Streetwise Professor

Not long ago I wrote a post about commodity forward curves, focusing on the confusion between “backwardation” as the term is used in the market, and as misused by Keynes, to the confusion of many.  The basic point was that  Keynesian “normal backwardation” stories cannot explain directly observable forward curves.  Normal backwardation is about risk premia–differences between futures prices and expected spot prices–and these risk premia are not observable directly.

For an asset that is always in positive supply, there can be backwardation in the Keynesian sense but the forward curve will always be at full carry.  Arbitrage considerations drive the forward curve, and risk preferences of the marginal speculator affect both spot and futures prices, without affecting the spot-futures spread.  In essence, if the futures price is downward biased, the spot price will be less than the present value of the expected spot price; this price depression causes an appreciation in the spot price that rewards someone holding the asset for the risk, and this upwards drift over and above the risk free rate is exactly the same as the upward drift in the futures price.  Changes in risk preferences affect both spot and futures prices in the same way by the same amount, leaving spreads unchanged.

But commodities are not always in positive net supply.  There are sometimes stockouts.  Indeed, stockouts must occur in an efficient equilibrium, as if not, some units of the commodity would be produced but never consumed, which would be wasteful.

If risk preferences are to affect the forward curve, then, it must be through their effect on stockholding.  I have investigated this using a dynamic structural storage model of the kind that I examine in detail in my forthcoming book.

The technical details in a nutshell:  I utilize a simple model in which there is one random, mean reverting demand shock; that is, the demand shock follows an O-U process.  Production costs are subject to decreasing returns.   I solve the dynamic programming problem giving the optimal storage rule using the standard machinery.

To take risk preferences into account, I take a trick from contingent claim pricing theory.  If the marginal speculator is risk neutral, the forward price is the expected spot price, where expectations are taken with respect to the true (physical) probability measure.  If the demand shock risk is priced, however, due to risk aversion, the forward price is the expected spot price, where the expectations are taken with respect to an equivalent measure.  The demand shock process in the equivalent measure has a “drift” that differs from that of the process under the physical measure.  A negative drift adjustment means that the forward price is downward biased (Keynesian backwardation).  A positive drift adjustment means that the forward price is upward biased.

I solve the dynamic program for the storage problem under three values of the drift: zero, as under the assumed physical measure, plus 5 percent and minus 5 percent.

The results are interesting, and intuitive (I think, anyways).  The drift–and hence risk preferences–have a first order effect on inventories.  With downward bias, inventories are lower than under the physical measure.  Intuitively, downward bias makes it costly to hedge inventories, so inventories are smaller.

I’ve studied the performance of these model economies using long simulations.  Interestingly, even though inventories are smaller in the downward biased economy, the effects on prices are relatively small.  Plots of the spot prices (based on the same sequence of simulated shocks) from the two economies are almost on top of one another, and the average difference in prices across the simulations is about 1 percent.  There is a slight difference in price volatility (about a 5 percent difference).  Volatility is higher in the downward biased economy as demand shock-buffering inventories are smaller in that economy.  Importantly, prices are highly correlated across the two economies.  Demand shocks are the main drivers of price movements in both economies, and for an identical set of demand shocks, price movements are highly correlated.

Spot-forward spreads are affected somewhat.  (I simulate a spot-3 month spread).  Backwardations are more pronounced, and more frequent, in the downward bias economy.  This is because stockouts are more likely in this economy due to the smaller stockholdings.  But overall, the differences in calendar spreads between the two economies are not large (although they are larger than the price differences); the time series plot of the simulated spread for the downward biased economy is a slight displacement of the simulated spread for the risk neutral economy.  Backwardations peak at about the same times in each simulation, and contangoes/full carry periods exhibit large overlaps (though not complete overlaps, because there are times that the downward biased economy exhibits departures from full carry when the risk neutral economy does not).

One key result is that almost never in the simulations does a substantial backwardation exist in the downward biased economy while the risk neutral economy is at full carry.

Results for the upward biased economy are symmetric.  Inventories are larger, price volatility smaller, and prices about the same in the upward biased economy as in the risk neutral one.  Spreads tend to be closer to full carry, and backwardations are not as extreme, although the timing of backwardations is highly coincident in the two economies.

This has implications for the speculation debate.  Changes in market structure that lead to increased integration between a commodity market and the broader financial markets can, in theory, have an impact on the behavior of the commodity market.  In general, if you believe that a commodity market that is, as in the Keynesian treatment, isolated from the broader financial market exhibits “normal backwardation”, then the entry of diversified speculators that results in a dissipation of downward bias will have some effect on prices and spreads, and potentially a big effect on inventories.

