Streetwise Professor

In his megalomaniacal effort to use the financial crisis as a Trojan horse to advance his campaign “on every front to increase the role of government,” Barney Frank is hellbent on fixing things that demonstrably didn’t break.   Even under the extreme stresses of the crisis.   Case in point: he wants to require clearing of foreign exchange derivatives transactions:

If it didn’t break, why fix it?

That is the question being asked by foreign exchange bankers after Barney Frank, chairman of the House Financial Services committee, announced currency derivatives would not, after all, get an exemption from proposed US rules that would require all derivatives trades to be processed through a centralised clearing system.

Mr Frank’s move came as policymakers are debating the detail of legislative proposals designed to increase transparency and reduce risk in the vast over-the-counter derivatives market. While the proposals are not final, the U-turn on his previous stance has stunned the FX market.

Get used to it, guys.   Barney’s all about the u-turns, pace his volte face on clearing and exchange trading in his obviously thoughtfully considered OTC regulation bill.

The FX folks are point out some things I mentioned months ago, such as the fact that clearinghouses can concentrate risk, and therefore exacerbate systemic risks:

Bankers have also warned that clearing in FX could create new concentration dangers which they fear could create fresh systemic risk, given the size and significance of the FX market. The market is already concentrated among a handful of top international banks.

But it is Barbara Matthews that brings out the key point:

Barbara Matthews, managing director of BCM International Regulatory Analytics, believes there is a general issue to be considered about concentrating so many markets on to clearing platforms. She warned that policymakers must be aware that clearing houses could create new “choke points” in the system – not unlike the risk created now by any large bank – which must be considered carefully. “Its perfectly natural in a time of uncertainty to look towards some kind of central arrangement,” she said. “But I’m hearing people say it eliminates risk and that’s not true – it just transforms it. If the idea is that risk will be gone, then some people are in for a nasty surprise.”

That last bit bears repeating: “But I’m hearing people say it eliminates risk and that’s not true – it just transforms it. If the idea is that risk will be gone, then some people are in for a nasty surprise.”

Exactly right.   Those who have advocated clearing mandates–Geithner, Gensler, and Frank most prominently–commonly assert that clearing eliminates counterparty risk.

Wrong.   It doesn’t.   It reallocates it.

The only question is whether they know better and are lying, or are ignorant.   Either way, they selling a bill of goods, and as Barbara Matthews says, are laying the groundwork for the next nasty financial surprise.

Last week I wrote about one justification for exchange trading and clearing mandates–the market power argument.  This week I’ll examine another argument, and render a similarly skeptical verdict.

In a chapter of Restoring Financial Stability, Viral Acharya, Rob Engle, Steve Figlewski, Anthony Lynch and Marti Subrahmanyam argue that bilateral transactions in OTC derivatives markets involve an externality.  Their argument is not stated that clearly, but FWIW here it is verbatim:

[A]ll OTC contracts . . . feature collateral or margin requirements, wherein counterparties post a deposit whose aim is to minimize counterparty risk.  The deposit is marked to market daily, based on fluctuations in the value of the underlying contract and the creditworthiness of the counterparties . . . . The difficulty, however, is that such collateral arrangements are negotiated on a bilateral basis.  Parties in each contract do not take full account of the fact that counterparty risk they are prepared to undertake in a contract also affects other players; indeed, they often cannot take account of this counterparty risk externality in an OTC setting, due to inadequate transparency about the counterparty’s positions and its interconnections with the rest of the market.  While bilateral collateral arrangements do respond to worsening credit risk of a counterparty, such response is often tied to agency ratings, which are sluggish in capturing credit risk information and potentially inaccurate.

An externality means that some cost or benefit is not priced.  By invoking the concept of externality Acharya et al (“AEFLS”) are asserting that something–a bad in this instance–isn’t priced.  They are a very vague on just what this is, but here’s my interpretation of what they mean.

A firm that has already entered into financial contracts affects the risk exposure of its existing counterparties when it enters into new deals.  A firm that has a large number of commitments outstanding can enter into additional contracts that substantially increase its riskiness, thereby harming the incumbent counterparties.  The cost imposed on these incumbent counterparties isn’t, in this telling, priced.

This is, in essence, an asset substitution argument.  And indeed, asset substitution is always a concern in any credit relationship, whether it is between a bank and a borrower, or derivatives counterparties.

But an understanding of the way these markets work suggests that the asset substitution problem is far less important than AEFLS suggest.  One way of controlling this problem in lending relationships is to rely on short term debt, allowing repricing of old debt frequently and thereby limiting the gains from asset substitution.

In OTC derivatives markets, similar mechanisms are at work.  The main dealers rely heavily on short term financing.  Thus, attempts to engage in this type of behavior can lead to substantial increased financing costs, and indeed, a loss of access to short term funding altogether–this is a death sentence to a financial institution, as Drexel found out in the 1980s, Salomon almost experienced in the 1990s, and Bear and Lehman suffered during the crisis.

In fact, Diamond and Rajan argue that the “fragile” capital structure of financial intermediaries–the vulnerability to runs or other mechanisms that result in the rapid withdrawal of access to funding–are intended precisely to  provide such discipline.  Thus the supposed bug–the vulnerability of a big liquidity supplier to failure–is, in some respects, a feature.  Without it, the opportunism that AEFLS worry about would be a greater concern.

OTC dealers also trade derivatives extensively with one another.  Thus, changing creditworthiness can affect their ability to deal in these markets, and the pricing of these deals.

There are, therefore, mechanisms by which financial institutions internalize the costs associated with the riskiness of their dealings.  Of course, these do not work perfectly.  Of course, information is imperfect.  But it is essential to note that myriad lenders and counterparties are continuously interacting with big OTC dealers in a variety of different markets.  They are doing their own credit appraisals.  They are voracious consumers of any bit of information about other players in the marketplace.  The markets for funding and derivatives can serve to aggregate this private information in the prices and credit terms of derivatives trades, and in the funding costs that the institutions pay, thereby pricing (albeit imperfectly) counterparty risks.

