Streetwise Professor

Other than the price, that is.  The excellent Izabella Kaminska continues her fascinating coverage of the relation between oil prices and fundamentals at FTAlphaville. Izabella provides additional data on the continuing accumulation of oil and product inventories in the face of rising prices, and links to a Goldman Sachs analysis thereof.  

A positive co-movement between inventories and prices is an anomaly in the standard theory of storage model.  In that model, an negative demand shock (or a positive supply shock) leads to (a) a decline in price, and (b) an increase in inventories.  

I have devised a model (the ideas for which I first explored on SWP) in which you can get a positive covariation between prices and inventories due to stochastic fundamental volatility.  The basic idea is that when fundamental uncertainty goes up, people increase precautionary inventory holdings.  The only way to do this is to bid up price in order to reduce consumption and increase production.  

Although I think that this model can explain some market behavior (such as in the post-hurricane period 2005-2006), it doesn’t seem to fit the current episode.  If anything, fundamental uncertainty is declining of late.  Stock prices have been rallying.  The volatility indices (e.g., the VIX) have been declining.  

Here’s an alternative explanation.  Traditional models posit Markovian processes for (net) demand shocks.  This means that current demand shocks imply a distribution of future demand.  Moreover, the models are typically stationary, meaning that a given current demand shock leads to a smaller change (in the same direction) in expected future demand.  In these models, the distribution of future demand changes only if current demand changes.  

An alternative model (which is hard to implement formally) incorporates “future” shocks that are distinct from current shocks.  (A Fama-French JF paper on metals prices from 1988–if I recall the year–explores this idea.)  That is, information may arrive today that has no implications for current demand or supply, but does has implications for future demand or supply.  So, for example, if new information arrives that suggests the economy will be better in 6 months than than had been previously anticipated, a rational economic response is to add more to inventory in anticipation of higher future demand.  Expected future prices rise due to the bullish future information, and in conditions of full inventory, the cost-of-carry relationship causes current prices to rise too.  (Indeed, holding current demand constant, the higher price induces lower consumption and higher production, which allows the accumulation of additional inventory.)  

This is pretty close to the Goldman-Sachs story.  Goldman also argues that if oil storage facilities fill up, the connection between future prices and spot prices will break down.  In the context of the model, if the marginal cost of storage becomes very steep, the increase in future demand leads to a rise in the future price, but a much smaller rise in the spot price; it is too costly to accommodate the future demand shock by adding even more to inventory due to the very high and rapidly rising cost of storage.  Thus, current inventory (and hence current consumption) do not respond to the future demand shock; since consumption doesn’t respond, spot prices don’t change either.  

Note that the nature of the “future shock” (to steal the name of an old book) is not specified here.  It could be a real shock or a nominal one.  That is, it could be that information arrives that suggests that real demand will increase in the future, or that only nominal (money) demand will increase.  That is, inflation is expected to increase.  This could lead to increases in nominal spot and futures prices, even in the face of stagnant or declining real demand.  

One piece of evidence that could bolster this interpretation is that nominal Treasury yields are beginning to rise.  The 30 year auction yesterday was something of a disaster, and 10 and 30 year yields are rising. Indeed, over the past week when oil prices have been rising, the breakeven rate (the difference between 10 year nominal T-note rates and the corresponding TIPS yield) has increased from about 1.41 percent to 1.58 percent.  Not a big deal, but the direction is interesting.  

So, the oil market could be a “green shoot” signaling an impending recovery of demand.  One not quite here yet, but on the horizon.  Or, it could be a “green” shoot in the sense that (a) money is green, and (b) per Milton Friedman, inflation is always and everywhere a monetary phenomenon.

Banking stocks have experienced a big rally, given impetus by the anticipation, realized in the event, that the “stress tests” would show that big financial institutions were solvent, and would require only modest additional amounts of capital.   Indeed, the conventional wisdom now appears to be that the banks can earn their way out of the hole in relatively short order.

I have my doubts about this Alfred E. Neuman “What, Me Worry?” rally.   Indeed, the entire stress test exercise resembles Kabuki Theater, and the market response seems to be more appropriate to a matinee presentation of Peter Pan (“We believe, Tinker Bell!”)

Here’s one thing that feeds my doubts.   A bank is insolvent if its liabilities exceed its assets.   This would be easy to determine if the assets in particular were easy to value.   But many are not, so we cannot get a snapshot of the current solvency of banks.

But, apparently the whole idea of the stress test is to estimate bank solvency under alternative scenarios of future unemployment, economic growth, interest rates, housing prices, etc.  

So, apparently we are to understand that it is impossible to determine bank solvency at the current moment because we cannot value the assets, but we can estimate their future value under various future economic contingencies.

Just how is that possible?

Or maybe there is another interpretation.   Maybe one can interpret the stress tests as an attempt to determine the current value of these assets by estimating a distribution of future cash flows under alternative economic scenarios, taking an expected value across them, and discounting back to the present.     This interpretation would suggest that the operating assumption of the analysis is that current market prices (to the extent that they exist) do not reflect the true value of the assets, due perhaps to steep liquidity discounts.   This is the line the Fed, the banks, and Treasury have been pushing since the beginning of the crisis.  

But, if it were that easy to determine the “true” value of these assets, why is it that they are so illiquid, 7 months post-Lehman, and after the Fed has created unprecedented amounts of liquidity?     How could there be such a big disconnect between “true” asset values and market prices?   Are these just rating agency models writ large?   What assumptions underlay the modeled relations between asset cash flows and economic outcomes?   How do the stress tests capture how defaults and recoveries on various kinds of loans (commercial real estate, residential real estate, credit cards, etc.) will vary depending on economic conditions?   Given that we are going into unexplored economic territory, skepticism is almost mandatory.     History may provide little guidance.   Defaults and recoveries on debts incurred during a period in which it was widely believed that a severe economic contraction was highly unlikely will be quite different from those experienced in severe recessions in the increasingly distant past.   How much will they differ?   Who knows?  

I would suggest that there is an acid test for such beliefs.   If the banks are really solvent and don’t require much additional capital because their assets are really worth pretty close to the values banks have currently assigned to them, then both banks as sellers and numerous investors as buyers would be willing to participate in the PPIPs program.   Investors would be willing to buy the assets at close to the prices implicit in the stress test results, because the government is supplying on very generous terms the liquidity necessary to carry these assets.   Banks could sell assets firm in the knowledge that these prices investors are willing to pay would not be so low as to prove to the world that the banks are insolvent.  

Until investors and banks put their money and assets where their mouths are, and start buying and selling these assets at prices close to the values at which banks currently value them on their books, I will be deeply suspicious of the stress tests, and any other bank or government assurances that the toxic asset problem is modest and containable.

Here’s a more skeptical—indeed, cynical—explanation of what’s going on.   There is a confluence of interests between the banks, the Treasury, and the Fed.   The banks, of course, want to have the option to earn, not to say gamble, their way of their current predicament.   The Treasury and the Fed realize that there is no Congressional support for additional funds for troubled banks.   They further realize that the operational and legal challenges involved in resolving huge bank holding companies are incredibly daunting.   So, all concerned have an incentive to kick the can down the road.   To defer action in the hope that a turnaround in the economy or some stroke of luck—or a burst of inflation—will eliminate the necessity of winding up insolvent institutions.  

