July 1, 2010
A Chip Off the Old Blog
My daughter, Renee, is a member of the Young Leaders Program at the Heritage Foundation for this summer. She is working on Heritage’s Index of Economic Freedom. She just authored her first post on Heritage’s “The Foundry” blog. An excerpt:
Seven of the eight economies ranked most free in the Index of Economic Freedom were once British colonies or trade posts. It’s no coincidence. Political institutions developed by the British such as representative democracy and rule of law provide a vital base for economic freedom.
Yet the U.K. no longer has the distinction of being ranked in the top ten freest economies. Its economic freedom score has fallen significantly in recent years due to expensive welfare programs that have eroded economic freedom and slowed growth.
As they say, read the whole thing. That’s an order!
Renee will be presenting a paper on the parallels between commodity regulation in the 1930s and today at the Von Mises Institute Conference in Italy in October.
Congratulations, Renee. Keep up the good work.
June 29, 2010
Selected Observations on Frank-N-Dodd
I have read the derivatives and clearing titles of the Frank-N-Dodd act, so you don’t have to: you can thank me later.
Here are some random thoughts.
First, a good chunk of it is mind-numbing language dividing authority between the CFTC and SEC, and instructing the agencies on how to coordinate and cooperate. Note to self: if they start rationing anesthetics under Obamacare, read one of these legislative monstrosities. It will certainly beat biting a bullet and taking a swig of bourbon for inducing a pain-dulling stupor.
Second, the fading of the Lincoln provision is quite artfully done. I had to read the damn thing several times to figure out just how they did it. The bill starts out with: “NO FEDERAL BAILOUTS OF SWAPS ENTITIES” and then says with the exception of insured depository institutions. Pretty big exception. So where did the exclusion of commodities and equity swaps come from? Well, the bill permits:
Acting as a swaps entity for swaps or security-based swaps involving rates or reference assets that are permissible for investment by a national bank under the paragraph designated as ‘‘Seventh: of section 5136 of the Revised Statutes of the United States ( 12 U.S.C. 24), other than as described in paragraph (3).”
And what does this “Seventh” paragraph say? It says that banks are allowed to:
Seventh. To exercise by its board of directors or duly authorized officers or agents, subject to law, all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes according to the provisions of this title.
So swaps based on rates or reference assets including typical bank activities including borrowing and lending, FX, and bullion (presumably precious metals) are all OK. The paragraph specifically precludes trading in stocks, meaning that equity derivatives are out. Commodities (other than bullion) aren’t mentioned, so they’re not covered by the exception, and must be spun off. (The ability to trade bullion-based derivatives means that my calculations of the share of bank derivatives business that will have to be spun off were biased upwards, since a decent fraction of bank commodity trading is in gold and silver.)
Third, the bill does an amazing amount of punting on key issues. The problem is that the punts won’t be fielded by Darren Hester, Billy “White Shoes” Johnson, or Gale Sayers. Instead, they will be returned by the same shlubs that fumbled so often in the most recent crisis–the existing regulators (think Madoff, Alan Stanford, AIG, and oh yeah, dodgy FSU shell companies.) If you look at all the things that the CFTC has to do in the next 12 months, you just know the agency will be overwhelmed.
Fourth, two things relating to margins jumped out at me.
The bill states:
MARGIN REQUIREMENTS.—The margin required from each member andparticipant of a derivatives clearing organization shall be sufficient to cover potential exposures in normal market conditions. [Emphasis added.]
But supposedly the whole objective of the clearing mandate is to reduce systemic risk, in part by requiring increased collateralization. But periods of systemic instability are, by definition, highly abnormal. So what’s the point of mandating clearing, and then just allowing the CCPs to impose margins just sufficient to cover normal every day price moves? This language will give CCPs tremendous leverage in fighting off regulatory efforts to increase collateral. Not that I mind that, but it suggests a complete disconnect between what the legislation promises and what it can actually deliver. It promises a collateralization mechanism that will reduce the likelihood of chain reaction failures under stressed market conditions, but then only requires the posting of collateral sufficient to cover losses under non-stressed conditions.
