Streetwise Professor

There’s an old military adage: no plan survives first contact with the enemy.*  Obamacare has met its enemy, and that enemy is reality.

The reality that the government is horrid at IT.  (Amazingly, Obama blamed government red tape-namely, contracting requirements-for the failure of his red tape machine to work.  Seriously.  I could not make up that sh*t.)  The reality that the need to stock the insurance pool with healthy individuals who would be charged prices well above cost would lead to the cancellation of the private policies that many healthy individuals have (despite an Obama promise that if you like your plan you can keep it).  The reality that any scheme built on cross-subsidies is inherently coercive.  The reality that any system that imposes what are effectively price controls on suppliers will result in reductions in quality (i.e., increasingly limited choices of physician, despite an Obama promise that if you like your doctor you can keep him/her.)

And more brutal counteroffensives from reality are to come. There are reports that the administration will attempt to mitigate the sticker shock that many are experiencing (or will inevitably experience) on the exchanges by increasing eligibility for subsidies.  This means that the reality will be that Obamacare will inflate the deficit (despite an Obama promise, duly endorsed by the CBO-arguably under a combination of duress and deceit-that ACA would reduce the deficit.)  And then there will be the reality that Obamacare will not reduce health care costs: how can a plan that extends coverage (both in terms of the comprehensiveness of the policies and the number of people covered) reduce costs?  More reality will bite later.  For instance, the effects on labor supply, due to the effect of Obamacare on effective marginal tax rates. Or effects on the structure of employment, as some companies substitute to part time employment for full time in order to avoid employer mandates.

All of this was predictable.  All of it.  And ironically, those who predicted it are being demonized as wreckers and saboteurs.  If only.  Wrecking this nightmare would prevent the wreckage of a substantial chunk of the US economy-and millions of lives.

* In the US this expression is often attributed to Eisenhower, but it probably traces its origin to a remark by von Moltke the Elder.

For years-probably going on 7-I have argued that Russia was in for a long period of economic stagnation.  I referred to Putin’s Hamster Wheel From Hell, on which Russia would just continue spinning.

This prediction was based on my belief that Russia’s “natural state” politico-economic system was inimical to sustained growth.  Yes, the country could experience Cocaine Blues spurts of growth (“took another shot of cocaine and away I run”)-with the Russian economic cocaine being black and gooey instead of white and powdery-but the fundamental institutional deficits would continue to hold it back.  Indeed, the rent seeking and redistributionist policies that resource wealth sustain were-and are-a detriment to the country’s long term prospects.

I stopped writing about Russian stagnation so much, well, because I didn’t want the blog to stagnate along with them 😉  What new was there to say?

Today the Russian Economics Ministry released a forecast that echoes what I’ve been on about all these years:

Russia acknowledged for the first time on Thursday that its economy would lag global growth over the next two decades, setting the stage for an era of stagnation that could threaten President Vladimir Putin’s grip on power.

Economy Minister Alexei Ulyukayev forecast that Russia’s economy would grow at an average rate of 2.5 percent during that period – down from an earlier 4 percent and half the rate Putin targeted before his return to the Kremlin last year.

The downward revision casts Russia as the poor relation in the BRICS group of large emerging markets that includes Brazil, China, India and South Africa. The ministry expects the BRICS to grow at a 5.2 percent clip during that time.

With the ministry expecting global economic growth to average 3.4-3.5 percent, the outlook threatens to make a mockery of Putin’s oft-repeated pledge to lift Russia into the world’s top-five economies by the end of this decade.

And it is still based on an oil price forecast many analysts view as over-optimistic, showing just how much Putin’s Russia, the world’s largest oil producer, relies on not only high, but rising, oil prices to prosper.

Over-optimistic.  Too funny.

Note this isn’t a forecast about a year to two.  This is a forecast that extends to beyond Putin’s departure (likely, anyways, but not absolutely certain-which is symptomatic of the problems).  It is a damning verdict on Russia’s fundamental structural and institutional flaws.  From their own mouths.

One bank analyst sarcastically remarks: “Stagnation is starting to look like a policy goal in Russia.”  Actually, there is much truth in this remark, as I also noted in my writing on this subject going back to ’06-’07.  Autocratic systems like Russia’s that exist to redistribute rents in order to maintain political control and stability hate economic dynamism.  It creates new sources of wealth that can be used to challenge existing power structures.  It creates new groups of individuals, of middling means, who aspire for greater liberties and a political voice.

Meaning that given the choice between stagnation and control on the one hand, and dynamism and a lack of control on the other, Putin and the siloviki will choose stagnation in a heart beat.  Stagnation is a policy goal.  Stagnation means that those are on top stay on top, profiting wildly from their parasitism.  And that, ultimately, is the point.

Until it all falls apart.  Which it will.   The system is strong, in its way (note the utter demoralization of the opposition), but it is brittle.  Dynamic societies can adapt to big shocks.  Stagnant ones not so much.  They tend to shatter into little pieces instead of bending and adapting in response to big shocks.

I’ll sit here patiently waiting for all those soi-disant “Russophiles” who criticized, and at times ridiculed, my earlier prognostications as the product of a Russophobe mind to explain to me how the Economic Minister is similarly Russophobic.  Because he’s just saying what I’ve said for years. Some people are slow learners.  And some are no learners.  Which means I’ll probably be waiting a long time.

Today the creepy Jay Carney (the most aptly named man in show business) attempted valiantly to deny, against all evidence, that Obama did not deceive when he said-over and over and over-that if you like your health care policy you can keep it:

After the passage of Obamacare, the president has repeatedly insisted that if any individual likes their health care plan, they could “keep it.”