Hence, the Kabuki Theater of the stress tests.   Each side plays its part in a very stylized way.   The banks even put up enough of a stink to make it seem like something is being forced on them.   Professional wrestling looks authentic by comparison.

Viewed in this way, the rally in bank stocks is understandable too.   Of course, part of it can be “we believe” optimism that the economy is recovering, and that bank earnings will similarly rebound, or that the stress tests show that previous pessimism about the severity of the toxic asset problem was overdone.   But, it also makes sense to the extent that it is now quite clear that the banks will be allowed to continue to operate with little risk of resolution, bankruptcy, or nationalization.   To the extent that bank equity is effectively an option, the revelation that this option will not be terminated any time soon is extremely bullish news.   Moreover, since debt of insolvent banks is also effectively equity, and hence effectively an option, extending the option to gamble one’s way out of ruin also enhances the value of bank debt.   Immediate resolution would probably lead to the immediate loss of a good part of the value of unsecured bank debt, but survival could permit recovery of a good fraction of that value. This can explain the tightening of CDS spreads on banks—an indication that the value of their debt is rising.

Viewed in this way, the rally in bank securities is explained by the market’s estimation that the stress tests, and the apparent willingness of the government to eschew any efforts to restructure big banks, extends the life of the gamble to survive option.

But, if this view is correct somebody has the short position in that option.   Normally, an increase in the value of the gamble to survive option would benefit equity at the expense of debt.   But given the potential for a bailout that may provide some support for creditors in the event the gambles do not pay off, it is possible that extending the life of this option could help both bank debt and equity.    

Under this interpretation, that somebody holding the short position would be taxpayers, or the holders of dollar denominated claims who will pay an inflation tax.   Heads, the bank shareholders and bondholders win.   Tails, the taxpayers pick up the tab.  

Although there is no direct market in these things, Treasury securities prices do provide something of a signal.   Greater debt or greater inflation put upward pressure on Treasury yields, and we are beginning to see evidence of that.

So, I am highly skeptical about the stress tests, and their interpretation.   Given the very gloomy prognostications of the IMF and others about the total unrealized losses on toxic assets, the stress test results and the way they are being spun seem too good to be true.   Maybe we are in Neverland.   But maybe the banks, Treasury and the Fed have their own reasons to double down and hope for the best, and the stress tests are providing the cover to do that.   The artificiality of the stress tests, and the weird nature of the entire exercise (i.e., how can you value what banks will be worth tomorrow if you can’t value what they’re worth today?), make me suspect that the latter is a very real possibility.    

Today is the 110th of Hayek’s birth.  Reading a couple of items in the FT brought to mind one of Hayek’s most trenchant observations.  Specifically, Hayek was extremely suspicious of the use of the word “social” as a modifier.  He viewed it a a meaningless appendage at best, a means of undermining (or intimidating the exercise of) independent thought at its worst.  Hayek believed that the positive connotations of the word “social” were used to justify profoundly illiberal, and at times oppressive, actions and policies.

The s-word is cropping up a lot in discussions of the Chrysler bankruptcy, and the administrations attempts to strongarm those standing on their contractual rights.  One example:

“The financial interests of investors may conflict with what the government is trying to do from a social perspective,” says Steve Persky, managing director of Dalton Investors, a Los Angeles-based hedge fund that specialises in distressed debt.

And another:

The message that all the constituencies involved in Chrysler must share in the pain originated in the White House. “The government played a very strong hand,” says the person representing one agent bank. “All the senior lenders got the short end.

“The government had one eye on the social element and one eye on not abrogating contracts, but can you reconcile these two goals?”

Translation: “social perspective” and “social element” mean policies intended to benefit one group of individuals at the expense of another, but that the beneficiaries are called “society” and the victims of the redistributive policy are by implication “anti-social.”  I can’t think of a better example of Hayek’s warnings about the use of “social.”

No, the 60,000 Chrysler workers are not “society.”  They are a politically favored group.  And no, the senior creditors are not “anti-social.”  They are individuals and firms whose contractual rights are being threatened.

Indeed, the insinuation that the deprivation of a small number of individuals’ contractual rights is somehow necessary to achieve larger benefits for “society” turns reality on its head.  By undermining the security of contract to benefit a small, politically favored interest group, these actions will reduce the wealth of Americans–and indeed people around the world–by a far larger amount than it will increase the wealth of the Chrysler workers and retirees.  It will raise capital costs and transactions costs throughout the entire economy, making most of us far poorer (except, perhaps, for lawyers and lobbyists).   The rule of law and contractual rights are essential to the production of wealth, and to economic growth.  Undermine these, and less wealth will be generated, today and in the future.  

And, to provide some perspective on how the word “social” is used to rationalize robbery, here’s a wonderful quote from Obama’s Book Club buddy, Hugo Chavez, rationalizing the expropriation of oil services firms who actually had the temerity to demand payment for services rendered (can you believe?):

“Tomorrow we’ll start recovering the goods and assets that will now belong to the state — social property as it always should have been,” Mr. Chávez said in a televised speech Thursday. “Mr. Man on the moon, cover your ears because the cries of anguish from the bourgeoisie will reach all the way to the moon.”

We’re not Venezuela or Russia yet, by any means, when it comes to undermining property rights.  We still have independent courts.  But the administration’s (and Congress’s) disregard for property rights, and its willingness to run roughshod over them to benefit certain political constituencies promoted to the rank of “society” is an ominous precedent.

As is the other news in the second FT article quoted above.  Namely, the use of big banks dependent on the government to serve as the enforcers of the government’s will:

But whatever the final ruling, the talks last week illustrated that four banks, led by JPMorgan, which acted as agent for the loan, were acting to advance the government’s agenda, according to people familiar with the talks. The core lenders, which also included  Morgan Stanley,  Goldman Sachs  and  Citigroup, have all taken taxpayers’ money through the troubled assets relief programme.

The efforts of Mr Lee at JPMorgan, which originally had $2.7bn of Chrysler debt, were supported by the three other agent banks, Citi, with about $900m in face value of loans, Morgan Stanley and Goldman Sachs with well under $600m each. Mr Lee declined to comment.

The four banks divided up the work of contacting other creditors, with each calling those with whom they had the strongest relationships, the people familiar said.

In some cases, the large banks were lenders to smaller Chrysler creditors, in others, they had sold them the Chrysler debt. “There was a lot of high drama stuff,” recalls one creditor. “There was a lot of we will never do business with you again kind of talk.”

That can be standard in the tough negotiations over the fate of troubled borrowers. But in this case, there was another element. In an illustration of how dramatically the financial world has changed during the financial crisis, bankers from the agent banks say they felt under pressure from the US government.

This is the kind of abuse of effective government control over large financial institutions that has led me to oppose nationalization as a means of addressing bank insolvencies.  We again seem to have the worst of both worlds: the government gives every impression of being captured by the major banks when it comes to dealing with insolvency (I hope to write about the stress tests in a bit), but exerts pressure on them to divert resources to its favored constituents.  And perhaps this is the disturbing quid pro quo: the banks get the opportunity to gamble themselves out of trouble, and in exchange, assist the government in undermining contracts so as to benefit its favored interests.

