Streetwise Professor

In an early South Park episode, desperate for help on a school project requiring them to formulate a business plan, Stan, Kyle, Kenny, and Cartman enlist the aid of their jittery friend Tweek’s Underpants Gnomes (h/t KW).  The Gnomes’ foolproof plan?:

1. Collect Underpants
2. ?
3. Profit

The Gnomes see to have taken their brilliance to Europe, because the vaunted rescue scheme hatched over the last few days looks like:

1. Announce grandiose plan
2. ?
3. End Crisis

Each major element of said grandiose plan has many “?”.

Take the bank “recapitalization”–please.  How do the Eurognomes know that banks will respond to the capital requirement by adding equity capital, rather than dumping assets and contracting their balance sheets?  If the banks do decide to raise capital, who is going to invest?  Is compliance with the capital ratio going to be determined using legit asset valuations–particularly on Euro debt, or some mark to fantasy accounting?  What happens if the banks don’t meet the new requirement?

Next consider the “haircuts.”  The IIF (a banking industry group) cross-its-heart-hope-to-die promised that banks would volunteer to take a 50 percent haircut on Greek debt.  Will the banks actually respond to the call?  Is 50 percent really adequate to address Greece’s problems?  Recall that just last week it was revealed that 60 percent reductions in Greek debt were necessary to put the country on a sustainable path: 50 percent of 50 percent of Greece’s overall debt is less than 50 percent of the way to 60 percent.  And is it really 60 percent?  There are evidently “sweeteners” in the deal: where is that money going to come from?  And doesn’t every Euro in financial HFCS just reduce the amount of Euros the vaunted EFSF has to backstop other countries?  If Greece gets a 50 percent haircut (OK, 25 percent), what effect will that have on the Portuguese, Italians, etc.?

And speaking of the EFSF, let us turn to “leveraging” it.  Where is the additional money going to come from?  Where is the money going to come from?  Where is the money going to come from?  (Repeat as needed.)  ECB money–out.  Sarkozy is going to China, hat in hand.  The Eurognomes are hinting broadly that the BRICs, the IMF, your Aunt Fanny, are all welcome to invest in some CDO/SPV contraption that will buy debt from shaky Euro countries.  The EFSF will take the first 20 percent of the default losses.  But investors could buy debt in the secondary market or at auction at prices that reflect estimates of default probabilities and recovery rates.  What is the real benefit of getting involved in the Gnomes’ financial engineering scheme?

No, this entire scheme is aspirational.  It defines the end state that the Euros would like to achieve, but does not specify an even remotely credible path to get there. Just like the Underpants Gnomes’ dreams of profit.

Nonetheless, the equity market and the Euro staged a euphoric Tinker Bell rally yesterday–one of the most frenzied yet.  Ominously, however, today’s Italian bond auction was not a success, with low participation and yields on the 10 year at over 6 percent.

Betting on the Eurognomes foolproof plan is, IMO, foolish.  They are failing to grapple with the fundamental arithmetic, and the fundamental choices: amputation or gangrene, socialization or monetization.  Until they do, you’re better investing in Tweek’s Gnomes’ strategy for financial security.

Starting with my earliest post-crisis writings on clearing, I have pointed out repeatedly that the supposed virtues of clearing–netting and greater collateralization–look far different when you examine the nexus of financial contracts as a whole, rather than focusing on derivatives alone.  A primary effect of netting and greater collateralization  is to increase the seniority of derivatives in bankruptcy.  But if you increase the seniority of one claim, the seniority of other claims is reduced.  Sure, you can make derivatives more secure, but at a cost of making other claims less secure.

The systemic implications of this are ambiguous.  The implicit presumption seems to be that derivatives are somehow uniquely threatening to the stability of the financial system.  I say “implicit” because the clearing pom-pom squad has never discussed explicitly the distributive aspects of reshuffling priority via regulation, so I don’t even know if they are even aware of it.

But it is not hard to imagine scenarios in which giving derivatives even greater advantages in bankruptcy (due to safe-harbor provisions they already have a lot) can cause a systemic problem, but through another channel.  For instance, derivatives counterparties of a firm teetering on the brink of failure may rest easy given their priority status, especially if the CCP is considered safe.  But other claimants may not be so serene.  For instance, consider money market mutual funds  that invest in the paper of the dodgy firm.  Realizing that they will be totally hammered in bankruptcy, the investors in the money market fund may run.  That would not be pretty.

It’s even more complicated than that, because given the new seniority rules, there is likely to be widespread alterations in capital structures of derivatives market participants, and repricing of those claims.  Who knows how that is going to play out, and what new fragilities will be baked into the new structures?

