Streetwise Professor

September 18, 2018

He Blowed Up Real Good. And Inflicted Some Collateral Damage to Boot

I’m on my way back from my annual teaching sojourn in Geneva, plus a day in the Netherlands for a speaking engagement.  While I was taking that European non-quite-vacation, a Norwegian power trader, Einar Aas, suffered a massive loss in cleared spread trades between Nordic and German electricity.  The loss was so large that it blew through Aas’ initial margin and default fund contribution to the clearinghouse (Nasdaq), consumed Nasdaq’s €7 million capital contribution to the default fund, and €107 million of the rest of the default fund–a mere 66 percent of the fund.  The members have been ordered to contribute €100 million to top up the fund.

This was bound to happen. In a way, it was good that it happened in a relatively small market.  But it provides a sobering demonstration of what I’ve said for years: clearing doesn’t eliminate losses, but affects the distribution of losses.  Further, financial institutions that back CCPs–the members–are the ultimate backstops.  Thus, clearing does not eliminate contagion or interconnections in the financial network: it just changes the topology of the network, and the channels by which losses can hit the balance sheets of big players.

Happening in the Nordic/European power markets, this is an interesting curiosity.  If it happens in the interest rate or equity markets, it could be a disaster.

We actually know very little about what happened, beyond the broad details.  We know Aas was long Nordic power and short German power, and that the spread widened due to wet weather in Norway (which depresses the price of hydro and reduces demand) and an increase in European prices due to increases in CO2 prices.  But Nasdaq trades daily, weekly, monthly, quarterly, and annual power products: we don’t know which blew up Aas.  Daily spreads are more volatile, and exhibit more extremes (kurtosis), but since margins are scaled to risk (at least theoretically–more on this below) what matters is the market move relative to the estimated risk.  Reports indicate that the spread moved 17x the typical move, but we don’t know what measure of “typical” is used here.  Standard deviation?  Not a very good measure when there is a lot of kurtosis (or skewness).

I also haven’t seen how big Aas’ initial margins were.  The total loss he suffered was bigger than the hit taken by the default fund, because under the loser-pays model, the initial margins would have been in the first loss position.

The big question in my mind relates to Nasdaq’s margin model.  Power price distributions deviate substantially from the Gaussian, and estimating those distributions is challenging in part because they are also conditional on day of the year and hour of the day, and on fundamental supply-demand conditions: one model doesn’t fit every day, every hour, every season, or every weather enviornment.  Moreover, a spread trade has correlation risk–dependence risk would be a better word, given that correlation is a linear measure of dependence and dependencies in power prices are not linear.  How did Nasdaq model this dependence and how did that impact margins?

One possibility is that Nasdaq’s risk/margin model was good, but this was just one of those things.  Margins are set on the basis of the tails, and tail events occur with some probability.

Given the nature of the tails in power prices (and spreads) reliance on a VaR-type model would be especially dangerous here.  Setting margin based on something like expected shortfall would likely be superior here.  Which model does Nasdaq use?

I can also see the possibility that Nasdaq’s margin model was faulty, and that Aas had figured this out.  He then put on trades that he knew were undermargined because Nasdaq’s model was defective, which allowed him to take on more risk than Nasdaq intended.

In my early work on clearing I indicted that this adverse selection problem was a concern in clearing, and would lead CCPs–and those who believe that CCPs make the financial system safer–to underestimate risk and be falsely complacent.  Indeed, I argued that one reason clearing could be a bad idea is that it was more vulnerable to adverse selection problems because the need to model the distribution of gains/losses on cleared positions requires detailed knowledge, especially for more exotic products.  Traders who specialize in these products are likely to have MUCH better understanding about risks than a non-specialist CCP.

Aas cleared for himself, and this has caused some to get the vapors and conclude that Nasdaq was negligent in allowing him to do so.  Self-clearing is just an FCM with a house account, but with no client business: in some respects that’s less risky than a traditional FCM with client business as well as its own trading book.

Nasdaq required Aas to have €70 million in capital to self-clear.  Presumably Nasdaq will get some of that capital in an insolvency proceeding, and use it to repay default fund members–meaning that the €114 million loss is likely an overestimate of the ultimate cost borne by Nasdaq and the clearing members.

