Streetwise Professor

Apropos my visit to Germany: Bloomberg reproduced a piece from InsideClimateNews.com titled “Can the US Create Its Own German-Style Energy Revolution.”  It is a paean to Germany’s Energiewende. Indeed, it is the capstone to a 6 part series (available as an Amazon eBook!) plus a slide show that is one big slobbering wet kiss to Germany’s top-down policies designed at controlling how energy is produced and consumed.  And of course, German top-down social control policies have always worked out so well.

The piece is a classic in the genre.  It measures “progress” in alternative energy purely by outputs.  How many MWs generated by wind.  How many generated by solar.  The cost of these MWs as compared to alternatives is not even mentioned, except obliquely.  And that oblique reference illustrates the absurdity of the whole exercise, not that the author of the piece notices:

For Tunnicliff, who works in natural resource management, adopting native landscape was a logical choice in a desert climate. Bolted to his roof was another rational choice: a solar photovoltaic system that supplies most of his family’s electricity needs. He installed the system even though he estimates it will take 12 years to break even on the investment.

“That is the future of energy,” he said, pointing to the dark blue panels on his roof.

12 years to break even on solar.  In Phoenix.  If that’s the future, we’re screwed.

Interestingly-but not surprisingly-the piece fails to mention any of the problems with Energiewende, in particular the huge costs of implementing the policy-costs that are far larger than originally estimated, and which are causing unease even in the relatively docile German populace as electricity tariffs are skyrocketing.  It also fails to mention the degradation in electricity quality that results from a reliance on solar and wind, which are vulnerable to the vagaries of the weather.

But there is one paragraph in the piece that should be sufficient to convince any American that this is a crack-brained idea:

The absurdity of the U.S. impasse over energy reform was highlighted when the primary author of the Germany law, Hans-Josef Fell, told me what I already had heard from other German leaders—that he was inspired to write the act by what today seems like an unlikely source.

“Your President Jimmy Carter was the first politician to promote an industrial revolution with renewables,” Fell said when we met in his Berlin office in April. “I looked to the USA in the 1970s. There was wind power in California and solar power on the White House. I thought, ‘Oh, this is wonderful! Why can’t we have this in Germany?'”

Jimmy Carter thought it was a great idea.  That’s all you need to know.

We don’t need energy revolutions.  We need energy evolution that is driven by balancing costs and benefits.  Costs and benefits that are highly unpredictable, and which can change rapidly in short periods due to technological, economic, and political shocks.   Exactly the circumstances in which top-down, socially planned, command-and-control-type approaches are extraordinarily inefficient, and prone to creating economic havoc.

I think Germany will come to regret Energiewende when it moves beyond dreaming about the environmental benefits and actually has to pay to costs of achieving them.  So let’s hope that the US doesn’t smuggle in Jimmy Carter’s energy policies using Germany as a cutout.

John Parsons and Antonio Mello at Betting the Business rightly slam the SEC’s evaluation of JP Morgan’s application to create a physical copper ETF. They are spot on that the SEC’s Division of Risk, Strategy, and Financial Innovation’s analysis was superficial, and quite frankly, silly.  Who knew that there was no connection between copper prices and inventories?

That said, I think that Parsons & Mello are far too generous in their praise for the comment letter submitted by the Americans for Financial Reform (an advocacy organization with strong ties to organized labor).  That letter posits some very speculative feedback loops: prices go up, people get excited about copper, they buy more of the ETF shares, driving up the price, and on and on.  If that mechanism exists, wouldn’t it exist even without the ETF?  And I’m dubious about the strength of that mechanism if it exists, and in fact doubt its very existence.

The only real concern is that the physical ETF somehow constrains the response of inventories to supply and demand shocks.  Inventories should rise when there are surprise negative demand shocks or positive supply shocks, and should fall with surprise positive demand shocks or negative supply shocks.  Speculative storage adjusts inventory in response to changes in fundamental conditions, and the forward curve is determined simultaneously.

If the ETF somehow impeded inventory adjustments, there would be a problem.  Here it should be noted that there is an asymmetry.  It is hard to see how that the ETF could in any way constrain increases in inventories.  If demand declines, for instance,  there is nothing to preclude traditional speculative storers from adding to inventories.

Things are conceivably different when inventories should decline.  One can at least consider the possibility that holders of the ETF would lock up inventory.

There is a redemption mechanism that limits this possibility.   “Authorized participants” (basically broker-dealers) can redeem ETF shares and receive physical copper in return: these firms would likely be ones that act as speculative storers in the absence of the ETF.  Thus, an ETF share is effectively a perfect substitute for copper warrants, and its creation does not obviously alter the market mechanism in a fundamental way.

