Streetwise Professor

I have long been nauseated by the hagiography surrounding Warren Buffett.  The veneration of St. Warren has reached a peak of late, as he is Obama’s go to guru, providing protection against accusations that the president is anti-business, and giving cover to Obama’s plans to jack up taxes on the wealthy.  After all, if a man richer than God is on your side, how can you possibly be a class warrior?

My cynicism about the saintly Buffett dates from almost exactly 14 years ago. There is substantial evidence that in February, 1998, Buffett cornered the silver market.

I repeat: there is substantial evidence that Warren Buffett cornered the silver market.  Cornered, as in manipulated.

Yes, Saint Warren was almost certainly a manipulator.

The story in a broad outline. Beginning on 25 July, 1997, Buffett began to accumulate large quantities of silver via Phibro, a subsidiary of Salomon Brothers, an investment bank in which Buffett had a big stake, and which he had saved from extinction when Salomon traders cornered the Two Year Treasury note market in 1991.  He eventually acquired nearly 130 million ounces of silver.

He stood for big deliveries in February, 1998.  The market went nuts.  All of the inidicia of a corner were present.  Nearby prices skyrocketed relative to prices for delivery in the spring.  The following chart depicts the spread between the March, 1998 COMEX silver price, and the prices for May and July. 

Note that the spread blows out when Buffett stood for delivery, during the first week of February, with the March-July spread going from -.2 cents/oz on 1/29/98 to 20 cents/oz on 2/5/98.  The March 98 price went up a dizzying $1.25/oz (about 20 percent) during that week.

The loco London lease market for silver also showed acute signs of a squeeze.  (The lease rate is the cost of borrowing metal.  If you need silver in a hurry to make delivery, you are willing to pay a big premium for nearby delivery, that is, you are willing to pay a lot to borrow/lease silver.  Formally, the forward price of silver is the spot price times one plus the interest rate minus the lease rate.  If the lease rate is very high, the forward price will be below the spot price: that is, the market is in backwardation.)

This depicts the one month lease rate for silver.  Note it skyrocketing right around the time of the deliveries.  In early February, the lease rate was quoted as much as 75 percent annualized (some press reports say 80 percent).

There were physical distortions characteristic of a squeeze.  People around the world scrambled to get silver and transport it to London–often by plane.  The silver market in India, a major consumer, almost shut down:

But in the past two months, work at the refinery has slowed–because of one man half a world away. Until a few days ago, most Indians had never heard of Warren Buffett. They even say his name wrong, confusing it with buffet. No matter. Since last October, when Buffett began buying silver, imports into India have nearly stalled as Indians decided that the metal costs too much. Today, more and more Indians are selling their dishes and jewelry made of silver, which now fetches $7.25 an ounce, 20% above the normal $6. That makes for an interesting match-up: 960 million Indian sellers vs. one billionaire buyer from Omaha. “Tell [Buffett] he can’t last,” thunders dealer and refiner Mukul Sonawala. “Indians say the price is too high. They’re saying: `Mr. Buffett, have your buffet, we’ll wait till the price drops. Good-bye.”‘

There were backlogs processing the silver flooding into London: the official weighers couldn’t keep up.  The London Bullion Market Association responded to the bottleneck by extending the normal 5 day delivery period to 15 days.

There was plenty of silver in New York, but Buffett didn’t buy it there, even though it was cheaper there (more on this below).  Instead, silver was shipped from NY to London, by airfreight(!) mainly, where it had to be re-assayed because the assay marks were from a firm no longer in existence.  This created yet another bottleneck.

As soon as the deliveries were completed, prices, spreads and lease rates collapsed: by 27 February, the London price had fallen 22.5 percent off its peak, and lease rates were down to where they’d been before the frenzy began in the immediate aftermath of a Buffett press release (see below).  These price and price relation changes are also symptomatic of a corner.  They are the manifestations of what is often referred to as “burying the corpse”–a phrase I’ve been accused of coining.*

What did Buffett have to say?  This (on February 3, 1998):

During 1998, Berkshire has accepted delivery of 87,510,000 ounces in accordance with the terms of the purchase contracts and the remaining contracts for 42,200,000 ounces call for delivery at varied dates until March 6, 1998. To date, all deliveries have been made on schedule. If any seller should have trouble making timely delivery, Berkshire is willing to defer delivery for a reasonable period upon payment of a modest fee.

Over 30 years ago, Warren Buffett, CEO of Berkshire Hathaway, made his first purchase of silver in anticipation of the metal’s demonetization by the U.S. Government. Since that time he has followed silver’s fundamentals but no entity he manages has owned it. In recent years, widely-published reports have shown that bullion inventories have fallen very materially, because of an excess of user-demand over mine production and reclamation. Therefore, last summer Mr. Buffett and Mr. Munger, Vice Chairman of Berkshire, concluded that equilibrium between supply and demand was only likely to be established by a somewhat higher price.

