Streetwise Professor

By now you’ve no doubt heard or read the news about the loss of a US helo with 38 troops aboard.  The most recent reports state that 22 of the dead are from Seal Team Six (also known as DEVGRU)–the same unit responsible for killing Bin Laden in May.

Also among the dead were 7 Afghan commandos and a translator, as well as USAF personnel.

Helluva coincidence.  I imagine there are delirious celebrations amongst the jihadis.

At the risk of sounding conspiratorial, the deaths of men in the same unit (perhaps including some of the same men–we’ll likely never know) that killed Bin Laden so soon after the event raises some very dark possibilities.  This could well be a case of the Golden BB (or RPG, in this instance, apparently).  But other explanations come to mind.

The SEALs are fanatical about operational security, but given the involvement of Afghan personnel it is not improbable that some Afghan authorities, or intel sources within the Taliban who provided the information which was used in the planning of the mission, were aware of the operation.  And some “trusted” Afghans are not all that trustworthy: recall the incident in January of 2010 in which a “trusted” Afghan Jordanian informant entered a CIA camp in Afghanistan to meet with American agents, and then detonated a suicide belt, killing 7 CIA officers including the station chief?

Again, betrayal is not necessarily the most likely explanation.  In war, bad stuff happens.  Even the best of the best can be the unlucky victims of a random shot.  Moreover, like I say, the SEALs are fanatical about operational security and are certainly aware of the dubious reliability of their ostensible allies, and would be on guard against it.  But betrayal is not out of the realm of possibility, especially in the AfPak cesspool, where mortal treachery is as common as air.  There was–is–no bigger target for jihadis than those who killed Bin Laden.  To those of that turn of mind, aiding in their deaths would be a ticket to paradise.  There is certainly motive here, and quite likely opportunity.  Thus it is not unreasonable to countenance the possibility that the MH-47  was flying into an ambush.

My prayers go out to the brave men who perished, and to their families.  But a question lingers in my mind: was this the fortunes of war, or something more sinister?

Update: The most recent reports are that unnamed “US officials believe” that none of those who died in the crash participated in the Bin Laden mission.  That doesn’t change the fact that inflicting a major blow on ST6 would be a jihadist’s dream.  What’s more, these kind of reports must be taken with huge doses of skepticism because of the desire to conceal the identities of operators.

Belmont Club also raises the “Payback” hypothesis.  Ditto Steve Hayward at Powerline.

Zero Hedge provides a reminder of the approaching automatic triggering of an increased haircut on Spanish and Italian government bonds in RepoClear.  Earlier this year LCH indicated that it would increase margins on Irish bonds when the spread hit 450 bp, and Italian and Spanish debt is reaching that level.

This is the kind of action that is individually rational for a clearer to take, but which can be destabilizing, pace my earlier posts on the hike in silver margins earlier in the year.

The haircut spiral plays a central role in a recent paper by BOE Financial Stability Executive Director Andrew Haldane and two co-authors.  The paper is nicely done, and the use of numerical methods to study the highly non-linear dynamics of complicated financial networks is the right way to go.

I am not persuaded that the paper focuses on the real sources of financial crises, however.  The reason is directly related to my post earlier in the week on clearing and systematic risk.  Haldane et al study how an idiosyncratic shock to the bank-specific haircut of a particular bank can propagate through a complex, densely connected network.  In some cases, such a shock can lead to a systemic crisis resulting from a cascade of banks deciding to hoard liquidity.  Not surprisingly, they find that the likelihood and intensity of such a contagion depends on the connectedness of the network, the skewness of the sizes of firms in the network, and the size and connectedness of the bank hit by the shock.

But I remained unconvinced as an empirical matter that major financial crises, at least in recent years, have developed in this fashion.  For this story to work, a single bank–and in the Haldane et al results, that bank would likely have to be a very big, highly connected one–is hit by an idiosyncratic shock that results in it having to pay higher haircuts on its secured lending.  In the real world, this could happen as the result of a rogue trader risk or some other major operational failing.

Perhaps the canonical example of such an episode would be the Kervial debacle at SocGen.  But even though that occurred when the markets were already stressed (in January, 2008), it didn’t lead to contagion.  I would be interested to hear of other examples, but I can’t think of any that have led to the cascade of failures like that that plays the central role in the Haldane et al analysis.

