Et Voilà

By Grant Williams


In years to come, when financial historians look to pinpoint the precise moment in time when the excesses of Quantitative Easing reached their apex, I suspect that November 15th, 2017 may well be the date upon which they settle.
 

On that Wednesday, on opposite sides of the Atlantic Ocean, two events occurred which – once hindsight provides its inevitable clarity – will, I believe, provide the perfect crystallization of both the degree to which central bank-inspired asset price inflation has run amok and the utter folly of the negative interest rates inspired by those same academic assassins.
 

Were it possible to bring lawsuits against the men and women holding the highest financial offices in the world for financial malfeasance in an attempt to recover losses, then these two near-simultaneous events would be submitted as exhibits A and B in the biggest class action suit ever filed.
 
 
The image on the cover of this week’s edition of Things That Make You Go Hmmm... [Ed. note: reproduced above] is a clue to the event which transpired on the Western side of the Atlantic while the simple logo below provides everything you need to pinpoint the moment of madness at its eastern extremes.
 
 
 
Let’s begin in New York, shall we? At 20 Rockefeller Plaza to be precise.
 

On the evening of November 15th, the Christie’s Post-War & Contemporary Art Evening Sale attracted a bumper audience – largely due to Lot 9B, an oil on panel measuring 25 7/8 x 18 in. which was neither post-war (unless the wars in question were the Wars of the Roses or the Albanian–Venetian War), nor was it particularly ‘contemporary’ (unless the contemporaries in question included Ludovico il Moro Sforza (the Duke of Milan), or Sandro Botticelli).
 

The oil on panel in question had found its way into the British Royal Family’s personal collection by way of marriage when Queen Henrietty of France married Charles I in 1625, and there it stayed for almost 150 years until, in 1763, the painting went missing.
 

It didn’t surface until the late 19th century when it appeared in the private collection of Sir Frederick Cook, an expatriate English nobleman living in the great state of Virginia, USA.

n 1958, the painting was auctioned by Sotheby’s for £45 ($126) and sold to someone identified only as “Kuntz”. In the sale brochure, the artist credited with creating the near-$150 painting at that time was Giovanni Antonio Boltraffio, a young painter from Lombardy who worked in the studio of Leonardo da Vinci.
 

The painting was then not seen again for over half a century until, at an estate sale in 2005, a New York art dealer named Alexander Parish purchased it for $10,000 and, while it is essentially impossible to adjust the painting’s value for inflation going back to1625, we can do so to 1958 with considerable ease.
 

In 2005, the $126 paid for the painting 47 years prior was worth $851.28 in inflation-adjusted dollars so the $10,000 price tag shows just how well the painting had kept its value in the intervening years. However, all this happened before 2008.
 

Before ZIRP.
 

Before QE.
 

Once we enter the Twilight Zone of extreme monetary policy experimentation, things start to get really wacky.
 

Parish and a consortium of fellow dealers including Sheldon Adelson and Robert Simon ‘authenticated’ the painting as a genuine Leonardo and, in 2013, they sold it to Yves Bouvier, the Freeport King, for an astonishing $80 million.
 

At this point in the proceedings, I feel it important to point out that $10,000 in 2005 dollars adjusted for inflation to 2013 equates to $11,928.
 

What happened next was even more mind-boggling as Bouvier then immediately re-sold the painting to Russian oligarch Dmitry Rybolovlev (the owner of AS Monaco) for...wait for it...$127.5 million.
 
Aaaaaaand just to remind you of those numbers again:
 
The painting sold for $80 million and $127.5 million IN THE SAME YEAR.
 
It’s almost as if people couldn’t get rid of their fiat currency fast enough. We should all thank our lucky stars that there’s no inflation.
 

Rybolovlev purchased Salvator Mundi as part of a $2.1 billion collection of some 37 pieces which Bouvier put together for him but, when word of the gigantic markup Bouvier had made on the Leonardo, reached the oligarch’s ears, he filed both civil and criminal suits against Bouvier in both Monaco and Singapore claiming fraud and accusing Bouvier’s consortium of ‘significantly overcharging him’.
 

Source: St. Louis Fed
 
 
In the build-up to the sale, the chattering classes were focusing on whether or not Rybolovlev would be forced to take a nasty haircut on the supposedly inflated price he’d paid four years prior for the Leonardo:
 
(Al Jazeera): A Russian billionaire believes he was swindled when he bought it for $127.5 million. This week he will find out if he was right...
 
The auction house, which declines to comment on the controversy and identifies the seller only as a European collector, has valued it at $100 million.
 

Going into the auction, Christie’s certainly seemed to take the ‘under’ with their valuation and speculation ahead of the sale centred almost exclusively around validation rather than any great expectation of a headline-grabbing price being achieved.
 
...the price will be closely watched -- not just as one of fewer than 20 paintings by Da a’s hand accepted to exist, but by its owner, Dmitry Rybolovlev, the boss of football club AS Monaco who is suing Swiss art dealer Yves Bouvier in the city-state Hof Singapore].
 
Rybolovlev accuses Bouvier of conning him out of hundreds of millions of dollars, in parting with an eye-watering $2.1bn on 37 masterpieces. One of those works was “Salvator Mundi” which has been exhibited at The National Gallery in London.
 
Bouvier bought the Leonardo at Sotheby’s for $80 million in 2013. He resold it to the Russian tycoon for $127.5 million.
 
Despite its rarity (Salvator Mundi remains the only Leonardo in private hands – all his other known works are held in institutional collections or museums), the expected sale price was well short of the record for a piece of art sold at auction which had been fetched through the sale of Pablo Picasso’s The Women of Algiers (Version O) for $179.4 million in 2015.
 

When the auctioneer’s gavel came crashing down to cheers and thunderous applause after an electric bidding process (you can put yourself in the room by clicking here), the old record had been shattered as the formerly disputed Leonardo, which had been the subject of a multi-million dollar lawsuit over fraudulent over-charging, changed hands once again... this time for a little shy of half a billion dollars.
 