Further, that’s probably similar to the amount of capital that an FCM would have had to have to carry a client position as big as Aas’.   That’s not inherently more risky (to the clearinghouse and its default fund) than if Aas had cleared through another firm (or firms).  Again, the issue is whether Nasdaq is assessing risks accurately so as to allow it to set clearing member capital appropriately.

But the point is that Aas had to have skin in the game to self-clear, just as an FCM would have had to clear for him.

Holding Aas’ positions constant, whether he cleared himself or through an FCM really only affected the distribution of losses, but not the magnitude.  If Aas had cleared through someone else, that someone else’s capital would have taken the hit, and the default fund would have been at risk only if that FCM had defaulted.  But the total loss suffered by FCMs would have been exactly the same, just distributed more unevenly.

Indeed, the more even distribution that occurred due to mutualization which spread the default loss among multiple FCMs might actually be preferable to having one FCM bear the brunt.

The real issue here is incentives.  My statement was that holding Aas’ positions constant, who he cleared through or whether he cleared at all affected only the distribution of losses.  Perhaps under different structures Aas might not have been able to take on this much risk.  But that’s an open question.

If he had cleared through another FCM, that FCM would have had an incentive to limit its positions because its capital was at risk.  But Aas’ capital was at risk–he had skin in the game too, and this was necessary for him to self-clear.  It’s by no means obvious that an FCM would have arrived at a different conclusion than Aas, and decided that his position represented a reasonable risk to its capital.

Here again a key issue is information asymmetry: would the FCM know more about the risk of Aas’ position, or less?  Given Aas’ allegedly obsessive behavior, and his long-time success as a trader, I’m pretty sure that Aas knew more about the risk than any FCM would have, and that requiring him to clear through another firm would not have necessarily constrained his position.  He would have also had an incentive to put his business at the dumbest FCM.

Another incentive issue is Nasdaq’s skin in the game–an issue that has exercised FCMs generally, not just on Nasdaq.  The exchange’s/CCP’s relatively thin contribution to the default fund arguably reduces its incentive to get its margin model right.  Evaluating whether Nasdaq’s relatively minor exposure to default risk led it to undermargin requires a more thorough analysis of its margin model, which is a very complex exercise which is impossible to do given what we know about the model.

But this all brings me back to themes I flogged to the collective shrug of many–indeed almost all–of the regulatory and legislative community back in the aftermath of the Crisis, when clearing was the silver bullet for future crises.   Clearing is all about the allocation and pricing of counterparty credit risk.  Evaluation of counterparty credit risk in a derivatives context requires a detailed understanding of the price risks of the cleared products, and dependencies between these price risks and the balance sheet risks of participants in cleared markets.  Classic information problems–adverse selection and moral hazard (too little skin in the game)–make risk sharing costly, and can lead to the mispricing of risk.

The forensics about Aas blowing up real good, and the lessons learned from that experience, should focus on those issues.  Alas, I see little recognition of that in the media coverage of the episode, and betting on form, I would wager that the same is true of regulators as well.

The Aas blow up should be a salutary lesson in how clearing really works, what it can do, and what it can’t.   Cynic that I am, I’m guessing that it won’t be.  And if I’m right, the next time could be far, far worse.

September 6, 2018

Carter Page’s Good Deed Was Punished: Will the Same be True of the FBI’s Bad Deeds?

Filed under: Politics — cpirrong @ 6:36 pm

Paul Sperry reports the least surprising news evah: the FBI omitted crucial details about Carter Page’s involvement with (convicted) Russian spies, including the fact that they thought he was an “idiot” when applying for a FISA warrant on Page.

This is my shocked face.

But Sperry doesn’t note two other facts that make this even more damning.

First after two of their operatives had been caught three years before, they would have gone back and tried to identify everyone they had interacted with.  Everyone.  They surely would have identified Page, not least because the statement of an FBI agent filed with the court in February, 2015 contained details that would have led them to identify Page as “Male-1.”  Further, since the filing states that the FBI had interviewed “Male-1”, the Russians would have known that Page had cooperated with the FBI.

So this is a guy they are going to use as part of a clandestine scheme to bribe Donald Trump?  Not in several thousand lives of the universe.   They would have considered him a threat, not an opportunity.

