Streetwise Professor

The coordinated intervention of central banks calmed the European situation in the runup to 9 December EU summit, but the fundamentals of the situation have not really changed.  To get a handle on how things might play out, it’s worthwhile to lay out the basic facts.

1. Some countries on the Euro will never be able to pay back what they owe.  Greece is clearly at the top of the list, but Portugal is likely in the same boat.
2. Other countries, notably Italy and Spain, are not clearly insolvent, but they are in a sufficiently parlous fiscal condition, and have enough short term debt that must be rolled over, to make them vulnerable to speculative attacks that make these rollovers impossible.  In the event, this would result in default.  Put differently, these countries are sufficiently dodgy fiscally that they are at serious risk of a shift from a rollover equilibrium to a run equilibrium.
3. The European Central Bank is not supposed to print.
4. The ECB is not supposed to serve as a lender of last resort (LOLR).
5. In terms of the insolvent countries, default would be very costly not just for the debtors, but the creditors.  Some highly leveraged European banks with huge balance sheets would likely become insolvent, likely requiring government bailouts.
6. Given the price stability mandate of the ECB, the debts of Greece, etc., can’t be inflated away.  Even if the ECB mandate was abandoned, inflating away the problems of the Greeks, etc., would have huge distributive effects in a single currency. The real value of all Euro-denominated sovereign debts would decline.  (As would the real value of Euro-denominated private debt.)   This would lead to huge transfers of wealth across the Eurozone and worldwide.  It could cause S&L-like problems with European banks, as the real value of their long term assets would decline more than the value of their shorter term liabilities, making them insolvent on a mark-to-market basis.  German fear of inflation is not just a Weimar neurosis.
7. There are various means of allocating losses as a way of avoiding default.  Some of the obligations of the insolvent countries could be assumed effectively by richer countries through Eurobonds, for example.  Some of the obligations could be written off “voluntarily” by holders of the debt of insolvent countries.
8. The liquidity problems of Italy could potentially be addressed by allowing the ECB to act as LOLR, but this exposes the ECB to substantial credit risk.  Realization of credit losses could result in inflation (with the implications discussed in 6) or the recapitalization of the ECB, with the cost paid by the taxpayers of the more fiscally solid countries.
9. Any mechanism (e.g., Eurobonds, closer fiscal union) to address the debt problems of insolvent or illiquid nations will likely create substantial moral hazards.
10. The bargaining problem is a multi-lateral one.  Moreover, the bargainers (heads of government) are agents for disparate interests that will be impacted very differently by alternative outcomes.
11. Multiple issues/alternatives are up for negotiation.
12. There are serious problems with enforcing any deal that is negotiated.  For instance, if Germany prevails in its insistence that any fiscal transfer mechanism be accompanied by fiscal reforms in the debtor countries, its ability to enforce this agreement is highly limited.
13. Germany and the other relatively fiscally sound states could afford to bail out Greece, and maybe Greece plus Portugal.  Those plus Italy, or Spain, or Spain and Italy–no.
14. A deal extended to any state (e.g., a substantial writedown of Greek debt) becomes a precedent (or focal point) in negotiations with any other state.

In other words: a fine mess.

The costs of default or inflating away debts are large for the creditor countries.  This gives the big debtors substantial leverage in negotiations: it is well know that it corporate bankruptcies, equity can often extract substantial amounts from creditors, and something analogous is true with spades here.

Also, these costs give rise to a huge bargaining range, which in turn encourages all sorts of opportunism and gamesmanship, and which can result in failures to come to agreement.  EU political mechanisms, and the large number of parties involved, increase the likelihood of such a bargaining failure.

It’s hard to see this ending well.  If I had to guess, I’d say it will go something like the following.  The costs of default, or of inflating away insolvent countries’ debts, are so large that the debtors will have substantial bargaining power. Germany et al will have to find some way of writing off or absorbing a big chunk of these debts, but will demand in return some mechanism to ensure that the debtors adhere to fiscal discipline, to which the debtors will grudgingly promise to implement.  Given such a deal, the ECB will find its way to serve as an LOLR, mitigating the liquidity problem for Italy.

But the debtors’ promises to get their fiscal houses in order will not be credible, and will not be enforceable.  So even if the Euros successfully escape their immediate predicament, it will return with a vengeance before too long.

And even this not-so-rosy-rosy-scenario (in which reckoning is merely postponed for a bit, rather than banished for all time) is not a sure thing.  The bargaining problems–huge bargaining range; the massive distributive effects of any deal, and the fact that different deals could have very different distributive effects; large numbers of participants in the negotiation, with the negotiators being subject to conflicting demands from their diverse domestic constituencies; the difficulty of enforcing any deal–are ugly individually, and arguably intractable collectively.  Failure is a very real option.

And in the event of failure, the various amputation options become much more likely.

