Streetwise Professor

Near zero interest rates are wreaking havoc among FCMs. I recall reading something about that.  Heck, I remember writing something about that about a week ago.

There is a puzzle here, though.  Why don’t commissions vary inversely with interest rates?  The FCM business is pretty competitive, meaning that FCMs should earn the competitive rate of return, i.e., roughly speaking revenues should equal costs plus a fair return on capital.  If interest rates rise, generating more revenues for FCMs, competition should lead them to cut commissions in order to attract customers.  Conversely, if interest rates fall, reducing FCM revenues, competitive pressures should induce them to raise commissions.  Why have commissions remained at rock bottom levels despite the loss of revenues from interest on customer funds that the FCMs hold and invest?

One possible explanation is that due to technological change (e.g., the expansion of electronic trading) there is excess capacity in the FCM industry, and some firms should exit.  The excess capacity keeps downward pressure on commissions, which will not rise until there is a significant shakeout.

Perhaps MF Global, or Peregrine, or both, were unwilling to concede that they were no longer economically viable and should exit.  Frequently the need to secure external funds to keep operating is what forces unviable businesses to exit even though individual managers or owners may want to try to gamble or cheat for resurrection.  Financial firms’ (including FCMs’) ready access to cash (even if it isn’t really theirs) can permit them to engage in these sorts of actions without securing external funds.  This is why financial sectors under stress are particularly vulnerable to fraud and excessive risk taking: not only do stressed firms have the incentive to engage in this kind of conduct (which is true of stressed firms in other industries too), but they have opportunities that stressed firms dependent on external finance do not.

A couple of LIBOR-related items.

1. Timmy! claims that he and the FRBNY were “very forceful from the beginning” in dealing with LIBOR manipulation.  This is an example of why Timmy! (AKA Rodney Dangerfield) gets no respect.  His letter to the BOE was a classic example of bureaucratic CYA and buck passing: the BOE then exchanged the buck and passed the pound to the BBA which did . . . nothing.  More nothing happened for over three years, and it wasn’t the FRBNY that drove the process.  The scary thought is that is what passes for forceful in Timmy!’s world: the scary alternative is that Geithner is just BSing about his past forcefulness.  The thought that Geithner’s 2008 actions were forceful is Pythonesque, really:

Cardinal Ximinez: Cardinal Fang! Fetch… the Comfy Chair!
Cardinal Fang: [horrified] The Comfy Chair?
[Fang scuttles off, then returns with the Comfy Chair and sits the old lady down in it]
Cardinal Ximinez: Now, you will sit in this chair until lunchtime, with nothing but a cup of coffee at 11!

2. Central bankers are looking for an alternative to LIBOR, EURIBOR, etc

Central banks are exploring whether financial markets might be steered to adopting benchmarks other than Libor. Mr. Bernanke suggested a few alternatives at his hearings this week. Among them: The rate that financial institutions charge each other for short-term loans in “repo” markets in which they use their large securities portfolios as collateral for short-term loans. He said derivatives markets also provide alternatives, such as “overnight index swap,” or OIS, rates, which track central bank lending benchmarks.

That’s great going forward, but what about the $800 trillion or so in notional and/or principal amount of outstanding derivatives, loans, and other financial instruments with payments tied to LIBOR and its European and Asian cousins?  That would be a helluva lot of contracts to orphan.

LIBOR needs to be fixed, because of this massive amount of legacy contracts.  But how?  It won’t be easy, since the transactions that LIBOR et al should be related to-unsecured interbank transactions-aren’t orphaned: they’re damned near extinct.  Any decree by regulators that henceforth LIBOR should be something different than the creature that existed at the time these contracts, loans, etc., were created would potentially result in the shift of many billions of dollars of wealth, and spawn intense legal challenges.  (Ironically, any fines or damages arising from LIBOR manipulation-related legal actions will weaken banks and make the return of unsecured lending all the more remote a prospect.)

Looking for a replacement going forward is the easy problem: market participants have an incentive to come up with something more robust, there will be experimentation and competition, and perhaps with a little regulatory shepherding, in not too long something better (no doubt some sort of secured rate) will emerge as the benchmark.  Going forward, market participants can find transactions and benchmarks that are mutually beneficial.  That provides an incentive to get it right.

Finding a way to deal with the legacy of the past is going to be a much, much more difficult problem.  The primary effects of changes will be redistributive, rather than creative.  This will give rise to massive rent seeking and legal conflict.  Much fun will be had by all.  Especially the lawyers.

I owe thanks to Tim Worstall (never to be confused with Timmy!) for his Forbes blog post on, and compliments of, my Blame it on Ben? piece from Saturday.

I also owe Tim props, for he recognized the dangers that low interest rates pose to the traditional broker model back when MF Global went bust.

