Streetwise Professor

Obama has repeatedly said that the US cannot afford to lose to China in the solar panel industry.  Well, I am (not) pleased to report that the US is being very competitive in this race.  Very.

Surely you are saying to yourself: SWP has finally lost it.  Has he forgotten Solyndra? Abound Solar?  First Solar?

Of course I haven’t forgotten these testaments to industrial planning and the miraculous insights that Nobel Prize winners in physics bring to it.  It’s just that the vaunted Chinese have done just as badly.  The competition to lose the most is very fierce indeed:

As solar panel prices continue to march lower, Chinese solar companies are struggling with heavy debt loads, triggering expectations many will be forced to seek a new infusion of funds through takeovers or mergers.

Suntech Power Holdings (STP.N) could be liable for hundreds of millions in new payments after it disclosed a potential fraud by a partner, while peers such as LDK Solar (LDK.N), JA Solar Holdings Co (JASO.O), Trina Solar (TSL.N) and Yingli Green Energy Holding Co (YGE.N) are also feeling pressure.

With prices for solar panels barely covering the cost to build them, dozens of small Chinese solar companies are believed to have shut their doors, and equity investors have fled the sector, sending share prices of the U.S.-listed Chinese companies down more than 85 percent since early 2011.

Most of the Chinese solar companies will be able to stay open only if government lenders continue to keep lines of credit open despite forecasts of several more quarters of red ink.

More:

Since Jiangxi LDK Solar Hi-Tech Co. Ltd. settled in Xinyu, in southeastern China’s Jiangxi Province, the local government has gone out of its way to give it preferential treatment, making the company a focus of the local economy.

However, the manufacturer of solar modules, along with other similar Chinese firms, has encountered difficult times of late. In the past few years, these companies have built up large inventories even as demand has fallen off and profits all but disappeared. Naturally, LDK Solar ran up large debts.

All of this left the government with a choice: let the company fend for itself, or intervene, doubling down on its support. In fact, this wasn’t much of a choice, as the government has reflexively lent even more support to the troubled company, bringing into full view the relationship between government and business in China.

Governments at the city and provincial levels have taken steps to protect LDK Solar’s creditors and prevent the firm from filing bankruptcy. At the same time, the government has tried to find a white knight to buy the company, which employs thousands in Xinyu.

The situation in China’s solar industry and especially at LDK Solar shows the degree to which government becomes involved, for better or worse, in the market in China and how some companies become too big to fail.

Isn’t Chu a Chinese name?  Just wondering.

The Chinese and Americans join the Germans and Spanish in the solar bloodbath.  Billions have been thrown down this rathole.

Remind me again why we have to-HAVE TO-win this competition?  If the Chinese want to subsidize the production of solar panels, far be it from me to stop them.  Consumers around the world can benefit from China’s beneficence-and stupidity.  There is no reason for us to imitate it.

In the comments on an earlier post, pahoben and I exchanged views about the analogy between China circa 2012 and Japan circa 1990s.  I remember that in the 1990s, Smart People like Lester Thurow told us that America’s economic fate hinged on who “won” the flat panel display industry.  Really?  How’s that looking now?  And what is so wonderful about “winning” the competition to produce products that will inevitably become commoditized-as flat panels did?

Now we are being told by Smart People like Tooltime Tom Friedman and our very own POTUS that solar is the future, my boy.

How is that supposed to work, since everybody who tries to force feed this “business” loses money?

I’ve seen that movie repeatedly.  I know how it comes out.  Badly.

Profits are a signal that guide resources to their highest value use.  If subsidized companies can’t earn a profit, what does that tell you?

It tells me that this is a competition that we should gladly let some other sucker win.  But the Smart Set in the US seems hell bent on winning the Biggest Sucker competition.  Can’t we just be slacker losers instead?  It’s much cheaper.

Maybe that’s a disturbing mental image, but the title is more than apt given Gensler’s recent NYT oped, “Libor, Naked and Exposed.”  As is his wont, demonstrated repeatedly on Frankendodd-related issues such as clearing and SEF mandates, Gensler presents a misleading and distorted analysis to advance some regulatory or political agenda.

Gensler questions the integrity of Libor.  This is certainly understandable in the light of the deluge of revelations in the past couple of months.  But the “evidence” that Gensler uses to justify his skepticism is completely off point, and certainly grossly overstates the impact of any manipulation on this important benchmark rate.