I could perhaps see some kind of relatively stable, long-term deal coming out of this process if there was a robust enforcement mechanism, and if political commitments made today were credible and binding on future politicians.  But there isn’t, and they aren’t.  From which I conclude that the ultimate demise of the Euro is a matter of when, not if.

The Bank of England’s most recent Financial Stability Report includes an extended discussion of the various systemic risks posed by CCPs.  For SWP readers, the analysis will be familiar.  It focuses on the margin mechanism as a channel of contagion, procyclicality, and wrong way risk.  It emphasizes the risks arising from the pivotal role of sovereign debt in the clearing system.  Adverse shocks to sovereign debt prices can initiate the destabilizing margin cycle.  Moreover, given the correlation between the financial condition of CCP members and sov debt prices, sovereigns are a source of wrong way risk in teh system

Recognizing the very real possibility for a CCP failure, the BoE recommends the implementation of a resolution regime for CCPs to ensure that the market can continue to operate even if a CCP exhausts its financial resources.  I recommended this in  my ISDA white paper.

So I concur wholeheartedly with this BoE analysis.  But as was the case with Bernanke’s warnings about the systemic risks of CCPs, I ask: where the hell was the BoE  when everyone was drinking the clearing KoolAid?  Some of this realism would have been much more constructive before Frankendodd, the G-20 clearing commitments, and other moves to mandate clearing around the world.   Right now, the BoE, the Fed, and more than a few financial journalists remind me of someone who stood on the platform waving goodbye to a departing train, but are now running down the track screaming that its brakes are defective.

So regulators are no scrambling to figure out how to buttress the much expanded clearing system against its inherent vulnerabilities.  Would that as much thought and effort had been expended to identify, anticipate, and mitigate these vulnerabilities before regulation and legislation imposed such heavy reliance on CCPs.

Clearing was mandated in haste.  Unfortunately, given the current tumult in world financial markets, we may not have the luxury of mitigating the risks of these mandates at leisure.

A while back–summer of 2010, if memory serves–I predicted that any CFTC position limit rule would be the subject of legal challenge.  My prediction was that someone would argue that the CFTC did not have the statutory authority to promulgate position limits because it had not made a finding that there was indeed excessive speculation that made it necessary to impose limits.  Subsequently, a DC Appeals Court decision that overturned an SEC regulation due to a failure to carry out an adequate cost-benefit analysis, made it clear that  this would be a major vulnerability for a variety of CFTC rulemakings, position limits among them. The day after the post-Dodd-Frank position limit rule was passed, speaking at a JP Morgan commodity conference, I said a suit challenging the rule would be “coming soon to a courthouse near you.”

Well, soon means about 6 weeks.  Today ISDA and SIFMA filed suit in DC contesting the position limit rule.   These organizations allege that the CFTC:

— Erred in concluding that the Dodd-Frank Act required it to establish position limits without first determining whether they were even necessary;

— Failed to present a reasoned analysis or consider all evidence in setting position limits;

— Failed to conduct an adequate cost-benefit analysis as required by law;

— Conducted a flawed rulemaking process that prevented commenters from meaningfully participating.

I imagine that others–such as the CME and maybe ICE–will follow suit, as it were.  I also expect that other rules will also wind up in court.  The position limit rule is probably the most vulnerable because of the statutory language about excessive speculation, but all of the rules the CFTC has passed are on extremely shaky on cost-benefit analysis grounds.

Frankendodd is under some pressure in Congress, but given the Democratic control of the Senate and the White House, nothing is going to happen on that front.  Instead, pieces of it will be chipped away in court.  Position limits could well be the first chip off the block.  Which is as it should be.

I know that a trip to any ER or trauma center in the US hardly a walk in the park, but when a Russian hospital makes a heavily tattooed mixed martial artist (or would that be “artiste”?), who has seen and shed his share of blood blanche, that’s saying something:

Primitive conditions and equipment in a Moscow policlinic alarmed mixed martial artist Jeff Monson after his bloody defeat and Putin’s booing, but doctors say the size of their tools scared him.

. . . .

When Monson was taken to hospital afterwards he was appalled by the battered and bloodied patients he saw wandering the wards and the rough and ready approach he encountered, while full of praise for the doctors’ bedside manner.

. . . .

Many of Monson’s fellow patients were in a bad way, Monson said afterwards, “The hallways were full of wandering patients that looked like they were just out of a civil war battle,” he told Mixed Martial Arts news portal MMA Mania.

But what’s actually more sobering (an ironic statement that will become clear in a minute) is that the doctors basically said, “so what’s the big deal?”  That, and the reason they considered it no big deal:

The doctors at City Hospital No. 36 on Fortunatovskaya Ulitsa said he was probably just alarmed as he came in when there were lots of drunks, “You can indeed see an influx of patients everyday at around 6:00 pm with beaten up faces,” doctors told Moskovsky Komsomolets.

“About 40 – 50 patients will be like that, they are all local drunks or have been injured in domestic fights. They wait their turn to see the doctor in the corridor and by all accounts this is what Monson saw,” medical staff told the paper.

