Streetwise Professor

I think it’s fair to say that I was one of the early lockdown (AKA Karentine) skeptics. In one post (19 March) I asked rhetorically whether we were destroying society to save it. Evidence accumulates daily that the lockdowns were indeed wildly costly compared to the benefits, and in the case of the healthcare industry in the US in particular, it is only slightly rhetorically excessive to say that yes, we destroyed it to save it.

Recall that the primary justification for lockdowns was to prevent the healthcare system from being overwhelmed. With a few very localized (and highly publicized) exceptions, it never was, nor was it in any danger of being so. (And for those who claim this was the result of the lockdowns, there is mounting empirical evidence both within the US and internationally that variations in lockdown policy in terms of stringency and timing have trivial impacts on the trajectories of the epidemic.)

But to “save” the healthcare system, the non-coronavirus-targeted system was almost completely shut down. One major effect of this has been financial: hospital systems and individual physicians and nurses have been financially devastated. I can’t put my hands on the citation right now, but I read that something like 40 percent of the large decline in US GDP in March was due to reduced output in the healthcare sector.*

And there will be severe health consequences as well. “Elective” procedures are not unnecessary ones: avoiding or even delaying treatment of many conditions increases the risk of death, and the number of deaths. Such avoidance or delays can also lead to serious declines in quality of life.

These effects are part of the “unseen” that I mentioned in my earlier post. People will die because of the lockdowns, but there are no Lockdown Death Trackers. And those responsible for the lockdowns, or for cheerleading for them (which includes most major media outlets), have absolutely no incentive to create them. Because you can’t handle the truth, apparently.

It is sickly ironic (deliberate word choice) that many of the most strident defenders of lockdowns were, in normal times, almost equally strident in their insistence that the lack of adequate government provided or funded health care caused people to receive too little care, thereby leading to increased mortality and greater incidence of debilitating ailments. And no, don’t bother trying to reconcile these positions: it’s impossible.

I also note that the persistence of the lockdowns, especially in places like California, Michigan, Illinois, Wisconsin, and Minnesota gives the lie to the “flattening the curve to save the healthcare system” justification for them. In California in particular, but also in the other states (outside of perhaps Detroit, which has its own pathologies decades in the making), there has been a yawning gap between ICU capacity and utilization. Yet despite these what should be welcome data, and increasingly restive citizenries in these states, their governors refuse even to countenance relaxation. So it wasn’t really about the healthcare system, was it? Or if it was, it’s now about something else.

And what is that something else? Power.

Gavin Newsom’s tirade against those who dared to go to beaches is a particularly odious example. He basically treats the 40 million people of his state as would a control-freak father incensed at the audacity of his children in defying his authority. This is not a statewide lockdown. This is a statewide grounding–and if you break the rules again, sonnie, the grounding will be extended! Indefinitely! Not because it has any public benefit. But because you dared to challenge Governor Cartman’s–excuse me, Governor Newsom’s–authoritah.

And, of course, Google and Facebook in particular are willing–nay, eager–accessories to these mass deprivations of rights. They have become censors in chief, extirpating (sorry, “deplatforming” and “removing” are too weak) content that crosses the authoritahs’ official line.

The logic behind the lockdowns was always dubious, and they were NEVER based on reliable data. (And don’t get me started on the models.). But whatever logic there was, it is non-existent now. They have become self-perpetuating. Or rather, they are being perpetuated in order to perpetuate the powers seized by governors and local officials.

And if it destroys the healthcare system (not to mention the livelihoods of tens of millions of Americans)? Well, as a man who is apparently the role model for many governors once supposedly said, you can’t make an omelet without breaking some eggs.

*Here are the data. (See p. 9.) GDP fell $234b in the first quarter. Since GDP was rising rapidly–about 3.5 percent annualized–in Q4, and the lockdowns didn’t kick in until March, virtually all of this likely occurred in the last half of March. A pretty staggering decline in a few weeks.

Expenditures on health care fell $110b, almost exactly the 40 percent I mentioned in the original post. This contrasts to a $27b increase over Q4.

