Streetwise Professor

Dmitri Medvedev announced today his support for Putin’s return to the presidency in 2012.  According to the NYT story, Medvedev made the announcement in a voice cracking with emotion.  His statement touched off uproarious applause: this seems like something out of a Communist Party Congress of Soviet days.

Forcing Medvedev to make the announcement, standing alone before the United Russia party members, was the ultimate humiliation to this rather pathetic figure.  It completes his slow-motion emasculation, and although the process has gone so far it would seem to require microsurgery to finish the job, Putin did it with a figurative chainsaw–just so no one could miss the point.

I admit that I was surprised–wrong–that Putin did not attempt some constitutional judo to remain in the presidency in 2008.  So why the change in 2011?  The answer to the question is overdetermined.  Numerous factors all push in the same direction.

First is Putin’s narcissism and love for power.  I don’t put too much weight on this factor as even as mere Prime Minister he has remained the dominant force in Russian politics, and has been able to work non-stop at building an ego building cult of personality.

Second, there is no constitutional obstacle this time around.  Legitimacy is important, and although the issue could have been finessed in 2008, doing so would have compromised his legitimacy and left him open to challenge on constitutional grounds.  He squared the circle by appointing a cipher to succeed him, all the while retaining an iron grip on the true sources of power in Russia (even though these are formally in the remit of the president).

Third, Russia felt itself to be flying high in 2007-2008.  Oil prices were soaring.  Growth was robust.  The US was reeling from its engagements in Iraq and Afghanistan.  There were no readily apparent threats to stability.  A relaxation of the system of unitary control seemed safe.

But everything changed almost exactly 3 years ago, mere months after Medvedev’s election, with the financial crisis in the West.  Although Putin at first boldly stated that Russia would weather the storm with no difficulty, that turned out to be a wildly inaccurate prediction.  The crisis hit Russia harder than any major country, and shook the country’s economic and political system to the core.  The seemingly inexorable rise of the country proved chimerical: collapse and chaos were serious possibilities.

Although Russia and Putinism survived the crisis, the country–and Putin–were shaken by the experience.  Listen to Putin’s rants against the West generally, and America in particular.  They reveal a control freak who rages against the fact that there are existential things outside of his control.

The country emerged from the crisis–the first crisis–shaken and weakened.  The crisis undermined the flow of rents that keep the natural state together.  Although growth has returned, it is not nearly as strong as in 2006-2007, and is unlikely to reach those levels any time soon.

Thus, whereas Putin probably calculated that circumstances were so favorable in 2007 that the country’s political and economic system could withstand a division of the power vertical, his calculations are doubtless far different now.  A near death experience has a way of concentrating the mind.  The heady visions of 2007 have proved illusory.

And importantly, another crisis looms, a crisis could actually be more shattering than the last.

In brief, it is likely that Putin believes that his system can no longer operate safely with the ambiguities and slippages and potential for conflict and division inherent in a duumvirate.  Hence Medvedev’s public humiliation and Putin’s triumphant return.

A final note on the implications of this for the US.  It is clear that this development puts paid to Obama’s sucker bet–the “Reset.”  The administration foolishly thought it could play divide and conquer, and quite transparently courted Medvedev and treated Putin with disdain.  Indeed, it is hard to express just how self-evidently foolish this was, and harder still to explain how the administration could have possibly thought this would work.

The administration will soon find out that payback is truly a bitch, and that Putin is all about payback.  It is in his DNA.  Expect Russia to become even more truculent, obstructionist, and revanchist in the months to come.  Putin and Obama–and whoever succeeds Obama, either in 2013 or 2017, for Putin will be around that long, health permitting–will not be burger buddies.  But I hear Dmitri has time on his schedule.  (Would that they share their burger in retirement, reminiscing about the old days when they were somebody.  In 2013.)

What happens in the coming months is highly contingent on what happens in Europe.  The EU is teetering on an economic precipice, and I cannot conceive of a plausible scenario which does not involve it plunging over the edge.  In that (likely, IMO) event, the consequences will be shattering worldwide, but especially so in Russia.  The last crisis showed its vulnerability, and a bigger crisis closer to home will subject the system to a daunting test.

The real possibility of such a crisis is exactly why I believe Putin is returning.  Putnism is under threat, and Putin has concluded that it can survive only in its pure, unadulterated form.

James Hamilton and Jing Wu have a new paper on speculation and oil futures pricing (h/t Brian Goff).  The paper is very carefully done and very impressive econometrically.  It presents some provocative results, but IMO the radical simplifying assumptions James and Jing used in order to come up with something that they could estimate cast serious doubts on the results.  I am also sure that the results will be overinterpreted and misinterpreted to advance political agendas, and regret that the authors provide the hook in a few careless statements that should have been heavily qualified, but weren’t.

Here are my initial detailed comments:

