Streetwise Professor

JP Morgan just announced a huge-$800 million $2 billion!-mark-to-market loss in the synthetic credit portfolio run out of its Chief Investment Office.  Bruno Iksil-“The Whale”-is almost certainly wearing the collar for this bloodbath (uhm, I think that’s a mixture of 3 metaphors-whatev).

Some immediate reactions.

1. Whales get harpooned.  No matter how big you are, the markets are bigger.
2. Traders can move prices by putting on big enough trades.  It’s not moving prices that is the trick: it is profitably closing big positions after you moved the price.  There has to be some asymmetry.  If your buying drives up prices, your selling to exit a position is almost certain to drive them down-and indeed, drive them down more due to market frictions.
3. That is, to be profitable, Whale Trades require an exit strategy.  Corners have an exit strategy-but even these are not foolproof, as many cornerers have found to their dismay.  Some other manipulative strategies, such as moving a price that affects the payoff to a related derivative, also have an exit strategy.  But just flexing, just moving a price by trading in huge size, is vanity and usually results in losses because there is no exit strategy. Like the Duke of York, you can march up the price hill by buying a lot, but you end up marching down the hill again when you try to sell.
4. Banks can kiss any weakening of the Volcker Rule adios! Indeed, the rule is likely to be tightened considerably.  I’m sure Jamie Dimon is getting lots of love from his fellow CEOs.  Lots.
5. Speaking of Dimon, I wonder if he can kiss his job good bye.

Very interesting of juxtaposition of stories involving Norway and Russia (h/t R).

Story one-Norway’s Statoil and Russia’s Rosneft agree to exploration joint ventures in the Russian Arctic:

Statoil (OSE:STL, NYSE:STO) and Rosneft today signed a cooperation agreement. The companies have agreed to jointly explore offshore frontier areas of Russia and Norway and to conduct joint technical studies on two onshore Russian assets.

The agreement also envisages Rosneft’s acquisition of participating interests in selected Statoil projects.

. . . .

Under the agreement, Statoil and Rosneft will set up joint ventures, with Statoil holding 33,33% in each. The partners will jointly explore the Perseevsky licence in in the Russian part of the Central Barents Sea and three licences – the Kashevarovsky, Lisyansky and Magadan-1 – north of Sakhalin island in the Sea of Okhotsk. The four offshore licences cover an area of more than 100,000 square kilometres, equalling approximately 200 blocks on the Norwegian continental shelf.

Are the Norwegians setting themselves up to be the next victims of expropriation? A couple of things to note.

First, this an exploration deal.  Although this involves irreversible investments, the real risk of expropriation spikes when production begins.  This is particularly true inasmuch as even if the exploration identifies commercially attractive opportunities.  Rosneft would be in no position to try to freeze out Statoil after it had paid to discover the prospects because the Russian company seriously lacks the expertise to develop these resources itself: this is why it is so assiduously pursuing agreements with all the major western majors.

Second, it appears that Statoil is following the hostage model pioneered by ExxonMobil:

The cooperation agreement also provides Rosneft with an opportunity to acquire interests in selected Statoil exploration licences and assets in the North Sea as well as in the Norwegian sector of the Barents Sea.

This article, and all the others I’ve tracked down about the deal, are maddeningly short of details on this crucial aspect of the transaction.  But it is evident that the deal is structured so that Rosneft has a valuable asset at risk if it (or the Russian government) tries its old tricks.

Note to reporters: please get a clue and get more detail on this aspect of the agreement.  This is the crucial term in the agreement.

The hostage mechanism is an oft-used way of enforcing good behavior in transactions involving long-lived investments in specific assets.  Williamson wrote about this mechanism in detail in The Economic Institutions of  Capitalism and elsewhere.

The devil is truly in the details, though.  XOM is apparently confident that it can provide incentives for good behavior from the Russians, and apparently Statoil has taken XOM’s confidence to heart.  But how it works in practice remains to be seen.  Don’t underestimate the ability of the Russians to behave opportunistically.

A particular risk is that the values of the investment opportunities in Russia and in Norway (or in the US Gulf, in the XOM deal) diverge.  Let’s say that the Russian resource turns out to be extremely valuable, but the Norwegian (or Gulf) resource comes a cropper.  Then the hostage has no value, and the risk of expropriation rises dramatically.

That risk seems to be particularly acute in this context, given the extreme uncertainty about the commercial value of the different projects.  Much information will be developed over time about the value of the various resources.  Moreover, technologies will change, affecting the commercial prospects of each.  There is an appreciable risk of a divergence in hostage values.  Given the asymmetric risk of opportunism, that divergence is particularly hazardous for Statoil and Exxon.

This probably explains why all of the deals involve bundles of several exploration prospects.  This diversification reduces the risk of the loss of hostage value.  Only if all of the Norwegian prospects turn out badly do the hostages die, leaving Rosneft free to screw the Norwegians out of any attractive opportunities in Russia.  Note in this regard that the Norwegian prospects are in two different regions-the North Sea and the Barents Sea.  This increases the diversification.

