Streetwise Professor

December 16, 2015

Russia’s Shambolic Logistics in Syria

Filed under: Military,Politics,Russia — The Professor @ 9:39 am

In responding to Micheal Weiss’s idiotic hyperventilating (but I repeat myself) about Russian intervention in Syria, I quoted the old adage: Amateurs talk tactics, professionals talk logistics.  I noted that logistics severely constrained Russia’s military capacity in Russia. Look no further than this for evidence of how shambolic Russia’s logistics are:

Earlier this year, an old refrigerator ship called the Georgiy Agafonov, built to transport fruit and vegetables for the Soviet Union, was quietly gathering rust in the Ukrainian port of Izmail where the Danube flows into the Black Sea.

Its owners, a Ukrainian state company, assumed it would never sail again. When a Turkish company offered to buy it for $300,000, they watched as the hulk was towed away, presumably for scrap.

Nine months later the ship is back at sea, renamed Kazan-60, reflagged as part of Russia’s naval auxiliary fleet, and repurposed as an unlikely part of Moscow’s biggest military operation outside the old Soviet boundaries since the Cold War.

. . . .

The need for the extra cargo ships arose because Russia’s warships did not by themselves have enough capacity to supply the mission, said Vasily Kashin, senior research fellow at the Moscow-based Centre for Analysis of Strategies and Technologies.

“Before we had to use amphibious landing ships to carry supplies to Syria. But now they are not sufficient and we are creating a new class of military transports which are part of the navy but in fact are pure cargo ships,” he said.

An icebreaker called the Yauza was also sent to the Mediterranean from the Arctic to beef up Moscow’s logistics. According to publicly available shipping data, it made two trips to Syria in October and November.

Buying old cargo ships gives Moscow more control than contracting out its transport to commercial carriers, said Gerry Northwood, chief operations officer with British maritime security firm MAST.


Russia has utilized some flashy weaponry–such as surface and submarine launched cruise missiles–in its Syria campaign. But this is military Potemkinism, a dazzling facade that distracts from the shabby and creaking structure beneath. Especially now, with rumblings about Turkey closing the Bosporus to Russia, those freaking out about Russia’s involvement in Syria need to look beneath the facade, and understand how the realities of logistics, which have doomed far more campaigns than anything that has transpired on battlefields, fundamentally limit what Russia can even hope to achieve.


December 9, 2015

Guns, Laws, and Money

Filed under: Politics,Regulation — The Professor @ 8:49 pm

The San Bernardino massacre unleashed an all-too-common phenomenon: literally (and I am using the word properly) before the bodies were even cold, politicians, pundits, and the hoi polloi (especially on Twitter) were using the atrocity to advance their own preferred narrative. The most common of these on the left was the gun control narrative. Hillary Clinton was one of the first off the mark to use San Bernardino to call for more stringent gun control measures. You know, before anyone–most notably one Hillary Rodham Clinton–knew anything about what had happened, beyond the fact that more than a dozen people had died. Obama was actually somewhat reserved, by his standards on this issue, and unexpectedly soft-pedaled his gun control message in his Oval Office speech on Sunday. But on the left the gun control drum was pounded for all it was worth, notably in a New York Times front page editorial.

Mass shootings like San Bernardino and Colorado Springs catalyze a flurry of calls for further restrictions on gun ownership, though these calls are frequently lacking in specifics, and are often more like ritual acts and political signaling of right-thinking (or should I say left-thinking?) views than concrete proposals. Moreover, mass shootings also unleash a volley of bad and misleading statistics. So bad, in fact, that those using them are almost certainly doing so in bad faith.

This phenomenon is not limited to activists, or the left generally. Even allegedly reputable mainstream publications like The Economist also peddle agitprop. The MO is to claim that mass shootings occur almost daily in the US: when brought up in the context of a Newtown or Aurora, the clear intent is to suggest that these types of mass shootings are representative. But even a cursory look shows that this is definitely not the case.