Like I’ve said.  These things don’t average out: being too nice to the banks on some things and leaning on them in others is to commit two errors that compound, rather than offset.  (Like the old lawyer joke: “I’ve won cases I should have lost.  I’ve lost cases I should have won.  Therefore, on average, justice has been served.”  No.  It’s been dis-served twice.)

To close the circle, this quote from an article about science prizes illustrates perfectly Hayek’s warnings about the low and dishonest rhetorical use of the word “social”:

“I hate these inducement prizes and their language of social benefit,” says University of Pennsylvania prize scholar James F. English, author of “The Economy of Prestige: Prizes, Awards and The Circulation of Cultural Value.” “It’s a cover for what they are really about, which is getting attention. I don’t think that kind of small-scale frantic prize-chasing investment is the best way for us to solve big problems.”

Different context, to be sure.  But a wonderful illustration of Hayek’s point that when you hear the word “social” being used, be very, very careful.  There is a very good chance you’re either being played–or intimidated into silence.

The Obama administration–and President Obama personally–have inserted themselves where they do not belong, in the midst of the Chrysler bankruptcy. Obama and his administration have clearly engaged in strongarming secured creditors in order to serve the interest of an unsecured creditor, the UAW, which just happens to be the Democrat Party’s Siamese twin:

Chrysler LLC filed for Chapter 11 bankruptcy protection in New York on Thursday, saying that it would sell its core assets including its Chrysler, Jeep and Dodge brands into a new company that would be owned by the U.S. government, Fiat SpA (FIA.MI) and the company’s workers.

The plan, however, depends on U.S. Bankruptcy Court approval of the sale, and this group of lenders feels the current plan to sell those assets within 30 to 60 days may infringe on their legal rights.

“We’re just standing on the law,” said Tom Lauria, a bankruptcy attorney at White & Case, representing a group of about 20 Chrysler first lien senior secured lenders.

“They (Chrysler) say they are going to allocate out and distribute the proceeds of the sale in a way that they couldn’t do if they were going to do it under a Chapter 11 plan,” he added.

The group of lenders Lauria represents includes Oppenheimer Funds, Stairway Capital and other secured lenders who have their own group of investors, including teachers’ credit unions, pension funds, retiree plans, college endowments, and retirement funds.

He said the group understands the need for Chrysler to sell itself and for the industry to restructure, but owes a fiduciary duty to its investors and objects to the way Chrysler is trying to divy up the proceeds of the bankruptcy sale without putting it to a creditor vote.

“This is not an objection to rescuing Chrysler, Lauria said.

Rather, Lauria said, Chrysler’s proposed plan “inverts” the classic priority scheme written into the bankruptcy code, where senior secured creditors are paid in full first, followed by junior lenders, administrative claims, unsecured lenders and equity holders.

“The sale is an attempt to end-run the procedural protections that are provided to stakeholders by Chapter 11,” he said.

“What’s happening is the senior secured creditors are going to get 29 cents on the dollar and the unsecured creditors are going to get $10 billion dollars.”

Lauria said his clients had viewed the quality of their collateral as secure and took correspondingly low interest rates on their loans to Chrysler because the loans were “seemingly secure.” But now the lenders find themselves effectively subsidizing more junior creditors, in a way that would not typically occur under the bankruptcy code, Lauria said.

. . . .

“Based on the pressure the administration has put on a number of my clients who have received no TARP funds in the last 24 hours, I cannot imagine the pressure that it brought to bear on the lenders in our group who received TARP funding,” Lauria said.

“I’ve never seen the President of the United States personally thrust himself into a bankruptcy case. The executive branch is going to be present in the court and it will really put pressure on the court to demonstrate to the people of this country that it’s watching what’s going on in an independent and unbiased way.”

In a televised appearance from the White House, Obama termed the dissenting Chrysler debtholders “speculators” who had endangered the automaker’s future by holding out.

“I don’t stand with those who held out when everybody else is making sacrifices. That’s why I’m supporting Chrysler’s plan to use our bankruptcy laws to clear away its remaining obligations,” Obama said.

The part about “us[ing] the bankruptcy laws” is particularly rich, as the aggrieved creditors are clearly standing on the bankruptcy laws, and numerous precedents thereunder, while the UAW and the administration are just as clearly doing everything possible to subvert those laws and precedents.  

Selective intervention of this sort has consequences.  Any potential lender or investor to any politically sensitive firm will certainly raise his/her estimate of the likelihood that their investment will be expropriated if it serves the interests of this administration, or some future one.  The cost of finance, both debt and equity, will rise accordingly.  

The main saving grace here is that there is a possibility that an independent court will slap down this usurpation.  That is what–so far, anyways–has kept this country sliding down too far on the path towards an unconstrained executive, and away from a rule based system in which personal liberties–including property rights–are protected from the awesome power of the state.  The Supreme Court did so when overturning the NRA in the poultry case, and in ruling in the Youngstown case against Truman’s seizure of the steel industry during the Korean War.    

We’ve seen what happens when the power of the government favors organized labor in the airline industry, and the railroad industry before that.  It was not pretty.  In the case of the airlines, it is still pretty ugly.  

So, where will the effect be biggest?  Right now, I’d say Ford.  The company has been relatively fortunate, but it will definitely face higher capital costs going forward.

 Another industry worth watching is the banking industry.  You know, the one that needs massive recapitalization.  Maybe in the 12-13 figure range.  No big deal.  Sure you’ve read about it.  

In banking, the schizophrenia is manifest.  On the one hand, the government is reluctant to permit the operation of existing processes and precedents that would impose losses on bank creditors, thereby permitting undercapitalized banks to continue to operate without necessary restructuring.  On the other, in the auto industry it is taking actions that undermine the ability of banks to attract new capital by undermining the law’s protections to creditors.  That is, it is taking actions that run roughshod over the operation of rules governing the disposition of firms in financial distress, in one instance protecting creditors, in the other screwing them.  But it is protecting from the effects of the law those who don’t deserve protection, and attempting to deny its protections from those who do.  

And no.  These things don’t average out.  

This greatly increases the uncertainty and unpredictability in the capital markets.  It means that we are transitioning from a largely rule-driven system, albeit an imperfect one, into a discretionary, political-driven system.  As ugly as the bankruptcy process is, at least it is a process, and one that offers some protections.  Executive extemporization based on political calculations is the antithesis of process.  The resulting increase in the risk/uncertainty will have huge effects on contracting going forward, and will tend to impede investment and growth.  

Some pooh-pooh these problems.  Felix Salmon, for one:

Oh come  on. When Detroit raised debt capital in the past, its lenders weren’t operating on the assumption that they would be paid off in full before the UAW got a penny — and if they were, they were being foolish in the extreme. The UAW, after all, is necessary for the continued existence of the company: they’re doing the equivalent of putting new money in to the operation, in the form of their labor going forwards. I don’t see the creditors offering to put up any new capital.

Sure, the creditors might have a point about seniority if the firms were to be liquidated with the loss of all jobs. But let’s not forget that a huge part of the reason why they lent their money in the first case was that the US auto industry is systemically important, and that the government would never allow it to be liquidated. They were making a moral hazard play, and believed the car companies when they said that bankruptcy would be disastrous, and so they assumed that the government would keep the car companies out of bankruptcy.

Where to begin?  Time is at a premium, so I will just make a couple of comments.

