Streetwise Professor

The NYT hatchet job has elicited quite a bit of discussion on the web, and on Twitter.  Several major bloggers have saddled up and ridden to the defense of Scott Irwin and I.  Pride of place goes to Felix Salmon, who wrote a long and thoughtful post at Reuters. This is particularly gratifying, because Felix and I have had our differences in the past (e.g., over the empty creditor problem) but I have always found him to be extraordinarily fair and open minded.  Felix wrote his piece before I posted mine, meaning that his was based on publicly available information (including his past interactions with me) which confers a considerable degree of objectivity: most importantly, it shows that information that the NYT ignored or distorted was there in plain sight.  Felix is like a judge entering a summary judgment motion against the NYT, with prejudice, making it unnecessary for the defense even to present its case.  I think it’s correct to say Felix’s verdict is pretty brutal, but eminently fair.

Other members of the cavalry include Jeff Carter’s Points and Figures blog (who was the first to arrive on the scene), Peter Klein at Organizations and Markets, Sonic Charm (or is it Crimsonic?) at Rhymes With Cars and Girls (who always cracks me up, whatever he’s calling himself these days), and John Hinderaker at Powerline. Peter and John point out the double standard under which academics who work with private business are often accused of being corrupt, whereas the motives of those who accept money from the government are almost never questioned.   Peter focuses on the Fed, John on climate research.  The common conclusion of all is that the NYT piece was a deeply biased smear written in bad faith with ulterior motives.  Crimsonic calls for a retraction.  Interesting idea.

Felix’s post and mine also unleashed a torrent of tweets.

Thanks to all.  I’m sure this isn’t over yet.  So keep your horses watered and your powder dry.

Whenever I see a picture of Rusal CEO Oleg Deripaska, I know that Neanderthals still walk the earth.  This particular Neanderthal is in serious financial difficulties these days.  When Rusal IPOd about four years ago, it was priced at HK$10.20/share, and it’s been all downhill since.  The stock is now trading for about 75 percent less, at HK$2.32.  Rusal is levered up to the wazoo, and Deripaska has other pressing obligations, including construction projects at Sochi  made at Putin’s insistence which will almost certainly be huge white elephants.

The main reason for My Favorite Neanderthal’s financial distress is the depressed price of aluminum, which is down by about a third in the past three years.  For a smelter like Rusal, the only saving grace is the high premium of cash aluminum over the prices of metal in LME warehouses.  That premium is inflated by a bottleneck at LME warehouses like Goldman Sachs’s Metro in Detroit.  If that bottleneck is widened, the huge stocks accumulated during the financial crisis will make their way onto the market, crushing premiums and bringing down the price that Rusal (and Alcoa and Chinalco) get for their production.  This would probably be enough to put Rusal and Deripaska over the brink.

Stung by intense criticism, the LME has announced rule changes intended to loosen the bottleneck.  The mooted rule changes are a mortal threat to Deripaska, so he’s suing in London.  This is not surprising, because Deripaska has nothing to lose.

What is somewhat surprising is the specific claim that Rusal/Deripaska are making:

“Rusal has alleged that the consultation conducted by LME was unfair and procedurally flawed, that the LME’s changes to its warehousing policy are irrational and disproportionate, and that Rusal’s human rights have thereby been breached,” Hong Kong Exchange and Clearing, also known as HKEx, said in a news release. [Emphasis added.]

Human rights.  What a riot.  I know that many Russians have sued in European courts claiming that their human rights have been violated by the Russian government.  In 2012, there were over 22000(!) such claims filed in the European Court of Human Rights, which I believe is the largest total for any country.  The Court rejects virtually all these claims, but still enough proceed to make Russia consider invalidating the Court’s decisions.  (Ironically, this story appears today.  Merry Christmas!)

