Streetwise Professor

The disappearance of Malaysia Air Flight 370 is one of the most disturbing episodes of recent years.

Initially, I concluded that the plane had exploded at high altitude, a la TWA 800 (though at a much higher altitude): the sudden disappearance from radar and the deactivation of the transponders supported this conclusion.  I thought terrorism would have been the most likely cause, but did not rule out some other catastrophic but accidental failure (e.g., ignition of fumes in a fuel tank).

I was skeptical about the initial reports that Malaysia had tracked the plane across its airspace on military radar because the utter inability of the Malaysian authorities to tell a coherent story made me doubt anything they said.  And recall the story was denied soon after it ran, and there appeared to be a conflict between civilian and military authorities, which cast doubt on everything.

But it is now confirmed that the plane was indeed tracked by Malaysian military radar traversing the country before turning into the Straits of Malacca. Now the official story, as yet uncontradicted, is that the plane flew on for 7 hours in an unknown direction (northwest? southwest?).  Meaning that it could be anywhere in about 10 percent of the earth’s surface, most of that trackless ocean.

This is so disturbing precisely because it is totally unprecedented as a hijacking or act of terrorism.  It is almost certainly deliberate, but the purpose is unfathomable.

Many aboard were Chinese, suggesting that if it was terrorism, it would be directed at the PRC.  But China’s only serious terrorist threat, the Uighers, have never mounted anything nearly so sophisticated and bold: mass knife attacks in railway stations is more their MO.  And what would be the purpose of creating a mystery with no known perpetrator, rather than making a dramatic statement?  (Unless, of course, the hijackers/terrorists communicated with the Chinese government, which has declined to say anything.)

Thus, this is a puzzle that will unlikely to be solved anytime soon.  If ever.

I just want to raise questions that to my knowledge have not been asked, let alone answered.  Why did the Malaysian military permit an unidentified aircraft traverse its airspace without challenging it?  Did the military challenge the UIA by radio?  Did it get a response? If not, or if the aircraft did not respond to the challenge or follow instructions, did Malaysia attempt to intercept?

The 777 apparently flew quite close to one of Malaysia’s largest cities, Penang.  Is the Malaysian military in the habit of allowing unidentified aircraft fly unhindered over its major cities? Is 9-11 that long ago?

I am a firm believer in the adage “never attribute to malice which can be explained by incompetence.”  And Lord knows, the Malaysians have displayed plenty of incompetence.  But more sinister possibilities cannot be excluded.

In any event, Malaysia must be confronted on its response-or more accurately, its lack of response-to a mystery plane waltzing across its airspace in the direction of a city of 1.5 million people.  If the Malaysian Air Force had acted properly, and intercepted the errant plane, perhaps lives would have been saved.  And even if they had not, and even had a hijacker bent on killing all the plane’s passengers for some unknown purpose crashed the plane or flown on in defiance of orders to land, at least we would not be where we are now: which is not having any idea of where the plane is, let alone how and why it got there.

The embarrassing nature of this question may explain Malaysia’s repeated obfuscation.  The confused signals given by various parts of the Malaysian government suggested that something was being covered up.  If the Malaysian military did not respond in any serious way to the invasion of its air space, the urge to cover up would be intense, especially in a shame-based culture.

We may never have definitive answers about what happened to MAH370 and why.  But Malaysia definitely owes the world some answers for its shockingly inept response to the intrusion of a jumbo jet into its airspace.

@libertylynx reminded me of one of the whoppers that went unnoticed because of all the even bigger whoppers in Putin’s presser 10 days back:

Now, the stock market. As you may know, the stock market was jumpy even before the situation in Ukraine deteriorated. This is primarily linked to the policy of the US Federal Reserve, whose recent decisions enhanced the attractiveness of investing in the US economy and investors began moving their funds from the developing markets to the American market. This is a general trend and it has nothing to do with Ukraine. I believe it was India that suffered most, as well as the other BRICS states. Russia was hit as well, not as hard as India, but it was. This is the fundamental reason.

