Streetwise Professor

FCM, investment bank, primary dealer, and wanna be Goldman MF Global declared bankruptcy today.  As is typical with financial firms, the end came quickly.  The firm’s problems metastasized quickly last week.  Another quarterly loss, a ratings downgrade, and worries about losses on trades in European government bonds led to the typical downward spiral of lost funding and lost customers.  These firms are very fragile.  When they fall, they usually don’t get up.

Ironically, MF’s FCM operation was acquired from  . . . REFCO, which cratered almost exactly 6 years ago, in October, 2005.  Will anyone dare to take on this cursed franchise?

Piecing things together, I surmise that the firm bought about $6 billion in Italian and other southern Euro bonds and repo’d them out.  Due to the decline in the prices of these bonds, and the firm’s deteriorating financial condition, the repo counterparties demanded higher haircuts.  The firm couldn’t come up with the cash, and in desperation maxed out its credit lines.  But that couldn’t stop the hemorrhaging.

The most likely explanation for all this is that the firm was already foundering, and CEO John Corzine tried to gamble on resurrection by ramping up the risk.  As is so often the case, this more often results in a more rapid descent to financial hell than resurrection.

One major irony is that MF Global was pushing hard for low capital requirements for members of OTC derivative CCPs.  How’s that idea looking now, GiGi?

Especially since suspicions are rife that MF has misused segregated customer funds, presumably to keep the resurrection gamble going.  Reports state that the firm is stonewalling regulators on turning over records, and that about $300 million in customer funds are missing.  This is one of the most egregious things a brokerage firm can do.

This is already a major fall for former Goldman CEO, US senator, and NJ governor Corzine.  He is also a major Obama fundraiser, who is presumably now a Nonperson.  If the suspicions about misuse of customer funds prove true, major fall won’t even come close to describing what lies in store for Mr. Corzine.  He will long to be merely a Nonperson.

I am a longtime China bear.  The basic reasons for my skepticism are (a) an economy that relies on extensive government intervention and direct and indirect control of prices will inevitably experience massive misallocations of resources that will eventually require substantial rebalancing (“recalculation” in Austrian terms), and (b) the financial sector is particularly distorted, an myriad credit losses have been papered over in schemes that would make Enron’s Andy Fastow blush.  Massive fixed investment can generate remarkable increases in GDP, but there is reason to be skeptical about the efficiency of these investments.

Initial signs of cracking include an evident imminent collapse in the housing bubble, a steep selloff in the stock market, and growing problems in the vast shadow banking sector and municipal finance.

A couple of pieces that discuss this include this article and an interview with Jim Chanos.  From the article:

An alarming report from Schroders said Chinese banking operates in a “twilight zone” of phony accounting and shadow money and it’s all coming apart. “Almost half of all credit creation in China is off balance sheet,” wrote the team at Schroders.

They think this situation could unravel “over the next three to six months,” producing a huge crisis with international implications. Most Chinese banks, they predict, will end up as “zombie banks.”

. . . .

Albert Edwards at SG Securities warned that China’s long-running investment boom has no precedent and is bound to burst. “China is a ‘freak’ economy,” he wrote. “To my knowledge no other economy in history has experienced such high investment/GDP ratios and seen so many sequential years of strong investment growth.” The Asian tigers in the 1990s? Japan? Nothing comes close, says Edwards.

The Chanos interview is definitely worth watching.  The interviewer does her best to push the China case, but Chanos smacks her down pretty effectively.  And there’s a bonus line in the interview.  When asked about China helping Europe, Chanos responds that Sarkozy is the worst possible person to send to ask them for money.  And from initial reports, it appears that he’s right.  Although methinks that anybody the Euros could have sent would have been received just as coldly.  What could they possibly offer?

What happens in China definitely bears watching (sorry–couldn’t resist).  Financial steroids and narcotics help maintain appearances for a while, a la Michael Jackson, but eventually it all falls apart.  And in a place as big China, with its seething social undercurrents, that would not be pretty.