The effect on prices and spreads is likely to be very hard to detect.  Even with a relatively big bias like that I assumed in the simulations, the effects on prices and spreads are not large.  Scholars have had a very hard time detecting any risk premium/bias in forward prices going back to the seminal contribution of Telser in 1960.  Certainly, there are no reliable estimates of bias as large as I assumed in my simulations.  This suggests that any effects of increased speculation on price bias/risk premia would be too small to have any effect on prices and spreads that could be identified reliably.

So, I am skeptical that any “financialization” of commodities that has occurred in recent years has had an effect on price levels or forward curves that can be distinguished against the normal noise in prices and spreads.

It should be noted, moreover, that integration of the commodity markets into the broader financial markets leads to consistent pricing of risks across markets.  Indeed, arguably differences in risk prices is a major driver of flows of capital.  If, for instance, a commodity market (say, oil) is not perfectly integrated in the financial system, so the price of oil price risk is higher than the price justified by risk premia on other investment opportunities in the economy, investors have an incentive to take on more oil price risk in order to capture its too high price. This will reduce the bias.

Integrating fragmented markets and equalizing price differences is typically efficiency enhancing.  It leads to a more efficient allocation of risk.  That’s a big part of what capital markets should be about.

In the commodity case, if the isolated commodity market exhibits downward biased forward prices, the entry of speculative capital that reduces this bias makes hedging cheaper, and encourages the holding of larger buffer stocks.  This reduces price volatility.

Phil Verleger has argued that this process has occurred in the energy markets.  That due to greater financialization, inventories are larger.  He points to the specific case of heating oil, and argues that recent stock buildups encouraged by more speculative activity in the market have helped prevent big price spikes during cold snaps.

These conclusions are also diametrically opposed to the scare stories that are repeatedly told about the effects of the entry of financial players into the commodity markets.  People telling those stories–and you know who they are–assume that the good old days when commodities and finance didn’t mix (which was never completely the case) were some sort of golden age, and that the entry of financial players has upset the operation of the market.

The simple model I’ve set out here implies that such entry may indeed change the market, but in a salutary way by leading to a more efficient allocation of risk.  The effects on price levels and spreads are likely small, and certainly not  immense, as the commodity Cassandras have asserted.  The effects on inventories are likely larger, but this effect is salutary, and tends to reduce price disruptions in the market.

The basic moral of the story: be very skeptical about claims that changes in the degree of financial participation in commodity markets have first order effects on prices and spreads.  Don’t try to explain changes in the shape of forward curves based on changes in speculative activity in the markets.  Intertemporal optimization–adjustment of inventories–in response to fundamental shocks is the most important driver of forward curves, and changes in financial participation likely have second or third order effects on prices and spreads.

Dripping with condescension, Timmy! blew off the concerns of, oh, I don’t know, just about everyone in every kind of business about the effects of the regulatory avalanche that the administration and Congress have unleashed.  No sign here of that deep empathy that is supposedly he hallmark of Obama appointees (h/t R):

“Businesses always want their taxes lower and always want to live with low regulation,” Geithner said. “There is nothing remarkable, or particularly interesting frankly, that we’re in the midst of another debate, which you hear in almost any administration, with people looking for ways to help affect the outcome on the basic path of regulation and taxes.”

. . . .

But when asked a third time by The [Daily Caller] to address the [Business Roundtable] memo, Geithner said it was “a long, diffuse list of familiar concerns, again reflecting nothing remarkable … in the fact that business would like to operate with fewer restrictions.”

Translation: “The concerns expressed from coast-to-coast by businesses large and small, in virtually every industry, are not legitimate.  They are just petty, grubby attempts to achieve favorable regulatory treatment and reduced taxes.  Those who advance these concerns are self-interested and mercenary, and beneath the contempt of a high minded Olympian such as I.  Let them eat regulation.”

Astoundingly, Geithner dismisses any idea that the financial deform and health care bills are creating spending-suppressing uncertainty:

Geithner contested the idea that the health and financial regulation bills have made it more difficult for businesses to plan for the future.

“The basic framework is set. And that should help again give people a lot of clarity about what the basic rules they’re going to operate under is [sic],” he said. “But of course there’s a lot of rule-writing design, and there should be. A lot of the existing set of rules, muck of rules, were not any good. And so you want people to go back and revise and reform.”

Anyone who could say this is either a mendacious liar or a clueless clown.  (And yes “both” is making a strong run for the money.)  In the financial bill alone, there are at least 243 rules touching on every aspect of banking, securities, and derivatives markets that remain to be written: the true total is probably higher.  Nobody knows what those rules will be.  Nobody knows how those rules will interact.  Nobody knows how businesses and households are going to respond to this blizzard of new ukases.

