Streetwise Professor

At the dedication of a new Rosneft refinery (for giggles imagine in your mind’s eye Obama doing something similar at an Exxon one), Putin made a strong statement regarding the compensation-or not-of the TNK-BP minorities.  In a nutshell: you’ll take the crumbs I give you and you’ll like it.

Rosneft should buy out the minority shareholders of TNK-BP Holding at the prevailing market price, not at the peak levels of the past, Russian President Vladimir Putin said on Friday, indicating there will be no increase for investors hoping for an improved payout.

“The valuation and payouts should be carried out for those who wish to sell not at peak levels but today’s market price,” said Putin, who was in Tuapse on the shore of the Black Sea for the opening of an oil refinery by Rosneft. “That should be the basis. No one should be deceived or robbed.”

Oh no one is being deceived here, but robbery is another matter: the minority holders know they are getting robbed.

Note that Putin doesn’t advocate the payment of a premium on the market price, or acknowledge that the market price was depressed as the result of legitimate fears-stoked by Sechin’s Rosneft-is-not-a-charity rhetoric-that the minorities would get a pittance.

This is everything that Sechin could ask for-and probably did.  But it is a huge dis of Medvedev.  Medvedev had publicly pressed Sechin (in a joint appearance) to up the compensation for the minority shareholders, by paying a premium over the average of the market price since the time of Rosneft’s acquisition.  Medvedev had said that this measure was an essential step in assuring foreign investors that they would be treated fairly, thereby making them more willing to invest.

Putin’s decisive rejection of Medvedev’s position tells you all you need to know about the prime minister’s influence in the country, and his ability to control Sechin and other silovki.  Perhaps more importantly, it tells you that Putin couldn’t care less about fixing the severe legal and institutional defects that make investment in Russia so fraught with risk, and which have brought on the stagnation that some have been predicting for some time (ahem) and which is now pretty much obvious to anyone who pays the slightest attention.  (The IMF’s recent appraisal of the Russian economy pretty much puts the seal on stagnation as the new conventional wisdom.  The few Russians of stature who can speak out-and by few, I mean like one, Kudrin-say the same.)

This may seem a small story, but it speaks volumes.  For those of you cock eyed optimists who had hope that Putin would feel compelled to reform in order to stave off stagnation and rejuvenate economic growth, now is time to face reality and abandon it.

I choose (d): All of the above.

Sechin held forth on the purchase of the TNK-BP minority shareholders.  The circumstances were rather extraordinary.  Late Friday night Rosneft’s PR people called a press conference to be held the next morning.  Obviously this was something that couldn’t wait

As for the “thief” part, Sechin gave no ground on piddling compensation to be offered the minority shareholders.  (I should note that BP is a beneficiary of this theft, and arguably an accessory after the fact to Rosneft’s theft of Yukos assets.)  He went with the “we’re paying the market price” line even though the market price of the minority shares had been hammered by realistic fears that Rosneft would not pay fair value.

But that wasn’t the main focus of his remarks.  That’s where the “thug” part comes in.  He was furious-furious-that an investor had the temerity to bring up the subject to Putin:

He seemed less concerned about the substance of the shareholder’s complaint–the fund manager voiced a concern widely held in the market that Rosneft’s offer to buy out minorities was unfairly low–than the fact that the investor had taken it directly to Mr. Putin during a public question-and-answer session at an investment conference.

“This was an attempt to apply pressure, maybe even to manipulate the market,” Mr. Sechin said of the fund manager’s question to the president.

“They should have said, ‘We thank Vladimir Vladimirovich (Putin) for the opportunity to work in Russia and please let us buy something else,’” he added, with only the faintest hint of a smile.

The concern was voiced by a representative of Franklin Templeton Investments, a veteran of emerging-markets investing. Templeton, the questioner said, had bought a stake in TNK-BP Holding, the traded unit of Anglo-Russian oil giant TNK-BP Ltd. in 2006. When Rosneft bought TNK-BP in March of this year, it bought out BP PLC and a group of Russian billionaires who were the British giant’s partners, paying a total of about $56 billion in cash and stock.

The Franklin Templeton representative said last week the stock had been trading at about 85 rubles ($2.10) a share before the Rosneft-TNK-BP deal was announced. The price Rosneft paid to BP and the Russian billionaires, he said, worked out to about 100 rubles a share. Then he added that Rosneft had just announced it planned to report a gain on the transaction because auditors had found the real value of TNK-BP was even higher than what Rosneft had paid–about 123 rubles a share.

His questions were simple: he asked the president if he thought Rosneft’s 67 rubles was a fair price and if such behavior would serve as a precedent for other state-controlled companies.

But here’s the good part.  And by “good” I mean “bad”:

“They’re a great fund, but no one should put pressure on us,” he added, referring to Franklin Templeton. Mr. Sechin said he’d had his staff identify the employee who asked the question, as well as to pull the records of the fund’s ownership, how much it had earned in dividends and how it had voted at annual meetings.

“Everything suited them,” he said, marveling that after such returns the fund would accuse Russia of “putting the squeeze on investors.”

Identify the employee who asked the question, etc.  No.  One would never construe that as a threat in Russia.  Never ever ever, right?

Reality: The message to Franklin Templeton is clear: we know who you are, and if you do that again, we will make you pay.  And for anyone else that has an idea of opening his pie hole, you might want to think about that again, fool. Ask Browder about that.

As for hallucinations, there were several.  For instance, Sechin lauded Russia’s investment climate.  No, really!  He did!

Mr. Sechin praised Russia’s investment climate, repeatedly crediting Mr. Putin for passing regulatory and other changes to stimulate oil production on the Arctic shelf and in other hard-to-produce fields.

“We have reinforced-concrete political stability led by Vladimir Vladimirovich,” Mr. Sechin added.

No further comment necessary.  Other than to say that Sechin’s nose will look tanned even in the middle of a sunless Arctic winter.

Another hallucination involved the shale revolution:

His brief tour of competing oil producers covered the Middle East and Venezuela, but didn’t include North America. [Talk about whistling past the graveyard!] When asked later about surging production of shale oil and gas that’s likely to help the U.S. overtake Russia as the largest producer of the fuels in the world this year, he acknowledged the boom but seemed dismissive. Echoing a view common among Russian officials but discounted in much of the rest of the oil world, he said the impact would be limited to the “local market.”

“We won’t be competing with them on global markets,” he said.