Instead, the major financial crises, most notably that of 2007-2008, the one that may be impending,  1998, etc., have been marked by an adverse shock hitting virtually all major financial institutions due to the similarity of their balance sheets.  European banks today are on the brink because they are all–all–heavily exposed to Eurozone government debt, and in particular to PIIGS debt.  This is a system-wide shock–a systematic shock, not a diversifiable, idiosyncratic one that is magnified through the web of interconnections among banks.  Such interconnections, margin spirals, liquidity hoarding, and so is a real possibility and could exacerbate the effects of the shock, but the point is that what is going on now, and what went on in 2007-2008, and what went on in 1998 is very different than the mechanism studied in the Haldane et al paper.

Perhaps many of the recommendations that Haldane and his coauthors make based on their analysis of the propagation of an idiosyncratic shock carry over to the case of a common shock hitting virtually all banks.  For instance, bigger liquidity cushions might be stabilizing in this situation as they are in the Haldane et al setup.

But maybe not.  Especially when one considers that for a variety of reasons–financial repression among them–sovereign debt is, and likely will remain a major component of any liquidity buffer.

That doesn’t work so well when the collapse of the creditworthiness of the governments issuing the debt is the root of the crisis, as is the case today.

I recommend the Haldane paper, but I think that it,  and many other papers that are based on tracing out the implications of idiosyncratic shocks to individual banks in a dense network, aim well wide of the mark.  I would like to see empirical work–hell, a case study, or even an anecdote–showing this mechanism working in practice.  If it is instead the case, as I am highly confident that it is, that financial crises are typically the result of an economy-wide, non-idiosyncratic, shock, the mechanism will be different and the policy implications will almost certainly be different.

A conjecture: in such a world, the greatest crisis accelerant is the similarity of balance sheets across major financial institutions.  To some degree, this cannot be avoided.  But there is no doubt in my mind that uniform regulations–and the Basel standards and other coordinated risk-based capital requirements–encourage even greater similarities in balance sheets.  This is a real danger, and if my conjecture is correct, many of the efforts currently underway to harmonize capital and liquidity requirements could make crises more rather than less likely . Basel Faulty and all that

The self-interested role of governments in cramming down more of their burgeoning debt will only exacerbate this problem, as regulators have an incentive to tilt capital and liquidity requirements in favor of holding government debt.  As dodgy as that debt is these days, it’s hard to imagine a better way to create the next crisis.

I’ve been humming It’s the End of the World As We Know It for the last couple of days, and having 2008 flashbacks. Although a much attention has been on the US, the real epicenter is in Europe–though the US will not be immune, and is in poor shape to withstand the shock.

Europe is experiencing, I think, its Wile E. Coyote moment. It has been levitating over the chasm, for a lot longer than Wile E., actually. But with Italy and Spain in dire straits, and Greece, Ireland, and Portugal well-known basket cases, economic gravity is about to reassert itself.

Runs, be they on banks, currencies, countries, or romantic (but unnatural) supernational groupings, are coordination games, with multiple, self-fulfilling equilibria. The global games literature shows the role signals that agents get about the economic circumstances of the bank or currency, etc., play in sparking runs. Small changes in these signals (which are noisy representations of the fundamentals) can induce discontinuous changes in behavior by millions.

To some–like the old goat who is the Italian prime minister–the discontinuity of these changes demonstrate that “the market is wrong.” The abrupt shifts are no doubt disorienting to politicians and policy makers. But it’s not like there isn’t precedent–and it demonstrates the dangers of trying to skate by and avoid making fundamental changes that would appreciably reduce the likelihood of wandering into the run risk zone.

It may be well too late, coming as it has in a week when US government debt (the official stuff, not counting the countless zillions in government liabilities that aren’t in the calculation) breached 100 percent of GDP, but one would hope that American policymakers are taking serious notice. One would hope–but hopes like these are made to be disappointed, I fear. Europe is playing Ghost of Christmas Future. We should take heed, but probably won’t. The debt deal charade, and the hyperbolic reaction of the left to it (e.g., Rep. Doyle’s lament that the evil Tea Partiers have left the government without “any money to spend”, give or take $4 trillion) and the impending election mean that nothing serious will be done voluntarily before 2013.