Matt Levine wrote a typically amusing piece highlighting the role of Trade at Settle (TAS) contracts in the 4/20/20 oil futures debacle:

But actually a lot of oil changed hands at those negative prices. Not because a bunch of investors came to the market all at once looking to sell, and no one would buy from them at negative prices, but for a more technical reason. Some oil traders use “trade-at-settlement” contracts: Instead of buying (or selling) oil futures at the market price at the time of your trade, you agree in advance to buy (or sell) them at whatever the official 2:30 p.m. settlement price is that day. 1  This is a good trade, for you, if your job is to obtain the day’s settlement price: For instance, if you run an index fund or exchange-traded fund that is benchmarked to that price, using TAS futures guarantees you the benchmark price. If you invest in oil futures and your boss fires you if you miss the benchmark, you might use TAS futures, that sort of thing. If you are a savvy oil trader attuned to minute-by-minute changes in supply and demand and trying to capture as much value as possible from your skills, you’ll probably just trade the futures at their current prices, selling if the price is too high and buying if it’s too low. But a lot of oil traders are doing something else, something a bit more passive, and for them the ability to guarantee the settlement price is useful.

He goes on to ponder whether the TAS mechanism could be manipulated, and whether manipulation could have contributed to the settlement fire that Red Adair couldn’t have put out:

The basic pattern—agree in advance to buy (sell) stuff at the official settlement price at some fixed future time, and then sell (buy) a bunch of that stuff in the minutes leading up to the official settlement time with the effect of pushing down (up) the price at which you are buying (selling)—is incredibly common, and the gradation from “sensibly pre-hedging the exposure you will get at settlement” to “sloppily pre-hedging the exposure you will get at settlement” to “manipulating the market to push down the price you will get at settlement” is blurry. If you type in a chat room “lol I’m gonna pound out 500 contracts to push down the settlement price and make fortune on my TAS trades, I am really ripping those muppets’ faces off, hope I don’t go to prison bro, hashtag fraud hashtag crime hashtag manipulation,” you will get in trouble. But if you don’t type that, and you quietly sell the 500 contracts and the price goes down, then as far as anyone knows that was just pre-hedging.

So could somebody have popped CLK20 with a TASer last Monday?

Funny you should ask. I wrote a paper on TAS manipulation a while ago. My interest was sparked by the CFTC’s action against Dutch trading firm Optiver, which the agency accused of doing exactly the kind of thing Levine writes about in crude, gasoline, and heating oil futures back in March, 2008. You can read the complaint–and listen to some actual “ripping those muppets’ faces off” trader braggadocio.

How does manipulation work here? First, to make manipulation profitable, there has to be an asymmetric price response to purchases and sales. If the manipulator’s purchases impact prices the same as sales, just buying and selling a lot can’t move prices in a profitable direction. Indeed, the manipulator would have to pay transactions costs (crossing the spread, brokerage, etc.) and this would cause the trading to be unprofitable.

The model in the paper derives conditions under which purchases and sales of TAS have a smaller impact on prices than do trades in the underlying futures. The basic idea is that if information is short-lived, or if there is intense competition among informed traders, new information will be incorporated into prices very quickly. Under those circumstances, informed traders will not want to trade TAS: their information will already be incorporated into the price by the time settlement occurs. Thus, TAS is a mechanism that allows traders to signal that they are uninformed: many “muppets” choose to trade TAS, and the informed don’t. Thus, the price impact of TAS trades is smaller than the price impact of regular outright trades: trades move prices because of the possibility that they are motivated by private information, so trades that are unlikely to be privately informed move prices less than trades that are more likely to be so.

This creates the asymmetry that makes manipulation possible: the manipulator buys, say, the TAS and then sells in quantity immediately before and during the settlement period and profits as Levine describes.

