Streetwise Professor

Almost exactly a year ago, I testified before the House Ag Committee and wrote an oped for the WSJ on the effect–or lack thereof–of speculation on oil prices.  The issue was high on the political agenda at the time, as oil prices hit $147/bbl, and gas prices were above $4/gal.  The collapse in prices during the financial crisis put the issue on the backburner, but it is back with a vengeance.  To loud Congressional hosannahs, the CFTC has announced its intent to impose a far reaching regime of position limits on energy and other commodities “in finite supply“–pray tell, what traded commodities are in infinite supply?

So, I guess I have to roll that rock up the hill, yet again.  (I have posts on the subject of “excess speculation” and position limits from 2006, 2007, 2008, and 2009.)  

At the risk of becoming even more of a repetitive bore than usual, I’ll restate my objections to the intellectual basis to these policy initiatives, and the policy initiatives themselves.  Before doing so, it is worthwhile to define “excessive speculation,” something those that hurl around the phrase with abandon almost never do.  I define “excessive” speculation as that which drives prices away from the competitive price consistent with available information.  That is, excessive speculation distorts prices.  Now, my objections:

• The mechanism by which speculators allegedly distort prices is almost never specified, and when it is, it makes no sense.  Advocates of the “excessive speculation” hypothesis routinely say that speculators inject artificial demand into the market.  Given that most speculators almost never actually take delivery, and thus offset their positions as they become prompt, they are not influencing either supply or demand for the physical commodity.  This is a point that has been recognized since at least 1902 in a report authored by the US Industrial Commission, which included several Congressmen and Senators.  Which I guess goes to show that Congressional IQ exhibits an inverse Flynn Effect.  
• This is especially the case for commodity index traders, who almost all trade cash settled instruments, and hence can in no way influence supply or demand.
• That is, none of the boatloads of money allegedly flowing into commodity funds actually goes into, you know, actual commodities.  Some of the money in commodity-linked investments is purely notional (e.g., in commodity swaps, or index swaps).  Some goes into T-bills (in the form of margin, or in fully collateralized commodity trades).  
• The evidence of a distorting speculative effect is laughable.  Distortions in prices should lead to distortions in quantities, e.g., in commodity stocks.  No reliable evidence of such an effect exists.  Indeed, I have looked at one commodity–copper–in close detail as part of a chapter of my upcoming book on commodity price modeling.  People were screaming about a speculative bubble in copper last year at the same time as the (louder) screams about a speculative bubble in oil.  But copper stocks (and the stocks of other industrial metals) were drawn down sharply at the same time prices were spiking: this is exactly what one would expect to observe with a positive demand shock.  Indeed, I am working on calibrating a rational expectations theory of storage model to copper data, and this model can explain the twists and turns of prices and stocks during the extreme events of the last several years.  That is, speculative irrationality is not required to explain the movements in copper prices AND inventories over the 1997-2009 period.  (I’ll post more on this when I finish a couple more parts of the analysis next week, hopefully.)
• Some of the “evidence,” logically ungrounded as it is, doesn’t even support the assertion of a speculative effect.  For instance, a common piece of “evidence” is that prices rose right along with measures of long speculative interest in the oil markets.  (This was a Michael Masters favorite).  Set aside the correlation-causation post hoc/propter hoc problems, and the potential for spurious regression problems whenever one examines the relation between two highly autocorrelated series.  Just look at the graph in this WSJ story:

Sure, prices and long non-commercial positions were both trending up in 2005-2008 (not that that means a damn thing).  But look at what happens in late-08 and early-09.  Prices and long spec positions are mirror images: prices were plunging when long interest was rising, and then, just as long spec interest peaked and began to fall, prices ceased their fall and moved strongly upwards.  How can you possibly explain this if the market dances to the speculators’ tune?  The speculative Pied Piper story says that these measures should move up and down together, not in opposite directions.  Now, this Masters style analysis is B.S., but those who used it to rationalize their assertions of a speculative effect are hoist on their own petard: they vouched for the validity of non-commercial long open interest as a measure of the “excess” demand for oil caused by speculation, but the most recent experience is decidedly inconsistent with that story.  Not that that they have even paused for thought, but continue to flog the same story.  

• Not to mention that numerous analyses, relying primarily on Granger causality, have failed to find any reliable connection between changes in speculative positions and price changes.  Or the analysis (by the CFTC!) showing that commercial traders tend to be market leaders and speculators are followers.

The calls for government regulation have gone international, and gone beyond calls for mere position limits.  Gordon Brown and Nicholas Sarkozy penned a WSJ editorial advocating widespread governmental “supervision” (Euphemism alert!) of the energy markets (including cooperation with OPEC):

For two years the price of oil has been dangerously volatile, seemingly defying the accepted rules of economics. First it rose by more than $80 a barrel, then fell rapidly by more than $100 before doubling to its current level of around $70. In that time, however, there has been no serious interruption of supply.

The oil market is complex, but such erratic price movement is cause for alarm. The surge in prices last year gravely damaged the global economy and contributed to the downturn. The risk now is that a new period of instability could undermine confidence just as we are pushing for recovery.

Where does one even begin the ridicule (beyond noting the point that whenever French and British politicians agree, it must be a really bad idea)?  Regarding volatility.  Uhm, the past two years have been among the most volatile in the memory of most living people–you have to go back to the 1930s to find anything remotely similar.  In 2007-FH2008, Chinese (and Asian growth generally) greatly spurred demand for commodities.  Note that in addition to commodity prices, shipping charter prices skyrocketed, even though the price of something perishable like transportation on a ship can hardly be distorted by speculative buying, because it has to be consumed and hence is impossible to hoard.  That was followed by a financial collapse and economic recession of severities unseen since aforementioned 1930s.  Look at every measure of uncertainty, notably such things as the VIX volatility index.  These things have been at dizzying heights since last August (and had begun their rise even earlier, in 2007).  What would be weird is if oil prices (and commodity prices generally) HADN’T been volatile during this period.  

Regarding “serious interruption of supply.”  Uhm, Gordo, Nicky–there’s this concept called “demand.”  Believe it or not, it’s one of the “accepted rules of economics.”  Don’t take my word for it.  It’s in all the textbooks.  Price evolution in the recent period is clearly demand driven, not supply driven.  Prices spiked when demand spiked.  Prices plummeted when demand cratered.  

And there have been supply shocks.  Nigeria is an ongoing source of supply shocks, and during the price spike last summer losses of sweet Nigerian crudes in the face of very high demand for distillates (driven in part by European regulations regarding clean diesel) led to big spreads between benchmark sweet crudes like WTI and Brent and sourer crudes.  What’s more, OPEC output cuts (especially by Saudi Arabia) played a key role in the firming of prices following the price collapse in October-January.

