Streetwise Professor

Krugman and others have been doing a victory dance, claiming that the Reinhart-Rogoff work on the relationship between debt and growth has been repudiated.  Hardly.  The R&R spreadsheet error (but I repeat myself) is embarrassing, but of minor consequence.  The other criticisms leveled by Thomas Herndon, Michael Ash and Robert Pollin are matters of judgment and interpretation, not definitive error.

James Hamilton has a balanced overview, as do Betsy Stevenson and Justin Wolfers.   Matthew Klein dissects the matter of New Zealand, which proves pivotal in the analysis.

Not surprisingly, Niall Ferguson is quite scathing in his criticism of Krugman’s gloating.  Ferguson just points out the obvious.  There is a limit to debt, and accumulation of too much debt leads to either default or inflation.  You can’t borrow a trillion (or about 6 percent of GDP) forever, or even for a modest period, without coming a cropper.

The most interesting part of Ferguson’s analysis draws an analogy I’ve used before: between governments and Enron.  (And Niall is nice, not pointing out that Krugman took Enron’s checks as an “advisor.”)  What do they have in common?  Hiding huge liabilities off balance sheet.  Well, that’s not really correct.  Governments don’t have proper balance sheets.  “Government accounting” is something of an oxymoron.  But in the main, the point holds.  The debt that was on Enron’s books was only a fraction of its actual liabilities, and the official debt of the US government (and most governments, for that matter) is only a fraction of its (and their) actual liabilities.  Indeed, Medicare, Social Security, loan guarantees, and so on are so large compared to official debt that the US government makes Ken Lay and Jeff Skilling and Andy Fastow look like petty grifters.

So debating whether debt greater than 90 percent of GDP results in a substantial reduction in growth is really a sideshow.  The US is around that level now (somewhat over it when all government debt is counted, somewhat under it when only debt in public hands is)-but when you tote up only Treasury bonds, notes, and bills.   When you add it the off-balance sheet items, 90 percent looks like the epitome of prudence and thrift.

Of course the government has off-balance sheet assets too-like its taxing power.  How do you value that? (Which is perhaps one of the reasons governments don’t keep formal balance sheets.)  But that taxing power is not unlimited.  What’s more, due to the deadweight costs of taxation, it is precisely using that “asset” that can be a drag on growth.

All in all, though, when you consider the true state of US government finances and count all the liabilities, the academic debate over whether there is a growth threshold when debt hits 90 percent of GDP appears, well, academic.

HSBC’s Gary Dunn said something at the ISDA AGM that I think is very important:

Dunn pointed out the risk characteristics of a CCP are very similar to that of collateralised debt obligations, the tranched credit products that were prevalent in the run-up to the 2008 financial crisis.

In the CCPs default waterfall, the initial margin payments from clients and default fund contributions from clearing members are comparable to the equity or first loss and mezzanine tranches of a CDO. In other words, these are the first sources of funds that get eaten into to cover any losses.

According to Dunn, the super senior tranche (which in the case of CDOs tended to attract Triple A ratings, but often subsequently sustained losses during the credit crisis) is the additional steps the clearing house might take when all other funds are exhausted, whether it is haircutting, asking for more capitalisation from clearing members of possibly even a government bailout.

“If you start modelling the risks of a CCP as a CDO, you realise the correlation risks in a CCP aren’t at the moment fully appreciated, very much like they weren’t when we had CDOs and CDO squareds,” said Dunn.

“The probability of a CCP failing is still relatively low, but there is a reasonable probability that people or banks lose money even if a CCP doesn’t fail,” he added.

I can hear you saying: “Where have I read that before?”  Or: “When have you said that before?”  In January, 2011, now that you ask 😛

Let’s see how this relates to CCPs, and in particular to the default funds of CCPs that are the ultimate backstop of cleared contracts.  Default funds are analogous to protection written on supersenior tranches.  The collateral (margin) that firms must post to CCPs when they hold derivatives positions absorbs most of the losses due to movements in market prices.  Indeed, margins are usually set to absorb 95-99 percent of market moves.  Beyond margin, CCPs often have their own financial resources to cover the losses associated with the default of any member firm not covered by margin.  If the margin and CCP-resource elements of the CCP “waterfall” (note the similarity of terminology used to describe tranched structures and CCPs) are breached, then the members must absorb the remaining default losses, up to some pre-established commitment level.

This means that CCP members must cover defaults only in extreme circumstances, just like writers of protection on supersenior tranches must cover defaults only under extreme circumstances.  Indeed, the oft-touted features of CCPs, such as collateralization create the seniority/out-of-the-moneyness that gives rise to wrong way risk if the pre-requisite dependencies also exist.

