Streetwise Professor

March 31, 2021

Margin Call: From Movie to Reality Show

Filed under: Economics,Financial crisis — cpirrong @ 2:10 pm

The film Margin Call is an entertaining portrayal of big bank culture and behavior during the Financial Crisis. The basic plot involves a Wall Street bank that realizes that it holds a lot of toxic real estate/mortgage securities, and wants to unload them before everyone else figures out that their price is going to collapse. It succeeds, and saves itself from the fate of Lehman or Bear. I had to look past the basic plot vehicle: the ability of the bank to execute such massive sales without causing the price decline that it predicted is rather doubtful, at best. That said, the plot does provide an excellent backdrop for the personal dramas and interpersonal dynamics and characters that are Wall Street (and the City).

The Archegos implosion is a reality show version of Margin Call–right down to the title. The massive “private office” run by former Tiger Management wunderkind Bill Hwang put on massive positions (some long, some short) in a relatively small set of stocks. At least some of those positions were in the form of total return swaps, rather than purchases of the underlying stocks. Swaps embed leverage. A TRS is equivalent to a position in the stock financed with borrowing. It’s not clear from the reporting, but some may also have been old fashioned leveraged bets, with purchases of stocks on margin.

When prices went against the positions, Hwang faced huged margin calls that he did not meet. The prime brokers with whom he dealt then needed to liquidate large positions in the losing securities. Some of these stock holdings might have been the collateral that Hwang had posted, which the prime brokers seized when he defaulted. Some of them were almost certainly shares that the banks had bought as hedges of the total return swaps. Once Hwang defaulted, the banks’ short positions in the TRS went away, and they no longer needed the hedges.

Here’s where the Margin Call analogy really kicks in. Apparently Hwang’s major prime brokers, including Credit Suisse, Nomura, Morgan Stanley, and Goldman, discussed a coordinated liquidation of the stock positions in order to mitigate a panicked . Goldman (and maybe MS) listened politely, then pipped the others to the post and sold the stocks in big blocks before the others did. As a result, Credit Suisse and Nomura lost billions, and apparently Goldman and Morgan Stanley didn’t.

Goldman’s behavior is redolent of what they did in the Long Term Capital Management (LTCM) situation. One would have thought that CS and Nomura would have taken that into consideration, and hadn’t made themselves into the hindmost for the Devil’s taking.

Interestingly, although the block “fire sales” impacted the prices of the stocks Hwang traded, there doesn’t appear to have been a wider market fallout. Billions ain’t what they used to be. Even tens of billions ain’t what they used to be.

March 18, 2021

Putin on the Brain–Assuming Biden Has a Functioning Brain

Filed under: China,Politics,Russia — cpirrong @ 7:10 pm

Low oil prices, economic malaise (with stagnating GDP and declining real personal income), and demographic decline have combined to enervate Russia, and undermine Russian power. Seven years ago Putin invaded Crimea, and was top of the world, ma!–now he is a peripheral nuisance, far more focused on internal issues and concerns over succession and legacy, with an occasional turn at playing international spoiler.

But he looms large in the imaginations of American Democrats. He is the bogeyman who is the root of all evil. His machinations made Trump president, right? What could be worse than that? To this day, the American intelligence community (proving yet again that phrase to be an oxymoron) claims that he intervened in the 2020 election (yet provides absolutely no factual basis to support that claim). Everything bad in the world, they trace back to Putin. They have Putin on the brain.

Get real people. Putin reached his zenith in 2008: indeed, I can date it almost exactly to 8/8/8, with the invasion of Georgia. Thereafter, the financial crisis and the concomitant crash in oil prices gutted Russia’s economy, and put paid to Putin’s plan to exploit high energy prices to propel Russia back to being a superpower. The succeeding 12+ years have been a litany stagnation interrupted by periods of severe depression. Putin and Russia have been marginalized–objectively, anyways.

But Biden–with a big assist from the handmaiden media that has been flogging the Putin-as-Voldemort line since 2016–handed Putin an opportunity to get attention and twist America’s tail. In an interview with George Stephanopolous, simulacrum president Joe Biden agreed when asked whether Putin was “a killer.”

Putin didn’t miss a beat. He trolled Biden brilliantly. He turned the other cheek, and wished Biden good health:

This was no doubt a jab at the fact that Biden is clearly anything but healthy.