Not long ago, Vladimir Putin told an assemblage of foreign executives that Russia was a great place to invest.  How great?  Well, don’t ask Mikhail Prokhovrov.  Prokhorov made the mistake of getting enmeshed in the machinations of Kremlin political technologists, and had the temerity to show a smidgen of independence.  Bad idea.  So now Putin is sending Mikhail a little reminder of how tenuous his fortune and his empire are:

A delay in allowing billionaire tycoon Mikhail Prokhorov’s gold firm Polyus to sail into the prestigious FTSE 100 Index, while probably procedural, leaves nagging concerns that politics and business in Russia make for a dangerous cocktail.

The postponement, ordered by a committee chaired by Prime Minister Vladimir Putin, comes just two months after Prokhorov’s sudden exit from Russian politics following an acrimonious clash with the Kremlin.

In his brief foray into politics, Prokhorov had hoped to lead a liberal party that enjoyed official backing into December’s parliamentary election, but his autonomy and ambition unnerved Russia’s leaders and he was abruptly ousted.

Putin’s announcement that he will run for a third term as president in 2012 has reinforced concerns amongst Russia’s super rich that they own their assets at the pleasure of the country’s rulers. Prokhorov’s fortune has been estimated at $18 billion by Forbes magazine.

“The power is such that nothing is really safe,” said one industry source.

Nice little gold company you got here, Mikhail.  Pity if something happened to it–or to you.  Mikhail.  That name sounds familiar–just like Mikhail Khodorkovsky, no?

Need another example?  How about more travails for BP?  TNK-BP is continuing its efforts to torture the British supermajor: its management board is recommending that the full board vote to join in a shareholder lawsuit against BP for its attempt to deal directly with Rosneft:

But the legal net is tightening around BP after TNK-BP’s management recommended its main board discuss filing suits claiming billions of dollars in damages over the failed Rosneft bid.

The disclosure, which came on the eve of BP’s third quarter results, looked aimed at raining on the UK oil group’s parade as it seeks to turn a corner following the Gulf of Mexico disaster and the botched Rosneft deal.

The move looks likely to pose a serious new headache for the group, which is already battling a slew of lawsuits over the Rosneft bid claiming it breached a shareholder pact granting TNK-BP the right of first refusal to any new venture in Russia or the Ukraine.

So go ahead.  Be a sucker.  Listen to Putin’s blandishments.  Fools and their capital are soon parted.

It is hard to figure out what is more ludicrous, the Occupy “movement”, or the media coverage thereof.  After reading this article from the NYT (big h/t to R), I think it has to be the latter.  Your challenge this evening: to see whether you can read this article without either doubling over in laughter or vomiting uncontrollably.  It starts out ridiculously, and then plunges downhill from there:

Many Americans these days, from the huddled masses of Occupy Wall Street to the coifed confines of the presidential campaign, are talking about the future of capitalism.

Masses?  A couple of hundred people in this city, a couple of hundred more in that, in a country of 300 million, count as “masses”?

The article is about the efforts of people in the People’s Republic of Boulder, CO to replace its “corporate” utility with a publicly-owned venture.

What really stands out is the incredible, overweening self-regard of these people.  For example:

Proponents of ballot issues 2C and 2B, which includes a $1.9 million tax increase in the first year to pay for planning and analysis, say that the utility industry desperately fears a public awakening, and that a John Brown-like raid on a monopoly in one place could galvanize electricity consumers all across the nation to push for change.

John Brown?  Really.  Yeah, fighting against chattel slavery.  Renewable energy.  Same thing.

And yeah.  I’m sure electricity execs are just paralyzed with fear.

And this:

In the electricity fight, left-leaning politics have been aligned with hard science, supporters say, creating a unique platform for thinking creatively about electricity and democracy.

