Streetwise Professor

Yesterday I was exchanging emails with a couple of folks about CFTC Chair Gary Gensler’s increasingly apocalyptic jeremiads against OTC derivatives.  (Indeed, I think I’ll start referring to him as “Jeremiah.”)  I offhandedly wrote “Pretty soon he’ll be saying that OTC derivatives cause cancer.”  Lo and behold, what do I read in today’s FT:

US taxpayers bailed out AIG with $180bn when that company’s ineffectively regulated $2,000bn derivatives portfolio, managed from London and cancerously interconnected to other financial institutions, nearly brought down the financial system.

I personally find it very disturbing that I can channel Gensler’s thinking.

The substance of the oped is more Gensler same-old, same-old.  Clearing is again the deus ex machina of his sermon:

Clearing houses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. Transactions are moved off the books of derivatives dealers, which are part of financial institutions that may be both “too big to fail” and “too interconnected to fail”, and on to those of well-regulated central counter-parties. Centralised clearing has helped to lower risk in futures markets for more than a century.

Uhm, just who backs that guarantee, Jeremiah?  Could it be the very same derivatives dealers?  Meaning that the risk really isn’t moved off their books, and that they’re still interconnected?

Arguendo ad AIG makes its stock appearance (see the first quotation).  George Stigler once wrote that data is not the plural of anecdote.  What’s unbelievable is that Gensler (and Geithner and others) can’t even find multiple anecdotes, let alone anything rising close to the level of data.  What’s even more unbelievable is that his use of the AIG anecdote is deeply misleading–so deeply, that Gensler is either very dishonest or very badly informed.  First, although OTC derivatives deals were one source of AIG’s loss, they were not responsible for anything near the entire $180 billion bailout, but Gensler insinuates that they were.  Second, since it is unlikely that the AIG deals were clearable then, or would be today, it is misleading to use them to advocate clearing.  Third, Gensler doesn’t address the counterfactual question of what would have happened if AIG hadn’t written protection on mortgage CDOs; arguably, the crisis would have been worse.

Gensler also asserts that OTC derivatives were the underlying cause of the financial crisis.  He provides no evidence whatsoever–other than the tired AIG trope.  This is a complete misreading of the history of the crisis.  If you don’t believe me, I suggest you read Rene Stulz’s piece on derivatives and the crisis in the most recent issue of the Journal of Economic Perspectives.

Gensler also makes some assertions that are categorically incorrect.  For instance, he says: “The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk.”  It is, in fact, well known that excessive transparency can reduce liquidity.  There is NOT a monotonic relation between transparency and liquidity, as Gensler asserts.

More generally, on the transparency and exchange trading arguments, Gensler implies that market participants that willingly choose to trade on OTC markets instead of readily-available exchange alternatives don’t know their business.

I could go on and on, but I’ll let it rest here for now.

If the substance is tiresomely familiar, Gensler’s rhetoric reaches new heights.  He pegs the metaphor meter with his lurid comparison of the role of OTC derivatives in the financial crisis to the Chicago Fire, and the banks to the cow in Mrs. O’Leary’s barn that kicked over the lantern that ignited the fire.  (At least he spares us the apple story.)  (The reference to Mrs. O’Leary’s cow is actually quite fitting here, as that poor creature is almost certainly the least plausible cause of the Chicago fire; the editor of the Chicago Republican admitted he made up the story for its entertainment value.  He’d be more accurate talking about meteorites or Pegleg Sullivan–he should check out the Alkaline Trio song about old Pegleg.  But accuracy is merely an obstacle, it appears, in Gensler’s shrill attacks.)

(And another parenthetical about the metaphor overload: is cancer “interconnected”?  Usually cancer is used as a symbol of something maliciously that spreads, which is somewhat different from interconnection.)

Perhaps this remarkable performance is actually good news.  Gensler apparently believes that he has to ramp up the rhetoric in order to achieve his (defective) policy goals; that’s usually a sign of desperation, and a lack of success in previous efforts to persuade.

