Streetwise Professor

May 25, 2012

Beyond Disgusting, But True to Form

Filed under: Military,Politics,Russia — The Professor @ 1:52 pm

Russian military intelligence, the GRU, has solved the Sukhoi SuperJet crash mystery: The Americans Did It!  Of course we did.  Hell, we can bring down space probes with our mysterious radar facilities, so bringing down a passenger jet with our diabolical electronic warfare technologies is child’s play:

Russia’s military intelligence agency, the GRU, suspects that US-inspired industrial espionage may have caused the May 9 crash in Indonesia of a Sukhoi Superjet 100 – Russia’s only hopeful entry in the civilian aviation market – according to Moscow’s leading tabloid newspaper, the usually reliable and officially connected Komsomolskaya Pravda.

While most Russian aviation experts contacted today dismissed the sabotage theory, they say there is a deepening mystery about how Russia’s most modern civil aircraft, with all its systems apparently functioning perfectly, came to slam into the side of a mile-high volcano during a routine demonstration flight.

“All the theories put forward so far are badly flawed, there is a shortage of hard information and there are a lot of irresponsible rumors,” says Roman Gusarov, editor of, an online aviation journal. “I am afraid that Russia is not going to emerge from this story without taking a black eye.”

Citing an unnamed GRU general, Komsomolskaya Pravda claimed that electronic jamming of the plane’s on board equipment is the most plausible explanation for how the jet, which was making a demonstration flight out of Jakarta airport with 45 people aboard, smashed into a mountainside even though an initial investigation has found that its terrain and collision avoidance systems were all functioning properly.

“We are investigating the theory that it was industrial sabotage,” the GRU officer is quoted as saying. He said that Russian intelligence has long monitored the activities of US military electronic specialists at the Jakarta airport.

“We know that they have special equipment that can cut communications between an aircraft and the ground or interfere with the parameters on board,” he said. “For example, the plane is flying at one altitude, but after interference from the ground onboard equipment shows another.” [Or maybe the plane’s electronics were defective.  Just saying.]

. . . .

“Maybe he didn’t see that the plane was heading straight at the mountain. On the other hand, we don’t rule out the possibility that this was deliberate industrial sabotage to drive our aircraft from the market,” an unnamed official at Sukhoi, the plane’s manufacturer, told Komsomolskaya Pravda. “Fortunately, we don’t foresee any loss of orders [for the SuperJet].”

This is self-satirizing.  Sick satire, but satire nonetheless.

Some notorious Russophobes criticize these paranoid ravings.  As for there being some sort of commercial motive for US sabotage:

Oleg Pantaleyev [another clever disguise!], an expert with [an infiltrator!], an online aviation news service, points out that the US does not produce this particular class of aircraft, and several foreign firms, including Boeing, have been involved in the SuperJet’s development and have big stakes in its success.

Another Russophobe criticizes Sukhoi’s oh-so-Russian handling of the crash aftermath:

Mr. [Roman] Gusarov [editor of] says that Sukhoi has handled the information side of the SuperJet disaster very badly.

“From the very beginning they developed this plane as if it were a secret combat jet rather than a civil airliner,” he says. “Now they’re putting out contradictory statements, and making all sorts of premature declarations. For instance, how can they assert that there were no system failures based on an examination of the cockpit voice recorder alone?

“Of course, all possible theories are bad. Either we have a fault with our newest and most hopeful plane, or with one of Russia’s finest aircrews. So, finding a scapegoat, putting out a story about some malicious external force bent on wrecking the SuperJet is just the thing they needed.”

Or, as Mr. Pantaleyev says:

“It’s this very lack of objective information plus low professional ethics that gives rise to all these rumors. They should be ignored.”

Hey, if some people didn’t have low professional ethics, they’d have no professional ethics at all.

My working hypothesis is that the American sabotage story is being put out there because the actual facts are quite embarrassing to Sukhoi and Russia, just as with Phobos-Grunt.