The only way they would have used Page is to try to pass disinformation back to US intelligence.

Failing to detail Page’s full involvement with the prosecution and conviction of the Russian agents was therefore another crucial omission from the FISA warrant application.  Given this information, Page’s plausibility as a Russian agent would have been zero.

Second, Sperry doesn’t remind us that after failing in its first try to get a FISA warrant on Page, a dossier report miraculously appears which contains the account of a meeting in which Sechin supposedly offered Trump, via Page, a stake in Rosneft.  Presented with the new “information” of Page’s deep ties with the Russians, et voila!, the court issues the warrant.

This makes it highly likely–certain, in my view–that Steele was a short order cook serving up made-to-order material intended to advance the anti-Trump campaign.  His–and the FBI’s/DOJ’s.

The FBI’s cynicism here is off the charts, and appalling.  Carter Page helps them out in an investigation of Russian spies.  But Peter Strzok and his fellow badged gangsters saw that Page was now useful in their attempt to sabotage Trump, so they viciously twisted his previous cooperation with them into evidence of connivance with Russian intelligence by leaving out the crucial details of his cooperation, the Russian views of him, and the likely Russian knowledge of him.

Moral of the story? Support your local sheriff, perhaps, but the FBI–you’d be a complete fool to do so, because they will F*** you sideways when it is in their interest to do so.  Page is the poster boy for “no good deed goes unpunished.”

Carter Page should have a massive civil rights case against the US government, and the individuals who lied and conspired to deprive him of his 4th Amendment right against unlawful search and seizure–Strzok, McCabe, Comey, Yates, and others.  And quite frankly, it should be a class action lawsuit, including in the class everyone who was surveilled, or whose communications were read, pursuant to the Page warrant.

Let’s hope that the karma for Page’s punishment for good deeds will far more draconian punishment of those who committed bad deed after bad deed when using Carter Page to achieve their sordid goals.


September 5, 2018

Nothing New Under the Sun, Ag Processing and Trading Edition

Filed under: Commodities,Economics,Politics,Regulation — cpirrong @ 2:30 pm

New Jersey senator Corey Booker has introduced legislation to impose “a temporary moratorium on mergers and acquisitions between large farm, food, and grocery companies, and establish a commission to strengthen antitrust enforcement in the agribusiness industry.”  Booker frets about concentration in the industry, noting that the four-firm concentration ratios in pork processing, beef processing, soybean crushing, and wet corn milling are upwards of 70 percent, and four major firms “control” 90 percent of the world grain trade.

My first reaction is: where has Booker been all these years?  This is hardly a new phenomenon.  Exactly a century ago–starting in 1918–in response to concerns about, well, concentration in the meat-packing industry, the Federal Trade Commission published a massive 6 volume study of the industry  The main theme was that the industry was controlled by five major firms.  A representative subject heading in this work is “[m]ethods of the five packers in controlling the meat-packing industry.”  “The five packers” is a recurring refrain.

The consolidation of the packing industry in the United States in the late-19th and early-20th centuries was a direct result of the communications revolution, notably the development of railroads and refrigeration technology that permitted the exploitation of economies of scale in packing.   The industry was not just concentrated in the sense of having a relatively small number of firms–it was geographically concentrated as well, with Chicago assuming a dominant role in the 1870s and later, largely supplanting earlier packing centers like Cincinnati (which at one time was referred to as “Porkopolis”).

In other words, concentration in meat-packing has been the rule for well over a century, and reflects economies of scale.

Personal aside: as a PhD student at Chicago, I was a beneficiary of the legacy of the packing kings of Chicago: I was the Oscar Mayer Fellow, and the fellowship paid my tuition and stipend.  My main regret: I never had a chance to drive the Weinermobile (which should have been a perk!).  My main source of relief: I never had to sing an adaption of the Oscar Mayer Weiner Song: “Oh I wish I were an Oscar Mayer Fellow, that’s what I really want to be.”

Back to the subject at hand!

Booker also frets about vertical integration, and this is indeed a difference between the 2018 meat industry and the 1918 version: as the Union Stockyards in Chicago attested–by the smell, if nothing else–the big packers did not operate their own feedlots, but bought livestock raised in the country and shipped to Chicago for processing.