Moreover, as Peter Klein pointed out in an earlier post on O&M, it is necessary to make an explicitly comparative analysis when evaluating policy alternatives.  The identification of an imperfection of the OTC market is not sufficient to conclude that it should be replaced by some other alternative that is inevitably imperfect as well.

In this regard, a comparison of the OTC market with the particular alternative that AEFLS advocate–central clearing–demonstrates that OTC markets arguably dominate clearing even on dimensions emphasized by AEFLS.

Most notably, clearinghouses almost NEVER condition margin levels on the creditworthiness of the member firms.  If they do (as, for example, LCH.Clearnet does in limited circumstances) they rely soley on agency ratings.  This reflects a variety of factors, including a lack of information to make such judgments.  Moreover, it reflects the fact that it would be very difficult, in practice, for a clearinghouse to discriminate among its members.  Such discrimination–which could have serious competitive effects–would expose the clearinghouse to intense influence activities.  (Thus, clearinghouses are most likely to work effectively when the members are homogeneous, and heterogeneity can be an impediment to their formation.)  This means that clearinghouses do NOT price counterparty risk in a discriminating way.  In a cleared market, a major determinant of counterparty risk is in the public domain, and not priced.  This is not conducive to an efficient allocation of trades among firms, or in the scale of trading activity.

In contrast, in the OTC market, dealers have a wide variety of sources of information about the creditworthiness of potential counterparties that they take into account when determining the terms on which they are willing to deal with these counterparties.  That is, although their information is imperfect, big dealers almost certainly have better information on the creditworthiness of other dealer firms than a clearinghouse would.  What’s more, the fact that any given firm is being evaluated by multiple counterparties and lenders means that (a) the private information aggregation mechanism noted before can work in the OTC market in a way impossible with a single evaluation by a clearinghouse, and (b) evaluation errors are somewhat diversified in the OTC setting, but with one monitor in a cleared market, if the clearinghouse gets it wrong the problem can be huge.

That is, counterparty information in OTC markets is imperfect, but almost certainly better than in a cleared market.  Moreover, there are a greater array of mechanisms available to price counterparty risk based on this information: not just in margins, but in the pricing of deals (many deals explicitly adjust prices to reflect credit terms), the pricing of the financing that dealers require to operate, and in the sizes of transactions.

I’ve argued extensively in some working papers that as a result of these information advantages, contrary to the claims of AEFLS, counterparty risks are likely to be priced MORE accurately in a bilateral market than a cleared one.  Clearing can offer some offsetting advantages, but the key point is that a trade-off is involved.  In my view, it is highly likely that this trade off frequently favors bilateral, OTC dealings rather than central clearing.

Like so many advocates of clearing, AEFLS fall victim to the Nirvana fallacy.  They point out imperfections in OTC markets, and do not carry out a comparative analysis of the relative imperfections of alternatives.  What’s more, their analysis of the supposed failings of the OTC market is incomplete because they do not fully explore how market participants structure their transactions to deal with the putative market failure they identify.

They’re miles ahead, though, of Barney and Chris and Timmy! and Gary and Mary and the gang.  At least AEFLS try to identify an alleged market failure.  Even though they fall into the classic Nirvana fallacy, at least they point out a potential inefficiency, thereby permitting an rigorous exploration and analysis of this possibility.  Which is way more than can be said for the Sorcerer’s Apprentices attempting to reorganize completely the largest and most complex financial markets in the world.

Cross posted on O&M.

Krugman is bashing Timmy! Geithner for his role in the AIG bailout.   This poses something of a dilemma for yours truly.   My sentiments parallel those of Henry Kissinger during the Iran-Iraq War: too bad they both can’t lose.

All snark aside, the SIGTARP report that has put Timmy! (oh, that was snarky–sorry) on the hotseat raises some questions that have been totally ignored over the debate over whether the Fed should have sent Goldman et al to the barber shop to get a haircut on the valuations of their swaps with AIG.

The indisputable fact is that billions of cash went out the door to Goldman et al as a result of the Fed’s actions.   The Fed took ownership of the CDOs underlying the swaps that AIG had entered with the banks, and effectively paid the banks 100 cents on the dollar.   That is, they ensured that the CDO hedges were perfect (belying the old trader adage that the only perfect hedge is in a Japanese garden).

The question is, therefore, what were the alternatives?   The alternative that has garnered all the attention is that the Fed should have paid less than 100 cents on the dollar.

But that’s not the only alternative.   Hank Greenburg has suggested that the Fed should have simply guaranteed the swaps, thereby vitiating the need to provide any collateral payments.   (I made a similar suggestion in an earlier post on AIG).

The SIGTARP report states clearly (p. 14) that this alternative was considered, but dismissed.   The ostensible reasons for the rejection seem very dubious, indeed.

First, “FRBNY told SIGTARP that a perceived downside of this structure from FRBNY’s perspective was that it could involve FRBNY in long-term credit relationships with supervised institutions.”   Please.   The Fed has gone hog wild in extending credit (through repos, for instance) with supervised institutions.   It has taken all kinds of dodgy collateral at all kinds of dodgy valuations.   That certainly involves taking a long term credit exposure.   (Spare me any protests that there is no credit risk here because these repos are collateralized.   Given the quality of the collateral, and the counterparties, there is an appreciable probability that the Fed will suffer a credit loss on these deals.) And if the Fed’s actions were a response to an existential event, which is the gravamen of its defense of its actions, such prissiness over protocol appears decidedly inappropriate–making this explanation exceedingly implausible.

Further thought (added at around 1900 CT):  Given that the CDS were so far underwater to AIG, if the government had guaranteed them, the likelihood that the Fed would have become a creditor to the banks on the other sides of the deals was exceedingly remote.  That is, it was highly unlikely that the Fed would have been exposed to default losses on these deals, meaning that the “credit relationship” was a fiction.  (Besides, at the time, were most of the counterparties even under Fed supervision?   Most were foreign banks, and even the US counterparties, with the exception of Wachovia, were investment banks that I do not believe were under direct Fed supervision, except perhaps as Treasury primary dealers, rather than as banks.)