The mass-shooting-a-day statistics are based on a very expansive definition of mass shooting, such as three or more victims (not necessarily fatalities). Moreover, they lump together a very heterogeneous collection of episodes, which differ materially from the mass shooting events like those that have occurred in San Bernardino and Colorado Springs. For instance, they include gang drive by shootings or the likely gang-related shooting at a park in New Orleans 3 weeks ago. They also include a brawls at biker bars and other such criminal mayhem involving more than two people.

The one-size-fits-all term “mass shooting” doesn’t fit such varied phenomena, and one-size-fits-all-policies are unlikely to work either.  Indeed, even the most deadly mass shootings that get the most attention, are highly idiosyncratic. Newtown is very different from Colorado Springs is very different from San Bernardino is very different from Charleston is different from Fort Hood in terms of the perpetrators, methods,  and targets.

Contrary The Economist’s risible claim that “such atrocities are still drastically underreported,” the attention that  they get may arguably overstates their importance. The Newtown-type attacks  kill about as many Americans in a year as the average daily homicide toll. The United States does have a high murder rate (both gun and non-gun) compared to other high-income nations, although the rate has about halved in the last two decades.

Furthermore, murder, including murder with firearms, is not uniformly distributed across the US. To the contrary, it is highly concentrated geographically, and demographically. The statistics are quite shocking.

About 75 percent of murders occur in 3 percent of the counties in the US. Demographically, the concentration is even more pronounced. It is not exclusively, but overwhelmingly, a young, black, male phenomenon. The white murder rate is about 2.5 per 100,000. That’s roughly double of European rates, but not nearly as anomalous as the US rate overall. Indeed, white murder rates outside the South and Southwest are pretty much the same as European rates.

The truly horrific rates are among young black urban males, with especially high rates in Southern cities. Whereas the US firearms homicide rate is about 4/100,000, among African American men 20-24, it is almost 90. Yes: more than 22 times higher.  Even black women in that age cohort have a high rate, 7 per 100,000, or about 5 times the white female murder rate.

In sum, gun laws are fairly uniform across the United States, and gun ownership is widespread, but gun murder is not: if anything gun laws are most restrictive in places where gun crime is most rampant. Therefore, relatively easy access to guns is not sufficient to explain America’s elevated (compared to other OECD countries) murder rate. The regional and demographic variation shows that cultural and socioeconomic factors are important drivers. (The fact that non-firearm murder rates in the US are high compared to other countries, and also exhibit similar geographic and demographic variations reinforces this point.) Again contrary to The Economist, it is not true that “the link between guns and gun violence” is obvious. There are a lot of guns where there’s not a lot of violence. Guns don’t exercise a malign mesmeric effect on anyone who touches them. There is a mixture of social and cultural factors and guns that produce violence.

This tends to undercut the proposition that increasing restrictions on gun ownership will have much of an impact on murder rates. That said, even if other factors drive murder rates, greater restrictions on guns could still be beneficial: guns are complements to these other factors in the production of violence, including mortal violence, and the taxation of complements can be a way of reducing the frequency and severity of bad conduct produced using them.

But it is highly doubtful whether any remotely politically possible law–that is a law that would not have large effects on the hundred million-plus law-abiding gun owners in America, many of whom are very politically active–will have a meaningful impact on the pathologies that inflict many communities in the US.

In brief, it is evident that those who commit crimes with guns are highly inelastic demanders. Most of the high-murder rate localities already have draconian gun control laws, which include substantial penalties for violations. Furthermore, those most likely to kill (and be killed) with firearms are engaged in illegal conduct (e.g., drug dealing) that is subject to severe legal sanctions, and believe that guns are necessary for them to engage in this conduct. Thus, those most likely to kill with a firearm possess them despite the fact that they incur a large cost to do so. Further restrictions are unlikely to induce them to adjust on either the intensive or extensive margin (e.g., by changing “careers”), because they will lead to only small increases in the cost they incur to possess and use weapons.*

(Those bent on mass mayhem, be they terrorists, or psychotics, or narcissists looking for fame, or racist losers looking to spark a race war, are also likely to be inelastic demanders. These acts are the productive of obsessions that will drive those in their grip to go to great lengths to circumvent any attempt to prevent them.)