I am a skeptic about market power-based explanations of vertical integration, and there is no robust economic theory that demonstrates that vertical integration is anti-competitive.  The models that show how vertical integration can be used to reduce competition tend to be highly stylized toys dependent on rather special assumptions, and hence are very fragile and don’t really shed much light on the phenomenon.

Transactions cost-based theories are much more plausible and empirically successful, and I would imagine that vertical integration in meat packing is driven by TCE considerations.  I haven’t delved into the subject, but I would guess that vertical integration enhances quality control and monitoring, and reduces the asymmetric information problems that are present in spot transactions, where a grower has better information about the quality of the cattle, and the care, feeding, and growing conditions than a buyer.

I’d also note that some of the other industries Booker mentions–notably bean and corn processing–have not seen upstream integration at all.

This variation in integration across different types of commodities suggests that transactional differences result in different organizational responses.  Grain and livestock are very different, and these likely give rise to different transactions costs for market vs. non-market transactions in the two sectors.  It is difficult to see how the potential for monopsony power differs across these sectors.

Insofar as the major grain traders are concerned, again–this is hardly news.  It was hardly news 40 years ago when Dan Morgan wrote Merchants of Grain.

Furthermore, Booker’s concerns seem rather quaint in light of the contraction of merchant margins, about which I’ve written a few posts.  Ironically, as my most recent ABCD post noted, downstream vertical integration by farmers into storage and logistics is a major driver of this trend.

To the extent that consolidation is in play in grains (and also in softs, such as sugar), it is a reflection of the industry’s travails, rather than driven by a drive to monopolize the industry.  Consolidation through merger is a time-tested method for squeezing out excess capacity in a static or declining industry.

Booker’s bill almost certainly has no chance of passage.  But it does reflect a common mindset in DC.  This is a mindset that is driven by simplistic understandings of the drivers of industrial structure, and is especially untainted by any familiarity with transactions cost economics and what it has to say about vertical integration.

September 3, 2018

The McCain Funeral: The Political Version of the Dunning-Krueger Effect

Filed under: Politics — cpirrong @ 5:49 pm

I am still agog at the most flagrant public display of political onanism in living memory, by which I am of course referring to the McCain funeral.

Although ostensibly praising the deceased, the praise was really for the (unfortunately) still breathing–the political establishment.  McCain was wonderful! McCain was one of us! Therefore, we are wonderful! Wonderful beyond words!

I was going to ask, rhetorically, whether these people could be THAT clueless?  But the answer is obvious, which kind of saps the force of a rhetorical device.

This is nothing less than the political version of the Dunning-Krueger effect: an entire class of individuals with low ability, a history of poor performance, and a complete lack of perception and self-awareness, believing that they are God’s gift.  And believing that the hoi polloi who voted for Trump are vicious ingrates for not recognizing how totally awesome the elites are.

Almost two years after the election, these people still fail to comprehend that the reason they have been rejected and scorned by tens of millions of ordinary Americans is their litany of failures post-1990.  It is a record unblemished by success.  A perfect record, in a perverse sense.

By failing even to question their own genius–and indeed, to loathe anybody who dares do so–they are only feeding the disdain in which they are held.

The cluelessness is crystalized in a tweet by a person laughably described as the Washington Post’s conservative voice–the truly repulsive Jennifer Rubin:

It is disgusting enough to equate the Trump presidency to 9/11–and have no doubt that is what she is doing.  The fact that she actually thinks that the funeral “eschew[ed] tribalism” is beyond belief.  As I said in my post the other day–it was all about tribalism.  It was the two clans of the political establishment tribe uniting to excoriate The Other under the pretense of having a funeral.  Rubin’s assertion is an inversion of reality.

Several historical comparisons come to mind when thinking about the funeral bloviations.

The first is Talleyrand’s remark about the Bourbons, who learned nothing and forgot nothing.

The second is Pericles’ funeral oration.  I watched a BBC show about the Spartans the other day in which the narrator summarized the oration as: “Everything about the Athenians is right.  Everything about the Spartans is wrong.”  Substitute the US political establishment for the Athenians, and Trump for the Spartans, and you have the McCain funeral orations to a “T”.