On which I call Bull!

If it was a long term investment, why did Buffett take delivery at a huge premium over deferred prices? If he was betting on the long term fundamentals, why not sell nearby silver at its huge premium, and buy silver at a much lower price for delivery in July, say?  If he was right about the fundamentals, the July price would rise as the “equilibrium [was] established.”

Taking delivery at a premium price was actually foolish, if long term investment was the actual goal.  Buffett paid a premium of about 45 cents/oz to get silver in early-February.  He was buying high and selling low. If he wasn’t manipulating, and his trading wasn’t causing the price distortions, he could have sold spot silver, bought silver for delivery in a month, and picked up 45 cents/oz by doing so (instead of standing for delivery).  Warren Buffett did not get that rich by being that stupid.  No, the evidence clearly shows he had another, very short-term objective in mind.

Put differently, if Buffett had been acting purely as a long term investor, why would he have needed people around the world–as far away as India–to scrape up all the silver they could find, put it on planes, fly it to London to get in the customs queue to be delivered in a five day window (later extended to 15 days)?  Why did Mr. Long Term need silver on those 5 (15) days? What was the big hurry, if he was taking the long view?

And why did he need it in London? This chart depicts the difference between the London silver fix and the COMEX March futures price.  Note the spike when Buffet was taking deliveries in early February.  At the margin, he paid a premium of 56 cents/oz–representing almost 8 percent of the NY price–to get silver in London in early February rather than getting it in NY.  Note too that the premium crashed after the bottleneck cleared.

The answer to these questions: demanding delivery in a short time window in a single location had nothing to do with a long term view on silver.  It was a corner, pure and simple, exploiting the frictions involved in bringing large quantities of silver to London on short notice. That made it very costly to deliver, allowing Buffett to loan out silver very profitably at the inflated lease rate.  He created an artificial shortage, and likely profited accordingly.  An investor acquiring silver based on a long-term view would attempt to minimize cost by purchasing in the cheapest locations and dates.  Buffett bought a lot of silver at the most expensive location and the most expensive date.

And note well the little insult that Buffett added to economic injury:

If any seller should have trouble making timely delivery, Berkshire is willing to defer delivery for a reasonable period upon payment of a modest fee.

A reasonable period.  A modest fee.  How saintly.  Note well again: the market rate for deferring delivery by as little a month was as high as 75 percent on an annualized basis.  In dollar terms, about 45 cents/oz (6 percent of the price) to defer delivery by one month.  Does that sound “modest” to you? Not to me.  Does it sound like the actions of a purely long term investor, who shouldn’t need to get the silver RIGHT NOW? Couldn’t a long term investor wait a month? Wouldn’t a long term investor want to buy at the cheapest location, not the most expensive?

The lease rate tells you exactly what that “modest fee” was.  Deferring delivery for one month cost 75 percent annualized–over 6 percent per month.  That’s not even that modest for loan sharks.

No, the market showed acute signs of shortage, and that shortage had one cause: Buffett standing for huge deliveries.

So keep this in mind when you hear Buffett praised to the heavens.  He is more than willing to play smash mouth to add to his fortune.  He is also very willing to lie about it, and to claim sanctimoniously that he is doing those he is smashing a favor.

That doesn’t sound too saintly to me.

* I wish.  Actually, the phrase originates with P. D. Armour, a famous Chicago grain and meat magnate in the 19th and early-20th centuries.  (You might have had Armour chili–same company.)  He was asked whether it was easy to corner the market.  He responded that it was like a murder: ” to commit murder is very simple, the trouble is to bury the corpse”, the corpse being the excessive quantities of the commodity delivered to the market, that the cornerer had to unload later at a loss.

I’m sure you’ve noticed that I haven’t written much about clearing lately. (And yes, I can hear the Hallelujah Chorus.)  Simple reason, really.  Most of the clearing related news warrants schadenfreud, and an “I told you so” response.  I enjoy a good Lulz as much as the next guy, but I know it gets old.

But this article hits on so many things at once I have to impose on you all.  It basically gives the lie to all the justifications for the clearing mandates in Frankendodd.

1. The advocates of mandates, notably GiGi and Timmy! asserted repeatedly that clearing would reduce the connectedness of the financial system, and in particular, would reduce the importance of big banks in those connections.  I argued in response that clearing mandates would just change the topology of the network; that it would remain densely connected; big banks would still be tightly connected; and that the new topology was not obviously less systemically risky than the old one.

