Streetwise Professor

November 30, 2012

Putin’s Agorophobia: Physical Health, or Political?

Filed under: Politics,Russia — The Professor @ 8:35 pm

All sorts of rumors are flying about regarding Putin’s health.  The most recent due to the cancellation of Japan PM Noda’s visit to Moscow: Noda supposedly blamed the cancellation on Putin’s health.  The restricted travel schedule-and the lack of macho stunts-do suggest that Putin has suffered some sort of injury.  The excuses given-notably, Putin doesn’t want to leave his dacha because of his concerns about Moscow traffic-strain credulity, so something is amiss clearly.

I wonder though if that the main issue is not physical health, but political.  The current spate of accusations of corruption-Serdyukov and others in the MOD, the head of Rostelecom, the head of GLONASS-have been portrayed as an attempt by Putin to co-opt the opposition (Navalny in particular), or as a means of reorganizing the cadres upon his resumption of power.  But another interpretation is that it is symptomatic of a breakdown in the equilibrium between contending factions-clans, if you like-in the elite.

In Russia, everyone in the elite is corrupt.  Corruption is a way of providing incentives to play along (you play along, you get a slice of the spoils) along the lines of what Douglas Allen describes as the role of corruption in early-modern Britain.  And corruption is not just carrot, but stick: everyone is dirty, and therefore vulnerable to corruption charges if they don’t play along.  It is a form of MAD-mutually assured destruction.

If that equilibrium holds, everyone is corrupt but no corruption charges are ever filed agains the elite.  If that equilibrium breaks down-which can occur if the political longevity of the leader comes into question, as is plausible for Putin given the unexpected rise of the opposition and the perhaps surprising discontent with his way of reassuming the presidency-one plausible effect is a series of tit-for-tat corruption allegations/charges. So the spate of corruption allegations is potentially politically portentous.

The breakdown in the MAD equilibrium-or even the suggestion that the MAD equilibrium is tenuous-makes it very dangerous for Putin, whose main job is to maintain that equilibrium, to travel abroad for extended periods.  No doubt he remembers that the 1991 coup against Gorbachev occurred when he went to Crimea on holiday.

It could well be that Putin is willing to put up with rumors about his bad back because admitting the real reason for staying close to Moscow almost continuously-a highly unstable political situation among the elite-would have cataclysmic effects.  Nothing destabilizes a regime like an admission that the regime is potentially unstable.  As I wrote long ago, a regime like Putin’s depends on exploiting the difficulty of the opposition to coordinate and coalesce.  The main way of increasing this difficulty is to convince those dissatisfied with the regime that their opposition is futile because the regime is popular and united.  If it becomes evident that the regime is in fact vulnerable, this can become self-fulfilling.  Opponents-and not just the Navalnys, but people within the elite thinking of seizing their main chance-become emboldened, and that can unleash a feedback loop that spirals out of control.

Putin’s reluctance to go outside-his agoraphobia, if you will-therefore may have little to do with his physical condition, although that may provide a convenient (if denied) excuse.  It may have much more to do with his political condition.

I don’t know for sure, but it bears watching.

November 27, 2012

A Little Perspective

Filed under: History,Military — The Professor @ 10:53 am

In the comments, So? mentions the successful Chinese landing of a J-15 jet on its new aircraft carrier as evidence of China rising.

It is an advance for China, definitely. But a baby step when you consider the complexity of carrier operations, especially at a true operational tempo, with 120 sorties (takeoffs and landing) per 12 hour flight day, sometimes surging to 190 per day. The ballet of the deck is an amazing-and amazingly dangerous-thing. Especially when you start doing it with live ammunition hanging from wings and waiting on deck, and especially especially when you do it day after day and crews become fatigued.

The US Navy has been doing this for close to a century. The accumulated experience and knowledge will take the Chinese a generation to match. (Only four navies-the US, Japan, the UK, and France have operated carriers in a serious way.)