Too many are taking solace in the fact that interest rates on US debt remain low–and indeed, are going lower as money flees Europe. But the European experience shows, yet again, that these things can turn on a dime. Or a trillion or two.

The aftershocks are being felt everywhere. Japan is playing beggar-thy-neighbor with its currency. Moreover, these events put a particularly interesting twist on Putin’s recent tirade before a Nashi audience about the parasitical US.

One consequence of the market shock has been a steep decline in the price of oil. Brent crude is down about $10/bbl in the last two days. A sustained economic downturn would put further pressure on the price.

Putin’s electoral strategy is to use oil rents to promise all sorts of goodies, including both guns and butter–a huge defense procurement binge and higher social spending. It is likely that this would be reversed post-election, as even with $120 oil these promises are unaffordable. Putin thought he was in fat city with turmoil in the Middle East and emerging market growth propping up the price. But now he realizes that–yet again–his grandiose plans are hostage to things outside of his control.

No doubt, like me, he is having very unpleasant flashbacks to 2008, when his dreams last came crashing to earth due to economic turmoil in the US. You know it just makes him hysterical to realize that he is at the mercy of the US. That his fate is driven largely by a country and a society he despises.

Put differently: if the US is parasitical (and there are certainly parasitical aspects to US policies, although the main host is productive Americans), then Putin and Russia are little more than parasites living on the bigger parasite. (H/T R), but I cleaned it up: check her out on Twitter for the unexpurgated version).

No, Vladimir. There will be plenty of pain to go around. You no doubt will rage at the injustice of it all. But few will listen, as they will have their own problems to deal with.

PS. I included this in the “Financial Crisis” category. I may have to add a new category to distinguish posts on the next financial crisis from the last one.

Taranto has a long piece on how whenever Obama is in political trouble, his defenders accuse his critics of racism.   Obama is in a world of political hurt right now–the worst yet by far–so the accusations are reaching a fever pitch.  They’ve inspired, for example, a new Twitter hash tag #BeforeBlackPresidents where the president’s advocates attribute every imaginable (negative) contrast between the world pre-2008 and today to racism.  Which sort of raises the question: If Obama’s race is such a big deal, how did he get elected in the first place? Did people just start noticing he was black?  (Which would be kind of hard, even for the blind, given how much his race has been touted–by him and his followers.)

Look: Obama’s current political predicament has nothing to do with race, and everything to do with color.  A sizable majority is distraught and angry not because Obama is black, but because the country is deeply in the red.  That, and the fact that nobody seems to be really serious about tackling that problem–least of all Obama.

Cries of racism are the new last resort of the scoundrel.  Politically opportunistic charges of racism are extremely corrosive.  They will have the effect of poisoning race relations, and jeopardizing much of the real progress that has been made in recent years.

The lesson is a simple one.  It isn’t much of an exaggeration to say that anybody can become president.  It’s no exaggeration at all to say that anyone who is elected can fail at the job.  Many white guys have proved that in the last 224 years.

Central counterparties work on the principle of mutualization.  CCP default funds are a mechanism for mutualizing–sharing–counterparty loss risk, where the CCP-insurer has some protection in the form of a “deductible” that consists of the defaulter’s margin plus default fund contribution.

Insurance works when risks are diversifiable.  So, to the extent that the risks of default exhibit relatively little correlation across clearing members (CMs), mutualization through a CCP can improve the allocation of risk: through diversification, the variability of the average default loss across all CCP members is smaller than the variability of any CM’s default loss profile.

It should be noted that these diversification effects work in OTC markets too: market participants who deal with multiple counterparties diversify exposure to counterparty losses.  Moreover, in OTC markets, it is often possible to hedge counterparty risk through the CDS market.  [Which raises a question: how do you hedge CCP credit risk?  It is highly unlikely that CDS will be traded on CCPs.  Perhaps using a portfolio of CDS on CMs?  But who clears those CDS?  Sounds like the wrong way risk from hell.]

