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Submitted by Tyler Durden on 06/05/2011 21:42 -0400
While the dominant topic of conversation when discussing margin hikes (or reductions) usually reverts to silver, ES (stocks) and TEN (bonds), what everyone so far is ignoring is the far more critical topic of real margin risk, in the form of roughly $600 trillion in OTC derivatives. The issue is that while the silver market (for example) is tiny by comparison, it is easy to be pushed around, and thus exchanges can easily represent the illusion that they are in control of counterparty risk (after all, that was the whole point of the recent CME essay on why they hiked silver margins 5 times in a row). Nothing could be further from the truth: where exchanges are truly at risk is when it comes to mitigating the threat of counterparty default for participants in a market that is millions of times bigger than the silver market: the interest rate and credit default swap markets. As part of Dodd-Frank, by the end of 2012, all standardised over-the-counter derivatives will have to be cleared through central counterparties. Yet currently, central clearing covers about half of $400 trillion in
interest rate swaps, 20-30 percent of the $2.5 trillion
in commodities derivatives, and about 10 percent of $30 trillion in
credit default swaps. In other words, over the next year and a half exchanges need to onboard over $200 trillion notional in various products, and in doing so, counterparites, better known as the G14 (or Group of 14 dealers that dominate derivatives trading including Bank of America-Merrill Lynch,
Barclays Capital, BNP Paribas, Citi, Credit Suisse, Deutsche
Bank, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley, RBS,
Societe Generale, UBS and Wells Fargo Bank) will soon need to post billions in initial margin, and as a brand new BIS report indicates, will likely need significant extra cash to be in compliance with regulatory requirements. Not only that, but once trading on an exchange, the G14 "could face a cash shortfall in very volatile markets when daily margins are increased, triggering demands for several billions of dollars to be paid within a day." Per the BIS "These margin calls could represent as much as 13 percent of a G14 dealer's current holdings of cash and cash equivalents in the case of interest rate swaps." Below we summarize the key findings of a just released discussion by the BIS on the "Expansion of central clearing" and also present a parallel report just released by BNY ConvergEx' Nicholas Colas who independetly has been having "bad dreams" about the possibility of what the transfer to an exchange would mean in terms of collateral posting (read bank cash payouts) and overall market stability, and why a multi-trillion margin call could result in the biggest buying spree in US Treasurys... Ever.
First, for those who are unfamiliar, here is what happens when an exchange (or a Central Counterparties) proceeds to trade OTC derivatives with any given counterparty (from the BIS):
CCPs typically rely on four different controls to manage their counterparty risk: participation constraints, initial margins, variation margins and non-margin collateral.
A first set of measures are participation constraints, which aim to prevent CCPs from dealing with counterparties that have unacceptably high probabilities of default.
The second line of defense is initial margins in the form of cash or highly liquid securities collected from counterparties. These are designed to cover most possible losses in case of default of a counterparty. More specifically, initial margins are meant to cover possible losses between the time of default of a counterparty,8 at which point the CCP would inherit its positions, and the closeout of these positions through selling or hedging. On this basis, our hypothetical CCP sets initial margins to cover 99.5% of expected possible losses that could arise over a five-day period. CCPs usually accept cash or high-quality liquid securities, such as government bonds, as initial margin collateral.
As the market values of counterparties’ portfolios fluctuate, CCPs collect variation margins, the third set of controls. Counterparties whose portfolios have lost market value must pay variation margins equal to the size of the loss since the previous valuation. The CCP typically passes on the variation margins it collects to the participants whose portfolios gained in value. Thus, the exchange of variation margins compensates participants for realised profits/losses associated with past price movements while initial margins protect the CCP against potential future exposures. Variation margins, typically paid in cash, are usually collected on a daily basis, although more than one intraday payment may be requested if prices are unusually volatile.
Finally, if a counterparty defaults and price movements generate losses in excess of the defaulter’s initial margin before its portfolio can be closed out, then the CCP would have to rely on a number of additional (“non-margin”) resources to absorb the residual loss. The first of these is a default fund. All members of the CCP post collateral to this fund. The defaulting dealer’s contribution is used first, but after this other members would incur losses. The default fund contribution of the defaulting dealer would be mutualised among the non-defaulting dealers according to a predetermined formula. Some additional buffers may then be available, such as a third-party guarantee or additional calls on the capital of CCP members.
Otherwise, the final buffer against default losses is the equity of the CCP. In order to calculate initial and variation margins, CCPs rely on timely price data that give an accurate indication of liquidation values. Clearing OTC derivatives that could become unpredictably illiquid in a closeout scenario could impose an unacceptable risk on the CCP.
Table 1 summarises the risk management practices of SwapClear, ICE Trust US and ICE Clear Europe, which are currently the main central clearers of IRS and CDS.