That’s right. With fees, Lot 9B sold for $450.3 million as an anonymous collector took the decision to exchange a pile of fiat currency for a real asset which has clearly more than held its value in the five centuries since its creation. His last bid increase of $30 million (when the price had been climbing in $1 million and $2 million increments), was both shocking and highly illustrative of my point.
 

Presumably the lawsuit against Bouvier will now be withdrawn, but these oligarchs have a habit of not letting go once they’ve sunk their teeth into something.
 

Incredibly, the $450 million dollars was handed over despite an enormous amount of debate as to the authenticity of Salvator Mundi (call me old fashioned, but if I’m going to drop half a billion on something, I’m gonna want to know it’s real):
 
(Bloomberg): Even before Leonardo da Vinci’s Salvator Mundi went to auction Wednesday night at Christie’s in New York, naysayers from around the art world were savaging its authenticity. Various advisers were muttering darkly, both online and in the auction previews. A day before the sale, New York magazine’s Jerry Saltz wrote that though he’s “no art historian or any kind of expert in old masters,”just “one look at this painting tells me it’s no Leonardo.”
 
And that was before the painting obliterated every previous auction record, selling, with premium, for $450 million.
 
Shortly after the gavel came down, the New York Times published a piece by the critic Jason Farago wherein—after also noting that he’s “not the man to affirm or reject its attribution”—he declared that the painting is “a proficient but not especially distinguished religious picture from turn-of-the-16th-century Lombardy, put through a wringer of restorations.”
 
Had the buyer of the most expensive painting in the world just purchased a piece of junk?
 
“All of the most relevant people believe it’s by Leonardo, so the rather extensive criticism that goes ‘I don’t know anything about old masters, but I don’t think it’s by Leonardo’ shouldn’t ever have gone to print,” says British old masters dealer Charles Beddington. “Yes, it’s a picture that needed to be extensively restored.
 
But the fact that it’s unanimously accepted as a Leonardo shows it’s in good enough condition that there weren’t questions of authenticity.”
 
On a visit to preview the sale, noted art critic and host of the Viceland series ‘Most Expensivest’, the rapper 2 Chainz offered his thoughts on the Leonardo:
 
(NY Timez): Wearing a black Supreme hoodie, red-and-white track pants, white Balenciaga sneakers and maybe five pounds of gold chains, 2 Chainz rolled into the auction house a few minutes after 4pm on a windy Tuesday with a crew that included a stylist, a personal photographer, a publicist and a bodyguard.
 
He moved through Christie’s with the eager, excitable air of a dutiful student, fist-pounding and taking selfies with security guards. He respected fine art but knew little about it.
 
Chainz was shown Andy Warhol’s Sixty Last Suppers (a composition of 60 black-and-white silk screen interpretations of Leonardo’s iconic painting which was valued at $50 million and ended up selling for $60.87 million) and offered a critique:
 
“This is the best thing I’ve ever seen in my life,” said 2 Chainz, temporarily struggling for words as he gazed at the gargantuan piece of art. “This makes me want to be a billionaire. Can you imagine having this over your dining room table? Oh my God. You’d have to have the longest dining room table in history.”
 
Finally though, Chainz could stand it no longer. With the preview’s 5pm closing time rapidly approaching, enough was enough:
 
“Take me to the big one,” he said, referring to the work that Christie’s has called ‘The Last da Vinci’.
 
A line of about 100 people were still waiting to catch a glimpse of the rare painting by the Italian master, but Ms. Celis led 2 Chainz again through a back door to view it without waiting.
 
“Oh my God. $100 million,” 2 Chainz said, referring to the estimated value and shaking his head in disbelief as he gazed upon the revered painting of Christ...
 
A crowd of roughly 20 people still hovered around Salvator Mundi, but with Christie’s set to close in ten minutes, security guards informed everyone it was time to leave...
 
Before he left, however, Chainz had one question he wanted to ask his guide:
 
Being a keen arbiter of luxury, 2 Chainz remained skeptical of the painting’s worth.
 
“So,” he said turning to face Ms. Celis. “Tell me one more time, how do we know it’s not a copy of a copy?”
 
Copy or not, away from the Leonardo, there was a wealth of other post-war and contemporary art for sale and, wherever you looked, the prices being paid were not so much indicative of a catalogue stuffed to the gills with priceless treasures, but more of a group of potential buyers flush with cash and in a desperate hurry to get rid of their paper dollars and exchange them for something more tangible, lest the value of those paper dollars be debauched further by the monetary mandarins atop the financial totem pole. (In all, a total of almost $800 million was paid over the course of the evening.).
 

Lot 15B, a painting of vermilion spirals by the British artist Cy Twombly (below), painted just 12 years ago (how’s THAT for contemporary?) with a brush tied to the end of a pole fetched $46 million and Fernand Leger’s Contrastes de Formes sold for $60 million.
 

Source: Cy Twombly

 
 
In short, New York’s auction houses were the scene of a fiat feeding frenzy and, if you are paying close enough attention, it isn’t the only one of its kind.
 

Just this week, bitcoin passed the $9,000 $10,000 $11,000 mark and, while there is undoubtedly real value in both the coins and the underlying blockchain technology, to say that currently the price is anything but a bubble is to fail to acknowledge a chart pattern which is familiar throughout financial history and clearly recognizable as a bubble (see chart below. Yes, that last gap up is essentially a vertical line).
 

Source: Bloomberg
 
 
Bitcoin now has a market cap of ~$200 billion – the vast majority of which represents profits made in the last 12 months so it will be interesting to see what that chart looks like when more established markets reacquaint themselves with the idea of volatility.
 