And that lack of success is not surprising.  Yes, it might have something to do with the fact that incumbents don’t want major changes in the ways they do business.  But it’s also due to the fact that faulty analysis unsupported by reliable facts or data is usually unpersuasive.

But perhaps there’s an upside; we have a new entry in the Bulwer-Lytton fiction contest: it qualifies both because it is fiction, and because of its overwrought writing.

I am reading Reinhart and Rogoff’s This Time Is Different.  Interesting, in a scary sort of way.

One thing that struck me with particular force, particularly in light of recent news, is their lament at the difficulty of ascertaining just how much debt governments have issued.  They state quite forcefully that government accounting is notoriously opaque, and that governments are the enemies of transparency.

Ripped right from the headlines, that.  Think all the news stories emanating from Europe, focusing on Greece, but making it clear that dodgy accounting and budgetary gamesmanship is rife throughout Europe.  Not that the US is much better.  Just look at the steadfast refusal to account honestly for the impact of the Federal takeover of Fannie & Freddie–which follows the refusal of the government to account honestly for the contingent liability inherent in the implicit guarantees extended F&F (which weren’t all that implicit, were they?)

This is of direct relevance to current fiscal policy debates.  Krugman and other pro-stimulus/pro-deficit types argue that the current debt/GDP ratio of the US is nothing to worry about.  We had a higher one after WWII, and we grew out of that, right?  But things are very different now.  The demographics are extremely different.  The US’s relative economic standing is very different.  Moreover, and most importantly, the true debt burden is far larger than the “official” figures would suggest–think Social Security, Medicare, Medicaid, and the vast unrecognized but very real contingent liabilities and guarantees and implicit commitments the government has undertaken.  And it makes sense to borrow from the future to fund an existential conflict like WWII; the spending proposed by Obama, let alone Krugman et al, is certainly not needed for any such existential end.

So, remember: most of what you read about the government’s finances is incomplete and/or misleading, when it isn’t an outright lie.

This, of course, from the very same people who lament the lack of transparency in various private endeavors (e.g., dark pools, OTC derivatives, corporate accounting).  Yes, there are some concerns in these areas, but the systemic consequences of government finance here and abroad are far more important.  Far more.  Those in government–legislators, Treasury, the Fed, regulators–who want to mandate greater transparency for private actors should therefore start their sunshine campaign a little closer to their work.  A lot closer, actually.

Like that’s going to happen.

The House financial regulation “reform” bill passed last year includes the Lynch Amendment, which puts limits on the ownership of central counterparties/clearinghouses by financial intermediaries.  I blogged about this a bit.  The essence of my argument was that although there are potentially competitive concerns arising from dealer control of CCPs, there must be an alignment between economic interest and ownership structure.  Whoever bears the default risk is going to demand an influence over the governance of the CCP.  If you expect the big banks to bear the risk, they are going to require some control over the operations of the clearinghouse.  If you deny them this control, you have to find somebody else to bear the risk.  Competitive concerns are best addressed through anti-trust tools.

Sad to say, the “thinking” behind the Lynch Amendment has jumped the Atlantic, and the European Parliament is contemplating a similar restriction on dealer ownership:

Derivatives dealers should not be allowed to own stakes in central counterparties (CCPs) or their risk management systems – and CCPs should not be allowed to compete with each other, according to advice from the European Parliament’s committee on economic and monetary affairs (Econ).

The (anonymous) reactions of a European banker are spot on, and echo my earlier analysis:

“It’s ludicrous. Clearing houses were mutual organisations. They were originally mutually-owned and their job is to mutualise risk, so to say that users shouldn’t have any influence or ownership of governance or direction – it just betrays complete ignorance of what the function of a clearing house is and how a clearing house can be built and become operational,” says one head of market structure at a European bank.

. . . .

“It is our money in the default fund of the clearing house. For dealers to have some kind of oversight or some kind of say in the functioning of the clearing house is entirely reasonable. We’re not going to support a clearing house if we’re not satisfied with the risk management processes it operates. To think that the smart way to make this all happen is to remove the big dealers from the process is just dumb,” says the head of market structure.

“Complete ignorance.”  “Just dumb.”  That’s about right.

