The ETF Illusion: An Inside Look

by: The Heisenberg

- Bond ETFs - and especially the high yield variety - should come with a bright, red "buyer beware" stamp on the prospectus.

- But they don't. Which means it's up to you to do the research and understand what the risks are.

- Herein find my most comprehensive look at ETF liquidity to date.

Ok, today's the day.

I've been trying to free up some time to write this post for nearly a week, and I keep putting it off because between French election drama and a veritable deluge of new research from analysts looking to quantity the chances of an equity market selloff, there's simply been too much going on for me to refocus on what very well might be my favorite topic: bond market liquidity and the danger posed by corporate credit ETFs.

To be sure, we've been down this road before. Regular readers will recall Heisenberg's Labradors (here and here) and the series of posts that came later.

The thrust of the argument is as follows.

Corporate bond ETFs create what I like to call "phantom liquidity." What you see (or what you think you see) is not in fact what you get. This problem is especially acute in high yield ETFs like the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) and the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK).

In the post-crisis regulatory environment, dealers aren't willing to serve as middlemen - the cost of balance sheet is simply too high. What that means, in the simplest possible terms, is that in a pinch, no one is going to be willing to catch a falling knife or, in market parlance, "inventory" these bonds.

This creates a very real problem that the vast majority of ETF holders do not fully comprehend.

Consider the following excerpt from a 2016 Vanguard report amusingly called "ETFs: Clarity Amid The Clutter":
The creation and redemption mechanisms help ETF shares trade at a price close to the market value of their underlying assets. When rising demand for the shares causes them to trade at a higher price (i.e., at a premium), the AP may find it profitable to create shares by buying the underlying securities, exchanging them for ETF shares and then selling those shares into the market. Similarly, when falling demand for the ETF shares causes them to trade at a lower price (i.e., at a discount), an AP may buy shares in the secondary market and redeem them to the ETF in exchange for the underlying securities. These actions by APs, commonly described as "arbitrage activities", help keep the market-determined price of an ETF's shares close to the market value of the underlying assets.
Ok, so this is one of those times when you have to "just step back from it" (to quote Sgt. Jeffrey 'Jeff' Rabin in the "Usual Suspects").

That is, don't get bogged down in the lingo or let yourself be blinded by the technicalities because that's precisely what Vanguard does in the paper from which that excerpt is taken and it's precisely why they don't seem to understand the inherent risk here.

What that passage basically says is that in the event there's a lot of selling pressure in a particular ETF causing the shares to trade below the supposed value of the underlying assets (in this case bonds), broker-dealers are going to arb away that difference by buying the ETF shares at a discount, exchanging them for those underlying assets, and (implicitly) pocketing the spread.

Do you see a conceptual problem with that? I say "conceptual" because again, I'm not an ETF sponsor, so I'm not here to try and do a deep dive into the technicalities of this and/or try and quantify the extent to which this mechanism works on a daily basis. I don't care about that because obviously, I'm not talking about what happens on a daily basis. I'm talking about what would happen should something go wrong. When we start thinking in those terms, what was merely "conceptual" very often becomes reality.

So with that in mind think again about this statement from the Vanguard report (my highlights):
When falling demand for the ETF shares causes them to trade at a lower price (i.e., at a discount), an AP may buy shares in the secondary market and redeem them to the ETF in exchange for the underlying securities.
As I put it a few weeks ago in "'How Do You Sell It?' Vanguard Misses The Point On ETFs": "I'm not entirely sure how willing broker-dealers would be to arb this in a panic."

I mean think about it: would you want to try and arbitrage that disconnect if it meant taking on the balance sheet risk associated with exposing yourself to the underlying bonds? Probably not.

So having reviewed the back story here, I want to draw your attention to some new commentary from Barclays, whose analysts penned one of the most enlightening takes on this entire debate way back in June of 2015.

Let's start with a review of an important concept. I've paraphrased the above mentioned Barclays note (the one from 2015) so many times that I'm afraid we might be subject to the "Chinese whispers" effect, so I went back and dug up the original note.

