Streetwise Professor

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.

The most recent derivatives/speculation kerfuffle involves something novel—futures contracts on movie box office receipts.  Two entities, Cantor Fitzgerald and Movie Derivatives, Inc.  have announced plans to introduce such contracts.  The film industry is in a tizzy at the prospect, and has enlisted the help of the usual anti-speculation suspects on Capitol Hill.

The virulence of the reaction is interesting, and deserves explanation.  Here’s my initial stab at the problem.

The most likely effect of the introduction of this contract is that it will facilitate “box office discovery.”  That is, information about the likely success (and quality) of a movie prior to its release will improve.  This will occur because those with private information about films, and those who can better utilize public information to predict a film’s performance, will be able to trade on this information.  The resulting price will aggregate this information, leading to more precise predictions about box office receipts.

Moreover, and crucially, potential filmgoers can utilize the information in the prediction to choose which movies to attend.  If the predictions are good signals of quality, they will have a certain self-fulfilling feature: bad (good) movies will have low (high) contract prices, which will result in low (high) attendance.*

At first blush, this sounds great, but it may not be good news for film producers, distributors, or theaters.  To fix ideas, consider this simple model.  Assume that when movies are released, there is no information that allows potential patrons to determine which movies are good, and which are bad.  Making their decision about which films to view from behind this veil of ignorance, consumers will randomize, and all movies will earn (roughly) the same revenue when first released.  Subsequently, word of mouth and other information will lead to revelation of the true quality of movies, and good (bad) movies will earn high (low) revenues in the weeks after release.

Thus, ignorance effectively reduces the variability of film revenues in the first days after release.

With better information, available immediately upon release due to the existence of a market, however, good (bad) movies will earn more (less) right off the bat.  Thus, one would expect that the variability of receipts will increase due to the new derivatives.  This will make risk averse firms and individuals who are long a piece of the revenues worse off.  (Diversification across films is one way of addressing this risk, but due to the nature of the business, diversification possibilities may be limited.  Nonetheless, it would be reasonable to expect an increase in diversification, perhaps through consolidation of producers, distributors, etc., and perhaps through expansion of equity-like sharing relationships.)

Of course, there is already some information about film quality that is available to consumers before release, so the above characterization is extreme.  Nonetheless, to the extent that the new derivatives improve information, the variability of receipts soon after release should increase.

This revenue risk increasing effect could explain the hostility of the industry to the innovation.  Against this, it could be argued that the contracts would permit hedging.  I am skeptical, however, that these contracts will become sufficiently liquid to make hedging practical.  Virtually the entire industry is long; there is nobody who is short receipts.   This natural hedging imbalance would require substantial speculative participation to offset.  Moreover, given that movies are heterogeneous and relatively numerous, no single benchmark can emerge that can serve as a liquid hedging and speculative market the way that CBT corn or NYMEX WTI can.  Put differently, basis risk is huge here, almost by definition.  The fragmentation of the market is antithetical to liquidity, and without liquidity hedging won’t thrive.  That is, the market is likely to remain a fringe, boutique market that generates valuable information that increases the riskiness of producing and distributing films, but does not work as a hedging mechanism.

There are other potential sources of opposition.  In particular, incumbent producers of information do not like competition from a new source.   The incumbent producers of information include studio marketing departments, advertising firms, and the trade media.

In brief, the angry response is quite understandable.  Film derivatives will likely gore many quite wealthy and well-connected oxen who are quite adept at self-promotion.  Indeed, it’s hard to see a natural constituency that would favor them.

It is also consider the effects of better information resulting from a market on the allocation of resources.  One effect will be to lead a better match between moviegoers and movies (i.e., fewer disappointments).  This is beneficial (and would tend to increase the demand to see movies, because there will be lower risk when choosing which movie to see, which would be something of a benefit to the industry.)  Moreover, it could influence the incentive to increase quality, through, for instance, greater selectiveness in choosing projects to produce, and greater effort to ensure quality during casting, filming, etc.   In my veil of ignorance story, movie quality is essentially in the public domain at release, reducing the value of quality internalized by producers (opening revenue is based on expected quality, not the quality of any particular film).  Finally, there is always the possibility that the ability to trade on information leads to rent seeking, as is true of any market; the social value of private information does not necessarily match well at all its private value.   (I won’t go into manipulation possibilities here.  Most of the horror stories told about this seem overblown.   Very Hollywood, in fact.)

