Streetwise Professor

November 30, 2013

It’s Not Your Retro Brent-WTI Spread

Filed under: Commodities,Derivatives — The Professor @ 5:47 pm

The Brent-WTI spread reached a record level last week, defying predictions that the gap would continue to close.  But this isn’t the retro spread of the last couple of years.

When Brent-WTI was at its earlier record wides, the spread between Brent and Gulf Coast crude prices (e.g., LLS) was not that anomalous.  Instead, WTI was at a huge discount to LLS. This reflected a bottleneck in getting crude from the Midcontinent to the Gulf.

Now that bottleneck is largely eliminated: LLS is only at a $4 premium to WTI, which is pretty close to marginal transportation costs.  The current price structure is that the LLS-WTI spread has normalized, but the LLS-Brent spread has cratered.

So where’s the bottleneck now?  Part of it is legal: it is impossible to export crude from the US, except in a limited way to Canada.  It is possible to export products, and US refined product exports are at all time highs, nearly 3 times larger than the level of only 8 years ago.  (Interestingly, US product exports started their upward trend in 2005, well before the splurge in US oil production.)  However, refinery capacity is insufficient to close the gap, and there are logistical constraints that limit the amount of products that can be shipped out.   Some simple distillation units are being built to refine crude into products (including fuel oil) that can be exported.

Meanwhile, production issues in Libya and Nigeria are supporting Brent prices.

If the differential persists, it will be interesting to see whether there is pressure to eliminate, or at least relax, the constraints on exports of US crude.  I would presume that even if pressure begins to build, there will be a political battle in the US that will likely long delay any such relaxation or elimination.  So in the meantime this will be a boon for domestic refiners, and a roller coaster ride for traders.  The political, infrastructure, and refining bottlenecks that separate Brent and WTI will not close anytime soon, and the supply shocks on either side of the divide will cause prices to move with considerable independence.  A continued spike in US production will weigh on US prices, but can’t be communicated efficiently to Brent prices because of the bottlenecks; similarly, another shock to Nigerian or Libyan production will primarily move Brent.

In some ways, the world oil market, which is conventionally considered a “world” market due to the relative ease of shipping the stuff around the world, is becoming more like the natural gas market, with regional markets separated due to various bottlenecks, and the prices in these markets driven by idiosyncratic supply and demand shocks in those regional markets.  The adjustments necessary to ease the bottlenecks in crude are likely cheaper than those in gas, but they won’t take place overnight.  And until they do, Brent-WTI will remain a major speculative play.

Clockwork Orange? Will the Bell Toll for Yakunovich a Second Time?

Filed under: Military,Politics,Russia — The Professor @ 5:04 pm

There ware widespread protests in Ukraine, especially western Ukraine (Kiev and Lvov).  The police responded violently to protests in Kiev yesterday.  Today, Yanukovich’s chief of staff and the ambassador to Canada resigned.  The police seem to be less aggressive today.

This is a manifestation of the widespread anger at Yanukovich’s decision to spurn the Association Agreement with the EU, and his kowtowing to Russia.  The bow is getting only deeper, as the PM Azarov just announced that Yanukovich was on his way to Moscow to negotiate a roadmap with Putin.  Yanukovich pretends that he can blaze an independent path, but if he really believes this, he is delusional.  He chose Russia, and is going to Putin to receive terms, not negotiate them.

The events in western Ukraine echo the Orange Revolution of almost exactly 9 years ago, in which Yakunovich was ousted as president.  That episode shook Putin to his core, and intensified his already extreme paranoia about western designs to overthrow him.  Putin’s relentless campaign against the opposition in Russia was in large part the product of events in Kiev in 2004.

Given that, I would have thought that Yanukovich and Putin would have potentially anticipated, and acted to undermine and preempt, a repeat in response to the Ukrainian government’s abandonment of the deal with the EU.  That’s why when there were some protests in the immediate aftermath of the vote halting preparations for approving the agreement that I was skeptical that the movement would grow sufficiently to threaten the government.  Now I am not quite so sure.

This bears watching.  In particular, it bears watching to see whether Putin and Russia will intervene more directly if it seems that Yakunovich loses his nerve.

November 28, 2013

The Iran Deal: Folly, Blunder, or Something Worse?

Filed under: History,Military,Politics — The Professor @ 1:21 pm

The United States, and the other countries in the 5+1 group, have reached some sort of agreement with Iran which trades a relaxation in sanctions for some temporary limitations on Iran’s nuclear program.  Most of the discussion has focused on the specifics of this deal, but that is short sighted.  All parties admit that this is just an interim step along the path towards a more permanent settlement.  We need to look forward and try to anticipate where that path will lead.  It is unlikely to lead anywhere good, from an American perspective, and likely to be highly favorable to Iran.

