Streetwise Professor

A couple of LIBOR-related items.

1. Timmy! claims that he and the FRBNY were “very forceful from the beginning” in dealing with LIBOR manipulation.  This is an example of why Timmy! (AKA Rodney Dangerfield) gets no respect.  His letter to the BOE was a classic example of bureaucratic CYA and buck passing: the BOE then exchanged the buck and passed the pound to the BBA which did . . . nothing.  More nothing happened for over three years, and it wasn’t the FRBNY that drove the process.  The scary thought is that is what passes for forceful in Timmy!’s world: the scary alternative is that Geithner is just BSing about his past forcefulness.  The thought that Geithner’s 2008 actions were forceful is Pythonesque, really:

Cardinal Ximinez: Cardinal Fang! Fetch… the Comfy Chair!
Cardinal Fang: [horrified] The Comfy Chair?
[Fang scuttles off, then returns with the Comfy Chair and sits the old lady down in it]
Cardinal Ximinez: Now, you will sit in this chair until lunchtime, with nothing but a cup of coffee at 11!

2. Central bankers are looking for an alternative to LIBOR, EURIBOR, etc

Central banks are exploring whether financial markets might be steered to adopting benchmarks other than Libor. Mr. Bernanke suggested a few alternatives at his hearings this week. Among them: The rate that financial institutions charge each other for short-term loans in “repo” markets in which they use their large securities portfolios as collateral for short-term loans. He said derivatives markets also provide alternatives, such as “overnight index swap,” or OIS, rates, which track central bank lending benchmarks.

That’s great going forward, but what about the $800 trillion or so in notional and/or principal amount of outstanding derivatives, loans, and other financial instruments with payments tied to LIBOR and its European and Asian cousins?  That would be a helluva lot of contracts to orphan.

LIBOR needs to be fixed, because of this massive amount of legacy contracts.  But how?  It won’t be easy, since the transactions that LIBOR et al should be related to-unsecured interbank transactions-aren’t orphaned: they’re damned near extinct.  Any decree by regulators that henceforth LIBOR should be something different than the creature that existed at the time these contracts, loans, etc., were created would potentially result in the shift of many billions of dollars of wealth, and spawn intense legal challenges.  (Ironically, any fines or damages arising from LIBOR manipulation-related legal actions will weaken banks and make the return of unsecured lending all the more remote a prospect.)

Looking for a replacement going forward is the easy problem: market participants have an incentive to come up with something more robust, there will be experimentation and competition, and perhaps with a little regulatory shepherding, in not too long something better (no doubt some sort of secured rate) will emerge as the benchmark.  Going forward, market participants can find transactions and benchmarks that are mutually beneficial.  That provides an incentive to get it right.

Finding a way to deal with the legacy of the past is going to be a much, much more difficult problem.  The primary effects of changes will be redistributive, rather than creative.  This will give rise to massive rent seeking and legal conflict.  Much fun will be had by all.  Especially the lawyers.

Obama’s Roanoke Field of Nightmares speech (“You didn’t build it, so we will come and take it”) is attracting considerable attention, at least from the conservative and libertarian sides of the blogosphere: MSM, not at all.  As it should.  It is arguably the most radical speech given by a US president; whereas (the progressive) Theodore Roosevelt’s “Malefactors of Great Wealth” speech was focused at a relatively narrow group (the 1907 version of the 1 percent), Obama’s speech questions the legitimacy and contributions of entrepreneurs and strivers.

In trying to think of a similarly radical vision by a major political figure in the US, the closest I could come was Huey Long, who advocated the “Share Our Wealth” program.  But even that was focused on the ultra-wealthy.

So the Obama vision reflects change, all right.  Hope, not so much.

I owe thanks to Tim Worstall (never to be confused with Timmy!) for his Forbes blog post on, and compliments of, my Blame it on Ben? piece from Saturday.

I also owe Tim props, for he recognized the dangers that low interest rates pose to the traditional broker model back when MF Global went bust.

One clarification.  I didn’t mean to suggest that low interest rates caused MF Global, or Peregrine, or the Whale, in the sense that low rates were a sufficient condition for these things to occur.  Low interest rates aren’t necessary either: some firms take risk or commit fraud when interest rates are high, obviously.

But risk taking (such as MF Global’s gambling for resurrection) and fraud (such as Peregrine’s) are more likely when firms are on, or over, the financial brink.  Low interest rates put these firms on the brink, and made the courses of action that Corzine and Wasserman chose more attractive and compelling than they would have been had they been making money the old fashioned way.  Put differently. low interest rates increase the odds of such conduct.