The first comparison Gensler makes is between Libor and Euribor.  He notes that dollar Euribor is about double dollar Libor.  But what Gensler omits to say is that this is an apples to horse apples comparison, given the major differences between the banks in the Libor and Euribor panels.  The former includes major banks (crucially, TBTF banks that benefit from the implicit and explicit support of governments and central banks), and most notably major US banks with ready access to dollar funding.  The latter includes something of a dog’s breakfast of foreign banks.  It has two Spanish and one Portuguese cajas and five German landesbanken, for crissakes.  And Dexia! The Euribor panel banks are all weaker, and don’t benefit from the same safety net as the banks in the Libor panel.  Moreover, since the beginning of the crisis, foreign banks have much greater difficulty in securing dollar funding than US banks.  Even big European banks (such as French giants like Paribas)  have faced acute dollar funding problems.  This is one reason why they have been deleveraging, and selling off dollar assets.  The Euribor banks almost certainly have even worse problems.

This issue of fragmentation of funding markets also bears on Gensler’s second piece of evidence: the divergence between Libor and the dollar rate implicit in FX swap prices. Gensler treats the violation of the interest rate parity relation as an indicia of manipulation.

But again, this reflects the acute problems European banks have faced in securing dollar funding.  They can borrow in Euros, but have to swap it into dollars to fund their dollar assets.  They are willing to, and the market is making them, pay a premium to execute this transaction.

Gensler claims “this divergence between theory and practice has yet to be adequately explained.”  Really?  It is well-understood.  Don’t believe me?  How about some economists from the New York Fed?  They investigated this issue in detail in 2009, and concluded that the divergence in the basis between the FX swap implied USD rate and USD Libor was caused by the dislocations associated with the financial crisis.

Indeed, Gensler’s oped implicitly recognizes this: he notes that implied and Libor rates have not been aligned “since 2008.”  Hmm.  What happened in 2008?  Think, think, think.  A financial crisis maybe?  Could that be it?  I’m thinkin’.

One key piece of evidence that FRBNY economists  Coffey, Hrung, Nguyen, and Sakar present is that the basis blowout was not limited to Libor.  It was also present when they used the New York Funding Rate produced by ICAP.  It was also present when they used Eurodollar deposit rates.

Look, anybody who has followed this knows that basis relationships that had been steady as a rock for years went haywire starting in August, 2007.  (Happy Anniversary!)  The CDS-cash bond basis went haywire.  Interest rate spreads (e.g., OIS-Libor) went haywire.  Spreads between borrowing rates across banks have become much more dispersed and become much more volatile.  (This relates directly to the Euribor-Libor comparison: banks are much more heterogeneous now than in, say, 2006, making comparisons between averages across different groups of banks much less meaningful now than then.)

This pertains to another piece of evidence: the lack of comovement between bank CDS spreads and their Libor submissions.  This could be informative, particularly in normal times, but it is problematic during crisis times.  CDS spreads and yields on the underlying cash bonds diverged dramatically, and often exhibited little comovement, during the period of the crisis.  CDS spreads were being driven by liquidity and risk aversion issues.  If the CDS-cash bond basis became much more volatile, it’s not at all surprising that the CDS-Libor spread also became much more variable, given that CDS and cash bonds have closer kinship than CDS and unsecured short term borrowings.

Noticing a pattern here? Basis relationships of every sort became much more volatile during the crisis period, and hence are far less reliable evidence of manipulation in Libor than would have been the case more than 5 years ago.  In essence, Gensler is trying to tell time with a broken watch.

Recall that Gensler mentions “the divergence between theory and practice.”  Anybody who has been paying attention understands why that’s true.  The theory is predicated on an assumption of frictionless financial markets.  Financial markets where capital and liquidity constraints are not binding, thereby permitting arbitrageurs to eliminate swiftly divergences in prices across related markets.  That was a reasonable approximation of reality in say, July, 2007: certainly in July, 2005.  It is completely unreasonable post-August, 2007.

Or as the FRBNY economists put it:

The widening of the basis illustrates the breakdown in arbitrage relationships that has afflicted many markets during the financial crisis. For example, eurodollar interest rates in New York and London diverged during the crisis-as did yields on corporate bonds and credit default swaps, which are closely related securities.  The element common to all of these phenomena was increased funding costs, which impeded arbitrageurs from shrinking the basis between these types of securities.  In addition, counterparty credit risk became prominent, and previously risk-free arbitrage trades suddenly became risky . . . funding constraints and counterparty risk explain the rise in the basis and the relative importance of each factor changed as the crisis evolved. [Emphasis added].