Second, “there was a lack of statutory authority of the Federal Reserve to provide such a guarantee.”   Please, again.   There are a variety of structures that effectively create guarantees.   For instance, if the Fed could see its way clear to setting up and capitalizing a special purpose vehicle (SPV) to buy the CDOs, it could have set up and capitalized an SPV, and then novated the deals to the SPV.   If it was concerns about counterparty risk that made the banks so insistent on receiving collateral payments, this structure would have allayed their concerns–and required no cash to go out the door.

In this structure, the government’s risk exposure would have been the same as under Maiden Lane and its purchase of the underlying CDOs: it would have been long the CDOs.

In sum, the rationales given for not providing some sort of guarantee are completely unpersuasive.   Completely.   A guarantee would also not have required agreement on valuation with the counterparties.   They would have been assured of receiving their contractual payments, and that should have been that.

The transparently implausible rationale for eschewing the guarantee alternative tells me that the Fed’s–and Geithner’s–injured and adamant denial that “the financial condition in the counterparties was not a relevant factor” (p. 15) in deciding to pay 100 cents on the dollar is dishonest.   Geithner has said many other things that do not pass the honesty smell test, so it wouldn’t surprise me that if this was the case here as well.

Thus, it is highly likely in my view that this was a backdoor way of providing liquidity to systemically important institutions at a time that their financial condition was in serious question.

In this regard, it could well be that Goldman was the firm that was in greatest need of an injection of cash.   The SIGTARP report states that, unlike the other AIG counterparties, “Goldman Sachs did not hold the underlying CDOs but rather had sold equivalent credit protection to its clients who held those positions.”   Very interesting.   It is likely that these client counterparties were demanding collateral from Goldman.   If so, if Goldman didn’t receive cash from AIG–or the government–it would have needed to find additional cash to make these payments.

Yes, Goldman states that it was hedged by its purchase of credit protection on AIG.   But, (a) in prevailing conditions, there was considerable credit risk in those CDS, meaning that Goldman may not have been paid out 100 percent of what it was owed, and (b) even if the CDS paid out, there would almost certainly have been a cash flow date mismatch, with Goldman needing the cash to make margin calls to its clients immediately, and receiving any cash payments on CDS at some later date.   Given the state of the credit markets at the time, funding this gap would have been an expensive, and dicey, proposition.

Given the supposed First Commandment to Treat All Banks Equal (p. 29), the Fed could not have bought out Goldman and not the other banks.

Against that, if providing liquidity to Goldman alone was the objective, there should have been ways of doing that directly–unless the Fed was concerned that special treatment of Goldman would have commenced a destablizing run on it like the one that cratered Lehman.

I therefore can’t conclude for certain that the AIG bailout was really a Goldman rescue in drag.   One can tell that story, but there are alternative explanations.   However, given that the Fed’s explanation for not taking actions that would have required no cash payments is so weak, my conclusions are that the AIG bailout was an indirect of providing liquidity to systemically important institutions, and that one cannot exclude the possibility that this was an indirect way of providing liquidity to one institution in particular–Goldman.

(One question unanswered by the SIGTARP report: if Goldman didn’t own the CDOs that eventually wound up in Maiden Lane, how did they get there?   Did Goldman buy them from its clients in a mirror image deal that involved swap tearups, and then sell them to Maiden Lane?   It would seem that would be necessary to deal with Goldman’s own sales of protection. )

A couple of other points related to the SIGTARP report.   First, as I emphasized in “It’s a Wonderful Life: AIG Edition,” if AIG hadn’t been born and hence not around to sell protection, the owners of the CDOs would have taken a bath.   Thus, it is not credit default swaps per se that were the ultimate source of the problem; it was the underlying CDOs.   Only to the extent that the existence of AIG contributed to a larger CDO market could CDS have contributed to the financial crisis.   Indeed, the crisis–that is, the losses suffered by big banks–could have been worse if AIG hadn’t taken a $50 billion hit.

Second, one of the narratives has been that AIG didn’t have to post collateral, and hence took on bigger positions than it would have if it had been required to do so.   It indeed didn’t post any initial margin, but it is clear that the deals contemplated the posting of collateral even absent an AIG credit event.   AIG had posted at least $22 billion in collateral prior to its downgrade (Table 1).   Perhaps the necessity of posting initial margin would have reduced AIG’s appetite, but likely not, in my view.   First, by not requiring original margin, counterparties were extending AIG credit, and presumably charged for it; only to the extent that it would have been costlier to finance initial margin payments would the posting of such margin have made AIG reduce its positions.   Second, given that it lost huge sums on mortgage backed in its security lending program and other operations, it is clear that AIG viewed these as very attractively priced risks.   Sure, a slightly higher cost (due to the necessity of posting initial margin) might have induced it to cut back some, but likely not very much.

To conclude: given the availability of another alternative to buying out the banks at 100 percent of par, that would not have required a cash payment, and the weak justifications for avoiding that option, make it highly likely that the AIG bailout was structured in part to provide liquidity to major banks (and perhaps, but not conclusively, one particular bank).   Which makes the Fed’s–and Geithner’s–denial that the financial health of these firms was an irrelevance highly dubious, not to say, a lie.

Yes, Russia can breathe easy.  Even when it comes to corruption, it’s not the worst!  Bad–tied for 146th out of 180, according to an average of surveys assembled by Transparency International–but not the worst.  Indeed, not even the worst in the FSU–several ‘Stans are all well below Russia.

And I am sure that the “whatabout Ukraine” crowd is asking, well, “whatabout Ukraine.”  Well, amusingly, it is tied for 146th place, although since ties (based on rounding to 1/10th of a point) are arranged alphabetically, and the lowest and highest scores for Ukraine are both higher than Russia’s, my guess is that without rounding Ukraine edged out its former Gulag cellmate.

Speaking of ties, Zimbabwe joined Russia and Ukraine in 146th place.  Now that’s something to be proud of.

It should also be noted that Russia isn’t even close to being the least corrupt in the FSU. Indeed, one ‘Stan–Kazakhstan–came it at 120, and even Azerbaijan beat Russia’s 2.2 score (out of 10!) by a tenth of a point. The Baltic states aren’t even in sight, with Estonia at 27 and Lithuania and Latvia at 52 and 56, respectively.