And we know prohibitionism doesn’t work. It didn’t work with alcohol in the 20s and 30s. It hasn’t worked with narcotics for decades. It doesn’t work with guns now, even in places like France, where terrorists clearly have had no problem obtaining deadly arsenals. (Take a look at reports of how many guns French and Belgian police seized in raids in the days after Friday, November 13.) The world is awash in guns. Guns that are quite functional for criminals are quite easy to manufacture. (Anybody remember the days when “Saturday Night Specials,” not Glocks or AKs were the bane of society–back when murder rates were far higher, by the way?) Those who think that passing laws against guns, including outright bans, will keep them out of the hands of those most likely to commit crimes with them–including mass murder–has their eyes closed to reality.

It is also ironic that many of those who are most vocal in calling for draconian restrictions on guns are also loudest in their condemnations of how the burdens of drug prohibitionism fall most heavily on minorities, who are imprisoned at high rates for drug crimes. Whom, pray tell, do they expect will be most frequently imprisoned for gun possession or trafficking, given that the same demographic is responsible for a greatly disproportionate fraction of gun crimes?

It should also be noted that minority communities are not enthusiastic about gun control, and for understandable reasons. Gun laws in cities like Chicago and DC are (a) almost wholly ineffective in curbing gun crime, and (b) render law-abiding people, mainly minority, defenseless against the (illegally) armed predators that live among them.

Americans recognize all this for the most part. Even though Obama and Hillary and others on the left furiously attempt to exploit any mass slaying to advance the gun control agenda, a solid (and growing) majority of Americans disagree. Indeed, they tend to vote with their wallets: a mass shooting, and political posturing about gun control, is followed by a spike in gun sales as surely as day follows night. Some wags have suggested that Obama must own shares in Ruger and Smith & Wesson, because he is so good for business.

The gun debate has become repetitive and sterile, more of a political Punch & Judy show than a constructive conversation. It is particularly appalling that innocent victims are seldom no more than political props in these debates.

Gun murders, which range from crimes of passion to political terrorism, are too diverse and complex to be addressed with simplistic, one-size-fits-all solutions. Prohibitionism, or draconian restrictions that approach prohibition–to the law abiding–despite (or is it because of?) its popularity on the left, is particularly counterproductive.

Murder, including murder by firearms, has declined substantially in the past 20 years. We should be grateful for that, and focus on ways to extend that decline: revising drug laws and punishments is likely to be a more productive way to do this than revising gun laws. But progress will at best be incremental. And the most difficult area to make progress will be mass shootings, given the extreme motivation of the perpetrators, and the diversity of their motives.

* This is related to the “Mickey Mouse Monopoly” effect that Walter Oi wrote about years ago. Oi noted that the demand for tickets to Disneyland was highly inelastic because the ticket itself contributed a relatively modest amount to the total cost of going to Disneyland. For everyone but locals, trip to the park required extensive travel (e.g., a plane trip or long car trip), lodging for several nights, dining out, etc. If the price of a ticket represented say 10 percent of the total cost of the trip, doubling the cost of a ticket only increased the cost of the entire trip by 10 percent. This made the demand for tickets inelastic. If the demand for a visit to Disneyland had an elasticity of 1, the demand for tickets had an elasticity equal to 1 times the share of a trip represented by the ticket. So if that share was 10 percent, the elasticity for tickets was only .1, meaning that Disney could raise ticket prices substantially without reducing the number of visitors much at all.


December 7, 2015

Clearing Mandates: Would That Regulators Had Remembered Takeoffs are Optional, But Landings Are Not

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 9:41 pm

ln 2010 and 2011 I was a clearing Cassandra, sounding warnings about the potential systemic risks arising from clearing mandates. Prominent among those dismissing my criticisms were “macro prudential” regulators, notably the Federal Reserve and the Bank of International Settlements.

Things are rather different now. Regulators, including notably the Fed and the BIS, are now making the rounds expressing recognition, and arguably concerns, about systemic risks in clearing.