One clarification.  I didn’t mean to suggest that low interest rates caused MF Global, or Peregrine, or the Whale, in the sense that low rates were a sufficient condition for these things to occur.  Low interest rates aren’t necessary either: some firms take risk or commit fraud when interest rates are high, obviously.

But risk taking (such as MF Global’s gambling for resurrection) and fraud (such as Peregrine’s) are more likely when firms are on, or over, the financial brink.  Low interest rates put these firms on the brink, and made the courses of action that Corzine and Wasserman chose more attractive and compelling than they would have been had they been making money the old fashioned way.  Put differently. low interest rates increase the odds of such conduct.

With that clarification made, just let me say thanks Tim, and keep up the good work.

The futures industry is reeling over the latest theft of segregated customer funds, this time by Peregrine Futures’ Russell Wasendorf.  Wasendorf admitted to stealing seg funds in a note left at his side when he attempted suicide after it looked like his scheme was unraveling.  He has been indicted for fraud committed over the 2010-2012 period.  Over $200 million is missing, and his company is undergoing Chapter 7 liquidation.

Following hard on the heels of the MF Global disaster, the Peregrine revelations are raising further fears about what had once been considered sacrosanct: that customer funds are inviolate.  Even the CME Group, which has historically been a stalwart defender of the traditional segregation model in which FCMs are the custodians of customer money, has suggested that changes may be necessary:

Without question, the current system in which customer funds are held at the firm level must be reevaluated.

CME Group recognizes that the demand for its services is reduced to the extent that suppliers of complementary services-such as brokerage-are deemed untrustworthy.

I consider it virtually inevitable that this will be the last nail in the traditional segregation model.  This will lead to a dramatic change in the organization of the FCM industry.  Though (as I discuss a below) that industry was already under tremendous strain.  Peregrine and MF Global are symptoms of that strain.

Other big news this week was JP Morgan’s reporting of a $4.4 billion dollar Q2 2012 loss, and a $459 million restatement of its Q1 results-along with an admission that the “integrity” of the marks in the CIO books.

Do Peregrine, MF Global, and JP Morgan’s travails have anything in common, except for bringing further discredit onto the finance and banking industry?  I think they do.  I think they are all consequences of near-zero interest rates.

The traditional FCM revenue model relied on interest income from customer funds invested by the FCM.  Very low interest rates make that model unviable.  That is a major reason why Corzine felt it imperative to transform MF Global-and to take on more risk.  I conjecture that similar pressures led Wasendorf to commit fraud.  (Though his admission that he had been doing so for 20 years cuts against that interpretation.  A hypothesis: Wasendorf had been engaging in this activity on a smaller scale for years, but escalated it sharply as the financial pressures on Peregrine grew in the low interest rate environment.)

The Morgan story is different, but the extraordinary monetary policies that have driven interest rates to extremely low levels are at the center of the story.  Morgan had about $360-$500 billion in deposits that it needed to invest, but traditional investments such as Treasuries offered such low yields that the bank went hunting for yield, and invested in more risky securities and derivatives to get it.  Yield chasing in Fed-created low interest rate environments has contributed to previous big losses, such as Orange County’s in 1994.

Bernanke and the Fed initially pursued a low interest rate policy in an attempt to prevent another depression, and have continued it in attempt to spur growth.  These are the justifications for these policies, and they are defensible ones.  But these policies cause collateral damage.  Financial blowups-from MF Global to Peregrine to the Whale-are plausibly just that.

This provides a truly fascinating insight as to how Russia works:

Sucres et Denrees SA, a French sugar trader with processing in Russia, may offer a stake in Russian assets to Kirsan Ilyumzhinov, a former regional governor, to help protect operations, its head of the local business said.

“This can be the case if Mr. Ilyumzhinov helps to save our assets from the corporate raiders,” Etienne Pelletier, also a member of the company’s executive committee, said today by phone. Ilyumzhinov, governor of Kalmykia until 2010 and World Chess Federation president, has “necessary contacts,” he said.

“Necessary contacts.”  Those two words speak volumes.

Ilyumzhinov is a real piece of work, by the way.  (And his WCF involvement provides yet more evidence, as if any is needed, of the deeply dysfunctional and corrupt nature of virtually every international sports organization, e.g., the IOC, FIFA, Formula 1.)

This part is particularly illuminating:

The trader has been in legal disputes over ownership of Russian assets since 2008 after contracts to buy equipment for plants were challenged by local counterparts. Sucden has three sugar plants in Russia that processed 2.5 million metric tons of beet into 316,000 tons of sugar last year, company data show.

This illustrates the challenges that commodity trading firms face generally, as many must deal in jurisdictions in which the state is predatory and/or the the state does not protect property rights and/or the line between the state and predatory elites is somewhere between blurry and non-existent.  Russia presents all of these problems.