From the article:

Where do you find the spare $2 trillion needed as collateral for cleared swap trades?

With new regulation in the US and Europe set to move the bulk of the over-the-counter derivatives market towards central clearing from next year, swap buyers and dealers will soon be faced with that very question. Many custody banks believe they could provide the answer.

Already heavily involved in the plumbing of the clearing market, custodians act for almost every major financial services firm without a custody arm – including most dealers and every clearing house.

Most also offer collateral management services, including securities lending and collateral improvement – the process of turning less-liquid securities into eligible collateral to post as surety in transactions.

This experience could prove invaluable with the advent of new swap clearing rules, which come in with the expected implementation of the Dodd-Frank Act in the US from early next year, increasing the demand for collateral transformation services.

David Field, managing director with banking consultancy Rule Financial, said: “The buyside simply doesn’t have enough quality collateral available to lodge for clearing.

Executing brokers are expecting to generate strong post-trade revenues from collateral transformation – but the custody banks are the ones holding the collateral.

This is a huge opportunity for custodians, and several are already investing anywhere between $50m and $100m to position themselves.”

In other words, big custodial banks will be even more tightly connected with all major participants in the derivatives trade because of their comparative advantage in providing collateral transformation, and the strong economies of scope between providing this service and providing other custodial services.

2. The advocates of mandates argued that it would reduce leverage in the system.  I responded repeatedly that this was not at all obvious, and that the most likely effect would be to transform the nature of leverage.  The big move to collateral transformation makes it abundantly clear that this is in fact happening.  I go into this in much more detail in my forthcoming Journal of Applied Corporate Finance article titled “Clearing and Collateral Mandates: The New Liquidity Trap?”

Credit means credit risk.  So the clearing mandate has not eliminated credit risk from the derivatives market, or even reduced it sharply.  It has just transformed it, relocated it.  And it has definitely not eliminated derivatives-related credit risk from big banks.   Indeed, it is moving more risk to some big banks.  BNY-Mellon and JP Morgan are also the most important settlement banks, and play a vital role in the repo market.  This is already a source of systemic risk.  These banks are arguably the most important pieces of the financial infrastructure, and these developments will make them even more important, and also concentrate more risks from disparate markets (e.g., repo and derivatives) in them.

3. The advocates of mandates asserted that it would make the derivatives market less concentrated and more competitive (although nb these are NOT equivalent).  From the article:

Tech-heavy effort

Among the most ambitious to gain business in the swaps market is BNY Mellon, the world’s largest custodian with $25.8 trillion of assets under custody. The bank sees its existing footprint as a springboard towards dominance in the collateral services market for OTC derivatives.

[A director] for collateral management and clearing at BNY Mellon in London, believes it will be a tech-heavy effort. He said: “According to recent Isda Margin Survey figures, roughly 80% of collateral used in the OTC swaps market is cash, with about 15%-20% being fixed-income securities.

If even 20% of the estimated extra $2 trillion of collateral required to clear OTC swaps via central counterparties is in the form of securities, that puts a big onus on the collateral managers to offer smart, quick systems capable of handling huge draws on client collateral daily.”

Rival US custodian State Street has also been boosting its presence in the cleared derivatives markets, launching a swaps clearing operation in September. In a signal of intent, the bank has quietly begun hiring senior futures brokers from established rivals.

Charley Cooper, senior managing director at State Street Global Markets, said: “State Street’s unconflicted approach combined with the operational efficiencies gained from clearing with a custodian, gives us a significant edge in the emerging clearing marketplace.”

A senior derivatives banker said that clients are already looking at custodians as a viable counterparty.
He said: “In the past six months, we’ve seen growing migrations to the custodial clearing business.

Some have a better credit rating than almost every investment bank, and it’s unlikely they will be subject to capital ring-fencing regulations.”

He said that if a major custodian is able to convert even half of its existing custody clients into clearing clients, it could be looking at a share of anywhere between 10% and 20% of the OTC clearing market.”

The incumbents

But existing derivatives flow dealers – especially ones with large custody and treasury businesses – are unlikely to shy away from a revenue-generating opportunity.

Citibank, in particular, is hoping to combine a swaps clearing operation with its custody and treasury services in the US.

Jerome Kemp, global head of exchange-traded derivatives and OTC clearing at Citi, is in no doubt which direction the market is heading.

He said: “We’re looking at a re-dealing of the cards in the derivatives clearing space. Post-Dodd-Frank implementation, clearing will be led by the larger, well-capitalised banks.”