The other thing relates to margins on non-cleared derivatives. The bill gives prudential regulators the power to set margins (and capital requirements) on these trades:
Each registered swap dealer and major swap participant for which there is a prudential regulator shall meet such minimum capital requirements and minimum initial and variation margin requirements as the prudential regulator shall by rule or regulation prescribe.
Meaning that the prudential regulators (e.g., the Fed, OCC, FDIC) can set margin requirements. Prudential regulators will set margins that will:
be appropriate for the risk associated with the non-cleared swaps held as a swap dealer or major swap participant.
This is potentially quite dangerous. It is a form of price control, and such controls will have perverse effects (as they always do).
In the present instance, I have been critical of clearing mandates in large part because CCPs do not have as good information as dealer banks to set appropriate margin levels. Regulators will be even less well informed, and at a greater informational disadvantage relative to those trading the instruments. This is particularly true for the instruments at issue–the exotic swaps that will not be cleared even under a clearing mandate.
Better informed market participants will readily identify which risks regulators have underpriced, and which ones they have overpriced. They will overtrade the underpriced risks, meaning that defaults risks will be greater than the regulators think.
We’ve seen this before. The recourse rule that gave very favorable capital treatment to AAA securities encouraged banks to load up on them, with disastrous consequences. Since the regulators’ pricing errors will apply to all market participants, these errors will have systemic effects, encouraging myriad financial institutions to overtrade the same risks. As I’ve written before, regulation and legislation create systemic risks because they apply to broad swathes of market participants. This is another example of that. Getting the risk prices wrong–as regulators will inevitably do–means creating incentives for all affected institutions to overload on the underpriced risks.
Now THAT’s Chekist Chutzpah!
My response to the substance of the Russian spy ring story is a shrug. It is not a surprise that Russia is engaged in espionage. It has been well known that Russia’s foreign intelligence service, the SVR, has been extremely aggressive in recent years. Many countries, including, if memory serves, the UK and Canada (Canada!) have complained about the intensity of Russian espionage. I presume that the US is engaged in espionage against Russia as well. Indeed, the main surprise is that these agents were not operating under official cover. It’s hard to recall reports of the arrest of such a large number of such types by any country, even back in the days of the Cold War.
What has amazed me–and believe me, Mark A.’s opinion to the contrary, it takes a lot for anything Russian politicians do to amaze me–is the Russian response to the news of the arrest. Putin’s crazed statement is priceless:*
“Back at your home, the police went out of control [and] are throwing people in jail,” Mr. Putin said. “I hope that all the positive gains that have been achieved in our relationship will not be damaged by the recent event.”
That’s so good, it bears repeating:
“Back at your home, the police went out of control [and] are throwing people in jail,” Mr. Putin said. “I hope that all the positive gains that have been achieved in our relationship will not be damaged by the recent event.”
I mean, to get lectured by Putin of all people about out of control police throwing people in jail is just too much. After all, he comes from the land of out of control police throwing people in jail–and often leaving them there to die without medical treatment. But it’s not only high profile cases like Magnitsky that point out the out of control nature of the Russian police. Just look at the reaction of the authorities to any protest march, or even a gay pride parade, if you want to see out of control. (To Obama’s gay supporters: how do you reconcile your support for him, given the “reset” and his being best buddies with Medvedev, and not saying a word about Russia’s routine persecution of gays?)
Indeed, arguably the greatest source of discontent of the Russian people is the lawlessness, arbitrariness, corruption, violence,brutality and just plain out-of-controlledness of the militia (police).
I guess the only possible distinction to make would be that Putin alleged that the US police “went out of control” (suggesting that this was an atypical development to transition from in control to out of control) whereas Russian police are always out of control.