Actually, the most embarrassing thing is the reflex to place blame for disasters everywhere except where it belongs-somewhere within the boundaries of the largest country in the world.

The Price is Never Right

Filed under: Economics,Energy,Politics,Russia — The Professor @ 1:35 pm

Putin decreed that five energy companies are “strategic” and therefore will not be privatized (h/t R).  The most important of these companies is Rosneft, to which Igor Sechin is returning as Chairman.  Putin argues that the companies are undervalued:

“We can argue that at this particular moment and in the current conditions they are undervalued,” he said in televised remarks. “We would hate to see them privatized for pennies and then sold off for big money.”

Of course, the primary reasons that Russian companies-and especially Russian energy companies-appear “undervalued” relative to comparable non-Russian firms are, inter alia, the huge political risk of operating in Russia, the lack of protection for minority shareholders, the lack of transparency, and extreme deficiencies in corporate governance.  That, and the fear if they are indeed sold off for big money later, there is the risk that the Russian government will claw them back, claiming that the poor government has been taken advantage of (especially if foreigners are the ones who profit.)

The Russia discount is, in other words, made in Russia.  And Putin’s meddling in the decisions of Russian companies contributes to that, in a big way.  It is clear that Russian companies operate subject to the whims of the power structures, and are more vulnerable to these whims than companies elsewhere-including in other emerging markets.

Putin’s remarks are therefore a sort of self-fulfilling prophecy. As illustrated by the fact that the companies became more undervalued immediately after he made them:

The moves helped push Russia’s benchmark MICEX down 3.4 percent on Wednesday, though those losses were also due to fears of the impact of Europe’s financial turmoil. RusHydro tumbled 9.4 percent on the news, FSK and MRSK also posted substantial losses on Wednesday.

On Thursday, the MICEX recovered some 1.3 percent, though shares in FSK were still 6.2 percent lower, RusHydro 4.9 percent, and MRSK 3.8 percent.

Putin wants to get first world prices but live by third world rules.  He can’t have it both ways.  If he wants to live by third world rules, in which everyone’s property is held at the sufferance of those in political power, the price will never be right.

May 24, 2012

Russophobes on the Rampage on the High Beta Economy

Filed under: Commodities,Economics,Energy,Financial Crisis II,Politics,Russia — The Professor @ 1:52 pm

Apropos my Russia-as-a-high-beta-economy theme, consider this Russophobic jeremiad:

Vladimir Putin faces the risk of Russia’s political stability being shaken if Greece leaves the euro area, triggering a global crisis and sinking the price of oil, according to the Center for Strategic Studies in Moscow.

There’s a more than 50 percent chance of a Greek exit, which would lead to more countries pulling out of the currency union, Mikhail Dmitriev [what a clever disguise!], the research institute’s head, said in an interview yesterday. Russia’s main risks are a worsening economy, which would swell anti-Putin sentiment, and increased political repression, according to a study published today by the institute, which advises the government.

“If these trends continue, we will see the escalation of political violence and repression on one hand, and the worst economic crisis on the other,” said Dmitriev, a deputy economy minister from 2000 to 2004. “This may lead to Putin losing control and a chaotic political transformation.”

The article goes on in a familiar vein, linking Russia’s economic fortunes to the price of oil, and the price of oil to the impending train wreck in Europe.  Nothing you haven’t read here, if you’ve been reading here.

Moreover, Dmitriev echoes another long-standing SWP theme.  Namely, that in the present political environment, a sufficiently severed adverse economic shock could threaten Putin’s brittle political system:

“The political crisis could quickly become acute if it’s aggravated by a fresh economic crisis,” it said. “This is highly likely to provoke a rapid loss of political control and an accelerated change in the political system.”

Dmitriev predicts that in the event, Putin will respond with repressive measures.   Indeed, one can see the new law imposing huge fines on demonstrators as a preparation for such an eventuality.

