Streetwise Professor

Although Medvedev fulminated at the injustice of the Badinov Bank solution, subsequent Russian reaction has been more accepting: the man who matters-Putin, not Medvedev-“has decided to support it.”

Perhaps Putin is just bowing to reality.  I’m more interested in whether the deal makes economic sense, especially as compared to the levy scheme that went down in flames.

The fundamental fact is that the two big Cypriot banks are insolvent.  Assets are less than liabilities.  The resulting loss must be borne by someone or someones, specifically:

1. Equity holders. (Ha!)
2. Bondholders.
3. Unsecured depositors.
4. Secured (guaranteed) depositors.
5. Taxpayers.
6. Extraterrestrials.

With all due deference to Krugman, let’s rule out (6).  With respect to (5): (a) Cypriot taxpayers-uhm, Cyprus is bankrupt (which is why it needs 10 billion euros in bailout funds), so Cypriot taxpayers aren’t a realistic alternative, and (b) bowing to political pressure and an impending election, Merkel has ruled out German taxpayers.

So that means that the loss must be borne by those with claims on the insolvent banks.  The proper way to do it is to work through those claimants in order of seniority from junior (equity) to senior (insured deposits).  That’s what has been done now.  That’s the right way to do it.  It’s what should have been done at the outset, given the economic and political realities.

The problem with the solution that went down in flames is that it violated the priority of claims.  Apparently in an attempt to appease the Russians, Cyprus’s president Nicos Anastasiades decided to reduce the losses imposed on uninsured depositors-who include many Russians-by imposing losses on insured depositors, most of whom are the countrymen he was actually elected to represent. Moreover, the levy was imposed equally across claims on Cypriot banks, regardless of the severity of their insolvency.  This was also highly objectionable, because it meant that depositors at banks that were truly egregious in their risk taking were treated identically to those who were less egregious.  Under that rule, no depositor has any incentive to avoid especially risky and reckless banks, or to monitor bank riskiness.

The Badinov Bank alternative is therefore defensible on rule-of-law grounds, whereas the levy alternative was not: moreover, the Badinov bank alternative is economically more sensible, especially in terms of giving depositors better incentives.

The irony, of course, is that Russia would have been better under the Anastasiades alternative.  Russian depositors at the Popular Bank of Cyprus will be especially hammered under the Badinov bank alternative, because that was the baddest bank of them all.  Whereas they were looking at a 10 percent loss under the levy scheme, they are now looking at losses upwards of 30 percent.

Oh well.  That’s the way the seniority cookie crumbles.  And that’s how it should be.  Let the crumbs fall where they may.

The contours of the latest deal between the EU and Cyprus are becoming clear.  No “levy” on deposits.  Deposits under 100ks will not be touched.

In place of the levy, Cyprus will move to a good bank-bad bank structure.  All deposits less than 100k will go to the good bank.  All deposits over 100k will go to the bad bank.  Since the bad bank’s assets will be, well, really bad, its depositors will get cents on the euro.  Estimates are that the bad bank depositors will suffer losses of between 30 and 90 percent.

A large fraction (most?) of the bad bank deposits will be Russian.  Meaning that Russians will take a big hit.

This is pretty much what the IMF and the Germans wanted initially, but backed off from in the face of intense opposition from Cyprus-which didn’t want to shaft the Russians, in the hope of perpetuating its status as an offshore haven.

Imposing big losses on depositors, insured or not, makes runs in Spain and Italy more likely in the event that it appears that they will have to throw themselves on the tender mercies of the Europeans (read Germans).

The Russians will no doubt be furious, setting up potential confrontations going forward.  The Cyprus drama seems to be a proxy war between Russia and Germany, which is hard to explain given Germany’s previously benign approach to Russia: for instance, Germany scuppered US attempts to advance the progress of Georgia and Ukraine towards Nato membership.  So why is Germany so insistent on doing something that inflicts large losses on Russia-and elite Russians?  Can the impending German election explain it?  Or does Germany think that the fate of the Euro is on the line, and if saving the Euro p*sses off the Russians, so be it.  Or is it something else?  I wonder.

Regardless of the exact reason, Russians are now effectively the not so proud owners of a bad bank.  Bank Badinov, as it were:

I’ve been asked for my take on the Senate report/hearings on the London Whale.  I’m responding more out of a sense of duty, rather than any actual enthusiasm for the subject.