I will write more about bitcoin in January as it is an absolutely fascinating topic worthy of its own edition of Things That Make You Go Hmmm... but for now, let’s leave its price chart as merely another indication of the madness which has been fomented in one way or another by monetary policy.
 

What both bitcoin and the price of fine art both do, however, is demonstrate beyond any doubt the fallacy which speaks to there being no inflation (or at the very least that inflation is difficult to generate).
 

Inflation (of the asset price variety at least) has been running rampant as those fortunate enough to be near the central bank spigot have been the beneficiaries of eight years and multiple trillions of dollars of monetary largesse. Those further down the financial food chain haven’t been nearly so fortunate.
 

Each successive throwaway comment delivered by a central banker explaining how he or she is ‘concerned about rising wealth inequality’ is as shameful as it is mendacious.
 

The sale of Salvator Mundi by Rybolovlev is just one example of the lunacy that central bank actions have created around asset prices (yes, equity markets like the S&P500 qualify) but the Russian is also no stranger to another asset class which has been blessed by the central banks – luxury real estate.
 

Source: Bloomberg
 
 
Until the duplex penthouse on the 89th and 90th floors of the One57 Tower on 57th street in Manhattan changed hands in January of 2015 for $100,471,452.77, Rybolovlev’s daughter, Ekaterina was the proud owner of the city’s most expensive home, having paid $88 million for the Central Park West penthouse of former Citigroup chairman Sandy Weill.
 

The charts of median sales prices in the Manhattan co-op and condo market (below) show precisely what has happened as the rich have gotten richer thanks to central bank policy over the last eight years.
 

Source: Miller Samuel Inc.
 

Source: Miller Samuel Inc.
 
 
The median sale price of a Manhattan co-op or condo has recovered nicely since the depths of the post-2008 fall but it remains below its inflation-adjusted high, set in (of course) mid-2008.
 

Meanwhile, if we take a look at new development prices we can see that virtually all the new co-op and condo development in Manhattan has been at the super luxury end of the market – designed specifically to cater to those who have been enriched beyond their wildest dreams over the last eight years and who need nice real assets into which they can swap their fiat gains.
 

I’ve said it before but it bears restating; the consistent narrative surrounding the curious absence of inflation is nothing more than a canard.
 

Whilst the CPI has remained (to central bankers at least) puzzlingly benign, the trillions in QE has ended up in the bank accounts of those who already had money and assets and the inflation in those areas has been astronomical.
 

This really isn’t something you need a PhD. in economics to figure out folks.
 

This asset price inflation somehow stays hidden in plain sight and all anybody seems to care about is headline inflation of the PCE / CPI variety – the very measure followed by the Fed when trying to achieve one half of their dual mandate.
 

However, there are signs of stirring in the inflationary cave which, unlike the whole ‘rising wealth inequality’ will have central bankers genuinely concerned.
 
But we’ll get back to those a little later on.
 

For now, we need to head East, across the Atlantic to that other event which occurred on November 15th.
 

The scene for this particular sign of the apex of the era of Quantitative Easing occurred, not in an auction room, but in the corporate finance department of Société Générale in Paris.
 

Soc Gen was the sole bookrunner of a €500 million 3-year senior unsecured zero coupon bond issue which was priced at 5 basis points over swap rates (the tightest ever issuance for 3-year corporate bond).
 

Fittingly, with rates at multi-century millennia lows, the company (whose executives I feel certain could hardly believe their luck when the book closed), dates back to the time of Napoléon. No, the other one.
 

I’m talking, for those of you who may have missed the press release on the cover of this week’s Things That Make You Go Hmmm..., about Veolia Environnement S.A.
 

We’ll get to the subject of that press release shortly but first, a little more useful history.

 
The story of Veolia Environnement S.A. is a remarkable tale which dates back to the times of Louis-Napoléon Bonaparte, the first French Head of State to hold the title of President and, until the election of Emmanuel Macron in 2017, the youngest appointed to that office.
 

Bonaparte was the nephew and heir of Napoléon Bonaparte (yes, THAT Napoléon Bonaparte) and his term as President ran from 1848 until 1851 when, barred from seeking a second term by the country’s constitution, he orchestrated a coup d’état and took the title of Emperor on December 2, 1852 (the forty-eighth anniversary of his uncle’s coronation).
 

A year after ascending the throne Napoléon III (as he was known), issued an Imperial decree which established the Compagnie Générale des Eaux to provide water to the citizens of Lyon and, seven years later, it was granted a similar concession for the City of Paris.
 

All was well (pun intended) for ohhhh a little over a century as CGE focused its activities in the water sector but, with the 1970s came a new CEO, Guy Dejouany, and Guy had somewhat broader ambitions for the Company:
 
(Wikipedia): Beginning in 1980, CGE began diversifying its operations from water into waste management, energy, transport services, and construction and property. It acquired the “Compagnie Générale d’Entreprises Automobiles”(CGEA), specialized in industrial vehicles, which was later divided into two branches: Connex and Onyx Environnement. CGE then acquired the “Compagnie Générale de Chauffe”, and later the Montenay group. The Energy Services division these companies became part of was later (1998) renamed “Dalkia”.
 
CGE’s expansion into communication commenced with the establishment of Canal+ in 1983, the first Pay-TV channel in France. This expansion was accelerated after Jean-Marie Messier succeeded Guy Dejouany on 27 June 1996. In 1996, CGE created Cegetel to take advantage of the 1998 deregulation of the French telecommunications market, accelerating the move into the media sector which would culminate in the 2000 demerger into Vivendi Universal and Vivendi Environnement.
 
Yes, the water company founded during the Napoleonic era became media conglomerate Vivendi S.A. in 1998 and, two years later, in the midst of the dot-com bubble, the company spun off its core businesses (dahling, public utility companies were just sooooo 1850s) as Vivendi Environnement S.A., later renamed Veolia Environnement S.A., lest the hip, cool media group be somehow associated with water and waste management.
 