With that clarification made, just let me say thanks Tim, and keep up the good work.

Obama’s speech in Roanoke, VA, contains this bit of creepy collectivism:

There are a lot of wealthy, successful Americans who agree with me — because they want to give something back.  They know they didn’t — look, if you’ve been successful, you didn’t get there on your own.  You didn’t get there on your own.  I’m always struck by people who think, well, it must be because I was just so smart.  There are a lot of smart people out there.  It must be because I worked harder than everybody else.  Let me tell you something — there are a whole bunch of hardworking people out there.  (Applause.)

If you were successful, somebody along the line gave you some help.  There was a great teacher somewhere in your life.  Somebody helped to create this unbelievable American system that we have that allowed you to thrive.  Somebody invested in roads and bridges.  If you’ve got a business — you didn’t build that.  Somebody else made that happen.  The Internet didn’t get invented on its own.  Government research created the Internet so that all the companies could make money off the Internet.

You know the latent message here: You didn’t earn it.  So you have no right to it.  Since you have no right to it, “we”-the government-will take what we want.

Let’s consider that Internet example from the perspective that Obama routinely applies to private wealth.  Putting aside the question of whether the Internet is truly the child of the government-funded ARPANET, the Federal government has recouped in taxes on income and capital gains from Internet-related economic activity many, many times what it spent in developing ARPANET.  Indeed, I would wager that the government will collect more in taxes from the Facebook IPO than it spent on ARPANET, even taking into account inflation/compounded interest.  When private fortunes are concerned, Obama’s philosophy is “I do think at a certain point you’ve made enough money”, meaning that you should pay more-much more-in taxes.  But that doesn’t apply to government investment, evidently.  If it did, it would be greedy to cash those tax checks from Internet businesses and workers.

What’s more, whatever the contribution of government initiatives like ARPANET to the Internet, it is blindingly obvious that virtually all the value generated by the Internet is the result of private initiative, private innovation, and private investment.  So when you are cashing that government benefit check, realize that the government didn’t get there on its own.

And the last statement (“[g]overnment research created the Internet so that all the companies could make money off the Internet”) is a flagrant lie. This statement implies intent: that government research on ARPANET had, as its explicit purpose, the encouragement of private economic activity.  Nothing could be further from the truth.

Obama then fired up the Wayback Machine for further examples of the pivotal role of government:

So we say to ourselves, ever since the founding of this country, you know what, there are some things we do better together.  That’s how we funded the GI Bill.  That’s how we created the middle class.  That’s how we built the Golden Gate Bridge or the Hoover Dam.  That’s how we invented the Internet.  That’s how we sent a man to the moon.  We rise or fall together as one nation and as one people, and that’s the reason I’m running for President — because I still believe in that idea.  You’re not on your own, we’re in this together.

Uhm, who is this “we”?  A pitch-perfect illustration of the collectivist mindset.

At least he spared us a disquisition on the Intercontinental Railroad.  (Now that would have been a feat!).  As for the things he did mention:

Man on the moon?  NASA is a tragic shadow of its former self-with Obama’s approval.

Hoover Dam?  Please.  You think it could be built today?  Really?  The enviros* and progs hate dams.  Hate them.

And even something seemingly more benign, like the Golden Gate Bridge, would never be built today, or certainly not as quickly or cheaply as the original. The environmental impact statements, the legislative log rolling, the designs and redesigns to meet the objections of this constituency or that, all make such project a thing of the past.

No, nowadays, infrastructure projects aren’t shovel ready.  They are rent seeker ready.  Lawyer ready.  Bureaucrat ready.  Just look at the train wreck (literally) that is high speed rail in California.  Or the Big Dig in Boston, as Walter Russell Mead reminds us:

It turns out that Boston’s “Big Dig” construction project cost taxpayers much more than expected — and enormous bills for interest payments and mass transit are still rolling in.

Hailed at its inception as an example of “smart government” and proof that “government can still get things done,” the project was originally estimated to cost $2.8 billion. Thanks to corruption, construction mishaps and the usual friction on projects of this kind, the project took a decade longer than planned to complete, and was said at the time (December 2007) to have cost a total of $14.6 billion.

There was much shock and finger-pointing when these numbers came out, but as Boston.com reports, those cost estimates were still much too low. By the time the whole mess is finished and accounted for, this beautiful proof of governmental competence and efficiency, this magnificent testimony to the ability of big infrastructure projects to turn the US around will end up costing about twice that much: at about $21 billion, the final cost will be about seven times the original estimate — an original estimate, by the way, so large that it blew peoples’ minds at the start.