The dynamic will favor Iran because it is easy for them to delay or evade any substantive cutbacks in their efforts to obtain nuclear weapons, and because it will be difficult for Obama to resist Iranian demands.  Look at the protracted and frustrating and largely futile attempt to stop the North Korean nuclear program: Obama’s personal investment in the Iran initiative will make the US even more likely to make concessions in order to keep the process alive.

Other news illustrates exactly how this process works.  The Russians have repeatedly violated the Intermediate Range Nuclear Forces Agreement but the administration has refused to make these violations public because . . . well, you have to read it to believe it:

Inside the meeting, Kerry expressed anger and frustration about the Russian cheating and warned that if the violations became widely known, future efforts to convince the Senate to ratify arms control treaties would be harmed.

In other words, we can’t possibly acknowledge treaty violations because that would impede our ratification of treaties  . . . that would be violated. Treaty-making becomes an end unto itself, rather than a means of securing American interests.  That mindset gives anyone we are negotiating with a tremendous advantage: they know they can play us for patsies because we are so obsessed with the process, rather than the results.

And Iran is pressing its advantage.  It claims that the agreement recognizes its right to enrich uranium, which the administration denies: in response Iran released a statement calling the administration a liar.  Moreover, it announced that it is commencing talks with international oil companies, thereby signaling its belief-expectation, actually, or demand, actually actually-that sanctions will be lifted.

And why not?  They know Obama has entered the bazaar, and can’t get out.  It would be a humiliating setback for Obama to admit that his initiative has failed, and knowing that, the Iranians will keep upping the price for a deal.  They further know that Obama’s domestic political weakness, courtesy of Obamacare, makes him all the more dependent on claiming a major foreign policy achievement.  Obama’s approval rating is around 40 percent.  This represents rock bottom for him: these 40 percent would support him even if he mandated adoption of Swift’s A Modest Proposal by executive order.  Admitting failure would help cement his loss of power and influence.

The costs of this are already large, and will only grow over time.  In the short run, the biggest cost will be endured by Syrians, who have been consigned to the tender mercies of Assad and the jihadis: Obama cannot simultaneously pursue an agreement with Iran and confront Iran’s major ally in the region.  This casts Obama’s decisions regarding Syria in August and September into a whole new light.  Following through on his threat to attack Iran’s client Assad would have seriously complicated, and likely derailed, a deal with the Iranians.  Although political considerations and his incautious off-teleprompter “red line” remark forced him to make noises about attacking, he was desperate to find a reason not to, which the Russians graciously offered.

And no doubt the Russians were aware of his predicament, and the Iranian angle to that.  The Saudis found out about the US-Iran talks, and tipped off the Israelis.  It is inconceivable that the Russians weren’t aware as well, given all the potential sources of information.  No wonder they found it so easy to give Obama a deal he couldn’t, and wouldn’t, refuse, even though it made him look craven and feckless.

Viewed in retrospect, the administrations actions during the weeks leading up to the CW deal with Syria look all the more bizarre and discreditable.

The longer run consequences will be even more malign.  Iran, already an aggressive power with dreams of hegemony in the Middle East will be emboldened, and will have more resources to fund their ambitions.  And again, they know that Obama will be reluctant to push back, lest he admit that his initiative was ill-conceived.  In response, other powers in the region, notably Saudi Arabia, will take a more independent and aggressive posture, knowing their interests are no longer aligned with those of the US at least as long as Obama is president: Saudi Arabia may well go nuclear by placing a carry-out order with Pakistan.  Feeling threatened and abandoned, the risk of an aggressive Israeli response is also greater.   Iran’s Lebanese client, Hezbollah, will be strengthened, raising the odds of conflict in Lebanon and between Hezbollah and Israel. The diversion of Israeli resources to counter a more powerful Hezbollah will encourage attacks by Hamas.

This makes the administration’s response to those criticizing the rapprochement all the more disgusting.  Carney and some Congressional Democrats (like Nelson of Florida) have claimed that refusing the deal and increasing sanctions on Iran would actually be a “march to war.”  This is truly a false choice: particularly outrageous coming from a president who always accuses his political opponents of advancing false choices.  An emboldened, richer Iran increases rather than reduces the odds of conflict in the region.