Since then, the coefficient of financial friction has reached record levels.  Capital and liquidity and funding constraints are binding everywhere, and binding hard.  In particular funding markets-and Libor is a measure of a funding costs for some banks-have been dysfunctional for 5 years.  Severely dysfunctional.  Most of the European banking system relies on the ECB for funding.  Markets across regions that were once highly integrated are now fragmented as never before.

This is particularly important for dollars.  Having access to dollar funding via deposits and access to the Fed (like major US banks) is completely different than having to raise dollars through wholesale markets, like most European banks that have been hit hard by the flight of US money market funds and other sources of dollar liquidity.  This is what drives things like the Euribor-Libor differential, and the swap-Libor basis.

Hell, there is fragmentation of funding even within currency areas, in particular, the Eurozone.  European subsidiaries are attempting to fund their local lending with local deposits, especially in countries where conversion risk (i.e., the risk that a country will leave the Euro) is acute.  For instance, Italian subsidiaries of French banks are funding their loans to Italian businesses with local deposits, rather than money from the parent banks.

In other words, Gensler is relying on a textbook model that presumes a frictionless world.  That ain’t our world, today.  The textbook needs to be thrown out.  But Gensler uses it as his bible.

There are two explanations of this, both quite frightening.

The first is that he really doesn’t understand this.  That he doesn’t understand that the financial system has suffered cataclysmic shocks and doesn’t work the way it used to.   It would inspire confidence, wouldn’t it, that an individual playing a crucial role in reshaping that financial system through the promulgation of rules under Frankendodd doesn’t understand why things are working-or not working-the way they are?

The second is that he is a fan of the band Say Anything.  That he knows that his “evidence” has nothing to do with Libor manipulation, but he is saying it to advance some regulatory or political agenda.

I’m betting on the second alternative, because Gensler is a serial offender in this: look back at my posts from 2009 and 2010 and you will see numerous times where I called BS on the former Goldman managing director for making ludicrous statements about financial markets-all of which were calculated to justify Frankendodd and a massive expansion of Federal regulation of derivatives markets.

Regardless of the reason, one thing is clear: Gensler’s misleading analysis lies naked and exposed. This is not to say that Libor was not manipulated.  It is to say that what Gensler hypes is not evidence of the existence of manipulation, or the magnitude of its effect.

It is unfortunate that he penned such a distorted oped, given that his agency provided a very rational proposal to reform the Libor fixing process in its Barclay’s settlement order.   Gensler should limit himself to promoting that proposal, rather than writing pieces that sow confusion and promote misunderstanding about a highly contentious issue that could have huge and costly impacts on banks-and hence on the world financial system, stressed as it already is.  That is not constructive.  It is irresponsible and dangerous.

I have crossed pixels with Felix on occasion, most notably over the issue of “empty creditors,” in which I took the Coasean position.  But today, I largely agree with his take on the Knight Capital implosion:

We’re seeing the same thing with the fiasco at Knight Capital, where a highly-sophisticated high-frequency stock-trading shop lost an enormous amount of money in a very small amount of time, and small investors lost absolutely nothing. On the grounds that we can’t present this as news without somehow determining that it’s bad for the little guy, it took no time at all for grandees to weigh in explaining why this really was bad for the little guy after all, and/or demonstrates the need for strong new regulation, in order to protect, um, someone, or something. It’s never really spelled out.

Knight lost $440 million.  That really stinks for its shareholders, but its loss is a windfall for those on the other side of its Hal moment.   Every dollar lost by Knight is a dollar gained by someone who entered an away from the market limit order that Knight triggered, or arbitrageuers that took advantage of the price anomalies.  You might argue that the temporary distortions in prices for dozens of stocks is a source of welfare loss, but I defy you to identify a real decision (e.g., the amount of investment by an affected firm, or its capital structure) that was affected by the very short lived fluctuations.

The final score: Knight -$440 million.  Others who bought and sold the affected stocks: +$440 million.  Third parties (not counting those who get the vapors when the markets don’t work as neatly and tidily as they think they should): $0.  Net result: $0.

Not quite, though, because of the pour encourager les autres aspect of Knight’s travails: to me this episode is an example of Darwinian selection in action.  Those who don’t adequately check their code are driven from the market (or almost are-Knight was rescued from bankruptcy on very harsh terms by a group of brokers and dealers).  Indeed, the outcome here is likely to be more efficient than a purely Darwinian one: here others can learn from Knight’s tale (“there but the grace of a geek go I: I’d better be extra vigilant”) whereas that learning mechanism doesn’t operate under pure natural selection.

Although I sometimes agree with Felix Salmon, the same cannot be said of me and John Kemp, another Reuters writer.  The correlation between our views pushes -1.