1. The paper focuses on risk premia.  Hallelujah!  The price of risk is what speculators are most likely to affect, because most speculative transactions involve a transfer of risk, rather than the commodity.  A very basic point, but one which is all too frequently overlooked.
2. The most provocative result in the paper is a huge discontinuity of their estimate of the risk premium in oil futures  between the pre-2005 period and 2005-2011 (see Fig. 5).  This discontinuity is an artifact of HW’s splitting of the sample.  They motivate the choice of splitting date by observing that the growth in crude oil futures open interest increased dramatically beginning in 2004.  It would be preferable to do some testing for structural breaks and estimate accordingly.
3. More generally, I am very suspicious of such a sharp discontinuity.  I think it is highly likely that it is symptomatic of other changes going on in the market, and the limitations of their model.  (More on the latter below).
4. The model is not complete, even on its own terms.  Although it discusses the role of speculators (“arbitrageurs” in HW) in absorbing risk from hedgers, hedgers are not formally modeled.  This is a huge hole.  Moreover, “investors”–such as those who trade via index funds–are modeled extremely mechanically.  Yes, once they are in the market, index traders tend to trade mechanically, but the allocation of speculative capital between index funds and other investment opportunities is not as mechanical a process as the paper assumes.  Indeed, in the model the index-fund investors’ trading does not depend at all on risk-return tradeoffs.  They are just automatons that flow in and out of the market based on some autoregressive process. This is extremely problematic: index investor capital allocation decisions are presumably the result of an optimization process that reflects their investment opportunity set and the pricing of risk across these opportunities.  (Again, more on this below).
5. Relatedly, since hedgers are not in the model, there is no effect of index investors shocks on hedger behavior.
6. The model of fundamentals is extremely cramped and limiting.  I am no big fan of affine models generally, but even overlooking that, it is definitely the case that more than one (latent) fundamental factor drives spot oil prices.  Thus, the model becomes a two-factor model, with one (fundamental) factor driving the spot price and the “risk neutral” forward curve and the other (index-investor buying) affecting the shape of the forward curve.
7. One cannot generate interesting forward curve dynamics using a one-factor fundamental model.  One cannot generate interesting and realistic inventory-price relations using a one factor model.  As I show in my forthcoming book, at least two fundamental factors are needed to generate reasonable dynamics.  Furthermore, as I also show in the book, the homoskedastic error structure for the fundamentals variable assumed in the HW paper cannot generate price and inventory behavior observed in the real world.
8. Thus, the fundamentals model is almost certainly seriously mis-specified.  I can understand the modeling choice, but it has consequences.  It is my sense that this mis-specification is so severe that it casts serious doubts on the results.
9. In a frictionless world, risk premia for a particular factor are determined by the covariation between that factor and the pricing kernel.  In markets with frictions (as in the Hirshleifer models of the late-80s, early-90s), idiosyncratic risk of the factor may impact risk premia, in addition to the effect of systematic risk (driven by the covariation).  HW is a single market model: the oil market is all there is, and only factors within the oil market affect risk premia.  This is in essence an old-school Keynesian model of the risk premium.  Again, this is highly problematic.  In particular, since the whole movement of financial investors into commodities strengthens the linkage between broader financial markets and commodity markets, ignoring systematic risk (and hence inter-market covariation) is a serious deficiency.
10. It is a stylized fact that correlations between commodity returns and returns on broad equity indices and FX have changed substantially in recent years.  Although some have asserted a connection between index trading and this change in correlation structures, you can tell fundamentals-based stories as well.  For instance, if supply shocks were dominant in pre-2005, but demand shocks (e.g., the growth of China, the financial crisis) were dominant since, one would tend to observe the oil-S&P correlation to change from negative to positive.  As long as you are not in a Keynesian world with each commodity and investment an island with risk borne only by those living on that island, this change in correlations would lead to a change in risk premia.  The change in sign in the risk premium at the end of the sample corresponds to the financial crisis and associated major recession.  During this time demand shocks were clearly driving oil prices, and the correlation between the S&P and crude prices was very high and positive.  Thus, there was more systematic risk 2007 and later, and this would be expected to affect risk premia, but the model precludes this.
11. The omission of systematic risk in a model of risk premia is a serious, and IMO disabling, limitation.  It is particularly odd to ignore this in a paper that examines “financialization” of a commodity market, since financialization involves financial investors adding commodities to broadly diversified portfolios in order to optimize some risk-return trade-off.
12. These issues all affect how one interprets the HW findings.  What if risk premia did in fact change?  This could well reflect more accurate risk pricing due to the integration of commodities into investor opportunity sets.  Risks are going to be priced differently–and more efficiently–if there is more trade between islands.  A reduction in frictions, and an increase in the connections between markets, should lead to better risk pricing.  So finding a change in risk pricing could represent a very salutary development.
13. Indeed, tying some of these threads together, doesn’t “financialization” reflect a normal economic process of equilibrating prices between segmented markets?  Here, the prices are the prices of risk, and the movement of resources (risk) is more abstract than the movement of physical oil between Cushing and the Gulf.  In the latter example, profit seeking traders will drive the difference in prices in the two markets to the cost of transportation between them.  In the case of risk premia, any innovations (which could well include index investing) that reduces the costs of moving resources (risk bearing capacity) between prices will affect the prices in those markets, and tend to equalize them.  Since in the broader financial markets, oil and other commodities are small relative to the broader capital markets, it should be expected that the risk prices of commodities should account for the bulk of the change toward equalization.  It should also be welcomed.
14. To summarize a bit, the crucial questions include: what risks are priced?  Who participates in the market that determines these prices?  and, What are the investment opportunities available to these participants?  I think on every question, the HW paper is on very, very shaky ground.  The one-dimension model of fundamentals is far too restrictive, and the dynamics are far too simplistic.  Crucial players–hedgers–are left out, and others are treated mechanically.  In a paper that attempts to determine the effect of the movement of well-diversified financial investors into commodities, the Keynesian islands approach is inadequate: these investors have extensive investment opportunities that affect their behavior–and the pricing of risk that is the whole subject of the paper.  Mechanical treatment of one group of agents can make sense in some models, as in noise trader microstructure models.  Mechanical treatment of investors actively and aggressively looking for superior risk-return performance is a serious shortcoming in a model of the pricing of this trade-off.
15. I sympathize with James and Jing.   The impressive empirical cleverness required to estimate even this radically simplified model demonstrates just how challenging is the task of understanding the pricing of commodity risk.  I could readily believe that it could be impossible to estimate a richer model that includes fundamentals subject multiple, potentially heteroskedastic shocks, and three classes of optimizing investors with diverse investment opportunities. But the very complexity of the problem should make people very reluctant to make strong statements about the effects of “financialization” on price behavior.
16. In summary, I believe Hamilton-Wu are eminently correct to focus on risk premia as the variable that could be affected by the entry of a new class of market participant, but the daunting nature of that task is evident.  The radical simplification (again, understandable as a practical matter) needed to permit estimation, which involves abstraction from virtually all of the important economic issues makes their conclusions and results highly dubious as a basis for policy.  But there are plenty of fools out there (and let’s be clear, I do not include the authors in that category) who will no doubt rush in where prudent and thoughtful angels fear to tread.
17. For this reason, I wish they would have abstained from statements likely the valediction in their paper: “We suggest that increased participation by financial investors in oil futures markets may have been a factor in changing the nature of risk premia in crude oil futures contracts.”  This kind of suggestion only encourages the fools.  Every link of the chain of reasoning supporting this suggestion is flimsy.  Most importantly, the suggestion rests on a structural break which corresponds roughly with a period of time during which more financial investors participated in commodity markets.  But many other things changed during the same period.  Indeed, Hamilton himself has repeatedly pointed out that this period was one in which there was a virtual cessation in the growth of oil output.  That’s a pretty important fundamental.  Moreover, this was a period in which emerging markets, notably China, began to impact commodity markets dramatically.  Furthermore, most of the period (say 2007-2011), was one of financial an economic upheaval not observed since the 1930s.  That’s a pretty big change too.  Why put all the focus on index investing?  The model certainly doesn’t support that, because (a) all of these other factors are omitted altogether, and (b) even the model of index investing is crude and mechanical.
18. That is, to attribute the change in risk premia estimated from a clearly mis-specified model to a single change among many that occurred during the period of change is highly, yes, speculative, and an extremely tenuous piece of post hoc ergo propter hoc reasoning.