He brushed off a suggestion from a Russian journalist that Rosneft should focus on its own vast reserves of shale oil and gas and leave its current costly drive into the Arctic offshore for the future.

“There will be competition, but we have competitive advantages,” he said.

Um, the oil market is essentially a world market, and supply shocks in one “local market”-you know, like North fricking America-have world-wide implications.  A one percent change in world output emanating from North America has pretty much the same effect on price as a one percent change in world output emanating from Iraq or Nigeria or Russia or Libya: roughly speaking, about a 10 percent impact.  In the medium to long run, there is no “local” in the oil market.  This is Oil 101.  But apparently it’s lost on the CEO of the largest oil producer in the world.

Moreover, the technology of shale is mobile, and will be, after tweaks to accommodate disparate geologies in China and elsewhere, this technology will lead to increased world output, lower world prices-and lower profits for Rosneft.

But the hallucinations don’t end there:

Russian state oil giant Rosneft has plans to extract oil in the next 100 years and sees no significant threat from the increase in shale gas production in the United States, CEO Igor Sechin told journalists Sunday.

“We have a 100 year work prospect,” Sechin said. “As for the shelf, we have no other alternative. In general, oil needs to be extracted,” he said adding that the US shale production is high-cost, which makes it impossible for export.

So shale is expensive, but Arctic projects are cheap?  Seriously?  “Oil needs to be extracted”?  What, regardless of cost?

Yes, shale oil production is expensive compared to other, more traditional resources.  But Arctic projects are incredibly costly, especially for an inefficient, technologically lagging company like Rosneft, which needs western partners to develop these resources-but can’t find the way to play nice with its ostensible collaborators.  Hell, even Shell, which is a far more technologically sophisticated company than Rosneft, and which has a proven track record with technologically challenging projects, has been humbled by its recent failures in the Arctic:

Voser, who will be replaced next year, also said Shell’s failed Alaskan Arctic exploration, marred by technical and regulatory problems, is one of his biggest disappointments on the job, the FT said in a story published Sunday.

Shell RDSA still doesn’t know if it will return to the Arctic next year or in 2015, he said. The company spent $5 billion in the Arctic without being able to complete any wells.

If Shell finds the Arctic a perhaps insurmountable challenge, one can only laugh that Sechin thinks that Rosneft will be able to produce oil in the Arctic economically, even if that oil just needs-needs, I tells ya-to be produced.

One can only marvel at Sechin’s performance. It encapsulates myriad Russian dysfunctions.  A complete disregard for property rights.  Thuggish intimidation of those who question authority.  A complete denial of reality, with the only question being whether that denial is the product of delusion, or just plain dishonesty.

As a friend often reminds me.  Eta Rossiya.

Linking to a speech by Benoit Coeuré of the ECB (who gave the keynote at the Paris conference I spoke at a month ago), ISDA’s Derivativiews blog points out how the reporting of derivatives transactions has been totally botched due to jurisdictional fragmentation:

Mr. Coeuré asks an important question about transparency in his speech: “Does…the supervisor responsible for the supervision of a large cross-border financial institution at a consolidated level have direct and immediate access to information on OTC derivatives transaction that encompass all transactions entered into by all entities of this group? Is the information accessible, in other words can it be easily aggregated across trade repositories and jurisdictions?”

He then goes on to say: “My answer would be a clear no!”

And we agree.

Mr. Coeuré went on to discuss privacy laws, blocking statutes and indemnification clauses in several jurisdictions which restrict access to the detail of OTC derivatives transactions; the inability to aggregate data across trade repositories and jurisdictions; and differences in the type and level of information required for reports across jurisdictions. He ultimately broke the problem into three main issues: information gaps, data fragmentation across trade repositories and jurisdictions and obstacles impeding authorities’ access to data.

ISDA notes that this mess was predictable, and predicted.  I agree: I was one of those who predicted this years back, based in part on my experience with attempting to create an energy data hub in 2003-2004.  Both commercial and political pressures have led to the proliferation of repositories.  Market participants and regulators have beavered away erecting a derivatives Tower of Babel, a collection of databases that serve as a barrier to the sharing of information, rather than a means of sharing information.

I would further note that there are other, deeper problems that call the entire exercise into question.  It may do more harm than good.

First, OTC derivatives represent only a subset of exposures, and therefore even if one had a single, unified database of all derivatives trades one would still have an incomplete picture of interconnections in the system as a whole.

Second, and more fundamentally,  even if regulators were to know the totality of interconnections with only a slight degree of imprecision, what could they do with that information?   The financial system is complex, and it is impossible to know how the system will react to the failure of one node (or several nodes) in that system, or even the threatened failure of some nodes.  Indeed, the actions of market participants depend on their beliefs; the stability of the system depends on how market participants behave; and the beliefs of these market participants is unknowable.  Meaning that even an accurate map of all interconnections is not sufficient to understand the susceptibility of the system to crisis: one has to know about the expectations and beliefs of market participants.

Moreover, if one views a crisis as a period when the financial system goes chaotic (in the technical sense of the term), even the slightest imprecision in measuring the state of the system (where the state includes actual interconnections/exposures and beliefs about these interconnections and the beliefs of others and beliefs about how people will act on those beliefs and on and on) means that one cannot predict how the system will behave: the defining characteristic of a chaotic system is extreme sensitivity to initial conditions, so if you measure those conditions with even the slightest error, you will not be able to predict its evolution, or its response to a shock.  Moreover, it means that one cannot predict the effect of interventions in the system when (a) the system is chaotic or on the cusp of chaos, and (b) one cannot measure the state of the system with near perfect precision.

In other words, even if the Tower of Babel problem is corrected, and one measures derivatives exposures with considerable accuracy, one can have little confidence that regulators will have the information necessary to identify an incipient systemic event, or how their interventions will affect the system.  Indeed, in crisis situations, a little knowledge can be a dangerous thing: interventions in a chaotic system based on an imprecise measurement of the state of the system, let alone an incomplete understanding of the dynamics of the system, can make things worse, not better.

This suggests that the entire enterprise of attempting to map the system is futile, and perhaps even dangerous.   This enterprise is predicated on a mechanical view, a view that characterizes the financial system as stable and predictable if you have enough information.  If instead the system is complex and on the edge of chaos, this view is completely misguided because no amount of information is enough.  Moreover, this view encourages hubris and can result in interventions that destabilize instead of stabilize.