I should also note that recent research by Lutz Kilian (nicely summarized in his JEL piece) shows that movements in oil prices hew more closely to movements in proxies for demand than measures of supply.  James Hamilton disputes Kilian’s contention that supply shocks are unimportant, but Kilian does demonstrate that demand is clearly an important price driver.  (I also have some reservations about some of Kilian’s analysis, most importantly his conclusion that changes in demand for precautionary inventories is also an important driver of prices.  I don’t disagree with the logic, having written several posts and an academic paper–which will also be another chapter in the book–showing rigorously how that can work in practice.  My problem is that Kilian does not measure factors that could affect precautionary inventories directly, but instead attributes oil price movements not explained by supply or demand measures to an “oil market specific” factor which he asserts is related to the precautionary inventory effect.  I am currently working on developing some more direct measures that would influence precautionary inventory holdings.  I have a good handle on measuring demand side risks that could influence such holdings, but measuring supply side risks is far more difficult.)

In recent months, the oil market and world equity markets have exhibited unprecedented positive correlation (something I called attention to in October-November).  Oil and equities swooned together; they rallied together March-June; and have been selling off together in the last couple of weeks.  This reflects the dominant role of demand in commodity prices at present.  Both equities and commodities are responding to rapidly evolving views in a highly uncertain situation about the likelihood and strength of economic recovery.  They are also responding to government policies, notably aggressive quantitative easing strategies that raise the specter of inflation.  

Now, you could argue that this is speculative.  And indeed it is.  Both equity market and commodity market participants are speculating on the future course of the world economy.  But is it destablizing speculation?  

What’s more, to the extent that energy prices (and commodity prices) are reflecting information/perceptions/sentiment about the future course of economic recovery, and are reflecting the same information/perceptions/sentiment as equity markets and bond markets, why would anyone think that position limits on commodity derivatives would break this linkage?  Once embedded in equity prices, information/perceptions/sentiment about future economic growth become public information that will be embedded in prices even if speculators are forced to trade less.  

The arguments against position limits as a policy are well known.  Speculators absorb risk from hedgers, and supply liquidity.  They therefore impair ability of the markets to serve their essential risk shifting function.  They therefore increase the costs of managing risk, and impose harm on hedgers.

This makes a mockery of the distinction that politicians and regulators draw between the “good hedgers” with price exposures inherent in their businesses that need to be managed, and “bad speculators” who have no underlying exposure to manage, but are taking on risk like gamblers in a casino.  But there is a symbiotic relationship between hedging and speculation.  To whom do hedgers transfer the risk if not to speculators?  And if there are no speculators, how is it possible to hedge risks?; after all, hedging doesn’t make risk magically disappear, it just transfers it to somebody willing to hold it–a speculator.  Thus, politicians and regulators who invariably say that they just want to protect “legitimate” commercial participants from the predations of evil speculators are more full of it than usual.

That said, there is an apparent puzzle: many of the most ardent critics of speculation are physical market participants.  But it’s not necessarily a puzzle, for the same reason that nobody should be amazed that Walmart supports Obama’s health care plan: many firms benefit from regulations that make markets less efficient.

In the commodities case, here are a couple of examples.

It is well known that some commercial market participants are informed traders who make money on the basis of their information.  A Cargill, for instance, has an extensive information network that allows it to trade profitably.  (I sat at the trading desk of Continental Grain some years back, and observed that the traders had access to information around the world about weather conditions and grain flows due to their physical presence in numerous markets.  This gave them an information edge.)  Such firms don’t hedge mechanically.  They trade futures and other derivatives strategically to optimize a risk-return trade-off.  Their information advantage allows them to time the placement and unwinding of their hedges so as to make money.  

Competition from informed speculators tends to erode the competitive/information advantage that informed commercial firms have.  Hamstringing such competition could provide a greater benefit to such firms than would result from the loss of liquidity from speculators.  

As another example, a reduction in market liquidity resulting from speculative position limits almost certainly has disparate impacts on commercial firms.  Some firms, due to capital structure, operational leverage, real options, or other reasons, get more benefit out of hedging than other firms in the same industry.  A regulation that reduces market liquidity raises everybody’s costs, but the first type of firm’s costs go up more than the second type of firm’s.  Thus, the second type of firm may actually support regulations that make hedging costlier or less effective because it raises their rivals costs more than its own costs go up.  

So, the support of some commercial firms for restrictions on speculation is not necessarily a puzzle.  In my view, it more likely reflects an opportunistic use of the regulatory process to distort competition in a way that profits some firms.  This is a ubiquitous phenomenon, observed in many industries and many regulations: why should derivatives trading be any different?  

Well, that’s all I have to say for now, though I doubt this will be last word on the subject, hardy perennial that it is.  Like Sisyphus, I am resigned to the unending task of rolling the rock of enlightened reason up the slope of benighted ignorance, only to see it slip back down again:)

The European Commission has just released a Commission Staff Working Paper  on “Ensuring efficient, safe, and sound derivatives markets.”  Not surprisingly, it comes out in favor of extending central clearing, especially to credit default swaps.  It must be said that the EC’s paper is far superior to the product of the US Treasury Department (a low bar, to be sure).  That said, I believe that many of the arguments and conclusions are fundamentally wrong.  The paper does the best job I have seen in making the case for extending clearing, but in so doing has unintentionally pointed out the flaws in that case.  Indeed, the basis for many of the paper’s conclusions actually supports the exact opposite of what the paper recommends.

At a high level, the failings of the paper are: (1) it identifies alleged benefits of central clearing, virtually all of which are private benefits, but completely begs the question “if these (private) benefits are as large as the EC says, why haven’t private parties adopted central counterparties (CCPs) more widely?”; (2) relatedly, it does not provide any explanation of why the market share of products purportedly traded on inefficient market structures has increased in recent years; (3) it fails to take into account the endogeneity of market structure, or explain how these structures arose and why–or why not–they are inefficient; and (4) although it clearly identifies the unique risks associated with CDS, it draws the exact wrong conclusion about how default risks from CDS should be borne–bilaterally or through a CCP.

The paper’s main case for CCP clearing (set out in section 2.4.2 and 2.4.2.2) focuses on netting, and the benefits associated therewith including “more efficient use of collateral” and “operational efficiencies.”  But these are benefits captured by the members of a CCP, and provide no rationale for mandating the adoption of clearing.  There’s no externality related to these issues that needs internalizing.  Relatedly, the paper asserts that a CCP is “considered a zero risk counterparty” and hence frees regulatory capital.  Really?  Clearinghouses can fail.  Cf. Hong Kong, 1987, and the near failures in Chicago at the same time, and the near failure on COMEX on “Silver Tuesday” 1981.  If regulators really treat it this way, a CCP would be a source of regulatory arbitrage, again meaning that market participants would have a strong–too strong, in fact–incentive to adopt it.  

With respect to risk sharing and collateral, the paper mistakenly claims that all collateral can be used to cover the costs of a default.  This is obviously wrong–as the box on SwapClear default management process in section 3.2.5.1 shows.  