This type of manipulation is particularly pernicious because manipulative trades have persistent price impacts because they cannot be distinguished from informed trades (or liquidity trades, for that matter). Note that in Optiver, prices did not reverse after the firm’s trades,

This strategy is likely to be particularly profitable when markets are relatively illiquid, as in an illiquid market outright trades have bigger price impacts. Liquidity (measured by the bid-ask spread, quantity at the top of the book, price impact coefficients, etc.) has plummeted for everything since the CovidCrisis began, and the decline in CL liquidity has been particularly pronounced. Moreover, contracts close to expiration are less liquid anyways. Add to this the extreme physical constraints (which mean that small shocks to fundamentals have big price impacts) and the raging uncertainty about the logistical situation at Cushing, and it is likely that small volumes at the settle could have big impacts on prices.

To this I would add that an unexpected shortfall in buy orders (due to shorts exercising market power) at the settle could have price impacts, and exacerbate the price impacts of sell orders by exacerbating order imbalances.

Thus, the potential for a big asymmetry in price impact was pronounced on that fatal Monday.

In sum, it is not implausible that the market did indeed get TASed. Or at the very least, a TASer jolt contributed to the collapse. (Sort of like in this video!)

A final remark on the economic benefits and costs of TAS trading. TAS is a form of “cream skimming”–i.e., the skimming off of uninformed order flow. This tends to make the order flow in the regular continuous market more toxic, which reduces liquidity in that market. For this reason, other cream skimming mechanisms used primarily in equity markets (payment for order flow, dark pools, block trades) are frequently criticized. (This is why some regulators, particular in Europe, have attempted to curb such activity and force more trading into “lit” venues.)

I showed in my Market Macrostructure paper that things aren’t so simple. If the regular market isn’t perfectly competitive, the increased competition from a cream skimming mechanism can improve welfare. Moreover, there are distributive effects here: the uninformed traders who can utilize the TAS mechanism (e.g., those who are hedging exposures tied to the settlement price) benefit, while uninformed traders who can’t lose. Informed traders can lose too. Moreover–and this is a point that is almost always overlooked–some informed trading is essentially rent seeking (e.g., trading on information that will be released shortly anyways, and accelerating its incorporation into prices has little effects on resource allocation decisions). Reducing rent seeking informed trading is a good thing.

All in all, the role of the TASer is yet another piece of the 4/20/20 WTI WTF puzzle. The forensic analysis of this entire episode will be fascinating.

Today was one of the most epochal days in the history of oil trading, which is saying something. The front month May contract–which expires tomorrow (21 April, 2020)–(a) settled at a negative price of -$37.63, (b) declined $55.90 from the previous day’s settlement, and (c) exhibited a trading range of $58.17, which is about 3.5x Friday’s settlement price.

Even these eye-popping numbers don’t tell the full story. The last traded price was -$13.10. Note that the settlement price is based on the volume weighted average price during the last two minutes of trading, so an average price of $-37.63 in the last two minutes and a last traded price of -$13.10 means prices moved more that $25/bbl in these minutes.

And we’re not done yet! As I write at 1841 CDT, the price is up to -$5.00–an increase of $32.63.

That there’s what they call volatility, folks.

To put these numbers in perspective, the largest trading range on the any day of the last three trading days of CL contracts from 2000-2019 is $26.65, a day around the time of the financial crisis and the aftermath of Hurricane Ike (October 2008 contract): here’s what I wrote about that event. The median intra-day range on the last three days is $1.6, the mean is $1.5, and the standard deviation is $1.47. So we are around a 40 standard deviation event here.

The largest daily price change during the last 3 trading days is $16.37, with a median of $.73 and a standard deviation of $1.45.

The calendar spread is also extreme, settling at $58.06 between the June and the May. Meaning that if you had storage, you could get paid to take delivery, sell it forward, and lock in that $58.06 (net of what the storage costs you). I guess you could call that the megacontango.

All in all, a historically unprecedented day.

The proximate cause of these wild gyrations, and unprecedented negative prices is, of course, the collapse of demand and the looming exhaustion of storage space, including at the delivery point of Cushing, OK. But although this is a necessary condition for today’s events, it is not a full explanation.