And by the time China catches up with that, the US will have moved on. It is already moving on. For on virtually the same day China landed a manned jet on a carrier, the US loaded an X-47B Unmanned Aerial Vehicle onto the USS Harry Truman for flight testing:

So while China takes its first steps into the 20th century doing what the US (and the UK) first did in 1945-land a manned combat jet on a CV-the US is moving into the 21st by testing unmanned combat jet on a CV.

So who is really making history? And is a gap closing, or opening?

November 26, 2012

And They Said It Couldn’t Be Done!

Filed under: Economics,Energy,Politics,Russia — The Professor @ 2:03 pm

By “they” I mean Gazprom, and by “it” I mean pricing long term European gas contracts off of a spot gas index, rather than an oil index:

Norway’s Statoil ASA signed a 10-year gas supply deal with Germany’s Wintershall AG, based on spot gas prices that challenged Russian gas export monopoly OAO Gazprom, which insists on oil-linked prices despite European Union opposition.

Statoil agreed on Tuesday to supply Wintershall, the natural gas unit of chemicals firm BASF SE, with 45 billion cubic metres of gas worth $17.4-billion (U.S.) at current prices, in a deal aimed at creating a flexible gas market in northwestern Europe.

“This is the first contract of such magnitude and length in continental Europe,” Statoil executive vice-president Eldar Saetre told Reuters.

Government-controlled Statoil, Europe’s second biggest gas supplier after Gazprom, is now selling about half of its gas under spot terms, including more than 40 per cent of its European gas, Mr. Saetre said.

As I’ve often written, there will be a positive feedback effect here.  More index-linked pricing will enhance the liquidity of the spot market and the spot indices, making gas hub indexed pricing more viable, and on and on.  Note this:

Analysts at SocGen said oil-indexation was already down to 55 per cent of total volumes of gas sales in Europe, and that spot indexation would be the dominant form of pricing by 2014.

The tipping point is nigh.  So Gazprom can hold its breath insisting on oil linked pricing until it turns blue, but competitive pressure and the insistence of buyers and the increasingly evident absurdity of its denigration of gas index pricing will eventually force it to capitulate.

This is one source of trouble for Gazprom.  Another source is the shale gas revolution.  It’s not right to say that there’s gas under every rock, but it’s not too much of an exaggeration to say there’s gas in every rock, and becoming easier to access every day.  Like in Algeria.

Other sources of trouble are closer to home.  Like Ukraine (“Little Sovok”) threatening to cut purchases of gas from Russia (“Great Sovok”).

And as Anders Aslund points out, at home proper-through an insane investment program pushed by Putin.  Even though North Stream is operating below capacity, it is plunging ahead with South Stream (gas supplies to be named later) and adding additional capacity on North Stream at a combined cost in the $50 billion range.  It is also moving forward on a massive greenfield production and LNG project in Siberia (cost-$40-$65 billion) to supply China.  You know, that big Asian country that Russia has failed to negotiate a deal with for traditional piped gas despite 5 (or is it 6?) years of bargaining: but hey, they’ve agreed on everything but price!

So, Gazprom is supposed to complete a gargantuan production and LNG project on spec, and negotiate the terms with the Chinese later, after the investment is sunk?  How do you say “holdup” in Russian?  And did I mention that Gazprom has never delivered on an LNG project?

That makes sense how, exactly?

The only way it makes sense is as a means of tunneling resources out of Gazprom into well connected pockets from steel pipe makers to Putin.  But that’s the epitome of good sense in Russia.

Aslund is right that the world’s most malign company-Gazprom-is in desperate straits.  Indeed, the splurge suggests that they know the game is up and are tunneling while the tunneling is good.  Maybe Putin realizes the game is up, and as Aslund suggests, is putting his chips on Rosneft instead, and in the meantime is directing an insane capital investment program to move as much money out of Gazprom as possible.  (Sechin’s ascendence is bad news for Gazprom as well: the bad blood between him and Gazprom is well known.  Thinking of which also reminds me of how insane BP was to go to Sechin to help them out with their Kovytka problem with Gazprom.  What could they have been thinking?)