Doubts about the prudence-and even sanity-of Obama’s initiative are only deepened by one of the justifications given for it: namely that it is a response to the strengthening of moderate elements in Iran, and will bolster the moderates’ strength going forward.  Unbelievable.  We’ve heard about “Iranian moderates” since 1979, and numerous previous US attempts to deal with chimerical Iranian moderates have ended in American tears, for the Iranians play American delusions about moderates like a violin.  Just ask Robert McFarlane.  Many defenders of Obama on Twitter harken to Reagan’s Arms for Hostages debacle, claiming “at least Obama isn’t selling weapons to the mullahs.”  This is a defense?  Fool me once, shame on you.  Fool me twice, shame on me.  The Reagan experience should be a stern warning of how treacherous the Iranians can be.  They responded to payments for releasing hostages by taking more hostages.  That should make one all the more reluctant to deal with the mullahs today.

Obama is also disregarding Iran’s long running and relentless terrorist  campaign against the US.  The attacks on the US embassy and Marine barracks in Beirut and on the American Air Force personnel in Khobar Towers are only the most egregious examples.

Khobar Towers is of particular interest.  After an extended investigation, US intelligence concluded the Iranians were behind the attack.  This was extremely awkward for the Clinton administration, because at the time it was in the midst of an attempt to open relations with the . . . wait for it . . . “moderate” Iranian president Khatami.  Clinton sent a secret letter to the Khatami demanding that Iran punish those responsible, which the then reigning Mr. Moderate dismissed with the back of his hand. Either the moderates aren’t really moderates, or the moderates don’t call the shots.  Either way, same result: basing strategies on the influence of Iranian moderates is as delusional as making plans dependent on the intervention of magical unicorns.

In sum, Obama has entered into an agreement that will not be honored, will subject him and the US to increasing demands that he cannot refuse, will strengthen and embolden a sworn enemy of the United States, will destabilize the region and increase the risks of conflict, and betrays and confuses our allies.

Given that this endeavor is inimical to American interests, reputation, and prestige (both of which affect our ability to advance our interests) one wonders about the motivation.  Folly or blunder based on a desire to achieve a legacy or a fundamental misunderstanding of reality are actually the least frightening alternatives.  The more sinister possibility is that Obama is acting on a view of American interests and proper place in the world that is at odds with the mixed idealist-realist view that has shaped US policy since at least WWII.   I usually adhere to the maxim not to attribute something to malice which can be explained by stupidity, but it gets harder to do that every day.

November 27, 2013

Some of Cassandra’s (AKA SWP’s) Warnings on Clearing Begin to Take Hold

Filed under: Clearing,Derivatives,Financial crisis,Regulation — The Professor @ 9:49 pm

I’ve been hammering on the theme of the systemic risks of central clearing-especially mandated central clearing-for around five years.  And now those concerns are being expressed with greater frequency.  Fed Governor Jerome Powell gave a speech focusing on the most straightforward source of systemic risk in mandated clearing: the concentration of risk in the clearinghouse, which becomes a single point of failure whose collapse could jeopardize the broader financial system.   Bernanke made a similar argument a couple of years back.

Some articles from the last several days highlight more subtle, but in my view more important, concerns.  This Reuters piece mentions several things I’ve focused on over the years: the strains that clearing can put on the liquidity of individual firms, and the system at large; margin pro-cyclicality;  and crucially, the fact that self-preserving actions taken by CCPs may have destabilizing effects elsewhere in the financial system.

This last point demonstrates a danger in the Powell approach which focuses on making CCPs invulnerable, which I’ve referred to as the levee effect.  Just as making the levee higher at one point does not reduce flooding risk throughout a river system, but redistributes it, strengthening a CCP can redistribute shocks elsewhere in the system in a highly destabilizing way.  CCP managers focus on CCP survival, not on the survival of the entire system, and this is quite dangerous when as is almost certainly the case, their decisions have external effects.  Indeed, greater reliance on CCPs increases the tightness of the coupling of the financial system, which can be highly problematic under stressed conditions.  Liquidity and funding are the primary channels by which CCP decisions will have external effects on the broader financial markets.

These considerations are related to a broader point, which is that CCPs are merely parts, albeit important ones, of a broader financial system, and they must be evaluated in the context of the entire system.  An article in the International Financing Review by Christopher Whittall provides another illustration of this, again related to liquidity.  He notes that Basel III’s leverage ratio clashes with the tremendous thirst of CCPs for liquidity:

“The move towards central clearing creates a focus on how to fund margin requirements, which should dictate an increase in repo activity from banks. The problem is repo becomes very unappealing for banks under the leverage ratio.”

So sayeth the head of fixed income at a major bank.  CCPs create tremendous funding needs, and particularly contingent funding needs that are especially large in stressed conditions when liquidity is hard to come by.  These needs are hard enough to address in the absence of a leverage ratio, but as the fixed income guy notes, this is an even bigger problem when it is present.  As he says: “Viewed as a whole, we can start to start to see how these different regulations don’t quite hang together from a macro-prudential perspective.”