There are two issues that need to be distinguished, IMO: the operational aspects of JPM’s CIO, and the economic substance of the transactions that cost the bank billions.

The operational aspect is indeed appalling.  The reliance on a spreadsheet with manual inputs to quantify the risks of the CIO is truly appalling.  Division, multiplication-whatever!   The failure to take into account market liquidity, and the ability to get out of a huge position in the event that circumstances changed.

The battle over marks-hardly surprising.  It has always been so, and will continue to be so long after we have all shuffled off this mortal coil.

With respect to the economic substance, I don’t have much to add beyond what I said last summer, or beyond what the wickedly sardonic Rhymes With Cars and Girls has written over the past days.  I encourage you to read Crimson Reach’s posts.

In a nutshell, Crimson ridicules the presumption that banks can invest in ways that are immune to the risk of loss, and mocks the Shocked! Shocked! response when losses are actually realized.  Relatedly, he eviscerates the attempts to distinguish between “hedges” and “speculative” trades.

These distinctions are indeed Talmudic.  Any investor-including banks-makes risk-return trade-offs.  With respect to banks particularly, they are in the business of taking credit risk.   There are myriad ways of taking on credit risk.  Making loans.  Buying or shorting corporate debt.  Buying or selling CDS .  What really matters is the risk of the overall portfolio.  There are many ways to achieve the same risk profile.  And since banks inevitably take on risk, there are many ways to lose money.  And believe me, banks have found them all.  Sovereign debt (remember the LatAm debt crisis, anyone?), mortgages, corporate debt, consumer lending.

What JPM described as a “hedge” was really a trading strategy was not a mechanical offset of an existing position.  It was designed to perform (relatively) well in a particular state of the world, i.e., another financial crisis.  In that sense, it was taking a view on the potential damage associated with that state of the world, and the likelihood of that state.  That state didn’t occur, and the position performed badly.

Like I said, there are myriad ways to invest or trade based on that view, and there’s virtually no way to prevent banks from investing or trading based on their views on risk.  That’s what banks do.  Deal with it.

These views will often be wrong.  Which is why banks frequently lose a lot of money.  When they share the same views, and hence trade/invest the same way, they will lose money at the same time: that’s when we have a systemic risk problem.  Again: LatAm sovereign debt in the ’80s; mortgages in the ’00s.  The blessing of the JPM case was that it was pretty much alone in its strategy.

Insofar as the atmospherics are concerned, I am sure that any forensic examination of any of these loss-making episodes would reveal the same kinds of behavior documented in the Senate report.  The same duplicity.  The same attempts to avoid blame.  The same attempts to defer recognition of losses.  The same arguments and backbiting.

The biggest problem with JPM was that, well, it was big.  If you look at many major financial debacles, a common feature is that big institutions make bets that are so big that they become price makers rather than price takers.  When the bets go wrong, and they want to get out, or to reduce exposure, size becomes a liability, rather than an advantage.  Size creates positive feedbacks, and in financial markets, positive feedbacks have very negative effects.  The holder of a big position suffers losses, and tries to reduce exposure: they are so big that these attempts move prices against them, thereby exacerbating the losses.

That’s what happened to LTCM.  That’s what happened to JPM’s CIO.  The difference was that JPM had the capital to survive: LTCM didn’t.  Another good thing.

Carl Levin is using the Whale Trade to dragoon the regulators into implementing the Volcker Rule, which is intended to prevent banks from “trading”, and to limit their activities to “lending” instead.  Again color me unimpressed.  Banks have proved since time immemorial that they can lose vast sums lending, thank you very much.  One of the virtues of trading is that the discipline of mark-to-market forces realization of losses sooner: it’s harder to conceal losses on the trading book than the banking book.  (I understand the complexities here.  Especially when banks are subject to capital requirements, realizing losses can force banks to shrink balance sheets in ways that generate fire sales and positive feedbacks.)  Yeah, the traders at CIO tried to finesse/manipulate the marks to defer recognition of the losses.  But they wouldn’t have even had to resort to chicanery had these losses been on the banking book: in a (perhaps perverse) way, the frantic attempts to jigger the marks demonstrate the ruthless disciplinary effects of marking to market.

