Streetwise Professor

December 20, 2011

Don’t Let the Door Hit You on the Way Out, Barney*

Filed under: Derivatives,Economics,Financial Crisis II,Politics,Regulation — The Professor @ 9:54 am

Retiring Congressman Barney Frank, the Frank of Frankendodd, felt compelled to share some parting wisdom on whether in the aftermath of MF Global it was appropriate for the CME to exercise self-regulatory powers:

“I have no doubt about the CME’s integrity, but nobody should be in the position of having a dual role,” Rep. Frank said. “We should make sure [a conflict of interest] doesn’t arise, that the temptation isn’t there, that people are not unconsciously influenced

. . . .

Rep. Frank pointed to the separation of the Nasdaq Stock Market, now owned by Nasdaq OMX Group Inc., from the National Association of Securities Dealers.

That process began in 2000 and saw the NASD become a full-time regulatory body now known as the Financial Industry Regulatory Authority, or Finra. Part of the rationale of that move was to separate the regulatory function from a for-profit exchange operation.

“I think it would be better if they did what NASD did,” Rep. Frank said.

He said that.  He really did.  He held up Finra–the Finra that couldn’t find Madoff and Stanford with a map and both hands–as the model to emulate.  Seriously.

Of course the Finra (or government regulation) models are superior because the people who work for them are saintly, and never subject to temptation.  They are never subconsciously influenced.  They are Spock-like creatures, incapable of being captured, influenced, or duped.

And they have the best information and the strongest incentives.

Sure they do.

As I said in my weekend post, perfection is not an option here.  A serious analysis of incentives and information is required.  And of course, as I said in that post, Barney Frank doesn’t provide any serious analysis.  His is the epitome of Beltway superficiality: he invokes “conflict of interest” as if that is the only relevant consideration, and cites some example that is ridiculous on its face.

And he doesn’t get called on it.

Would somebody please–please–ask the man a serious question in response to such bleatings?  Would somebody please  challenge him on the Finra lunacy?

* Because doors are expensive.  Note: click on the link only if you have a strong stomach.

December 19, 2011

The Chinese Humpty Dumpty

Filed under: Economics,Energy,Financial Crisis II,Politics — The Professor @ 12:55 pm

I’ve opined for over two years that China’s economy is very fragile and deceptively robust: I characterized it as a “Michael Jackson economy” kept functioning by doses of artificial stimulants, which postpone the ultimate adjustment, but which make that reckoning all the more harrowing when it comes–as it must. There have been other advocates of this view, notably short sellers like Jim Chanos, but until relatively recently the consensus was that China would slow gently, and experience a “soft landing”.  In recent weeks, however, the consensus is clearly shifting towards the alternative view that China is increasingly vulnerable to a big fall.

This is best illustrated by the fact that nearly polar ends of the opinion spectrum, from the WSJ to Krugman, have agreed that China’s situation is increasingly fraught.

The previous optimism by some was actually the primary reason for my pessimism.  The Tom Friedman School of Sinology, which has far too many adherents (including many corporate types here in the US), argues that China’s centralized policymaking system will allow it to respond to crises in a forceful, technocratic way unhindered by the political messiness that has interfered with economic policy in the US, and particularly Europe.

Alas, fascism always has its admirers, not least among the smart set opinion makers and the board rooms of large corporations, where it is all to common to think of economies like companies run by managerial fiat, rather than as spontaneous orders coordinated via the price system and other forms of market contracting.

To me, this centralization is a bug, not a feature.  Centralized resource allocation invariably leads to substantial distortions.  In China’s case, the extreme orientation towards investment in driving GDP growth should be a clear signal of misallocation.  In 2008 and 2009, China responded to the crisis by dramatically easing credit and encouraging investment in infrastructure and housing.  A lot of money got spent, and a lot of measured GDP was created, but it is increasingly doubtful that the true market value of these investments, which would represent the actual value created, is anywhere near the amount invested.  The decline in housing prices is one symptom of that.  The fact that many big infrastructure projects, like the glittering high speed rail systems that Obama marvels over like an 8 year old watching a Lionel whiz around the track on Christmas morning, are unable to cover even variable costs, let alone generate a return on investment, is another.