Case number one: Fed Governor Daniel Tarullo:

However, as has been frequently observed, if the financial system is to reap these benefits, the central counterparties to which transactions are moving must themselves be sound and stable. Extreme but plausible events, such as the failure of clearing members or a rapid change in the value of instruments traded by a CCP, could expose it to financial distress. If the CCP has insufficient resources to deal with such stress, it may look to its clearing members to provide support. But if the problems arise during a period of generalized financial stress, the clearing members may themselves already have been weakened or, even if they remain sound, the diversion of their available liquidity to the CCP may prevent customers of the clearing members from accessing needed funding. If the CCP fails, the adverse effects on the financial system could be significant, including the prospect that the CCP’s default on its obligations could amplify the stress on other important financial institutions.

. . . .

While the question of what constitutes the optimal default fund standard needs more analysis and debate, I think there is little question that more attention must be paid to strengthening stress testing, recovery strategies, and resolution plans for significant CCPs. The typical CCP recovery strategy does not take a system-wide perspective and is premised on imposing losses on, or drawing liquidity from, CCP members during what may be a period of systemic stress. Many of these members are themselves systemically important firms, which will likely be suffering losses and facing liquidity demands of their own in anything but an idiosyncratic stress scenario at a CCP. Moreover, in at least some cases, uncertainty is increased by the difficulty of estimating with any precision the extent of potential liability of members to the CCP, thereby complicating both their recovery planning and efforts by the official sector to assess system-wide capital and liquidity availability in adverse scenarios.

The failure of regulators to take a “system-wide perspective” in their analysis of systemic risk generally, and in the effect of clearing mandates on systemic risk in particular, was one of my oft-expressed criticisms.

Tarullo is an interesting case. When I made a presentation  expressing my warnings about the systemic risks of clearing before the Fed Board of Governors in October, 2011, Tarullo was sitting right next to me at the big table in the Fed Board Room. He was, to put it mildly, dismissive of what I had to say.

Glad to see he’s coming around.

Case number two: Fed Governor Jerome Powell. I was particularly pleased to see that Powell recognizes that the picture that was repeatedly used to sell the benefits of clearing is highly misleading because it fails to take a system-wide approach: I criticized this picture in presentations as early as 2011, and also in some published work. Though I would say that Powell still omits many of the other connections between major financial institutions in a cleared world.

More from Powell:

I am a believer in the potential benefits of central clearing under the right circumstances. But central clearing is not a panacea. Charts similar to that in Figure 1 are often used to illustrate the netting of exposures and simplification that central clearing can bring to an OTC market. The tangled and highly opaque picture of a purely bilateral market is replaced by the neat hub-and-spoke network in which a CCP is buyer to every seller, and seller to every buyer, allowing netting and greater transparency for participants and regulators alike. Of course, reality is not so elegant, as Figure 2 illustrates. There are multiple CCPs, even within product classes, and major dealers act as clearing members across a broad network of CCPs. Clearing members also perform a range of services for CCPs, including custody, liquidity provision, and settlement. By design, increased central clearing will concentrate risks in CCPs; it is essential that, as these risks accumulate, the CCPs build up their ability to manage them. It is often noted that CCPs made it through the recent financial crisis without direct government assistance. But many of their major clearing members did receive such assistance. CCPs must now plan for a world in which these large firms will fail and be resolved without government support.

. . . .

All of these efforts are directly aimed at strengthening FMIs. But the strength and resilience of a CCP ultimately depends on the strength and resilience of its clearing members. I’d now like to shift focus to the relationship between these market utilities and the institutions that use them.

Barring an operational event, CCPs only face credit or liquidity risk when one of their members fails to make a payment when due. Thus, one effective way to make a CCP safer is to make its members safer. In that sense, the post-crisis reforms that have greatly strengthened our largest and most systemically important banking institutions have directly benefitted CCPs and other FMIs.

This last part, of course, raises the obvious question: would measures to “[strengthen] our largest and most systemically important banking institutions” been sufficient to address macro prudential concerns about OTC derivatives, making unnecessary clearing mandates?

But the biggest, and most surprising case is the BIS:

Clearing though a CCP creates a centralised network of trading exposures. Conceptually, this may influence systemic risk in two main ways. First, central clearing may affect the propagation of an (exogenous) shock through domino effects: the losses deriving from a counterparty default could trigger further defaults and spread the shock through the system. Second, central clearing, and the associated risk management practices, may affect the likelihood and impact of endogenous “run and deleveraging” mechanisms even in the absence of an initial default. While, in practice, both mechanisms may interact, considering them separately helps us to understand possible changes in the nature of systemic risk.