The paper fails to mention that netting is not necessarily a social benefit, and can facilitate redistribution from one group of firms to another.  This redistribution can also give excessive incentive to form a clearinghouse.  

The paper also fails to recognize that more rigid collateral mechanisms can reduce the utility of a market as a hedging mechanism, and forcing adoption of these mechanisms can actually increase risks some firms face by precluding otherwise mutually beneficial hedging trades.

The paper touts that a CCP “an institution whose sole focus is risk  reduction.” But the world involves trade-offs, and an organization with a “sole focus” is not able to make such trade-offs. If the CCP prices risk appropriately, and therefore charges the right amount of collateral, then other market participants will make the appropriate decisions. But as I’ve argued extensively here, in my Regulation Magazine piece, and in working papers and presentations, for many transactions the clearinghouse is at an informational disadvantage relative to dealers in appraising risk–in which case it is less likely to price risk appropriately.

Moreover, the paper does not consider the incentives that the CCP faces. Yes, it has one job, but how strong are its incentives to do that job? A CCP is typically subject to low-powered incentives (e.g., non-profit form), which is understandable since it is an agent, and an agent of multiple principals; whereas a dealer bears many of the costs of poor counterparty risk management, as an agent the CCP does not. Moreover, although the CCP is touted as a solution to systemic risk, if systemic risk gives rise to externalities that affect those beyond its membership, this benefit is overstated: the CCP does not internalize all relevant externalities and therefore takes too few measures to address systemic risk.

The clear logical implication of the EC paper is: “If clearing is so great, somebody should have done it by now.”  Like virtually all advocates of the idea, the EC paper does not raise, let alone answer, that objection.  To do so, the EC must identify the market failure, and show how its proposed solution would ameliorate it. It has not done so.  It has not even recognized the necessity of doing so.  

The paper also asserts that clearing can “solve[] disruptive information problems” by improving information on positions.  But this can be achieved without the mutualization of risk that clearing entails.  

The paper sets out in great detail the dramatic growth in OTC trading, and the limited penetration of clearing, even in relatively standardized sectors.  Again, given the asserted benefits of clearing and other changes to OTC market structure, this calls for an explanation that is completely absent from the paper.  There must be something else going on here sufficient to overcome the supposed advantages of a CCP.

The paper does provide a very nice description of the variations in structure across different OTC products.  Note that these structures arise endogenously.  This raises the questions: (1) why do different products (e.g., interest rate swaps and CDS) have different structures? and (2) are these structures inefficient?  The endogenous variation suggests that there are fundamental differences across products and participants, and that different structures have evolved to accommodate these differences.  The paper sets out no serious argument or evidence that these variations are accidental, or inefficient.  As a result, it provides no basis for recommendations on how to change market structure via regulation.  

This failure to grapple with endogeneity–the causes of variations in market structure across products–leads to silly inferences, such as: “CCPs have proven to be resilient even under stressed market conditions . . . and showed their ability to ensure normal market function in the case of failure of a major market player” (2.4.2.1).  Yes . . . but this does not imply that similar results would obtain if all products were cleared.  The products that are cleared, and which worked successfully, have attributes that differ from the attributes of products that are not cleared–a point that the paper makes very forcefully.  Therefore one cannot conclude that requiring clearing of other products would work as well.  It could also be stated that other non-cleared products, e.g., CDS, also worked successfully in the face of the failure of a major dealer.

This issue of the differences across products is essential, and one that the paper raises repeatedly before drawing the wrong conclusion.  For instance, in the Executive Summary, and elsewhere, the paper says that CDS are different because of their “binary and discontinuous pay-out structure, concentrated dealer market structure, difficulty in valuing the rights and obligations contained in the contract, especially for the less liquid single name part of the market, lack of solid risk management measures and disproportionate dimension of the derivatives market with respect to the underlying market.”  I agree, completely.  

But I disagree with the conclusion drawn from these differences: “CDS have particular risks . . . all of which are difficult to mitigate . . . . For all these reasons, CCP clearing is desirable.”  But all of these features pose major informational challenges to clearing, and in my view, make it sensible to share risks bilaterally; the conclusion therefore does not follow from the stated premise.   Similarly, the paper points out the valuation difficulties involved in setting collateral from some products, due to the difficulties of valuation.  Again, agreed.  But the relevant question is who can do this better, bilateral parties or a CCP.  For some products, a CCP can do just fine, but for other products, it is quite likely that dealers can do a better job.  

These very considerations are why many operators of clearinghouses–who at first blush would seem to have an interest in a clearing mandate–have come out almost universally against such a requirement.  Note, this is not allegedly self-interested dealers talking: it is the clearing operators.  They recognize the unique risks of clearing some products, notably CDS, and believe that these risks make some products inappropriate for clearing.  That’s been the gravamen of my argument all along, but the paper completely overlooks this point–even though the clearing operators expressed their reservations very publicly weeks before the paper was released.  

Relatedly, in section 2.4.1.4 the paper identifies as a “Potential weakness of bilateral clearing” to be the fact that it relies on “each party’s internal ‘risk engine’ . . . . These risk engines are essential parts of a bank’s comparative advantage and while the broad contours may be similar each bank has a slightly different approach to risk assessment.  Overall, the crisis has highlighted the difficulty of designing models that adequately measure market risk.”  True, again.  But the relevant–unasked–question is: in this imperfect world, who can design the better model?  (Not perfect, but better.)  Due to the very “comparative advantage” aspect the paper identifies, dealers and other big traders have stronger incentives and better information to build better models than a CCP.  (A point I first made back in the 1990s.)  Moreover, an argument can be made that diversification in models is beneficial as a way of reducing the market’s exposure to model risk, whereas a clearinghouse chooses one model, and exposes the market in a big way to its (inevitable) limitations.  

In sum, in my view the paper presents a very thorough and accurate overview of the various OTC markets and products, and the unique characteristics of these products.  It then either ignores the implications of these differences altogether when making its recommendations, or makes recommendations that do not follow from its factual analysis.  Indeed, its recommendations are often the opposite of what a thorough consideration of the implications of these differences would imply.  

That is, the paper is very effective at pointing out the wide variation in the informational and risk characteristics of the various products traded in the OTC market.  It also effectively characterizes the wide variation in trading structures.  But it fails altogether at connecting these two inherently interconnected things.  Moreover, it focuses on the private benefits of its favored “solution” (clearing), even though this cannot be the appropriate basis for its policy recommendation.  There must be some sort of externality or other market failure that results in the adoption of inefficient institutional arrangements, but the paper fails altogether to identify what this externality or other market failure.

In brief, whereas the Treasury Department earns an F+ (and I am a generous grader), the EC merits a gentleman’s C.  It at least provides a factual basis for a considered analysis of the trade-offs entailed with different market structures.  I disagree with the conclusions it draws from its facts, but it’s a start, and a big improvement over Treasury’s arguendo ad AIG.