Governments can spend, or distort prices to encourage spending.  Creating actual value from the spending is something else again.

Moreover, China’s supposedly wise planners have created a financial system that would make Rube Goldberg proud, and which exhibits all the pathologies and brittleness of past systems that have collapsed in ugly crashes.

The Chinese have constructed a system that is intended to (a) channel savings via big banks for lending to the kinds of companies and projects that the government wants to support, and (b) generates spreads for banks to help them generate income to overcome the consequences of past bad investments.  This system involves paying very low rates to depositors who have limited investment alternatives.  Most Chinese depositors actually earn negative real returns.

But these price controls–like all price controls–encourage efforts to circumvent them.  In China’s case, investors looking for higher returns are circumventing the formal banking sector by directing capital to the informal shadow banking system. This system utilizes a crazy quilt of products like wealth management products, letters of credit, and bank acceptances.

Much of the capital raised via the shadow banking system has been channeled into real estate, loans to companies rationed out of the formal banking system as the result of government policies to try to rein in inflation and speculation, and to lending to local governments with extremely dodgy finances (being heavily dependent on real estate sales for funding).  Thus, the asset side of the balance sheets of these entities is extremely risky.  The liability side is, moreover, very fragile and prone to runs–just like the shadow banking system in the US was in 2007-2008.

Put this together and you have a very big financial Humpty Dumpty teetering on the verge of a very big fall: risky assets funded with run-prone liabilities, and all that operating in the financial shadows.  Those who marvel at the wonders of a state dominated system (e.g., the Tom Friedman China cult) are not worried.  They are serenely confident that all the Party’s horsemen and all the Party’s men will be able to put Humpty Dumpty back together again.  This optimism is passing strange, given that CCP policies are primarily responsible for Humpty Dumpty’s existence, and his parlous state: policies that encouraged the rapid expansion of a shadow banking system, and which stimulated extremely investment-intensive growth with little regard to the economics of the projects this stimulus spawned.

What could give Humpty a push?  Well, given China’s export-orientation, the most obvious candidate is a slowdown in Europe which appears increasingly certain.  The main open question here is how severe the contraction will be.  That depends on the wildly unpredictable (because it is primarily politically-driven) outcome of attempts to address its sovereign debt crisis.  But it is also possible that Humpty could fall purely due to internal factors, without an external push.  The existing balance is very precarious.

As I’ve mentioned before (mainly in the comments), it is very difficult to predict the timing of these things.  But it is plain to see that Humpty is teetering, and that the odds of a fall are appreciable.

This helps explain why open interest in very low strike crude oil puts is increasing dramatically: if Humpty does fall, it will be extremely bearish for commodities.  (Deep-out-of-the-money-calls on crude are also quite popular now, reflecting the situation with Iran.)

So I remain pessimistic on China.  It is interesting to have much more company in that view.  Interesting, and at the same time a little unsettling: having Krugman on the same side is always reason for a rethink!

December 17, 2011

Perfection is Not an Option

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 4:54 pm

Donkey years ago, when major exchanges were beginning the process of transforming from not-for-profit member owned firms to for-profit investor owned ones, there was a considerable amount of discussion over whether it was appropriate for for-profit exchanges to exercise regulatory functions.  The concern was that they would be subject to conflicts of interest that would undermine their incentive to regulate fraud and manipulation on their marketplaces.

I wrote a paper on the subject at the time, but shelved it in large part because these fears dissipated rather rapidly.  In the aftermath of the MFer debacle, however, they have returned with a vengeance.  Barney Frank just opined that the CME should not be a self-regulatory organization.  Yeah, I know, it’s Barney Frank (and aren’t you leaving Barney, so why not shut up?), but he’s not alone in his call.  Indeed, I get the sense that this is the emerging conventional wisdom.