So it seems that CCPs are potentially vulnerable to wrong way risk.  They are effectively financial structures of a type that can, given the right (or wrong, depending on your perspective) dependence, give rise to a serious wrong way risk problem.  Which raises the question: are the dangerous dependencies likely to be present?  That is, are the contributors to a CCP default fund likely to be in bad financial straits just when their contributions are needed to absorb default losses? Are those that are insuring default losses (through mutualization) likely to be in dodgy condition precisely when they are most likely to have to pay off on that insurance?

This is a big deal. Wrong way risk is particularly poisonous, and a source of systemic risk in systemically important institutions like big CCPs. Policymakers have been largely oblivious to this very important problem.  I’ve been on about it for over two years, but we see how that matters.  Maybe if people like Gary Dunn start raising the alarm this issue will get the attention it deserves.

But, of course, Anat Admati, etc., will dismiss this as self-interested scaremongering by banks, and will criticize me as being some sort of tool (which she has, by the way).

I understand perfectly that such self-interested scaremongering occurs.  But I also understand that sometimes there is a wolf.  This is one of those times.

There are all sorts of proposals out there to rein in HFT.  The Europeans in particular-and in particular, particular, the Germans-want to do so.

I’ve long argued that there is good HFT and bad HFT, and that trading platforms have an incentive and the information to adjust fee structures and trading protocols in order to mitigate the latter.  For example, some exchanges have cracked down on excessive cancellations or the entering and canceling of orders far away from the current inside market.

Today’s FT reports another example, and a rather dramatic one.  One of the biggest FX trading platforms, EBS, is jettisoning the venerable time priority (“first come-first served) system with continuous trading.  Instead, it will collect orders that arrive during a period lasting a few milliseconds, and then execute them in a batch.  Instead of a continuous market, it appears to be a high speed sequence of call markets.  This eliminates the advantage of getting your quote in a millisecond sooner than someone else.  Perhaps it will also deter forms of gaming, such as strategies that (allegedly) attempt to create and exploit latency.

Will it work?  Who knows?  But that’s the point.  Markets facilitate the process of discovery.  Market participants compete to find solutions to problems.  EBS has identified a problem, and are trying to fix it using a fairly innovative change to the matching process.  If they’re right that some kinds of HFT are detrimental to market performance (and thereby reduces the demand for to trade on the platform), and their replacement of continuous trading with high speed calls impedes this detrimental HFT without impeding the good kind, they’ll make money.  And others will likely imitate, or take the basic idea and try to improve on it.

Or maybe it won’t work as planned. In which case they can try something else, or lose business to a platform that devises a better protocol.  The point is that a trading platform identified a problem with HFT, and is doing something about it, on its own.

All of this is far superior to top-down, one-size-fits-all government mandated “solutions” that are driven by political economy considerations first, efficiency considerations second . . . or third . . . or Nth.  Trading platforms may not internalize all the costs and benefits of better trading rules and fee structures, but their information and incentives are far better than regulators or legislatures.  Between competition among HFT firms, and the efforts of trading platforms to optimize the demand for their services, it’s likely that HFT’s rough edges will be smoothed out.  And if trading platforms don’t adopt such measures, you have to doubt seriously whether there’s a problem in the first place.  Because if there is a problem, they’d be the ones in the best position to know, and the best position to fix it.

Pre-Crisis, there was very little academic writing on clearing.  Post-Crisis, with questions about the role of derivatives in creating systemic risk, and the mandating of clearing of derivatives as a means of mitigating this problem, this is changing.  This is a good thing, but unfortunately, this burgeoning academic literature is at risk of irrelevance, and worse, of being misleading, because the theoretical models of clearing are nothing like clearing as it actually is.  These models tend to focus on the mutualization of risk within CCPs.  That’s important, but as I’ll discuss in more detail below, mutualization is not the most important feature of CCPs.  Collateralization is.

I’ll just talk about a couple of papers in detail, Adam Zawadowski’s Entangled Financial Systems in the most recent RFS, and Clearing, Counterparty Risk, and Aggregate Risk by Biais, Heider, and Hoerova.

These papers have some important insights, and I don’t want to seem overly critical.  I just want to persuade scholars that the focus of these papers, and many others, is misdirected, and to suggest where they should direct their attention.

“Entangled Financial Systems” presents a model of the periodic collapse of the financial system through the channel of inter-bank derivatives exposures.  The paper is rough sledding, in part because it tackles a complicated issue, and in part because the exposition and especially the proofs are hardly paragons of clarity: I have my doubts about some of the proofs.  That said, the story is a plausible one.  Banks use fragile capital structures (short maturity debt to fund long-lived assets) to solve an agency problem.  They use derivatives to manage risk in order to protect non-pledgeable income.  Banks are at risk of blowing up due to an idiosyncratic, exogenous shock: perhaps an operational risk, like a rogue trader.  If a bank blows up, its counterparties don’t get paid in full on their derivatives.  If these counterparties don’t insure against this risk, they may fail, and so on, with the result being a daisy chain of failures.  Thus, one idiosyncratic failure can lead to the collapse of the entire system.