(My most vivid memory of a trip to Moscow was that I’ve never been in any place where I was far more nervous when the police were present than when they weren’t. They were, almost to a man (or boy–many being quite young), slovenly and unprofessional looking, their hats shoved back on their heads, staring at everyone with predatory, wolfish looks. I saw police shake down people not once but twice in broad daylight. In one case, a cop car drove by a street vendor, clearly from the Caucasus; the car flashed his lights and the vendor threw a wad of bills into the car’s open window. This happened a block from Red Square. In the other case, the cop just waved over a car at random. I was sitting in a park, at a discrete distance, and watched the whole thing. The transaction–and it was just that–ended with the driver shoving some bills in the officer’s hand.)
Other Russian responses had a fair share of chutzpah, but nothing in Putin’s league. The Tarantula (Lavrov) complained about the timing of the bust: “The only thing I can say today is that the moment for [the arrests] has been chosen with special elegance.” He was whining that the arrests had been made so soon after Medvedev and Obama went on their all-but-holding-hands date. From the WSJ:
Many Russian officials and analysts said they presumed that hawkish elements within the U.S. government had engineered and timed the arrests to embarrass President Obama and undermine the “reset.”
OK, Mr. Lavrov. Please tell us just what time would be acceptable. I’m kind of thinking that “never” would be your answer. If the glow from a recent meeting of the presidents wasn’t a problem, something else would be. Like some Russian holiday or Putin washing his hair.
Lavrov also said “They haven’t explained to us what this is about. I hope they will.”
Uhm, Sergei. Read the indictment. That will tell you exactly what it is about.
The Russian reaction is especially rich given how they’ve howled at episodes of alleged western espionage in Russia. Remember the shrieks of outrage over the rock in the park incident allegedly involving British intelligence?
Perhaps what has really got Putin’s shorts in more of a knot than usual is that (a) his peeps got caught, and (b) more importantly, it appears that the FBI thoroughly compromised the SVR’s communications:
The FBI operation represents the biggest penetration of the SVR communications in recent memory. The FBI read their emails, decrypted their intel, read the embedded coded texts on images posted on the net, bugged their mobile phones, videotaped the passing of bags of cash and messages in invisible ink from one agent to another, and hacked into their bogus expenses claims.
Ouch. That’s gotta be a major kick in the stones to a proud Chekist like Putin.
This episode will probably provide some entertainment in the coming weeks, but is unlikely to have a major impact on US-Russian relations. I do encourage, however, the FBI and the attorneys from the SDNY to continue to release details of the incompetence of these agents, and the way that the FBI apparently totally undressed the SVR. Just for the pure enjoyment of watching Putin’s reaction.
* Putin said this in the presence of Bill Clinton, who laughed when this was translated. I wonder what Clinton found funny: was he also entertained by the complete insanity of Putin’s remark? Even if that’s the case, Clinton should have taken the opportunity to point out the difference between American and Russian law enforcement.
A Blog Recommendation
I just came across the blog Deus Ex Macchiato, because its (anonymous) author kindly linked to a couple of my posts. I took some time going through the blog, and was quite impressed. It’s very much worth following if you are interested in banking, finance, derivatives, and market infrastructure related issues. I only wish I knew of it earlier.
DEM is a clearing skeptic–one of a select breed. The post that attracted my attention lists 10 misconceptions about CCPs. Spot on. There are many more, but the ones DEM lists are important indeed.
I consider the name of the blog somewhat ironic, given that I’ve frequently referred to CCPs as deus ex machina, that will descend from the heavens to solve all our systemic risk problems.
A couple of notes to DEM, if you stumble across this:
- I’ve written a lot more about clearing on SWP and elsewhere than the couple of things you link to, if you’re interested. I’ve also written working papers that I’d be glad to point you to.
- I know you’re anonymous, but I’d be interested in sharing thoughts more directly. You can get in touch with me at cpirrong@gmail.com if that’s of interest to you. Glad to do it in strict confidence. Use a pseudonymous email address if that’s more to your liking.
June 28, 2010
Eve Lincoln
I transfered from the Naval Academy to the University of Chicago as a junior. I knew that I had gone from the alpha of academic institutions to the omega when I learned soon after my arrival in Chicago of the Lascivious Costume Ball. No such thing in Annapolis, let me assure you. How lascivious? Well, I remember one woman in my dorm who went as Eve, complete with a snake and three strategically placed fig leaves. (Maybe they were lettuce leaves. I wasn’t checking that closely.)