No, pointing out that  (a) Russia is hostage to international economic conditions, and (b) Russia’s brittle polity is in turn vulnerable to economic shocks is not Russophobic.  It is a very reasonable appraisal of reality, and many Russians viewing the situation objectively, like Mikhail Dmitriev and the Center for Strategic Studies, arrive at the same conclusion.

May 23, 2012

Train in Vain

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 8:38 pm

Francois Hollande took the high speed train from Paris to Brussels for the latest EU summit.  He might as well have stayed home.  As the FT headline put it, “European Leaders Put Off Key Decisions.” Whoa.  That’s never happened before. Ever.

In inimitable Euro fashion, they promise-promise-to do something at their next meeting in June. Like what’s the hurry?

Although Hollande’s train trip was apparently an affected display of frugality, my initial thought on reading the headline was that it was an environmental gesture, an attempt to reduce his carbon footprint.  But that’s nothing: the Euros’ biggest contribution to a low carbon future will be that their policy paralysis will lead to a serious economic contraction that will put far more of a dent into emissions than any cap and trade scheme could ever hope to achieve: and that’s true even if Athens and Madrid and Rome-and even Paris-burn.

The Clash on Fridays – "Train in Vain" by Timmy_Ramone

May 21, 2012

Ivan FUD

Filed under: Economics,Energy,Politics,Russia — The Professor @ 11:54 am

Russia is continuing its Fear, Uncertainty, and Doubt campaign aimed at arresting the decline in oil prices (h/t R):

Some countries favor more than ever using a military strike to stem Iran’s nuclear ambitions, Russian Deputy Foreign Minister Sergei Ryabkov said.

Talks this month in Baghdad must show progress on reaching an agreement over the Persian nation’s nuclear program to placate the international community, he said today on a flight as he returned from the Group of Eight meeting in the U.S.

“Russia is concerned that an attempt to resolve this problem with military methods is still a possibility,” Ryabkov told reporters. “We periodically get signals publicly and via private channels that certain capitals favor this option much more than they did up to this point.”

How constructive.  When interpreting any Russian statement on these issues, never forget that Russia benefits directly from turmoil in the Persian Gulf.  Anything it can do to raise concerns about the risk of conflict there also raises the price of oil-which redounds directly to Russia’s benefit.

May 20, 2012

Reading For the Seven Dwarves

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 3:14 pm

The G8-perhaps with the conspicuous exception of Angela Merkel-apparently believe that if you say growth enough, like a mantra, it will magically appear.  Obama and Hollande and Monti and even Osborne (who seems a great candidate for the Upper Class Twit of the Year Contest: Jeez how British conservatism has devolved) appear convinced that some sort of stimulus funded by more debt is just the ticket to pull Europe out of the morass:

In an interview with CNN to be broadcast on Sunday morning, Mr Monti said: “We link back to the notion of demand … I think we should regard it more positively than the most conservative European authorities do.” [Yeah, he’s looking at YOU, Angela.]

But reflecting German resistance to authorise monetary easing from the ECB, Mr Monti added: “On the other hand, if it is an across-the-board crusade for more demand, then I believe that the German reluctance to that is not entirely unfounded.”

Obama is of course desperate for anything that pushes the inevitable reckoning beyond the first Tuesday in November.

Although the Seven Dwarves are importuning Merkel to give in and put German taxpayers to work supporting 55 year old Greek retirees and French bureaucrats, she will give them short shrift (and good for her!) and respond to the German electorate.   Obama doesn’t cast a vote in Thuringia or Bavaria, and she will base her calculations on those who do.

Germans are being pulled in opposite directions by years of indoctrination about the necessity of being Good Europeans on the one hand and deep-seated German aversion to profligacy on the other, so it is difficult to predict exactly how her electorate will react.  My sense is that ultimately Germans will recognize that shouldering the entire burden of funding Europe will be throwing good money after bad, and that Germany will not take one for the Euro team.  Though I would not be surprised if the ultimate decision comes next year, unless events force a decision earlier-which may well be the case.