So perhaps it’s time to revisit and revise that paper–thankfully Word is backward compatible!

I’ll use this post to summarize some of the arguments in that paper, and apply them to the MF/CME situation.

The main conclusion of the paper is that in comparing alternatives–self-regulating non-profit, member owned exchanges and self-regulating investor owned ones, the latter probably have stronger incentives to regulate most forms of bad conduct.

I divided the kinds of misconduct potentially subject to exchange oversight into two categories: misbehavior by agents (such as brokers cheating their customers), and market manipulation.  Based on my extensive analysis of self-regulation of manipulation, I concluded that neither type of exchange can be expected to self-regulate manipulation well.

With respect to agency problems, I concluded that for-profit exchanges are actually likely have a stronger incentive.  Member owned exchanges have more of a potential conflict of interest because the agents are among the exchange owners: some owners benefit directly from the (bad) conduct at issue.  Moreover, there is a collective action problem: perhaps one broker’s misconduct harms the others, by damaging the reputation of the exchange, but this is a public bad from the perspective of other broker-owners and free rider problems undermine the incentive of the brokers to act against it.

If you want a great example of that, look at the conduct on the floors in Chicago that was uncovered in the 1989 FBI sting.

With a for-profit exchange, however, inefficiently lax oversight of agents reduces the derived demand for the exchanges services, reducing its profits.  Put differently, for profit businesses are harmed when the suppliers of complementary services engage in misconduct that harms customers: brokers and exchanges provide complementary services, and misconduct by the former harms customers and reduces the demand for the latter’s services and hence its profits.  This gives the latter–the exchanges–a high powered incentive to police the supplier of (complementary) brokerage services.  Making them self-regulatory organizations permits them to engage in such policing and act on this incentive.

Against this it is sometimes argued that exchanges are likely to go easy on big brokerage firms that are their big customers.  But the ultimate customer is vitally important here too.  It is in the exchange’s interest that these ultimate customers are served by the most efficient, highest quality agents.  Higher cost/lower quality agents translates into lower derived demand for the exchange’s services.  Customers served by a broker that poses undue risks to its clients can go to another broker if the exchange cracks down  on the malfeasor.  The crackdown doesn’t reduce the exchange’s derived demand: it increases it, even if the broker is large.  Indeed, the risk posed by a bad broker to the exchange is all the greater, the bigger that broker is.  Which all means that there are fundamental problems with viewing the brokerage firms like MF as the exchange’s customers.

My argument depends crucially on there being a mechanism by which the self-regulating exchange incurs a cost when it engages in too little oversight.  The most likely mechanism is a reputational one, in which revelation of broker misconduct not caught by the exchange leads demanders of trading services to revise downward their estimate of the quality of the product they are getting (i.e., they conclude that they are at greater risk of being cheated by brokers), trade less (or are only willing to pay lower prices for exchange services), and thereby reduce exchange profits.

In the case of the CME and MF, this mechanism is clearly at work.  In the price of CME stock has fallen about $21/share since immediately prior to the MF blowup.  This represents a decline of market capitalization of $1.4 billion–approximately the same magnitude as the the missing money.  The work in the 1980s of Peltzman & Jarrell shows that it is quite common for product quality problems (that result in recalls) causing losses in market cap to the firm whose products are recalled that are far larger than the cost of the recall itself.  Bad quality outcomes have costly reputational effects.  This provides an incentive to avoid bad quality outcomes.

My paper drew from the property rights literature, which showed how the power of incentives could affect the incentives to supply quality.  That literature shows that a high power incentive system (like for-profit organization) could lead to a less efficient supply of quality than a low power incentive system (like non-profit organization) when quality was non-contractible or non-observable, and other mechanisms (like reputation) don’t cause a for-profit entity to internalize the effects of providing inefficiently low quality.  I concluded that this non-contractibility/non-observability issue was not relevant for the agency problems and other problems (such as informed trading).  Thus, I concluded that for-profit exchanges were likely to be better self-regulators of agent misconduct than non-profit ones.

