Streetwise Professor

Europe is thrashing about like a gaffed fish on a boat deck.  The proof?  In a sure sign of desperation, and an effective confession of impotence, Germany has instituted a broad ban on short selling:

Germany will temporarily ban naked short selling and naked credit-default swaps of euro-area government bonds at midnight after politicians blamed the practice for exacerbating the European debt crisis.

The ban will also apply to naked short selling in shares of 10 banks and insurers that will last until March 31, 2011, German financial regulator BaFin said today in an e-mailed statement. The step was needed because of “exceptional volatility” in euro-area bonds, the regulator said.

The panic is particularly evident in the hurried nature of the ban–it goes into effect almost immediately.  (In fact, it went into effect a few minutes before I posted this.)

And it don’t stop there, folks.  Germany’s ruling coalition is also calling for implementation of a transaction tax.

Germany.  Shooting the messenger with an MG-42.  Fat lot of good it will do them.

Indeed, if anything, these measures will make things worse.  This is true in part for signaling reasons.  Markets can smell desperation, and react to it.  This is a desperate move that signals utter policy bankruptcy, and an unwillingness to grapple with the underlying problems.  If people want to short, it is because they think things are overvalued.  And nothing shouts overvalued like financially strapped governments with deep structural budgetary problems spending time and effort tilting at speculative windmills, rather than tackling these underlying problems.  And if the Germans thought things were under control, why take such measures?  The immediate inference is that the Germans think things must be pretty bad.

These measures will also make things worse because they will impair liquidity, and shift selling pressure into other markets.  Some “naked short” CDS are in fact hedges.  Dirty hedges, but hedges nonetheless: market participants may short a more liquid credit in order to hedge a position in a related, but illiquid credit (perhaps one for which no CDS is traded at all).  But if they’re doing this, it’s because they want to reduce their exposure.  The ban doesn’t make that desire go away.  So, they’re likely to respond by selling off some of the more illiquid cash positions.  Shorting liquid bank stocks can also be a dirty hedge for exposures in less-liquid bank stocks or debt.  Again, the ban will redirect some selling into less liquid instruments.

The transactions tax, if implemented, could be especially pernicious in these conditions.  It will reduce liquidity.  It will also impede the reallocation of risks to those willing to pay the most for them.  This is hardly the way to bolster the financial sector.

All of the measures Europe has adopted, starting with the bailout, to the not-so-sterilized intervention that has cratered the ECB’s credibility, to the short sale ban, fail to come to grips with the underlying solvency problem.  Indeed, they all signal a basic refusal to deal with that–especially the last.

In the initial EUphoria following the announcement of the $1 trillion initiative, I thought that the key indicator of its ultimate success would be the Euro.  And after an initial spike, it has been down.  Down hard.

It is now trading at a 1.21 handle.  It is down 2 cents since about 11:30 CT today (CME futures).  I haven’t been able to confirm the time that the BaFin announcement was released, but I received an email with a story confirming the ban at 1:30 today.  So I suspect that most of the hard selloff in the Euro was a direct response to the announcement.  (Hey, if you can’t short the governments or the banks, might as well short the currency!)

That’s great for those of us planning a European vacation (volcanoes permitting), but it is a very bad omen for Europe.

It ain’t so great for the rest of the world either.  The European chaos, combined with China’s attempts to de-fizz is weighing on commodity prices: oil is down (below $70/bbl on the WTI) and copper is down too, below $3.00/lb.  This does not bode well for growth in the near term.

Look out below.  Especially in the Eurozone.  And no, a short selling ban doesn’t make much of a parachute.  An anvil is more like it.

Sarah Lynch has a VERY interesting story in today’s WSJ about how CFTC economists could find little evidence that speculation distorted commodity prices, and energy prices in particular.  (I’m quoted towards the end.)

Not that I’m surprised.  Hard to find stuff that don’t exist.

An Aug. 21, 2009 memo written by two agency economists and addressed to Treasury Secretary Timothy Geithner points to an internal CFTC debate over position limits. A CFTC spokesman said Mr. Gensler hadn’t read the memo or sent it to Mr. Geithner.

The memo analyzes the impact a lack of position limits may have had on energy markets after Congress voted in 2000 to replace them with a new and less stringent accountability level regime. Accountability levels are non-binding thresholds that merely trigger additional oversight if exceeded.

According to the memo, New York Mercantile Exchange data from between 2000 and 2009 show that the switch to the new accountability regime in 2001 didn’t change energy-price volatility.

“In our analysis of the impact of position limits, we find little evidence to suggest that changes from a position limit regime to an accountability regime, or changes in the levels of position limits impact price volatility in either energy or agricultural markets,” the CFTC memo states. “Our results are consistent with those found in the existing literature on position limits.”

Again.  No surprise.  In 2004 I did a very extensive study on the effect of the move to an accountability regime on volatility in nat gas at the behest of the Industrial Energy Consumers of America.  I found nothing.  IECA was not pleased.

It is revealing that Gensler allegedly never saw the memo.  Nor did Geithner, to whom it was addressed.  But since Gensler assuredly had his mind made up already (and/or had marching orders from Congress), it probably made no difference.

Here’s the most interesting part of the article:

Other internal emails drafted in August 2009 by the agency’s now Acting Chief Economist James Moser reveal he was concerned about how to craft a position limit rule.

Mr. Moser was at the time the agency’s deputy chief economist and sent an email to CFTC Commissioner Jill Sommers’ staff member expressing his views.

“I think of a position limit as a tool,” he wrote. “That tool needs to be calibrated to the problem it hopes to solve. Because we have no statistical evidence of a problem, we are not able to calibrate the tool to fix the problem.”

I feel your pain, Jim.  What you said is spot on.  But your big mistake is your touching belief that policy should be made on the basis of evidence.  How quaint.  (By the way, you can tell everybody you don’t know me.  I’ll understand.)