So I guess Rusal is playing turnabout is fair play.  Good luck with that, Oleg. Methinks the LME will prevail, cash aluminum premiums will fall $75/$80 per tonne or so, and Rusal will soon be staring bankruptcy in the face.  And maybe Neanderthals will become extinct after all.  Financially, anyways.

A few days ago the WSJ reported that US securities exchanges are close to upgrading one of the Securities Information Processors, the part of the RegNMS market structure that links the various exchanges.  The SIP consolidates and disseminates quote data from the various exchanges.  It provides the linkages that are necessary for the links-and-information structure created by RegNMS.

The SIPs have been a source of chronic complaints in the industry.  The current fix was compelled by a breakdown in the SIP over the summer that caused a shutdown in trading of some stocks.  But even when the SIPs work, they disseminate information more slowly than the private connections between exchanges and HFT firms.  This gives an advantage to HFT traders.

The WSJ story indicates that the operating system of the SIP is obsolete.

This issue illustrates an inherent problem with a utility-type model in securities markets. I discussed this problem in my research in the late-90s and early-00s, including in a JLEO article that was published in 2002.  That research was focused on a CLOB model, but the same issue is relevant for a the current SLOB (Simulacrum of a Limit Order Book) model. Specifically, a utility CLOB (or SLOB) has strong public good aspects.  All market participants benefit from better technology and improved performance, but would prefer that others pay for it.  Collective action and public goods problems tend to lead to under provision of quality and technological improvement.

SIPs are industry public goods, and face the same problems.  No wonder they are obsolescent.

There are other problems with the linkages approach that undermine incentives to  invest in SIP quality and technology.  The whole idea behind the linkages approach is to facilitate competition between exchanges.  But exchanges have no incentive to facilitate competition between themselves.  Competition is likely to be weaker with a kludgy linkage system, so why should exchanges push to improve it?  Not to mention that some interests, notably HFT, which would face a diminished competitive position with  more advanced SIP, also have an incentive to impede updates.

This is an inherent challenge to the linkages approach.  Its effectiveness depends on, well, the technology that links markets.  But the incentives to invest in those linkages are suboptimal due to the public good problems, exacerbated by the fact that competing exchanges don’t have an incentive to intensify competition between them.

But as I’ve often written, the alternatives have their own problems.  Most notably, if you don’t mandate linkages between markets, order flow network effects tend to cause the dominance of a single exchange.   So you need linkages and socialization of order flow if you want competition, but there will be underinvestment in the linkages.

US securities markets are committed to the linkages approach.  Public goods problems that provide inefficiently weak incentives to invest in the links necessary to make the approach work mean that it will be beset by chronic difficulties.

I mentioned this in the earlier post, but it deserves a post of its own. The more I think about it, the more astounded I am at the folly of using Russia’s national welfare fund to buy Ukrainian government debt.  The purpose of this fund is to provide a cushion in the Russian state budget in the event of a decline in economic activity and government revenues, most likely due to a decline in the price of oil.  For all of its dysfunctions in property rights, the rule of law, etc., Russia earned high marks for its relatively prudent fiscal policy, largely due to the guidance of Alexei Kudrin.  The reserve funds were a big part of that, building up when times were good and available to be tapped when things went sour.  In recent years, Putin’s need to buy support has undermined this prudent policy.  Now all prudence is out the window.

For as I noted earlier today, this “investment” is rife with wrong-way risk.  Due to the same tight connection between the Ukrainian economy and the Russian one that compelled Yanukovych to submit to Putin, there will be a strong positive correlation between the price of these bonds and the performance of the Russian economy.  If the Russian economy tanks (due to an oil price decline, for instance), Ukraine’s economy will tank right along with it.  More severely in fact.  And when its economy tanks, the price of its bonds will tank too.

This is exactly what you don’t want in a “rainy day” investment.  Preferably you’d like something negatively correlated, but at the very least, you’d like something only weakly correlated  But instead Putin has invested one-sixth of the national welfare fund in a highly correlated investment that will perform badly just when Russia would need the money.  This is financial insanity.  Kudrin must be stroking out.