What brought that to mind, you ask? A review of the Office of the Comptroller of the Currency’s data on bank derivatives activities.
No. Seriously.
Why? Well, the data make it abundantly plain that the financial regulation bill that emerged from conference gave Arkansas Senator Blanche Lincoln the merest of fig leaves to cover a near complete retreat from her earlier position.
Recall that the original Lincoln plan would have required banks to spin off all derivatives trading activities (or lose their access to the Fed discount window). The final bill allowed banks to retain interest rate, FX, and some credit trading, and spin off only commodities, equity, and some credit derivatives (as I understand it, CDS on junk securities). The OCC data shows that the spun off activities are small beer, indeed, compared to the stuff that banks are allowed to keep.
Here are the market values, by category (gross positive values followed by gross negative values):
$ in billions
Q1 2010 Q4 2009 Change %Change Q1 2010 Q4 2009 Change %Change
Interest Rates 3,147 3,121 27 1% 3,052 3,023 30 1%
FX 347 354 (7) -2% 345 344 1 0%
Equity 77 91 (14) -15% 78 90 (12) -13%
Commodity 41 50 (9) -18% 40 49 (8) -17%
Credit 390 437 (47) -11% 370 409 (39) -10%
Total 4,002 4,053 (51) -1% 3,886 3,915 (29) -1%
So, equity and commodity gross positive values total $118 billion, compared to a $4 trillion total–or about 3 percent of the total. (Gross negative values give a similar share.) Credit totals $390 billion, but only a relatively small fraction of that will have to be spun off. This means that based on market values, banks will be required to spin off less than 10 percent of the total value of positions.
Here are the notionals:
Interest Rate Contracts 181,981 179,555 2,426 1% 84%
Foreign Exchange Contracts 17,596 16,553 1,043 6% 8%
Equity Contracts 1,571 1,685 (114) -7% 1%
Commodity/Other 940 979 (39) -4% 0%
Credit Derivatives 14,364 14,036 329 2% 7%
Total 216,452 212,808 3,645 2% 100%
Commodities are rounding error. Equity and commodities is about 1 percent of notional. Even adding in all of credit, and you don’t get to 10 percent.
It would be nice to have a risk breakdown, but that’s not in the OCC data.
Regardless, it is clear that the banks kept the big part of the business, and gave up a few minor pieces of the business to provide Lincoln with some political cover.
It’s not a big deal to the banks, but it is a pretty big deal to the commodities business. Spinning off commodities will make it more expensive for dealers to make markets. Some may decide it’s not worth the bother. So this will reduce the liquidity of the commodities derivatives markets, and make it costlier to hedge.
This is just one of several hits to the commodity business in the bill. Indeed, commodities are arguably the biggest loser.
The bill says the CFTC “shall” impose position limits on OTC commodities. This will also impair liquidity and raise hedging costs by constraining the ability of speculators to offer risk bearing capacity. Indeed, the effect will likely extend to exchange traded markets as well, because one factor that was limiting the CFTC’s aggressiveness on energy futures position limits was the fear that tight limits would force more business OTC. The agency now has the power to shut that escape valve, and thus is likely to impose more draconian limits on both OTC and exchange traded products.
Moreover, the bill adopts the Senate bill’s more restrictive exemption from clearing requirements for end users. The CFTC has some discretion on crafting this exemption, but the current leadership has made it clear that it is opposed to generous exemptions. More onerous clearing (and hence margining) requirements for end users will further raise the costs they incur to hedge.
In sum: the compromise bill shafts commodities not once, not twice, but three times. This will force commodity producers, processors, and marketers to bear more risk, and to incur higher costs to manage risks.
And for what? The spinoff of banks’ commodity business certainly won’t have the slightest effect on systemic risk given the trivial size of the trade relative to the other activities they still undertake. The niggardly end user exemptions will not affect systemic risk either. The position limits will not reduce price distortions in the market.