The storage issue has been known for weeks, and discussed intensely. It had been priced in to a considerable degree: contango was already at a historically high level. What information about the availability of storage arrived between Friday and today? Unlikely to be anything that could cause such chaotic price movements.

The likely cause is the difficulty of liquidating about 100,000 open contracts (100 million barrels!) in such extreme technical conditions. It is plausible, and indeed likely, that strategic behavior–perhaps rising to the level of manipulation–is the major cause of how prices moved today against the background of conditions that were widely known on Friday.

Let me start out by noting that something similar, though not as extreme, occurred during the demand collapse and associated flooding of storage during the Financial Crisis. As I documented here, the expiries of the January, February, and March 2009 WTI contracts saw what were then historically unprecedented price collapses. So did other US grades of oil. Here’s a picture from the linked document:

The big downward spikes in the front month-back month spreads correspond with the days around expiry.

How does strategic behavior/market power/manipulation play into this? The model of short manipulation in my 1996 book (only $169 paperback–buy two!) and 1993 J. of Business article formalizes the argument, but the intuition is fairly straightforward. Manipulation exploits frictions and bottlenecks. (My article/book refer to “frictional manipulations.”). There is now a huge friction/bottleneck in Cushing–constrained storage. This bottleneck makes the demand curve for crude at Cushing extremely inelastic, and means that the movement of even small excess quantities of oil into that location will cause prices to decline dramatically.

In these conditions, a trader, or a group of traders with modest-sized short positions can exercise market power by delivering even a small amount of oil over and above the quantity that should flow to Cushing. This drives down the price and allows the trader or traders to cover his (their) position(s) at artificially low prices.

In this situation, the storage bottleneck is the gasoline, the exercise of the market power is the match. With 100,000,000 barrels of open long positions needing to liquidate, given the storage constraint, the resulting conflagration can be epic.

This is, at this stage, a hypothesis. It is a possible explanation of the beyond extreme movements observed today. Under the circumstances, it is a very plausible explanation, and one that deserves scrutiny. And given the amount of money that changed hands today (~$6 billion on a mark-to-market basis) I’m sure that it will get it.

The only parallel I can think of is the onion market in 1955, when the movement of a couple of superfluous carloads of onions into Chicago, and delivery thereof against futures, caused the price to crash below the cost of the bags that they had to be delivered in. There was no demand for the onions (being perishable, and people eat only so many hot dogs), so many of the excess plants ended up getting dumped into the Chicago River. (Which, in 1955, probably improved the water quality.) (Another irony being that Chicago means “stinky onions” in the Miami-Illinois Indian language.)

In 1955, demand was inelastic because onions are perishable (i.e., they can’t be stored). In a way, the lack of storage space makes oil perishable. Even if that analogy isn’t perfect, the economics are the same: an economic constraint (the non-storability of, or the lack of storage space) leads to extremely inelastic demand that makes short market power manipulation possible.

Tomorrow is the last trading day for CLK20. Strap it up! It’s going to be a wild ride.

A little more than a month ago, when the China virus was first wreaking havoc in the oil market, Vladimir Putin and Igor Sechin demurred when the Saudis requested an extension of OPEC+ oil cuts. Furious, the Saudis retaliated by promising to ramp up oil production by more than 1mbpd, and prices truly cratered.

No problem!, said Vladimir and Igor. This is part of our master plan to destroy US shale! (Never mind such “logic” is right out of Economics for Mouth Breathers.) Furthermore, Russia has ample financial reserves, and its government can ride out a long stretch of low prices. (The Russian people? Ha! Demonstrating the state-centric nature of Russian policymakers.) The ruble crashed. No worries! In fact this is GREAT for Russian oil producers, because their costs are in rubles and the weakening of the currency cushions the impact of a lower dollar oil price on revenues. (The Russian populace? Again Vova and Igor DGAS.)

But despite the bold talk (which in some ways reminded me of the old story about G. Gordon Liddy holding his palm over an open flame to prove how he could take pain without cracking), the magnitude of the collapse, and the possibility that it would endure, obviously caused considerable consternation in the Kremlin.

