Iran Incongruities

As the world inches closer to official and non-official deadlines given to Iran on nuclear negotiations, something in the international equation just doesn’t add up.

The relevant players here are the P5+1 (the permanent five members of the UN Security Council plus Germany), Israel, the Sunni gulf states, and Iran. It’s worth evaluating their interests one by one, since a composite view of the situation will involve an intersection of these interests with their respective capabilities.

China—not thrilled about the prospective of nuclear proliferation, but even less thrilled about the prospect of interruptions in its energy supplies. China imports almost 60% of its oil from the Persian Gulf, and its largest trading partner is Iran. This means that the odds of China agreeing to the only sanctions that would really hit home in Iran—a gasoline embargo—are slim to none, since economic weakness directly translates to innerpolitical turmoil and trouble for the Communist Party. The only worse prospect is armed conflict, which would almost certainly close off the Straits of Hormuz entirely.

France—Sarkozy has been clear that France will not tolerate a nuclear-armed Tehran. Iran’s numerous and continuing infringements against UN resolutions give the administration a legal basis to an increasingly militant posture.

The UK—in line with France and the US. Will not tolerate a nuclear-armed Iran, but like both countries, would prefer to avoid commitment of armed forces (for obvious reasons of economic and political costs and risks).

Germany—Germany is in a much more conflicted position than some of the government’s rhetoric would lead one to believe. For one, Germany (and close relative Austria) has substantial commercial interests in Iran. Secondly, although people and government are publicly very anti-nuclear-proliferation, both distrust US leadership, and have absolutely zero appetite for any type of conflict anywhere in the world, let alone in the neighborhood of Iraq, which is widely viewed as a symbol for All That is Wrong With America. The Germans have a tendency to view all conflict as fundamentally driven by self-interest, which is therefore intrinsically immoral (unless Germany’s own interests are at stake). Finally, Germany’s increasingly cozy relationship with Russia, borne both from energy dependence and diverging interests with the US, means that Germany is unlikely to form a united front with the rest of the West to exert pressure on the other stakeholders in the brewing conflict.

Russia—Russia already has extensive commercial ties with Iran, specifically in two sensitive and lucrative sectors: nuclear technology (the Buschehr plant) and armaments (particularly SU-300 SAMs). The country therefore has a vested interest in business-as-usual, except that the alternative (strict sanctions or war) have a potential to be even better for the Kremlin’s bottom line. A closing of the Straits of Hormuz would lead to an explosion in oil prices, and gasoline sanctions would allow Russia to make a killing exporting fuel overland to Iran at inflated prices. Even more importantly, Russia would like to see nothing more than to see the Middle East suck in American resources even further, since this would allow it to continue reasserting control over its sphere of influence in the former Soviet Union (particularly Ukraine and the Caucasus). The only balancing aspects are that Russia is also interested in a stable Afghanistan, meaning that a shift in US combat capabilities out of the country would require added expenses by the Kremlin to secure that border; and secondly, a nuclear-armed Iran will likely further push US ballistic missile defense system proliferation in Eastern Europe. News that the US has shelved these plans, whether true or not or for whatever reason, do not change that long-term reality. Overall, though, between its oil export capability, potential to disrupt American air attacks by the dissemination of air defense systems, and even nuclear support, Russia can make a difficult situation just that much worse.

The US—the US doesn’t really want war, and can’t afford it. The latter is not just a matter of defense appropriations and budget deficits, but also opportunity costs and the deep socioeconomic malaise that would follow the inevitable rise in crude prices following Persian Gulf action. However, the US cannot tolerate a nuclear-armed Iran, for the following reasons: 1) it is illegal under the NPT and would weaken the international state system, 2) it would constitute an existential threat to all US allies in the region, particularly Israel; 3) it could very well lead to an arms race in the Middle East that harbors immense fat-tail risks. Finally, Obama is seen internationally as young, untested, and possibly weak, and he is a Democrat, which means that at the domestic level he must constantly prove his foreign-policy steel. He cannot afford to appear even slightly weak here.