In the model, the original risk of a blowup is idiosyncratic and insurable.  But in equilibrium, banks don’t buy insurance against a counterparty failing because they don’t internalize the impact of their failure on their other counterparties.  Thus, there is a “market failure”: the system blows up periodically because it is privately efficient but socially inefficient not to buy counterparty insurance.

One crucial issue with the paper is that most things are, laudably, endogenized, but one crucial thing is not: each bank can trade with only two counterparties located adjacently on a circle.  The choice of counterparties is exogenously specified. This concentration of counterparty exposure is crucial in making the system vulnerable to collapse.

Zawadowski recognizes that greater diversification of exposures across counterparties reduces the fragility of the system.  Although the externality may induce insufficient diversification across counterparties (because the systemic benefits of this aren’t internalized), market participants in reality have a variety of reasons to spread their trades across many counterparties.  Meaning that real financial systems may be less fragile than in the model, with its exogenously imposed concentration of exposures.

I’m also skeptical that an idiosyncratic risk at a single institution can bring down the entire financial system.  Look at some of the rogue trader losses-Kerviel at SocGen, Adoboli at UBS.  These guys cost their banks billions-but even such huge losses didn’t lead to a financial system meltdown via any channel, including a derivatives channel.  Instead, the 2007-2008 Crisis was related to a systemic shock-a decline in US real estate prices-that hit multiple financial institutions and investors.  It’s hard to identify an actual episode where the channel analyzed in the model-an idiosyncratic shock at a single financial institution-led to a financial meltdown.  The idiosyncratic nature of the risk is important: that’s what makes the risk insurable.  The paper therefore has little to say about non-insurable risks.

Where does clearing come in?  In the paper, clearing is a form of counterparty insurance.  Mandating clearing internalizes the externality.

There are several problems here.  The first is that in the model, counterparty insurance is supplied by a continuum of investors who can diversify away the risk.  A CCP in theory can also diversify the idiosyncratic risk by mutualizing it.  But note that CCPs are voluntary cooperative arrangements among financial institutions.  If there is a gain from collective action-internalizing the externality through cooperation-why don’t financial institutions voluntarily cooperate to form CCPs?   (Though in the context of the model, sharing the risk among financial institutions is more costly than passing the risk to investors.  Still, there is a collective benefit from cooperation among the financial institutions.)  Such cooperation increases joint wealth: why don’t market participants cooperate to internalize the externality?  What stands in the way of consummating such mutually beneficial bargains?   Moreover, why does it happen in some markets, not in others?

But the mutualization issue generally is the bigger problem, and the root of my qualms about the developing literature on CCPs.  Most of the models, including the Biais et al paper, formalize CCPs as a mutual risk sharing/insurance mechanism.  (Hell, I’ve done that myself.)

But mutualization is only one of the functions of CCPs As We Know Them.  Indeed, I am increasingly leaning to the view that it is the most problematic of their functions.

CCPs operate on the “defaulter pays” principle.  That is, real world CCPs attempt to choose margins (collateral) and default fund contributions so that they almost always cover a defaulter’s losses, and that non-defaulters’ default fund contributions are seldom used to make good a defaulter’s losses.  That is, default funds are tapped-and risk mutualized-only in rare, and arguably extreme, situations.

Put differently, only tail risk is mutualized in real world CCPs, and the primary function of CCPs is to set margins so that default losses are NOT mutualized, except in extreme circumstances.  CCPs are like monoline insurance of supersenior positions well down on the default waterfall.

In the context of the _ paper, this is particularly problematic, as he shows that collateralization is an inefficient way to address the externality problem.  It ties up valuable resources that could be used to fund positive NPV projects.   This is just one problem with collateral: the “initial margin problem”, if you will.  There’s also the variation margin problem that I’ve written about over the years.

I consider the tail-risk mutualization aspect of CCPs highly problematic because of the wrong way risk problem.  Like super-senior tranches of a CDO, losses hit the default fund during systemic episodes when those exposed to the default fund (the members of the CCP) are under stress.

This all means that the academic literature, which is modeling CCPs as mutual insurers, has two big problems.

The first problem is one of positive economics.  Existing models are not able to predict (a) why clearinghouses form, and (b) why they are primarily mechanisms to net and collateralize exposures, and only mutualize extreme risks.  They do not predict why market participants sometimes cooperate to implement a “defaulter pays” model, and sometimes don’t-and why they have never implemented a fully mutualized insurance scheme.

