Streetwise Professor

Let’s look at the basics to try to figure out the real strength of the SEC’s case.

One.  Goldman was marketing a synthetic CDO to potential customers, including ACA.  The customers would be long the credit, and would lose if the reference names declined in value, due, for instance, to unexpectedly high defaults.

Two.  Every synthetic CDO has a protection buyer (who is short the credit) and a protection seller (as above, long the credit).  So ACA and other potential protection sellers knew that there was somebody or somebodies who wanted to short these particular credits.

Three.  The possible motive of the party short the credit are, roughly speaking, hedging and speculating.   The speculator has a view, which may be based on non-public information, or proprietary analysis of public data, or maybe just his horoscope, that the value of these credits will decline.  The hedger may have such a view, but may be risk averse and be willing to sell the credits for less than he thinks they are worth in order to reduce risk exposure.  Most hedgers have mixed motives, and hedge selectively: they are more likely to short the credit when they anticipate a price decline.

These three factors are common to every derivatives transaction.  There is a positive probability that the buyer is trading with someone who has information or a belief that the price will decline.  This potential for adverse selection is a risk the buyer faces in every transaction.

Four.  In most transactions in derivatives and securities markets, brokers have no obligation to disclose the identify of their principal; indeed, they are obliged not to disclose their principal.  That is true even though the identify of the agent might be very pertinent information.  Indeed, market participants try mightily, and spend real money, in order to attempt to learn who is the ultimate counterparty, because that can be informative.  Knowing that, other traders go to great lengths to conceal their identities and their trading–that’s why they use brokers in the first place.  Moreover, the traders who are willing to disclose their identity usually do so because they can demonstrate that they are uninformed.

This means that, in general, the party to a derivatives trade doesn’t know, and doesn’t have the right to know the ultimate counterparty.  (I don’t know, as a legal matter, if they ask, it is illegal for the broker to lie.  My guess is it’s just that “don’t ask, don’t tell” is the rule.)

It also means, in general, that they want to know because the identify of the counterparty can be informative.

The fact that most markets are anonymous, and that brokers are obligated not to disclose the identity of the principal they represent, means that the default policy presumes that the benefits of counterparty disclosure are less than the costs.  One may argue about whether that is the correct judgment, but it is the one implicit in the law.

The one factor that supposedly separates this case from other transactions is that Paulson selected a set of credits to include in the synthetic.  But every buyer of X knows that someone wants to sell X, regardless of what X is.  That is, the always seller chooses what he wants to sell in any transaction.  The fact that Paulson chose the particular names doesn’t distinguish this case from the typical transaction; the adverse selection risk is present in any trade.

Another allegedly distinguishing feature is that Goldman allegedly insinuated that Paulson was a buyer, not a seller.  But still, the actual potential buyers knew that there was somebody who wanted to sell.

The strongest argument that can be made is this.  ACA and the German bank allegedly thought that Paulson was long, based on Goldman’s representations (though Goldman disputes this).  Paulson participated in the selection of the credits to be included.  ACA drew a different inference about what private information Paulson had based on its belief that he was a buyer, than it would had it known he was a seller.  The supposed absence of the seller from the design of the CDO–and hence, the apparent delegation of the decision of what to sell to somebody other than the ultimate seller–plausibly reduced ACA’s estimate of the adverse selection risk it faced.  Thus, ACA entered the deal at a price that was higher than it would have, had it known of Paulson’s true role.

How much higher?  Impossible to say, but “not much” is a plausible answer.  Because, again, at the end of the day that ACA knew that it faced a winner’s curse: there was a real risk that the actual short would only pull the trigger on the deal if it were priced unfairly to ACA.

But the anonymity of most financial transactions, and the obligation of brokers not to reveal their principals, suggest that you have no right to be free of adverse selection risk.  It seems that the case will turn, therefore, on (a) whether it is unlawful to deceive the counterparty about your principal, and (b) whether Goldman did deceive ACA, etc.  Would Goldman have been fine if it had just stuck to “don’t ask, don’t tell”?  Did it, in fact stick to DADT?

It may be difficult to show that Goldman actually and intentionally deceived ACA.  And without that, the transaction is very difficult to distinguish from virtually another other transaction in which the buyer faces the risk of dealing with a better informed seller whose identity it does not know.  With adherence to DADT, it would be hard to justify finding Goldman guilty.

What’s more, it’s not as if Paulson was offstage during this entire drama.  Quite the opposite.  He met several times with the ACA team and actively and personally participated in the selection of the mortgages.  If the mortgages that he was pushing were so bad, you’d think ACA would notice and start questioning his true involvement: “You want all this real garbage in the structure.  WTF: Are you buying or are you selling?”

The SEC faces a tension here.  The harder it tries to argue that the mortgages were really, really, really bad, the more it strains credulity to argue that ACA was duped.  ACA could have observed information related to the criteria that the SEC says in its complaint that Paulson used to select candidates for the pool.  They evidently took a different view of the implications of these criteria than Paulson.  Where’s the material, non-public information about the mortgages themselves that might justify a more traditional case?  If ACA looked at the same information Paulson did, and came to a different conclusion, it is hard to argue that it wouldn’t have entered into the transaction if it had known that Paulson had decided to short the mortgages based on this information.

