Streetwise Professor

Soon after the 2oo8 election, I wrote a post titled “No Joy in Mudville” in which I prophesied numerous malign effects of the Obama election: the post got some notoriety, including a pickup by the WSJ Political Diary.  Although I was off on some of the specifics, I think I was right on the essentials.  Four years of cascading progressive statism, with a heavy measure of foreign policy incompetence as an added bonus.  And four years of moribund economic performance.

My pre-election appraisal was that defeating Obama was a necessary but not sufficient condition to stave off serious decline, and perhaps crisis.  I had little hope that Romney or the Republicans would have been able to address the deep structural problems the nation faces, especially if they had prevailed in a close election.  But I am nearly metaphysically certain that Obama and the Democrats won’t, in large part because they don’t perceive that we face serious structural problems arising from unsustainable entitlements, a fiscally incontinent government, and crushing regulatory burdens.  Indeed, they see these as features, not bugs. These were the main planks in Obama’s real platform: no substantive change in entitlements, more government spending-excuse me, “investment”-and more regulation.

Consequently, I predict continued sluggish economic growth-if we’re lucky-with a heightened risk of fiscal (and consequently financial) crisis, timing TBD.  The regulatory burden-most notably the Four Horsemen of Frankendodd, Obamacare, the EPA, and Other Assorted Insanity From Agencies You’ve Never Heard of-will make us pine for the growth rates of the 1970s.  Redistributionist-driven changes to the tax code which will raise marginal rates and particularly increase taxes on capital will create further drag, all the while doing nothing to improve the country’s fiscal situation (and in fact worsening it with non-trivial probability)

Slow growth, combined with continued high levels of government spending, a failure to address entitlement spending, and increased expenditures arising from Obamacare, will accelerate the deterioration of the nation’s fiscal condition.  Given the multiple equilibrium nature of government finances (where small changes in circumstances can lead to a jump from an equilibrium in which lenders are willing to rollover debt to one in which they aren’t), this deterioration increases the risk of a funding crisis that would make what is going on in Europe now look like a pleasure cruise.  (For those of you who take solace in the fact that other people might have it even worse, there’s always Japan, which would love to have our trivial problems.)  Any such crisis would inevitably be accompanied by a huge inflationary spurt, as inflation is de facto default: If it occurs before the Fed has trimmed its bloated balance sheet-and there is no sign that Ben will slim it down anytime soon-the spurt will be that much worse, as all those reserves (the Fed’s liabilities) that have been moving with virtually no velocity will start to turn over at an accelerating rate.

In other words, après nous le déluge doesn’t quite capture it.  Le déluge est maintenant. Well, perhaps not now now, but uncomfortably soon, and certainly en avant notre disparition, actuarially speaking.

There is widespread disquiet about the country’s fiscal and economic circumstances.  Indeed, if only economic and budgetary issues were in play in the election, it is my sense that the outcome would have been different.  But cultural, social, and religious issues prevented Romney from assembling a winning coalition.  The single issue cultural and religious right that blessed us with monstrosities like Mourdock and Akin-who became the poster boys of the Republican Party as a whole, due to the combined efforts of the Obama campaign and a supportive media-drove away many people with libertarian sympathies on both economic and social issues who would have been willing to vote for Romney if only economics and public finances were at issue.

Righteousness has a way of interfering with good judgment, and the ability to make rational calculation.  Cultural and religious conservatives have no way of prevailing on their agenda.  If anything should seem obvious in the aftermath of this election, that should be it.  Obama should have been extraordinarily vulnerable on the economic and budget issues that are conventionally believed to be decisive in national elections, but he prevailed nonetheless.  Why?  Social and cultural issues are the most likely explanation.

The result: a president and a Congress (especially the Senate) that is actively hostile to the agenda of the cultural and religious right instead of one that is at least not an enemy (even though it would be unable and unwilling-unless suicidal-to push that agenda), and inexorable movement towards fiscal catastrophe.

Well played.

If it were only about economics I would have some optimism-not much, but some-that we could address the growth, regulation, spending and entitlement issues.  But it’s not only about economics.  Social and cultural divides make it nigh on to impossible to assemble a coalition (under the aegis of the Republican Party) that can win a national election, and win it decisively enough to permit serious action on these budgetary and economic issues.

No Joy in Mudville, indeed.

In more non-Benghazi news, some clearing stories.  (Contain your excitement, people.)

First, Gretchen Morgenson is still wretched. (So I said this was a post about news.  Sue me.)  She kills CO2 absorbing trees to criticize the very thought of providing CCPs access to central bank liquidity:

But placing them at the bailout trough is wrong, according to Sheila Bair, the former head of the Federal Deposit Insurance Corporation. In a recently published book, Ms. Bair wrote that top officials at the Treasury and the Fed, over the objections of the F.D.I.C., pushed to gain access for the clearinghouses to Fed lending.

The clearinghouses “were drooling at the prospect of having access to loans from the Fed,” she wrote. “I thought it was a terrible precedent and still do. It was the first time in the history of the Fed that any entity besides an insured bank could borrow from the discount window.” .

“The Treasury’s and the Fed’s reasoning was that since another part of Dodd-Frank was trying to encourage more activity to move to clearinghouses, we should provide some liquidity support to them,” she said in an interview last week. “Our argument back was, if you have an event beyond their control with systemwide consequences, then you have the ability to lend on a generally available basis. What they wanted was the ability to lend to individual clearinghouses.”