The first indication was when the Russians claimed that the Saudis had taken their action to harm US oil producers, a complete flip for Russia’s bragging that that’s why they were taking the hard line.

In the past few weeks, Trump cajoled the parties to the bargaining table, and yesterday–after overcoming a Mexican holdout–the parties agreed to a deal. And what a deal it is, involving Russia agreeing to cut production by 2.5mbpd–almost 23 percent–an amount 4 times what they refused to accept a little more than a month ago. (I also note that it flies in the face of repeated Russian statements over years saying that it was operationally impossible for them to cut more than trivial amounts.)

The Russians had insisted on formal commitments from the US to cut. Trump–who brokered this deal–said that US production would fall due to price declines. (True dat–I’ll try to provide some estimates tomorrow.). The Russians said that wasn’t good enough (apparently demonstrating an ignorance of the limited ability of the US government to force output reductions)–they wanted mandated cuts. But in the end, the deal was done, absent any formal US commitments.

In other words, Putin and Sechin cried uncle. Hell, they tapped out like an MMA fighter in a chokehold. This makes a mockery of their bold front of a month ago. I think it reveals that they were truly shocked by the Saudi reaction, and were desperate to find a way out, but they didn’t want to show it. They needed some sort of fig leaf, and Trump gave them one.

Now this is being spun as some sort of Putin master plan to curry favor with Trump to gain negotiating leverage on other issues.

All together now: Suuuurrrre it is, Vova. Suuurrrre. Trump don’t owe you–you owe him.

I oppose the deal, despite the fillip it will provide to the US oil industry. Artificially boosting oil prices will harm already devastated consumer economies (including the US). Further, this will potentially rejuvenate OPEC post-crisis. Again that would be good for the US oil industry, but not for the US.

I also wonder whether Putin (and the Saudis) will come back later with proposals to get the US government to take measures to reduce output in a coordinated fashion. Just how that would be done is rather mysterious. The only plausible measure that I could think of would be some sort of tax (either on production, or on exports). But this would require Congressional action–it’s not something Trump or any president could negotiate unilaterally–and I don’t see that happening.

But that’s for the future. In the present, Putin and Sechin reaped what they sowed. They thought they could force the Saudis into bearing the brunt of supporting oil prices, while they could continue to produce at capacity. The Saudis responded like it was 1986, and the resultant collapse in prices brought the brilliant schemes of the KGB masterminds crashing down. In the end, they had to capitulate. No matter how hard they try to spin it, it’s obvious that they did.

You are seeing a lot of covid-19 numbers thrown around. Virtually all of those numbers are bullshit.

The death rates are bullshit. In a given country, there is considerable subjectivity regarding how deaths are qualified. The Great Scarfini* (Dr. Deborah Birx) pretty much let that cat out of the bag when she acknowledged that not only are the decedents who test positive (regardless of other co-morbidities) declared as covid-19 deaths, but those who have some colorable connection to covid-19 (clinical presentation, exposure to someone who tested positive) are declared to be covid-19 deaths.

It is likely that hospitals and physicians–and politicians–have an incentive to attribute deaths to covid-19. These incentives can be financial (a hospital could get greater compensation from covid victim than someone dying of something else) or power (death numbers are being used to justify draconian restrictions).

Further, different countries use different methods to count deaths.

What we are really interested in is people who would not have died but for covid-19. The official death statistics do NOT do this. And the fact that virtually all of the dead are aged and/or have multiple serious health problems, a but for attribution is dubious even in the presence of a positive test.

The only rigorous way to estimate these but for deaths is excess deaths (i.e., deaths in excess of expected deaths, conditioning on time of year, demographics, etc.). And preferably excess deaths from respiratory illness (or at least excess deaths from non-accidental causes). This is a good template for the analysis. This also presents some good cross-country data, which shows that in Italy and Spain there is evidence of excess deaths. Elsewhere? Not so much. Of particular interest is Sweden, which has implemented mainly voluntary social distancing measures, to the hysterical response of those deeply invested in mandatory lockdowns.