But that means that this fits in perfectly with Putin’s obsession with Ukraine.  So he’s “won” the Ukraine (assuming, of course, that Clockwork Orange doesn’t strike again).  But what has he won?  An economic basket case, a cesspool of corruption, and a dysfunctional Sovok state.  He’s spent $15 billion (plus another $5 billion in gas price cuts), but he’ll spend a lot more.  Because this will not address Ukraine’s fundamental economic problems.  Yanukovych will be back for more, and more, and more.

And why is Putin committing such a blunder?  Because of his delusions of grandeur. His desire to reverse the collapse of the USSR, which he considers history’s greatest geopolitical tragedy.  His obsession with gathering again the Russian lands.  And the Russian obsession with Ukraine.  They truly believe it to be naturally subordinate to Russia.  Not a real country, as Putin said to Bush.  To Putin, and to most Russians, an independent Ukraine is a monstrosity.

Insane.  Utterly insane.

You’ll read about this being the latest in Putin’s run of political and diplomatic triumphs.  With a few more such triumphs, Russia will be undone. He has won the bidding war with the EU (not that it was much of a contest).  But he-and Russia-will suffer the winner’s curse.

Be careful what you ask for, Vlad.  Be very careful.

The inevitable has happened.  Yanukovych traveled to Moscow, and received Putin’s promise to purchase $15 billion in Ukrainian government debt using the Russian sovereign wealth fund, and a further promise to cut gas prices substantially (though temporarily).  These terms are very similar to what Edward Lucas tweeted a couple of weeks ago, so his sources are vindicated.

There was no quid pro quo announced.  Specifically, Putin claimed that Ukraine’s joining of USSR Lite-the Customs Union-was not discussed.

This was a tactical choice.  Announcement of a formal agreement to join, or a plan to join, would have stoked the protests in Maidan and elsewhere in Ukraine.  But everyone can see the writing on the wall, and so I don’t think that makes much difference.  Announcing Ukraine’s accession to the organization would have just been gilding the lily.

This is something out of the Godfather, with Putin in the role of Don Corleone, and Yanukovych in the role of Bonasera.  “Some day I will call on you to do a service for me.”

For all the attention the deal is getting, it really doesn’t change much.  It was almost inevitable that Yanukovych would throw in with Putin.  As I said on Twitter, Putin was offering Yanukovych a fix, and the Euros were offering him years of rehab.  Easy choice for a corruption addict like Yanukovych.  The opposition and protestors will see through the lack of a formal announcement about the Customs Union, and will take this as proof that Yanukovych has sold out Ukraine to Russia.  The die has been cast, and the standoff between the protestors and the government will continue.  If the protests do not fade away, Yanukovych will have to decide whether to repress it, or just try to wait it out.

And as before, the key figures will be the oligarchs and the military and security forces.  In one ominous note, Putin offered increased cooperation between the Russian and Ukrainian militaries.  I’m sure he did.  He wants to make sure they are reliable.

What’s in this for Russia, as opposed to feeding Putin’s imperial ambitions?  Well, Putin has tied Russia to a money pit.  The Russian economy is already moribund, and the sovereign wealth fund is not sufficient to withstand a substantial drop in oil prices (which is a real possibility).  Investing in Ukrainian junk bonds is hardly the action of a prudent fiduciary.  Moreover, this cannot be the end of it.  This is just the first fix for the junky.  He will need more, and more, and more.  The $15 billion will get him over the immediate fiscal crisis, but it will soon rear its ugly head again, because the fundamentals of the Ukrainian economy are still abysmal.  And the investment is a wrong-way risk from Putin’s perspective.  If the Russian economy takes a hit, due to a fall in the oil price or anything else, the Ukrainian economy will take a hit too, and the bonds Russia has bought will tank.  This is exactly the opposite of the kind of investment one should put in a “rainy day fund.”