Lynch’s story also includes a link to a CFTC report on the effects of speculation and commodity funds on prices.  The study is an extension of earlier CFTC work that had drawn the ire of Commissioner Chilton.  The extended report, which as Lynch says expressed the no-speculative-effect view “more forcefully” never saw the light of day until it was unearthed via a FOIA request.  Go figure.

In its position limit NOPR, CFTC disclaims any need to show that speculation actually has caused unwarranted fluctuations in prices before imposing the limits.  It has to say that, because it’s pretty clear that its economists can’t do so.  But this isn’t about economics.  Its about belief, and politics.  Gary Gensler and Bart Chilton have a fixed belief about speculation and a political agenda to implement.  They’re not about to let something as irrelevant as evidence get in their way.  Hopefully the other commissioners feel differently.

As I am quoted saying in the article, CME and FIA have argued that as a legal matter CFTC must make a finding of speculative impact before imposing limits.  I don’t know if they’re right as a matter of law, but I’m sure we’ll find out soon enough.  And if a judge decides it must, GiGi is going to be in a very, very awkward position.

And doesn’t this story make you feel warm all over at the prospect of handing over vast new powers to the CFTC, especially a Gensler led CFTC?  A cavalier approach about economic logic and evidence about speculation in energy markets is bad enough.  Extending such an approach to oversight of trading and clearing of the vast OTC markets would be infinitely more dangerous.

Sergei Guriev and Ekaterina Zhuravskaya of Moscow’s New Economic School have produced an excellent paper comparing Russia with South Korea.  The starting point of their analysis is the superficial similarity between South Korean economic growth performance in the 1980s-1990s, and Russia’s performance in the 1990s and 2000s (i.e., lagged about 11 years).  This similarity is sometimes touted as evidence that Russia is the next South Korea development miracle.

Not so fast, there, say Sergei and Katia.  There are huge differences between South Korea and Russia.  Notably, virtually 50 percent the latter’s growth is (per calculations by Guriev and Tysvinski cited in the paper)  is attributable to natural resources (notably oil), whereas none of Korea’s is.

More importantly, the authors emphasize that when evaluating future prospects for growth, it is necessary to take account of the staggering institutional gap between Russia and Korea.  By all measures, both contemporary, and comparing Russia today to South Korea in the late-1990s, Russia’s institutions are extremely weak relative to Korea’s, and this weakness is inimical to growth.  Sergei and Katia argue that, without a substantial improvement in Russia’s political and economic institutions, notably its protection of property rights, Russia has no chance at being a Eurasian Tiger.  No chance.

And here’s where their analysis is particularly pessimistic.  They emphasize the interaction between the resource rents that have accounted for huge share of Russia’s growth, and the prospect for developing growth-supporting, modernization-supporting institutions; specifically, they note that the resource curse undermines the development of robust market-supporting institutions.  They further note that, consistent with the predictions of a good portion of the resource curse literature, the energy and resource boom in Russia has led the elites to take measures to reinforce the status quo in order to protect their access to resource rents.  That is, the resource boom has coincided with a weakening of institutions, and the still-birth of any modernization efforts.  (The reinforcement of the power vertical and the erosion of federalism are the main examples they discuss.)

None of this should be a shock to SWP readers.  Guriev and Zhuravskaya are advancing arguments and evidence that I’ve been making for the past four years.

For those giddy with the success of a bond sale, or the nascent signs of a Russian economic recovery on the back of strong oil prices, the Guriev-Zhuravskaya analysis should be a bracing corrective.   The long term prospects for Russia’s development as anything other than a resource appendage, at the mercy of the economic prospects of the rest of the world (which determine the demand for the country’s resources), depend crucially on the development of strong institutions that constrain kleptocracy, corruption, expropriation, and rent seeking.  But, ironically, the dynamics of a resource-oriented polity are inimical to the development of those strong institutions.

This implies, as G-Z state,

that Russia’s long-term prospets are rather bleak. . . . Russia is very likely to embark on a slow-growth trajectory.  Even in the best-case scenario, it will not catch up with the advanced economies in the foreseeable future, and in the worst case, Russia will follow the fate of the Soviet Union.

Put differently, in SWP-ese: Russia: In economic purgatory for the foreseeable future.

Very bad.

Problem one is obviously the ban on “Federal assistance” to any “swaps entity” where “Federal assistance” includes a Fed loan.  It is ironic, and disturbing, that (a) the bill mandates extensive clearing, and thereby makes swaps clearinghouses a central pillar of the financial system, but (b) denies these entities the ability to access liquidity via the Fed.  This goes against the recommendations of Duffie et al in their policy piece for the FRBNY, the European Commission, and now the IMF:

Hence, those [CCPs] deemed to be systemically important should have access to emergency central bank liquidity.  However, any such emergency lending should be collateralized by the same high-quality liquid securities as those typically posted against monetary policy operations. Also, it should not be done in any way that might compromise the central bank’s monetary policy or foreign exchange policy operations. [IMF, Making the OTC Derivatives Markets Safer (April, 2010), p. 20.]

In short, Lincoln’s bill goes against the advice of virtually all those who have analyzed the implications of clearing mandates–including strong supporters of these mandates.

During periods of market stress, and ESPECIALLY in cleared markets, the demand for liquidity increases dramatically.  Firms need liquidity to meet margin calls in response to big price moves.  CCPs that can borrow on behalf of their members can facilitate this process.  Denying these entities access to central bank liquidity facilities is a major mistake, and will in effect make the markets like they were prior to the formation of the Fed in 1913.  Can you say “Panic of 1907”?  I knew you could.

And even allowing CCPs to access liquidity facilities, while denying swap dealers from the same option–effectively requiring banks to hive off derivatives dealing activities–will cause problems.  If the idea is to reduce systemic risks arising from counterparty risk, it is desirable to ensure that market participants, including derivatives market participants, have access to liquidity during periods of market stress.  A firm experiencing a liquidity shock, due, for instance, to a big collateral call, but which is solvent, would be forced by this provision into fire sales or defaults that would exacerbate systemic risks.  It would do so by threatening to transform liquidity shocks into crises.

