Streetwise Professor

In my first post on the Obama administration’s flouting of creditor priorities in the Chrysler bailout/bankruptcy, I argued that a likely consequence would be to impair the ability of firms with substantial union membership (e.g., Ford, the airlines) to obtain credit.  Now numerous financiers have rendered a similar verdict:

Hedge fund managerGeorge Schultze  says he may avoid lending to any more unionized companies after being burned by President Barack Obama in Chrysler LLC’s bankruptcy.

Obama put Chrysler under court protection on April 30 after lenders balked at a proposal giving them about 29 cents on the dollar for their $6.9 billion in debt. The investors said the president’s plan favored a union retiree medical fund whose claims ranked behind them for repayment. It was offered a 55 percent equity stake in the automaker.

Pacific Investment Management Co., Barclays Capital and Fridson Investment Advisors have joined Schultze Asset Management LLC in saying lenders may be unwilling to back unionized companies with underfunded pension and medical obligations, such as airlines and auto-industry suppliers, because Chrysler’s creditors failed to block Obama’s move. The reluctance may put additional pressure on borrowers seeking capital in the worst financial crisis since the Great Depression.

“Lenders will have to figure out how to price this risk,” Schultze, 39, said in a telephone interview from his office in Purchase, New York. “The obvious one is: Don’t lend to a company with big legacy liabilities or demand a much higher rate of interest because you may be leapfrogged in a bankruptcy.”

. . . .

‘Rights Were Trashed’

Jack Welch, former chief executive officer of General Electric Co., criticized how the government handled Chrysler’s bankruptcy, saying unions were favored at the expense of creditors.

“I didn’t like the terms,” Welch, 73, said in an interview yesterday at the Boston Convention Center. “The creditors’ rights were trashed and the unions got 55 percent of the company.”

. . . .

‘Justifiably Concerned’

“Creditors are justifiably concerned” about what precedent the auto bailouts are setting, said  Mark Kiesel, global head of corporate bond portfolios at Pimco in Newport Beach, California. Pimco managed $747 billion as of Dec. 31.

“When you get these companies that have legacy costs, that’s something you have to factor in when evaluating credit risk,” Kiesel said. “Any investor is going to price in increasing political risk in considering where to put their money.”

Pimco, manager of the world’s largest bond fund, didn’t have a stake in Chrysler and owns an “infinitesimally small” amount of GM debt, according to a  report  by co-chief investment officer  Bill Gross  on the firm’s Web site.

The government’s “grassroots trend” signals “an increasing uncertainty of cash flows from financial assets” and risk premiums will increase as a result, Gross wrote.

Warren Buffet has expressed similar concerns.  (Irony alert: I am no big fan of Buffet, Jack Welch, or Bill Gross.)  

This is actually pretty obvious, but the resulting dynamic may be far more obscure, and insidious.  Unionized firms with limited access to capital are more vulnerable to financial distress.  And under the current administration, they are likely to receive Federal support, furthering government control over the economy.  (Government support may include direct financial support, but also regulatory changes or tax advantages.)  

When I was a kid, Jay’s Potato Chips had an ad: “You can’t eat just one.”  There are some similarities to bailouts, and to the erosion of contractual rights.  Once that process starts, there is a feedback mechanism that raises the likelihood there will be more.  And the Chrysler fiasco has started that process with a bang.

Philadelphia Fed President Charles Plosser has publicly acknowledged concerns about damage to the Fed’s credibility as a result of its aggressive quantitative easing program, and its close coordination with the Treasury:

The Federal Reserve’s myriad emergency programs for the U.S. economy threaten the central bank’s independence, raising the risk of future inflation, Philadelphia Federal Reserve President Charles Plosser said on Thursday.

To resolve the problem, Plosser argued the Treasury Department should agree to take on riskier assets like mortgage bonds that have been absorbed by the Fed in an effort to free up credit markets.

“When a nation’s treasury or finance ministry and its central bank work too closely together, there is a clear risk that the government’s spending will end up being financed by the central bank’s power to create money,” Plosser said at a Money Marketeers meeting in New York.

“History shows us that you can get very bad economic outcomes with rapidly rising inflation,” he said, citing the case of Zimbabwe as an extreme example.

. . . .

Plosser emphasized the need for autonomous central bank policy to a healthy and stable financial system. He expressed worries about the more than $360 billion in mortgage debt that the Fed has taken onto its balance sheet, part of a commitment to buy up to $1.5 trillion in mortgage and agency debt.

Such obligations, he said, are no less the debt of the U.S. government than an actual Treasury note.

“We need to draw a bright line once again between monetary policy and fiscal policy,” Plosser warned, adding that some aspects of the current debacle were “eerily reminiscent” of the 1970s.

“We have rapid monetary expansion in the face of an apparently substantial output gap.”

. . . .

Plosser has supported the Fed’s actions as a temporary support, but has been consistent in warning that there should be a better game plan.

“These actions have the potential of altering the delicate political balance of the (Fed), putting at risk its independence and, in so doing, diminishing its credibility and ability to maintain price stability,” Plosser said.

“Eerily reminiscent of the 1970s”=Stagflation.  That’s what Plosser is warning about, and I agree.

Richard Fisher, President of the Dallas Fed, has similarly acknowledged the threats to the Fed’s credibility and independence, and the resulting threat of inflation:

His bigger concern these days would seem to be what he calls “the perception of risk” that has been created by the Fed’s purchases of Treasury bonds, mortgage-backed securities and Fannie Mae paper.

Mr. Fisher acknowledges that events in the financial markets last year required some unusual Fed action in the commercial lending market. But he says the longer-term debt, particularly the Treasurys, is making investors nervous. The looming challenge, he says, is to reassure markets that the Fed is not going to be “the handmaiden” to fiscal profligacy. “I think the trick here is to assist the functioning of the private markets without signaling in any way, shape or form that the Federal Reserve will be party to monetizing fiscal largess, deficits or the stimulus program.”

. . . .