The MF case doesn’t change my opinion on that.

But that is not necessarily the alternative being advanced by Frank et al. They presumably want to transfer all regulatory authority to the government.  To agencies like the CFTC and the SEC–which also had regulatory oversight responsibilities over MF, and didn’t stop the blowup and the possibly illegal appropriation or transfer of customer money.  Agencies that are subject to very low power incentives (except maybe for ass covering).  The CME is being pilloried for failing to stop the transfer of money that apparently began immediately after its auditors left MF: the SEC didn’t catch Allen Stanford or Bernie Madoff from stealing huge sums over periods of years–years–despite numerous warnings.

So I’m sure that yeah, handing over all regulatory responsibility to the CFTC and SEC will ensure nothing like MF ever happens again. And I also believe, as Christmas approaches, that Santa Claus is going to bring me a new Ferrari.

Actually, to extend Samuel Johnson’s aphorism, such recommendations are like 5th marriages: a triumph of idiocy over experience.

The facts in the MF case are still murky.  The collapse of a brokerage firm is not all that exceptional.  The potential theft of a billion plus in customer seg funds is very exceptional.  The issue is whether the CME could have stopped this theft.  Quite clearly such an action cannot be stopped by any ordinary and routine auditing.  Indeed, the money disappeared immediately after the last audit.  So preventing the theft would have required some extraordinary action, such as taking over control MF’s customer funds, transferring accounts, etc., earlier.  Given the truly exceptional nature of what MF apparently did, any assertion that CME should have done that reeks of hindsight bias: a common theme of the post-event commentary by industry people is that MF did the unthinkable, so it is pretty unrealistic to expect anyone to take actions to prevent the impossible (or unthinkably unlikely).

Self-regulation is imperfect.  Government regulation is imperfect.  Under either system, stuff happens.  Choosing which of these systems is, as Churchill said of democracy, the worst except for all the others that have been tried from time to time, requires a careful comparative analysis that focuses on incentives and information.  I’ve done that type of analysis in the past, and concluded that there is no single answer.  Exchanges do a lousy job at policing manipulation, and that function is best left to ex post legal enforcement–including private enforcement via civil lawsuit.  Exchanges–especially for-profit exchanges–do better at policing bad agents like brokers.  Not a perfect job, but their information and incentives are stronger in this case than in the case of manipulation.

The MF case shows that there is a market feedback mechanism at work that imposes costs on exchanges when people and firms they regulate do bad things.  Self-regulation harnesses that feedback mechanism, and it would be foolish to discard it on a whim based on an incompletely understood single instance like MF.  That’s doubly true given that the proposed alternative–complete reliance on government regulators–has more than its share of examples of proven failure, with Madoff and Stanford again being only the most prominent examples.

Remember.  Perfection is never an option.  Getting the right institutions in place requires a careful comparative analysis of the alternatives.  I can guarantee you Barney Frank hasn’t done that.  Nor have most people who are bold in their opinions on the matter. I’ve carried out such an analysis some years ago, and don’t claim to have the answer, but I know enough to say that (a) the situation is not so cut and dry and Barney et al make it, and (b) there is a colorable case that exchange self-regulation of certain forms of conduct is like what Churchill said about democracy.

And also remember that data is not plural of anecdote, and that anecdote and analysis are not synonyms.  Right now people are making strong recommendations on the basis of a single anecdote, and doing so before it is understood in any detail.  So I will withhold judgment, and when I make it I will endeavor to do so informed by the MF example, but also by a more complete comparative analysis of the incentives and information under the alternatives.

December 15, 2011

TiVo Time: SWP Media Watch

Filed under: Uncategorized — The Professor @ 4:25 pm

I am scheduled to be on Bloomberg TV with Stephanie Ruhle at 0745ET/0645CT tomorrow, 16 December.  Talking about Europe and/or MF.  So set your DVRs!