Lincoln’s bill evidently mistakes a bailout for the exercise of lender of last resort functions.  The latter, if Bagehot’s basic framework is followed, eases liquidity crises by lending freely against good collateral.  (The Fed’s promise to do so in October, 1987 almost surely saved the CME and CBT clearinghouses during the crash).  A bailout transfers wealth from taxpayers to the claimants of an insolvent firm.  Lincoln’s provision threatens to turn liquidity shocks into full-blown crises.

In some respects, Lincoln’s confusion is understandable.  After all, the Bernanke Fed has clearly blurred the line between Bagehot-esque lender of last resort activities and bailouts.  That’s a serious issue, that should be addressed.  But Lincoln’s approach would be a very bad way of doing that.

The bill’s end user exemption is extremely, extremely limited.  That’s also a problem, for reasons I’ve discussed before.  What’s particularly amazing is that the end user exemption is basically limited to commodity producers and consumers (although firms like J. Aron or Morgan Stanley that handle physical commodities are expressly excluded from the exemption).  That means that a firm, say IBM or Merck that uses currency or interest rate swaps would not be eligible for the exemption.

Oi.

The bill also extends position limits to the OTC market.  More pain, without gain.

The proposal requires trading on either exchanges or swap execution facilities, and precludes voice brokerage.  It mandates pre-trade price transparency, and “real time” price reporting.  I’ve commented extensively on these ideas in the past, and find them no more reasonable now than I have before.

About to jump on a plane, so I will add more later.  One last thing.  The bill envisions a massive expansion of responsibilities for the CFTC.  To be honest, the CFTC does not have the capabilities to handle its current responsibilities, let alone the new and extremely complex ones it would have under the bill.  This is a setup for future regulatory failure, in a situation where the regulation is much more pervasive–and systemic. Regulators failed before. They will fail again. The likelihood of failure will be higher, and the consequences of failure more catastrophic, when regulatory responsibilities are expanded greatly and foisted onto an agency that is ill prepared to handle them. Even if the CFTC is funded much more generously, it will face daunting challenges in scaling up, and obtaining the expertise it needs to do a much expanded job. This is a train wreck ready to happen.

OK.  Time for one more thing, something that the bill doesn’t do.  Manipulation is a potential problem in derivatives markets, and existing law and regulation has proved problematic (at best) in deterring it.  I’ve advocated for years that a statutory fix is required, and this bill (or the Frank bill, or the Dodd bill) would present opportunities to do that, but they don’t.  So we have a bill (bills, actually) that does many things it shouldn’t and doesn’t do something it can and should.  Great.

No, it’s not that both can make you cry.  It’s that if Sen. Blanche Lincoln (D-AR), chair of the Senate Ag Committee has her way, futures trading on both will be banned.  Onion futures have been banned since 1958, and the passage of Public Law 85-839 (legislation spearheaded by Gerald Ford, by the way).  Since that time, onions have had the dubious distinction of being the only commodity in which futures trading is specifically banned.  Now, the draft of Lincoln’s derivatives regulation bill would give onions company, by proscribing futures trading on “motion picture box office receipts, or any index, measure, value, or data related to such receipts.”

Now you could make a case–a weak one, but a case nonetheless–for the onion ban.  There were periodic manipulations of onion futures in Chicago.  Onions are perishable, and short sellers would sometimes bring in a few extra carloads of onions and deliver them.  Due to the perishability, a modest enhancement in supply would crater the price, generating a profit for the futures short.  There are stories that the price of onions would fall below the cost of the bags they were delivered in.

That said, empirical studies of the effects of the ban have shown that the ban did not reduce the volatility of onion prices.  Thus, the ban didn’t have any measurably beneficial effect.  But the CME (where onions were traded) has moved onto other things, and the market isn’t big enough to make it worth anybody’s while to lobby Congress to get the ban lifted.  So it has remained, a quaint curiosity.

Given that movie futures haven’t even started to trade yet, dire stories of adverse effects are, pardon the pun, mere speculation.  But a visible, connected, and influential interest group, that just happens to give Democrats in particular large sums of money, supports a ban.  So it made it into Lincoln’s bill, and into the news, ironically, on the day that the CFTC gave initial approval for such contracts.

But oh, were this the worst part of the bill.  As it is, it is merely a visible, risible, symbol of just how bad the bill is.  I will blog more on it later, but it has all the bad things in the Dodd and Frank bills, and much more to boot; it is the Dodd bill on steroids–or meth.  It is chock-full of anti-bank populism.  Most notably, it precludes any swaps dealer from having access to the Fed window.  As if banks can’t get themselves in financial trouble the old fashioned way, with no derivatives involved.

(It would be interesting to hear an explanation of how, if derivatives dealing is as obscenely profitable as Timmy! and Gensler and various Congresspeople argue, depriving banks of this revenue is going to make them healthier and less likely to require government help.)

Moreover, although the Lincoln bill mandates clearing, and offers only very limited exemptions from the clearing requirement, it also denies clearinghouses access to the discount window.  Even those broadly supportive of wider use of clearing recognize the potential systemic issues, and recommend that clearinghouses have access to central bank liquidity facilities.  But Stella–I mean, Blanche–thinks differently.  (Maybe somebody should tell her about the near death of the CME and CBT clearinghouses on 20 October, 1987.)

Let’s see, Congress  creates systemically important institutions that concentrate risk by mandating clearing, and then deprives them of access to the lender of last resort whose responsibility is to provide liquidity to systemically important institutions in times of crisis.  Just how is that supposed to work?