In brief, drawing distinctions between “hedging” and “speculating” or between “trading” and “lending” or “investing” or “market making” is typically futile.  Banks can f*ck up-or make lots of money-doing any of these things. And have.  Rather than attempting to micromanage the activities of banks, it’s better to focus on making sure they have the incentives to take risks prudently, and have the capital to absorb the inevitable losses.

Which is why, as far as I am concerned, the would-be Ahab Carl Levin set out to kill a great whale, and brought home a minnow.

SWP, 18 March 2013: “Cyprus: The Essence of FUBAR.”

Krugman, 21 March 2013: “Cyprus: The Sum of All FUBAR.”

It wouldn’t be the first time someone has lifted something from SWP, but Krugman?  The mere possibility forces me to re-evaluate my thinking on Cyprus.  But then again, you know what they say about blind hogs and acorns.

Around here, Russian Deputy PM Dmitri Rogozin goes by the sobriquet “Rogozin the Ridiculous” for his frequent buffoonery.  This has apparently elicited envy from his ostensible boss, Prime Minister Dmitri Medvedev.  Responding to the meltdown in Cyprus, the man best known for bopping to “American Boy” and forgetting to put an SUV in park in the midst of a crowd made the following suggestion:

Russia, involved in a global uproar around the Cyprus bail-out plan, should think of creating its own off-shore zones in the far-east region by the Pacific Ocean, Prime Minister Dmitry Medvedev said Thursday.

. . . .

“Maybe we should consider creating a [special] zone in the far east. We have many fine places — Sakhalin, Kuril Islands. Maybe as well a part of our money, which is in Cyprus and other zones…which are not being mentioned for obvious reasons, like BVI (British Virgin Islands), Bahamas etc. will come to us,” Mr. Medvedev told a government meeting.

Mr. Medvedev added that such initiative will contribute to development of the far-east region.

You know, I always get the BVI and the Kurils mixed up.  Ditto the Bahamas and Sakhalin.  Luxembourg, Jersey, Siberia.  Who can tell them apart, really?  They’re all such “fine places.”  TFF.

I’m dying here.  Seriously.  I can’t remember when I’ve heard anything so stone cold idiotic.  And I’ve been following Eurotard pronouncements on Cyprus quite closely.

So where should these “special zones” be?  Why do they have to be islands?  Siberia is vast, and there are many places that could use an economic boost.

I have an idea: what about Chita?  There’s already an (ex) billionaire there.

Better yet: what about some former Gulag establishments?  I’m sure they could use an economic boost.  Kolyma, for instance.  It’s synonymous with gold, after all.

Of course climate-and the lack of, you know, actual people-isn’t the only thing that makes Siberian locales unlikely sites for financial centers that cater to the rich.  Not even the most important thing. Global warming could turn Siberia into Miami and the place would still be a very hostile climate for foreign money, because of the lack of property rights and the rule of law in Russia.  Note that Cyprus was a financial player primarily because Russians wanted to get their money out of Russia: if the Russians want to get their money out, who in their right mind would want to put their money in?

Indeed, capital flows out of Russia continue apace, to the tune of $16 billion in the first two months of the year, an interesting contrast to the $10 billion for the entire year predicted by the Russian Central Bank.  I say again: if Russians are frantic to get their money out, who with two synapses to rub together wants to put their money in? Into freakin Siberia no less.

Utterly ridiculous.

But Rogozin is not going to take this lying down.  Apparently in anticipation of Medvedev’s challenge, Rogozin preemptively doubled down on ridiculousness, by appealing to Steven Seagal to lobby Congress to relent on restrictions on the importation of Russian sporting rifles.  Where to begin? Like Steven Seagal would matter even when there isn’t anti-gun hysteria in DC.  And how absurd that a Deputy PM of a country that demands to be taken seriously is reduced to appealing to a washed up actor  who was something of a joke even at his prime to help out a minor Russian industry.

As inane as Rogozin’s appeal is, it pales in comparison to Medvedev’s suggestion.  The Kurils as a financial center.  Such a fine place.  A fine place indeed.

I can’t stop chuckling.

Rosneft closed the TNK-BP deal today, and is crowing that it is now the world’s largest publicly traded oil company.  Measured by production and reserves that’s true.  By market capitalization-not even close.  And that disparity between size measured by production and size measured by market cap is very, very telling.