This is the knowledge problem on krokodil.  Centralized intervention in a complex system based on imperfect knowledge is a very dangerous thing indeed.

SEC Chair Mary Jo White has made something of a stir with her recent speech on equity market structure.  One interesting thing was her attempt to downplay regulation as a cause:

Although some have argued otherwise, these developments are not attributable solely to regulatory choices. Competition plays a powerful role. Well before Regulation NMS, market participants were trading in dark pools and trading with highly automated strategies. Many jurisdictions around the world with different regulatory structures than ours are dealing with analogous issues related to off-exchange venues and automated trading.

This is a slippery and somewhat disingenuous argument. It starts out with an Obama-esque straw man: I don’t know of any credible analyst of these issues who claims the problems in market structure are “attributable solely” to regulatory choices.  Having knocked down that straw man, she focuses on somewhat off-topic technological issues and thus totally sidesteps saying what role regulation, and notably RegNMS have played.

I generally agree with her emphasis on empirical evidence as the basis for policy choices.  But the empirical research has to consider all potential issues-including potential regulatory culpability.

The part of White’s speech that attracted the most comment relates to exchange competition and the self-regulatory model:

Exchange Competition and Self-Regulatory Model

Another set of assumptions about our current market structure is related to the nature of exchange competition and the nature of the self-regulatory model itself.

Equity exchanges today operate fully electronic, high-speed trading systems using a business model that mostly was developed by electronic communications networks, or ECNs, prior to Regulation NMS. Indeed, in many ways, today’s exchanges are yesterday’s ECNs.

Exchanges differ from ECNs, however, in significant respects. Exchanges, for example, continue to exercise self-regulatory functions, even as they operate as for-profit entities.

This model for exchanges has encountered challenges. As I noted earlier, for example, the “lit” exchanges no longer attract even one-half of long-term investor orders.

From time to time, equity exchanges have adopted trading models that use different fee structures or attempt to focus on different priorities, such as order size or retail investor participation. These models have been met with mixed success, which raises the question as to whether exchanges have a real opportunity to develop different trading models that preserve pricing transparency and are more attractive to investors.

As is true for all important aspects of our current market structure, the current nature of exchange competition and the self-regulatory model should be fully evaluated in light of the evolving market structure and trading practices. This evaluation should include whether the current exchange regulatory structure continues to meet the needs of investors and public companies. Does it provide sufficient flexibility for exchanges to implement transparent trading models that can effectively compete for investor orders? Does the current approach to self-regulation limit or support exchange trading models?

This evaluation should also assess how trading venues can better balance their commercial incentives and regulatory responsibilities. For example, is there an appropriate balance for exchanges in key areas, such as the maintenance of critical market infrastructure? And are off-exchange venues subject to appropriate regulatory requirements for the types of business they today conduct?

One thing that jumps out at me is the suggestion that there is a tension between the for-profit model and self-regulatory responsibilities, with the corollary suggestion (rather obliquely made) that for-profit exchanges should be stripped of some regulatory responsibilities.

Let me break it to everyone: there is a tension between the not-for-profit model and self-regulatory responsibilities as well.  Not-for-profit exchanges were not charitable organizations.  They were established and run by very profit driven intermediaries (brokers, liquidity suppliers) who adopted the non-profit form to prevent redistribution of wealth among heterogeneous members.  This form was economically rational in floor trading days, when intermediaries and exchanges had highly specific capital that needed protection against expropriation. A big technological shock-the move to electronic trading-meant that the non-profit form was not longer needed to protect these specific investments, or to prevent exchanges from using pricing of their services to redistribute wealth among members.

As I wrote about extensively during the mid-90s, traditional exchanges did a good job at some self-regulatory functions, and a bad job at others.  Manipulation was one that exchanges policed quite badly, for instance: contract enforcement was one they did quite well.

In these papers, I identified a couple of factors that affected the effectiveness of exchange self-regulatory efforts.  One was whether the exchanges internalized the benefits.  In the case of manipulation, for instance, the effects of corners and squeezes on the derived demand for the services of exchange members did not reflect the effects of corners and squeezes on market participants generally.  The price and quantity of exchange services depends on the impact of manipulation on marginal customers, but inframarginal customers bore the brunt of manipulations.  Moreover, some effects were public bads, such as the effect of manipulation on the informativeness of prices.

Another factor is the distributive effects across exchange members.  Self-regulations that led to overall efficiency gains but hurt some members were often not adopted due to such conflicts: the battles over grain warehouses in Chicago in the 1860s and 1870s is an example.

Similar problems afflict for profit exchanges, though internalization problems are probably the most acute now: the movement to the for-profit form has reduced the conflicts within exchanges.

Back around 2000, when the move to for-profit exchanges was gaining momentum, I wrote a paper on the implications of this for self-regulation.  I put it aside.  I should probably dust it off and revise, but the basic conclusion holds true, I think: for-profit exchanges have good incentives to regulate some things, bad incentives to regulate others.  The task is to identify these various strengths and weaknesses, and allocate regulatory responsibilities accordingly, always keeping in mind that the alternative-public regulation-has its weaknesses and strengths too.

The one major issue that has brought this to the fore is the breakdowns in the SIPs that connect exchanges and are necessary for the information-and-linkages approach adopted by the SEC in RegNMS (and Congress under the original NMS mandate) to work.  This is predictable, based on the analysis presented above.  SIPs have some attributes of public goods, and no exchange internalizes the benefits and costs of SIP performance.  Not surprising, then, that this has proved to be a weak link in the current market structure.  But since SIPs have natural monopoly characteristics, it’s not an easy task to determine how they should be owned, priced, and governed.  But the question hasn’t been framed this way, which means that it’s unlikely to be answered properly.  (Recall that the old Intermarket Trading System was also a chronic problem in the pre-RegNMS world: it was sort of a joke, actually.)  SIPs are analogous to transmission in electricity, and transmission has always proved the most difficult part of the system to regulate and price.  (Yes, there are important technological differences, but the similarities are relevant.)

Some things in White’s speech appear contradictory.  For instance, she questions whether a one-size-fits-all market structure is appropriate, then denigrates exchange efforts to experiment with different models: “These models have been met with mixed success, which raises the question as to whether exchanges have a real opportunity to develop different trading models that preserve pricing transparency and are more attractive to investors.”  It seems to me that exchanges have had plenty of opportunities, and that the mixed success suggests that the potential for differentiation (including moving away from one-size-fits-all) is rather limited.