This is all quite encouraging.

Who says there’s no good news?

Now That’s What I Call an Outtrade!

Filed under: Economics,Energy,Russia — The Professor @ 1:15 pm

In the futures pits, the bane of traders’ existences was an outtrade-when a trade was submitted for clearing but the buyer and seller couldn’t be matched.  An outtrade could be due to a difference or price or quantity.  The worst kind was when both parties thought they were on the same side of the trade.  Another kind of scary outtrade was when a trader said he bought, but there was no matching sale, or the reverse.

Ukraine and a Spanish company have such an outtrade apparently.  To the tune of $1.1 billion:

Ukraine, keen to show it is weaning itself off Russian gas, announced on Monday it had created a consortium to build a $1.1 billion liquefied natural gas plant, but its reported partner, Gas Natural of Spain, swiftly denied any involvement.

Ukraine said it would build the first LNG regasification terminal within its borders, in partnership with Gas Natural, which would allow it to import gas from all over the world, breaking its dependence on Russia.

But Gas Natural flatly denied signing any deal with Ukraine.

“Gas Natural has not signed any contract to invest in an LNG plant in the Ukraine, nor are we leading any consortium to develop such a terminal… nor are we studying anything along these lines,” the company said in a statement. [Sounds pretty definitive!  No ‘effing way I traded with you lot. I didn’t even think about trading with you lot.]

. . . .

Even after the official denial by Gas Natural, Ukraine’s state investment agency insisted the deal had been signed and said it was looking into the report stating otherwise.

“There must have been some miscommunication,” a spokeswoman for the agency said.

A miscommunication.  Over $1.1 billion.  It could happen to anyone!

As sometime commenter Elmer says, Ukraine is sovok.  It shows, and maybe this is an example of that.  But I wonder if sovok central-Russia-put the word in a Spanish ear.

November 25, 2012

Where Are the Tugboats?

Filed under: Military,Politics,Russia — The Professor @ 9:33 am

In any world crisis, it is said that the first question any American President asks is: “Where are the carriers?”

In Russia, it is: “Where are the tugboats?”

The decrepitude of the Russian navy is so pronounced that every deployment is accompanied by a salvage tug, just in case (and the case is quite likely) the sortied combat ships break down at sea.

Two examples.  A Russian anti-piracy deployment in the Gulf of Aden:

Led by the Udaloy class destroyer Marshal Shaposhnikov, the task force also includes the Irkut tanker and the Alatau rescue tug boat.

And it’s not just the Navy that needs help:

Salvage tug SB-36, a part of the squadron of the Russian Navy in the Gulf of Aden, met in the open ocean in distress schooner famous Russian traveler Fyodor Konyukhov and now accompanies her to the port of Salalah in Oman. On Wednesday reported RIA Novosti news agency, citing the press service of Defense Ministry.

Second example: the totally-totally!-benign deployment of Russian ships to Gaza:

“The detachment of combat ships of the Black Sea Fleet, including the Guards missile cruiser Moskva, the patrol ship Smetliviy, large landing ships Novocherkassk and Saratov, the sea tug MB-304 and the big sea tanker Ivan Bubnov, got the order to remain in the designated area of the Eastern part of the Mediterranean Sea for a possible evacuation of Russian citizens from the area of the Gaza strip in case of escalation of the Palestinian-Israeli conflict”, the spokesperson said.

I swear to God, every freaking time I read a headline about deployment of Russian Navy vessels, I ask: “Is there a salvage tug bobbing along after the cruiser or destroyer or whatever?”  And every freaking time I click the link, the answer is: “YES!”

Sorry.  It just cracks me up.