Mr. Fisher defends the Fed’s actions that were designed to “stabilize the financial system as it literally fell apart and prevent the economy from imploding.” Yet he admits that there is unfinished work. Policy makers have to be “always mindful that whatever you put in, you are going to have to take out at some point. And also be mindful that there are these perceptions [about the possibility of monetizing the debt], which is why I have been sensitive about the issue of purchasing Treasurys.”

He returns to events on his recent trip to Asia, which besides China included stops in Japan, Hong Kong, Singapore and Korea. “I wasn’t asked once about mortgage-backed securities. But I was asked at every single meeting about our purchase of Treasurys. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States. That seems to be the issue people are most worried about.”

As I listen I am reminded that it’s not just the Asians who have expressed concern. In his Kennedy School speech, Mr. Fisher himself fretted about the U.S. fiscal picture. He acknowledges that he has raised the issue “ad nauseam” and doesn’t apologize. “Throughout history,” he says, “what the political class has done is they have turned to the central bank to print their way out of an unfunded liability. We can’t let that happen. That’s when you open the floodgates. So I hope and I pray that our political leaders will just have to take this bull by the horns at some point. You can’t run away from it.”

And Fisher’s last sentence is what scares me.  Prayer is the right word to use there, for rational calculation suggests that political leaders are highly unlikely to take the bull by the horns. His diagnosis of the actions of the “political class throughout history” pressuring the central bank into profligate printing of money is spot on.  So why should we expect things to be that much different in the US in 2009, especially given the degraded condition of our politics, and our political leadership?  Fisher’s “prayer” brings to mind Samuel Johnson’s judgment on second marriages: a triumph of hope over experience.  

Plosser’s and Fisher’s statements suggest a coordinated plan by the Fed to calm fears regarding the Fed’s credibility and independence.  Bernanke suggested as much in his answer to my question at the Atlanta Fed conference two weeks back.  

And these fears are very real.  It’s nice and all that Bernanke et al are trying to allay concerns, but talk is just that.  The question is whether the Fed can withstand the intense political pressure that will come as the Fed tries to navigate between the dangers of throttling an incipient recovery and sparking a huge inflation.  With the massive government spending in the coming years, and the resulting explosion in the Federal debt, the Fed’s apparent commitment to supporting the housing sector, and myriad other factors, there is a major risk that today’s fine words will mean little when push comes to shove.  Given the choice between voting for a massive tax increase, or dragooning the Fed into an imposing on inflation tax for which it will have no accountability, my money is on Congress doing the latter. After all that’s what political classes have done throughout history.  Just as Richard Fisher.

I like Jeremy Grant of the FT, and his colleague Gillian Tett is a media darling right now, flogging her book on the financial crisis.  But in their article on the Geithner derivatives proposals (along with Aline van Duyn), they laid an egg.  They repeat the conventional wisdom on clearing, and the supposed benefits of forcing OTC trading onto exchanges.  Actually, it would be more accurate to say that they repeat the conventional ignorance on the subject.

They say that on exchanges “[t]rades are then ‘cleared’ on a central platform, which completes a deal even if one counterparty collapses.”  Similarly, they say that in OTC markets, “[t]hat means in many cases there is no centralised system to monitor prices or deals nor any third party to ensure a trade is completed if a counterparty fails.”  These quotes suggest that counterparty risk does not exist in a cleared market like it does in an OTC market.  This is wrong, because the clearinghouse can fail.  More to the point, given the size of the position of a defaulting party, clearing only affects the allocation of losses, not their total amount.  Now, this allocation can be superior, but not necessarily so.  But I grind my teeth at the suggestion that clearing magically makes default risk disappear.  

This also has implications for systemic risk.  In a cleared market, the default risks are borne in the first instance by clearinghouse members, who are typically systemically important banks.  Clearing can actually concentrate and increase the counterparty risks that these systemically important banks bear.  This point is seldom made, but it is important.  Grant, Tett and van Duyn overlook it altogether.  

Most egregiously, they say this:

The proposals Mr Geithner, Ms Schapiro and others have unveiled try to tackle these problems in four ways. First, they demand all “standardised” derivatives are  centrally cleared to remove counterparty risk, even if they are not traded on an exchange.  [Emphasis added.]

No. No. No. NO!  Clearing DOES NOT REMOVE COUNTERPARTY RISK.  The three FT reporters should be sentenced to write that sentence over and over again on a blackboard, Bart Simpson-like, until they get their minds right.  Moreover, to atone for this, the FT should be required to devote an entire front page consisting entirely of “CLEARING DOES NOT REMOVE COUNTERPARTY RISK” in headline-sized type.  

Again.  Clearing redistributes the losses arising from counterparty default.  It does not remove it, or make it magically disappear.  What’s more, it does so in a way that can reduce efficiency, and increase systemic risks.  

Sheesh.  Grant et al state: “A public debate about derivatives is long overdue.”  I agree.  It would be nice if that debate would be based on a thorough, fact-based, understanding of the actual tradeoffs involved in clearing and exchange trading.  Instead, this article just recycles the same old bromides.  

The article does the service of quoting this gem by new SEC head Mary Shapiro (which I had wanted to call attention to when I saw it last week, but got distracted):

As Mary Schapiro, chair of the Securities and Exchange Commission, says: “OTC derivatives, particularly credit derivatives . . . contributed to the financial mess we are cleaning up today.”

Just how did they contribute?  Yes, like the Treasury letter, you can point to the OTC posterchild, AIG, but that would be incredibly dishonest (as it was when Treasury did it).  It is dishonest because the type of contracts AIG traded would never be cleared, and never traded on exchanges, and hence would be/have been unaffected by the Treasury proposal.  But although credit derivatives have been accused over and over again of contributing to the financial crisis, the type of products that would be affected by the Treasury proposal are conspicuous by their absence from any honest accounting of culpability for the crisis.  

This only goes to show that Mary Shapiro’s replacing of the execrable Chris Cox has not increased the intelligence or market knowledge at the SEC.  And that is a very scary thought.

