Streetwise Professor

There is an increasing drumbeat of stories warning about the systemic risks posed by CCPs.  This FTAlphaville article discusses several dangers I’ve discussed repeatedly, including the stresses put on liquidity, the concentration of risk resulting from the reconfiguration of the topology of the financial network that results from central clearing, and wrong way risks.  Several articles, including this one, report on the BOE’s Deputy Governor Paul Tucker warning about the lack of plans for resolving insolvent clearinghouses–a fear echoed by the ECB’s Peter Praet. Risk has a long article about various CCP risks; particularly interesting is the discussion of the contingent liability that clearing members face in the event of a “forced allocation” of a defaulting member’s portfolio.  The Risk article also reprises an SWP theme about the stupidity of limiting clearing member ownership and control of CCPs.

And the beat goes on.  Although not about clearing directly, this story on the downgrading of MF Global does have implications for clearing, given the CFTC’s decision to require admission of firms with as little as $50 million in capital to CCPs.  And speaking of the CFTC, its recently adopted clearinghouse rule requires CCPs to have enough capital to cover the failure of its single largest member, not the two largest: as I noted in my ISDA white paper, not only should a CCP have enough capital to cover two big defaults, it should have plan to replenish capital after even a single failure.  Although the CFTC may revisit the requirement later, pending negotiations with the Financial Stability Oversight Council, a failure of a single member–not even the largest one–of a CCP will likely require the services of Kevin Bacon do deal with the resulting run:

Needless to say, none of these stories are a surprise to me. I’ve been warning that CCPs could be Trojan Horses packed with systemic risk for a long time, to no avail. I hope that, unlike Cassandra, my warnings are mistaken. But it is becoming abundantly plain that these concerns are becoming far more widespread. It would have been better had that happened before politicians, regulators, and central bankers fallen victim to groupthink and seized on clearing as a “solution” before they had closely analyzed the problem in all its complexity. But the G-20 put its imprimatur on clearing, and the groupthinkers are not about to admit a mistake and start all over. So market participants and regulators are having to deal with the realities of a framework that poses dangers that may be different than, but just as threatening, as those clearing was intended to address.

So now we know where commenter “a” (he of the Chicago obsession) has been hanging out (courtesy AT):

I actually love this.  Chicago, and Friedman in particular, are so in their heads it isn’t even funny.  Obsession is the sincerest form of flattery.

Ever since the financial crisis began, those who had been smarting at the whipping that Friedman had delivered over the previous decades leaped on the crisis as an opportunity to heap scorn on him, who conveniently for his critics, was dead.  Had he been alive, he would have delivered another whipping.

This attempt to blame the crisis on Chicago is rather pathetic–and a fact- and logic-free exercise.  Anybody who thinks that recent American, let alone European, policy was designed, built, or even approved at 59th and University is, quite frankly, an ignoramus.

Bleating about “deregulation”–whatever.  Many deregulatory policies that did bear the Chicago stamp, and which were actually implemented, in things like trucking, rail,  and air transport, have worked pretty much as advertised–and had nothing to do with the crisis.  But to think that financial policy over recent decades is largely Chicagoan is just wrong.  Yeah, Chicago types generally supported changes to Glass-Steagall, but these changes had absolutely nothing to do with the crisis, just as Glass-Steagall itself changed things that had nothing to do with causing the Great Depression.

I could go on about this for far longer than I have time for right now, but let me just mention a couple of things about Friedman in particular that prove just how bogus it is to heap blame on him for what blew up in 2008.

The first is monetary policy.  Friedman was an arch foe of the discretionary monetary policy implemented by Greenspan and then Bernanke in 2001-2008.  You may criticize Friedman’s monetarism, and if it was implemented during the 90s and 00s maybe different problems would have occurred.  But if Greenspan and Bernanke had been acting according to Friedman’s lights, they never would have committed the egregious errors that they did.  Friedman did not believe in “maestroes.”  Indeed, he believed they were dangerous.  He was utterly correct in his beliefs.