Government today is all about transfer payments, rather than investment in public goods.  When it tries to build stuff, it soon engages in a Bacchanal of waste and incoherence.  Its greatest efforts are directed at redistribution via cashing checks from some and writing checks to others.  That, and controlling via regulation economic activity large and small.

Interesting, isn’t it, that Obama couldn’t find an example of a seminal contribution of government post-1969?

If you are paying attention to what Obama says, it is clear that his vision is inherently a collectivist one that is deeply hostile to private enterprise and wealth creation.  A vision that credits the government for the lion’s share of wealth creation if government has touched the creative process, however slightly or indirectly.  A vision that cannot see Bastiat’s unseen-the wealth not created because of the very visible strangling hand of government.

* WordPress’s auto spell kept wanting to replace “enviros” with “enviers.”  That works.

The futures industry is reeling over the latest theft of segregated customer funds, this time by Peregrine Futures’ Russell Wasendorf.  Wasendorf admitted to stealing seg funds in a note left at his side when he attempted suicide after it looked like his scheme was unraveling.  He has been indicted for fraud committed over the 2010-2012 period.  Over $200 million is missing, and his company is undergoing Chapter 7 liquidation.

Following hard on the heels of the MF Global disaster, the Peregrine revelations are raising further fears about what had once been considered sacrosanct: that customer funds are inviolate.  Even the CME Group, which has historically been a stalwart defender of the traditional segregation model in which FCMs are the custodians of customer money, has suggested that changes may be necessary:

Without question, the current system in which customer funds are held at the firm level must be reevaluated.

CME Group recognizes that the demand for its services is reduced to the extent that suppliers of complementary services-such as brokerage-are deemed untrustworthy.

I consider it virtually inevitable that this will be the last nail in the traditional segregation model.  This will lead to a dramatic change in the organization of the FCM industry.  Though (as I discuss a below) that industry was already under tremendous strain.  Peregrine and MF Global are symptoms of that strain.

Other big news this week was JP Morgan’s reporting of a $4.4 billion dollar Q2 2012 loss, and a $459 million restatement of its Q1 results-along with an admission that the “integrity” of the marks in the CIO books.

Do Peregrine, MF Global, and JP Morgan’s travails have anything in common, except for bringing further discredit onto the finance and banking industry?  I think they do.  I think they are all consequences of near-zero interest rates.

The traditional FCM revenue model relied on interest income from customer funds invested by the FCM.  Very low interest rates make that model unviable.  That is a major reason why Corzine felt it imperative to transform MF Global-and to take on more risk.  I conjecture that similar pressures led Wasendorf to commit fraud.  (Though his admission that he had been doing so for 20 years cuts against that interpretation.  A hypothesis: Wasendorf had been engaging in this activity on a smaller scale for years, but escalated it sharply as the financial pressures on Peregrine grew in the low interest rate environment.)

The Morgan story is different, but the extraordinary monetary policies that have driven interest rates to extremely low levels are at the center of the story.  Morgan had about $360-$500 billion in deposits that it needed to invest, but traditional investments such as Treasuries offered such low yields that the bank went hunting for yield, and invested in more risky securities and derivatives to get it.  Yield chasing in Fed-created low interest rate environments has contributed to previous big losses, such as Orange County’s in 1994.

Bernanke and the Fed initially pursued a low interest rate policy in an attempt to prevent another depression, and have continued it in attempt to spur growth.  These are the justifications for these policies, and they are defensible ones.  But these policies cause collateral damage.  Financial blowups-from MF Global to Peregrine to the Whale-are plausibly just that.

During all the whinging about WTI, and the claims that it was inferior to Brent as a benchmark, I pointed out that although the former was subject to short term issues that could be fixed by investment in infrastructure, the latter was plagued by far more intractable problems that would compromise its viability over the medium-to-long term.  Indeed, WTI’s problems reflected an unexpected supply surge that actually bodes well for its long term viability, whereas Brent’s inexorable production decline would be virtually impossible to fix.

That reality is now becoming more widely recognized, pace Javier Blas’s piece in the FT:

The drop in production is putting the Brent benchmark in danger. Platts, the pricing agency that acts as the de facto regulator of the Brent physical market, is looking for solutions. It will need to work closely with ICE Europe, the exchange home of Brent futures and options, and the UK’s Financial Services Authority, which has an interest in the Brent derivatives market running smoothly.