Always Look on the Bright Side of Life

Filed under: Economics,Politics,Russia — The Professor @ 10:35 am

I thought I’d seen everything.  I thought that I could not be surprised by Putin chutzpah.  I was wrong:

Prime Minister Vladimir Putin said the positive side of bribery in Russia is it shows that people have money to spend.

Putin was speaking in his annual call-in television show from Moscow today.

The entire 4.5 Castro-esque filibuster was chock full of paranoid rantings about the US, which included an assertion (immediately rejected) that US Special Forces killed Gaddafi and claims that the US was fueling the protests in Russia.  He scorned the protesters, saying that he thought their symbolic white ribbons reminded him of condoms tied in an unusual way.   He flipped out on John McCain–who is becoming a pathetic figure, which makes Putin’s fury all the more pathetic itself. In a characteristic moment of projection, he claimed that the US wanted vassals not allies.

With regards to corruption, I’m reading Douglas Allen’s The Institutional Revolution, which argues that corruption in pre-modern England (mid-17th century, say) was an efficient way of aligning the incentives of servants of the monarchy with the interests of the crown in an era when measurement costs precluded the use of modern bureaucratic ways of inducing good behavior by government agents.  This got me to thinking of whether a similar argument can be made in Russia.  Commenter markets.aurelius has pointed me to an interesting PhD dissertation by a German poli sci student that speaks to that point.

I’ll give it some further thought.  I can see corruption as a way of aligning incentives in a hierarchical system.  The main difficulty in applying the Allen argument to modern Russia is that it does not seem immediately obvious that the measurement cost argument holds: Allen relies very heavily on the fact that in pre-modern times the ability to control and observe outcomes was highly limited by technology.  For instance, given the vagaries of the winds, it was very difficult to know whether an admiral’s fleet didn’t close for battle because he was a coward or a shirker, or because the winds didn’t cooperate.  According to Allen, the development of standardized production and measurement technologies made it easier to control and observe outcomes, thereby reducing monitoring costs, and reducing the need to rely on “efficiency wage” type incentives, which Allen believes corruption to be.

So, hopefully more on this topic at a later date.  Until then, just marvel at Putin’s cheeky effort to look at the bright side of corruption.  And sing along with Eric Idle.

*Or, as @SaraLabib tweeted, Putin is looking at the bribe side of life. You’re right Sara. He does: 24-7.

December 14, 2011

The Putin Market. Now That’s a Judo Move!

Filed under: Economics,Politics,Russia — The Professor @ 2:44 pm

Since the Russian Duma election, Russian markets have been swooning.  The Ruble is off about 3.6 percent.  The two major stock indices, RTS and MICEX, are down about 11 percent.

But they are stellar performers compared to companies tied directly to Putin. Including particularly his judo buddy Gennady Timchenko’s Novatek, and utilities that Putin is likely to slap around as part of a populist political campaign.  I wonder if Timchencko’s (and if reports are to be credited–Putin’s) truly malign oil trading company Gunvor is seeing counterparties get a little nervous and wanting to price political risk into some of their deals.  That would be perfectly understandable as there would be a lot of rocks turned over if Timchenko’s political krysha and possible partner were to fall from power.  Those dealing with Gunvor would no doubt have a lot of ‘splainin’ to do Lucy.  That would be uncomfortable at the very least, and perhaps quite costly, and these costs will affect their willingness to deal with Gunvor and the prices at which they are willing to trade.

The whole point of judo is to turn one’s opponent strength and energy against him.  Even a slight loss of balance puts Putin–and his judo buddies and other various elements benefitting from the nouveau kormlenie system–at risk of a very big fall.

Behold the natural state at work.  In which political connection is a company’s most important asset, and where even a modest tremor in the political landscape can trigger big sell-offs.

And yes, the US is becoming more of a natural state–witness GE.  Which is precisely why I write about Russia: it serves as a cautionary tale of the dystopian results of a natural state order that is personalized and politicized.  Extreme and pure cases are often the most revealing, and Putin’s Russia is about as pure an example of the personalized, de-institutionalized natural state as you can find in the modern world.