I do not want to close on a negative note.  I admire that Hamilton and Wu have focused on the right issue and have brought impressive econometric skills to the problem.  Improving our understanding of these issues would best be achieved by following the direction James and Jing have pioneered, by incorporating some of the features discussed above.  It will be a hard road, but worth taking.  Hamilton-Wu is a helpful first step along that road, and I hope that people understand it is only that, and that much hard slogging remains.

******

A few technical asides:

1. The use of NYMEX data in which time to expiration changes presents some complications to the estimation and interpretation.  It would be worthwhile to look at LME metals data (e.g., copper) because (a) it has also been claimed that financial investors have affected metals pricing, and (b) LME trades constant-maturity contracts that are easier to handle empirically.
2. If the focus is on index investors, who by definition trade in multiple commodities in a mechanical way, it seems that cross-sectional evidence would be quite informative.  For instance, did risk premia change in a way similar to that claimed for oil in other markets that are also part of commodity indices?

I am in London for the ISDA Annual Europe Conference, where like in the NY version, I moderated a panel on clearing.  Yesterday’s panel was very informative and interactive, and made for some good copy.  As in NY, it was only possible to scratch the surface, but that in itself is revealing because it tells you just how many knotty issues are still unresolved.  Another thing that came through loud and clear was how interconnected these issues are.

The most entertaining debate centered around interoperability.  The looming fragmentation among CCPs has regulators around the world trying to mitigate the cost and risk increasing consequences of fragmentation by pushing for CCPs to interoperate.  The three major clearers represented on the panel–Michael Davie from LCH.Clearnet, Paul Swann from ICE Clear Europe, and Kim Taylor from CME Clearing–were all pretty negative on the idea, with Michael and Paul being adamantly opposed, and Kim only slightly more accepting of the idea.  Michael wins the quip of the day award for his characterization of the idea: “It’s crackers.”

Jurisdictional fragmentation was foreseeable months ago: I discussed the problem in some detail in my 2010 Cato and Journal of Applied Corporate Finance pieces, and again more recently in my ISDA study.  It is on the front page now, with the face-off between the UK and the ECB over the latter’s insistence that any clearer of Euro-denominated derivatives be domiciled in the Eurozone, with access to the European Central Bank.

There is some economic sense to the ECB’s position, but there is also economic sense to having global CCPs that can maximally exploit economies of scale and scope arising from netting and capital efficiency.  But this just illustrates the ill-thought out nature of clearing mandates.  Global banks can access central bank liquidity in a variety of currencies and net efficiently and collateralize efficiently across multiple currencies.  Forcing clearing eliminates some netting and capital efficiencies (but can potentially improve others), but creates thorny issues about access to central bank liquidity that makes global CCPs problematic.

The Canadians are now grappling with the very difficult tradeoff between efficiencies that come from global CCP scope, and the potential systemic fragility that could arise from concentrating so much risk in a single entity.  A Bank of Canada official, Tim Lane, warned:

In carrying out the G20 mandate requiring all OTC derivatives to be centrally cleared, it is essential to ensure that we do not unduly concentrate risk in a relatively small number of institutions that are direct clearing members of global CCPs,” he said.

These were the very institutions that spread and amplified contagion through the global financial system in 2008, Mr Lane told the annual Sibos settlement and payments conference.

Quite a puzzle, no?  Who could have possibly anticipated this?  (You don’t need to answer that.)

And the COO of the DTCC has warned about the difficulties and dangers of clearing CDS.

“We may be creating a much higher level of risk,’’ he said, by requiring swaps to be turned into standardized products, traded on electronic exchanges and where risks are covered by a central counterparty, backing up the two sides of a trade.

He noted, for instance, that a central counterparty failed during the Asian financial crisis of the ‘90s.

Again, who knew?  Again: no need to answer.

Lawrence Sweet, a senior VP at FRBNY replied:

Risk management procedures must be strong and the new systems “sufficiently robust” to guard against failure of central counterparties or firms involved in the trades.

And, he said, those swap contracts that are too complicated or risky to be put into centrally cleared, electronic markets should not be. The question is “how much can we put in there in a safe way,’’ he said.

And the answer is?!?!  [Crickets.]  Stating a set of desiderata without providing a reasonable strategy for getting there is gratuitous, at best, and reminiscent of the Steve Martin “How to Make a Million Dollars Without Paying Taxes” routine.

Why stop now?  From the FT, Jeremy Grant’s article from yesterday (2 SWP bonus quotes) is summarized by the FIA’s news brief as follows: “Complications arise as regulators detail clearing rules.”   I am so shocked that I am speechless.

Witness what the Sorcerer’s Apprentices have wrought.  Perhaps to some clearing mandates sounded like a good idea at the time, but it’s pretty evident that those very same some hadn’t fully thought through the issue.  Everybody is now dealing with the implications of the mandates on the fly, and are learning that the “solution” is just another package of problems.  Gazing across the fence from OTC World into Clearing Land, the grass in the latter seemed so, so much greener.  Now, having jumped, the jumpers are finding plenty of weeds, and plenty of nettles.

I have a warm spot in my heart for German Finance Minister Wolfgang Schaeuble, because of his periodic slapdowns of Timmy!  (I think there is another slapdown-ready opportunity arising, given Timmy!’s–and Obama’s–recent penchant for giving the Euros gratuitous advice on dealing with their existential crisis.)

But he said a couple of things recently that give me pause.  First (h/t R) is this speech:

German Finance Minister Wolfgang Schaeuble said that while markets are the most efficient means of creating wealth in an economy, they can also be irrational and therefore need regulation.

“Markets are the best means of finding solutions, but they’re not always rational” and can destroy themselves, Schaeuble said today in a speech in Berlin. “That’s why they need rules and bounds.”

It is the job of the government to create an order that promotes, rather than hinders, moral behavior, Schaeuble also said at an event organized by the Catholic Academy in Berlin.

On an abstract level, that’s not really objectionable, because only some anarchists deny the need for market rules.  (Anarchocapitalists believe that rules shouldn’t be imposed, but created by cooperation and consent.)  The questions are: What rules are the right ones?  Where should the bounds be set?  Who decides?  How?

In this speech, Schaeuble gave an example of how he answers these questions, and those answers suggest that his pro-market rhetoric is boilerplate camouflaging another statist control freak:

German Finance Minister Wolfgang Schaeuble on Wednesday called for regulating all innovative financial products and urged banning so-called over-the-counter trade.

