Streetwise Professor

A common theme in much reporting and commentary on the Russian financial crisis is that it represents the oligarchs’ comeuppance, and the opportunity for the Russian state to reverse the theft of state property in the 1990s. In this narrative, the oligarchs are thieves and rogues who stripped the state of its patrimony, and they deserve to lose everything–and worse. The state will use its funds to acquire stakes in the oligarchs’ firms, cutting them down to size, and in the end, restore a simulacrum of the old Soviet system. As Stratfor puts it, “having a system where Russian firms cannot tap foreign capital markets and are instead dependent on the state is precisely how the Soviet state maintained operational and political control. It might not be central planning per se, but it is not too far off.”

This prospect is highly satisfactory to many Russians, and not just in the corridors of power. It is quite popular throughout Russia because, quite simply, the oligarchs are very unpopular.

I will stipulate that the oligarchs are, with no exception that comes to mind, a pretty odious bunch. They indeed acquired their vast holdings by means foul and fouler. They profited while the state, and the nation, starved. They deserve no pity or sympathy.

But restoring the control of what was taken from the state to the state is hardly an improvement, and may be a step backwards. This is in part because those in the state who will benefit are not obviously less odious than the oligarchs. But even overlooking that, expanding state control will reduce Russian wealth and economic growth. More extensive and intrusive state control will feed corruption; encourage rent seeking at the expense of wealth creation; weaken incentives to innovate and invest; reduce competition; and all in all just ensure that the Russian economy remains in purgatory, at best.

One Russian government spokesman said that the state had no plans to nationalize the firms acquired, and would sell them when conditions were more favorable. This statement is not credible–it is, as Mary Poppins said, a pie crust promise, easily made and easily broken. Once in powerful hands, it will be very hard to pry them loose. And even if there is a formal “reprivatization” process, what is the likelihood that it will be transparent, equitable, or efficient? Small. What is the likelihood it will represent another opportunity to create a new set of oligarchs? Pretty high.

In Darkness at Dawn, David Satter claimed that Yeltsin’s young liberal economists were actually prisoners of their Soviet educations. They believed Marxist dogma about primitive capitalist accumulation, and that any transition to capitalism would inevitably entail the enrichment of those with the least scruples. But, in their view, the creation of a market state would eventually tame and discipline these unworthy acquirers. Regardless of the original disposition of property and property rights, efficiency would ensure that resources would soon flow to high value uses, and that the managers and owners best able to create value would end up owning and controlling them. (Thus, I guess, they simultaneously believed in Marxist dogma, and the Coase Theorem as a reasonable approximation of reality.) To them, anything was better than state ownership and control, and primitive capitalist accumulation was merely an unsavory but necessary transitional step to a modern economy.

It didn’t work out that way. Institutions matter, and Russian institutions did not–and do not–fully encourage and support wealth enhancing Coasian bargains. Instead, rent seeking, the lack of a rule of law, and weak property rights have prevented the realization of the liberals’ vision.

So, it is likely that the pendulum will swing back towards state dominance, which is perhaps better described as state oligarchism, rather than private oligarchism. This trend has been evident for almost exactly 5 years–Khodorkovsky was arrested 5 years and a couple of days ago–but the financial crisis is accelerating the process dramatically.

In essence, Russia is between the Devil of state control and the Beelzebub of oligarchic dominance. There have been steps towards a more “normal country” market system (particularly in consumer goods), but a more thoroughgoing transition of large swaths of the economy (namely the “strategic” sectors which account for a large fraction of output) is nowhere in prospect. The unjust and fantastical enrichment of a tiny minority is being reversed, but this will not contribute to a more moderate enrichment of most Russians. Indeed, given the inefficiency of state management and control, it may even have the opposite effect.

Today’s New York Times discusses the challenges posed by falling oil prices to Venezuela, Iran, and Russia. Here is an excellent, one sentence description of a natural state dependent on natural resource rents to maintain political stability: “At home, oil money allowed Iran’s ideological hard-liners to preserve their monopoly on power, to buy political allegiances and to offset the fiscal damage of their economic policies.” When resource rents fall, it is much harder for authoritarian (and worse) natural states to maintain cohesion.