Clever.  I hope it works out for them.

Hey, Tim Newman-your insights would be greatly appreciated.

To emphasize why such measures are particularly important in dealing with Russia, consider the second story, about Russia banning Norwegian salmon imports:

Russia temporarily halted chilled salmon imports from 13 Norwegian firms, the animal and plant health watchdog in Moscow said.

The ban followed repeated instances of microbe pollution, a spokesman for the regulator said on Saturday.

Norway’s food Safety Authority said on April 30 it had received advance notice of the ban, which does not include frozen salmon, and was working with the firms to resolve the “very serious” issue.

Russia is Norway’s biggest salmon market.

Shares in fish and seafood products company Russian Sea . rose 7 percent in Moscow on Saturday.

. . . .

The global salmon market is experiencing a glut, and many firms are struggling to shift their stocks.

There are no “microbes” in salmon caught in Russian nets?  Sure there aren’t.

No.  The last two sentences tell the real story.  A supply glut is weighing on prices, hurting Russian fishers.  So the Russians gin up (or would that be vodka up?) the “health and safety” issue to justify an import ban.  Lo and behold, Russian fishing companies (or at least one, anyways, but there is no reason to believe it is exceptional) realize a windfall.

I’ve written in the past about how Russia routinely manipulates health and safety concerns as a protectionist instrument. (Search the site for “swine flu” and a couple of posts will come up.) (And yes, I recognize and condemn the fact that Russia is not the only sinner in this regard.  The US also engages in various forms of legerdemain to protect US firms.)  That this continues even as Russia joins the WTO indicates that it is still not too keen on rules and agreements that constrain its ability to take from foreigners to benefit domestic interests.

So, this fish story should focus Norwegian minds on the risks that they assume when trawling for other riches in cold waters.  Maybe the hostages will keep the Russians in line.  But the point is that you need hostages in dealing with them, for reputation and contracts alone aren’t enough.  You just need to hope that your hostages don’t die before you need them.

On the anniversary of the passage of Frankendodd, I named the swaps execution facility mandate as the Worst of Frankendodd.  There was intense competition for the honor, to be sure, but I stand by that conclusion.

Gary Gensler sortied into enemy territory at the ISDA AGM in Chicago to do his best to defend the worst.  My verdict (based on press coverage): #Fail.

Interestingly, although Gensler used to focus (wrongheadedly) on the supposed competitive benefits of a SEF mandate, in Chicago he tried to portray it as a bulwark against systemic risk:

“Transparency to the public lowers the risk [for] clearinghouses,” he told the conference.

“Clearinghouses can only survive if they have reliable pricing feeds on a daily basis to mark to market their positions, and also have reliable, liquid markets in default scenarios,” Gensler said.

“There is far less risk in a clearinghouse if you have both pre-trade transparency and post-trade transparency.”

Dealers have criticised the move to electronic execution of OTC derivatives, complaining the large size and small volume of trades means such rules are inappropriate for the market.

This is clearly-no pun intended-incorrect, particularly when viewed in the context of Gensler’s desire for extensive pre-trade transparency and near real time reporting of trades.

CCPs will obtain the prices of deals cleared through them, that they can use to determine marks on a periodic basis.  Moreover, they have access to information from member firms that will permit marking deals to market.

Pre-trade transparency is particularly irrelevant in this context.

And Gensler is positively delusional if he thinks that the pre- and post-trade transparency is going to ensure “reliable and liquid markets” in default scenarios-especially if those scenarios involve the default of a systemically important clearing member.   Note that even for normally listed, exchange traded products CME used an auction procedure, rather than normal trading protocols, to handle the Lehman default.  Also note that LCH was able to handle the Lehman IRS portfolio default in a pretty effective and orderly way even without mandated centralized trading.

Gensler appears to believe that OTC derivatives markets, even for cleared products, will be like exchange trade futures.  Hardly.  One size does not fit all.  The nature of the transactions, the transactors, and the products is very different.  That’s why there are different markets and different market structures: the different structures are discriminating ways of accommodating the diversity of trades and traders. Market structures are endogenous, and reflect the characteristics of trades and traders, a point that is lost on Gensler and all too many others.

Indeed, the biggest problem that CCPs will not be obtaining price information on fairly active products, even if those products trade without pre-trade or post-trade transparency: even without SEFs, it will be relatively easy to mark 10 year USD IRS or active credit indices to market.  The problem will be obtaining information on the value of the products that don’t trade.  Gensler apparently believes in the Field of Dreams Theory: if you build a SEF, the trades-and bids and offers-will come, for everything.

No, actually.  Many products traded OTC do not trade frequently.  That’s a major reason why a dealer market structure rather than a centralized auction market structure, predominates there.  Moreover, the life cycle of trading activity in OTC and listed products is quite different.  Exchange traded products start out illiquid, and if they become liquid at all, become progressively more liquid as their maturity/time to expiry declines.  With OTC products, the cycle is the reverse.  Five year and 10 year swaps are quite active and liquid, and a lot of deals are done.  Those deals live on, and the 10 year swap becomes a 9 year swap and then an 8 year swap, and so on, and these products are far less liquid than the benchmark maturities.  You can have all the SEFs in the world, and 3.35 year swaps ain’t going to be trading, and won’t even be bid or offered.  Meaning that it SEFs will matter exactly bupkus for such products.