Let’s Hope Not

Filed under: Climate Change,Economics,Energy,Politics,Regulation — The Professor @ 4:48 am

Apropos my visit to Germany: Bloomberg reproduced a piece from titled “Can the US Create Its Own German-Style Energy Revolution.”  It is a paean to Germany’s Energiewende. Indeed, it is the capstone to a 6 part series (available as an Amazon eBook!) plus a slide show that is one big slobbering wet kiss to Germany’s top-down policies designed at controlling how energy is produced and consumed.  And of course, German top-down social control policies have always worked out so well.

The piece is a classic in the genre.  It measures “progress” in alternative energy purely by outputs.  How many MWs generated by wind.  How many generated by solar.  The cost of these MWs as compared to alternatives is not even mentioned, except obliquely.  And that oblique reference illustrates the absurdity of the whole exercise, not that the author of the piece notices:

For Tunnicliff, who works in natural resource management, adopting native landscape was a logical choice in a desert climate. Bolted to his roof was another rational choice: a solar photovoltaic system that supplies most of his family’s electricity needs. He installed the system even though he estimates it will take 12 years to break even on the investment.

“That is the future of energy,” he said, pointing to the dark blue panels on his roof.

12 years to break even on solar.  In Phoenix.  If that’s the future, we’re screwed.

Interestingly-but not surprisingly-the piece fails to mention any of the problems with Energiewende, in particular the huge costs of implementing the policy-costs that are far larger than originally estimated, and which are causing unease even in the relatively docile German populace as electricity tariffs are skyrocketing.  It also fails to mention the degradation in electricity quality that results from a reliance on solar and wind, which are vulnerable to the vagaries of the weather.

But there is one paragraph in the piece that should be sufficient to convince any American that this is a crack-brained idea:

The absurdity of the U.S. impasse over energy reform was highlighted when the primary author of the Germany law, Hans-Josef Fell, told me what I already had heard from other German leaders—that he was inspired to write the act by what today seems like an unlikely source.

“Your President Jimmy Carter was the first politician to promote an industrial revolution with renewables,” Fell said when we met in his Berlin office in April. “I looked to the USA in the 1970s. There was wind power in California and solar power on the White House. I thought, ‘Oh, this is wonderful! Why can’t we have this in Germany?'”

Jimmy Carter thought it was a great idea.  That’s all you need to know.

We don’t need energy revolutions.  We need energy evolution that is driven by balancing costs and benefits.  Costs and benefits that are highly unpredictable, and which can change rapidly in short periods due to technological, economic, and political shocks.   Exactly the circumstances in which top-down, socially planned, command-and-control-type approaches are extraordinarily inefficient, and prone to creating economic havoc.

I think Germany will come to regret Energiewende when it moves beyond dreaming about the environmental benefits and actually has to pay to costs of achieving them.  So let’s hope that the US doesn’t smuggle in Jimmy Carter’s energy policies using Germany as a cutout.

November 24, 2012

Meet the New Boss, Same as the Old Boss

Filed under: History,Politics — The Professor @ 10:11 am

Egyptian President Mohamed Mosri, already clothed with immense legislative and executive powers (and yes, Lincoln inspired that line), has now usurped judicial powers in what opposition figures are referring to as a coup.  Of course Mosri claims that his assumption of these powers is merely temporary.  Of course he claims that he is only doing so to “protect the revolution” and secure democracy.

How many times have we heard that before?  How many times has it turned out to be true?

Mubarek, whom Mosri replaced (and whom he is now retrying) was a corrupt, autocratic bastard.  It’s too soon to tell whether Mosri will be, as virtually all of his ilk eventually become, corrupt.  But it is not too soon to tell that he is an autocratic bastard, and an Islamist one as well.  All in all, Islamist trumps corrupt.  Easily.

So the title of this post isn’t quite right.  Mosri isn’t exactly the same as Mubarek.  And the crucial difference-his Islamism-makes him a far more dangerous figure.

The timing of this is telling.  Very telling.

Mosri made his move within hours of his brokering of a cease fire in Gaza.  He received fulsome-sick-making, actually-praise from Obama and Hillary Clinton for his role there.  For his peacemaking role, he was lionized.