We need models that help us understand why market participants sometimes cooperate to implement a defaulter pays mechanism, supplemented by mutualization of the extreme risks; why they sometimes don’t; and why they never fully mutualize.  That is, we need to understand why so few risks are mutualized, even when market participants choose to form CCPs.

With all due modesty, I think the answers will will be found in my original analysis from the 90s: that the usual bugbears of insurance-adverse selection and moral hazard-make it uneconomically costly to mutualize risk, and that these problems also make centralized/delegated setting of collateral levels more costly than bilateral arrangements for doing so, depending on the characteristics of the traded instruments and those trading them.

The second problem is one of normative economics and policy prescriptions derived from models.  Policy recommendations based on models of CCPs that are flatly contrary to the way CCPs really operate are highly misleading, and dangerous.  Eliding from a model that says “mutualization of risk is socially efficient but privately unprofitable” to prescribing a policy of mandating CCPs is deeply flawed, when in practice CCPs won’t mutualize risk as in the models, but will instead implement a defaulter pays model.  (NB: of late regulators are telling CCPs that their main source of concern is that CCPs will set margins too low.  That is, regulators want to make sure that CCPs really make defaulters pay.  So in practice, mandated CCPs will mutualize only extreme risks, and collateralize the rest.  Nothing like what’s in the models.)   It’s a sort of bait-and-switch.

Prudent normative policy recommendations need to be based on a model with good positive content. We need to understand much better why market participants eschew implementing the defaulter pay model before mandating it.  For that’s what clearing mandates do: they impose the implementation of defaulter pays, NOT the implementation of the kinds of mutualization in many formal models of clearing.   Given the costliness of collateral (IM-not to mention the destabilizing effects of VM), it is particularly misleading to advocate policy measures that will lead to increased collateralization based on models in which collateral plays no role whatsoever.  Again-a bait-and-switch.

In sum, I’m pleased that many talented scholars are turning their attention to clearing. Especially when they cite me 😛 But it will be a shame if these scholars go on a wild goose chase, and construct models of CCPs that are completely disjoint from real world CCPs.  This goes double when they make policy prescriptions based on their models.

We need to understand the costs and benefits of defaulter pays, with the mutualization of only extreme risks.  For that’s what CCPs are really about.  We need models that are based on an understanding of collective action issues-because non-mandated CCPs are institutions that arise from collective action.  Only when we understand these issues should we have much confidence about making policy recommendations.

What’s up with the prevalence of the name Vlad in the comments?  It reminds me of one of my favorite Python sketches:

So, to all commentors: Mind if I call you Vlad?

This morning, in a post on Syria, chemical weapons, and how Obama would react to reports that Assad had used them, I asked “Will Obama Study Calculus?”   Apparently, based on remarks he made after I posted, the answer is yes!:

OBAMA: The Use Of Chemical Weapons In Syria Will ‘Change My Calculus’

“To use weapons of mass destruction on civilian populations crosses another line in terms of international norms and laws,” Obama told reporters in the Oval Office, according to a White House pool report.

“That’s going to be a game changer.”

Asked whether Syrian President Bashar al-Assad had crossed a “red line” by using chemical weapons, however, Obama hedged carefully:

“Knowing that there’s chemical weapons in Syria doesn’t tell us when they were used or how they were used. We ourselves will be putting a lot of resources on this,” he said, according to the pool report.  “A line has been crossed when we are seeing tens of thousands killed by the regime.”

“For the Syrian Government to use chemical weapons on its people will change my calculus,” Obama added. “This is not an on and off switch, it’s an on going challenge that all of us have to work with.”

Earlier Friday, White House Press Secretary Jay Carney also took steps to hedge the administration’s claim that Syrian President Bashar al-Assad had used chemical weapons against the opposition.

“We are continuing to work to build on the assessments made by the intelligence community, that the degrees of confidence here are varying, that this is not an airtight case,” Carney told reporters.

Note the use of use of the word “hedge” twice: who knew Obama was so into risk management?

He also said:

“Obtaining confirmation and strong evidence, all of those things we have to make sure that we work on with the international community,” the president said. “And we ourselves are going to be putting a lot of resources into focusing on this.”

Leading from behind.  Again. And talk about lawyerly caviling (which I did in this morning’s post)-his remarks are about as perfect an example of political circumlocution as you’re ever likely to see.  All in all, playing to the form I predicted in the morning.