In potentially ominous news, Gazprom has entered an agreement with Azeri national energy company SOCAR to purchase Azeri gas at a price of $350/thousand cubic meters.  Initial volumes of 500 mcm for 2010 are modest, but Gazprom is allegedly to be a preferential buyer (whatever that means) for gas from the second stage of the immense Shan Deniz field.  

The price in the deal is very interesting, given that Gazprom is balking at paying the same price from Turkmenistan (admittedly the Azeri gas is closer to market, and should receive something of a premium).  Indeed, recent reports tend to confirm my initial conclusion that the gas pipeline “explosion” in Turkemenistan was just a consequence of the Russian reneging on its contract to buy gas at $345 from the Turkmen, a price that seemed like a good deal at the time, but which looks very rich given the current market:  

Gazprom wants Ashgabat to reduce either the price or the volume of Turkmen gas delivered to Russia; or some combination of the two reductions. In either case, Turkmenistan’s national income (based almost entirely on gas exports) would be severely hit.

Russia’s prolonged stoppage puts Ashgabat under growing pressure to re-negotiate the existing agreements. High-level Russian delegations have been descending on Ashgabat almost on a weekly basis recently. During June, for example, Russian First Deputy Prime Minister and concurrently Gazprom Chairman Viktor Zubkov, Gazprom CEO Aleksei Miller, and the company’s vice-president and Gazexport Director-General Aleksandr Medvedev, held talks one after the other in Ashgabat with President Gurbanguly Berdimuhamedov and other Turkmen officials (Interfax, June 3, 14, 19, 21, 24).

Moscow apparently feels that it has the upper hand and can continue the import stoppage as long as necessary. On the occasion of Gazprom shareholders’ annual meeting, just held in Moscow, Medvedev simply recommended to “wait and see how the talks proceed” with Turkmenistan. More to the point, Miller indicated to the press that Ashgabat has no alternative option for export or swap operations until the Turkmenistan-China pipeline comes on stream (Interfax, June 26).

Ashgabat is intensifying its contacts with the European Union, European companies, and the United States in search of export diversification options for the future. Meanwhile, China provides the first alternative option at hand.

It must be particularly irksome to Turkmenistan that at the same time Gazprom is stiffing it by saying that $345 is too high a price, and that it doesn’t need all the gas it contracted for, it is running off to Azerbaijan to enter into a deal to buy additional volumes at $350.  Square that circle, dudes.  

Presumably the wily Azeri president  Ilham Aliyev is well aware of Gazprom’s practices, and is watching Gazprom’s heavy-handedness with Turkmenistan carefully.  So why would he deal with this devil?  Perhaps this is wishful thinking on my part, but what would make sense is that Aliyev is losing patience with European dithering over Nabucco.  By showing a willingness to deal with Gazprom, he is sending a shot across the bow of the EUnuchs, letting them know with actions rather than words that they need to move sooner rather than later or Nabucco is going to turn into a, well, pipe dream.  

Will the Europeans get it through their thick skulls?  I highly doubt it.  They are so divided–with Russia and Gazprom merrily promoting and exploiting those divisions–that they will be mightily pressed to get their act together soon.  If they don’t Azerbaijan may figure that it has no real alternative but Gazprom.  And what a pity that would be.  

In other gas news, as I wrote in a sarcastic piece earlier, Gazprom and Nigeria have entered a joint venture. Responding to the inflammatory choice of a name for the venture, one Nigerian said:  “White people are making too much of this. As long as the Russians pay us, they can call it what they like.”  

But that’s the rub.  “As long as the Russians pay us.”  That’s a big if, especially considering Gazprom’s cash flow problems (requiring an 85 percent dividend cut and a 50 percent cut in capex), and its hugely expensive commitments on core strategic projects North Stream and South Stream, plus its need to develop new reserves in Russia to replace its declining fields.  Where’s the money going to come from?  

Now, it seems nigh on to impossible that Gazprom can finance its commitment in the Nigaz venture along with all its other needs in these straitened times.  So “pay us” is unlikely to mean “pay us over the table to invest in the joint venture.”  But, given that it is Russia and Nigeria that we are talking about here, “pay us” could mean payments under the table–payments European and American companies would have a difficult time matching (and would certainly incur more risk to match).  These payments would be intended to keep the Nigerian gas from going to Europe.  Under the table payoffs to stymie development of gas could be much more profitable to the powers that be in Nigeria than legitimate investments to spur their development.  

Regardless of whether one takes the JV at face value–a sincere Russian effort to develop additional gas supplies–or treats it more cynically–as just another in a long line of Gazprom efforts to keep potentially competitive sources of gas offline–it should be another red flag to the Europeans.  Yet another warning that Russia is aggressively pursuing a strategy to restrict the competition it faces in the European market.  (Which is why nobody in their right mind should expect Russian help in Iran–the possessor of the 2d largest gas reserves in the world, now largely unavailable due to Iran’s oh-so-convenient pariah status.)  

Do the Europeans get it?  Do they understand the significance of the Azeri-Russian deal?  I wish I could say yes.  But although Europe yammers on about diversifying its gas sources, its actions belie its words.  Pretty soon, it won’t have any actions available to it, except to go hat in hand to Moscow.  They will have no one to blame but themselves.

About That Indigenous Financial Market Thing.  It ain’t doing so well.

Fitch and Alfa Bank have issued very harrowing accounts of the financial straits of Russian banks, and the burdens this will place on the government’s finances:

Russian banks need $20 billion to $80 billion in extra capital this year, a senior executive at ratings agency Fitch said, although the head of Russia’s top private bank said the need could be as high as $130 billion.

The forecasts follow a recent assessments by ratings agency Moody’s, which put the need at around $40 billion, and the central bank, which said the need for extra capital would not exceed 500 billion roubles ($16.07 billion) this year.

“We expect loans quality deterioration to be serious enough. We think the banks will need additional capital one way or another on a one-year horizon,” Alexander Danilov, senior director at Fitch’s Russian office, told a conference on Tuesday.

Danilov said the agency’s own stress test had shown that, in an optimistic scenario, non-performing loans (NPL) would reach 15 percent of banks’ loan portfolio by year-end. In the base scenario it would rise to 25 percent, and in a pessimistic scenario 40 percent.

Speaking at a separate conference, Pyotr Aven, president of Alfa Bank, Russia’s largest private bank, said the government must boost its bank recapitalisation plans 10-fold to 10 percent of gross domestic product as defaults may hit $130 billion in the next 12 months.

Aven, known for his bearish views of the impact of the crisis on the banking sector, told a conference the government’s current measures to support the banking sector were not enough.

“The banking sector needs up to 10 percent of GDP, otherwise we won’t restart,” Aven told a conference.

“We are now going down the Japanese path when problems are simply masked… We need to begin from scratch… We are not talking about liquidity, we are talking about capital, about long-term money,” he said.

Earlier, Standard and Poor’s said problem loans could soar to 35-50 percent of total lending in Russia, Ukraine and Kazakhstan, though actual loan losses would not be more than half that level in Russia [ID:nLJ957879].