In the meantime, Merkel might want to circulate this paper by Valerie Ramey to the members of the Anti-Austerity Cult:

This paper asks whether increases in government spending stimulate private activity. The first part of the paper studies private spending. Using a variety of identification methods and samples, I find that in most cases private spending falls
significantly in response to an increase in government spending. These results imply that the average GDP multiplier lies below unity. In order to determine whether concurrent increases in tax rates dampen the spending multiplier, I use
two different methods to adjust for tax effects. Neither method suggests significant effects of current tax rate changes on the spending multiplier. In the second part of the paper, I explore the effects of government spending on labor markets. I find
that increases in government spending lower unemployment. Most specifications and samples imply, however, that virtually all of the effect is through an increase in government employment, not private employment. I thus conclude that on balance government spending does not appear to stimulate private activity.

In other words, “stimulus” via government spending does not translate into growth.  Indeed, the Ramey analysis suggests quite the opposite.

Not that it will matter to the Dwarves, but their growth mantra-which presumes that more spending by already nearly bankrupt states will magically reverse Europe’s economic problems-is based on a highly dubious theory for which empirical evidence is either lacking, or in the case of the Ramey paper, empirical evidence utterly contradicts.  Will Merkel-and the German electorate-have the courage of their convictions and oppose the Dwarves? I am not certain, but when push comes to shove, I believe that she-and they-will do just that.

Holy Makarov

Filed under: Economics,Energy,Financial Crisis II,Military,Politics,Russia — The Professor @ 7:42 am

Russia has been notably obstreperous on two foreign policy issues: American missile defense plans and Syria. In each instance, members of the leadership have threatened direct military confrontation if Russia’s will is thwarted.  Ironically, the more veiled of these threats-Medvedev’s with respect to Syria-led to a bigger blowback on Russia.

A little over two weeks ago, Chief of the General Staff of the Armed Forces of Russia and First Deputy Minister of Defense Nikolai Makarov stated that Russia might launch a preemptive attack against US antimissile systems based in Europe if “the situation worsened.” Makarov would not make such a statement unless it was approved at the highest levels-meaning Putin.

Makarov’s warning was paired with a presentation of a computer simulation in which a diabolical US system shot down a barrage of Soviet I mean Russian ICBMs headed for the US.

It is flattering, I guess, that the Russians believe that US ABM systems are so capable, or will be in less than a decade’s time.  But if they actually believe this, they are delusional.  The particular installations in Europe against which Makarov vented, and threatened to attack, are of no use whatsoever against a Russian ICBM launch against the US.  They are not on the path of outgoing land based Russian missiles (which would take a polar trajectory), of no use whatsoever against SLBMs, and are laughably few in number.  US systems based in North America are also very limited in number and coverage.

Indeed, even the Russians themselves can’t tell a consistent story. They tout the evasive capabilities of their new ICBMs and the difficulty of ABM systems in dealing with large numbers of decoys.  Rogozin the Ridiculous tweeted:

If someone tried 2 build MD system right under our noses, it’d only give’m illusion of defense. We’ll pierce that fence

The mixed messages, and the underlying unreality of the characterization of the threat, make it rather difficult to interpret exactly what Putin et al are thinking.  Any reasonable interpretation does not give comfort.  Paranoid and panicky vs. using missile defense as a pretext to attempt to cow the Europeans and split them from the US.  Or both.  Oh joy.

An even higher authority-at least de jure-uttered the other apocalyptic threat.  Dmitri Medvedev obliquely raised the threat of nuclear war in remarks on Syria:

In his comments at a conference for lawyers in St. Petersburg, Mr. Medvedev started out by ruminating on the unintended outcomes of military campaigns. That is a theme often taken up by Russian officials as a line of criticism for what they see as America’s interventionist policies in the Middle East.

