pay.  He was then assigned duty as a wagon driver–probably not an endorsement of his soldierly qualities.

Maybe he straightened out, or the need for infantrymen was pressing, for he was in the ranks again for the Atlanta Campaign.  Unfortunately for him.  He was shot in the left arm close to the shoulder joint at the Battle of Dallas, GA, 28 May, 1864.  The surgical record indicates that the regimental doctor performed a resection of his left arm, removing the bone from the shoulder to the elbow.  This surgery was required because the ball struck too close to the joint to amputate.

My great-grandmother told my grandfather that “Uncle Eli had a dead arm.”  His arm dangled uselessly at his side, and my great-grandmother remembers him using his right hand to lift up his left to rest it on the dinner table.

John, on the other hand, served without incident or injury from October, 1861 to the muster out of the regiment in July, 1865.  Pretty amazing, given that the regiment fought at Shiloh, the Siege of Vicksburg, Chattanooga (the storming of Tunnel Hill, the bloodiest part of the battle), the Atlanta Campaign (including the Battle of Atlanta on 22 July, 1864), the March to the Sea, and the Battle of Bentonville.  One lucky brother, one unlucky.

LR has published a translation of the most recent Nemtsov white paper on Putinism.  There is really little surprising here.  FOPs (Friends of Putin) with virtually no business background to speak of wind up billionaires or near-billionaires.  Interestingly, three of those profiled–Gunvor head Timchenko and the Rotenberg brothers–were judo buddies of Putin’s.  (Here’s a recent article from Time discussing the same phenomenon.)  Heretofore judo skills were not known to be the route to stupendous financial success.  Somehow I’m thinking that Bill Gates and Warren Buffet didn’t hang around the dojo.

The Nemtsov piece documents the natural state means by which mouth-breathers achieve fabulous wealth.  State firm assets are sold to companies they control at cut rate prices.  Hardly genius.  Hardly creative.  Just old fashioned asset tunneling facilitated by connection to power, facilitated by the existence of massive state corporations not subject to ordinary market or legal discipline.

Which makes the issue of the presence of politicians on state corporation boards all the more interesting and important.  Two narratives are emerging, which I guess is appropriate in a duumvirate.  The problem is that both narratives are arguing essentially axiomatically, in the absence of any new facts.

Narrative one is that Putin is in complete agreement with this plan–indeed, it is his plan.  The axiom underlying this narrative is that Putin is the dominant party in the duumvirate, and that Medvedev would not do anything without his blessing.

Narrative two is that this is Medvedev’s strike against Putin, his attempt to create an independent identity and to win the presidency on his own.  The axiom underlying this narrative is that Medvedev recognizes that Putinism is a dead end and that he is serious about his modernization agenda.

For his part, Putin’s spokesman denies any split.  Which is the conventional response.  It could mean that there is no split, and that narrative one is correct, or that Putin just doesn’t want a public confrontation now, the key words being “public” and “now.”

The narratives should be viewed as hypotheses that flow from the axioms.  At present, there is insufficient empirical evidence to reject either theory.

In brief, we are witnessing another fight of the dogs under the carpet. Or friendly dogs roughhousing under the carpet.  But we can’t tell which.  With the election coming, however, before long there should be a more definitive understanding of just what is going on.

Even if the second narrative is correct, optimism is premature.  Medvedev’s modernization agenda is a necessary condition for Russia to jump off the hamster wheel from hell, but not a sufficient one.  The problem is that any initiative from the top is unlikely to lead to the development of enduring institutions that are conducive to truly modern development.

Russia has experienced all of the pitfalls of centralized attempts at modernization before.  The successful modernizer becomes too enamored of power himself, and is unwilling or unable to cede control to independent institutions;  promises to support the development of alternative sources of power are of dubious credibility.  The modernizer just ossifies or loses energy; entropy takes over.  Those harmed by the proposed changes succeed in undermining them, and sharply limiting their scope.

Perhaps the best that can be said is that there is some potential for escaping the purgatory of Putinism.  Things like Nemtsov’s paper spell out some of the more odious features of that purgatory.  Whether loosening the nexus between the state and business is sufficient to change it in a serious way remains to be seen.