The third is that funeral was a perverse reversal of Mark Antony’s line in Julius Caesar.  Instead of “I have come here to bury Caesar, not to praise him” the assembled bloviators in DC in effect said “we come here pretending to praise McCain, but actually to bury Trump.”

This got me thinking about  some parallels between Rome in the 40s BC and DC today. Caesar was a member of the elite who appealed to the masses–both in the sense that he directed appeals to them, and that they found what he said appealing.  He also insulted the elite at every turn, and implemented policies that attacked their interest and affronted their inflated sense of dignity.  This frightened, incensed and enraged the Roman establishment, which was centered in the Senate.  Caesar’s popularity, his disdain for the elite, and his refusal to kowtow before it, combined with the elite’s obsession with its power, privileges, and amour propre, brought the country into civil war.

No, history does not repeat, and late-Republican Rome is vastly different in many (most) ways from (hopefully not late-) Republican America (referring to the form of government, not the party).  Yet the present spookily rhymes with the distant past, with Trump playing the role of Caesar, and the US Senate playing the role of, well, the Roman Senate.

Again, I’m not pushing the analogy too far.  But there are enough points of comparison to make thoughtful people take pause.  But, alas, the phrase “thoughtful people” is not one that describes the assembled “mourners” at McCain’s funeral, or their camp followers.

September 1, 2018

Robert Mueller Does Mr. Micawber

Filed under: Politics — cpirrong @ 7:43 pm

Robert Mueller brings to mind Dickens’ character Wilkins Micawber: “Something will turn up.”  McCawber was vexed by his inability to strike it rich: Mueller by his inability strike the collusion goldmine he was tasked to find (perhaps unconstitutionally).  While he is waiting for collusion to turn up, Mueller is hustling after penny ante process crimes.

The latest was a plea to the federal crime of failure to register as a foreign agent by lobbyist Sam Patten, whose heinous offense was to find someone who would buy tickets to Trump’s inauguration for a Ukrainian oligarch who tried to buy them directly–but was turned down by the Trump inauguration committee.  In other words, if the guy tried to bribe Trump, he was rejected! That kinda contradicts the collusion narrative, don’t it?

Compared to this, jaywalking is mass murder.

And if justice were enforced blindly–I know, don’t laugh–would we have enough jails to hold all the malfeasors? For certainly with truly fair justice that is more than an exercise in scalp collecting to justify the continued existence of Mr. Mueller and his Merry Band, Mr. Patten should have plenty of company, starting with pretty much anyone involved with the dossier not to mention every lobbyist in DC.

It was sickly amusing to watch the hyperventilating media.  The New York Times covered the story with five–five!–reporters.  I know NYT reporters are pretty dim, but wouldn’t three have sufficed?  Thursday night I saw a tweet by some media bigfoot (which of the idiots, I can’t remember) breathlessly advising us to read the news Friday, because Mueller would drop some bombshell in the morning. Instead, this dud landed with a thud.

The media is also barely able to contain itself over the claim by George Papadopolous (in his sentencing brief for his heinous process crime) that Trump nodded when George suggested a meeting with Putin. Nodded, I tells ya! Um, if Putin owned Trump–or had him “over a barrel”, in the words of Christopher Steele–why would it be necessary for George to suggest a meeting?

If it wasn’t so serious, this would be the most farcical farce in the history of farces.  Alas, Micawber-Mueller’s waiting for something to turn up is morphing into waiting for Godot–a play with no point and seemingly no end.  But it will go on, and on, and on, because it is in the interest of the political class for it to do so.  So even if nothing turns up, its very existence has its political uses.

I Honor the Veteran, Not the Senator

Filed under: Politics — cpirrong @ 6:33 pm

Do you remember the commemoration of the passing of Leo Thorsness?  George Day? James Stockdale?

Perhaps you are not familiar with the names.  They were all Vietnam War POWs.  Day shared a cell with John McCain, and McCain made a sling for Day after his arm was horribly injured by torture.  Their records prior to capture were far more distinguished than McCain’s: Thorsness won the Medal of Honor for his acts in air combat in an F-105.