. . .

For example, the size of a shock would matter for systemic risk to the extent that defaults inflict a liquidity shortage on a CCP. If one or more clearing members fail to meet their clearing obligations, the CCP itself must provide liquidity in order to make timely payments to the original trading counterparties. The CCP’s own liquid assets and backup liquidity lines made available by banks may provide effective insurance against liquidity shocks resulting from the difficulties of one or a few clearing members. But they can hardly provide protection in the event of a systemic shock, when a large number of clearing participants – potentially including the providers of liquidity lines – become liquidity-constrained, thereby triggering domino effects.

. . . .

A centralised structure of trading exposures may also affect the likelihood and nature of endogenous shocks in the form of forced deleveraging, fire sales and runs. The critical issue in this regard is the interaction between CCPs’ risk management practices and those of clearing participants. On the one hand, if stringent risk management by a CCP replaces lax counterparty risk management in bilateral markets, central clearing would tend to reduce the risk of such procyclical behaviour. On the other hand, an unexpected tightening of CCP risk management could still lead to liquidity pressures on participants that could ultimately trigger fire sales and a self-reinforcing deleveraging (Morris and Shin (2008)).

. . . .

Turning to the risk of endogenous deleveraging, the assessment of the impact of post-crisis trends is similarly ambiguous. The fact that an increasing share of trading positions is subject to daily variation margin payments has arguably reduced the risk that counterparties are confronted with sudden big losses, as was for instance the case with AIG. However, the shift towards the centralised risk management of trading positions, including collateralisation and high-frequency margining, is also likely to affect market-wide liquidity dynamics. For example, extreme price movements in cleared financial instruments could result in large variations in the exposure of clearing members to the CCPs and therefore in the need for some of them to make correspondingly large variation margin payments. Such payments can be large, even if margin requirements remain unchanged. But they may be exacerbated if the CCP increases initial margins and/or tightens collateral standards in the face of unusually large price movements.


I made all of these points, or closely related ones, going back as far as 2008-2009, at times to the disdain of the BIS. One example occurred when made a presentation at the Notre Dame Financial Regulation Conference in May, 2011, where two BIS economists said I was being alarmist. Another was at a conference sponsored by the BofE, ECB, and Banque de France in September, 2013.

So it’s nice to see them come to their senses.

The last point in what I quoted is particularly amazing. One BIS position that I have ridiculed was that variation margin flows created no liquidity demands because they were zero sum: every dollar paid by the loser is received by the winner, allowing the collateral to be recycled. Presumably by having the winners lend to the losers. Even overlooking the operational impossibilities of this, what’s the point of variation margin (which reduces credit exposure in derivatives contracts) if variation margins are funded by credit? And there are operational issues. Liquidity is needed precisely because payments are not frictionlessly and instantaneously recycled. Timing mismatches create a need for liquidity and credit.

So it’s particularly nice to see the BIS get beyond its risible dismissal of the possibility that variation margins can create systemic risks via a liquidity channel, and recognize that this is a serious issue. Because it is. The most important risk in clearing, in my opinion, and one that becomes even more important when regulators take other measures to protect CCPs.

All in all, it’s good to see regulators starting to grapple with the potential systemic risks inherent in clearing. It is better than continued cheer-leading, as was the norm from 2009 until very recently.

But that said, the time to start worrying about potential major design flaws in an aircraft isn’t when it is just reaching cruising altitude. Takeoffs are optional, landings are not. It’s best to make sure that a safe landing, rather than a crash, is highly likely before taxiing down the runway. In their wisdom, legislators and regulators in a hurry didn’t do that. They rushed a new, complex, and untested design into the air. Let’s hope that the newfound awareness of the potential risks allows them to make in-flight repairs and adjustments that will make a crash unlikely.


December 5, 2015

Can You Shave an Islamist’s Beard With Occam’s Razor?