Look, one of the reasons I think Frankendodd is monstrous is precisely because clearing and collateral mandates impose tremendous contingent liquidity demands.  Last week I spoke at in Osaka at the annual meeting CCP12, an organization of 30+ CCPs (which apparently uses the Big Ten as a naming role model).  An exec at an Aussie CCP asked me what the most worrisome unintended consequence of derivatives “reform” would be.  I answered before the words were out of his mouth: the potential for a liquidity crisis in times of market stress.

That’s what happened 25 years ago, on Black Monday and the following Tuesday morning.  The Fed prevented an apocalypse by leaning on banks to lend to FCMs to meet margin calls.

Clearing mandates without some mechanism to provide additional liquidity, either directly to CCPs or indirectly via clearing members, are a recipe for disaster.  Like Gary Gorton, I am increasingly skeptical of moral hazard being the major concern: the major concern is the inevitability of periodic liquidity crises even in efficiently structured financial markets.  Forcing use of clearing and collateralization of uncleared swaps while simultaneously depriving CCPs or their members of access to central bank liquidity would be like mandating the use of matches in an oil refinery and banning fire extinguishers.

So, not surprisingly, Wretched Gretchen goes the wrong way, yet again.

And speaking of wrong way, ICE has received approval to clear European sovereign CDS.  I’ve written before that clearing sov CDS is very problematic, due to the wrong way risk inherent in these trades.  The sovereign-bank feedback loop means that clearing members-or a CCP’s default fund-are required to make big payouts on sovereign CDS precisely when they are under severe financial strain.

ICE Clear Europe claims that it has taken measures to reduce the wrong way risk.  I am deeply skeptical that these measures are adequate.  (Sorry, Paul-I calls ’em like I sees ’em.)

One thing ICE Clear Europe points to is that margins and default fund contributions will be in dollars, not Euros.  This actually creates a new risk. One thing we’ve seen is that during flare ups of the Eurozone crisis is that European banks have faced serious problems accessing dollar liquidity.  Meaning that in the event of a jump to default by a major European sovereign, Eurozone some banks that are members of ICE Clear Europe may well need to come up with big dollars to pay margin calls, or to cover the costs of a defaulting customer, or to meet default fund contributions, but need to do so precisely when they find dollars very hard to come by.

Meaning that (pace Wretched Gretchen) they will be desperately dependent on Fed support through dollar swap lines.

The other measure ICE has taken is to preclude “affiliates” of a sovereign from clearing CDS on that sovereign. Yeah, have to do that, but that doesn’t really come close to addressing the real wrong way risk.  If Spain or Italy-or even Portugal or Ireland or Greece-jump to default, a Eurozone-wide financial crisis that hits all banks will likely result.  Meaning that all major Eurozone banks-including members of ICE Clear Europe-and not just affiliates of the defaulting sovereign, are likely to be in distress at that time.  Further meaning that they will be in distress precisely at the time they are expected to absorb some costs arising from the default (big margin calls, covering the losses of defaulting customers, or incurring default fund obligations).   That’s the wrong way risk we really need to worry about, and nothing that ICE Clear Europe says in its filing with the SEC provides any inkling that their plan addresses that risk.

I also have serious concerns about the risk modeling here.  Wrong way risk is devilishly complicated, especially in a sovereign risk context especially in Europe (given all the potential cross-country linkages).  I am skeptical in the extreme about the ability to set margins properly, and strongly suspect that any methodology is likely to be highly procyclical.

In brief, I continue to believe that clearing sovereign CDS is highly dangerous.  It’s good that ICE Clear Europe recognizes the inherent wrong way risk problem, but in my (strong) opinion, they haven’t really addressed that problem, and indeed may have introduced another source of wrong way risk via the cross-currency mechanism inherent in their design.

I hope I’m wrong.  I hope for all of us it never comes to a test.

Finally, Deutsche Boerse is going to have to stump up $150 mm or so in new capital for Eurex’s clearinghouse, in order to meet European capital standards.  And that’s cheap! LCH.Clearnet will have to come up with 375 mm Euros (or about $500 mm) in new capital:

However, tough new European regulatory capital rules appear to have caught the industry unaware. Eurex is the second major clearing house to admit to a shortfall after LCH.Clearnet, the Anglo-French group, said it would need to increase regulatory capital by an estimated extra €300m-€375m last month

So much for clearing mandates being a cheap way of mitigating credit risk.

We are just approaching the G-20 deadlines to move most derivatives trading into clearing.  And the fun just can’t wait for the official kickoff.  There will be much more fun-and cost, and risk-to come.

Today is the 25th anniversary of Black Monday, the 1987 Crash.  This event had a profound effect on my professional trajectory.  I worked at an FCM at the CME-GNP Commodities-during the Crash.  The firm was owned and run by Brian Monieson, a former chairman of the Merc, and a board member at the time.  I walked into his office on the morning of the 20th, and he told me about how the CME clearinghouse had almost failed.  I had only a dim appreciation for clearing prior to that, but that sparked my interest in the subject.