Carney on Tuesday added a crucial caveat to that promise, saying Americans could keep their insurance if the plan is “still available.”

In other words, if the plan is modified, coverage options that don’t meet Obamacare standards could be canceled.

Still, Carney accused Republicans of distorting the impact of the cryptic administrative ruling.

“What we’re talking about here is the 5 percent in the country who currently purchase insurance on the individual market,” he said.

That 5 percent of the country is over 10 million people, but remember what Uncle Joe said about omelets and eggs.

So you unlucky 5 percent: lie back and take it for the Motherland.  And no, sorry, but KY Jelly is not covered under the Bronze, Silver or Gold plans. Read the fine print.

And fine print is exactly what Carney’s-and every other administration flack’s-defense relies on.  If your policy changed in the slightest way, it’s not grandfathered anymore.  So even if you prefer the new version of your old policy, with a different deductible or coverage, to the  Bronze, Silver, or Gold plans you’re SOL.

Think of that any time a prog says s/he is “pro-choice.”  This prog plan is all about limiting choice in order to redistribute. But you shouldn’t be surprised, because that’s what progs are all about.

For those who say “I supported Obamacare until I found out I had to pay for it”, there are many words of wisdom in this clip. Including the “you trusted us” bit, and the part about “it’s gotta work better than the truth” (which is advice the Obama administration has obviously taken to heart:

Both, actually.

The administration’s response to every one of the mounting pile of FUBARs is “Obama didn’t know.”  The latest: Obama didn’t know about impeding Healtcare.gov fiasco.  And he didn’t know that the NSA was collecting electronic intelligence on Merkel and other foreign leaders.  Add this to the IRS, Benghazi, etc., etc., etc.

This happens so frequently that it is becoming as regular a bit in the Obama Show as Sergeant Schultz’s “I know nothing! I see nothing!’ bit was in Hogan’s heroes.  Obama’s denials are about as plausible as Schultz’s.  It’s just not nearly as funny in real life.

As the fiascos mount, scapegoats must be found!  It is going to get very, very crowded under the bus.

The NSA situation is the worst, with Obamacare running a close second.  Sources within the NSA have claimed that the White House and the State Department gave permission for the surveillance of Merkel and others.  The White House denies, denies, denies, and points to a statement from the NSA to support the denial:

With the issue mushrooming into a major diplomatic headache between the U.S., Germany and other allies, the administration stepped up its insistence that Obama knew nothing, though it has yet to explicitly acknowledge that the snooping occurred in the first place. An NSA spokesperson said Sunday that agency head Gen. Keith Alexander “did not discuss with President Obama in 2010 an alleged foreign intelligence operation involving German Chancellor Merkel, nor has he ever discussed alleged operations involving Chancellor Merkel. News reports claiming otherwise are not true.”

Spare me.  That denial is so narrowly drawn that an amoeba could run laps around it in seconds. Taking it at face value, Alexander has never discussed this with Obama.  Fine.  What about any of the thousands of other NSA employees?  CIA employees?  His briefer (when he deigns to have a briefing)?  His briefing books (which Valerie Jarrett assures us that he peruses with god-like discernment).  Hasn’t been a mention of anything that Merkel said not from a public source that would make even the slow witted ask: “How do we know that”?  The specificity and narrowness of the denial seems to be a lawyerly evasion by the agency, and may in fact be so specific and narrow as to signal that yes, indeed the NSA informed Obama: what is left out is the elephant in the room.

This is a horrible situation.  Political survival instinct and Capitol Hill outrage and cowardice will produce a battle between the political branches and the intelligence community, from which the intelligence community will not back down, and in which it has some substantial advantages.  Information is power.  The Bush administration was wounded deeply by the CIA’s war against the White House.  This is a battle that Obama fights with extreme handicaps, but it’s a battle we don’t need period.  Better to just tell the Europeans to grow up, or to ignore them until the storm passes.  (The Schaefer piece provides an analysis of the reasons to monitor Merkel even before she became PM that echo those I made over the weekend.)

The health care situation is not much better.  Today’s storm, overtaking the ongoing website farce, is that the Obama administration knew that millions would lose their individual coverage once Obamacare went into effect.  The administration-sit down, because this may shock you-denies.  The know nothing! They see nothing!

So here’s the choice: either the people responsible for implementing and designing Obamacare failed to anticipate this consequence, which is devastating for millions of people, despite the fact it was eminently predictable, or it is lying.  Great to have choices, ain’t it?

With respect to predictability, it’s clear as day.  To “work” (on its own terms, not that working on its own terms is a good thing), healthy individuals have to be attracted to-or forced onto-the exchanges so they can be charged premiums that exceed the costs that they will incur, in order to subsidize those who impose more costs than they will pay in premiums.  Due to the nature of the individual insurance market, those who are able to buy on this market are likely to be healthy, low risk individuals: indeed, the inability of high risk individuals to get coverage was one of the reasons given for the need to implement Obamacare in the first place.  So the privately, individually insured represented a pool of people tailor made to force onto exchanges.

And how was that done?  By a bait-and-switch.  The Obama promise of “if you like your health insurance policy you can keep it” was supposedly implemented by grandfathering existing policies.  But the grandfathering rule was written so narrowly that any change in the policy-coverage, deductible, co-pay, etc.-negated the grandfathering.  So even modest changes that occur with regularity in these policies have led to mass cancellations of policies that are not grandfathered and do not offer the coverage mandated by the ACA, thereby creating a population of sheep to be sheared on the exchanges.