What’s more, mandated pre- and post-trade disclosure has costs  (mainly in the form of lower liquidity as disclosure of trades and price information raises risks to liquidity suppliers, inducing them to supply less), and these costs will vary by product.  Again, one-size-fits-all is misguided in the extreme.  Gensler dismisses these costs, and pays even less attention to the heterogeneity of products and transactions.

ISDA has pretty much acquiesced to most of the clearing-related rules, but is still fighting hard against the SEF mandate:

A theme of the ISDA conference, which includes large dealers as well as users of derivatives, is that while central clearing reduces systemic risk, regulators should not impose new rules on how derivatives trade, because it could disrupt those established markets and reduce trading volumes.

“Listed and over-the-counter markets are completely different, and it’s important that lawmakers and regulators keep this in mind,” said [ISDA Chairman and Morgan Stanley’s head of Global OTC Clearing Stephen] O’Connor,

He added that the industry was open to more public reporting, but with restrictions such as not revealing the size of very large trades or delaying trade reporting. “We’re not anti-public reporting,” he said.

I agree with O’Connor, but you might say “but he’s biased and protecting the dealers’ gravy train.”  Fine.  But interestingly, a supposed beneficiary of what Gensler wants so badly, isn’t sold on the idea:

Michael Davie, head of LCH.Clearnet’s SwapClear platform, agreed that regulators, clearers and market participants must know what is going on, but public reporting isn’t essential.

As I’ve argued ad nauseum, regulators will know what is going (in terms of positions and trades) due to swap data repositories.  As Davie says, public trade reporting-particularly in near real time-isn’t important for CCPs to do what they need to do.  And as I state above, public reporting of trades won’t help CCPs at all if there are no trades.

No, Gary.  SEF mandates are still the Worst of Dodd-Frank.  And slathering on the systemic risk lipstick won’t make that pig any more attractive.

A quick comment about the ISDA AGM.  A perusal of the press coverage is fascinating.  Virtually every issue-every damn one-that is the subject of intense debate at the AGM was raised here on SWP, or in my academic writing years ago.  Going back to 2008-2009, and sometimes to the late-90s (obviously pre-SWP, but not pre-Pirrong clearing research).  That old Cassandra feeling is particularly powerful right now.  I was invited to participate in the meetings, but had to decline due to another commitment, which alas did not materialize due to the vagaries of court scheduling.  (No! I am not on trial!  Sorry to disappoint some of you.) It would have been a fascinating experience.

John Parsons and Antonio Mello at Betting the Business argue that the dominance of OTC derivatives is not indicative of their efficiency, but instead resulted from the banks underpricing credit risk:

The logic that OTC markets are superior only works on the premise that banks are competing with exchanges on a level playing field. But prior to the financial crisis of 2007-2008 (and until the effort to reform finance is successfully completed), the playing field has been not level: banks have enjoyed some significant privileges. Key among them was the failure of some banks and regulators to properly price the credit risk embedded in derivatives.

This is a very strong statement, and one which John and Antonio do not provide persuasive evidence.  Their evidence is a post at FTAlphaville by David Murphy, which details the history of credit value adjustments (CVA), and a BIS report.  David notes that although in the early days of OTC markets, banks did not charge for the credit embedded in derivatives, they eventually did so.  Parsons-Mello argue, based on the BIS report, that regulators lagged these developments, and did not impose adequate capital charges on OTC derivatives exposures, particularly on CVA exposures which were larger than actual default losses.

There is some empirical evidence that speaks to this issue.  Papers dating back to the 1990s demonstrated that interest rate swap prices vary with counterparty credit risk, although the effect was small primarily because netting and the fact that principal is not at risk in an IRS made the credit exposures relatively small.  Counterparty credit risk in CDS is much larger.  Recent work by Gandhi, Longstaff, and Arora found small pricing effects in intedealer CDS trades, that became larger in the aftermath of the 2008 Crisis.  They conclude that the small effect reflects the fact that most interdealer traders were collateralized, though by variation margin rather than independent amounts (the OTC equivalent to initial margin).  The use of collateralization to reduce credit exposure is inconsistent with the hypothesis that credit risk embedded in derivatives is underpriced.

No doubt Parsons-Mello would interpret the evidence differently than Gandhi et al.

Collateralization is one way to control credit exposure.  Credit limits are another.  Reducing credit limits of firms that suffer adverse shocks to creditworthiness would tend to reduce the impact of such shocks on pricing.  Since credit exposure can be managed on a variety of margins-pricing, collateralization, credit limits-just looking price effects is not sufficient to determine whether credit risks embedded in derivatives are overpriced or underpriced.