“The recent, hasty military operations inside foreign states usually end with the arrival of radicals in power,” Mr. Medvedev said shortly before 1 p.m. on Thursday.

He went on to add that: “At some moment, such actions, which undermine sovereignty, can end with a full-fledged regional war, or even, and I don’t want to scare anybody, the use of nuclear weapons.”

Russia has been shrill in its defense of its client and big arms buyer, the murderous Assad regime, and was outraged at the demise of another client (and big arms customer), the Khaddafy regime.  It has made it clear that it will not abide a repeat of what transpired in Tripoli and Benghazi in Damascus and Homs.  In this context, raising the possibility of the use of nuclear weapons can only be interpreted as a threat by Medvedev (which again would not be made without Putin’s approval) to employ nuclear weapons in response to NATO/US efforts to overthrow Assad.

Is the threat credible? Unlikely, but who is taking chances? Certainly not the markets:

An unusually candid reference to nuclear war by Russia’s prime minister prompted a sell-off in the nation’s stock market this week, underscoring how nervous traders here have become about worsening relations with the West, a street protest movement in Moscow and an overall slump in emerging markets.

. . . .

The Russian Micex index, a gauge of large blue chips traded on the domestic market, fell sharply. By the market closing, the index had lost 3.5 percent and ended the day at its lowest level in seven months. Some large Russian companies tumbled even further. Sberbank, the country’s largest lender, dropped 7 percent.

Yes, there were other bearish developments, notably a drop in oil prices, but the market drop appears to large to be explained by these other developments alone.

Why the reaction? One explanation is that they highlight the political risk of investing in Russia. They emphasize the importance of geopolitical objectives to the Russian leadership, and that they are not all that interested about comity with the west.  Such a confrontational posture will almost certainly create risks for foreign investments in Russia, and the Russian economy generally.

Here is another interpretation.  Yes, the remarks did coincide with a selloff in oil.  And that may be exactly why Medvedev uttered them.  The Russian economy and the Russian fisc are highly dependent on the price of oil.  Oil prices are currently below the level necessary to balance the Russian budget, which is not a good thing given the tumult in European capital markets. Brent is now trading at about $107/bbl.  Given current spending, Russia needs a price in the $115-$120/bbl range to balance the budget, and around $150/bbl to fund Putin’s elaborate election promises.

As my friend Sergei Guriev notes, Russia’s vulnerability is acute:

“It’s very hard to overestimate how vulnerable the Russian economy is to external pressures” from the oil price, Sergei Guriev, the rector of the New Economic School in Moscow, said in a telephone interview. “That vulnerability is huge, which is why Russia must be very vigilant. The spending is a risk.”

That vulnerability is huge.  No lie. That Sergei must be another one of those damned Russophobes.

Given this huge vulnerability, perhaps it is not surprising that Medvedev rattled the nuclear saber in the midst of a sharp selloff of oil: what better way to goose the price of oil than a threat of nuclear Armageddon in the Middle East?  Under that interpretation, his remarks would betray a certain, shall we say, anxiety about the current economic situation.  Which would help explain the sharp selloff in Russian stocks, or perhaps even suggest that the selloff was underdone.

May 19, 2012

How Are Dogs and Investors (Including Banks) Alike?

Filed under: Economics,Financial Crisis II,Politics,Regulation — The Professor @ 2:40 pm

Dogs chase cars.  Investors chase yields.  Especially in low yield environments.  And the consequences of “succeeding” in the chase is often the same for dogs and investors: they get crushed.

Many financial disasters occur in low yield environments, as investors despairing of finding the kinds of returns they expect in low risk instruments, pile into higher risk ones-especially ones with a lot of embedded short options.  Orange County and Gibson Greetings are two examples from the early-to-mid-1990s.