And speaking of ruminants, of course scapegoats must be found! And you guessed it: the insurance companies are being rounded up and rounded on, most notably by the loathsome, mendacious and incompetent Valerie Jarrett:

FACT: Nothing in #Obamacare forces people out of their health plans. No change is required unless insurance companies change existing plans.

Get ready for the daily five minutes of hate.  Where by “five minutes” I mean twenty-four hours.

Wherever you cast your gaze, your eyes light on a debacle.  Consider that Russia is exploiting Obama’s inept handling of Egypt, where he managed the clever feat of getting everyone to hate him (no Cairo Speech II, I’m guessing-nor Brandenberg Gate II either):

Russian President Vladimir Putin is considering paying a state visit to Egypt to take advantage of frayed ties between Washington and Cairo and possibly gain access to Mediterranean ports, the Sunday Times of London reported.

Nearly 40 years of US policy up in smoke. The Choom Gang rides again.

The headline says it all: it emphasizes that Putin is exploiting the “US vacuum.”  That is the Obama foreign policy in two words: the second coming of the Hoover Administration.

Indeed, the appellation “Hoover Administration” is fitting in so many ways, because you know what vacuum cleaners do, right?

I’ve been beavering away at the clearing section of my next book, which will be titled Market Macrostructure.  It’s been something of a struggle, because there are so many aspects to this issue that it is challenging to organize the material in a logical fashion.  I analogize it to trying to write a history of a complicated battle, where many things are happening simultaneously over space, and these things interact.  Inevitably, the narrative must jump around in either space or time or both, and the writer must summarize some material about one action at one time to relate it to the narrative of what is going on at another place at another time.

So it is with writing an analysis of clearing.  There are many moving parts that interrelate and interact, so there is always the challenge of relating detailed analyses of important pieces to one another, and to clearing as a whole, and to the trading process (execution and clearing) as a whole.

One virtue of this struggle, however, is that it can lead  the writer to new insights.  Conceptualization at a fairly highly level facilitates organization, and the process of conceptualization can lead to new ways of understanding.  So it is, I hope anyways, with the clearing analysis.

This post is my first attempt to crystalize those thoughts; indeed, one of the original purposes of the the blog was to provide a place where I could think out loud and commit to pixels some early thoughts to be refined going forward in more formal writing.

The issue that I have been grappling with is why are some trades cleared, and others not?  Why do we see exchanges that trade cleared contracts operate side by side with bilateral markets trading similar contracts (and sometimes nearly identical ones) that aren’t cleared?  What determines the division of trade between these alternatives?

This is an issue that I’ve been looking at since the ’90s, and I identified some factors, but I was never completely satisfied.  But putting together some pieces that I have written about before, I think I’ve come up with a more complete explanation that captures some of the salient aspects of the economics of clearing and counterparty risk generally.

The first piece is that in theory-and indeed, in most theoretical treatments of clearing by academics (including yours truly)-clearing can operate as a classical risk pooling/insurance mechanism, in which market participants pool counterparty risk.  To the extent that this risk is idiosyncratic, such pooling allocates risk more efficiently and makes risk-averse participants better off.

But as I pointed out in my earliest work, and emphasized more in some later papers, like any risk sharing arrangement, mutualization of counterparty risk creates the potential for adverse selection and moral hazard problems.  Moral hazard problems are likely to be particularly acute.  Clearing participants can affect the distribution of the default losses they impose on the mutualization pool by adjusting the riskiness of their trading positions in the cleared derivatives.  They can also do so by adjusting the risks of their balance sheets, through, for instance, adjusting their trades in non-cleared derivatives (or in derivatives cleared at another CCP), changing their leverage, or adjusting the risk of other assets on their balance sheets

The prospect for moral hazard will inevitably lead to limits on the amount of insurance provided through the clearing mechanism.  That is, not all default risk will be mutualized.

Clearinghouses use margins to limit the amount of risk that is mutualized.  Only losses on defaulted positions in excess of margin posted by the defaulter are mutualized.  The higher the margin cover, the lower the level of risk sharing.

In practice, CCPs utilize a “defaulter pays” model in which margin covers losses on defaulted positions with extremely high probability, e.g., 99.7 percent of the time.  In a defaulter pays model, the amount of risk mutualization is very low.  CCPs are not, therefore, primarily an insurance mechanism.  They insure only tail risks (which has important implications for systemic risk and wrong way risk).

Note LCH.Clearnet’s boast that it had collected far more margin than necessary to cover the realized losses on the Lehman’s derivatives positions that it cleared.   The CME also had more than enough Lehman margin to cover losses on its positions (although there were shortfalls on some product segments that were covered by excessive margins on others).

At the Paris conference I attended in September, the head of Eurex Clearing, Thomas Book, was adamant that the goal of his CCP, and of CCPs generally, was to avoid mutualizing risk if at all possible.  His answer surprised Bruno Biais, whose model of clearing in the paper he presented focuses on the role of the CCP as a default risk insurer.

I confess that I have been inadequately appreciative of this point as well.  Understanding its implications has important consequences, as I hope to show in a bit.

To summarize.  CCPs generally operate on a defaulter pays basis: this is also sometimes referred to as a “no credit” system.  That term will help illuminate the differences between cleared and uncleared markets.  The defaulter pays system means that the amount of risk shared through a CCP is extremely limited.  This limitation on risk sharing is best explained as the consequence of moral hazard.