The second is the nexus between finance and government.  One of the foundations of Friedman’s belief in small and limited government is that private interests would exploit government power to seek rents. A lot of that went on in the lead up to the crisis.  To blame it on Friedman-Chicago libertarianism is farcical.

The third relates to the current crisis, which has the potential to make one look back wistfully on the halcyon days of 2008 and 2009.  It is a crisis of government spending, government entitlements, and government debt.  All of which Friedman in particular warned about for virtually his entire life.

I could go on.  The Euro and the EU, for example.  But suffice it to say that blaming Crisis I or Crisis II on Friedman and Chicago economics is delusional.

But we enjoy the attention!

And we really enjoy living rent free in your heads, particularly since there is so much available space.  Beats rent control any day.

The Euro summit is apparently a complete disaster.  No surprise.   There’s just no way around the math.

The most recent estimate is that to get Greek debt to sustainable levels of 110 percent of GDP by 2020, it will be necessary for Greek bondholders to take a 60 percent haircut–but the Euro fin mins are still talking about 50.  Always a day late and a few billion Euros short.

But 110 percent isn’t sustainable, really.  Especially for a country with as feckless a tax system as Greece’s.  80 percent may be stretching it.  So that gets us to approximately a 70 percent haircut.

These numbers threaten to consume the EFSF “in one gulp.”  And that’s before getting to Portugal, not to mention Spain and Italy.

One minister recognizes reality:

So pointless was the gathering, that Didier Reynders, the Belgian finance minister, left early to attend the world premiere of the new Tintin film, The Secret of the Unicorn.

The Euros really need the secret of the unicorn.  It may be their only hope.

Update.  As Tim Worstall notes, the haircut the private debtors must take is larger because the others (like the ECB) cannot take haircuts.

If you were wondering whether the Fed has run out of ideas, wonder no longer:

Federal Reserve officials are starting to build a case for a new program of buying mortgage-backed securities to boost the ailing economy, though they appear unlikely to move swiftly.

The idea would be to target any new efforts by the central bank at the parts of the economy that are most severely impeding a recovery—the housing and mortgage markets—by working to push down mortgage rates.

Lower mortgage rates, in turn, could encourage more home buying and mortgage-refinancing, and help the economy by freeing up cash for consumers to spend on other goods and services. Mortgage rates are already very low, but some Fed officials believe they might be pushed lower. Moreover, Fed officials believe their past purchase programs helped to lift stock markets, by driving investors from low-risk investments toward riskier investments.

What is it that Einstein said about doing the same thing repeatedly, and expecting a different result?  Now I remember: insanity is what he called it.  The emphasized paragraph suggests that the Fed is ready for the rubber room.

OK.  Don’t look for help from monetary policy.  What about fiscal policy?  Well, today’s WSJ presents a Keynesian lament that Americans’ saving is impeding a recovery:

Since the financial crisis erupted, millions of Americans have ditched their credit cards, accelerated mortgage payments and cut off credit lines that during the good times were used like a bottomless piggybank. Many have resorted to a practice once thought old-fashioned—delaying purchases until they have the cash.

As a result, total household debt—through payment or default—fell by $1.1 trillion, or 8.6%, from mid-2008 through the first half of 2011, according to the Federal Reserve Bank of New York. Auto loan and credit-card balances in August had their biggest drop since April 2010, the Federal Reserve said.

The national belt-tightening, known as deleveraging, comes as the U.S. economy struggles to fend off a double-dip recession. Paying off bills slows consumer spending on appliances, travel and a slew of other products and services. Home sales, the engine of past economic recoveries, remain depressed.

Is it somehow shocking that Americans are trying to rebuild ravaged balance sheets?  Is it shocking that they realized they were overleveraged prior to the financial crisis, and are trying to achieve a more sane level of debt?

This also means that Krugmanesque, Old School Keynesian borrowing solutions are unlikely to work either.  Those solutions depend on leveraging up on behalf of households, but those households can undo–and are likely to undo, given their recent behavior–most of all of that by reducing private leverage in response.  Hair of the leverage dog will not cure the hangover.