Some simple facts.  Since the beginning of March, the Russian market is down 13.74 percent.  The largest decline, of over 10 percent, occurred on the Monday after the upper chamber of the Duma authorized an invasion of Ukraine.  In the same time, the MSCI Emerging Market Index was down 2.55 percent: since Russia is included, non-Russian EM stocks were down less than 2.55 percent.  The MSCI EM Index also includes Turkey, which is lurching into chaos. As for India, it is up about 6 percent, and was down less than 1 percent on the day the Russian market crashed 10 percent.

So who you gonna believe?  VVP or those lying charts? Obviously what has hit the Russian markets is not a Fed-driven phenomenon common to BRICs or emerging markets.  This was a Russia-specific phenomenon.  Which means it’s all about Putin and Ukraine.

But the most revealing thing is that Putin can say such readily falsified things with such confidence and panache.  Has he convinced himself it’s true?  Or does he know that his real target audiences, Russians dependent on TV for news, and useful idiots in the West, will just swallow his swill as Gospel and won’t bother to check?

I’m guessing the latter, but I can’t rule out the former.

Russian government officials and Duma members  have threatened that if the US and/or EU impose financial sanctions in response to Crimea/Ukraine, Russian corporates will just default on their debt:

A Kremlin aide warned last week that Moscow might refuse to pay off loans to U.S. banks as a retaliation measure against sanctions.

Mikhail Yemelianov from pro-Kremlin party A Just Russia went even further: “If they (the West) freeze our assets, then our companies could stop paying foreign debts. The Russian corporate debt exceeds $700 billion”.

Please.

Banks don’t lend to Russia in large sums on an unsecured basis.  One of the things that caused Putin to freak out in 2008-2009 was that Russian companies (notably Deripaska’s Rusal) had pledged stock as collateral against loans.  Putin got Russian government banks (Sberbank, VTB) to extend credit to these companies so they could pay off the loans to western banks, thereby preventing them from defaulting and having large blocks of shares pass out of Russian hands.

I don’t know about all $700 billion of Russian debt, but I do know a bit about loans to one company mentioned in the linked article: Rosneft.

Rosneft borrowed upwards of $10 billion to finance the TNK-BP acquisition.  The structure of the borrowing shows just how dodgy even the biggest, most politically connected, state enterprises are viewed by western banks.

The loans were structured as prepays, and included trading firms Glencore, Vitol, and Trafigura as part of the structures.  Rosneft entered into off-take agreements with the trading firms that obligate the Russian company to deliver oil to them over the next several years.  The trading firms will then sell the oil, and send the receipts from the sales to the lending banks, thereby paying off the loans.  That is, the banks do not trust Rosneft to pay.  Rosneft never touches the money from the oil sales.   It goes from the trading companies directly to the banks.

In other words, Rosneft’s oil is security for the loans.  And as I noted when the deals were done, real supermajors (as opposed to pretend ones) don’t have to pledge such security in order to borrow.

So what would happen if Rosneft carries through on Yemelianov’s threat?

The only way to do that would be to default on the off-take agreements, i.e.,  to fail to deliver the contracted volumes to  Vitol et al.

Good luck with that.  The second Rosneft fails to deliver on the off-takes, and tries to sell  cargoes pledged to the trading companies on the open market, the trading companies will take legal measures to seize those cargoes to enforce their legal rights.  Knowing that, no buyer in his right mind will contract with Rosneft once it has stiffed Vitol, Glencore, and Traf.  Meaning that Rosneft cannot just walk away from its debt, if it ever wants to export a barrel of oil ever again.

In Rosneft’s case, therefore, the threat to walk away is an empty one.  The banks and trading companies have seen to that in the way the deals are structured.  Precisely because they don’t trust Russian companies enough to lend on an unsecured basis.