Re “[w]hen Detroit raised debt capital in the past, its lenders weren’t operating on the assumption that they would be paid off in full before the UAW got a penny”: “paid off in full” is a straw man (very Obama-esque of Salmon, BTW, for Obama is the master of the straw man gambit).  No doubt they were operating under the assumption that in any renegotiation or bankruptcy procedure, the normal horsetrading would mean that unsecured creditors would receive something, and that they secured creditors would take a haircut.  But no doubt they were also not operating under the assumption that the government would attempt to undermine completely their contractual and legal protections, and exert tremendous pressure to force bondholders to subsidize the UAW to this extent.  

Re “[t]he UAW, after all, is necessary for the continued existence of the company: they’re doing the equivalent of putting new money in to the operation, in the form of their labor going forwards [sic]. I don’t see the creditors offering to put up any new capital.”  Uhm, I’m pretty sure they are going to get paid for their labor going forward.  Any concessions re wages and benefits?   Apparently not.  This is about the priority of an unsecured claim that the UAW willingly agreed to in the past, and whether that priority should be honored going forward.  (And, insofar as the UAW’s necessity for the company’s continued existence is concerned:  It is largely responsible for its current predicament, and its increased dominance will hamper the company even more going forward.)  

Re “moral hazard play” and “liquidation”: Another straw man.  Pretty Olympian of Salmon to put himself in the minds of myriad bond investors.  Moreover, he suggests that seniority matters only in liquidation.  But, first, neither ex ante or ex post would anybody consider full liquidation a likely outcome.  Second, seniority affects bargain power, and hence payoffs, in restructuring outside of bankruptcy, and within bankruptcy.  An unexpected, ex post attack on seniority therefore transfers wealth from one group to another even outside of liquidation.  

The key word here is “unexpected.”  If this heavy handed intervention was unexpected–and it seems pretty clear that it was–after observing it rational investors will revise their estimates of likely outcomes involving future politically connected, financially distressed companies.  In particular, they will revise their expected payoffs downwards.   They will revise upwards their estimates of transactions costs and risk.  All of these effects will inevitably lead to higher capital costs for this kind of firm.

Salmon calls this argument a “groaner.”  Sadly, he’s the one who deserves the groans.

Commentor Sandrew was feeling overlooked because I didn’t pick up on his comment on the Felix Salmon post, a comment that hit the key point in my later response to Salmon.  Here’s his comment:

I think you may be focusing on the wrong transaction costs. To pierce the Coasean retort, one must demonstrate that frictions exist to impede the unwinding of CDS and the transfer of bonds. Pirrong argues that if such transactions are efficient, then the perverse incentives that bond hedging via CDS create can be efficiently diffused.

That said, I’m not convinced that the bond and CDS markets are as well lubricated as Pirrong seems to suggest. To me, the enormity of the CDS market is as much evidence for the presence of significant CDS unwind costs as it is for the popularity of the instruments. If unwinding or novating CDS was so cheap, why did the aggregate notional amounts balloon to umpty-trillion bucks over the course of the past decade?

Sandrew’s comment re the Coasean retort is correct.  Re his second paragraph, well, I don’t really take a stand on how well “lubricated” the CDS market is, except to say that if the empty creditor problem is a really big deal, and the bad incentives resulting from hedged bond positions lead to huge costs, in my view it is likely that the CDS market is sufficiently lubricated to permit market participants to avoid such costs.  I note that re the ballooning of aggregate amounts, etc., when it became apparent that there were large costs associated with failing to close offsetting positions, market participants acted with alacrity and did large amounts of tear-ups through TriOptima, etc.  As a result, notional amounts have fallen dramatically (by about 40 percent if memory serves).  

Thanks for the comment on Salmon’s blog, Sandrew.  You are on point, and get props from me, if belated ones.

So, Sandrew–consider your head patted;-)

Felix Salmon does me the kindness of responding in detail to my post on Coase Meets CDS.  Color me unpersuaded.  

Felix (if I may) strikes the pose of the Practical Man, juxtaposed to his portrayal of me as the Ivory Tower Pointy Head.  It is of course essential to keep the practicalities in mind, but  the Practical Man  (a) is often limited by what has been, and has a difficult time envisioning alternatives, and (b) often lacks a conceptual framework that helps sort through complex situations.  I respectfully suggest that Felix falls victim to both problems.  The comparative advantage of the Ivory Tower Pointy Head is that s/he–I, in this instance–can bring some conceptual order to the complexity.  Indeed, that’s the whole beauty of the Coase Theorem in particular.  By imagining an impractical world, it identifies the key practical aspects of a problem that deserve analytical attention.

Let’s focus on what is the issue at hand, and which Felix doesn’t IMHO adequately isolate, and instead in Practical Man fashion buries in a jumble of other empirically/observationally motivated considerations.  

The issue at hand is: What is the incremental contribution of CDS to the costs of financial distress?  Felix mentions the well-known transactions costs of the bankruptcy process.  But these costs were well known before CDS were a glimmer in some J.P. Morgan banker’s eye.  Relatedly, Felix mentions “very few people trade in [distressed credit]: basically it’s the province of a small number of distressed-debt funds who like to buy the debt cheap and then wade into invariably-arduous litigation.”  True.  But it was true before CDS.  It is true today even for distressed credits on which CDS are not traded, or for which the volume of CDS trading is de minimus.  Relatedly, Felix talks about how “arduous debt renegotiations are.”  True again, but the same remarks hold.  This does not address in any way the incremental contribution of hedged creditors to the arduousness of renegotiations.  So, these remarks are completely off point in responding to the issue at hand.  

The charge before the bar is that by undermining the incentives of hedged creditors to undertake part in value-enhancing pre-bankruptcy restructurings, the costs of these restructurings are higher when some creditors are hedged when they are not.  (Relatedly, it is possible that bankruptcy procedures themselves are higher when some creditors are hedged.)  Discussing the costs of workout and bankruptcy in general says absolutely nothing about this key issue.

When addressing that specific charge, the Practical Realities that Felix mentions are not particularly illuminating, because they are common to all dealings involving distressed credits.  

The relevant issue is the incremental cost of eliminating the putatively perverse incentive arising from hedged trades.  The very liquidity in CDS that Felix touts suggests that this incremental cost is not particularly high; the hedged creditor can reverse the CDS position.  If the creditor does not want to retain the risk exposure associated with the remaining debt that would result after reversing its CDS position, an EFP-style trade (a simultaneous transaction in the underlying credit and the CDS) with a party with an offsetting CDS position, to a first approximation (i.e., abstracting from basis risk) leads to an identical allocation of risk and the elimination of the putatively perverse incentive.  Win win.  Value created that can be shared.

EFP trades have been common features of derivatives markets since their beginnings (though they go by a bewildering variety of names).  Nothing new here.  Nothing complicated here.  Very Practical, in fact.  Practical Men have used them for a long time in many markets.  Nothing Ivory Tower about them.  Indeed, I can say from 20+ years of academic experience that 90+ percent of Ivory Tower finance people have never heard of an EFP.  I learned about it from being in the markets.  

Let’s stipulate that this isn’t being done, at least in quantity.  That means that the costs exceed the benefits.  This could be because the costs are high, or because the benefits are low.  Neither Felix nor any of the other disquisitions on this subject I’ve read present a convincing case that the benefits are high (because the empty creditor problem is particularly pernicious.  The absence of these sorts of trades is also consistent with the benefits of eliminating the empty creditor problem being small.  