Twenty-five to forty percent to fifty percent problem loans?  That’s apocalyptic.  

But don’t worry!  Putin has it all under control.  He’s ordering banks to invest $16 billion dollars in struggling Russian companies, and telling bankers not to take any holidays until they have implemented his orders:

Russian Prime Minister  Vladimir Putin  told state-run banks to expedite loans to companies to help stem a financial crisis that will force the government to run deficits for at least three years.

Putin called on banks such as  OAO Sberbank  and VTB Group to boost lending by as much as 500 billion rubles ($16 billion) by October. The government will guarantee 300 billion rubles of the total, he said.

“The government expects that banks will consistently expand lending for the priority industries and reduce borrowing costs,” Putin said today on state television.

What idiocy.  Politicized lending will only weaken further the already shaky banks, as some recognize:

Russia’s plan to use state guarantees to boost lending may exacerbate liquidity risks as state banks expand their portfolios through business loans to unsustainable projects,  Trust Investment Bank  said.

Lenders may require additional support from Russia’s  central bank  after Prime Minister  Vladimir Putin  yesterday instructed banks such as  OAO Sberbank  and VTB Group to boost lending by as much as 500 billion rubles ($16 billion) in the next three months, Moscow-based Trust said in a report today.

The program, which allocates 300 billion rubles in state guarantees on corporate loans, also runs the risk of “dragging out the lives of ineffective companies,” according to the report.

“Banks should be extremely cautious in extending credit, providing it only to those enterprises which have significant potential for development and improving their effectiveness in the future,” Trust said in the report.

And regardless, this Hail Mary is unlikely to make a material difference in an cratering economy.  Russia’s own Economic Development Ministry just posted the low bid in the Dutch auction of forecasts of Russian economic performance in 2009, undercutting the World Bank’s 7.9 percent decline projection:

The Economic Development Ministry has revised its forecast for gross domestic product growth, predicting that the economy will shrink 8.5 percent this year, compared with 6 percent to 8 percent as forecast before, Prime-Tass cited a source in the ministry as saying.

Last week, the World Bank put the contraction at 7.9 percent, compared with 4.5 percent that it forecast earlier, while the Organization for Economic Cooperation and Development estimated a 6.8 percent drop, which is greater than the 5.6 percent it estimated earlier.

The ministry was more optimistic in its inflation forecast. It downgraded the inflation estimate for the year to 12 percent to 12.5 percent, down from 13 percent.

It will be interesting to see how well and how long all the machismo Putin theatrics involving everything from pork chop prices to wage arrears in monotowns to banks will wear in the face of these grim realities.  All of these little plays are intended to demonstrate his control and power.  If, as is likely, the economy continues to implode, they will only demonstrate his impotence.  

A couple of interesting stories about investment and Russia: one about investment in Russia, the other about Russia as an investor.

The investment in Russia story involves Putin’s invitation to Shell to participate in the Sakhalin III and IV projects.  Shell, if you recall, was browbeaten into giving up a stake in the Sakhalin II project at a bargain basement price to Gazprom.  The new offer (along with deals with German Eon and French Total) is widely considered a symptom of Russian desperation for cash as a result of the financial crisis, and its technological backwardness, combined with the desperation of the supermajors to replenish reserves.  

To me, reserves or no, it is the height of folly for Shell to rush back in.  Russia has proven time and again that it has myriad ways to separate oil majors foreign and domestic from their oil investments.  Environmental regulations, taxes, labor law, you name it.  Although some have suggested that Shell will only invest if it receives “international bank guarantees”  I don’t find this credible.  What bank would take this risk?  How could you write a contract that would specify the relevant contingencies, given the imagination of the Russians in finding ways of exerting pressure to extort wealth?

Russia may be desperate.  Today.  They were desperate in the late-90s when they entered the PSAs with Exxon and Shell and others.  They took the terms offered, then undid some of the deals when prices turned around and they felt that they didn’t need the supermajors’ money.  

Indeed, Russia used the fact that it agreed to the PSAs due to its economic exigencies to justify its subsequent attacks on Shell and others; it had been taken advantage of, Russia whined, and was taking back what had been taken from it due to its weakness.  

It is eminently predictable that it will do the same again when the market turns around at some future date. Indeed, if Shell and others rush back in now, it will reassure Putin and future Russian leaders that they pay no price for expropriation.  Steal from them today, and they’ll be back tomorrow.  

So, it appears that Shell is ready to play Charlie Brown yet again.  Good luck with that.

The other story relates to GM’s second thoughts about selling Opel to Magna, Sberbank, and Russian automaker GAZ.  GM is seeking other potential buyers, and demanding Sberbank pay 14 times more than it originally offered (perhaps reflecting a perception that the economy has firmed and the value of Opel is higher as a result).  

Another sticking point is concern about technology:

However, the Magna talks have run into difficulty over access to the Detroit group’s global technology, which Magna wants to secure on behalf of Russian partners. If the sale proceeds, Magna and Sberbank plan to build Opel-based cars in Russia with Gaz, billionaire Oleg Deripaska’s car company.

This is wise.  Property rights in Russia are weak, and this is especially the case with respect to intellectual property.  It will be very difficult for Opel and GM from keeping GAZ from circumventing any contractual protections on its IP.  

In short, whether you are thinking of investing in Russia, or having Russians invest in you . . . be VERY careful.

Soon after posting my piece on the Treasury White Paper where I repeated my argument about the failure of most regulators and commentors to think through the equilibrium responses that would likely occur as a result of regulatory changes, I came across this Seeking Alpha post by David Enke that makes the point nicely:

Gensler believes that “central clearing will further lower risk,” but will it? While this is probably true initially, the long-run benefits could disappear. How so? Given that dealers will need to abide by stricter capital and margin requirements, the capital requirements will no doubt continue to grow as the added liquidity risk of less actively traded contracts is accounted for. While again this seems sensible, the extra cost will force even more contracts to move on to the exchanges. This will in turn reduce the amount of OTC contracts that are likely to be offered. Once again, all good, right? Not necessarily.

One of the benefits of OTC contracts is that you can develop a specialized contract that better matches the risk you are trying to hedge. Standardized contracts do not offer the same flexibility, causing a company to enter into less than perfect hedges, thereby making the company more risky over the long-run. This has the effect of causing risk management to be more expensive and less efficient for companies, just at the time when additional risk management is being encouraged.

Once again, raising capital requirements on risky assets has some obvious benefits, but hopefully the added burden is not so much as to eliminate the efficient use of the OTC market. If this happens, regulators may find themselves dealing with yet another problem.  

Just so.  Couldn’t have said it better myself.  

The statement about “eliminat[ing] the efficient use of the OTC market” gets to the nub of the issue.  The Geithners, Genslers, and legislators looking to clamp down on the OTC market seem to believe that “efficient use of the OTC market” is an oxymoron.  I think that they are they are wrong, and in their misguided distrust of these markets, they will make things worse, not better.