The excerpts that follow are from the June 2015 Barclays piece. What you're about to read is a lengthy quote. It's lengthy on purpose. It is quite literally impossible to overstate how important this is for high yield ETF investors to understand. I'm not going to highlight anything here because frankly, it should all be highlighted. I strongly encourage you to read every word - maybe twice. To wit:

Are ETFs good or bad for corporate bond liquidity? In our view, the answer depends on the correlation of flows at the individual fund level. Although fund flows have been a major focus of market participants over the past several years, the aggregate flows attract the most attention. This is particularly true in the high yield market, where retail ownership is relatively high and the price swings associated with contemporaneous fund flows have been well documented.  
Aggregate flows have effectively become a market signal. 
However, fund managers actually have to manage their particular inflows and outflows, not the aggregate flows. From the perspective of an individual fund manager, the risk posed by fund flows and the strategies available to help mitigate that risk depend to a large extent on the correlation of flows across funds. If flows are highly correlated then the risk is relatively high. Funds will have a difficult time selling bonds when they experience an outflow, since other managers would similarly be selling. In this circumstance, managers have a relatively short list of strategies to deal with flows. They can keep increased cash on hand, or (less likely) they can hope that other non-retail buyers step into the market at a reasonable discount to market levels. 
On the other hand, if flows are relatively uncorrelated they may, in principle, pose less of a risk - funds with outflows can sell to those with inflows. Funds can exchange bonds (or portfolio products, see below) with other funds, rather than draw down on or build cash. This process may be made more difficult by the decline in liquidity, but the price discount/premium faced by an individual fund with an inflow or outflow could, theoretically, be limited by the existence of investors looking to go in the opposite direction. 
While diversifiable flows limit the risks to portfolio managers in principle, the reality of the high yield market is more complicated. Managers have specific views on tenor, callability, sectors, covenants, and, most importantly, individual credits, such that actually finding buyers for specific bonds can be quite difficult. In the pre-crisis period, dealers ran large inventories that effectively facilitated the netting of flows across funds (Figure 1). A fund with an outflow would sell bonds into the dealer community, and funds with outflows would buy bonds out of the dealer inventory. When inventory is large, the fact that the specific bonds bought and sold did not match was largely irrelevant. Funds with outflows could sell the bonds of their choice, and the funds with inflows could pick investments from the large variety of inventory held by dealers.

The matching problem has become more acute as dealer inventories have declined.  
Even if funds can net flows in principle, dealers are much less willing to warehouse bonds, and are much more likely to buy only when they believe they can quickly offload the risk. Under this scenario, the fact that flows can theoretically be netted is of little practical use to fund managers - actually netting individual bonds is extremely difficult, particularly in the short time frame required by funds offering daily liquidity to end investors. This is where portfolio products come in. Investors can use portfolio products to fund outflows/invest inflows immediately and execute the necessary single-name bond trades over time as liquidity in the underlying bond market allows (Figure 2). In this scenario, funds with inflows and outflows simply exchange portfolio products, sidestepping (the immediate need to trade single-name corporate bonds.
Do you see what's going on here?

No one is trading the high yield bonds that underpin these ETFs. When your fund manager experiences an outflow, he/she can effectively dodge the underlying bond market by trading ETF shares with another fund manager who is experiencing inflows.

This is what Vanguard means when they say things like this (my highlights):

Figure 3a shows the percentage of daily equity ETF trading volume conducted solely on the secondary market. The median ratio was 99%, suggesting that for every €1 in trading volume, only 1 cent resulted in primary market trading. Put another way, 99% of the trading volume resulted in no portfolio management impact and no trading in underlying securities (Figure 3b shows the same analysis for bond ETFs - the median ratio here was also 99%).

Notice how Vanguard is pitching this as a good thing. As I explained in what is now the most read piece in the short history of the Heisenberg Report, it is most assuredly not a good thing.

What it means (again) is that no one is trading the actual bonds. If one day everyone was dumping high yield ETFs, this entire model goes out the window. Recall what Barcalys said in the passages cited above (this time I will use highlights):
If flows are highly correlated then the risk is relatively high. Funds will have a difficult time selling bonds when they experience an outflow, since other managers would similarly be selling. In this circumstance, managers have a relatively short list of strategies to deal with flows. They can keep increased cash on hand, or (less likely) they can hope that other non-retail buyers step into the market at a reasonable discount to market levels.
See the problem? Note the bit about "they can keep increased cash on hand." Consider that, and then consider this headline that Reuters ran back in 2015:

Starting to get the picture? Here's a quote from that Reuters piece:
The biggest providers of exchange-traded funds, which have been funneling billions of investor dollars into some little-traded corners of the bond market, are bolstering bank credit lines for cash to tap in the event of a market meltdown.
Ok now, if you're following along, your next question should be something along these lines: "my God Heisenberg, how much of the trading in high yield ETFs is actual investors and how much is just portfolio managers swapping shares around?!"

Or, put differently: "to what extent, when I look at volumes in popular HY ETFs, am I seeing money managers dodging the actual markets for the bonds that underpin the ETF shares?!"
Or, my favorite derivation of the question: "to what extent am I watching portfolio managers sow the seeds of their own destruction?"