Bottom line: the commodities business will be riskier and less efficient, and there is no corresponding benefit to offset this cost. All to give a politically desperate senator a fig leaf.
June 27, 2010
They Fight the Law. Will the Law Win?
Myriad commentators have criticized the Obama administration’s repeated flouting of the law. Professor Bainbridge has a list of some of the greatest hits the law has taken at Obama’s hands. So does Victor Davis Hanson. I wouldn’t go as far as Thomas Sowell in seeing in all this the first steps to the gas chambers or the Gulag, but it’s bad enough.
The $20 billion BP compensation fund is the most expensive, and most egregious, of these transgressions. Taking time off from his day job telling American corporations what they can pay their executives (another extra-legal monstrosity), Kenneth Feinberg assures us that “fairness” is his guidepost:
State laws will have to be made as consistent as possible to ensure that some victims of the Gulf of Mexico oil spill are not treated unfairly, says Kenneth Feinberg, the lawyer chosen by the White House and BP to administer a $20bn claims fund.
Determining which claims are eligible and which are not will be a “challenging” task, says Mr Feinberg, a renowned mediator who will soon take over the day-to-day running of the claims process from BP.
“How do we deal with a restaurant in Boston that can’t get shrimp for its favourite dish or the strip joint in New Orleans where business is off because the fishermen aren’t coming in?” Mr Feinberg asked.
“I think the best way to look at it is the way Congress looked at 9/11 cases. Would your claim be applicable under state and, in this case, maritime law? If the state would recognise it, then I will recognise it. If not, I should not,” he said.
So I see. There are state laws and maritime law that govern liability and damages in such matters. I’m going out on a limb here, but given that, I’m guessing that there are like courts and stuff with established procedures, rules, and precedents that are capable of applying such laws. Indeed, not just capable, but Constitutionally charged with the responsibility of applying them.
Not only does the BP fund trample separation of powers, it also rides roughshod over federalism. Feinberg will, like some imperial vizier, decide which state laws apply and which do not:
Overcoming differences in state laws will be another challenge, and Mr Feinberg’s team is now going through state laws to check for inconsistencies.
Although their initial inspection showed that the laws were “sufficiently similar”, the lawyer is also looking at creative ways to deal with any problems.
For example, if the law is the same in 41 states but not in the other nine, he might choose to apply the law of the majority across the board.
“I am very worried about unfair treatment. I can’t conduct and administer a fund where one person in one state would get their claim and another person in a different state would not,” he said.
I see. It’s all about fairness. Let me wipe this tear from my eye.
No, it’s not all about fairness, actually. In this federal system, there is a demarcation between state law and federal law. Each state has its own laws, duly passed by its legislature, its own courts for interpreting these laws and making judgments under it, and its own executive, for enforcing them. Citizens of those states have access to the courts under established principles of standing and jurisdiction. Individuals have made choices where to live based in part on those laws. They have entered into contracts under those laws. That’s the way it works, and the way it has worked for centuries.
Where does Ken Feinberg, and the Obama administration, get the power to turn this system completely on its head? Under what Constitutional theory does an unaccountable “official” (I use the quotes because the “position” he holds does not appear to have any legal sanction whatsoever) get the power to disregard some state laws to award claims that presumably have a legal basis in these same state laws? Since when does a majority of state laws trump the laws of the remainder? I mean, this is an absolutely bizarre legal doctrine.
This does not exhaust the deep problems with the BP fund. Obama and individual Congressmen have made it plain that BP funds will be used to compensate those who suffered losses from events for which no court likely would hold BP liable. Specifically, BP will pay oil workers for income lost due to the administration’s own drilling moratorium.
A competent court has already found the existing version of the moratorium to be legally deficient. It is remarkable indeed to expect BP to pay for costs arising from a government policy that has no legal basis.