The Russian banking system has been teetering since the beginning of the crisis.  The government intervened relatively effectively at the beginning of the crisis to address the severe liquidity problems in the banking system; this was one of the most salutary aspects of the government’s performance during the crisis.  But if the liquidity crisis has abated, a solvency crisis is looming due to the havoc wreaked by the near collapse of the real Russian economy, and the concomitant spike in non-performing commercial,industrial, retail, and construction loans.  The government appears to be planning to respond to this impending catastrophe by nationalizing the banks, and using funds built up during the seven fat years to recapitalize them:

Russia is looking at a bail-out of its banks that would go further than the emergency action taken by the US, amid growing fears that  bad loans  could paralyse the country’s economy.

Igor Shuvalov, deputy prime minister, will consider taking stakes in troubled banks when a group of experts on the financial crisis meets on Friday to discuss ways to recapitalise Russia’s banking system, according to a draft proposal seen by the Financial Times.

The proposal, one of several under consideration, would see the government issue OFZ treasury bills, a type of bond, to boost the balance sheets of the biggest banks. In return, the state would receive preferred shares.

Unlike the US  bank bail-out, the Russian scheme would see the government take board seats and have veto rights.

Analysts said such a plan would allow banks to declare the true level of their bad loans and, once their balance sheets were cleaned up, enable them to start lending again in 2010.

About $100bn in domestic loans fall due by the end of the year and the central bank has said bank profits would be wiped out if non-performing loans reached 10-12 per cent of the total.

With high interest rates and a dearth of new credit, bankers say they fear non-performing loans could hit as much as 20 per cent of overall credit portfolios by the end of the year.

Ratings agencies Standard & Poor’s and Moody’s have warned that Russia could need to spend $40bn recapitalising the banking system.

The recapitalisation funds would be limited to the top 55 banks in Russia’s 1,100-strong banking system, analysts said. The draft bill says only banks with a minimum of Rbs50bn ($1.6bn) in assets would be eligible.

. . . .

If the government continues to delay, “this means that many banks will just stop operations. They will continue to exist but they won’t be able to provide new loans,” Ms Orlova said.

The government fears it could spend its entire Rbs4,000bn reserve fund and more, once it begins to recapitalise the private banking sector, she added.

The demands on Russia’s “rainy day” funds escalate by the minute.  It is almost certain that they are insufficient to fill all the holes in the Russian dike: financial aid to regional governments to pay workers at idled factories; social expenditures; bank bailouts.  

Steel and coal company Mechel’s SEC filing provides a chilling, and relatively objective, take on the kinds of problems that afflict Russian companies–and hence the banks who have lent to them:

Going Concern

 

Russian business environment

 

The Russian economy is vulnerable to market downturns and economic slowdowns elsewhere in the world. The ongoing global financial crisis has resulted in capital markets instability, significant deterioration of liquidity in the banking sector, and tighter credit conditions within Russia. While the Russian government has introduced a range of stabilization measures aimed at providing liquidity and supporting debt refinancing for Russian banks and companies, there continues to be uncertainty regarding the access to capital and cost of capital for the group and its counterparties, which could affect our group’s financial position, results of operations and business prospects. These considerations similarly apply to other jurisdictions where our group operates.

 

Our group’s activities in all our operating segments have been adversely affected by the uncertainty and instability in international financial, currency and commodity markets resulting from the global financial crisis. The recession is affecting most economic regions, forcing us to reduce production, cut costs, manage increased risk factors and strengthen our competitiveness, including curtailing production, halting non-critical capital expenditures, accelerating new strategies for raw materials, initiating headcount reductions, suspending major investment programs, and making other liquidity enhancements.

 

We believe we are taking appropriate measures to support the sustainability of our business in the current circumstances. We believes our operational cash flow in 2009 will be sufficient to fund proprietary capital expenditure projects and permit us to operate the business in a profitable fashion during 2009. However, further market deterioration could negatively affect our consolidated results, financial position and cash flow in a manner not currently determinable.

 

Going concern

 

The current economic environment is challenging and we believe that the outlook for the next several years presents significant challenges in terms of sales volume and pricing as well as input costs. Specifically, the current economic conditions create uncertainty about (1)  the level of demand for our products; (2)  the pricing of major commodities mined or manufactured by us; (3)  the exchange rate between the Russian ruble and U.S.  dollar and its impact on the cost of our inventories; and (4)  the availability of bank financing in the foreseeable future.

 

We believe we have taken measures to deal with the uncertainties in our operating environment and that our operating cash flows in 2009 will be sufficient to allow us continue to operate in the normal course of business including routine working capital and priority capital projects, assuming the successful restructuring of our debt as described below.

 

As of December  31, 2008, we breached a number of financial and non-financial covenants (as discussed in “—  Liquidity and Capital Resources  â€” Covenant breaches” below)  and as a result, the lenders can request accelerated repayment of a substantial portion of our long-term debt. As of December  31, 2008, we had $5.149  million of loans repayable during 2009, including $1.564  million of long-term debt that was classified as short-term liabilities as of that date because of the covenant violations. We do not have the resources to enable us to repay the total of these loans if repayment were called.

 

Our group has commenced discussions with our bankers about additional facilities to be provided on a  long-term  basis. Our group is also seeking to refinance  and/or  restructure the terms and conditions of our existing debt to extend  maturities beyond 2009 and provide greater working capital flexibility. Our group is currently in negotiations with the consortium of banks, but it is likely that the terms and agreement on the conditions of these borrowing arrangements will not be completed until the second half of 2009. Based on negotiations conducted to-date, we believe that we will successfully refinance or restructure the terms and conditions of (1)  $1,000.0  million out of the $1,500.0  million “Oriel” credit facility and (2)  its $1,781.0  million “Yakutugol” syndicated loan. To repay the remaining $500.0  million of the “Oriel” credit facility, we plan to use half of the credit line obtained from Gazprombank referred to below.

 

We have succeeded in obtaining additional financing by reaching the following credit line agreements:

 

	•	Gazprombank  â€” $1,000.0  million U.S.  dollar-denominated credit facility repayable in quarterly installments in  2010-2012  for a partial repayment of its “Oriel” and “Yakutugol” credit facilities. As a security for these credit facilities the group pledged 35% of the shares in Yakutugol and Southern Kuzbass Coal Company;
	•	VTB  â€” 15  billion rubles ($510.1  million) credit facility expiring in November 2009 under the guarantees issued by Mechel and pledges of Southern Kuzbass Coal Company and Chelyabinsk Metallurgical Plant production assets;
	•	Sberbank  â€” 3.3  billion rubles ($112.3  million) credit facility due in 2010.