This point is finally dawning on people.  One person who caught on long ago is Harvard’s Mark Roe.  Today, he published an oped that makes the point clearly and forcefully. It is definitely worth a read.

Money quotes:

Equally problematic is the fact that, while the clearinghouse and its participants can net wins and losses to reduce risk for those inside the clearinghouse, the clearinghouse does not assuredly eliminate the basic risk facing the entire financial system. Often, it merely transfers that risk to creditors outside the clearinghouse.

. . . .

Whether the clearinghouse reduces systemic risk depends on the relative systemic importance of those inside and those outside the clearinghouse – AIG versus Citibank in this basic example – not on the clearinghouse’s capacity to reduce risk among its members. In this example, if Citibank is precarious and is as systemically vital as AIG, the clearinghouse has obscured that it has saved AIG only by transferring risk from the clearinghouse to Citibank, which then fails.

Much recent regulatory activity has focused on enabling, enhancing, and requiring clearinghouses for these kinds of financing arrangements. Yes, clearinghouses offer many benefits, including greater transparency, better pricing, and better regulatory focus, and we should try to make them viable. But regulators world have overestimated their overall benefit. Too much of what is justified as reducing systemic risk is really just offloading risk onto others.

Exactly.

Reading Mark’s piece  brought to mind Bernanke’s quoting of Puddin’ Head Wilson in his discussion of CCPs.  Bernanke said if you are going to put all your eggs in one basket, keep a very close eye on that basket.

One of my problems with the whole CCP debate is that too often the tendency is to treat derivatives as the only eggs that matter.  But if you pay attention only to the basket with the derivatives eggs, you will not pay attention to other ones that are as valuable, or moreso.

To change metaphors, target fixation all too often leads one to miss the bogey that just jumped your six, with fatal results.  The obsessive focus on derivatives, and clearing, is a form of target fixation.  It risks diverting attention from other potentially mortal dangers. You need to have a system-wide perspective to truly understand systemic risk.

Mark is generally negative on giving derivatives any priority.  He has written things very critical of safe harbors.  He and I have discussed this, and have agreed to disagree: I can see reasons for differentiating the treatment of derivatives from other claims.  But the important point is to understand that this is an issue, and one that has to be examined from a system-wide perspective, because seniority rules shift risk around.

Mark gets that, and makes serious arguments about what the right rules should be.  Unfortunately, all too many of those who make the decisions and the rules don’t appear to get it.

Like Tim Worstall, I am puzzled at all of the machinations in Europe to avoid a hard Greek default in order to avoid triggering CDS.  Apparently the concern is that payoffs on CDS would potentially jeopardize the financial health of banks that sold protection, leading to contagion.

Greek CDS represents about 1 percent of debt outstanding, with a notional amount outstanding of about $4 billion.

Look.  If European banks collectively cannot handle a $4 billion payout (which would be the maximum, assuming zero recovery), then their problems are even worse than feared.

To worry about the $4 billion CDS, rather than the $471 billion in outstanding Greek government debt, is beyond bizarre.  This suggests some weird sort of obsession among the Euros about derivatives, and CDS in particular.  You don’t have to look far for more evidence of this obsession.

And remember, CDS are zero sum.  Ever dollar paid by one party is received by the counterparty.

Moreover, many of the CDS contracts will have been entered by banks looking to hedge exposure to Greek sovereign debt, and private Greek debt.   Restructuring Greek debt in a way that leads to substantial writedowns but does not trigger CDS screws the hedgers worst: they suffer losses on their bonds, and their hedges do them no good whatsoever.

Punish the hedgers.  Wow.  That’s a really constructive policy.

And there are long-term consequences.  In particular, the effective abrogation of Greek sovereign CDS contracts will raise questions about the reliability of other outstanding sov CDS.  Many hedges are looking far shakier now, for if the Euros do backflips to avoid triggering Greek CDS payouts, just think of what they would do for Italy or Spain.  Since it is the most risk averse banks that would have decided to hedge, and since risk aversion depends in large part on the bank’s financial condition, this hurts the most risk averse (and likely weakest) banks most.  Less hedging will be done going forward, but risks will be transferred regardless–through the cash markets.  CDS prices will become less reliable (probably a feature rather than a bug to the Eurocrats).

Ironically, this creates a new speculative trade–a trade on the basis between CDS and the bonds–in which the parties effectively speculate on the political risk inherent in CDS.