“We must apply the rules of transparency to all market participants–hedge funds and private equity funds,” Schaeuble said at an event sponsored by the Konrad Adenauer Foundation and the Catholic Academy ahead of a planned state visit to Germany by Pope Benedict XVI.

“We should ban OTC trade where possible, because we don’t have transparency (in these markets). And then we should try to regulate all innovative financial products. We cannot achieve everything through regulation, but we can try to tighten the rules.”

Another slave to the god of transparency.   Like that will solve everything.  And apparently a market in which consenting adults make mutually advantageous transactions about which they don’t reveal everything is far worse than no market at all.

I would further note that there is no perfectly transparent market.  Futures and stock exchanges have a great deal of pre-trade and post-trade price transparency, but the identity of traders is concealed: the markets are anonymous, and the buyer does not know the identity of the seller.  Thus, even on exchanges not everything is transparent.  OTC, the buyer typically knows the seller, but there is less pre- and post-trade transparency.  There are trade-offs involved, and different mechanisms have developed to permit market participants to choose which kinds of transparency rules work best for them.  The side-by-side existence of exchanges and OTC markets gives choices that can accommodate differences in the costs and benefits of alternative forms and levels of transparency across market participants.

And if transparency is such an unalloyed good in markets, Herr Schaeuble, does the same principle hold for governments?  Is Germany’s government a paragon of transparency?  Do you conduct all of your discussions and decisions in the full public glare?  Does your government have secrets?  Does Europe’s?  Is this a good thing?

We all know the answers to those questions.  It would be quite illuminating to hear why secrecy–very incomplete transparency–is acceptable and even necessary for governments that wield vast coercive powers, but some modicum of secrecy is completely unacceptable for private actors who cannot coerce anybody.

Schaueble’s remarks, and the place where he delivered them, suggest a typical European conservative mindset that is ambivalent, at best, towards markets and individual choice.  Hayek’s essay “Why I Am Not a Conservative” provides an illuminating analysis of this mindset.

So please confine yourself to putting the (verbal) boot into Timmy!, Wolfie.  There are enough control freaks about, thank you.

This week marks the beginning of a whirlwind couple of months in which I give talks or participate in conferences on either clearing or Frank-n-Dodd (there of course being a big overlap there).  Tuesday I moderated a panel at the ISDA Annual New York Conference, and yesterday I participated in a panel on Frank-n-Dodd at a Futures Industry Association event in New York.

First, the FIA event.  What came through loud and clear was the widespread belief that the SEF mandate in Frank-n-Dodd is wholly wrongheaded.  The consensus is that it is an attempt to jam a one-size-fits-all model on an inherently heterogeneous and non-standardized business–the business of executing OTC derivatives transactions.  That heterogeneity reflects the inherent heterogeneity of particular transactions, and the firms that want to execute them.  The market has evolved to accommodate heterogeneity, and the SEF mandate will impose uniformity.  Everybody better fit a 42-regular sportcoat, because that is what Frank-n-Dodd is going to force everybody to wear.

Of course there are dissidents from the consensus: most prominently those who do, or want to, operate SEFs.  Big surprise.  The NYT recently ran an article describing the efforts of these firms to influence policy.  The point you should take away from that article is that the idea of SEFS is not new, that SEFs have tried to gain traction in the market for some time (they are not “Johnny-come-latelys” in the words of one exec quoted in the article), but they have not made a big dent in the marketplace.

The failure to this point of SEFs to transform execution in the swap market, the way electronic trading did for listed derivatives, is a crucial fact.  It is not dispositive proof that the SEF mandate is misguided, but it does raise serious questions about it.  Before remaking the world, it is a pretty good idea to understand why the world is the way it is and why it isn’t the way you want to remake it.  Competition is never perfect, but competitive forces usually work inexorably towards the adoption of more efficient practices.  The rebuttable presumption should be that competition has pretty much gotten it right, and that policy prescriptions that are wildly at odds with existing practice are likely based on ignorance.  Those advocating a wholesale re-engineering of the results of market processes should be required to advance a coherent justification, based on rigorous logic and empirical evidence.

This the SEFocrats have not done.  Not even close.  And no, invoking the magic word “transparency” or advancing theories that presume that half the market is suffering from something akin to battered spouse syndrome don’t cut it.

The SEF rules are a particularly prominent example of the deficiency in cost-benefit analysis in CFTC rulemaking.  I have it on good authority that some analysis will soon be forthcoming that demonstrates that the cost of these rules will be immense.  As for benefits, the six members of the FIA panel couldn’t name one–even when pressed to do so.  We, collectively, couldn’t even come up with a “well you don’t sweat too much for a fat girl” compliment.  (If you don’t like that remark, direct your complaints to Ty Cobb:  I stole it from him.)  So, insofar as cost-benefit analysis is concerned–you should be able to do the math pretty easily.

The title for the post, by the way, is a joint product.  Tom LaSalla of CME Group coined “SEFdom” to describe what Frank-n-Dodd will soon bring on us.  I added the Hayekian allusion.  (Go figure.) I think the comparison is apt.

Insofar as the ISDA panel on clearing is concerned, I walked away from it thinking what I do after hearing any informed discussions of this subject: that it is the most devilishly complex issue you can possibly imagine.  It is one of the world’s biggest onions, and neither I nor anyone who has spent considerable time and effort thinking about it or actually doing it has gotten through even a small fraction of its layers.  The number of serious issues, their complexity, and their interconnectedness, is hard to exaggerate.

Which further demonstrates the frivolity of legislators and regulators around the world,who seized upon it as a panacea and imposed it without due consideration of these complexities.  The idea was hatched out of superficial understanding by panicked people who then proceeded to let others deal with the brain-twisting realities.

One hopes (though I do not expect) that regulators will be sufficiently patient and flexible to permit people who actually know something accommodate these complexities, and make the hard trade-offs that are necessarily involved.  New ideas on ways to perform the same functions as CCPs are still being developed: ISDA chief Conrad Volstad mooted a promising approach that would achieve the purposes of the clearing mandate, but at far lower cost.  These approaches deserve analysis and development before another one-size-fits-all approach is locked in.

I don’t like clearing mandates, but think that clearing has its virtues if it is done right, and in a way that reflects its comparative benefits and costs.  In this way it differs from the SEF mandate, which is why I gave the latter my Worst of Frank-n-Dodd Anniversary Award.  But rigid and superficial conceptions about how the mandate should work (and you know whom I am talking about) raise the very serious possibility that the potential benefits of clearing will be swamped by the unintended costs of imposing it where it is inappropriate, or in a way that is not adapted to its strengths and weaknesses.