In Walther Bagehot’s famous formulation, central banks should lend during crisis situations “against good collateral at penalty rates.” Apparently, during the maelstrom of the crisis in September, 2008, the Fed considered pretty much anything “good collateral,” except perhaps Lloyd Blankfein’s baseball card collection and a ’72 Buick up on blocks in front of an old doublewide somewhere in Alabama. As revealed in documents pried out of the Fed as result of a FOIA request, the US central bank lent massive amounts against very dodgy collateral:

At the height of the financial crisis, the Federal Reserve allowed the world’s largest banks to turn more than $118 billion in junk bonds, defaulted debt, securities of unknown ratings and stocks into cash.

Collateral of those asset types made up 72 percent of the total $164.3 billion in market-rate securities pledged to the Fed on Sept. 29, 2008, two weeks after the bankruptcy of Lehman Brothers Holdings Inc., according to documents released yesterday. The collateral backed $155.7 billion in loans on the largest day of borrowing from the Primary Dealer Credit Facility, which was created in March 2008 to provide loans to brokers as Bear Stearns Cos. collapsed.

. . . .

The Fed loans on Sept. 29, 2008, represented a 5.49 percent “collateral cushion,” the amount by which the pledged assets exceeded the loan value, according to the Fed data. Equities comprised $71.7 billion, or 43.6 percent of the total. High- yield debt, including the defaulted issues, accounted for $18.4 billion, or 11.2 percent. Collateral of unknown rating was $28 billion, or 17 percent.

High-yield, high-risk bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- by Standard & Poor’s.

The haircut–the percentage by which the collateral value exceeded the amount of money lent–was amazingly small, given the quality (or lack thereof) of the collateral, and prevailing market conditions.  The 5.5 percent haircut was far smaller than the 40 percent number that was prevalent during these days (as estimated by Gary Gorton).  Moreover, it was a pitifully small number for the equity that made up the largest single component of the collateral accepted by the Fed.  On the 29th, the VIX equity volatility index closed at a record of 46.72.  Thus, there was a very high likelihood of an adverse price move that would have put the equity collateral under water.

It’s also an open question of whether the marks on the collateral reflected true market values.  I pretty much doubt it.  It’s not outside of the realm of possibility that the real haircut was negative.

Note too that very few Treasuries were posted as collateral: presumably all this was out on repo, and the desperate need for liquidity forced banks to pawn everything else in the safe at Uncle Ben’s Cash America.

These eye opening data reveal just how extreme the situation was post-Lehman.  Or at least how extreme the Fed considered the situation to be.  Given those extraordinary circumstances, it is understandable why the Fed acted in a truly extraordinary way, and honored Bagehot more in the breach than the observance.

The real issue that still remains unresolved is how this in extremis situation came to be.  Did the Fed’s and Treasury’s handling of Lehman, and before that Bear, create the panic?  The Fed’s version of Pawn Stars on steroids is but a symptom of what had transpired in the days, months, and years leading up to 29 September.  That’s what we need to understand better–far better–than we do now.

There are additional calls for Robert Gates to resign, including here at CFR (a post by Elliott Abrams) and here at Information Dissemination (a good Navy blog).  The argument is the conventional one.  Gates is undermining the authority of the elected commander-in-chief.  QED.

Understandable and understood.  But Gates knows this.  He is no MacArthur.  He has been a very conventional, very loyal, civil servant for over 30 years.  He is more apparatchik than maverick.  He has never gone off the reservation.  Never.  He would, no doubt, agree with the conventional arguments–in conventional circumstances.

But by applying conventional templates to Gates’s behavior, his critics are completely overlooking the fact that when such a conventional man does something so uncharacteristic, there are reasons–and the reasons are likely to be quite disturbing.  I can conjecture what those reasons are, but that’s not really my point here.  Instead, the point is that the critics should take note of the extraordinary nature of what Gates has said, and try to determine why he said it.  What is going on behind the scenes that would compel Gates to do something that you have to know he would agree would be a firing offense in normal times?

The analogy that comes to my mind is that of US Navy Commander Jeremiah Denton, who blinked out “T-O-R-T-U-R-E” in Morse Code when being questioned by his North Vietnamese captors in 1966. Like Denton, Gates is signaling that something very wrong is going on off camera.