Recently the Russian government reported that GDP was down in the first quarter 9.5 percent year on year.  More alarmingly, it was down 23.2 percent quarter on quarter:

Russia’s economy contracted sharply in the first three months of the year, hit by the global slowdown, Federal State Statistics figures show.

Economic output for the period to the end of March fell 23.2% compared with the previous quarter. On a year-on-year basis, output dropped 9.5%.

Russia’s economy had been growing thanks to high oil prices, which peaked at around $147 a barrel last summer.

But since then, the price of oil, a key export, has fallen by more than half.

The latest figures for the first three months of the year confirm estimates released last month by the government.

Industrial output has slowed in the wake of the global economic slowdown, and investors have withdrawn significantly from Russia.

I scratched my head when I first read the 23.2 percent number in a Bloomberg piece on Saturday (a piece which has mysteriously disappeared).  None of the articles I’ve read explain it fully, and the Russian government statistics websites are appallingly bad, so I couldn’t find the original source.  (The Federal Statistics Service website had a poll.  The least favorable response was “Could be improved”–which 90 percent of the 800 respondents had chosen.  A more reasonable alternative would be: “Couldn’t possibly be worse.”)  

My guess is that this is an annualized rate, indicating that quarter on quarter, GDP fell about 5.7 percent.  That is, fell from 100 on December 31, to 94.3 on March 31.  Ouch.  This is horrid, even by the abysmal standard set by Germany (a 3.8 percent decline, or about 16 percent annualized) in the first quarter, or Japan’s 12.7 percent annualized decline in the fourth quarter of 2008.  

\Russian manufacturing output continued to crater, and banks are racing to revise downwards their forecasts of 2009 growth; today Alfa Bank cut its forecast to -5.7 percent.  The only bright spot is the price of oil, which has been rebounding on OPEC cuts, the possibility of supply disruptions in Nigeria, and most importantly in my view, the prospects for inflation due to the Fed’s (and other central banks’) aggressive monetary policy.  

In other news of potential interest to some SWP readers (and you know who you are), today’s AFP carries an article on the implications of the economic contraction for Russia’s demographic woes:

Now the financial crisis has added to Russia’s pernicious mix of ill-health and  low birth rates, heralding an early reversal of the cheerier birth rates of the last three years, statisticians and sociologists said.

Russia’s state statistics agency Rosstat recorded 270,800 births in January and February, down by 3,700 from last year.

Rosstat head Vladimir Sokolin last month said the economically active population was shrinking by one million people per year and the country could face labour shortages as it emerges from the  global financial crisis.

“At this rate, the crisis could reduce to nothing all the government’s efforts of the last years to stimulate births,” said Valentina Petrenko, the head of Russian upper house’s committee for social policy and health.

“The risk of losing employment is in a big way linked to  pregnancy  and caring for young children.  Expectant mothers  and women, as a rule, are the first to be laid off,” she said.

Experts say that in the face of financial uncertainty more women plan against pregnancy and are opting for abortions.

Only five percent of women surveyed by state pollster VtsIOM as the first economic stress was felt in November said they planned pregnancies in the next two years.

Outside a city-run maternity hospital in northern  Moscow, two women stood apart from the knots of chatty families waiting in the spring sun with flowers and bottles of sparkling wine to celebrate a new addition to the family.

The two sat heads together, smoking and looking almost under dressed in jeans and sneakers.

Irina, who preferred not to give her last name and nervously grasped her friend’s hand, had come for the free abortion services offered at such clinics.

“I am still paying down my apartment each month, I can’t imagine being without a job much less anything else right now,” she confided, adding she was not living with her boyfriend.

“A friend of mine lost her job, but she said it would give her time to raise her child, but I don’t know…. I think it’s a bit crazy,” she said.

Andrei Akopyan, the head doctor at one of the Moscow’s reproduction and  family planning clinics, predicted the number of abortions would increase by 10 to 12 percent due to the  economic instability.

“It may be some families planned to have children, but they then found themselves forced to turn back on that decision,” he said.

“There are, of course, already more women who want to have abortions,” Khazem Alsoabi, a doctor at one private clinic, MedClinica, said. “The reasons I hear are financial, there’s no question of that.”

Searches for “abortion” on the Russian Internet portal Yandex have more than doubled since the onset of the financial crisis. The number of people who keyed in the search jumped from 94,526 in October to 151,471 in November.

According to the  United Nations,  Russia  has the highest rate of abortions in the world, in a hold over from Soviet times when the operation replaced traditional forms of contraception.

Last year was the first since the  fall of the Soviet Union  when the number of births narrowly outstripped the number of abortions in the country.

“There is even a new social category of women who say they are having abortions because they can’t pay back their loans,” said Svetlana Rudneva, who heads the Family and Childhood fund, offering counseling forunplanned pregnancies.

She said the charity fund had seen a hike in calls to its crisis line and more inquiries from women seekinglate-term abortions. The operation is legal up to the 12th week in Russia.

Women are increasingly citing economic insecurity as the reason why their families might pressure them to have an abortion, said Irina, a psychologist at another pregnancy hotline.

“It’s one of many reasons cited to justify the abortion. But today, material difficulties is the main reason,” she said.

Migration to Russia could help compensate for the country’s drastic  population decline, said Anatoly Vishnevsky, head of the Institute of  Demography  at the Higher School of Economics.

But, for want of work,  migrant workers  are leaving Russia in droves. The number of migrants in the country fell by 27 percent in the first quarter of this year, according to the federal migration service.

“The situation was bad already. We’ve always been seen as a country in a demographic crisis. The population is falling and will keep falling,” Vishnevsky said.

“Of course, the current crisis will have an effect and that effect can’t possibly be good.”

This is journalism, not data.  But it does seem pretty clear that the economic bad news cannot be good news for Russian demographics–or public health.  