Which brings to mind other subjects.  One is the weird conjunction between Russia, as epitomized by RT, and the Paulian fringes who are very convinced that the US is already a corrupt natural state.  The other is the utter silence of Zero Hedge on what is going on in Russia.  ZH gives extensive play to the corruptocracy theme–if the US is involved.  It lionizes OWS.  It typically motivates this advocacy with some connection to market events.

The course of Russian markets over the last 10 days provides a perfect opportunity for Tyler Durden or WTF writes for ZH to fulminate about the perverse effects of the politicization of companies and markets, and to laud those protesting a corrupt system.  But nothing but crickets chirping.  Hell, ZH is so quiet on this you can hear one-legged crickets chirp.  That’s not surprising: just another data point.

The Kremlin Endorses SWP

Filed under: Politics,Russia — The Professor @ 1:49 pm

I’ve often written about Russia being on Putin’s Hamster Wheel From Hell.  From the WSJ, a Kremlin insider concurs:

“We perfectly realize what is going on,” one Kremlin ideologist told me recently. “But it’s too late to jump off the train. The new authorities will come after us and arrest us [if we lose power]. That’s why we have no option but to keep running like a hamster on a wheel.”

Amazing how some people come to revelations about the abuse of police powers for political purposes, and the potential benefits of a rule of law.  Mr. Ideologist is projecting/mirror imaging, but sadly, he’s probably right to do so.  Because that is a testament to the larger hamster wheel Russia has been on for centuries.

December 12, 2011

Economic Policy By Escher–or an ’80s LA Hard Punk Band

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 10:27 pm

Trying to follow the latest European approaches to the sovereign debt crisis is enough to induce vertigo.

Earlier today I noted that Sarko said that European banks should buy more European government  debt.  A while later I read Yalman Onaran’s article in Bloomberg, which said that southern European banks were looking to their governments to bail them out:

European banks turning to their governments to raise required capital could trigger a downward spiral of declining sovereign-debt prices and further losses for the lenders.

The European Banking Authority ordered the region’s banks on Dec. 8 to raise 115 billion euros ($154 billion) by June. Faced with dwindling profits and unable to tap capital markets to sell new shares, firms may be forced to seek government help. About 70 percent of the capital requirement falls on lenders in Spain, Greece, Italy and Portugal, countries struggling to convince the world they can pay their debts.

So the banks bail out the governments and the governments bail out the banks.

It seems that Escher had sketched out these plans in some detail years ago:

And if you know what band I’m referring to: get your mind out of the gutter!

Precommiting to Print

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 1:40 pm

In the ongoing European crisis, everyone is looking at the European Central Bank to ride in to save the day.  The ECB is to serve as the lender of last resort (LOLR) for sovereign borrowers suffering liquidity problems.

There are two major problems with this.  First, lending to sovereigns is very different than lending to private institutions.  Second, there is a substantial probability that there are solvency problems for many European sovereigns.

The idea of an LOLR is that it can provide liquidity to financial institutions that cannot fund themselves on the market due to runs or the unwillingness of creditors to roll over debt.   These funding problems can arise due to a coordination problem among depositors/creditors.  The LOLR can prevent the coordination on an inefficient “run/don’t fund” equilibrium, meaning that just its existence can prevent the occurrence of runs, and if a run does indeed occur, it can mitigate its adverse effects.

In the 19th century Bagehot described the basic rules for the LOLR: lend against good collateral, at penalty rates.  This has been the mantra of central bankers ever since, although in the crisis both of these principles were pushed to their limit–and perhaps beyond.

The penalty rates aspect of the Bagehot formula is to ensure that healthy institutions do not attempt to get cheap funding at the central bank’s expense.  The collateral aspect is intended to increase the likelihood that the borrower is in fact solvent–it has assets sufficient to back the loan that is being extended to it.  Of course, valuing that collateral is a challenge, particularly in times of market stress when fire sale problems can cause the market values of assets used as collateral to plunge.