Exactly.  Illustrating another theme: Regulatory responses to the crisis have tended to focus on the individual pieces with too little attention paid to how regulations of one piece affect the other pieces.  The interaction between the leverage ratio and clearing mandates is a particularly worrisome example.  In any complex system, it is the interaction between interconnected pieces of the system that can lead to abrupt collapses.  Making each piece of the system more robust doesn’t necessarily make the system more robust.  Indeed, the opposite can be true.

Yes, I’ve been a Cassandra on these issues.  So in some sense, it’s good to see that the concerns that prompted my prophesies are now getting more widespread attention.  But methinks that the post-crisis regulatory juggernaut is impossible to reverse, and that although some of the problems in clearing and the interactions between clearing and other aspects of financial regulation can be ameliorated, the basic sources of systemic risk inherent in the new financial and regulatory structure will persist.

November 23, 2013

Ukraine & Russia. Sovok Players. Sovok Tactics. Sovok Results. No Surprises Here.

Filed under: Economics,Energy,Politics,Russia — The Professor @ 1:27 pm

Ukraine has shocked many Europeans and dismayed many Ukrainians, by announcing that it will suspend preparations to enter into an Association Agreement with the EU.  Russia was violently opposed to such an agreement that would have moved Ukraine away from Russia and towards Europe.  Hence, this is viewed as another “diplomatic” triumph for Putin.

It’s not really that shocking, or that much of a triumph.  If you think of the correlation of forces (to use the Soviet military term), it decidedly favored the Russians. There is geographic proximity.  There is the fact that the Ukrainian economy is a basket case, and extremely vulnerable to Russian pressure-pressure which Putin had been exerting for months, and would only have intensified had Ukraine gone along with the Europeans.  There is the fact that the Ukrainian political and economic elite has a lot to lose if Europe insists on reforms that open up the economy and increased transparency.  There is the fact that Old Europe was decidedly lukewarm about the prospect of drawing closer to a corrupt, dysfunctional, and bankrupt country that could become another money sink.  Europe also insisted on the freeing of Ukrainian President Yakunovich’s arch rival and predecessor, Yulia Tymoshenko, which could be extremely perilous for Yakunovich.  Countries on the front line with Russia-notably the Poles and Baltic States, but also the Swedes, who are seeing repeated Russian aerial intrusions and other indications of Russian aggressiveness-were pushing this, but they aren’t the main forces in the EU. In contrast to tepid European interest, Ukraine is a near obsession with Putin.

And then there is money and corruption.  Days before the Ukrainians hit the brakes, Yakunovich traveled to Russia.  There were conflicting reports about whether he even met with Putin, and if he did, where, and what was discussed in the meetings (if they occurred).  Also, in the midst of one of the repeated standoffs between Gazprom and the Ukrainians over gas, it was announced that Gazprom would sell gas at a large discount to Ukrainian oligarch Firtash.  Firtash had been the intermediary in shady gas deals between Russia and Ukraine in the past, but had been cut out by Tymoshenko. Now he’s back, and will deliver gas to Ukraine.  Since Firtash is an ally of Yakunovich, the opposition immediately charged that this was a corrupt bargain that will put money into Yakunovich’s pocket, and bankroll his reelection campaign.  Putin, in other words, could make deals that the Europeans could not hope to match.

Putin, in other words, had all the cards.  Only overweening European self-regard about the obvious superiority of their system could have deluded them into believing that the odds were on their side.

Putin, of course, couldn’t resist chewing the scenery, joining Lavrov in accusing the Europeans of blackmailing Ukraine.   Of course Putin was the one really doing the blackmailing-and the bribing.  He had the sticks.  He had the carrots.  He used them both, and thereby cajoled the Ukrainian ass to turn its back on the EU.

Sovok players.  Sovok tactics.  Sovok results.  Is this really surprising?

Syria: Russian Cynicism, American Fecklessness.

Filed under: History,Military,Politics,Russia — The Professor @ 12:50 pm

The Wall Street Journal’s story about Syria’s 21 August chemical weapons attack details the regime’s ruthlessness and American fecklessness.  It also makes it plain that The Russians lied repeatedly on Assad’s behalf in the aftermath.  For the Russians (and the Iranians) were aware of it almost immediately, and called Assad on it*:

Calls came in to the presidential palace from Syrian allies Russia and Iran, as well as from Hezbollah, the Lebanese militant group whose fighters were inadvertently caught up in the gassing, according to previously undisclosed intelligence gathered by U.S., European and Middle Eastern spy agencies. The callers told the Syrians that the attack was a blunder that could have profound international repercussions, U.S. officials say.