There’s a very simple choice here.  If you don’t want banks to exercise control over a clearinghouse, don’t look to them to bear the default risk.  If you want them to bear the default risk, you’ll have to give them considerable influence, and arguably de facto control.  And if you choose the first alternative, you need to answer: who is going to bear the default risk, and what price are they going to charge to do so?  And if you’re worried about competition, you should worry that the price this non-bank-owned CCP is going to charge, because it will almost certainly have market power.

The Lynch Amendment and its proposed European cousin both reflect a fundamental misunderstanding of just what clearing is about.  It is a risk allocation mechanism.  Which immediately should raise the question: who is going to bear the risk?  Clearing is not a risk fairy that makes risk disappear.  Those that bear the risk will almost certainly demand an active role in the organization that measures and manages it.  So if you make a governance and ownership choice, you’ve ruled out some risk allocation choices.  Our Solons, and Europe, apparently haven’t figured that out; they haven’t provided any idea on whom they expect to bear the risk, and are mandating or threatening to mandate models that have seldom, if ever, been tried in practice.  Which is very scary.

Like Claude Rains in Casablanca (which was on Turner Classic Movies yesterday), the Germans and others are Shocked! Shocked! that Greece used swaps priced off the market to borrow, for all intents and purposes.  For all purposes, that is, but one: accounting for the public debt to determine its adherence to European Monetary Union requirements.

Except that it wasn’t a secret at all.  Risk wrote about one of these deals back in 2003. S&P issued a note describing these types of deals in 2002.   The New York Times reports that there were many of these deals, from the very outset of the European experiment:

For all the benefits of uniting Europe with one currency, the birth of the euro came with an original sin: countries like Italy and Greece entered the monetary union with bigger deficits than the ones permitted under the treaty that created the currency. Rather than raise taxes or reduce spending, however, these governments artificially reduced their deficits with derivatives.

. . . .

But with the help of JPMorgan, Italy was able to do more than that. Despite persistently high deficits, a 1996 derivative helped bring Italy’s budget into line by swapping currency with JPMorgan at a favorable exchange rate, effectively putting more money in the government’s hands. In return, Italy committed to future payments that were not booked as liabilities.

The NYT also reports that these types of deals were a subject of fierce debate among European finance ministers going back to 2000.

In other words, nobody in government finance has any more reason to be shocked about these transactions than Captain Reynaud had to be shocked about gambling going on at Rick’s.

Some of the debates that are going on about the probity of these deals reminds me of discussions of who is to blame for drug addiction: the addict (Greece, for instance), or the pusher (e.g., Goldman, Morgan, Deutsche Bank, etc.):

“Politicians want to pass the ball forward, and if a banker can show them a way to pass a problem to the future, they will fall for it,” said Gikas A. Hardouvelis, an economist and former government official who helped write a recent report on Greece’s accounting policies.

In other words, politicians were being politicians, and bankers were being bankers, and they were engaged in mutually beneficial transactions.  The difference being, of course, that there are other people–millions of other people–who will pay costs.

If forced to choose, I guess I’m have a less favorable view of the politicians, for two reasons.  First, they never cease to tell us how morally superior they are, whereas bankers are for the most part (not universally) less sanctimonious.  Second, the politicians are ultimately violating a responsibility that they are entrusted with, whereas the bankers are actually carrying out their responsibilities to their principals.

But this is really all a side issue.  The central issue is what to do about Greece, and ultimately, the other countries that are at risk to following it over the edge.

I tend to lean towards what John Kemp writes in Reuters:

Most commentators have concentrated on the need for the EU to bail out Greece. But in reality any rescue would be another subsidy for excessive-risk taking by the country’s bankers and the institutions that have sold credit default swaps (CDS) on Greek debt.

Forcing the country into an austerity programme and arranging an emergency loan from other EU members or the IMF would ensure the bankers got their money back (again), but inflict years of misery on the country’s households and businesses.

If market discipline is ever to be re-established after the boom and bailouts of the last five years, it is imperative creditors face the real prospect of making losses if they extend large loans and fail to price the risk on them properly. The sellers of CDS insurance must face up to making real payouts in return for all the premiums they pocket.