The Mello-Parsons argument depends crucially on inconsistent capital treatment across equivalent categories of risk.  It is also somewhat in tension with an argument that they have made before that collateralization mandates do not raise the costs of trading OTC derivatives.  As they have pointed out before (as have I), credit that is embedded in a derivatives trade can be unbundled into a default free (collateralized) derivative and an unsecured credit line.  If capital charges are set consistently across equivalent risks, regulations that reduce credit exposure in a derivatives trade (e.g., a collateral or clearing mandate) can and will be offset by a substitution of an equivalent form of credit, leading to little or no change in overall exposure, just a change in its composition.

There is no reason to believe that regulators set capital charges consistently.  I think that John and Antonio are arguing that they should.  I would suggest that this is an impossibility.  This has been a theme of mine in several posts relating to Basel rules (you can find more related posts by typing “Basel” into the search bar).  The capital charges are inevitably make crude distinctions between different sources of risk.  Banks who understand the true risks far better optimize their activities to take advantage of disparities between their more informed estimates of actual risk and the regulatory risk charges.  Moreover, they tend to do so in a way that is highly correlated across banks because they all face the distorted capital cost structure.  Maybe making derivatives-related capital charges more sensitive to counterparty credit risk will reduce the subsidy of risk arising in derivatives books and the risk exposure there will fall commensurately; but the resulting structure of capital charges are likely to subsidize another risk, leading banks to pile into that activity.

In other words, risk based capital charges are an extremely blunt tool. They are a form of regulated pricing, and like virtually all regulated price structures, lead to acute distortions.  I am skeptical that they are a reliable means of reducing systemic risk.  Indeed, by inducing correlated risk taking across financial institutions, they can actually exacerbate that risk. (Mello-Parsons do recognize the difficulties of setting the capital charges: I think the difficulties are so acute as to make it virtually impossible to get anywhere near right, and very easy to make big mistakes.)

Assessing a CVA-based capital charge also creates the very serious risk of inducing vicious cyles/feedback loops, especially during times of crisis.  CVA charges are based on CDS prices, and CDS prices vary not just with expected default rates and losses, but also embed risk premia and liquidity adjustments that depend on market frictions and market-wide conditions.  Put differently, CDS prices reflect default rates and losses in the equivalent measure, and the market chooses the measure.  During crisis periods in particular, as liquidity dries up and risk limits (e.g., VaR limits) bind, expected default losses in the equivalent measure rise relative to expected default losses in the physical measure, meaning that CDS spreads widen absolutely and relative to what the spreads implied by expected default losses.

With CVA-based capital charges, such widening in CDS spreads will lead to higher CVAs and more variability in CVAs, which depending on how the CVA charge is implemented, could lead to higher capital charges, or to actions intended to reduce capital charges.  Increases in capital charges raise the costs associated with outstanding positions and new deals, thereby leading to reductions in positions, increases in collateral postings, or both.  These will tend to exacerbate market stresses, as firms dump positions to reduce exposures (and CVA) and sell assets to raise cash to meet collateral calls, which will lead to additional price movements that can affect CVAs, and on and on.

Put another way, it binds regulatory capital very tightly to conditions in the CDS market.  The more concerned you are about the functioning of that market, especially during times of stress, the more concerned you should be about hardwiring regulatory capital requirements to the CDS market.

That is, like any market-price based mechanism for setting collateral or capital charges (think of VaR), a CVA-based mechanism is highly likely to be procyclical, and perhaps severely so.  This makes it a major potential source of systemic risk.

In sum, I do not discount the possibility that capital requirements led to an underpricing of credit risk in OTC derivatives, and hence caused these markets to be larger than they should have been, or would have been given requirements that discriminated accurately among different risks in banks’ books.  The evidence one way or the other is rather thin.  I am highly skeptical, however, of the ability of regulators to address this problem without creating others equally severe, given the information advantages that banks have and their ability to optimize their risk taking subject to the (distorted) structure of capital requirements.

Moreover, I am downright frightened of basing derivatives capital requirements on CVA, or any market-price based measure.  It is individually rational for banks to price using CVA, but tying capital charges to this measure will almost certainly lead to procyclical capital charges that are highly correlated across major financial institutions.  That is a very bad-and very scary-idea.

I therefore do not dismiss the Mello-Parsons diagnosis, though I am not completely sold.  I am particularly concerned that any “cure” could be worse than the disease.

The Commodity Futures Modernization Act has been demonized as a major contributor to the financial crisis-unfairly in my view. This view is ahistorical, and fails to understand what led up to its passage.  In brief, the evolution of derivatives markets, and particularly the growth of the swaps market in the 1980s and 1990s created legal and economic challenges that the Commodity Exchange Act, dating from 1922 with a major modification in 1936, was completely unable to handle.  The CEA was passed at a time where “off exchange” transactions meant $10 bets at bucket shops, not huge deals between major banks and corporations.  The categories of market participants and the kinds of derivatives traded that Congress had in mind when drafting this legislation were vastly different from those developed during the wave of financial innovation that began in earnest in the early-1970s. As a result, by the mid-1980s, and certainly by the 1990s, the regulatory framework in place was completely ill-adapted to market conditions.