But recall the weeks after this.  Lavrov and other officials repeatedly denied that the regime was behind the attacks.  They supported Assad’s claim that the attack was launched by the rebels.  They cynically and shamelessly denied what they knew to be true and asserted what they knew to be false in order to protect their client.

Further recall that the Russians played this situation flawlessly, and achieved their aim: no American attack on Assad, Assad is in place and the tide is turning in his favor, and if anything the US is now a de facto supporter of the regime as its continued existence is necessary to carry out the elimination of its CW.   All of this done with the assistance of Obama and Kerry, the only question being whether this assistance was witting, unwitting, or just dimwitted.

And the Russians know it.  Indeed, they are pinching themselves over how easy it all was:

President Bashar al-Assad has tightened his hold on power. His regime has denied using chemical weapons, blaming the attacks on the rebels. In exchange for giving up his chemical arsenal, he avoided an American military intervention and likely will get even more support from Russia and Iran. Mr. Assad has pressed ahead with his offensive using conventional arms. U.S. intercepts show a Russian official later boasting to a Syrian counterpart about how easy it had been to get the U.S. to back off strike plans, officials briefed on the intelligence say.

The story is based on accounts of US intelligence intercepts provided by government officials.  And that is interesting in itself.

Unlike many intelligence leaks (e.g., the Osama raid, Stuxnet, the junk bomber) these are not calculated to make Obama and the administration look good, to portray them as aggressively and cleverly attacking America’s enemies.  To the contrary, they are uniformly damning.  Not just the revelation that the Russians think that Obama was (and is) an easily played chump.  But the revelations that the US had observed previous CW attacks.  That they observed the build up to this one, but didn’t react because they thought it was just going to be another “minor” attack like the earlier ones: apparently none of these met the Obama “whole bunch” test.  The revelations that the US was slow in responding in part because the intercepts had not been translated.

Which raises the question: who is leaking this damning information, and why? Is this the Intelligence Community’s payback for Obama throwing them under the bus over Snowden (which I noted and predicted in the aftermath of the Merkel cellphone kerfuffle)?  Or the consequence of the internecine battles over foreign policy in this administration?

Regardless, it is a uniformly depressing story.   But it can teach some lessons.  The most obvious of these is that the Russians will say anything to advance their interests, even if that something is 180 degrees from the facts.  Keep that in mind in events involving Syria in the future.  And also keep it in mind when you read anything the Russians say about Iran.

And keep in mind this administrations fecklessness and cluelessness when evaluating any deal it reaches with Iran.  Combine this with the fact that the Russians will run interference for Iran, just as they did with Syria, and the overwhelming odds are that no deal is far better than any deal Obama is likely to strike.

*Which means, OMG, we’re spying on foreign leaders! Heaven forfend. What will the NSA do next?

November 22, 2013

All Pain, No Gain: The CFTC’s Rule on CCP Qualifying Liquid Resources

Matt Leising had a nice article a few days back about the CFTC’s rule that does not treat US Treasury securities as “qualifying” liquid resources for CCPs.  Instead, under new regulation 33-33 they must obtain “prearranged and highly reliable funding.” Based on Fed rules, this means that a CCP must get  committed line of credit from banks.   This imposes a substantial cost on CCPs, because under new Basel III rules, committed lines impose a large capital charge on the issuing banks.  For purposes of calculating capital, the banks have to assume that the lines are fully drawn.  This capital cost will be passed onto CCPs.

It is ironic that outgoing (resisting the great urge to snark) Chairman Gary Gensler repeatedly argued that one of the main benefits of the Frankendodd clearing mandate is that it would reduce the interconnectedness of the financial markets, especially interconnectedness through derivatives contracts.  Now he has pushed through a regulation that mandates an interconnection among major financial institutions via a derivatives channel: the lines connect derivatives CCPs to major banks.   I have long pointed out that Gensler’s claim that clearing would reduce interconnectedness was grossly exaggerated, and arguably deceptive.  Instead, I pointed out that the mandate would reconfigure-and is reconfiguring-the topology of the network of connections between financial firms.  What the CFTC has done is dictate what that form of interconnection will be.  This particular dictate is extremely problematic.

A CCP needs access to liquidity in the event of a default of a clearing member.  The CCP needs to pay obligations to the winning side of the market, in cash, in a very tight time window.  Failing to make these variation margin payments could impose financial distress on those expecting the cash inflow, and more disturbingly, call into question the solvency of the clearinghouse.  This could spark a run in which parties try to close positions in order to reduce exposure to the CCP.  Given that this is likely to occur in highly unsettled market conditions, such fire sales (and purchases) will inevitably inject substantial additional volatility into price that can exacerbate pressures on the clearing mechanism.