Climate and weather research, in particular, has a huge presence in the city, at federal institutions like the National Center for Atmospheric Research and the National Oceanic and Atmospheric Administration along with the tech-heavy University of Colorado that sprawls through the center of town. More than two-thirds of the population over age 25 has a bachelor’s degree or higher, according to census figures — compared with just over 36 percent for Colorado as a whole.

Aren’t they special?  Obviously so superior to the other ignorant Coloradoans.  (Wait: I thought Occupy was fighting on behalf of the 99 percent–many of whom don’t have “bachelor’s degrees or higher.  The condescension is nauseating.)

And of course, many of these two-thirds have degrees that might–might–qualify them to serve a latte.

If Boulder wants to serve as a vortex of stupidity and overpay for electricity, far be it from me to stand in their way.  But the Occupy movement wants to inflict its idiocy on the rest of us.  That’s a different story.

The OWS types and their fellow travelers are abetted by a media that consistently overlooks the hard core leftist elements, the incoherence of its message, and the anti-social behavior of many of its (ironically, socialist) participants.  The utter credulousness of this NYT piece on Boulder, with its gratuitous and silly portrayal of the Occupy types as representative of some “huddled masses” that exist only in the imagination of Kirk Johnson and his ilk, is all too typical of most media coverage.  If Occupy was shown for what it truly is, a collection of muddled asses, the entire charade would collapse in an instant, exeunt accompanied by well-deserved gales of derisive laughter.

Gillian Tett of the Financial Times is shocked! shocked! to learn that Frankendodd: (a) has dramatically increased the complexity of financial markets; (b) creates myriad opportunities for regulatory arbitrage; and (c) gives advantages to big, sophisticated, politically juiced players that can decode, game, and influence the regulatory process most effectively.

Yeah.  I can sympathize.  It’s not like anybody could have seen that coming.  Nosiree.

In an early South Park episode, desperate for help on a school project requiring them to formulate a business plan, Stan, Kyle, Kenny, and Cartman enlist the aid of their jittery friend Tweek’s Underpants Gnomes (h/t KW).  The Gnomes’ foolproof plan?:

1. Collect Underpants
2. ?
3. Profit

The Gnomes see to have taken their brilliance to Europe, because the vaunted rescue scheme hatched over the last few days looks like:

1. Announce grandiose plan
2. ?
3. End Crisis

Each major element of said grandiose plan has many “?”.

Take the bank “recapitalization”–please.  How do the Eurognomes know that banks will respond to the capital requirement by adding equity capital, rather than dumping assets and contracting their balance sheets?  If the banks do decide to raise capital, who is going to invest?  Is compliance with the capital ratio going to be determined using legit asset valuations–particularly on Euro debt, or some mark to fantasy accounting?  What happens if the banks don’t meet the new requirement?

Next consider the “haircuts.”  The IIF (a banking industry group) cross-its-heart-hope-to-die promised that banks would volunteer to take a 50 percent haircut on Greek debt.  Will the banks actually respond to the call?  Is 50 percent really adequate to address Greece’s problems?  Recall that just last week it was revealed that 60 percent reductions in Greek debt were necessary to put the country on a sustainable path: 50 percent of 50 percent of Greece’s overall debt is less than 50 percent of the way to 60 percent.  And is it really 60 percent?  There are evidently “sweeteners” in the deal: where is that money going to come from?  And doesn’t every Euro in financial HFCS just reduce the amount of Euros the vaunted EFSF has to backstop other countries?  If Greece gets a 50 percent haircut (OK, 25 percent), what effect will that have on the Portuguese, Italians, etc.?

And speaking of the EFSF, let us turn to “leveraging” it.  Where is the additional money going to come from?  Where is the money going to come from?  Where is the money going to come from?  (Repeat as needed.)  ECB money–out.  Sarkozy is going to China, hat in hand.  The Eurognomes are hinting broadly that the BRICs, the IMF, your Aunt Fanny, are all welcome to invest in some CDO/SPV contraption that will buy debt from shaky Euro countries.  The EFSF will take the first 20 percent of the default losses.  But investors could buy debt in the secondary market or at auction at prices that reflect estimates of default probabilities and recovery rates.  What is the real benefit of getting involved in the Gnomes’ financial engineering scheme?