A lot of clarity my [insert body part of choice here]. “Revise and reform” suggests an incremental process to fix known problems.  In contrast, what we face in the coming years is anything but incremental, but is instead a wholesale re-engineering of the entire financial sector.  And the same is true of the health care legislation.

Let’s just take one slice of one piece of legislation: the derivatives title of Frank-n-Dodd.  What has to be cleared?  No idea.  What will margin requirements be?  Who knows?  What capital requirements will regulators impose?  Oh, probably somewhere between zero and 100 percent.  Who will be exempted from the clearing requirements?  I’ll get back to you on that.  How will derivatives be traded (e.g., WTF is a “swaps execution facility”)?  I haven’t the foggiest idea.  What will energy position limits be?  Ditto.  And on and on and on.

Then, once you’ve finally learned what the rules will actually be, now try to figure out how market participants will respond to them.  What will happen to credit?  Prices?  Entry and exit?  Liquidity?

I talk to quite a few people in finance and energy on a regular basis.  A big part of the reason that I talk to them is that they’re trying to figure out what the hell is in the bills, how regulators are going to respond, and what the implications are for their businesses, and they figure that maybe I have some insights onto that.  And my answer is: I only wish I knew.

“A lot of clarity.”  All that people are clear about is that NOTHING is clear.  As a result, the pucker factor is quite high.

In typical administration fashion, Geithner admits that there is uncertainty out there, but this has nothing to do with anything the administration or Congress has done.  It’s just a psychological phenomenon, a sort of financial post traumatic stress syndrome dating to 2008–conveniently before Obama and Geithner arrived to save us peons:

“The big uncertainty that the world is still in … is that people, again, scarred by the trauma induced by the crisis are still looking to see how strong is growth going to be,” he said.

No, Timmy!  The big uncertainty is that, letting “no crisis go to waste,” the administration and Congress have played the Sorcerer’s Apprentice, and cast spells touching on every aspect of the economy, the effects of which by their own admission they have not the slightest understanding.  (Cf. Nancy Pelosi: “And we will find out what is in the Bill, as soon as it passes,” and Chris Dodd: “We don’t know ultimately how well the ideas we’ve incorporated here will achieve the results we desire” and “No one will know until this is actually in place how it works.”  Yeah, just screams “clarity,” doesn’t it?)  If the people who wrote this stuff have no idea, how are the rest of us poor slobs supposed to figure it out?

In fact, if it sticks with the attitude Geithner expressed, the administration is signing its own death warrant.  Call it a capital strike, going Galt, what have you.  With this barrage of regulations; pea soup fog of uncertainty; and higher spending and taxes as far as the eye can see, investment and consumer spending and employment growth will remain moribund, at best, with devastating political consequences.  And in 2010 or 2012, if things do indeed play out this way, the incantation “Bush did it” won’t work any electoral magic.  Sadly, by then the damage that the nation will have suffered will be immense.

I have a  couple of recent publications that may be of interest to some of you.

A couple of folks have expressed interest in my recent Energy Law Journal paper on manipulation.  Here it is: my policy recommendations are at the end.

Cato just released a Policy Analysis I did on clearing mandates. The link is here: you can download the paper from that page.

A very strange thing indeed.

There are rumors that ExxonMobil is considering a takeover of BP.  I have no firm opinion on the likelihood of such a combination.  But it would be a challenge to combine these two behemoths, for more than the usual reasons.  In particular, Exxon is not trading oriented, but BP is.  BP has an extensive and highly profitable trading operation, Exxon does not.  Indeed, recent experience (the trading joint venture with Duke Energy) probably did a lot to confirm Exxon’s belief that trading is far more trouble than it’s worth.

So what would happen, in the event of a merger?  Would Exxon spin off the BP trading operation?  But who would buy, since so much of the trading operation derives its profitability from trading around physical assets?  Would Exxon just shut down, or cut back, BP’s trading?  But given that  a non-trivial portion of BP’s profits come from trading, if it were to do that the price that XOM would be willing to pay might be considerably less attractive to BP.

All things considered, it seems like a most unnatural combination.

I have read the derivatives and clearing titles of the Frank-N-Dodd act, so you don’t have to: you can thank me later.

Here are some random thoughts.

First, a good chunk of it is mind-numbing language dividing authority between the CFTC and SEC, and instructing the agencies on how to coordinate and cooperate.  Note to self: if they start rationing anesthetics under Obamacare, read one of these legislative monstrosities.  It will certainly beat biting a bullet and taking a swig of bourbon for inducing a pain-dulling stupor.

