Streetwise Professor

One of the predictable though unintended consequences of Frankendodd (and its European cousins) will be to increase concentration in the banking sector.  Not just predictable: predicted, including by me (notably at the JP Morgan Commodity Conference in October 2011, and here on SWP).

The logic is fairly straightforward.  Frankendodd creates a huge regulatory overhead that in turn leads to scale economies.  Smaller-to-medium-sized entities will not be able to afford these overhead costs, and will exit the business, and the bigger firms will get bigger.  The overall level of activity is likely to go down as a result of the exit and expansion, but the biggest firms are likely to get bigger even if the market overall gets smaller.  Moreover, the capital and collateral requirements in Frankendodd, including in the derivatives title, have disparate impacts on different market participants  Since the smaller entities typically have higher capital costs than the bigger ones, this increase in capital needs to support trading businesses in particular will lead the smaller market participants to contract more than the bigger ones; this increase in their capital costs may also induce them to exit altogether, especially when taken in conjunction with the increase in regulatory overhead associated with trading businesses in particular

Given that Frankendodd was allegedly intended to address the too big to fail problem, it is perverse that one of its predictable consequences is to increase concentration, and likely increase the size of the biggest firms in the market.

We may be seeing the first major move in this direction, just as Frankendodd’s big boot is starting to kick in.  Morgan Stanley announced deep job cuts, and rumors are flying that it will exit the fixed income trading business:

Now the storied company — whose take-no-prisoners trading desks have at times been rivaled only by firms like Goldman Sachs — is cutting even deeper, raising questions among some on Wall Street about whether it should spin off or ditch much of its trading business as its Swiss rival UBS has, a suggestion the firm eschews.

. . . .

Morgan Stanley’s board, said people briefed on the matter, has discussed closing its fixed-income department. Instead, the firm is shrinking the unit, arguing that it is important to offer its customers those trading services. By cutting jobs and costs and exiting lines like structured products and other complex financial investments and focusing on less risky, less capital-intensive businesses like the trading of interest rates, executives contended that the division can generate a healthy return.

So they’ve discussed it, but decided to keep it in a shrunken state.  But it may have to revisit the more drastic measure:

In recent years, the fixed-income department has not been able to make enough money to cover the cost to Morgan Stanley of this capital, according to people briefed on the matter but not authorized to speak on the record

If it hasn’t covered its cost of capital pre-Frankendodd, lotsa luck with covering it afterwards.

Frankendodd will cause a contraction of the financial sector, which isn’t necessarily a bad thing.  But the contraction will be uneven, and the fundamental nature of Frankendodd favors a relative expansion, and perhaps an absolute expansion, in the biggest-the JP Morgans and Goldmans and Deutsche Banks.

Hardly what was intended.  But that’s different to say it wasn’t predictable.

Stephen Bainbridge, an eminent UCLA law prof of my (slight) acquaintance, has been rocking on the Ace Greenberg suit against the federal government.  He brutally eviscerates those in Congress and the media that exhibited their high dudgeon at the temerity of AIG’s board in even considering joining the Greenberg suit.  But more importantly, he reinforces and complements the point in my previous post on the subject.  Specifically, he argues that there are serious issues at stake here.  That the fact that the government provided “assistance” to AIG during crisis conditions does not give the government carte blanche to dictate the price of that assistance, if in so doing (a) it tramples on the legal rights of AIG shareholders, and (b) expropriates wealth from those shareholders by exploiting AIG’s financial distress to impose punitive conditions on that assistance.

During the crisis, the government asserted that the gravity of the emergency justified extraordinary measures that trampled well-established legal protections and procedures.  The terms of the Chrysler bailout are one clearcut example.  The AIG case is plausibly another.

This turns things on their head.  If particular measures-like protecting AIG’s derivatives counterparties-are so important that they create a substantial amount of wealth, paying fair compensation shouldn’t be a problem. Moreover, doing that reduces fears that the government will expropriate wealth in the future, and that limits the chilling effects on investment that expropriation threats engender.  In contrast, the attitude that property and legal rights are forfeit when the government in its wisdom deems that emergency conditions justify it, has an extremely corrosive effect.