I guess one could tell a story that goes something like this.  Irrational investors (not participants in the physical markets) hold onto ETF shares even if some of those shares should be redeemed and inventories released onto the market.  As a result, prices become too high.  Due to the excessively high prices, the Authorized Participants don’t buy and redeem the ETFs, cancel the warehouse receipts and load out copper when it should be loaded out.

For this price distortion to occur, the quantity held by the stubborn, irrational ETF investors must represent a binding constraint: they must end up holding the entire inventory.  Thus, a necessary condition-but not a sufficient one-for the ETF to distort inventory holdings (and hence prices) is that the ETF holds 100 percent of inventories.  (Note: things are a little more complicated because LME warehouses are located around the world, but the JPM ETF’s copper holdings will be limited to its Henry Bath warehouses.  It is conceivable that some inventory should be taken out of Bath warehouses, but isn’t due to the stubbornly irrational ETF holders.  So ETF holdings=100 percent of Bath inventories could be a symptom of a distortion, even if there are inventories in other LME regular warehouses.  However, to the extent that inventories in other locations are close substitutes for Bath inventories, the potential for a distortion is limited.   That’s one reason to have multiple delivery locations.)

Moreover, stubborn ETF holders who distort prices present a great short selling opportunity.  That also tends to limit the potential for a price distortion, particularly a large, enduring one.

My take on the JPM phyz ETF is therefore Alfred E. Newman-esque.  What?  Me worry?  One can imagine circumstances where it causes a problem, but the symptoms of this are clear: the ETF owns all the copper.  If those symptoms don’t arise, there’s no problem.  If they do-an unlikely event, IMO-take a look at it then, and figure out what to do in that event.

In other words: don’t borrow trouble.  Deal with trouble when-and if-it arises.

It is hard to overstate the importance of this report by Hal Scott and the Committee on Capital Markets Regulation, titled “Interconnectedness and Contagion.”  It evaluates the issue of systemic risk through the lens of the Lehman Brothers failure (and to a lesser degree, the AIG failure).

One way to summarize the report is “everything you knew about Lehman was wrong.”  Certainly, everything Gensler and Timmy! and Frank and Dodd and legislators and regulators around the world knew was wrong.

That conventional narrative is that Lehman’s failure brought the world financial system to its knees because it was so interconnected to the rest of the financial system.  That losses on exposures to Lehman-an most notably through derivatives exposures-threatened to propagate through an interconnected set of large financial institutions.   That the crisis was the result of a “daisy chain” or “domino” effect via what Scott refers to as “asset interconnectedness” (e.g., derivatives exposures) or “liability interconnectedness” (e.g., a big supplier of credit/liquidity fails, thereby forcing those dependent on it for credit or liquidity to fail).

Scott thoroughly debunks the interconnectedness narrative.  Instead, he shows persuasively that a contagion caused the crisis.  The Lehman shock dramatically shifted beliefs about whether large financial institutions would be bailed out, and also conveyed information about the severity of losses on real estate assets that were held not just by Lehman, but by a wide array of financial institutions.  This raised doubts about the solvency of all financial institutions, resulting in a run on their liabilities and a refusal to roll over these liabilities.  Given the dependence on short term credit, this run caused a major crisis.

In other words, it’s all about the funding mechanism.  It’s about liquidity.   It’s about runs.

Scott notes that the configuration of the financial network does affect its vulnerability to contagion, but that attempting to mitigate systemic risk through policies intended to affect the degree of interconnection is unlikely to reduce substantially the risk arising from contagion.

This is incredibly important because Frankendodd and EMIR and all of it is largely predicated on the belief that interconnection is the source of systemic risk.  But the diagnosis is wrong, meaning that the prescription is almost certainly wrong too.

Scott looks at CCP mandates in particular, and gives them 1.5 cheers.  I think that’s one or 1.5 too many, but it is gratifying to see that he does forthrightly downplay the potential benefits of CCPs as a means of preventing future crises.

The reason that I think he is not negative enough on this point is that he only looks at the first order impacts of CCPs, through their effect on derivatives netting, for instance.  He does devote some attention to the effects of CCP mandates on funding and liquidity, but more focused attention on the indirect effects of clearing and collateral mandates would, in my view, raise more serious concerns, especially in light of the primacy of funding/liquidity contagion channel in creating systemic risk.

Scott, citing Duffie’s work, claims that CCPs may reduce the incentive to run on big financial institutions.   I can see that in some scenarios, but I can also envision others in which a rigorous, highly-time sensitive, no-credit system like that will result from CCP and collateral mandates can lead to runs, either on the CCP, or on firms connected to the CCP.  That’s my take on what happened on Black Monday, 1987.