Bailing out Greece would be wrong. Not because it would harm the eurozone’s credibility, but because it would reinforce the rampant moral hazard in financial markets. It would perpetuate the inequitable and politically unacceptable situation where structuring fees are retained by the banks as private profits while credit losses are socialised and passed onto taxpayers.

Greece would do everyone a favour by declaring a moratorium and forcing a rescheduling. The country faces years of misery in any case. The threat of being shut out of capital markets rings hollow. But by triggering losses on these derivative transactions and a credit events under the CDS it would help ensure a much more prudent approach in international banking markets.

Bailing out Greece so everyone can pretend the country can remain “current” on its loans when it patently cannot would simply deepen the moral-hazard crisis. If market discipline is ever to be re-established (something which everyone agrees is desirable) then at some point creditors must take a loss. Greece is a good place to start.

Yes.  As I discussed in an earlier post, it is the lenders–the creditors–that are ultimately the source of moral hazard.  If they are convinced that they will be bailed out, they will continue to feed the bad habits of profligate borrowers, including sovereigns.  Bailing out Greece, or others, will just increase expectations of future bailouts, and we’ll be in a sort of moral hazard Groundhog Day. Only it won’t be quite so funny.

Spain’s intelligence service, Centro Nacional de Inteligencia (CNI), is investigating “speculative attacks” against the country (via the CDS market), and Europe generally (via the currency market).  This article in El Pais tells the story.  Based on my shaky Spanish, it seems that Zapatero is blaming “Anglo-Saxon” speculators and journalists and pundits with conspiring against Spain, and the European project generally.

The speculators are indeed out in force, and there is a game of chicken between them and the European governments individually and collectively.  But the speculative attack is driven by the shaky finances in the Eurozone, and especially in Greece, Spain, Portugal, and Ireland.  The politicians have created the opportunity through profligate fiscal policies, and it is more than a little rich to hear them take umbrage at the markets holding them accountable.

If you chum the waters, Mr. Zapatero et al, why are you surprised when the sharks appear?

I’ve written some about the sustainability of Chinese economic growth, expressing the opinion that it is a “Michael Jackson economy” kept going with artificial stimulants that are resulting in massive distortions in the allocation of capital.  These concerns are becoming more widespread.  The most notable skeptic is noted short seller (and sometime SWP lurker by proxy) Jim Chanos.  Here’s a video of Chanos laying out his views on why China is a bubble.

Bloomberg has a long article today that quotes Chanos’s views and many more as well:

nvestor concerns have spread beyond real estate. Among 15 major Asian markets, the benchmark Shanghai Composite Index is valued third-highest relative to estimates for this year’s earnings, after Japan and India, even after falling 8 percent this year.

A glut of factories in China is “wreaking far-reaching damage on the global economy,” stoking trade tensions and raising the risk of bad loans, the European Union Chamber of Commerce in China said in November.

More than 60 percent of investors surveyed by Bloomberg on Jan. 19 said they viewed China as a bubble, and three in 10 said it posed the greatest downside risk. The quarterly poll interviewed a random sample of 873 Bloomberg subscribers and had a margin of error of 3.3 percentage points.

Digesting the debt from a popped property bubble may slash bank lending and drag growth lower for years in an economy that Nomura Holdings Inc., Japan’s biggest brokerage, says will provide more than a third of world growth in 2010.

Japanese Comparison

The risks are so great that a decade of little or no growth, as Japan experienced in the 1990s, can’t be dismissed, said Patrick Chovanec, an associate professor in the School of Economics and Management at Beijing’s Tsinghua University, ranked China’s top university by the Times newspaper in London.

The alternative view is that China need not worry about the gridlock of democratic politics, and its central government will be able to play Goldilocks, and make everything just right by intervening at just the right thime, and failing that, will fall back on its dollar hoard.  This, to me, represents a completely unrealistic view of the wisdom of central planners in general, and Chinese mandarins in particular.  I do not see how this can end well.