And we may be seeing a similar phenomenon in the Morgan loss.  Many big banks are swimming in deposits, and looking for places to invest the money.  That’s what Morgan’s CIO was doing:

The unit made a deliberate move out of safer assets such as US Treasuries in 2009 in an effort to increase returns and diversify investments. The CIO’s “non-vanilla” portfolio is now over $150bn in size.

Moreover, this is apparently an issue with all major banks (though you might want to take this statement with a grain of salt, coming as it does from Dimon, who, er, has something of a stake in the matter):

JPMorgan Chief Executive Officer Jamie Dimon said on a conference call with analysts on May 10 after announcing the loss that all banks have “these fairly large portfolios” that invest excess cash. Dimon had encouraged the unit to boost earnings by buying higher-yielding assets, including structured credit, equities and derivatives, ex-employees said in April.

But have no fear! The Fed is studying the problem:

JPMorgan Chase & Co. (JPM)’s $2 billion trading loss has prompted the Federal Reserve Bank of New York to examine how banks in its district are managing cash after receiving a flood of deposits since the credit crisis, according to a person familiar with the matter.

New York-based JPMorgan’s trading loss, announced last week, occurred in its chief investment office, which oversees about $360 billion, the difference between deposits and what the bank lends. The New York Fed is reviewing the structure of investment units and similar businesses at other banks it regulates, said the person, who wasn’t authorized to discuss the matter publicly and declined to be identified.

This pegs the irony meter.  Hell, it breaks it.  This problem is a consequence-unintended, surely, but still a consequence-of deliberate Fed policy to flood the market with liquidity.  You can defend that policy, but the Fed has to live with the reality that yield chasing is the inevitable consequence of ZIRP.  Indeed, it has long wanted to rejuvenate the mortgage and securitization markets, and that necessarily entails risk. The Fed appears to be doing its best Captain Renault impersonation here, expressing Shock! that banks are taking on risk in a low interest rate environment deliberately created by the Fed.

So, one wonders if in its “study”, the Fed will realize that the underlying fault is not in the banks, but in itself.

Will the Fed Take Facebook Shares as Collateral?

Filed under: Economics,Financial Crisis II,History,Politics,Regulation — The Professor @ 2:07 pm

Yesterday’s news was dominated by the Facebook IPO.  I don’t have much to say about Facebook qua Facebook or IPOs: not my area.  I will just say that it is hard to justify the valuation.  The only rationalization I could provide is that the $100 billion plus market cap is the premium on the option to monetize its huge base of users.  I say option, because its clear that the existing sources of revenues can’t support the stratospheric evaluation.  There is a tremendous amount of uncertainty about the ability to devise such a monetization strategy, and that can support some high option-driven valuation-but $100+ billion?  I’m skeptical.  (And if there are doubts about the ability to monetize Facebook’s user base, what does one even say about Twitter?)

I will comment on companies associated with the IPO that are closer to my comfort zone: NASDAQ and the underwriters, specifically Morgan Stanley.

The IPO was beset by technical hitches, with a delayed opening, difficulties in handing the avalanche of orders in the opening process, and a consequent delay in sending out trade confirmations-something that is guaranteed to generate extreme angst among those trading the stock.

The post-open trading was also chaotic, with crossed and locked markets.

This suggests that despite its extraordinary efforts to prepare, NASDAQ had insufficient capacity to handle the huge interest in Facebook.  This, in turn, harkens back to an issue that was the subject of the first SWP post, almost 6.5 years ago: exchange capacity and capacity outages.  I seriously doubt it would be efficient for NASDAQ to invest in sufficient capacity to handle such an extreme case without any hitches.  That is, in an efficiently scaled system, there should be occasions when capacity is maxed out. It doesn’t make sense to build capacity to handle all contingencies.

The benefit from investing in the additional capacity to handle the FB IPO would redound almost exclusively to FB and those who wanted to participate in the IPO opening.  It doesn’t make any commercial sense for NASDAQ to pay for that.  The investment is pretty much specific to FB, so if it wanted the additional capacity, it should have paid for it.