Six o’clock.  The drinking starts early, apparently.  That, and the domestic abuse. That’s normal, isn’t it?  What’s this American getting all riled up about?

Monson was also appalled by the Frankenstein stitch-up on his bloodied lip:

“I got 16 stitches on the inside and outside of my lip with a material that could of passed for chicken wire. It was so sharp it was making my gums bleed so I took them out myself,” he said.

Again, the doctors were dismissive:

But the hospital say that everything was perfectly standard and speculate that maybe it was the size of their instruments that gave him a fright, “Maybe, he had been given short-term anesthesia on previous occasions, so he hadn’t seen what size they were,” surgeons suggested to MK.

Anesthesia?  MMF wussie.  Man up, dude.  You’re in Russia now, son.  When we aren’t using these big awls to stitch people up, we repair shoes with them.

If you’ve been following the news, you’ll recognize Monson as the fighter who lost in the fight that Putin attended.  There was booing after the fight, when Putin was in the ring with the fighters.  There’s been a raging controversy whether the booing was directed at VVP.

The problem is, that the excuses intended to refute claims that Putin was the object of the cat calls tend to make regular Russians look bad.  One excuse is that the Russians were booing the battered Monson: this insult to Russian sportsmanship was offered by none other than Putin’s press flack, Dmitry Peskov.  Another, advanced by the Nashi trolls, is that the crowd was, uhm, just pissed.  Figuratively and literally.  Or, maybe it would be more accurate to say that they wanted to be pissing because they were pissed (in another colloquial use of the term):

Soon after the incident Kristina Potupchik, press-secretary for Kremlin youth group Nashi, mocked anyone who thought Putin was being heckled by the angry crowd. “Don’t you recognize a greeting?” She wrote on her Live Journal page.

She later conceded that the calls were scornful ones, but denied they were directed at the prime minister. “The occasional cries of ‘foo’ were caused by the stupid entry and exit system…That’s why some of the 22,000 bladders filled with beer started protesting,” she wrote.

“Foo”?  Really?  She should have said that the audience actually thought that they’d seen Dave Grohl in the crowd.  At least that wouldn’t have made the crowd look like unsportsmanlike boors.

So, just as the emergency room was filled with drunken brawlers, the audience for the actual MMA brawl was another bunch of drunks.

So Mr. Peskov and Ms. Potupchik: Congratulations for making ordinary Russians look so good!  I guess it’s better to slander your countrymen by the gross as drunken bad sports than admit even the possibility that people do not worship unconditionally the New Tsar.

I ask again: just who are the Russophobes?  Here, in one story, Russians in positions of authority–doctors, presidential shills, and “youth group” spokesgal–reflexively slag their fellow Russians as drunken, violent, louts.  Well done!

PS. But apparently some realize that this story hardly makes Russians look good.  I originally saw the story on RiaNovosti.  Then, a couple of hours later, the story wasn’t there.  Now it’s back.

My new book, Commodity Price Dynamics: A Structural Approach (Cambridge UP) is now available.  Only 3 left in stock at Amazon!  Order Soon!  Sorry–no Kindle version.

From the book description:

Commodities have become an important component of many investors’ portfolios and the focus of much political controversy over the past decade. This book utilizes structural models to provide a better understanding of how commodities’ prices behave and what drives them. It exploits differences across commodities and examines a variety of predictions of the models to identify where they work and where they fail. The findings of the analysis are useful to scholars, traders, and policy makers who want to better understand often puzzling – and extreme – movements in the prices of commodities from aluminum to oil to soybeans to zinc.

I’d quote from the blurbs, but I’m just too darned modest.

In all seriousness, the book represents the culmination of years of my professional research.  I’m currently working on some extensions that apply the techniques utilized in the book to some current policy issues, such as the effects of speculation and commodity pricing anomalies, such as the huge basis observed for wheat in particular (and corn and soybeans too) in the mid-to-late ’00s.

I think the structural approach is quite useful in understanding how commodity prices behave, and crucially, how commodity derivatives should be priced. That’s where the book differs from earlier explorations of the structural approach, like the book of Williams and Wright from the early 1990s.

Moreover, I believe that the structural approach is useful in demonstrating that price behaviors that are commonly considered to be irrational, and driven by excessive speculation or noise trading, are in fact perfectly consistent with rational expectations-based models.

Also, I try to resist the quite common tendency to fall in love with the models one works on. One of the main contributions is to show where the structural model for storable commodities fails miserably, and to suggest extensions that may correct these failures. As I say in the introduction, I try to break the models and learn from the pieces.

For my next book, I’m changing gears, and working on a subject that has been covered in myriad SWP posts. It will be titled “Market Macrostructure” and will also be a Cambridge imprint. The first half of the book will analyze the organization of the execution of financial transactions, focusing on issues like liquidity network effects and dark pools. The second half-will examine the organization of post-trade services, most notably clearing. I’m sure that you are all shocked by that.