Some of the very facts that Felix cites are consistent with the conjecture that the empty creditor problem isn’t that serious because workouts prohibitively costly when this problem is absent.  A lot of firms go into bankruptcy–meaning that pre-bankruptcy workouts are not universal.  Again, this was true before CDS, and is true for firms for which CDS hedging is not that material. This means that the transactions costs of the workout are sometimes prohibitively costly even in the absence of hedged creditors.  Indeed, I would argue that the relative rarity of workouts in situations not complicated by CDS suggests that the incremental contribution of CDS is likely to be small.  

Felix makes some lazy arguments.  About laziness, in fact: “Bondholders have discovered that if they hedge themselves in the CDS market, they can be lazy about such matters.  And there aren’t any easy ways to get a lazy bondholder do hard negotiating work.”  

Again.  If the empty creditor problem–now renamed the “lazy bondholder problem”–is that serious, then laziness is very costly.  There is value on the table that can be used to bribe the lazy to transfer their positions to somebody who is not lazy.  Indeed, the truly lazy can completely wash their hands of everything and pick up some spare change in the bargain.  Sounds tailor made for the lazy.  

There has always been the issue of control rights not being held by those best able to exercise them.  Insurance companies buy corporate bonds not because they have a comparative advantage in participating in workouts, but because the risk-return characteristics of the bonds meets their investing needs.  In the event of an issuer’s financial distress, the insurance company is unlikely to have the comparative advantage in participating in the workout.  The company could–and sometimes does–sell bonds to someone who can exercise the rights more efficiently.  But often it does not.  One reason for doing this is that the rights are not that valuable in the first place–due, in large part, to the arduousness of workouts even in the absence of hedging.  

In the end it’s all about a very basic economic proposition.  A very practical economic proposition that is lived out in markets every day, as it has been for millennia past.  That proposition is that resources flow to their highest value uses.  As modified by Coase, the “highest value use” takes transactions costs into consideration.  Those worrying about the lazy bondholder problem assert that CDS dramatically raise the transactions costs and impede the flow of control rights into their highest value use.  The case is not proven by a longshot.  

Felix objects to my starting the story at the end–i.e., when financial distress looms, rather than when the hedger initiates a CDS trade.  This objection is readily addressed, and indeed, extending the analysis in that direction strengthens my point.

First, that’s the natural starting point in addressing the empty creditor argument, precisely because that’s where Hu and others started it.  

Second, and more importantly, taking this into consideration forces one to consider the effects of CDS in their entirety–something I did in the last paragraph of my post.  The possibility that value will be destroyed due to perverse incentives in the event of financial distress will be priced into the CDS when a hedger initiates a position.  In particular, the costs arising from an inefficient resolution of a financially distressed firm will tend to increase the costs of protection accordingly; the protection seller, anticipating the possibility of making larger payouts in the event of financial distress on the named credit, will price that into the protection.  If consenting adults make the trade nonetheless, it means that the net benefit of the CDS transaction to them is positive even taking into account the possibility of a lazy bondholder problem.  Although it might be desirable to undertake actions that reduce transactions costs in the event of financial distress, there is no justification whatsoever for restricting trading of CDS based on fears of the empty creditor problem.  You may save on some costs, but only by imposing even greater costs in return.  You know that you are imposing even greater costs because you are preventing consenting adults from engaging in trades they deem to be mutually beneficial even given the possibility of the lazy bondholder problem down the road.  

This understanding motivates a very Practical Way of analyzing how to improve the CDS markets.  Focus on reducing the transactions costs of dealing in CDS and corporate bonds.  Avoid measures that constrain the ability of market participants to trade CDS–either to initiate, or reverse positions.  Sadly, to the extent the worries about the empty creditor problem contribute to the CDS are bad meme, they are invoked to support measures that would restrict CDS trading, thereby eliminating some mutually (and socially) beneficial trades.  As an example of the former policy, moves to improve standardization and fungibility would facilitate the development of EFP-style trades in CDS.  (Lack of standardization and fungibility make it costlier to deal with others than with the original counterparty, thereby limiting the possible universe of CDS trades.)  

A couple of final points.  Felix chides my CDS auction speedup proposal because it doesn’t address the pre-bankruptcy workout issue.  I make that very point in my post.  

And finally, Felix states that my original post is a “very long” one.  LOL.  That’s nothing, dude.  Want to see long?  Prowl around the site awhile and you’ll see long!

Reading about the bizarre circumstances involving the government’s role in negotiations between the bailed-out auto company and bailed-out banks puts me in mind of a story from the pre-Civil War army about a particularly cussed officer, Braxton Bragg*:

As commander of the company he made a requisition upon the quartermaster–himself–for something he wanted. As quartermaster he declined to fill the requisition, and endorsed on the back of it his reasons for so doing. As company commander he responded to this, urging that his requisition called for nothing but what he was entitled to, and that it was the duty of the quartermaster to fill it. As quartermaster he still persisted that he was right. Unable to resolve the dilemma, Bragg referred the whole matter to the post commander, who exclaimed: “My God, Mr. Bragg, you have quarreled with every officer in the army, and now you are quarreling with yourself.”

With the government on both sides of the bailout–I mean bargaining–table in the Chrysler negotiations, similar absurdities are inevitable.

Every dollar extracted from the banks to help Chrysler is a dollar of bank capital gone.   Given that (a) the banks are arguably insolvent, or teetering on the precipice of insolvency, and (b) the government has effectively guaranteed to recapitalize the banks, this is just robbing Peter to pay Paul.   And you, dear taxpayers, are Peter.

The government’s metastasizing presence throughout the “commanding heights” of the American economy is a recipe for policy incoherence, and intense distributive feuds over rents.   People have been throwing around scare words–socialism, fascism–to describe what’s going on.   For the most part, those terms are unnecessarily provocative and inaccurate.   It is fairer, and far more accurate, to forecast that we are devolving into corporatism.   And corporatism, in my view, would sentence the American (and world) economies to decades of Olsonian sclerosis.

One other quick economic comment.   I wonder if anyone has rerun the Obama deficit projections based on either OECD or IMF growth forecasts, which are considerably gloomier than the Obama assumptions, and even the more pessimistic CBO assumptions.   (This goes for spades in the UK, BTW.)   I would imagine that the already shocking deficit projections would be stupefying.

I read in a Bloomberg piece today that the mortgage backed securities market is 10 percent larger than the US Treasury securities market.   Not for long, folks.   Especially if IMF is right.

* Bragg later became a Confederate general who commanded the Army of Mississippi and the Army of Tennessee.   He was notoriously unsuccessful, except in the area of inspiring hatred among his subordinates.   Grady McWhiney, who wrote the quoted passage, was planning a multi-volume biography of Bragg.   He found Bragg so odious a character that he gave up after a single volume, and let one of his graduate students finish the biography.   Isn’t that what graduate students are for?   To do the jobs their advisors won’t?   [That was sarcastic/ironic, BTW.   Not reflective of my personal views, but a sardonic comment that cuts painfully close to the truth far too often.]