For the answer, we go to Barclays again. These excerpts are from a note out last week (my highlights):

On average, 54% of fund flows are "diversifiable," meaning that portfolio managers can reliably use ETFs instead of trading bonds to satisfy a significant share of their own fund flows. Indeed, an analysis of the magnitude of fund flows at the fund level suggests that approximately 25% of the outstanding float in high yield ETFs could be held by portfolio managers with daily liquidity needs. 
Several pieces of evidence support this view (alongside anecdotal evidence from money managers and ETF traders). The first is the high concentration of assets among passive high yield funds. The top three passive funds represent 68% of passive high yield assets, while the top three passive government and equity funds represent 39% and 16% of passive assets, respectively. All of the large passive funds in high yield are ETFs, which have the benefit of trading in the secondary market. High concentration leads to larger secondary flows, which is useful for institutional managers trying to use ETFs to manage inflows and outflows. Without sufficient secondary trading, selling of shares is more likely to lead to share destruction, which relies on the liquidity of the underlying market. ETFs mitigate liquidity needs only to the extent that their secondary trading volumes are large relative to primary volumes (ie, share creation and redemption volumes). A large number of thinly traded ETFs would not be useful to institutional managers.  
Indeed, the largest four high yield ETFs have secondary volumes of 4-8x primary volumes. 
The passive share of high yield fund AUM can therefore be thought of as comprising two different types of owners: retail investors that own ETFs as part of their investment strategy and institutions that use them primarily for liquidity management. Secondary flows from the first group are not replacing corporate bond trading - they are similar to gross flows for an open-end mutual fund, which are netted at NAV. Secondary flows from institutions, however, may be replacing trades in the underlying corporate bonds. 
This is an important differentiation, because the overall flows for high yield ETFs are large relative to the size of the high yield market, despite the relatively small size of the funds. Daily TRACE volumes in high yield bonds averaged $12bn last year. Secondary trading in the four largest high yield ETFs, which represent only about 3% of total high yield assets, was $1.6bn daily in 2016. The contrast in turnover is striking: we estimate annual turnover of about 1.4x for high yield, while the ETF numbers imply annual turnover of 10.7x. Secondary ETF volumes are so significant that, if they were fully substituting away from secondary corporate activity, the implications for bond turnover would be substantial. Figure 7 divides total secondary ETF volume by the size of the high yield market to convert those volumes into a turnover-equivalent measure.

Please take a second to think about that.

Fully one quarter of the outstanding float in popular HY ETFs is likely portfolio managers using the ETFs to manage flows. Translation: you are not looking at what you think you're looking at when you assess trading in those vehicles.

As for the last three bolded sentences in the excerpted passages above and the chart that follows them, I truly hope you internalize the message there. If what you're seeing in terms of action in HY ETFs translates directly into what we might call a "migration" from the cash bond market, the effect on turnover of the actual bonds is huge.

Barclays calls it "substantial." They're being polite. Allow me to employ a popular Katt Williams meme to illustrate what your reaction to that last excerpted paragraph should be:

As I've said more times than I care to remember, the problem with all of this (and hence the problem with Vanguard's take) is that when you stop using something (anything really, but in this case we're referring to the actual market for the underlying bonds), it invariably falls into disrepair.

That disrepair, combined with the absence of banks willing to lend their balance sheet (i.e. inventory bonds) in a pinch, means there's no liquidity for the assets that underpin these ETFs.

That lack of liquidity causes fund managers to use those very same ETFs to match flows. That substitution itself exacerbates the very same illiquidity that prompted the substitution in the first place. It's a self-fulfilling prophecy.

This is a textbook example of "caveat emptor."

The problem is, these ETFs don't come with a "buyer beware" stamp on the prospectus. Instead, they come with a BlackRock or a Barclays (an irony of ironies given the analysis above) stamp of approval.

With that, I'll close with a quote from Carl Icahn who spoke about all of the above in the summer of 2015:
Well, BlackRock has a great name, they're sitting with $4.7 trillion. That's pretty good. And we could buy one of their ETFs. OK, woo, that sounds good. Why not?

Stop Freaking Out About Body Fat

Fat is a vital organ that our bodies work hard to protect—so instead of battling fat, we should focus on maintaining a healthy level of it

By Sylvia Tara

Our culture is obsessed with shedding flab, writes Sylvia Tara, but normal amounts of fat help keep us healthy. Photo: iStock

The holidays are long over, but many Americans still have something to remember them by: extra pounds of fat. Our collective effort to fight the bulge makes the first few months of the new year the peak sales period for the U.S. dieting industry. Americans spend a fortune each year trying to get rid of fat, but the flab often creeps back, despite our best efforts. It seems as if our fat has a mind of its own—which, it turns out, isn’t as far-fetched as it sounds.

We usually think of fat as unhealthy excess storage to be gotten rid of at all costs, but researchers have reached a different conclusion: Fat is actually a vital organ that releases essential hormones and sends crucial messages to our brains. And because fat is so important, our bodies work hard to protect it. Instead of simply battling fat, we need to focus on how to maintain a healthy level of it.