But, according to accounting firm PWC, Russia IS the worst, when it comes to, er, agency problems:

Russia is the worst country in the world for companies in terms of employee theft and extortion by officials, a PricewaterhouseCoopers LLP survey showed.

Seventy-one percent of domestic and foreign companies in Russia were victims of fraud in the past year, double the rate reported in fellow BRIC countries Brazil, India and China, PwC said in a report released today. That’s a “shocking” increase of 12 percentage points from 2007, when the last survey was conducted, PwC said. In Japan, the figure is 9.6 percent.

Theft and bribery hit Russia’s financial, energy and mining industries the hardest, according to the survey of 3,000 executives from 55 countries, including 86 Russians. “The nature of these industries means that they are particularly exposed to both asset misappropriation and corruption, the two most prevalent types of economic crime,” PwC said.

. . . .

PwC said the prevalence of government graft in Russia is twice the global average, with 48 percent of all companies surveyed reporting an instance of bribery or corruption in the last 12 months.

The problem has been exacerbated by the country’s record economic contraction, which has lowered the “morale” of employees and made “asset misappropriation” more tempting, PwC said. The economy shrank 10.9 percent in the second quarter, the most on record, and 8.9 percent last quarter.

More people are feeling “real pressure to ‘cross the line’ or to look the other way,” PwC said.

The line about the special vulnerability of energy and mining is of particular interest.

One other Russia bit caught my eye today.  Russia’s industrial output contracted in October:

Russia’s  industrial slump deepened in October as companies failed to build up inventories and credit remained tight even after eight central bank interest rate cuts since April.

Output fell 11.2 percent from a year earlier after the decline eased to 9.5 percent in September, the  Federal Statistics Service in Moscow said via e-mail today. Production rose a non-seasonally adjusted 0.8 percent on the month. The medianestimate in a Bloomberg survey of 10 economists was for an annual decline of 8.1 percent.

. . . .

Manufacturing in October plummeted an annual 17.5 percent, the most since May, and dropped 4.3 percent compared with the previous month in the first monthly decline since August.

Output and generation of electricity, heat and water dropped 6 percent last month compared to the same period in 2008, the smallest annual decline since April.

Passenger car production in October plunged an annual 58 percent, while output of trucks declined 54 percent compared to last year, the statistics service said.

Wage arrears increased in October by 6.4 percent, to 5.4 billion rubles ($188.4 million) after declining 8.6 percent in September, the statistics service said in the report today.

This may be the case of every silver lining having its cloud.  The strengthening of commodity prices (thanks, Ben! thanks, China!) has bolstered the ruble, which adds another blow to an already devastated manufacturing sector.

The corruption news–with the energy and mineral industries at its heart–and the Dutch Disease effect, both demonstrate just how hard it will be to transform Russia’s economy.  The powerful won’t want to stop the gravy train, and as long as it is going it will be very difficult for non-resource industries to take hold.

Like I say.  Purgatory.

All of the legislative proposals relating to over-the-counter derivatives would impose seismic changes on the way that these instruments are traded, and the performance risks related to them are managed.  Indeed, it is fair to say that these proposals, if implemented would dramatically shrink the OTC market, and perhaps destroy it altogether. Under either the House (Frank) or Senate (Dodd) bills, most derivatives would have to be traded on exchanges, and be cleared.  (Clearing is a way of mutualizing default risks.  At present, default risks in a particular contract are directly limited to the buyer and seller.)  (BTW, when you hear “Frank and Dodd” do you think Fannie Mae and Freddie Mac?  I do.  Does this inspire confidence?  Self-answering question.)   These efforts are strongly supported by Treasury Secretary Timothy Geithner, CFTC head Gary Gensler, and SEC head Mary Shapiro.

These legislative proposals are clearly predicated on a very strong belief: participants in the derivatives markets routinely chose the wrong institutional arrangements.  That this immense market is and was in fact arguably the largest market failure in financial history.

And these markets are indeed immense.  According to Bank of International Settlements data, notional (“face”) values of these instruments totaled $683 trillion in June, 2008 (right before the onset of the financial crisis), and their market values totaled $20 trillion (ballooning to $34 trillion by the end of 2008).

Moreover, these markets had grown dramatically over the years–at a double digit annual pace.  They also dwarfed the market for exchange traded (and cleared) derivatives.  The BIS reports that at the end of 2007, total notional values of outstanding contracts traded on exchanges were $28 trillion, which had shrunk to less than a mere $20 trillion at the end of 2008.  (I won’t go into the quibbles over the interpretation of these numbers, which make true apples-to-apples comparisons impossible.  Suffice it to say, difficulties of interpretation duly considered, the exchange traded markets are huge, but the OTC markets are HUGE.)

But our betters on Capitol Hill think that these collective results of the individual decisions of thousands of informed participants with major skin in the game are wrong, wrong, wrong.  They know better.  EVERYTHING should be traded on exchanges.  EVERYTHING should be cleared.  The emergent order is fundamentally flawed; a constructed one must be substituted for it by legislative fiat.

This assertion of systematic, immense market failure demands a coherent explanation.  It is, to be honest, quite hard to find one.  In this post and some that follow, I’ll examine some of the attempts at explanation.

Cliffs’ Note version of my conclusion: I’m still searching for a coherent story.

One of the most commonly heard stories is that OTC derivatives are enormously profitable for big banks due to the lack of transparency in the market.  Exchange trading and clearing would shrink profit margins, costing the banks big money.  So they have deliberately kept the market dark in order to enhance their market power and their profits.

Of course, all dominant incumbents want to maintain market arrangements that protect their market power and monopoly profits.  This is why GM is enormously profitable due its continued dominance of the automobile market.

Back to our regularly scheduled reality.

To justify the profit protection story, it is necessary to demonstrate the existence of entry barriers.  It is possible for banks to charge their customers supercompetitive prices persistently only if there is no possibility for competitors to undercut these prices (where the idea of “price” should be interpreted broadly to incorporate all of the costs that customers pay to trade derivatives.)  There are, however, strong reasons to believe that such entry barriers don’t exist, or aren’t sufficiently strong to explain the dominance of the OTC markets.