An interesting possibility is that the SEC finds Goldman guilty, but that damages in a civil lawsuit against Goldman may be small.  Certainly, it will be very difficult to estimate the “but for” price of the deal, i.e., the price that the parties would have negotiated had Paulson’s role been known.  Certainly, the synthetic buyers will try to argue that their realized loss is their damage, because they wouldn’t have entered the transaction if they had known Paulson was on the other side.  But that’s not all that plausible; they might have entered the deal, but at a slightly lower price.  There’s no “curative disclosure” here, so estimating that but for price would be devilishly hard.

A couple of last, broader, policy points.  First, the SEC has been broadening its interpretation of what “material nonpublic information” is.  Depending on how the SEC argues this case, the evidence of actual deceit about Paulson’s role (as opposed to silence), and how it is decided, this case could affect how the materiality of counterparty identity is interpreted.  This could have a big impact on the securities and derivatives industry more broadly, and reduce the anonymity of brokered financial transaction.  Perhaps more troublingly, it could add uncertainty into the interpretation of an intermediary’s rights and obligations to its clients.  Hard cases make bad law, and this one has that potential.

Second, this case is being trumpeted as a perfect illustration of why sweeping new regulation is needed.  Indeed, the White House and the Democrat Party are using this as a fund raising plug: they started with this campaign a mere 30 minutes after the complaint came down.  But, if Goldman’s conduct is actionable under the current law, how can that conduct demonstrate the need for more laws and regulations?

That said, all is not well on Wall Street, obviously.  But this case is a distraction from the main issues, notably too big to fail.  The current legislative proposals are not encouraging in this regard.  This Goldman case is factually and legally ambiguous morality play that diverts attention from the central issues, and which could result in the passage of much legislation and the implementation of much regulation that is irrelevant to the main issue, and ultimately destructive.

Very bad.

Problem one is obviously the ban on “Federal assistance” to any “swaps entity” where “Federal assistance” includes a Fed loan.  It is ironic, and disturbing, that (a) the bill mandates extensive clearing, and thereby makes swaps clearinghouses a central pillar of the financial system, but (b) denies these entities the ability to access liquidity via the Fed.  This goes against the recommendations of Duffie et al in their policy piece for the FRBNY, the European Commission, and now the IMF:

Hence, those [CCPs] deemed to be systemically important should have access to emergency central bank liquidity.  However, any such emergency lending should be collateralized by the same high-quality liquid securities as those typically posted against monetary policy operations. Also, it should not be done in any way that might compromise the central bank’s monetary policy or foreign exchange policy operations. [IMF, Making the OTC Derivatives Markets Safer (April, 2010), p. 20.]

In short, Lincoln’s bill goes against the advice of virtually all those who have analyzed the implications of clearing mandates–including strong supporters of these mandates.

During periods of market stress, and ESPECIALLY in cleared markets, the demand for liquidity increases dramatically.  Firms need liquidity to meet margin calls in response to big price moves.  CCPs that can borrow on behalf of their members can facilitate this process.  Denying these entities access to central bank liquidity facilities is a major mistake, and will in effect make the markets like they were prior to the formation of the Fed in 1913.  Can you say “Panic of 1907”?  I knew you could.

And even allowing CCPs to access liquidity facilities, while denying swap dealers from the same option–effectively requiring banks to hive off derivatives dealing activities–will cause problems.  If the idea is to reduce systemic risks arising from counterparty risk, it is desirable to ensure that market participants, including derivatives market participants, have access to liquidity during periods of market stress.  A firm experiencing a liquidity shock, due, for instance, to a big collateral call, but which is solvent, would be forced by this provision into fire sales or defaults that would exacerbate systemic risks.  It would do so by threatening to transform liquidity shocks into crises.

Lincoln’s bill evidently mistakes a bailout for the exercise of lender of last resort functions.  The latter, if Bagehot’s basic framework is followed, eases liquidity crises by lending freely against good collateral.  (The Fed’s promise to do so in October, 1987 almost surely saved the CME and CBT clearinghouses during the crash).  A bailout transfers wealth from taxpayers to the claimants of an insolvent firm.  Lincoln’s provision threatens to turn liquidity shocks into full-blown crises.

In some respects, Lincoln’s confusion is understandable.  After all, the Bernanke Fed has clearly blurred the line between Bagehot-esque lender of last resort activities and bailouts.  That’s a serious issue, that should be addressed.  But Lincoln’s approach would be a very bad way of doing that.

The bill’s end user exemption is extremely, extremely limited.  That’s also a problem, for reasons I’ve discussed before.  What’s particularly amazing is that the end user exemption is basically limited to commodity producers and consumers (although firms like J. Aron or Morgan Stanley that handle physical commodities are expressly excluded from the exemption).  That means that a firm, say IBM or Merck that uses currency or interest rate swaps would not be eligible for the exemption.

Oi.

The bill also extends position limits to the OTC market.  More pain, without gain.

The proposal requires trading on either exchanges or swap execution facilities, and precludes voice brokerage.  It mandates pre-trade price transparency, and “real time” price reporting.  I’ve commented extensively on these ideas in the past, and find them no more reasonable now than I have before.

About to jump on a plane, so I will add more later.  One last thing.  The bill envisions a massive expansion of responsibilities for the CFTC.  To be honest, the CFTC does not have the capabilities to handle its current responsibilities, let alone the new and extremely complex ones it would have under the bill.  This is a setup for future regulatory failure, in a situation where the regulation is much more pervasive–and systemic. Regulators failed before. They will fail again. The likelihood of failure will be higher, and the consequences of failure more catastrophic, when regulatory responsibilities are expanded greatly and foisted onto an agency that is ill prepared to handle them. Even if the CFTC is funded much more generously, it will face daunting challenges in scaling up, and obtaining the expertise it needs to do a much expanded job. This is a train wreck ready to happen.