In this week’s edition of Energy Metro Desk, John Sodergreen wrote: “Normally, Pirrong is a ‘take no prisoners’
sort of economist.”  He was referring to my apparently serene response to the Singleton paper on energy speculation.

Rest assured, all, that I am not mellowing in my old age.  My response to Singleton qua Singleton was serene primarily because the results are capable of many interpretations, many of which are quite compatible to my views.  Further rest assured that I am my scathing self when it comes to the efforts to misinterpret and overinterpret Singleton’s results.  It is being waved about as the smoking gun proving that speculation distorts prices.  This is completely wrong, and reflects either the ignorance or agenda–or more likely, both–of anyone making the claim.

Remember what Puddin’ Head Wilson said: “We should be careful to get out of an experience only the wisdom that is in it — and stop there.”  People are getting far too much “wisdom” out of Singleton than there is in it. Singleton’s results are perfectly consistent with a favorable or benign effect of speculation.

But there is nothing more likely to get me to break out the black flag than an epistle from Bart Chilton, and yesterday he did not disappoint.  The NY Times’ Dealbook had this gem from our ol’ buddy Bart:

It’s a familiar cry from Wall Street executives and Congressional Republicans: New regulations will dampen profits and crimp an already-feeble job market.

But some federal regulators, now charged with writing dozens of new rules for Wall Street, beg to differ. Bart Chilton, a Democratic member of the Commodity Futures Trading Commission, argues that a regulatory shake-up would actually spawn a wave of hiring on Wall Street and in Washington.

“The possibilities for economic growth and competition here are mind-boggling,” Mr. Chilton said on Friday during a speech at the University of Maryland.

The debate centers on the controversial Dodd-Frank Act, which overhauled financial regulations after Wall Street nearly collapsed during the financial crisis. The law, among other things, transformed the $600 trillion derivatives markets, a lightly regulated industry at the center of the mess.

. . . .

“I have no doubt that these new regulations, instituting new types of clearing, trading and reporting platforms, will foster a landslide of hiring in the financial sector,” Mr. Chilton said.

In particular, Mr. Chilton forecast growing demand for technology experts. “All of this new trading activity, with new regulatory oversight requirements, will mean the development of new technologies, both in the private and public sectors,” he said.

The mind boggles.  Chilton, like all too many regulators and legislators, confuses costs and benefits.  This is the broken window fallacy on crack.  Said regulators and legislators should be required to have Bastiat’s discussion of the seen and the unseen flashed before their eyes repeatedly, Clockwork Orange-like, until the idea sinks in.  Short of that, I am at a loss at how to educate them on this profound–yet simple–concept.

Yes, we can see all the accountants and lawyers beavering away on Sarbanes-Oxley-related work.  But what about all the other–and actually productive–things those people could be doing if Congress in its infinite wisdom and overweening arrogance hadn’t seen fit to create an artificial demand for their services, that distracted them from doing something that is actually socially productive?  What about the companies that are smaller, and the companies that don’t exist, because of the burdens of this and other counterproductive regulation?

Frank-n-Dodd is Sarbanes-Oxley raised to a power far greater than one.  Yes, there will be lawyers and compliance people working in their tens of thousands to ensure adherence to its mind-numbing dictates.  Yes, the idiotic SEF requirement will result in a splurge in spending on technology, and there will be much rejoicing among programmers and IT people.  To the bean counting regulator or legislator this is good.  To the more perceptive, it is a crime.

Riddle me this, Bart: If this technology were actually valuable, why do you and your ilk have to force its creation?  You, in particular have been critical of the dizzying pace of technological development in the trading space.  So you know this is obviously a technologically dynamic industry where there is intense competition to create new products and services and methods of delivering them, not some tradition-bound backwater.  If the kind of technology Frank-n-Dodd is going to bring into existence were actually delivering value to market participants, you can be damned sure that somebody would have figured that out.  Many somebodies, in fact, who would be competing like hell to bring it to market faster and better than anyone else.

And further: please tell me what actually beneficial inventions will not be created, or will be delayed, because their would-be inventors are instead (rationally) responding to some inane government mandate?  You can’t, and I can’t.  But they exist.  Just because you can’t see them, doesn’t mean they aren’t there

And please: tell me how you distinguish a cost from a benefit.

Sadly, the inability to tell cost from benefit is rife in the 202 area code.  The disease is probably most acute at EPA, which blessed us with this gem of economic analysis:

In fact, the EPA has even suggested that new regulations can have a positive impact on job growth. “In periods of high unemployment, an increase in labor demand due to regulation may have a stimulative effect that results in a net increase in overall employment,” the agency wrote in February.

This is the kind of moronism we are dealing with, people.  And the rot is spreading.  Including to the CFTC, apparently.

When you read or hear this or that macroeconomic theory about why the recovery–such as it is–has been so weak, and why the economy totters on the brink of another recession, put it in its proper perspective.  Yes, macro factors are important.  But so too is the massive regulatory millstone hanging around our collective necks.  People who think costs are benefits are running amok.  And sad to say, they are just getting warmed up.

We need to fight these people.

* The Degüello was a bugle call dating from the Moorish Wars of the Reconquista in Spain. Literally, it means “throat slashing” and was played to signal “no quarter–take no prisoners.” Santa Ana’s army played it before the final charge at the Alamo.

There are news reports providing some glimpses into draft regulations regarding the regulation of derivatives and securities markets in Europe.  It looks like it is taking some of the worst of Frank-n-Dodd, and adding some dumb flourishes of its own.

Insofar as the worst of Frank-n-Dodd is concerned, despite initial indications to the contrary, it looks like the proposal is going to incorporate something like a SEF requirement.  You might recall that on The Monster’s first birthday, I named the SEF requirement as its worst feature.  Well, the Euros (don’t they have bigger problems right now? Just asking.) don’t look to be avoiding the US’s mistake:

Widely traded derivatives would have to be transacted on an electronic platform to improve transparency and safety, draft European Union rules showed on Monday.

The bloc is overhauling its markets in financial instruments directive (MiFID) to catch up with technological advances, apply lessons from the financial crisis and deal with problems such as price fragmentation raised by the original rules.

“The main aim of the proposal is to ensure that all organised trading is conducted on regulated venues and is fully transparent,” the draft, seen by Reuters, said.

More specifically, world leaders agreed in 2009 that derivatives, largely traded bilaterally between banks in an opaque $600 trillion sector, should be traded electronically.