Let’s consider for a minute the legislative proposals.  They want to force trading onto exchanges.  They believe that this trading will be cheaper and more efficient due to greater transparency and competition, and share default risks more efficiently, than the current OTC markets.  But exchanges already exist.  For years they have been striving mightily to make inroads into the OTC derivatives markets.  Futures brokerage firms have also been trying mightily to market their services to the customers of OTC dealers.  Exchanges have launched head-to-head competition in many areas–and failed miserably in most of them.

If exchanges are really cheaper, because OTC dealer banks exercise market power and charge supercompetitive prices, why haven’t the exchanges made greater penetration?  Why haven’t they drawn business from the OTC dealers?  Why has the market share of OTC derivatives grown?

I’ll wait.  Barney?  Chris?  Tim?  Gary?  Mary?  [Humming quietly to myself.]

Put differently: the alternative market arrangement that the DC crowd says is more efficient and cheaper has been available to the allegedly poor, exploited customers of dominant dealers for years, and they’ve chosen to trade with the dealers nonetheless.  How to explain this?  Battered spouse syndrome?  Masochism?  It is a puzzle, no?

But it gets better.  There are many markets in which virtually identical products trade OTC and on exchanges.  In many of these markets, consenting adults knowingly choose to trade the uncleared, bilateral OTC contracts.  Why would that be if OTC markets are beset by market power that inflates the costs that customers pay?

Moreover, there are cases where clearing has developed organically in an OTC market without the benefit of a government mandate.  Most notably, clearing has grown dramatically in OTC energy derivatives since 2003.  This demonstrates that clearing can succeed competitively where customers want it.  This undercuts the idea that clearing (or exchange trading) is at an inherent competitive disadvantage relative to OTC dealer.  Ironically, and tellingly, this development has occurred precisely when the firms that dominate the OTC financial markets–e.g., Goldman Sachs, J.P. Morgan, Morgan Stanley, and other big banks–began to dominate trading in OTC energy derivatives.  How come they didn’t strangle the clearing baby in the crib to create and protect a privileged position in the energy markets?

In sum: there have been vigorous attempts of the putatively cheaper, more efficient exchange trading platforms to enter the market, suggesting that entry barriers do not preclude such competition.  These competitive efforts have often failed, and have certainly failed to displace OTC trading.  Where given a choice, customers sometimes choose cleared or exchange traded products–and oftentimes don’t.

Which calls into serious, serious question the received story as to why the inefficient, opaque, market-power ridden OTC market has survived and thrived. Instead, this “explanation” appears to be yet another of the many Just So Stories that have proliferated in the aftermath of the financial crisis;  a superficially plausible explanation that does not withstand scrutiny.

But on the basis of such Just So Stories, we are supposed to countenance the complete re-engineering of the world’s financial markets.

[Cross posted at Organizations and Markets.]

Pavel Baev makes a point I’ve emphasized repeatedly: change destabilizes the Russian natural state.  As a result, they system is brittle, and Medvedev’s questioning of the entire basis for the state and the country’s economy could have catastrophic consequences:

The conclusion that the Byzantine political system built (or rather re-built) by Putin is incompatible with modernization appears both impossible and irrefutable. Medvedev dares not to utter one word of criticism directed at his co-ruler and waffles over the need to build a team of modernizers who could make at least a few innovations indeed happen (Nezavisimaya Gazeta, October 30). However, he constantly spells out the proposition that the conveniently corrupt business-as-usual is over, and this message -hesitantly conveyed by the official media- gradually becomes a catalyst for the growing sense that a period of change has arrived yet again (Moskovsky Komsomolets, November 3).

This perception gained more ground after Medvedev’s strong condemnation of Stalin’s crimes that appeared first on his video-blog and was then broadcast by all television channels. Insisting on re-examining the repressions, he went against the widespread desire to close those dark pages in Russian history and also challenged the tendency towards “rehabilitating” Stalin, which was carefully cultivated by Putin (Nezavisimaya Gazeta, November 2). This step signifies a risky departure from the policy of saying only things that people want to hear, since for large groups of “patriots” Medvedev has instantly become a “traitor.”

The divide within society over Soviet history connects directly with the splits on the way out of the current crisis, which were illustrated by the ambivalent celebrations of the November holidays. There were perhaps as many ultra-nationalist rallies as officially sponsored festivities on the recently established Day of National Unity, while the communists brought thousands to the streets on the Great Revolution Day. Still, a healthy 63 percent of respondents affirmed that they would celebrate neither day (www.levada.ru, October 29).

The rising momentum of change makes the political elites edgy about setting and switching their loyalties. The more Medvedev is trying to argue (as in a recent interview with Der Spiegel) that “today, there is no doubt that our tandem, as we are commonly referred to, is working rather coherently,” the more doubts arise about its future. Commentators and economic experts pondering the pseudo-liberal discourse and budgetary populism increasingly describe the situation inside the Kremlin as panic (Vedomosti, November 2; www.gazeta.ru, October 21).

In this turbulent environment, Putin wants to position himself as a “rock” of confidence standing against the ill-conceived “innovations,” asserting at every meeting of the government that “our plans are still alive and well, and they will continue and be completed. There is no doubt about it.” He can hardly fail to see, however, that time is not on his side, and the central question of the leadership acquires critical urgency well before the presidential elections in 2012. Medvedev might think that time is working for him, but re-inventing himself as a champion of change is an order much taller than his limited intentions, which he will present this week in an address to the parliament. He fancies “modernization” as an evolutionary and certainly non-violent process over which he would preside benevolently disallowing any “excesses.” The problem is that the strength of the thoroughly corrupt system of power to which Medvedev belongs entirely is in its rigidity. Thus, opening it up for transformation – even if only by words – could trigger a spontaneous collapse. The Berlin Wall is an object lesson in such a breakdown, and Medvedev may find himself to be merely the weakest part of the wall of fear and lies that Putin has built. [Emphasis added.]

Twenty years ago, Gorbachev was the Sorcerer’s Apprentice who, convinced that the Soviet system needed to be changed in order to survive–and to realize Lenin’s vision(!)–unleashed forces that he could not control.  The Soviet system was grossly inefficient, but it had an internal coherence and a set of self-supporting norms and institutions.  Attempting to change some of these, while retaining the essence (a one party state), destroyed this coherence and caused its collapse in short order.