The Gulf States—America’s Sunni allies in the Persian Gulf, and chiefly Saudi Arabia, are extremely concerned about the prospect of nuclear armament in the region and its potential to shift the balance of power. Many battle with social issues around the integration of Shiite minorities within their own borders. The question, as always, is not only one of capability, but of political will—how to balance their populations’ antipathy to everything Israeli with the confluence in national interest? As is the case with Palestinian support, rhetoric will sharply diverge from policy.

Israel—has made its position abundantly clear: Iran will not be allowed to acquire nuclear weapons. Netanyahu is playing a complicated political game balancing domestic and international politics (best shown in settlements ‘freeze’). In recent weeks, he has tried to buy the Russians, cajole the Americans, intimidate the Iranians, and ratchet up the pressure as much as possible. To mount an attack across Iraqi/ American airspace, Jerusalem needs Washington’s approval. But the wild card here is Obama’s perceived coolness to the Israeli cause—if the Israelis do not predict help as forthcoming, they may feel freed to undertake radical action themselves.

Iran—is playing the usual games. They are attempting (and succeeding) and changing the debate from revolving around nuclear issues, to revolving around the debate itself. They have done this by proclaiming first that nuclear issues are not on the table during the upcoming negotiations (scoring domestic political points and adding another hurdle for foreign diplomats), then proposing Tehran as the negotiation site (which is impossible, since negotiations are at head-of-state level, but would be a major victory if agreed upon), by making small meaningless concessions. (such as letting inspectors back into an enrichment plan), and finally, by releasing a position paper. The last bit allows the more recalcitrant participants (Germany, Russia, China) to claim that diplomacy is making progress and thus oppose stricter sanctions, when really the situation has not changed at all. The hoped-for outcome is that, after a year of meetings, all players go home exhausted, and with even fewer options than before.

The point is, everyone has very different priorities, and everyone is trying to push the situation as far as possible thinking no one else will act. For example, no one thinks Israel will act without US support, and no one thinks the US will (or can) act at all; but these assumptions don’t necessarily hold true. Expecting a few months of negotiation with no tangible outcome simply does not make sense when some players simply cannot afford to let that happen at almost any cost (particularly Israel and the Arabs). Also, Obama is thinking of Kennedy and the Cuban missile crisis, and has a strong incentive to move fast. With so many miscalculations and moving pieces, the situation could escalate rather quickly.

There are a few possible accommodations that could be made to change the constellation of players. The most intriguing is a Grand Bargain between Russia and the US (of which the recent US scrapping of missile defense systems may well have been the starting gun). It would really cost the US, above all in credibility, since it would basically have to withdraw support from Georgia, the pro-western sections of Ukraine, and even to some extent Poland, and lessen its presence in Central Asia; but policymakers might well decide that this is worth it since n the long-term, these losses can be regained. If the West were truly unified—Germany being the problem here, not France—then this would be more easily achievable, since Russia would both see a bigger stick waving and could be offered more carrots.

Another possibility is a massive change in US strategy. It would take a while to implement because of the formidable logistical obstacles, but the US could shift forces right back out of Afghanistan into the Gulf region, abandon the Afghan effort altogether (thereby creating a liability for Russians), to ratchet up pressure on Iran and signal a willingness to fight.

A wild-card here, ignored in most discussions, is China. How would the Middle Kingdom react to military action in the Gulf that reduces oil imports or raises their price? For that matter, could the country be convinced to support sanctions if the only alternative is war (which would be even worse economically)? The Chinese talk like a superpower, but haven’t paid the costs yet—maybe they will begin to here?

In any case, no matter what pattern of escalation follows between Iran and the West, or Russia and the US, or whichever constellation of powers, nuclear war is not the risk. But the odds of an economic disruption of some sort are rising with every day that there is not a realignment of the interests described above. And thus, it might well make sense for investors to hedge what could be a substantial fat-tail risk. In almost any scenario, crude oil and Russian indices should do well, and the US (and most of the rest of the global economy) should do relatively worse. Alternative energies would get a boost. And given that the popular media coverage of the situation has been muted thus far, this kind of protection should still be affordable.

Special thanks to my brother (who knows much more about geopolitics than I) for his input into this article. This article is a product of a long phone conversation with him, and the ideas in it should be considered his more than mine.