The gist of the BIS paper focuses not so much on the inboarding costs and concerns of migrating hundreds of trillions of products to CCP - a topic evaluated much more in depth by Nick Colas - the BIS does instead look at a hypothetical example of what may happen in the case of a "risk flaring" episode, and how much variation margin G14's may need to post:
As shown in the left-hand panels of Graph 2, estimated initial margins can vary significantly with prevailing levels of market volatility, especially for CDS. The upper left-hand panel shows, for example, that Dealer 7 would need to post $2.1 billion of collateral to clear its hypothetical IRS portfolio in an environment of low market volatility, similar to that prevailing before the recent financial crisis. This would grow by around 50%, to $3.2 billion, if volatility increased to the “medium” level seen early in the crisis, just before the rescue of Bear Stearns. And it would grow by around 150%, to $5.3 billion, if volatility increased to the “high” level seen at the peak of the crisis, amidst the negative market reaction to the US Troubled Asset Relief Program (TARP) and before government recapitalisation of banks began in the United Kingdom. In comparison, the bottom left-hand panel shows that initial margin requirements for the hypothetical CDS portfolio of Dealer 7 would increase by around 160% or 325% from $0.6 billion if the prevailing level of market volatility increased from low to medium or high. The total initial margins that the CCP requires clearing members to post are $33 billion (low), $70 billion (medium) and $105 billion (high) for IRS and $6 billion (low), $20 billion (medium) and $35 billion (high) for CDS.
Nevertheless, it seems unlikely that G14 dealers would have much difficulty finding sufficient collateral to post as initial margin. The diamonds in the left-hand panels show collateral requirements relative to dealers’ unencumbered assets, with different colours again representing different levels of market volatility. Even the requirements based on high levels of volatility do not exceed 3% of the unencumbered assets of any dealer for which it was possible to estimate this figure. Although many unencumbered assets held by dealers do not presently qualify as acceptable collateral for initial margins, some of these could be swapped for assets that do qualify.
By contrast, dealers may need to increase the liquidity of their assets as central clearing is extended. The centre panels of Graph 2 show similar patterns in potential variation margin calls as prevailing levels of market volatility change. In the worst case, variation margins could be several billions of dollars, which would have to be paid in cash within a day. These margin calls could represent as much as 13% of a G14 dealer’s current holdings of cash and cash equivalents in the case of IRS. A five-day sequence of large variation margin calls that could be expected with a probability of one in 200 would equate to around 28% of current cash and cash equivalents in the worst case.
These results also have direct implications for the liquidity provisions of CCPs, as they would have to pay variation margins in the case of default of a clearing member. Access to central bank funds in distressed circumstances would help to ensure that CCPs could make substantial variation margin payments in a timely manner.
With a probability of one in 10,000, non-margin resources at risk from the failure of one particular dealer, two particular dealers or any dealer with sufficiently adversely affected portfolios would respectively be 20%, 37% and 42% of total initial margins for IRS, and 36%, 46% and 65% of total initial margins for CDS. If prevailing levels of volatility were high, these figures would equate to $21 billion, $39 billion and $44 billion for IRS, and $13 billion, $16 billion and $23 billion for CDS. By comparison, the G14 dealers contributing to default funds had equity of around $1.5 trillion as of 30 June 2010.
Alas, the problem is that the bulk of this "equity" is, for lack of a better word, worthless, as it is based on such assets as intangibles, and MTM-locked up assets, whose true value is far, far lower than where banks carry these. And of course, the need to sell them would come precisely at a time when everyone else would be selling. Which means that in the event of a market lockup, there would be no one on the other side of the trade, meaning the entire CCP experiment would likely collapse spectacularly, as nowhere near enough cash is available.
Next, we look at one of the "percentile probability" charts to determine just where the system is weakest, because these uber-6 sigma events tend to become the norm when TSHTF. According to the BIS, the absolute worst case scenario from a risk management standpoint is a 0.002% probability event, at which dealers could see $160 billion in total margin shortfalls across the IRS and CDS book. And there are those who wonder why banks are stockpiling cash for a rainy day...
The BIS issues a rather ominous warning at this point:
Even after incorporating expected shortfalls into initial margin requirements, however, a sizeable gap remains between the total margin shortfalls (relative to total initial margins) that could be expected with very low probabilities for CDS and equivalent shortfalls for IRS. CCPs clearing CDS may wish to make an adjustment to default fund contributions to ensure that this is taken into account.
Will dealers do this? Of course not.