A major concern for Russian policymakers has to be that the measures they have taken so far appear to be having little effect:

Russia’s central bank could once again face a choice between allowing the rouble to weaken and taking steps to support the economy, says Gabriel Stein, chief economist at Lombard Street Research.

“According to estimates, Russian GDP shrank by 9.5 per cent in the first quarter from a year earlier,” he says. “There are some ‘green shoots’ of recovery – but even President Medvedev has acknowledged stimulus measures to boost the economy have so far not worked.”

Mr Stein says Russia is paying the price for its double exposure to the “most serious hazards of the modern world – energy and exports to continental Europe.” The former, he says, is the result of Moscow’s single-minded pursuit of energy control, regardless of the damage to Russia’s business climate.

“The rouble has strengthened this year, partly on . . . optimism about emerging markets, partly due to – but also a cause of – Russian stock market gains and partly  [on] high  interest rates.

“Rates were cut to 12 per cent last week, [but] remain attractive – and should provide a barrier to the rouble collapse that the state of the economy seems to call for.

“If maintaining the value of the rouble remains the goal, it will be very difficult to ease monetary policy further. Better to act now to moderate a devaluation which represents the loss of income implied by the collapse of energy prices.”

This is just basically a re-iteration of what I’ve said about the very difficult policy trade-offs that Russia faces.  

And other shoes remain to drop.  There are widespread predictions that loan performance will degrade dramatically in the coming months.  Moreover, the deep contraction will likely make the even more pessimistically revised government budget numbers non-operative in the very near future.  This will require a more rapid depletion of reserve funds.  

Inflation does appear to be abating–contrary to what I’ve been expecting.  But other than that, the prospects are very dark indeed.

Update.  This Bloomberg piece states that industrial output fell by a record in April.  This contradicts earlier estimates, based on PMI, that the pace of manufacturing contraction has been slowing.  

Russian  industrial production  fell at a record pace in April as the global economic crisis squeezed demand and companies cut investments.

Output dropped an annual 16.9 percent, the sixth consecutive decline and the biggest since the  Federal Statistics Service  moved to a new methodology in 2003, compared with a drop of 13.7 percent in March, it said in Moscow today. The median estimate in a Bloomberg survey of 11 economists was a decrease of 14 percent. Production fell 8.1 percent from March, when it grew 11.1 percent.

The economy of the world’s biggest oil producer shrank an annual 9.5 percent in the first quarter, the most in 15 years, as industrial output slumped and a 3 trillion-ruble ($93.4 billion) state stimulus package failed to boost lending. A $9 billion slate of state guarantees “failed” to kick-start lending to strategic companies, President  Dmitry Medvedev  said on May 13.

“The situation in manufacturing didn’t improve at all,” said  Vladimir Tikhomirov, the chief economist at Moscow’s UralSib Financial Corp., before the report. “Companies were still under a big strain to try to attract capital and were diverting a lot of their investment money to repaying current debt. Investment programs had to be postponed.”

The World Bank said on March 30 that a “silent tsunami” of bad debt threatens to stall a recovery in the world’s largest energy-exporting economy. As companies default on loans, the government may need to provide as much as $50 billion for bank bailouts, more than twice the amount pledged to banks in this year’s budget, according to UniCredit SpA.

Rate Cuts

The central bank cut its key interest rates for the second time in less than a month on May 14 in a bid to reduce high borrowing costs during the downturn.

Manufacturing tumbled an annual 25.1 percent in April, compared with a drop of 20.5 percent in March. Cement and brick output fell 34.7 percent and 39.9 percent respectively in April while production of trucks and vans fell 68.1 percent. Car production tumbled an annual 55.9 percent.

Billionaire  Mikhail Prokhorov, Russia’s richest man, said Russian property developers may suffer more as the country slides into the worst economic slowdown in a decade.

“The crisis hasn’t hit developers in full yet,” Prokhorov told reporters in Yelets, Russia, on May 15. “The worst is yet to come.”

“The worst is yet to come.”  Frightening words, indeed.

Several gems were contained in this Bloomberg story about the 9.5 percent decline in the Russian GDP in 2009Q1.  [Your bet is looking pretty good, Michel.]  In particular, no sooner had I written my post about short-termism in Russia, did I read this in the linked article:

A $9 billion slate of guarantees aimed at kick-starting lending to the companies designated as strategic enterprises had “failed,” Medvedev said on May 13.

Today, Medvedev poured cold water on the government’s bid to diversify the economy away from a dependence on exporting oil, gas and metals.

. . . .

“There have been no significant changes in the technological level of our economy,” Medvedev said in a meeting today outside Moscow.

‘Only on Paper’

The country’s venture fund, special economic zones and so- called techno-parks, all aimed at nurturing high-tech industries, “exist only on paper,” he said. Businesses are also to blame and only invest where a “high, quick return” is guaranteed, he said. [Emphasis added.]

So, Medvedev agrees with my diagnosis of the myopic economic behavior of Russians–a diagnosis that I’ve made for years, and which I have consistently attributed to the fundamental institutional and demographic weaknesses that pervade Russian society; in particular, when life, liberty, and property are insecure, it makes eminent sense to focus on the here and now, rather than the future.  (Here’s another post that explores this theme.)  

Please keep Medvedev’s words in mind, all you self-styled Russophiles, the next time you want to take issue with my analysis of the institutional impediments to Russia’s long term economic prospects.

And I wonder if the high-tech industries that “exist only on paper” (per Medvedev) include that much vaunted nanotech sector.  Anyone (ahem) care to comment?

I’ve written about the hard-to-explain behavior of oil prices and stocks.  But oil isn’t the only commodity around, so I thought it would be worthwhile to look at some others to see whether their behavior may shed light on which version of the “green shoots” theory their behavior supports–the green shoots of a recovery in output, or the money-is-green version that the price rises are a harbinger of inflation.