And more to the point-he was also immunized.  Immunized from criticism of his power grab.  How could Obama possibly criticize him or take measures to oppose him in response to his putsch after having praised him to the heavens just hours before?

Not for the first time on the international stage, Obama was not a player.  He was played.

I wonder if he realizes that.  I sort of doubt it.  Speaking of immunized, he seems immune to recognizing his errors.

One more thing about the timing.  Mosri no doubt has been contemplating this for some time: the judiciary has represented the only check on his power.  But he no doubt had to tread carefully, given Egypt’s fraught economic condition (especially regarding its parlous food situation) and resultant dependence on American aid.

Perhaps Mosri just acted opportunistically, seizing the chance to execute his coup when circumstances tied American hands.

But perhaps-and this is just an observation that is consistent with the data, but not proved or likely even provable-there’s something more than that.  Perhaps Mosri is like the arsonist who makes himself a hero by rescuing children from the building he set alight.  He goads Hamas into action, or at the least, signals to them that he will support them in an attack on Israel.  Hamas takes the bait, and Mosri offers his, er, good offices to a desperate US to broker a settlement.  He then banks US goodwill for getting Obama out of the difficult political problem of supporting Israel, which is very popular in most of the US and very unpopular everywhere else, and among Obama’s prog constituency.  Goodwill in the bank, Mosri makes his move.

In any event, Obama is no doubt breathing a sigh of relief that the situation in Gaza has cooled down.  But this is only a respite.  An Islamist who is fundamentally (or should that be “fundamentalist-ically”?) opposed to the US is consolidating dictatorial powers in the largest Arab nation, and can exert tremendous leverage on the US via his ability to regulate-or not-the conflict in Gaza.  Mosri has Obama by the balls, and can squeeze at will.

Apropos the Who song that inspired the title: I tip my hat to the new (Egyptian) constitution; take a vow for the new revolution . . . . I get on my knees and pray, we won’t get fooled again.

But my prayers will not be answered, almost surely. Obama will get fooled again. And again and again.

A programming note.  Wordpress informs me that this is SWP post #2000.  Hard to believe.  The blog started in January, 2006, so that works out to about 6 posts/week.  (It seems I take off the seventh day too :-P).  I am writing this from Eltville am Rhein, Germany, which is kind of appropriate I guess since I’ve posted from 15 countries on four continents.  (This also represents the completion of my Axis Tour 2012: I was in Italy in June and Japan earlier this month.)

I owe a debt of gratitude to all those who have read SWP over the years.  I am continuously humbled by your attention.  The blog has gone in directions I had never anticipated when I started it.  It has had an influence, in a small way, particularly on arcane matters related to financial regulation, a subject I arguably at least know something about.  But the posts on Russia and politics-subjects I did not intend to address when I started SWP, and which some would claim I arguably know nothing about-have attracted the most interest and comment.  I value all the comments, and appreciate all the commenters-even those who bust my ass on a continual basis.  I truly miss people when they disappear from the comments.

This blog has evolved into an interesting micro-community uniting disparate people from around the world with somewhat overlapping interests, and whose interests overlap my rather diverse and idiosyncratic ones in some way.  It has changed my life in ways I had never expected.  I hope it has added something to yours.

And to close, a musical interlude (complete with my role model, Keith Moon!):

November 21, 2012

An Alfred E. Newman Take on JPM’s Physical CU ETF

Filed under: Commodities,Derivatives,Economics,Politics,Regulation — The Professor @ 4:01 pm

John Parsons and Antonio Mello at Betting the Business rightly slam the SEC’s evaluation of JP Morgan’s application to create a physical copper ETF. They are spot on that the SEC’s Division of Risk, Strategy, and Financial Innovation’s analysis was superficial, and quite frankly, silly.  Who knew that there was no connection between copper prices and inventories?