As you can see from the chart [below], Vivendi never quite recaptured its former glory and, while Veolia scaled new heights of its own before the next market peak in 2007, it too has taken a knee and is essentially refusing to budge from the canvas.
 

Source: Bloomberg
 

Source: Bloomberg
 
 
During the life of Veolia, the credit ratings agencies have taken something of a skeptical view of the company’s prospects with both Moody’s and S&P keeping their credit ratings just above the chasm between investment grade and junk throughout the company’s seventeen year existence (chart below).
 

Source: Bloomberg
 
 
Quelle surprise then, when Société Générale announced that the company’s €500 billion 3-year unsecured notes would be priced to yield... wait for it... -0.026%.
 

Yes, that’s right folks, a BBB-rated company managed to convince investors to pay them, at issuance, for the privilege of lending the company money.
 

I make this distinction around a new issuance because, amazingly, Veolia already has a bond trading at a negative yield.
 

The company’s 4.375% issue due December 2020 spent the first three years of its existence declining in value as the yield moved from 4.375% to 7.5% and then... QE happened.
 

In March 2009, the company’s bonds were yielding 6.5% but once central banks began buying bonds, that yield began looking juicier by the day and so the frontrunners bought them to later sell to the ECB and the yield just kept on falling – all the way to the zero bound and below.
 

Alongside Veolia, thanks to the lunacy largesse of the European Central Bank’s bond purchase programme, sit another five companies, all of which are rated BBB or lower by S&P and all of which currently have fixed coupon bonds yielding less than zero.
 

All of the sub-zero club are utilities (AffinityWater and South EastWater in the U.K., Germany’s Innogy SE and two Italian companies, A2A
 

SpA and Enel SpA) and all of them seem to have convinced investors (if not the ratings agencies) that they are worthy of membership of this little club because their cashflows are nice and steady.
 

Or something...
 

This is part of a wider phenomenon which [this] chart … highlights beautifully:
 

Source: Bank of America Merrill Lynch
 
 
 
Bond markets have also reached the blow-off insanity phase BUT, that insanity is being concentrated in places where a guaranteed central bank bid makes a lot of sense and provides a huge tailwind to investors who are once again bent over at the spigot and drinking as fast as they can.


The Secret History of the Russian Consulate in San Francisco

Overflights, mapping fiber-optic networks, “strange activities.” Moscow’s West Coast spies were busy.

By Zach Dorfman
Illustrations by Matt Rota


The first thing you need to understand about the building that, until very recently, housed the Russian Consulate in San Francisco — a city where topography is destiny, where wealth and power concentrate, quite literally, at the top — is its sense of elevation. Brick-fronted, sentinel-like, and six stories high, it sits on a hill in Pacific Heights, within one of the city’s toniest zip codes. This is a neighborhood that radiates a type of wealth, power, and prestige that long predates the current wave of nouveau riche tech millionaires, or the wave before that, or the one before that. It is old and solid and comfortable with its privilege; its denizens know they have a right to rule. Indeed, from Pacific Heights, one can simultaneously gaze out on the city, the bay, the Golden Gate Bridge — and, beyond, the vast, frigid Pacific.

The second thing you need to understand about the closure of Russia’s San Francisco consulate is that, after the Trump administration summarily announced on Aug. 31 that it would shutter the building 48 hours later, the news coverage that followed almost uniformly focused on two things: the dumbfounding heat (this city, cool and grey, is in California but not of it) and the black smoke wheezing from the consulate’s chimney, as employees rushed to burn up, one assumes, anything confidential or inculpatory.

People were right to look upward, toward the building’s roof, but their focus was misplaced: It was, in reality, the motley array of antennas and satellites and electronic transmittal devices dotting the rooftop — objects viewed with deep suspicion and consternation by U.S. intelligence community officials for decades — that tells the story of the Russian Consulate in San Francisco, not the ash drifting listlessly over the neighboring mansions.

I rushed to the consulate the day the closure announcement was made and watched the building sit impassively in the heat, while the media crews cooled off in the shade. A suspiciously large number of delivery vans were circling, and there was an unusual concentration of loiterers (in their cars, on computers; in biking gear, across the street) on an otherwise very quiet block. Pedestrians walked by, snapping photos on their iPhones.

San Francisco, it was clear, was now embroiled in the increasingly feverish diplomatic confrontation between the two nuclear superpowers. In July, Russian President Vladimir Putin had announced, in an interview on state-run television, that he was decreasing by 755 the total number of personnel working at U.S. diplomatic facilities in his country. Closing the San Francisco consulate (and two smaller diplomatic annexes) was the Trump administration’s retaliation for this move. Putin, for his part, claimed that he was merely responding to the Barack Obama administration’s December 2016 shuttering of two Russian recreational compounds on the East Coast; the expulsion of 35 Russian diplomats, identified as spies, from the country (this list included four employees of the San Francisco consulate, including the building’s “chef”); and a new round of congressional sanctions. The Obama administration, of course, made these moves in retaliation for the unprecedented Russian meddling in the 2016 U.S. presidential election.

But why the focus on San Francisco? Why not close one of Russia’s other three consulates, in New York, Seattle, or Houston? And why now?

The answer, I discovered, appears to revolve around an intensive, sustained, and mystifying pattern of espionage emanating from the San Francisco consulate. According to multiple former intelligence officials, while these “strange activities” were not limited to San Francisco or its environs, they originated far more frequently from the San Francisco consulate than any other Russian diplomatic facility in the United States, including the Russian Embassy in Washington, D.C. As one former intelligence source put it, suspected Russian spies were “doing peculiar things in places they shouldn’t be.” Russian officials in Washington failed to respond to multiple attempts via email and phone for comment.