The best data on prices and especially stocks for industrial commodities is available for non-ferrous metals.  Here are the comparisons (all data from the LME):

• Copper 3/2/09.  Cash: $3329, 3 Months: $3355, Stocks: 530,875 MT.
• Copper 5/13/09.  Cash: $4507, 3 Months: $4530, Stocks: 373,750 MT.
• Lead 3/2/09.  Cash: $1160, 3 Months: $1166, Stocks: 60,750 MT.
• Lead 5/13/09.  Cash: $1450, 3 Months: $1440, Stocks: 73,500 MT.  
• Nickel 3/2/09.  Cash: $9602, 3 Months: $9607, Stocks: 99,378 MT.
• Nickel 5/13/09.  Cash:  $12450, 3 Months: $12545,  Stocks: 111,648 MT.
• Primary Aluminum 3/2/09.  Cash: $1270, 3 Months: $1310, Stocks: 3,243,900 MT.
• Primary Aluminum 5/13/09.  Cash: $1428, 3 Months: $1521, Stocks 3,880,325 MT.
• Tin 3/2/09.  Cash: $11,047, 3 Months: $10702, Stocks: 9,140 MT.
• Tin 5/13/09.  Cash: $13,890, 3 Months: $13,615, Stocks: 13,405 MT.
• Zinc 3/2/09.  Cash: $1078, 3 Months: $1104, Stocks: 355,500 MT.
• Zinc 5/13/09.  Cash: $1430, 3 Months: $1475, Stocks: 322,025.

Note that the prices of each commodity have risen.  Depending on the metal, the rises have been between about 15 percent and 40 percent.  For some of the metals, spreads have narrowed.  For instance, the contango in copper has decreased, as has that of lead (which has gone from contango to backwardation).  For aluminum, however, the spread has widened, as it has for zinc (though not in percentage of the spot price).  

Interestingly, lead, nickel, tin, and especially aluminum stocks have increased; stocks for copper and zinc have decreased, especially the former.  Aluminum is of special interest, as this is a major industrial commodity, and is highly sensitive to industrial uses (e.g., in autos).  

Overall, the story is quite mixed.  Copper suggests bullish fundamentals: a sharp rise in price and a pretty steep fall in stocks.  But, overall, the stocks data give no evidence of a near term strengthening in demand that would explain the price rises across all metals.  Note the rise in aluminum price and the contemporaneous nearly 20 percent increase in stocks.  Hardly a signal of a rebound in industrial demand.

There are two interpretations consistent with the data: (1) spot demand remains low, but demand is expected to pick up in the future, and (2) real spot demand remains low, future real demand is expected to remain in the doldrums, but prices are being buoyed by expectations of a possible inflationary burst (i.e., the money is green version of green shoots).  

Even the copper data, and perhaps data from the oil market, are potentially consistent with (2).  It is widely reported that China is stockpiling copper and oil.  Indeed, some of the copper stocks decline may be a mirage as copper is merely being transferred from LME warehouses to Chinese strategic stockpiles that are invisible to the market, rather than being consumed.  This could reflect a Chinese substitution of dollars/dollar denominated assets into real assets such as copper (and perhaps oil) due to their fears about the US dollar and inflationary pressures in the US.  That would be consistent with the inflationary expectations story, and indeed, a channel by which these expectations influence current prices.

If I had to choose between (1) and (2)–between an anticipated increase in future real demand and an anticipated increase in nominal demand due to inflationary pressures–I guess I would choose (2).  Suffice it to say that although I’m not metaphysically certain as to which explanation is right, the data do not contradict the inflationary expectations story.  Moreover, the future demand/spot demand story is not that convincing.  Anticipation of future demand should lead to an increase in current demand, but that is not being reflected in stocks.  

With stocks largely signaling weak real demand (especially when one considers that the copper stock drawdown may not reflect an actual increase in copper consumption), but prices rising, there is a very good chance that metals prices are in fact a harbinger of inflation.  In his speech at the Atlanta Fed conference on Tuesday, John Taylor suggested that the Fed may not have much time before it has to decide whether to switch gears and fight inflation.  The metals data support that suggestion.  Indeed, if China’s actions in the copper market reflect a substitution of real stuff like the red metal for dollar denominated nominal claims, rather than a real need for the commodity, the time for choosing may be coming much more quickly than is conventionally believed.

Just sayin’.  Or, perhaps I should rephrase that: Just the metals market sayin’.  Listen up, Chairman Bernanke.

Not like they would, but anyways . . .  

The Treasury Department today released a letter on “Regulatory Reform Over-The-Counter (OTC) Derivatives” [sic–“in”? “for”? “of”?].  There are a few good ideas in it, but on balance the bad far outweighs the good.  

The centerpiece of the proposal (which has received a warm welcome from Congressional powers like Barney Frank and Collin Peterson) is to mandate clearing for “all standardized OTC derivatives.”  “Standardized” is not defined, but the letter suggests how this will be determined: If a clearinghouse offers to clear it, it’s standardized: “For example, if an OTC derivative is accepted for clearing by one or more regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared.”  

On Tuesday, I gave a presentation at the Atlanta Fed conference where I reiterated my argument–which debuted here on SWP–that mandating clearing is a bad idea.  Even for standardized products (my argument nowhere depends on standardization, except to the extent that there is some correlation between standardization and the magnitude of information asymmetries), it is quite possible that information costs are higher in cleared markets than in bilateral markets.  For particular transactions, involving particular transactors, it is possible that information costs are lower in a bilateral trade.  These lower information costs can make it efficient NOT to clear such deals; for other trades, in the same or similar instruments, clearing may be more efficient.  

In a nutshell, there is no basis for the presumption that the costs of clearing are lower than the costs of bilateral trades.  Moreover, I have not seen a credible argument showing that the social benefits of clearing exceed the social costs, but the private benefits are smaller than the private costs; such a showing would be necessary to justify a mandate  for clearing.  At the Atlanta Fed conference, Ed Kane of Boston College (the moderator of my session) argued that the safety net arising from deposit insurance and the implicit promise to bail out too big to fail banks could lead to such a circumstance.  I do not see the economic basis for this conclusion.  Moreover, there have been cases in the past–namely at the CBOT in the 1920s and the LME in the aftermath of the Tin Crisis–where exchanges resisted government pressure to adopt clearing even though there was no safety net that could have caused a divergence between private and social costs/benefits.  