CCPs have been sold as a means of reducing systemic risk.  The basic story is that in bilateral OTC markets, the failure of one entity can cause the failure of other entities in falling-domino-like fashion.  In this telling, a CCP reduces interconnectivity of the financial market, and thereby reduces the likelihood of that the failure of one firm–even a big one–will cause the failure of others.  Put differently,  in this view default/counterparty risk is insurable because it is diversifiable, and therefore mutualization can improve the allocation of risk.

But is the domino-model really a good description of systemic risk?  Is the system really threatened by the isolated, idiosyncratic failure of one firm, even a big one?

Here’s an alternative story, in which a big, system-wide shock hitting many institutions simultaneously is the source of systemic crisis.  Some examples: Black Monday in 1987, the Asian and Russian crises in 1998, and the subprime meltdown of 2007-2008.

In such episodes, there are large price moves across asset classes.  These price moves often blow through margins–and by a lot.  During the subprime crisis, for instance, even well-before the Lehman episode, some prices moved by huge amounts.  In August, 2007–more than a year before Fannie-Freddie, Lehman, and AIG–David Viniar of Goldman lamented that there had been several 25 standard deviation moves in multiple markets.  In a “normal” (Gaussian) world, 25 sd moves don’t occur.  Period.  People don’t set margins based on the possibility of 25 sigma moves.  So when such moves occur–and they occur in the real, non-normal world–margins get blown through.  Meaning that if someone defaults, they’re well into the default fund, and the protection of the “deductible” is gone.

Moreover, such earth-shaking episodes are typically associated with adverse shocks to bank (CM) balance sheets.  What’s more, such events raise serious doubts about the solvency of banks/CMs: adverse selection problems can run rampant, causing markets to freeze.  This tends to cause funding and liquidity to dry up.  Due to actual insolvency, and illiquidity driven by widespread fears of potential insolvency, those facing big margin calls may face substantial difficulty in meeting them.   Thus, they are more likely to default.  This is what happened to AIG and Lehman.

Since the shock hits all financial institutions simultaneously, and since the shock is big, this risk of default is not idiosyncratic; it is highly correlated across firms.  Given such a shock, if one firm defaults, others are at elevated risk of default too.

If defaults that breach margins occur, the surviving CMs who contribute to the default fund must absorb the loss, and take a hit to their capitals.  But this hit occurs exactly when capital is very valuable/costly for them.  That is, hits to the default fund are likely to come at the absolute worst times–during adverse moves in the overall market.

It is possible that a CCP’s default exposure in such a circumstance could crater the clearinghouse.  But even if the CCP survives, its surviving members suffer a loss (via to their exposure to the default fund) when they can afford it least.

This has some interesting implications.  In particular, it means that the systematic risk of default fund capital is very high, which in turn means that default fund capital is extremely expensive.  The default fund is like a deep out of the money short put on the market.  Such puts are essentially bets on systematic risk, and hence are very expensive.

The expense of such capital means that CMs are likely to want to minimize the amount they post.  They have every incentive to try to construct risk measures that make CCPs look safe, with very low risk of default, in order to reduce their exposure to the default fund.

Think that this can’t be done?  Think again: that was essentially the entire game in CDOs.  As Coval-Jurek-Stafford show in an AER paper, “super senior” CDOs were claims that had low probabilities of default, but that defaults would occur precisely during periods of crisis–analogous to the foregoing characterization of the risk profile of default funds.  C-J-S present empirical evidence that these CDOs–which were AAA rated–were grossly underpriced, meaning that those who were buying these securities didn’t fully appreciate how heavily they loaded on systematic risk because analysis–and ratings–were framed almost exclusively in terms of unconditional default probabilities, and the rating agencies and many investors and regulators ignored the fact that defaults would occur when the value of capital was very high.  I can see the same thing happening with CCPs–who will reflect the interests of their members–focusing on default probabilities to justify their capitalization to regulators.

Another interesting implication is for what instruments should be cleared.  Instruments that have big losses during big systematic shocks–those that load heavily on systematic risk–are exceptionally dangerous for CCPs.  This means that clearing things like senior or supersenior tranches (or derivatives on them) is exceptionally dangerous.

This has a corollary: anybody that uses AIG to justify clearing mandates doesn’t know what the hell they’re talking about.  AIG’s positions in derivatives on supersenior tranches were, as C-J-S show, systematic risk time bombs.  Clearing those things would dramatically increase the systematic risk of default funds, because they would expose default funds to losses precisely during systemic crises.