There will be knock-on effects too.  If private contracts can be circumvented for political reasons in the case of sovereign CDS, the risk that other derivative contracts can be effectively nullified increases too.  The risk is probably greatest for other CDS–notably European bank CDS–but it exists for other types of derivatives too.  All because once you admit the principle that “payouts on derivatives contracts can spread contagion”, you can’t limit its application–or the risk that the principle will be applied–only to Greek CDS.  Just this once.  Pinky swear.

Looking at the whole European fiasco brings to mind Churchill’s quote about the United States always doing the right thing, after trying everything else first.  The Euros try about everything, but they don’t look like they are going to the right thing.  The exact opposite in fact.

Obama made another unilateral move, this time on student loans.  Here’s the uhm, highlight of the article:

Obama is going to take steps that bypass Congress “every week going forward,” White House Communications Director Dan Pfeiffer told reporters yesterday in Washington.

I’m waiting for the NYT editorial raging against the Imperial Presidency.  Any minute now.

All this debt forgiveness somehow brings Shay’s Rebellion to mind.  Or the Populist and Granger ferment of the late-19th century.  It is inherently divisive, because every dollar that the debtor gets is a dollar the creditor–or the taxpayer–has to pony up.

Obama also warned that if he loses in 2012, the government won’t help you: “You’ll be on your own”:

At a million-dollar San Francisco fundraiser today, President Obama warned his recession-battered supporters that if he loses the 2012 election it could herald a new, painful era of self-reliance in America.

“The one thing that we absolutely know for sure is that if we don’t work even harder than we did in 2008, then we’re going to have a government that tells the American people, ‘you are on your own,’” Obama told a crowd of 200 donors over lunch at the W Hotel.

“If you get sick, you’re on your own. If you can’t afford college, you’re on your own. If you don’t like that some corporation is polluting your air or the air that your child breathes, then you’re on your own,” he said. “That’s not the America I believe in. It’s not the America you believe in.”

Count me out of that “you”, pal.  No, the America I believe in produced Ralph Waldo Emerson.  You know, the author of “Self-Reliance.”  Somehow I think nanny-in-chief BHO is not a big RWE fan.

Inspired by the “self-reliance” reference in the story quoted above, I found Emerson’s essay on line, and began to read it.  (It’s been a while since I have read it.)  I stopped short at the first line of the second paragraph:

There is a time in every man’s education when he arrives at the conviction that envy is ignorance

That is obviously an anachronistic statement, and a comment on how education has devolved.  Listen to the sociology majors in OWS and you’ll understand that many have received an education, such as it is, that celebrates–worships, fetishizes–envy.

The polarization between the Emersonian America, and the anti-Emersonian America epitomized by Obama is becoming more extreme by the day.  It is, to use the title of a Sowell book, the conflict of visions that will define 2012 and the years that follow.  The visions are so fundamentally different that the prospects for compromise are nil.  Meaning that the next 12 plus months are going to be like nothing seen in this country for a long time indeed.

All you clearing and market infrastructure aficionados must read Bill Hodgson’s piece on collateral transformation at DerivSource.  He points out quite accurately the new sources of fragility and vulnerability to stress that will arise from collateral transformation services that are being offered to finance CCP margins in the aftermath of clearing mandates.

The bitter irony here is that many derivatives end users (real money investment funds, industrial hedgers) did not pose any real systemic risk under bilateral structures.  But forcing them to clear drives them to utilize funding mechanisms that are systemically risky.  As one big corporate end user told me: clearing mandates have transformed credit risks into liquidity risks: I can manage the first, but the second scares me.

I continue to gape in amazement that the sorcerer’s apprentices that created these mandates did not think to step two.  They did not step back and ask: “Gee, we’re imposing a major change on the structure of financial markets.  How will market participants respond?”  This is especially unbelievable since a big component of the narrative of the financial crisis is that it was the result of excessive financial engineering.  What, did FrankenDodd, Timmy!, GiGi, the G-20, the EC, etc., think that the big changes that they imposed would not lead to a new burst of financial engineering?  Are they really that clueless?

I think I know the answer.  I think you do too.

Markets do not stand still.  Market participants will adjust contracts in response to regulations and laws motivated by beliefs that the existing system of contracts is flawed.  A useful first approximation is that these contractual adjustments will try to reproduce the economic substance of the banned or restricted contracts.  However, many of the work-arounds necessarily utilize less efficient–and often more fragile–ways to achieve that substance.  Which means that vulnerabilities have largely been relocated, rather than eliminated, and in many cases the new vulnerabilities are more dangerous than the old.