That’s true today, with respect to Kemp’s analysis (if that’s the right word) of ICE’s decision to relabel swaps as futures.  Kemp presents this as a smashing victory for Frankendodd.  Now it may seem churlish of me to criticize, given that Kemp did give my blog post extended play in his piece: I am aware of Brendan Behan’s dictum that there is no such thing as bad publicity, except where your obit is concerned.  But duty calls.

Kemp spends inordinate space in a disquisition on the Talmudic distinctions under the Commodity Exchange Act between contracts for future delivery and commodity forward contracts.  All of which is completely irrelevant because the ICE contracts transubstantiated from swaps to futures are definitely not commodity forward contracts exempt from CEA exchange trading requirements.  Kemp quotes my statement that nothing of economic substance changes as a result of the relabeling-and doesn’t disagree.  But he cavils:

Pirrong has been critical of Dodd-Frank and much of the CFTC’s rule-making. In this instance, he appears to argue that the sole outcome will be another round of regulatory arbitrage. (“A swap by any other name” Aug 2)

Arguably, however, ICE’s decision to re-label its cleared swaps as futures suggests regulators have won this round of the battle, ensuring that all contracts with an economically equivalent purpose will be treated in the same way, rather than subject to an artificial distinction.

Note the attempt to cast doubt on my analysis by pointing out my (unapologetic) criticism of Frankendodd, and Igor’s (i.e., the CFTC’s) implementation thereof. (“Distrust the skeptic!”)

Sorry, but I’m finding it hard to see the great regulatory victory here.  Nothing of economic substance has changed: Kemp does not dispute this, and in fact agrees with it (though he doesn’t go far enough, because the transactions are equivalent in form and substance as well as purpose).  The “artificial distinction” he criticizes is in fact a creation of the regulation: it is the direct result of Frankendodd’s establishment of a separate regime for swaps.  By revealed preference, the regulatory regime that ICE has chosen to operate under is less burdensome that the swap regime created by Frankendodd.  Since the economic substance of the transactions at issue hasn’t changed, this implies that either the swap regime is inefficiently costly (at least for some transactions), or the futures regime is inefficiently lax but a mere relabeling permits ICE and others to take advantage of that laxity.

I guess you have to take your victories where you find them, but that’s pushing it.

ICE has created something of a kerfuffle by its announcement that it will convert its cleared energy swaps contracts to futures.  Despite a lot of breathless reporting, there is less here than meets the eye.

ICE has merely relabeled its cleared energy swaps as futures in order to avoid burdening its customers with the costs that Frankendodd imposes on swaps.  Futures and swaps are subject to different regulatory regimes.  Firms with sufficiently large swap positions are considered swap dealers under Frankendodd, and must meet a variety of requirements that those not blessed with this designation can avoid: holders of equivalent futures positions need not meet the same requirements.  Swaps trades also involve additional reporting obligations not imposed on futures trades.

So what ICE will do effective in January is change the name of its contracts, thereby reducing the regulatory burden on its customers, without changing their economic substance one iota.  Note that these are cleared swaps, so the change doesn’t create a new clearing obligation on those trading them.  The central counterparty for the futures will be the same as for the swaps: ICE Clear Europe. The contracts will have identical settlement terms.  They will have identical cash flows.  They will trade on the exact same ICE platform.  The economic substance of every aspect of the old “swap” transaction and the new “futures” transaction remains the same, from execution to clearing to settlement.  Nothing changes but the name.

And the regulatory burden.

Which points out the potential for absurd outcomes under Frankendodd.  The CFTC has labored mightily to craft definitions of a swap and swap dealers and major swap market participants.  Where one falls under these definitions matters a lot.  Firms will endeavor to take measures that minimize the regulatory burden they face. ICE is basically picking the low hanging fruit, and taking note of Congress’s morbid obsession with “OTC swaps” and idealization of futures by magically transforming the former into the latter, and thereby making life easier-and cheaper-for its clients.

The incentive to label or structure transactions to achieve the same economic outcome at lower regulatory cost will be quite strong in the Frankendodd era.  This will initiate a regulatory dialectic in which regulators will attempt to adjust regulations in order to limit such attempts to escape regulatory burdens by relabeling or restructuring; the regulated will adjust to the adjustments; the regulators will adjust some more; and on and on.*

The lawyers will rejoice.

Much of the reporting on the ICE move has been pretty far off base, such as this from the WSJ:

Derivatives exchange IntercontinentalExchange said it plans to overhaul trading in trillions of dollars of energy contracts starting in January, becoming the first exchange to take such a step ahead of new financial regulations.