In particular, the exchange trading requirement of the CEA constrained the ability of market participants to undertake mutually beneficial transactions.  Those entering into perfectly sensible OTC deals risked running afoul of the requirement, which put their transactions at considerable legal risk.  The CFTC responded to this situation by issuing a variety of interpretative statements and no action letters and exemptions that were intended to give relief to these transactions.  Soon a confusing thicket of ambiguous and often contradictory rulings, exemptions, no action letters and interpretations grew up around OTC derivatives trades. The legal, logical, and linguistic contortions became increasingly absurd.  Although these permitted certain transactions to go forward, they did not address the very serious risk that someone could challenge whole categories of OTC trades and instruments in court, and that a judge would find them in violation of the CEA.

This was the genesis of the CFMA.  The “modernization” was intended to create a legal framework that reflected modern market reality, and which gave legal certainty to economically beneficial transactions.  It was an effort to clear the thicket, to replace an often absurd and contradictory set of ad hoc improvisations with a coherent structure.

The fundamental problem that CFMA was intended to address was that legal and legislative categories did not correspond to market reality.  The CFTC reacted by crafting ad hoc fixes.  But in the face of rapid innovation, the bolting of one ad hoc fix onto another created a vast Rube Goldberg contraption that was an accident waiting to happen.

Move forward 10 years from CFMA to Frankendodd.  Frankendodd creates numerous categories of instruments and market participants-swap, securities swap, swap dealer, major swap market participant, and on and on. It then delegates to multiple regulators the task of establishing detailed criteria describing these categories. Frankendodd itself weighs in at 2400+ pages, and the myriad regulations thereunder will run to many thousands of additional pages.

And that will just be the beginning.  The proliferation of categories that do not correspond to market realities today, let alone market realities in the future that develop in response to fundamental economic changes, financial innovations, and the regulations themselves, will lead to serious contradictions between what makes commercial and policy sense, and the letter of the law and the regulations.  The regulators will inevitably respond today the way they did in the 1980s and 1990s-with ad hoc responses intended to address the specific transactions and transactors at issue, with only passing regard for the coherence of the overall set of rulings and interpretations.  A Talmudic mind will be required to sort through it all.

Lawyers will rejoice and prosper-hence the rejoicing-because the most important design consideration for a transaction or a new structure will be how it can be jiggered to satisfy the regulations and interpretations, rather than the most efficient way to achieve a particular economic objective.  And even then there will be considerable uncertainty given the inevitable contradictions in the regulations, interpretations, judicial rulings, and on and on.

In due course, the whole edifice will become utterly unworkable and incoherent, and create a real systemic risk-a risk arising from the serious legal uncertainty that is inevitable.  And the problems arising out of Frankendodd will be all the worse than those arising out of CEA because it is more sweeping, the markets are more complicated and international, and the categories and distinctions and requirements it creates are vastly more numerous.

The ink on some regulations arising out of Frankendodd is barely dry, and this regulatory dialectic is already beginning.  The regulators are already making ad hoc adjustments.  From the FT:

US regulators are exploring ways to give large foreign banks and overseas subsidiaries of US lenders a reprieve from stringent new derivatives rules, potentially alleviating one of the biggest concerns facing global financial institutions.

The US Commodity Futures Trading Commission is looking to grant a temporary exemption to swap dealers that may fall under the jurisdiction of foreign financial authorities from complying with a host of post-financial crisis regulations governing derivatives transactions, people familiar with the matter said.

If you think this exception is the exception, you have another thing coming.  This is just the beginning of the dialectic.  Moreover, the international nature of the derivatives industry, and the creation of laws, rules, and regulations in different jurisdictions around the world will just accelerate it.

Within a period of a few years, derivatives regulations will be another absurd Rube Goldberg contraption.  And in its inimitable fashion, Congress (and the EU-if it still exists) will feel compelled to pass The Derivatives Modernization Act of 2020 (to choose a realistic round number).  Mark my words.

The CFTC had to play Goldilocks and decide the level of OTC swaps activity required to make a firm a swap dealer and thereby subject to the collateral and capital requirements and other obligations entailed in such a designation.  Earlier proposals ($100 million, then $3 billion) were commonly deemed too small.  Industry proposals were deemed to be too big.  The Commission decided on $8 billion, with the possibility of reverting to $3 billion depending on the results of forthcoming data collection and analysis by the Commission.

The usual suspects-like “Better Markets”-claim that the limit is far too big, and represents a huge loophole.  Genlser (no Goldilocks, if you know what I mean) fired back, claiming that the limit was actually quite small, compared to the immense size ($300 trillion notional) in the US swaps market.

These kinds of debates are frustrating in any event, because cutoffs like this economize on information, but are inherently arbitrary.  They focus on the easily measured, rather than the economically significant.  They reduce multi-dimensional problems to a single dimension, which inevitably leads to distortions.  In particular, they provide incentives to devise transactions and structure business to circumvent the rule.