Put differently, a government that creates a reputation for protecting property and legal rights even during extreme circumstances also creates an environment that is conducive to growth.  In contrast, one that creates a reputation for opportunistically exploiting crisis situations by transferring wealth to itself, or to favored constituencies (like Chrysler’s unions), creates an environment that is hostile to investment and growth.

Sort of like Russia, in other words.

The US Senate s sometimes called the World’s Greatest Deliberative Body.  At times-most times, in fact-it seems that it would be more apt to call it the Deliberative Body With the World’s Greatest Proportion of Room Temperature IQs.  Many notable dimwits come to mind-Barbara Boxer, for instance. But the dearly departed (from the Senate, anyways) Blanche Lincoln was oh-so-special in her dimness.

As a sort of parting gift prior to her electoral rout in 2010, Blanche succeeded in inserting the eponymous Lincoln Amendment into Frankendodd.  This was the “swaps push out” provision, which precluded any “swaps entity” from receiving assistance from the Federal Reserve.  This requires banks to “push out” dealing in derivatives to separately capitalized subsidiaries that have no access to the Fed discount window, or other sources of federal support.

Crucially, the Lincoln Amendment was limited: basically, only equity derivatives, some credit derivatives, and commodity derivatives (with the exception of gold) were pushed out.  Banks were allowed to maintain their bread-and-butter rates derivatives business, as well as some of their credit trading businesses.  I guess the theory was that commodities are scary risky, but banks can’t jeopardize themselves by playing in interest rates.  Or something.

Well, that’s true of US banks, anyways.  But due to the meticulous drafting that characterizes Frankendodd, branches of foreign banks cannot avail themselves of the same exemptions.  This includes behemoths like Barclays and Deutsche Bank.

So now the Fed is trying to clean up after Congress, endeavoring to find ways to blunt the effects the provisions of the Lincoln Amendment on foreign banks.  Easier said than done, because despite the fact that “Ms Lincoln called her amendment’s treatment of foreign banks’ uninsured US branches a ‘significant oversight’ that was “unfortunate and clearly unintended. . . . the language of the legislation is clear, regulators are unable to use [Lincoln’s] statements on the Senate floor to unilaterally change the implementation of the law. ”

Good times.  Good times. Just another of the land mines lurking in Frankendodd.  Think of how many more are to be found.  And how many are buried in Obamacare.

Like I said.  Good times.

This poll finds that cockroaches, head lice, and Ghengis Khan are held in higher esteem than Congress.

Hahaha.  Very droll.

Look. I hold Congress in very low esteem myself.  But here’s the thing.  This poll, and others like it, will be used to discredit and undermine any Congressional opposition to what the One Musketeer wants.  (The One Musketeer being Obama, of course: The One for the One, and All for the One.)

Obama has made it clear that on any issue ranging from guns to the debt ceiling he is willing to use extraordinary executive measures to achieve what he wants.  To do so, he must circumvent Congressional opposition, notably Republican opposition in the House.  The most effective way to circumvent is to discredit, and the most effective way to discredit is to ridicule.

Congress, alas, provides much fuel for ridicule.  But given the choice between unfettered presidentialism that can do something, and a clown Congress that can’t do anything, I much prefer the latter.

There is a lot of evidence (and theory) showing that presidentialism leads to bad outcomes, in the spheres of economics and civil liberty.  As buffoonish as Congress can be, an ineffectual legislature is much less a danger to our lives, liberty, property, and prosperity than a highly effectual executive.  To paraphrase Eugene McCarthy, the only thing that saves us from government is its inefficiency. Give me an inefficient Congress over a ruthless, determined, and effectual executive any day.

The Founders knew this.  (Cf. the Federalist Papers.)  We have forgotten their wisdom.

Embracing presidentialism in haste, and because of our disdain for Congress, is a mistake.  A major mistake.  Embrace presidentialism in haste, repent at leisure.