There is a debate going on in the blogsphere about whether the moral hazard model is helpful in understanding the financial crisis.  One view is that it is not.  For instance, Jeffrey Friedman argues that it does not:

First, the moral hazard of “too big to fail” (TBTF). Empirical problem: Before the bailouts, nothing of this scale had ever happened, so no bank could have been sure they would be bailed out. And if one actually reads accounts of the decision making in the years leading up to the crisis, such as Gillian Tett’s Fool’s Gold and William D. Cohan’s House of Cards, no decision makers factored bailouts into their calculations. Why? Because they didn’t think they were doing anything particularly risky (an ignorance-based human error), so they didn’t even consider the chances of being bailed out.

Second, the moral hazard of “corporate compensation systems,” i.e., bonuses.

Empirical problem #1: When this theory took hold, there was virtually no evidence for it (whereas now there is one study for it and one against it)–see Wladimir’s and my post on the topic (below).

Empirical problem #2: There was, and remains, the following overwhelming evidence against the theory: 93% of the banks’ mortgage-backed securities were either guaranteed by the U.S. government (i.e., Fannie and Freddie) or were rated AAA–the “safest” and *lowest-yielding* securities available. Triple-A bonds are the last thing revenue-seeking, bonus-hungry, risk-indifferent (i.e., risk-knowledgeable, rather than risk-ignorant) bankers would have bought.

Russ Roberts thinks otherwise:

I don’t think bankers planned on being bailed out. But I think it affected their decision-making. . . .

Hmmm. Not the best evidence. Do you really expect Jimmy Cayne, the CEO of Bear Stearns to tell a reporter that he threw away his firm’s money because he thought he’d get it back from taxpayers? But here’s what he does tell William Cohan:

The only people [who] are going to suffer are my heirs, not me. Because when you have a billion six and you lose a billion, you’re not exactly like crippled, right?

And then there’s this moment from Andrew Haldane?, the Executive Director of Financial Stability of the Bank of England:

A few years ago, ahead of the present crisis, the Bank of England and the FSA commenced a series of seminars with financial firms, exploring their stress-testing practices.  The first meeting of that group sticks in my mind.  We had asked firms to tell us the sorts of stress which they routinely used for their stress-tests.  A quick survey suggested these were very modest stresses.  We asked why.  Perhaps disaster myopia – disappointing, but perhaps unsurprising?  Or network externalities – we understood how difficult these were to capture?

No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight.

All of the other assembled bankers began subjecting their shoes to intense scrutiny.  The unspoken words had been spoken.  The officials in the room were aghast.  Did banks not understand that the official sector would not underwrite banks mis-managing their risks?

Yet history now tells us that the unnamed banker was spot-on.  His was a brilliant articulation of the internal and external incentive problem within banks.  When the big one came, his bonus went and the government duly rode to the rescue.

I think that both Jeffrey and Russ might be looking for moral hazard in all the wrong places.  If lenders to big financial institutions figured they would get bailed out, they would be willing to extend cheaper credit to these institutions than would be the case in the absence of the expectation of a bailout.  It’s pretty clear that Fannie and Freddie were able to borrow at very attractive rates, and hence grow grotesquely large, because of the expectation that the government would not let them fail.  Similarly, lenders expecting that a Citi or BofA were too big to fail might also have expected that they would be bailed out with high probability, allowing these banks to borrow at rates that did not reflect the true risks.

The managers of these institutions would have faced distorted price signals: debt was cheaper than it should have been (due to the lenders’ expectation that a bailout was possible, or even likely), so the financial institutions became bigger and more leveraged than they should have been.  Importantly, this would have happened even if the bankers themselves had discounted the possibility of a bailout, or believed that a bailout would not save the equity holders (including them) or their bonuses.

Turning to today’s news, this source of moral hazard is exactly why the Euros are playing with fire if they actually do bail out Greece, not to mention Portugal or Spain if it comes to that (as it might).  Once this crisis passes, especially if it passes due to a bailout, lenders will feel quite safe in extending credit to profligate governments in the future, which will just lay the groundwork for another crisis.