Citi hired aggressively to expand its futures commission merchant business last year, including the hire of Kemp, previously co-head of listed derivatives and clearing at JP Morgan, who arrived with a raft of colleagues.

Kemp thinks the next battleground for the bigger futures commission merchants, which will act as clearers for many firms on the buyside, could hinge on the bundling of services across clearing and asset servicing.

JP Morgan, meanwhile, is also looking to leverage its existing prime services footprint for its hedge fund clients for whom swaps clearing will be a new experience.

The bank has merged its listed and OTC clearing teams, and invested heavily in client roadshows and clearing masterclasses since the Dodd-Frank Act was passed in 2010.

Dale Braithwait, a member of JP Morgan’s OTC clearing team, said: “It’s to our advantage that we’re a big collateral manager too.

For a lot of asset managers, who do not feel they are able to use prime brokerage services, it’s a big benefit to have someone who can act as a custodian and a clearer.”

So there is a big fixed cost to play in this game.  The resulting scale economies tend to increase concentration.  Moreover, there is a strong scope economy across collateral management and transformation services, and other custodial services.  Meaning that the big custodian banks have a strong competitive advantage in providing the new collateral management and transformation services that will become a crucial component of the OTC derivatives markets.

It is particularly ironic that BNY-Mellon will be a major beneficiary of this.  You might recall the execrable NYT piece (written by Louise Story) about the evil derivatives dealer cabal.  One of the most memorable parts of the article was BNY’s whinging about its inability to break into the dealer space.  Read this new piece and you can just imagine BNY execs rubbing their hands together in glee, throwing their heads back, and laughing an evil laugh.  All your cabal belong to us.

So let’s summarize, shall we? Clearing mandates (and requirements to collateralize uncleared swaps) will result in the formation of new links between buyers and sellers of swaps (including dealer banks who do not offer custodial services) and a handful of major custodian banks.  These links will involve the extension of credit, and hence the existence of derivatives-related counterparty risk in which big banks still have substantial exposure.  If anything, the mandates will increase concentration in an important part of the derivatives market.  Moreover, it will arguably increase the concentration of credit risk exposure in a handful of systemically important banks.

Well played!  The actual results of Frankendodd will be the exact opposite of what was claimed by its tireless advocates (And yeah, I’m looking at you, Timmy! and GiGi.  I’m trying not to look at Barney, but that’s a whole other story.)

Unintended consequences, indeed.  Unintended, but predictable–and predicted.

Reports suggest that some of the MF Global customer funds may have made their way to MF’s UK subsidiary.  In which case, I found it, and right around the block no less!

Donkey years ago, when major exchanges were beginning the process of transforming from not-for-profit member owned firms to for-profit investor owned ones, there was a considerable amount of discussion over whether it was appropriate for for-profit exchanges to exercise regulatory functions.  The concern was that they would be subject to conflicts of interest that would undermine their incentive to regulate fraud and manipulation on their marketplaces.

I wrote a paper on the subject at the time, but shelved it in large part because these fears dissipated rather rapidly.  In the aftermath of the MFer debacle, however, they have returned with a vengeance.  Barney Frank just opined that the CME should not be a self-regulatory organization.  Yeah, I know, it’s Barney Frank (and aren’t you leaving Barney, so why not shut up?), but he’s not alone in his call.  Indeed, I get the sense that this is the emerging conventional wisdom.

So perhaps it’s time to revisit and revise that paper–thankfully Word is backward compatible!

I’ll use this post to summarize some of the arguments in that paper, and apply them to the MF/CME situation.

The main conclusion of the paper is that in comparing alternatives–self-regulating non-profit, member owned exchanges and self-regulating investor owned ones, the latter probably have stronger incentives to regulate most forms of bad conduct.

I divided the kinds of misconduct potentially subject to exchange oversight into two categories: misbehavior by agents (such as brokers cheating their customers), and market manipulation.  Based on my extensive analysis of self-regulation of manipulation, I concluded that neither type of exchange can be expected to self-regulate manipulation well.

With respect to agency problems, I concluded that for-profit exchanges are actually likely have a stronger incentive.  Member owned exchanges have more of a potential conflict of interest because the agents are among the exchange owners: some owners benefit directly from the (bad) conduct at issue.  Moreover, there is a collective action problem: perhaps one broker’s misconduct harms the others, by damaging the reputation of the exchange, but this is a public bad from the perspective of other broker-owners and free rider problems undermine the incentive of the brokers to act against it.

If you want a great example of that, look at the conduct on the floors in Chicago that was uncovered in the 1989 FBI sting.