Perspectives on Obama's Tire Tariff

Pres. Obama's recent 35% tax (on top of an existing 4% tariff) on tires imported from China has generally been denounced as a protectionist move motivated by domestic political factors. Bill Witherill of Cumberland Advisors called it a "cynical and dangerous move" because the US tire manufacturing industry is internationally uncompetitive anyway. Some have speculated the tariff will lead to another Smoot-Hawley effect on the world economy. With the lessons from the Great Depression hanging heavy over everyone's head, the recent trend of trade retaliation (such as competing Buy America and Buy China policies) is certainly alarming.

But while the tariff may seem ominous from an economic perspective, from a geopolitical perspective the tariff makes more sense. A recent article from Stratfor (which is unfortunately not public) argues the moves of both countries were politically motivated and are unlikely to escalate. I don't agree, but it's an interesting argument. First they point out this is not a normal WTO case, because Obama never even mentioned any unfair trade practices. Obama did it because he can. In the 2001 Chinese WTO accession agreement, Clinton insisted on including a particular section 421, which basically allows the US to sanction any product without making a case for trade violations until the end of 2013. For that reason, China cannot react in any way that will actually hurt the US, because it could provoke Obama to use section 421 again, completely legally. We have yet to see any meaningful retaliation. China declared it would probe "unfair practices" in US chicken and auto products, but that's it.

But why would Obama do this for domestic political reasons as the FT, WSJ, Stratfor, and others have claimed? Sure he's having trouble with healthcare, but why would he trade a small boost in his base for further complications in Iran? As Stratfor points out, China could easily retaliate by refusing to cooperate with sanctions or stonewalling negotiations. But this would make Obama look terrible. Obama has a lot of political capital riding on Iran. His criticism of Bush's unipolar attitude and unwillingness to negotiate was one of his main foreign policy selling points during the campaign. I think its more likely Obama enacted the duty to remind China of its economic leverage before the P5+1 negotiations with Iran. China is not enthused about sanctioning its third-largest supplier of oil.

Obama said on Wall Street this Monday,

"Make no mistake, this administration is committed to pursuing expanded trade and new trade agreements. It is absolutely essential to our economic system. But no trading system will work if we fail to enforce our trade agreements. So when, as happened this weekend, we invoke provisions of existing agreements, we do so not to be provocative or to promote self-defeating protectionism. We do so because enforcing trade agreements is part and parcel of maintaining an open and free trading system."

These words imply the US sees its ability to tariff-at-will as a right in return for opening up trade with China. While his choice of industry might have been politically motivated, his decision to raise tariffs in the first place was likely a geopolitical one. It will be interesting to see how the trade and Iran issues evolve alongside each other.

Armageddon In Retrospect, Part 2

Days away from the anniversary of Lehman's collapse, it's interesting to assess the degree to which financial markets and institutions have changed since. Today: interest rates.

Central banks aggressively cut rates after the first tremors in the financial system in 2008. Money markets at first reacted to Lehman by seizing up. The Libor-OIS spread, which measures the premium banks pay for borrowing from each other and indicates banks' perception of the credit quality of other banks, surged to 364bps from a mean of 10bps. Now the spread is back to a normal level at 13bps.

Libor also surged after Lehman collapsed. 3-month Libor peaked at almost 5% a month after the bankruptcy. Now that Central Banks have committed to maintain their low rates until recovery is assured, Libor is flirting with its record low at .30%. The low Libor rate also reflects the vast amount of government guarantees in the market. Another measure that has returned to normality is the 2yr US Swap Spread. The swap spread measures the spread between treasury yields and swap rates (Libor) for a given maturity. The 2yr swap spread is now at its lowest level in 5 years. Credit hasn't been this cheap in a long time. The new trust with which banks lend to each other, reflected in the Libor-OIS and swaps spreads, isn't healthy and organic but fake, propped up by implicit government guarantees.

The one measure that is distinctly different from pre-Lehman is the 30 year swap spread. A little more than a month after Lehman failed, the 30-year swap spread dipped to negative 25bps. Since then, it hasn't moved much as swaps and treasuries increased at a similar pace. The market is saying it views 30-year treasuries as riskier than 30-year swaps. In other words, the US government has higher credit risk than AA rated companies. This is curious because it is clearly a mispricing--the US government has no default risk. It could reflect negative sentiment about the US' ability to repay its long-term debt, but I doubt it. The FT wrote the negative spread is a result of firms wanting to hedge against deflation without paying the principal and a revival of demand for interest rate hedges. That seems plausible. But it is still a strange inefficiency. I would expect someone to be able to arbitrage the difference.