The IMF World Economic Outlook makes extremely dispiriting reading.  Especially for Russia.  The IMF completes the trifecta of major international organizations (after the World Bank and OECD) to revise sharply downwards its prognostication for Russian economic growth.  (SWP paging Bob!  SWP paging Bob!)  Indeed, Russia is the champ, according to IMF.  That is, the IMF reduced its estimate of growth for every country, but the reduction in Russia’s GDP growth forecast was the largest, at -5.3 percent.  Indeed, the IMF’s forecast of Russian growth is lower than its forecast for any country other than Japan for 2009: IMF estimates that Russian GDP will drop 6 percent, compared to Japan’s decline of 6.2 percent.

Russia is also the champ when one compares 2007 or 2008 growth rates to forecast 2009 growth rates.  Whereas Japan’s growth rate in 2009 is forecast to be 5.6 percentage points below its 2008 growth rate, Russia’s 2009 rate is forecast to be 11.6 percent below.  Comparing 2007 and 2009 growth rates implies a difference of 8.6 percentage points for Japan, and a whopping 14.1 percentage points for Russia.  Say that slowly.  Fourteen point one percentage points.  That’s huge.

An article in the Moscow Times should only deepen the sense of gloom.  The article notes that Russian inflation was 5.8 percent in the first quarter.  This is consistent with another SWP prediction that Russia is mired in a deep stagflation.  The acceleration of inflation at the same time the economy is plunging is deeply troubling, and reflects the forces that I mentioned in some earlier posts, namely, the quite reasonable decision by people to exchange rubles for goods.  I doubt the ruble can maintain its rally under such circumstances.  Unbelievably, though, the government is sticking with its forecast of 13 percent inflation for 2009.  Dudes.  You’re like 45 percent of the way there after 25 percent of the year.  Expecting a dramatic slowdown of inflation is very unrealistic, especially given the seemingly entrenched inflationary expectations among the Russian people.

The head of the Kremlin’s anti-crisis task force, Vladimir Mai channels the SWP theme that Russian policy options are extremely limited, especially given the sharp inflation:

“Inflation limits the tools of our anti-crisis policy. Many measures used in the United States and Europe are not available for us. We cannot carry out quantitative easing, we cannot use budget stimulus and we need to maintain high interest rates,” he said.

Mau fears that renewed growth in commodity prices could stall the modernization drive and bring the government back into a complacency mode that characterized the last years of Vladimir Putin’s presidency.

“During an economic boom, it is impossible to carry out a modernization policy,” he said. “If prices for oil and gas are high, there will be no diversification.”

Translation: “We’re screwed.”

The last paragraph is of particular interest.  The political will for modernization and diversification is lacking in times of economic crisis because the government is in survival mode then.  The political will for modernization and diversification is lacking when the economy is strong due to high oil and gas prices because under such circumstances, who needs modernization?  Laissez les bon temps roullez!  Especially for the kleptocrats.    Where’s the Goldilocks spot?  You know, the one that’s just right to facilitate modernization and diversification?  Uhm, somebody will have to get back to you on that one.

For the foreseeable future, if anybody (now who could that be?) uses the words “nano” and “Russia” in the same sentence, my immediate reaction will be to think of the order of magnitude of the probability that Russia will achieve the economic ambitions that harbored a mere six months ago, let alone achieve the fantasy set out in the Russia 2020 pipe dream.

In this environment, Putin’s statements about the economy are delusional.  Beyond delusional.  As are the pursuit of “prestige” projects like Sochi, billion dollar bridges to Godforsaken islands, and large expenditures on new weaponry.

Kudrin may be overly pessimistic in saying that this crisis has set the country back 50 years, but maybe not.   The crisis has derailed for the foreseeable future measures necessary to cope with Russia’s serious long term problems, such as demography and health, and infrastructure.  I hope to write soon on a couple of articles on Russia’s demographic situation, but given that economic growth of the first decade of this millenium led to only a modest decline in Russia’s downward demographic trajectory, there is a serious prospect that the current crisis will eliminate that faint progress, and lead to the return of the apocalyptic trends of the 90s.  Similarly, the prospects for addressing Russia’s serious infrastructure problems are fading fast.  The resulting deterioration in human and physical capital undermines the prospects for long term growth.  Upon consideration, maybe the “stressed” Mr. Kudrin is an optimist.

The Rodney Dangerfields of financial instruments, credit default swaps, are now getting disrespected for impeding workouts of companies teetering on the edge of bankruptcy.  This argument was first flogged by UT law professor Henry Hu last year.  Now, lawyers in General Growth Properties and AbitibiBowater bankruptcies are blaming debtholders who hedged by buying CDS protection on these companies with having little interest in achieving a workout.  Several bloggers, including the estimable Megan McCardle  and the very good (but not quite so estimable, IMHO) Felix Salmon  have expressed similar concerns.  The somewhat supercilious, but usually provocative, Charles Davi takes the opposite view.

I come down on Davi’s side, but for very different reasons.  This is essentially an argument about the effect of the distribution of property rights/ownership.  Those who claim that there are perverse effects of CDS argue that the distribution of ownership has effects on the allocation of resources.  There will be a different allocation if some debt is owned by those who also have CDS positions, than if all debt is owned by the unhedged.  In particular, outcomes will be less efficient, in this view, if some debts are owned by firms that are hedged.

Well, the proper way to begin any analysis of the effects of the original distribution of ownership is with Coase, and the Coase Theorem.  This states, of course, that in the absence of transactions costs, the initial distribution of ownership has NO effect on the ultimate allocation of resources. This result obtains because without transactions costs, the original owners can negotiate mutually beneficial trades that put the resources in their highest value uses.  Indeed, they will trade until the final allocation of ownership maximizes value, regardless of the initial allocation.

This means that any “problem” with the distribution of ownership is a transactions cost problem.  This leads one to (a) attempt to identify the sources of transactions costs, and (b) determine whether there is any change in laws, regulations, etc., that could reduce transactions costs.

In the CDS context, this means that in the frictionless Coasean world, the “empty creditor problem” that arises when creditors are hedged is in fact an “empty problem”–that is, not a problem at all.  It is therefore necessary to evaluate, and do so more carefully than those I have seen weigh in on this subject, whether transactions costs seriously impede value maximizing trades, and if so, what are the most efficacious means of reducing these costs.  

Here’s my argument in more detail:

A completely hedged debtholder (i.e., a party that has purchased protection in an amount equal to his holdings) would appear to have no incentive to behave constructively during the reorganization.   But this means that a potential source of value—the control and legal rights attached to the ownership of the debt security—is not being maximized.   There is therefore a set of mutually beneficial transactions that would leave the insured debtholder no worse off than if he acts in the passive manner that the critics of CDS hedgers suggest, but would result in the efficient exercise of the control and legal rights.   Specifically, another party could purchase the debt from the insured current holder at a price that is satisfactory to the latter, but which allows the purchaser to capture some of value associated with the control rights.   That is, there is a set of transactions that would allow the hedged debtholder to capture some of the benefits of the control rights.

The anti-CDS analysis presumes that there is money left on the table.   The total value of the debt and insurance contracts are higher if the control rights are efficiently exercised.   This creates an economic incentive to structure transactions to ensure that they are so exercised.

The credit protection that hedgers have is not (from a social perspective) an economic asset.   It has zero value because the gain to the buyer is offset penny for penny by a loss to the seller.   This suggests another value enhancing transaction.   The protection seller and the protection buyer could agree to cancel the contract at a mutually acceptable price that effectively splits the value associated with the control rights between them.   This would be mutually beneficial even if the debtholder is overhedged, i.e., has bought more protection than he holds in the debt.    