In contrast to a cleared market operating on the no credit model, dealers in bilateral OTC markets historically extended credit to derivatives counterparties.  Put differently, OTC deals often bundled a derivatives trade with credit provision.  That is, dealers often willingly took on exposure to a default loss when entering into a derivatives deal with a customer.  (This is not true for all types of customers.  For instance, hedge funds typically had to post margin.)  Taking credit exposure is equivalent to extending credit to the counterparty.

Now consider whether a firm will prefer to trade a cleared derivative, requiring the posting of a high margin and which thus embeds no credit, or prefers instead to trade an otherwise identical OTC product that does embed credit.  To fix ideas originally, let’s consider a firm that is cash constrained.  Therefore, if it wants to trade the cleared product, it must borrow to fund the initial margin.  The cleared derivative is a no credit transaction, but that doesn’t mean that moving to clearing necessarily reduces the amount of credit the firm obtains: it can borrow the money needed to post margin, and indeed, may have to borrow it.

One source of credit is dealer banks.  So the firm could either enter into an uncleared bilateral trade with a dealer, or borrow money from the dealer bank to fund the IM.  (The argument doesn’t really depend on dealing with the same bank on the derivatives deal and the borrowing: this just facilitates the exposition.)

Here’s were the loser pays aspect of margin comes in.  Let’s say that the firm is selling a derivatives contract with payoff P. If the firm defaults, the OTC counterparty’s exposure is max[P,0].  But in a loser pays model, the margin M is almost always greater than max[P,0].  Thus, the borrowing from bank to fund margin almost always exceeds the default loss that the bank would incur if it entered into a bilateral deal with the firm.

I can show formally that if the firm already has debt outstanding, under standard pro rata/pari passu default loss allocation mechanisms, holding everything equal,  the bank’s default losses if it extends credit to the firm to fund margin almost always exceed, and never are smaller than*, the default losses that it would incur if it had entered an uncleared bilateral trade with the firm.  This, in turn, will make the cleared transaction more expensive for the cash-constrained firm, and it will prefer to trade the OTC product.

There are at least a couple of reasons why the cleared transaction can be more expensive.  One is what is effectively a debt overhang problem.  In order to induce the bank to lend the margin for posting at the CCP, the firm must promise it higher payments in non-default states than it has to promise the bank in these states when it trades OTC instead.  Since the firm’s managers, acting in the interest of equity, only care about payoffs in non-default states, this means that returns to shareholders are lower when it borrows to fund margin than when it deals OTC.  This can be seen another way.  I can also show formally that the payoffs to the firm’s other creditors are almost always higher, and never lower, if it borrows to fund margin than if it trades OTC.  Thus, the value of the the firm’s non-margin-related debt is higher if it trades a cleared product and funds the margin by borrowing, than if the firm uses the OTC product.  Since the value of the firm’s assets doesn’t differ in the cleared vs. uncleared cases, and since value is conserved, this means that equity is less valuable when the firm trades cleared products than bilateral ones.   Some of the benefit of borrowing to fund margin flows to other creditors; this is where the analogy to debt overhang comes in.

This is most easily seen in the following scenario.  The firm can become insolvent when max[P,0]=0, i.e., the bilateral contract is out of the money to the bank, and the bank suffers no loss due to default, and all the losses of insolvency would fall on other creditors.  However, if the bank had lent the firm money to fund margin, it would suffer a loss on the margin loan in this circumstance.  This loss would reduce the loss suffered by the other creditors.

OTC is cheaper than cleared products in other models of capital structure.  For instance, moral hazard (or adverse selection) mean that the firm will be credit constrained: the amount it can borrow is limited by its collateral, and/or the amount of cash flows that it can credibly pledge to lenders.  The same formal analysis implies that more cash flows in non-default states must go to supporting a margin loan in a defaulter pays clearing model than in a bilateral transaction.  This leaves less cash flows to support other borrowing, so by borrowing to fund margin loans the firm must borrow less to support other investments (which, in this sort of model, it has insufficient equity to fund itself).  Thus, borrowing to fund margins on cleared transactions crowds out borrowing to fund positive NPV investments.

This analysis implies that this cash constrained firm will choose to trade OTC rather than cleared products with defaulter pays margins funded with loans.  The bank is indifferent, because it will price the product or the loan to cover its costs, but the firm is always better off  with the bilateral trade because it has to pay the bank less if it trades OTC than if it borrows to fund margin.

Moreover, the analysis implies that if the firm is forced to clear, it will either scale back its derivatives trading (because the cleared transaction is more expensive), and/or reduce its investments in positive NPV projects. Cutting back derivatives trading is costly if this trading reduces the deadweight costs of debt, for instance.  Indeed, I can show that the cost of margin is especially high when the derivatives trade is a “right way” risk, as would occur when the firm is hedging.

Clearing mandates are therefore expensive for such firms, and there is a legitimate reason to exempt such firms from clearing requirements.  (Note that even if these firms are exempted, other rules affecting dealer banks, e.g., punitive capital charges on OTC derivatives trades, can induce an inefficient use of cleared transactions.)

This analysis explains the preference of many firms, especially corporate end users, for uncleared OTC trades that embed credit, as opposed to cleared transactions that must be funded by increased borrowing.  This, in turn, can explain the growth of OTC markets relative to exchange traded markets from the 1980s onwards.