Moreover, to craft a moratorium that passes legal muster, the administration (Interior Department) would almost certainly have to argue that deepwater drilling is so inherently risky that it cannot be countenanced. At most, the BP spill demonstrated the risks of drilling, risks that must exist independently of BP if all drilling is to be stopped: if the administration is correct that the irremediable and indefensible risks of drilling demand termination of the activity forthwith, those risks are inherent in the activity and would exist and have existed regardless of whether the BP well had exploded or not. That is, if the administration’s argument justifying the moratorium is correct, it would be correct regardless of whether the BP spill had occurred or not. How can you make BP pay for people not making money for not performing an activity they shouldn’t be performing in the first place?
Thus, there is no reasonable theory of causation that can attribute the lost income of oilworkers to BP. Given the lack of any colorable case that BP’s actions caused this lost income, there is no way that any court would find BP liable for this loss. The loss arises from the administration’s decision. And if you believe the administration’s justification for the moratorium, you must also believe that there should be no oilworkers in the Gulf anyways. Why provide compensation for the inability to undertake a wasteful activity? (Should the makers of locks pay for the lost income of burglars?)
Shredding federalism, separation of powers, and due process—not bad for a day’s work.
As appalling as this is, it should not be a surprise. It is the natural product of the progressive (and Progressive) legal mindset. Dating back to the dawn of the Progressive movement in the US, adherents to progressivism have viewed the separation of powers, federalism and the resulting patchwork of 50 sets of state laws, and due process as atavistic impediments to the achievement of rational and beneficial public policies. (For a distilled essence of this view, read any one of Tooltime Tom Friedman’s China For a Day wet dreams.) Progressives don’t blanch at the destruction of certain Constitutional principles dating from the birth of the Republic, and legal principles pre-dating that. They revel in it. They believe it is a good thing.
And if you don’t share their belief, you should oppose Obama’s actions, regardless of what you think of BP. There are ways of making sure that BP pays for the damages it has caused without trashing the rule of law; why do you think the country has so many trial lawyers? But if you are a Progressive, this trashing is a feature, not a bug. Progressives have been fighting the law for a long time. Let’s all hope that the law wins.
June 26, 2010
BP and Counterparty Risk
Several reporters have called me to ask about the implications of BP’s travails for its trading operations, and more crucially, for the markets broadly. Here are some key points:
- BP probably has the largest energy trading operation of any firm in the world.
- There is a non-trivial risk of BP going bankrupt as a result of ballooning liabilities associated with the Gulf spill. Don’t believe me? Look at the company’s gargantuan CDS spreads.
- BP’s counterparties are well aware of this, but are adopting a public “what, me worry?” response to any queries about BP’s counterparty risk. Nobody wants to raise doubts that could be self-fulfilling and spark a run.
- That said, in private they all are lacing up their running shoes, and putting contingency plans in place. Nobody wants to be last in line if it looks like the company is teetering towards bankruptcy. And knowing that the government is first in line to begin with cannot inspire confidence among those who have exposure to BP.
- Things can move from “what, me worry?” to “Panic! Run for your lives! Devil take the hindmost!” very quickly, and in response to small shocks. That is, situations like this are inherently non-linear, and small things can spark a run or a cascade that results in the collapse of BP’s trading operation in a stunningly short period of time. I’m NOT saying this is a certainty. I’m not even saying it is the most likely outcome. I am just saying that such an outcome cannot be dismissed. We’ve seen it happen too many times before.
- The broader market consequences of a BP failure depend crucially on whether, in the event of a bankruptcy, its positions are in or out of the money. Enron’s failure, which was not caused by losses on its trading book, was not that disruptive to the energy markets because counterparties generally owed Enron money, rather than the reverse; hence, these counterparties did not suffer losses with consequent knock-on effects. Moreover, its failure did not cause large market price movements that worsened the company’s losses. A BP bankruptcy similarly would not be caused by losses on its trading book, but by metastasizing liabilities from the spill. It is possible that BP could go bankrupt, but there would not be knock-on effects because its trading book is profitable and it doesn’t owe counterparties money.