Some people know this.  Jon Gregory, for instance.  When discussing “market coverage of a CCP”, he states:

Finally, CDO tranches (especially supersenior) would be expected to have serious correlation [i.e., systematic risk] impact since in a scenario where there are losses on these tranches it is likely that many CCP counterparties [and CMs] are in a distressed state.

The above analysis is to some degree subjective but one general point–probably beyond argument–is that the most important trades products to be traded through CCPs are arguably the most risky from the point of view of the stability of the CCP.  There has been much recent interest to trade all CDS index products and single-name products through CCPs. . . . The general point is that the products that market participants will most want and need to trade through a CCP will be the precise products that are most difficult to handle in this way (pp. 381-382).

In sum, the belief that CCPs can reduce systemic risk is predicated on a particular narrative of  the likely source of a future crisis.  This view is that the failure of a single institution, arising from some shock idiosyncratic to it (a bad trading decision, an operational risk such as a rogue trader) can lead to the failures of other institutions via a contagion mechanism.

But, in my view, that isn’t an accurate characterization of the actual crises that have occurred over the years.  These have been associated with broad-based shocks that hit large numbers of institutions simultaneously.  Again: Black Monday, Asia/Russia, subprime.

There have been multiple examples of large, one-off collapses of highly interconnected and leveraged institutions that have not resulted in a cascade of failures that led to a systemic crisis.  To name several off the top of my head: MG (1992), Barings (1995), Amaranth (2006). For a while, it looked like the Hunt collapse in 1980 could have broader, systemic consequences, but that fear evaporated rather quickly.

The contrast between the effects of the collapse of Amaranth in 2006 and the crisis surrounding the problems of LTCM in 1998 is particularly instructive.  Amaranth was actually bigger than LTCM (though it should be noted that the markets were bigger too), and had large OTC positions.  The difference was that Amaranth’s collapse was not caused by a systematic shock, whereas LTCM’s was.  LTCM engaged in strategies that blew up because of major shocks arising in Asia and Russia.  It was thus on the verge of failure precisely when liquidity had dried up, and its (big bank) counterparties were in bad financial shape because of the crisis.

The Amaranth collapse was effectively a diversifiable risk, and potentially clearing improved the allocation of that risk (many of Amaranth’s positions were cleared).  But the bilateral markets could have likely handled it quite well too.  In contrast, LTCM’s risk was not diversifiable.  Clearing would have still passed the risk of its failure onto stressed financial institutions, and likely resulted in some similar emergency measure to mitigate the impact of its huge losses.  (I’ve long argued that the same would have been the case with AIG.)

Along these lines, FTAlphaville has a very interesting post describing some forthcoming research which shows that incorporating “common jumps” into models of index option prices go a long way towards explaining the volatility skew, and reconciling the skews of index components and the skew of the index:

According to a technical paper published on Risk.net by Alex Langnau, global head of analytics at Allianz Investment Management and Daniel Cangemi, head of FICC trading at EFG Financial Products, Wall Street’s next top (risk) model is actually a copula that attempts to explicitly link correlation skew to systemic risk so as to improve tail risk management of large portfolios.

The basic premise lies in the idea that the downside risk of a portfolio of assets is generally substantially higher than the downside risk of its components — because assets tend to correlate more strongly in times of crisis.

. . . .

As the authors conclude this could become extremely useful for trying to figure out the additional risk attached to asset portfolios:

We have presented a generalisation of the Merton jump option formula to multi-assets as well as diffusive skews and found that common jumps are an appropriate and intuitive way to define copulas that describe the systemic risk of a portfolio.

Financial institutions should start treating systemic risk as market data across asset classes and start to mark, risk-manage and price these effects in a systematic way.

This suggests that these common jumps are of first order importance.  And these common jumps aren’t diversifiable.  What I argue above is that the major risk that CCPs face arises from such system-wide, common shocks.  And in the event, mutualization is all but irrelevant.  Except, perhaps, to the extent that CMs attempt to limit their exposure to this risk via the default fund by undercapitalizing CCPs, thereby threatening the ability of these vital–and soon to be even more vital–pieces of market infrastructure to survive a systematic shock.  In which case, mutualization makes things worse because if some CCPs don’t survive, the knock-on effects from the original shock will be even more catastrophic.