This raises another issue that I’ve discussed from time to time, although in a slightly different context: the pricing of exchange services.  What should NASDAQ have charged to handle the IPO, and what price would FB have been willing to pay to reduce the likelihood of SNAFUs?  This raises some interesting industrial organization issues as well, as in this context it involves the arms-length negotiation of a specific investment.  Integration is often the efficient response to such a situation, but that appears problematic to me in this context.

Insofar as the secondary market trading is concerned, this is an example (the Flash Crash being another) of the implications of the SEC’s “information and linkages” market structure choice inherent in RegNMS.  This approach results in fragmentation and locked and crossed markets during periods of extreme market activity.

The alternative is a central limit order book, but a CLOB would likely have experienced different problems, likely similar to those experienced in the NASDAQ open, since the huge amounts of trading activity likely would have taxed and perhaps overwhelmed the CLOB’s capacity.

Again, the exceptional nature of the FB IPO would have likely stressed any market mechanism.  What happened yesterday is how the information-and-linkage approach behaves under stress-fragmentation and crossed markets.

On to Morgan Stanley.  It is evident that the underwriters-of whom MS was the leader-bought large quantities of stock to support the $38 issue price.  The exact total amount, and the amount bought by any of the underwriters, is not known, but it could represent billions of dollars.  The underwriters can’t afford to grant free puts for very long, so it is quite possible that Facebook will trade below the issue price, thereby imposing losses on the underwriters.

This experience triggered my historical reflexes, and I thought about the experience of another legendary underwriter-Jay Cooke. There are some superficial similarities between Cooke and MS.  I don’t take them too seriously, but one can hear echoes.

Cooke was the lead underwriter of another innovative entity with a dicey revenue model: the Northern Pacific Railway, of which Cornelius Vanderbilt said “you can’t build a railroad from nowhere to nowhere.” Jay Cooke & Company underwrote sales of the railroad’s bonds, and ended up taking ownership of large quantities of them, in anticipation of selling them-and selling them particularly to Europe.  But it proved unable to market the bonds, due in large part to economic shocks emanating from Europe: there were several bank failures in Europe in Vienna that spread to other European countries.  Moreover, there was a monetary shock emanating in Germany-namely, that country’s decision to cease minting silver coins-that had averse consequences for the US. Furthermore, Germany demanded a large reparation from France in the aftermath of the Franco-Prussian War, which was also financially destabilizing.

Once Cooke & Company’s depositors became concerned about the company’s inability to market the bonds, a run commenced, and the firm suspended and went into bankruptcy. This sparked a broader financial panic in the US-the Panic of 1873.

So, in both 1873 and 2012 a big investment bank takes a large position in a company with a highly speculative revenue model, against the background of financial crisis in Europe.

We saw what happened in 1873.  We will see what will happen in 2012.  Almost certainly the outcomes will be quite different, because even if MS took a multi-billion dollar stake in Facebook, this is not a bet-the-company investment in the way that Cooke’s foray into the NPRR was.  It may cause some discomfort for MS and its shareholders, but likely nothing more than that.

And of course, the biggest difference between 1873 and 2012 is that there was no Fed in 1873. Again, I do not consider it at all likely that Morgan Stanley would be mortally harmed even if Facebook stock falls well below $38, but if it were the post-Lehman-we’re-not-going-to-let-that-happen-again-Fed would no doubt ride to the rescue, raising the question: would it take Facebook shares as collateral?

This seems like a highly speculative question, and perhaps even an idle one, but in these times one cannot rule out anything, no matter how fantastical it appears.

Addendum: The most likely reason why the Fed would be taking FB shares as collateral is if Europe well and truly implodes, and threatens to take down US institutions along with it.  The risk of a FB position alone is not great.

May 17, 2012

Beta Test

Filed under: Commodities,Economics,Energy,Financial Crisis II,Politics,Russia — The Professor @ 12:52 pm

I have often noted that Russia is a high beta economy.  This reflects, primarily, its extreme dependence on raw materials generally, and energy particularly.  Economic contraction reduces the demand for, and prices of, these commodities, and this hits Russia hard.