While there is much more in the full BIS paper extract (found here), we were less than impressed with the methodology used to construct hypothetical CDS and IRS portfolios. In a nutshell, the BIS assumed a hedged book and matched-maturity positions: something, which every OTC trader knows, absolutely never happens, as the whole purpose of derivatives is to take low margin risk positions that coincide with the herd, and thus, not hedge (otherwise what is the point?). As such, we believe, that the full potential shortfall on the up to $600 trillion in gross notional is the full net exposure in the market at any time. Which we are convinced is well over the $160 billion 0.002% case (according to some estimates, between CDS (this one is easy - just look at weekly DTCC data) and IRS (this one is far more complicated), the net notional at risk at any given moment is anywhere between $2 and 8 trillion. And this is capital that the G-14 supposedly have handy for a rainy day?
And next, moving away from dry academia, we shift to one of our favorite authors, BNY's Nicholas Colas, who coinicdentally, discussed precisely this issue in his Friday edition of his Mornina Markets Briefing:
Bad Nightmares and Good Collateral
Summary: The rulemaking around Dodd-Frank is far from over, but one area of new regulation drawing a lot of attention is what to do about over-the-counter derivates trading. It is a huge market – some $600 trillion at the end of last year – and dominated by interest rate contracts, where the notional value is $465 trillion. Just a little perspective – the entire value of the S&P 500 is $12 trillion. If even a portion of this trading moves to a quasi-exchange structure, it will require significantly more collateral than is currently used to support this market. That is strongly bullish for sovereign debt, should these changes come to pass. This dynamic got us wondering what “good collateral” really means anymore. U.S. dollars and Treasury securities are the bedrock of trading collateral, but those assets might not work as well for this function in the next financial crisis as they have in the past. The reason is that sovereign debt is increasingly losing its “risk-free asset” status as developed countries – not just the U.S., mind you – issue more debt to stimulate their economies and avoid taking the pain for previous mistakes.
My longest lasting repeat nightmare, which this year celebrates its third decade festering in my psyche, is that I have failed a class in business school and therefore don’t actually have my degree. For the first 10 years after graduating I kept my diploma under my bed, so vivid was that particular dream. The actual class that causes this lingering worry was ‘The Pricing of Illiquid Securities,” focusing primarily on exotic mortgage backed bonds. It was part fixed income analysis, part options math, and wholly difficult to understand. I almost failed it. Almost. Thankfully it was pass/fail, and the transcript clearly has a “P.”
But pricing illiquid assets has become a popular form of reality TV, from PBS’ Antiques Roadshow to Pawn Stars to Auction Kings . The formula is largely the same – walk in with something obscure, and an expert will tell you what it’s worth and/or give you cold, hard cash for the item. The analysis is a combination of authentication, historical sleuthing and market analysis of likely buyers and the price they will pay. The head of a rare doll might fetch $10,000. An entire motorcycle, even if owned by a minor celebrity, might only be $5,000. Every item is different and has to be appraised on its own history and merits.
There has been a recent flurry of activity in one capital markets dedicated to oddball illiquid securities – the pricing and trading of over-the-counter derivatives such as interest rate contracts. The reason for the attention is the Dodd-Frank Wall Street Reform and Consumer Protection Act, which gave the Securities & Exchange Commission and the Commodities Futures Trading Commission the power to restructure the ways in which OTC derivatives trade and settle. The new rules aren’t out yet, and likely won’t be available until July, according to various press accounts. That said, there are a few “Hard points” to consider:
- The global market for OTC derivatives is huge. According to the Bank for International Settlements, the notional amount of total contracts was $601 trillion at the end of 2010.
- It is primarily an interest rate market. Of the $601 trillion, just over 75% ($465 trillion) is tied up in interest rate contracts, most of which are swaps.
- This interest rate swaps market is still growing. The poster child of troublesome OTC derivatives, Credit Default Swaps, is down to just $30 trillion in notional value from $42 trillion in December 2008. At the same time, the market for interest rate contracts continues to grow, up to the previously mentioned $465 trillion from $433 trillion in December 2008.
The reason all is this is significant is simple: a change in how these instruments trade, from strictly OTC to something that more closely resembles an “exchange” could involve market participants posting consistent and predetermined collateral in order to clear trades. That’s not the way it is done now. The major banks that drive this market have freedom to determine what collateral is needed both to initiate a trading relationship and to keep it going. See here for more details: http://www.risk.net/risk-magazine/news/2074073/margin-proposals-lock-usd2-trillion-assets.
All this brings up a whole host of interesting issues, such as how much collateral the major players in OTC derivatives will have to pony up in order to keep trading. It is impossible to come up with a number at this point, given that the rules are still being written and the market structures to support a new trading regime are not yet assembled. July 2011 was the initial target date for proposed rules, but it appears to be slipping. See http://www.businessweek.com/news/2011-06-01/wallstreet-asks-swaps-regulators-to-re-propose-new-rules.html.