There is a serious risk that the EU and the Euro cannot survive a bailout.  Germans in particular are dissatisfied with the Euro as it is; a bailout of the Greeks and whoever else comes knocking will only stoke that dissatisfaction.  Especially if it is not accompanied by credible institutional constraints that will prevent the problem from recurring: the credibility of the original constraints on member country budgets is already in tatters.

But it is not clear that the Euro (and the EU) can survive no bailout either.  The natural course for the affected countries is to go off the Euro and devalue, or default

That’s why it seems that the EU is playing a huge bluff.  There are important sounding announcements of hazy plans to support Greece in its hour of need, even though a bailout could well violate EU law. The Germans, French, etc., are hoping that the promise of a bailout will calm the markets, allowing the crisis to pass without the need for the bailout actually to take place.

Paulson tried that gambit with Fannie and Freddie.  We all know how well that worked out.  The credibility of the promise is so suspect, that it is highly likely that some big funds will bet against it, and call the bluff.  Hence the jeremiads against speculators:

In a joint press conference with Mrs Merkel, the French president, Nicolas Sarkozy. said euro-zone countries were offering “solidarity” in exchange for Greek promises of “rigour and transparency”. This would give Greece’s promises vital “credibility”, he said. Challenged on the lack of detail in the summit declaration, Mr Sarkozy said “speculators should understand” that Europe had agreed a strategy for defending the euro zone, and “we will come up with tactics as needed.”

That swipe at speculators probably offers a hint about the political tactics that Mrs Merkel and other leaders may employ to sell any Greek bail-out to voters. Already, politicians including José Luis Rodríguez Zapatero, the Spanish prime minister, have portrayed market pressure on their countries as part of a broader plot by murky market forces that want to destroy the euro and fight off tougher financial regulation within the EU. Expect to hear more about European political solidarity versus the speculators.

Knowing that his country is also on shaky ground, Spain’s Zapatero also launched a verbal strike against speculators, adding an element of conspiracy theory that would make a truther or a birther proud:

Mr Blanco told Cadena Ser radio that attacks on Spain were attacks on the euro, and were “rather dirty dealings” on the part of speculators, who:

“now that they see we are emerging from the crisis, do not want to see better regulation of their activities, [but] want to be free to carry on pursuing their own interests… None of what is happening, including editorials in some foreign media with their apocalyptic commentaries, is happening by chance, or innocently. It is the result of certain special interests.”

Here is Mr Zapatero:

“There is an attack underway by speculators against the euro, against tougher financial regulation of the financial system and of the markets”.

How dare those speculators say the emperor is naked!

The crisis, arguably born of moral hazard, is by no means over.  And “solving” the crisis may just ensure that moral hazard will survive, bigger and badder, in the future.  Just don’t ask the bankers or national leaders about it.  Ask the people who lend them money.

One of the tales about derivatives clearing, told repeatedly by Timmy! Geithner and Gary Gensler is that the clearing fairy magically makes counterparty risk disappear.  The reality is that it doesn’t make it disappear: it just moves it around.  And not necessarily in a better way, as members of the CME clearinghouse clearly understand.

Many of these members are extremely leery of the CME’s plan to clear CDS.  This week, according to Bloomberg and DJ (not online, fortunately), big brokers Newedge and MF Global came out forcefully against the CME proposal precisely because they fear that clearing CDS will allocate the risk their way, and their customers’ way:

Newedge USA LLC, the largest U.S. futures broker, and MF  Global Holdings Ltd. are urging the U.S. to prohibit CME Group Inc. from using customer funds to back credit-default swap  trades alongside futures transactions in its clearinghouse.  The brokers said the lack of an underlying frequently traded contract for credit-default swaps, such as a future based on the swaps, made it too difficult to price the derivatives for risk-management purposes, according to a Feb. 4 joint letter the companies sent to the Commodity Futures Trading Commission.

“We do not believe it would be appropriate for the commission to now require futures customers to effectively cross guaranty CDS risk, however remote some may suggest the likelihood of a cleared CDS default to be,” the firms and CME Group members wrote in the letter. “MF Global and Newedge are not satisfied that the risks to futures customers’ funds and to our own guaranty deposits — risks we never signed up for — may adequately be assessed or contained.”