Medvedev’s vision is somewhat similar.  He wants to change some of the system–notably, its reliance on extractive industries and its innovative backwardness–but retain a dominant state led by a bureaucratic elite operating through an overawing party.  But these goals are largely incompatible.  Like Gorbachev, Medvedev–or anyone–could never control what a wave of creative destruction would destroy.  The state structure and the resource dependent economy are highly symbiotic.  The resource dependent economy creates the rents that feed the state and its rulers.  A truly entrepreneurial economy creates sources of power that challenge the incumbents.  (Heck, even a resource economy with truly independent firms does this; which is why Khodorkovsky had to be destroyed.)  The economic side of the arch supports the political, and vice versa.  Disrupt the economic side, and the political side is likely to fall.

Hence the panic at the thought that Medvedev might play Sorcerer’s Apprentice.  Putin is much more realistic on this score.  He clearly understands that this is not like ordering from a Chinese menu–one item from column A and another from column B.  It is a package deal.

The main difference is that Gorbachev was in a position to do something, whereas Medvedev’s position is much more ambiguous and tenuous.  Moreover, having seen this movie before, the apparatchiks will be loath to embark on another socio-politico-economic experiment.  As Twain said of the cat that sat on a hot stove: it will never sit on a hot stove again, but it won’t sit on a cold one either.  Hence, it is highly unlikely that Medvedev will be able to secure the internal support necessary to act on his vision–even if he has the intestinal fortitude to try.  The gulf between his words and deeds suggests, furthermore, that he truly lacks that too.

The most likely outcome is for Putin and Putinism to prevail.  As deadening as its effects are, it is still an internally coherent system (as are natural states generally).  It works to the benefit of those in power, and it has atomized the population to such an extent that the risk of popular revolt is remote (though not non-existent).

It is not, as I’ve written, immune to collapse especially under conditions of economic stress that undermine the rents that hold it together.  But better to run that risk, than to run the much greater risk of trying to implement changes that are inherently destabilizing. Therefore, I would expect that as long as Medvedev is just talk, Putin and the siloviki will tolerate him despite the angst that this causes.  If Medvedev actually tries to act on his words, however, his days would almost certainly be numbered.  Those with vivid memories of the “greatest geopolitical catastrophe of the century” will not countenance another Sorcerer’s Apprentice run amok.

They’re both virtually uninsurable:*

Political risk insurance premiums have risen across emerging markets in the last year, fueled by rising resource nationalism and unrest linked to the financial crisis as well as a renewed concern over risk amongst investors.

Foreign direct investors use the political risk insurance market to buy protection against nationalization, expropriation, political violence or capital controls preventing convertibility of earnings. It generates some $1.5 billion in premiums each year.

. . . .

RUSSIA ALMOST UNINSURABLE

Madagascar, Ecuador, Kyrgystan and others have also seen examples of expropriation or effectively forced renegotiation that have worried insurers. However, in some other countries — such as Brazil or South Africa — a slight rise in leftist rhetoric has had less impact on premiums.

The industry is particularly concerned over risks in Russia, where extractive projects have become almost uninsurable.

BP (BP.L) faced a difficult battle for control of its local joint-venture TNK-BP last year, but problems have not been limited to the oil sector and Norwegian telecom Telenor faced a similar battle this year over its stake in mobile operator Vimpelcom.

“The main difficulties seem to be in any sector you can describe as strategic,” said Elizabeth Stephens, head of credit and political risk analysis at London insurance broker Jardine Lloyd Thompson.

No doubt the “We’re Not the Worst!” crowd that routinely pipes up in response to any criticism of Russia and Putin will seize on the fact that another ex-Soviet basket case is in the same, uhm, basket:

Buying coverage for investment in Ukraine has also become almost impossible, she said, as the country struggles with both financial and economic crisis. Ukraine’s state gas firm Naftogaz defaulted on a $500 million Eurobond last month before restructuring.

Take your solace where you can get it, I guess.

Looking at the roster of other virtually uninsurable countries–Bolivia, Venezuela,  Madagascar, Ecuador, Guinea, and Kyrgystan–should be a source of deep shame for proud Russians.  But we are routinely bombarded with harangues about the restoration of Russia’s power and its assuming its proper place in the world, all led by that stalwart avenger of Russia’s humiliation, Vladimir Putin.

But what has he really accomplished?  To turn Russia into an economic pariah (to all except the Germans in their current at-your-feet mode) condemned to economic purgatory for the foreseeable future.  The radioactivity of Russian political risk is a striking testament to the true wages of Putinism.

But in this era of hyperactive, grasping government, America should take heed Russia’s lesson:

The huge increase in Western government intervention in financial markets following the global crash had also prompted some firms to worry about the risk of expropriation in developed economies, Zurich’s Roorden said.

“We’ve had some enquiries about the United States, mainly concern over the risk of nationalization as governments take extraordinary measures due to the crisis,” he said.

We’re nowhere near Russia on this score yet, but the journey to hell begins with the first step.  The actions of the US government with respect to major banks, the automakers, and perhaps, health care insurers and providers, raise questions about the vulnerability of property rights in this country too.

* And I bet you were thinking, “Uhm, drunk drivers?”

I welcome Gillian Tett’s recognition that clearing is not the silver bullet–or the “magic wand”–that will make financial crises a thing of the past.  This bit is particularly spot on:

What is notable about the reform debate this year, is that there has been remarkably little public discussion among politicians – or among regulators – about how to guarantee that any future clearing house will be strong enough to withstand future shocks.

In part, that silence may reflect a lack of imagination. Politicians and regulators have never seen a situation where a clearing house has collapsed; leaving aside one small exception in the commodities world a few decades ago [not quite right: the Hong Kong Clearing Association failed in 1987, and the CME and CBT clearinghouses were under extreme stress too], that has never happened before. However, I suspect the silence may also reflect delicate political sensibilities. If politicians were to demand that a clearing house should be so utterly rock solid that it could withstand financial Armageddon, the future members of any clearing platform would have to make massive financial commitments. That would necessarily limit membership to a small cabal of ultra-powerful banks – not something that most politicians wish to encourage.