With a for-profit exchange, however, inefficiently lax oversight of agents reduces the derived demand for the exchanges services, reducing its profits.  Put differently, for profit businesses are harmed when the suppliers of complementary services engage in misconduct that harms customers: brokers and exchanges provide complementary services, and misconduct by the former harms customers and reduces the demand for the latter’s services and hence its profits.  This gives the latter–the exchanges–a high powered incentive to police the supplier of (complementary) brokerage services.  Making them self-regulatory organizations permits them to engage in such policing and act on this incentive.

Against this it is sometimes argued that exchanges are likely to go easy on big brokerage firms that are their big customers.  But the ultimate customer is vitally important here too.  It is in the exchange’s interest that these ultimate customers are served by the most efficient, highest quality agents.  Higher cost/lower quality agents translates into lower derived demand for the exchange’s services.  Customers served by a broker that poses undue risks to its clients can go to another broker if the exchange cracks down  on the malfeasor.  The crackdown doesn’t reduce the exchange’s derived demand: it increases it, even if the broker is large.  Indeed, the risk posed by a bad broker to the exchange is all the greater, the bigger that broker is.  Which all means that there are fundamental problems with viewing the brokerage firms like MF as the exchange’s customers.

My argument depends crucially on there being a mechanism by which the self-regulating exchange incurs a cost when it engages in too little oversight.  The most likely mechanism is a reputational one, in which revelation of broker misconduct not caught by the exchange leads demanders of trading services to revise downward their estimate of the quality of the product they are getting (i.e., they conclude that they are at greater risk of being cheated by brokers), trade less (or are only willing to pay lower prices for exchange services), and thereby reduce exchange profits.

In the case of the CME and MF, this mechanism is clearly at work.  In the price of CME stock has fallen about $21/share since immediately prior to the MF blowup.  This represents a decline of market capitalization of $1.4 billion–approximately the same magnitude as the the missing money.  The work in the 1980s of Peltzman & Jarrell shows that it is quite common for product quality problems (that result in recalls) causing losses in market cap to the firm whose products are recalled that are far larger than the cost of the recall itself.  Bad quality outcomes have costly reputational effects.  This provides an incentive to avoid bad quality outcomes.

My paper drew from the property rights literature, which showed how the power of incentives could affect the incentives to supply quality.  That literature shows that a high power incentive system (like for-profit organization) could lead to a less efficient supply of quality than a low power incentive system (like non-profit organization) when quality was non-contractible or non-observable, and other mechanisms (like reputation) don’t cause a for-profit entity to internalize the effects of providing inefficiently low quality.  I concluded that this non-contractibility/non-observability issue was not relevant for the agency problems and other problems (such as informed trading).  Thus, I concluded that for-profit exchanges were likely to be better self-regulators of agent misconduct than non-profit ones.

The MF case doesn’t change my opinion on that.

But that is not necessarily the alternative being advanced by Frank et al. They presumably want to transfer all regulatory authority to the government.  To agencies like the CFTC and the SEC–which also had regulatory oversight responsibilities over MF, and didn’t stop the blowup and the possibly illegal appropriation or transfer of customer money.  Agencies that are subject to very low power incentives (except maybe for ass covering).  The CME is being pilloried for failing to stop the transfer of money that apparently began immediately after its auditors left MF: the SEC didn’t catch Allen Stanford or Bernie Madoff from stealing huge sums over periods of years–years–despite numerous warnings.

So I’m sure that yeah, handing over all regulatory responsibility to the CFTC and SEC will ensure nothing like MF ever happens again. And I also believe, as Christmas approaches, that Santa Claus is going to bring me a new Ferrari.

Actually, to extend Samuel Johnson’s aphorism, such recommendations are like 5th marriages: a triumph of idiocy over experience.

The facts in the MF case are still murky.  The collapse of a brokerage firm is not all that exceptional.  The potential theft of a billion plus in customer seg funds is very exceptional.  The issue is whether the CME could have stopped this theft.  Quite clearly such an action cannot be stopped by any ordinary and routine auditing.  Indeed, the money disappeared immediately after the last audit.  So preventing the theft would have required some extraordinary action, such as taking over control MF’s customer funds, transferring accounts, etc., earlier.  Given the truly exceptional nature of what MF apparently did, any assertion that CME should have done that reeks of hindsight bias: a common theme of the post-event commentary by industry people is that MF did the unthinkable, so it is pretty unrealistic to expect anyone to take actions to prevent the impossible (or unthinkably unlikely).