As I said at the Atlanta Conference, my issue is not with clearing per se.  It is with who decides what gets cleared.  Chuck Vice from ICE (no, I did not make that up;-) had chided me after my talk where I cast doubt on the virtues of clearing for some products and participants by saying “I thought you were my friend, Craig.”  I replied: “I am your friend, Chuck.  If you (i.e., ICE) build a clearing system, and market participants come–as happened in energy–more power to you.  That’s great.  What I’m worried about is the ‘We’re from the government and here to help you’ problem.”   By substituting its judgment–an ill-informed judgment IMHO–for the judgment of market participants who (a) have better information on the costs and benefits, and (b) have skin in the game, and hence an incentive to make the right decisions (though since information and incentives are imperfect, they will some times make decisions that an omniscient agent would not), the Treasury risks reducing efficiency. This is a serious risk, in my view.

I have yet to hear any indication from the Treasury, Congress, or the Fed that the issues relating to information costs, and the implications thereof for the benefits of clearing have been acknowledged, let alone addressed.  Since information costs are an essential determinant of the efficiency of any risk transfer mechanism–which is what clearing is–this is a serious omission that undermines any presumption that the proposal is based on a thorough consideration of the relevant considerations.  

Some other issues.  First, the Treasury letter is framed in a very dishonest way.  It starts by saying “[a]s the AIG situation has made clear, massive risks in derivatives markets have gone undetected . . . even if those risks had been better known, regulators lacked the proper authority to mount an effective policy response.”  As its first proposed policy response, it recommends mandatory clearing of standardized products.  But the AIG products were highly non-standardized, and it is extremely unlikely that these products would ever be clearable.  But by linking clearing with AIG, the letter suggests that the former would have prevented the latter.  Nothing in any of the proposals would have had any effect on any of the AIG deals.  This linkage is dishonest, in my view; a classic bait-and-switch.  If a firm did something like that in a securities prospectus, the SEC would nail it.  Similarly, if somebody did something similar in an infomercial, FTC would be all over them.  

Second, the standardization issue will raise no end of difficulties.  It will create an incentive for parties who recognize that the costs of clearing exceed the benefits to enter into non-standard transactions.  The letter says somebody must “ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP.”  The subject of the sentence is “CCPs.”  So, are we to believe that CCPs are to investigate bilateral transactions, and make a judgment on the motives for such deals?  There is a real conflict of interest here, as the CCP has the incentive to force business its way, and look at all non-standardized deals with suspicion.  (I should also note that if the dominant CCP is a member-owned entity dominated by banks, they may influence things in the other direction.)  More likely, the regulator will be required to make such judgments.  So, CFTC (or whomever ends up being the regulator) is supposed to put itself in the heads of transactors, and decide what their motives are for a particular trade?  This is a recipe for litigation, conflict, and most importantly, legal uncertainty.  

This will raise all of the issues that created problems under the Grain Futures Act and the CEA.  Those laws required “futures” to be traded on exchange, but allowed cash market contracts to be traded bilaterally.  So, what is a future?  What is a cash market contract?  Who knows?  In part, the answer depended on the economic purposes of the transactions.  Same now with the “standardized” vs. “non-standardized” distinction.  Such distinctions are recipes for dispute, and invitations for financial engineering to circumvent the clearing requirement.  The possible implications for legal certainty are particularly disturbing.  

Third, the letter emphasizes the role for “robust margin requirements.”  There is no recognition that margining can actually contribute to systemic risks, and that the rigid types of margining that CCPs perform may be particularly susceptible to this problem.  Margin calls can induce liquidations that move prices away from equilibrium values, and set off positive feedback mechanisms that destabilize the market.  Similar problems can arise in OTC markets, but the greater flexibility in these sort of arrangements, including the ability to utilize a broader range of collateral, can mitigate the problem there.  It is by no means clear that rigid CCP-style margining reduces systemic risk; it can increase it in some circumstances.  

On the issue of margins, I was interested to hear Chuck Vice (of ICE–I just like saying/writing that;-) say that ICE Trust took an “agnostic view” of the credit risk of member firms in setting margins, and therefore would charge everyone the same margin level that would be sufficient to cover the likely loss on a particular position during an extreme market move.  Bug or feature?  Chuck thinks feature.  I think bug.  Different members pose different default risks (just look at disparities in CDS spreads among the members of ICE Trust), and this would suggest the optimality of different margins–that is done in the OTC market.  One size fits all doesn’t fit everybody when people are of different sizes.  In the OTC market, parties can customize collateral levels to reflect risks, and this has virtues.  

Back to the Treasury letter . . .  

Another pernicious proposal is that the CEA be amended “to authorize the CFTC and SEC to impose . . . . The movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems.”

Again, this is the GFA/CEA redux–like those laws, this proposes to force a subset of all trades onto centralized exchanges, or electronic trade execution systems that are very exchange-like.  The reason for such a mandate is not stated.  Nor do I think it exists.  What externality is being internalized?  At what cost?  What is the basis for substituting the government’s judgment as to how trades should take place for the judgment of the transactors themselves?  

This is certainly a boon for the CME, and arguably ICE.  And shazaam, their stock prices took off after the release of the letter.  Who would have thought?  

Again, as under pre-CFMA CEA/GFA, the on-exchange/off-exchange distinction will lead to dispute, litigation, and legal risk.  

One could argue that exchanges are more transparent, and that transparency is a benefit.  However, other parts of the letter–namely, the requirement that all trades (including non-standard ones) be reported to a trade repository made available to regulators, and the development of a price reporting system–address the transparency issue.  Indeed, these are better ways to address transparency concerns than either clearing or forced exchange trading.  I said just that in my FRB Atlanta presentation, and in my academic writings on the subject.  Exchange trading may be sufficient to produce price transparency, but it is not necessary.