Which all means that both fiscal and monetary policies are at dead ends.  There are no quick policy fixes.  Indeed, frenetic attempts to find and implement such fixes are likely to make things worse, not better.

Kinder Morgan’s Richard Kinder let it all hang out last week.   He laid into two of my favorite targets: the Obama administration’s unicorn-based energy policy and Gazprom.

On US energy policy:

Mr. Kinder didn’t stop there. He also regaled company employees, including many watching by webcast, with tales of his meetings with President Barack Obama and his energy secretary, Steven Chu.

He said he was “astounded” at how little consideration they gave to natural gas as a “game changer.” As time has gone on, he said, Mr. Obama and his aides have come to realize that “in the real world that the rest of us live in, you know, natural gas is really important.” But they “still like bicycles and wind,” Mr. Kinder said. And “you know, they loaned a lot of money for solar panels,” he said to laughs, in an apparent reference to the administration’s loan guarantees to Solyndra LLC.

That’s gonna leave a mark.  The White House’s response?  Pathetic:

“The President has made clear that natural gas has a central role to play in our energy economy,” a White House spokesman said in response.

Whatever.  Yes, gas will play a central role in the US’s and the world’s energy economy.  And Obama and Chu won’t have squat to do with it.  Private ingenuity and private capital are changing the game.  Public “ingenuity” and public “capital” generate waste, not power, pace the Solyndra debacle (which is only the first and most well-known of a slew of government-funded alternative energy snafus).

On Gazprom:

The bankers advising him, he said, had declared it to be the biggest pipeline company in the world. “And I said, ‘Wait a minute. What about that Russian company called Gazprom?'” he recounted at the company’s Houston headquarters. “We are not as big as [Russian Prime Minister Vladimir] Putin’s Gazprom, but then we don’t break people’s kneecaps either,” he said. “We just have to rely on ordinary persuasion, you know.”

Too true.  Too funny–in a kind of black way.  And as the previous post demonstrates, if Gazprom ever has to rely on ordinary persuasion, it is in deep trouble.

By the sounds of this speech by deputy chairman Alexander Medvedev, Gazprom is indeed feeling that its beloved oil-linked pricing mechanism is under siege.  Medvedev’s tone is very defensive, and his arguments risible.  How risible?  Let’s deconstruct.

Fail #1:

“Oil-indexed , long-term contracts that ensure the basic supply volumes from Russia, Qatar, Norway and Algeria… are exactly the mechanism that protects all the parties, since the gas market is not like, for example, the fish market, where you can catch, sell, and make a profit in one day,” Medvedev said.

Well.  Oil isn’t like fish: don’t catch, sell, and profit in a day on oil.  But there are vibrant spot and term markets for oil: oil prices aren’t linked to anything else, but fluctuate minute-to-minute with market forces.  And gas isn’t like fish either, but there is a vibrant spot and term gas market in North America.  So it’s obviously nothing inherent in gas as a commodity that precludes the development of a vigorous spot market, or necessitates oil-linked pricing.

Jeez, apparently Medvedev has been consulting with Gensler about inane market analogies.  Gensler: apples.  Medvedev: fish.  Both: lame.

Fail #2:

“Two-and-half years of abominably low spot prices in Europe have created the illusion that gas has lost its link to oil once and for all. This is not true.

So gas has decoupled from gas in the short run.  Even if they recouple in the future, gas is always coupled with gas.  A gas-based pricing mechanism can never become decoupled from gas, but gas and oil can become decoupled.  So the movement away from oil-linkages towards reliance on robust gas pricing mechanisms reduces the risk of decoupling and more efficient pricing.

Fail #3:

Spot-price trading is incapable of giving correct price signals to the market due to the small volumes and low liquidity.