Of the three states, Venezuela is probably the most vulnerable. Although the oil industries in Russia and Iran have faced problems maintaining output, Chavez has done an especially good job at kneecapping his country’s oil business, by politicizing the operations of national oil company PDVSA (including the firing of many of the most knowledgeable and skilled employees, whom Chavez considered a political threat) and seizing four private oil projects in the Orinoco River region. Venezuela also faces challenges because its heavy crude is notoriously hard to process, so the know-how of the BPs and Exxons and Chevrons is especially vital.

Today is the SWP’s birthday, and for some reason, this song keeps popping into my head.   Along these lines, I have at least been able to avoid getting a real job, and hence haven’t had to cut my beard.   Like I say, TGFA.

In the midst of the credit crisis, it has become conventional wisdom that OTC derivatives, especially credit derivatives, should be centrally cleared. Like Dudley Dooright, the central counterparty (CCP) will come in and save the day. Given that this idea is supported by many people who had probably never heard of clearing until quite recently, there is room for doubt that these high expectations are grounded in a firm understanding of what clearing is and what it entails.

I will explore various aspects of OTC clearing in several posts, of which this is the first.

The motivation behind these posts is a simple question: If clearing is so obviously wonderful,why has it not been adopted before this?

I think there are two answers to this question, answers which are not mutually exclusive. The first is that clearing would be welfare enhancing, but as a result of some collective action problem it has not been implemented. The second is that there are costs and benefits to clearing, that these costs and benefits vary by product, and for some products, the costs exceed the benefits.

The public policy implications of the two alternatives are obviously quite different. The first provides a justification for robust government intervention: the second does not. I think that both factors have an element of truth. This implies that there is a basis for government involvement, but that considerable care should be exercised.

I have explored both questions in my academic work, and will draw upon that work in drafting these posts. I have recently done more work on the collective action issue, and will report the results of that analysis for the first time in the blog; I will write up the results of the analysis more formally in the coming weeks.

This post focuses on the collective action issue. If clearing is welfare enhancing, but it has not been adopted due to transactions costs/collective action problems, then arguably a case can be made for regulatory or legislative initiatives to encourage–or even force–its creation. Indeed, one can argue that the NY Fed’s frantic efforts in recent weeks to push market participants towards creation of a CCP reflects such a belief.

I first mooted the possibility that CCPs were not adopted due to some sort of collective action problem in a working paper in 1997. I also mentioned this idea in a more recent paper. The basic idea was that clearing could have distributive effects, most particularly, redistributing wealth from well capitalized firms to less well capitalized ones. This could occur if clearing leveled the competitive playing field by eroding the competitive advantage held by well-capitalized OTC dealers.

In my earlier work, this argument was made verbally. It is not an easy thing to formalize it, but I have made some progress in that direction. The model is a relatively simple one. There is a representative agent hedger, with CARA utility. The hedger has an endowment of a risky asset. There are two risk neutral dealer firms. These dealers are risk neutral, and have no endowment of the risky asset, but they have limited capital. Their capital is also risky. Therefore, if they enter into derivatives contracts, they may default as their losses on their derivatives positions may exceed their capital.

The two dealers have different starting capitals. There is a large dealer and a small one. The volatilities of the firms’ capitals can also differ. The dealer capitals are imperfectly correlated.

The dealers incur operational costs to execute derivatives transactions. For simplicity, these costs are quadratic in the quantity of contracts executed. Although the dealers have different capitals, I assume that they are equally operationally efficient. That is, their costs of execution are the same for a given number of transactions.

It is well known that a defaultable derivatives contract, such as a forward or swap, is effectively an option. In this model, the hedger that buys a forward contract from a dealer actually enters into contract with a payoff equal to the minimum of the payoff on a non-defaultable contract, and the counterparty-dealer’s capital.