Second, the fading of the Lincoln provision is quite artfully done.  I had to read the damn thing several times to figure out just how they did it.  The bill starts out with: “NO FEDERAL BAILOUTS OF SWAPS ENTITIES” and then says with the exception of insured depository institutions.  Pretty big exception.  So where did the exclusion of commodities and equity swaps come from?  Well, the bill permits:

Acting as a swaps entity for swaps or security-based swaps involving rates or reference assets that are permissible for investment by a national bank under the paragraph designated as ‘‘Seventh: of section 5136 of the Revised Statutes of the United States ( 12 U.S.C. 24), other than as described in paragraph (3).”

And what does this “Seventh” paragraph say? It says that banks are allowed to:

Seventh. To exercise by its board of directors or duly authorized officers or agents, subject to law, all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes according to the provisions of this title.

So swaps based on rates or reference assets including typical bank activities including borrowing and lending, FX, and  bullion (presumably precious metals) are all OK.  The paragraph specifically precludes trading in stocks, meaning that equity derivatives are out.  Commodities (other than bullion) aren’t mentioned, so they’re not covered by the exception, and must be spun off.  (The ability to trade bullion-based derivatives means that my calculations of the share of bank derivatives business that will have to be spun off were biased upwards, since a decent fraction of bank commodity trading is in gold and silver.)

Third, the bill does an amazing amount of punting on key issues.  The problem is that the punts won’t be fielded by Darren Hester, Billy “White Shoes” Johnson, or Gale Sayers.  Instead, they will be returned by the same shlubs that fumbled so often in the most recent crisis–the existing regulators (think Madoff, Alan Stanford, AIG, and oh yeah, dodgy FSU shell companies.)  If you look at all the things that the CFTC has to do in the next 12 months, you just know the agency will be overwhelmed.

Fourth, two things relating to margins jumped out at me.

The bill states:

MARGIN REQUIREMENTS.—The margin required from each member andparticipant of a derivatives clearing organization shall be sufficient to cover potential exposures in normal market conditions. [Emphasis added.]

But supposedly the whole objective of the clearing mandate is to reduce systemic risk, in part by requiring increased collateralization.  But periods of systemic instability are, by definition, highly abnormal.  So what’s the point of mandating clearing, and then just allowing the CCPs to impose margins just sufficient to cover normal every day price moves?  This language will give CCPs tremendous leverage in fighting off regulatory efforts to increase collateral.  Not that I mind that, but it suggests a complete disconnect between what the legislation promises and what it can actually deliver.  It promises a collateralization mechanism that will reduce the likelihood of chain reaction failures under stressed market conditions, but then only requires the posting of collateral sufficient to cover losses under non-stressed conditions.

The other thing relates to margins on non-cleared derivatives.  The bill gives prudential regulators the power to set margins (and capital requirements) on these trades:

Each registered swap dealer and major swap participant for which there is a prudential regulator shall meet such minimum capital requirements and minimum initial and variation margin requirements as the prudential regulator shall by rule or regulation prescribe.

Meaning that the prudential regulators (e.g., the Fed, OCC, FDIC) can set margin requirements.  Prudential regulators will set margins that will:

be appropriate for the risk associated with the non-cleared swaps held as a swap dealer or major swap participant.

This is potentially quite dangerous.  It is a form of price control, and such controls will have perverse effects (as they always do).

In the present instance, I have been critical of clearing mandates in large part because CCPs do not have as good information as dealer banks to set appropriate margin levels.  Regulators will be even less well informed, and at a greater informational disadvantage relative to those trading the instruments.  This is particularly true for the instruments at issue–the exotic swaps that will not be cleared even under a clearing mandate.

Better informed market participants will readily identify which risks regulators have underpriced, and which ones they have overpriced.  They will overtrade the underpriced risks, meaning that defaults risks will be greater than the regulators think.

We’ve seen this before.  The recourse rule that gave very favorable capital treatment to AAA securities encouraged banks to load up on them, with disastrous consequences.  Since the regulators’ pricing errors will apply to all market participants, these errors will have systemic effects, encouraging myriad financial institutions to overtrade the same risks.  As I’ve written before, regulation and legislation create systemic risks because they apply to broad swathes of market participants.  This is another example of that.  Getting the risk prices wrong–as regulators will inevitably do–means creating incentives for all affected institutions to overload on the underpriced risks.

I transfered from the Naval Academy to the University of Chicago as a junior.  I knew that I had gone from the alpha of academic institutions to the omega when I learned soon after my arrival in Chicago of the Lascivious Costume Ball.  No such thing in Annapolis, let me assure you.  How lascivious?  Well, I remember one woman in my dorm who went as Eve, complete with a snake and three strategically placed fig leaves.  (Maybe they were lettuce leaves.  I wasn’t checking that closely.)