Underneath this bubbling surface of regulatory confusion, however, there is an equally interesting existential topic: what is “good” collateral, anyway? In some ways, it is probably easier for a pawn shop to determine the appropriate price for a used electric guitar than it is for an exchange to decide what assets a market participant needs to post in order to transact buy/sell orders. In the spirit of a thumbnail case study, we went to the CME Group website and pulled what kinds of assets they consider “Good Collateral” and the haircuts they give certain types of assets. Before we review that data, however, it makes sense to consider what makes some collateral better than others. A quick list:
- Good collateral should be something that everyone agrees is valuable. Basically, it is anything that you would rush to pick up off the street before someone else got to it. Gold, developed country currency, and fixed income instruments are all good collateral.
- It shouldn’t vary too much in price, regardless of market conditions. Ideally it would appreciate slightly in value when financial troubles strike, since that is most likely when counterparties fail and you need the collateral to ensure a trade can clear.
- It should be very liquid. Again, markets only really worry about the value of collateral when things are going south. That’s not the time to find out that South Florida condo real estate isn’t anyone’s idea of solid collateral.
The attached chart shows some assets that the CME considers “Good Collateral” and the haircuts it gives to those assets. The bigger the haircut, the more of the asset you have to post to support your positions. You can find them here: http://www.cmegroup.com/clearing/financial-and-collateral-management/. A few observations:
- U.S. Government and agency paper is “King of the Hill.” Only two assets get no haircut: U.S. dollar cash and U.S. Treasury bills. Agency debt is a 3% haircut, and longer dated Treasuries are 3.5-5.0%.
- Then comes developed country currencies and debt, at 5-9% haircuts.
- Gold and the Mexican peso aren’t often put in the same risk category, but they are here. Both receive a 15% haircut, which means that in the eyes of the CME they have equivalent appeal as collateral.
- At the far end of the equation are the Turkish lira (20%) and equities (30%).
Two things pop out to me from this quick analysis:
- If there ever is an exchange-like trading mechanism set up for OTC derivatives, there is going to be a real run on U.S. government paper. The CME’s list of assets and haircuts tells the story – Treasuries are the most efficient way to fund collateral. The notional amount of interest rate swaps alone – some $465 trillion – is enough to swamp the $14.3 trillion of total government debt outstanding, let alone the $9.7 trillion that is actually available for purchase.
- The whole notion of good collateral is very much anchored in the thought that U.S. sovereign debt is “risk free.” Whether or not that is true in the absolute sense is irrelevant. Remember that collateral needs to be at least crisis-resistant and preferably negatively correlated to asset prices during financial stress. With the U.S. government currently at loggerheads over how to deal with the Federal Debt Ceiling and the most likely path is to simply issue a lot more government paper, the time could be coming where Treasuries no longer fulfill the purpose of “Good Collateral” during crisis. They are just as likely to be the cause of a financial storm rather than provide shelter from the rain.
Bottom line: instead of wondering how to nudge the silver market (lower) or the ES and TEN contracts (higher), perhaps it is time for the key exchanges, which are obviously captured by the very same G14s on whose tithes their existence depends, to actually proactively engage in some risk-mitigation when it comes to the one biggest threat: not that of the measly several billion dollar silver market, but of the $600 trillion IRS and CDS market, which is and continues to be the biggest ticking timebomb in capital markets. And on the other hand, if anyone is wondering what will cause the biggest run on US government bonds... ever... then as soon as every dealer is forced to be on a CPP, all one needs to do is a massive "risk-flaring" collapse which sends everyone scrambling to provide collateral. And since there is a 40-to-1 ratio of notional outstanding in OTC derivatives to total US debt, well, readers can do the math.
How are you going to check that?
Much of the disparity between U.S. and european leverage measures comes from the treatment of derivatives. Under U.S. GAAP , banks are allowed to offset derivatives and repurchase agreements held with the same counterparty, a process called netting. For example, JP Morgan Chase & Co. held gross derivatives with fair value of about $1.5 trillion on March 31, according to its filings. After netting adjustments, JP Morgan’s derivative assets were about $70 billion, or about 3 percent of its balance sheet.
1Q13 Quarterly | occ.gov, espec. Table 1, Table 2 "ratio"
Compare that with Deutsche Bank, which reported derivative assets of 768 billion euros at the end of 2012, a figure that doesn’t benefit from netting adjustments, and amounts to 38 percent of its balance sheet. The suggestion that U.S. banks might have to report derivatives under IFRS in this way prompted a response from the International Swaps and Derivatives Association last summer.
In a policy paper, ISDA complained that such an accounting change would have “added pressure to the worldwide reces - sion as financial institutions would have been required either to increase their capital or deleverage”. The bulk of the paper is devoted to buttressing the argument that because derivatives netting is legally watertight, the IFRS requirement to report gross derivatives values should be junked in favour of U.S. GAAP.