In the course of reporting this story, I spoke to over half a dozen former high-level U.S. intelligence officials about the closure of the consulate. Some of these individuals, almost all of whom worked on counterintelligence in San Francisco, spoke on the record generally about Russian espionage in Northern California; extensive conversations with other former intelligence officials occurred on background, in order to discuss sensitive matters related to recent Russian activities in the Bay Area and beyond. These sources confirmed that the San Francisco consulate served a unique role in Russian intelligence-gathering operations in the United States, as an important, and perhaps unrivaled, hub for its technical collection efforts here. But, as I discovered, it was what these efforts entailed that is key to understanding why San Francisco — the oldest and most established Russian Consulate in the United States — was singled out for closure.

For many decades, U.S. officials have been keenly aware that, because of the consulate’s proximity to Silicon Valley, educational institutions such as Stanford and Berkeley, and the large number of nearby defense contractors and researchers — including two Energy Department-affiliated nuclear weapons laboratories — Russia has used San Francisco as a focal point for espionage activity. The modalities of Russian espionage in the Bay Area have historically been well known to U.S. counterintelligence personnel, who understand (at least generally) what the Russians will target and how they will try to achieve their objectives.

One former senior counterintelligence executive, for example, recalled the “disproportionate number” of science- and technology-focused Russian intelligence officers based in San Francisco, some of whom were experts in encryption and were tasked with identifying new developments in such technologies in Silicon Valley. A second former intelligence official noted the long-standing interest of Russian intelligence operatives in San Francisco in building relationships with local tech experts and venture capital firms. What has evolved, noted multiple former officials, is the intensity of Russian efforts. According to Kathleen Puckett, who spent two decades working on counterintelligence in the Bay Area, “there was more aggressiveness by the Russians in the 2000s than back in the 1980s.”

Starting roughly 10 years ago — and perhaps going even longer back, according to multiple former U.S. intelligence officials — something changed. Suspected Russian intelligence officers, often fully aware they were being surveilled by the FBI, began showcasing inexplicable and bizarre behaviors in remote, forlorn, or just seemingly random places.

It is highly likely, sources told me, that the consulate’s closure was linked to U.S. intelligence officials definitively proving long-held suspicions about the objectives of these Russian activities — or that officials could simply no longer countenance these extraordinarily aggressive intelligence-collection efforts and seized on the opportunity to disrupt them after Putin’s latest diplomatic salvo.

What seems clear is that when it came to Russian spying, San Francisco was at the very forefront of innovation.


Imagine driving up and over Mount Tamalpais, the iconic 2,500-foot peak located just north of San Francisco, then switch-backing precipitously through a redwood-studded ravine until, over the horizon, you spot a giant, shimmering, curvilinear beachfront. This is Stinson Beach, a 45-minute drive from the city. Now imagine that, standing out at the water’s edge, is a man in a suit — a man known to U.S. intelligence as a Russian intelligence officer. He has a small device in his hand. He stares out at the ocean for a few minutes, turns around, walks to his car, and leaves.

This account, confirmed to me by multiple former U.S. counterintelligence officials, is one example of a spate of such odd behaviors. Suspected Russian intelligence operatives — under diplomatic cover as well as travelers visiting the country — were also found idling in wheat fields and in the mountains of the Pacific Northwest, among other places. Russia has a “long and successful record of using legal travelers” for intelligence-gathering purposes, Steven Hall, the CIA’s former chief of Russia operations, told me. “This ranges, for example, from someone who gets a visa to do a scholarly presentation to someone who says they want to visit Napa Valley on their vacation,” he said.

Some suspected Russian intelligence officers were found engaging in weird, repetitive behaviors in gas stations in dusky, arid burgs off Interstate 5, California’s main north-south artery. In one remarkably strange case, said one former intelligence official, two suspected Russian spies were surveilled pulling into a gas station. The driver stood next to his car, not purchasing any fuel. The passenger approached a tree, circling it a few times. Then they both got back into the car and drove away. Suspected Russian intelligence operatives would perform the same strange rituals multiple times at the same gas stations.

Multiple theories about these activities emerged. One was that the Russians were trying to confuse and overwhelm their FBI surveillance teams, in order to gauge just how extensive their coverage really was — in other words, to test the capacity of their counterspies. Another theory revolved around a long-standing communications technique among Russian spies, known as “burst transmissions,” wherein intelligence operatives transmit data to one another via short-wave radio communications. But for these, said another former intelligence official, you need a line of sight, and such transmissions are only effective at relatively short distances.

Many of these behaviors, however, didn’t seem to fit a mold. For one, the FBI couldn’t establish that these suspected Russian intelligence operatives — some of whom were spotted with little devices in their hands, others without — were engaging in any communications. But according to multiple sources, one recurrent and worrying feature of these activities was that they often happened to correspond to places where underground nodes connected the country’s fiber-optic cable network. (In a June article, Politico’s Ali Watkins reported a few instances of these strange behaviors, tracing them back to the summer of 2016, as well as their potential connection to the fiber-optic network.)

Over time, multiple former intelligence officials told me, the FBI concluded that Russia was engaged in a massive, long-running, and continuous data-collection operation: a mission to comprehensively locate all of America’s underground communications nodes, and to map out and catalogue the points in the fiber-optic network where data were being transferred. They were “obviously trying to determine how sophisticated our intelligence network is,” said one former official, and these activities “helped them put the dots together.”

Sometimes, multiple former U.S. intelligence officials told me, Russian operatives appeared to be actively attempting to penetrate communications infrastructure — especially where undersea cables came ashore on both the Atlantic and Pacific coasts. They were “pretty sure” said a former intelligence official that, on at least one occasion on land, a Russian operative successfully broke into a data closet (a telecommunications and hardware storage center) as part of an attempt to penetrate one of these systems.