This is how the natural state works.  Which makes the following borderline insane:

Investors should buy European stocks with sales in Russia as the oil-producing nation’s economic growth will outperform the debt-stricken euro region’s, according to Citigroup Inc. (C)

“The point is that Russia has growth while Europe is facing stagnation,” Kingsmill Bond, chief strategist at Citigroup in Moscow, said in a phone interview today. “A lot of the growth that European companies will generate will be from their Russian operations.”

First, Russian growth is highly dependent on what happens in Europe.  Remember, Russia is a high beta economy, and due to the natural resource dependence an economic crisis in Europe or China will hit Russia even harder.  So the idea that investing in Russia is some sort of hedge against economic troubles elsewhere is particularly daft.  Second, Russian operations pose their own special risks to foreign companies.  Such as having to get a krysha from corrupt governors who believe they were abducted by aliens.

Like Freddie Krueger, I’m baaaaaack again, folks.  This time, more regularly, I trust.

Catching up on a few things that have caught my eye since last time-and like Freddie, I brought my knives.

1. The LIEBOR mess continues to metastasize.  It is now sucking in regulators.  Including Timmy! It appears that the dissembling about LIBOR, TIBOR, EURIBOR, etc., was the worst kept secret in the world’s financial centers.  And let’s pray that’s true.  If the Fed, the Bank of England, etc. DIDN’T know that there was a complete disconnect between the rates that banks reported to the BBA and the rates at which they were actually borrowing (or not)-now THAT would be a reason for panic.  In fact, they were all-bankers and regulators alike-operating pursuant to the Juncker Maxim: “When it becomes serious, you have to lie.”
2. I detest manipulation of markets, and have made a life’s work of studying it, calling out manipulators, and now and again testifying against them.  But I find it disgusting to hear high government officials in high dudgeon on the subject, when they are in fact often the most outrageous and shameless manipulators.  The most flagrant example: the Lilliputians who are the collective “leadership” of the EU and the Eurozone.  For what else can you call their repeated fudges, misstatements, lies, etc. related to the latest “solution” to Greece’s problems, or Spain’s, or Italy’s, than “manipulation”?  How many billions have changed hands on the EUphoric rallies that occur after the announcement of such solutions, and on the, umm, “retracements” that occur when the truth comes out.  The agreement on a Spanish bailout, and banking regulation changes, that came out of the most recent Summit of the Lilliputians is only the latest example.  Look.  Europe is screwed.  Metaphysically.  The math does not work.  Cannot work. Even mores, the politics cannot work.  The core is empty.  No real deal is possible.  Accept it.  And once you accept it, mock any pronouncement of the next “solution”.  And for God’s sake don’t buy except on the theory that other suckers buy and you will sell out before they do.
3. FCM Peregrine Financial Group apparently absconded with $220 million of “segregated” customer money.  This is both shocking and depressing 10 months after MF Global.  The scheme has apparently been going on for at least two years.  But the CFTC allegedly gave all FCMs the full anal probe post-MF, and saw-like Sergeant Schultz-NOTHINK! So since they can’t find a rather banal fraud at a middling futures brokerage, it’s truly obvious that they have game to regulate the entire world, and every complex financial institution and complex derivative trade in it.  What could go wrong? No doubt that the Peregrine debacle will lead to calls for more regulation.  Regulation, the only human activity where failure is the primary justification for more of it.
4. The CEO of inter dealer broker GFI, Mike Gooch, has said that hedge funds need to become liquidity suppliers/market makers in order to fill the gap left by banks, post-Volcker Rule.  I predicted this would be the outcome in a couple of posts written soon after the rule was mooted.  There is a serious question here: will this really lead to greater stability during times of financial turbulence?  Given that credit to hedge funds-which comes largely from banks, by the way (funny thing, that!)-typically contracts severely during periods of such turbulence, their market making activities are likely to contract as well during such times.  Meaning that market liquidity supplied by hedge funds will be highly pro-cyclical.  Bank supplied market liquidity is too, but the ones subject to the Volcker Rule-you know, the ones who have sticky insured deposits-are likely to be able to resist these cyclical pressures better than hedge funds because their funding is not as fragile.  So yes, Mike, hedge funds will be needed to fill the gap left by the exit of prop trading banks, but they won’t be there precisely when needed.  Things will work just swell.
5. Gazprom was named the most opaque corporation in the world.  I am shocked and stunned.  It is allegedly the most profitable.  Again, no surprise: government enforced monopoly is a nice gig.  But the company has been forced to make price concessions on contracts to big customers.  It is fighting a rearguard action against the flood of gas being discovered around the world.  It won’t happen overnight, but government mandated monopoly or no, the company’s future is not bright.
6. The to-ing and fro-ing over privatization in Russia continues.  Putin allegedly threw a spanner into Sechin’s ambitions to acquire “privatized” assets, including electricity generators.  But his words are pretty weak: “That does not mean we should limit ourselves to participation by Rosneftegaz.”  So you could envision some competitors in the bidding process, and them prevailing enough times to give the impression that a real privatization is going on.  But this is likely to be a Potemkin privatization, and Sechin et al are likely to prevail.  Sechin certainly thinks so: “Russia’s most influential energy official, Igor Sechin, said on Tuesday the state-owned energy holding Rosneftegaz was given permission to invest cash on its balance sheet in comments which seem to contradict assertions by a top government official [Akardy Dvorkovich].” I would bet on Sechin.  Hands down.
7. There is a spate of bad news about the weakness in China’s economy.  I have been a China bear for going on three years, or more actually.  The first reason for my pessimism has always been China’s ramshackle and rigged financial and banking systems: this predates the crisis.  This post provides an excellent overview of the reasons to find that system “scary.” Yes, the Chinese government has papered over past problems, but there are limits to this, as there are to all things.  Indeed, as the economy has gotten larger, and in the aftermath of the crisis and the massive monetary and fiscal response thereto, the state’s capacity to continue to do this is very questionable.  The second reason is that, contra Tom Friedman or Ray LaHood, I adamantly do not believe that the allocation of capital by the state, directly, and indirectly through financial repression and a hugely distorted banking system, will end well.  In fact, I believe the exact opposite is true.  Suppressing price signals and allocating capital to cronies and state owned enterprises is a recipe for grotesque misallocations of capital.  In the short to medium term, it can lead to impressive GDP numbers.  But spending insane amounts on investment eventually leads to catastrophe if that investment doesn’t produce returns.  That, in a nutshell, is what China looks like to me.  And these two sources of pessimism feed off one another: when the investments don’t generate returns, and in fact generate losses, the banks and trust companies and insurance companies and whatever that provided the finance are toast.  When you force feed a goose, you can at least get good liver pate (but not in California!).  When you force feed investment, eventually you get a bust.