Insofar as the gas price is concerned, Gazprom’s stock price fell only slightly on the news.  Since the deal was largely anticipated, that’s not much of an indication of whether the price cut, which is substantial in dollar terms (almost 50 percent) is expected to last long.

One final note.  Yanukovych comes off looking even more buffoonish than before, which I hardly thought possible.  He justified his decision by saying that given the dependence of the Ukrainian economy on Russia’s, he had no choice but to throw in with Putin.

What?  He just noticed this dependence?  It escaped his notice while he was negotiating with the Euros?

This statement is almost as buffoonish as his threat to investigate those who negotiated the Association Agreement with the EU because they had put Ukraine at risk.  Again: he had no idea what was being negotiated, and what its implications would be?

It’s very Obamaesque, in fact.  Apparently Yanukovych only learns about these things by reading the paper, or something.

In sum, what transpired in Moscow today just formalizes what everyone who was paying attention predicted.  It really changes nothing.  The divide between the protestors and the government remains, and how that plays out from here no one can predict with any certainty.

According to one of my industry contacts, this article in the Fiscal Times has “created a lot of unwanted buzz” in DC.  Because our betters find it so very inconvenient when reality intrudes on their fantasies.

The article focuses on the clearing mandate.  It points out that the main effect of the mandate is to shift risk around, and concentrate it in CCPs.  The risk doesn’t go away.  It moves.

Let me think.  Who was pointing this out five years ago?  Modesty prevents me from naming names.

Clearing was sold-most notably by my bêtes noire Geithner and Gensler*-as a magic box that made counterparty risk disappear.  This was a false claim, and arguably a dishonest one.  I find it hard to believe that Gensler, for instance, really believed what he said.  And the alternatives are ugly.  He (and other advocates of the clearing mandate) either made arguments he (they) knew to be untrue, or was (were) utterly ignorant of the implications of the policies that he (they) was (were) implementing and supporting.  Choices: (A) Idiot. (B) Liar. (C) There is no choice (C).

In reality, clearing mainly shifts around counterparty risk, and creates new risks, most notably liquidity risks.

All of these things were foreseeable, and foreseen-by some. Who were ignored, and at times reviled.

Why did this happen? It seems to me that in the heated days of the crisis, there was a desperation to find a solution.  For a variety of reasons, most notably the fact that the major cleared markets dealt with the Lehman situation without much problem, policymakers seized on clearing as the panacea.  And once they had done that, getting the clearing mandate passed became an end in itself.  The decision had been made, all doubts had to be suppressed.

But where does that leave us? With the growing recognition that the alleged panacea was nothing of the sort.  With the creeping recognition that the mandate has created a new set of risks.  A new set of potential sources of systemic instability.  So now policymakers are scrambling to address and to mitigate these problems.

It would have been so much better had these problems been anticipated, in advance, and the law drafted accordingly.

This is not Monday morning quarterbacking. I and others anticipated these problems at noon on Sunday.  But we were left on the sidelines, while the geniuses called and ran the plays. We are going to be dealing with the consequences of that for years to come.

*One blessedly departed from government “service”, and the other blessedly about to do so.

The latest extra-legal, ad hoc attempt to stave off the cataclysmic consequences of Obamacare, and the utterly inept implementation thereof, is quite something to behold.  Because the vaunted Healtcare.gov website does not incorporate a payment function (such an exotic concept, I know) and because insurers are receiving so much bad information, it is likely that a pathetically small fraction of the pathetically small number of individuals who have run the gauntlet to complete an application will actually pay their premiums in time to be covered by 1 January, 2014.  To avoid the catastrophe of large numbers of individuals finding themselves uncovered in the new year, the administration is “strongly encouraging” (euphemism alert!) insurers to play claims on policies that have not been paid for.  Moreover, since there is mounting concern over access to physicians, the administration is also “strongly encouraging” insurers to pay claims for physicians and hospitals that are not in the networks associated with the policies the insurers have issued. Furthermore, there is further “strong encouragement” that insurers pay to renew prescriptions that are not covered under existing policies.