Another alternative is for the protection seller to buy back the protection and the debt.  The “empty creditor” problem goes away because there is no hedge once this transaction is completed.  The risk profile of the buyers and the sellers is unchanged.  The formerly hedged creditor had no risk exposure after the trade because he was hedged; he has no exposure afterwards because both positions are closed.  (The former statement is something of a simplification.  The “hedged” firm still faces basis risk–a not immaterial consideration, especially of late.  Thus, risk exposure actually goes down for this firm.)  The former protection seller’s risk exposure doesn’t change either.  He was long the debt (via the CDS position) before the trade; he is long the debt itself afterwards.

In other words, CDS critics essentially overlook the Coase theorem, and assume that the allocation of rights is somehow locked in, and cannot be changed by mutually profitable value-enhancing trades.

Of course, transactions costs are not zero in the real world.   It may be costly to find the insured holder of the debt (although insurance sellers could always find their counterparties and commence a negotiation.)   More substantively, different parties may have different—and private—information about the value of the control rights.   Similarly, absent some disclosure requirements, the positions in the debt and protection of each market participant are private information.   This private information can create transactions costs that impede the transfer of the valuable control rights to those who can exercise them most efficiently.

The CDS critics focus on potential problems in negotiations in bankruptcy, or in pre-bankruptcy negotiations between debtors and creditors, and among creditors.  This is a myopic view.  That lawyers (pace the FT piece) advance it is not a surprise, in some sense, because that’s their world.  It is a myopic view because there are many other potential transactions; between protection sellers, buyers, creditors, and third parties that can reallocate the relevant control rights and mitigate the allegedly perverse incentive effects of hedged positions.  If hedges destroy value, by impairing incentives, greedy market participants have an incentive to unwind the hedges to capture that value that would otherwise be destroyed.  These transactions can involve the CDS, the underlying debts, or both.  The world of possible value enhancing transactions does not begin or end at the law firm door, or the steps of the bankruptcy court.  

Thus, at root, as is the case with any asserted inefficiency, the anti-CDS argument is implicitly one about transactions costs.    The anti-CDS  argument holds only if transactions costs materially impede the consummation of value enhancing bargains, but those advancing this argument undertake no analysis of transactions costs, or of ways to reduce them.

To take the skeptics’ view at face value (no pun intended), is to assume that transactions costs are very high indeed.  For the skeptics argue that large amounts of value are destroyed by the empty creditor problem, it must be the case that the transactions costs of circumventing the problem are even larger.  Given the presence of large, sophisticated market participants, this seems something of a stretch.  And indeed, it’s not just the original holders of the debt and CDS that are potential players here.  Hedge funds or vulture funds or others could realize the value opportunity, and structure trades that maximize the value of the control rights.  

The fact that a relatively simple trade–the reversal of an earlier CDS trade, combined with the simultaneous purchase of debt–could eliminate the empty creditor problem suggests that this is much ado about nothing.  The transactions costs of reversing an earlier transaction, in what is effectively an “EFP” (“exchange for physicals,” a commonplace derivatives trade), are not all that high.  Certainly not that much higher–if at all–than the original trade.  

Even if my conjecture that the empty creditor problem isn’t that big a deal, or somebody (or many somebodies) would have engaged in trades to make it go away is incorrect, the debate over how to deal with the issue has been pretty much off point.  It has a sort of “woe is me what are we going to do with these awful CDS” flavor to it.  The more high strung among the critics suggest that trading in CDS should be severely constrained.

A more constructive approach is to identify the sources of transactions costs that are interfering with the efficient reallocation of control rights, and to devise policies to reduce these costs.  (And again, I would emphasize that greedy financial innovators have strong incentives to figure out ways of doing this all by themselves.  If they aren’t doing it . . . maybe the problem isn’t that serious.  Especially since a vanilla EFP will do.)  

This suggests some policy responses that would not entail substantial impediments to (and perhaps the banning) the trading in credit derivatives and the underlying credits.   One policy response is to reduce transactions costs that would arise when a company approaches financial distress, or perhaps declares bankruptcy.   One way to reduce transactions costs would be to reduce the importance of information asymmetries about positions.   Like a poker player, someone who knows his positions and knows that nobody else knows them, can bluff and negotiate in a way that impedes efficient transactions.   This inefficiency can be eliminated, and efficient trading encouraged, by requiring revelation of all positions in the underlying debt, credit protection, and equity of the troubled company at the time of a credit event.   This would facilitate value enhancing transactions between credit protection buyers and sellers by making it easy to identify the economic interests of all parties, and eliminating the ability to bluff about positions and interests in an attempt to extract value from other participants.

Another policy response is to undermine the bargaining power of hedged debtholders, or to remove those with weak or poor incentives from the reorganization process.   This could be done in bankruptcy by reducing the voting and representation rights of debtholders by the amount of the protection they have purchased.   For instance, the holder of $50 million in debt who has purchased credit protection on $25 million, would be treated equivalently to the holder of $25 million of the debt (and the total holdings used to apportion voting and representation rights would be correspondingly reduced.)

The mechanics of settlement of credit derivatives could also be designed to mitigate the perverse incentives that concern the CDS skeptics.   For instance, if payoffs to a credit derivative are determined very soon after the formal declaration of a default or bankruptcy, but before the completion of a reorganization, the concern evaporates.   An ISDA auction soon after a default or bankruptcy would establish prices at which all outstanding credit derivatives on the defaulting firm are settled.   Once this price is determined, the value of outstanding credit derivatives is fixed, and consequently indifference or strategic behavior by the buyers of protection is no longer an issue.   The derivatives effectively disappear, and all that is left is the underlying debt securities, along with their associated control and legal rights, uncompromised by conflicting incentives created by derivatives instruments.   The debtholders then have an incentive to exercise control and legal rights efficiently.*

In summary, Hu and others have identified a potential concern about the adverse incentive effects of credit derivatives, but their analysis is incomplete.   It overlooks an important consideration that should inform any analysis of an asserted inefficiency; namely, the fact that regardless of the original distribution of economic rights, self-interested market participants have an incentive to engage in transactions to allocate these rights to maximize their value.    The skeptics’  analysis presumes that individually and collectively, market participants are not maximizing the size of the economic pie—the value of a firm undergoing a reorganization.   This can only happen if transactions costs materially impede the efficient reallocation of these rights, but Hu and the other critics do not analyze—or even mention—transactions costs, or the potential for consenting adults to make trades that enhance value.   Moreover, since transactions costs may exist in the real world, policy responses designed to reduce these transactions costs deserve serious attention before more draconian restrictions on credit derivatives are contemplated.

Finally, it should be noted that even if credit derivatives do result in some efficiency loss because of their effects on the incentives of debtholders during reorganizations, or the transactions costs that perpetuate these incentives, these costs must be weighed against the benefits of credit derivatives.   Credit derivatives also facilitate the efficient allocation of risk among market participants.   Moreover, credit derivatives play an increasingly important role in price discovery and enhancing the transparency of the credit markets.   These benefits are appreciable, and the phenomenal growth of these instruments is a testament to the magnitude of these benefits.   Any policy response to the problem that the skeptics identify should be crafted so as to preserve these benefits. Thus, a light-touch approach that focuses on reducing transactions costs or modifying the bankruptcy process would mitigate the importance of the CDS skeptics’ concern, without jeopardizing the risk management and price transparency benefits of credit derivatives.