OK.  Time for one more thing, something that the bill doesn’t do.  Manipulation is a potential problem in derivatives markets, and existing law and regulation has proved problematic (at best) in deterring it.  I’ve advocated for years that a statutory fix is required, and this bill (or the Frank bill, or the Dodd bill) would present opportunities to do that, but they don’t.  So we have a bill (bills, actually) that does many things it shouldn’t and doesn’t do something it can and should.  Great.

I have several reactions to the SEC’s fraud complaint against Goldman.

First, some of the more sensationalist reporting emphasizes that Goldman was short the RMBS structures that it was selling to its customers.  (Yeah, it’s the NYT, basing its opinion on reporting by Wretched Gretchen Morgenson, so take it for what it’s worth–meaning not much.) Well, that’s true, but Goldman was also long.  After all, it was the counterparty, the protection seller, to Paulson’s CDS.  It then entered into offsetting transactions.  Goldman was essentially a conduit of risk between other financial firms and Paulson.  Note paragraph 66 of the complaint, which indicates that Goldman paid most of the $840 million it received on short positions in the  Abacus deals to Paulson.

This means that Goldman took on substantial counterparty risk, which is also revealed in the complaint.  Although the complaint does not spell out the exact transactions in detail, it appears that ACA Capital sold hedges on the Abacus deal, and that the risk that ACA Capital would not be able to perform was assumed (for 17 basis points) by ABN.  In the event, ACA Cap could not perform, and ABN’s purchaser, RBS, ended paying off on the protection (to Goldman).

This is related to something I blogged about last year (which attracted Jim Chanos’s attention).  Specifically, as a market maker both long and short credits, Goldman was vulnerable to default by its counterparties on its long positions.  That’s why AIG’s impending demise was so threatening to Goldman.  AIG owed collateral to Goldman, and Goldman owed collateral to its counterparties.  If AIG had failed, Goldman likely would have failed too.  That still seems to me to be the key issue that is often overlooked in discussions of the AIG bailout, and Goldman’s stake in that bailout (which it vociferously denies–too vociferously, IMO).

As to the specifics of the complaint, yes, I’m sure that ACA Management, and the ultimate buyers of the Abacus deal would have liked to know Paulson’s true role in the transaction, and his true economic interest.  And it appears that Goldman was deceptive in its representations about Paulson’s role.  Whether that’s enough to secure a judgment is debatable, however.

It’s worthwhile to note that it is unlikely that Paulson had material, non-public information about the mortgages at issue. He certainly had a view, based on his analysis of the market.  But, according to the complaint itself, that view was based on the analysis of what is most likely public information:

In late 2006 and early 2007, Paulson performed an analysis of recent-vintage Triple B RMBS and identified over 100 bonds it expected to experience credit events in the near future. Paulson’s selection criteria favored RMBS that included a high percentage of adjustable rate mortgages, relatively low borrower FICO scores, and a high concentration of mortgages in states like Arizona, California, Florida and Nevada that had recently experienced high rates of home price appreciation.

All that information was available to ACA Management, and to the ultimate buyers.

Paulson had a view on what was going to happen in the mortgage market, and desired a structure that would pay off substantially if that view was correct.  At the time others did not take the same view, even when looking at the same information.  That said, one would have been wise to take pause at buying this stuff had they known that Paulson had such a strong view on the market.

One curious thing in the complaint.  Typically annoying investment banker jerk Fabrice Tourre (who seems to have stepped out of a Tom Wolfe novel) is the only named defendant.  Didn’t oodles of people at Goldman have to sign off on this deal?  Why aren’t they named?  That seems to suggest a certain weakness in the case.

The self-styled “Fab” is a natural target primarily because of his big mouth–or more precisely, his lurid emails.  Emails like this are catnip to reporters–and prosecutors.  But any prosecutor who makes such correspondence the keystone of his case is taking a huge risk, as the recent Bear Stearns cases illustrate clearly.  The emails should be used like the cherry on the sundae–not the entire dessert.  To make the case, the SEC will need more substantive evidence about Goldman’s actions–including the actions of others beyond Tourre, including any putative adults in legal.  Yes, it’s hard for juries to follow.  Yes, it’s boring.  But that’s the hard work that must be done to secure a conviction.

One last comment.  The timing of the complaint is quite interesting, coinciding with the administration’s big push for financial regulatory “reform” and its identification of this as a major winning issue.  It could be just that–a coincidence.  But maybe not.

Moreover, it is cases like these that build the narrative that is used to justify the need for wide-reaching regulation, most of which relates to matters far removed from the specifics of any particular case.  That extrapolation is dangerous (extrapolation always is), and almost always results in bad policy.

Much of the regulation introduced in the 1930s was built on similar narratives, that were similarly removed from the specifics of the laws and regulations.  The Goldman story is most resonant of the stories of bank perfidy in marketing corporate and sovereign securities in the 1920s; this narrative was an important part of the justification for Glass-Steagall.  But as much recent research has shown, the empirical evidence does not support the view that banks systematically profited (and screwed their clients) by keeping good loans and palming off the bad ones through the securities markets.  No doubt that happened at times, but the evidence doesn’t support the broader narrative that this was the rule, rather than the exception.