This will give supervisors the full picture of who is affected when a counterparty gets into trouble, which they lacked when Lehman Brothers bank collapsed three years ago.

“The proposed revision will shift trading of the suitably developed derivatives to such platforms,” a draft of the MiFID reform, now circulating widely in Brussels, said.

“This obligation will be imposed on both financial and non financial counterparties,” the draft added.

Another unfortunate imitation is the adoption of restrictions on commodity speculation, including position limits:

The European Securities and Markets Authority should have the power to impose position limits on traders in crisis situations when “the stability of the whole or part of the financial system” is threatened or “delivery arrangements for physical commodities” could break down, the document says.

The Euro flourishes are clearing-related, although here I have to say that the reporting is not too clear.  As I’ve written in the past, European regulators are obsessed with the vertical integration of execution and clearing–the silo issue.  Various reports (including the two linked above) and this one suggest that the regulators will force CCPs to be open access.  The reporting also states that integrated exchanges will have to share data streams, including calculations of indexes that are the basis for traded products.

Insofar as open access is concerned, the FT article quotes language stating that CCPs will be required to accept trades for clearing “on a non-discriminatory and transparent basis, regardless of the trading venue on which the transaction is executed.”

The idea here is to facilitate competition between CCPs, apparently.  But it is fraught with difficulties.

For one, there is the question of why a dominant CCP, including one that is integrated with an execution venue, would turn away business.  Even if it is a monopoly, it could sell clearing services at the monopoly price.  If, as the anti-silo crowd commonly argues, the execution of transactions is potentially highly competitive, absent some cost, the monopoly CCP would maximize profits by selling its services at the monopoly price.  It wouldn’t be necessary to mandate open access.  The CCP would gladly offer access–for a price.

It is therefore necessary to understand why an integrated CCP wouldn’t sell clearing services to others on an open access basis.

One possible reason is that the dominant CCP believes that open access rules will eventually result in the regulation of the prices it can charge for its services.

I think a more important reason relates to a fundamental misunderstanding  among the Europeans of the way competition is likely to work.  There are two possibilities.

One possibility is that there remains a single clearer–given the cost conditions in clearing, that’s not unlikely, although it seems that the Europeans think that they are constructing rules that will reduce the likelihood of this outcome.  Note that particularly now, financial trading is highly technological.  There will thus be the necessity of coordinating technologies and changes in systems between the execution venues and the clearer.  This can be very difficult to achieve across firm boundaries; this is one of the factors that I identified as justifying integration well over 5 years ago.  It should also be noted that this is precisely the reason given for many recent exchange decisions to integrate into clearing; the LSE is the most recent and prominent example of this.

The other possibility is that there are multiple CCPs offering to clear a particular instrument.  There are myriad challenges to this, but I’ll focus on just one.  In particular, assume a transaction in a particular instrument is cleared at CCP A and CCP B.  A trade is executed on venue X.  If the parties to the trade can choose independently where to clear, the buyer may submit the trade to A and the seller to B.  In this case, A and B must be interoperable.  Interoperability is extremely challenging.  It is likely to increase collateral costs (as A and B are going to require collateral from each other).  Moreover, A and B may find it difficult to negotiate an interoperability arrangement because of (a) competitive pressures (the model the Europeans seem to have in mind involves a unique balance of competition and cooperation), and (b) distrust of each other’s risk management, arising from the difficulties of monitoring.  Moreover, the technology/system coordination issues are now multiplied, as X has to coordinate with both A and B.  And if there are multiple execution venues (Y and Z, say) as the Euros presumably hope and expect, these difficulties are multiplied accordingly.

Having an exclusive arrangement with an execution venue avoids this problem.  Those trading on X could be required to clear on A, for instance.  But that just raises the same kinds of problems as if there is only a single clearer.

In brief, it is hard to see how robust competition between CCPs is possible.  Once that is admitted, the whole basis of the regulation collapses.

The whole evolution of the exchange space–most notably in Europe–in the past 5 years is exactly contrary to the thrust of the proposed regulation.  And maybe that’s the point: the Euroregulators are clearly bugged by this trend.  But maybe they should try to understand it first; it’s pretty evident that they don’t now.

Case in point: LCH.Clearnet’s difficulties–its loss of exchange clearing business (EuronextLIFFE, ICE, and almost certainly LSE)–suggests that integration is not primarily driven by anticompetitive impulses.  Instead, in my view it reflects the difficulties of coordinating complementary activities across firm boundaries in a highly technologically dynamic industry.*  At the very least, the Euros should consider that possibility, and take it seriously, before attempting to micromanage the structure of a dynamic industry with strong network characteristics.

Instead, it seems that the regulations are based on an intellectual framework that would be suspect in any industry (as I’ve written about before), and which does not seem to take into account that unique characteristics of financial trading: network effects, scale  and scope economies, technological dynamism, and information asymmetries with respect to performance risk.

So, if the European endeavor is truly the son of Frank-n-Dodd, it may well be the ugly bastard child.  It has the defects of F-n-D, and adds some more–as if more were needed.

Perhaps this is Brussels’ negotiating position.  There is considerable opposition (particularly in Germany–go figure) to some of these initiatives, and maybe the EU is proposing a more radical change in the knowledge that it will have to be watered down.   One can only hope that it drowns.

* I spoke at an FIA panel that touched on this issue in March, 2007.  I made the coordination point.  Charlie Carey, then head of the CBT (which had already agreed to sell out to the CME–this was the day before ICE made its surprise offer) was sitting next to me.  After I made this point, he handed me a note that said that was an extremely important, but insufficiently appreciated, fact.

There has been a lot in the news lately about the bankruptcy of solar panel maker Solyndra, the recipient of both massive Federal largesse (a mere $535 million), and lavish praise from Obama as the exemplar of the potential for green jobs and Federal programs to support them.  “The future is here” spake Obama (starting about the 9:00 mark):

Now, I actually have to agree completely with Obama on this one.  It is indeed a great example of what we can expect when subsidizing “clean energy” companies. Incredible potential to propel our economy for years. Right. But in which direction?

But that issue has been well-covered by others.  I want to focus on a narrower issue.  Remember in 2009, when the secured creditors of Chrysler were expropriated (that’s a nice way to say “hosed”) when that company went into bankruptcy?  Their purportedly senior claims were in fact subordinated to junior, unsecured creditors.  The secured creditors were the subject of vitriolic criticism from Obama personally, and from the administration and its media water boys.  It was an early indicator of the crony capitalism to come.