He challenged Biden to a debate, mano a mano:

That would be a riot: I would pay large $ to watch that on PPV. And quite frankly, Putin would trounce Biden, even if this “open direct discussion” was in English, given the simulacrum president’s obvious mental decline. And don’t think for a moment that Putin is not well-informed (better than Americans, certainly) about Biden’s actually physical and mental condition, which emboldens them to propose something he knows Biden (or more realistically, his puppeteers) could never agree to. (Ironically, the hysteria over Russian hacking gives great credence to this claim.)

I don’t think Obama did a lot of things right, but largely ignoring Putin was one of them. (Though he was an idiot in trying to play up the hapless Medvedev.) The obsessive attention that Democrats have given Putin post-Obama elevates his prestige and importance far beyond what the correlation of forces would justify.

So Biden gives Putin a perfect opportunity to troll him, and you can’t believe for a second that Vova would pass on it.

The obsession with Putin and Russia is particularly perverse given that the real strategic challenger to the US is China: focusing on Russia is a distraction from the real threat. But whereas Biden believes that deference to “cultural norms” justify giving China justifies soft-pedaling what is arguably genocide and a host of other grotesque repressions orchestrated by Xi, he gives no such deference to Russia and Putin. So I guess only non-white dictators get a pass because of “cultural norms.” Pretty progressive, right?

Putin is a pain. He has malign intent. But whether someone is a threat depends on both intent and capability. Russia’s capability has been waning inexorably for over a decade. Obsessing on intent while capability erodes and the capability and bad intent of another actor (China) grow is idiotic. But that’s where we are. Putin is relevant primarily because Democrat obsessions make him so. Biden’s latest gaffe will only make it worse.

March 15, 2021

Deliver Me From Evil: Platts’ Brent Travails

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — cpirrong @ 6:41 pm

In its decision to change speedily the Dated “Brent” crude oil assessment to include US crude and to a CIF basis, Platts hit a hornets’ nest with a stick and now is running away from the angry hive.

Platts’ attempt to change the contract makes sense. Dated “Brent” is an increasingly, well, dated benchmark due to the inexorable decline in North Sea production volumes, something I’ve written about periodically for the last 10 years or so. At present, only about one cargo per day is eligible, and this is insufficient to prevent squeezes (some of which have apparently occurred in recent months). The only real solution is to add more supply. But what supply?

Two realistic alternatives were on offer: to add oil from Norway’s Johan Sverdrup field, or to add non-North Sea oil (such as West African or US). Each presents difficulties. The Sverdrup field’s production is in the North Sea, but it is heavier and more sour than other oil currently in the eligible basket. West African or US oil is comparable in quality to the current Brent basket, but it is far from the North Sea.

Since derivatives prices converge to the cheapest-to-deliver, just adding either Sverdrup or US oil on a free on board basis to the basket would effectively turn Dated Brent into Dated Sverdrup or Dated US: Svedrup oil would be cheaper than other Brent-eligible production because of its lower quality, and US oil would be cheaper due to its greater distance from consumption locations. So to avoid creating a US oil or Sverdrup oil contract masquerading as a Brent contract, Platts needs to establish pricing differentials to put these on an even footing with legacy North Sea grades.

In the event, Platts decided to add US oil. In order to address the price differential issue, it decided to move the pricing basis from free on board (FOB) North Sea, to a cost, insurance, and freight (CIF) Rotterdam basis. It also announced that it would continue to assess Brent FOB, but this would be done on a netback basis by subtracting shipping costs from the CIF Rotterdam price.

The proposal makes good economic sense. And I surmise that’s exactly why it is so controversial.

This cynical assessment is based on a near decade of experience (from 1989 to 1997) in redesigning legacy futures contracts. From ’89-’91, in the aftermath of the Ferruzzi soybean corner, I researched and authored a report (published here–cheap! only one left in stock!) commissioned by the CBOT that recommended adding St. Louis as a corn and soybean delivery point at a premium to Chicago; in ’95-’96, in the aftermath of a corner of canola, I advised the Winnipeg Commodity Exchange about a redesign of its contract; in ’97, I was on the Grain Delivery Task Force at the CBOT which radically redesigned the corn and beans contracts–a design that remains in use today.