It was widely thought that Lincoln’s bill would be more moderate than Dodd’s but the reverse turned out to be true.  Some reporting suggests that she was near a compromise with her committee’s ranking Republican, Saxby Chambliss, but that the White House pressured her to back off.  The administration certainly made derivatives regulation a centerpiece of its rhetoric last week, and has evidently decided that anti-bank, anti-derivatives populism is a winning political issue that will put Republicans in an uncomfortable position.  Lincoln is in trouble in her re-election bid, so she could use the populist cred too.

It has all the appearances of a good cop-bad cop routine.  Don’t like the Dodd bill?  Just look how bad the alternative is.   Sad to say, I think that this means that the Dodd bill, or something close to it, is likely to become law.

Today was chock full of derivatives-related news.  One big story was that Senate Ag Committee Chair Blanche Lincoln is apparently going to propose a derivatives regulation bill that can best be described as the Dodd bill on steroids, with very few end user exemptions and a strict exchange trading requirement.  You can guess my appraisal of those ideas, but I’ll defer my analysis until something official is released.  I will say now, though, that it is evident that the administration is going full bore with a derivatives crack down.  Obama spoke out on the issue personally today, and Treasury people have been very vocal.  Ugh.

The other big story was that an un-redacted version of the Valukas report was released, revealing the names of the winning bidders for Lehman’s CME positions, and the payments to them.   According to the report, the winning bidders received consideration worth about $1.2 billion dollars more than the liabilities that they assumed.  Valukas argues that the Lehman estate could have a claim against the CME for forcing the liquidation of the positions, and against the winning bidders.

There are several related points that are relevant here.

The first is that Valukas’s valuation was based on settlement prices on Wednesday, 17 September, 2008.  The auction was held on the morning of the 18th.  The positions were large, and there is no guarantee that they could have been liquidated at those settlement prices.  The report details only the values of the options in the Lehman portfolios, based on the previous day’s settle.  This means that it values the futures at zero, meaning that it implicitly assumes that the settlement price hadn’t changed over night.

The SPAN margin values for the positions were large, indicating that the positions were large and risky.  Particularly given the extraordinary conditions at the time, assuming that the positions could have been liquidated at the previous day’s settle is extremely problematic.  Prices were extraordinarily volatile, and they could be expected to get only more volatile in the aftermath of a Lehman bankruptcy.  Moreover, liquidity was drying up, major financial institutions were suffering serious liquidity strains, and could not count on tapping the capital necessary to carry big risk positions.  Given the conditions in the market, it was possible that it would take some time to unwind positions assumed in the auction, and that the winning bidders would have faced considerable risk of loss during that unwind process.  In these circumstances, it was inevitable that firms would assume these positions only at discounted values.  Just how big a discount was warranted is impossible to say given the sparse disclosure in the Valukas report.

Indeed, even with much better knowledge of the positions, given the turmoil prevailing at the time determining the “fair” price to assume such a large position is a difficult and highly subjective exercise.  (Knowledge of the CME GLOBEX order book would be somewhat helpful in estimating market depth, but still any analysis would involve considerable conjecture.)  The SPAN risk numbers are probably a better benchmark than the position marks  that Valukas used to derive his $1.2 billion figure.  The transfer of margin monies exceeded the SPAN requirements by $100 million, but given the exceptional conditions at the time, SPAN is a problematic benchmark too.  SPAN attempts to adjust to reflect changes in volatilities and correlations, but whether it did so in a realistic way on 17 September, given the virtually unprecedented conditions in the market, is open to serious question.  It is quite possible that the bidders had much different estimates of the risk that they were assuming than that generated by SPAN, and bid accordingly.  I would argue that the sophisticated bidders had at least as good information and risk modeling as that embedded in SPAN, and almost certainly better, for reasons I’ve set out in some academic papers over the years.  SPAN also doesn’t explicitly incorporate liquidity risks (i.e., risks related to the time it would have taken to move positions, and the price impact of doing so), but in the conditions at the time liquidity risks were arguably huge, and bidders would have taken that into account.  I would therefore not place too much weight on second guesses based on SPAN.

Suffice it to say that Valukas may be right that there is a colorable claim, but the case is far from proven, and it will be extremely difficult and contentious to prove it.

The second point is that although the replacement risk associated with defaulted positions has received a good deal of attention in OTC markets, it is not absent in cleared markets.  The idea is that in OTC markets, when somebody defaults, its counterparties have to find new firms to take the place of the defaulter.  In stressed market conditions associated with the failure of a major dealer or trader (e.g., LTCM), it is likely that these replacement trades will occur at prices that deviate substantially from the prices prevailing before the default; those stepping in for the defaulter are only willing to trade at far more favorable prices than the pre-default prices.

Well, that’s exactly what happened here.  Goldman, DRW, etc., replaced Lehman as the counterparty on these trades, and were only willing to do so at prices that differed substantially from the pre-auction prices.  In the event, Lehman’s collateral was sufficient to cover the replacement cost (this can happen in the OTC market too), but it is not outside the realm of possibility that the collateral of a big defaulter would not be sufficient, and that other clearing members would be called on to make up the difference.

This should be a cautionary tale for those hot to force a substantial extension of the use of clearing.  Many of the products that are not cleared now, but which would be cleared under mandates, would be less liquid, more difficult to value, and pose risks more difficult to evaluate than currently cleared products like those that Lehman held at CME (and similarly, at LCH.Clearnet’s SwapClear).  As a result, any replacement cost problem would likely be more severe than that experienced at CME in 2008, and the risk that collateral would be insufficient would be greater.

Put differently, just because clearing worked OK (not great) for the futures and futures options at issue at CME with Lehman, does not mean that things would work just as well with an expanded set of cleared products.  Indeed, things would almost inevitably be worse.  The set of cleared products is not exogenously determined: it is endogenous.  The products that are easier to clear are more likely to be cleared now.  Forcing, exogenously by government fiat, clearing of more products which almost by definition are more difficult to clear (and perhaps substantially so) means that the process of handling the next Lehman will be messier than the process of handling the last one at CME.