That’s all for now folks.  Catch you again soon. Promise.

Notorious Russophobe Alexei Kudrin is sounding the alarm on Russia’s economy.  (No doubt “a” is fulminating about him now.)

Mr. Kudrin, who was ousted from the government last year after protesting rising military spending, said he listened to presentations and speeches at the forum, where Russian officials typically woo foreign investors, and heard expressions of “worry” and discussions of “worst-case scenarios.”

Still, he said, “the situation is a lot worse than it was presented.” With Europe apparently slithering into recession this summer, Russia is now more likely than not to suffer a crisis of its own this year, he said. While he acknowledged that other economists were less worried about Russia than he is, he said, “I saw even less worry in the Russian government.”

Banks and investors are already pulling money out of Russia, he said in a question-and-answer session with journalists at the close of the three-day St. Petersburg International Economic Forum, while indications from Europe worsen by the day.

Mr. Putin, in contrast, spoke of Europe’s turmoil largely to highlight that Russia is better off.

The best part is at the end:

Mr. Kudrin did allow that his former boss’s speech struck a positive note in highlighting new business-friendly laws and promising a new round of privatization of state enterprises to shore up the budget. In his address, Mr. Putin said these privatizations would be conducted more fairly than those in the 1990s.

Mr. Kudrin said the actions would matter more than talk. “Putin’s speech was good, if it is realized,” he said.

Absolutely.  Putin talks a good game, especially when it comes to reducing Russia’s high beta economy’s dependence on energy, privatization, fighting corruption, and creating a rule of law.  Follow through, not so much.

Very interesting to see Kudrin call Putin out so clearly.  For most people, not a very healthy habit.

Luigi Zingales is a brilliant guy.  I find his advocacy in the FT of a return to Glass-Steagall less than brilliant.

Zingales identifies four reasons for supporting G-S.  Three are wildly implausible, the fourth hardly persuasive enough to justify a return to 30s-era regulatory structures.

The first reason is that it makes sense to restrict commercial banks’ participation in “very risky activities.”  There are at least two problems with this, when evaluated in the context of the financial crisis.

First, the investments and activities that put commercial banks at risk during each of the last two crises-mortgages and MBS in Financial Crisis I and sovereign debt in Financial Crisis II (the one currently ongoing, particularly in Europe)-were blessed by regulators as low risk activities.  They almost surely would have passed muster under Glass-Steagall.  There were other major banking crises under Glass-Steagall.  It is painfully clear that G-S is not sufficient to prevent banks from taking on risk in sufficient amounts to put individual banks and the banking system at risk.