Due to this optionality, the problem is inherently non-linear, and even assuming CARA utility, must be solved numerically. Therefore, since that nettle has already been grasped, there is no need to make the drunk-looking-for-his-wallet-under-the-lamppost assumption of normality in the distribution of the price of the risky asset, or the values of the dealers’ capitals. Normality facilitates the determination of closed form solutions in linear problems, but since this problem is non-linear that is of no help. I therefore utilize more realistic assumptions. I allow for heavy-tailed and skewed price distributions, by assuming that returns on the risky asset are characterized by a negatively skewed normal inverse Gaussian distribution. (This means that crashes are more likely that upward spikes in prices, as is the case for equity indices.) I assume that dealer capitals are characterized by fat-tailed Student-t distributions. Skewness and kurtosis are realistic features of real markets, and may provide an important reason to hedge and affect the likelihood of default. The world is not normal, and non-normality is especially important in this context.

I first solve for equilibrium in a bilateral OTC market. I assume that all parties are price takers. The resulting equilibrium is quite sensible. The hedger trades more with the firm with the greater capital, and sells at a higher price to the less-well capitalized firm. That is, since the deals are negotiated individually, and since the counterparties are heterogeneous, the terms of trade and quantities of trade differ. The hedger sells more at a lower price to the advantaged well-capitalized firm.

I next solve for equilibrium in a cleared market. In the cleared market, the two dealers form a CCP and share default risk. If one firm defaults, the other party covers the loss, up to the amount of its capital. The hedger suffers from a default only if the dealers’ collective losses on their trades is larger than the sum of their capitals.

The details of possible sharing arrangements under a CCP are complex, and potentially varied, so I simplify matters by assuming that the CCP allocates trades among the two so as to maximize joint profits. This would require some sort of pricing mechanism, or some other means of allocation, which is not modeled specifically. I do turn attention to the possible pricing issues later.

Due to the equal operational efficiency of the two firms, the efficient outcome is for the output of the two dealers to be equal. In the clearing equilibrium, (a) the hedger trades more, (b) the output of the small capital dealer goes up, and (c) the output of the large capital dealer goes down. Moreover, the price at which the large dealer buys goes up slightly, and the price at which the small dealer sells goes down. The hedger’s expected utility rises, and joint profits of the dealers are higher because (a) total output is higher, and (b) total costs go down due to a more efficient allocation of output across the dealers. There is also a more efficient allocation of risk, and the incidence of default falls, even though the scale of trading rises, because of the diversification of the dealers’ capital risks.

In brief, the formal model, solved numerically, generates results along the lines of what I laid out informally in the earlier working papers.

The implications are quite striking, and important. Implementation of a first-best risk sharing mechanism improves welfare (obviously) but redistributes wealth from the large dealer to the small dealer. The small dealer’s smaller capital makes him a less desirable trading party for the hedger, even though from a social perspective diversification and operational costs make it efficient for the hedger to split his trades between the two dealers. That is, from a welfare perspective, pooling of the dealers’ capitals is efficient as it facilitates efficient allocation of output across dealers. (This raises the question of why don’t the dealers just merge? Well, merger of all the dealers into one would effectively create a clearinghouse. Moreover, there may be sources of diseconomies of scale and scope not captured in the simple, formal model that mean that sharing of risk via a clearinghouse is a more effective way of pooling capital for default mitigation purposes than a formal merger.)

Since the joint profits of the dealers are higher under clearing, the small dealer’s profits rise more than the large dealer’s profits fall. In the absence of transactions costs, the dealers would execute a Coasean bargain that would make both better off, and one would expect the CCP to form.

However, it is well known (see particularly Libecap’s work–some done with Steve Wiggins–on the creation of property rights in natural resources), that distributive effects can interfere with the creation of efficient property rights. The common pool problem in oil (which I discussed in earlier SWP posts) is a classic example of this. Even though unitization of oil fields–the efficient allocation of output across potential producers–maximizes joint profits, it has proved devilishly complicated in practice for competing drillers to consummate this wealth-enhancing bargain, due to the tussle over rents.