Witness the events of recent days.  Europe is re-entering crisis mode, with Greece teetering again, and Spain-a much bigger problem-also in extremis.  China is exhibiting serious signs of weakness.  As a result, commodity prices are down, about 7 percent this month (as measured by the DJ commodity index).

And Russia is down along with commodity prices:

While most countries’ stock markets have been hammered amid Greece’s sovereign-debt woes and its possible exit from the euro, the plunge in Russian stocks—which have dropped from their 2012 highs by nearly twice as much in percentage terms as the MSCI Emerging Markets Index—has been particularly fierce.

“Such is the level of risk-phobia in the world right now, and Russia, despite the generally positive domestic backdrop and very cheap asset base, is viewed as being the most at-risk economy in the world,” said Chris Weafer, chief strategist at Troika Dialog, an investment bank in Moscow.

Moreover, capital outflows are continuing:

Activists who clashed with police before Putin’s May 7 inauguration are protesting non-stop in Moscow, using the Occupy Wall Street movement’s tactics. As the benchmark RTS equity index entered a bear market, Russia-focused equity funds recorded $251 million of outflows in the seven days to May 9, the most this year, while China lost $127 million, India $148 million and Brazil $167 million, EPFR Global data show.


Russia’s top central banker warned on Wednesday that capital flight is a “serious problem,” as newly released figures showed $42 billion has left the country in the first four months of the year.

“Capital outflow continues to be a serious problem for the Russian economy,” the central bank’s chairman, Sergei Ignatyev, told Russia’s lower house of Parliament.

The ruble is weakening too, down about 5 percent this month.

This follows a first quarter in which Russian growth exceeded expectations.  But that was also a quarter in which oil and commodity prices spiked.

One thing that complicates interpretation of these figures is that multiple things are going on. The first is the economic problems in Europe and Asia.  The second is the ongoing political uncertainty in Russia.  Both are pushing money in the same direction-out of Russia.  The difficulty is trying to determine how much of the outflow is attributable to each of these factors.  It is quite remarkable, however, that the election and the ebbing of the protest movement has quite evidently not staunched the outflow.

With respect to the outflows, Russian officialdom is whistling past the graveyard-and blowing smoke up everybody’s collective rear. Yeah, they say, we’ve had problems-but Happy Days Are Around the Corner!  The flows will reverse manana.

I howled when I read this:

Russian financial officials have assured that Russia would start seeing capital inflows in the second half of the year after the new government is formed. Prime Minister Dmitry Medvedev has submitted candidates for the cabinet to President Vladimir Putin for him to sign on the list of new ministers by the end of the month.

Yeah.  It’s all that uncertainty about the cabinet that is driving money away.

To the extent that the outflows are politically driven, rather than a manifestation of the high beta effect, the exact opposite is true.  It is the realization that the Putin Purgatory, with all its legal nihilism, is here to stay that is the problem.  Investors-including, it should be noted, many rich Russians-have seen the future, and know it won’t work.

When a strong world economy or supply shocks keep commodity and energy prices high, the high beta effect covers a multitude of sins in Russia.  When these factors reverse, things get double ugly.  There is the ugliness of the natural state, Putin’s Purgatory. That is, sadly, arguably a constant.  Then there is the ugliness that comes with a commodity price-crushing world economic contraction.

The thing to watch going forward is how these things interact.  Economic weakness resulting from the high beta effect will impact politics in Russia-and Putin will react to that in ways that will likely exacerbate Russia’s politically-grounded economic difficulties. The populism and promises of government largesse that Putin used to campaign for re-election will not be sustainable.  What will the popular backlash? How will Putin hit back?

Meaning that if the world economic situation continues to deteriorate, the brittleness of the Russian natural state will be tested.

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