Clearing and collateral mandates will lead to a whole series of changes to the demand for liquidity, and the mechanisms for supplying it.  A cleared system is more tightly coupled; increases the likelihood in big shocks to liquidity demand; potentially ties up liquidity (especially under rigorous segregation regimes); and on and on.  Given the nature of cleared systems (and the imposition of rigorous daily variation margin based on mark-to-market for non-cleared derivatives), market users will make arrangements to secure contingent liquidity.  As a result, the entire financial network topology will change.  How it will change, and how these changes will affect systemic risk, are impossible to divine at present.  But it is certain that these changes will be profound and it is not difficult to imagine scenarios in which the new topology is as fragile in the face of large shocks as the old one.  Indeed, it’s not hard to imagine scenarios in which the new topology is more fragile than the old.

Clearing and collateral mandates should also be viewed as regulations of capital structures.  (“No credit extended through derivatives transactions” and “derivatives are at the top of the priority queue.”)  Capital structures will respond to this regulation, again in unpredictable ways, and in ways that affect the vulnerability of the system to contagion.

I am giving a talk on Monday at a joint Bundesbank-University of Frankfort conference about central banking.  My talk is about systemic risk and CCPs, and I will explore all of these themes.  The overarching theme is that you cannot view an intervention into the structure of financial markets, like a CCP mandate, in isolation.  You have to consider the endogenous responses throughout the system. The entire structure of financial contracts will change as the result of such a big intervention, and this structure will have its own special vulnerabilities.

When evaluating these vulnerabilities, one should pay special attention to liquidity issues, and liquidity contagion.  This was a theme of my JACF article “Clearing and Collateral Mandates? The New Liquidity Trap?”  Scott’s report adds special force to this contention that liquidity and contagion, rather than interconnection, should be the focus of any regulatory and legislative efforts.

It also suggests that much, and arguably virtually all, of the regulatory response to the 2008 Crisis was misdirected, and hence will either not reduce systemic risk, and may increase it.   Given the costs that these regulations impose, this is a sobering conclusion.

It finally suggests that it all comes down to central banks, as lenders of last resort.  If it is a liquidity problem (and in this Scott is closely aligned with Gary Gorton), the institutional means for supplying liquidity in times of crisis-which now means central banks-is of paramount importance.

Russia is relentlessly pushing a plan to revolutionize the governance of the internet.  Working behind the scenes, Russia is scheming to place control of crucial aspects of the internet under the auspices of the UN’s International Telecommunications Union.

The Russian Federation is calling on the United Nations to take over key aspects of Internet governance, including addressing and naming, according to documents leaked on Friday from an upcoming treaty conference.

The Russians made their proposal on November 13 in the lead-up to December’s World Conference on International Communications in Dubai. The conference will consider revisions to the International Telecommunications Regulations (ITRs), a treaty overseen by the UN’s International Telecommunications Union (ITU). The treaty has not been revised since 1988, before the emergence of the commercial Internet.

Russia’s proposals would, if adopted, dramatically affect Internet governance, transferring power from engineering-based organizations such as the Internet Society and ICANN to national governments, all under the authority of the UN.

There are 193 Member States participating in the WCIT. Each gets a single vote on proposed changes to the treaty. The treaty negotiations and its documents are secret, though many have been exposed through the Web site WCITLeaks, run by two researchers at George Mason University.

“The [proposed] additions to the ITRs…are aimed at formulating an approach that views the Internet as a global physical telecommunications infrastructure, and also as a part of the national telecommunications infrastructure of each Member State,” the Russian proposal says.

Russians propose bringing “IP-Based Networks” under UN control

Currently, the ITRs cover only international telecommunications services (PDF). But the Russians propose adding a new section to the treaty to deal explicitly with “IP-based networks.” Bringing the Internet into the treaty in any capacity would represent a major expansion of the scope of the ITU’s authority.

A congerie of the world’s civil liberties lovelies, including Iran and China as well as Russia, is pushing this initiative.  If that doesn’t engender warm and fuzzy feelings, what will?  What could possibly go wrong?

A word to the wise: putting anything under the auspices of the UN is to surrender it to the control of autocrats and kleptocrats, and autocratic kleptocrats.  Where the UN treads, freedom dies.

There is no surprise that Russia, China, Iran and the other assorted modern day fascists want to control the internet.  Where information is free, autocrats are vulnerable.  Control of information is necessary to maintain control of power-and the spoils that go along with it.