Per its press release announcing the original deal, Rosneft compares itself to ExxonMobil (XOM).  It notes that Rosneft’s production will be nearly double XOM’s, which is in turn substantially larger than the production of Chevron, Shell, Total, etc.  Its reserves will also outstrip XOM’s and all the other non-NOCs.

Market cap? Totally different story:

Rosneft market cap: $82 billion.

XOM Market cap: $397 billion.

Chevron Market cap: $233 billion.

Shell Market cap: $210 billion.

BP Market cap: $129 billion.

Total Market cap: $112 billion.

So Rosneft produces more than XOM, and has more reserves, and has about 1/5th of the market cap.  It has a smaller capitalization than other firms that it dwarfs in terms of production and reserves.

And that’s Russia in a nutshell.  It is grossly inefficient at creating value.  Think of what ExxonMobil or Chevron or ConocoPhillips could do with access to Rosneft’s reserves-in a world where property rights and the rule of law were respected.  Think of what their market caps would be if Rosneft’s reserves were in North America, rather than Russia.

In other words, the yawning gap between Rosneft’s standing in the production table, and its placement in the market cap table is a damning indictment of Russia.

And, believe it or not, as bad as Rosneft is, it’s not the worst Russian energy behemoth.  That dubious distinction goes to my fave, Gazprom.  Check out this article from the Economist that provides the gory details.  But this shouldn’t be news if you’ve been hanging out here at all over the past 7 years.

One Cyprus scenario that has received considerable hype is that Gazprom will bail out the country in exchange for rights to develop its offshore gas resources.  IMO, this reflects a fundamental misunderstanding of Gazprom’s interests.  If anything, Gazprom has an incentive to pay to ensure that Cyprus’s gas reserves are not developed.

That is, Gazprom has every reason to want the gas to remain under the sea.  Eastern Med gas would compete with Gazprom’s Russian production: if Gazprom controlled Cyprus’s gas, sales from these fields would cannibalize sales of Russian gas.  Meaning that Gazprom has no real interest in developing Cypriot gas-to the contrary.

Obtaining exclusive development rights would give Gazprom the right to not develop, and to prevent anyone else from doing so.  This would suit it quite well, and it might be willing to pay something for that right.  But as desperate as Cyprus is, it has to realize that giving Gazprom control over its gas destiny would deprive it of the future revenue its resources could generate.  It is highly doubtful that Cyprus could negotiate a deal that would effectively compel Gazprom to develop the country’s gas.  Therefore, by dealing with Gazprom it would essentially be writing off any prospect of enjoying the benefits of future gas production.

This means that Gazprom’s interests and Cyprus’s are not aligned: the latter wants to maximize the commercial development of its gas fields, the former has no such interest.  Cyprus’s horizon might be very short, given its pressing financial needs, but it would have to discount the future extremely heavily to make a deal with Gazprom remotely rational.  I consequently deem it very unlikely that Cyprus and Gazprom could reach a mutually beneficial deal.

Development rights to Cyprus’s gas might be valuable collateral for loans that ease the country’s current financial straits.  But Cyprus should look energy firms whose interest is to maximize the commercial prospects of its gas resources, rather than Gazprom, which would like nothing better than to sabotage their development.

Just because I find the expropriation of Russian deposits in Cyprus wrong doesn’t mean that I’ve gone soft on Russia.  To the contrary, my criticism of Russia and my criticism of the Cypriot confiscation grow from the same roots: a belief in the rule of law, and a deep dislike for the natural state.

A couple of stories along those lines.  First, a Russian court permitted a Russian firm, Agroterminal, to walk away from an interest rate swap it had entered with the Italian bank Unicredit:

The court’s ruling was based on a clause in the swap documentation that says a party can unilaterally terminate if there are no outstanding obligations at that point. Agroterminal had made one of the swap’s quarterly payments to UniCredit Bank and terminated immediately afterwards, arguing that as the new quarterly payment had not been calculated, there was no outstanding obligation.

Put differently, per the Russian court’s interpretation, the party to a swap has the ability to walk away at any time between payment dates.  Yeah, the market will totally work under that interpretation.  It turns the swap into an option: each party has the choice to walk away when the swap is underwater immediately after each calculation date. Since the swap will be underwater to one of the parties, this means that the swap is a non-starter.  Not a forward starting swap: a non-starting swap.