But what was “really unnerving,” said the former senior counterintelligence executive, was the Russians’ focus on communication nodes near military bases. According to multiple sources, U.S. officials eventually concluded that Moscow’s ultimate goal was to have the capacity to sever communications, paralyzing the U.S. military’s command and control systems, in case of a confrontation between the two powers. “If they can shut down our grid, and we go blind,” noted a former intelligence official, “they are closer to leveling the playing field,” because the United States is widely considered to possess superior command and control capabilities. When I described this purported effort to map out the fiber-optic network to Hall, the former senior CIA official, he seemed unfazed. “In the context of the Russians trying to conduct hybrid warfare in the United States, using cyber-types of tools,” he said, “none of what you described would surprise me.”

Multiple former intelligence officials also told me that U.S. officials were concerned that Russian intelligence operatives would provide these coordinates to deep-cover “illegals” — that is, Russian spies in the country under non-diplomatic cover (think of the Anna Chapman network) — or travelers, who might then carry out a sabotage campaign. There were also concerns that Russia could share these coordinates with other hostile foreign-intelligence services, such as a potential illegal Iranian network operating within the country.

As these strange activities persisted over the last decade, former intelligence officials told me, the FBI began to collate and compare surveillance reports from across the country, overlaying them with Russian flight paths occurring as part of the overt Treaty on Open Skies collection program.

The treaty, which entered into force in 2002, allows both the United States and Russia (and 32 other signatories) to conduct a limited number of unarmed surveillance and reconnaissance flights over each other’s territory per year. (According to the State Department, as of 2016 the United States had flown a total of 196 such flights over Russia, while Russia had flown 71 flights over the United States.) The methods of collection — video, photographic, infrared, and radar — are highly regulated and circumscribed, and the country whose territory is being flown over must approve the requested flight path. Flights are monitored in person by representatives of the host government. Afterward, upon request, the collected data must be shared with all treaty signatories. Open Skies was conceived, essentially, as an arms-control agreement: an attempt to decrease, through greater transparency, the uncertainties surrounding each great power’s array of military forces, which could lead to an erroneous nuclear exchange.

But U.S. intelligence officials began to notice a disturbing pattern vis-à-vis these “strange activities” and Open Skies: Suspected Russian operatives were appearing in places that had recently been, or were later, part of Russian flyovers. If these operatives were on the ground prior to the flight, U.S. officials suspected that they were likely helping shape coordinates for subsequent Open Skies missions, multiple former intelligence officials told me. If they appeared afterward, U.S. officials believed that the Russians had identified a potential object of interest (such as a fiber-optic node) and wanted in-person confirmation on what previously been identified during a flyover. There is simply “no substitute for someone literally going to locations and recording GPS coordinates,” said the former senior counterintelligence executive. “From 30,000 feet, you’re not necessarily going to have accuracy if you’re pinpointing a portal.”

Eventually, U.S intelligence officials hit on another series of correlations: Not only were suspected spies visiting the same places that Russian surveillance planes were flying over as part of their Open Skies missions, but they were also appearing directly beneath these planes, in real time, while these flights were ongoing. “The idea was that some kind of communication could have been taking place between the plane and guy on the ground,” one former intelligence official told me. “The hard part was to confirm exactly what they were doing.” (Foreign Policy could not verify whether U.S. officials were able to definitively establish if, or how, such communications indeed occurred.)

One theory, relayed to me by multiple sources, was that the Russians might have been using the flights as a communication platform — airplanes can act as a kind of cell tower, the former officials noted, receiving and transmitting data. If Moscow was concerned that U.S. counterintelligence was able to intercept encrypted data from secure communications facilities based in their diplomatic compounds, the Russians might have been seeking to bypass this possibility by secretly routing data through the passing airplanes. “If a U.S. monitor is watching three functions aboard an Open Skies flight,” worried one former intelligence official, “maybe the fourth function is covert — out of sight and out of mind of observers — and while the monitor is looking at these other functions, the transmission and receipt of data is occurring under their nose.”

If true, these actions by Russia would appear to violate the spirit of the Treaty on Open Skies, if not the letter itself. The treaty has strict restrictions on the types of collection that is permitted, and any covert ground-to-air communication or data transfer occurring between an aircraft and a suspected intelligence officer located below would seem to clearly contravene the agreement. This entire data-collection operation for the western United States, said one former senior counterintelligence executive, was being managed out of the San Francisco consulate.



Russia has aggressively exploited its diplomatic presence in San Francisco for decades, and the United States has historically responded in kind. In 1983, for instance, the State Department issued new guidelines forbidding Soviet diplomats and journalists from visiting Silicon Valley.

In the Ronald Reagan era, the consulate figured prominently in a number of sordid cases featuring American turncoats — including those of Allen John Davies, a former Air Force sergeant who offered the Soviets information on a secret U.S. reconnaissance program, and Richard Miller, the first FBI agent ever to be convicted of espionage, who was sleeping with — and passing information to — a Soviet agent being run out of San Francisco. In 1986, 13 San Francisco-based Soviet diplomats, accused of spying, were expelled by the Reagan administration; soon after, the Soviets publicly accused the FBI of operating a sophisticated bugging system in San Francisco via a tunnel it had secretly bored under the consulate. (“Obviously” the building was bugged around this time, said Rick Smith, who worked on Russian counterintelligence for the FBI in San Francisco from 1972 to 1992.)

In the 1970s and 1980s, the Soviets’ interest in San Francisco “was primarily about economic, and not really political, intelligence,” said Oleg Kalugin, a former KGB major general who served as the deputy (and later acting) chief of the KGB station at the Soviet Embassy in Washington from 1975 to 1980. “The main priority of Russian intelligence at that point was industrial development, technological development, to get equal to the United States,” said Kalugin.

Quietly but unquestionably, San Francisco had become a locus of Russian spying. “In recent years,” states a 1984 UPI article, “there have been frequent reports that 50 or more spies report to the San Francisco consulate general.” In fact, wrote the San Jose Mercury in 1985, “FBI officials believe Soviet spying on the West Coast is controlled” from this location. “Agents say the Soviets eavesdrop on the Silicon Valley from the roof of the consulate using sophisticated electronics made in the United States.”