Second, and I realize I am an apostate on this, although moral hazard is a concern associated with deposit insurance, funding and liquidity risk is as dangerous and arguably more dangerous.  Runs are more likely, the less sticky the funding.  Concentrating riskier activities in institutions like stand-alone investment banks that rely on wholesale markets rather than stickier insured deposits for funding increases the risk of destabilizing runs and makes the system more fragile.   It therefore seems extremely dangerous to allow the institutions with the riskiest funding hold the riskiest assets, and preclude the institutions with the safest funding not hold such risky assets.  Look for other means-such as risk-based deposit insurance premiums or capital requirements-to control the moral hazard problem.

Zingales’s second reason is that Glass-Steagall was simple.  Well, yes, the original bill was (as compared to Frank-n-Dodd or the Volcker Rule portion thereof) but there did grow up a thicket of regulations and interpretations and decisions around it.  This is inherent in any law that attempts to draw lines between activities: such laws generate efforts to engineer products that cross the lines in substance but seem to comply to the letter.  This generates a process of litigation, interpretation, regulatory challenge, etc.

And does anybody believe that if Glass-Steagall were to be brought back, it would be the same today as in the 1930s?  Glass-Steagall was simple in part because it was the product of simpler times  Financial markets are much more complicated today, and splitting the baby would be far harder.  Any attempt to do so would almost certainly result in a Son of Glass-Steagall that is far more complex, and far longer, than the nearly 80 year old original.

I have to say that Zingales’s third reason is cracked:

The third reason why I came to support Glass-Steagall was because I realised it was not simply a coincidence that we witnessed a prospering of securities markets and the blossoming of new ones (options and futures markets) while Glass-Steagall was in place, but since its repeal have seen a demise of public equity markets and an explosion of opaque over-the-counter ones.

I realize this is a newspaper oped, with tight space limits, but Luigi provides no serious evidence to support his realization that coincidence equals causation.  With respect to the demise of public equity markets, trading volumes have skyrocketed, and although there has been an increase in “dark markets”, such things existed in the glory days of G-S, just under a different name (“third markets”, for instance), and there are good economic reasons why this is so.  Moreover, some problems associated with equity markets are attributable to other regulations, notably Sarbanes-Oxley.

With respect to OTC instruments, Zingales’s characterization of cause and effect is muddled and ahistorical.  OTC derivatives began to grow rapidly in the 1980s, while G-S was still in force, but their growth was constrained by regulation.  However, it was legal uncertainty under the CEA that was the main problem, not Glass-Steagall.  This was addressed by the CFMA of 2000, rather than the Gramm-Leach-Bliley  (GLB-wouldn’t it have been funny if there had been a fourth co-sponsor with a name starting with “T”?) of 1999, which repealed G-S.  Commercial banks and investment banks both did OTC derivatives before GLB, and would likely continue to do them under Son of Glass-Steagall.  What’s more, they are constrained-over-constrained, IMO-by Frank-n-Dodd.

Zingales continues in a rather bizarre vein:

To function properly markets need a large number of independent traders. The separation between commercial and investment banking deprived investment banks of access to cheap funds (in the form of deposits), forcing them to limit their size and the size of their bets. These limitations increased the number of market participants, making markets more liquid. With the repeal of Glass-Steagall, investment banks exploded in size and so did their market power. As a result, the new financial instruments (such as credit default swaps) developed in an opaque over-the-counter market populated by a few powerful dealers, rather than in a well regulated and transparent public market.

But the IBs that got into trouble (Bear, Lehman, Merrill, Morgan Stanley) never had access to deposits post-GLB.  Not before, not after.  So the cause-effect link between the repeal of G-S and the explosion in size of IBs that Zingales posits (resulting from the the access to deposit funding for IBs inside CBs) never happened.

No one knows the exact cause (global imbalances, Fed looseness), but the financial system was flooded with funding liquidity in the 2000s.  That is what permitted the IBs to lever up and risk up, not a sudden access to insured deposits.

And by objective measures, markets were more liquid-substantially so-post-G-S.  Spreads were smaller.  Volumes were bigger.  The number of participants was larger: hedge funds proliferated, for instance.  Really, I don’t think anybody noticed the markets getting less liquid post-G-S.  If anything, the concern was that there was too much liquidity, too much trading.

And insofar as CDS are concerned, it is hard to believe that G-S would have (a) prevented the creation of these instruments, or (b) resulted in them being traded by something other than big dealer institutions.  Again, note that stand-alone IBs were major dealers in these instruments, and that they were first developed by a commercial bank (JP Morgan) prior to 1999.  In many respects, the disintermediation of banks by capital markets, a process that started and became quite pronounced under the G-S separation led banks into other, non-lending forms of intermediation.

I would also emphasize that there are intense economies of scale in responding to expansive regulation like Dodd-Frank, meaning that regulation can contribute strongly to consolidation in finance, with its consequent effects on competition, the number of market participants, and systemic risks.