The usefulness of West Texas Intermediate, the US crude oil, as a global benchmark has suffered over the past two years due to the so-called ‘Cushing syndrome’ – a glut at the Oklahoma town that serves as the delivery point of the contract. This glut is due to surging production and limited pipeline offtake capacity, and pushed WTI prices below what global fundamentals suggested.

Brent is now suffering from the opposite problem. The ‘North Sea syndrome’ – falling regional output combined with unlimited seaborne offtake capacity. The problem could push Brent prices above what global fundamentals suggest.

It is a lot easier to build pipelines than develop vast offshore oilfields. (Well, it is if administrations I won’t bother to mention let pipeline development proceed.)  This means that WTI’s “problems” can be fixed-and indeed, that its problem (a surge in supply in regions tributary to the delivery point) is a feature not a bug.  Brent’s.  Not so much.  Meaning that before very long CME/NYMEX is likely to be laughing, and Platts and ICE will be sobbing.

This provides a truly fascinating insight as to how Russia works:

Sucres et Denrees SA, a French sugar trader with processing in Russia, may offer a stake in Russian assets to Kirsan Ilyumzhinov, a former regional governor, to help protect operations, its head of the local business said.

“This can be the case if Mr. Ilyumzhinov helps to save our assets from the corporate raiders,” Etienne Pelletier, also a member of the company’s executive committee, said today by phone. Ilyumzhinov, governor of Kalmykia until 2010 and World Chess Federation president, has “necessary contacts,” he said.

“Necessary contacts.”  Those two words speak volumes.

Ilyumzhinov is a real piece of work, by the way.  (And his WCF involvement provides yet more evidence, as if any is needed, of the deeply dysfunctional and corrupt nature of virtually every international sports organization, e.g., the IOC, FIFA, Formula 1.)

This part is particularly illuminating:

The trader has been in legal disputes over ownership of Russian assets since 2008 after contracts to buy equipment for plants were challenged by local counterparts. Sucden has three sugar plants in Russia that processed 2.5 million metric tons of beet into 316,000 tons of sugar last year, company data show.

This illustrates the challenges that commodity trading firms face generally, as many must deal in jurisdictions in which the state is predatory and/or the the state does not protect property rights and/or the line between the state and predatory elites is somewhere between blurry and non-existent.  Russia presents all of these problems.

This is how the natural state works.  Which makes the following borderline insane:

Investors should buy European stocks with sales in Russia as the oil-producing nation’s economic growth will outperform the debt-stricken euro region’s, according to Citigroup Inc. (C)

“The point is that Russia has growth while Europe is facing stagnation,” Kingsmill Bond, chief strategist at Citigroup in Moscow, said in a phone interview today. “A lot of the growth that European companies will generate will be from their Russian operations.”

First, Russian growth is highly dependent on what happens in Europe.  Remember, Russia is a high beta economy, and due to the natural resource dependence an economic crisis in Europe or China will hit Russia even harder.  So the idea that investing in Russia is some sort of hedge against economic troubles elsewhere is particularly daft.  Second, Russian operations pose their own special risks to foreign companies.  Such as having to get a krysha from corrupt governors who believe they were abducted by aliens.

Like Freddie Krueger, I’m baaaaaack again, folks.  This time, more regularly, I trust.

Catching up on a few things that have caught my eye since last time-and like Freddie, I brought my knives.