ICE is pushing trading of certain energy contracts onto its exchange, a move that would likely diminish the more-opaque world of over-the-counter derivatives trading. The plan will likely appease lawmakers who have decried the lack of transparency in such portions of the financial markets.

Derivatives exchange IntercontinentalExchange said it plans to overhaul trading in trillions of dollars of energy contracts starting in January, becoming the first exchange to take such a step ahead of new financial regulations.

ICE is pushing trading of certain energy contracts onto its exchange, a move that would likely diminish the more-opaque world of over-the-counter derivatives trading. The plan will likely appease lawmakers who have decried the lack of transparency in such portions of the financial markets.

. . . .

Many energy producers and users generally have preferred swaps contracts because each contract can be written up individually and to a company’s own specifications. That has enabled them to be more targeted in their hedging. Futures contracts, by contrast, are generally standard contracts covering the price of a specific energy grade to be delivered at a certain time.

Pretty much none of that is true.  All of it suggests a change in the way these instruments are designed, traded, and cleared, none of which is in fact changing. The contracts are already standardized, traded on an electronic platform, and cleared.  This is not a movement of bespoke, uncleared, bilateral contracts onto an exchange.

Look.  It’s long been known that the economic substance of swaps and futures are effectively identical, especially when the former are cleared.  Changing the label-hell, call them bananas-doesn’t change the economics.  If the CFTC had even less burdensome regulations for bananas, ICE would launch ICE Bananas.

Which illustrates that Frankendodd is quite often and in many ways truly bananas.

* Relabeling of derivatives contracts was employed in the 19th century to avoid legal restrictions.  When Illinois banned options trading, traders bought and sold the same things, but started calling them privileges.

Timmy! is deeply offended by SIGTARP Barofsky’s assertion that he was too close to Wall Street while he was head of FRBNY. In related news, Geithner defended himself against allegations that he had not been sufficiently aggressive in his handling of the LIBOR situation:

“We, at least I, first learned about those concerns in the early parts of spring of 2008 and we acted very quickly at that stage. At that time, this is in the spring of 2008, we took a very careful look at these concerns, we thought those concerns were justified,” Geithner said.

“And we took the initiative to bring those concerns to the attention of the broader U.S. regulatory community, including all the agencies that have responsibility for market manipulation and abuse,” he said, citing a specific meeting of the president’s working group on financial markets.

Note this:

The first trove of documents from the New York Fed showed that Barclays had flagged concerns as early as 2007 and Geithner sent the email to Bank of England Governor Mervyn King in June 2008 with the Libor recommendations.

So let’s review the timeline:

• In August, 2007 Barclays admits to FRBNY personnel that it submitted misleading LIBOR quotes, and claims that this practice is widespread.
• In April 2008 the WSJ runs an article providing evidence that banks were systematically underreporting LIBOR rates.
• In June 2008-AFTER the WSJ article-FRBNY sends a letter to the BOE suggesting procedural and governance changes to LIBOR in order to reduce the incentive to misreport.  This letter says nothing about Barclay’s admission that it had in fact misreported LIBOR 10 months earlier.
• BOE does nothing.  FRBNY does nothing.  FRBNY does not follow up when BOE does nothing.

So I guess we now now what “all I could” means in Timmyspeak.

I would have more respect for Geithner had he said: “Given the state of the banking system it would have been catastrophic to pursue aggressively misreporting of LIBOR.” The weaseling-not so much.  That is truly offensive.  (The “We, at least I, first learned” weaseling is particularly offensive.  Just where did the buck stop at FRBNY?)

Incidentally, the NYT has turned on Geithner for his role-or lack thereof-in cracking down on the misreporting.  Moreover, it has come out in support of Gary Gensler as a replacement for Geithner, in the event of a 2d Obama term:

And when the time comes to choose a new Treasury secretary — Mr. Geithner has said he does not expect to remain if President Obama is re-elected — the next president would do well to look for candidates among the regulators who have distinguished themselves by their willingness to confront the banking system’s manifest problems. One such person is Gary Gensler, the chairman of the Commodity Futures Trading Commission, which pursued the rate-rigging allegations against Barclays, securing a record fine and referring the matter to the Justice Department for criminal investigation.

A couple of things.  First, the CFTC acted almost five years after the initial information came to light: that’s confrontation?  Second, has the NYT maybe like heard of MF Global?  Peregrine?

Admittedly, a Gensler Treasury would probably be well down on the list of debacles in the event of Obama’s reelection.  But a debacle it would be, and the LIBOR case-in which the CFTC worked with DOJ and the BOE-is hardly sufficient grounds to justify Genlser’s elevation, especially in light of the two confidence-shattering, and unprecedented, breaches of customer fund segregation that occurred on his watch.