Filed under: History,Military,Politics — The Professor @ 12:10 pm

Not if the barber is Barack Obama. Two days after it was blindingly obvious that the atrocity of San Bernardino was a terrorist attack carried out by Islamists, Obama clung to the possibility that this was workplace violence (yeah, of the Nidal Hasan variety). He also grudgingly admitted that it was possibly terrorism, but even then he would not speak its name. Rather than name the specific ideology that inspired this brutal act, Obama retreated to his usual circumlocution of “people succumbing to violent extremist ideologies.” Then he descended into the vapidity of calling for more gun control: after all, no crisis should go to waste, right?

Truth be told: gun control will do nothing to impede people like Syed Farook and Tashfeen Malik, who broke numerous state and federal firearms and explosives laws, and who engaged in an attack that they knew would certainly result in their deaths. Such people (and I use that term loosely) are extremely infra marginal demanders of firearms and bombs. The increase in the cost of obtaining these instruments of mass mayhem caused by any even remotely plausible gun laws would still put that cost below their very high willingness to pay, and if they are not deterred by the prospect of violent death, the punishment for violating gun laws is clearly not going to deter them either.

Although Obama has seen fit to lecture us in the aftermath of Charleston, Sandy Hook, Ferguson, and even Louis Gates, for Christ’s sake, his statements in the aftermath of San Bernardino were limited primarily to his weekly radio address, recorded before he went to party down at the White House holiday party, with, among others, BLM luminary Deray McKesson. Priorities, you know.

One of the obvious early tells of the Islamist nature of the attack was that mere hours after Farook had been identified, his family members were participating in a press conference with Muslim Brotherhood front organization CAIR. Another tell came yesterday, when the Farook family’s scumbag lawyers gave a press conference that can be summarized as: “Who is the real victim here?” Hint: Farook, Malik and Muslims generally. After all, somebody teased Farook about his beard, and that might have set him off.

The administration picked up the victimhood narrative, with Attorney General Lynch saying that  her “greatest fear” is the “incredibly disturbing rise of anti-Muslim rhetoric” and promising to prosecute speech that “edges towards violence” (whatever the hell that means). So, along with trashing the Second Amendment, the administration has its sights set on the First. No doubt the 5th can be jettisoned too, if guns or politically incorrect speech are involved.

No doubt the administration’s denial of reality and its attempt to suppress speech has many causes. For one, San Bernardino totally contradicts the administration’s narrative on terrorism. For another, it creates serious problems for the administration’s plans to bring in large numbers of Syrian refugees. Within a few hours of her being named, Tafsheen Malik’s numerous family connections to Islamists in her home country of Pakistan and her adopted country of Saudi Arabia were documented. Pakistani intelligence said that the family had well known extremist connections: Now they tell us. Her father was an extremely conservative and rabidly anti-Shia immigrant to Saudi Arabia.

Yet the State Department and the immigration authorities failed to uncover these facts in their investigations of potential terrorism connections before granting her a fiancee visa. So yes, we can’t vet someone who has lived in countries with functioning governments that are (allegedly) our allies, but we can evaluate the risk of tens of thousands of people coming from a country embroiled in a  civil war, for whom it will be impossible to obtain any documentation whatsoever. And so much for the women pose no risk thing.

With Obama’s obduracy, we can expect more of the same. The demonization of domestic opposition, and the turning of a blind eye to real enemies within and without.

December 1, 2015

The Red Queen’s Race: Financial Regulation Edition

Filed under: Clearing,Derivatives,Economics,Financial crisis,Regulation — The Professor @ 8:44 pm

Well over four years ago, I raised concerns about clearing mandates leading to the rise of “collateral transformation” whereby those needing high-quality assets to pledge as collateral against derivatives trades would obtain them via repos collateralized by low-quality assets. I argued that these transactions were inherently fragile, and could go pear shaped during period of market stress.

If this were the only problem that post-crisis regulations created, how lucky we would be! Yesterday, the FT ran a nice (meaning scary) piece about other regulation-related driven spurts in securities lending that are collateral transformation on steroids.