But the new narrative that parallels that of the 1930s is well established, and the Goldman complaint will only cement it in place.  And this may turn out to be the most socially costly aspect of Goldman’s actions.  These actions will help advance laws and regulations that pose considerable risk of doing far more harm than good.

Today was chock full of derivatives-related news.  One big story was that Senate Ag Committee Chair Blanche Lincoln is apparently going to propose a derivatives regulation bill that can best be described as the Dodd bill on steroids, with very few end user exemptions and a strict exchange trading requirement.  You can guess my appraisal of those ideas, but I’ll defer my analysis until something official is released.  I will say now, though, that it is evident that the administration is going full bore with a derivatives crack down.  Obama spoke out on the issue personally today, and Treasury people have been very vocal.  Ugh.

The other big story was that an un-redacted version of the Valukas report was released, revealing the names of the winning bidders for Lehman’s CME positions, and the payments to them.   According to the report, the winning bidders received consideration worth about $1.2 billion dollars more than the liabilities that they assumed.  Valukas argues that the Lehman estate could have a claim against the CME for forcing the liquidation of the positions, and against the winning bidders.

There are several related points that are relevant here.

The first is that Valukas’s valuation was based on settlement prices on Wednesday, 17 September, 2008.  The auction was held on the morning of the 18th.  The positions were large, and there is no guarantee that they could have been liquidated at those settlement prices.  The report details only the values of the options in the Lehman portfolios, based on the previous day’s settle.  This means that it values the futures at zero, meaning that it implicitly assumes that the settlement price hadn’t changed over night.

The SPAN margin values for the positions were large, indicating that the positions were large and risky.  Particularly given the extraordinary conditions at the time, assuming that the positions could have been liquidated at the previous day’s settle is extremely problematic.  Prices were extraordinarily volatile, and they could be expected to get only more volatile in the aftermath of a Lehman bankruptcy.  Moreover, liquidity was drying up, major financial institutions were suffering serious liquidity strains, and could not count on tapping the capital necessary to carry big risk positions.  Given the conditions in the market, it was possible that it would take some time to unwind positions assumed in the auction, and that the winning bidders would have faced considerable risk of loss during that unwind process.  In these circumstances, it was inevitable that firms would assume these positions only at discounted values.  Just how big a discount was warranted is impossible to say given the sparse disclosure in the Valukas report.

Indeed, even with much better knowledge of the positions, given the turmoil prevailing at the time determining the “fair” price to assume such a large position is a difficult and highly subjective exercise.  (Knowledge of the CME GLOBEX order book would be somewhat helpful in estimating market depth, but still any analysis would involve considerable conjecture.)  The SPAN risk numbers are probably a better benchmark than the position marks  that Valukas used to derive his $1.2 billion figure.  The transfer of margin monies exceeded the SPAN requirements by $100 million, but given the exceptional conditions at the time, SPAN is a problematic benchmark too.  SPAN attempts to adjust to reflect changes in volatilities and correlations, but whether it did so in a realistic way on 17 September, given the virtually unprecedented conditions in the market, is open to serious question.  It is quite possible that the bidders had much different estimates of the risk that they were assuming than that generated by SPAN, and bid accordingly.  I would argue that the sophisticated bidders had at least as good information and risk modeling as that embedded in SPAN, and almost certainly better, for reasons I’ve set out in some academic papers over the years.  SPAN also doesn’t explicitly incorporate liquidity risks (i.e., risks related to the time it would have taken to move positions, and the price impact of doing so), but in the conditions at the time liquidity risks were arguably huge, and bidders would have taken that into account.  I would therefore not place too much weight on second guesses based on SPAN.

Suffice it to say that Valukas may be right that there is a colorable claim, but the case is far from proven, and it will be extremely difficult and contentious to prove it.

The second point is that although the replacement risk associated with defaulted positions has received a good deal of attention in OTC markets, it is not absent in cleared markets.  The idea is that in OTC markets, when somebody defaults, its counterparties have to find new firms to take the place of the defaulter.  In stressed market conditions associated with the failure of a major dealer or trader (e.g., LTCM), it is likely that these replacement trades will occur at prices that deviate substantially from the prices prevailing before the default; those stepping in for the defaulter are only willing to trade at far more favorable prices than the pre-default prices.

Well, that’s exactly what happened here.  Goldman, DRW, etc., replaced Lehman as the counterparty on these trades, and were only willing to do so at prices that differed substantially from the pre-auction prices.  In the event, Lehman’s collateral was sufficient to cover the replacement cost (this can happen in the OTC market too), but it is not outside the realm of possibility that the collateral of a big defaulter would not be sufficient, and that other clearing members would be called on to make up the difference.

This should be a cautionary tale for those hot to force a substantial extension of the use of clearing.  Many of the products that are not cleared now, but which would be cleared under mandates, would be less liquid, more difficult to value, and pose risks more difficult to evaluate than currently cleared products like those that Lehman held at CME (and similarly, at LCH.Clearnet’s SwapClear).  As a result, any replacement cost problem would likely be more severe than that experienced at CME in 2008, and the risk that collateral would be insufficient would be greater.