What did I learn from these experiences? Well, a WCE board member put it best: “Why would I want a more efficient contract? I make lots of money exploiting the inefficiencies in the contract we have.”

In more academic terms: rent seeking generates opposition to changes that make contracts more efficient, and in particular, more resistant to market power (squeezes, corners and the like).

Some anecdotes. In the first experience, many members of the committee assigned to consider contract changes–including the chairman (I can name names, but I won’t!)–were not pleased with my proposal to expand the “economic par” delivery playground beyond Chicago. During the meeting where I presented my results, the committee chairman and I literally almost came to blows–the reps from Cargill and ADM bodily removed the chairman from the room. (True!)

The GDTF was formed only because a previous committee formed to address the continued decline of the Chicago market was deadlocked on a solution. The CBOT had followed the tried-and-true method of getting all the big players into the room, but their interests were so opposed that they could not come to agreement. Eventually the committee proposed some Frankenstein’s monster that attempted to stitch together pieces from all of the proposals of the members, which nobody liked. (It was the classic example of a giraffe being a horse designed by committee.). It was not approved by the CBOT, and when the last Chicago delivery elevator closed shortly thereafter, the CFTC ordered the exchange to change the contract design, or risk losing its contract market designation.

Faced with this dire prospect, CBOT chairman Pat Arbor (a colorful figure!) decided to form a committee that included none of the major players like Cargill or ADM. Instead, it consisted of Bill Evans from Iowa Grain, Neal Kottke of Kottke Associates (an independent FCM), independent grain trader Tom Neal, and some outsider named Craig Pirrong. (They were clearly desperate.)

In relatively short order we hashed out a proposal for delivery on the Illinois River, at price differentials reflecting transportation costs, and a shipping certificate (as opposed to warehouse receipt) delivery instrument. After a few changes demanded by the CFTC (namely extending soybean delivery all the way down the River to St. Louis, rather than stopping at Peoria–or was it Pekin?), the design was approved by the CBOT membership and went into effect in 1998.

One thing that we did that caused a lot of problems–including in Congress, where the representative from Toledo (Marcy Kaptor) raised hell–was to drop Toledo as a delivery point. This made economic sense, but it did not go over well with certain entities on the shores of Lake Erie. Again–the distributive effects raised their ugly heads.

The change in the WCE contract–which was also eminently sensible (of course, since it was largely my idea!) also generated a lot of heat within the exchange, and politically within Alberta, Manitoba, and Saskatchewan.

So what did I learn? In exchange politics, as in politics politics, efficiency takes a back seat to distributive considerations. This insight inspired and informed a couple of academic papers.

I would bet dimes to donuts that’s exactly what is going on with Platts and Brent. Platts’ proposal for a more efficient pricing mechanism gores some very powerful interests’ oxen.

Indeed, the rents at stake in Brent are far larger than those even in CBOT corn and beans, let alone tiny canola. The Brent market is vastly bigger. The players are bigger–Shell or BP or Glencore make even 1997 era Cargill look like a piker. Crucially, open interest in Brent-based instruments extends out until 2029: open interest in the ags went out only a couple of years.

My surmise is that the addition of a big new source of deliverable supply (the US) would undercut the potential for delivery games exploiting “technical factors” as they are sometimes euphemistically called in the North Sea. This would tend to reduce the rents of those who have a comparative advantage in playing these games.

Moreover, adding more deliverable supply than people had anticipated would be available when they entered into contracts last year or the year before or the year before . . . and which extend out for years would tend to cause the prices for these longer dated contracts to fall. This would transfer wealth from the longs to the shorts, and there is no compensation mechanism. There would be big winners and losers from this.

It is these things that stirred up the hornets, I am almost sure. I don’t envy Platts, because Dated Brent clearly needs to be fixed, and fast (which no doubt is why Platts acted so precipitously). But any alternative that fixes the problems will redistribute rents and stir up the hornets again.

In 1997 the CBOT got off its keister because the CFTC ordered it to do so, and had the cudgel (revoking contract designation) to back up its demand. There’s no comparable agency with respect to Brent, and in any event, any such agency would be pitted against international behemoths, making it doubtful it could prevail.

As a result, I expect this to be an extended saga. Big incumbent players lose too much from a meaningful change, so change will be slow in coming, if it comes at all.

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