Little known fact: I Granger Caused the Crash.  Throughout the late summer and fall of  ’87 I had been having issues with my direct boss, and soon after I defended my thesis in August I had received a good offer from one of my advisors, Dennis Carlton, to work at Lexecon.  I tried to work things out at GNP, but by mid-October it appeared hopeless.  I told Brian, and we had several phone calls on the 17th and 18th where he tried to convince me to stay.  I thought it over, and on the evening of the 18th decided that it wasn’t going to work.  So I walked into my boss’s office at 7AM on the 19th and slapped down my resignation letter on his desk.  Apparently the news leaked, and the rest is history 😛

The anniversary has spurred retrospectives from many quarters.  Many of these focus on the role of computers in the Crash, and how this was a harbinger of the supposed horrors the machines are inflicting on the markets today.  One good-well, representative-example of this is “Rage Against the Machine” in the FT:

It has been 25 years since Black Monday, when stock markets crashed around the globe and Wall Street woke up to the risks of computerised trading.

Yeah.  The computers were blamed then.  Suspect number one was “program trading”, a good deal of which was garden variety index arbitrage.  This is not a destabilizing strategy, and numerous postmortems absolved program trading as a cause or aggravator of the Crash.

Indeed, if technology was a problem, it wasn’t that computers were trading too fast: it was that printers were printing to slow.  Seriously.

At GNP we did a little index arb trading.  In the morning, it appeared that the arb was extremely profitable.  The price of the cash index (we were doing MMI) was way, way above where the futures were trading.  It looked like a great opportunity.  My colleague Matt who was in charge of this called down to the CBT floor before doing a trade, to see where the floor was trading.  Our floor clerk said (I don’t remember the numbers exactly): “Somebody is offering X over here.  Somebody else is offering X+20 over there.  Somebody else is offering X-20 over there.  I have no fucking idea what the price is.”  Matt didn’t make the trade.

Which was good, because the apparent opportunity was a mirage.  That’s where the slow printers come into play. Specialist posts on the NYSE had old fashioned daisy wheel printers.  Very, very slow.  They were overwhelmed by the order flow.  At 10AM the printers were spitting out orders that had been entered at 8 or earlier.  So the orders being executed on the NYSE were actually very stale, and the prices didn’t reflect current market conditions.  The futures didn’t have that problem.  So at 10 or 11 NYSE prices were reflecting orders submitted hours before, and the futures were reflecting current conditions.  Hence the futures were way below the cash, making it appear that there was a huge arbitrage opportunity.

The problem was that this induced more people to submit sell orders to the NYSE before they caught onto the fact that NYSE prices were not reflective of current conditions.  This exacerbated the backlog on the printers.

So it wasn’t fast technology that caused problems on 19 October ’87.  It was slow technology.

Program trading wasn’t an issue, really, but portfolio insurance was.  This is sometimes called “computerized trading” but it’s not, really.  Yeah, computers were used to calculate deltas, and these deltas were used to determine trading strategies.  You could have used an HP-12C (complete with Reverse Polish Notation!-and no, that’s not an ethnic joke) and the normal cdf table from Handbook of Tables For Mathematics (pp. 922-929 of the Fourth Edition) to do the same thing.

The problem with portfolio insurance was that, unlike index arbitrage and most market making strategies employed today in HFT, it was a positive feedback strategy, rather than a negative feedback strategy.  As prices fell, portfolio insurers had to sell more, which drove down prices further, which led them to sell more . . . until they pulled the plug on the strategies.  That is, unlike market making strategies which are buy low-sell high trades, portfolio insurance was buy low, sell lower.

The FT article uses the ’87 Crash as a springboard to make the usual litany of complaints about current market structure and computerized trading.

Some of the criticisms are defensible.  The current fragmentation of equity structure in the US is indeed the product of SEC RegNMS, which I characterized at the time of its introduction as implementing an “information and linkages” approach to market structure, in lieu of mandating a CLOB.  This socialization of order flow has some problems, particularly during times of market stress.  Links are vulnerable during times of stress.  Moreover, the proliferation of order types that has complicated trading dramatically is directly the result of this approach: many of the new order types are related to order routing, which is a much more complex task with many execution venues as opposed to one (as in futures markets where order flows are not socialized).

Other criticisms are less defensible.  The authors of the FT piece are apparently scared of the dark, as they warn of the dangers of dark pools.  These things are not new.   They just used to be called “third markets” or “block markets”.

The FT piece also warns that in the computerized world, liquidity can evaporate quickly.  They acknowledge that liquidity evaporated quickly in the old days-as it did on Black Monday-but suggest that can happen more quickly today.  Not really.  At all.  Locals could shut up or keep their hands in their pockets very quickly back on the floor if it looked like order flow was getting toxic.  And they were pretty quick at picking up on that.  Moreover, during the Crash clearing firms pulled their locals from the pits.  You would have thought that the pits would have been in a state of pandemonium on the 19th, but after the initial frenzy, they were actually spookily empty, as most locals and many brokers had been yanked from the floor by their clearing firms.

In brief, the functions of markets haven’t changed.  The technology for performing these functions has.  But the fundamental economics of performing the functions hasn’t.  Face-to-face and machine-to-machine markets have the exact same basic vulnerabilities.  Those who focus on the technology miss the economics.