Moreover, due to the complexities in bargaining, and the potential costs of enforcing any arrangement among the firms, the dealers may arrive at a pricing or trade allocation structure that limits the distributive impact of the formation of a CCP. In the stark model, however, any such deals reduce welfare. Thus, even if a CCP is formed, it may not achieve the efficient outcome. Alternatively, the feasible bargaining outcomes may not include the efficient outcome. If there are fixed costs to implementing the CCP, it may not form.

In particular, as I have shown in my work on exchanges (JSTOR access privileges required), coalitions of heterogeneous firms create the potential for redistributive rent seeking. As a result, organizational form and governance structures for coalitions of heterogeneous firms are usually crafted to mitigate the potential for such redistribution. The resulting structures and pricing mechanisms may not be first best.

It should also be noted that even though CCPs are typically formed as coalitions of dealers, some of the benefits flow to (in the model) hedgers. That is, CCPs are usually coalitions of sell-side firms, but the benefits of CCPs spillover to buy side firms. Again, since the CCP is first best (in the model), there is a potential grand bargain that makes the buy side and the sell side firms better off. This only expands the bargaining complications, however.

Thus, one explanation for the failure to adopt a CCP in OTC derivatives is that even though it is efficient, collective action and bargaining problems have impeded, and in some cases precluded, its creation. Distributive effects can preclude the adoption of efficient organizations and institutions. The model shows that the adoption of clearing can have pronounced distributive effects. Therefore, the failure to adopt clearing may reflect the effects of distributive effects and rent seeking behavior that impede collective action.

In this situation, government action (and essentially, government can serve as a mechanism to reduce the costs of collective action) can improve welfare to the extent that it reduces transactions/coordination costs.

In essence, government is just another mechanism through which parties can act and bargain to achieve a given outcome. Government possesses coercive powers. Moreover, especially in democratic/republican polities, a broad array of interests can influence/bargain through the government. This can be important, and sometimes result in enhanced efficiency–though it can reduce efficiency at other times. In the present instance, for example, buy side firms that would benefit from the formation of a CCP can exert influence on various government entities (the Fed, Treasury, the legislature), and beseech the government to employ its coercive powers to advance the interests of these firms. It may be cheaper for these firms to bargain through the government, than directly with the sell side firms.

This analysis reflects the strongest case for government intervention to, ahem, encourage the formation of a CCP for credit derivatives, and other products traded OTC. But one must be careful. Clearing is a risk sharing arrangement, and it is well known that risk sharing arrangements are often plagued by adverse selection and moral hazard costs. These costs can vary depending on the type of risk being insured. These costs reduce the amount of risk sharing, and in some cases, can make it better not to share risks at all. Thus, the failure to form a CCP that shares default risks for some products may also be due to the fact that moral hazard and adverse selection costs are so large as to make risk sharing inefficient. I will consider that possibility in the next post, and argue that this possibility is particularly pertinent for products like credit derivatives. Thus, the benefits of the formation of a CCP for these types of products may be substantially smaller, and the case for government intervention weaker, than the collective action problem-focused analysis of this post suggests.

It is painfully evident that the financial engineering profession–of which I am a member, at least of the academic branch–created models that were painfully inadequate for the purpose of valuing, and appraising the risks of, highly credit sensitive mortgage derivatives.   The real products were too complicated, too non-linear, too dependent on unknown and arguably unknowable parameters to value accurately.

Thinking about that sparked thoughts of a topic that I blogged about extensively some time back–climate science and climate models–but which I have largely ignored since.   Financial engineering and climate modeling have a lot in common.   Both attempt to characterize sometimes highly non-linear things by solving numerically partial differential equations.   The results generated by both types of models are highly dependent on the values of certain parameters that are not directly observable, and often times very difficult to estimate even approximately given the limited data available; hence, parameter inputs for both types of models are often guesstimates, at best.