In some respects, the issues I’ve discussed here reflect an older literature on bank runs.  One view of bank runs is that they are idiosyncratic in origin (i.e., a bad shock–perhaps even a sunspot–hits a single bank, leading to a run), but have systemic effects due the interconnectedness of the financial system.  In this view, widespread panics spread like a wildfire from a single, isolated spark.

An alternative view, associated most strongly with the work of Calomiris and Gorton, is that runs occur when depositors receive adverse information about the aggregate economy, which raises concerns about the viability of all banks.  In this view, panics involving runs at many financial institutions reflects the fact that all banks are exposed to a common risk.

The Calomiris-Gorton view, and the evidence they amassed to support it is persuasive.  In more recent times, major periods of crisis have been associated with a common shock hitting many financial institutions, rather than from the contagion of an idiosyncratic shock to one big institution laying low otherwise healthy institutions.  In these types of events, mutualization of risk isn’t of much help, and can actually make things worse.  Meaning that clearing mandates were sold largely on the basis of a misleading portrayal of, or misunderstanding of, the real dynamics of financial crises.

One takeaway from this is that there should be a very hard look at CCP capitalization, and at measuring the cost of default fund capital.  The exposure that default funds face to systematic risk affects the cost of capital–and hence the cost of clearing.  That cost should be taken into consideration when deciding the scope of clearing mandates–that is, when deciding what should be cleared.   For the analysis suggests that clearing can be very expensive, and that a major source of cost has been largely overlooked.  Forcing too much to be cleared can create costs with no corresponding benefit.

John Lothian has an interview with Deutsche Boerse’s Head of Media Relations, Frank Herkenhoff.  Compare:

John Lothian: The vertical integration of your clearing house is continuously criticized by your competitors…

Frank Herkenhoff: Vertical integration between trading and clearing generates significant user benefits. Vertical integration allows maximum innovation in trading and clearing services, by aligning incentives at the trading and clearing level, as well as promoting systemic stability. Vertical integration is efficient as it reduces double marginalization and transaction costs. NYX had already initiated the move to vertical integration, independent of this transaction. The integrated business model has proven to be efficient and secure and has consequently become a role model for the industry over the past years.

And contrast:

The execution, clearing, and settlement of financial transactions are all subject to substantial scale and scope economies which make each of these complementary functions a natural monopoly.  Integration of trade, execution, and settlement in an exchange improves efficiency by economizing on transactions costs.  When scope economies in clearing are more extensive than those in execution, integration is more costly, and efficient organization involves a trade-off of scope economies and transactions costs.  A properly organized clearing cooperative can eliminate double marginalization problems and exploit scope economies, but can result in opportunism and underinvestment.  Moreover, a clearing cooperative may exercise market power.  Vertical integration and tying can foreclose entry, but foreclosure can be efficient because market power rents attract excessive entry.  Integration of trading and post-trade services is the modal form of organization in financial markets, which is consistent with the hypothesis that transactional efficiencies explain organizational arrangements in these markets.

This is the abstract from a paper about vertical integration in clearing that I wrote in 2006, and then updated in 2007: similar material will be in the monograph I’m working on now.

If you have way too much time on your hands, and delve into the paper, you’ll see that I discuss explicitly how the alignment of incentives between execution and clearing facilitates innovation, and improves coordination of responses to systemic shocks.  I go into great detail about double marginalization.  The parallels between Herkenhoff’s last sentence (integration is the role model) and the last sentence of my abstract (integration is the modal form of organization) are also pretty obvious. So Herkenhoff hits basically all the points I made in my paper.

Coincidence?

Today is August 1.  This article suggests that 31 days of tragedy are on the way in Smolensk and points east.  It’s a long article–and it only chronicles August disasters since 1998.  (Which means that the ’91 coup is not included.  Whether you would put that in the disaster category tells a lot about you.)