Jeffrey Friedman, a molecular biologist at Rockefeller University, was among the first to discover that there was more to fat than just storing calories. In the 1980s, he was researching mice that ate uncontrollably. After nine years, Dr. Friedman discovered that fat produces a hormone that he named leptin (from the Greek leptos, or thin), which is released into the bloodstream and binds with areas of our brain responsible for appetite. His lab’s obese mice had a genetic defect in their fat that prevented them from making functional leptin and getting the signal to stop eating. Humans with a similar genetic defect can eventually eat themselves to death.

Fat’s connection with leptin poses a dilemma: When we lose fat, we also have decreased levels of leptin. As a result, we are hungrier than before weight loss. Leptin also affects our muscles and thyroid hormones, and reduced amounts of it slow down our metabolism. These combined effects of decreased levels of leptin drive us to regain weight.

We now know that fat also can affect brain size. People who are genetically leptin-deficient have smaller brain volume in some areas, as do patients who are malnourished because of anorexia. Leptin also enables wounds to heal faster and strengthens our immune system by activating T-cells.

And leptin isn’t the only crucial hormone produced by our fat. It also manufactures adiponectin, a hormone that keeps our blood clear of harmful toxins and fats.

The benevolent type of fat that is the primary producer of leptin and adiponectin is subcutaneous, found directly under our skin in places such as our abdomens, thighs, buttocks and arms. This should be distinguished from visceral fat, which is stored under the stomach wall, nestled against our internal organs. The latter is the “bad” fat that we hear so much about. It can become inflamed and lead to diabetes and heart disease.

But “good” fat can fight “bad” fat. By making adiponectin, subcutaneous fat guides circulating fats in our blood out of our veins and into the subcutaneous fat tissues where they belong. The hormone also reduces visceral fat. Luckily, exercise promotes the release of adiponectin. This is why sumo wrestlers are both fat and fit (at least until they retire): They exercise around seven hours a day, which helps keep their visceral fat under control even as they pile on the subcutaneous fat that they need to compete.

The new science of fat suggests some health pointers. First, we should appreciate our fat. Our culture is obsessed with shedding flab, as any sports or fashion magazine cover will tell you, but normal amounts help to keep us healthy.

Second, if you’re going to worry, focus on visceral fat, which is associated with disease. For those of us who aren’t sumo wrestlers, jogging 20 miles a week or doing intensive interval training three times a week has been linked with a reduction in visceral fat. Intermittent fasting—prolonging the overnight gap between meals to 14 hours or more—also can help.

Finally, if you are above the average fat mass range of 25-30% for women and 18-24% for men, and you want to maintain your weight loss, it may take more effort than you expect. Fat can alter our appetite and metabolism to drive us to regain weight, an effect that can last for years.

So real weight loss requires a long-term effort. By better understanding how fat works, what makes it accumulate (which isn’t just sloth and gluttony) and selecting a diet that will work over the years, we are more likely to succeed at keeping the pounds off.

And as you pick your personal weight targets, remember: Obesity is unhealthy, but too little fat isn’t good for you either.

—Dr. Tara is the author of “The Secret Life of Fat: The Science Behind the Body’s Least Understood Organ and What It Means for You” (Norton).

Donald Trump, Saudi Arabia, and the Petrodollar

by Nick Giambruno

Obama pulled out his veto pen 12 times during his presidency.

Congress only overrode him once…

In late 2016, Obama vetoed the Justice Against Sponsors of Terrorism Act (JASTA). The bill would allow 9/11 victims to sue Saudi Arabia in US courts.

With only months left in office, Obama wasn’t worried about the political price of opposing the bill. It was worth protecting Saudi Arabia and the petrodollar system, which underpins the US dollar’s role as the world’s premier currency.

Congress didn’t see it that way though. Those up for reelection couldn’t afford to side with Saudi Arabia over US victims. So Congress voted to override Obama’s veto, and JASTA became the law of the land.

The Saudis, quite correctly, see this as a huge threat. If they can be sued in US courts, their vast holdings of US assets are at risk of being frozen or seized.

The Saudi foreign minister promptly threatened to sell all of the country’s US assets.

Basically, Saudi Arabia was threatening to rip up the petrodollar arrangement, which underpins the US dollar’s role as the world’s premier currency.

Donald Trump and the Saudis

Unlike every president since the petrodollar’s birth, Donald Trump is openly hostile to Saudi Arabia.

Recently he put this out on Twitter:

Dopey Prince @Alwaleed_Talal wants to control our U.S. politicians with daddy’s money. Can’t do it when I get elected.