Russia recently implemented an internet control regime that gives you a flavor of exactly of the kind of thing Putin et al have in mind:

On the surface, it’s all about protecting Russian kids from internet pedophiles. In reality, the Kremlin’s new “Single Register” of banned websites, which goes into effect today, will wind up blocking all kinds of online political speech. And, thanks to the spread of new internet-monitoring technologies, the Register could well become a tool for spying on millions of Russians.

Signed into law by Vladimir Putin on July 28, the internet-filtering measure contains a single, innocuous-sounding paragraph that allows those compiling the Register to draw on court decisions relating to the banning of websites. The problem is, the courts have ruled to block more than child pornographers’ sites. The judges have also agreed to online bans on political extremists and opponents of the Putin regime.

. . . .

Most importantly, however, the new Roskomnadzor system introduces DPI (deep packet inspection) on a nationwide scale. Although DPI is not mentioned in the law, the Ministry of Communications — along with the biggest internet corporations active in Russia — concluded in August that the only way to implement the law was through deep packet inspection.

In other words: all your packets belong to us.

The invocation of child pornography to justify these efforts is typically cynical.  Russia has long been the largest producer and exporter of child pornography (not to mention virtually every other species of internet crime), and hasn’t done a damn thing about it.  Presumably because those who produce it and export it have paid well for the requisite krysha.  The interests of the state and the criminals are aligned.

Presumably-hopefully-the US will fight these efforts to extend the UN’s malign influence to the internet.  But if the Russian initiative succeeds-or even portions of it are implemented-do not believe for a moment that the USG will not take advantage of the powers it would confer.  Have any doubts about that?  Just look at the Petraeus-Broadwell episode, in which a ditzy socialite can call a self-righteous FBI agent friend who unleashes a efishing expedition and leaks the results to a Congressman when the investigation doesn’t proceed as he thinks it should, thereby unleashing a personal and national security nightmare.

I began to write about Russia precisely because it is a real life libertarian dystopia, and as such should serve as a warning to those who have been heretofore able to maintain some semblance of civil liberties and property rights (a redundancy, actually, because property rights are the foundation to civil rights).  But we in the West, and in the US are specifically, are converging to Russia from above.   There are aspects of the Benghazi debacle that provide further evidence of that convergence.   More on that soon.

Jon Corzine caused the demise of MF Global.

Poor management decisions by MF Global former CEO Jon Corzine triggered the brokerage firm’s collapse, while lax protections for customer funds contributed to the loss of an estimated $1.6 billion of customer money, congressional investigators have determined.

Evidence unearthed by the House Financial Services Subcommittee on Oversight puts the blame squarely on Corzine, the panel’s chairman, Rep. Randy Neugebauer, said in a preview of the report that will be released on Thursday.

“The responsibility for failing to maintain the systems and controls necessary to protect customer funds rests with Corzine,” the report says. “This failure represents a dereliction of his duty as MF Global’s chairman and CEO.”

Who knew?

Except anyone paying the slightest attention, I mean.  It has been beyond blindingly obvious since even before the implosion of the brokerage that Corzine was gambling for resurrection, and made the decisions that destroyed MF Global.  It was also clear that the firm was a managerial mess, a disaster waiting to happen.

But his “spokesman” says the failure was a collective one for which Corzine is not personally culpable:

A spokesman for Mr. Corzine said that “all of the firm’s significant business decisions…were subject to review, debate and approval” by MF Global’s board. “At all times, Mr. Corzine acted in good faith and did what he believed was necessary to turn around MF Global.”

Because boards are never, ever, ever the creatures of domineering, out of control CEOs.

The spokesman, Steven Goldberg, said that the panel didn’t find any evidence of “intentional wrongdoing” and that Mr. Corzine was working to turn around an already-failing business.

I see.  Taking huge risks-and running roughshod over risk controls to do so-is a turn-around strategy that only unintentionally results in mayhem.  His intentions were good, so everything’s just fine.  Big harm, no foul-because he didn’t mean it.

The fact that MF Global was “already failing” is precisely the motive for Corzine’s rashness.

The Neugebauer panel punts on the most important open question: who was directly responsible for the loss of customer money?  We all know that Corzine was the first mover who set of the chain of events that ultimately led to the looting of MFG’s not-so-segregated customer funds.  We knew that on Halloween, 2011.  But why, pray tell, we don’t know exactly who authorized this looting more than a year and two weeks after the firm’s collapse?

As I’ve written before, Edith O’Brien is essential to answering that question, but Edith O’Brien is silent because prosecutors refuse to grant immunity.