Self-regulation is imperfect.  Government regulation is imperfect.  Under either system, stuff happens.  Choosing which of these systems is, as Churchill said of democracy, the worst except for all the others that have been tried from time to time, requires a careful comparative analysis that focuses on incentives and information.  I’ve done that type of analysis in the past, and concluded that there is no single answer.  Exchanges do a lousy job at policing manipulation, and that function is best left to ex post legal enforcement–including private enforcement via civil lawsuit.  Exchanges–especially for-profit exchanges–do better at policing bad agents like brokers.  Not a perfect job, but their information and incentives are stronger in this case than in the case of manipulation.

The MF case shows that there is a market feedback mechanism at work that imposes costs on exchanges when people and firms they regulate do bad things.  Self-regulation harnesses that feedback mechanism, and it would be foolish to discard it on a whim based on an incompletely understood single instance like MF.  That’s doubly true given that the proposed alternative–complete reliance on government regulators–has more than its share of examples of proven failure, with Madoff and Stanford again being only the most prominent examples.

Remember.  Perfection is never an option.  Getting the right institutions in place requires a careful comparative analysis of the alternatives.  I can guarantee you Barney Frank hasn’t done that.  Nor have most people who are bold in their opinions on the matter. I’ve carried out such an analysis some years ago, and don’t claim to have the answer, but I know enough to say that (a) the situation is not so cut and dry and Barney et al make it, and (b) there is a colorable case that exchange self-regulation of certain forms of conduct is like what Churchill said about democracy.

And also remember that data is not plural of anecdote, and that anecdote and analysis are not synonyms.  Right now people are making strong recommendations on the basis of a single anecdote, and doing so before it is understood in any detail.  So I will withhold judgment, and when I make it I will endeavor to do so informed by the MF example, but also by a more complete comparative analysis of the incentives and information under the alternatives.

Whenever I need a good laugh I look around to see what Gazprom says about the perils of spot pricing mechanisms for gas.  (OK.  I confess.  My sense of humor is, uhm, idiosyncratic.)  And they seldom disappoint!

Like this gem:

Spot prices, which European customers have asked the Russian gas export monopoly to factor into long-term contract prices, should play a “subordinate, balancing role,” said Sergei Komlev, head of pricing and contract formation at Gazprom’s export division.

Gazprom supports “the existing dual hybrid pricing model,” Komlev said today at a conference in Moscow. Switching to 100 percent spot indexation or de-linking oil and gas prices “is unacceptable to gas producers because it will create opportunities for predatory pricing.”

Uhm, just how would that “predatory pricing” work, exactly?  Predatory pricing involves the sale of a product at below marginal cost with the intent to drive competitors out of the market.  Once exit occurs, the predator then raises price to supercompetitive (and perhaps monopoly) levels.

The problem with this strategy, as appealing as it is to the economically illiterate (well, I am talking about Gazprom management, so . . . ), is that (a) it can only work under very special conditions, (b) these conditions unlikely to hold in practice, and (c) the documented examples of successful–or even attempted–predation are virtually non-existent.  And I would say that the use of the modifier “virtually” is unduly cautious.

Predation is unlikely to work in an industry as unconcentrated as gas–and if anyone is in a position to be a predator, it is Gazprom, as the world’s largest producer with the world’s largest reserves.

But the more basic problem is that predation can’t destroy the competitor’s productive assets.  For instance, if a big gas producer tried to charge a below-cost price in an attempt to drive Gazprom out of business, Gazprom’s wells and pipelines would still exist, and could come back on line as soon as the predator attempted to raise price.  Meaning that the predator would lose money driving down prices, but would never be able to profit by raising them to supercompetitive levels.

In other words, predation is usually a great way for the predator to lose money.  Which is why it is more a figment of heated imaginations than an economic reality.

As for empirical examples, Rockefeller’s Standard Oil was the poster child.  Ida Tarbell–the daughter of a refiner that lost out in competition to Rockefeller–alleged in various muckraking articles and books that predation is how Standard Oil was built.  But the painstaking, non-muckraking, historical research of John McGee (then at Chicago, and published in the JLE) showed that Tarbell’s characterization was all wrong.  Standard Oil did not engage in predatory pricing.

So, predatory pricing is just another Gazprom bogeyman.  A risible scare tactic employed to defend an increasingly indefensible position.

Gazprom reminds me of the little Dutch boy, holding back the waters by putting his finger in the hole in the dike.  But Gazprom’s problem is that there are more holes than it has fingers.  Just follow the news and you’ll see story after story about gas exploration and development and export just about everywhere in the world.

One interesting development occurred the other day in Qatar.  Russia has downgraded its diplomatic relationship with the Gulf country because of an incident in which a Russian diplomat was roughed up, allegedly when Qatari officials tried to seize the diplomatic pouch he was carrying.