So what does the netting provision mean in practice? It starts with the concept of “set-off”, under which it is legally permissible for an entity to offset an asset and liability with the same counterparty, reducing the gross exposure. At this point IFRS and U.S. GAAP diverge.
IFRS only allows the positions to be net - ted out for accounting purposes if there is clear intent to settle or realize the contracts - which doesn’t necessarily apply to derivatives that have many years to run. However, U.S. GAAP recognises something called “close-out netting”, which means that multiple contracts with a single counter - party can legally be netted out and settled in the event of termination or default. That possibility - even if never exercised - is reflected upfront in U.S. bank balance sheets and the leverage ratios used by regulators.
According to the practising Law Institute, which published a book on derivatives termination in 2010, Lehman is a “cautionary tale” on the inablility to successfully net-out derivative contracts during a turbulent bankruptcy. U.S. GAA p might therefore present a too-flattering picture of bank leverage compared with IFRS by encoding these over-optimistic assumptions into accounts.
Bloomberg, "Risk", 28 June 2013
03/10/2008 Subprime Crisis & Derivatives: Origins
by niccolo caldararo
The origins of the present subprime crisis can be found in the Nixon Administration when his appointment to the SEC, Mitchell, removed the prohibitions to trades in futures and similar "bets" that has made our markets so unstable. A number of academics including Fisher Black, created a series of formulas by which traders could manipulate the markets and make huge profits. The result of this behavior would led to our crisis by creating the impression that risk could be eliminated.
The origins of the present subprime crisis can be found in the Nixon Administration when his appointment to the SEC, Mitchell, removed the prohibitions to trades in futures and similar "bets" that has made our markets so unstable. A number of academics including Fisher Black, created a series of formulas by which traders could manipulate the markets and make huge profits. The result of this behavior would led to our crisis by creating the impression that risk could be eliminated.
The current crisis on trading floors of the major markets and the hedge fund offices and banks might lead one to think that no one has had any idea that such a crisis might unfold. However, lessons from the Crash of 1907 and that of 1929 led to changes in the laws governing finance during the 1930s under FDR.
A number of articles have appeared recently in your paper attempting to describe the point of origin and the blame for the current liquidity crisis. Many feel, like that the government should step in and correct the problem by making the taxpayers pay for the imprudent acts of some, while noting that we have learned that financial institutions were too lenient with credit. Others have traced the evolution of the crisis and shown that post-Depression (1929) laws regulating credit producing entities were removed in the last 30 years making way for the subprime collapse. This is the correct lesson to learn. As Donald MacKenzie and Yuval Millo have shown in their 2003 article, "Constructing a Market, Performing a Theory," J. of Sociology, v. 109, the legal barriers to the trading in derivatives were removed by political interference with the post-Depression experience with speculation. This grew out of the peculiar social environment of the Chicago markets in the 1960s and 70s and the way traders rediscovered option theory, taking advantage of volatility skew.
The Chicago Board of Trade hired former Presidential aide H.H. Wilson to become its president in 1967. Wilson hired Joseph W. Sullivan, a Wall Street Journal political correspondent as his assistant. Together they began to explore the feasibility of trading in futures on commodities of a variety of products with the involvement of a trader named Leo Melamed. This led to discussions to revive trade in financial futures that had fallen in disrepute during the first half of the 20th century.
Gillian Tett, in an article in the Financial Times (8/27/07), noted that market collapses have been associated with innovations that seem to have changed the rules. However, as in 1907 and 1929 our present dilemma is not due to a new innovation but one packaged as new. Stock options and futures were, as MacKenzie and Millo note (from analysis by Max Weber in his time) "integral to 19th century exchanges." The 1929 crash put such activities and speculation in derivative instruments under the category of wagers and gambling. They note that as late as the 1960s the SEC "remained deeply suspicious of derivatives....A futures contract was legal, the Supreme Court ruled in 1905, if it could be settled by physical delivery of a commodity such as grain. If it could be settled only in cash, it was an illegal wager."
Sullivan and his associates went to work on the political framework to undermine this institutional memory of disaster and the legal restrictions that reinforced it. SEC Chair Manuel Cohen refused to listen comparing options to "marijuana and thalidomide." But by using university economists like Burton Malkiel and Richard Quandt, Sullivan was able to create the argument that there was a mathematical and rational basis for options to make the market more efficient. With help from William Baumol, Malkiel and Quandt, and with the resources of Robert R. Nathan Associates, they produced a campaign purporting to show that an options exchange was in the public interest.
In 1971 Richard Nixon appointed tax lawyer William Casey as chair to the SEC and the result was an end to the prohibition of a market in options and futures derivatives. In the 1980s Fisher Black and Merton, two professors of economics, developed formulas to streamline this process in the modern context and a number of firms like J.P. Morgan invented financial devices in the 1990s to sell debt associated with securitized mortgages based on their ideas.