The dopey prince that Trump is referring to is Al-Waleed bin Talal, a prominent member of the Saudi royal family. He’s also one of the largest foreign investors in the US economy, particularly in media and financial companies.

The Saudis openly backed Hillary during the election. In fact, they “donated” an estimated $10 million–$25 million to the Clinton Foundation, making them the most generous foreign donors.

Besides Hillary Clinton, the single biggest loser from the US presidential election was Saudi Arabia.

The Saudis did not want Donald Trump in the White House. And not because of some bad blood on Twitter. There are real geopolitical issues at stake.

At the moment, Trump seems determined to walk back on US support for the so-called “moderate” rebels in Syria.

The Saudis are furious with the US for not holding up its part of the petrodollar deal. They think the US should have already attacked Syria as part of its commitment to keep the region safe for the monarchy.

Toppling Syrian President Bashar al-Assad is a longstanding Saudi goal. But a President Trump makes that unlikely. That’s not good for Saudi Arabia’s position in the Middle East, nor its relationship with the US.

This is just one of the ways President Trump will hasten the death of the petrodollar.

Saudi Arabia, Islam, and Wahhabism

I loathe quoting a neoconservative historian like Bernard Lewis, but even a broken clock is right twice a day:

Imagine if the Ku Klux Klan or Aryan Nation obtained total control of Texas and had at its disposal all the oil revenues, and used this money to establish a network of well-endowed schools and colleges all over Christendom peddling their particular brand of Christianity.

This is what the Saudis have done with Wahhabism. The oil money has enabled them to spread this fanatical, destructive form of Islam all over the Muslim world and among Muslims in the West.

Without oil and the creation of the Saudi kingdom, Wahhabism would have remained a lunatic fringe in a marginal country.

This is actually an apt description of Wahhabism, a particularly virulent and intolerant strain of Sunni Islam most Saudis follow. ISIS, Al Qaeda, the Taliban, and a slew of other extremists also follow this puritanical brand of Islam. That’s why Saudi Arabia and ISIS use the same brutal punishments, like beheadings.

Many Wahhabis consider Muslims of any other flavor—like the Shia in Iran, the Alawites in Syria, or non-Wahhabi Sunnis—apostates worthy of death.

In many ways, Saudi Arabia is an institutionalized version of ISIS. There’s even a grim joke that Saudi Arabia is simply “an ISIS that made it.”

After living in the Middle East for three years, it’s clear to me that many people in the region despise everything about Wahhabism. Yet it flourishes in certain Sunni communities, among people who feel they have nowhere else to turn.

It’s also widely believed in the Middle East that Western powers deliberately fostered Wahhabism, to a degree, to keep the region weak and divided—and as a weapon against Shia Iran and its allies. That includes Syria and post-Saddam Iraq, which has shifted its allegiance towards Iran.

Thanks to WikiLeaks we know the Saudi and Qatari governments, which are also the two largest foreign donors to the Clinton Foundation, willfully financed ISIS to help topple Bashar al-Assad of Syria. Julian Assange says the email revealing this is the most significant among the Clinton-related emails his group has released.

Here’s an excerpt of the relevant interview with Assange:

Interviewer: Of course, the consequence of that is that this notorious jihadist group, called ISIL or ISIS, is created largely with money from people who are giving money to the Clinton Foundation?

Julian Assange: Yes.

Interviewer: That’s extraordinary…

With all this in mind, Vladimir Putin opened an unusual conference of Sunni Muslim clerics recently.

It took place in Grozny, the capital of Chechnya, a Sunni Muslim region within Russia’s southwestern border.

The conference, which included 200 of the top non-Wahhabi Sunni Muslim clerics, issued an extraordinary statement labeling Wahhabism “a dangerous deformation” of Sunni Islam.

These clerics carry serious weight in the Sunni world. The imam of Egypt’s al-Azhar mosque, one of the most important Islamic theological centers, was among them. (Egypt is the Arab world’s most populous Sunni country.)

Basically, Putin gathered the world’s most important non-Wahhabi clerics to “excommunicate” the Saudis from Sunni Islam. In other words, Putin is going for the jugular of the petrodollar system.

Russia and Saudi Arabia have been enemies for decades. The Russians have never forgiven Saudi Arabia (or the US) for supporting the Afghan mujahedeen that drove the Soviet Army out of Afghanistan. And they haven’t forgiven the Saudis for supporting multiple Chechen rebellions.

As far as I know, the British writer Robert Fisk was the only Western journalist to cover this extraordinary conference.

Here’s Fisk:

Who are the real representatives of Sunni Muslims if the Saudis are to be shoved aside? And what is the future of Saudi Arabia? Of such questions are revolutions made.

If the Saudis are shoved aside, it could strike a fatal blow to the petrodollar system.