The Newedge/MF Global broadside gives the lie to other clearing fairy tales: namely, that contractual standardization is sufficient to make instruments appropriate for clearing, and that clearinghouses magically create transparency.  To the contrary, clearinghouses consume transparency/information: they need liquid markets with active price discovery to work effectively, and contractual standardization is not sufficient to ensure such liquidity.

Note their concern that risks may not be adequately assessed.  This requires information  about pricing and risk characteristics.  This information is hard to come by for many CDS, particularly single-name CDS.  Moreover, dealers may have better information than a clearinghouse.

In other words, clearing is not magic.  It doesn’t make risk disappear.  At best, it reallocates it.  Moreover, it can actually create problems, rather than mitigate them, when the clearer lacks the information to price the risks properly.  Newedge and MF Global, and before them Thomas Peterffy, the FIA, and Penson’s Chris Heymeyer, recognize that.  When will those who want to mandate clearing as broadly as possible figure it out?

In a burning ring of fire?  One can hope.  I refer to the price of Rusal stock, which has tanked even further since its inauspicious reverse pop immediately after the IPO:

United Co. Rusal Ltd., the world’s largest aluminum producer, fell for a third day in Hong Kong trading, extending its drop since last month’s initial public offering to 20 percent.

The shares slumped 4.5 percent to close at HK$8.66 ($1.11) on the Hong Kong Stock Exchange. They cost HK$10.80 each in the IPO. Today marked the eighth slide in nine sessions for Rusal, controlled by billionaire Oleg Deripaska, since trading began.

“Hedge funds that participated have been disappointed with the dynamics of the IPO and are closing the trade and taking the loss,” said Joseph Dayan, head of international sales and trading at Otkritie Securities Ltd. in London. “The fact that liquidity is drying up is another negative.”

Now, part of this decline can be laid to the decline in world markets and the related news regarding the increasingly bleak prospects for the world economy in the past couple of weeks.  But it also arguably reflects that the Rusal IPO had more than a little pump and dump aspect to it.

Speaking of Rusal, Oleg Kozlovsky and I discussed Deripaska during our conversation.  Oleg said that it was widely perceived that Deripaska is willing to abase himself any way Putin desires in order to maintain his position, and that most of the public interactions between the two (e.g., Pikalyovo) are only so much theater.

No, not me–although I am sure that a few of you would disagree.  No, I refer to Senator Maria Cantwell (D-WA) and her confreres, who clearly have some deep seated neuroses and phobias when it comes to anything involving derivatives and speculation.

Cantwell actually earns a twofer today.

First, she is the co-sponsor of a new cap & trade bill.  Although cap & trade isn’t dead, it is coughing up blood; even Obama has recognized that it has no chance of passing soon.  Along with Senator Collins (R, sorta-ME), Cantwell has introduced a bill that would institute a cap & trade regime.  It is, blessedly, much simpler than the grotesquely bloated, complicated, and convoluted ACES bill that passed the House in 2009; apparently Cantwell and Collins believe that ACES is doomed, and that a simpler bill may be the only hope.  Conservation of paper is, alas, its main redeeming feature.

It isn’t really a cap & trade bill.  It’s better described as cap, definitely, trade, not so much.  And the latter feature is what lays bare Cantwell’s phobias.  To read what she and Collins have proposed is to enter bizarro world.  They impose onerous restrictions on the trade of emissions rights and derivatives on them, apparently out of a belief that (a) speculation is evil, and (b) derivatives can only be used for speculation.

There are two completely non-sensical provisions in the bill that relate to trading emissions rights, and derivatives on them.

First, the bill permits only emitters to own certificates, and to purchase them at (an annual) auction.  This means, specifically, that financial institutions cannot buy or trade certificates.  Presumably, this is intended to bar the market to those malign speculators.  But its actual effects will be to make the market extremely illiquid, and to make it unnecessarily costly for those who have more permits than they need to trade them with people who have fewer than they need; financial institutions would be the natural market makers and liquidity suppliers, and baring their participation would starve the market of liquidity.  This will hamper the efficiency of the market, and make it costlier to achieve the emissions reductions imposed by the cap feature of the bill.  Moreover, it is likely that absent such a restriction, certificates could be used as collateral and facilitate end user financing, an alternative that would be precluded under the bill, making it more costly for emitters to finance their purchases of certificates.