In the Solyndra case, a major Obama bundler George Kaiser–from very red-state Oklahoma, of all places–is an investor in Solyndra.  More to the point, when the company was in trouble back in March, it borrowed $75 million dollars, in part from the George Kaiser Family Foundation.   Crucially, this loan was made senior to most of the outstanding debts owed to the Federal government ($385 million out of the $535 million in total provided by Uncle Sucker).

So it will be quite interesting to see whether Kaiser, the Obama donor, gets the Chrysler secured creditor treatment, or whether the administration will have found a strange new respect for the virtues of strict adherence to priority rules in bankruptcy.

I read Mark Thoma’s Economist’s View blog to get a view on the views of people who think quite differently than I.  It is particularly useful in that regard because although Thoma writes quite a few posts, he is more of a linker than a writer, so EV is an efficient way to get exposed to the views emanating from the Keynesian-left of the blog world.

Which means that whereas I think “aggregate demand” has something to do with the cement market, Thoma is definitely of the what-we-have-here-is-a-failure-to-demand-enough-in-aggregate kind of guy.  Which further means that he is frequently looking to rebut alternative explanations for poor economic performance.  Him being him and me being me, I usually find his efforts implausible, but this one particular effort of his is particularly lacking, and is sufficiently close to my bailiwick to warrant a rebuttal.

“Of his” might be a little strong, for the post in question primarily endorses the analysis of another blog, but he doesn’t even quibble, so attributing ownership is fair.  In any event, the alternative theory at issue is “regime uncertainty”; the view (originally developed by Robert Higgs) that uncertainty about government policy (and the economic environment at large) discourages hiring and investment.  Higgs originally applied the idea to the Great Depression: he argued that the frenetic regulatory activity of the Roosevelt administration created investment-killing uncertainty that prevented a normal rebound.  The similarities between what happened in the 1930s and what is happening today has led to an application of this view to current circumstances, just as it has led to a revival of old school Keynesianism which was born during the Great Depression.

Thoma links to a Gary Burtless piece that purports to debunk regime uncertainty as a cause of the current lack of growth in hiring and investment:

A couple of hours after talking to an ABC correspondent about the woeful job numbers and what might be done to improve them, I was in the Bloomberg TV studios debating a guy from Heritage. He went on for several minutes about the damage being done by high taxes, excess regulation, business “uncertainty” about future tax hikes and regulatory burdens.  I asked Bloomberg’s host whether he was aware that corporate profits relative to national income had just hit a 60-year peak?  He had heard rumors to that effect.  Was he aware that taxes on corporate earnings were at a 60-year low?  The Heritage guy had heard that might be the case.

Then why was uncertainty about taxes and the future burden of the Affordable Care Act holding back business investment and hiring right now?  If managers thought taxes or regulatory costs might go up in the future, wouldn’t it make sense to take advantage of today’s low taxes and lower burdens to invest and hire today?  According to the “uncertainty” argument, businesses are fearful they might face high taxes and extra health costs in 2016 or 2018.  Shouldn’t they expand hiring right now and scale back employment when they actually face higher costs (if they ever do)?

The “tax uncertainty” and “regulatory uncertainty” arguments would make more sense if, say, taxes were already high and might be going higher or regulatory burdens were heavy and might be getting heavier. But when taxes are at a 60-year low and the regulations are pretty much the same as they were in the 1990s boom, the argument makes no sense at all.  As we used to say down on the farm, you should “make hay while the sun shines.” In other words, if you think it’s going to rain later in the week, it strengthens the case for cutting and baling right now.

This is utterly confused, and a complete mischaracterization of the regime uncertainty view.  It focuses on expected costs associated with policies like Obamacare (and, I might add, like Frank-n-Dodd and the EPA and the NLRB and on and on); the argument is essentially that if costs are expected to be higher in the future, why not hire more today?

But this focus on expectation (itself flawed–more below) is to misstate completely the essence of the regime uncertainty argument, which, believe it or not, is about uncertainty–variation around the expectation.   It can be conceived best as a real options argument.  Hiring is like an investment: there is a cost of hiring–and firing–workers.  This cost is not immaterial.  This cost is like the strike price of an option on the right to hire a worker and receive a stream of benefits from employing her.

This stream of benefits is uncertain.  Moreover, policy uncertainty is a major driver of the variability of this stream of benefits.  Nobody knows how Obamacare is going to play out.  Nobody knows what the actual costs of compliance are going to be.  If the burden turns out to be very high, the stream of benefits from hiring a worker (or investing in a new machine or a new product) could be quite low, and even negative.  If the burden turns out to be low, the stream will be commensurately higher.

Options pricing theory basically implies that in the face of such uncertainty, it is often optimal to defer paying a sunk cost (the strike price) until the uncertainty is resolved.  This is why it is usually better to defer the exercise of an option as long as possible, unless there is a stream of benefits (e.g., dividends, interest on the strike price) that can be obtained only after the option is exercised.  When to exercise the option–including exercising the option to hire somebody–depends on a trade-off between getting some benefits immediately, and waiting for the resolution of uncertainty about the value of those benefits in the future.

An immediate implication of this is that the greater the uncertainty about the future, the costlier it is to exercise an option early.  In the present context, higher uncertainty about the future means that firms will hire less today, all else equal.  Hiring a worker today (or investing in a machine or product) generates a stream of benefits for the employer in the short term, but if there is considerable uncertainty about the future value of that stream, it is often wise for potential employers to defer incurring the strike price (the cost of hiring) until some of that uncertainty is resolved.

In the investment literature, the option value of waiting for the resolution of uncertainty drives a wedge between the rate at which firms discount risky expected cash flows and the discount rate implied by something like the CAPM.  It helps explain why firms frequently use very high hurdle rates in capital budgeting decisions–and high hurdle rates tend to discourage investment, relative to those that would be undertaken using CAPM.  In other words, real optionality tends to reduce investment.

The same effect is at work here.   The Burtless argument endorsed by Thoma focuses on expected future benefits.  But since these future benefits are risky, and a cost must be sunk to achieve these benefits, there is a cost wedge–the option value of waiting–that is attributable to uncertainty.  The more the uncertainty, the greater the wedge.

In other words, the Burtless-Thoma “rebuttal” of the regime uncertainty analysis is nothing of the sort, because it completely misses the basic insight of that analysis.  When hiring is viewed as a real option–which is a fair analogy–uncertainty matters.  It is variation around the expected value that matters, but Burtless-Thoma focus on the expected value.

In other words: swing and a miss.  (Burtless’s argument is also strange even on its own terms because it presumes that firms don’t take future costs into account when making hiring decisions today.  Even absent uncertainty, higher future costs will deter hiring today if there is a fixed cost to hiring.)