There is one form of differentiation that White seems to be quite suspicious of: trading on dark venues:

A steadily increasing percentage of trading occurs in “dark” venues, which now appear to execute more than half of the orders of long-term investors.

Combine this with her desideratum for trading: models “that preserve pricing transparency and are more attractive to investors.”  Well, here we have a great example of a non-one-size-fits-all model that is obviously more attractive to some investors, but it bothers White (and regulators generally).  One of the things that makes dark venues popular to long-term investors is precisely the lack of price transparency.   Ironically, the SEC has always claimed the markets should favor long-term investors, and indeed White starts her speech by arguing that the markets cannot serve their capital formation function without long-term investors.  Thus, the “and” in that phrase is problematic.

One interpretation is that White doesn’t want one-size-fits-all, but that the varieties that have evolved-dark venues that accommodate long-term investors and lit venues that accommodate some long-term investors and most others-aren’t to her liking.  This is not a convincing position.  It begs the question of why the long-term investors White favors prefer a venue she disfavors.  It also doesn’t come to grips with the literature which shows that off-exchange trading venues reduce trading costs for uninformed, liquidity traders-which can include long term investors who initiate and liquidate positions for non-information driven reasons.  It also is in tension with her statement that for-profit exchanges with a strong profit motive are trying to innovate: if they are losing business to dark venues as a result of, say, predatory conduct carried in lit markets, they have an incentive to devise rules and pricing structures that curb the predatory conduct and thereby attract the return of those who have fled to dark venues.

It also bears emphasis, for this point is often forgotten, that dark venues have always been with us, and that large, long-term investors have been the users of these venues.  Back in the day, this was the function of block markets.  Dark venues have largely replaced the block markets, serve the same function, and service the same investor base.  That’s true even though much of the trading on dark venues is not in blocks (although some dark markets are essentially for block trading).  As Duane Seppi demonstrated years ago, block trading and the protocols surrounding it were ways of screening out informed traders.  Dark venues have other means of performing the same function, without imposing the constraint that trades occur in blocks.

Summing up, it’s good to see these market structure issues get such serious attention.  It’s less encouraging to see that regulators are focusing on secondary or tertiary issues (e.g., whether self-regulation is incompatible with for-profit exchanges) and have certain preconceptions that makes them unduly suspicious of departures from one-size-fits-all trading that accommodate the needs of an important category of market users-indeed, the category that the SEC has long said it desires to protect. (As an aside, which I may expand upon later, the SEC’s preferences, and its suspicion of dark markets, is likely driven by political economy considerations.  Namely, exchanges exert more political influence, and have influenced the SEC to advance their interests.)

In my opinion, the SEC’s immediate priority should be fixing the SIP (if it deems that links-and-information is sacrosanct).  This fix should look at ownership, organization, and governance, based on an understanding of the public good attributes of the SIP.  (Longer term, the RegNMS links-and-information approach needs a new look.)  In addition, the empirical approach that White rightly advocates should look at dark venues through objective eyes, free from prejudices which are all too apparent (as the very term “dark” demonstrates).  It’s especially important that the reasons for the commercial success of dark markets be understood and explained before it is lamented.  A case can be made that the non-one-size-fits-all model that works best could consist of dark and light venues operating side-by-side, serving different investor clienteles.   It’s certainly a model that has existed over time, and in a wide variety of different countries.  Maybe there’s something to it.  Perhaps we should understand what that might be, before monkeying with market structure any more.

In one of those episodes of Kabuki theater so common in Russian politics, Igor Sechin and Prime Minister Dmitri Medvedev discussed buying out minority shareholders in TNK-BP.  Medvedev expressed concerns about Russian corporate governance, and the nation’s bad reputation among international investors, and suggested to Sechin that a gesture by a state corporation could help improve this image:

Warning that Russia faced an economic “abyss” if it did not push through serious market reforms, Mr Medvedev urged Rosneft to improve corporate governance. “A state company can give an example of the right way to treat minorities. This will improve the investment climate,” he said

Sechin responded by saying that the company would consider voluntarily buying out minority shareholders in the TNK-BP holding company, despite the fact that it was under to legal obligation to do so.

My first reaction was one of surprise, and positive.  Then I saw the details.  Medvedev and Sechin agreed that the minority holders would be paid a 20 to 30 percent premium over the average price over the last several months.   A premium? Great, right?

Not really.  Sechin’s previous refusal to buy out the minority shareholders had crushed the share price.  He said they’d get squat, and the stock price fell to squat.  Now he’s generously offering to pay squat plus 20 percent.  Yes, this is better than nothing, but doesn’t really represent reasonable compensation.

In other words, the stock price was predicated on an estimate of what pittance Sechin might be persuaded to part with, rather than an objective appraisal of the value of the shares.  Offering to pay a small premium over the pittance price is hardly a great boon to the minority holders.

In terms of precedent, it also creates uncertainty due to the circularity of the process.  Think about a future episode.  The price of minority shares will depend on what shareholders and potential buyers think the acquirer can be persuaded to give up in compensation.  This compensation is not based on an independent appraisal of the value of the assets but the previous price, which is based on an estimate of the compensation; this is an infinite loop with no linkage to the value of the assets which the shares give a claim to.   This makes the price indeterminate.

The only thing that likely connects the price to value is the knowledge that someone in Sechin’s position would refuse to go along with the deal if the compensation paid represented a large fraction of value.  That is, in the present instance, Sechin may be willing to act all cooperative because the stock price has been so far below value that he’s not really giving up that much.   Here the fraction of value believed acceptable to the acquirer can anchor the stock price to value-or, more accurately, some fraction of value.

For instance, say the fair value of the shares is 100 Rubles, and that it is widely believed that an acquirer like Sechin will be willing to pay 15 percent of this value to make the minority shareholders go away, or to get political pressure off his back, or to make it look like he’s being all magnanimous.  So the shares sell for 15 Rubles.  If the conjecture is correct the future Sechin will be able to get the shares for 15 Rubles, which he’s willing to pay, but which is far below value.   So again, it’s what the acquirer is willing to pay-or believes he can get away with paying to avoid political flack-rather than value that determines price.  That doesn’t provide any real protection to minority shareholders.

This means that this apparent concession really doesn’t fix the fundamental problem that vexes Medvedev.  Only some independent appraisal mechanism and a legal obligation to treat minority shareholders fairly will do that.  Tying the buyout price to the previous market price doesn’t.