Trading volume is endogenous.  Liquidity feeds liquidity.  As the US experience shows, liquid and deep cash and derivatives markets can develop very quickly given the right structural conditions: movement away from oil-linked mechanisms would accelerate this process dramatically.  What’s more, the Dutch gas hub is already pretty liquid, as is the UK’s National Balancing Point.  They certainly give better pricing signals than oil.  They will only give more accurate signals as market liquidity develops–which it will quite rapidly if oil-linked pricing and contracts fade away. Moreover, prices that don’t reflect fundamentals spur transactions that tend to eliminate inaccuracies.

Fail #4:

“US prices are so low they do not cover operating costs and in our opinion this situation will not last long. The situation there will return to normal and will make the US market attractive again.”

A lot of smart people are betting otherwise.

And here’s some whine to go with all that fail:

Medvedev also hit out at Europe’s efforts to reduce Gazprom’s dominance. “Natural gas has become a hostage of geopolitics in which there is an artificial demonisation of Gazprom,” he said. “Sometimes it seems that if even the export of bananas or coal were the largest source of budget revenues for Russia, it is in this area that political games would be played. We do not believe that there is an energy security problem in the EU.”

All at once now: awwwwwwwwww.  Boo-frickin’-hoo.  Poor, poor, persecuted Russia.  Poor, poor, misunderstood Gazprom.

Amazing.  Gazprom is a grotesquely inefficient state protected monopoly with a reputation for thuggishness, corruption, and opacity.  Gazprom isn’t demonized: it is justifiably reviled.  100 percent natural ingredients: nothing artificial about it.

Again, it warms the cockles of my heart to hear Gazprom attempt to defend an archaic pricing mechanism.  The defensiveness means they are feeling the heat: the silliness of their arguments makes it plain that the economics are inexorably consigning oil-linked contracts to oblivion.  The fundamentals of the gas market are changing as dramatically as the contracting practice: indeed, these fundamental changes will drive the move to new pricing mechanisms.

Medvedev knows that Gazprom is a Soviet relic that will face daunting difficulties in a more competitive environment in which gas fundamentals, not oil fundamentals, drive prices.  Gazprom is attempting to fight market forces, but in the end, market forces will win–with bleak consequences for Gazprom, and the parasitical class that feeds off it.

I have only had time to skim press coverage of the new Mifid & Mifir promulgated by the European Commission, but on my initial read, that appears to be a fair description.  All of the bad ingredients of Frankendodd made worse, with some special Euro accents of a decidedly dirigiste flavor.  The same deep suspicion of markets, the same cartoonish view of why market structures have evolved as they have, the same conceit of knowledge and control, the same breezy disregard for unintended consequences.

Sorcerer’s apprentices run amok, again.  Led by a French apprentice no less.

After July 21, 2010, who woulda thunk that regulatory arbitrage would have thrown business in the US’s direction?  If Mifid and Mifir go through anything like what Barnier et al propose, that could well happen.

There has been a lot of hyperventilating over this Bloomberg story about the transfer of derivatives positions from Merrill Lynch to Bank of America.  Much of the commentary, most notably by Felix Salmon, has expressed outrage at dumping risk on the deposit insurance fund.

The Bloomberg story focuses on the fact that FDIC and the Fed are at odds over the transfer. This tells you a lot, and what it should tell you is not comforting.  Both sides are talking their book, and what the Fed is saying reveals its concerns about stresses in the market, and particularly on dealer firms.

FDIC is obviously and justifiably concerned about the contingent liability it assumes as a result of the transfer.  Presumably the Fed is not oblivious to this.  So why would it favor the transfer?

I think it speaks volumes about the Fed’s concerns over the condition of dealer firms.  In the current environment, the most worrisome ones would be Merrill, Morgan Stanley, and perhaps to a lesser degree Goldman.  All of these have seen their credit spreads widen recently.  Concerns about creditworthiness of these firms can lead to runs.

I don’t think that runs on derivatives per se are the issue: yes, counterparties can seek to novate, or find other ways to get cash out of their dealers with whom they have in-the-money positions (although that’s not as much of an issue with standard interdealer CSAs in which no credit is extended.)  But counterparties, customers, and lenders of/to dealer firms who are concerned about the derivatives exposure of a dealer of questionable creditworthiness have an incentive to reduce their exposure to the dodgy firm.