August started early this year.  In July, actually, with two nautical disasters, including one in right in the center of Moscow on Sunday.  Walter Russell Mead notes that Russia is held together by duct tape, and wonders whether there is a shortage of the stuff:

Since the Brezhnev era, Russia has been skimping on maintenance. Factories, highways, bridges, rail networks, schools, hospitals: Russians have been trying to keep them running rather than investing money they don’t have to maintain, upgrade and replace them.

Corruption, low salaries and the general malaise of post-Soviet Russia make things worse.  Russia has been running on duct tape for twenty years, and now the duct tape is starting to fray.

. . . .

Ceci n’est pas un bric.

I would put more emphasis on the “general malaise” explanation.  That, and one Mead overlooks: vodka.

It is interesting to conjecture, though, why August seems so cursed.  Is it so?  And if so, why?  Thoughts, people?

This morning’s recon mission for derivatives-related stories turned up bumper crop of realizations that should have been painfully obvious, but were not made when it could have made a difference–meaning that the real pain is to come.

First, from the FT:

Quite simply, the regulators succumbed to the sheer volume of rulemakings and an avalanche of comments from the industry. There was not enough time to meet the deadline, and it became clear that implementing Dodd Frank was going to be far more complicated than initially thought.

Thought by whom, exactly?  We need to know, because anybody who admits to not foreseeing a train wreck should be disqualified from further comment or participation in these matters, (a) for not foreseeing the obvious, and (b) for copping to such cluelessness.

Next, from Financial News.  In response to the rhetorical question “Are clearing houses ‘too big to fail'”, Ben Wright writes (heh):

It is a real concern that not enough people have asked this question before now and even more worrying that no one has provide a satisfactory answer.  [The answer is almost certainly yes, though I guess that is unsatisfactory substantively.]  As the possibility of some form of huge sovereign credit event grows ever-more imminent, a solution need to be found, and fast.

It’s a little late to start thinking about packing a parachute when you’re already 30,000 feet up. But that’s Frank-n-Dodd in a nutshell (with an emphasis on the “nuts”).

Wright also recalls a speech by the BoE’s Paul Tucker (which I blogged about in June), in which this worthy

said clearing houses had to think of themselves as system risk managers and start behaving as such.  Clearing houses should, therefore, steer clear of procyclical margin practices, monitor the soundness of their members, and plan for their disappearance.

No disagreements here, except that it is insane to think that CCPs will think of themselves as “system risk managers.”  Because they aren’t “the system”, but only part of it.  They will act in their interest and the interest of their members.  That is quite different from–and often contrary to–acting in the interest of “the system.”  Clearing does not internalize most of the key externalities that create systemic risk, and all the wishing and should-ing in the world won’t change that fact.

And from Dow Jones:

Dealers and clearing experts have urged regulators to introduce so-called living wills for clearing houses, warning that a “credible” plan for unwinding critical pieces of market infrastructure is “vital to financial stability”. The comments come amid growing fears that the US government’s inability to raise its debt ceiling could prompt a global credit event.

. . . .

Roger Barton, founder and managing director at Financial Reform Consultancy, said: “It is arguable that the whole issue of clearing house resolution should have been addressed earlier.”

“Arguable”?  Go out on a limb there, Roger.

I wonder if it’s possible to fashion a parachute from the seat covers and a few stray blankets in the overhead bins.

Then there’s this article on portability in Risk.  It’s long (and gated), but the moral of the story is easily stated: this is a major issue, with systemic implications, but which is totally up in the air.  (Lot of company up there.)  There’s one on portability in the FT, coming to pretty much the same conclusion.

What, never heard of portability?  Apparently the Sorcerer’s Apprentices hadn’t either.

I could go on.  In recent days there have been numerous articles about myriad issues in clearing–collateral, margining, capital requirements, and on and on–all of which are (a) unresolved, and (b) of first order systemic importance.  All the important details were left to the end–most likely because those that demanded the system remade it, and wrote legislation demanding its remaking didn’t even know what the relevant details are.

An entire system that evolved organically with all of the complexity and interconnectedness that implies is being re-engineered on the fly.  Anyone even marginally cognizant of the complexity of the system would have been too humble to even contemplate remaking it root and branch.

But unfortunately, the marginally cognizant weren’t in charge.  The imperious, overconfident, ignorant, and foolish were–some were all of the above.