And think of the spillover effects.  Consider a realistic scenario in which during the next crisis, difficulties associated with positions that are cleared only because of a mandate imperil a big clearinghouse, like the CME’s or ICE’s.  This could impose losses not just on those products, but on the other products cleared, including those that would have been cleared without the mandate.  (For instance, if replacement cost losses on these newly cleared products were so large that the CME clearinghouse’s financial condition were threatened, those trading ordinary futures contracts could suffer default losses too.)

Again, clearing does not make risk disappear.  The experience of CME with the Lehman situation shows that clearly.  Forcing risks that are harder to manage into a clearinghouse does not necessarily improve the safety of the financial system.  It could do the exact opposite, by threatening the safety of clearinghouses that could handle the risks they currently manage, but not the additional, more problematic risks forced upon them.

The third issue relates to the auction process.  CME originally solicited bids from 6 firms, and then in a second round from only 5 (dropping Morgan Stanley because its earlier bids had been uncompetitive.)  Felix Salmon considers this “scandalous”:

Not only was the whole thing utterly unprecedented, it was also far from transparent: only six firms were invited to bid. If the CME was actively trying to get the lowest possible bids it’s hard to think how they could have done better than this, holding a hurried auction in the midst of utter market chaos, with no minimum bids and seemingly not a care in the world about whether Lehman was getting a fair price for its assets. It looks very much as though the CME wanted to hand Lehman spoils to its largest clients, since Lehman itself was clearly not going to be a client going forwards and was in no position to object.

Regarding “unprecedented”–well, circumstances were pretty unprecedented.  Regarding “hurried . . . in the midst of utter chaos”–is Salmon proposing a langourous process, waiting for the market to return to “normal”?  Like, when, exactly?  And what if CME had waited, and Lehman had gone bankrupt, what then?  Would it have been any easier to deal with these defaulted positions?  As if.

Regarding the number of bidders.  Consider the CME’s position.  It didn’t want to jump from the frying pan into the fire, and transfer the positions to another firm or firms that didn’t have the capital to handle the risk thereby assumed.  It wanted to move the positions into firms that it felt could handle them.  (Not that, in retrospect, Goldman and Morgan Stanley were in much of a condition at the time to handle the risk.)  Under the circumstances, limiting the number of bidders makes some sense.

And consider the irony of Salmon’s concern for whether Lehman was getting a “fair price.”  (Just exactly what were fair prices “in the midst of utter market chaos,” Felix?) The whole reason that many–including Salmon–advocate a move to clearing is to protect other financial entities from the knock-on effects of a default by a particular entity.  That’s exactly what CME was trying to do: to protect the other clearing members from the knock-on effects of a default.  Yes, that has distributive effects: to the extent  that the clearinghouse reduces the losses its members suffer, the defaulter’s other creditors lose, dollar for dollar.  But that’s part of the clearing package, as I’ve written repeatedly.  By advocating clearing, you are providing advantages to one set of creditors, at the expense of others.  That may be advisable, if the advantaged creditors are more systemically important than the disadvantaged ones.  But if you advocate that one group of folks should get first crack at the seats in the lifeboats, in the event you really can’t cry over the people left at the rail while the ship goes down.  That’s a predictable consequence of the choice.

One would hope that this window onto clearing as it is, as opposed to clearing in the fantasy land that is DC, would be a revelation to Timmy!, and Gensler, and Dodd, and Frank, and now Blanche Lincoln.  But, alas, one would almost surely hope in vain.

As derivatives legislation wends its way through the Senate, with the Dodd bill and another being written in the Senate Ag committee, the battlelines are pretty well drawn.  The administration in particular is still on the clearing bandwagon, and is overtly hostile to any proposals to exempt end users from the clearing requirement.  The most strident rhetoric on this issue emanates from Gary Gensler (go figure), but also from Treasury.  Deputy Treasury Secretary Neal Wolin said: “we will oppose all attempts to create loopholes or carve-outs.”

By “carve outs,” he is referring to end user exemptions, primarily.  Which is all so ironic.  If you think through how clearing works in futures markets, it is primarily a mechanism to shift default risks from end user customers (the buy side) to the clearinghouse members.  That is, it is a customer protection institution.  But here many customers are adamantly opposed.  Thus, there must be some costs that offset–and indeed, more than offset–the benefits associated with this customer protection.

But instead of an effort to step back, and ask “why” and consider in an intellectually serious way what are the costs and benefits of clearing, the administration and many on Capitol Hill plunge ahead.  When they attempt to explain end user opposition at all, they stoop to asinine conspiracy theories.  Gensler, for instance, attributes the end user opposition to their being waterboys for the dealer banks.

Yeah, Caterpillar, etc., are just creatures of the banks.  Whatever, Gary.

But this is all so odd.  Gensler argues that the dealer banks routinely rape their customers, by exploiting the purported lack of transparency in the OTC market to extract supercompetitive spreads.

So, why would the rape victims (in one of Gensler’s narratives) be the willing supplicants of the banks (in another)?  Stockholm Syndrome?  Battered Spouse Syndrome?

Can we please have a serious discussion, with some serious analysis of trade-offs, rather than these dueling, and facially inconsistent, morality tales?

Yeah, I know.

But I will say that in Europe they are being far more serious and adult.  (And it kills me to have to say that.)  For instance, Jeremy Grant reports that European regulators recognize the legitimacy of end user concerns:

Industrial companies have won recognition from European regulators that they should be granted exemptions from sweeping regulation of the over-the-counter derivatives markets.

It marks a partial victory amid fears that a crackdown on off-exchange derivatives markets, blamed by some for exacerbating the financial crisis, could unfairly penalise corporate users of such instruments.

. . . .

In a “discussion paper” from the European Commission’s directorate general for internal markets, regulators say that “in principle, non-financial institutions could be exempt from the clearing obligation”.