The FT article, and others like this one in Bloomberg,  blame computerization and HFT, and the consequent alleged “loss of confidence” among investors, for the decline in equity volumes recently.  Color me skeptical.  Futures volumes have dropped too, despite a very different market structure, and a different composition in market users.

Historically, trading volume has ebbed and flowed.  It ebbed and flowed in the pre-computer era. It shouldn’t be any surprise that it ebbs and flows now.

If you are looking for the big lesson from the  1987 Crash that we should heed today, ignore all the BS about technology.  Look at clearing.  Look at the Brady Report and other post-Crash studies of what happened in clearing.  That’s what almost brought the markets down.  The operation of variation margining-which is usually a source of stability-threatened to bring the markets to a halt, with even more devastating consequences.

Then think of what will happen during the next big market move, given that the scope of clearing has been expanded substantially due to Frankendodd, and parallel efforts around the world.  Don’t worry about the technology of execution: worry about what happens after the trade, during clearing and settlement.  That’s where the truly systemic vulnerability lies.

There’s an old adage in the military: amateurs talk tactics, professionals talk logistics.  In the markets, the parallel is that most commentary focuses on execution, when much of the real important action happens out of sight, in clearing and settlement-the logistics of the financial markets.  That happened in post-Crash commentary, and it is being repeated today.  That’s a big mistake.  When looking for object lessons from Black Monday, don’t look at the computers and the execution of trades.  Look at what almost happened with disastrous consequences in clearing.  And worry deeply about how the system is vulnerable to a repeat in the future.  Arguably more vulnerable, given the dramatic growth in the size of the markets and the mandated reliance on clearing, and margining of non-cleared derivatives.

That’s the lesson I first began to grasp in Brian’s office early on 20 October.  And that experience has decisively shaped my criticism of efforts, like Frankendodd, intended to fix the markets.

This afternoon I attended the Working Group on Financial Markets at the Chicago Fed.  The scintillating topic was segregation models.  Really!  It was scintillating!  For a certain kind of geek, of which I am one.

It was scary, actually.

Segregation of customer money has been a subject of discussion post-Frankendodd, and I have written several posts on the subject.  Segregation has received even more discussion post-MF Global (AKA Corzine-gate, but since he’s a made man I guess he will skate).  The model that has been implemented for cleared swaps, and which (according to clearing maven John McPartland of the Chicago Fed) is likely to be adopted for cleared futures is LSOC-legally segregated, operationally commingled.

Back in the summer of 2011, I wrote that segregation could make the markets more fragile, because it would tend to reduce credit (mainly intraday credit) used to finance variation margin.  This is important, because the markets depend on using credit to fund margin payments.  If this credit freezes up, the markets will freeze up.  Indeed, a cleared system works on such tight deadlines that an interruption of credit can be catastrophic.  If margin calls aren’t met in a timely fashion, absent credit, margin payments don’t flow to those on the winning side of trades.  When this happens, the clearing system breaks down.  And in a Frankendodd world dependent on clearing, a breakdown in clearing means a meltdown in the markets.

Indeed, even delays of hours or even minutes in making margin payouts, or doubts that CCPs will make margin payments in a timely fashion, can be catastrophic.  Almost exactly 25 years ago, on 19 October, 1987, the mere rumor that the CME would not pay out variation margin led to a run on FCMs and the CME clearinghouse that almost brought the market to a crashing halt.

One of the speakers at today’s event, Barclays’ Kevin Murphy, noted that under segregated models FCMs don’t have a lien on  the collateral in customer accounts.  Which means they won’t extend credit to customers because there is no collateral backing the loans.  Murphy said that broker intraday credit is likely to be a thing of the past under greater segregation.

Think of the consequences on a day when markets move a lot.  Those on the winning side are expecting to receive variation margin payments.  Those on the losing side will be scrambling for cash to meet their VM obligations.  Where will they get it?  Not from their FCMs.  From their banks?  Uncertain-even if the customers arrange credit lines, banks can often find reasons to delay providing the credit, or not providing it at all.

This all means that there is a risk that VM owes will not be paid in time.  With no credit being extended, or the amount of credit being sharply constrained, there is a serious risk that VM pays will not be made on time.   If that happens, particularly during a period of market stress, all bets are off.  Almost literally.  People will fear that CCPs are insolvent, and there will be runs on them-people will liquidate positions to recover their margin money.

That would be very ugly indeed.  Again, a cleared system is very tightly coupled, more tightly coupled than OTC markets.  Tightly coupled systems are more prone to going non-linear, and failing catastrophically.  Segregation increases the tightness of the coupling.   Connect the dots.

Of course, markets don’t stand still.  People will recognize the need for contingent liquidity, and make arrangements for it.  But will those arrangements be as robust as the system we have now?  There is serious room for doubt.  If more robust alternatives are available, why weren’t they chosen before?  I know this argument is not dispositive, given the coordination issues involved, but there are strong incentives to adopt better systems.   We should be very leery of changes that implicitly assume that market participants with large amounts of money and risk in the game systematically choose wrong.

The whole move to clearing has been intended to wring credit risk from the derivatives markets.  But every move to reduce credit risk-including moves to greater segregation-almost always involve creating greater liquidity risk.

If given a choice between credit and liquidity risk, I would choose credit risk every time .