That said, I think that Parsons & Mello are far too generous in their praise for the comment letter submitted by the Americans for Financial Reform (an advocacy organization with strong ties to organized labor).  That letter posits some very speculative feedback loops: prices go up, people get excited about copper, they buy more of the ETF shares, driving up the price, and on and on.  If that mechanism exists, wouldn’t it exist even without the ETF?  And I’m dubious about the strength of that mechanism if it exists, and in fact doubt its very existence.

The only real concern is that the physical ETF somehow constrains the response of inventories to supply and demand shocks.  Inventories should rise when there are surprise negative demand shocks or positive supply shocks, and should fall with surprise positive demand shocks or negative supply shocks.  Speculative storage adjusts inventory in response to changes in fundamental conditions, and the forward curve is determined simultaneously.

If the ETF somehow impeded inventory adjustments, there would be a problem.  Here it should be noted that there is an asymmetry.  It is hard to see how that the ETF could in any way constrain increases in inventories.  If demand declines, for instance,  there is nothing to preclude traditional speculative storers from adding to inventories.

Things are conceivably different when inventories should decline.  One can at least consider the possibility that holders of the ETF would lock up inventory.

There is a redemption mechanism that limits this possibility.   “Authorized participants” (basically broker-dealers) can redeem ETF shares and receive physical copper in return: these firms would likely be ones that act as speculative storers in the absence of the ETF.  Thus, an ETF share is effectively a perfect substitute for copper warrants, and its creation does not obviously alter the market mechanism in a fundamental way.

I guess one could tell a story that goes something like this.  Irrational investors (not participants in the physical markets) hold onto ETF shares even if some of those shares should be redeemed and inventories released onto the market.  As a result, prices become too high.  Due to the excessively high prices, the Authorized Participants don’t buy and redeem the ETFs, cancel the warehouse receipts and load out copper when it should be loaded out.

For this price distortion to occur, the quantity held by the stubborn, irrational ETF investors must represent a binding constraint: they must end up holding the entire inventory.  Thus, a necessary condition-but not a sufficient one-for the ETF to distort inventory holdings (and hence prices) is that the ETF holds 100 percent of inventories.  (Note: things are a little more complicated because LME warehouses are located around the world, but the JPM ETF’s copper holdings will be limited to its Henry Bath warehouses.  It is conceivable that some inventory should be taken out of Bath warehouses, but isn’t due to the stubbornly irrational ETF holders.  So ETF holdings=100 percent of Bath inventories could be a symptom of a distortion, even if there are inventories in other LME regular warehouses.  However, to the extent that inventories in other locations are close substitutes for Bath inventories, the potential for a distortion is limited.   That’s one reason to have multiple delivery locations.)

Moreover, stubborn ETF holders who distort prices present a great short selling opportunity.  That also tends to limit the potential for a price distortion, particularly a large, enduring one.

My take on the JPM phyz ETF is therefore Alfred E. Newman-esque.  What?  Me worry?  One can imagine circumstances where it causes a problem, but the symptoms of this are clear: the ETF owns all the copper.  If those symptoms don’t arise, there’s no problem.  If they do-an unlikely event, IMO-take a look at it then, and figure out what to do in that event.

In other words: don’t borrow trouble.  Deal with trouble when-and if-it arises.

It’s Contagion, Stupid-Not Interconnectedness.

It is hard to overstate the importance of this report by Hal Scott and the Committee on Capital Markets Regulation, titled “Interconnectedness and Contagion.”  It evaluates the issue of systemic risk through the lens of the Lehman Brothers failure (and to a lesser degree, the AIG failure).

One way to summarize the report is “everything you knew about Lehman was wrong.”  Certainly, everything Gensler and Timmy! and Frank and Dodd and legislators and regulators around the world knew was wrong.

That conventional narrative is that Lehman’s failure brought the world financial system to its knees because it was so interconnected to the rest of the financial system.  That losses on exposures to Lehman-an most notably through derivatives exposures-threatened to propagate through an interconnected set of large financial institutions.   That the crisis was the result of a “daisy chain” or “domino” effect via what Scott refers to as “asset interconnectedness” (e.g., derivatives exposures) or “liability interconnectedness” (e.g., a big supplier of credit/liquidity fails, thereby forcing those dependent on it for credit or liquidity to fail).