The Bagehot formula doesn’t work well with sovereigns.  What collateral will Italy pledge, for example?  The Uffizi Gallery?  The Coliseum?

But there is a more fundamental problem.  It has long been known that sovereign debt is different than private debt because of the higher cost of enforcing payment on sovereign debt.  Indeed, it is something as a puzzle as to how sovereign debt can exist in the first place: why would the sovereign ever repay?  One answer is that reputational concerns lead to repayment.  But it is prohibitively expensive to rely on reputation to enforce every debt contract in every state of the world: sometimes the benefits of avoiding existing debts exceeds the cost of not being able to borrow more in the future.

Since sovereign debt is different, and far more difficult to collect on–due to the lack of collateral and the high cost of enforcement of the debt contract–an LOLR to a sovereign is in an entirely different position than an LOLR to a private entity.   One should therefore be very cautious about extending the LOLR model from banks to countries.

This likely explains the ECB’s reluctance to commit to serving as the LOLR for Eurozone countries.

The European governments are trying to entice the ECB by providing political promises and ad hoc treaty changes to serve as a substitute for collateral, and as a way to enforce the payment of sovereign debts.  Last Friday’s “deal” was just the latest attempt at this–and the latest failure.  It is evident that the mechanisms advanced by Sarkozy and Merkel are inadequate.  First, they are just a variant on the pie crust promises made–and broken–in the past.  They will be, for instance, just another invitation to engage in Greek-style accounting and financial engineering.   Second, the mechanism of a “fine” for violation of deficit limits is something of a joke.

And consider the full game tree.  Let’s say that based on the promises of big borrowers to behave in the future, the ECB buys huge amounts of Greek, Italian, Portuguese, etc., debt today.  It now faces tremendous credit risk, and is at serious risk of holdup.  For example, if the ECB holds several hundred billions in Italian debt, and a year from now Italy has not made serious progress on restoring its fiscal balance and as a result is facing continued difficulty in rolling over its debt, what is the ECB going to do?  Will it say to Italy: you didn’t live up to your commitments, so you’re on your own?  Then Italy spins into the abyss and the ECB suffers a huge credit loss–and almost certainly becomes insolvent itself.  It can’t seize and sell collateral (see above).

No, instead, the ECB is likely to throw good money after bad.  Knowing this, Italy can play hardball with the ECB, and fade its commitments to fiscal probity.

It’s like the old joke.  If you owe the bank $1000 and you can’t pay, you have a problem.  If you owe the bank $1,000,000,000 and you can’t pay–the bank has a problem.  (Cf. Donald Trump’s bankers.)   And if you, sovereign borrower, owe the ECB on the order of 100 (or 500 or 1000) times that, the ECB has a big problem.  Lending today effectively commits it to lend more and more and more in the future.

Given this reality, the ECB’s response to the “deal” has been equivocal.  It understands the game tree.  It understands that the mechanism proposed by Sarkozy and Merkel does not overcome the fundamental problem with sovereign debt.  It understands that lending huge amounts to Italy or another European government today will put it in a position where it will feel compelled to lend even more in the future.

The markets’ response to the ECB’s equivocation has pretty brutal: European credit spreads widened, the equity markets have sold off, and the Euro is down about 1.5 percent.

Sarko in particular is panicking.  Here’s all the evidence you need: given that the ECB won’t lend to countries directly, he is proposing to launder the money through European banks:

At its monetary policy meeting on Thursday, the ECB offered ultra-long 3-year financing to banks and eased rules on the collateral it requires from them to tap its funds. It also cut its interest rates to a record low of 1.0 percent.

Euro zone leaders seized on the increased liquidity provision as a means to help fight the debt crisis, which has pushed up borrowing costs for countries on the periphery of the bloc – including G7 economy Italy – to unsustainable levels.

French President Nicolas Sarkozy said the ECB’s increased provision of funds meant governments in countries like Italy and Spain could look to their countries’ banks to buy their bonds.