I don’t know the structure of every loan provided by western banks to Russian corporates.  But the structure of the Rosneft loans tells you that the banks have zero trust with Russian companies, and demand some form of security against the credit extended: the form of security will vary by the borrower and type of loan.  Meaning that Russian corporates that attempt to retaliate against sanctions by defaulting on obligations to western creditors will suffer major, major pain.

So I say: call the Russians’ bluff.  Impose sanctions.  If Putin forces Russian companies to default in response, they-and he-will pay a far higher cost than anything inflicted on the nations sanctioning Russia.

In his Monty MacArthur speech, the Big Oaf Formerly Known As President of Ukraine said this:

By the way, everyone knows how the U.S. government intends to allocate one billion dollars to this gangster regime. As far as I know, Article 84 22, Chapter 22, USC of US law prohibits the provision of financial assistance to the government of any state with an illegally elected president or where a legitimately elected president was deposed in a military coup or by any other illegal decision.

The Big Oaf’s masters-the Russian government-agrees:

“By all criteria, issuing funding to an illegitimate regime that seized power by force is unlawful and goes beyond the framework of the American legal system.”

The Oaf was apparently referring to 22 USC 8422, which relates to-wait for it-aid to Pakistan.  Like virtually every foreign aid appropriation since 1985, this prevents the State and Defense Departments from distributing aid to military governments that have taken power as a result of a coup d’etat.   If The Oaf’s research assistants had been more diligent they would have found the relevant language from Section 7008 of the FY2013 Consolidated Appropriations Act, which states:

None of the funds appropriated or otherwise made available pursuant to titles III through VI of this Act shall be obligated or expended to finance directly any assistance to the government of any country whose duly elected head of government is deposed by military coup d’etat or decree or, after the date of enactment of this Act, a coup d’etat or decree in which the military plays a decisive role:

Provided, That assistance may be resumed to such government if the President determines and certifies to the Committees on Appropriations that subsequent to the termination of assistance a democratically elected government has taken office:

Provided further, That the provisions of this section shall not apply to assistance to promote democratic elections or public participation in democratic processes:

Provided further, That funds made available pursuant to the previous provisos shall be subject to the regular notification procedures of the Committees on Appropriations.

Note that the language is very specific: “duly elected head of government is deposed by military coup d’etat or decree or, after the date of enactment of this Act, a coup d’etat or decree in which the military plays a decisive role.”  Nothing of the sort happened in Ukraine.  The military stayed in its barracks.  Indeed, it is clearly the case that the failure of the military to intervene on Yanukovych’s behalf is what doomed him.

There was no military coup in Ukraine.  Period.  There is no military government in Ukraine.  Period.  Hell, sad to say, there’s hardly even a military.

Note how The Oaf reads into the law language that just ain’t there: he claims that a government formed “by any other illegal decision” is also ineligible for aid.  (The Kremlin and its flacks, including those on RT, also read in language that isn’t there.)

No.  The language is quite specific: “deposed by military coup d’etat or decree.”  There is nothing more, and certainly nothing about “any other illegal decision.”

Yanukovych was not deposed by military coup d’etat or decree.  Ergo, providing financial assistance breaks no law.

End of story.

Note too that 7008 permits the president to provide financial aid by affirming that a democratically elected government is in place (which is true in Ukraine), and to provide aid to support elections (which are forthcoming in Ukraine in May).

Arguably US law was broken when military aid was provided to the military government in Egypt that overthrew Morsi.  But there is no doubt whatsoever that US financial assistance to Ukraine would not contravene the letter or spirit of US law.

In other words, add this to the steaming, stinking pile of Putin lies.

And please direct some extra scorn at anyone (like Alex Jones, Paulians, and other assorted loons) who wafts the stench of Kremlin ordure.

When it comes to legal opinions, you are much better advised to get it from Lionel Hutz than Yanukovych and his Kremlin scriptwriters.  But hey, there is something of a resemblance.

German utilities claim to be developing work-arounds that would provide Ukraine with gas in the event Russia cuts off supplies due to non-payment, or as part of an economic war against Ukraine.