In other words, you have to pick your poison: credit risk or liquidity risk.  Yeah, credit risk may be like arsenic.  But liquidity risk is more like cyanide.

I know which one I would choose.

In response to Bank of Canada Deputy Governor Timothy Lane’s speech about the systemic importance of major global commodity trading firms (GCTFs), the FT’s Javier Blas asks: “Has Glencore become ‘too big to fail’?”

And I answer: hell no.

I will write much more on this subject-much more-when a few things clear.  For now, a few of my reasons:

• GCTFs-even the biggest, like Glencore, Cargill, and Koch-just aren’t that big.  Glencore, the biggest, has about the same amount of assets as Kraft and Fiat and Hitachi and Fubon Financial Group (assuming you’ve heard of it).  Are those TBTF too?  The biggest GCTFs have asset values an order of magnitude smaller than the banks that have been designated SIFIs by the Financial Stability Board.  Again: not that big, in systemic terms.
• GCTFs aren’t highly leveraged.
• GCTFs don’t engage in extensive maturity transformation.  Indeed, current assets and current liabilities are closely matched, and for many firms the maturities of their liabilities exceeds that of their assets.
• Commodity trading firms, e.g., Enron, have failed without significant knock-on effects.  Indeed, an entire commodity trading sector-the merchant energy sector in the US-imploded without disrupting the financial system, or the trade in physical power and gas.
• GCTFs weathered the 2008-2009 financial crisis fairly well.
• Even if a large firm were to fail, disrupting commerce in commodities for which it accounts for a significant fraction of the trade, (a) the quantity of trade in these commodities is very small relative to total international trade or GDP, (b) other firms are likely to be able to fill the gap quickly, in part because the assets used in commodity trade can be redeployed quickly, and (c) disruptions in trade have few knock-on effects on global or even regional GDP.  As an example, the 2011 Japanese earthquake and tsunami severely interrupted trade in electronics and auto parts, but the effects on GDP in Asia were small and transitory, and the effects on GDP outside of Asia negligible.

This is not to say that GCTFs are always on the side of the angels: definitely not.  Nor is it say or that some additional regulation (notably in the nature of disclosure, and better anti-manipulation laws) is not worth consideration.  It is just to say that we don’t need to add them to the list of too big to fail enterprises.  We should be looking to pare that list, not expand it, and GCTFs do not pose the systemic risks that warrant SIFI designation.

Again, more to come in the weeks to come.

I have long been a bear on China.  Prior to 2008 because of the shakiness of its banking system; post-Crisis, because of my deep skepticism about the effects of the huge stimulus program-including its impact on the banking system, or more properly, the shadow banking system.

I am not alone.  The Bank of China is warning about the country’s shadow banks:

A senior Chinese banking executive has warned against the proliferation of off-book wealth management products, comparing some to a Ponzi scheme in a rare official acknowledgement of the risks they pose to the Chinese banking system.

China must “tackle” shadow banking, particularly the short term investment vehicles known as wealth management products, Xiao Gang, the chairman of the board of Bank of China, one of the top four state-owned banks, wrote in an op-ed in the English-language China Daily on Friday.

“Unsurprisingly, although Chinese banks’ non-performing loans are at a low level of 0.9 percent, the potential risks are worse than the official data suggest,” Xiao wrote, adding that a problem could come as indebted borrowers face cash flow problems or enter default, straining the banking system.

“The music may stop when investors lose confidence and reduce their buying or withdraw from WMPs,” he said, referring to wealth management products.

He warned of a mismatch between short-term products and the longer underlying projects they fund, adding that in some cases the products are not tied to any specific project and that in others new products may be issued to pay off maturing products and avoid a liquidity squeeze.

“To some extent, this is fundamentally a Ponzi scheme.”

Xiao’s op-ed is in line with similar warnings issued by outsiders, particularly the Fitch Ratings agency whose China banking analyst Charlene Chu has long warned of a maturity mis-match and the threat to the Chinese banking system of products with various terms and interest rates.

Moreover, there is a widespread belief among investors in these products that banks are offering liquidity puts:

Although the products are technically more risky than deposits, most investors believe they are backed by the banks’ implicit guarantee and they are marketed aggressively in bank branches nationwide. Xiao acknowledged this perception posed a risk for banks’ bottom line.

“The rollover of a large share of WMPs could weigh heavily on formal banks’ reputations, because many investors firmly believe that banks won’t close down and they can always get their money back,” Xiao said.

In June, People’s Bank of China vice governor Liu Shiyu said many banks are not transparent enough about the risks wealth management products carry.

“China’s shadow banking system is complex, with a close yet opaque relationship to the regular banking system and the real economy,” Xiao concluded by saying.

“It must be tackled with care and sufficient flexibility, but it must be tackled nonetheless.”

Recall that the movement of SIVs back onto bank balance sheets was a major channel by which problems in the shadow banking sector were communicated to US banks.

These “wealth management” products grew up as a direct result of the intervention of the supposedly wise direction of the Chinese state.  It wanted to restrict bank lending that had been stoked by the 2009 stimulus, in a step-on-the-gas-whoops-step-on-the-brakes maneuver so common to attempts to “fine tune” economies.  The bank credit was basically redirected to the informal sector.

I’m sure it will work out swell.