What brought that to mind, you ask?  A review of the Office of the Comptroller of the Currency’s data on bank derivatives activities.

No.  Seriously.

Why?  Well, the data make it abundantly plain that the financial regulation bill that emerged from conference gave Arkansas Senator Blanche Lincoln the merest of fig leaves to cover a near complete retreat from her earlier position.

Recall that the original Lincoln plan would have required banks to spin off all derivatives trading activities (or lose their access to the Fed discount window).  The final bill allowed banks to retain interest rate, FX, and some credit trading, and spin off only commodities, equity, and some credit derivatives (as I understand it, CDS on junk securities).  The OCC data shows that the spun off activities are small beer, indeed, compared to the stuff that banks are allowed to keep.

Here are the market values, by category (gross positive values followed by gross negative values):

$ in billions

Q1 2010  Q4 2009  Change  %Change  Q1 2010  Q4 2009 Change  %Change

Interest Rates 3,147 3,121 27 1% 3,052 3,023 30 1%

FX 347 354 (7) -2% 345 344 1 0%

Equity 77 91 (14) -15% 78 90 (12) -13%

Commodity 41 50 (9) -18% 40 49 (8) -17%

Credit 390 437 (47) -11% 370 409 (39) -10%

Total 4,002 4,053 (51) -1% 3,886 3,915 (29) -1%

So, equity and commodity gross positive values total $118 billion, compared to a $4 trillion total–or about 3 percent of the total.  (Gross negative values give a similar share.)  Credit totals $390 billion, but only a relatively small fraction of that will have to be spun off.  This means that based on market values, banks will be required to spin off less than 10 percent of the total value of positions.

Here are the notionals:

Interest Rate Contracts 181,981 179,555 2,426 1% 84%

Foreign Exchange Contracts 17,596 16,553 1,043 6% 8%

Equity Contracts 1,571 1,685 (114) -7% 1%

Commodity/Other 940 979 (39) -4% 0%

Credit Derivatives 14,364 14,036 329 2% 7%

Total 216,452 212,808 3,645 2% 100%

Commodities are rounding error.  Equity and commodities is about 1 percent of notional.  Even adding in all of credit, and you don’t get to 10 percent.

It would be nice to have a risk breakdown, but that’s not in the OCC data.

Regardless, it is clear that the banks kept the big part of the business, and gave up a few minor pieces of the business to provide Lincoln with some political cover.

It’s not a big deal to the banks, but it is a pretty big deal to the commodities business.  Spinning off commodities will make it more expensive for dealers to make markets.  Some may decide it’s not worth the bother.  So this will reduce the liquidity of the commodities derivatives markets, and make it costlier to hedge.

This is just one of several hits to the commodity business in the bill.  Indeed, commodities are arguably the biggest loser.

The bill says the CFTC “shall” impose position limits on OTC commodities.  This will also impair liquidity and raise hedging costs by constraining the ability of speculators to offer risk bearing capacity.  Indeed, the effect will likely extend to exchange traded markets as well, because one factor that was limiting the CFTC’s aggressiveness on energy futures position limits was the fear that tight limits would force more business OTC.  The agency now has the power to shut that escape valve, and thus is likely to impose more draconian limits on both OTC and exchange traded products.

Moreover, the bill adopts the Senate bill’s more restrictive exemption from clearing requirements for end users.  The CFTC has some discretion on crafting this exemption, but the current leadership has made it clear that it is opposed to generous exemptions. More onerous clearing (and hence margining) requirements for end users will further raise the costs they incur to hedge.

In sum: the compromise bill shafts commodities not once, not twice, but three times.  This will force commodity producers, processors, and marketers to bear more risk, and to incur higher costs to manage risks.

And for what?  The spinoff of banks’ commodity business certainly won’t have the slightest effect on systemic risk given the trivial size of the trade relative to the other activities they still undertake.  The niggardly end user exemptions will not affect systemic risk either.  The position limits will not reduce price distortions in the market.

Bottom line: the commodities business will be riskier and less efficient, and there is no corresponding benefit to offset this cost.  All to give a politically desperate senator a fig leaf.

Myriad commentators have criticized the Obama administration’s repeated flouting of the law.  Professor Bainbridge has a list of some of the greatest hits the law has taken at Obama’s hands.  So does Victor Davis Hanson.  I wouldn’t go as far as Thomas Sowell in seeing in all this the first steps to the gas chambers or the Gulag, but it’s bad enough.