However, if a clearing house is made more accessible to a wider pool of members, then it will only have credibility if it is backstopped by the government itself to ensure that trades are always settled. Most politicians are not keen to highlight that option either, given the wider sense of public anger about the degree to which the government is bailing out the financial world.

Tett is in fact too kind about the lack of public discussion.  Politicians–most of whom, truth be told, couldn’t explain to you how clearing actually works, and probably hadn’t even heard of it a year ago–have seized on the clearinghouse as a cure all.  There has been virtually no serious discussion of the economics of clearing, or the economic implications of clearing mandates.  Much of the discussion has been notably distorted and misleading; Timothy Geithner and Gary Gensler have been particular guilty of this.  Nobody has answered (and arguably, nobody has seriously asked) why clearing has not been adopted heretofore, and why non-cleared products have grown relative to cleared ones, if clearing is so great.  (And no, I don’t count the superficial “it will cut the banks profits” argument.)  Instead, clearing is a deus ex machina, invoked to resolve all the thorny issues involved in financial market structure.

Tett’s statement that memberships in clearinghouses lacking a government guarantee would limited to a “cabal of ultra-powerful banks” illustrates the inanity of much of the debate.  We need clearing to permit big banks to share counterparty risk because big banks are too interconnected.  Huh?

The alternative she poses–government guarantees of clearing–is truly scary.  We need to find ways of weaning the system off the government guarantees that currently exist, and which are the main source of moral hazard-induced systemic risk, rather than look to find new things to guarantee.

Tett is sympathetic to clearing, as is indicated her invocation of the lack of the failure of a major clearinghouse.  This is a weak argument, however, because the market structure–and crucially, the choice of clearing vs. bilateral arrangements–is endogenous.  Clearing has been adopted where conditions favor it.  The fact that it has worked in these areas does not imply it will work equally well with other products and other participants.  Indeed, it is quite possible that mandating clearing for products/participants for which it is not well adapted (as indicated by the failure to adopt it voluntarily) will make things worse, rather than better.

Tett’s concluding paragraph makes an important point:

One lesson that financial history shows is that the issues which blow up the financial system are not usually those which caused the last crisis; instead, the biggest threats tend to come from the areas swathed in a lazy consensus, or where there is a strong political impetus to clutch at easy solutions. That might yet apply to the clearing houses. In theory, I still believe that clearing houses could – and should – make the derivatives world safer. In practice, though, they could end up creating new dangers if they are not put on a sound footing – particularly if the fact that no clearing house has ever failed before creates a false sense of security.

We need a serious examination of the costs and benefits of alternative market structures.  Sadly, this has been completely absent.  Instead, we have had superficiality masking as deep analysis; cheerleading instead of critical appraisal.  This will not end well, because, as Tett notes, such superficiality leads to the false sense of security that lays the groundwork for the next crisis.

I have been a Cassandra on this issue for some time now.  It’s good to have some company, even if Gillian Tett still has too rosy a view of clearing for my taste.  But the fact that at least somebody is questioning the conventional wisdom is encouraging.

A couple of other clearing stories that deserve mention.  First, incredibly, Barney Frank has endorsed NJ Rep. Stephen Lynch’s amendment to regulate clearinghouse ownership structures:

Mr. Frank said he hopes in part to address potential conflicts of interest at clearinghouses with a provision pushed by Rep. Stephen Lynch (D., Mass.) that would limit big banks’ controlling stake in clearinghouses to 20%. That provision was included in the bill, but hit a procedural hurdle recently and had to be removed.

“We are encountering resistance to that on the part of many, including my colleagues in the House Agriculture Committee,” Mr. Frank said of the Lynch provision. “As I believe it is important to reduce the stake in the clearinghouses of these firms…I continue to support Congressman Lynch’s amendment.”

WTF was I thinking when I said something nice about this dangerous, dangerous man?  The man who, more than any other, is responsible for the Fannie and Freddie fiasco (the costs of which make the expense of AIG pale in comparison).

Second, and an excellent counterpoint to the Lynch-Frank effort to micromanage the ownership of clearinghouses, LCH.Clearnet has completed a restructuring that gives large banks more control:

The clearer said on Friday that with the redemption finalised, large users now owned 63 per cent of the business, up from 37 per cent. LCH.Clearnet defined large users as those which contributed more than 1 per cent towards group clearing fees and which together represented, in aggregate, more than 80 per cent of the group’s clearing revenues.

LCH.Clearnet is now owned 83 per cent by users of its services and 17 per cent by  NYSE Euronext and the London Metal Exchange.

Sixty-five shareholders, including Euroclear Bank, a unit of Euroclear, the settlement services group, have had their shareholdings either redeemed or “significantly reduced”.

The total number of LCH.Clearnet shareholders is now 105, down from an earlier 120.

Most of LCH.Clearnet’s “large” users are also members of the bank consortium – codenamed “Lily” – that abandoned its takeover attempt last month, largely because the LCH.Clearnet scheme largely satisfied its demands for greater control of the clearer.

The consortium had wanted control of LCH.Clearnet largely for its SwapClear interest rate swaps clearing business, turning the clearer for the London Stock Exchange, Euronext and the London Metal Exchange into more of a clearer of OTC derivatives.

Interesting, isn’t it, how market participants with experience and skin in the game are doing the exact opposite of what politicians who don’t want them to do?  This should at least raise questions as to why market participants favor a mutualized structure with a rough equivalence between risk exposure and control.  Could it be because this offers serious efficiency advantages?  But no, all we get from financial sophisticates like Frank and Lynch is superficial bleating about “conflict of interest.”

Reading all this makes this quote from Hayek (which serendipitously Russ Roberts reminded me of yesterday) all the more apropos:

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

When it comes to politicians and regulators, Hayek’s phrase should be amended to say:

The curious task of economics is to demonstrate to politicians and regulators how very, very little they really know about what they imagine they can design.

Vladimir Putin is whining, predictably, about the GM board’s decision to terminate the sale of Opel:

“We will have to take into account this style of dealing with partners in the future, though this scornful approach toward partners mainly affects the Europeans, not us,” Putin told a cabinet meeting in Moscow. [nL5471607]

“GM did not warn anyone, did not speak to anyone … despite all the agreements reached and documents signed. Well, I think it is a good lesson.”