It is useful to step back a bit here, and understand what is really going on.  In essence, in this model clearing is expensive because it causes one agency problem to exacerbate another.  CCPs adopt defaulter pays because of an agency problem: the moral hazard associated with risk sharing.  Debt is expensive or constrained for firms because of agency problems (e.g., debt overhang problems, or constraints on borrowing due to moral hazard).  Effectively, the firm must obtain more credit to support a cleared position than an uncleared one, and  the cost of debt arising from agency problems makes this higher level of credit more expensive.

This analysis raises the question of why firms would ever choose to clear.  There are a couple of answers to that.

First, there may be other (private) benefits.  For instance, netting economies may be greater with clearing.  Of course, the efficiency effects of netting are equivocal (because netting primarily has the effect of redistributing losses among creditors), but as a positive matter is is pretty evident that netting offers private benefits, and thus the mulitilateral netting that can occur in clearing, but not to the same degree in bilateral trades, could induce some traders to prefer clearing.

Second, the analysis started from the assumption that the firm at issue is cash constrained and hence has to borrow to fund margin on the cleared trade.  Some firms are not.  One example would be an ETF like USO or USNG, which collect the entire notional value of derivatives in cash from their investors.  These firms do not require any credit to meet margins.  Large real money funds, like a Pimco, that collect cash from investors and use derivatives to gain exposure to price risks would be another.

Even many hedgers may not suffer from cash constraints that limit their ability to trade cleared contracts.  Consider commodity trading firms.  They typically use derivatives to hedge inventories of commodities.  Banks, in turn, are willing to lend against these inventories as collateral.  Thus, the commodity trader can fund margin using borrowings secured by commodity inventories, and the lender does not share in default losses pro rata with other creditors.  This type of borrowing is fundamentally different than the borrowing considered above, in which the firm borrows against its balance sheet and default losses are shared with other creditors.

Thus, the simple models would predict that whereas cleared derivatives used to hedge liquid inventories are as cheap or cheaper than uncleared derivatives, it is much more expensive to use cleared derivatives to hedge cash flows on illiquid assets, or to hedge broad balance sheet risks.  This is largely consistent with my understanding of the pattern of usage of cleared and uncleared derivatives.

This model, which combines a model of the cost of risk sharing at a CCP with a model of the capital structure of firms, has both positive and policy implications.  In particular, it can explain the adoption of defaulter pays by CCPs.  It can also explain the disparities between OTC and cleared markets when CCPs utilize defaulter pays.  Moreover, it demonstrates that clearing mandates can be inefficient if they are applied too broadly.  One source of this inefficiency is that the mandate leads to a perverse interaction between agency problems.

Of course, a rationale for clearing mandates is that clearing reduces systemic risk.  Anyone who has read my work will know that I am dubious of that rationale on many grounds, but it is worthwhile to consider the implications of the foregoing analysis for systemic risk.

The model is too sparse to make very strong conclusions, but one consideration does stand out.   If firms borrow from OTC dealer banks to fund margins, holding the rest of the firm’s liabilities and assets constant, these banks suffer larger losses when the firm goes bankrupt if they lend to them to fund margins on  derivatives trades than if they enter into identical uncleared OTC derivatives trades.  As noted before, there is a distributive effect: other creditors suffer smaller losses.  The systemic implications of this redistribution depend on the relative systemic importance of the banks and the other creditors.  Dealer banks are definitely systemically important, but other creditors may be too.  Therefore, it is not evident how this cuts, but if one believes that large financial institutions that serve as OTC dealers are especially crucial for systemic stability, moving to cleared trades would tend to increase systemic risk because clearing actually increases their credit exposures to customers.

But again, caution is warranted here.  The redistribution result holds capital structure and derivatives trades constant, but of course these will be different if firms have to clear than if they don’t.  These changes are difficult to predict, and the systemic riskiness of different configurations is even more difficult to compare given how little we really know about the sources of systemic risk.   But the fact that clearing can lead to adverse interactions between agency problems should raise concerns about the systemic implications of forcing clearing.

*To be more precise.  When P>M, the CCP and the lender suffer default losses, and the sum of these default losses is the same as the bilateral counterparty would incur on an uncleared trade.  Relatedly, other creditors of the bankrupt firm suffer the same default losses in the cleared and uncleared cases when this condition holds.  They suffer smaller losses whenever this condition does not hold and the firm goes bankrupt.

The Economist has come a long way since Bagehot.  I said long way, not good way.

The latest case in point: its support for two “whistleblowers”, Edward Snowden and Hervé Falciani:

WHAT Edward Snowden is to mass surveillance, Hervé Falciani is becoming to private banking. In 2008 the now 41-year-old native of Monaco walked out of the Geneva branch of HSBC, where he had worked for three years, clutching five CD-ROMs containing data on thousands of account holders. The theft lobbed a bomb into Europe’s private-banking market, spawning raids and tax-evasion investigations continentwide. In the latest, this week, Belgian agents swooped on the homes of 20 HSBC clients, including some with ties to Antwerp diamond dealers.

I am having a devil of a time trying to reconcile this simultaneous boosterism of Snowden and Falciani.  The pro-Snowden narrative is that he has revealed a vast program of government collection of information on private individuals.  So what did Falciani do?  He stole information on private individuals from his employer, HSBC, and provided it to governments.  So if you are hung up on the government having access to your private information, maybe-maybe-you could lionize Snowden.  But then you’d have to hate on Falciani.  But not The Economist.  It loves both of them.

And here’s a big difference between them. A huge difference, and one that makes The Economist’s position even more bizarre.

In the US and UK, there are extensive measures in place to prevent the information collected by NSA and GCHQ from being used in criminal prosecutions.   Indeed, one of the most recent Snowden leaks is that GCHQ waged a long fight AGAINST using intercepts in criminal prosecutions. (The Guardian is pathetically spinning this as another huge scandal.  WTF?)