If one looks at the numbers, it seems as if the US is emerging from a deep recession and that interest rates should rise soon. But yield curves do not predict this. The amount of government intervention necessary to quantitatively ease yields taints these optimistic numbers. Libor and swap spreads indicate that the panic is gone, but yield curves indicate a large amount of government assistance is still required. There is yet something rotten in the state of Denmark.

Approaching Option ARMageddon

One idea that is fairly widespread in the blogosphere is that a slew of interest rate resets on option Adjustable Rate Mortgages in 2010 and 2011 will trigger another round of writeoffs and possibly a double-dip recession (see here and here). Recent news indicates these losses could be imminent.

Fitch Ratings stated in a report that 88% of securitized option-ARMs are yet to be reset. Considering that 94% of option-ARM debtors chose the lowest payment option and 75% of option-ARMs were made in California, Florida, Arizona, and Nevada (where housing prices are down 48%), the future doesn't look good. Loan-to-Value ratios have gone from 79% to 126% today. That means the average option-ARM homeowner is underwater by more than 25% of their homes value. For a $300,000 home, that is $75,000.

Furthermore, only 3.5% of these loans have been modified. These loan modification doesn't seem to help much anyway. 24% of modified option-ARMs default in 90 days, while 37% of untouched loans default after 90 days. The most interesting thing about the numbers, however, is that the outlook is worse than was expected less that a year ago. Loss severities on MBS have risen from 40% a year ago to 60% today. Considering that vast amount of option-ARMs that still have to reset, these losses should continue to increase. (read more here)

Personally, I don't think that the option-ARM resets will cause the armageddon some have predicted. As long as regulators remain foreberant in regards to recognizing fair value, banks will be able to spread out losses over the next five years, similarly to the early 80's Latin American debt crisis. One possible consequence of this is less lending as banks have to hold capital against these assets. This could actually benefit investment banks because it forces companies to raise capital through the capital markets.

Armageddon In Retrospect, Part 1

With the anniversary of the Lehman collapse a few days away, I thought it would be interesting to look at what has changed for consumers, the banking industry, and finance as a whole over the last year. Today I will focus on how banking has changed for the consumer, using Washington Mutual as a case study.

In 2003, CEO and Chairman of WaMu, Kerry Killinger, boldly claimed, "We hope to do to this industry what Wal-Mart did to theirs, Starbucks did to theirs, Costco did to theirs, and Lowe's-Home Depot did to their industry. And I think if we've done our job, five years from now you're not going to call us a bank." Killinger was right for the wrong reasons. A little over five years later, I doubt anyone would call WaMu a bank anymore.

WaMu's business model focused on building a consumer friendly way of banking, without ATM fees, monthly checking charges, and so on. Its ubiquitous commercials featured young people in casual clothes rallying against the old-fashioned commercial banks, represented by old men in fancy suits often depicted counting money (see here and here). Another line of commercials used the slogan "The Power of Yes" to emphasize WaMu's "flexible lending rules", underscoring the tremendous amount of loans originated by WaMu (for a particularly funny commercial, see here). These commercials underscore WaMu's success in issuing loans and gathering deposits. But WaMu's democratization of commercial banking ended up being its downfall. Its large amount of home loans left it very vulnerable during the subprime crisis. Its "flexible lending rules" meant that half of its $119bn mortgages were option ARMs (aka POAs, see here). When depositors pulled out $16.7bn in 10 days, WaMu was left with almost no capital. Ironically, JPMorgan Chase, the archetype of an old-fashioned commercial bank, ended up acquiring WaMu at a fire sale price.

From a business perspective, Washington Mutual deserved to fail. Its lending was irresponsible and myopic. But from a consumer's perspective, the failure of WaMu represents a bank that was friendly to the little guy being taken over by a bank that was too big to fail (and a $25bn TARP recipient). A friend of mine who banked at WaMu was dismayed to hear the new owners had instated the very fees WaMu had promised to avoid.