Read Bill’s piece to get an excellent illustration of this dynamic at work.  And then remember that the biggest systemic risk is government, and in particular, ill-considered government policies.  And that’s especially true when static-minded legislators and regulators attempt to impose their vision on a dynamic, strategic, reacting, self-ordering system.

There is an increasing drumbeat of stories warning about the systemic risks posed by CCPs.  This FTAlphaville article discusses several dangers I’ve discussed repeatedly, including the stresses put on liquidity, the concentration of risk resulting from the reconfiguration of the topology of the financial network that results from central clearing, and wrong way risks.  Several articles, including this one, report on the BOE’s Deputy Governor Paul Tucker warning about the lack of plans for resolving insolvent clearinghouses–a fear echoed by the ECB’s Peter Praet. Risk has a long article about various CCP risks; particularly interesting is the discussion of the contingent liability that clearing members face in the event of a “forced allocation” of a defaulting member’s portfolio.  The Risk article also reprises an SWP theme about the stupidity of limiting clearing member ownership and control of CCPs.

And the beat goes on.  Although not about clearing directly, this story on the downgrading of MF Global does have implications for clearing, given the CFTC’s decision to require admission of firms with as little as $50 million in capital to CCPs.  And speaking of the CFTC, its recently adopted clearinghouse rule requires CCPs to have enough capital to cover the failure of its single largest member, not the two largest: as I noted in my ISDA white paper, not only should a CCP have enough capital to cover two big defaults, it should have plan to replenish capital after even a single failure.  Although the CFTC may revisit the requirement later, pending negotiations with the Financial Stability Oversight Council, a failure of a single member–not even the largest one–of a CCP will likely require the services of Kevin Bacon do deal with the resulting run:

Needless to say, none of these stories are a surprise to me. I’ve been warning that CCPs could be Trojan Horses packed with systemic risk for a long time, to no avail. I hope that, unlike Cassandra, my warnings are mistaken. But it is becoming abundantly plain that these concerns are becoming far more widespread. It would have been better had that happened before politicians, regulators, and central bankers fallen victim to groupthink and seized on clearing as a “solution” before they had closely analyzed the problem in all its complexity. But the G-20 put its imprimatur on clearing, and the groupthinkers are not about to admit a mistake and start all over. So market participants and regulators are having to deal with the realities of a framework that poses dangers that may be different than, but just as threatening, as those clearing was intended to address.

So now we know where commenter “a” (he of the Chicago obsession) has been hanging out (courtesy AT):

I actually love this.  Chicago, and Friedman in particular, are so in their heads it isn’t even funny.  Obsession is the sincerest form of flattery.

Ever since the financial crisis began, those who had been smarting at the whipping that Friedman had delivered over the previous decades leaped on the crisis as an opportunity to heap scorn on him, who conveniently for his critics, was dead.  Had he been alive, he would have delivered another whipping.

This attempt to blame the crisis on Chicago is rather pathetic–and a fact- and logic-free exercise.  Anybody who thinks that recent American, let alone European, policy was designed, built, or even approved at 59th and University is, quite frankly, an ignoramus.

Bleating about “deregulation”–whatever.  Many deregulatory policies that did bear the Chicago stamp, and which were actually implemented, in things like trucking, rail,  and air transport, have worked pretty much as advertised–and had nothing to do with the crisis.  But to think that financial policy over recent decades is largely Chicagoan is just wrong.  Yeah, Chicago types generally supported changes to Glass-Steagall, but these changes had absolutely nothing to do with the crisis, just as Glass-Steagall itself changed things that had nothing to do with causing the Great Depression.

I could go on about this for far longer than I have time for right now, but let me just mention a couple of things about Friedman in particular that prove just how bogus it is to heap blame on him for what blew up in 2008.

The first is monetary policy.  Friedman was an arch foe of the discretionary monetary policy implemented by Greenspan and then Bernanke in 2001-2008.  You may criticize Friedman’s monetarism, and if it was implemented during the 90s and 00s maybe different problems would have occurred.  But if Greenspan and Bernanke had been acting according to Friedman’s lights, they never would have committed the egregious errors that they did.  Friedman did not believe in “maestroes.”  Indeed, he believed they were dangerous.  He was utterly correct in his beliefs.

The second is the nexus between finance and government.  One of the foundations of Friedman’s belief in small and limited government is that private interests would exploit government power to seek rents. A lot of that went on in the lead up to the crisis.  To blame it on Friedman-Chicago libertarianism is farcical.

The third relates to the current crisis, which has the potential to make one look back wistfully on the halcyon days of 2008 and 2009.  It is a crisis of government spending, government entitlements, and government debt.  All of which Friedman in particular warned about for virtually his entire life.