My story has some empirical implications.  It implies that the variability of movie receipts (in the cross section) in the days after release should be higher with derivatives than without them.  It also implies that the variability in receipts in the time series should be lower, because the disparities in information about film quality will be smaller over time with derivatives.  These effects should be more pronounced, the more informative the derivatives prices (net of any effect that their introduction has on the amount of information produced from traditional sources, which should decline due to the new source of information.)

All in all, this will be a fascinating experiment on the informational effect of the introduction of a new market.  If, that is, the powers that be don’t strangle it in the cradle.

* One could argue that this self-fulfilling effect could lead to a perverse outcome.  Let’s say that all trading in the new derivatives is noise trading, and the prices are uninformative, but moviegoers think they are informative.  Then they will go to movies with high derivatives prices, and avoid ones with low prices.  Voila—the uninformative prices look informative ex post.  I doubt that this will in fact occur, however.  Post release, word of mouth and other sources of information will exist, which will permit an ex post evaluation of the accuracy of the derivative price predictions of movie quality.  If consumers learn that the prices are in fact poor measures of quality, they will not rely on them to choose what new releases to attend.

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.

Barney Frank stomped his little feet in anger at the fact that his former senior staffer Peter Roberson decamped to become a lobbyist for ICE.  Frank has barred Roberson from contacting staff for as long as he is head of the Committee.  House rules preclude Roberson from contacting staff for a year.  Wouldn’t it be sweet, I mean ironic, if the the year long bar, rather than the as-long-as-Frank-chairs-the-committee restriction turned out to be the binding constraint?

I had some dealings with Roberson late last summer.  He contacted me about my interest in, and availability for, testifying about OTC derivatives in front of the House Banking Committee.  I indicated that I would be interested and available, but about a week later Roberson told me that Frank did not want me to testify.  (Imagine that.)

Said personal rejection by Frank I wear as a badge of honor.

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.

Economics of Contempt makes a point that I’ve advanced for well over ten years now (including fairly recently in a guest piece at FTAlphaville.) Namely, that clearing depends on price transparency and liquidity to work; it does not create these things.  Clearinghouses consume price transparency and liquidity–they don’t create them.

Moreover, trying to clear things for which price information is lacking due to a lack of trading can create systemic risks, rather than reduce them.  CCPs can’t price risks adequately for illiquid products.  Moreover, they have a very difficult time of managing the risks of any defaulted positions in illiquid products.  This means that taking on exposure to these products puts the CCP at risk, which, in turn, creates the potential for a clearinghouse failure, an eventuality that EoC “would rather not see . . . in [his] lifetime.”  Having stared it in the face (in 1987), I concur wholeheartedly.

EoC echoes another frequent SWP argument, namely the chronic misinterpretation of the AIG debacle.  He notes that contrary to what is commonly stated, AIG’s positions WERE collateralized, and indeed, it was the collateralization mechanism that was the proximate cause of the firm’s demise.  Those who flog the clearing solution really, really, really need to spell out how having AIG pay variation margin to a CCP, instead of Goldman and Deutsche Bank and French banks, would have made any substantial difference whatsoever.  (See the post “It’s a Wonderful Life: AIG Edition” for my statement of this argument.)  Indeed, it could have made things worse.

It should also be emphasized that collateralization is often the positive feedback mechanism that creates systemic events; big collateral/margin calls in the aftermath of big market moves lead to liquidation of positions, which moves prices more, which weakens the financial position of those affected by the initial price moves more, etc. Geithner and Gensler and others suggest that more, and more rigid, collateralization (via a clearinghouse) unambiguously reduces systemic risk.  Not so.  It is more plausible to say that collateral can mitigate some moral hazards, and can be a way of pricing some risks, and can be a way of mitigating one-off, non-systematic defaults.  But it can also be the doomsday machine that accelerates the spread of financial distress.