Speaking of Medvedev, this Kabuki play seems to be a part of a political campaign on his part.  In addition to the colloquy with Igor, he published a long article in Vedemosti raising an alarm that Russia faced a serious risk of prolonged economic stagnation.  The central part of his diagnosis is Russia’s institutional rot, the natural state that I’ve written about since the very early days of this blog:

I believe that the protection of private property and competition remains our unconditional political priority. The Russian economy still posts low investment levels, and this is not only caused by specific arithmetic calculations of potential capital-efficiency volumes. Investors still harbour irrational fears of working in an incomprehensible and sometimes unpredictable Russia. Add to this the absolutely explainable distrust of public institutions, including the judicial system and law-enforcement agencies. This is something which is very sad. As Fyodor Dostoyevsky wrote, capital likes external and domestic stability, otherwise it hides.

Among other things, this situation is caused by the fact that many officials, judges and police officers (although, of course, not all of them) still believe that state property, and therefore state companies, have the right to better protection, and that these rights are infinitely greater than those of individuals. They also believe that the latter pursue exclusively personal interests and are therefore suspicious and must be rigidly controlled.

The most frequently quoted phrase in this (“the irrational fears”) actually doesn’t make sense: in context, it is clear that Medvedev believes the fears are very rational.  Read that way, the diagnosis makes perfect sense: it’s not all that different from what I’ve written here for years.

But when it comes to recommending reforms, Medvedev shrinks from his diagnosis and advances technocratic proposals that will do nothing to correct the very real evils he identifies in the paragraphs quoted above.  The proposal that companies like Rosneft and Gazprom create and operate their own universities is particularly risible.  Russia’s problem is not a shortage of institutions of higher education, and the idea that corrupt and hidebound entities like Gazprom or Rosneft would be able to become world class educators is so bizarre that one wonders what Medvedev was thinking.

In other words, Medvedev is playing his by now familiar role of being one of the few in the elite that speaks frankly about Russia’s serious institutional weaknesses (Kudrin being another), but being completely unable to do anything about it.  The buyout of the minority shareholders in TNK-BP is just another one of those token efforts that betray an understanding of the Russia’s fundamental problems, and the complete lack of will to do anything serious about it.

My frequent sparring partner, John Kemp of Reuters, reads the IHS study justifying the benefits of bank involvement in commodity markets, and is not convinced. I agree that the report is rather lame, but am not convinced by Kemp’s critique, and the policy implications he draws.

One of Kemp’s points is that banks are not essential to the purchase, sale, transportation, storage, or processing of commodities.  Other entities, most notably commodity trading firms like Vitol or Glencore or Trafigura, can provide the same services as the banks.

This is true, but beside the point.  There are few types of firms that are utterly essential, with no substitutes.  Even banks are not irreplaceable in the functions that Kemp, and others, agree is appropriate for them.  Their core function of providing credit can be performed by the capital markets.  Or loan sharks.

The fact that banks can profit as a result of their activities in physical commodities should create a rebuttable presumption that they are providing economic value.  In a reasonably competitive market, where costs and benefits are internalized, firms that survive do so because they can provide a good or service of equal or better quality at equal or lower cost to other potential suppliers.  Indeed, in these circumstances, all active sellers have marginal costs that are approximately equal: cost functions determine the relative outputs of the active suppliers.   Driving out suppliers who can profitably service part of the market will drive up prices, reduce output, and reduce welfare: some of the output supplied by the eliminated firms will go unproduced, and the rest produced at higher cost.

Competition is not the issue. The market for commodity intermediation is highly competitive: even the big banks account for a relatively small share of activity, and the biggest players account for no more than 5-6 percent of trading activity in any major commodity market.  And even if banks accounted for a big share, that could be due to a cost advantage.

Which brings me to Kemp’s second objection, which potentially has more merit.  The above says “where costs and benefits are internalized.”  Kemp brings up, quite properly, the possibility that banks get a subsidy as a result of too big to fail, and hence the true costs of their activities are not internalized.

The immediate implication of this is that banks are too big, and that there market share in physical commodity activities is too big.  But “too big” does not mean that the right share is zero.  Banning bank participation in physical commodity markets, or excluding them from certain activities, is likely to be an overreaction, not a Goldilocks (“just right”) strategy.  They might be too big now, but zero is almost certainly too small.

Note too that eliminating banks from physical commodity markets, or restricting their participation, does not eliminate the TBTF subsidy.  Yes, they might not be able to exploit the subsidy by getting too big in commodities, but they are not going to let the subsidy money burn a hole in their collective pockets.  Won’t let them exploit the subsidy in commodities?  They’ll find someplace else to do it.  Restricting activity in one market segment will not appreciably reduce the TBTF subsidy that banks reap.

The right way to address this problem is to find ways to get banks to internalize the true costs.  This is best done by capital requirements that reflect the risks of the activities banks engage in, and the costs associated with bail outs.  Restrictions on permissible activities are a meat cleaver approach that will not mitigate the TBTF subsidy.

Kemp also goes on about the metals warehouse games.  As I’ve said repeatedly, both here and in media interviews, banks are not uniquely positioned to engage in such sorts of shenanigans.  If the conditions are right, whoever owns the warehouses will play the games. The best way to deal with this problem is ex post deterrence, either through private action (e.g., the numerous class action lawsuits against Goldman for its alleged warehouse manipulations) or government enforcement actions.

The role of banks in physical commodity markets will remain under scrutiny-and attack-for the foreseeable future. Many of these attacks are predicated on ignorance, not to say stupidity.  Kemp isn’t guilty of those things, but his analysis is nonetheless misguided.  Even when he identifies a real potential problem-the TBTF subsidy-eliminating banks from the physical commodity market is not the appropriate way to address it.

This illustrates a general point I’ve mentioned in many forums.  Attempting to address TBTF problems, and systemic risk problems, through structural interventions such as clearing mandates, SEF mandates, Glass-Steagall, or preventing banks from participating in commodity markets, is inefficient and likely ineffectual.  It is better to operate at the level of fundamental incentives, by getting banks and other financial intermediaries to internalize the costs and benefits of their activities. This is an easy principle to state in the abstract, though hard to implement in practice: just what is the right capital charge overall, and how should different bank activities contribute to this charge?  Not an easy question to answer.  Although imperfect, that’s still a better way of addressing these problems than mandating market structures.

If you want an illustration of the primitiveness of the Russian economic and political system, and that of the systems in the Former Soviet Union generally, look no further than this story.