But then again, DC has always been a living, breathing, pulsating embodiment of the Peter Principle, so it just might happen.

Near zero interest rates are wreaking havoc among FCMs. I recall reading something about that.  Heck, I remember writing something about that about a week ago.

There is a puzzle here, though.  Why don’t commissions vary inversely with interest rates?  The FCM business is pretty competitive, meaning that FCMs should earn the competitive rate of return, i.e., roughly speaking revenues should equal costs plus a fair return on capital.  If interest rates rise, generating more revenues for FCMs, competition should lead them to cut commissions in order to attract customers.  Conversely, if interest rates fall, reducing FCM revenues, competitive pressures should induce them to raise commissions.  Why have commissions remained at rock bottom levels despite the loss of revenues from interest on customer funds that the FCMs hold and invest?

One possible explanation is that due to technological change (e.g., the expansion of electronic trading) there is excess capacity in the FCM industry, and some firms should exit.  The excess capacity keeps downward pressure on commissions, which will not rise until there is a significant shakeout.

Perhaps MF Global, or Peregrine, or both, were unwilling to concede that they were no longer economically viable and should exit.  Frequently the need to secure external funds to keep operating is what forces unviable businesses to exit even though individual managers or owners may want to try to gamble or cheat for resurrection.  Financial firms’ (including FCMs’) ready access to cash (even if it isn’t really theirs) can permit them to engage in these sorts of actions without securing external funds.  This is why financial sectors under stress are particularly vulnerable to fraud and excessive risk taking: not only do stressed firms have the incentive to engage in this kind of conduct (which is true of stressed firms in other industries too), but they have opportunities that stressed firms dependent on external finance do not.

A couple of LIBOR-related items.

1. Timmy! claims that he and the FRBNY were “very forceful from the beginning” in dealing with LIBOR manipulation.  This is an example of why Timmy! (AKA Rodney Dangerfield) gets no respect.  His letter to the BOE was a classic example of bureaucratic CYA and buck passing: the BOE then exchanged the buck and passed the pound to the BBA which did . . . nothing.  More nothing happened for over three years, and it wasn’t the FRBNY that drove the process.  The scary thought is that is what passes for forceful in Timmy!’s world: the scary alternative is that Geithner is just BSing about his past forcefulness.  The thought that Geithner’s 2008 actions were forceful is Pythonesque, really:

Cardinal Ximinez: Cardinal Fang! Fetch… the Comfy Chair!
Cardinal Fang: [horrified] The Comfy Chair?
[Fang scuttles off, then returns with the Comfy Chair and sits the old lady down in it]
Cardinal Ximinez: Now, you will sit in this chair until lunchtime, with nothing but a cup of coffee at 11!

2. Central bankers are looking for an alternative to LIBOR, EURIBOR, etc

Central banks are exploring whether financial markets might be steered to adopting benchmarks other than Libor. Mr. Bernanke suggested a few alternatives at his hearings this week. Among them: The rate that financial institutions charge each other for short-term loans in “repo” markets in which they use their large securities portfolios as collateral for short-term loans. He said derivatives markets also provide alternatives, such as “overnight index swap,” or OIS, rates, which track central bank lending benchmarks.

That’s great going forward, but what about the $800 trillion or so in notional and/or principal amount of outstanding derivatives, loans, and other financial instruments with payments tied to LIBOR and its European and Asian cousins?  That would be a helluva lot of contracts to orphan.

LIBOR needs to be fixed, because of this massive amount of legacy contracts.  But how?  It won’t be easy, since the transactions that LIBOR et al should be related to-unsecured interbank transactions-aren’t orphaned: they’re damned near extinct.  Any decree by regulators that henceforth LIBOR should be something different than the creature that existed at the time these contracts, loans, etc., were created would potentially result in the shift of many billions of dollars of wealth, and spawn intense legal challenges.  (Ironically, any fines or damages arising from LIBOR manipulation-related legal actions will weaken banks and make the return of unsecured lending all the more remote a prospect.)

Looking for a replacement going forward is the easy problem: market participants have an incentive to come up with something more robust, there will be experimentation and competition, and perhaps with a little regulatory shepherding, in not too long something better (no doubt some sort of secured rate) will emerge as the benchmark.  Going forward, market participants can find transactions and benchmarks that are mutually beneficial.  That provides an incentive to get it right.