But governments, notably the French and German governments (doesn’t that peg the irony meter?) are gleefully using the information Falciani stole from his employer to prosecute individuals.

So I guess intrusive surveillance of your private information, including your financial information, is A-OK with The Economist as long as it is for the purpose of ensuring that you render unto Caesar what is Caesar’s.  But collection and retention of some private information (e.g., metadata) that may be used if it is subsequently connected with known terrorists, and only then under rigorous protocols, is somehow an outrage.

Look, people. If you are concerned about your liberty and privacy, you have far more to fear from your country’s tax authorities than its intelligence services.  Quite frankly, the NSA couldn’t give a rat’s ass about your financial affairs, unless those somehow intersect with the financial affairs of terrorists.  The IRS, on the other hand, cares very much.  Very much.

And let’s get one thing straight right now.  Let’s drop any pretense that Snowden’s actions were driven by his deep, deep, deep concern for individual privacy.  Yeah, that was the teaser in his original disclosures: and those disclosures weren’t really news.  That’s the story that he uses to wrap himself in the mantle of righteousness. But virtually every Snowden leak since June has been about US government intelligence operations directed at other countries.  Which is, you know, what intelligence services do.  And which you should be damned glad the NSA, CIA, etc., do in fact do.

If you have any doubts, consider the following.  Snowden stole 30,000 documents from the Defense Intelligence Agency. How is that related to US civil liberties and privacy?  It is infinitely more likely that such documents would be related to the US military’s attempts to monitor and understand and analyze US enemies and potential enemies.  What was my first clue? Maybe “Defense” in the title of the agency whose documents Snowden stole.

And lo and behold, what is the first piece of information released from this ill-gotten trove? A revelation that a NATO country is collecting information on the Russian military:

In one case, for instance, the files contain information about a program run from a NATO country against Russia that provides valuable intelligence for the U.S. Air Force and Navy, said one U.S. official, who requested anonymity to discuss an ongoing criminal investigation. Snowden faces theft and espionage charges.

Let’s shave with Occam’s Razor again, shall we?  Snowden hides out in the Russian consulate in Hong Kong. Snowden decamps to Russia. Snowden hides out with the FSB. (Spare me the BS about him not being in control of Russian security services. I didn’t fall head first off the cabbage truck.) Snowden’s lawyer is a well-known FSB apparatchik. Snowden steals US military intelligence documents. One of these documents is released revealing the cooperation of a NATO country with the US in an intelligence collection operation directed against Russia. (Good!-and I mean good that we’re collecting such information, not that this is being revealed.) Not to mention that many of Snowden’s revelations are wreaking havoc with America’s relationships with its allies.  And never forget Putin’s zero sum mindset: what hurts the US, helps Russia.

So what’s more likely?  That Snowden (and his enablers Poitras and Greenwald) are oh-so-concerned about the privacy of Americans and Europeans and Brazilians? Or that this lot is-and likely has been all along-tools of Putin and Russian intelligence, and are revealing information that is damaging to the US and beneficial to Russian interests?

The Romans had an expression for this: cui bono? The answer in this instance: Putin bono. So Snowden is either a useful idiot, or an active collaborator.  As Orwell would have put it: He is objectively pro-Russian, and pro-Putin.

Snowden and Poitras and Greenwald are rendering unto Putin.  Every damned day. It’s beyond obvious.  But it’s never pointed out, particularly by those who should know better. And yeah.  I’m looking at you, Luke Harding.  Why won’t you investigate the nexus between Snowden and The Mafia State?  It seems a natural.  What are you afraid of?

In September, the CFTC’s new SEF rule threw swap market participants into a panic when they realized that footnote 88 buried within the rule would require instruments that were thought to have been outside the scope of the rule to be traded on the new SEFs:

Further muddying the waters is a footnote that was written into the margins of the final rules that could end up having a major impact. Footnote 88 requires certain entities that offer trade execution of swaps on a multiple-to-multiple basis to register as SEFs, even if they only execute or trade swaps that are not subject to the trade execution mandates.

This could lead to a significantly expanded SEF universe, which is already expected to be crowded. Trading participants would have to code and test to these various SEFs, some of which will have hastily assembled their platforms in order to be compliant. The on-boarding process will be rushed for participants in order to generate needed liquidity at the Oct. 2 starting point.

“For some of our members who have decided that they’re going to connect to each one of the platforms that’s available, they’re going to need this unique coding and connectivity to these new platforms,” Nevins says. “That’s a lot of work in a very short period of time.”Those who don’t want to connect to each venue will have to decide quickly which SEFs they want to work with, and they still need to hurry the coding and connection of pipes to the SEFs.

But two can play the footnote game.  Today Bloomberg reports that the banks have found a footnote in the rule that allows them to shelter some trades from the SEF execution mandate.  Footnote 513.  (The number itself should give an indication of how bloated and complex the rule is.)

Wall Street, trying to preserve profits from swap trading in the face of tougher scrutiny from Washington, has found a new way to keep some of its overseas deals private. It’s called Footnote 513.

Banking lawyers have seized on the wording of the footnote, contained in an 84-page policy statement issued in July by the main U.S. regulator of derivatives. The largest banks told swap brokers in late September that the language means certain swaps still don’t fall under the agency’s new trading rules, according to three people briefed on the discussions.