The real questions that should be asked in determining the criteria for swap dealer designation are: What is the market failure that this regulation is intended to address? and What criteria will mitigate that market failure in a cost-effective way?

The whole justification for Frankendodd is that derivatives pose a systemic risk.  Systemic risk, properly understood, involves some sort of externality.  One potential externality is that a default by one large derivatives trading firm can lead to a daisy chain of defaults.  Another is that default costs are passed onto taxpayers in the form of bailouts.  Swap dealer designation, and the consequent regulation of their activities, are supposedly intended to address these externality problems.

Viewed from this perspective, $8 billion in notional amount seems like a very small number.  Based on BIS numbers, market values are about 3 percent of notional amounts.  Applying this to an $8 billion notional gives a market value of $240 million.  The financial system can withstand such a default, and even several such defaults.  Yes, counterparty risk also depends on gross amounts, but even an $8 billion loss is not catastrophic, especially inasmuch as any such loss would be spread over a number of counterparties.

To put things in perspective, look at the notional holdings of firms whose collapse or threatened collapse arguably posed a systemic threat.  LTCM’s derivatives book was $1.25 trillion-in 1998.  That’s 2 orders of magnitude bigger than the $8 billion figure being imposed 14 years later, when the markets are substantially larger.  Lehman’s was about $35 trillion-over 4000 times the  $8 billion threshold.  Bear Stearns: $13.5 trillion, about 1700 times the $8 billion. AIG’s notional was down to $1.6 trillion-200 times the threshold-at the time of its default.   And note that Lehman and AIG failed nearly simultaneously.

I am unaware of any default by a firm with $8 billion notional that created a systemic risk.

So I am in the too small camp.  I don’t know exactly what the number is, but there should be a pretty close correspondence between firms that are deemed to be systemically important and those that are subject to the requirements imposed on swap dealers.

Yes, the default of a firm with $8 or $10 billion in notional would presumably be painful for its counterparties.  But absent any knock-on effects, any externalities, that loss is internalized by the contracting parties.  This does not require any regulation to protect them.  Let them protect themselves, contract as they will, and live with the consequences.

I should also note that swap dealer regulation, which is effectively microprudential in focus, and which attempts to regulate only a part of firms’ capital structure, will not have the desired effects on systemic risk even if it is applied only to systemically important firms.  As I’ve noted repeatedly, firms can contract around this restriction, and will substitute different forms of leverage-and potentially riskier and more fragile forms of leverage-for the leverage squeezed out of derivatives transactions through collateral requirements.

In sum, all this to-ing and fro-ing over the swap dealer rules has resulted in a regulation that is far more inclusive than necessary to achieve its ostensible purpose of reducing systemic risk.  Moreover, the whole idea is fundamentally flawed for a reason I’ve written about often: it is virtually impossible to reduce the risk in the financial system by regulation of the pieces.

Yesterday Obama delivered another of his it-must-have-been-some-other-body-it-wasn’t-me (h/t Chuck Berry) speeches on energy.  And, true to form, he delivered another clarion call to round up the usual suspects: evil speculators, whom he confabulates with manipulators .  (And I am being generous, because confabulation is inadvertent, whereas I Obama’s slander is almost certainly deliberate):

That’s what’s happening right now.  It’s those global trends that are affecting gas prices.  So even as we’re tackling issues of supply and demand, even as we’re looking at the long-term in terms of how we can structurally make ourselves less reliant on foreign oil, we still need to work extra hard to protect consumers from factors that should not affect the price of a barrel of oil.

That includes doing everything we can to ensure that an irresponsible few aren’t able to hurt consumers by illegally manipulating or rigging the energy markets for their own gain.  We can’t afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage, and driving prices higher — only to flip the oil for a quick profit.  We can’t afford a situation where some speculators can reap millions, while millions of American families get the short end of the stick.  That’s not the way the market should work.  And for anyone who thinks this cannot happen, just think back to how Enron traders manipulated the price of electricity to reap huge profits at everybody else’s expense.

. . . .

That includes doing everything we can to ensure that an irresponsible few aren’t able to hurt consumers by illegally manipulating or rigging the energy markets for their own gain.  We can’t afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage, and driving prices higher — only to flip the oil for a quick profit.  We can’t afford a situation where some speculators can reap millions, while millions of American families get the short end of the stick.  That’s not the way the market should work.  And for anyone who thinks this cannot happen, just think back to how Enron traders manipulated the price of electricity to reap huge profits at everybody else’s expense.

He used the word “manipulate” or “manipulation” 11 times in his relatively brief remarks.  In typically dishonest fashion, he isn’t responding to specific, credible evidence of manipulation; he provides no evidence that manipulation is rampant or is at all responsible for current price levels.  Hell, he can’t even come up with a current example, having to reach back more than a decade to Enron (itself a dubious example).  He merely insinuates and implies.  But the average listener or reader will conclude from his remarks that manipulation is causing their pain at the pump.  Rather than encouraging a sober and realistic appraisal of the role of speculative trading in energy, he is feeding suspicions and encouraging a witch hunt.