“This means that each state can turn to its banks, which will have liquidity at their disposal,” Sarkozy told reporters at the summit in Brussels.

No problems with that plan. None whatsoever.

Well, other than the fact that European banks are hugely leveraged; have been under pressure to increase capital which they have done by shedding assets, including the debt of the riskier European countries; and are effectively backed by the very sovereigns whose debt they are supposed to buy.  Sarkozy’s “plan” that undercapitalized banks buy more government debt and then use it as collateral for ECB loans creates the very same problem for the ECB as it would face if it lent directly to Italy or Spain: a huge exposure to European sov debt credit risk that would effectively force it to continue to buy, buy, buy in the future even if the fiscal condition of these countries stays bad or gets worse.

And it is beyond satire that someone like Sarko, who has conniptions over banks taking on sovereign credit risk via CDS, thinks it’s perfectly copacetic to take it on by buying the actual bonds.

The basic problems with sovereign debt and the parlous condition of European sovereign borrowers means that if the ECB intervenes aggressively today, either directly or indirectly via the Sarko cutout plan, it will likely be doomed to monetize in the future.  A LOLR to sovereigns can’t do the same things that a LOLR to private debtors can.  Sovereign debt is different.  If reputational effects, or different mechanisms, don’t induce governments to do today what they need to do to get the markets to fund them, why would these mechanisms get them to do that in the future?  Indeed, the problem is all the worse once the LOLR provides the funding today because those that it lends to can threaten to bankrupt it in the future if it doesn’t.

The ECB may capitulate.  It is under tremendous pressure.  But that won’t make the problem go away: it will just defer it and likely make it worse. We’ll just proceed down the game tree until the ECB prints like crazy.

What are the alternatives?  Relatively flush governments agree to assume some of the debts of the weak sisters?: but the willingness and ability of Germany, etc., to do that is limited.  An agreement that credibly commits borrowers to perform, and take measures that ensure their ability to do so in the future?:  given all the problems with negotiating and enforcing such an agreement, this seems farfetched.

No, the fundamental problems with sovereign debt seem to put all the conventional solutions out of reach.  Sovereign debt contracts have to be self-enforcing, and current conditions have put those contracts outside of the self-enforcing range, or at the very edge of it.  Making the ECB a sovereign LOLR won’t address these fundamental self-enforcement problems, and indeed, it may make them worse.

December 10, 2011

Beneath Their Olympian Gaze

Filed under: Politics — The Professor @ 8:05 am

An interesting parallel between AG Holder’s (AKA Mark Rich’s flack) and Jon Corzine’s testimony at different hearings in the House this week.


Holder said he is “ultimately responsible for everything that happens in the Department of Justice” but that it is unrealistic to think he is aware of every investigation — even those that could have international ramifications such as the outrage in Mexico over Fast and Furious.

“There are all kinds of operations going on right now in the Justice Department about which I know nothing [Sergeant Schultz again!]  because of the way the Department of Justice is structured,” he said.


“I never intended to break any rules. I’m not in a position given the number of transactions to know about the movement of any specific funds. I certainly would never intend to have segregated funds moved,” said Corzine.

. . . .

In his testimony, Corzine distanced himself from some hands-on aspects of the firm’s business practices.

“Even when I was at MF Global, my involvement in the firm’s clearing, settlement and payment mechanisms and accounting was limited,” Corzine said.

“I was stunned when I was told on Sunday, October 30, 2011, that MF Global could not account for many hundreds of millions of dollars of client money.” [It would have been much better had he said “I was shocked! shocked!”]

Guns used to kill hundreds walking across the border with not just the cognizance of Federal “law enforcement” officials, but their active connivance.  A mere billion dollars walking out the door, and vanishing into thin air.  Details.  Details.  Far beneath the Olympian gaze of progressive titans such as Eric Holder and Jon Corzine.

So riddle me this: how can one take seriously their progressive promises to look out for the little people when they apparently know little and couldn’t care less about what the little people that work for them do?

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