Now Germany’s major energy utility companies are developing strategies to help Ukraine fill the shortfall if Moscow decides to cut gas supplies. Companies including RWE and E.on are working on plans to supply Ukraine with weeks’ worth of gas.

Currently, Ukraine taps around half of it gas needs from Russia. But last Friday, Russian Gas monopolist Gazprom threatened to suspend deliveries to Ukraine if the country doesn’t pay its outstanding February bill of €1.7 billion ($2.35 billion).

In an emergency, the flow through Europe’s pipelines could simply be reversed, with gas getting pumped from German reservoirs through the Czech Republic and Slovakia directly to Ukraine. Following this year’s especially mild winter, Germany’s reservoirs are much fuller than usual. Even long-term deliveries would be conceivable at the moment.

Ukraine already signed a framework agreement in 2012 with RWE to make the gas deliveries possible. Under the contract, the company has committed itself to delivering up to 10 billion cubic meters of gas per year to Ukraine, which the country was going to use this summer to fill its reservoirs for the coming winter. But RWE executives say they could provide deliveries much sooner.

RWE currently draws its gas from Norway or the Netherlands, both major suppliers in Western Europe. It would also be possible to redirect Russian gas from the Nord Stream Baltic Sea pipeline — which connects Russia and Germany — through pipelines in the Czech Republic and Slovakia to Ukraine.

Color me skeptical.

The article notes that there are clauses in the contracts with Gazprom that preclude redirection of supplies, but the German utilities claim these are readily circumvented: given that gas in German storage reservoirs comes from multiple sources, how  could Gazprom prove its gas has been redirected?

But this is based on the naive view that Gazprom’s sole (or even preferred) recourse against German supply of Ukraine would be to file a legal action.  It could decide instead to retaliate for German shipments of gas to Ukraine by shutting off gas flowing on the Nordstream and Yamal pipelines. Given no gas would be flowing to Germany via Ukraine, if Gazprom did so the German companies would soon be drawing down their stocks rather heavily and be vulnerable to Gazprom’s  tender mercies going forward.

Would they really be willing to take that risk on behalf of Ukraine?

And there is also the matter of the huge political pressure Russia would exert on Germany if RWE and E.on were to attempt such a thing. After all, former Chancellor Gerhard Schroeder chairs the Nordstream board and still exercises considerable influence in Germany, and Germany has proven quite vulnerable to Russian pressure in the past.  Numerous German businesses would be importuning Merkel not to antagonize Russia.

I strongly suspect that this “plan” and the article about it have been created and planted to give Merkel and Steinmeier political cover: “See! We are doing something to help Ukraine.”  But if called upon to perform on their promises, I would expect the Germans to fold like a cheap suit in the face of Russian threats to cut off gas.  And Putin is playing for keeps here.  Don’t think for a moment he won’t do it even though he would incur a greater economic cost than the Germans (and other European consumers of German gas).

And remember, gas is not the only lever.  Coal is the major alternative to gas, but Germany (and also the UK, to an even greater degree) get a large fraction of their coal supplies through Russia.   This is a real game of chicken, and I am not putting my money on the Germans.

That’s because based on experience, and my perception that Germany is trying to get short run political benefits by dispelling serious doubts about its commitment to Ukraine, I do not consider the proposed plan to be very credible.  Just as the French (and British) made promises to the Poles in 1939, and then left them hanging when Poland called on them to deliver, I think there is a strong possibility that these German promises will be of the piecrust variety: easily made, easily broken.

In other words, Ukraine should not base its plans on the assumption that Germany has its back on gas, or anything else for that matter.

Matt Leising has an interesting story in Bloomberg about a consortium of insurance companies that will offer an insurance policy to clearinghouses that will address one of the most troublesome issues CCPs face: what to do when the waterfall runs dry.  That is, who bears any remaining losses after the defaulters’ margins, defaulters’ default fund contributions, CCP capital, and non-defaulters’ default fund contributions (including any top-up obligation) are all exhausted.