In terms of economic primitiveness, the fact that a dispute over potash (potash! FFS)  is elevated to a matter of state requiring the direct involvement of heads of state illustrates perfectly the dependence of FSU countries on the production and export of basic materials.  For all the yammering about economic transition, all the FSU economies, including notably Russia’s, remain dominated by the production of basic materials.  As witnessed by evidence accumulating day-by-day that the FSU countries are becoming economic satrapies of China, as demonstrated by the Chinese acquisition of a large stake in Uralkali, the mooted Chinese acquisition of huge tracts of land in Ukraine, and the plethora of Chinese energy deals in Kazakhstan and Turkmenistan.

But the episode is more interesting for its demonstration of the institutional primitiveness of Russia, and the other FSU countries.  In advanced countries, commercial disputes are adjudicated or arbitrated through institutional processes:  indeed, they would have never have progressed to the point at which Belarus and Russia now find themselves.  But the institutional underdevelopment in Russia and Belarus and other FSU states means that rule is personalized, and commercial disputes between large businesses must be resolved-or not-through the personal intervention of heads of state.

Could anything illustrate more tellingly the personalized, de-institutionalized nature of rule in Russia than Putin’s personal involvement in such a matter?  Could you hallucinate, even after a bender that would put the Hangover I, II, or III to shame, Obama or Bush or Clinton doing any such thing?  And this is not a one-off.  Putin is repeatedly involved in grubby commercial negotiations (usually over natural resources) within Russia, and between Russia and other FSU countries.

This is a perfect illustration of why I have long believed that Russia is doomed for perpetuity to exist in an economic limbo as a natural resource state falling further and further behind not just more advanced, institutionally developed nations like the US, but even other institutionally challenged countries like China.

In other words, the Former Soviet Union is Totally F’d Up.  And will remain so.

The BIS has been one of the major advocates for mandated clearing.  They have produced an analysis claiming that mandated clearing will increase GDP growth by .1 percent or more per annum.  I criticized this calculation claiming that it was predicated on a fallacy: namely, that multilateral netting and collateralization, result in a reduction in the costs of OTC derivatives borne by banks, and thereby reduce the risk that they will become dangerously leveraged.  In fact, these measures redistribute losses, and will not affect the overall leverage of a financial institution in the event of an adverse shock to its balance sheet.

Stephen Cecchetti, the head of the BIS’s Monetary and Economics Department has responded to this sort of criticism.  Here’s his argument regarding multilateral netting:

Before turning to the costs, I think it is worth responding to criticism of this approach. First, some critics have argued that, by focusing on derivatives exposures, the Group has ignored the impact of multilateral netting on other unsecured creditors. The main claim is that multilateral netting dilutes other unsecured creditors.

This is correct. Multilateral netting does dilute non-derivatives-related claims to some extent. However, this is neither new, nor is it unique to derivatives. In fact, repos, covered bonds and any other secured loans result in dilution and subordination. For repos, that counterparties can close out a position and seize collateral in default has led to comment and worry for some time. Given that this is all well known, I would think that it is already reflected in the pricing of the instruments involved. Presumably no one will be terribly surprised by this when it is applied to derivatives, and so the impact will be muted. It is a stretch to see how this redistribution of a part of the risk associated with OTC derivatives transactions increases systemic risk.

This argument totally fails to meet the criticism.

First, there has been some repricing, but it is incomplete.  Repricing only takes place to the extent that adoption of mandated clearing occurs, or is at least anticipated, and does not occur for derivatives contracts and other liabilities until they mature.  Since many derivatives and other liabilities have maturities extending well beyond the clearing implementation dates, these have yet to be repriced.

Yes, the most run-prone liabilities, such as short term debt, have been repriced, but that’s not all that important.  Even if banks adjust their capital structures to reflect the repricing, they will still have large quantities of such liabilities which are now more junior and which will pay off less in states of the world when a bank is insolvent.  The higher yield received in normal times compensates the creditors for the lower returns that they get in bad states of the world, and most notably in crisis times.  And it is exactly during these crisis times that these liabilities are a problem.  Due to repricing, there may be a lower quantity of such short term debt, but this debt will be more vulnerable to runs as a result of the subordination inherent in multilateral netting.  Excuse me if I don’t consider that a clear win for reduced systemic risk, and fear that it in fact represents an increased systemic risk.  That is no stretch at all.  None.  Cecchetti’s belief that it is a stretch reflects a cramped and incomplete analysis of the implications of subordination.

In terms of the BIS’s claim that will boost economic growth, Cecchetti’s argument does not rebut in any way what I have been saying.  The BIS argument is based on a belief that netting makes the pie bigger.  My argument is that it does not make the pie bigger, but just resizes the pieces, making some smaller and others bigger.  Nothing in what Cecchetti writes demonstrates the opposite, and in fact, his acknowledgement that netting dilutes other creditors is an admission that the effects of netting are redististributive.

Once that is recognized, the entire premise behind the BIS macroeconomic analysis of the OTC derivative reforms collapses, and the conclusions collapse right along with it.

Cicchetti mischaracterizes the critique when he insinuates that it means that netting increases systemic risk.  I’ve said that’s one possible outcome, but mainly have used the redistribution point to refute the claim (made by the BIS and others) that netting reduces systemic risk. The channel by which the BIS claims it will is predicated on the belief that netting reduces default losses rather than reallocates them.  If they only reallocate them-which Cicchetti effectively acknowledges-this channel is closed, and the asserted benefit does not exist.  It’s very simple.

Therefore, Cicchetti may “remain convinced that the Group’s analysis accurately captures the benefits of the  proposed reforms,” but his conviction is based on faith rather than economic reasoning: his attempted defense notwithstanding, the Group’s analysis is contrary to the economics.

Here’s what Cicchetti says about collateral:

A second concern that has been raised is that the regulatory insistence on increased collateralisation will simply redistribute counterparty credit risk, not reduce it. To see the point, take the simple example of an interest rate swap. The primary purpose of the swap is to transfer interest rate risk. But the mechanics of the swap mean that there is always a risk that the parties involved will not pay. This is a credit risk. In the case where the swap is completely uncollateralised, it is clear that the instrument combines these two risks: interest rate (or market) risk, and credit risk.

Now think of what happens if there is collateralisation. At first it appears that the credit risk disappears, especially if there is both initial margin to cover unexpected market movements and variation margin to cover realised ones. But the collateral has to come from somewhere. Getting hold of it by borrowing, for example, will once again create credit risk.