The truth is, the petrodollar system is in its death throes. It doesn’t matter if the Saudis willfully abandon it, or if it crumbles because the kingdom implodes. The end result will be the same.

Right now, the stars are aligning against the Saudi kingdom. This is its most vulnerable moment since its 1932 founding.

That’s why I think the death of the petrodollar system is the No. 1 black swan event for 2017.

I expect the dollar price of gold to soar when the petrodollar system crumbles in the not-so-distant future. You don’t want to find yourself on the wrong side of history when that happens.

But that brings up another crucial point. There’s also likely to be severe inflation.

The petrodollar system has allowed the US government and many Americans to live way beyond their means for decades.

The US takes this unique position for granted. But it will disappear once the dollar loses its premier status.

This will likely be the tipping point…

Afterward, the US government will be desperate enough to implement capital controls, people controls, nationalization of retirement savings, and other forms of wealth confiscation.

I urge you to prepare for the economic and sociopolitical fallout while you still can. Expect bigger government, less freedom, shrinking prosperity… and possibly worse.

It’s probably not going to happen tomorrow. But it’s clear where the trend is headed.

It is very possible that one day soon, Americans will wake up to a new reality.

Once the petrodollar system kicks the bucket and the dollar loses its status as the world’s premier reserve currency, you will have few, if any, options.

The sad truth is, most people have no idea how bad things could get, let alone how to prepare…

The Worst and the Dimmest

The wheels are falling off Donald Trump’s foreign policy, and the adults aren’t at the Wheel.

By Max Boot

The Worst and the Dimmest

Back in 2001, during the “end of history” interregnum between the Cold War and 9/11, Henry Kissinger published a book called Does America Need a Foreign Policy? It was obviously a rhetorical question coming from a master of diplomacy. But now it is a very real issue, because the United States under President Donald Trump does not actually seem to have a foreign policy. Or, to be exact, it has several foreign policies — and it is not obvious whether anyone, including the president himself, speaks for the entire administration.

On Feb. 15, for example, Trump was asked, during a joint news conference with Israeli Prime Minister Benjamin Netanyahu, whether he still supported a two-state solution for Israel and Palestine. His insouciant reply? “So I’m looking at two-state and one-state, and I like the one that both parties like. I’m very happy with the one that both parties like. I can live with either one.” This immediately prompted news coverage that, as a New York Times article had it, “President Trump jettisoned two decades of diplomatic orthodoxy on Wednesday by declaring that the United States would no longer insist on the creation of a Palestinian state as part of a peace accord between Israel and the Palestinians.”

But had Trump meant to do that? His remarks sounded as if they were being improvised off the top of his head. Did they actually denote a change of policy? Sure enough, 24 hours later, Trump’s ambassador to the United Nations, Nikki Haley, told reporters that “the two-state solution is what we support. Anybody that wants to say the United States does not support the two-state solution — that would be an error,” thus suggesting that the president was mistaken about his own administration’s policies. It soon emerged, thanks to Politico’s reporting, that the secretary of state, Rex Tillerson, had not been consulted or even informed beforehand about what was, in theory at least, a momentous policy shift: “At the White House, there was little thought about notifying the nation’s top diplomat because, as one senior staffer put it, ‘everyone knows Jared [Kushner] is running point on the Israel stuff.’”

This was not, of course, an isolated incident. Trump’s recently fired national security advisor, Michael Flynn, apparently did consult with the Department of Defense prior to announcing, ominously, on Feb. 1 that Iran was being put “on notice,” whatever that means. But, according to a New Yorker profile of Flynn, the Pentagon’s attempts to soften some of his language and to take out criticism of the Barack Obama administration were simply ignored. And there clearly was no preparation at either the Defense Department or Central Command to back up this ultimatum that could result in war with Iran. “Planning is trying to keep up with the rhetoric,” a “senior defense official” told Nicholas Schmidle of the New Yorker.

So much for the hopes that Trump’s seasoned cabinet appointees — especially retired Gen. John Kelly at Homeland Security, retired Gen. James Mattis at Defense, and former ExxonMobil CEO Rex Tillerson at State — could direct administration policy on a more mainstream course. Perhaps they will exert a bigger influence down the road, especially now that they will have a valuable ally in the new national security advisor, Lt. Gen. H.R. McMaster, but so far their impact has been decidedly limited. They have had to fight for influence with Steve Bannon, the white nationalist ideologue who has been inexplicably granted a place on the National Security Council’s top-level Principals Committee, and Jared Kushner, Trump’s son-in-law who has been granted nebulous authority over areas such as Mexico and Israel. Bannon has even created his own shadow NSC, called the Strategic Initiatives Group, staffed by people such as the anti-Muslim extremist Sebastian Gorka.