Scott thoroughly debunks the interconnectedness narrative.  Instead, he shows persuasively that a contagion caused the crisis.  The Lehman shock dramatically shifted beliefs about whether large financial institutions would be bailed out, and also conveyed information about the severity of losses on real estate assets that were held not just by Lehman, but by a wide array of financial institutions.  This raised doubts about the solvency of all financial institutions, resulting in a run on their liabilities and a refusal to roll over these liabilities.  Given the dependence on short term credit, this run caused a major crisis.

In other words, it’s all about the funding mechanism.  It’s about liquidity.   It’s about runs.

Scott notes that the configuration of the financial network does affect its vulnerability to contagion, but that attempting to mitigate systemic risk through policies intended to affect the degree of interconnection is unlikely to reduce substantially the risk arising from contagion.

This is incredibly important because Frankendodd and EMIR and all of it is largely predicated on the belief that interconnection is the source of systemic risk.  But the diagnosis is wrong, meaning that the prescription is almost certainly wrong too.

Scott looks at CCP mandates in particular, and gives them 1.5 cheers.  I think that’s one or 1.5 too many, but it is gratifying to see that he does forthrightly downplay the potential benefits of CCPs as a means of preventing future crises.

The reason that I think he is not negative enough on this point is that he only looks at the first order impacts of CCPs, through their effect on derivatives netting, for instance.  He does devote some attention to the effects of CCP mandates on funding and liquidity, but more focused attention on the indirect effects of clearing and collateral mandates would, in my view, raise more serious concerns, especially in light of the primacy of funding/liquidity contagion channel in creating systemic risk.

Scott, citing Duffie’s work, claims that CCPs may reduce the incentive to run on big financial institutions.   I can see that in some scenarios, but I can also envision others in which a rigorous, highly-time sensitive, no-credit system like that will result from CCP and collateral mandates can lead to runs, either on the CCP, or on firms connected to the CCP.  That’s my take on what happened on Black Monday, 1987.

Clearing and collateral mandates will lead to a whole series of changes to the demand for liquidity, and the mechanisms for supplying it.  A cleared system is more tightly coupled; increases the likelihood in big shocks to liquidity demand; potentially ties up liquidity (especially under rigorous segregation regimes); and on and on.  Given the nature of cleared systems (and the imposition of rigorous daily variation margin based on mark-to-market for non-cleared derivatives), market users will make arrangements to secure contingent liquidity.  As a result, the entire financial network topology will change.  How it will change, and how these changes will affect systemic risk, are impossible to divine at present.  But it is certain that these changes will be profound and it is not difficult to imagine scenarios in which the new topology is as fragile in the face of large shocks as the old one.  Indeed, it’s not hard to imagine scenarios in which the new topology is more fragile than the old.

Clearing and collateral mandates should also be viewed as regulations of capital structures.  (“No credit extended through derivatives transactions” and “derivatives are at the top of the priority queue.”)  Capital structures will respond to this regulation, again in unpredictable ways, and in ways that affect the vulnerability of the system to contagion.

I am giving a talk on Monday at a joint Bundesbank-University of Frankfort conference about central banking.  My talk is about systemic risk and CCPs, and I will explore all of these themes.  The overarching theme is that you cannot view an intervention into the structure of financial markets, like a CCP mandate, in isolation.  You have to consider the endogenous responses throughout the system. The entire structure of financial contracts will change as the result of such a big intervention, and this structure will have its own special vulnerabilities.

When evaluating these vulnerabilities, one should pay special attention to liquidity issues, and liquidity contagion.  This was a theme of my JACF article “Clearing and Collateral Mandates? The New Liquidity Trap?”  Scott’s report adds special force to this contention that liquidity and contagion, rather than interconnection, should be the focus of any regulatory and legislative efforts.