In the scheme of things, she doesn’t matter.  It is highly unlikely that she would have taken it upon herself to throw good customer money after bad Corzine bets.  And even if she did, letting her escape legal punishment would have no effect on the odds of a future recurrence of such a debacle.  It is more likely that someone else higher up in the firm made the call.  Given Corzine’s dominance, he is the most likely candidate for making that call.  Letting him skate would set a bad precedent that would encourage other CEOs to engage in such misconduct.  The balance of costs and benefits is clearly on the side of getting Ms. O’Brien’s testimony.

And indeed, this is Federal Financial Crime Prosecution 101: go for the big fish by catching and releasing the little ones.  The failure to follow this tried-and-true strategy is quite revealing, given the identity of the biggest fish: a made man in the Democratic Party, a former Senator and governor, and fund raiser for Obama.

Because of this pointed refusal to do something that would put Corzine at risk, the MF Global collapse remains the Immaculate Destruction, and the firm remains the Financial House Not Destroyed by Human Hands.  And the House Financial Services Subcommittee on Oversight does nothing to resolve that mystery.

Go to a conference where derivatives or Frankendodd are discussed, and you can’t escape without hearing somebody’s tongue trip over the word “extraterritoriality” (say it 5 times fast!) -the imposition of Frankendodd rules (such as swap dealer registration) on foreign firms.  Gensler has been quite aggressive in his interpretation of where the CFTC’s writ extends: in his mind, it basically extends everywhere that directly or indirectly could have an impact on US markets.  In an interconnected financial world, that doesn’t limit things much.

Foreign financial institutions (and other firms, such as pension funds and money managers) are less than thrilled.  To say the least.  Some smaller institutions have announced their intention to have no dealings with US firms that could put them in the monster’s grip.

Foreign regulators have also criticized US assertions of authority, both in writing and now in GiGi’s face:

Financial regulators from around the world have rounded on the main US swaps regulator over its attempts to extend new rules on derivatives overseas, warning of destabilising effects on the global financial system.

Supervisors from Japan, Europe and Hong Kong have previously criticised the Commodity Futures Trading Commission in written correspondence. On Wednesday, the regulators set out their concerns during a public meeting at the CFTC in Washington.

GiGi nodded, and then defended the CFTC’s actions.

Regulatory arbitrage is a concern, but unilateral assertions of US authority, and foreign pushback on those assertions, raise various concerns of their own.  In particular, they threaten to balkanize derivatives markets (and financial markets generally) as non-US firms limit their dealings with US entities.  This will reduce liquidity; tend to lead to concentrations of risk; and will impede the efficient allocation of risk.

Per usual, Gensler is appealing to a simplistic version of the financial crisis to justify his position, and not acknowledging the adverse consequences-most notably due to fragmentation-that will result from over-aggressive American initiatives.  Regulatory consistency across jurisdictions (which would mitigate regulatory arbitrage) ironically is undermined by the unilateral efforts of the US regulator to impose its will around the world.

This is particularly amazing given the CFTC’s less than glorious record at regulating a subset of US derivatives markets.  Hubris, anyone?  And unfounded hubris at that?

Speaking of regulatory hubris, David at Deus ex Macchiato is justifiably outraged at the assertion by an Irish regulator that global regulations of OTC markets had “the explicit policy objective” of reducing the size of these markets.  Because of course regulators know exactly how big OTC derivative markets should be and know with metaphysical certainty that the markets will reconfigure themselves to the regulatory fiat in ways that enhance stability.  Yes, these are the most complicated, interconnected markets in the world, so of course guys in Dublin and DC should know exactly how big they should be and exactly how they should be configured.  Because that always turns out just swell.

This is exactly what Hayek meant by “the fatal conceit.”  And I fearlessly predict that this very conceit will be the source of the next crisis.

Soon after the 2oo8 election, I wrote a post titled “No Joy in Mudville” in which I prophesied numerous malign effects of the Obama election: the post got some notoriety, including a pickup by the WSJ Political Diary.  Although I was off on some of the specifics, I think I was right on the essentials.  Four years of cascading progressive statism, with a heavy measure of foreign policy incompetence as an added bonus.  And four years of moribund economic performance.

My pre-election appraisal was that defeating Obama was a necessary but not sufficient condition to stave off serious decline, and perhaps crisis.  I had little hope that Romney or the Republicans would have been able to address the deep structural problems the nation faces, especially if they had prevailed in a close election.  But I am nearly metaphysically certain that Obama and the Democrats won’t, in large part because they don’t perceive that we face serious structural problems arising from unsustainable entitlements, a fiscally incontinent government, and crushing regulatory burdens.  Indeed, they see these as features, not bugs. These were the main planks in Obama’s real platform: no substantive change in entitlements, more government spending-excuse me, “investment”-and more regulation.