Do this for a variety of jurisdictions (countries, states in the US) and you would have enough cross-sectional and time series variation to do some real analysis that could provide reasonable support for policy decisions..

The case numbers are bullshit, at least if you want to measure infection rates. As I’ve been saying for weeks, there are so many selection biases that the numbers tell you NOTHING about the prevalence of the virus in the population, either at a point in time or crucially over time. Indeed, the CDC guidelines could be titled “How to Produce a Wildly Biased Sample”:

This testing protocol could be justified on clinical and diagnostic grounds, but it is a disaster from the perspective of generating data that is useful in shaping policy.

Further, trends in positive test numbers is driven to a considerable degree by . . . a greater number of tests.

The graphs that you see depicting trends deaths or cases across countries over time are bullshit. They are bullshit because the inherit all the flaws of the data discussed above (exacerbated by the fundamentally different data reporting methods across countries), and they almost fail to adjust for population size or demographic characteristics.

Chinese numbers are obviously bullshit. No need to elaborate this point.

The models that are being used to drive (or at least justify) lockdowns are bullshit. Their predictions went from apocalyptic to well, a small fraction of apocalyptic. Sometimes between one day and the next. Models should be evaluated on predictive accuracy. The predictions of these models have proved to be excessively pessimistic, i.e., bullshit.

And don’t buy the line that the lockdowns reduced the death tolls. For one thing, many of the models’ predictions included the effects of social distancing–and still came out way too high. For another, many countries’ death and case rates (above caveats apply) peaked before the lockdowns could have had any effect.

I keep hearing the IHME model referred to as the “top model.” Who says? On what basis? Basically because somebody else said it. And oh, Bill Gates is somehow involved. So that claim is bullshit too.

Also be very suspicious that the modelers are very opaque. We don’t see their assumptions or their methods. Notoriously, the most influential modeling team (at least initially) that did more than any to spark the panic, has not released its modeling code.

At least the honest modelers admit that social isolation and shutting down the economy doesn’t change the integral under the curve (i.e., the total number of deaths) but merely the time pattern of those deaths. And some epidemiologists claim that extending the period of time before the burnout may result in a higher number of total deaths.

But even putting that possibility for a higher total toll aside, the argument is made that it is necessary to “flatten the curve” in order to reduce the burden on the healthcare system. Well, one thing the models vastly overpredicted hospitalization/ICU visits as well. And I have yet to see any evidence of systematic shortages of ICU beds/ventilators. Yes, there are hotspots. But that just means that we need to understand the hotspots–and the non-hotspots–better.

Along those lines, I can’t say the numbers on ICU utilization are bullshit–because the numbers are largely non-existent. Instead we’ve had anecdotal journalistic (i.e., “if it bleeds it leads”) accounts that provide no objective quantitative standard by which to evaluate how binding the constraints are in the healthcare system.

But again the issue is cost-benefit. Basically what lockdowns do is discount future deaths/cases relative to present deaths/cases (since they accept an approximately equal number of future deaths for each death that does not occur today). And the discount rate is huge. We are losing trillions of dollars in lost output/income to push some deaths into the future. The interest rate is astronomical. Put differently, we are paying an immense price to kick the can down the road.

I understand the the supply of ICU beds, ventilators, physicians and nurses is pretty inelastic over the short run. But even given pretty substantial inelasticity, it would be far more efficient to throw billions at expanding capacity in the short run than to sacrifice ~25 percent of world income to reallocate the deaths over time. Capacity is not a fate. It is a choice.

And the fact that well into the crisis the foretold capacity disaster in hospitals has not been realized, the additional capacity required may well be quite small.

There is also the issue of how much the temporal pattern of deaths will really change. This depends on a variety of factors, including when the virus first spread and its virulence. The more we learn, the more likely it is that the virus has been spreading since late-fall/early-winter 2020. Which means that the lockdowns are reactive, not proactive, and that they have little impact even on the time pattern of deaths let alone the number: they are the proverbial locking the barn door after the horse done bolted.