It also suggests that much, and arguably virtually all, of the regulatory response to the 2008 Crisis was misdirected, and hence will either not reduce systemic risk, and may increase it.   Given the costs that these regulations impose, this is a sobering conclusion.

It finally suggests that it all comes down to central banks, as lenders of last resort.  If it is a liquidity problem (and in this Scott is closely aligned with Gary Gorton), the institutional means for supplying liquidity in times of crisis-which now means central banks-is of paramount importance.

November 20, 2012

Turning Japanese

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 9:58 pm

One of the things that turned Japan’s initial early-90s crash into Double Dip Lost Decades was the refusal to let failing firms die and the failure to force other firms to restructure or reorganize.  Zombie banks were allowed to live on, rather than being wound up or recapitalized.  Zombie banks continued to lend to inefficient loss making firms in desperate need of reorganization, restructuring, or seppuku, letting them stumble on unreformed, half-alive, half-dead.   The overwhelming urge was to retain the status quo to the greatest extent possible, and to resist the forces of creative destruction by all means available.

We can see the results, with a Japanese economy lurching along, also half-alive, half-dead.

A Reuters article suggests that the social and political pressures to maintain the status quo, to prop up existing firms (that just happen to have political connections), are leading China down the Japanese path:

The problems at China’s Yingli Green Energy Holding Co Ltd (YGE.N), the world’s No.3 solar-panel maker, are going from bad to worse as the company struggles with mounting losses, collapsing product prices and a stock in free-fall.

And yet, despite a government directive to rein in loans, Chinese banks keep extending credit to the New York-listed firm, and at below-market rates. Outstanding short-term borrowing has almost tripled to 8.2 billion yuan ($1.3 billion) since 2009, according to Yingli’s 2011 annual report.

. . . .

Yingli is one of many companies in China receiving life support from the country’s banks. That support – at a time when China’s economy and financial system are also under pressure – is raising fears that a spike in bad loans will push Chinese lenders into default.

“Banks like lending to us,” said Yingli’s Chief Financial Officer Bryan Li in an interview. “They feel that we are a potential winner if there is any consolidation in the industry.”

That feeling may come back to haunt the banks.

A Reuters News analysis on 40 of China’s most indebted companies – most of them from sectors already reeling with overcapacity such as wind-turbine maker Xinjiang Goldwind Science & Technology Co Ltd (002202.SZ) and COSCO Shipping Co Ltd (600428.SS) – showed debt levels rising as profits decline across industries that Beijing has said it wants to promote.

On average, operating profit at these companies dropped 15 percent in 2011 as their debt piles grew by the same percentage, according to company and Thomson Reuters data.

. . . .

Goldman Sachs & Co (GS.N) estimates in a research note that the NPL ratio is more than six times the official rate. [Gotta love that official Chinese data!] That’s already less pessimistic than most investors, who expect NPL levels of at least 10 percent, according to the bank.

Much of the pressure to lend to unprofitable firms comes from the government’s desire to prevent a total collapse in industries struggling in an economy that has slowed for the seventh consecutive quarter.

“If you run a bank’s operations in a certain province and the governor tells you to roll over a loan, you are going to do it even if it doesn’t make commercial sense,” said Arthur Kwong, head of Asia Pacific equities at BNP Paribas Investment Partners.

Japan misallocated capital for years, and is paying the price now.  China, through its stimulus programs, showcase projects, and now these efforts to prop up politically connected losers, is also wasting capital on a colossal scale.  When originally “invested”, this money shows up as GDP, and props up the growth rate.  But if that capital is used unproductively, that GDP gold turns to dross.

The Chinese hatred for everything Japanese-a hatred that is waxing particularly hot right now-will likely prevent them from learning something from the Japanese experience.  But by failing to heed the Japanese experience, China is running the very serious risk of repeating it.

It is far better to submit to the gales of creative destruction than to attempt to preserve an unviable structure and unviable firms.  Japan tried otherwise and failed.  China seems intent on making the same mistake.

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