Consequently, I predict continued sluggish economic growth-if we’re lucky-with a heightened risk of fiscal (and consequently financial) crisis, timing TBD.  The regulatory burden-most notably the Four Horsemen of Frankendodd, Obamacare, the EPA, and Other Assorted Insanity From Agencies You’ve Never Heard of-will make us pine for the growth rates of the 1970s.  Redistributionist-driven changes to the tax code which will raise marginal rates and particularly increase taxes on capital will create further drag, all the while doing nothing to improve the country’s fiscal situation (and in fact worsening it with non-trivial probability)

Slow growth, combined with continued high levels of government spending, a failure to address entitlement spending, and increased expenditures arising from Obamacare, will accelerate the deterioration of the nation’s fiscal condition.  Given the multiple equilibrium nature of government finances (where small changes in circumstances can lead to a jump from an equilibrium in which lenders are willing to rollover debt to one in which they aren’t), this deterioration increases the risk of a funding crisis that would make what is going on in Europe now look like a pleasure cruise.  (For those of you who take solace in the fact that other people might have it even worse, there’s always Japan, which would love to have our trivial problems.)  Any such crisis would inevitably be accompanied by a huge inflationary spurt, as inflation is de facto default: If it occurs before the Fed has trimmed its bloated balance sheet-and there is no sign that Ben will slim it down anytime soon-the spurt will be that much worse, as all those reserves (the Fed’s liabilities) that have been moving with virtually no velocity will start to turn over at an accelerating rate.

In other words, après nous le déluge doesn’t quite capture it.  Le déluge est maintenant. Well, perhaps not now now, but uncomfortably soon, and certainly en avant notre disparition, actuarially speaking.

There is widespread disquiet about the country’s fiscal and economic circumstances.  Indeed, if only economic and budgetary issues were in play in the election, it is my sense that the outcome would have been different.  But cultural, social, and religious issues prevented Romney from assembling a winning coalition.  The single issue cultural and religious right that blessed us with monstrosities like Mourdock and Akin-who became the poster boys of the Republican Party as a whole, due to the combined efforts of the Obama campaign and a supportive media-drove away many people with libertarian sympathies on both economic and social issues who would have been willing to vote for Romney if only economics and public finances were at issue.

Righteousness has a way of interfering with good judgment, and the ability to make rational calculation.  Cultural and religious conservatives have no way of prevailing on their agenda.  If anything should seem obvious in the aftermath of this election, that should be it.  Obama should have been extraordinarily vulnerable on the economic and budget issues that are conventionally believed to be decisive in national elections, but he prevailed nonetheless.  Why?  Social and cultural issues are the most likely explanation.

The result: a president and a Congress (especially the Senate) that is actively hostile to the agenda of the cultural and religious right instead of one that is at least not an enemy (even though it would be unable and unwilling-unless suicidal-to push that agenda), and inexorable movement towards fiscal catastrophe.

Well played.

If it were only about economics I would have some optimism-not much, but some-that we could address the growth, regulation, spending and entitlement issues.  But it’s not only about economics.  Social and cultural divides make it nigh on to impossible to assemble a coalition (under the aegis of the Republican Party) that can win a national election, and win it decisively enough to permit serious action on these budgetary and economic issues.

No Joy in Mudville, indeed.

In more non-Benghazi news, some clearing stories.  (Contain your excitement, people.)

First, Gretchen Morgenson is still wretched. (So I said this was a post about news.  Sue me.)  She kills CO2 absorbing trees to criticize the very thought of providing CCPs access to central bank liquidity:

But placing them at the bailout trough is wrong, according to Sheila Bair, the former head of the Federal Deposit Insurance Corporation. In a recently published book, Ms. Bair wrote that top officials at the Treasury and the Fed, over the objections of the F.D.I.C., pushed to gain access for the clearinghouses to Fed lending.

The clearinghouses “were drooling at the prospect of having access to loans from the Fed,” she wrote. “I thought it was a terrible precedent and still do. It was the first time in the history of the Fed that any entity besides an insured bank could borrow from the discount window.” .

“The Treasury’s and the Fed’s reasoning was that since another part of Dodd-Frank was trying to encourage more activity to move to clearinghouses, we should provide some liquidity support to them,” she said in an interview last week. “Our argument back was, if you have an event beyond their control with systemwide consequences, then you have the ability to lend on a generally available basis. What they wanted was the ability to lend to individual clearinghouses.”