London-based ICAP Plc (IAP), one of the largest swap brokers, told the banks it didn’t agree with their interpretation, said the people, who spoke on condition of anonymity because the discussions weren’t public. Other brokers accepted the banks’ position and have been trading billions of dollars in contracts outside the new regulatory system, the people said.

The deals in question include swaps for foreign clients that are arranged by U.S.-based traders or brokers and then booked through a U.S. bank’s overseas affiliate. Bank lawyers say that if the trade goes through an affiliate it can stay private and doesn’t need to be handled on one of the public electronic trading platforms approved by the Commodity Futures Trading Commission, two people said.

Other than lawyers, who thinks this Duel of Footnotes is anyway to run a railroad?  (I know, I know: most lawyers think this is stupid too.  It’s just that they’ll be about the only ones that profit from it.)

And remember it’s not just footnotes.  It’s commas too.  As I wrote about a year ago, the decision overturning the CFTC’s position limit rule hinged in part on the placement of commas.

The whole structure is still under construction, and it is already requiring a plethora of ad hoc fixes, in the form of exemptions and no action letters, which Commissioner Scott O’Malia trenchantly criticized.

And it’s not just in the US.  The rules and paperwork are metastasizing in Europe too.  As one commentator puts it, “Regulation descends into a Kafkaesque bureaucracy.”  Yeah.  This will work.  Especially when their Kafkaesque bureaucracy clashes with our Kafkaesque bureaucracy.  Kafka squared. Woot!

And it’s not just derivatives.  It’s hedge funds.  And I could go on.

The hedge fund article also points out something I’ve been hammering on for years now: perversely, since compliance costs have a huge fixed cost element, the regulatory onslaught creates scale economies that favor concentration and consolidation, and which can potentially reduce competition.  You are seeing it in hedge funds.  You are seeing it in banking.  You are seeing it in FCMs.

And I do mean perverse, because among the ostensible purposes of these regulations were mitigating the too big to fail problem, and promoting competition.  The dramatic increase in regulatory overhead that favors the big over the small is completely at odds with these purposes.

Moreover, don’t forget another point that I’ve made.  These rules are systemic in nature, in the sense that they affect myriad financial market participants, and in pretty much the same way.  Meaning that if one of the rules is fatally flawed, it could lead to a serious systemic problem.

Which raises the question: what footnote-or what comma-in what rule will create a future crisis?  Perhaps that’s a little hyperbolic, but not outrageously so.

The tragic farce that Obamacare lurches from our nightmares into our reality.  The Healthcare.gov website is the poster child for an IT FUBAR.

But if only the Tsar had known!  Then none of this would have happened! Because the Tsar is omnipotent-just not omniscient, apparently. (h/t @MaryForbes14).

I actually don’t want to put too much emphasis on the website clusterf*ck, because it will probably be fixed. Eventually. (Cue the “Comeback Kid!” narrative.)  Indeed, I sincerely wish that the website worked, so that people could learn about the complete economic dysfunction that is Obamacare.  (One hypothesis to explain the insane website design that doesn’t permit shopping for plans until you’ve registered is that the government spider doesn’t want you little flies to know what you’re in for until you’re well and truly stuck.)

The Obamacare train wreck shares a lot of similarities with another train wreck from the real land of the Tsars.  Namely, the implosion of something that is supposed to explode, in a very big way: the Bulava missile.

I’ve written about its myriad failures before.  For a while it seemed that the program had been fixed, and was on track.  But then another test failure occurred.  As a consequence, Russia “return[ed] of all its systems to the manufacturer” and suspended sea trials of the subs (the Nevsky and Monomakh) designed to carry it.

This is apropos the discussion going on in the comments regarding the sanity, or lack thereof, of Putin’s defense buildup, and especially his throwing trillions of rubles at the Russian Navy.

Read this, and I think you will see the parallels between Bulava and Obamacare:

Although Defense Minister, Army-General Sergei Shoigu and Deputy Prime Minister Dmitry Rogozin publicly clashed over the Bulava issue, the commission was due to complete its investigation by October 1. Many specialists, however, believed it would take much longer (RIA Novosti, September 18; Rossiyskaya Gazeta, September 19). The first deputy general director of the Votkinsk factor, Sergey Proskurin, remained cool about the investigation, insisting that his company was “prepared for any commission. We have had inspections after other failed launches of the Bulava, but in no case was a fault of the Votkinsk factory discovered. We assemble the missiles according to the design-engineering documentation, and the level of quality is sufficiently high, and there is proof of this” (Vzglad, September 26).

In short, the Russian answer is that no one is to blame, apparently leaving the Kremlin with the explanation that the Bulava is simply supernaturally jinxed. Independent Moscow-based defense analyst Aleksandr Golts notes that more than 650 defense companies are involved in the overall manufacturing and design and eventual “success” of the Bulava project, and sees the recurring nightmare of repeated failures as a symptom of the weaknesses of the domestic defense industry. “Generally, the rearmament of the Russian Army is entering a new cycle. Without any kind of results,” Golts concludes (http://kommersant.ru/doc/2280505).

It seems that the situation is no better for the much vaunted Bulava; failure to launch has become a national embarrassment. Bulava production must reach an estimated 128 missiles and many more warheads, overcome system design issues, planning flaws, technical and defense industry weaknesses. It has thus become synonymous with failure and with all that is wrong in Russia’s defense industry. In this context, as steps are taken to correct these flaws and eventually introduce Borei-class submarines equipped with Bulava missiles as part of the nuclear triad, Western governments should remain highly skeptical about other claims from Moscow about progress toward advanced conventional forces or, yet more farcical still, the long promise of “cyber-warfare command, which, like the Bulava, remains good on paper but not as a working instrument. More mysterious still, in this context, is the fact that Shoigu and Rogozin remain in their posts. [All emphasis added.]