Update: If, as is plausible, this New Republic explication (by Steven Metz) of the alleged logic behind the administration’s policy is correct, then Gates’s insurrection is quite understandable:

Clearly the Obama strategy is designed to find the middle ground between disengagement and domination. The idea seems to be to maximize flexibility by keeping all options open as long as possible. This is a good idea in a highly fluid situation. [Yes, keeping options open is sensible–but the essence of military force is imposing your choices on the enemy, and denying him options.]

. . . .

In a broader sense, President Obama is struggling to transcend American history. For two centuries, Americans have believed that any use of military power is war, and the objective in war is victory over the enemy. They have little tolerance for military operations that deviate from this pattern, such as the limited use of force in support of diplomacy or armed action leading to something other than decisive victory. [That’s Jacksonian America.]  After a foray into “limited war” from Korea to Vietnam, the United States walked away from the idea. What became known as the Weinberger-Powell principles argued that the U.S. military should never be committed unless vital interests are at stake—and then, only with the intention of clear victory. This became inculcated into the American strategic culture. And, since World War II, Americans have also come to expect that the United States will dominate any military operations in which it participates. The normal state of affairs, Americans believe, is for the United States to be is the senior partner in a coalition.

The Obama strategy represents a step away from the Weinberger-Powell principles and the notion that the United States must dominate any operation where its military is involved. Whether it works will be determined by the unpredictable whims of Muammar Qaddafi, the willingness of other states to take some or all of the burden off of America’s hands, and the president’s ability to sell the American public and its elected leaders on a strategy that runs counter to their tradition and inclinations. While Obama’s Libya strategy has a distinct logic, its success thus remains in the balance.  [We are ceding the initiative to Khaddafy?  This is a good thing? Really?  This is a “strategy”?]

“After a foray into ‘limited war’ from Korea to Viet Nam.”  Seriously.  Metz wrote that.  Thirty-five years and 100,000 dead Americans is a “foray”?

Here’s another way to put it: the Obama administration isn’t “transcending American history.”  It is failing to learn from it.  It is revisiting the failed policies of the past–as even it’s own defenders (e.g., Metz) are admitting, but claiming it is a feature not a bug.  It is doing its best to prove Marx right, re-enacting a tragedy as a farce.

Metz’s interpretation makes Obama’s policy appear very post-modern, making military action and victory and defeat all matters of semantics.  Post-modernism is heavy on the irony, and that’s here too as well.  For this administration–and its defenders–is chock-full of people who were strident in their criticism of the Viet Nam “foray”.

Weinberger-Powell was a reaction to Viet Nam.  It was the product of the military’s agonizing appraisal of what had gone wrong and how to avoid the repetition of these errors.  By casting Weinberger-Powell aside–consciously, if Metz is to be believed–Obama runs the grave risk of making the same mistakes that gave rise to it.  Gates is likely representing the views of the uniformed military that are grounded in this appraisal of Viet Nam, as updated and reinforced by the experiences in Iraq.  That is, most likely, the root of the SecDef’s insurrection.

Jennifer Rubin says that SecDef Robert Gates should resign for his statement that ground troops will not be committed to Libya while “I’m in this job.”  Rubin interprets Gates’s remark as a threat to the president.

That is a very plausible interpretation.  What should we make of it then?

The first thing to note is that Gates is not in the habit of making threats.  He is not a grandstander.  He is not a prima donna. He has a long record of service as a loyal servant in several administrations.  His remarks are an exception.  There must be an exceptional reason for him to make them.

Recent events provide clues for Gates’s outburst–which his remarks were, compared to his very low key norm.  In particular, the let-the-rebels-do-it “strategy” has proved to be utterly fantastic and farcical.  As a Patton, not a Gates, would have put it, these rebels couldn’t fight their way out of a p*ss-soaked paper bag. Testimony by Gates and Admiral Mullen revealed that there are perhaps 1000 with any military training.  They have no heavy weapons.  No discipline.  They are prone to indiscriminate killing–so much so that NATO has threatened to bomb these ostensible “allies” in the fight against Khaddafy unless they knock it off. Good luck with that.

Recognition of this is predictably leading to a serious potential for mission creep.  For instance, since the effectiveness of air power is sharply limited in supporting offensive operations by the lack of targeting assets on the ground, a proposal is afoot to have US troops train rebels as forward observers.