Lord knows, I yield to no one in my disdain for Timmy! But with the appointment of consummate DC apparatchik and noted infighter Jack Lew to succeed Geithner at Treasury, I think we may soon look back wistfully on Timmy!’s days as SecTreas.  I am missing him already.

AIG has attracted a lot of ridicule and anger with the announcement that it might join Ace Greenberg’s suit contesting the Constitutionality of the firm’s bailout in 2008.  The prevailing theme is that AIG is being extremely ungrateful.  If the Feds hadn’t bailed it out, it would have gone bankrupt, and its shareholders would have gotten nothing.

Well, Greenberg’s point is that its shareholders did get nothing, and gave up something valuable in return.  That the government exploited AIG in its hour of distress.

I realize that the suit has a snowball’s chance in hell, and that there is a rather tragicomic aspect to it.  But, contrarian that I am, I feel obliged to offer up a couple of counterpoints to the conventional wisdom.

Most notably, bankruptcy law incorporates several provisions intended to protect the claimants of financially distressed firms from the depredations of would-be saviors.  Preference and fraudulent conveyance provisions of the bankruptcy code permit other creditors to claw back money from a “savior” that buys assets from a distressed firm at bargain prices.

AIG didn’t declare bankruptcy, so this isn’t a legal issue.  Moreover, it would be a remedy available to creditors, not shareholders.  But the basic principle is pretty clear: you can’t take advantage of a firm’s financial distress to extract unduly favorable loan terms, or to buy the firm’s assets at unduly favorable prices.

That’s the gravamen of Greenberg’s claim.  That the Fed and Treasury obtained control of AIG at a fraction of its true value because the firm had no alternative but to accept these terms.  “The firm was  going to fail if it didn’t accept my terms” doesn’t fly in bankruptcy court.  Given the implicit principle in that, why shouldn’t the same argument apply to the US government?  I would actually suggest that the question should be: why shouldn’t that argument apply with special force to the US government, given its disproportionate power, especially during such extraordinary times?  Bankruptcy law is structured to protect the creditors of desperate firms from the the predations of those who exploit that desperation.   An efficiency-driven economic story can be told to justify that structure.  That story applies when the potential exploiter is the government.

Interestingly, at the time of the crisis, Bernanke testified before Congress that due to the liquidity crisis, market prices of assets were far below their fair values based on discounted expected cash flows.  He did so, in part, to justify Fed assistance to everyone from banks to money markets: “It’s a liquidity problem, not a solvency problem, so we’ll get paid back.  It’s not really a bailout.” Given the evaporation of liquidity and the implosion of asset markets at this time, it is pretty clear that conditions were extraordinary, and those with money to spare-like the Fed and the Treasury-wielded the whip hand.  The liquid were in a dominant position to extract wealth from the illiquid.

And that in a nutshell is what Greenberg is claiming that the Fed did: the Fed exploited AIG’s illiquidity (which reflected the general implosion of liquidity) in order to get assets for a song.  So Greenberg’s claims should not be dismissed out of hand.  Indeed, Bernanke’s Fire Sale Chat provides considerable validation for his claims.

That said, there are other considerations.  Moral hazard, for instance.  Bagehot’s dictum for the lender of last resort-lend against good collateral, at penalty rates-reflects a balance between liquidity and moral hazard considerations: the penalty rate provides a disincentive to court trouble.  Pour encourager les autres, it was appropriate to pay below fair value for AIG’s assets/equity, lest others take excessive risks in the comfort that a Fed put would protect them from the worst.

But how much below?  That’s a harder question.  But it’s by no means obvious that 100 percent below is the right answer.  Those responding to Greenberg and AIG in such high dudgeon believe it is the right answer.  Contrarian that I am, I wouldn’t be so sure.

Back in the mid-to-late-1990s, when I first started reading about global warming (which has since be relabeled to the more, umm, flexible “climate change”), one thing that struck me is that estimations of temperature trends were statistically daft.  The temperature data appeared integrated, that is, non-stationary.  (The data are I(0) I(1) technically.) This means that temperatures are characterized by “stochastic trends.”  So estimating some sort of time trend, and projecting it into the future, is statistically nonsensical.  The trends estimated in that way jump around randomly.