The point is that, by collateralising the transaction, the market and credit risk are unbundled. I would argue fairly strenuously that unbundling is the right thing to do. Unbundling forces both the buyer and the seller to manage both the interest rate and the counterparty credit risks embedded in a swap contract. In the past, some parties seem to have simply ignored the credit component. Unbundling sheds light on the pricing of the two components of the contract. A more transparent market structure with more competitive pricing will almost surely result in better decisions and hence better risk management, risk allocation and ultimately lower systemic risk. The AIG example is a cautionary tale that leads us in this direction.

I agree completely that clearing unbundles price and credit risks.  This is particularly true under a defaulter pays model, in which the CCP members bear very little default risk.   In fact, this is the focus of a chapter I’m writing for my next book.

But Cicchetti’s assertion that unbundling is a good thing begs a huge question: why were risks bundled in the first place?  By way of explanation, sort of, Cicchetti asserts, without a shred of evidence, that market participants often ignored credit risk bundled in derivatives trades.  Even if that’s true, why would they necessarily take it into consideration merely because it’s unbundled?  I think the most that can be said is that ex post it appears that market participants underestimated credit risk prior to the crisis.   And if they did this with derivatives, they did it with unbundled credits too: look at the massive repricing of corporate paper and the virtual disappearance of unsecured interbank lending starting in August 2007.

But more substantively, there can be good reasons for bundling market risk and credit risk.  I explore these reasons in detail in my Rocket Science paper, which has been around for years.  In particular, there can be informational synergies.  These are quite ubiquitous in banking, and explain a variety of phenomena, such as compensating balances which require firms that borrow from a bank to hold some portion of the loan in deposits at the same bank: this is a form of bundling.  Moreover, bundling can be a way of controlling a form of moral hazard, namely asset substitution/diversion.

At the very least, bundling is so ubiquitous in banking (and finance generally, e.g., trade credit) that it is extremely plausible that there are good economic reasons for it.  The reasons for this practice should be understood before implementing massive policy changes that forcibly eliminate it for massive quantities of contracts.  It is rather frightening, actually, that Cicchetti/the BIS are so cavalier about this issue, and are so confident that they know better than market participants.

And again, even if credit risk is priced more accurately in an unbundled world (which Cicchetti asserts rather than demonstrates), bank capital structures in an unbundled world can be fragile and a source of systemic risk.  For instance, collateral transformation trades used to acquire collateral to post as CCP margin are arguably very fragile and systemically risky even if they are priced correctly.

What’s needed is a comparative analysis of the fragility/systemic riskiness of the bundled and unbundled structures, and this BIS/Cicchetti do not provide.

Cicchetti’s speech suggests that BIS has heard the criticisms of clearing mandates, but doesn’t really understand them, or is so invested in clearing mandates that it refuses to take them seriously.  Regardless of the reasons, one thing is clear.  The BIS has taken a big swing at a rebuttal, and missed badly.

I am working on a project about the economics of commodity trading firms.  One of the interesting questions is what physical assets commodity trading firms own.  In my research on this question, in an attempt to get some historical context, I turned to the excellent Federal Trade Commission Report on the Grain Trade, a five volume study released in the early-20s.  (There is reputedly a sixth volume on manipulation which I and others-Jerry Markham, for one-have feverishly searched for without luck.)   This is truly an excellent piece of work.  Many of the analyses are off, but as a detailed portrait of the grain trade in the 1900-1920 period, it cannot be beat.  Unfortunately, there is nothing comparable for other time periods.

In perusing Volume I, on country grain marketing, I came across this choice quote from the president of the CBOT in 1887:

The alliance between railroads and elevators has resulted in reaching out after millions of bushels not naturally tributary [to Chicago] and when gathered here preventing it by such tricks of the trade as you are familiar with from ever getting away again as long as storage can be collected on it.

. . . .

The grain bought elsewhere by warehouse proprietors is promptly sold to you here on future delivery, which, however, you can only get on payment of such premiums as the urgency of demand may enable them to exact.

. . . .

While the elevator proprietors are willing to pay 1 cent per bushel more for grain to “go into store” in their own warehouses than the market price of the same grain in store . . . is conclusive that the first storage charge is not legitimate, and also that the subsequent terms of storage are unduly profitable.

Replace “grain” with “aluminum”, and you could run this as a news story in 2013.  Goldman’s operations at Metro are almost identical to the operations of the warehousemen in Chicago that President Wright fulminated about 126 years ago.

The FTC study also notes that shuttling grain between warehouses was a part of the game more than a century ago.  It quotes Taylor’s magesterial history of the CBOT, describing an event from 1896:

The Armour Elevator Co. was charged with having transferred 1,200,000 bushels of wheat from one part of the north side system to another, without inspection, on such dates that the receipts resulting therefrom were just regular on the delivery day, May 1.

And not a bankster in sight.  (It is an interesting coincidence that 1896 was the year Goldman-Sachs was invited to join the NYSE.)

The morals of the story.  First, the ability to play warehouse games is inherent to the business of public warehousing of commodities. Second, banks are not uniquely susceptible to playing those games: when conditions are right, whoever owns the warehouses can play the games.  Third, systems of self-regulation are often incapable of addressing these problems.

On the last point, it is important to remember that the seminal case in the history of regulation in the United States, Munn v. Illinois, grew out of the warehousing battles in Chicago during the Civil War and its immediate aftermath.  The Supreme Court decided that the State of Illinois had the power to regulate grain warehouses, and this decision provided the basis for subsequent exercise of regulatory powers by states and the Federal government.

In other words, what is old is new again.  Journalists and regulators and legislators act as if the kinds of games played today are somehow new and unique.  They aren’t.  The commodities business hasn’t changed that much in a century and a half.  The things that were good, bad, and ugly in 1869 are around today, and will be around in 2069 and 2169.

Legendary Chicago prop shop* DRW has sued the CFTC, asking a Federal judge to enjoin the agency from filing an enforcement action against the firm.  Based on the facts alleged in the DRW complaint, CFTC should pray that the judge grants the injunction, thereby saving the agency of total humiliation at trial.

The details are kind of geeky, but I’ll try to summarize in as close to plain English as I can.  At issue is DRW’s trading-and quoting-of swap futures contracts traded on the Nasdaq Futures Exchange and cleared on the International Derivatives Clearinghouse.  As a cleared contract, the swap futures was subject to daily mark-to-market.  OTC swaps (at the time) were not collateralized or subject to mark-to-market.  As basically anybody who has been around futures markets since the early-90s knows, this differential margining treatment should cause swap prices to differ from futures prices.