It says the main mechanism for transferring risk to the real economy during the crisis was through the financial sector. “This suggests that the appropriate boundary for a clearing obligation is between the financial sector and the non-financial sector.”

Richard Raeburn, chairman of the European Association of Corporate Treasurers, said: “This suggests that [the Commission] supports the need for an exemption for non-financial users. It is certainly the first time that we’ve seen such a clear statement.”

Eact in January sent a letter to Brussels, signed by 160 companies, warning that without exemptions there could be “a reduction in the amount of funds allocated to productive investment in the [European] economy”.

Just how to structure the exemption is still under discussion.  But at least there is a recognition that there are serious issues that deserve serious discussion.

Could somebody in Europe pick up the clue phone and give Gensler and Wolin and Dodd a call?

Grant also reports that the Europeans recognize that clearing is not the deus ex machina that will descend from the heavens and solve all the systemic risk problems.  Indeed, they understand that clearinghouses can create systemic risks, and hence it is advisable to proceed carefully in ordering a new market structure by fiat:

Watchdogs are concerned about the possibility that proposed linkages between clearing houses could pose fresh dangers to the financial system.

They fear two-way or three-way linkages between clearers could trigger a domino effect if one clearer was to default.

What?  You mean that clearing doesn’t eliminate interconnections in the financial system?  Who knew?  (I know who doesn’t know, sad to say.)

In fact, contrary to the bologna constantly ground out by Timmy! and Gensler et al, clearing creates a particular interconnection among financial institutions–the same financial institutions (by and large) that are too interconnected today in the OTC market.  Multiple clearinghouses creates another set of linkages.  These can by systemically problematic.

The Europeans haven’t sorted through all these issues yet.  But at least they recognize them.  We, alas, are governed by know nothings masquerading as know it alls.

Which suggests a new administration spokesman on derivatives market regulation.

My post on Gold Bugs from last week drew a lot of comment at SeekingAlpha.  It was largely predictable, tiresomely so.

Life being short, and the effort pointless, I won’t respond to the invective, insult, insanity, etc., all of which validated my judgment that it is an exercise in futility to engage in these matters.  But there is one thing that strikes me as so funny that, at the risk of unleashing another torrent, I have to write about it.  (Maybe I should hedge myself, by buying shares in Kraft, the manufacturer of KoolAid.)

Specifically, one of the supposedly shocking! shocking! discoveries that proves, proves I tells ya, that the precious metals markets are manipulated is that the amount of claims on gold exceeds the physical supply of gold.  As an example:

Continuing on the trail of exposing what is rapidly becoming one of the largest frauds in commodity markets history is the most recent interview by Eric King with GATA’s Adrian Douglas, Harvey Orgen (who recently testified before the CFTC hearing) and his son, Lenny, in which the two discuss their visit to the only bullion bank vault in Canada, that of ScotiaMocatta, located at 40 King Street West in Toronto, and find the vault is practically empty.

. . . .

It appears that this kind of lack of physical holdings by all who claim to have gold in storage, is pervasive as the actual gold globally is held primarily in paper or electronic form. Lenny Organ who was the person to enter the vault of ScotiaMocatta, says “What shocked me was how little gold and silver they actually had.” Lenny describes exactly how much (or little as the case may be) silver was available – roughly 60,000 ounces. As for gold – 210 400 oz bars, 4,000 maples, 500 eagles, 10 kilo bars, 10 one kilogram pieces of gold nugget form, which Adrian Douglas calculates as being $100 million worth, which is just one tenth of what the Royal Mint of Canada sold in 2008, or over $1 billion worth of gold. As Orgen concludes: “The game ends when the people who own all these paper obligations say enough and take physical delivery, and that’s when the mess will occur.”

. . . .

It is funny that central bankers thought they could take the ponzi mentality of infinite dilution of all assets coupled with infinite debt issuance, as they have done to fiat money, and apply it to gold, in essence piling leverage upon leverage. They underestimated gold holders’ willingness to be diluted into perpetuity – when the realization that gold owned is just 1% of what is physically deliverable, you will see the biggest bank run in history.

Maybe this is one of those things that just crept up on us “gradually” (the explanation of Adrian Douglas).

Yeah, if by “gradual” you mean “since the middle of the 17th century.”

What has the Bugs Gang so exercised is, in effect, fractional reserve banking in gold.  Which started in the middle of the 17th century.  Indeed, fractional reserve banking started in the gold market.

The story goes that in response to expropriation by King Charles I of gold stored in the Tower of London, holders of gold deposited metal with goldsmiths.  The goldsmiths issued receipts for the deposited gold, and soon recognized that they could engage in a lending business because the gold owners’ demand for return of the physical metal was usually only a fraction of the gold that had actually been deposited.  Thus, fractional reserve banking was born.

No doubt the Bugs are mainly skeptical of fractional reserve banking generally, and not just in gold.  And there have been a variety of arguments for requiring 100 percent reserve backing for certain kinds of bank liabilities, in particular, that fractional reserve banking is subject to runs/crises.  But there are benefits to liquidity and maturity transformation (inherent in fractional reserve banking), and the survival of the institution that achieves this transformation suggests that the benefits exceed the costs.

But regardless of where you stand on the issue of fractional reserve banking generally, you look pretty foolish when you consider it to be a shocking revelation that gold warehousemen engage in the practice.  I mean, they’ve been doing it only for the last 450 350 odd years.

I seldom comment on anything having to do with precious metals because, well, the subject tends to bring out, how to say it?, er, enthusiasts.  Monomaniacal enthusiasts.  But I feel somewhat compelled to do so, because Adrian Douglas, a board member of the Gold Anti-Trust Action Committee (GATA) structured his comments to the CFTC about metals position limits around one of my older writings on manipulation. (Douglas’s comments are all over the web–that’s just one link.)  (Douglas delivered some impromptu testimony at the CFTC hearings on the subject.)