These began the current explosion in liquidity. The devices were called derivatives and we know them from a number of letters, like LCDS (Loan credit default swaps), CDS of CDOs (credit default swaps of collateralized debt obligations), CFDs (contracts of difference) and basically they are means of placing bets on movements in the markets. The way was open to the floodgates of speculation.
What we need is a longer institutional memory and to reinstitute the laws prohibiting speculation and to separate banking, insurance and brokerage functions as we learned was necessary after 1929.
It might also seem from a casual observer that money (Credit) from the central banks, and especially the American Federal Reserve, has no limit. It is almost like magic, like the "Primitive" Melanesian idea of Mana, a force that can be conjurer up by a magician.
If one refers to any current source on Nassin Nicholas Taleb's life since the publication of his book, The Black Swan, one is reminded of Gillian Tett's interview with Robert Merton (in the Financial Times, May 21st 2007). Both articles produced some surprising comments. Just as Taleb's performance as a hedge fund manager has been spotty at best, Prof Merton made the claim, following the LTCM collapse, that derivatives protect us from crashes and seems remarkable.
In both cases it would be like Lord Treasurer Robert Hartley, the inventor of the South Seas Bubble in 1711, asserting that his scheme had protected England from economic panics in 1720. While Taleb is not an innovator of specific models underlying these devices as Merton is he has undertaken a similar role. Prof. Merton's view of a world of controllable risk by mathematics in the face of his admission that in the case of LTCM people did not behave in ways predicted by his model, based on his model's assumptions, that is, that people act rationally, is unconvincing.
Instead of acting as the model predicted, people behaved as a herd in panic. Canetti described such patterns in 1962 and a number of scholars from Krondratieff and Schumpeter to Stornette have attempted to develop an understanding of such panics and their role in economics (see my book, Sustainability published in 2004 or you can download for free an article I wrote that provides more detail and background to this discussion from the Social Science Research Network.
I think Mary Douglas, in her work on risk in various cultures, has shown that how risk functions varies in different cultures at different times. For Prof. Merton to say derivatives are like anti-lock brakes and if people drive faster because they have them we should do not blame the brakes, is preposterous, because is that not the problem?
If you reduce the probability of adverse events in people's minds, will they not engage in more risky behavior? Many products exist which allow people to feel better and ignore the consequences of their behavior temporarily, like heroin, but we do realize that eventually reality does intercede. It is an apt choice of words to refer to Prof. Merton's enthusiasm for his idea as "evangelical zeal," since we should recall John Maynard Keynes' caution that we should not mistake what is probable for either knowledge or reality.
We presently live in a globalized financial economy where if there are problems they affect everyone. A lack of diversity in any system makes it susceptible to any stress throughout the entire system. There is little resilience in a "flat world." The Chinese and the Japanese are constantly under pressure to become more enveloped in this system. At present the Japanese are less affected that other economies, but the Anglo-Americans the most. The idea of such an economic unity has been favored by a number of economic theories, but in historical comparison it looks little different from the binding of ones subjects by kings or as happened in the late Roman Republic. It takes on the character of tribute to a hegemonic center, like Italy after the Civil Wars where little was produced and its people had to be increasingly supported by imports. In like fashion, Americans have been on a spending spree for nearly 20 years with little or no saving. We live on credit. Some have come to regard American debt as money in a most strange view of value.
The Bush Administration, while criticizing any bailout of the banking industry has been doing just that. The amount of this "bailout" is frightening today, but minor in effect in the financial markets, as described in Krishna Guha's article in the Financial Times (12/18/07). What is disturbing is the transfer of the risk created in the past 5 years via SIVs, derivatives, etc. from private financial institutions to the Federal Home Loan Bank system. Guha reports that roughly three-quarters of a trillion dollars a year has been assumed.
Essentially while we were all watching the Fed lower interest rates and create cooperative agreements to shore up the financial system, the "shadow banking system" that created the current subprime balloon and the derivative industry has been shunting off the risk to the public purse.
This reminds me of the old Welsh Sinne-eaters described by James Frazer, who were called upon to transfer evil from one person to another. In our present case, the FHLB may eat all the sins of the banking industry but we cannot expect the process to take place without catastrophic effects on the dollar.
The only winners will be the financial wizards who have had sufficient connections to be able to regurgitate their risk on the taxpayer. It is also interesting that Japanese companies, like Nomura's recent interest in Collins Stewart, the British investment bank, are making purchases abroad. We may be seeing Japan coming out of the collapse of credit and a property bubble, while we are heading into one. This is like Einstein's dilemma of looking so far ahead in a circular galaxy that we then see the back of our heads.