I could go on.  The Euro and the EU, for example.  But suffice it to say that blaming Crisis I or Crisis II on Friedman and Chicago economics is delusional.

But we enjoy the attention!

And we really enjoy living rent free in your heads, particularly since there is so much available space.  Beats rent control any day.

The Euro summit is apparently a complete disaster.  No surprise.   There’s just no way around the math.

The most recent estimate is that to get Greek debt to sustainable levels of 110 percent of GDP by 2020, it will be necessary for Greek bondholders to take a 60 percent haircut–but the Euro fin mins are still talking about 50.  Always a day late and a few billion Euros short.

But 110 percent isn’t sustainable, really.  Especially for a country with as feckless a tax system as Greece’s.  80 percent may be stretching it.  So that gets us to approximately a 70 percent haircut.

These numbers threaten to consume the EFSF “in one gulp.”  And that’s before getting to Portugal, not to mention Spain and Italy.

One minister recognizes reality:

So pointless was the gathering, that Didier Reynders, the Belgian finance minister, left early to attend the world premiere of the new Tintin film, The Secret of the Unicorn.

The Euros really need the secret of the unicorn.  It may be their only hope.

Update.  As Tim Worstall notes, the haircut the private debtors must take is larger because the others (like the ECB) cannot take haircuts.

If you were wondering whether the Fed has run out of ideas, wonder no longer:

Federal Reserve officials are starting to build a case for a new program of buying mortgage-backed securities to boost the ailing economy, though they appear unlikely to move swiftly.

The idea would be to target any new efforts by the central bank at the parts of the economy that are most severely impeding a recovery—the housing and mortgage markets—by working to push down mortgage rates.

Lower mortgage rates, in turn, could encourage more home buying and mortgage-refinancing, and help the economy by freeing up cash for consumers to spend on other goods and services. Mortgage rates are already very low, but some Fed officials believe they might be pushed lower. Moreover, Fed officials believe their past purchase programs helped to lift stock markets, by driving investors from low-risk investments toward riskier investments.

What is it that Einstein said about doing the same thing repeatedly, and expecting a different result?  Now I remember: insanity is what he called it.  The emphasized paragraph suggests that the Fed is ready for the rubber room.

OK.  Don’t look for help from monetary policy.  What about fiscal policy?  Well, today’s WSJ presents a Keynesian lament that Americans’ saving is impeding a recovery:

Since the financial crisis erupted, millions of Americans have ditched their credit cards, accelerated mortgage payments and cut off credit lines that during the good times were used like a bottomless piggybank. Many have resorted to a practice once thought old-fashioned—delaying purchases until they have the cash.

As a result, total household debt—through payment or default—fell by $1.1 trillion, or 8.6%, from mid-2008 through the first half of 2011, according to the Federal Reserve Bank of New York. Auto loan and credit-card balances in August had their biggest drop since April 2010, the Federal Reserve said.

The national belt-tightening, known as deleveraging, comes as the U.S. economy struggles to fend off a double-dip recession. Paying off bills slows consumer spending on appliances, travel and a slew of other products and services. Home sales, the engine of past economic recoveries, remain depressed.

Is it somehow shocking that Americans are trying to rebuild ravaged balance sheets?  Is it shocking that they realized they were overleveraged prior to the financial crisis, and are trying to achieve a more sane level of debt?

This also means that Krugmanesque, Old School Keynesian borrowing solutions are unlikely to work either.  Those solutions depend on leveraging up on behalf of households, but those households can undo–and are likely to undo, given their recent behavior–most of all of that by reducing private leverage in response.  Hair of the leverage dog will not cure the hangover.

Which all means that both fiscal and monetary policies are at dead ends.  There are no quick policy fixes.  Indeed, frenetic attempts to find and implement such fixes are likely to make things worse, not better.

I have only had time to skim press coverage of the new Mifid & Mifir promulgated by the European Commission, but on my initial read, that appears to be a fair description.  All of the bad ingredients of Frankendodd made worse, with some special Euro accents of a decidedly dirigiste flavor.  The same deep suspicion of markets, the same cartoonish view of why market structures have evolved as they have, the same conceit of knowledge and control, the same breezy disregard for unintended consequences.

Sorcerer’s apprentices run amok, again.  Led by a French apprentice no less.

After July 21, 2010, who woulda thunk that regulatory arbitrage would have thrown business in the US’s direction?  If Mifid and Mifir go through anything like what Barnier et al propose, that could well happen.