The giveaway, even then, was the roof: covered with satellite dishes, antennae, and makeshift shacks, these devices pointed to a robust Russian signals-intelligence presence. (The shacks, which persisted until recently, one former intelligence official told me, were erected to conceal the shape of the transmission devices from U.S. intelligence agencies, which would occasionally conduct reconnaissance overhead.)

During that time, “there was nothing but antennas and signals” on the top of the building, recalled former FBI agent LaRae Quy, who spent nearly two decades working counterintelligence in San Francisco. “It was embarrassing that we would allow that to happen. But I guess that’s what the Russians did for us as well.” Quy, who retired in 2006, also told me that at least 50 percent of all San Francisco consulate personnel in the 1980s were full- or part-time spies.

This focus on signals and technical intelligence persisted until much more recently, multiple former U.S. intelligence officials told me. “It was almost like everyone they had there was a technical guy, as opposed to a human-intelligence guy,” one former official recalled. “The way they protected those people — they were rarely out in the community. It was work, home, work, home. When they’d go out and about, to play hockey or to drink, they’d be in a group. It was hard to penetrate.” The same official also noted that San Francisco was integral to the discovery by U.S. intelligence of a new class of Russian “technical-type” intelligence officer, working for the rough Russian equivalent of the National Security Agency, before this organization was eventually folded by Putin back into the FSB. This group, which was not based at the consulate itself, was identified via its members’ travel patterns — they would visit the Bay Area frequently — and the types of individuals, all in high-tech development, with whom they sought contact. According to this former U.S. official, these Russian intelligence officers were particularly interested in discussing cryptology and the Next Generation Internet program.

But it was the consulate’s location — perched high atop that hill in Pacific Heights, with a direct line of sight out to the ocean — that likely determined the concentration of signals activity. Certain types of highly encrypted communications cannot be transmitted over long distances, and multiple sources told me that U.S. officials believed that Russian intelligence potentially took advantage of the consulate’s location to communicate with submarines, trawlers, or listening posts located in international waters off the Northern California coast. (Russian intelligence officers may also have been remotely transmitting data to spy stations offshore, multiple former intelligence officials told me, explaining the odd behaviors on Stinson Beach.) It is also “very possible,” said one former intelligence official, that the Russians were using the San Francisco consulate to monitor the movements, and perhaps communications, of the dozen or so U.S. nuclear-armed submarines that routinely patrol the Pacific from their base in Washington state.

All in all, said this same official, it was “very likely” that the consulate functioned for Russia as a classified communications hub for the entire western United States — and, perhaps, the entire western part of the hemisphere.



The closure of the San Francisco consulate cannot, of course, be decoupled from the political circumstances surrounding it. Because of the unique, and uniquely unsettling, history and attitude of U.S. President Donald Trump toward Russia — the one country treated with forbearance by a president who blithely aggrieves adversaries and allies alike — the administration’s actions in San Francisco were viewed with perplexity and suspicion by a number of the former intelligence officials with whom I spoke.

First, some note, there is the issue of retaliatory balance: In these kinds of diplomatic conflicts, there is an expectation of parity in terms of the damage you inflict on your antagonist. Putin’s move — to order a 755-person staff decrease among U.S. diplomatic mission employees in Russia — appeared far more aggressive than it actually was. The U.S. government employs hundreds of Russians (knowing full well that some may be spies) to help staff its diplomatic facilities in that country, and almost all the affected individuals under these cuts were Russian nationals, not U.S. diplomats or intelligence officials in Russia under diplomatic cover. The sting of this decision was further lessened by the fact that, as one source told me, U.S. intelligence officials have been pushing the State Department for years to decrease local staff in its diplomatic facilities in Russia because of ubiquitous concerns about espionage. Putin’s decision, then, was not without risks for Russian intelligence-gathering operations themselves. “The downside for the Russians is that [by ordering the staffing decrease] you’re the cutting number of potential informants,” noted Hall, the CIA’s former chief of Russia operations.

The outright shuttering of the San Francisco consulate by the Trump administration, then, seems to be a more severe countermeasure than the Russian actions that immediately precipitated it. The closure announcement, Hall said, was “great news, and long overdue.” Stephanie Douglas, who served as the FBI special agent in charge of the San Francisco Division from 2009 to 2012, characterized the administration’s decision as “incredibly aggressive and pretty stunning, honestly.” It was “a blow to the Russians to have this consulate close, in particular,” the former senior counterintelligence executive said. Another former intelligence official called it “unprecedented.” Compounding the mystery further has been Russia’s relatively muted response; a sign, this last former official speculated, that Putin may still be holding out hope for some kind of grand bargain with the Trump administration. “If they don’t react to closing of the San Francisco consulate,” wondered the former official, “what’s the payback they’re waiting for?”

The incongruities here are unsettling. On the one hand, Trump’s decision to shut down the San Francisco consulate was far more consequential and assertive than most realized at the time; on the other hand, there is no evidence — nor any good reason to believe, given his past proclivities — that Trump himself understood the gravity of his own move. “Based on my other interactions with West Wing officials, and the depth of their understanding on the issues in general, I would be very surprised personally if President Trump had any … comprehension of that at all,” said Jeffrey Edmonds, who served as the National Security Council’s director for Russia until April 2017.

Edmonds suggested the locus of the closure decision was likely the National Security Council’s Principals Committee — particularly Secretary of State Rex Tillerson and Secretary of Defense James Mattis — and that the move was thereafter delivered to Trump as a fait accompli. “I’ve heard that, generally, when Tillerson and Mattis come to an agreement and present something to the president, he’s usually pretty on board with that,” Edmonds said.