With respect to the paying claims on unpaid-for policies, the administration is essentially enforcing insurers to extend credit in a business that does not normally extend credit.  In private insurance markets, policies doe not come into effect until premiums are paid.  Given that a good fraction of those on exchanges are likely not to be very creditworthy, this exposes insurers to the risk of substantial credit losses.  Since the policies were priced on the presumption that they did not embed credit, insurers are exposed to losses for which they will not be paid.

Are insurers to be compensated for the inevitable credit losses?  By whom? The Federal Government?  If so-has such compensation been duly authorized by Congress?  (Rhetorical question.)  If Congress hasn’t authorized it, where is the money going to come from?

If not-is this diktat not an unconstitutional taking of the property of insurers?  Does it not compel them to provide services without compensation?

Similarly, insurers designed policies, physician and hospital networks, and premiums to trade-off costs and benefits.  To economize on premiums, they limited network access.  Forcing them to provide costly access to a broader network, but not permitting changes in premiums, is yet another taking

In other words, Sebelius is trying to play Santa Claus, but in so doing, is running afoul of the Takings Clause.  The property of private insurers is being taken without compensation. They are being forced to provide valuable things (credit, access to a broad physician network, prescription coverage) for which they are not being paid.  All to shield the administration from the catastrophic consequences of the baked-in defects of Obamacare, and its comical incompetence in implementing it.

The lawlessness of this administration, especially when it comes to Obamacare, is quite beyond belief.

For the past weeks, Shanghai has been enveloped in a choking toxic smog.   This is a tremendous embarrassment to China, so two official news agencies responded by attempting to find the figurative silver lining in the literal cloud:

In online articles, state broadcaster CCTV and the widely read tabloid the Global Times, published by the Communist Party’s official People’s Daily, tried to put a positive spin on the smog problem.

The Global Times said smog could be useful in military situations, as it could hinder the use of guided missiles – giving the example of smoke used by Serbian forces against Nato airstrikes in the Kosovo war.

Meanwhile, broadcaster CCTV listed five “unforeseen rewards” for smog, including helping Chinese people’s sense of humour.

This came to mind when reading this NYT article which makes every excuse possible for the next predictable failure of Obamacare: the dropping of group coverage by small business, resulting in turning over millions of employees to the tender mercies of The Website From Hell, Medicaid, or, if they’re lucky, the government approved Junk Insurance Plans that would be unconscionable if an insurance company sold them to you (according to Obama, anyways).

All in all, I find the Chinese propaganda more amusing and plausible than the NYT’s.

The Fascism With A Smile campaign to fool suckers into signing up for Obamacare is in full swing.  The White House is engaged in a flood-the-zone campaign to get people to Get Covered.

What a concept! Imagine if they had, I dunno, a website where people could sign up, send their information to an insurance company, pay their premium.  That would be amazing!

But today this campaign surpassed the ability of even a Swift to satirize.   The White House posted this on Twitter.

Peace. Piece. I know.  I always have such a hard time knowing when to use which.

Perhaps this is a Freudian slip.  The administration knows that the success of Obamacare depends on a lobotomized population.  People who have lost a piece of their minds, if they had any to begin with. Or maybe it’s just that the creator of this propaganda has issues with Mom.  S/he wants to give her a piece of her/his mind.  But what about the “quality control”? The “editing” process?  Does everyone at the WH have Mom issues?

Isn’t it grand? Turning over control of 1/6th of the US economy to people who don’t know the difference between “piece” and “peace”, or who don’t care enough to make the distinction when producing propaganda intended to gull the great unwashed.

The next challenge for the administration: to grasp the subtle differences between “there”, “their”, and “they’re”.

We are so screwed.