In brief: our betters are destroying futures based on bullshit data. It’s as simple as that. And they are vastly increasing their power as a result, so they are destroying freedoms too.

In an earlier post I said that we have to grasp the nettle and decide what price are we willing to pay to save a life (usually of an aged, ill person). But it’s actually worse than that. It is very likely that the real question is: how much are we willing to pay to defer a death (of such a person) a few months? The cost that those who govern (or rule) us (and those who support them) are apparently willing to pay is astronomical.

*Dr. Birx is always adorned with a scarf. On my first trip to NYC in 1978, when NYC was near its nadir, I saw an obviously psychotic individual dancing on near Grand Central Station waving around a long scarf. Every once and a while he would shout “I AM THE GREAT SCARFINI” and then start dancing again.

There is an ongoing outbreak of Covid-19 on the Nimitz class carrier, USS Roosevelt. The outbreak is severe, and today the CO, Capt. Brett Crozier, wrote an impassioned letter requesting onshore quarantine of the entire crew.

The first criticism that Captain Crozier raises is “Inappropriate focus on testing.” Crozier objects that tests provide little information: given the close proximity of those on board, they have presumptively been exposed, and should be isolated. Further, Crozier quantifies a relatively high rate of false negatives.

The captain is certainly correct regarding what is his primary responsibility–his ship and crew. But testing on the Roosevelt could provide invaluable information that could lead to far better policies in the United States, and the world at large. From a larger perspective, the opportunity for testing on the Roosevelt is something that cannot be allowed to slip away.

As I have noted repeatedly here, and on Twitter, policy is currently based on incredibly flawed data. In fact, the most useful piece of data is from a cruise ship Diamond Princess. The Roosevelt could provide a far bigger sample, and one that contains valuable information about the impact on non-elderly, relatively healthy individuals.

Even one of the things that Captain Crozier objects to–the presence of false negatives–is important. Quantifying that rate can provide information that greatly improves the inferences that can be drawn from other samples (apropos my earlier Bayes Rule post).

I understand that there are myriad competing considerations here. The health of the crew. The operational readiness of one of the most important combatants in the US Navy. Operational safety–e.g., who is going to operate the reactors and ensure that other systems are maintained properly even if the ship is not deployed? (You don’t leave a CVN parked in the driveway for a few weeks.)

Among those competing considerations, from Captain Crozier’s perspective, testing is indeed a near irrelevance. But it is extremely relevant for informing how we deal with the crisis around the world. The social value of this data is great indeed. I hope that those in the Pentagon, and in the administration, find a way to address Captain Crozier’s concerns while at the same time seizing on this opportunity to generate data that could save thousands of lives and trillions of dollars.

Coda: Another benefit here is that by the nature of the military, there would be excellent data at hand on virtually any interesting covariate you can think of–age, health conditions, socioeconomic background, etc. Combining BUPERS data with testing and clinical data from CVN-71 could provide a plethora of actionable insights.

In the aftermath of the last crisis, I played the role of Clearing Cassandra, warning that in the next crisis, supersizing of derivatives clearing would create systemic risks not because clearinghouses would fail, but because of the consequences of what they would do to survive: hike initial margins and collect huge variation margin payments that would suck liquidity out of the system at the same time liquidity supply contracted. This, in turn, would lead to asset fire sales, that would distort asset prices which would lead to further knock-on effects.

I wrote a lot about this 2008-2012, but here is a convenient link. Key quote from the abstract:

The author also believes that the larger collateral mandates and frequent marking‐to‐market will make the financial system more vulnerable since margin requirements tend to be “pro‐cyclical.” And more rigid collateralization mechanisms can restrict the supply of funding liquidity, and lead to spikes in funding liquidity demand that can reduce the liquidity of traded instruments and generate destabilizing feedback loops. 

Well, the next crisis is here, and these (conditional) predictions are being borne out. In spades.