This National Security Council-centered account was the most benign theory I heard. One former intelligence official offered that the consulate’s closure may be a signal from Trump to Robert Mueller, a way for the president to show the special counsel appointed to investigate election-year collusion with Moscow that his administration is not in thrall to Russian interests, financially or personally. A second former official speculated that the closure will be temporary and that after, say, a future terrorist attack in the United States, Moscow might ostentatiously offer to provide intelligence on the perpetrators, and the Trump administration — grateful for Russia’s cooperation and assistance — might then return the building to its erstwhile tenants.

These former U.S. officials were as united in their opinion about Russia’s long-term objectives as they were divided about Trump’s short-term intentions. Every former intelligence officer I spoke with for this story was confident that Russia will continue aggressive human-intelligence-gathering operations in the Bay Area, likely through individuals under non-official cover — say, via engineers or data scientists. “Silicon Valley loves Russian programmers,” remarked one former intelligence official.

The dynamics and methods they employ will necessarily change, these officials said, but San Francisco and Silicon Valley are simply too target-rich, too valuable, and too soft for them to cease activities here. The spy war will endure; the Russians will, over time, rebuild their networks, adjusting their activities to account for their lack of local diplomatic cover. Ultimately, the circumstances surrounding the closure of the San Francisco consulate are just one piece in a much larger, and far more shadowy, antagonism between the two nuclear superpowers. “The great game is upon us again,” one former intelligence official said to me. “San Francisco has always been a focal point for Russian interests. The work won’t stop.”


Zach Dorfman is a senior fellow at the Carnegie Council for Ethics in International Affairs and an investigative journalist.


Why Europe need not kowtow to China

With a modicum of confidence, EU nations can set the terms of the relationship

Philip Stephens



It is a commonplace in Chinese commentary that Europe is in irreversible decline. Hope, you suspect, is welded to expectation. Democracies, the story goes, are in trouble as the old economic powers are left behind. China is stealing a technological march. As the US turns inward, an enfeebled Europe will have to turn eastward. China’s grand “one belt, one road” project will connect east to west, new to old. Guess who will be in charge?

Western liberalism, this prognosis has it, has outlived its time. Cumbersome, inefficient and divisive, it lacks the unity of purpose harnessed by autocratic regimes. Nor can it any longer meet the demands of the people — witness the trouncing of the old elite by Donald Trump in the US and the nationalist backlash in much of Europe. The future belongs to strongman leaders untroubled by the competing demands of pluralist societies — Vladimir Putin in Russia, Recep Tayyip Erdogan in Turkey and, above all, China’s Xi Jinping.

Europeans are often too feeble in the face of such jibes. The autocrats, otherwise intelligent people mutter, have a point. Mr Xi has attached the might of the state to his great China dream. The breathless advance of technology is allowing autocrats to tighten their grip on the state. Look at China’s chilling experiment to capture digitally every detail of its citizens’ lives in a single electronic “rating”, combining everything from credit status to fealty to the party.

Economic weakness at home has seen EU governments scramble for the benefits of doing business with a booming China. They have allowed Beijing to play divide and rule. London, Paris and Berlin have had their sights on the rich market for exports; smaller economies on the eastern periphery seek a new source of investment. Human rights now take a back seat.

All true. But, as the European Council on Foreign Relations says in an excellent analysis of the balance of power in the EU-China relationship, even the most enthusiastic mercantilists have begun to count the costs of doing business with Beijing. Win-win too often refers to a double whammy for China.

There is anyway a bigger flaw in these grand predictive sweeps. The organising assumption is that history travels in straight lines — that Europe’s troubles are inescapable and that China will be forever impervious to the economic cycle and the human desire for freedom.

To the contrary, the EU is on the mend. Sure, Britain is leaving, but every passing week simply confirms Brexit as a grotesque act of self-harm. The rest of the continent has rediscovered economic growth. Unemployment is falling and investment rising. Greece no longer threatens to collapse the eurozone. The migration crisis has subsided. There are strong hopes in Paris and Berlin for a reinvigoration of the Franco-German relationship. In short, Europe no longer feels like a continent flat on its back.

As for European democracy, the populists have been held at bay. For all the imperfections, successive crises have also shown the peculiar resilience of democratic systems. Chucking out the rascals is a safety valve. Angry though they might be, voters are not clamouring for curbs on individual freedom or yearning for despotic rule. What is needed now is for Europe to recover confidence in its values and institutions.

The oft-rehearsed argument between those certain that China will soon rule the world and others sure that it will collapse under the collision of rising living standards and political repression is a silly one.

What can be sensibly be said is that China has plenty of hurdles yet to jump before it realises Mr Xi’s dream. Party rule rests on a fragile bargain — economic prosperity in return for the absence of freedom. One of the striking features of authoritarian regimes is their brittleness.

They are unassailable until the moment they break.

Where Beijing is right is that the relationship between China and Europe will be as important as any in shaping geopolitics during coming decades. The belligerent isolationism of Mr Trump’s foreign policy is unlikely to survive beyond his presidency, but it is a fair assessment that his successors in the White House will draw tighter lines around America’s international commitments.

So the focus of geopolitical attention will shift from the littoral states of the north Atlantic to what the late Zbigniew Brzezinski once called the “axial supercontinent” of Eurasia. This is the vast space over which China would like to hold sway during the second half of the 21st century.

The EU has a choice: it can be supplicant, partner or roadblock.

Europe is rich, technologically advanced and educationally sophisticated. “One belt, one road” is an offer it can refuse. At the very least it can set its own terms for the relationship. If China wants connectivity it must open up its own economy; if it wants to be an investment partner, it should observe European standards and norms. All that is required of EU nations is a modicum of confidence and shared resolve.

Europe has taken a battering. China’s rise has been amplified by western disarray. Geopolitics, though, is a long game. Not so long ago the US called itself the indispensable superpower.

Beijing is not immune from such hubris. China may be at the gates, but Europe should feel no obligation to bow to Beijing.