Hell, this has been known in the academic literature since 1981, with the publication of a paper by Cox, Ingersoll, and Ross.  The basic idea is that marked-to-market futures have payoffs that are linear in the interest rate, but swaps have payoffs that are a convex function of the interest rate due to discounting: futures cash flows respond immediately to interest rate changes due to daily variation margining, but the effects of interest rate changes on the swap are not realized until the expiration date of the swap.  This leads to a “convexity bias”: the futures are biased relative to the swap, due to the fact that with discounting, the present value of the swap cash flows are a convex function of interest rates.

Basically, there’s an advantage to being short the futures compared to being short the swap.  If interest rates go up, the short futures position profits, and the short can invest the resulting variation margin inflow at the higher interest rate.  If interest rates go down, the short futures position loses, but the short can borrow to cover the margin call at a low interest rate.  The  swap short can’t play this game because the OTC swap is not marked-to-market.  This advantage of being short the future should lead to a difference between the futures yield and the swap yield.

DRW recognized this difference between the swap and the futures.  Hence, it did not enter quotes into the futures market that were equal to swap yields.  It entered quotes at a differential to the swap rate, to reflect the convexity adjustment.  IDC used these bids to determine the settlement price, and hence daily variation margin payments.  Thus, the settlement prices reflected the convexity adjustment.  Not 100 percent, because DRW was trying to make money arbing the market.  But the settlement prices were closer to fair value as a result of DRW’s quotes than they would have been otherwise.

CFTC apparently believes that the swap futures and the swaps are equivalent, and hence DRW should have been entering quotes equal to swap yields.  By entering quotes that differed from swap rates, DRW was distorting the settlement price, in the CFTC’s mind anyways.

Put prosaically, in a way that Gary Gensler (the lover of apple analogies) can understand, CFTC is alleging that apples and oranges are the same, and that if you bid or offer apples at a price different than the market price for oranges, you are manipulating.

Seriously.

The reality, of course, is that apples and oranges are different, and that it would be stupid, and perhaps manipulative, to quote apples at the market price for oranges.

The CFTC is completely confused.  Shocking, I know.  Perhaps-perhaps-trading to affect the settlement price is a necessary condition for a manipulation allegation.  It is not a sufficient condition. The crucial issue is whether the trading/quoting moves the price towards the appropriate competitive price, or away from it.  Prevailing law requires a finding of an artificial price (for a completed manipulation) or the intent to cause an artificial price (for an attempted manipulation).  DRW’s trading-quoting, actually-moved the settlement price closer to the proper value, relative to OTC swaps.  That is, its activities made the settlement price less artificial.  Bidding/offering at the OTC swap yield would have been artificial because such quotes would not have reflected the substantive economic differences between futures and swaps.  Due to convexity and the lack of any adjustment for it in the Nasdaq Futures contract, there should have been differential between the two prices.  Bidding/offering at zero differential would have caused settlement prices to diverge from fair value relative to swaps.

In other words, DRW contributed to convergence of the settlement price to fair value relative to swaps.  Manipulative acts cause a divergence between the settlement price and fair value.

Many futures contracts have been mispriced for a considerable period of time post-introduction,.  Eurodollars were mispriced relative to swaps until people figured out the convexity issue in the early-to-mid-90s: the academic literature diffused into practice much more slowly back in those days.  But even simple cash-and-carry relationships have sometimes been violated in new futures.  Most notably, S&P 500 futures were mispriced for a considerable period too in 82-83, and maybe a little bit afterwards (I’ll have to go dig up the papers that provide the evidence of this).  Were people that bid/offered/traded to take advantage of/arbitrage this mispricing manipulating?  That would be an odd theory, since this trading made prices less “artificial”, i.e., closer to fair value relative to the underlying.

In a sane world-or at least, in a world with a sane CFTC (an alternative universe, I know)-what DRW did would be called “arbitrage” and “contributing to price discovery and price efficiency.”  Voluminous CFTC materials (and testimony by CFTC officials before Congress) identifies these as legitimate, and indeed salutary, futures market activities.

Another shocking aspect of this story is that the two biggest firms on the other side of the contract from DRW-Jefferies and, yes, MF Global-didn’t understand the effect of convexity.  Jefferies claims it relied on IDC’s representations that swap futures and OTC swaps were equivalent, and hence thought it was making an arbitrage profit as a result of trading the futures and swaps at a differential.  In fact, it was the source of arbitrage profits because it was trading at a differential that was too small, relative to what it should have been to reflect fully the convexity effect.

Moreover, IDC should thank its lucky stars that DRW did nudge the settlement price through its quotes.  If it had marked the futures to market at the OTC swap yield instead of the price reflecting the DRW quotes, MF Global’s position would have been substantially under margined, subjecting the clearinghouse to substantial loss (or, at least, substantial delay to recovery) in the aftermath of MF’s default.

I shake my head in amazement at all this.  Especially at the CFTC.  It stands there dumb and mute when major manipulations occur, and then leaps on trading that is manipulative only in its deluded imagination (and complete ignorance of things practitioners have known for 20 plus years).  Its manipulation enforcement is a race between Type I and Type II errors.  It reminds me of the old joke about the lawyer who said “I lost the cases I should have won, but won the cases I should have lost, so on average, justice was done.”

Well, it would be a joke, but this isn’t funny. Especially since the CFTC’s authority now extends far beyond the futures markets, which are important enough as it is, to the far larger OTC markets.  Huge sums are at risk to the ignorant judgments of the CFTC.

The CFTC has apparently adopted the William Clayton Rule: “The word ‘manipulation’ . . . in its use is so broad as to include any operation of the . . .  market that does not suit the gentleman who is speaking at the moment.” This is not a good thing, when the “gentleman speaking at the moment” exercises the power of the Federal government. Hopefully the judge will do DRW, the markets-and the CFTC-a favor by slamming on the brakes on this inane enforcement action.

*Not to be confused with a chop shop! True story. My first year at Chicago a gang ran a chop shop out of the garage next to the student housing building where I lived.  Quite an adventure when the cops raided the place at 6AM one morning.  Shots fired. Reminded me of the old Second City bit where the cop fires several rounds and then shouts “Halt!”