A CCP holding Treasuries posted as IM by the defaulting CM can sell them to raise the cash.  Alternatively, it could repo them out.  During most periods of financial turbulence-and financial crisis-which is likely to be either the cause or effect of the default of one or more large CMs, there is a “flight to quality” and Treasury security prices rise and there is a rush to buy them by investors seeking a safe haven.  Moreover, under such circumstances the Fed will perform its lender of last resort function, and readily accept Treasuries as collateral: even if CCPs could not access the Fed directly*, they could access it indirectly.   Thus, in “normal” crises, Treasuries should be highly liquid, and a ready source of cash that can be used to meet variation margin obligations.

Put differently, from a liquidity perspective, Treasuries are a negative beta asset: they become more liquid when overall market liquidity declines-or verges on collapse.  This is a highly desirable attribute.  Another way to characterize it is that from a liquidity perspective, Treasuries have right way risk.

Bank lines are very different.  Banks become stressed during crisis situations, and face a higher risk of being unable to perform on credit lines under these circumstances.  (Indeed, what if the defaulter is one of the suppliers of a committed line?) Banks fighting for survival but which can perform might try to evade this performance during stressed market conditions, which in a tightly coupled system (and clearing is a source of tight coupling) can be extremely disruptive: a few minutes delay in performing could cause a huge problem.  And if the banks do perform, doing so poses the substantial risk of increasing their risk of financial distress.  That is, committed lines are positive beta from a liquidity perspective: that is, they pose wrong way risks.   If drawn upon, these lines can be an interconnection that is a source of contagion from a derivatives default to systemically important banks, precisely at the time that they are least able to withstand the shock.

In the event, a CCP that does collect Treasuries as IM can likely use these right way assets to raise the cash need to meet its obligations, and can avoid drawing down on its committed line.  But that would mean that the committed line is superfluous, and imposes unnecessary costs on the CCP, and hence on the users of the clearing system.

I also conjecture that having met its liquidity requirements with a committed line, pursuant to the CFTC reg, CCPs would  have a weaker incentive to take Treasuries as collateral, and a stronger incentive to permit the posting of lower quality assets (or incentivizing such posting by reducing haircuts assessed to such collateral) for IM. This would mitigate the cost impact to users that results from the CCP having to secure the committed line, and pay for it (the cost being passed onto the users), thereby reducing the loss of trading/clearing volume and the associated revenues.  This would increase the odds that the line will be drawn on (because the lower quality assets pose a substantial risk of becoming illiquid during a crisis situation-they embed wrong way risk too).  I’ll have to think this through more, because the situation is somewhat complex: it depends on the pricing of the line, which will depend on the likelihood it will be drawn against, and the market conditions at the time it is.  This will depend in part on the quality of collateral that the CCP collects.  I’m not sure of what the equilibrium outcome will be, but I suspect that mandating the obtaining of lines will undermine incentives to demand the posting of high quality collateral.  If it does, this is a bad outcome that increases wrong way and systemic risks.  If it doesn’t, then the cost of the lines is superfluous and a burden on clearing and derivatives trading.

There is one scenario in which Treasuries would not be good collateral: if the financial crisis (and default of a CM or CMs) was the result of a fiscal crisis in the US, or a default (real or technical)  of the kind feared during the last (but the last, most likely) debt ceiling standoff.  But that’s an Armageddon scenario in which banks are likely to be highly stressed and unable to perform, or in which they would incur exceptional and arguably existential costs if they did.  Put differently, there’s likely no good source of liquidity in this scenario, and the CFTC rule will hardly make a difference.

In sum, it is highly unlikely that bank lines are a better source of liquidity, especially under crisis situations, than Treasuries.  Indeed, they are plausibly worse, and actually create an interconnection that can transmit a shock to the derivatives market (and the CCP that clears it) to systemically important banks: this is the exact opposite of what clearing was supposed to achieve. The cost of the lines, which is likely to be substantial, particularly given their necessary size, is a deadweight burden on the markets: all pain, no gain.

Other than that, the rule is great.  And a fitting parting shot from Gensler.

* Frankendodd makes it difficult for US CCPs to obtain Fed liquidity support.  This is a serious mistake that could come back to haunt us in some future crisis.  To work effectively, the LOLR must be able to direct liquidity to where it’s needed,  quickly and efficiently.  CCPs could be a major source of liquidity demand in future crises, which makes isolating them from the Fed highly dangerous, and the invitation to an ad hoc response in some future crisis.