There is no doubt that uncertainty is abounding today.  Just look at Europe for one example.  But even closer to (my) home, the uncertainty is immense.  One small example: the Obama administration’s request that the EPA defer action on ozone rules.  The key word here is defer.  It hasn’t been killed with certainty.  Its return depends on future political and economic developments: Obama loses, it is likely dead forever; Obama wins, it is likely to be revived, especially if the economy is doing somewhat better.  These future developments are fraught with uncertainty.  Moreover, the costs of the rule itself are highly uncertain, ranging from the EPA’s (typically risible) estimate of around $100 billion to more than ten times that.  Which means that although the suspension of the rule should reduce the expected cost of compliance which should in turn lead to greater economic activity, the suspension also creates a significant increase in uncertainty that will offset this effect.

One could repeat this exercise over and over and over.  Just focusing on one agency–the CFTC–would provide numerous examples.  And if you think that particular policy uncertainty would just affect, say, banks, you would be so wrong.

It is foolish in the extreme to disregard the economic drag that such policy uncertainty can create.   Most economic decisions–hiring and investment notable among them–are effectively real options.  The decisions to exercise real options depend on the amount of uncertainty.  Uncertainty has first-order effects on these decisions.  Thoma (and Burtless) may believe they have discredited regime uncertainty as an explanation for our current malaise, but they have done nothing of the kind.  Indeed, they completely miss the point and thrash a straw man.  Regime uncertainty is still a very viable and plausible explanation of the reluctance of firms to hire and investment.

I’ve followed the Bank of Moscow story with one eye.  Howard Roark asked me to blog about it, and I’ve been looking for an angle, but the facts are so obscure, and the sources of information so suspect, that’s hard to get a grip on things.

Speaking of suspect sources, the fugitive ex-CEO of BOM, Andrei Borodin, claims that the seizure and bailout were unnecessary, and by implication, political:

Andrei Borodin, who fled Russia in March and is wanted by authorities there over a loan Bank of Moscow made under his leadership, said the bank “never needed state help.”

“The problems there are of an artificial nature,” he said.

In early July, Russian regulators unveiled a $14 billion rescue package for Bank of Moscow after saying they discovered a huge hole in the bank’s balance sheet.

. . . .

His comments add to the controversy surrounding the bailout, which was so large it raised investor concerns about the soundness of the Russian banking system and the credibility of the central bank, the country’s main banking regulator.

Bank of Moscow was a key pillar of the regime of Yuri Luzhkov, the long-serving mayor of Moscow who was fired by President Dmitry Medvedev last fall. Part-owned by the Moscow government, the bank was a key lender to big real-estate developers such as Inteko, a company owned by Yelena Baturina, Mr. Luzhkov’s wife. The ousting of Mr. Luzhkov has set off a struggle for control of some of Moscow’s choicest municipal assets—Bank of Moscow among them.

Mr. Borodin, an ally of the former mayor, is wanted by Russian authorities over a $415 million loan that Bank of Moscow made in 2009 to Premier Estate, a company that state investigators say is linked to Ms. Baturina. The investigators claim most of the money ended up in her personal account. Mr. Borodin and Ms. Baturina have denied any wrongdoing. Ms. Baturina hasn’t been charged with any crime. Russian police put Mr. Borodin on an international wanted list two months after he fled the country.

. . . .

hen last month, VTB and Russian regulators said they had uncovered $12.6 billion in suspicious loans at the bank—more than half its total loan book.Officials said a large portion of the bad loans were made to companies linked to Mr. Borodin and other members of the bank’s former management.

Mr. Borodin insisted that the loans were fully collateralized and of high quality.

A spokeswoman for Mr. Borodin, Claire Davidson, said the bank’s former president had never been presented with a list of the alleged related-party loans and so couldn’t respond directly to the allegations.

She said a team of five officials from the Russian central bank had been monitoring operations at Bank of Moscow since 2008, and “if they knew there were problems at the bank, why didn’t they tell anyone?”

The bailout of the bank consisted of $10.2 billion in low-interest loans from state regulators and $3.4 billion in capital from VTB. Analysts were shocked by the size of the rescue package, which was equivalent to nearly 1% of Russia’s gross domestic product.

Earlier this month, Gennady Melikyan, head of banking oversight at the Russian central bank, resigned. The central bank declined to comment and Mr. Melikyan couldn’t be reached.

So, there are two theories on offer, neither of which gives one the warm and fuzzies about the Russian financial system, and the Russian politico-economic complex.

Theory One: BOM was a piggy bank for the politically powerful Mayor of Moscow and his billionaire wife.  They used the bank to tunnel funds to their pet projects–and their own pockets.  When the mayor was pushed off his political perch, the new powers that be discovered gaping holes in the balance sheet, necessitating a bailout.

Theory Two: BOM was actually healthy, and its loans were good even though a good chunk of them were made to the politically powerful.  Indeed, in Russia, what better security for a loan than a крыша from the local political Godfather?  Said Godfather was pushed out as a result of typical bulldogs-under-the-carpet infighting in Russia, and the scandal over the state of BOM and the bailout were all just part of the powerplay intended to discredit Luzhkov and Baturina, and to create leverage that could be used to force them to disgorge some of their billions.  Or all of them.

Corollary to Theory Two: The seizure/bailout is actually part of a scheme by the new powers in Moscow to direct state funds to them.

Given that no one involved here has any credibility, and indeed, are all up to their necks in corrupt and shady dealings, it’s hard to choose between these alternatives.  But it’s really not that important.  It just demonstrates the density of the nexus between politics and finance in Russia.  Finance is politics and politics is finance.  Following Lenin’s advice, the powers that be have seized and exploit the Commanding Heights.

Sadly, the nexus between politics and finance is very dense outside of Russia too, and becoming more so all the time.  Right now the shakiest bank in the US is Bank of America: its CDS has been gapping, its stock plummeting, and all sorts of rumors are swirling around it.  Former Treasury Secretary Paulson admitted that he basically forced BAC to buy Merrill Lynch.  BAC’s biggest problems stem from its acquisition of Countrywide, and there are suspicions that regulators at least cajoled BAC to buy Countrywide in January 2008.  Regulators were certainly happy when BAC bought the mortgage lender.

Big banking has always been politicized to some degree (because, like Willie Sutton said, that’s where the money is), but this tendency has accelerated in recent years.  But given the path-dependence of the situation, it’s hard to see how that will reverse any time soon.  Indeed, the dynamic seems to be pushing towards more politicization.  Which is hardly a good thing.