Please.  FO is a very demanding job that takes intensive training.  The US has acute difficulties in finding, training and keeping enough Joint Terminal Attack Controllers of its own.  It’s going to train some yo-yos whose main military qualification is shooting AKs into the air?  If these guys make mistakes, things go very wrong and people get killed.  In Libya, many of those killed would be civilians–the very people we are intervening to protect.

That this “solution” is even being considered is a confession of desperation.  To quote another famous military mind, Oliver Hardy: “Another nice mess you’ve gotten us into.”

Gates–unlike some other people I could name–is apparently thinking several steps ahead. He can foresee the dynamic of escalation and deepening involvement–he doesn’t want the mess to get worse.  Tentative measures fail.  A president has put his credibility on the line.  So the level of US involvement will creep up.  But not enough to achieve anything decisive.  So it will creep up some more.

Anybody seen this movie before?  Gates has, apparently, and is doing something that for him is exceptional in order to re-write the ending–or to stop filming altogether.

Checking an incompetent commander is always an extremely difficult endeavor.  In the US, Congress is supposed to check the executive.  That poses its own difficulties, because leadership by committee is always messy and erratic, and because politics and personality bedevil the process.  But messy oversight is often far superior to no oversight at all.  But in the case of this administration and Libya,  it has made it perfectly clear that it will not accept any Congressional control at all, going so far as to make the completely outrageous claim that it is actually in compliance with the War Powers Act.  You can argue that the WPA is unconstitutional, but you can’t argue that what Obama is doing adheres to it: but Hillary has done just that.  What’s more, so far Congress has acquiesced to this action and attitude, which had the president been of a different party it would have likely considered a usurpation of Congressional authority.

Checking a commander from inside the chain of command is even more fraught.  For dramatic depictions of the dilemmas involved, read (or watch) Mutiny on the Bounty or the Caine Mutiny or even Mr. Roberts.  Obedience is necessary in a military organization, but like anything, the obligation to obey cannot be unconditional.

That’s easy to say.  What’s far harder is to identify where the obligation ends, and how to limit insubordination to what is necessary to avoid catastrophe without destroying the military organization in the bargain.*

In this context, it is worth reading H. R. McMasters’ Dereliction of Duty.  McMasters is a Gulf War I hero who commanded a troop of the 2d Armored Cavalry that rolled over an Iraqi armored force at the Battle of 73 Easting (an event portrayed well in an episode of Greatest Tank Battles.)  He is now a brigadier general.  Dereliction of Duty is based on his PhD dissertation.  It argues that the Joint Chiefs of Staff were derelict because they acquiesced in McNamara’s gradual escalation strategy in Viet Nam even though they realized that it was a recipe for disaster.  McMasters argues the Chiefs should have made their objections to McNamara’s strategy known to the president, and failing to persuade him that way, to resign publicly.

That, of course, would have posed its own dangers.  But I think in the present circumstances Gates recognizes that it may come to that.  The handling of this military adventure is so appalling that there has to be deep discontent in the Pentagon, and in the ranks.  I strongly suspect that Gates is firing this warning shot now in the hope that he can stop the escalation process before it gets fully underway.  It’s a rather desperate measure, and given Obama’s narcissism and stubbornness, it’s unlikely to have an effect.  Arguably the best hope we have is that Obama really doesn’t have his heart in any military adventure, least of all this one: hopefully these sentiments will prevail over his desire not to be seen to retreat from the unnecessary confrontation with Khaddafy that he so thoughtlessly entered into.

So yes, maybe Gates should resign–but to make the point, not, as Rubin would have it, to atone for having made it through his threat to resign.

It should not have to come to that.  It would be far better for Congress to live up to its Constitutional duties.  But with Harry Reid adjourning the Senate in order to avoid forcing his caucus to have to vote on an amendment quoting Barack Obama v.2007 (“The President does not have power under the Constitution to unilaterally authorize a military attack in a situation that does not involve stopping an actual or imminent threat to the nation”) that doesn’t look likely any time soon.  So Gates, the archetypal loyal bureaucrat, is stepping up instead.

I doubt that it will be enough.  I shudder to think what will be enough.  May is only a month away.

* In my leadership class at Navy I wrote a paper on the necessity of disobedience in certain circumstances.  The prof was not amused.  Especially when I quoted Jackie Fisher: “In war the first principle is to disobey orders.  Any fool can obey orders!”