Bannon showed just how much power he wields when he vetoed Tillerson’s choice for deputy secretary of state — Elliott Abrams. One suspects that, from Bannon’s standpoint, Abrams had multiple strikes against him: Not only is he Jewish and a “neocon,” hence hostile to isolationism and nativism, but he has vast policymaking experience stretching back to the Ronald Reagan administration. Bannon, who has never served in government outside his time as a junior naval officer decades ago, must have known Abrams would be a formidable bureaucratic adversary — one who could make up for Tillerson’s own lack of policymaking background. So Bannon apparently sabotaged Abrams’s nomination by putting before Trump a single article that Abrams had written last year critical of him. That this is not just about loyalty to the president is obvious from the fact that Rick Perry, who once called Trump a “cancer on conservatism,” was appointed as energy secretary. But then nobody in the White House cares who runs the Energy Department or considers Perry any kind of threat. Abrams was different — and thus he could not be allowed to join the administration.

President Bannon’s insistence on maintaining control also appears to be behind the problems the administration is having in finding a new national security advisor to replace Flynn. The first choice — retired Vice Adm. Bob Harward — turned down the post after Trump made it clear that he would not be allowed to pick his own deputy (for some reason Harward did not think that K.T. McFarland was qualified despite her years of pithy Fox News commentary) or to get any guarantees of a clear chain of command that would exclude interference from Bannon and Kushner. This was, among other things, a message that Mattis, who is close to Harward and recommended him, does not exercise any more sway than Tillerson over key administration appointments.

Retired Gen. David Petraeus, another highly qualified pick, was said to have withdrawn from consideration next after he made similar demands. An anonymous official revealed the insular and arrogant White House mindset when he told the Wall Street Journal: “It is dumb to demand Flynn’s people go. Why are you creating embarrassment? If you make that a precondition, you are not a loyal soldier and you don’t deserve the job.” This is reminiscent of the misplaced self-confidence of the “best and brightest” of the John F. Kennedy and Lyndon Johnson administrations — only Trump and his circle are far from bright or the best at anything other than bamboozling those who credulously place faith in them.

Trump finally selected as his national security advisor H.R. McMaster, a serving officer who would have had difficulty in turning down the commander in chief, or conditioning his acceptance on certain conditions as Harward did. McMaster is one of the outstanding officers of his generation, a rare combination of soldier and scholar who has literally written the book — Dereliction of Duty: Lyndon Johnson, Robert McNamara, The Joint Chiefs of Staff, and the Lies That Led to Vietnam — on the need for the military to speak truth to its political masters. It is hard to imagine a better choice for the post, yet even McMaster will have difficulty bringing any order to American foreign policy as long as Bannon and Kushner continue to pursue their own policies and as long as the president continues to make incendiary and ill-considered statements that needlessly aggravate friendly states — most recently Sweden — while calling into question basic American foreign-policy commitments. Trump may think the White House is a “fine-tuned machine,” but it is in fact a jalopy whose wheels are falling off while it’s going 60 mph, and it’s far from clear that even McMaster can perform the needed repairs en route.
 Foreign officials watching this amazing and dispiriting spectacle are left in the uncomfortable position of not knowing who if anyone actually speaks for the United States. This became obvious over the weekend when Vice President Mike Pence and Secretary of Defense Mattis, among others, traveled to the Munich Security Conference to offer reassurance that the United States would remain committed to NATO and opposed to Russia. But of course European officials are well aware that Trump has repeatedly expressed his own skepticism of NATO and admiration of Vladimir Putin and has spoken longingly of doing a “deal” with Russia. Indeed, Time magazine reported that Bannon’s Strategic Initiatives Group is generating “its own assessment of Russia-policy options,” including concessions such as “reducing or removing the U.S. anti-ballistic-missile footprint in Central and Eastern Europe, easing sanctions imposed for election meddling or the invasion of Ukraine, or softening language on the Crimean annexation” — all options far removed from the tough talk in Munich.

Thus Germany’s defense minister, Ursula von der Leyen, pointedly replied to Mattis’s pro-NATO speech by expressing appreciation for the “secretary of defense’s strong commitment to NATO.” Not America’s strong commitment or the Trump administration’s strong commitment. Because who the hell knows anymore who actually speaks for America?