Douglas starts out all nice and stuff:

I recently read some of the work of Craig Pirrong, a recognized expert on commodity markets and market manipulation.

But then says:

Despite Pirrong’s alleged [thanks!] expertise in commodity markets, he considers that manipulation is mainly instigated by the “long” market participants in what is colloquially called a “corner.” He writes:

“Other speculative activities sometimes called manipulative are far more ephemeral than corners, and are of dubious practical relevance. For example, farm interests and farm state legislators frequently assert that large short sales of futures contracts by speculators are manipulative, and cause prices to fall below their ‘true’ value.

“Such ‘bear raids’ are profitable for the raiders only under very restrictive conditions. In order to realize a profit, it is necessary to sell high and buy low — that is, the short seller must eventually buy back his positions at a price which is lower than the price at which he initially sold. Since the number of contracts sold is equal to the number of contracts subsequently bought, this can happen if, and only if, the futures price responds asymmetrically to the speculator’s purchases and sales. That is, the price decline caused by the speculator’s sales must exceed the price rise caused by his subsequent purchases.

“There is no credible evidence that such an asymmetry exists or has existed in futures markets. Moreover, it is even difficult to construct a theoretical model that exhibits this property. As a result, it is highly unlikely that short manipulations of the type that is criticized so vigorously by the opponents of futures markets are a practical concern. Indeed, futures industry experts have been nonplused by the allegations of widespread ‘downward’ manipulation as far back as 1921, when there was no regulation; most recognized the real danger of squeezes and corners, but were deeply skeptical of the possibility of short manipulations.

“Nonetheless, the primary impetus behind the regulation of futures markets in the early 1920s was the collapse in agricultural prices after the end of World War I. Despite the skepticism of the industry witnesses, the promoters of the legislation regulating futures markets, such as Senator Capper and Representative Tincher, both of Kansas, were convinced that short-selling speculators were largely responsible for this collapse. As a result, Congress was intent upon preventing manipulative short selling. However, since it could not distinguish legitimate short selling for hedging purposes, for instance, from illegitimate short selling, Congress simply proscribed ‘manipulation’ and passed the buck to exchanges by requiring them to prevent what Congress could not define — or face the closure of their markets.”

I find it astonishing that an alleged expert could make such a claim. In the futures market there has to always be a buyer and a seller for every contract; that is, a “long” for every “short.” This means that there are as many longs as shorts. Whatever model can be proposed for long-side manipulation must, by symmetry, be possible for the short side. If one can drive prices up by buying a large amount of contracts, one can also drive the market down by selling a lot of contracts.

The prejudice that manipulation cannot be effectively carried out on the short side is a fundamental barrier to any intelligent and productive discussion of manipulation of the precious metals markets.

What the right hand giveth, the left hand taketh away.  Although Douglas then goes on to use other things I wrote in that article to support his arguments for a crackdown on manipulation in the gold market, which suggests that I’m not all bad:)  (Some friendly advice, Adrian: citing me is probably not the best way to persuade Gary Gensler and Bart Chilton.  Just sayin’.)

Mr. Douglas needs to read a little further, and a little more carefully.  I was addressing one type of short manipulation that was commonly alleged in the 1870s-1930s; the “bear raid,” in which a manipulator drives down prices by selling large quantities of futures and then profits by  . . .

Well, that’s the problem.  It’s hard to see how this could be profitable, because the manipulator has to buy back the contracts.  If selling contracts drives down the price, why wouldn’t buying them back at the end of the manipulation drive up prices?  And given the frictions (bid-ask spread, etc.) wouldn’t transactions costs make this unprofitable?  That’s why I said that there has to be some (unexplained) source of asymmetry in price impact to make such a strategy profitable.

I would agree that if such a strategy is profitable for a short, then the mirror image strategy would be profitable too.  The problem is, I don’t see either strategy being profitable, as I don’t see reliable evidence of the necessary asymmetry.

Manipulation can work by driving down prices in one market can enhance the profitability of other contracts with prices tied to that price.  (Again, the same thing can work in reverse.)  But that’s different than what I describe in what Douglas quotes.

Moreover, both large longs and shorts can sometimes manipulate by exercising market power in the “delivery end game.”  A long manipulation of that type–a corner–is what I focus on in the article Douglas quotes, and what is undoubtedly the most empirically important kind of manipulation.

And contrary to what Douglas claims, I did show in my 1993 J. of Business piece (and in a related chapter in my manipulation book) there IS asymmetry in market power manipulation.  The conditions that make long market power manipulation profitable (inelastic supply and elastic demand of the deliverable commodity) tend to make short manipulation unprofitable (and vice versa).  Therefore, one kind of manipulation should predominate in a particular market.  Short market power manipulation is usually found in perishable commodities, such as potatoes and onions.  Perishability makes the demand for these commodities very inelastic in the short run, which makes driving down the price relatively easy.  (Historical aside: frequent short manipulations led to a federal ban of trading futures on onions, the only commodity so honored.  There’s the answer to your question, Renee:)

Since gold (and, to a lesser degree silver) are held as stores of value (investments), their demand should be relatively elastic, making short market power manipulation very difficult and unprofitable.

Ironically, in the testimony before the CFTC, the main scare story the gold bugs told related to long manipulation.  Noting that the open interest in gold derivatives exceeds the physical gold available for delivery, they said that there would be extreme price disruptions if there was demand for delivery on a large number of contracts.  But this would be a long market power manipulation that drives prices UP, not a short manipulation that drives prices down, and which GATA claims has happened for years.

And that’s another problem.  GATA alleges that central banks, in cahoots with bullion dealers, have manipulated gold prices down for years.  But most manipulations are very short term affairs that have relatively short-lived effects on prices.