It surprised me that it didn’t seem that this had been recognized in mainstream climate science.  I searched around a little, and found a Russian scientist (a hydrologist, I believe, but I can’t put my hands on his name or his book) who had written about this.  (In a way, not surprising, because hydrological time series present interesting integration issues, including fractional integration.) We corresponded a few times, but the language barrier was a problem.  And it seemed like he was a voice in the wilderness anyways.  He wasn’t a climate scientist, and his book was obscure and badly translated.

Thinking about an integrated time series like temperature, and the theory that CO2 drives temperature, immediately brought to mind the question of whether temperature and CO2 are co-integrated.  Cointegration would suggest some causal connection between these variables: a lack of cointegration would suggest no causal connection.  Absent cointegration, the correlation between temperature and CO2 would  be a case of “spurious regression.”  Spurious regression occurs when two unrelated, but highly autocorrelated time series are regressed on one another.  One way of thinking about spurious correlation is: are you going to believe your lyin’ eyes? The answer is no: just because two (integrated) time series seem to move together does NOT mean that there is any causal connection between them. Basically it means that the association between CO2 and temperature, which seems so compelling to the naked eye, is statistical garbage.

But I never pursued the idea, because, well, I had lots of other fish to fry and climate science was/is not my comparative advantage.  Fortunately, years later-far too long, IMO-somebody has taken up the issue. Using more sophisticated techniques than I would have considered using, the authors of this paper demonstrate that temperature and anthropogenic variables (e.g., CO2) are not polynomially cointegrated.  At most, they find that shocks to CO2 have a temporary impact on temperature.

This is a major problem for global warming absolutists, who see a mechanical connection between CO2 output and temperature.

And I am amazed that it’s taken so long for someone to have explored this rather obvious research path.  But given the results . . . maybe not.

Note that most of the references in the paper are to the econometric literature.  Time series econometricians have thought deeply about integrated time series for a long time.  It’s about time for climate scientists to do the same.  Actually, it’s well past time.  About 15 years, at least.

Today is the 7th anniversary of SWP. What a long, strange trip it’s been.  The blog has evolved and morphed in ways I never expected.  I’ve always been a firm believer in serendipity, and this endeavor has only confirmed me in that belief.  Writing about Russia was the furthest thing from my mind when I started.  I didn’t anticipate writing much about politics.  Even my original ostensible purpose-writing about financial market infrastructure and commodities-manifested itself in wholly unanticipated ways.  The Financial Crisis and the laws and regulations it spawned, notably Frankendodd, propelled me in directions I couldn’t have even imagined at the apex of the Great Moderation in early-2006.

The stats: 2031 posts, and 15060 comments.  A pretty steady stream of 3500-4000 unique visitors/day, plus decent traffic at other sites that reproduce SWP content, like SeekingAlpha and Wall Street Pit.  A steady stream of links at other sites. The strangest stat?  That Latvia is the biggest non-US source of hits-about 10 percent of the total in November and December.

I’d just like to express my appreciation to all of you who read SWP, especially the regulars.  You are the reason I keep plugging away here.

Where will SWP goes from here?  Who knows? Certainly not I.  That’s because for the most part what I write is driven by what is happening in the world and the markets, and those are unpredictable.  Add to that my rather idiosyncratic, eclectic, and randomly evolving interests and fancies, all that I can predict is that unpredictability will characterize the future as it has the past.  The trip to Serendip will continue, and I hope you all continue to accompany me on that journey.

Proving again that Al will never let consistency of principle stand between him a a big payday, he is walking away from the sale of Current TV (surely you’re eyes are always glued to that, right?) to Al Jazeera with a reported $70 million.  Al Jazeera, of course, is largely funded by the Qatari government.  And Qatar is a major producer of the fossil fuels that Al dreads so much, particularly natural gas.  Indeed, Qatar is the world’s largest exporter of LNG, accounting in 2011 for 75.5 million tons out of a world total of 241.5 MT, far outdistancing number two exporter Malaysia which exports only a third of Qatar’s volumes. Quite impressive, given that Qatar only began LNG production in 1997.