No, this entire scheme is aspirational.  It defines the end state that the Euros would like to achieve, but does not specify an even remotely credible path to get there. Just like the Underpants Gnomes’ dreams of profit.

Nonetheless, the equity market and the Euro staged a euphoric Tinker Bell rally yesterday–one of the most frenzied yet.  Ominously, however, today’s Italian bond auction was not a success, with low participation and yields on the 10 year at over 6 percent.

Betting on the Eurognomes foolproof plan is, IMO, foolish.  They are failing to grapple with the fundamental arithmetic, and the fundamental choices: amputation or gangrene, socialization or monetization.  Until they do, you’re better investing in Tweek’s Gnomes’ strategy for financial security.

Starting with my earliest post-crisis writings on clearing, I have pointed out repeatedly that the supposed virtues of clearing–netting and greater collateralization–look far different when you examine the nexus of financial contracts as a whole, rather than focusing on derivatives alone.  A primary effect of netting and greater collateralization  is to increase the seniority of derivatives in bankruptcy.  But if you increase the seniority of one claim, the seniority of other claims is reduced.  Sure, you can make derivatives more secure, but at a cost of making other claims less secure.

The systemic implications of this are ambiguous.  The implicit presumption seems to be that derivatives are somehow uniquely threatening to the stability of the financial system.  I say “implicit” because the clearing pom-pom squad has never discussed explicitly the distributive aspects of reshuffling priority via regulation, so I don’t even know if they are even aware of it.

But it is not hard to imagine scenarios in which giving derivatives even greater advantages in bankruptcy (due to safe-harbor provisions they already have a lot) can cause a systemic problem, but through another channel.  For instance, derivatives counterparties of a firm teetering on the brink of failure may rest easy given their priority status, especially if the CCP is considered safe.  But other claimants may not be so serene.  For instance, consider money market mutual funds  that invest in the paper of the dodgy firm.  Realizing that they will be totally hammered in bankruptcy, the investors in the money market fund may run.  That would not be pretty.

It’s even more complicated than that, because given the new seniority rules, there is likely to be widespread alterations in capital structures of derivatives market participants, and repricing of those claims.  Who knows how that is going to play out, and what new fragilities will be baked into the new structures?

This point is finally dawning on people.  One person who caught on long ago is Harvard’s Mark Roe.  Today, he published an oped that makes the point clearly and forcefully. It is definitely worth a read.

Money quotes:

Equally problematic is the fact that, while the clearinghouse and its participants can net wins and losses to reduce risk for those inside the clearinghouse, the clearinghouse does not assuredly eliminate the basic risk facing the entire financial system. Often, it merely transfers that risk to creditors outside the clearinghouse.

. . . .

Whether the clearinghouse reduces systemic risk depends on the relative systemic importance of those inside and those outside the clearinghouse – AIG versus Citibank in this basic example – not on the clearinghouse’s capacity to reduce risk among its members. In this example, if Citibank is precarious and is as systemically vital as AIG, the clearinghouse has obscured that it has saved AIG only by transferring risk from the clearinghouse to Citibank, which then fails.

Much recent regulatory activity has focused on enabling, enhancing, and requiring clearinghouses for these kinds of financing arrangements. Yes, clearinghouses offer many benefits, including greater transparency, better pricing, and better regulatory focus, and we should try to make them viable. But regulators world have overestimated their overall benefit. Too much of what is justified as reducing systemic risk is really just offloading risk onto others.

Exactly.

Reading Mark’s piece  brought to mind Bernanke’s quoting of Puddin’ Head Wilson in his discussion of CCPs.  Bernanke said if you are going to put all your eggs in one basket, keep a very close eye on that basket.