- A known unknown is what effect a BP bankruptcy would have on energy prices, and what effect these price movements would have on the amount BP owes its counterparties. Hypothetically, if its bankruptcy moves energy prices, and these price moves impose losses on BP, its trading partners will suffer some losses as the result of a BP bankruptcy and default. The problem is, we won’t have any idea what the price response to a BP bankruptcy will be until it happens.
This situation is not an imminent crisis, but bears watching. If it moves, it will not move slowly, but with stunning speed.
Clearing and the Fed: A Hobson’s Choice
The issue of the systemic risks posed by a clearing mandate that expands the scale and scope of central counterparties has come to the fore of late. Too late, perhaps, but even at this late date it is an advance.
The focus of this concern is now on whether CCPs will be too big to fail, and whether they should have access to the Fed’s liquidity provision facilities.
Now that the financial defo . . . I mean “reform” bill is on the verge of passage, with (a) a clearing mandate, and (b) a provision granting CCPs access to the Fed, as one of the people who raised the profile of this issue I should restate my views.
First, yes, the clearing mandate will make CCPs a much more integral part of the broader financial system; CCPs can fail; a failure would be catastrophic; and hence CCPs are likely too big to fail.
TBTF is pernicious. So how to deal with it? In this instance, by not mandating clearing and thereby creating new TBTF institutions.
But it looks like a clearing mandate is inevitable, so the question becomes: given that CCPs are crucial financial institutions whose failure threatens the stability of the financial system, should they have access to the Fed?
Here, my answer is a qualified yes. The Fed has legitimate lender of last resort functions that involve the supply of liquidity to solvent institutions during times of liquidity crises. CCPs can be prodigious consumers of liquidity, especially during times of market stress that induce big price movements that trigger big flows of margin money. A solvent CCP could face a severe liquidity crunch in such circumstances, and access to Fed liquidity, either directly, or indirectly (a la 1987) can prevent this liquidity crunch from causing the failure of a CCP–which would have serious systemic consequences. These consequences include the closure of markets, large moves in asset prices, and asset fire sales. Thus, if one could trust the Fed to be a classical Bagehotian LOLR, lending to solvent institutions against good collateral, permitting CCP access to the Fed’s liquidity programs could improve the stability of the financial system. This would make a disastrous meltdown of CCPs due to liquidity problems less likely.
But that “if one could trust the Fed” clause is why my answer is a qualified one. The truth is that the Bernanke Fed has stretched and bent the Fed’s legitimate LOLR functions beyond recognition in a way that must have Bagehot spinning in his grave. Many of its actions (e.g., AIG) can legitimately be seen as bailouts that exacerbate moral hazard problems going forward. As a result, there is reason for legitimate concern that giving the Fed a new set of institutions to bail out is a very bad thing indeed.
But the problem is that although cutting off CCPs from the Fed altogether would preclude it from bailing them out, it would also preclude legitimate liquidity support. It is difficult to say, here and now and in the abstract, whether this package deal is superior to the alternative–a risk of bailouts, but the ability to prevent future liquidity crises from blowing up CCPs. As it stands, that is the choice. It is a stark one, and not an easy one to make.
This illustrates a fundamental problem with a lot of the financial regulation debate. The issues that are being debated are the consequence of underlying problems that remain unaddressed. In the present instance, the underlying issues are (a) the role, power, and discretion of the Fed, and (b) clearing mandates that expand clearing, and expand it into more problematic and difficult areas. Clearing mandates have been a given from almost the beginning. The Fed’s role has been debated, but it has emerged from the process as powerful, or more powerful than before. The failure to address these underlying issues is why we are confronted with the Hobson’s choice between risking CCP bailouts and being unable to respond to CCP liquidity crises.
The increasing angst over the Hobson’s choice should have led to a serious rethink of clearing mandates. To spark such a rethink was one reason why I have hammered on this issue for some time. But that hasn’t happened; since the whole rationale for clearing was to reduce systemic risk, to proceed apace with mandates even as it became evident that CCPs created their own systemic risks and then argue over how to deal with that consequence was irresponsible in the extreme. It should have also led to a more searching evaluation of how to constrain the Fed to its legitimate Bagehotian LOLR role. That hasn’t happened either.