For more background on the crazy-quilt Chinese banking sector, and all its fragility, this is a decent source.

Another reason for my bearishness is my innate skepticism-based on long experience-of state efforts to guide resource allocation.  Case in point: China has gone all out to promote investment in renewables, and has been awarded with huge losses:

hina in recent years established global dominance in renewable energy, its solar panel and wind turbine factories forcing many foreign rivals out of business and its policy makers hailed by environmentalists around the world as visionaries.

But now China’s strategy is in disarray. Though worldwide demand for solar panels and wind turbines has grown rapidly over the last five years, China’s manufacturing capacity has soared even faster, creating enormous oversupply and a ferocious price war.

The result is a looming financial disaster, not only for manufacturers but for state-owned banks that financed factories with approximately $18 billion in low-rate loans and for municipal and provincial governments that provided loan guarantees and sold manufacturers valuable land at deeply discounted prices.

China’s biggest solar panel makers are suffering losses of up to $1 for every $3 of sales this year, as panel prices have fallen by three-fourths since 2008. Even though the cost ofsolar power has fallen, it still remains triple the price of coal-generated power in China, requiring substantial subsidies through a tax imposed on industrial users of electricity to cover the higher cost of renewable energy.

The outcome has left even the architects of China’s renewable energy strategy feeling frustrated and eager to see many businesses shut down, so the most efficient companies may be salvageable financially.

Well played.  Remind me again why should we compete by throwing good dollars after bad renmibi?

(As an aside, to illustrate the absurdity of subsidy politics, Solyndra is suing Chinese solar panel makers for predatory pricing.  Predatory pricing suits are almost always meritless.)

A substantial fraction of measured Chinese growth in the recent past has been accounted for by investment.  But the relevant question is whether this investment is going to pay dividends, or whether it has been misdirected into white elephants.  The solar (and wind) experience suggests the latter.  Historical experience with politicized investment suggests the latter.  The influence of corruption and the political influence of the elite on the investment prices also suggests the latter.  I’m going with the latter.

The WSJ has a long piece on a Chinese economist who is similarly skeptical about the ability of the Chinese state to direct investment:

Mr. Zhang’s academic colleagues were all praise for the “China Model,” but in 2009 he was giving speeches entitled “Bury Keynesianism.” Then a top administrator at Peking University, where he now teaches economics, he argued that since the financial crisis was caused by easy money, it couldn’t be solved by the same. “The current economy is like a drug addict, and the prescription from the doctor is morphine, so the final result will be much worse,” he said.

. . . .

Ultimately, Beijing’s stimulus fed a false investment boom that stoked asset bubbles—then the morphine wore off while the government tightened. Officials claim the economy grew at 7.6% year-on-year between April and June this year. Skeptics think the real number is closer to 4%. (One London research house says 1%.) Meanwhile, industries dominated or favored by the state, such as steel or solar power, are idling from overcapacity. Countless sheets of copper are reportedly stacked in warehouses, blocking doorways and exemplifying Hayek’s notion of “malinvestment.”

It’s actually worse than merely Hayekian/Austrian malinvestment, IMO.  That arises from decisions made on the basis of false price signals that result from monetary stimulus.  That is surely present in China in spades.  But there is also a good deal of state-directed investment, or investment channeled to state enterprises, or investment influenced by corrupt and connected members of the elite.

A good analysis of these issues is to be found at Michael Pettis’s blog, including examples like this post.  He aims the following, trenchant questions at China bulls:

1. How much debt is there whose real cost exceeds the economic value created by the debt, which sector of the economy will pay for the excess, and what is the mechanism that will ensure the necessary wealth transfer?
2. What projects can we identify that will allow hundreds of billions of dollars, or even trillions of dollars, of investment whose wealth creation in the short and medium term will exceed the real cost of the debt, and what is the mechanism for ensuring that these investments will get made?
3. What mechanism can be implemented to increase the growth rate of household consumption?

All very good questions.  China’s recent GDP growth has really been driven by what are properly considered costs: the amount of money invested.  The relevant issue is the value produced by those investments.  Given the state domination of the process of making these investments-either directly, or via distortions of the price system through monetary stimulus and financial repression that distorts interest rates-I am dubious, in the extreme, that these investments will pay.

So today, 12 October, 2012, is the day when many Frankendodd rules go into effect.  Swap dealer registration for instance: but not position limits!

Yes.  848 pages of legislation (or 2319 pages, depending on how you count)-where commas matter-that spawned thousands of pages of rules (over 9k as of July, and where commas will also matter) that will spawn thousands more pages of interpretations, no action letters, legal rulings, etc.  All in an attempt to re-engineer a devilishly complex, interconnected financial system.  A system that will not stand still, but which will change in response to the law and the regulations, thereby producing myriad unintended consequences.

I’m sure it will turn out just swell.  Timmy! and GiGi and their successors have everything under control.  They’re from the government and there to help you!  Trust them on this!  Don’t you worry your pretty little head over it.

JK.  In reality, Mickey Mouse (how appropriate) gives you a better idea of how things are likely to turn out.

I fearlessly predict that the next financial crisis will follow directly from Frankendodd. It is a monster, which like Frankenstein’s, will escape its master’s control and wreak havoc. Mark my words.