November 19, 2013

This Is Chutzpah, Even by Lavrov’s Own Standards

Filed under: Politics,Russia — The Professor @ 8:47 pm

Never criticize Lavrov for lacking in chutzpah:

Russian Foreign Minister Sergei Lavrov accused the European Union on Tuesday of putting “unforgivable pressure” on Ukraine to join a trade pact with the EU.

If Ukraine meets the EU’s conditions, signing the trade pact this month would mark a historic shift away from Russia and towards western Europe.

“We are not putting anyone under pressure … this is a sovereign choice for any state,” Lavrov told a news conference.

“If you compare our, in my opinion, honourable and collegial position with that of some representatives from the European Union, then arguably unforgivable pressure is being applied from that side on the focus (ex-Soviet) states.”

If you’ve been following the news, you know Russia has been putting the python squeeze on Ukraine.  Crackdowns on inspections on the border.  Turning up the heat on gas.  Banning import of chocolate.  The Euros have been limited to tut-tutting about Tymoshenko.  And if anything, they have been trying to entice the Ukrainians, rather than bully them.

The Russians act as if you catch more flies with gall than honey: the Euros the reverse.  But despite all the abundant evidence, Lavrov suggests that the Russians have been the ones offering sweets (even as they cut off Ukranian exports of sugary comestibles.)

You have to give the guy credit.  Nobody does chutzpah like he does.

November 18, 2013

The Kazan Crash: Ordinary Russian Aviation Dysfunction, or Terrorism?

Filed under: History,Military,Russia — The Professor @ 10:04 pm

There was a tragic plane crash in Kazan, Tatarstan over the weekend. Fifty people were killed.  No one on the plane survived.

The initial reports said that the plane attempted to land, but the pilot needed to come around again, and crashed on the second attempt. One theory was that the plane’s wing “grazed” the ground on the second landing attempt.  The authorities almost immediately ruled out terrorism.

I initially credited these reports, writing off the tragic accident as likely caused by bad piloting or bad fuel. All too believable, given the atrocious Russian civil aviation safety record.

Stupid, stupid professor.

A video of the crash has been released (h/t @libertylynx).

That is no “wing grazing” caused by a lack of power on the second landing attempt. That is a vertical, uncontrolled power dive. No Boeing 737 has suffered a similar incident.

Note the flame on the right wing, possibly on or near the engine, which flares up right before impact. This, plus the fact that the initial stories are so contrary to the video evidence, plus the fact that the Russians rushed to rule out terrorism, makes me believe that it most likely was terrorism.

Tatarstan is a Muslim province. There have been signs of an incipient Muslim insurgency in the province. Notorious Chechen Islamist leader Doku Umarov has called for an uprising in the province. Islamic terrorists are looking to launch high visibility attacks in the lead up to Sochi. The head of the FSB in the region was on the plane, as was the son of the region’s president.

All of these conditions make terrorism plausible.

There’s also the history. Terrorist brought down two Russian airliners in 2004. Those attacks were most likely due to the detonation of explosives from inside the passenger cabin when the planes were at altitude. In the Kazan crash, the fire on the wing, and the fact that the fuselage appears to be intact, is inconsistent with a similar detonation here. The wing fire is more plausibly due to a man portable air defense system (MANPAD) hit.

There have been numerous MANPAD attacks against civilian airliners. Most MANPADs are heat seekers, meaning that a hit is most likely to occur near the engine. Given that airliners have multiple engines, the loss of one engine is not necessarily fatal, especially for four engine aircraft hit at altitude. Moreover, the thrust of large engines is often sufficient to deflect the blast, and an explosion aft of the engine is much less destructive than something getting sucked in the front end. Nonetheless, 70 percent of airliners targeted by MANPADs have crashed with significant loss of life. The vulnerability is greatest for hits at low altitude on takeoff or landing–like in Kazan.

Given all these facts, I would put a 70 percent probability at this being a terrorist attack by a MANPAD.

Not that we’ll ever know for sure. The Russians have every incentive to cover this up, and that is in fact the way that Russian authorities respond to every embarrassing. Indeed, the initial response suggests that the Sovok reflex to make stuff up is still operative, even in this era of ubiquitous video cameras that give the lie to official stories. But don’t count on a rigorous investigation intended to find, and more importantly disclose, the reality. Putin is totally invested in the image of the man who has eliminated Islamic terror in Russia, and the imperative of maintaining that image is all the more intense in the lead up to Sochi.

Ironically, Russia’s well-deserved reputation for civil aviation dysfunction will make people-like me, admittedly, at least initially-quite willing to believe such a story. But I am betting on terrorism, especially given the Russian haste to deny it.