Finding a way to deal with the legacy of the past is going to be a much, much more difficult problem.  The primary effects of changes will be redistributive, rather than creative.  This will give rise to massive rent seeking and legal conflict.  Much fun will be had by all.  Especially the lawyers.

I owe thanks to Tim Worstall (never to be confused with Timmy!) for his Forbes blog post on, and compliments of, my Blame it on Ben? piece from Saturday.

I also owe Tim props, for he recognized the dangers that low interest rates pose to the traditional broker model back when MF Global went bust.

One clarification.  I didn’t mean to suggest that low interest rates caused MF Global, or Peregrine, or the Whale, in the sense that low rates were a sufficient condition for these things to occur.  Low interest rates aren’t necessary either: some firms take risk or commit fraud when interest rates are high, obviously.

But risk taking (such as MF Global’s gambling for resurrection) and fraud (such as Peregrine’s) are more likely when firms are on, or over, the financial brink.  Low interest rates put these firms on the brink, and made the courses of action that Corzine and Wasserman chose more attractive and compelling than they would have been had they been making money the old fashioned way.  Put differently. low interest rates increase the odds of such conduct.

With that clarification made, just let me say thanks Tim, and keep up the good work.

Obama’s speech in Roanoke, VA, contains this bit of creepy collectivism:

There are a lot of wealthy, successful Americans who agree with me — because they want to give something back.  They know they didn’t — look, if you’ve been successful, you didn’t get there on your own.  You didn’t get there on your own.  I’m always struck by people who think, well, it must be because I was just so smart.  There are a lot of smart people out there.  It must be because I worked harder than everybody else.  Let me tell you something — there are a whole bunch of hardworking people out there.  (Applause.)

If you were successful, somebody along the line gave you some help.  There was a great teacher somewhere in your life.  Somebody helped to create this unbelievable American system that we have that allowed you to thrive.  Somebody invested in roads and bridges.  If you’ve got a business — you didn’t build that.  Somebody else made that happen.  The Internet didn’t get invented on its own.  Government research created the Internet so that all the companies could make money off the Internet.

You know the latent message here: You didn’t earn it.  So you have no right to it.  Since you have no right to it, “we”-the government-will take what we want.

Let’s consider that Internet example from the perspective that Obama routinely applies to private wealth.  Putting aside the question of whether the Internet is truly the child of the government-funded ARPANET, the Federal government has recouped in taxes on income and capital gains from Internet-related economic activity many, many times what it spent in developing ARPANET.  Indeed, I would wager that the government will collect more in taxes from the Facebook IPO than it spent on ARPANET, even taking into account inflation/compounded interest.  When private fortunes are concerned, Obama’s philosophy is “I do think at a certain point you’ve made enough money”, meaning that you should pay more-much more-in taxes.  But that doesn’t apply to government investment, evidently.  If it did, it would be greedy to cash those tax checks from Internet businesses and workers.

What’s more, whatever the contribution of government initiatives like ARPANET to the Internet, it is blindingly obvious that virtually all the value generated by the Internet is the result of private initiative, private innovation, and private investment.  So when you are cashing that government benefit check, realize that the government didn’t get there on its own.

And the last statement (“[g]overnment research created the Internet so that all the companies could make money off the Internet”) is a flagrant lie. This statement implies intent: that government research on ARPANET had, as its explicit purpose, the encouragement of private economic activity.  Nothing could be further from the truth.

Obama then fired up the Wayback Machine for further examples of the pivotal role of government:

So we say to ourselves, ever since the founding of this country, you know what, there are some things we do better together.  That’s how we funded the GI Bill.  That’s how we created the middle class.  That’s how we built the Golden Gate Bridge or the Hoover Dam.  That’s how we invented the Internet.  That’s how we sent a man to the moon.  We rise or fall together as one nation and as one people, and that’s the reason I’m running for President — because I still believe in that idea.  You’re not on your own, we’re in this together.

Uhm, who is this “we”?  A pitch-perfect illustration of the collectivist mindset.

At least he spared us a disquisition on the Intercontinental Railroad.  (Now that would have been a feat!).  As for the things he did mention:

Man on the moon?  NASA is a tragic shadow of its former self-with Obama’s approval.

Hoover Dam?  Please.  You think it could be built today?  Really?  The enviros* and progs hate dams.  Hate them.

And even something seemingly more benign, like the Golden Gate Bridge, would never be built today, or certainly not as quickly or cheaply as the original. The environmental impact statements, the legislative log rolling, the designs and redesigns to meet the objections of this constituency or that, all make such project a thing of the past.