One of my problems with the whole CCP debate is that too often the tendency is to treat derivatives as the only eggs that matter.  But if you pay attention only to the basket with the derivatives eggs, you will not pay attention to other ones that are as valuable, or moreso.

To change metaphors, target fixation all too often leads one to miss the bogey that just jumped your six, with fatal results.  The obsessive focus on derivatives, and clearing, is a form of target fixation.  It risks diverting attention from other potentially mortal dangers. You need to have a system-wide perspective to truly understand systemic risk.

Mark is generally negative on giving derivatives any priority.  He has written things very critical of safe harbors.  He and I have discussed this, and have agreed to disagree: I can see reasons for differentiating the treatment of derivatives from other claims.  But the important point is to understand that this is an issue, and one that has to be examined from a system-wide perspective, because seniority rules shift risk around.

Mark gets that, and makes serious arguments about what the right rules should be.  Unfortunately, all too many of those who make the decisions and the rules don’t appear to get it.

Like Tim Worstall, I am puzzled at all of the machinations in Europe to avoid a hard Greek default in order to avoid triggering CDS.  Apparently the concern is that payoffs on CDS would potentially jeopardize the financial health of banks that sold protection, leading to contagion.

Greek CDS represents about 1 percent of debt outstanding, with a notional amount outstanding of about $4 billion.

Look.  If European banks collectively cannot handle a $4 billion payout (which would be the maximum, assuming zero recovery), then their problems are even worse than feared.

To worry about the $4 billion CDS, rather than the $471 billion in outstanding Greek government debt, is beyond bizarre.  This suggests some weird sort of obsession among the Euros about derivatives, and CDS in particular.  You don’t have to look far for more evidence of this obsession.

And remember, CDS are zero sum.  Ever dollar paid by one party is received by the counterparty.

Moreover, many of the CDS contracts will have been entered by banks looking to hedge exposure to Greek sovereign debt, and private Greek debt.   Restructuring Greek debt in a way that leads to substantial writedowns but does not trigger CDS screws the hedgers worst: they suffer losses on their bonds, and their hedges do them no good whatsoever.

Punish the hedgers.  Wow.  That’s a really constructive policy.

And there are long-term consequences.  In particular, the effective abrogation of Greek sovereign CDS contracts will raise questions about the reliability of other outstanding sov CDS.  Many hedges are looking far shakier now, for if the Euros do backflips to avoid triggering Greek CDS payouts, just think of what they would do for Italy or Spain.  Since it is the most risk averse banks that would have decided to hedge, and since risk aversion depends in large part on the bank’s financial condition, this hurts the most risk averse (and likely weakest) banks most.  Less hedging will be done going forward, but risks will be transferred regardless–through the cash markets.  CDS prices will become less reliable (probably a feature rather than a bug to the Eurocrats).

Ironically, this creates a new speculative trade–a trade on the basis between CDS and the bonds–in which the parties effectively speculate on the political risk inherent in CDS.

There will be knock-on effects too.  If private contracts can be circumvented for political reasons in the case of sovereign CDS, the risk that other derivative contracts can be effectively nullified increases too.  The risk is probably greatest for other CDS–notably European bank CDS–but it exists for other types of derivatives too.  All because once you admit the principle that “payouts on derivatives contracts can spread contagion”, you can’t limit its application–or the risk that the principle will be applied–only to Greek CDS.  Just this once.  Pinky swear.

Looking at the whole European fiasco brings to mind Churchill’s quote about the United States always doing the right thing, after trying everything else first.  The Euros try about everything, but they don’t look like they are going to the right thing.  The exact opposite in fact.

Obama made another unilateral move, this time on student loans.  Here’s the uhm, highlight of the article:

Obama is going to take steps that bypass Congress “every week going forward,” White House Communications Director Dan Pfeiffer told reporters yesterday in Washington.

I’m waiting for the NYT editorial raging against the Imperial Presidency.  Any minute now.