Zingales’s history, in other words, isn’t history at all.

There’s another point here.  If G-S was that important, why didn’t its repeal lead to dramatic changes in market structure, with the demise of stand-alone IBs and the dominance of integrated, full-service universal banks with access to insured deposit funding?  Zingales’s narrative is inherently contradictory: he focuses on the metastasization of IBs post-GLB, but if you believe his story, the repeal should have caused IBs to shrink or die or get absorbed by commercial banks or turn themselves into universal banks funded substantially by deposits.  None of that happened.   Indeed, there were numerous studies in the mid-2000s, notably by the Fed, the Senate Banking Committee, and the St. Louis Fed that all concluded that GLB’s G-S repeal had very limited effects on the structure of US financial markets: most of the major changes in market structure had occurred in the 1975-1998 period.

It is also worth mentioning that the universal bank model that Glass-Steagall eliminated developed in a world without deposit insurance.  Indeed, Glass-Steagall created deposit insurance, which means that at least then implicit subsidies in deposit insurance couldn’t have caused the combination of investment and commercial banking.  Why should we believe that deposit insurance would cause such an integration today?  Especially in light of the fact that the elimination of G-S boundaries did not result in the absorption of investment banking into commercial banks.  Given the role that deposit insurance plays in Zingales’s narrative, this is a major problem for it.

Zingales also claims that the financial system was more resilient under G-S, and points to the contrast between the ’87 Crash (which was not followed by a financial crisis) and the ’08 debacle (which was) as an illustration.   I really don’t see any connection between G-S and how the broader financial markets fared post-Black Monday.  Zingales notes that commercial banks didn’t have problems post-Crash.  Well, investment banks didn’t either, for the most part.  The main difference is that in ’87, most equities were held by real money investors, not financial institutions: ditto the Dot Com crash.

In contrast, in ’07-08, the mortgages that cratered were held primarily by highly leveraged financial institutions-commercial and investment banks; many of these were destined to go to real money investors, but banks and investment banks were caught with them before they could securitize them and market them to real money.  Today, in Europe, sovereign debt is held mainly by leveraged financial institutions.  Banks today don’t hold huge amounts of equities, and an ’87-type event, where the crash originated in the equity market would probably have a similar result today.  The equity crash in ’08 was a response to the crash that was occurring in mortgages.  The events are very different.

And it is quite plausible that these two events were the direct result of regulations, notably the very favorable capital treatment of mortgages and MBS (especially those transformed into AAA securities despite the quality of the underlying collateral) and sovereign debt.

Luigi’s last point is that a divided financial industry is less effective in exerting political influence because commercial banks, investment banks, and insurers have divergent interests.  But again, commercial banks, investment banks, and insurers existed post-GLB.  There was not a wholesale shift to universal banking in the US.  Certainly this could have happened, post-GLB, but it didn’t.  The greatest impetus to consolidation was the crisis itself, when IBs either blew up or were absorbed into commecial banks.  Thus, again, the structural change that could have happened under G-S didn’t happen to that great an extent, meaning that the political economy didn’t change that much either.

Moreover, to the extent that the activities of financial institutions are siloed, as under G-S, they are not competing with one another in the marketplace.  This also limits their need to compete with one another in obtaining favorable legislation or regulation.  Each can focus its efforts on obtaining favorable laws and regulations pertaining to its silo.  Commercial banks focus on favorable rules for commercial banking activities; insurers focus on favorable rules for insurance; investment banks on favorable rules for broker-dealer and securities underwriting.  There is no Galbraithian “countervailing power” mechanism operating that pits investment banks against commercial banks when they are functionally separated a la G-S, because the very separation of these activities means that the firms in one segment are not competing for rents against firms in the other segment.

In brief, it appears that Luigi is aiming his argument at a world that could have arisen after the repeal of Glass-Steagall.  A world in which there was a decisive move to universal banking in the US, resulting in the disappearance of stand-alone investment banks.  Some certainly predicted that outcome in 1999, but it didn’t occur.  There were some changes in market structure, but only modest ones.  It is passing strange that Zingales attributes the growth in investment banks to a law that, under the most straightforward interpretation of his argument, should have led to their demise.  Most importantly, the mechanism that Zingales posits-the availability of cheap insured deposits to fund risk taking by investment banks-didn’t work that way in practice.  Risk taking was funded through the wholesale markets which were awash in money.  That was the vulnerability of the system.

Zingales’s history about the evolution of equity markets, OTC derivatives markets generally, and CDS markets in particular, is also suspect.

So when reading this article, a Mark Twain quote came to mind: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

The Bulava-esque trajectory of the “bailout” of the Spanish banks would be hilarious if it weren’t so tragic.  But it was predictably tragic.