But maybe there is some consistency here.  Al hates fracking.  Qatar hates fracking too.  Increases in output of gas in the US due to the fracking revolution, and the potential migration of that technology to other regions, represents a major threat to Qatari export volumes, and the price it can get from those exports.  Qatar is already cutting back spot volumes trying to lock Asian customers into long term contracts in anticipation of increased competition resulting from increased output of non-conventional gas, as well as gas offshore gas produced in Australia.

Qatar is no doubt looking for ways to crank up the propaganda war on fracking, and Current TV’s prog audience (to the extent it has an audience) is highly receptive to that message.  Need proof of that? New York governor Andrew Cuomo is allegedly spiking a state-commissioned report that demonstrates that fracking does not present a health risk. Why? Well let’s hear it from the horse’s mouth (and yeah, the other end too), the New York Times: “Mr. Cuomo, a Democrat, has long delayed making a decision, unnerved in part by strident opposition on his party’s left.”

So Current, which would not even enter into negotiations to sell to Glenn Beck because “they wanted to sell to someone they are ideologically in line with”, has apparently succeeded in that objective.  They found a fellow fracking foe to buy the network, therefore no doubt easing whatever qualms they have about selling to a network known for Jew hatred, which receives funding from a country that has become notorious of late for being the main arms trafficker for civil wars in Syria, Libya, and now Mali, with many of these weapons allegedly going to Al Qaeda affiliates.

Qatar bears watching.   It is difficult to figure out what its game is.  It is, as just noted, heavily involved in intramural Muslim conflicts in Africa and the Middle East.  Some of this is easy to understand: fighting Syria is a proxy war against arch-foe Iran.  The broader support for radical Islamic elements is far more difficult to understand, and quite troubling.   Is Qatar operating on its own?  Is it a Saudi cutout?  Qatar has also had tempestuous relations with Russia, culminating with a downgrading of relations following the battery of three Russian diplomats including the ambassador at the Doha airport: the fight erupted when Qatari securities and customs personnel attempted to wrest a diplomatic pouch from the ambassador.

But Al apparently doesn’t care about all this.  He has the green, and his green conscience is salved by a transaction with a fracking foe.  Even one whose gas exports account for 206,250,000 tons of CO2 every year, and whose oil production generates another 205,000,000 or so tons, volumes that commenter Green as Grass helpfully points out allow Qatar to claim the title of world’s largest CO2 producer per capita.  There’s an inconvenient truth for you, eh Al?

One of the kerfuffles that is adding to the sense of panic in DC is the prospect for a doubling of milk prices if a new farm bill doesn’t pass.

The story is not the most important thing going on, by far, but it does illustrate the bizarro world that is normality, DC style.

Here are the details.  In 1949, Congress passed a law that required the government to support the price of milk at 75 to 90 percent of 1914 parity levels.  That is, farmers would be guaranteed a price equal to as much as .9 times the price of milk in 1914.

By the early 1980s, it became clear that this price was insanely high given the substantial increases in productivity (driven, for instance, by mechanization and by artificial insemination that improved the quality of the dairy herd.*)  There was a very visible sign of how out of line the official price was.  The US government accumulated huge inventories of cheese that it bought and stored to prop up the price of milk.  By 1981, government cheese could have filled a freight train stretching from the tip of Maine to the Florida Keys.

But rather than let the market determine the price of milk, Congress periodically set new support levels.  These levels were above the competitive price, but below the parity price.

Here’s the kicker: the support levels are time-limited, and if Congress doesn’t pass a new support level when the old one expires, the support level reverts to that set by the 1949 bill.

That’s where we are now.  Congress hasn’t passed a new farm bill, and the support levels set in the old bill are about to expire.