No, nowadays, infrastructure projects aren’t shovel ready.  They are rent seeker ready.  Lawyer ready.  Bureaucrat ready.  Just look at the train wreck (literally) that is high speed rail in California.  Or the Big Dig in Boston, as Walter Russell Mead reminds us:

It turns out that Boston’s “Big Dig” construction project cost taxpayers much more than expected — and enormous bills for interest payments and mass transit are still rolling in.

Hailed at its inception as an example of “smart government” and proof that “government can still get things done,” the project was originally estimated to cost $2.8 billion. Thanks to corruption, construction mishaps and the usual friction on projects of this kind, the project took a decade longer than planned to complete, and was said at the time (December 2007) to have cost a total of $14.6 billion.

There was much shock and finger-pointing when these numbers came out, but as Boston.com reports, those cost estimates were still much too low. By the time the whole mess is finished and accounted for, this beautiful proof of governmental competence and efficiency, this magnificent testimony to the ability of big infrastructure projects to turn the US around will end up costing about twice that much: at about $21 billion, the final cost will be about seven times the original estimate — an original estimate, by the way, so large that it blew peoples’ minds at the start.

Government today is all about transfer payments, rather than investment in public goods.  When it tries to build stuff, it soon engages in a Bacchanal of waste and incoherence.  Its greatest efforts are directed at redistribution via cashing checks from some and writing checks to others.  That, and controlling via regulation economic activity large and small.

Interesting, isn’t it, that Obama couldn’t find an example of a seminal contribution of government post-1969?

If you are paying attention to what Obama says, it is clear that his vision is inherently a collectivist one that is deeply hostile to private enterprise and wealth creation.  A vision that credits the government for the lion’s share of wealth creation if government has touched the creative process, however slightly or indirectly.  A vision that cannot see Bastiat’s unseen-the wealth not created because of the very visible strangling hand of government.

* WordPress’s auto spell kept wanting to replace “enviros” with “enviers.”  That works.

The futures industry is reeling over the latest theft of segregated customer funds, this time by Peregrine Futures’ Russell Wasendorf.  Wasendorf admitted to stealing seg funds in a note left at his side when he attempted suicide after it looked like his scheme was unraveling.  He has been indicted for fraud committed over the 2010-2012 period.  Over $200 million is missing, and his company is undergoing Chapter 7 liquidation.

Following hard on the heels of the MF Global disaster, the Peregrine revelations are raising further fears about what had once been considered sacrosanct: that customer funds are inviolate.  Even the CME Group, which has historically been a stalwart defender of the traditional segregation model in which FCMs are the custodians of customer money, has suggested that changes may be necessary:

Without question, the current system in which customer funds are held at the firm level must be reevaluated.

CME Group recognizes that the demand for its services is reduced to the extent that suppliers of complementary services-such as brokerage-are deemed untrustworthy.

I consider it virtually inevitable that this will be the last nail in the traditional segregation model.  This will lead to a dramatic change in the organization of the FCM industry.  Though (as I discuss a below) that industry was already under tremendous strain.  Peregrine and MF Global are symptoms of that strain.

Other big news this week was JP Morgan’s reporting of a $4.4 billion dollar Q2 2012 loss, and a $459 million restatement of its Q1 results-along with an admission that the “integrity” of the marks in the CIO books.

Do Peregrine, MF Global, and JP Morgan’s travails have anything in common, except for bringing further discredit onto the finance and banking industry?  I think they do.  I think they are all consequences of near-zero interest rates.

The traditional FCM revenue model relied on interest income from customer funds invested by the FCM.  Very low interest rates make that model unviable.  That is a major reason why Corzine felt it imperative to transform MF Global-and to take on more risk.  I conjecture that similar pressures led Wasendorf to commit fraud.  (Though his admission that he had been doing so for 20 years cuts against that interpretation.  A hypothesis: Wasendorf had been engaging in this activity on a smaller scale for years, but escalated it sharply as the financial pressures on Peregrine grew in the low interest rate environment.)

The Morgan story is different, but the extraordinary monetary policies that have driven interest rates to extremely low levels are at the center of the story.  Morgan had about $360-$500 billion in deposits that it needed to invest, but traditional investments such as Treasuries offered such low yields that the bank went hunting for yield, and invested in more risky securities and derivatives to get it.  Yield chasing in Fed-created low interest rate environments has contributed to previous big losses, such as Orange County’s in 1994.

Bernanke and the Fed initially pursued a low interest rate policy in an attempt to prevent another depression, and have continued it in attempt to spur growth.  These are the justifications for these policies, and they are defensible ones.  But these policies cause collateral damage.  Financial blowups-from MF Global to Peregrine to the Whale-are plausibly just that.