Put differently, just because clearing worked OK (not great) for the futures and futures options at issue at CME with Lehman, does not mean that things would work just as well with an expanded set of cleared products.  Indeed, things would almost inevitably be worse.  The set of cleared products is not exogenously determined: it is endogenous.  The products that are easier to clear are more likely to be cleared now.  Forcing, exogenously by government fiat, clearing of more products which almost by definition are more difficult to clear (and perhaps substantially so) means that the process of handling the next Lehman will be messier than the process of handling the last one at CME.

And think of the spillover effects.  Consider a realistic scenario in which during the next crisis, difficulties associated with positions that are cleared only because of a mandate imperil a big clearinghouse, like the CME’s or ICE’s.  This could impose losses not just on those products, but on the other products cleared, including those that would have been cleared without the mandate.  (For instance, if replacement cost losses on these newly cleared products were so large that the CME clearinghouse’s financial condition were threatened, those trading ordinary futures contracts could suffer default losses too.)

Again, clearing does not make risk disappear.  The experience of CME with the Lehman situation shows that clearly.  Forcing risks that are harder to manage into a clearinghouse does not necessarily improve the safety of the financial system.  It could do the exact opposite, by threatening the safety of clearinghouses that could handle the risks they currently manage, but not the additional, more problematic risks forced upon them.

The third issue relates to the auction process.  CME originally solicited bids from 6 firms, and then in a second round from only 5 (dropping Morgan Stanley because its earlier bids had been uncompetitive.)  Felix Salmon considers this “scandalous”:

Not only was the whole thing utterly unprecedented, it was also far from transparent: only six firms were invited to bid. If the CME was actively trying to get the lowest possible bids it’s hard to think how they could have done better than this, holding a hurried auction in the midst of utter market chaos, with no minimum bids and seemingly not a care in the world about whether Lehman was getting a fair price for its assets. It looks very much as though the CME wanted to hand Lehman spoils to its largest clients, since Lehman itself was clearly not going to be a client going forwards and was in no position to object.

Regarding “unprecedented”–well, circumstances were pretty unprecedented.  Regarding “hurried . . . in the midst of utter chaos”–is Salmon proposing a langourous process, waiting for the market to return to “normal”?  Like, when, exactly?  And what if CME had waited, and Lehman had gone bankrupt, what then?  Would it have been any easier to deal with these defaulted positions?  As if.

Regarding the number of bidders.  Consider the CME’s position.  It didn’t want to jump from the frying pan into the fire, and transfer the positions to another firm or firms that didn’t have the capital to handle the risk thereby assumed.  It wanted to move the positions into firms that it felt could handle them.  (Not that, in retrospect, Goldman and Morgan Stanley were in much of a condition at the time to handle the risk.)  Under the circumstances, limiting the number of bidders makes some sense.

And consider the irony of Salmon’s concern for whether Lehman was getting a “fair price.”  (Just exactly what were fair prices “in the midst of utter market chaos,” Felix?) The whole reason that many–including Salmon–advocate a move to clearing is to protect other financial entities from the knock-on effects of a default by a particular entity.  That’s exactly what CME was trying to do: to protect the other clearing members from the knock-on effects of a default.  Yes, that has distributive effects: to the extent  that the clearinghouse reduces the losses its members suffer, the defaulter’s other creditors lose, dollar for dollar.  But that’s part of the clearing package, as I’ve written repeatedly.  By advocating clearing, you are providing advantages to one set of creditors, at the expense of others.  That may be advisable, if the advantaged creditors are more systemically important than the disadvantaged ones.  But if you advocate that one group of folks should get first crack at the seats in the lifeboats, in the event you really can’t cry over the people left at the rail while the ship goes down.  That’s a predictable consequence of the choice.

One would hope that this window onto clearing as it is, as opposed to clearing in the fantasy land that is DC, would be a revelation to Timmy!, and Gensler, and Dodd, and Frank, and now Blanche Lincoln.  But, alas, one would almost surely hope in vain.

As derivatives legislation wends its way through the Senate, with the Dodd bill and another being written in the Senate Ag committee, the battlelines are pretty well drawn.  The administration in particular is still on the clearing bandwagon, and is overtly hostile to any proposals to exempt end users from the clearing requirement.  The most strident rhetoric on this issue emanates from Gary Gensler (go figure), but also from Treasury.  Deputy Treasury Secretary Neal Wolin said: “we will oppose all attempts to create loopholes or carve-outs.”

By “carve outs,” he is referring to end user exemptions, primarily.  Which is all so ironic.  If you think through how clearing works in futures markets, it is primarily a mechanism to shift default risks from end user customers (the buy side) to the clearinghouse members.  That is, it is a customer protection institution.  But here many customers are adamantly opposed.  Thus, there must be some costs that offset–and indeed, more than offset–the benefits associated with this customer protection.

But instead of an effort to step back, and ask “why” and consider in an intellectually serious way what are the costs and benefits of clearing, the administration and many on Capitol Hill plunge ahead.  When they attempt to explain end user opposition at all, they stoop to asinine conspiracy theories.  Gensler, for instance, attributes the end user opposition to their being waterboys for the dealer banks.

Yeah, Caterpillar, etc., are just creatures of the banks.  Whatever, Gary.

But this is all so odd.  Gensler argues that the dealer banks routinely rape their customers, by exploiting the purported lack of transparency in the OTC market to extract supercompetitive spreads.

So, why would the rape victims (in one of Gensler’s narratives) be the willing supplicants of the banks (in another)?  Stockholm Syndrome?  Battered Spouse Syndrome?

Can we please have a serious discussion, with some serious analysis of trade-offs, rather than these dueling, and facially inconsistent, morality tales?