Look, one of the reasons I think Frankendodd is monstrous is precisely because clearing and collateral mandates impose tremendous contingent liquidity demands.  Last week I spoke at in Osaka at the annual meeting CCP12, an organization of 30+ CCPs (which apparently uses the Big Ten as a naming role model).  An exec at an Aussie CCP asked me what the most worrisome unintended consequence of derivatives “reform” would be.  I answered before the words were out of his mouth: the potential for a liquidity crisis in times of market stress.

That’s what happened 25 years ago, on Black Monday and the following Tuesday morning.  The Fed prevented an apocalypse by leaning on banks to lend to FCMs to meet margin calls.

Clearing mandates without some mechanism to provide additional liquidity, either directly to CCPs or indirectly via clearing members, are a recipe for disaster.  Like Gary Gorton, I am increasingly skeptical of moral hazard being the major concern: the major concern is the inevitability of periodic liquidity crises even in efficiently structured financial markets.  Forcing use of clearing and collateralization of uncleared swaps while simultaneously depriving CCPs or their members of access to central bank liquidity would be like mandating the use of matches in an oil refinery and banning fire extinguishers.

So, not surprisingly, Wretched Gretchen goes the wrong way, yet again.

And speaking of wrong way, ICE has received approval to clear European sovereign CDS.  I’ve written before that clearing sov CDS is very problematic, due to the wrong way risk inherent in these trades.  The sovereign-bank feedback loop means that clearing members-or a CCP’s default fund-are required to make big payouts on sovereign CDS precisely when they are under severe financial strain.

ICE Clear Europe claims that it has taken measures to reduce the wrong way risk.  I am deeply skeptical that these measures are adequate.  (Sorry, Paul-I calls ’em like I sees ’em.)

One thing ICE Clear Europe points to is that margins and default fund contributions will be in dollars, not Euros.  This actually creates a new risk. One thing we’ve seen is that during flare ups of the Eurozone crisis is that European banks have faced serious problems accessing dollar liquidity.  Meaning that in the event of a jump to default by a major European sovereign, Eurozone some banks that are members of ICE Clear Europe may well need to come up with big dollars to pay margin calls, or to cover the costs of a defaulting customer, or to meet default fund contributions, but need to do so precisely when they find dollars very hard to come by.

Meaning that (pace Wretched Gretchen) they will be desperately dependent on Fed support through dollar swap lines.

The other measure ICE has taken is to preclude “affiliates” of a sovereign from clearing CDS on that sovereign. Yeah, have to do that, but that doesn’t really come close to addressing the real wrong way risk.  If Spain or Italy-or even Portugal or Ireland or Greece-jump to default, a Eurozone-wide financial crisis that hits all banks will likely result.  Meaning that all major Eurozone banks-including members of ICE Clear Europe-and not just affiliates of the defaulting sovereign, are likely to be in distress at that time.  Further meaning that they will be in distress precisely at the time they are expected to absorb some costs arising from the default (big margin calls, covering the losses of defaulting customers, or incurring default fund obligations).   That’s the wrong way risk we really need to worry about, and nothing that ICE Clear Europe says in its filing with the SEC provides any inkling that their plan addresses that risk.

I also have serious concerns about the risk modeling here.  Wrong way risk is devilishly complicated, especially in a sovereign risk context especially in Europe (given all the potential cross-country linkages).  I am skeptical in the extreme about the ability to set margins properly, and strongly suspect that any methodology is likely to be highly procyclical.

In brief, I continue to believe that clearing sovereign CDS is highly dangerous.  It’s good that ICE Clear Europe recognizes the inherent wrong way risk problem, but in my (strong) opinion, they haven’t really addressed that problem, and indeed may have introduced another source of wrong way risk via the cross-currency mechanism inherent in their design.

I hope I’m wrong.  I hope for all of us it never comes to a test.

Finally, Deutsche Boerse is going to have to stump up $150 mm or so in new capital for Eurex’s clearinghouse, in order to meet European capital standards.  And that’s cheap! LCH.Clearnet will have to come up with 375 mm Euros (or about $500 mm) in new capital:

However, tough new European regulatory capital rules appear to have caught the industry unaware. Eurex is the second major clearing house to admit to a shortfall after LCH.Clearnet, the Anglo-French group, said it would need to increase regulatory capital by an estimated extra €300m-€375m last month

So much for clearing mandates being a cheap way of mitigating credit risk.

We are just approaching the G-20 deadlines to move most derivatives trading into clearing.  And the fun just can’t wait for the official kickoff.  There will be much more fun-and cost, and risk-to come.