The always thoughtful and considerate David at Deus ex Macchiato responds to my post on ring-fencing.  He concurs in part, and dissents in part.  Or he claims to dissent, but I think we’re more in agreement than he lets on.

His disagreement relates to my claim that entities outside the ring-fence could be too big to fail, and are reliant on fragile funding and hence vulnerable to destabilizing runs.  He basically argues that there are regulatory/supervisory responses to this, e.g., collateralization of OTC derivatives trades, higher capital charges on firms outside the fence looking in, rules intended to reduce the risk of runs on money market funds.

In essence, my interpretation is that David is arguing that it is possible to increase the stability of the shadow banking system through such supervisory/regulatory changes.  I wish I were so sanguine.

But it does provide a good way to frame the trade-off that is involved.  Ring-fencing increases reliance on wholesale funding and shadow banking by preventing the funding of certain activities with stickier deposits.

That’s what makes me concerned.  I think these wholesale/shadow banking funding structures are a source of vulnerability.  That’s basically the interpretation that Gary Gorton gives in his forthcoming book.

Given that, I think we should be very, very concerned about “reforms” that increase reliance on wholesale/shadow bank funding.  As David notes, this must be accompanied by other changes that address the fragility of these funding mechanisms.  I am much more skeptical than David, apparently, that such changes are likely to occur.  And this is the source of my concern about ring-fencing.  Especially about ring-fencing that is not bundled with measures that reduce the fragility of the wholesale/shadow bank funding mechanism.  That’s why ring-fencing alone is particularly worrisome. My priorities would be the reverse: focus on shadow banking and wholesale funding first.

But like I said, I think David is more aligned with me than he lets on.  For he says:

After all, as SWP points out, it wasn’t the universal banks who were most vulnerable: having deposit funding reduced their liquidity risk during the crisis. So perhaps there are systemic benefits to having casino and retail banking mixed? Surely that is something that we should settle before ring fencing.

Abso-effing-lutely.  That’s exactly what we need to settle first: that’s what I meant about “my priorities would be the reverse.”  That’s exactly why the fetishization of ring-fencing as a solution, or at the very least the first step in a solution, is highly dangerous.

To put it differently.   We need a back-to-basics rethink on what activities should be funded by insured deposits or some other form of guarantee; which should rely on wholesale mechanisms; and what can be done (short of some sort of insurance mechanism) to make the wholesale/shadow bank system more stable.  Is there a compelling economic reason why only traditional commercial banking activities should have access to insured funding?  This seems as much of a historical artifact as anything else, something that grew out of the banking system as it was in the 1930s.

Before lunging ahead with structural reforms that seem rooted more in nostalgia than economics, it is imperative that we think a lot more seriously about the right match between funding and the activities that are being funded, and what system of insurance or guarantees can improve the functionality of this match.  After all, during the crisis there was a massive ad hoc extension of guarantees to a wide variety of shadow banking and wholesale funding activities.  Wouldn’t it be better to think about that in advance, instead of making it up as we go along?

And again, that’s what worries me about the focus on ring-fencing.  It punts on this extremely vital issue; potentially force-feeds the shadow banking system; and puts us at risk of more ad hoc bailouts of this system in the future.  Which is precisely why I believe that it is naive-foolish, actually-to believe that ring-fencing protects taxpayers.  It could well put them at greater risk.

So on this big point, I think we agree, David: “Surely that is something that we should settle before ring fencing.”

The UK’s Vickers Report and the EU’s recently released Liikanen Group report both recommend a fundamental structural change to the banking system to reduce systemic risk and the likelihood of taxpayer bailouts of banks: “ringfencing.”    The taxpayer guaranteed deposits of a financial institution would be inside the ringfence, and the ringfenced entity that can fund itself with these deposits can engage only in a limited array of activities that are deemed to be of low risk.  Riskier activities, such as derivatives trading and securities underwriting, would have to be undertaken through separately capitalized affiliates that cannot be funded by the ringfenced entity.

This is, in essence, a variation on the Glass-Steagall approach of separating commercial and investment banking.  The Volcker Rule is another way of achieving a separation of deposit taking and trading and underwriting activities.

These structural approaches are completely misguided, in my opinion.  They are unlikely to have the desired effect of reducing systemic risk or insulating taxpayers from the fallout of risky trading activities.

Insured deposits are a potential source of moral hazard, and there is a case to be made for limiting the risks that can be funded with insured deposits.  But historically these activity limits have proved to be a very poor defense against risk taking.  Banks have gotten into trouble while engaging in traditional lending activities; the Latin American debt crisis and the S&L crisis are two prominent examples.  Ditto Northern Rock in the UK.

Moreover, it is beyond naïve to believe that making insured depositors whole is the only, or even the most important, cause of taxpayer funded bailouts.  A failing  investment bank-or a bank-owned trading entity outside the ringfence-poses a potential systemic risk that would likely result in a bailout even if insured deposits are not directly at risk.  Its derivatives counterparties-which are likely other big financial institutions, and which could well be ringfenced banks-would suffer losses if it went other.  Its lenders-which could include, for instance, money market funds that buy its short term debt-are also at risk.   This could lead to destabilizing runs on the money markets.  In brief, even entities outside the ringfence would be highly interconnected with the broader financial system, and with entities inside the ringfence.  The Fed or the ECB would likely deem problems at such interconnected institutions to be systemically threatening, and would find a way to provide support to prevent a failure.