All this debt forgiveness somehow brings Shay’s Rebellion to mind.  Or the Populist and Granger ferment of the late-19th century.  It is inherently divisive, because every dollar that the debtor gets is a dollar the creditor–or the taxpayer–has to pony up.

Obama also warned that if he loses in 2012, the government won’t help you: “You’ll be on your own”:

At a million-dollar San Francisco fundraiser today, President Obama warned his recession-battered supporters that if he loses the 2012 election it could herald a new, painful era of self-reliance in America.

“The one thing that we absolutely know for sure is that if we don’t work even harder than we did in 2008, then we’re going to have a government that tells the American people, ‘you are on your own,’” Obama told a crowd of 200 donors over lunch at the W Hotel.

“If you get sick, you’re on your own. If you can’t afford college, you’re on your own. If you don’t like that some corporation is polluting your air or the air that your child breathes, then you’re on your own,” he said. “That’s not the America I believe in. It’s not the America you believe in.”

Count me out of that “you”, pal.  No, the America I believe in produced Ralph Waldo Emerson.  You know, the author of “Self-Reliance.”  Somehow I think nanny-in-chief BHO is not a big RWE fan.

Inspired by the “self-reliance” reference in the story quoted above, I found Emerson’s essay on line, and began to read it.  (It’s been a while since I have read it.)  I stopped short at the first line of the second paragraph:

There is a time in every man’s education when he arrives at the conviction that envy is ignorance

That is obviously an anachronistic statement, and a comment on how education has devolved.  Listen to the sociology majors in OWS and you’ll understand that many have received an education, such as it is, that celebrates–worships, fetishizes–envy.

The polarization between the Emersonian America, and the anti-Emersonian America epitomized by Obama is becoming more extreme by the day.  It is, to use the title of a Sowell book, the conflict of visions that will define 2012 and the years that follow.  The visions are so fundamentally different that the prospects for compromise are nil.  Meaning that the next 12 plus months are going to be like nothing seen in this country for a long time indeed.

All you clearing and market infrastructure aficionados must read Bill Hodgson’s piece on collateral transformation at DerivSource.  He points out quite accurately the new sources of fragility and vulnerability to stress that will arise from collateral transformation services that are being offered to finance CCP margins in the aftermath of clearing mandates.

The bitter irony here is that many derivatives end users (real money investment funds, industrial hedgers) did not pose any real systemic risk under bilateral structures.  But forcing them to clear drives them to utilize funding mechanisms that are systemically risky.  As one big corporate end user told me: clearing mandates have transformed credit risks into liquidity risks: I can manage the first, but the second scares me.

I continue to gape in amazement that the sorcerer’s apprentices that created these mandates did not think to step two.  They did not step back and ask: “Gee, we’re imposing a major change on the structure of financial markets.  How will market participants respond?”  This is especially unbelievable since a big component of the narrative of the financial crisis is that it was the result of excessive financial engineering.  What, did FrankenDodd, Timmy!, GiGi, the G-20, the EC, etc., think that the big changes that they imposed would not lead to a new burst of financial engineering?  Are they really that clueless?

I think I know the answer.  I think you do too.

Markets do not stand still.  Market participants will adjust contracts in response to regulations and laws motivated by beliefs that the existing system of contracts is flawed.  A useful first approximation is that these contractual adjustments will try to reproduce the economic substance of the banned or restricted contracts.  However, many of the work-arounds necessarily utilize less efficient–and often more fragile–ways to achieve that substance.  Which means that vulnerabilities have largely been relocated, rather than eliminated, and in many cases the new vulnerabilities are more dangerous than the old.

Read Bill’s piece to get an excellent illustration of this dynamic at work.  And then remember that the biggest systemic risk is government, and in particular, ill-considered government policies.  And that’s especially true when static-minded legislators and regulators attempt to impose their vision on a dynamic, strategic, reacting, self-ordering system.