Wah, wah, wah.  Here’s more:

Prime Minister Vladimir Putin lashed out at General Motors on Thursday after a Russian-backed bid to buy carmaker Opel fell through, hinting that there may be repercussions down the road because of GM’s “disregard for its partners.”

“Nobody warned anybody about anything,” Putin said, referring to the surprise decision by the U.S. company not to sell its European unit. State-owned Sberbank and parts maker Magna had made preliminary agreements to buy the European carmaker, with GAZ Group named as a potential industry partner.

“Everyone was notified after the fact, despite the agreements that had been reached and the documents that had been signed, including legal ones,” Putin said.

The board’s ruling “doesn’t harm our interests, but it shows a rather peculiar communication style that our American partners use with their counterparts,” Putin said. “This is a good lesson. … We must take into account this kind of cooperation with our partners in the future,” he said, adding that the decision primarily showed disrespect to GM’s European partners.

“Peculiar communications style.”  Priceless.

Putin should recognize that the real lesson here is that the only way Russian companies were in the running for a piece of Opel at all was because of political machinations and a combination of bribery and blackmail (by the Germans, in cahoots with the Russians), rather than a rational economic calculation.  While nursing his hurt ego (when somebody says “it doesn’t hurt me” you can bet it really hurts), Putin should consider why the prospect of partnering with Russian firms is so repulsive that it is necessary to rely on such means to prevail.

Here are a couple of other priceless gems from other Russian winners.  First, from our old buddy Oleg Deripaska:

The problematic deal with Opel, with its international political overtones, is wrapped up in the “superstitions of the U.S. State Department,” Mr. Deripaska earlier told the Russian press. The State Department has denied Mr. Deripaska a visa to visit the U.S., although he recently visited the country in cooperation with the Federal Bureau of Investigation and met with Detroit executives.

I guess that Detroit meeting was a real success, huh, Oleg?  (BTW, it is pretty disgusting that the FBI acted as an intermediary in this way.  This whole episode deserves a lot more scrutiny that it has received.)  And just where did those superstitions originate?  It must be a trial to be so misunderstood.

And here’s the reaction of a United Russia parliamentary official:

“The motivation, it seems to me, is very simple: to keep Opel within the zone of political and economic influence of American business and American politics,” said Oleg Morozov, deputy head speaker in the lower house of Russian parliament for Mr. Putin’s United Russia Party.

The paranoia is so thick you could cut it with a knife.

Until these attitudes are replaced by a more critical appraisal of the reasons for Russian companies’ unattractiveness to potential foreign partners, the country can count on remaining in Putin’s purgatory.  Have fun with that.

For my adage: the greatest lesson of the Great Depression is that we learned the wrong lessons about the Great Depression.   Krugman’s (wrong) lesson?:

It took the giant public works project known as World War II — a project that finally silenced the penny pinchers — to bring the Depression to an end.

The lesson from FDR’s limited success on the employment front, then, is that you have to be really bold in your job-creation plans. Basically, businesses and consumers are cutting way back on spending, leaving the economy with a huge shortfall in demand, which will lead to a huge fall in employment — unless you stop it. To stop it, however, you have to spend enough to fill the hole left by the private sector’s retrenchment.

Beyond the creepiness of confusing mass destruction with creation, Krugman’s analysis is inane, not to say insane.   It highlights the dangers of obsessing on a single data point, and using a single episode to draw broad (and arguably universal) conclusions.   Put differently, the monomaniacal focus on the Great Depression blinds Krugman to the obvious reality that it is the exception rather than the rule.   By ignoring its exceptional nature, Krugman goes seriously astray.

Both its severity and its duration make the Great Depression exceptional.   Market economies had endured other downturns before, some (like the one of 1920-1921) nearly as severe at the outset as the 1930-1940 depression.   But in these earlier episodes, after a period of months or years, economic activity rebounded, usually without any massive fiscal intervention.   Similarly, post-War recessions did not endure for extended periods.

The temporary nature of previous (and subsequent) declines casts doubt on the kinds of Old School Keynesian (“OSK”) (not even neo-Keynesian) stories that Krugman is trying to tell.   In particular, it casts doubt on the reality of an autonomous collapse in “aggregate” demand (driven by animal spirits) that can last indefinitely, absent some external, fiscal demand stimulus to offset it, and which is immune to monetary policy.     That is, these OSK musings are explanations crafted to explain a single data point, but they don’t hold up in broader samples.

Which should raise the question: Why was the Depression exceptional?   It couldn’t be the lack of fiscal stimulus–which had been lacking in, say, 1920-1921 too, and in other episodes as well.   Relatedly: Could policy errors (e.g., interference in the price system that impeded adjustment to shocks, bad monetary policy) have made this particular depression a Great one?

By advocating a massive additional stimulus today based on his reading of the “lessons” of the Great Depression, Krugman also implicitly assumes that the conditions that contributed to the Great Depression’s severity are present today.   Even if one believes that the Great Depression was a Keynesian event that required a massive fiscal stimulus to end, that doesn’t imply that the current recession (severe by post-War standards, but mild compared to the Big One) is a Keynesian one as well.   Moreover, differences between the structure of the world economies then and now are so great, and the precipitating events are so different, that it is extremely dangerous to argue by analogy.

I’ve written before that it is my impression that business cycle theorists of all stripes have made the intellectual error presuming that all cycles are alike.   (EG., my recollection of Lucas’s macro course in which he said that a review of Mitchell’s work on quantifying business cycles had convinced him that they were so similar that they likely had a common cause).   Before swallowing Krugman’s recommendations for A Stimulus on Meth, it would be advisable to ask: (a) Is Krugman’s analysis of the Great Depression correct?, and (b) Is the analogy between the Great Depression and current circumstances an apt one?

The answers to both questions are most likely “no.”   The validity of the Old School Keynesian theory of depressions is dubious enough for the Great Depression, and its general applicability even more so.     Given these serious doubts, we would be fools indeed to embrace Krugman’s nostrums.