One big driver is the Liquidity Coverage Ratio, which requires banks to hold one month’s stress period liquidity needs in liquid assets like government bonds. Rather than sell other less liquid assets to raise the cash to buy Treasuries, Gilts, Bunds, etc., banks are posting their less liquid assets (including equities) as collateral against borrowing of government securities.

Think of how this could work in a crisis. Yes, a bank can sell the borrowed guvvies to raise cash to meet deposit outflows or other cash needs in a crisis. But it borrowed these securities, so it has to buy them back, eventually. Perhaps its liquidity crisis will have passed before the loan matures, but perhaps not. What then, genius? Liquidity crisis deferred, not necessarily prevented.

There are other concerns. The lender of the government bond is likely to haircut the collateral more steeply during crisis periods, meaning that the stressed bank is going to have to come up with more collateral to support its loan precisely when it can least afford to do so. The cyclicality of the collateral mechanism is a concern, and it can create all sorts of vicious cycles that have spillovers throughout the financial system.

Furthermore, the article notes that asset managers like BlackRock are the major securities lenders. They lend out bonds purchased to back government bond ETFs, and take other securities as collateral. That is, the asset manager is engaged in a financial transformation in which there can be a mismatch between the assets underlying the ETF and its liabilities: swapping government bonds for equity (or other assets) creates such a mismatch. What happens if the ETF sponsor is it by a wave of redemptions–especially if the redemptions occur because investors become concerned because the value of the collateral the sponsor has collected has fallen, and may be substantially below the value of the assets lent out (which is what the fund is intended to track)? One possibility is fire sales of the collateral and “fire purchases” of the assets the fund has lent out. A more likely outcome is that this is the kind of event which will cause the fund to demand significantly more collateral from the security borrower, setting off the vicious cycles described above.

Oh joy.

The article states that another reason for the rise in securities lending is that banks get better capital treatment on the borrowed securities than the securities posted as collateral. If this is true, it is totally nuts. The borrowed security is not an asset to the bank: the assets posted as collateral for the loan are. The borrower has the asset in his hot little hands, but has an obligation to give it back: these things offset. At the end of the day, the bank still has the other assets posted as collateral. If capital regs treat the borrowed bond as an asset, and don’t treat the securities posted as collateral as an asset, and reduce risk weighted assets (and hence capital requirements) as a result, the regulations are even dumber than I had thought possible.

That is really saying something.

The third reason for the rise in securities lending is my old favorite, collateral transformation to obtain CCP-eligible collateral. This part of the article made me laugh:

There is a third plus, too, as another facet of post-crisis regulation gains momentum. With so much derivatives trading moving to central counterparty clearing, there is increasing demand for high quality assets to be used as collateral. And for that, government bonds — even borrowed ones — avoid punitive haircuts imposed on some equities.

I laugh because in a collateral transformation trade, there is a potentially punitive haircut on the equities (or whatever) posted in the collateral transformation trade.

Whenever I see things like this I keep coming back to the story about the Indian village that was infested by mice, so it brought in cats which then multiplied and became such pests that they brought in dogs to run off the cats, but then the dogs became such a problem that they brought in elephants to scare away the dogs, and when the elephants started wrecking the place they reintroduced the mice to scare away the elephants.

Things like the LCR and clearing mandates were introduced to solve one set of problems (or perceived problems) inherent in the financial transformations that banks provide. But these regulations have led to the proliferation of other kinds of transformations that are problematic in their own ways. These new transformations create new, potentially fragile, interconnections. They create new counterparty and liquidity risks even as they mitigate some old ones.

Or to invoke another metaphor, this is like the Red Queen, running at breakneck speed to stay in the same place:

“Well, in our country,” said Alice, still panting a little, “you’d generally get to somewhere else—if you run very fast for a long time, as we’ve been doing.”

“A slow sort of country!” said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

Yes. Very much like that indeed. Perhaps we haven’t quite stayed in one place, but the running over the past 5 plus years has not moved us nearly as far as the Frankendodd and EMIR and MiFID II pom-pom squad claim.  Risks have been shifted and transformed, rather than eliminated. In the attempt to banish the devil we knew, we’ve teamed up with some lesser-known demons. Sadly, we are likely to become much better acquainted, sooner or later.

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