While we have been fixed on the spread of the collapse of liquidity and credit, the answers to fix the problem have been "old tech" those based in past theories of governmental intervention when markets fail. As Schumpeter argues in his analysis of Business Cycles (1939), these he noted are related to changing tempo in investments needed for the periodic renewal of productive forces. However, he also saw that discovery of new resources or invention and innovations could affect this tempo.
Financial devices of the past 2 decades have been theorized to have been productive innovations. This is debatable. Instead of productive innovations they seem to be in the class of wealth transfer devices, entertainment and gambling inventions (games, slot machines, etc.) and prestige display (like the destruction of wealth in a Northwest Coast Native American potlatch).
When looked at in this light, it appears as if there has been little productive innovation since the advances of biotechnology and internet expansion in the 1990s. There have been none in energy, certainly biofuels and ethanol have been shown to be poor changes in existing technology and not very productive and raise the cost of food. The main overall change in technology investment in the past 8 years has been in security and military spending and this has produced little in new technology and general applications.
If there is a recession it is due to low real investment in the developed countries and low saving and too much spending on luxury and prestige goods in the Anglo-American sector and this includes a large segment of spending in the housing area on renovations and overbuilding of large energy dependent housing units.
Niccolo Caldararo, Ph.D. Dept. of Anthropology San Francisco State University
The current crisis on trading floors of the major markets and the hedge fund offices and banks might lead one to think that no one has had any idea that such a crisis might unfold. However, lessons from the Crash of 1907 and that of 1929 led to changes in the laws governing finance during the 1930s under FDR. A number of articles have appeared recently in your paper attempting to describe the point of origin and the blame for the current liquidity crisis. Many feel, like that the government should step in and correct the problem by making the taxpayers pay for the imprudent acts of some, while noting that we have learned that financial institutions were too lenient with credit. Others have traced the evolution of the crisis and shown that post-Depression (1929) laws regulating credit producing entities were removed in the last 30 years making way for the subprime collapse.
This is the correct lesson to learn. As Donald MacKenzie and Yuval Millo have shown in their 2003 article, "Constructing a Market, Performing a Theory," J. of Sociology, v. 109, the legal barriers to the trading in derivatives were removed by political interference with the post-Depression experience with speculation. This grew out of the peculiar social environment of the Chicago markets in the 1960s and 70s and the way traders rediscovered option theory, taking advantage of volatility skew. The Chicago Board of Trade hired former Presidential aide H.H. Wilson to become its president in 1967. Wilson hired Joseph W. Sullivan, a Wall Street Journal political correspondent as his assistant. Together they began to explore the feasibility of trading in futures on commodities of a variety of products with the involvement of a trader named Leo Melamed. This led to discussions to revive trade in financial futures that had fallen in disrepute during the first half of the 20th century. I Here Tett, in an article in the Financial Times (8/27/07) noted that market collapses have been associated with innovations that seem to have changed the rules. However, as in 1907 and 1929 our present dilemma is not due to a new innovation but one packaged as new. Stock options and futures were, as MacKenzie and Millo note (from analysis by Max Weber in his time) "integral to 19th century exchanges."
The 1929 crash put such activities and speculation in derivative instruments under the category of wagers and gambling. They note that as late as the 1960s the SEC "remained deeply suspicious of derivatives....A futures contract was legal, the Supreme Court ruled in 1905, if it could be settled by physical delivery of a commodity such as grain. If it could be settled only in cash, it was an illegal wager." Sullivan and his associates went to work on the political framework to undermine this institutional memory of disaster and the legal restrictions that reinforced it.
SEC Chair Manuel Cohen refused to listen comparing options to "marijuana and thalidomide." But by using university economists like Burton Malkiel and Richard Quandt, Sullivan was able to create the argument that there was a mathematical and rational basis for options to make the market more efficient. With help from William Baumol, Malkiel and Quandt, and with the resources of Robert R. Nathan Associates, they produced a campaign purporting to show that an options exchange was in the public interest. In 1971 Richard Nixon appointed tax lawyer William Casey as chair to the SEC and the result was an end to the prohibition of a market in options and futures derivatives. n the 1980s Fisher Black and Merton, two professors of economics, developed formulas to streamline this process in the modern context and a number of firms like J.P. Morgan invented financial devices in the 1990s to sell debt associated with securitized mortgages based on their ideas. These began the current explosion in liquidity, the devices were called derivatives and we know them from a number of letters, like LCDS (Loan credit default swaps), CDS of CDOs (credit default swaps of collateralized debt obligations), CFDs (contracts of difference) and basically they are means of placing bets on movements in the markets. The way was open to the floodgates of speculation. What we need is a longer institutional memory and to reinstitute the laws prohibiting speculation and to separate banking, insurance and brokerage functions as we learned was necessary after 1929.