Well, Congress has made its choices, and we’ll all have to live with them. It’s summertime, but the living ain’t easy.
June 25, 2010
Does the Administration Get Its Policy Tropes From Rancid Lyrics?
On a lighter note, listening to some Rancid while driving through Germany I caught these two lyrics which are eerily similar to recent Obama Administration lines:
From Rancid’s Start Now (on Indestructible, 2003) (a song about war, and particularly unconventional war):
Another lesson has been learned,
In this days’ modern times,
Strangers in the mist appear,
Now there’s war, all the time,
Systematically go and destroy,
Commit another atrocity,
Aggressors are in their places,
Man-made catastrophe
From Janet Napolitano, head of the Department of Homeland Security:
In my speech, although I did not use the word “terrorism,” I referred to “man-caused” disasters.
From Rancid’s Liberty and Freedom (from Let the Dominoes Fall, 2009):
They’re gonna keep you down
step on your neck
Can’t move no more
From Secretary of the Interior Ken Salazar (and press goon Robert Gibbs):
“We will keep our boot on their neck until the job gets done,” U.S. Interior Secretary Ken Salazar told reporters after touring affected areas of the Gulf coast with Homeland Security Secretary Janet Napolitano and a group of U.S. senators.
Coincidence?
This Is Just Retarded
Can you say that any more? Well, even if use of the word “retarded” is increasingly frowned upon, there are some special cases in which its use is so evocative, and hence so appropriate, that it should be blessed.
The compromise on the Lincoln amendment is one such case:
The bill also includes a provision, authored by Sen. Blanche Lincoln (D., Ark), which would limit the ability of federally insured banks to trade derivatives. This provision almost derailed the bill following vehement objections from New York Democrats. Ms. Lincoln worked out a deal in the early hours of Friday morning that would allow banks to trade interest-rate swaps, certain credit derivatives and others—in other words the kind of standard safeguards a bank would take to hedge its own risk.
Banks, however, would have to set up separately capitalized affiliates to trade derivatives in areas lawmakers perceived as riskier, including metals, energy swaps, and agriculture commodities, among other things.
Under any modern understanding of what “risk” means, this makes no sense. Ever heard of diversification, or the fact that “risk” of a particular position is attributable to its contribution to the payoff distribution of the entire portfolio of risks, not anything inherent to the position itself? (Meaning that even if energy prices are volatile, doing energy swaps may not be that risky in a portfolio context.) Under any modern understanding of the economics of financial intermediation (in which information about counterparties is vital) this makes no sense either. (Meaning that the costs of intermediation are lower if information obtained in trading one instrument with a counterparty can be used when dealing in other instruments.) Under any modern understanding of counterparty risk, where maximizing netting opportunities can be quite valuable, this makes no sense; splitting up businesses in an arbitrary fashion like this reduces scope economies from netting and other things. It also makes no sense even on its own terms, because yes, banks use interest rate and credit derivatives to manage their own risks, but from my understanding of the provision, banks will still be able to be dealers in these products, and the whole basis of Lincoln’s proposal (to the extent that it had one) is that dealing is a particularly risky activity. Not that I am buying into that argument; I’m only pointing out that is that’s what you believe, this provision is contrary to that belief.
This is transparently a compromise to save the face of a senator in over her head, who made a wild legislative proposal to stave off a primary challenge. The banks were willing to throw a couple of bones in order to save their biggest books; metals, energy, and ags are small potatoes compared to interest rates and credit. Lincoln gets to do what senators do best–pose. The banks largely escape major damage.
Even by sausage making standards, this is revolting. It is good that the most egregious parts of the Lincoln proposal have been jettisoned. It is bad news, however, for liquidity and hedging in the disfavored products, especially commodities. This, along with the position limit measure in the bill, and the clearing mandate, will increase the costs of managing commodity price risks in particular.
All pain, no gain: the only thing that can be said is the pain could have been a lot worse.
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