Yeah, I know.

But I will say that in Europe they are being far more serious and adult.  (And it kills me to have to say that.)  For instance, Jeremy Grant reports that European regulators recognize the legitimacy of end user concerns:

Industrial companies have won recognition from European regulators that they should be granted exemptions from sweeping regulation of the over-the-counter derivatives markets.

It marks a partial victory amid fears that a crackdown on off-exchange derivatives markets, blamed by some for exacerbating the financial crisis, could unfairly penalise corporate users of such instruments.

. . . .

In a “discussion paper” from the European Commission’s directorate general for internal markets, regulators say that “in principle, non-financial institutions could be exempt from the clearing obligation”.

It says the main mechanism for transferring risk to the real economy during the crisis was through the financial sector. “This suggests that the appropriate boundary for a clearing obligation is between the financial sector and the non-financial sector.”

Richard Raeburn, chairman of the European Association of Corporate Treasurers, said: “This suggests that [the Commission] supports the need for an exemption for non-financial users. It is certainly the first time that we’ve seen such a clear statement.”

Eact in January sent a letter to Brussels, signed by 160 companies, warning that without exemptions there could be “a reduction in the amount of funds allocated to productive investment in the [European] economy”.

Just how to structure the exemption is still under discussion.  But at least there is a recognition that there are serious issues that deserve serious discussion.

Could somebody in Europe pick up the clue phone and give Gensler and Wolin and Dodd a call?

Grant also reports that the Europeans recognize that clearing is not the deus ex machina that will descend from the heavens and solve all the systemic risk problems.  Indeed, they understand that clearinghouses can create systemic risks, and hence it is advisable to proceed carefully in ordering a new market structure by fiat:

Watchdogs are concerned about the possibility that proposed linkages between clearing houses could pose fresh dangers to the financial system.

They fear two-way or three-way linkages between clearers could trigger a domino effect if one clearer was to default.

What?  You mean that clearing doesn’t eliminate interconnections in the financial system?  Who knew?  (I know who doesn’t know, sad to say.)

In fact, contrary to the bologna constantly ground out by Timmy! and Gensler et al, clearing creates a particular interconnection among financial institutions–the same financial institutions (by and large) that are too interconnected today in the OTC market.  Multiple clearinghouses creates another set of linkages.  These can by systemically problematic.

The Europeans haven’t sorted through all these issues yet.  But at least they recognize them.  We, alas, are governed by know nothings masquerading as know it alls.

Which suggests a new administration spokesman on derivatives market regulation.

Barney Frank stomped his little feet in anger at the fact that his former senior staffer Peter Roberson decamped to become a lobbyist for ICE.  Frank has barred Roberson from contacting staff for as long as he is head of the Committee.  House rules preclude Roberson from contacting staff for a year.  Wouldn’t it be sweet, I mean ironic, if the the year long bar, rather than the as-long-as-Frank-chairs-the-committee restriction turned out to be the binding constraint?

I had some dealings with Roberson late last summer.  He contacted me about my interest in, and availability for, testifying about OTC derivatives in front of the House Banking Committee.  I indicated that I would be interested and available, but about a week later Roberson told me that Frank did not want me to testify.  (Imagine that.)

Said personal rejection by Frank I wear as a badge of honor.

Work demands (go figure!) and some recent travel (some work-related, some not) have put a crimp on the blogging, and the reading to feed the blogging.  So, I only have time for a few quick hits on Russia.

First, the substance of Putin’s put down of Hillary, rather than just the atmospherics, is intriguing.  For one thing, Putin used an official forum with the cabinet member of the United States to make a special pleading for individual Russian oligarchs.  Tame ones, of course, who do Putin’s bidding.  (And, perhaps more.  Which makes me wonder whether it was a special pleading for . . . Vladimir Putin.)  So much for Putin, scourge of the oligarchs.  (No Ivan IV he, in this regard.)  For another thing, the whinge about the collapse in trade betrayed a certain desperation, as did the lament about the low level of direct US investment in Russia.  A leader convinced that his nation was in the midst of a robust recovery, particularly a prickly, nationalist one like Putin, would not be likely to engage in such a public whine.  But one who has deep concerns about the economic future, and who is known for his tendencies to blame his and his country’s miseries on anybody else, especially anybody else with the initials USA, would be.  Not exactly a “Russia off its knees” moment.  Intriguing indeed to wonder why.

And Vladimir, if you wonder about the plummeting of foreign direct investment in Russia, and you want somebody to blame: look in the mirror, and curse the vaunted power vertical.  Consider, too, this story about Conoco’s divestiture of half its stake in the Russian oil firm Lukoil:

But its apparent decision could reflect the shift in dominance of Russia’s energy sector towards state-backed companies such as Rosneft and Gazpromneft, the oil arm of Gazprom, the state-controlled gas group.

This has left Lukoil by the wayside since Conoco first bought into it in 2004, analysts said.

Chris Weafer, chief strategist at Uralsib investment bank in Moscow says: “When they bought into Lukoil it was a time when it was positioned as Russia’s premier oil company.

“At the time they expected they would be able to use that relationship to expand further into Russia.

“But today the rules of the oil game have changed in Russia; today you are not in it unless you are partnered with a state company”.

“The catalyst for the sale comes from their debt position but the reason they are selling is because the competitive position they had with this company when they acquired it no longer exists.”