Here’s what I wrote a few days ago as a contribution to the Regulatory Fundamentals Group newsletter:

In the aftermath of the last crisis of 2008-2009, G20 nations decided to mandate clearing of standardized OTC derivatives transactions.  The current coronavirus crisis is the first since those reforms were implemented (via Dodd-Frank in the US, for example), and this therefore gives the first opportunity to evaluate the performance of the supersized clearing ecosystem in “wartime” conditions.  

So far, despite the extreme price movements across the entire derivatives universe–equities, fixed income, currencies, and commodities (especially oil)–there have been no indications that clearinghouses have faced either financial or operational disruption.  No clearing members have defaulted, and as of now, there have been no serious concerns than any are on the verge of default. 

That said, there are two major reasons for concern.

First, the unprecedented volatility and uncertainty show no signs of dissipating, and as long as it continues, major financial institutions–including clearing firms–are at risk.  The present crisis did not originate in the banking/shadow banking sector (as the previous one did), but it is now demonstrably affecting it.  There are strong indicators of stress in the financial system, such as the blowouts in FRA-OIS spreads and dollar swap rates (both harbingers of the last crisis).  Central banks have intervened aggressively, but these worrying signs have eased only slightly.  

Second, as I wrote repeatedly during the debate over clearing mandates in the post-2008 crisis period, the most insidious systemic risk that supersized clearing creates is not the potential for the failure of a clearinghouse (triggered by the failure of one or more clearing members).  Instead, the biggest clearing-related systemic risk is that the very measures that clearinghouses take to ensure their integrity–specifically, frequent variation margining/marking-to-market–lead to large increases in the demand for liquidity precisely during circumstances when liquidity is evaporating.  Margin payments during the past several weeks have hit unprecedented–and indeed, previously unimaginable–levels.  The need to fund these payments has inevitably increased the demand for liquidity, and contributed to the extraordinary demand for liquidity and the concomitant indicators stressed liquidity conditions (e.g., the spreads and extraordinary central bank actions mentioned earlier).  It is impossible to quantify this impact at present, but it is plausibly large.  

In sum, the post-2008 Crisis clearing system is operating as designed during the 2020 Crisis, but it is unclear whether that is a feature, or a bug.  

It is becoming more clear: Bug, and the bugs are breeding. There have been multiple stories over the last couple of days of margin calls on hedging positions causing fire sales, with attendant price dislocations in markets like for mortgages. Like here, here, and here. I guarantee there are more than have been reported, and there will be still more. Indeed, I bet if you look at any pricing anomaly, it has been created by, or exacerbated by, margin calls. (Look at the muni market, for instance.)

But those in charge still don’t get it. CFTC chairman Heath Tarbert delivers happy talk in the WSJ, claiming that everything is hunky dory because all them margins bein’ paid! and as a result, derivatives markets are functioning, CCPs aren’t failing, etc.

This is exactly the kind of non-systemic thinking about systemic risk that I railed about a decade ago. Mr. Tarbert has a siloed view: he is assigned some authority over a subset of the financial system, sees that it is working fine, and concludes that rules regarding that subset are beneficial for the system as a whole.

Wrong. Wrong. Wrong. Wrong. WRONG.

You have to look at the system as a whole, and how the pieces of the system interact.

In the post-last-crisis period I wrote about the “Levee Effect”, namely, that measures designed to protect one part of the financial system would flood others, with ambiguous (at best) systemic consequences. The cascading margins and the effects of those margin calls are exactly what I warned about (to the accompaniment a collective shrug by those who mattered, which is why we are where we are).

What we are seeing is unintended consequences–unintended, but not unforeseeable.

Speaking of unintended consequences, perhaps one good effect of September’s repo market seizure was that it awoke the Fed to its actual job–providing liquidity in times of stress. The facilities put in place in the aftermath of the September SNAFU are being expanded–by orders of magnitude–to deal with the current spike in liquidity demand (including the part of the spike due to margin issues). Thank God the Fed didn’t have to think this up on the fly.

It also appears that either (a) the restrictions on the Fed imposed by Frankendodd are not operative now, or (b) the Fed is saying IDGAF so sue me and blowing through them. Either way, such liquidity seizure are what the Fed was created to address.