The Euros pulled one of their characteristic delay and pray moves.  (Though, being thoroughly pomo, I doubt praying had much to do with it.)  In essence, they funded-maybe, because the details of the funding and the identify of the funder(s) are Players to Be Named Later-the movement of Spanish bank liabilities onto the balance sheet of the Spanish government.  This boosted the debt-to-GDP ratio of Spain to the severe pain range: uhm, bringing the SPVs on balance sheet doesn’t make the entity stronger; quite the contrary.  A level that is likely unsustainable given the dire economic straits the country finds itself in, with GDP contracting and unemployment at Great Depression heights.  Moreover, the move has affected the game between the EU and the other debtor nations, who see that Spain extracted a deal that compares favorably, in terms of “conditions” to theirs.  Thus, Ireland may want a renegotiation of its deal, and the Greeks may conclude that telling the Troika to eff off might be the best course.  Moreover, it gave those holding bonds not just in Spain but in other precarious countries-notably Italy-serious concerns that they might be subordinated.

Furthermore, by absorbing a big chunk of EFSF/ESM resources, the Spanish bailout raised serious questions about their ability to assist other countries, with Italy again at the top of the list.  This further increases the angst of bondholders. (A warning to CCPs that have resources to absorb the default of N members, but no means to recapitalize.  When the N-2d or N-1st default occurs, there is likely to be a run on the CCP, making its ultimate demise almost inevitable.)

Hence, after an initial burst of foolish EUphoria, Spanish bond yields spiked, as did those on Italian debt.

Well played!  Well played! Bravo!

No, Europe’s real choices, as opposed to its finger-in-the-dike stopgaps, are exactly the same as they were last year, and the year before that.  Amputation or gangrene.  Socialization of debt or dissolution of the Eurozone as it currently exists.

But Europe refuses to grasp those nettles.  Truth be told, moreover, it seems impossible that they can negotiate the arrangement necessary to make socialization palatable to those who are likely to be net contributors-notably, the Germans. Germany obviously does not want to be Europe’s ATM, and reasonably demands mechanisms that limit its exposure.  Furthermore, it is highly unlikely that the electorates of other nations are willing to surrender sovereignty, or undertake the structural reforms* necessary to make them competitive and put them on a reasonable growth trajectory.

Indeed, look at the delusional policies that France is pursuing.  Lowering the retirement age.  Looking to make it virtually impossible to layoff or fire anybody-which will mean that it it will be financially insane to hire anybody in the first place.  In the name of growth!  These policies are popular-not only did Hollande win, but the Socialists won an outright majority in the just-finished parliamentary elections.

Good luck with that!  Be careful what you ask for!

Everyone is importuning Merkel and Germany to save them.  Particularly annoying are the gratuitous proddings of Timmy! and Obama.  Timmy!’s post-bailout-that-wasn’t-a-bailout remarks were particularly grating.  Sayeth Timmy!: the bailout represents”concrete steps on the path to financial union, which is vital to the resilience of the euro area.”

Read that again.  Geithner, whom the (relatively) solvent Euros loath, is telling Europe that financial union is the way to go.  What chutzpah.

Germany realizes that such a financial marriage in haste will permit it plenty of time to repent its error at its leisure.  But there isn’t time to negotiate a solid pre-nup before the whole thing goes up the spout.  And I doubt there is a pre-nup that all parties are willing to sign, or would adhere to if they did.

The core of this game is empty, it seems to me. Which means that it is a matter of time before the whole thing collapses.  And that time is drawing nigh.

* Structural reform-supply-side measures, if you will-are essential to supporting long run growth.  But commentators insist on either misunderstanding this, or grossly mischaracterizing it.

For instance, consider the recent Roubini-Ferguson oped on Europe:

Structural reforms that boost productivity growth should be accelerated. And economic growth needs to be jump-started. The policies to achieve this include further monetary easing by the ECB, a weaker euro, some fiscal stimulus in the core, more bottleneck-reducing and supply-stimulating infrastructure spending in the periphery (preferably with some kind of “golden rule” for public investment), and wage increases above productivity in the core to boost income and consumption.

Uhm, none of those are structural measures.  They are all variants on Keynesian nostrums.

But that is nothing compared to the truly aggravating Martin Wolf:

Moreover, “structural reform” is a woolly term. If by this Mr Schuknecht means that falling prices, induced by ultra-high unemployment, debt deflation and sovereign and banking insolvencies, will ultimately restore competitiveness, he is correct, provided the country is able to stick with such policies, for a very long period indeed (probably a decade, or even far longer). This is what is required if a country with a large private sector debt overhang and a sizable structural current account deficit is to eliminate its fiscal deficit, regain competitiveness and restore growth, particularly in a currency union whose core country has a structural current account surplus and low inflation. The question is whether democratic politics (or the eurozone) will survive the experience. I doubt it.