Second, and even more bizarrely, the bill prohibits those very end users from trading any derivative contract on emissions.

Let me repeat: the bill prohibits those very end users from trading any derivative contract on emissions.

Huh?

Under a cap and trade scheme (and I mean scheme), end users are exposed to carbon price risk, and over very long time horizons.  They are natural hedgers who need derivatives to manage that risk exposure, but the Cantwell-Collins bill would preclude them from doing that.  The bill creates risk by pricing carbon, but at the same time denies those affected by this risk the ability to manage it.  That borders on cruel and unusual, and just makes it unnecessarily costly to achieve carbon reductions.  Pain with no gain.

But note the bill doesn’t ban derivatives outright, so Cantwell and Collins are apparently perfectly willing to contemplate a carbon casino where only speculators can play (though not in the certificates themselves).  But the speculators will not be allowed to provide valuable risk bearing services to hedgers.  No, it doesn’t make sense to me either.

Seldom have I seen anything so inane coming out of Congress, and that is saying something.

Separately, Cantwell came out with a call for increased regulation of commodity derivatives generally:

The US commodities market should be freed from “reckless speculation” and abusive trading practices, a leading US senator has urged, as she attempts to stop the price of everyday items like petrol and food from being impacted by financial traders.

Senator Maria Cantwell, who is separately trying to revive the Glass-Steagall reforms of the 1930s which would prevent retail and investment banks from operating under the same roof, yesterday called for increased regulation of the commodities and derivatives market.

The Democrat politician is attempting to push regulation of the commodities markets – a hot topic in the summer of 2008 when oil prices topped $140 a barrel – back to the top of the political agenda.

She is calling for stronger powers for the Commodities Futures Trading Commission (CFTC), including the potential to police the unregulated over-the-counter derivatives market, which has worth $25 trillion at the end of June 2009.

And how, pray tell, does the Senator support her case?  By calling on the vaunted expertise of megatool Michael Masters:

Backed by hedge fund manager Michael Masters, of Masters Capital Management, she called for the proposed reforms to take their place alongside wider financial regulatory reforms currently being discussed by the US Congress.

Mr Masters believes that there is a strong correlation between the credit crisis and volatile commodity costs, which have seen a rise not only in oil prices but in basic food staples in recent years.

Correlation, causation.  Whatever.

Masters and I participated in a workshop on oil markets sponsored by the Energy Information Agency back in November.   I can state categorically that he doesn’t understand the economic function of derivative markets, or of the functions that financial intermediaries play in these markets.  He says things like (I quote from memory, but this is almost verbatim) “financial markets are for allocating resources over time, but commodity markets are to get goods from producers to consumers.”  Well, yeah, but commodity markets are also crucially about allocating resources over time, because the time patterns of consumption and production don’t necessary always match exactly.  In fact, they almost never do.  (Think about a seasonal commodity, like corn or natural gas.)

So even beyond risk shifting, you need futures and forward markets to encourage the efficient allocation of commodities over time; getting stuff from producers to consumers inevitably involves intertemporal trade.  What’s more, financial intermediaries are frequently the best able to perform the function of storing and financing commodities.  After all, what they do is facilitate intertemporal resource allocation, and commodity storage and financing is just a specific example of that.  But not in Mastersworld, evidently.

Talk about the blind leading the blind–or is it the phobic leading the phobic?  Maybe group therapy is available at a discount.

After Masters made this statement at the EIA workshop, I replied along the above lines.  Only less politely.  I started by saying something like: “I can’t believe you said that.  It’s one of the dumbest things I’ve ever heard.  Commodity markets are all about allocating resources over time.”  Always trying to win friends and influence people.

I doubt either of these measures is going anywhere.  Fortunately.  But they reveal a disturbing mindset that is all too common on Capitol Hill, and among the pilot fish that swim symbiotically with the senatorial sharks.