The transparency proposals are something I support.  Indeed, I view those as something of a vindication, as I was advocating such measures in energy markets in the 2003-2004 period.  The Data Hub lives!  

One issue with post-trade price and position transparency is the effect it will have on liquidity.  JP Morgan’s Eric Beinstein raised such concerns in his talk at the Fed conference.  This was a big deal with London dealers in the stock market, who feared that premature disclosure of trades would make it more difficult for them to lay off positions that they took on from customers.  Therefore, it may be advisable that some reporting delay be permitted.  

The letter also addresses market manipulation, fraud, and other abuses: “The CEA and securities laws should be amended to ensure that the CFTC and the SEC have . . . . Clear and unimpeded authority . . . to police fraud, market manipulation, and other market abuses.”  This is a red herring.  Relatedly the letter says that “under current law [OTC markets] are largely excluded from or exempted from regulation.”  This is wrong if it is meant to refer to exemptions from the manipulation or fraud provisions of the CEA.

CFTC already has authority to police manipulation of “any commodity traded in interstate commerce” and this clearly would extend to OTC swap markets as currently constituted.  Even the much (and wrongly, in my view) maligned CFMA did not exempt any market from the anti-manipulation or anti-fraud provisions of the CEA.  So, why is this language in the proposal?  Ignorance?  

More unfortunately, the letter recommends giving regulators the ability to set position limits on OTC market positions.  As I’ve written  in my book on manipulation, and often on SWP, position limits are an inefficient way to combat manipulation and fraud.  Ex post action is a better way.   CFTC should be better able to do this with better information about positions, so position limits are not advisable.

The problem, though, is not with CFTC’s powers or information.  It is with its willingness and ability to use them.  CFTC’s record in anti-manipulation litigation is hardly glorious.  Moreover, the legal precedents–especially CFTC decisions like in re Indiana Farm Bureau and in re Cox & Frey–have seriously undermined the deterrent force of government and private ex post litigation.  Treasury and Congress would do much more to improve deterrence by writing legislation to clarify manipulation law to undo the pernicious effects of these decisions.  Without doing that, Treasury is fooling itself when it says (in Geithner’s letter to Harry Reid, linked at the bottom of the link above) that  “With CCPs, trade repositories, and other market participants providing the CFTC and SEC with a complete picture of activity in the OTC derivatives markets, they should be able to detect and deter all such market abuses [emphasis added].”

As if.

Information is NOT the binding constraint.  When a manipulation is suspected, the subpoena power is sufficient to obtain the requisite information–and it is usually the efficient way.

I repeat: The binding constraints are (a) the intellectual confusion inherent in existing manipulation precedents; (b) the intellectual confusion at CFTC and other regulatory agencies when it comes to manipulation; and (c) the vague language defining manipulation in the relevant statute, which is ultimately the source of intellectual confusions (a) and (b), and which stemmed quite clearly from Congress’s own intellectual confusion.  I have been saying this since 1994.  So, don’t listen to me.  I’m used to it.  But don’t fool yourselves into believing that you will reduce manipulation efficiently through position limits and the collection of more information that is mis-used because of a failure to understand the economics of manipulation.

The letter also recommends actions to ensure that derivatives are not marketed to unsophisticated parties.  I have not analyzed this issue in detail, but it is my sense that this is another area in which ex post litigation, including private actions (including class actions) would be a preferable way to handle the problem.  Trying to write rules to determine ex ante who is, and who isn’t, sufficiently knowledgeable to enter into derivatives trades is extremely problematic.  I also worry about the incentive this provides for people to take risks, and then attempt to back out of losing contracts by claiming that they were duped.  Maybe they were, but I think there should be a pretty high standard of proof required to support such a finding.

In sum: There are a few good ideas in the Treasury proposal.  Very few.  The biggest, most important proposals are wholly misguided, in my view.  They reflect, again in my view, (a) a shockingly incomplete analysis of the relevant economics, (b) an unjustified and unsupported presumption that regulators’ and legislators’ judgments are superior to those of private transactors, and (c) a failure to identify market failures that the proposed regulatory changes would fix.

John Taylor of Stanford gave a very nice keynote speech at the FRB Atlanta Conference on Financial Crises & Innovation.   It was a very different speech than Bernanke’s, and much more critical of government as a cause of the crisis, and a potential source of systemic risk in the future.   Indeed, Taylor listed three major sources of systemic risk going forward that have been featured prominently on SWP as well:

·           Massive expansion of US government indebtedness.  Interestingly, Taylor said that “[t]here is certainly no  stimulus effect from such deficits, and they put a very heavy burden on the not so distant future.”  

·           A dramatic expansion of the Fed balance sheet, and serious questions about the credibility of any Fed promise to withdraw liquidity from the system, thereby leading to a substantial threat of inflation.

·           An undermining of the rule of law, primarily illustrated by the administration’s heavy-handed efforts to subvert bankruptcy law and debt contracts in the Chrysler case, as well as actions on executive compensation and forcing out CEOs.

I couldn’t agree more, obviously.   I think these are all major threats.   The first in particular is becoming greater by the day.   The second will become more acute as the Fed proceeds with various initiatives to acquire securities, thereby ballooning its already bloated balance sheet into the trillions, and as political pressures to avoid doing anything that could abort a recovery bias the Fed towards ease even if and when inflationary pressures become manifest.   The last is a new development, and it bears attention to see whether the government takes any further steps along this path.

Taylor’s overall theme was that massive government failure is a real possibility, and that government is a major source of systemic risk.   Agreed.   This is a message that bears repeating over and over again as regulatory and legislative nostrums are pushed in the coming months.