SecDef Hagel has acknowledged that Assad used Sarin against the rebels in Syria, but the White House is being much more circumspect in its appraisal.  The circumspection undoubtedly traces directly to the fact that Obama declared the use of chemical weapons to be a “red line” in the conflict, but he has zero interest in getting involved.  But remember, Obama qualified what constituted the crossing of the red line: it wasn’t any use of CW, it was the use and or movement of “a whole bunch” of CW.

Did I call this or what?  From last August:

But Obama has avoided even the suggestion of intervention in Syria like the plague.

Until now.  He has drawn a red line, but in so doing, he sows confusion rather than producing clarity:

Seeking re-election in November, Obama noted that he had refrained “at this point” from ordering U.S. military engagement in Syria. But when he was asked at a White House news conference whether he might deploy forces, for example to secure Syrian chemical and biological weapons, he said his view could change.

“We have been very clear to the Assad regime, but also to other players on the ground, that a red line for us is we start seeing a whole bunch of chemical weapons moving around or being utilized,” Obama said. “That would change my calculus.”

“A whole bunch of chemical weapons”?  ”A whole bunch”?  Really?  WTF constitutes “a whole bunch”?  Is he saying to Assad that he can move around and use a few chemical weapons, as long as he doesn’t cross the “whole bunch” line?  Wherever that is.

Excuse me while I go pound my head on the floor.

OK.  Back now.

Look.  There is a principle often invoked in foreign policy, and politics generally, of “constructive ambiguity.”  But this is completely unconstructive ambiguity, that creates the potential for a miscalculation.  Obama gives the impression that Assad can become a little bit pregnant in the use of WMD.  Think a dictator with his back to the wall just might see how pregnant he can become?

No, this is not Machiavellian ambiguity on Obama’s part.  It is an attempt to look all butch and tough while giving himself some maneuvering room down the road if Assad or whoever gets their hands on chem and bio weapons uses them in the coming weeks or months.  Obama can rationalize not responding by invoking the “whole bunch” clause.

And note the unspoken corollary to Obama’s red line: Anything short of the use of chemical or biological weapons will NOT lead Obama to change his calculus.  At least that is very likely to be the corollary that Assad (and his BFFs, the Russians) draws from Obama drawing the red line at WMD.

There are no easy answers in Syria, and non-intervention is a defensible position.  But Obama has wanted to have it both ways, and now his bluff is being called.  As many have pointed out, how he responds will be watched closely by North Korea and Iran, not to mention China and Russia-and Syria. Assad has gotten a little bit pregnant, and nothing has happened.  Given his desperate straits-with most of his shambolic military penned up in bases with little ability to move or take the offensive-he has every incentive to see how much more pregnant he can get.

Lawyerly caviling about what constitutes “a whole bunch” will only convince hard men around the world that Obama’s bluffs can be called, with no consequence.  That bodes ill.

There’s lots of angst in Euroland over the plunging price of European Union CO2 Allowances.  Trading activity has crashed along with prices. And the Eurocrats are casting about ways to “fix” the “problem.”  And Eurocrats being Eurocrats, their mooted fixes are interventionist monstrosities that make a mockery of the idea of a “market” for CO2.

The reason for the price decline is blindingly obvious.  The European economy is sputtering, and lower industrial activity translates into lower output of CO2, and hence lower demand for emissions allowances.

In other words, the Europeans wanted to reduce CO2 emissions, and they got their wish.  Just not the way they intended: a bad economy accomplished their mission for them.   If they’re so intent on reducing CO2, you’d think they’d be happy.

But no, of course, they’re not.  They were hoping that economic activity would be robust, and that the resulting demand for allowances would keep the price high, thereby making powering this activity by fossil fuels more expensive.  This, in turn, would lead to greater reliance on no-carbon renewables like wind and solar.  In this version of Euro Disneyland, where wishes come true, windmills and solar panels would be powering a thriving economy: they would have their low carbon cake, and their economic growth ice cream too.

But no such luck. The sluggish economies, and the resulting low price of CO2, have delivered a body blow to the economics of renewables.

And that’s where much of the angst is coming from.  If it was all about reduced CO2 output, it shouldn’t really matter how you get there.  But of course investors in wind, solar, etc., want to support those investments, and the cratering of the CO2 price is very bad news for them.

So the angst is about protecting investments in renewables.

How are they going to go about this?  There have been proposals to delay the issuance of some new allowances for a couple of years to support the price, but these were shot down in the European parliament.  That delay-“backloading”-was considered by many to be prelude to canceling them altogether.

Such interventions make a mockery of the idea of a carbon market.  The man-made “supply” of allowances is subject to change at political whim, and becomes contingent on price, and how that price affects political constituencies.  This adds a huge element of risk to trading in this market.  It also adds a huge element of risk to any investment that depends on the price of CO2.  This can include not just wind and solar, but conventional power plants, and any other investment (e.g., refining or chemical manufacturing) that emits CO2.  And once the EU allows the economic interests of industries to drive supply decisions so as to affect price, all these affected parties have an incentive to influence the process.  That consumes real resources, and given the unpredictable and shifting nature of political equilibria, adds to the uncertainty over future supply.