This, ironically, illustrates the systemic danger associated bankruptcy rules that give derivatives trades priority: it gives ostensibly junior claimants who can pull their money an incentive to get out first. You can’t evaluate the systemic risks of derivatives without considering capital structure more generally.

And there are reports that big non-dealer counterparties are getting nervous about dealer creditworthiness.  Novation inquiries are increasing as dealer credit spreads have gapped.

[Black humor moment in linked article:

“We’ve not experienced clients moving away from us. On the contrary, we’ve seen more clients come to us as a result of our strong positioning in the equity derivatives markets,” said a source close to one French bank.

Sure.  Remember that the French have claimed their banks have “no toxic assets.”  Which presumably explains why Sarkozy is running around like his head is on fire and his a** is catching it (h/t Charlie Daniels) trying to get the Germans to recapitalize French banks.]

Thus, my interpretation of the Fed’s action is this.  It sees the conditions are ripe for a customer and funder run on Merrill.  It wants to reduce the risk that customers and lenders perceive.  The less risk in ML, the lower the likelihood that customers and lenders will get the urge to go for a jog–or a sprint.  Reducing ML’s derivative exposure reduces its risk, and makes a destabilizing run less likely.  Not that BAC is in great shape, but it is less vulnerable to what the Fed fears than Merrill is, and less vulnerable to a depositor run precisely because of deposit insurance.

So that’s the real story here, IMO: the Fed’s encouragement of the move of ML’s derivatives to BAC reveals its nervousness about the vulnerability of ML, and some dealer firms generally, to a run.  From its perspective, moving the derivatives risk to BAC is the least bad option. If you believe that runs are an inefficient equilibrium outcome–and that is a reasonable belief–doing something to reduce the likelihood of a jump to that equilibrium makes sense.  And that’s what the Fed appears to be doing.

And no, that shouldn’t give you the warm and fuzzies.

During this week’s bus tour, Obama repeatedly asserted that it was necessary to pass the “jobs bill” in order to save the jobs of teachers, firemen, and the like.  Biden joined in, and predicted that failure to pass the jobs bill would lead to more rapes and murders, due to layoffs of police.  And it just ain’t Crazy Joe: Jay-the-most-aptly-named-man-in-DC-Carney said that Obama “absolutely” agrees with Biden.  Harry Reid weighed in, claiming that public employment was the priority, because “it’s very clear that private-sector jobs have been doing just fine.”

An aside. First: what planet is Reid living on?  (NB: not the first time I’ve asked this question to myself.)  Second: can you imagine the hue-and-cry, the gnashing of teeth, the rending of garments, had any Republican said anything remotely similar to what Reid did?  S/he would have been labeled the second coming of Marie Antoinette* for her/his callousness, insensitivity, lack of compassion, condescension, etc., etc.

But on to my substantive point.  Since when, in the nearly 225 years of this Republic, has the employment of firemen, policemen and teachers been the responsibility of the Federal government?  Indeed, the entire concept is a mockery of the idea of a “federal” system.

I know that the Constitution is a sad shadow of its former self, primarily the result of a relentless centralizing assault beginning in the Progressive era.  (The Progressives being arch-foes of many things in the Constitution, federalism among them.)  But the idea that it is somehow the responsibility of Washington to secure the employment of teachers, etc., represents a complete mockery of the most basic ideas of the Constitution.

Brought to you, ironically, by a former lecturer in Constitutional Law.  (Not professor.  Professors at least attempt to engage in original thought and scholarship.  Obama just lectured a few classes then: he lectures the world now.)

Public education, and police and fire protection are quintessentially local activities.  Local communities internalize the benefits of these activities, and should bear the costs.  It is fundamentally defective as an economic matter, even ignoring Constitutional constraints, to shift the costs of providing these services to people who do not realize the benefits.  That just leads to waste and inefficiency.

But this isn’t about the Constitution, or economic efficiency.  This is about paying off Obama’s (and Reid’s, etc.) constituencies.