Moreover, note the repeated and casual identification of manipulation and speculation.  This is itself a manipulative use of language.  Manipulation is not even a proper subset of speculation: hedgers can be some of the most dangerous manipulators.  It further encourages the popular suspicion that financial trading in commodity markets is inherently dishonest and crooked.

Insofar as concrete steps are concerned, he is demanding substantial increases in resources for the CFTC to oversee the energy markets and a substantial hike in the criminal and civil penalties for manipulation.  With respect to oversight, I’ve said more times that I should have to that the undetected manipulation is the unsuccessful manipulation.  If manipulation distorts prices, that distortion will be manifest.  Moreover, those harmed by the manipulation have every incentive to bring the manipulation to the attention of the regulators.  The idea that manipulation is rife and is having huge impacts on prices, but it is necessary to surveil the markets intrusively using “modern tools” to find it is an oxymoron.  Which means that greater penalties imposed ex post are defensible.

It doesn’t inspire confidence that Obama justifies the greater CFTC resources by quoting another of GiGi’s inane metaphors.

The other major concrete step is to give the CFTC authority over margins for energy derivatives.  This is another hardy perennial: similar proposals were made with respect to stock index futures in the aftermath of the 1987 Crash.

Obama’s justification for this is risible: “Congress should give the agency responsible for overseeing oil markets new authority to protect against volatility and excess speculation by making sure that traders can post appropriate margins, which simply means that they actually have the money to make good on their trades.”  So which is it? Are margins to ensure contract performance, or are they to reduce volatility and excess speculation?  If the former, there is zero evidence that CME Group or ICE or OTC market participants aren’t charging margins that are sufficiently high to control efficiently counterparty risk.  If the latter, there is (a) no evidence that there is excess speculation in energy, or that it is elevating volatility, and (b) no evidence that tweaking margins will have any impact on volatility.  Indeed, hiking margins can raise volatility by reducing the amount of speculative capital available to absorb fluctuations in hedging demand.

In sum, the parts of Obama’s markets aimed at speculator-manipulators are intellectually confused, empirically baseless, and deeply irresponsible because they encourage a witch hunt atmosphere by slandering (by slimy insinuations) legitimate market actors as criminal manipulators.

Well played.  Because of all the practice, no doubt.

A few other things stand out.  First, he repeats the “we use more than 20 percent of the world’s oil and we only have 2 percent of the world’s proven oil reserves” mantra.  Hell, even he admits he says this repeatedly: “But as I’ve said repeatedly.”  Repetition of a dubious factoid does not make the conclusion it is intended to support true. Indeed, that’s a staple of the Big Lie.

Second, he continues to take credit for increased US oil output when in fact he and his administration don’t have a damn thing to do with it, except that it could have been higher yet without some of their counterproductive policies.

Third, take a look at this remark: “We’ve added enough new oil and gas pipeline to circle the Earth and then some.”  To which my first response is:  What do you mean “we” kimosabe? Again, a guy who has never done anything that would risk getting a callous taking credit for the actions of those that actually put hands to shovel and made some truly shovel ready projects realities.  Moreover, it raises the question: if building so much pipeline capacity is such a great thing, why is he doing everything in his power to stall or stop Keystone?  Is that uniquely damaging? (To the environment, I mean, not to the fortunes of Buffett’s BNSF.)

A rule of thumb to keep in mind.  Whenever Obama talks about energy generally, and speculation specifically, it is safe to conclude you are being manipulated: that’s not at all speculative.

* Title suggested by R.

University of Maryland law professor Michael Greenberger is quoted often in the financial press on derivatives related matters. I have no idea why. He is a complete buffoon on these issues.

Perhaps it is his stint at the CFTC makes reporters think he’s credible. All the worse for the CFTC.

Personal anecdote. He and I were on the same panel when I testified on oil speculation before the House Ag Committee in July, 2008. He said something typically inane; I think it was about increases in Saudi oil output not driving prices down. I jumped on him, saying that he had overlooked the fact that Saudi crude was heavy and sour, and the market was short light, sweet crude. He was flustered, and responded by stammering “I’m not an economist” to which I responded: “That’s the first thing you’ve ever said that I agree with.”

And the last.

But Greenberger has crossed the line from buffoonery to mendacity with this interview:

Greenberger makes very serious allegations: criminal conspiracy to manipulate the prices of multiple commodities.

He says speculators are “working together.” “There is doubtless criminal conduct here.” He compares speculators to bank robbers and burglars. He asserts that the (alleged) huge profits of commodity speculators are due to their criminal conduct, and would not exist if prosecutors did their jobs; instead, they have “blindfolded themselves, stuffed their ears, held their noses” and let criminal conduct proceed uninvestigated, and of course unpunished.

He even gives this a political spin, saying that since higher gas prices are the only thing that can result in Obama’s defeat, the conspiracy could lead to the Republicans taking the White House, and racking up big gains in the House and the Senate.