 

We are also pursuing alternative sources of funding in the event the above mentioned negotiations do not result in adequate funding. Specifically, in February 2009, our group registered one-year ruble-denominated bonds in an aggregate principal amount of 30  billion rubles ($824.6  million) with the Moscow Interbank Currency Exchange (MICEX). Subsequently, in May 2009, the group registered another ruble-denominated bond issue of 45  billion rubles ($1,406.9  million) with the FFMS. Issuance of these bonds would be subject to market conditions at the time, and while we have not formally decided to proceed with the issuance of these bonds, if issued, these bonds would provide us with additional financing flexibility.

 

Furthermore, our group has been included in the Russian Government’s list of strategic businesses that are eligible for state financial support in the current economic environment. Subsequently, in January 2009 our group received an approval from the state-owned Vneshekonombank (“VEB”) for a one-year $1,500.0  million facility to refinance the “Oriel” credit facility, which to-date we have elected not to use. There is no assurance, however, as to how much further state financial support, if any, may be received by us.

 

We have concluded that the uncertainty about our refinancing and restructuring of our outstanding debt described above represents a material uncertainty that casts significant doubt upon our ability to continue as a going concern. However, based on our plans as noted herein, we believe that we have, or will secure, adequate capital resources and liquidity to continue in operational existence for the foreseeable future and have presented our consolidated financial statements on a going concern basis of accounting.

Need I say more?  

I’ll let the World Bank take it from here:

The Russian economy will shrink by 7.9 percent in 2009 despite a recent rise in commodity prices, the World Bank said on Wednesday, a much sharper contraction than the 4.5 percent it forecast earlier.

Russia’s economy contracted by 10.2 percent in January-May 2009, according to Economy Ministry estimates, and First Deputy Prime Minister Igor Shuvalov told Reuters on Tuesday the annual contraction may reach 9 percent. [ID:LN305314]

“Given a much larger gross domestic product contraction in the first quarter of 2009 than anticipated, Russia’s economy is likely to contract by 7.9 percent in 2009, despite higher oil prices assumed in the current forecast,” the World Bank said in its quarterly country report.

Russia, the world’s largest energy producer, has been hit hard by the plunge in global demand for commodities, while its banks and many businesses that had borrowed heavily abroad have been squeezed by the global credit crunch.

The World Bank’s lead economist for Russia Zeljko Bogetic told a news conference there was a “natural lag” before the recent upturn in commodity prices would have an impact on Russian growth, “provided that it holds, of course, which is not entirely clear.”

The World Bank forecast Russia’s jobless rate to rise to 13 percent by the end of this year, from its 9.9 percent May level, and said single factory towns will be the hardest hit by rising unemployment and wage arrears.

“Some stabilisation (in the jobless rate) is related to seasonal factors and job shedding is not over,” Bogetic said.

The World Bank projected Russia would return to moderate growth of 2.5 percent in 2010 and 3.5 percent in both 2011 and 2012 in a “gradual and prolonged” recovery.

“The speed of the subsequent recovery in Russia will to a great extent depend on the revival of global demand and the global financial system,” the report said, adding that Russia will reach pre-crisis growth rates only at the end of the third quarter of 2012.

 

FISCAL DEFICIT High oil prices may keep Russia’s fiscal deficit lower than initially forecast but the report noted spending risks linked to recapitalising the banking sector and extra social costs.

The report saw the fiscal deficit at 7.2 percent this year, and at 6.0 percent in 2010. The World Bank based its forecasts on average Russian Urals crude prices URL-E URL-NWE-E of between $56 per barrel this year and $63 per barrel in 2010.

Bogetic said Russia needed to reduce the amount of aid going to people who do not really need it, and boost the budget’s revenue base through raising liquor and tobacco excise duties.

The World Bank said a delay in Russia’s accession to the World Trade Organisation caused by a decision to form a customs union with Belarus and Kazakhstan could undermine benefits from a rules based trading regime.

The report said lower inflation has created room for more official interest rate cuts, which should help investment in the second half of 2009. But it also warned that overvaluation of the rouble could hurt the recovery.

It expects inflation to reach 11-13 percent this year. The nation’s current account surplus is forecast at $32 billion in 2009 and $36 billion in 2010.

The World Bank said capital outflows will total $60 billion this year and decline to $30 billion in 2010.

Non-performing loans could reach 10 percent of the total in banks’ portfolios, the report said, adding that consolidation in the sector should be accelerated.

The nationalization of Russian banks, will hardly facilitate the development of a robust financial system.  It will more likely result in an inefficient, politicized system that directs resources to the politically favored, rather than the economically viable.  This was the gravamen of my criticism of nationalization proposals in the US, and goes in spades in natural state Russia.  With sharply diminished ability to tap international capital markets, and a nationalized domestic banking system, Russia will have difficult times indeed financing a transition to a modern progressive economy.  

I was quoted in this week’s Economist in an article raising doubts about whether OTC clearing is all that it is cracked up to be.  It is good to see good reporters at reputable publications chipping away at the happy talk conventional wisdom surrounding clearing.  The last sentence in the piece is especially important, and poses a question I’ve often asked here at SWP: “If the benefits of CCPs in OTC markets are so overwhelming, why did they not emerge on their own?”  Kudos to Adam Creighton and the Economist.

Finally had a chance to look over the much anticipated Treasury White Paper on “reforming” financial regulation.   It’s a long document, addressing many issues with which I am not that conversant, so I will focus my attention on the Paper’s recommendations for OTC derivatives.

The Paper begins its analysis with an extended discussion of what it asserts was a “lax regulatory regime for OTC derivatives–and, in particular, for credit default swaps” (p. 44):

In the years prior to the crisis, many institutions and investors had substantial positions in CDS–particlarly CDS that were tied to asset backed securites (ABS), complex instruments whose risk characteristics proved to be poorly understood even by the most sophisticated market participants.   At the same time, excessive risk taking by AIG and certain monoline insurance companies that provided protection against the decelines in the value of such ABS, as well as poor counterparty risk management by many banks, saddled our financial system with an enormous–and largely unrecognized–level of risk.   When the value of the ABS fell, the danger became clear. . . . Lacking authority to regulate the OTC derivatives amrket, regulators were unable to identify or mitigate the enormous systemic threat that had developed (pp. 44-45).

Based on this rather tendentious reading of the history of highly non-standardized, illiquid instruments, and on this reading alone, the Treasury makes the following policy recommendation:

To contain systemic risks, the Commodity Exchange Act (CEA) and the securities laws should be amended to require clearing of all standardized OTC derivatives through regulated central counterparties (CCPs).

This has to be one of the most collossal non-sequiturs on record.   Highly non-standardized financial derivatives allegedly led to a systemic crisis–so we should mandate clearing for standardized products.   As an exercise in logic, by comparison to this the “Burn the Witch” scene in Monty Python in the Holy Grail is a model of precise reasoning.

Thus, as has been true all along, the case for clearing of standardized OTC derivatives levitates, with no evident means of logical or empirical support.   This could be a great Vegas magic act.

In retailing, this is known as the “bait-and-switch.”   Regulators often punish stores that engange in such conduct.   Here, we’re out of luck–because the regulators are the ones perpetrating the bait-and-switch.