The GATA story of how manipulation works also doesn’t make much sense.  GATA was most exercised in the 1990s and early-2000s, when gold producer hedging was quite common.  Producers would short gold forward to bullion dealers.  The dealers would cover this long position by borrowing gold from central banks, and then selling it.  GATA interpreted the gold sales as an additional flow of gold onto the market that depressed prices.

This is mistaken on many levels.  The stock of gold remained unchanged by these transactions, and the price of gold is determined by the size of the stock, and the demand for the stock.*  Moreover, just mechanically, a gold loan is a simultaneous sale and future repurchase, not an outright sale; the sale and subsequent repurchase are essentially a wash.

If anything, the gold loan mechanism, and the resulting possibility that a single firm can accumulate a long position that exceeds readily deliverable supplies, can make long market power manipulations possible.  There is some evidence in gold lease rate data that such long manipulations have occurred in recent years.  (This is analogous to the repo squeezes that occur in the Treasury market, and which were rife in the mid-2000s.)  But these have the opposite effect on prices than GATA alleges, and these effects tend to be temporary.

If gold hedging affects prices, it does so indirectly, and in a non-manipulative way.  By permitting producers to manage risks more effectively, hedging presumably allows them to increase output (e.g., it permits them to obtain financing on better terms to expand mines.)  This would tend to reduce prices, by increasing the rate of growth in gold stocks.  But this is not manipulative.  It represents a socially beneficial reduction in the costs associated with financial frictions.  This cost reduction is welfare enhancing, whereas true manipulation is welfare reducing.

So, the GATA story doesn’t wash with me.  It is just a repeat of the same allegations that have been directed at commodity derivatives markets for years, and suffers from the same fundamental misunderstandings of the ways these markets work.  The GATA allegations are made more lurid by the involvement of central banks, and the secrecy with which these institutions operate.  But at the end of the day, there’s nothing to see here folks, so just move along.  Not that the gold bugs ever will.  But I hope that having written this, I can.

* GATA and other gold bugs have chronic difficulties distinguishing between stocks and flows.  They point to the fact that the volume of trades in gold exceeds actual gold stocks.  The aptly-named (since it is high variance) ZeroHedge breathlessly repeats such things, claiming that this is evidence of a Ponzi scheme.  Did these guys just fall of the turnip truck?:  this is true for virtually every major commodity market.  For a variety of reasons, the number of transactions, and frequently the open interest, is a multiple of the underlying deliverable supply.  Douglas states that this has developed slowly over many years:

The futures markets were conceived to allow commodity producers to reduce risk by being able to contract to sell their yet-to-be-produced commodity at some time in the future. By the same token, it allowed commodity users to reduce risk by being able to contract to buy a yet-to-be-produced commodity in the future. The futures markets also served to perform the function of price discovery by matching future demand with future supply at a market-clearing price.

However, gradualism has resulted in the futures markets morphing into giant casinos where less than 5 percent of contracts get settled with a physical commodity delivery. The futures markets are now totally divorced from their intended function. The futures markets have become such a farce that the delivery of physical commodities has become an inconvenience that hinders speculation and market manipulation.

Uhm, not exactly.  The facts that the volume of trades, and open interest, exceed deliverable supply, and that very few contracts are settled by delivery, have characterized commodity markets since the birth of futures markets in the late-1860s.  They have been the subject of comment and frequent criticism since that time.  This is not, contrary to what Douglas says, a new thing: the “morphing” took place about, oh, 1867.

Prior to the health care wars, I only knew of Bart Stupak for his sponsorship of the “Prevent Unfair Manipulation of Prices Act,” related to energy speculation, which led me to ask: What is fair manipulation?  Indeed, when I testified about energy speculation before the House Ag Committee in July, 2008, the first question I received was about Stupak’s testimony on the previous day, in which he had compared speculation in energy futures markets in the 2000s to the Hunt Brothers in 1979-1980.  That one was teed up for me: I replied that Rep. Stupak had it exactly backwards.  A comparison of the Hunts to what had transpired in the oil markets in ’07-’08 in fact demonstrated how speculation almost certainly was not causing artificially high energy prices.

Stupak’s statements on speculation just marked him as an idiot.  His star turn in the health care drama marks him as a hypocritical, unprincipled, posing, publicity slut.

After seizing center stage, gaining all sorts of press attention for being the leader of a group of representatives whose no votes threatened to derail passage of the health care bill,  and making it seem like his opposition was a matter of deep principles about life and abortion; at the moment when the publicity potential was greatest; Stupak agreed to vote for the health care bill in exchange for a promise that Obama would sign an executive order preventing the expenditure of any federal money for abortion. He gets the spotlight.  He gets to speak on the floor.  And his so-called principles get heaved overboard.

In a post earlier today (which has already gotten 28 comments over at SeekingAlpha), I quoted Mark Twain: “I never can think of Judas Iscariot without losing my temper. To my mind Judas Iscariot was nothing but a low, mean, premature, Congressman.”  Seldom were truer words ever spoken.  For at least Iscariot got 30 pieces of silver:  Stupak got a fig leaf.  And a phony one at that.  It is phony because an executive order cannot override a statute.  This is just something that Stupak can wave in front of the gullible; a way to have his cake and eat it too.  To pretend that he won a victory on abortion AND saved the health care bill.

In fact, he saved the health care bill, but at the cost of his purported principles, for as soon as night follows day, government funds will be spent on abortion under the bill that is about to pass.  But, no doubt, he will gull enough people in his district that the executive order is actually more than a worthless piece of paper, and bask in the limelight that he evidently craves so desperately.

It should also be noted that if it were genuine, Stupak’s “compromise” would in fact compromise a jealously guarded right of the branch of government he serves: it is the Congress that has the right to appropriate money, not the executive, and Congress would never willingly surrender that right to the president.  But since this is all theater, political cover, Stupak isn’t compromising that right at all.

Damn how I wish Mark Twain were alive today, for I think only his pen could do justice to the presumptuous, unprincipled, hollow men and women that go by the epithet “Member of Congress.”