This dangerous dysfunction at the top — bad enough now at a time of relative peace and stability — will cause America and the world considerable grief when the administration has to deal with its first serious foreign-policy challenge. Imagine a Cuban missile crisis in which McGeorge Bundy, Robert McNamara, Dean Rusk, and Robert F. Kennedy all pursued their own policies without any coordination, and you get an idea of the danger ahead.
Max Boot is the Jeane J. Kirkpatrick senior fellow for national security studies at the Council on Foreign Relations. His forthcoming book is “The Road Not Taken: Edward Lansdale and the American Experience in Vietnam.”
Photo credit: MANDEL NGAN/AFP/Getty Images

Making Crises Great Again

Jeffrey Frankel

Trump bill Dodd Frank v2

CAMBRIDGE – Debates about financial regulation tend to focus on quantity, not quality. But “more versus less” isn’t so much the issue; the details are. And when it comes to financial reform in the United States, President Donald Trump is unlikely to get the details right.
Earlier this month, Trump issued an executive order directing a comprehensive review of the Dodd-Frank financial-reform legislation of 2010. The administration’s goal is to scale back significantly the regulatory system put in place in response to the 2008 financial crisis. This is a risky move.
Dodd-Frank’s key features – such as higher capital requirements for banks, the establishment of the Consumer Financial Protection Bureau, the designation of Systemically Important Financial Institutions, tough stress tests on banks, and enhanced transparency for derivatives – have strengthened the financial system considerably. Undermining or rescinding them would substantially increase the risk of an eventual recurrence of the 2007-2008 financial crisis.
This is not to say that current legislation could not be improved. The most straightforward way to do that would be to restore some of the worthwhile features of the original plan that have been weakened or negated over the last seven years. Dodd-Frank might, in theory, also benefit from a more efficient tradeoff between the compliance costs that banks and other financial institutions confront and the danger of systemic instability (in areas like the “Volcker Rule” restricting proprietary trading by banks).
But achieving this would be a difficult and delicate task. Contrary to what some in the financial industry seem to believe, there is no evidence that Trump will manage it properly. On the contrary, even before the review of Dodd-Frank gets going, Trump has already gotten financial regulation badly wrong.
As Trump ordered the review of Dodd-Frank, he also suspended implementation, pending review, of the so-called fiduciary rule, adopted, after extensive preparation, by President Barack Obama’s administration. The rule, which was supposed to take effect in April, is intended to ensure that professional financial advisers and brokers act in the best interests of their clients when collecting fees to advise them on assets invested through retirement plans.
The need for such a rule is clear. Many investment advisers and brokers are motivated by conflicts of interest to recommend a stock, bond, or fund that is not quite as good as another.
For example, the adviser may receive an undisclosed commission or de facto “kickback” for recommending a particular product. It may be the advising firm’s own offering. Because most investors assume that their advisers are obliged to act in their best interests, they don’t second-guess the recommendations. The end result is underperformance of the saver’s retirement account.
Canceling the fiduciary rule would have no purpose other than to maximize financial institutions’ profits, at the expense of the average American family. The rule’s opponents make the argument that the requirement amounts to government overreach, because it deprives families of choices. This is disingenuous, because it disregards the reason why savers seek the services of financial advisers in the first place: to help them figure out what investments best serve their interests.
A saver could always choose not to hire a financial adviser. Those who believe their judgment to be superior to that of the average investor can choose which individual assets or actively managed funds to buy and sell. Such investors distill information on their own and have no need for a retirement savings adviser to help them sift through the huge variety of financial assets, products, and funds that is available, particularly in a country like the US.
But there are downsides to this approach. Most investors who pursue it buy and sell too often, burn through a lot of money in cumulative transaction costs, and are unrealistically optimistic about their ability to pick winners or time the market.
An alternative, recommended by most economists, would be for savers simply to park their money in broadly diversified low-cost funds, such as the index funds offered by Vanguard.
Here, too, there is no need for a professional adviser. Recommended allocations of individuals’ total financial wealth are something like 60% equities, 30% bonds, and 10% cash, depending mainly on the saver’s degree of risk aversion and need for liquid assets.
Yet many small investors just can’t bring themselves to believe that index funds are the best they can do. Recognizing that they lack the time, skills, or interest necessary to invest their savings independently, they seek the services of an investment adviser. They want to discuss their portfolios with an expert, with someone they can trust to give them good advice. But if that expert can’t be relied upon to put savers’ interests first, why are they collecting fees?
Of course, not all financial advisers act contrary to their clients’ interests. Some apply a fiduciary standard in practice, to earn their clients’ trust, even though the law does not yet require them to do so. Truly ethical advisers tend to support Obama’s fiduciary rule, because the removal of unscrupulous competitors is good for their business.
In this sense, the financial industry is no different from the used-car business. The dealers who would oppose a law preventing them from turning back the odometer are probably the ones engaging in that practice. Honest dealers would favor it as a way to level the playing field. They do not claim that such laws deprive consumers of the “choice” to buy a used car under fraudulent terms.
It is in ordinary Americans’ best interest for the fiduciary rule to go into effect in April, as planned. They would be best served if the Trump administration kept its hands off Obama’s other financial reforms, too.