Proposals include variation margin haircuts, and initial margin haircuts.  Variation margin haircuts would essentially reduce the amount that those owed money on defaulted contracts would receive, thereby mutualizing default losses among “winners.”  Initial margin haircuts would share the losses among both winners and losers.

Given that the “winners” include many hedgers who would have suffered losses on other positions, I’ve always found variation margin haircutting problematic: it would reduce payoffs precisely in those states of the world in which the marginal utility of those payoffs is particularly high.  But that has been the industry’s preferred approach to this problem, though it has definitely not been universally popular, to say the least.  Distributive battles are never popularity contests.

This is where the insurance concept steps in.  The insurers will cover up to $6 to $10 billion in losses (across multiple CCPs) once all other elements of the default waterfall-including non-defaulters’ default fund contributions and CCP equity-are exhausted.  This will sharply limit, and eliminate in all but the most horrific scenarios, the necessity of mutualizing losses among non-clearing members via variation or initial margin haircutting.

Of course this sounds great in concept.  But one thing not discussed in the article is price.  How expensive will the coverage be?  Will CCPs find it sufficiently affordable to buy, or will they decide to haircut margins in some way instead because that is cheaper?

As I say in Matt’s article, although this proposal addresses one big headache regarding CCPs in extremis, it does not address another major concern: the wrong way risk inherent in CCPs.  Losses are likely to hit the default fund in crisis scenarios, which is precisely when the CCP member firms (banks mainly) are least able to take the hit.

It would have been truly interesting if insurers would have been willing to share losses with CCP members.  That would have mitigated the wrong way risk problem.  But the insurers were evidently not willing to do that.   This is likely because they are concerned about the moral hazard problems.  Members would have less incentive to mitigate risk if some of that risk is offloaded onto insurers who don’t influence CCP risk management and margining the way member firms do.

In sum, the insurers are taking on the risk in the extreme tail.  This of course raises the question of whether they are able to bear such risk, as it is likely to crystalize precisely during Armageddon Time. The consortium attempts to allay those concerns by pointing out that they have no derivatives positions (translation: We are not AIG!!!)  But there is still reason to ponder whether these companies will be solvent during the wrenching conditions that will exist when potentially multiple CCPs blow through their entire waterfalls.

Right now this is just a proposal and only the bare outlines have been disclosed.  It will be fascinating to see whether the concept actually sells, or whether CCPs will figure it is cheaper to offload the risk in the extreme tail on their customers rather than on insurance companies in exchange for a premium.

I’m also curious: will Buffett participate.  He’s the tail risk provider of last resort, and his (hypocritical) anti-derivatives rhetoric aside, this seems like it’s right down his alley.

Yanukovych held a public appearance today, his second since absconding from Kiev. It wasn’t a press conference, because he didn’t take questions.  After the last episode, a wise choice.

He repeatedly reiterated that he is alive.  It sort of reminded me of the Bring Out Your Dead Routine from Monty Python and the Holy Grail, where the old man that John Cleese is trying to get hauled away on the dead cart says: “I’m not dead. I feel happy! I think I’ll go for a walk.”

Then he went on about the fascist, Banderaist coup in Ukraine, and the illegitimacy of the scheduled election.  He claims to be still the legitimate president of Ukraine.

He then did his MacArthur turn, swearing that he shall return.

Put together the MacArthur bit and the legitimate president bit and things aren’t all that humorous.  Perhaps this is just bravado, but it dovetails all to well with the Putin counterrevolutionary agenda, in which Russian forces invade Ukraine (well, they already have, but the rest of it) with the excuse of restoring the legitimate government, and Yanukovych rides into the country in their baggage train.

You know Yanukovych would not have appeared without Putin’s consent, and that Putin (or his people) wrote Yanukovych’s script.  This is Putin talking, using a big, ex-zek marionette.  (And what is it about Putin and criminals as his political puppets?: the self-declared ruler of Crimea is another one, in his case a mobster with the nickname of “Goblin.”)  This is Putin signaling his intentions.