JPMorgan deservedly came out stronger from this crisis than it went in. But from a consumer's perspective, the consolidation that has occurred in the banking industry over the last year is not a good thing. A recent WashPost article describes how the crisis has created an oligopoly of four large banks--JPM, Citi, Wells Fargo, and BoA. These banks now issue one of every two mortgages and two of every three credit cards. Remember that before the financial crisis, regulations prevented any bank from having more than 10% of the nation's deposits. Now the top 3 commercial banks all violate this benchmark.

The most striking effect of this consolidation has been the increase in fees. In the last quarter, the top four banks have raised fees related to deposits by 8%, while smaller firms have lowered fees by 12%. Data shows that large banks have the ability to borrow more cheaply because they are assumed to have negligible counterparty risk. Large banks with more than $100bn in assets are borrowing at .34% less than the industry. In 2007, this number was only .08%. For a commercial bank, this lower cost of funding is a huge competitive advantage. One consequence is that large banks are able to easily outprice smaller ones.

The consolidation in the banking industry, caused by the financial crisis, can't be undone. In economics, one characteristic of an oligopoly is that fragmented buyers will have less bargaining power, resulting in prices higher than equilibrium. This strongly supports the need for the Consumer Financial Protection Agency. But something further needs to be done to promote competition among banks of all sizes. So far, there have been no proposals addressing the massive challenges facing small and mid-size banks in the future.

Consumer Credit Plunges in July

Yesterday the Federal Reserve released its July figures for consumer credit. Looking at the numbers, it seems as if we have passed the tipping point and started our descent regarding consumer credit. This will have drastic effects on the economy (consumer spending is 70% of GDP). Over the last decade, consumer spending has been fueled by easy credit and asset bubbles. If available credit falls off a cliff, consumer spending will follow soon after. Below is a graph of historical consumer credit since 1943 (source).

What is most striking about these numbers is the rate of change. In Q3 of 08, consumer credit growth was still positive at .6%. But from Q4 onwards, consumer credit has been falling at an accelerating rate. In Q1 of 09, consumer credit fell 3.7%. In Q2, credit fell 6.6%. This decline has continued throughout the summer. Consumer credit fell 7.4% in June and a striking 10.4% in July. The July figure is the most interesting. If consumer credit continues to decline as it did from June to July, then consumer spending will be much worse than expected. July could be an anomaly, so the August numbers will be interesting to keep an eye on. If this trend continues, a double-dip recession is a certainty.

Negotiating with Iran

In a press conference yesterday, Iranian President Ahmadinejad ruled out compromising on Iran's "undeniable right" to a nuclear program but stated he is open for discussion with Pres. Obama. This statement indicates the challenges facing President Obama's Iranian policy. Obama campaigned on the premise that he could talk to antagonistic leaders without preconditions and achieve multipolar solutions. But that is virtually impossible as long as Ahmadinejad is president of Iran.

As long as Obama follows a multi-polar strategy, Iran will be able to delay by playing members of the engagement against each other. Consider the deadline set by Obama for Iran to come to the negotiating table, which is less than three weeks away. If Iran refuses to talk, the G-8 has promised "crippling sanctions." The delegation that will negotiate with Iran consists of the UN security council plus Germany (US, UK, France, Germany, Russia, and China). The UK, France, and Germany can be expected to follow Obama's lead. But Russia and China care much less about a nuclear Iran than the US. Moreover, Russia and China have a significant stake in keeping Iran stable and gain nothing from sanctions. It is in Russia's interest to keep the US occupied in the Middle East and away from its periphery. Russia also trades with Iran and will want to protect this. China depends on Iran for commodities. As long as Iran is China's third largest oil supplier, China will not be willing to get tough on Iran while Iran maintains a semblance of co-operation.

Ahmadinejad has taken advantage of this division. His recent statements were vague enough for Russia and China to claim Iran is willing to negotiate, drawing the process out further. Ahmadinejad also notably invited leaders from these countries to Tehran, something Obama is unlikely to do for domestic political reasons. If parties can't degree on where to meet to negotiate, the negotiations are likely to be just as unproductive.

On the other hand, Obama has no alternative to a multi-polar strategy. Sanctions can only be effective if Russia and China participate. The US simply has little leverage over Iran, having exhausted most of its options in the past. Whatever happens in Iran will ultimately depend on Russia and China.