In other words, these man-made carbon markets are not time consistent.  Unless the EU can commit not to change supply in the future, the “market” will largely involve speculation on future policy, with a huge degree of feedback.  Speculations about policy will affect prices, and prices will affect policy, which will affect prices, and on and on.  (Example: the price of CO2 allowances fell by 50 percent when the Euro Parliament rejected backloading.)

Which is wickedly ironic, given Euro attitudes about speculation.

That’s no way to make a market.  And come to think about it, any “market” that is a completely political construction is almost a contradiction in terms.  It can be at best a simulacrum of a market, at most a form of “market socialism”, but not the idealized market socialism of years past, but a market socialism buffeted by special interest politics and political economy considerations.

I was invited to participate in a panel on clearing at ISDA’s Annual General Meeting in Singapore, but unfortunately I had to decline on account of my teaching obligations.  I therefore have to nod (vigorously0 in agreement from afar, because much of the discussion there has focused on the unintended consequences of the clearing and collateral mandates.  Consequences that I have been warning about for over four years.

One of the things that infuriated me about the advocacy for clearing (and yeah, I’m looking at you GiGi) was the claim that clearing would reduce the interconnectedness of the financial system.  I said this was patently false.  Clearing mandates would reconfigure the topology of the network of connections among financial institutions, but they would remain interconnected.  I noted that: CCPs would be vital interconnecting nodes in this new network: failure of these nodes would be catastrophic: and perhaps most importantly, CCPs could be vectors of contagion precisely during periods of financial stress.  I pointed out very early on that CCPs were repositories of wrong way risk because losses would hit default funds precisely during periods of extreme financial stress, and via that channel would bring that stress right back to the balance sheets of the banks with exposure to the default funds.  You know, when they were least able to stand the shock.  The CCP circuit connecting banks would be closed precisely when they were least able to stand the shock.

In retrospect, I seem like a Pollyanna.  Compared to people like HSBC’s Gary Dunn, anyways (Risk link-requires a subscription).  Gary went all Jeremiah at the AGM, warning of an apocalypse emanating from the clearing system.  Actually, his word was “Armageddon”:

Mandatory clearing of over-the-counter derivatives could jeopardise policy-makers’ hopes of a no-bailout financial system, according to Gary Dunn, senior manager for regulatory and risk analytics at HSBC.

Speaking at the annual general meeting of the International Swaps and Derivatives Association in Singapore today, Dunn sketched out an “Armageddon scenario” resulting from the fact that the same group of international banks are all members of the majority of central counterparties (CCPs) – so, a big bank default would simultaneously hit all CCPs of which it is a member.

“What happens when one bank defaults across six CCPs? The remaining members will have to pick up the bill. Given that they are almost certainly members of the other CCPs, this will result in a default contribution bill so large it could potentially lead to their failure also,” he said.

Given the key role CCPs will play in the future financial system, Dunn argued this would ultimately result in a taxpayer bailout amounting to trillions of dollars. In his Armageddon scenario, that bailout would be preceded by the complete liquidation of CCP initial margin stocks – much of which would likely be held in the form of government debt.

“The wrong-way risk in the current CCP system is so large it could potentially lead to a sovereign default,” he said. [Emphasis added.]

Interconnections between SIFIs via clearinghouses, with the fragility of these connections perhaps exacerbated by the fragmentation of CCPs (due to fragmentation along jurisdictional lines, perhaps).  Where have you seen that before?  Hint: Not in a Gensler speech.

The clearing panel also fretted abou the possibility that in its attempt to eliminate TBTF, the G-20 has just created new TBTF institutions.  Too big, and too interconnected:

Central counterparty clearers stand to be the next “too-big-to-fail” institutions and could pose an acute threat to the financial system if regulators stall on plans to manage the potential failure of a clearing entity.

At the annual general meeting of the International Swaps and Derivatives Association in Singapore today, a group of panelists highlighted the lack of clarity over resolution for failed CCPs as a significant concern for the G20 objectives of eliminating systemic risk.

“There are still no resolution plans for CCPs and it is murkier now that clearing houses have moved away from the utility model,” said Athanassios Diplas, senior adviser to the ISDA board, speaking at the event earlier today.