The lawyers quoted in the Risk piece attribute the court’s decision to ignorance and naivete.  Actually, what is naive is that interpretation.  Maybe the court was playing dumb, but it is pretty clear that Agroterminal had the home court advantage-literally.  That is, the court was just favoring a Russian firm at the expense of a damn furrin’ bank.  The decision is transparently silly: if one would take it literally, any floating rate claim (e.g., a floating rate bond) would be unenforceable between payment dates.  The Russian court was looking for some fig leaf to justify stiffing the Italians, and it found it.  Go figure.

The second story: Putin’s judo buddy Arkady Rotenberg has made billions on contracts for the Sochi Olympics:

Those contracts, which number at least 21, include a share of an $8.3 billion transport link between Sochi and ski resorts in the neighboring Caucasus Mountains, a $2.1 billion highway along Sochi’s Black Sea coast, a $387 million media center, and a $133 million stretch of venue-linking tarmac that will double as Russia’s first Formula One track.

Wow.  I keep kicking myself  for not taking up judo (but wouldn’t kicking be Karate-related? Whatever).  Arkady is not just the best producer of steel pipe for gas pipelines, he’s also the best builder of transportation systems, highways, media centers, and Formula One tracks.  His personal connection with Putin is no doubt totally coincidental: can he help it if he  has such varied talents?

These two stories illustrate different aspects of the Russian natural state.  The elites get fed. Kormlenie lives.   Sometimes courts do the feeding.  Sometimes the government feeds its friends, through contracts or restrictions on competition.  But the natural state rewards the connected.

And this is Russia’s curse.  This is why it is on the hamster wheel from hell.

I’m talking about the Brussels Bozos, so the post title is a completely rhetorical question.

What I’m referring to specifically is that the Eurocrats were supposedly “blind-sided” by the opposition to the depositor bail-in in Cyprus, and the impending defeat of the proposal in the legislature.

What, did they think that Cyprus would roll over and sheepishly-and I do mean sheepishly-comply with the EU’s dictates?  Did they really think that local politics wouldn’t rear its ugly head, and disrupt their orderly little world?

The sad thing is that I think the answers to those questions is “yes.”  Or, more accurately, “YES!”  The EU is an elite project and the elites presume that the hoi polloi will slavishly adhere to their master’s dictates.  That’s probably true on small matters.  Even medium-sized matters.  Perhaps many big matters.  But to Cyprus, this is an existential matter.  What does Cyprus have to lose?  Yes, the EU-and the Cypriot government-are telling horror stories about the nasties that await if they reject the monster mash bailout/bail-in, but the consequences of the monster mash are bad enough that it is perfectly understandable-to normal, sentient people, anyways-if the hoi polloi are willing to take a roll of the dice.  What’s more, such a reaction to a dictate from afar is more than perfectly understandable.  Human beings being human beings, damn them, will often refuse to take their medicine just because they are being forced to.  But I guess I am expecting way too much when I suggest that the Eurotards should actually condition their policies on an understanding of human nature in its fallen, tragic state.

The Euros choices were two: bailout Cyprus completely, or do the monster mash of bailout and bail-in.  Helluva choice.  Either alternative would have pernicious consequences in Spain, Italy, etc.   Encourage runs, or encourage moral hazard and brinksmanship.  And the fact that those are the choices is exactly why the Eurozone and the EU are beyond absurd.

The clearing and reporting requirements of Frankendodd have barely gone into effect, and the unintended consequences are already beginning to pile up.  Who coulda seen that coming, eh?

Even I couldn’t have made up the bestest of them.  Namely, as a result of the SEC’s bizarre portfolio margining rule, ICE has said that it will not clear single-name CDS.  You know, the weapons of financial mass destruction that were supposed to be the reason for needing a clearing mandate in the first place.  So ICE won’t clear the poster children for the clearing mandate.  Like I say: you cannot make up this stuff.

From Risk:

Ice Clear Credit has shelved plans to clear single-name credit default swaps (CDSs) for clients of its member firms, as a result of a new Securities and Exchange Commission (SEC) policy on portfolio margining. Under the terms of that policy, circulated late on March 8 – the last working day before the start of mandatory clearing for CDX index trades in the US – clients would be able to benefit from risk offsets between cleared index and single-name contracts, but the vast majority would be charged twice the margin calculated by a central counterparty (CCP).