Although it is perhaps unfair to compare or judge the conduct of those who endured the hell of North Vietnamese prison camps, it is worth noting that Day’s and Stockdale’s actions as POWs were deemed so exceptional even by comparison with other POWs that they were awarded Medals of Honor.

McCain shared this hell with them, and he is as deserving of as much recognition for his courage, perseverance, and suffering  as a POW that they received.  But he has received far, far more.  Flags are at half-mast.  He will lay in state in the Capitol.  The media praise has been fulsome, and almost non-stop since his death.

The difference in honors paid to McCain on the one hand, and Thorsness, Day, and Stockdale on the other, therefore cannot relate to his military service and captivity: instead, it is a tribute to his political career.

This is an inversion of priorities. I can think of few politicians who deserve such veneration.  Very few.  And John McCain is not one of them.

Formally, John McCain was a Republican.  But he reveled in tweaking his party, often to aggrandize himself and to attract praise from the “elite” media and the DC establishment.

The fact is that McCain was a member of the party of government.  On every major issue, especially during the period of his greatest power and fame, McCain supported expansion of the scope and power of government.  Sometimes he talked the limited government talk, but he very, very seldom walked the walk.

One of the refrains in the encomiums is that McCain was a strong believer in an practitioner in bipartisanship.  This is hardly an endorsement.  Bipartisanship is the religion of the party of government. And in DC, it is pretty much a one-way street.

In practical terms, “bipartisanship” usually entails a conspiracy of the two parties to stitch up the rest of us.  When someone praises bipartisanship, I grab my wallet and watch my back.

McCain’s signature issue–campaign finance “reform”–is a case in point.  From the first it was designed to protect incumbents and the institutional parties from competition and accountability.  I prefer gridlock and conflict: if they are fighting one another, they are less likely to shaft me and mine.

Further, today’s funeral featured speech after speech lauding McCain’s bipartisanship–and blasting Trump.

If you are mystified as to how paeans to bipartisanship mix (at a funeral no less) with relentless partisan attacks, let me explain.  Bipartisan in Washington-ese means the shared interest of the institutional parties and incumbents in protecting their sinecures and power.  Trump threatens both.  So rank partisanship–again, at a funeral!–is perfectly compatible with the DC meaning of “bipartisan” because Trump and his supporters are not part of the “bi”, and indeed threaten its parasitic existence.  This is one tribe–the establishment tribe–attacking The Other.

In recent years, moreover, McCain has wanted to involve the US in yet more wars, especially in the Middle East.  His advocacy of intervention in Syria in particular speaks very poorly of his judgment, especially in light of American experience in Iraq and Afghanistan.

And let’s be real here.  If McCain had died when Obama was president, or had Hillary been president, he would not be receiving nearly the amount of praise and attention as he is receiving in the Age of Trump.  McCain was a vocal critic of Trump, and praising McCain to the heavens is just another way of damning Trump.

It is particularly nauseating to see many of those who savaged him during his hapless presidential campaign celebrating him today.  As if further proof was necessary of the situational nature of political “ethics” in the US.

For his part, Trump has been less than gracious in his response to McCain’s death.  “Don’t speak ill of the dead” seems to be his operative principle.

At least he’s not a hypocrite on this matter, which is another thing that sets him apart in DC.

Further, let’s not delude ourselves into believing that McCain was some latter-day “happy warrior” to be contrasted with a vicious Trump.  He in fact had a mean, vindictive, and petty side–as demonstrated by his disinviting Sarah Palin from his funeral.  Methinks that much of McCain’s criticism of Trump’s behavior was projection.

And let’s not forget that in addition to being a vicious vocal critic of Trump (and I think “vicious” is a fair characterization), McCain played a low and dishonorable role in injecting the Steele dossier into the body politic.  It is sickly ironic that a man who believed that Russia is a mortal enemy of the United States has done far more to advance Putin’s objective of destabilizing American politics and society than anything Putin has done, or even could do, himself.

So I am quite willing to acknowledge and honor McCain’s service and sacrifice in the years ending in 1973, just as I did (and do) honor that of Leo Thorsness, George Day, James Stockdale and other Americans who served with honor and distinction in Vietnam.  But his political career, and the ongoing celebration thereof, are a testament to the dysfunctions of American government and politics, so I will not be joining in the hosannas for Senator John McCain.

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