The $20 billion BP compensation fund is the most expensive, and most egregious, of these transgressions.  Taking time off from his day job telling American corporations what they can pay their executives (another extra-legal monstrosity), Kenneth Feinberg assures us that “fairness” is his guidepost:

State laws will have to be made as consistent as possible to ensure that some victims of the Gulf of Mexico oil spill are not treated unfairly, says Kenneth Feinberg, the lawyer chosen by the White House and BP to administer a $20bn claims fund.

Determining which claims are eligible and which are not will be a “challenging” task, says Mr Feinberg, a renowned mediator who will soon take over the day-to-day running of the claims process from BP.

“How do we deal with a restaurant in Boston that can’t get shrimp for its favourite dish or the strip joint in New Orleans where business is off because the fishermen aren’t coming in?” Mr Feinberg asked.

“I think the best way to look at it is the way Congress looked at 9/11 cases. Would your claim be applicable under state and, in this case, maritime law? If the state would recognise it, then I will recognise it. If not, I should not,” he said.

So I see.  There are state laws and maritime law that govern liability and damages in such matters.  I’m going out on a limb here, but given that, I’m guessing that there are like courts and stuff with established procedures, rules, and precedents that are capable of applying such laws.  Indeed, not just capable, but Constitutionally charged with the responsibility of applying them.

Not only does the BP fund trample separation of powers, it also rides roughshod over federalism.  Feinberg will, like some imperial vizier, decide which state laws apply and which do not:

Overcoming differences in state laws will be another challenge, and Mr Feinberg’s team is now going through state laws to check for inconsistencies.

Although their initial inspection showed that the laws were “sufficiently similar”, the lawyer is also looking at creative ways to deal with any problems.

For example, if the law is the same in 41 states but not in the other nine, he might choose to apply the law of the majority across the board.

“I am very worried about unfair treatment. I can’t conduct and administer a fund where one person in one state would get their claim and another person in a different state would not,” he said.

I see.  It’s all about fairness.  Let me wipe this tear from my eye.

No, it’s not all about fairness, actually.  In this federal system, there is a demarcation between state law and federal law.  Each state has its own laws, duly passed by its legislature, its own courts for interpreting these laws and making judgments under it, and its own executive, for enforcing them.  Citizens of those states have access to the courts under established principles of standing and jurisdiction.  Individuals have made choices where to live based in part on those laws.  They have entered into contracts under those laws.  That’s the way it works, and the way it has worked for centuries.

Where does Ken Feinberg, and the Obama administration, get the power to turn this system completely on its head?  Under what Constitutional theory does an unaccountable “official” (I use the quotes because the “position” he holds does not appear to have any legal sanction whatsoever) get the power to disregard some state laws to award claims that presumably have a legal basis in these same state laws?  Since when does a majority of state laws trump the laws of the remainder?  I mean, this is an absolutely bizarre legal doctrine.

This does not exhaust the deep problems with the BP fund.  Obama and individual Congressmen have made it plain that BP funds will be used to compensate those who suffered losses from events for which no court likely would hold BP liable.  Specifically, BP will pay oil workers for income lost due to the administration’s own drilling moratorium.

A competent court has already found the existing version of the moratorium to be legally deficient.  It is remarkable indeed to expect BP to pay for costs arising from a government policy that has no legal basis.

Moreover, to craft a moratorium that passes legal muster, the administration (Interior Department) would almost certainly have to argue that deepwater drilling is so inherently risky that it cannot be countenanced.  At most, the BP spill demonstrated the risks of drilling, risks that must exist independently of BP if all drilling is to be stopped: if the administration is correct that the irremediable and indefensible risks of drilling demand termination of the activity forthwith, those risks are inherent in the activity and would exist and have existed regardless of whether the BP well had exploded or not.  That is, if the administration’s argument justifying the moratorium is correct, it would be correct regardless of whether the BP spill had occurred or not.  How can you make BP pay for people not making money for not performing an activity they shouldn’t be performing in the first place?

Thus, there is no reasonable theory of causation that can attribute the lost income of oilworkers to BP.  Given the lack of any colorable case that BP’s actions caused this lost income, there is no way that any court would find BP liable for this loss.  The loss arises from the administration’s decision.  And if you believe the administration’s justification for the moratorium, you must also believe that there should be no oilworkers in the Gulf anyways.  Why provide compensation for the inability to undertake a wasteful activity?  (Should the makers of locks pay for the lost income of burglars?)

Shredding federalism, separation of powers, and due process—not bad for a day’s work.

As appalling as this is, it should not be a surprise.  It is the natural product of the progressive (and Progressive) legal mindset.  Dating back to the dawn of the Progressive movement in the US, adherents to progressivism have viewed the separation of powers, federalism and the resulting patchwork of 50 sets of state laws, and due process as atavistic impediments to the achievement of rational and beneficial public policies.  (For a distilled essence of this view, read any one of Tooltime Tom Friedman’s China For a Day wet dreams.)  Progressives don’t blanch at the destruction of certain Constitutional principles dating from the birth of the Republic, and legal principles pre-dating that.  They revel in it.  They believe it is a good thing.