Rosneft emerged as Russia’s foremost oil producer from the state break-up of Mikhail Khodorkovsky’s Yukos, the target of earlier failed efforts by Exxon Mobil and Chevron of the US to gain entry into Russia’s oil sector via tie-ups with a local company.

Rosneft, Gazpromneft and Kremlin-friendly Surgutneftegaz are now seen as frontrunners for new licences to develop big new fields, while companies with foreign participation are treated with suspicion by the government, analysts said. [You don’t say.  “Suspicion” would be a good day.  Some companies throw parties when they are get promoted to suspicion.]

And, relatedly, TNK-BP, where the “blatant” expropriation is apparently  that the company walks away with nothing, whereas the kinder, gentler, non-blatant Sechin appropriation is that the company gets its initial investment back.  Which is better than nothing, but is still theft because a good deal of the value of such a property is the value of the option to invest optimally in the future.  Look, Vladimir, when the upside is always at political risk, don’t be surprised if FDI lags.

Next!  Russia’s military “reform” is now widely recognized as an abject failure:

Although the interview Gen. Nikolay Markov, the chief of the General Staff, gave to “Rossiiskaya gazeta” attracted fare more attention, the press conference Krivenko gave together with Soldiers Mothers Committee of Moscow chief Tatyana Kuznetsova and VTsIOM sociologist Konstantin Abramov provided many more details.

Speaking first, Krivenko explicitly stated that “the failure of military reform in the form in which it has been conducted up to now is recognized by the leadership of the country.” The planned shift to a largely professional force has failed, and the draft, given the reduced length of service the government has allowed, is not working either.

Plans for contract service have failed so far “not as a result of financial causes but as a result of the incompetent administrative decisions of the Defense Ministry,” Krivenko continued, but plans to try to rescue the situation by boosting the salaries of professionals still further would bust the budget, particularly if the relative number of less-well-paid draftees continues to fall.

But their numbers appear bound to fall, at least in the next few years, given the small size of the cohort born in the troubled 1990s. If the number of soldiers is to be kept at 700,000 and if draftees are to serve only one year, then the military would have to draft 700,000 young people each year, a number far exceeding the number in the prime draft age groups.

One could address that, he says, but forcing people who avoided service earlier and who are still under 35 years of age to serve, “but for this would be necessary another kind of state, and one can imagine just what it would be like.” Such “a draconian variant” is something no one is now seriously considering.

Krivenko stressed that “the president and the government understand this. And they understand that ahead is a dead end,” one from which the country can escape either by spending more money on the military, increasing the length of service for those who are drafted, or cutting the size of the services still further.

Increasing the length of service is the easiest in some ways: after all, Moscow did it in the 1990s, boosting the requirement from 18 months to two years. But Krivenko argued that there are two reasons Moscow might not want to go in that direction. First, “the difference between one year and two” “is qualitatively different” than the earlier much-smaller increase.

And two, such an increase could exacerbate social and political tensions, possibly having an impact, he explicitly suggests, on who will occupy the position of Russian president after the 2012 election. Consequently, decisions on force structure are likely to become more not less political in the coming months.

Guess they’ll just have to wait for that huge baby boom generation to grow up.  Yeah, right.

Lastly, the something for nothing gang strikes again.  Ukraine is seeking a deal to give up partial control over its pipeline system, in exchange for getting gas at a discount from European prices.  Russia’s response?  Yeah, we like the control thing, but fuggedibout any quid pro quo:

Russia’s OAO Gazprom does not view participation in a joint venture to manage Ukraine’s gas pipelines as sufficient grounds to lower the price Ukraine pays for imports of Russian natural gas, Kommersant reported, citing officials with the knowledge of the matter.

The dynamics of the Russian-Ukraine relationship will be quite interesting to watch.  I’m guessing Russia overplays its hand, either out of habit, overconfidence, desperation, or a confidence of all three.

I have a couple more items, but they’ll have to wait.

Economics of Contempt makes a point that I’ve advanced for well over ten years now (including fairly recently in a guest piece at FTAlphaville.) Namely, that clearing depends on price transparency and liquidity to work; it does not create these things.  Clearinghouses consume price transparency and liquidity–they don’t create them.

Moreover, trying to clear things for which price information is lacking due to a lack of trading can create systemic risks, rather than reduce them.  CCPs can’t price risks adequately for illiquid products.  Moreover, they have a very difficult time of managing the risks of any defaulted positions in illiquid products.  This means that taking on exposure to these products puts the CCP at risk, which, in turn, creates the potential for a clearinghouse failure, an eventuality that EoC “would rather not see . . . in [his] lifetime.”  Having stared it in the face (in 1987), I concur wholeheartedly.

EoC echoes another frequent SWP argument, namely the chronic misinterpretation of the AIG debacle.  He notes that contrary to what is commonly stated, AIG’s positions WERE collateralized, and indeed, it was the collateralization mechanism that was the proximate cause of the firm’s demise.  Those who flog the clearing solution really, really, really need to spell out how having AIG pay variation margin to a CCP, instead of Goldman and Deutsche Bank and French banks, would have made any substantial difference whatsoever.  (See the post “It’s a Wonderful Life: AIG Edition” for my statement of this argument.)  Indeed, it could have made things worse.