1. The LIEBOR mess continues to metastasize.  It is now sucking in regulators.  Including Timmy! It appears that the dissembling about LIBOR, TIBOR, EURIBOR, etc., was the worst kept secret in the world’s financial centers.  And let’s pray that’s true.  If the Fed, the Bank of England, etc. DIDN’T know that there was a complete disconnect between the rates that banks reported to the BBA and the rates at which they were actually borrowing (or not)-now THAT would be a reason for panic.  In fact, they were all-bankers and regulators alike-operating pursuant to the Juncker Maxim: “When it becomes serious, you have to lie.”
2. I detest manipulation of markets, and have made a life’s work of studying it, calling out manipulators, and now and again testifying against them.  But I find it disgusting to hear high government officials in high dudgeon on the subject, when they are in fact often the most outrageous and shameless manipulators.  The most flagrant example: the Lilliputians who are the collective “leadership” of the EU and the Eurozone.  For what else can you call their repeated fudges, misstatements, lies, etc. related to the latest “solution” to Greece’s problems, or Spain’s, or Italy’s, than “manipulation”?  How many billions have changed hands on the EUphoric rallies that occur after the announcement of such solutions, and on the, umm, “retracements” that occur when the truth comes out.  The agreement on a Spanish bailout, and banking regulation changes, that came out of the most recent Summit of the Lilliputians is only the latest example.  Look.  Europe is screwed.  Metaphysically.  The math does not work.  Cannot work. Even mores, the politics cannot work.  The core is empty.  No real deal is possible.  Accept it.  And once you accept it, mock any pronouncement of the next “solution”.  And for God’s sake don’t buy except on the theory that other suckers buy and you will sell out before they do.
3. FCM Peregrine Financial Group apparently absconded with $220 million of “segregated” customer money.  This is both shocking and depressing 10 months after MF Global.  The scheme has apparently been going on for at least two years.  But the CFTC allegedly gave all FCMs the full anal probe post-MF, and saw-like Sergeant Schultz-NOTHINK! So since they can’t find a rather banal fraud at a middling futures brokerage, it’s truly obvious that they have game to regulate the entire world, and every complex financial institution and complex derivative trade in it.  What could go wrong? No doubt that the Peregrine debacle will lead to calls for more regulation.  Regulation, the only human activity where failure is the primary justification for more of it.
4. The CEO of inter dealer broker GFI, Mike Gooch, has said that hedge funds need to become liquidity suppliers/market makers in order to fill the gap left by banks, post-Volcker Rule.  I predicted this would be the outcome in a couple of posts written soon after the rule was mooted.  There is a serious question here: will this really lead to greater stability during times of financial turbulence?  Given that credit to hedge funds-which comes largely from banks, by the way (funny thing, that!)-typically contracts severely during periods of such turbulence, their market making activities are likely to contract as well during such times.  Meaning that market liquidity supplied by hedge funds will be highly pro-cyclical.  Bank supplied market liquidity is too, but the ones subject to the Volcker Rule-you know, the ones who have sticky insured deposits-are likely to be able to resist these cyclical pressures better than hedge funds because their funding is not as fragile.  So yes, Mike, hedge funds will be needed to fill the gap left by the exit of prop trading banks, but they won’t be there precisely when needed.  Things will work just swell.
5. Gazprom was named the most opaque corporation in the world.  I am shocked and stunned.  It is allegedly the most profitable.  Again, no surprise: government enforced monopoly is a nice gig.  But the company has been forced to make price concessions on contracts to big customers.  It is fighting a rearguard action against the flood of gas being discovered around the world.  It won’t happen overnight, but government mandated monopoly or no, the company’s future is not bright.
6. The to-ing and fro-ing over privatization in Russia continues.  Putin allegedly threw a spanner into Sechin’s ambitions to acquire “privatized” assets, including electricity generators.  But his words are pretty weak: “That does not mean we should limit ourselves to participation by Rosneftegaz.”  So you could envision some competitors in the bidding process, and them prevailing enough times to give the impression that a real privatization is going on.  But this is likely to be a Potemkin privatization, and Sechin et al are likely to prevail.  Sechin certainly thinks so: “Russia’s most influential energy official, Igor Sechin, said on Tuesday the state-owned energy holding Rosneftegaz was given permission to invest cash on its balance sheet in comments which seem to contradict assertions by a top government official [Akardy Dvorkovich].” I would bet on Sechin.  Hands down.
7. There is a spate of bad news about the weakness in China’s economy.  I have been a China bear for going on three years, or more actually.  The first reason for my pessimism has always been China’s ramshackle and rigged financial and banking systems: this predates the crisis.  This post provides an excellent overview of the reasons to find that system “scary.” Yes, the Chinese government has papered over past problems, but there are limits to this, as there are to all things.  Indeed, as the economy has gotten larger, and in the aftermath of the crisis and the massive monetary and fiscal response thereto, the state’s capacity to continue to do this is very questionable.  The second reason is that, contra Tom Friedman or Ray LaHood, I adamantly do not believe that the allocation of capital by the state, directly, and indirectly through financial repression and a hugely distorted banking system, will end well.  In fact, I believe the exact opposite is true.  Suppressing price signals and allocating capital to cronies and state owned enterprises is a recipe for grotesque misallocations of capital.  In the short to medium term, it can lead to impressive GDP numbers.  But spending insane amounts on investment eventually leads to catastrophe if that investment doesn’t produce returns.  That, in a nutshell, is what China looks like to me.  And these two sources of pessimism feed off one another: when the investments don’t generate returns, and in fact generate losses, the banks and trust companies and insurance companies and whatever that provided the finance are toast.  When you force feed a goose, you can at least get good liver pate (but not in California!).  When you force feed investment, eventually you get a bust.

That’s all for now folks.  Catch you again soon. Promise.