November 17, 2013

Still Naive After All These Years

Filed under: History,Military,Politics,Russia — The Professor @ 2:55 pm

I would love to understand the State Department, but I am not a clinical psychologist.  All I know is they have some sort of collective complex that manifests itself in various delusions.

Case in point.  The Russians are asking to install 6 monitoring stations for their GPSski, know officially as GLONASS, in the US.  The CIA and the DoD are saying: “Are you freaking kidding me?  No freaking way!”  But not the gang that Truman used to refer to as the “striped pants boys at the State Department”.  (Yes, there are pretty of women there now.)

No.  The State Department is totally fine with this.  Indeed, they think it’s a great idea.  Why?  Because we need to fix our relationship with the Russians.

No.  I am not making that up. I am not that creative:

For the State Department, permitting Russia to build the stations would help mend the Obama administration’s relationship with the government of President Vladimir V. Putin, now at a nadir because of Moscow’s granting asylum to Mr. Snowden and its backing of President Bashar al-Assad of Syria.

Let me get this straight.  The Russians screw us sideways over Syria and Snowden, not to mention Putin’s routine anti-Americanism and aggressive attempts to undermine US interests around the world, and the US is the one that needs to do the mending?  By giving the surveillance-obsessed Russians potential listening posts throughout the US?


If the State Department is so clueless about the Russians and electronic intelligence, maybe they should ask the Finns.

But then again, the State Department is a serial offender.  In 1973, they granted permission the Soviets to build the embassy at the 3d highest point in DC, where it had direct line of sight to the White House, the Pentagon, Capitol Hill, and yes, the State Department.  The CIA and Pentagon (i.e., the NSA) objected.  There were well-grounded suspicions that the Soviets would use it for electronic intelligence.  The US prevented the Soviets from occupying the embassy until the US received a similarly favorably located facility.  Then it turned out that the Soviets had built over 100 listening devices right into the new US embassy in Moscow.  American security experts called the building “a giant microphone.” Some called it “the Bug House.”  As a result, it took years for the US to get a new embassy built.  The original building had to be torn down, and the whole project started from the ground up.

Note the big difference in US and Soviet (i.e., KGB/FSB/Russian) approaches:

“Unlike the Soviets … the United States did not employ a systematic, stringent security program to detect and prevent Soviet technical penetration efforts,” judged the report.

For instance, Soviet officials overseeing the Mount Alto construction site in Washington routinely changed their blueprints without warning during the architectural bidding process, according to the Senate study. Their design plans were vague, with rooms identified as nothing more specific than “office space.”

In contrast US blueprints identified office spaces by name, making the location of sensitive areas clear to the Soviet workers—and their overseers.

The Soviets would use only concrete poured on site. The US accepted precast concrete forms constructed off site with no American supervision.

The Soviets inspected all materials carefully and were willing to halt construction work if they had questions. The US inspection system was less stringent, and the construction schedule ruled.

Soviet officials used about 30 of their own personnel to oversee about 100 US workers in Washington, on average. The US used 20 to 30 Navy Seabees to watch upward of 800 Soviet workers in Moscow.

The Soviets used a badge identification system, maintained tight perimeter security, and installed multiple surveillance cameras. The US had perimeter sensors and closed circuit TV monitoring, but they were soon disabled due to various “mishaps,” according to the Senate intelligence committee.In sum, US counterintelligence was playing catch-up almost from the beginning of the Moscow embassy project.

That’s our State Department.  Talk about naivety:

In celebrating the occasion, then-Ambassador James F. Collins called the new building “one of the most challenging construction projects ever undertaken by the Department of State. It has been a task … beset by the unexpected.”

Only unexpected by those oblivious to the Russians and their ways. And State is still naive after all these years.

And if you say “that was the Soviets.  They’re gone.”  I say: have you looked at the resume of the current Russian president?  You know, the one who sings songs about the glories of the KGB?

Consider this assessment:

New construction began in September 1997. The embassy finally opened in May 2000, after more than two decades of delays and at a cost to the US of more than $370 million. Its tortured 31-year history remains a lesson in US diplomatic and technical hubris and a reminder of a spy-versus-spy world that may (or may not) be long past.

The spy-versus-spy world is not long past.  It is still with us: Snowden, and the Russians use of him, is just another battle in this war.

And the US diplomatic hubris is definitely not behind us.  You need to look no further than the State Department’s benign view of allowing GLONASS monitoring stations in the US to find evidence of that.

Every day I lose my faith in the maxim “never attribute to malice what can be explained by stupidity.” As dismissive as I am about the State Department’s understanding of the Russians, I find it hard to believe anyone could be this stupid, at this late date.

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