Put differently, an investment bank-like entity outside the ringfence can be too big to fail.

Indeed, looking at the 2008 experience, the most vulnerable institutions were not funded by deposits.  Bear Stearns was an investment bank-it was bailed out.  AIG was not deposit funded-it was bailed out, in large part (IMO) to prevent the failure of another non-deposit funded entity, Goldman Sachs (i.e., the AIG bailout was in part, and likely in large part, a backdoor bailout of Goldman).  Merrill was foisted on Bank of America to prevent its failure.  And of course there is Lehman.  It wasn’t bailed out-but you can be metaphysically certain that inaction won’t be repeated again.

It is quite easy to envision that there will be firms outside the ringfence that are deemed TBTF.  If one of these firms looks acutely vulnerable, central bankers and regulators concerned about systemic contagion will find some way to prop it up.  Taxpayer money will be at risk.

Moreover, the ringfencing idea creates a particular kind of vulnerability that proved to be an acute problem in 2008, and which is pretty well understood theoretically.  The funding of non-deposit funded entities is often quite fragile, and vulnerable to runs.  Like investment banks in ’08, entities outside the ringfence are likely to depend on short-term wholesale funding that can-and will-run if the entity looks shaky, and there is doubt that a bailout would be forthcoming.

Deposit funding is stickier, and a destabilizing-and inefficient coordination game equilibrium-run is less likely to occur with sticky funding.  Thus, putting trading activities outsie the ringfence, and funding these risky activities through the wholesale markets exacerbates a source of financial fragility.

Thus ringfencing increases the risk of liquidity/funding crises that trigger a bailout.  It exacerbates a form of fragility that was devastating in 2008, when it was financial institutions that were outside the Glass-Steagall ringfence that proved most vulnerable to the fallout from the decline in real estate prices.

The knotty issue here is why the funding of trading, market making, securities underwriting and similar activities is typically quite fragile.  The Diamond-Rajan story is that runs are a way of disciplining opportunistic intermediaries.  With the potential for externalities from runs (due to contagion effects) one could make a case that funding is excessively fragile.  But that is hardly an argument for ringfencing, which precludes the ability to use less run-prone deposits to fund these activities: indeed, if anything, it is an argument against ringfencing.

The nostalgia for Glass-Steagall-like structural “fixes” is pervasive.  But structural separation of certain forms of financial intermediation, and separation of certain forms of activity from deposit taking, don’t address a fundamental source of systemic risk: the reliance on short-term, wholesale funding that is vulnerable to runs.  Indeed, it likely makes the problem worse because it increases the reliance of the segments outside the ringfence on such funding.  It is delusional to think that just because taxpayer-guaranteed deposits are not directly at risk, that taxpayers are not on the hook for bailouts.  If a big, interconnected entity that sits outside the ringfence teeters on the brink, regulators and central banks may well deem it too big to fail: No More Lehmans is their motto.  Ringfencing does not isolate derivatives trading, underwriting, etc., from the broader financial system: entities outside the ringfence will still be interconnected.

So even if there is no explicit taxpayer obligation (as with insured deposits), there is an implicit one.  We’ve seen that implicit guarantee invoked before, and we could see it again.  Ringfencing does not address the problem of a non-depository SIFI that is highly interconnected.  Indeed, by increasing the number and size of such entities, it almost certainly makes this problem worse.

The Bank of Canada has decided that Canadian entities can meet their G-20 clearing obligations by clearing with international CCPs like LCH or CME.

The alternative-which was seriously considered, until fairly recently-was to require the formation of a domestic Canadian CCP through which Canadian financial institutions would be required to clear.  The Bank of Canada was leaning towards a “Canadian solution” because it believed that it could monitor such an institution more effectively, that a domestic CCP would insulate Canada from global financial shocks, and that it would be easier to provide C$ liquidity support to a domestic entity.

I co-authored a study for the Canadian Market Infrastructure Committee (CMIC) which argued that (a) these benefits were illusory because there would be C$ swaps traded by non-Canadian entities and non-Canadian entities would likely be important members of a Canadian CCP due to scale and scope economies, and (b) mandating clearing via a domestic CCP would dramatically increase collateral and liquidity costs of trading C$ swaps due to the fragmentation of netting sets (among other reasons).  As a result, I/CMIC recommended that Canadian banks, investment funds, and insurers be permitted to meet their G-20 obligations with an international clearer that could margin more efficiently.

It’s good to see that BoC acknowledged the force of these arguments, despite its initial preference for a domestic CCP.  Reason sometimes prevails.

I’m less enamored with BoC Deputy Director Timothy Lane’s argument that commodity trading firms (e.g., Cargill, Glencore, Vitol, Trafigura, Dreyfus) are systemically important.  Much more on that subject soon-it consumed much of my summer.  Hopefully he’s open to persuasion on this issue, as he was on the necessity of mandating the use of a domestic CCP for Canadian IRS.  But it would be gratuitous of me to make too much of a bother of the global commodity trading firm (“GCTF”) matter now.  So I say kudos to Mr. Lane, and the BoC, for setting priors aside; evaluating the arguments and evidence; and coming to the right choice (IMO) with respect to clearing of C$ swaps.