Which obviously begs the question: then why wouldn’t an Obama DOJ be falling all over itself to investigate? An Obama CFTC? An Obama SEC? I mean, this part of the interview alone marks Greenberger as completely unhinged, as it makes no sense that a hyper-politicized administration would refuse to investigate rampant criminality that threatens its re-election.

Greenberger’s evidence for his lurid claims about a criminal conspiracy to manipulate prices?-zip. Really. Zip. His claim that speculators are driving up prices by trading futures is without solid empirical foundation, but is common enough. But to allege criminal conduct, and a vast conspiracy among major financial institutions, goes far beyond the pale. He says he won’t name names. Why not? If he has the evidence, why shouldn’t he? Truth is an absolute defense in libel and slander.

And recall what Judge Easterbrook wrote over 25 years ago: an undetected manipulation is an unsuccessful manipulation. If there is such a vast and successful effort to manipulate prices, the evidence would be there for all to see.

If Greenberger can back up what he says about criminal conduct, and a criminal conspiracy, he should do so. Now. Stat. If he can’t, he shouldn’t be making such lurid claims. It is beyond irresponsible. It is mendacious.

The US DOJ has filed suit against Apple and some book publishers over their agreement to replace the existing wholesale model for ebooks with an “agency model.”  Under the old model, publishers would charge a wholesale price to a retailer, and the retailer would choose its own price.  Under the agency model, the publishers would set the retail price, and the agent/retailer (e.g., Apple) would receive a fixed margin (30 percent).

I am inherently more skeptical about antitrust actions involving vertical restrictions, although there is an element of horizontal coordination here.  Normally, you would expect that wholesalers/manufacturers would love retailers who sell for very low margins, and would resist guaranteeing a pretty fat margin, as lower margins downstream increase the derived demand at the wholesale level.  So why would publishers want higher margins downstream?  That suggests that there was some sort of inefficiency associated with the wholesale model that the agency model was intended to correct.

The agency model is, in essence, a resale price maintenance strategy.  Once upon a time these were per se illegal, but scholarship pioneered by my thesis advisor Lester Telser revolutionized understanding of this practice, and led to RPM being evaluated on a rule of reason basis.

Telser argued that free rider problems could undermine the incentives of retailers to provide information and special services that increased the demand for a wholesaler’s product: a consumer could go to a retailer that provided the information/service, then go to a cut price retailer that didn’t when actually purchasing.   Due to the discount retailer’s cut rate price, the information/service providing retailer wouldn’t get any return from supplying these (costly) services, so few or no services would be offered.  This would reduce the demand for the wholesaler’s product.  Wholesalers/manufacturers would have an incentive to guarantee a retail margin to prevent undercutting by free riders.

I don’t know enough about book publishing to opine whether resellers provide services or information that is subject to free riding.

In any event, publishers didn’t seem to be focusing on that issue.  It was Amazon’s dominant position as a retailer that seemed to be the reason for changing the model.

Time permitting, I give this some more thought.  Several questions suggest to me that this will be a challenge for the DOJ.  In particular, what were the publishers getting from Apple (and potentially other resellers adopting the model) that would make it worthwhile to guarantee the resellers a fat margin? Why didn’t the publishers love the fact that Amazon was willing to sell at very low margin?  These two questions suggest this is not a garden variety horizontal price fixing case, and that the conduct (and contracts) at issue were designed to address a free rider problem or other source of distortion.  How does Amazon’s potential monopsony power affect the analysis?  What are the implications of the high fixed cost-zero marginal cost nature of epublishing? Specifically, when combined with the potential for monopsony power downstream, could finding the agency model illegal have adverse dynamic implications (fewer books published, for instance)?

A lot of complicated issues here, and lurid tales of secretive dinners in London tell me zip about the economics.  My (rebuttable) presumption is that vertical restrictions usually have efficiency purposes.  The nature of the agreement with Apple shares similarities with other efficiency enhancing vertical restrictions, and doesn’t make a lot of sense as a means of facilitating collusion among publishers.  To persuade me (not that that matters in the scheme of things) the government would have to explain why colluding publishers would use this form of agreement, and why they would want to guarantee retailers a big margin.

I am sure the defendants’ lawyers will make every effort to make this into a vertical restrictions case instead of a price fixing case.   They seem to have considerable material to work with.

Posner & Weyl are continuing to flog their idea of an FDA for financial products.

I wrote about this really, really bad idea in February.  Given the swooning over the Posner-Weyl proposal, that post needs to be re-released.  So here it is.

I don’t need to change a word.  The FDA idea is a very bad one and the metaphor is completely inapposite.  Posner and Weyl are repeating their argument, and so my rebuttal needs no change.

It is good to see that not everyone is swooning.  This blog at The Economist rips into the proposal.  Great!

But gee, the points in the Economist post seem familiar.  Very familiar.  Every damn one.  To the points I made two months ago.

Purely coincidental, I’m sure.