Sadly, I have looked in vain to find any relatively prominent person in politics object to the Obama-Biden-Reid efforts on principled Constitutional grounds–which in turn are based on a solid political and economic principle of delegating decision making authority to those who are directly impacted by said decisions.  Which suggests that disrespect or indifference to the most basic Constitutional tenets is a bi-partisan affair.

Not that this is news, but seldom is it so blatantly on display.

*Yes, I know Marie Antoinette’s “let them eat cake” is a fabrication, first found in Rousseau.  Just another reason to pay no attention to Rousseau.  But for worse or for worse, Marie is the poster girl for callous indifference to human suffering.  In contrast, Harry Reid’s comment is fully documented, yet he is getting a pass.  Particularly from the intellectual heirs of Rousseau.

It is passing strange–or maybe not–that the OWS crowd/mob is giving Fannie Mae and Freddie Mac a pass.  They are the best example of an unseemly nexus between government and business.  Look at the guys who were their CEOs and board members over the years.  Democratic Party stalwart–and Obama BFF–James Johnson, who walked away with a cool $200 mil.  Former Clinton appointees Jamie Gorelick and Franklin Raines.  Bill Daley.  All of whom did very, very well feeding at the GSE teat.

Us?  Not so much.  For those of you keeping score at home, the tab for F&F is now $169 billion.  And the meter is still running: current estimates are for an additional $51 billion in losses over the next 10 years.  That’s $220 billion for you OWS types who majored in sociology.

The.  Biggest. Losers.  (I mean F&F, not OWS–but the race is a close one!)  But nary a has been hippie or wannabe hippie in sight camping out at those places.  Twinkles down, dudes.

Many economists on the left–notably Krugman, DeLong, and Thoma–deny, deny, deny that F&F were primarily culpable for the subprime crisis.  As I said in an earlier post, Krugman et al evaluate the F&F pudding by claiming that the ingredients were A-OK: specifically, they claim that F&F did not take on much subprime or Alt-A risk, but that banks did.  Hence, the banks did it.

There are two problems with this.  First, as former FNMA chief credit officer Edward Pinto has shown, the F&F puddings were in fact pretty well stuffed with low credit quality mortgages.

Second–and more importantly–loss follows the risk.  If F&F lost a lot on subprime and Alt-A, it is because they were exposed to its risks in massive amounts.  As the biggest losers, they were collectively the biggest risk takers.  The biggest suppliers of risk capital to the low-credit end of the housing market.

As I said in my earlier piece:

The proof of the pudding is in the eating.  We are now eating F&F’s losses.  They demonstrate, quite forcefully, that their brand of pudding was rotten.  Going on and on about statistics allegedly demonstrating the quality of the ingredients doesn’t mean squat if the first bite makes you puke.

And we’re still puking.  To the tune of $169 billion, with billions more on the way.

Krugman et al have never–ever–confronted this simple fact.  Their stirring defense of the GSEs has no credibility whatsoever until they can show how F&F lost such huge sums without being exposed to the housing price and credit risks inherent in subprime and Alt-A.

Clarifying question, guys (you can’t see my hand with my fingers cupped in the shape of a C, but it is!):  if they were exposed to these risks, and in huge amounts larger than any other single entity, and in larger amounts than the total represented by multiple non-GSEs, how is it possible to say that they were not a major contributor to the housing boom and bust?

The failure of Krugman et al to answer that question is very revealing.  I don’t see how it is possible to square the fact of the huge loss with their contention that F&F were bit players in the boom and bust.

And until the OWS people OFF, they are just adding additional proof–as if any is needed–that they are truly clueless about the truly outrageous nexus of corruption in US finance.  So folks, either OFF–or F-off.

Update: F&F are very similar to the kinds of corporations that Adam Smith and the Founders disliked and distrusted.  Specially chartered corporations that were give extraordinary privileges and used to dispense political favors.  Companies that grew large because of artificial advantages conferred by the Federal government, not as a result of prevailing in competition in the marketplace.