The pronounced deficiencies of financial engineering models, especially for credit sensitive mortgage products may hold a lesson for climate science, and for policymakers who base (directly or indirectly) decisions affecting literally trillions of dollars of wealth on the predictions of these models.   That lesson is a simple one: be very skeptical about the predictions of these models.   The one-eyed man is king in the land of the blind, and having a model is arguably better than not having one, in the sense that one’s predictions are more precise with a model than without one–but that does not mean that the precision is high in any absolute sense.   Indeed, the very elegance and deceptive precision of the models–they produce, after all, numbers to machine precision–can make them extremely alluring.   The models are so much more elegant, neater, ordered, and logical than messy reality.   Thus, modelers too often tend to fall in love with what they have created.   The financial crisis makes manifest the dangers inherent in this attraction.

If anything, climate and climate models are more complicated than CDOs and the models to value them (though that proposition may be arguable, given than climate lacks the strategic, and potentially psychological, aspect that is present in any situation involving human interaction, such as a financial market.)     Thus, the stunning demonstration of model error currently playing out in the financial markets should give pause to anyone who makes sweeping policy recommendations based on the predictions of climate models.   Not that I expect that it will.

Michel and Da Russophile are engaged in an interesting debate on Russia in the comments to Check Out Michel’s Comments. I’ll add my two cents (or should it be kopecs?) here.

The main issues in the colloquy between these two gentlemen are (a) the breadth of Russian prosperity, (b) its dependence on oil prices, and (c) the likely future course of oil prices.

With respect to (a), official statistics are not that illuminating, and anecdotal evidence is seldom conclusive. My one anecdotal data point is from a friend who recently returned to Russia (not Moscow or St. Petersburg, but a large city) after 2 years in the US. She said that yes, things had changed for the better but that “You live in a different world, and should be grateful for that.” In brief, things were better, but a long, long, long way from what Americans or Europeans take for granted.

I can speak with a little more authority on (b) and (c). I’ll start with (c). Insofar as the future course of oil prices is concerned, the price is effectively hostage to the strength of the world economy, and that is not a good place to be right now. All indicators are for a deep recession world-wide in the coming year. To the extent that emergency interventions in the banking markets work, they will primarily affect the depth and duration of the impending recession. Given the inelasticity of the demand and supply for oil, even a modest downturn in demand translates into a substantial decline in oil prices.

With respect to OPEC riding in to save the day (for those long oil, anyways)–don’t count on it. OPEC output restraints didn’t really contribute to the skyrocketing price over the last summer. Every OPEC producer was pumping flat out, with the exception perhaps of Saudi Arabia (which increased output some in the summer) and Nigeria (which is continuing to experience disruptions due to MEND and other anti-government groups.) When producers are operating at capacity, a cartel is having no effect. When demand falls, and OPEC faces an excess capacity situation, an effective cartel could prop up prices, and collectively its members would like to do so, but the incentives to cheat on any such agreement to restrict output are strong. Historically, OPEC members have cheated substantially on their quotas, and the cartel’s influence on prices has been sporadic at best during periods of excess capacity. I therefore wouldn’t count on OPEC to provide substantial relief to Russia by keeping the oil price from falling too low.

As to (b), in some respects whether the price of oil (Urals or REB) remains above $70/bbl is a secondary issue. (Tuesday’s price for Urals-Med was $73.44. Netting out transport costs, that is very close to the $70/bbl figure.) Certainly, the lower the price, the greater the budgetary pain, and a fall below $70/bbl will, per Kudrin, result in Russia running a deficit. Even if the price is substantially higher, however, there is considerable room for doubt as to whether the additional revenues will be directed to meet Russia’s most pressing needs, which include, to name but a few, public health, infrastructure, and pensions. Prices even in the $80s–which are very likely, and maybe even optimistic over the coming year given the bleak economic outlook–will allow Russia to avoid running a deficit, but are probably insufficient to go far in addressing Russia’s health and infrastructure capital deficits, especially given the, ahem, “leakage” of funds that pass through government hands.

Anyways, keep up the conversation, guys. I’m enjoying it.