Come si
Last week I wrote about how numerous Italian municipalities are regretting their decision to enter into interest rate swaps.  Today’s WSJ reports that many American cities, towns, and counties are experiencing similar regrets, and are talking about escaping their contractual obligations.

As reported in the WSJ, the facts seem pretty simple and straightforward.  On the basis of this reporting, the municipalities’ complaints are meritless.  Specifically, the WSJ states that the municipalities (a) borrowed at floating interest rates, and (b) swapped that floating rate into a fixed rate via a swap.  The terms of the swaps were such that the fixed rate in the swap were lower than the municipalities could have borrowed at fixed rates:

But municipalities also added swaps to the mix, promising to pay a fixed rate to banks, often 3% or more, while receiving payments from banks that vary with interest rates. On the swaps, the municipalities generally have been losers, as the interest that banks have to pay them have often fallen below 0.5%.

So, what the municipalities did is lock in an interest rate via a combination of floating rate borrowing and a swap.  They locked in a lower rate than they could have by borrowing at fixed rates.

Yes, if they hadn’t done that, their interest costs would have been lower due to the dramatic fall in rates–and if they’d borrowed at floating rates, rather than fixed ones.  But, by giving up the possibility of paying a lower floating rate, the municipalities protected themselves against the possibility of higher interest rates.

That’s what’s called hedging, people.  And you don’t evaluate hedges ex post, based on what did happen.  You evaluate hedges ex ante, by determining what transactions optimize your risk-return trade-off, based on what could happen.

You don’t evaluate hedges ex post because, lacking a crystal ball, you didn’t have that information available when you made the hedging decision.  If you can see the future you have no need to hedge.  If you can’t see the future, and want to avoid risk, you might want to hedge.  And if you do, roughly speaking, about half the time you will regret it ex post.  But woulda, coulda, shoulda is a bogus way to evaluate hedges.  You have to evaluate them based on the information you had when you made the decision, not based on what actually transpired in the unknowable future.

The municipalities seemed to have wanted to make one way bets: to protect themselves against rate increases, but profit from rate decreases.  You can do that, but you have to pay for the privilege–by buying options.  But even if they had done that, the municipalities would still have experienced ex post regret, and presumably would be whining about the wasted option premium spent buying caps that proved unnecessary after the fact.  (But, again, hedging decisions have to be made before the fact–they are decisions to reduce risk made in the presence of uncertainty about the future.)

So what the municipalities are claiming is that they should get FREE options that allow them to profit when rates are high but don’t impose any loss when rates are low.  Hey, I’d love to get free options too.  But good luck finding someone willing to give them to you. (Actually, Uncle Sugar does that with some regularity, through Too Big to Fail, or implicit guarantees of Fannie and Freddie.  There the taxpayers are the ones that end up paying for the options.)

The municipalities might have something to complain about if they could show that the swaps were priced off-market, or included various option features that were systematically mispriced in favor of their counterparty bank (as has been alleged in some Italian deals).  Even then, my sympathy would be limited because they could have and should have obtained independent valuation analysis to protect themselves against this sort of opportunism.  And I should note that the WSJ article doesn’t say a word about any mispricing or off-market pricing.

Absent evidence of deliberate mispricing (and perhaps not even then), the municipalities should get no legal relief from their contractual obligations.  There are attempts worldwide to escape transactions that were entered into voluntarily, but which were regretted afterwards because of the way the market moved.  In China, for example, energy consuming firms are exploiting government pressure to escape some of their obligations under various energy derivatives trades entered when prices were very high, and which went way underwater when prices plummeted.  Now the Italian and American municipalities.  (Notice how governments seem to think that contracts don’t apply to them when it’s inconvenient to perform?)  These efforts undermine the market, and have the perverse effect of making hedging more costly as counterparties have to price in the risk of not getting paid in full; indeed, they can make hedging impossible altogether as nobody is willing to enter a heads-I-lose, tails-the-municipality wins deal for no compensation.

It seems that the municipalities are attempting to exploit–and feed–the hostility towards derivatives to escape the consequences of their own decisions.  Let’s hope that if it comes to legal action, judges take a very skeptical view of such claims, and make municipalities play by the same rules as grown up commercial parties.

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.”