Way to bash a straw man there, Marty! You know that’s not what German FinMin official Ludger Schuknecht meant by the term, and for you to insinuate otherwise is truly low.  Schuknecht is referring to the kinds of labor market and other reforms that transformed Germany from the sick man of Europe to the prosperous nation whose pocket everyone wants to tap.  If you want to discuss structural measures, at least do it fairly.  John Stuart Mill you ain’t. (Mill was/is legendary for his even-handed characterizations of his opponents’ views.)

With these clueless or deeply misleading analyses from esteemed purveyors of opinion, structural reforms don’t stand a chance.  Especially in delusional countries like France, which are hell-bent on implementing structural deforms.

After all that, isn’t a little musical entertainment in order? I think it is!

Sorry about the prolonged interruption.  Work demands-notably testimony in a couple of cases-intervened.  One of the cases, believe it or not, stems from the California electricity crisis of the summer of 2000.  The wheels of justice do grind slowly.  We’ll see how fine.  On Tuesday, I testified at a FERC hearing/trial relating to refunds demanded by electricity buyers in California.

The interruptions may recur going forward.  I appreciate your patience, and the inquiries of those who wondered about my absence.

A few quick comments on things that caught my eye in the past couple of weeks.

• My last post was on the administration’s sole commitment to transparency, i.e., it’s chattiness on sensitive intelligence matters, in an information operation designed to make Obama look like a synthesis of Rambo and Thomas Aquinas.  In the weeks following, this issue has caught fire to some degree, at least in DC (though popular opinion has been somewhat muted).  There have been numerous calls for official investigations. These are not purely partisan. Diane Feinstein and Carl Levin have also expressed dismay at the leaks.  And in the latest episode of the inversion of transparency, Obama has asserted executive privilege in the Fast & Furious matter.  His assertion is either facially baseless and contrary to established precedent-or implicates him in a coverup.
• Hillary botched the Russian helo to Syria story. By suggesting that Russia was sending new equipment to Syria, Hillary gave the Russians the opportunity to make outraged denials. On the subject generally, here’s a question that I think is important, but which hasn’t been asked.  Where is Syria getting the spare parts and support services for its Russian/Soviet weapons?  Especially at the increased operational tempo, Syria would need a steady supply of spares to keep its forces in the field.  And likely also some repair and support services.  Arab armies are notoriously-notoriously-bad at this.  (It’s something that has driven American trainers assigned to Arab armies, such as Egypt’s, absolutely crazy over the years.)  I wish someone would ask, investigate, etc.
• Obama met with Putin in Cabo.  Obama came out of the meeting looking like he would have preferred 32 root canals sans anesthesia.  He got nothing from Putin.  Well nothing substantive, that is.  But I am sure that Putin gave him plenty of disdain.  Obama later said that China and Russia were not on board regarding Syria.  No sh*t.  What was his first clue?
• Putin looks bad in the photos from Cabo BTW.  His face looks puffy and waxy.  I’m guessing steroids.
• It has been reported that Putin will attend the Olympics in London after all.  Not the opening ceremonies, as is traditional, but the judo competition.  You know, to see the next generation of Russian billionaires.
• Putin jetted from Cabo to St. Petersburg, for the Annual Economic Forum.  He was in fine form, and in some ways, a flashback to 2008.  That is not a compliment.  In 2008, Putin famously asserted that Russia was an island of stability in the world economic storm.  That was right before the country suffered the biggest decline of any major economy.  Putin also lashed out at the west generally and the US in particular for causing the world crisis.  He repeated both themes yesterday, in a somewhat schizophrenic performance.  First, he stated that Russia is a strong country capable of withstanding another global economic crisis. This despite the fact that Russia is even more dependent on energy/oil now than in 2008, and that the link between economic crisis and oil prices is as strong today as it was four years ago. In other words, Russia is more dependent on oil than ever but Putin believes it is perfectly positioned to withstand another crisis.  Or something.  And speaking of oil, Brent is trading with an $89 handle, down 4 percent on the day and over 20 percent over the last several weeks, and Urals with an $88 handle (a $1.60 discount to Brent). Recall that Russia’s budget balances at Urals=$117.  This may explain the vituperativeness of Putin’s attack on the US and the west.  The more nervous he gets about economic conditions, the more he directs his salvos westward.  This reflects, IMO, his rage at the fact that Russia is hostage to the west, via the commodities price channel.  It is an inevitable consequence of the marriage of comparative advantage and the natural statism of Putinism.  And it drives him nuts.
• Putin also channeled his inner Barney Frank and said that the west needed more effective regulation of derivatives markets. (Bad mental image, I know.)  The man is an expert on everything.

That’s all for now, folks.  Will post as circumstances permit.