This problem is easily solved.  Pass a farm bill that (a) sets no new price support, and (b) repeal the reversion to the 1949 bill. Then milk prices would go down.

Since prices going up is a bad thing, prices going down should be a good thing, right? Right?  It works both ways, right?

But that isn’t even on the table.  Instead we get this shrieking about the return to the 1949 law, as if it’s somehow sacrosanct.

It gets better.  Agriculture Secretary Tom Vilsack gave a 5 hanky interview with Obama shill Candy Crowley in which he lamented the failure to pass a new farm bill as a sad testament to the powerlessness of rural America.

Seriously?

The persistence of price supports, in milk, and in sugar, and in other ag commodities, is in fact a testament to the disproportionate power of the ag lobbies.  These programs transfer billions of dollars from urban and suburban America to farmers.  Much of the impact is felt by poor Americans.  But don’t worry!  We’ll offset that by food stamps-pardon me, SNAP-a program that has metastasized, almost doubling in size in terms of participation, and more than doubling in dollars since Obama took office.

These price supports are an abomination.  They are textbook examples of redistributive government policy creating deadweight losses.

For Vilsack to get all weepy about the political weakness of rural America just adds insult to injury.

I knew Ross Perot was an economic idiot when during the 1992 campaign he expressed bewilderment at how the political power of the agriculture interests increased as the farm population declined.  Basic political economy provides the answer to that: small, concentrated interests exert disproportionate power The benefits are concentrated, the costs are diffuse.  The beneficiaries have a strong incentive to pay pols to advance their program because each individual gets a relatively large amount of money in the bargain, and those who pay the costs don’t have the incentive to organize an opposition because no individual pays a big cost (even though the collective costs are huge).  An individual farmer might make several thousand additional dollars.  An individual consumer pays a few dollars more.  No individual consumer has an incentive to spend to oppose the bill, but individual farmers do.  As the farm population has shrunk, it has become more concentrated and homogenous, and much more powerful as a result.

This is not the biggest policy disaster we face now, but it does demonstrate the dysfunction of our politics.  And no, it’s not the dysfunction that the Vilsacks and the other DC denizens routinely bewail: the inability to get things done.  In fact, getting things done is exactly the problem .

And what gets done is us.  Who gets milked to pay for the milk program? You do, sucker.

The apparent “solution” to the so-called Fiscal Cliff supposedly addresses this issue.  Oh joy.  Just another bolt on that Frankenstein’s neck.

The bill the Senate passed is truly a monstrosity.  It is wrong on every dimension.  It raises marginal tax rates on some, but doesn’t address any of the wasteful, and completely unjustified, inefficiencies in the tax code.  That is, it doesn’t eliminate any of the politically popular but economically inefficient deductions.  It raises taxes on capital (dividends and capital gains), which is horrible because capital taxes are highly inefficient.  It doesn’t cut spending.  It doesn’t address entitlements.  At all.

And to add to the seasonal joy, the IRS today announced rules related to Obamastein, AKA the Affordable Care Act.  Per the IRS, it won’t be so affordable for families.  Although ACA mandates that employers who provide insurance make available reasonably priced policies for employees, it says nothing about family coverage.   The IRS rules don’t either.  Meaning that a likely outcome is that many employers will offer cheap individual policies, and outrageously expensive family coverage.  Thereby driving people to . . . exchanges that many will not be eligible for?  Exchanges that might not even exist?

Obama assured us “you’ll be able to keep the coverage you have.” Hahahahahahahaha.  Joke’s on you, suckas.

So I wish you a Happy 2013, my fellow bovines.  Like all those cows who exist because of the federal government, you are about to spend 2013, and many years to follow, getting screwed then getting milked.

* My dad was president of an AI firm back in the 1970s, Curtiss Breeding Service.  It was a subsidiary of GD Searle.  The business’s bread and butter was a bull named Paclamar Astronaut, who sired upwards of 40,000 offspring.   My parents have a large print of Astronaut in their house.  He paid the rent for quite a while.  Until Don Rumsfeld became CEO of Searle, and disposed of Curtiss.