The last part is particularly apposite.  Just replace “Shoigu and Rogozin [The Ridiculous!]” with Sebelius [The Stooge!] and the fit is perfect.

Obamacare.  Bringing the best of Russian defense contracting to a doctor near you! Or maybe not.  Because the doctor near you may be out of network, and the doctor in your network may not be near you!

In some earlier posts discussing the role of banks in commodity markets, I suggested that the decision should not be a binary one: banks in, or banks out.  Instead, the preferable approach would be to levy capital charges on bank commodity operations that reflected the risks of these operations, thereby attempting to ensure that banks internalize the TBTF costs associated with them and scale their commodity businesses accordingly.

The WSJ reports that the Fed is leaning towards this approach:

Federal Reserve officials are considering imposing a new capital surcharge on Wall Street banks that own oil pipelines, metals warehouses and other lucrative physical-commodities assets, according to people familiar with the matter.

Such an approach could encourage banks to pare back their involvement in physical commodities, which has increasingly raised concerns among regulators and lawmakers.

While no decision has been made, imposing a surcharge would allow the Fed to sidestep a legal jam caused by existing laws that set Goldman Sachs Group Inc. and Morgan Stanley apart from peers and give the former investment banks broad leeway to own commodities.

The devil, of course, is in the details.  The question is whether the surcharge will be set in a way that accurately reflects the relevant risks, or whether instead it will be set at punitive levels to achieve via misdirection what the Fed is apparently reluctant to do in a straightforward fashion (due to fears of legal challenge): i.e., precluding banks from participating in physical commodity markets.

In other words, this proposal is fine in principal, but could be a disaster in practice.  If the Fed really wants to drive banks out of commodity markets, I would much prefer it do so forthrightly, rather than by hiding behind capital surcharges that it chooses to achieve that outcome.

The EPA bowed to reality, and has admitted that the blend wall is real.  That is, (a) the vast bulk of autos in the US can only use gasoline with 10 percent of less ethanol, and (b) the mandated level of biofuel consumption exceeds 10 percent of US gasoline consumption.  The gap between the mandated use of biofuels and the actual use of biofuels had led refiners to scramble to by Renewable Identification Numbers (“RINs”) that they can substitute for actual biofuels to meet their mandate obligations.  But the supply of RINs is limited, and their price had skyrocketed started in the spring.  The available supply of RINs for 2014 would have been totally inadequate to cope with the increase in the mandated quantity for that year.  A quantity set by Congress in 2007 when it had no idea what market conditions would be it kicked in, and in defiance of technological realities.  Congress anticipated a steady increase in gasoline consumption, but stagnant economic growth and other factors have led to stagnant gasoline consumption, leading to the current yawning gap between the mandated quantity of biofuels and the quantity that can actually be utilized.

As a result, the EPA has decided to cut the mandated quantity for 2014 by nearly 1/6th, or 3 million gallons.

Economically this is the right result, but legally and procedurally it is a monstrosity.  Congress did give EPA the discretion to waive the mandate, but limited that discretion.  The agency can modify the mandate for two reasons.  Here’s how Reuters describes it:

This can be used to reduce the volumes in two cases: if enforcing the law were to cause economic hardship; or if it were simply not feasible due to “inadequate domestic supply”.

Making the “economic hardship” case is hard, so the EPA is using the second justification.  No.  Seriously.

The plain language of the law makes it clear that inadequate domestic supply of biofuels is the criterion for granting the waiver.  But we have a surfeit of biofuels, if anything: we can produce more of them than can be consumed.

Here’s the gobbledygook the agency uses to justify its decision:

“We interpret the term ‘inadequate domestic supply’ as it is used under the general waiver authority to include consideration of factors that affect consumption of renewable fuel,” the agency wrote in the proposed rules.

Uhm, “consumption” is related to demand, not supply.  But whatever.

The EPA seems inspired by this famous bit from Through the Looking Glass:

‘When I use a word,’ Humpty Dumpty said, in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’

‘The question is,’ said Alice, ‘whether you can make words mean so many different things.’

‘The question is,’ said Humpty Dumpty, ‘which is to be master — that’s all.’

EPA is clearly determined to be master of the words in the Renewable Fuel Standard, and make them mean just it what it chooses them to mean.

The Reuters article states that the EPA’s action is sure to draw a legal challenge from the biofuels industry, and that’s no doubt true.

I yield to no one in my loathing for the Renewable Fuels Association, but they have the law on their side in this case, even if the law is indeed an ass. If the rule of law is to mean anything, laws must be enforced as written, not waived at will, especially when the justification for the waivers flies in the face of the black letter language of the statute.

If we really want a country of laws, the laws need to be enforced and followed, not waived.  We need to work to rule.  To bring home to Congress its folly, and to force it to change the law to bring it into conformity with economic reality, the RFS must be enforced, down to the last comma.

And the principle should be applied more broadly.  Obamacare is a prime example.  Ever G*d damned provision on every one of its 2000 plus pages should be enforced, no ifs, ands, buts or waivers, to make manifest its absurdity, thereby making possible a substantive change in the law-and perhaps scrapping it.

Maybe in the scheme of things RINsanity isn’t a big deal.  But it illustrates quite powerfully the degeneration of the rule of law in the US and the increasingly arbitrary nature of American government.