Recently, Qatar and Russia had been singing of the same hymnal with respect to gas contracting practices.  Moreover, Qatar has been Russia’s main interlocutor in discussions to create a gas cartel analogous to OPEC.  Given the proliferation of supply sources, actual and potential, the prospects for such a cartel are dim on economic grounds.  But political friction between Qatar and Russia makes the prospects even more remote.

Given the gravity of the accusation, one wonders what would have been so serious as to lead Qatar to take such an action.  Most likely guess: something related to Iran.  There are many indications that there is a covert war going on against Iran.  The Gulf states are in a cold war with Iran–and maybe it is a little warmer than that.  Russia’s role with Iran has been equivocal, at best.  Under these circumstances, one can readily imagine why Qatar would go after a Russian diplomat.

Regardless of the actual story, political tension between Qatar and Russia is just another hole for Gazprom to plug.

A while back–summer of 2010, if memory serves–I predicted that any CFTC position limit rule would be the subject of legal challenge.  My prediction was that someone would argue that the CFTC did not have the statutory authority to promulgate position limits because it had not made a finding that there was indeed excessive speculation that made it necessary to impose limits.  Subsequently, a DC Appeals Court decision that overturned an SEC regulation due to a failure to carry out an adequate cost-benefit analysis, made it clear that  this would be a major vulnerability for a variety of CFTC rulemakings, position limits among them. The day after the post-Dodd-Frank position limit rule was passed, speaking at a JP Morgan commodity conference, I said a suit challenging the rule would be “coming soon to a courthouse near you.”

Well, soon means about 6 weeks.  Today ISDA and SIFMA filed suit in DC contesting the position limit rule.   These organizations allege that the CFTC:

— Erred in concluding that the Dodd-Frank Act required it to establish position limits without first determining whether they were even necessary;

— Failed to present a reasoned analysis or consider all evidence in setting position limits;

— Failed to conduct an adequate cost-benefit analysis as required by law;

— Conducted a flawed rulemaking process that prevented commenters from meaningfully participating.

I imagine that others–such as the CME and maybe ICE–will follow suit, as it were.  I also expect that other rules will also wind up in court.  The position limit rule is probably the most vulnerable because of the statutory language about excessive speculation, but all of the rules the CFTC has passed are on extremely shaky on cost-benefit analysis grounds.

Frankendodd is under some pressure in Congress, but given the Democratic control of the Senate and the White House, nothing is going to happen on that front.  Instead, pieces of it will be chipped away in court.  Position limits could well be the first chip off the block.  Which is as it should be.

My new book, Commodity Price Dynamics: A Structural Approach (Cambridge UP) is now available.  Only 3 left in stock at Amazon!  Order Soon!  Sorry–no Kindle version.

From the book description:

Commodities have become an important component of many investors’ portfolios and the focus of much political controversy over the past decade. This book utilizes structural models to provide a better understanding of how commodities’ prices behave and what drives them. It exploits differences across commodities and examines a variety of predictions of the models to identify where they work and where they fail. The findings of the analysis are useful to scholars, traders, and policy makers who want to better understand often puzzling – and extreme – movements in the prices of commodities from aluminum to oil to soybeans to zinc.

I’d quote from the blurbs, but I’m just too darned modest.

In all seriousness, the book represents the culmination of years of my professional research.  I’m currently working on some extensions that apply the techniques utilized in the book to some current policy issues, such as the effects of speculation and commodity pricing anomalies, such as the huge basis observed for wheat in particular (and corn and soybeans too) in the mid-to-late ’00s.

I think the structural approach is quite useful in understanding how commodity prices behave, and crucially, how commodity derivatives should be priced. That’s where the book differs from earlier explorations of the structural approach, like the book of Williams and Wright from the early 1990s.

Moreover, I believe that the structural approach is useful in demonstrating that price behaviors that are commonly considered to be irrational, and driven by excessive speculation or noise trading, are in fact perfectly consistent with rational expectations-based models.

Also, I try to resist the quite common tendency to fall in love with the models one works on. One of the main contributions is to show where the structural model for storable commodities fails miserably, and to suggest extensions that may correct these failures. As I say in the introduction, I try to break the models and learn from the pieces.

For my next book, I’m changing gears, and working on a subject that has been covered in myriad SWP posts. It will be titled “Market Macrostructure” and will also be a Cambridge imprint. The first half of the book will analyze the organization of the execution of financial transactions, focusing on issues like liquidity network effects and dark pools. The second half-will examine the organization of post-trade services, most notably clearing. I’m sure that you are all shocked by that.