And if you don’t share their belief, you should oppose Obama’s actions, regardless of what you think of BP.  There are ways of making sure that BP pays for the damages it has caused without trashing the rule of law; why do you think the country has so many trial lawyers?  But if you are a Progressive, this trashing is a feature, not a bug.  Progressives have been fighting the law for a long time.  Let’s all hope that the law wins.

Several reporters have called me to ask about the implications of BP’s travails for its trading operations, and more crucially, for the markets broadly.  Here are some key points:

1. BP probably has the largest energy trading operation of any firm in the world.
2. There is a non-trivial risk of BP going bankrupt as a result of ballooning liabilities associated with the Gulf spill.  Don’t believe me?  Look at the company’s gargantuan CDS spreads.
3. BP’s counterparties are well aware of this, but are adopting a public “what, me worry?” response to any queries about BP’s counterparty risk.  Nobody wants to raise doubts that could be self-fulfilling and spark a run.
4. That said, in private they all are lacing up their running shoes, and putting contingency plans in place.  Nobody wants to be last in line if it looks like the company is teetering towards bankruptcy.  And knowing that the government is first in line to begin with cannot inspire confidence among those who have exposure to BP.
5. Things can move from “what, me worry?” to “Panic! Run for your lives! Devil take the hindmost!” very quickly, and in response to small shocks.  That is, situations like this are inherently non-linear, and small things can spark a run or a cascade that results in the collapse of BP’s trading operation in a stunningly short period of time.  I’m NOT saying this is a certainty.  I’m not even saying it is the most likely outcome.  I am just saying that such an outcome cannot be dismissed.  We’ve seen it happen too many times before.
6. The broader market consequences of a BP failure depend crucially on whether, in the event of a bankruptcy, its positions are in or out of the money.  Enron’s failure, which was not caused by losses on its trading book, was not that disruptive to the energy markets because counterparties generally owed Enron money, rather than the reverse; hence, these counterparties did not suffer losses with consequent knock-on effects.  Moreover, its failure did not cause large market price movements that worsened the company’s losses.  A BP bankruptcy similarly would not be caused by losses on its trading book, but by metastasizing liabilities from the spill.  It is possible that BP could go bankrupt, but there would not be knock-on effects because its trading book is profitable and it doesn’t owe counterparties money.
7. A known unknown is what effect a BP bankruptcy would have on energy prices, and what effect these price movements would have on the amount BP owes its counterparties.  Hypothetically, if its bankruptcy moves energy prices, and these price moves impose losses on BP, its trading partners will suffer some losses as the result of a BP bankruptcy and default.  The problem is, we won’t have any idea what the price response to a BP bankruptcy will be until it happens.

This situation is not an imminent crisis, but bears watching.  If it moves, it will not move slowly, but with stunning speed.

Can you say that any more?  Well, even if use of the word “retarded” is increasingly frowned upon, there are some special cases in which its use is so evocative, and hence so appropriate, that it should be blessed.

The compromise on the Lincoln amendment is one such case:

The bill also includes a provision, authored by Sen. Blanche Lincoln (D., Ark), which would limit the ability of federally insured banks to trade derivatives. This provision almost derailed the bill following vehement objections from New York Democrats. Ms. Lincoln worked out a deal in the early hours of Friday morning that would allow banks to trade interest-rate swaps, certain credit derivatives and others—in other words the kind of standard safeguards a bank would take to hedge its own risk.

Banks, however, would have to set up separately capitalized affiliates to trade derivatives in areas lawmakers perceived as riskier, including metals, energy swaps, and agriculture commodities, among other things.

Under any modern understanding of what “risk” means, this makes no sense.  Ever heard of diversification, or the fact that “risk” of a particular position is attributable to its contribution to the payoff distribution of the entire portfolio of risks, not anything inherent to the position itself?  (Meaning that even if energy prices are volatile, doing energy swaps may not be that risky in a portfolio context.)  Under any modern understanding of the economics of financial intermediation (in which information about counterparties is vital) this makes no sense either.  (Meaning that the costs of intermediation are lower if information obtained in trading one instrument with a counterparty can be used when dealing in other instruments.)  Under any modern understanding of counterparty risk, where maximizing netting opportunities can be quite valuable, this makes no sense; splitting up businesses in an arbitrary fashion like this reduces scope economies from netting and other things.  It also makes no sense even on its own terms, because yes, banks use interest rate and credit derivatives to manage their own risks, but from my understanding of the provision, banks will still be able to be dealers in these products, and the whole basis of Lincoln’s proposal (to the extent that it had one) is that dealing is a particularly risky activity.  Not that I am buying into that argument; I’m only pointing out that is that’s what you believe, this provision is contrary to that belief.