Pavel Baev has an interesting article in today’s Eurasia Daily Monitor.  He echoes several SWP themes.  (Indeed, Baev and I have been arguing along very similar lines for months.)  Key bits from his piece:

Manufacturing, for instance, registered a 20 percent decline in the first quarter of the year. Prime Minster Vladimir Putin tried to provide some reassurance for workers in the Tver railcar plant last week, but responding to a direct question about Kudrin’s forecasts he said only that the Finance Minister was “under a lot of stress” and had to protect himself from pressure (Kommersant, April 16). The high point in that “anti-crisis psychotherapy session” was Putin saying he had personally prevented the purchase of railcars from China.

Such personally-delivered stimulus packages for particular enterprises destroys the coherence of Kudrin’s fiscal course, which renders Russia’s anti-crisis policy far less efficient compared with the main world economies (Nezavisimaya Gazeta, April 17). The Consumer Confidence Index dropped accordingly to minus 35 percent in the first quarter and 48 percent of respondents expected further negative economic developments (PRIME-TASS, April 8). It is not only the middle-class that is experiencing a massive migration from the “upper” to the “lower” categories; the super-rich are also suffering: according to the Russian Forbes on April 16, the “golden hundred” of the richest individuals is now worth only $124 billion, having lost $380 billion in one year.

The simmering discontent among the most politically active and influential social groups worries Medvedev far more than rising unemployment, which compels experimenting with new ways of management and governance. His aides whisper, for instance, that the giant state corporations created within the past few years are no longer viable in the recession and must be compelled to open up their accounts before undergoing radical “sanitation” (RBC Daily, April 17). Putin, on the contrary, has taken a defensive stance insisting that his economic model of ever-increasing state control is sound and provides the best protection against the current turbulence -which will soon blow over. His own cabinet is deeply split over the priorities in budget and extra-budget funding, so that ministers declare diverging courses and their aides resort to in-fighting (Nezavisimaya Gazeta, April 16). This uncharacteristic lack of discipline within Putin’s team betrays more than his doubts about choosing a way out of the crisis; his very ability to control the forever feuding elite clans is also in doubt.

The natural response to any disturbance in the system of power created by Putin is to squash the opposition and squeeze the insufficiently loyal oligarchs; the enforcement mechanism, however, has become so corrupt that forceful responses cannot be mobilized. Complaining bitterly -and futilely- about corruption, Medvedev probably believes that the system he presides over has become incapable of acting on its own logic. Hence the hesitant steps towards a neo-perestroika policy aimed at ensuring that “the state and civil society can act in harmony and together,” as he told NTV in an interview on April 12. It is a different type of “harmony”‘ than the effective exclusion of society from politics that flourished in the autumnal years of Putin’s “era.” It is not certain that Medvedev will succeed in engaging the more dynamic parts of the middle classes in a new anti-crisis social contract, and the readers of Novaya Gazeta have good reasons to doubt that he will keep his part of the bargain while Putin looms over his less-than-heroic figure. Smooth words come easy to the accidental leader who cannot hide behind the fiction of “independence of the court” from the simple but stark dilemma: if Mikhail Khodorkovsky and Platon Lebedev are acquitted, it is all over for “Putinism.”

Putin’s ad hoc interventions are truly bizarre.  “Destroy[ing] the coherence” of Russian economic policy is an understatement.  Moreover, the adverse consequences will not be limited to their near term effects on the crisis response.  They will have the deleterious long term effect of cementing Russia’s reputation for arbitrary policy, thereby tending to deter plans by foreign firms to enter markets.  Case in point, this Bloomberg story about the effect of Putin’s Pull-a-Tariff-Out-of-My-A. . I mean Hat policies on Caterpillar:

Prime MinisterVladimir Putin‘s trade measures are starting to keep  Deere & Co.  combines andCaterpillar Inc.  trucks out of Russian wheat fields and coal mines, dimming the companies’ prospects for expansion abroad.

Deere and Caterpillar, reeling from the longest U.S. recession in a quarter century, were the companies most affected by loan restrictions and tariffs of as much as 25 percent that Putin imposed this year, according to a U.S. Chamber of Commerce survey of the top 50 American businesses operating in Russia.

Putin is trying to boost Russian industries with tariffs on everything from drugs to farm equipment as declining oil revenue saps the nation’s economy. The policies are hurting sales by Caterpillar,  Deere  and  Agco Corp.  in a market where revenue was forecast to rise as much as sixfold in the next decade.

The main casualty–Russian agricultural and industrial productivity.  Actions such as these are rob-Peter-to-pay-Pavel policies.  

But back to Baev.  I think his portrait of a leadership in disarray is probably realistic.  Putin is so clearly out of his depth in these matters, but he still wields tremendous authority.  More reasonable, knowledgeable people are trying to steer a saner course, but are in grave risk of foundering on the shoals of Putin’s authority.  But, an inflexible, out-of-touch leadership runs the risk of initiating a spiral of collapse.  (See Romanov, Nicholas II.)  

I know there are many smart economists in Russia who recognize that Rosneft and Gazprom and other “giant state corporations” are economic monstrosities that should not survive, that are a drag on the economy, and are hoping that the current crisis will hasten their demise.  But they are also the gravy trains for the siloviki, who are unlikely to go quietly into that good night.  

So the ingredients for a cataclysm are there.  A befuddled, out-of-its-depth leadership clinging to its privileges, power and wealth–including a large cohort of very scary, violent, amoral people.  A growing number of people in government and some business who recognize that the Putin course is erratic and insane, and who will try to work around it, leading to policy clashes and contradictions.  Oligarchs seeing their empires crumble, who are weighing the choice between risking the fate of Khodorkovsky and economic ruin.  Regional governments facing their own desperate straits.  A currently passive populace, but one which facing economic devastation.  

Putin’s instinct–and his only likely way to remain on top–is surely to crack down further while simultaneously throwing around what crumbs he has left to pacify increasingly unsettled constituents.  But there are so many things outside of his control.  He will try to use authority to keep things in order, but that authority is not limitless.  And what’s more, as soon as his control looks tenuous; as soon as the incoherence and extemporized nature of his actions become widely understood; the equilibrium can shift very dramatically.  The oligarchs will fear him less.  The regional governors will fear him less.  The bureaucrats will fear him less.  The people will fear him less.  Indeed, as his incapacity to deal with the situation becomes apparent; as the incoherence of his policies becomes more widely understood; as the disconnection between the reality of the situation and his delusional appraisal of it becomes even more pronounced; as the smallness and irrelevance of his attempts to blame-it-on-anybody-but-Russia become increasingly tiresome; he risks something that is deadly to a strongman: widespread ridicule.  A coalescence of these forces could–and I am tempted to say will–lead to a stunning collapse of Putin and Putinism.

His only hope is a world economic recovery that pulls Russia along with it.  But that is not in immediate prospect, and anyways, the dynamic in Russia is already so unfavorable that even a world recovery may be too little and too late to save the system.

Which raises the question: What will replace it?  I fear that the answers to those questions are not happy ones.