The move sparked a furious response from some buy-side firms and has now dissuaded Ice’s CDS clearing house from offering the service at all.

“Last Friday, the SEC issued a temporary approval requiring broker-dealer futures commission merchants (FCMs) to charge two times the initial margin requirement of the CCPs. This was unfortunate, so we made a decision, based upon that unexpected development – news of which we received very late in the day on Friday – and based upon input from many clients, that it would be better not to offer single-name clearing under those conditions than to make single names available,” Peter Barsoom, chief operating officer of Ice Clear Credit, told attendees at the Futures Industry Association (FIA) annual conference in Florida last week.

The SEC policy gives temporary approval for an FCM to allow cross-margining if it collects 150% of the margin required by a CCP, but only if the client has “virtually no credit risk”. For all other clients, 200% must be collected on positions held in the portfolio margin account, which participants say would apply to most buy-side firms.

Portfolio margining across asset classes is theoretically beneficial, but practically dicey due to the instability of correlations, which often result in positions being undermargined during conditions of market stress.  And yes, individual name CDS and indices can diverge, again particularly during periods of financial stress.  But a portfolio consisting of a position in an index and offsetting positions in single names (especially names in the index) is less risky than either leg on its own.  This means that it is possible to improve capital efficiency while holding risk level constant by giving margining offsets for portfolio benefits.  But noooooooooooo.  In its infinite wisdom, SEC has decided to punitively margin these portfolios.  This reduces substantially the benefits of clearing individual name CDS, so ICE says to hell with it.

Again, the irony is almost too much.  The risks of single-name CDS were constantly invoked to justify the clearing mandate.  Those arguments were largely bogus, but regardless, due to regulations adopted to implement the mandate, single-name CDS will not be cleared for the foreseeable future.  Yay!

This is yet another example of the perverse effects of regulatory setting of margin levels.  I’ve been saying this so much I’m blue in the face: you could call me the smurfwiseprofessor.   For the zillionth time: regulatory margin setting is a form of price control, risk price control specifically.  Price controls never work.  Worse than that, price controls always lead to distortions.  First with futurization and now with portfolio margining, we are seeing these distortions appearing, big time.  And they’ll likely only get worse, when margins on non-cleared swaps are finalized.

Regulators have neither the information or incentives to set these prices right.  They bewail regulatory arbitrage, but their attempts at price control are the destined to set off a regulatory arbitrage land rush.

Sheesh.

But it gets better!  Even the seemingly banal task of reporting swap trades is overwhelming the CFTC.  According to Scott O’Malia, they cannot find a London Whale in a phone booth:

Dodd-Frank Act derivatives rules are failing to give regulators a full picture of the swaps market and wouldn’t help them detect a loss similar to JPMorgan Chase & Co. (JPM)’s London Whale trades, according to Commodity Futures Trading Commission member Scott O’Malia.

Swap-trade data the agency has been receiving since the end of last year from repositories including the Depository Trust and Clearing Corp. is inadequate to identify large positions and have overwhelmed government computer systems, O’Malia said in a speech prepared for a Securities Industry and Financial Markets Association conference in Phoenix.

The data “is not usable in its current form,” said O’Malia, 45, one of the agency’s five commissioners. “The problem is so bad that staff have indicated that they currently cannot find the London Whale in the current data files.”

. . . .

Different swap dealers and trading counter-parties are using their own reporting formats because the government failed to specify standards, O’Malia said.

“It means that for each category of swap identified by the 70-plus reporting swap dealers, those swaps will be reported in 70-plus different data formats because each swap dealer has its own proprietary data format it uses in its internal systems,” he said. “The permutations of data language are staggering. Doesn’t that sound like a reporting nightmare?”

The CFTC’s computer systems are failing to handle the incoming data. “None of our computer programs load this data without crashing,” O’Malia said.

This should be no surprise.  The issues with CFTC computers particularly.  The GAO issued reports in the ’80s ripping the agency for its IT dysfunctions.

Frankendodd has barely come to life, and it is already wreaking havoc.  I am sure there are more good times to come!

And I am totally, totally sure that Obamacare will work just as well.  No prospect for unintended consequences there!