This is transparently a compromise to save the face of a senator in over her head, who made a wild legislative proposal to stave off a primary challenge.  The banks were willing to throw a couple of bones in order to save their biggest books; metals, energy, and ags are small potatoes compared to interest rates and credit.  Lincoln gets to do what senators do best–pose.  The banks largely escape major damage.

Even by sausage making standards, this is revolting.  It is good that the most egregious parts of the Lincoln proposal have been jettisoned.  It is bad news, however, for liquidity and hedging in the disfavored products, especially commodities.  This, along with the position limit measure in the bill, and the clearing mandate, will increase the costs of managing commodity price risks in particular.

All pain, no gain: the only thing that can be said is the pain could have been a lot worse.

Igor Sechin is on a charm campaign.

Let me repeat that.   Igor Sechin is on a charm campaign.

There is a long piece about him in a recent FT:

As Russia seeks to shake off an economic crisis that wiped out layer after layer of the oil-fuelled gains of the Putin era, Mr Sechin – viewed with fear and awe for overseeing the state takeover of the strategic heights of the economy – is striking a new, surprisingly accommodating tone. The Kremlin, taken aback by how vulnerable Russia’s oil and gas-driven economy proved to be to the global financial crisis and recession, has started to change its tune.

I said Sechin is trying to be charming.  I didn’t say that he had gone so far as to actually tell the truth, or anything.  In fact, he makes a couple of complete howlers.  One relates to how Rosneft, and other Russian state  energy companies, came by some of their prize assets:

In his first public comments on how the reinvigorated Putin state managed to recover important energy assets from oligarchs who picked them up cheaply during chaotic post-Soviet privatisations, Mr Sechin says these properties were not “repossessed”. It was, he insists, a legal process where state companies paid market prices for assets that are now managed no differently from private ones.

Riiiiigggghhhhtttt.  Legal process.  Market prices.  Uh huh.  Tell me another one, Igor.

So he obliges:

Russia’s state-controlled companies cannot use their resources as political weapons, or “instruments to put pressure on consumers” as he puts it. The likes of Rosneft and Gazprom are, he adds, “normal public companies, working under international laws, and this makes it impossible for them to break their obligations to consumers”.

Stop it, you’re killing me!

But he can’t stop:

Russian companies are not subject to state fiat in the same way as national oil companies set up by the world’s other big producers.

“When we speak with our colleagues from Opec, they say that Russia should operate quotas just like they do. I tell them that unfortunately we have no such instruments, because Russian oil companies are private companies. Even those that are partly state-owned are private companies. They are working in the conditions of the market and have obligations to their partners which do not allow them to take unilateral decisions.”

Sechin has been peddling this line going back to late-2008, when he was playing Lucy and the football with OPEC.  As I wrote then, and in early-2009, it is complete tripe.  Not that I WANT Russia to cooperate with OPEC, but even given that it has some “private” companies rather than completely nationalized oil sectors, Russia can control exports at a whim, and has the policy tool to do so: its export duty.  By raising the export duty, Russia would reduce export volumes, just as by reducing output national oil companies can reduce export volumes; both actions raise the world oil price.  Russia tweaks its oil export duty all the time.  It adjusts other export duties as well, in order to achieve policy objectives.

In brief: if Russian (and Sechin) wanted to coordinate output with OPEC, it would have no difficulty in doing so via the export duty.  The truth is, it doesn’t want to coordinate output with OPEC; it doesn’t want to cut Russian output.  Quite rationally, Russia wants OPEC to bear all the costs of supporting world oil prices by cutting OPEC output, and to reap the benefit by producing as much as it can.  That’s what Russia has done.  Like I say, as a net short, I (and the US) benefits from Russia’s action; the world is a better place for it.  But it doesn’t do Sechin’s credibility any good for him to tell such laughable falsehoods.

Perhaps Sechin’s choir boy act indicates that finally, Russia has learned that you catch more flies with sugar than gall.  Perhaps.

But I wouldn’t consider this to be a sincere conversion.  It is, at best, a pragmatic trimming in response to changed economic and political conditions.  And if and when those conditions change again, don’t be surprised if the Old Igor, the Bad Igor, returns, fangs bared.

Whether it is with Sechin or Lavrov or Putin or Medvedev: anyone who puts their faith in their more moderate statements does so at their peril.  For as Sechin demonstrates, even when he tries to act nice, he does so with a stream of falsehoods.