MIchel has some excellent comments to Under Pressure. His remark about the higher expectations of the Russian people (as compared to 1998) is very well taken. This is another factor contributing to Russian brittleness. A genuine improvement in living standards, the “splendid little war” in Georgia, American stumbles, European cravenness, and the steady diet of propaganda from the state controlled media have obscured Russia’s fundamental structural weaknesses, and fostered unrealistically high expectations about what the future holds for Russia. The country teeters on the economic brink–the world does, but Russia is arguably closer to the brink than just about anybody else–and if the deluge comes, a disappointed people that had put its faith in Putin and Putinism will turn on him (and it) in a fury.

Michel’s statement about the disconnect between the plans for an aggressive military buildup costing billions at the same time the country’s fiscal cushion is “melting before [their] eyes” is also right on the money. The $5 billion loan to Iceland, another extravagance apparently driven by geopolitical calculation, is another bizarre choice under the circumstances. Ditto the Venezuelan adventure. There is an air of unreality about all of this. The only thing that makes sense to me is that Putin, Medvedev, Sechin, et al, feel powerless to address the economic problems, so they are flogging the “Russia is Back”-military might-patriotism-derzhavnost line for all it is worth. They blame the US for all of the economic problems (and to be sure, the US has a lot to account for, but not all of Russia’s travails can be laid at the American doorstep), which feeds the hostility to the US, and exploit this with grandiose plans to rearm–by spending the money set aside for a rainy day. Memo to Vlad: It’s raining, dude. Like, really hard.

In the Under Pressure post I suggested that too many people viewed the reserve fund as a talisman. Evidently, nobody more than Putin and the siloviki. It gave them a sense of omnipotence that fueled their bumptiousness at home and abroad, near and far. This sense of omnipotence will melt along with the fund. And if and when that happens–and is seen to happen–Putin’s and Medvedev’s political support will erode, and their position will become precarious. How will they react? Most likely, with a combination of foreign adventurism and an intensification of political repression at home. Not a pretty picture.

Trading is open on CME GLOBEX.   Equity indices up slightly–S&P emini up 1.75, Dow up 20, NASDAQ up 4.25.   Dollar stronger across the board, including decent gains against the pound and the Euro.   Perhaps most importantly, Eurodollar futures up 2.5 (meaning a 2.5 basis point decline in forward 3 month LIBOR) and Fed Fund futures are down (meaning a 3 basis point increase in the Fed Funds forward rate), meaning that the credit spread has narrowed a bit–about 5.5 basis points.   Treasuries are also down.

Seems like a cautious, tentative endorsement of what’s going on.

Paul Goble has an excellent story describing the pervasive fraud in Russian military spending–fraud that will only increase with planned increases in expenditure. Whenever attempting to explain Russian policy, in my experience the best working hypothesis is that the policy is designed to facilitate siloviki tunneling of state cash flows and assets, rather than to achieve the publicly stated objective.

From the Washington Post:

Mikhail Berger, a professor at the Higher School of Economics, said two factions in the Kremlin are competing to set economic policy, one interested in further market reforms and integration in the world economy, and the other favoring greater state control and a more isolationist line against the West.

Putin appeared to lean toward the latter group in the aftermath of the war in Georgia, repeatedly declaring that Russia’s economy could continue to thrive without the United States or Europe. But since the stock market crash, he has adopted a softer tone and courted foreign investment.

“We are becoming more dependent on each other through mutual investments,” he said Friday, adding that Russia was “banking on private initiative, entrepreneurial freedom, openness and rational integration with the global economy.”

Private initiative? Entrepreneurial freedom?   Openness?   Rational Integration?   Orwellian doublespeak, all of it, including “on” and “the.”   If you wanted an accurate description of Putinism, collect the antonyms of each of these terms: government control; pervasive state restrictions and favoritism of large enterprises; a closed, opaque system; integration on parasitic, opportunistic, and asymmetric terms.

Only fools will take such tripe seriously.   Unfortunately, when investment in Russia is considered, past experience tends to support P.T. Barnum’s judgment about the demography of fools.