Other than his colorable legitimacy, Yanukovych is totally useless to Putin.  Absent his role as the excuse for a restorationist intervention, Yanukovych would have no doubt played out the rest of the Python routine. “You’re not fooling anyone, you know” followed by a bash on the head.

That will come later, either after Putin succeeds in his objective and Yanukovych is no longer needed, or Putin fails, and Yanukovych is no longer needed.  Either way, don’t try to sell the big dummy any life insurance policies.

Russia is decrying the “lawlessness” in eastern Ukraine.

Classic recipe. Sow chaos and lawlessness by inserting provocateurs into a fraught situation.  Loudly decry the dangers associated with such chaos, and lie about its sources.  Emphasize the chaos in an agitprop campaign to justify intervention.

Another rhyme with 1936-1939, by the way.

One has to have some grudging respect here, in the same way one has grudging respect for Satan in Paradise Lost.

I have no respect, however, for those erstwhile “leaders” in the west who fall for such well-worn and transparent ploys.

Like something out of 1984 (irony!), the disembodied head of Ed Snowden delivered remarks to SXSW in Austin.

Ed had nothing new to say.  Same old blah blah blah.  The only thing remarkable is that the appearance of the image of his talking head in front of the image of the Constitution did peg the cheesy-meter.  Jumping the shark doesn’t come close to conveying how lame this was.

Until someone asks Snowden “if as you claim your interest has been solely in exposing privacy violations against US citizens, why did you steal hundreds of thousands of documents relating to military and foreign intelligence matters, and why have the bulk of your leaks been related to such matters?” he deserves to be treated with extreme skepticism and scorned. But of course, the geek idiots at SXSW failed to do so.  Making them accessories after the fact in the Snowden operation.

It is becoming clearer by the day that the privacy campaign is an elaborate cover scheme meant to divert attention from an operation targeted at undermining legitimate US foreign and military intelligence functions.  It is also targeted at undermining US alliances, most notably with Germany, which has been (courtesy of Laura Poitras’s collaboration with Der Spiegel) the subject of a disproportionate number of the stories. The Germans are particularly vulnerable to such tactics, desiring so desperately to escape the burdens of their past by believing the Americans are as bad or worse.  (And by the way, German pusillanimity in the face of Putin’s aggression provides justification, as if any was needed, for surveilling German politicians.)

And look how important dividing the US from Germany is right now, in the midst of the Ukraine crisis.

There are no coincidences, comrades.

There have been many suggestions as to potential US/NATO military responses to Russian aggression in Ukraine. Some are quite stupid, or at least premature: for instance, one suggestion is to abrogate the US pledge not to station nuclear weapons in new NATO states like Poland.

By far the most important and effective military measure that the US can undertake is to provide Ukraine with intelligence.  Lots of intelligence. Satellite imagery detailing Russian deployments and movements. Intercepts from Russian tactical and command networks.

Today NATO announced the deployment of AWACS aircraft to Poland and Romania.

That’s great.  Question: who gets the information that the AWACS produce?  Only NATO? Or is it (or at least some of it) being shared with Ukraine?

Might I suggest something more: deployment of JSTARS aircraft, which provide a picture of deployments on the ground similar to what  AWACS provides in the air.

Intelligence is a force multiplier.  It would permit the Ukrainians to get inside the Russian OODA loop: forewarned is forearmed.  And it would help  make up for the Ukrainians’ relative weaknesses in armor, infantry, and combat air power. Though the disparities are somewhat overstated by comparing overall Russian and Ukrainian numbers, because there is no way that Russia can possibly deploy the entirety of its forces against Ukraine.  Given the advantages of the defense, and Russia’s serious logistical limitations, intelligence could be the difference maker.

Perhaps we are doing this already.  I surely hope so.  And if we are doing it, keeping it quiet is the right thing to do.