It should also be emphasized that collateralization is often the positive feedback mechanism that creates systemic events; big collateral/margin calls in the aftermath of big market moves lead to liquidation of positions, which moves prices more, which weakens the financial position of those affected by the initial price moves more, etc. Geithner and Gensler and others suggest that more, and more rigid, collateralization (via a clearinghouse) unambiguously reduces systemic risk.  Not so.  It is more plausible to say that collateral can mitigate some moral hazards, and can be a way of pricing some risks, and can be a way of mitigating one-off, non-systematic defaults.  But it can also be the doomsday machine that accelerates the spread of financial distress.

This could become a regular SWP feature: Gary Gensler continues to grind out the metaphors in his verbal attack on OTC markets.  The most recent: “[the dealer banks] is also the group that nearly drove us off the cliff.”

Wait a minute.  Just days ago he said: “The dealers collectively nearly burned down the financial system.”  So what is it, are dealers bad drivers?  Or arsonists?  Or, is it that they drove a car off a cliff, and the explosion of the gas tank on impact ignited a conflagration?

I’m so confused.  But I’m also a little disappointed.  Haven’t heard about apples in a while.

I’m also still waiting for an explanation of how dealers qua dealers sped over a cliff, or lit a huge fire, or sped a flaming car over a cliff, and how the regulations Gensler is advocating would address any of those problems.  And no, saying the AIG incantation for the zillionth time doesn’t count.

In an uncharacteristically dyspeptic opinion piece on his newsletter, John Lothian concludes that CFTC Chairman Gary Gensler has his eye on something more than Chairmanship of what has long been an also ran among Federal agencies:

There has been talk in Washington, Chicago and in the media that Gary Gensler has ambitions to become the next Treasury Secretary should Tim Geithner’s reputation continue to take a beating and be force out.  It has been written, said and whispered that he is positioning himself for this promotion.  After seeing him in action at Boca, I tend to agree with this assessment.  We have had short-timer CFTC Chairmen before, with ambitions for greater jobs.  One only has to think of Reuben Jeffrey, who was mailing it in as CFTC Chair shortly after being named to the position, or so it seemed at the time.

To which I say: well, yeah.  When asked by a reporter for my appraisal of the CFTC commissioners last August, I wrote that it was pretty clear that Gensler had his eye on Treasury.  It’s only become clearer since then.

And in his campaign, Gensler is willing to say anything–anything–even if it is misleading, or untrue.  Consider what he said in an interview with Jeremy Grant at the FT (available here, for now, anyways): “The dealers collectively nearly burned down the financial system . . . . We know that.”

It is no doubt true that firms that are dealers, namely Lehman and Bear, failed, thereby shaking the financial system to its foundations.  We know that other firms that serve as dealers dealt with AIG (which was not, as commonly understood, a dealer), and that these dealings played some role in AIG’s bailout (exactly what role none of the principals involved will state forthrightly or consistently).  We know that other firms that serve as dealers, such as Citi and BofA and Merrill, were in desperate financial trouble.

But it is misleading, and a non sequitur, to assert that these events justify the kinds of regulation that Gensler is flogging endlessly in purple prose.  For once, I would like Gensler to state specifically what these various dealers did, qua dealers, that put the financial system at risk, and how the proposed regulations would address this behavior.

Again: read the Valukas report on Lehman.  The catastrophic investments that Lehman made involved pretty much everything but its OTC derivatives business (which was in the black to the tune of $21 billion).  Residential real estate, commercial estate, CDOs, private equity, leveraged loans, you name it.  Merrill and Citi and BofA were also torpedoed not by their activities as OTC dealers, but as underwriters of and investors in CDOs and other real estate related investments.

It is a bait-and-switch to say that “dealers” cratered the financial system to justify regulation of dealer activities.  Doing so suggests that it was the OTC dealing activities that were the root of the problem, when they clearly were not.

But, you might argue: OTC derivatives dealing creates interconnections between firms that can communicate financial contagion.  It is definitely true that the events make plain something I’ve flogged myself for well over a year: namely, that balance sheet risk arising from other investments and activities is an important determinant of the default risks posed by any dealer firm.  But it is just this kind of risk that clearinghouses do not and cannot price, nor effectively control.  And it is just this kind of risk that can be spread to big financial firms via their interconnection through a clearinghouse.  Clearing does not make interconnection go away: it reconfigures the interconnections, and does so in ways that can be riskier, not safer.

So, balance sheet risk is arguably a problem, but clearing is quite definitely not the solution; exchange trading and post-trade price transparency are even less relevant to this problem.  Indeed, it can make the balance sheet risk problem worse, and will do so IMHO.

It is, in short, perfectly consistent to excoriate the banks for what they did (and sadly, for what some continue to do) while opposing the proposed regulations of OTC derivatives.  These banks are big, complex, and engage in a wide variety of activities.  Some of the risks that banks ran proved ruinous, or nearly so.  But the OTC  dealing activities are not high on the list of those risks, if they are there at all.  But that doesn’t stop Jeremiah (or is it Ahab?) Gensler.

And a shout out to Stacy-Marie Ishmael at FTAlphaville who joins me in mocking (though she is more gentle in her mocking than me) Gensler’s fondness for metaphors over-the-top, mixed, and just plain wrong*.  But literary merit–not to mention fairness or accuracy–is of little moment when there is a political battle to be fought–or a cabinet post to be won.

* I am still chuckling over the Mrs. O’Leary’s cow Genslerism.  It is the perfect metaphor for him to use.  Like much of what Gensler peddles, the story of Mrs. O’Leary’s cow was a complete myth.