The G20 objectives agreed in 2009 deem that no financial institution should be considered too big to fail and that taxpayers should not bear the costs of resolution for any institution that does fail

While regulators have been busy penning rules to deal with the problem of too-big-to-fail banks, concerns are shifting to clearing houses, and the increased concentration of risk held in them as the Dodd-Frank Act in the US and the European Market Infrastructure Regulation push an increasing number of standardised over-the-counter swaps through central counterparties.

“We’re getting very close to solving too big to fail globally for banks, but I worry that this risk could move to CCPs. I’m not convinced that we have made CCPs deeply resolvable yet – we have to do that to address systemic risk issue in a thorough way,” Wilson Ervin, vice-chairman of the group executive office at Credit Suisse told IFR.

All of which was perfectly foreseeable in 2009 when the G-20 blessed clearing as the silver bullet solution.  Foreseeable-and foreseen by some.

And the late start on addressing this issue before CCP mandates went into effect has left the world financial system in highly exposed:

While the Financial Stability Board addressed basic principals for clearing house resolution in June 2012, the issue remains on the back burner with many regulators as they continue to get to grips with a workable bank resolution regime

CCPs are the solution.  So in their wisdom governments decided to load risk onto them.  But dealing with the failure of these government-mandated SIFIs “remains on the back burner.”

Great.  That will turn out well.

Fools rush in where angels fear to tread.  Governments have rushed into prescribing the Clearinghouse Cure, but have relegated addressing the very dangerous potential side-effect of that cure “to the back burner.”

But we’re not done!  The panel also fretted about the potentially destabilizing effects of increasing collateral and margins-both initial and variation margin (can’t find a link to this Mary Childs story: I think it is only available on Bloomberg terminals):

The numbers are large enough to be very worrisome,” Athanassios Diplas, principal at Diplas Advisors LLC and a senior adviser to the ISDA board, said on the panel. “I don’t

think anyone has trillions lying around the couch cushions.” Regulators should be careful in setting the collateral requirements given that margin calls contributed to the escalation of the financial crisis in 2008, according to Kim Taylor, president of CME Group Inc.’s clearinghouse.

Spiraling Losses

“Margin calls triggered liquidation of assets for positions, which triggered mark to market losses for other parties. It contributed to the spiral, and I think there’s the  potential for threshold-based margin” to help avoid a repeat, she said on the panel.

Margin calls exacerbating a crisis.  Whoever heard of such a thing?  Only anyone who has studied past financial panics and market crashes.  But Gensler and Timmy! and so many others assured us that collateral is only good: the more collateral the better.  Just another item on the bill of goods they sold the world-and for which we may have to pay dearly later.

Scary addendum.  At a recent Chicago Fed conference, I told someone from a major central bank that although the initial margin issue was important, it worried me that central banks and regulators seemed to be ignoring how variation margin could destabilize the system, especially with an expansion of clearing, which creates a very tightly coupled system of margin payments that must operate on a very tight and rigid time schedule.  He told me that there wasn’t as much concern about variation margin because it netted out to zero.

Seriously.  I kid you not.   It’s as stupid as the Krugman “we owe national debt to ourselves” mantra.  The payers have to find the liquidity to make the payment to the receivers.  In stress situations, they have to find a lot of liquidity precisely when liquidity dries up.  In response, they do things that impose additional stress on the system, and can break it.  Money is not transferred instantaneously and frictionlessly between those who owe and those who receive.  Those frictions-and just the timing required to recycle the payments-can cause the system to freeze up during periods of stress.

The “what, me worry?” approach to variation margin is very worrisome indeed.

But don’t worry!  Regulators will ensure that CCPs don’t engage in a race to the bottom when setting margins:

Britain’s new regulator for market operators warned clearers of tougher policing of fees to stamp out cut-throat competition that risks undermining financial stability.

. . . .

“We are not in the business of preventing competition but what’s important is the terms of that competition,” Britain’s new clearing supervisor, Edwin Schooling Latter, told Reuters in an interview.

The Bank of England became the regulator for clearing houses this month and Schooling Latter said in his first media interview he will not tolerate “a race to the bottom” such as clearers allowing banks to post too low margins against trades.

Margins refer to traders of derivatives posting government bonds or other high quality collateral to help cover any losses and the level of margins is determined by the clearing house.

“We want a world where the clearing houses compete on the quality of their risk management and not on how low their margins are,” Schooling Latter said.

Because regulators, of course, are so skilled at pricing risks.  They did such a bang-up job of it when setting capital requirements under Basel.  And by “bang-up” I mean like a train wreck.

The Sorcerer’s Apprentice metaphor seems more apt by the day.  Regulators and legislators have cast the spell to bring massive CCPs to life, but cannot control the consequences-which can be dangerous indeed.  They intended to solve one problem, but they have created others, and are scrambling to deal with them.