There are many misconceptions about the CME’s responsibilities in the MF Global situation, and the implications of this situation for the CME’s longstanding claims that no customer has lost money as a result of a clearing member default.  These misconceptions are epitomized by this Sun Times article:

CME owns the Chicago Mercantile Exchange, Chicago Board of Trade and the New York Mercantile Exchange, where much MF Global business took place. It legally clears, or guarantees, the trading on its markets and often boasts that no customer has ever lost money because a trading firm failed.

That more than 100-year record may be in jeopardy with MF Global, one of the largest brokerages on the Chicago and New York commodity markets. Former New Jersey governor and Goldman Sachs Group Inc. chairman Jon Corzine led the firm but made a disastrous investment in European debt.

The claim is true, and regardless of what happens with MF it will remain true.  The clearing guarantee is not in play here.

If clearing firm A defaults, customers of clearing firms B, C, etc., will get paid as long as the clearinghouse is solvent.  That has always been the case in the past, and it is true now.

It is possible that customers can lose money under the omnibus account system employed in the US, if there is a default on A’s customer account, and A cannot cover it, then A’s customers bear some of the losses.  As an example of this, the London customers of Griffin trading lost money when that firm went bust in 1999: no US customer customer lost.  (Customers of a COMEX member, Volume Investors, did lose when that firm went under).

There was no default in either MF Global’s house or customer accounts, so the clearinghouse guarantee never came into play.  So the Sun Times account–like many others–is fundamentally misleading.

Moreover, 60 percent of customer margin associated with open positions was transferred to other clearing members.  Most of the missing money in question, from what has been reported, was customer money on deposit at MF Global but not margin associated with open positions.  (That is the case with two MF customers I know personally.)  The CME clearinghouse guarantee has nothing to do with that money.

CME has raised the amount that it is willing to commit to cover any shortfalls from the bankruptcy trustee’s distribution of cash to customers.  This is not the CME’s legal obligation, but is, as I said in an FT article a couple of weeks ago, an indication of the importance of this situation to CME’s reputation.

CME will be subject to scrutiny primarily for its role as the MFer’s Designated Self-Regulatory Organization (and hence responsible for auditing it) prior to the firm’s rapid implosion.  Moreover, as Jeff Carter (a one-time CME floor trader and board member) writes, CME has not done itself any favors with its handling of the “public perception of the crisis.” (Though I have also heard that CFTC is attempting to control what the exchanges–CME and ICE–are saying.  As well it might, as it will also come under considerable scrutiny.)

A big question in my mind is why Corzine isn’t getting the Madoff treatment from the Feds and the media.  He has been called to testify in front of a House committee.  I wonder if he’ll invoke the amendment that comes right after the one about unreasonable searches and seizures.  But it is amazing to me how little critical coverage he has received.  Especially given the bad press that rich bankers are getting these days.

Oh, I forgot.  He’s a progressive Dem in good standing.  What was I thinking?  My bad.

So there are two major things wrong with coverage of the MFer’s tale.  The first is that the role of the CME’s guarantee to its customers is being misrepresented with some regularity–including by the home field rag.  The second is that the most likely culprit–and certainly the person ultimately responsible for the firm’s collapse, and anything that occurred as the firm crashed and burned–is all but invisible.

Or you’ve been working to devise US energy policy over the last couple of decades.  But I repeat myself: the latter group is a proper subset of the former.

I am referring to articles running in the official house organs of the conventional liberal wisdom, the WaPo and the NYT, which confirm the obvious: government subsidies for energy, and particularly “alternative” energy and renewables, have proved to be a dreary litany of failure after expensive failure.

These failures were predictable–and in fact predicted.  But the predictions have been ignored.  For decades, as the WaPo article points out in excruciating detail.  Good money has been thrown after bad which had been thrown after worse.  These decisions have been driven by political economy rather than economic calculation.  If something needs a subsidy, that means it costs too much for the value it produces.  Yes, there can be circumstances in which there is some value that is not internalized by the producer, in which a subsidy may theoretically be justified.  But as the historical record makes abundantly clear, that’s not what drives how subsidies are allocated: they come out of the political sausage grinder, and it is politics and political connections that turn the crank.

Whatever you think about ExxonMobil, they deserve credit for not buying into the “beyond petroleum” moonshinery of BP and some other supermajors in the last decade.  During the Bush years, XOM CEOs Lee Raymond and Rex Tillerson steadfastly refused to commit capital into renewables and alternative energy, and resisted playing the subsidy game: they were unabashedly an oil company, and didn’t pretend otherwise.  They had seen the boondoggles of the 1970s–remember Synfuels?–and didn’t want to squander valuable capital on similar boondoggles in the new millennium.  Unfortunately, Congress and two administrations–particularly the current one–haven’t been quite so perceptive.   As a result tens of billions of dollars have been wasted, and wasted predictably.