To prove that this site isn’t all Benghazi all the time (even though I believe it is the most consequential story of the year), I now turn my attention to Sandy, and specifically the idiocy of governments (but I repeat myself).  Specifically, the states of Delaware, New York, New Jersey and Connecticut have forbidden insurers from applying hurricane deductibles:

Delaware regulators aren’t allowing property insurers operating in the state to apply special “hurricane deductibles” that can saddle homeowners with thousands of dollars of additional repair costs.

Delaware becomes at least the fourth state hit by superstorm Sandy to prohibit use of the special deductibles. The state’s ruling follows similar moves in New York, New Jersey and Connecticut.

Delaware Insurance Commissioner Karen Weldin Stewart said Friday her office informed the property-casualty insurance industry that the storm wasn’t fierce enough at the point it landed in the state to allow them to charge the deductibles.

The department acted on data from the National Weather Service that showed the storm didn’t have sustained hurricane-force winds when it made land in Delaware, “therefore companies may not impose a hurricane deductible on Delaware claims,” the department said in a news release Friday.

The hurricane deductibles are a feature of many standard homeowners’ policies in coastal areas, and would apply to damage from such things as fallen trees or wind-borne debris—expected to be a source of much of the damage.

Typically, the special deductibles are calculated as a percentage of the dollar amount of coverage on a dwelling, according to the Insurance Information Institute, a trade group. Terms vary by carriers, and deductibles can go as high as 5% under some policies.

Such special hurricane deductibles have become more common over the past decade as insurers have sought to have people with property in the riskiest area pay more of the cost of hurricane damage. Each state sets its own rules for when the deductibles can go into effect.

Because, of course, ex post invalidation of contracts always leads to such great outcomes.  The short run effect is a transfer of wealth from the shareholders of insurers to their policyholders.  Socially-though crucially, not politically-that’s zero sum.

The long run effects are more pernicious.

First, don’t cry to me, citizens of Delaware, NY, etc., if you can’t get hurricane coverage in the future, or find it much more expensive.  Insurers will either raise premiums or withdraw from the market altogether to mitigate the risk of ex post expropriation.

Second, insurance premia and risk sharing will no longer be able to vary with hurricane risk in a discriminating way.  This will tend to encourage overbuilding in vulnerable areas, and to induce the insured to take too few precautions to secure their property against hurricane damage: deductibles force the insured to bear some of the risk, which gives them an incentive to take actions to mitigate damage.

So the effects of these actions will be a one time wealth transfer, and wealth destruction in the future.  The typical outcome of politicized processes.

But it gets better! And by better, I mean worse.  For by undermining the private insurance market, these state governments will increase the demand for government “insurance” provided ex post, in the form of transfer payments to compensate the uninsured who suffer future hurricane losses.  Which means more deadweight losses from moral hazard, and the distorting effects of taxes to pay for these transfers.

But from politicians’ perspective, this is probably all feature, no bug.  For it involves the creation of a new client class, and gives them the opportunity to play Santa Claus in the future.  That’s because politicians are all about exploiting the seen (the public acts of “charity” and “compassion”) and counting on voters not understanding the unseen costs of these allegedly empathetic policies.

One last Sandy comment.  Can we truly be sure that is really Mayor Bloomberg doing such stupid sh*t, and this isn’t an extended Mel Brooks gag?  I mean, Mel and Bloomberg do look pretty similar.  My favorite is Bloomberg’s (or is it Brooks’s?) refusing National Guard assistance in Brooklyn because . . . I sh*t you not . . . the NG has guns.  And guns are bad!  Not that there are looters or thugs or anything like that in Crooklyn that might take advantage of the current circumstances or anything.  I am shocked Bloomberg hasn’t disarmed the NYPD.  (Though I’m sure he has his own armed escort-and did when he was just a filthy rich private citizen.)  But there’s always time for that after he’s vanquished the Biggie Soda and transfat menaces.

New York would indeed do better to have William J. Le Petomane as mayor.

Mere days after the collapse of MF Global, I was told by someone who would have reason to know that the key to unraveling the MF mystery was Edith O’Brien, the firm’s assistant treasurer.  A year later, Ms. O’Brien is still in limbo, refusing to testify without immunity from prosecution.

The likelihood that Ms. O’Brien would have conceived of and executed a massive fraud-the looting of MF Global customer segregated funds-is close to zero.  If there was a crime, it would have been conceived of and directed by someone far higher in the firm than Ms. O’Brien.

Prosecutors routinely give immunity to low-level employees in order to build a case against higher executives.  Prosecutors in the MF Global matter seem to be deviating from that routine.  This raises questions, the most notable of which is: are they departing from SOP because the individual who could be implicated is a well-known and highly connected Democratic politician, a former governor and senator, and bundler for Obama?

Maybe there’s a different explanation, but I’m hard pressed to think of one.