The news coming out of Boston that will have the greatest ramifications for American politics in the near-to-medium term is the revelation that the FBI interviewed Tamerlan Tsarnaev at the behest of the Russian government in 2011.   (Originally, reports did not mention a specific country, even though anyone who can add 2 and 2 could figure it out: who did they think they were fooling?)  Add this to the fact that Tamerlan spent about 6 months in Russian-including time in Dagestan, which is currently the most restive and violent part of the Russian Caucasus-and one question comes to mind: What did the FBI miss?

On the fringes, the answer would be: “Nothing. They knew all along and wanted it to happen.  Hell, they made it happen.”  Claims of a “false flag” attack began almost from the moment of the bombing.  The Tsarnaevs’ parents’ statements can only feed these suspicions:

“My son would never do this,” Tsarnaeva said. “He was controlled by the FBI for three to five years, they knew what my son was doing, they knew what actions, on what sites on the Internet he was going,” she said. “So how could this happen? They were controlling every step of his.”

. . . .

Tsarnaeva, whose younger son Dzhokar, 19, was captured after an almost 24-hour manhunt that shut down Boston and surrounding cities, said she had been interviewed by Federal Bureau of Investigation agents about Tamerlan, who had described him as an “extremist leader.”

The brothers’ father, Anzor, also denied his sons’ involvement in the Boston attacks in an interview with Russian state channel Rossiya 24 in Makhachkala, saying they couldn’t “hurt a fly.”

Anzor, in an interview with The Wall Street Journal, said he was present when the FBI interviewed Tamerlan in Cambridge. He said they visited for what they called “prevention” activities. “They said: We know what sites you are on, we know where you are calling, we know everything about you. Everything,” he said as cited in the interview.

From such seeds will grow a New Trutherism.  (Ironically, it appears that Tamerlan was a 911 Truther.)

From the non-fringe, the FBI’s failure to identify Tamerlan as a risk will spark accusations of political motives and political correctness (“the Obama administration is soft on Islamist terror”) from the right.  Those who use “never attribute to malice which can be explained by incompetence” as an operating principle will argue that the FBI (and American law enforcement generally) works off an outdated and flawed model of the modern terrorist threat: that it is fighting the last war.

There is something in the linked Bloomberg article that supports this view:

U.S. intelligence agencies reviewing international communications and other terrorism intelligence found no signs that the suspected bombers were members of, or inspired by, any foreign terror group, said a U.S. official who asked not to be identified because those matters are classified.

In other words, the focus of the investigation was on connections to foreign terrorist organizations.  But what about self-starting, volunteerist terrorists motivated by Islamist rhetoric, propaganda and preaching?  It’s not like this risk was unknown in 2011, or in 2012 when Tamerlan went to Dagestan.  Major Hasan, the Fort Hood killer, is a classic example.  The (failed) Times Square bomber is another.

I will warrant that it is far more difficult to assess this risk: connection with a terrorist group is a far more telling indication of intent and capability to commit terrorist acts than is reading or echoing Islamist materials.  But apparently the latter was enough to make the FBI concerned and get Tamerlan on its radar: evidently, though, only taking the next step and affiliating with a terrorist group would have kept him there, or put him into custody.  Taking actions against such individuals is also much dicier, from a civil liberties perspective.

But such individuals are arguably now the greatest terrorist threat in the US proper.  Thus, I expect that the FBI will undergo considerable scrutiny as to how it has evolved to address the home-grown, self-starting terrorist risk, especially post-Fort Hood/Times Square.

And the FBI is inherently a politicized organization, and has been for decades.  Its failures inherently lead to questions about the responsibility of the Attorney General and the President for them.  In some respect these questions are legitimate, but they will also feed partisan attacks.

So look forward to months of highly charged debate over the FBI’s failure to identify Tamerlan Tsarnaev as a terror risk despite been warned about him, leavened with fringe-but very loud-claims that it directed him as part of a dark conspiracy against the Republic.  Every revelation about Tamerlan’s travels, his Islamist reading or statements will only add fuel to the fire: “Why didn’t the FBI connect these dots?” The self-preservation instincts of politicians and bureaucracies ensures that there will be a war of leaks between the FBI and the administration-these too will fuel the controversy.  I wouldn’t be surprised if this also reanimates the moribund interest in Benghazi.   I also wonder what kind of information the Russians will announce, leak, or make up in an attempt to use the episode to advance their interests.

Heretofore, Obama has been largely immune from blame for terror attacks-Major Hasan and Benghazi being primary examples.  Boston hits much closer to home, however, and the FBI’s longstanding knowledge of the perpetrator means this situation poses a far greater risk for him.  And like I said in an earlier post, knowledge of this might have fed Obama’s rage at the Rose Garden temper tantrum on Wednesday.