A coherent case for mandating clearing would require a demonstration that OTC derivatives suitable for clearing pose a systemic threat, at least illustrated by anecdotes analogous to the now tired arguendo ad AIG.   (The absence of any such anecdotes is very, very telling–not to mention that argument-by-anecdote is a very de minimus standard because “data” is not the plural of “anecdote.”)   What’s more, the argument would require a rigorous comparative analysis of the systemic risks posed by alternative mechanisms–bilateral and centrally cleared.   Instead, we are repeatedly entertained by next part of the magic act: assertions that clearing makes these risks disappear!

Even the arguendo ad AIG has its defects.   To wit:

• If “the most sophisticated market participants” failed to recognize the risk characteristics of the CDS on ABS, how possibly could one expect a CCP to do any better?   Yet another magic trick: the CCP as deus ex machina, that magically appears to solve all of the difficulties that had stumped the most sophisticated.   Indeed, if anything, the CCP is likely to be a less sophisticated evaluator of risks.   So wouldn’t forcing things onto clearinghouses potentially make things worse?
• “Excessive risk taking by AIG and the monolines . . . saddled our financial system with an enormous . . . level of risk.”   This betrays a serious misunderstanding of the role of derivatives.   As I argued in It’s a Wonderful Life, AIG Edition, AIG et al took on existing risks associated with existing ABS.   If AIG et al hadn’t taken on the risk, it would have remained somewhere else in the financial system.   And it’s almost certain that it would have remained with Goldman, SocGen, DB, etc.   So, if the decline in ABS prices was so big to threaten the existence of those firms unless AIG paid off on its CDS, their existence would have been even more threatned without AIG’s equity absorbing a portion of the loss.   The bailout would have been bigger, not smaller.   The only substantive difference is that it would have gone to these firms directly, rather than being laundered through AIG.
• More generally, this points to a continuing defect with the Treasury analysis, and most other analyses of regulatory changes: the equilibrium responses to these changes.   It is clear that Treasury, and Washignton generally, now views OTC derivatives as the financial equivalent of Satan, and wants to crack down on them.   Let’s say this happens, and OTC derivatives shrink, or even disappear.   How will market participants respond?   Will there be less hedging because an instrument that revealed preference suggests is superior to available alternatives is constrained?   If so, will the system become more susceptible to disruption, not less?   By focusing on the seen, and failing to inquire at all about the endogenous, equilibrium effects of changes in regulation that are largely unseen, regulators are likely to make things worse, not better.
• As I’ve noted before, “standardization” is a red herring in many respects.   Standardized instruments may be unsuitable for clearing due to serious information problems.

Other policy recommendations also float in the air, untethered by logic or evidence.   For instance, the White Paper asserts in a decidedly conclusory way that “[m]arket efficiency and price transparency should be improved in derivatives markets by requiring the clearing of standardized products . . . and by moving the standardized part of these markets onto regulated exchanges and regulated transparent electronic execution systems . . . . Furthermore, regulated financial institutions should be encouraged to make greater use of regulated exchange traded derivatives.”

Note the implicit assumption that incumbent arrangements are inefficient, and result in an inefficient level of price transparency.   Why should inefficient market arrangements persist?   Surely, they can.   And if they do, it should be possible to present argument and evidence demonstrating this.   No luck if you are looking for anything about that in the White Paper, or virtually any government discussion of this issue.

Another lighter-than-air argument relates to “market integrity”: “Market integrity concerns should be addressed by making whatever amendments to the CEA and the securities laws that are necessary to ensure that the CFTC and the SEC . . . have clear, unimpeded authority to police and prevent fraud, market manipulation, and other market abuses involving all OTC derivatives” (p. 46).   What the necessary laws might be, the Paper doesn’t bother to say: I guess that’s the mind reading portion of the act.   Again, you would think that if there are demonstrable gaps in the existing authorities to punish manipulation, etc., it would be possible to cite chapter and verse to support the claim.   No such citations here.

I can only hope–and I am sure that it is just that–that the level of analysis is superior in the remainder of the White Paper.   All I can say is that the case laid out regarding the dangers of OTC derivatives, and the improvements that would result from the policy recommendations, is completely lacking.   Completely.   Like I said above, the policy recommendations regarding OTC derivatives levitate, unsupported by any serious analysis or evidence.   Out of such sloppy group-think legislative and regulatory disasters are made.   So get ready for an explosion when the spark of reality ignites the gas holding aloft this regulatory Hindenberg.

From Gazeta, Russia has realized that its plans to develop 6-7 carrier groups was a pipe dream:

Development of 6-7 carrier task groups in 2012 the Navy  Commander Vladimir Vysotsky announced a year ago is postponed.  Deputy Defense Minister (for Armaments) Vladimir Popovkin said  yesterday that their development would be premature at this point.  “Before going to the trouble, let us first decide what we need  carrier task groups for. What strategic interests far from home do we have? There is more to a carrier task group than the aircraft-
carrier alone. Aircraft-carriers need escorts. And the Russian  Navy only includes four fleets nowadays,” Popovkin said.

Last July, Vysotsky said that carrier task groups centered  around nuclear-powered aircraft carriers and capable of supporting  strategic nuclear submarines would be developed for the Northern  Fleet and Pacific Fleet. He promised that work on the colossal  project would begin in 2012.

Ruslan Pukhov of the Center for Analysis of Strategies and  Techniques appraised postponement of carrier task force  development as abandonment of global military aspirations by  Russia. “Everything we see plainly shows that Russia has focused  attention on conflicts in nearby foreign countries… like the one  in South Ossetia,” Pukhov said. “You don’t need aircraft-carriers  unless you plan to attack someone.”

Pukhov said as well that the plans to build aircraft-carriers  had appeared in the period of financial prosperity owed to high  oil prices.

According to the expert, even should the Defense Minister  change its mind again and concentrate on the aircraft-carrier  construction program, the Navy cannot expect the first of them  before 2020. “We only have two shipyards capable of construction  of so colossal and technologically complicated a ship. They are  the Northern Shipyards and the Baltic Factory, both in  St.Petersburg,” Pukhov said. “Considering that both are located in  the very center of St. Petersburg and allowing for shallow depths  of the Baltic Sea, we really have only one facility for the  project, namely Sevmash in Severodvinsk. Before putting aircraft-  carriers into its lap, however, we’d better wait and see how it  fares with the Admiral Gorshkov.” (Repairs of this heavy aircraft-  carrying cruiser have been under way this last decade, pending
completion of the negotiations with India.)

What is it about 2020 anyways?  Just near enough to seem possible, just far enough away that by then people will forget the visions proffered in 2009.

And, if the experience with the Gorshkov is the litmus test, 3020 is probably a more realistic date.

I wrote at the time that this plan was announced that it was a complete fantasy.  It was strategically idiotic, and practically unattainable given the state of Russian shipbuilding.  Interesting to see that even Putin et al can’t fight reality forever.