That never works out well.

Watching the follies of the Political Class brings to mind Cromwell’s speech dismissing the Rump Parliament in 1653:

It is high time for me to put an end to your sitting in this place, which you have dishonored by your contempt of all virtue, and defiled by your practice of every vice.

Ye are a factious crew, and enemies to all good government.

Ye are a pack of mercenary wretches, and would like Esau sell your country for a mess of pottage, and like Judas betray your God for a few pieces of money.

Is there a single virtue now remaining amongst you? Is there one vice you do not possess?

Ye have no more religion than my horse. Gold is your God. Which of you have not bartered your conscience for bribes? Is there a man amongst you that has the least care for the good of the Commonwealth?

Ye sordid prostitutes have you not defiled this sacred place, and turned the Lord’s temple into a den of thieves, by your immoral principles and wicked practices?

Ye are grown intolerably odious to the whole nation. You were deputed here by the people to get grievances redressed, are yourselves become the greatest grievance.

Your country therefore calls upon me to cleanse this Augean stable, by putting a final period to your iniquitous proceedings in this House; and which by God’s help, and the strength he has given me, I am now come to do.

I command ye therefore, upon the peril of your lives, to depart immediately out of this place.

Go, get you out! Make haste! Ye venal slaves be gone! So! Take away that shining bauble there, and lock up the doors.

In the name of God, go!

Yes, please–Go!

But a Cromwell with 40 musketeers is not the answer: authoritarian, Caesarian, approaches are not the way (although they are, ironically, what the Founders were concerned would be the fate of any republic–including theirs).  A nation of Cromwells a the polls repudiating and rejecting through politically legitimate means  is what is needed, and desirable.

And even then, Cromwell faced a far less daunting task, for even  if his scathing characterization of the Rump Parliament is a more than apt description of today’s legislative and executive branches, today’s Political Class is far too large to fit in a single room, and cannot be dispersed by a company of men or even a nation of voters.  Government has metastasized, and its supplicants, dependents, and co-dependents are embedded in all the tissues of the country–business, the law, and especially the media. Even when they are out of government, they still wield considerable power.

Via Ace, a pitch-perfect illustration of the cultural and intellectual divide between the Political Class and its adversaries, aka Tea Partiers [W=Brian Williams and M=Andrea Mitchell, both of NBC]:

W Andrea, you’ve seen ’em come and seen ’em go. This has hardly been a profile in courage. Have you ever seen anything like this?M … Now its stalemate, its gridlock. And I’ve never seen anything where there has been so little leadership and where people are angry, disgusted and, I think, really rebellious out there. People are wanting change and they don’t know how to get it.

W And a new dynamic, Andrea, in Washington – at least in the time you and I have been watching things. Some members have come to town and they don’t care if they get re-elected. That is a whole new dynamic. They are here for a single issue and are willing to go down in flames at the polls if they achieve it or don’t.

M There has always been anger and animus in among leaders and among the followers – the rank and file, the caucus. But these new members really are willing to tear the place down. And they not only don’t care whether or not are re-elected – they don’t want pork (laughs). There are no inducements to get them to follow the speaker or the other leaders. So they don’t want the traditional methods of buying loyalty here and that was a reform that now has changed the dynamic.

W Alright, Andrea Mitchell from our Washington newsroom. Wish there was better news to report to folks especially about our era in Govt. [Emphasis added.]

The utter confusion is palpable:  “Who are these strange people anyways?  They disdain our ways.  They do not want a lifetime sinecure, living on the public teat.  They do not respect the ritual of potlatch with other people’s money–in fact, they despise it.  How is it even possible to deal with such aliens?  With such barbarians?  They’re impossible!”

Given the wildly divergent world views between the Political Class and large numbers of The Rest of Us, the prospects for a true political accommodation are bleak, even in the aftermath of a decisive electoral result.  The contenting factions want such different things, and have such different visions, that bargaining is nigh on impossible.  As the Williams-Mitchell colloquy suggests, neither faction has anything the other wants, and indeed, each hates what the other can offer.

Which means that even a decisive repudiation of Obama and progressivism in 2012 would be, at best, the end of the beginning, and even then it is hard to see how things can come to a satisfactory conclusion.