At today’s session, AEI’s Vincent Reinhart made a point that I’ve also emphasized on SWP.   I’ve said that the biggest lesson of the Great Depression is that people learned the wrong lessons from the Great Depression, and passed useless or counterproductive legislation as a result.   Reinhart said, in a similar vein, that the most important thing going on today is the battle over the narrative as to what caused the financial crisis, because that narrative will determine what policies are adopted going forward.   He stated that the narrative of the Great Depression was wrong, and that as a result the regulatory and legislative response was wrong too.   He fears that the emerging dominant narrative is similarly misguided, and will lead to similarly damaging results.

Taylor’s talk was an attempt to counter the conventional wisdom narrative, and advance a counter-narrative.   Sadly, I think that this is an uphill battle indeed.   But, as Reinhart says, it is a battle that needs to be fought.

As I was getting on the plane to come back home, a reporter sent me an advanced copy of a letter that Geithner has sent to Congress outlining plans for regulation of the OTC derivatives market.  That letter embodies a particular narrative that I believe is particularly, and perniciously, in error.  This illustrates the relevance of Reinhart’s point.  I will deconstruct that letter in detail tomorrow, time permitting.  

When Ben Bernanke started to speak last night, it began to thunder and lightning.  Could be just a coincidence, but . . .

I am participating in the Atlanta Fed’s conference on Financial Crises and Innovation in Jekyll Island, GA.  The keynote speaker tonite (the first evening of the conference) was Ben Bernanke, Chairman of the Fed.  

Bernanke’s speech was about the stress tests.  I thought he did a good job in explaining and defending the tests.  He clarified a few things in my mind.  Which is not to say he persuaded me that all is well.  In other words, I’m not ready to help revive Tinker Bell just yet.

Three things he said about the stress tests gave me some disquiet.

First.  He emphasized that they were a “confidence building exercise.”  That seems like assuming the conclusion.  I would like a fact finding exercise, with a clear statement of the findings, good or bad.  Stating that the objective is to build confidence suggests a pre-ordained result–Kabuki Theater.  It’s like saying that something is needed to build “self-esteem.”  Success builds self-esteem, not the other way around.  Similarly, success builds confidence; confidence building does not ensure success.

Second, he argued that the stress tests were based on models calibrated to extensive historical experience.  Well, we are in uncharted territory here, which raises doubts about the probative value of historical experience.  I can think of some ways to massage historical data that could be useful.  But one of the problems I see is that the characteristics–the quality–of loans issued in the 2005-2007 period differed substantially from the quality of loans issued in prior years even holding measurable characteristics constant.  What’s more, the unemployment and growth scenarios used in the stress tests differ substantially from anything in the historical data likely to have been employed.  Thus, there are at least two reasons to believe that historical experience may be misleading.  

Third, Bernanke stated something that I had conjectured in my previous post Tinkerbell Goes to Wall Street.  Namely, that the stress tests are not intended to estimate the market value of bank assets under alternative scenarios, and are not intended to be solvency tests.  Instead, they are based on a view that market prices are deeply discounted from fundamental values due to liquidity effects, and that as long term investors funded by deposits, banks can hold assets to maturity.  As a result, when evaluating the capital banks need, expected losses (in the “physical measure” if you will) are the relevant measure, not mark-to-market losses.  

This last is a view that Bernanke has maintained since early in the crisis; he testified to this effect in the days immediately following Lehman.  Maybe.  But this is essentially speculation.  Indeed, although Bernanke cited one of the papers presented earlier in the day to support his view, the other paper (by Michael Brennan) supports a contrary view.  Specifically, that by focusing on expected losses alone one ignores the states of the world in which the losses occur, and the systematic risk of those losses.  Losses that occur in very bad economic times are discounted more heavily.  The disparity between valuations based purely on expected losses and market prices may be due to liquidity effects, but it may be due to fundamental risk pricing issues–the shift from the physical to the pricing measure.  By ignoring this possibility, the stress tests could seriously underestimate the amount of capital banks really need.

In sum, Bernanke took a particular view on why many asset prices are so heavily discounted.  It is a liquidity driven story, not a fundamentals-based, or market price of risk/systematic risk-based story.  If he is right, there is some justification for the stress test estimates of capital needs and the capital position of banks.  If he is wrong . . .

Bernanke took questions afterwards.  In response to his statement that the Fed was committed to price stability, I asked: “How does the Fed make its commitment to price stability credible in light of the extraordinary measures it has taken in the past year?”

Bernanke gave a very long answer–I’d guess it took 3-4 minutes.  He looked me in the eye the entire time.  His answer was, it seemed to me, well practiced.  But it was not entirely reassuring.  He said (and I paraphrase, obviously): we’re doing two things.  First of all, all of the members of the Board of Governors and the Fed Open Market Committee are making public our views on what the “right” amount of inflation is–about 2 percent.  Second, we are making clear that we have the tools–charging interest on reserves, reverse repos–to withdraw liquidity from the system without selling assets.  That’s fine, to a point.  I have no doubt he knows that inflation is costly and has the tools to fight it; the question, though, is whether he can credibly commit to use these tools.

He went on to say that he understands clearly the nature of the problem, and is getting heat from both sides–those that fear inflation if he doesn’t respond to a rebounding economy by withdrawing liquidity, and those who fear a prolonged recession/deflation if he withdraws liquidity too quickly.  He suggested that this is nothing new–he said a couple of times that this is the kind of problem central bankers always face when an economy is at a turning point.  

Fair enough.  But as with my reservations about the use of historical data in the stress test, here I believe that we are in uncharted waters, and that although this problem may be of a kind that central bankers are quite familiar with, it is of a scale that none (at least none living) have had to navigate.  The amount of liquidity overhang is so large; the severity of the recession is so much greater than any of recent memory, and as a result the political reaction to a “double dip” recession would be commensurately greater; the banking system is so much more fragile than during previous downturns; and the independence of the Fed has been called into question as a result of its extraordinary actions more than ever before.  All of these factors make the Fed’s job of steering between the Scylla of deflation and the Charybdis of inflation very daunting indeed.  And although Bernanke certainly was personally impressive and appealing, I still believe that there is a very serious inflationary risk going forward.

And for the record.  I’m damn glad I don’t have his job.