It might also seem from a casual observer that money (Credit) from the central banks, and especially the American Federal Reserve, has no limit. It is almost like magic, like the "Primitive" Melanesian idea of Mana, a force that can be conjurer up by a magician.
If one refers to any current source on Nassin Nicholas Taleb's life since the publication of his book, The Black Swan, one is reminded of Gillian Tett's interview with Robert Merton (in the Financial Times, May 21st 2007). Both articles produced some surprising comments. Just as Taleb's performance as a hedge fund manager has been spotty at best, Prof Merton made the claim, following the LTCM collapse, that derivatives protect us from crashes and seems remarkable. In both cases it would be like Lord Treasurer Robert Hartley, the inventor of the South Seas Bubble in 1711, asserting that his scheme had protected England from economic panics in 1720.
While Taleb is not an innovator of specific models underlying these devices as Merton is he has undertaken a similar role. Prof. Merton's view of a world of controllable risk by mathematics in the face of his admission that in the case of LTCM people did not behave in ways predicted by his model, based on his model's assumptions, that is, that people act rationally, is unconvincing. Instead of acting as the model predicted, people behaved as a herd in panic. Canetti described such patterns in 1962 and a number of scholars from Krondratieff and Schumpeter to Stornette have attempted to develop an understanding of such panics and their role in economics (see my book, Sustainability published in 2004 or you can download for free an article I wrote that provides more detail and background to this discussion from the Social Science Research Network at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1007819). I think Mary Douglas, in her work on risk in various cultures, has shown that how risk functions varies in different cultures at different times. For Prof. Merton to say derivatives are like anti-lock brakes and if people drive faster because they have them we should do not blame the brakes, is preposterous, because is that not the problem? If you reduce the probability of adverse events in people's minds, will they not engage in more risky behavior?
Many products exist which allow people to feel better and ignore the consequences of their behavior temporarily, like heroin, but we do realize that eventually reality does intercede. It is an apt choice of words to refer to Prof. Merton's enthusiasm for his idea as "evangelical zeal," since we should recall John Maynard Keynes' caution that we should not mistake what is probable for either knowledge or reality. We presently live in a globalized financial economy where if there are problems they affect everyone. A lack of diversity in any system makes it susceptible to any stress throughout the entire system.
There is little resilience in a "flat world." The Chinese and the Japanese are constantly under pressure to become more enveloped in this system. At present the Japanese are less affected that other economies, but the Anglo-Americans the most. The idea of such an economic unity has been favored by a number of economic theories, but in historical comparison it looks little different from the binding of ones subjects by kings or as happened in the late Roman Republic it takes on the character of tribute to a hegemonic center, like Italy after the Civil Wars where little was produced and its people had to be increasingly supported by imports. In like fashion Americans have been on a spending spree for nearly 20 years with little or no saving. We live on credit. Some have come to regard American debt as money in a most strange view of value. The Bush Administration, while criticizing any bailout of the banking industry has been doing just that. The amount of this "bailout" is frightening today, but minor in effect in the financial markets, as described in Krishna Guha's article in the Financial Times (12/18/07).
What is disturbing is the transfer of the risk created in the past 5 years via SIVs, derivatives, etc. from private financial institutions to the Federal Home Loan Bank system. Guha reports that "roughly three-quarters of a trillion dollars a year" has been assumed. Essentially while we were all watching the Fed lower interest rates and create cooperative agreements to shore up the financial system, the "shadow banking system" that created the current subprime balloon and the derivative industry has been shunting off the risk to the public purse.
This reminds me of the old Welsh Sinne-eaters described by James Frazer, who were called upon to transfer evil from one person to another. In our present case, the FHLB may eat all the sins of the banking industry but we cannot expect the process to take place without catastrophic effects on the dollar. The only winners will be the financial wizards who have had sufficient connections to be able to regurgitate their risk on the taxpayer.
It is also interesting that Japanese companies, like Nomura's recent interest in Collins Stewart, the British investment bank, are making purchases abroad. We may be seeing Japan coming out of the collapse of credit and a property bubble, while we are heading into one.
This is like Einstein's dilemma of looking so far ahead in a circular galaxy that we then see the back of our heads. While we have been fixed on the spread of the collapse of liquidity and credit, the answers to fix the problem have been "old tech" those based in past theories of governmental intervention when markets fail. As Schumpeter argues in his analysis of Business Cycles (1939), these he noted are related to changing tempo in investments needed for the periodic renewal of productive forces. However, he also saw that discovery of new resources or invention and innovations could affect this tempo.
Financial devices of the past 2 decades have been theorized to have been productive innovations , but this is debatable, instead of productive innovations they seem to be in the class of wealth transfer devices, entertainment and gambling inventions (games, slot machines, etc.) and prestige display (like the destruction of wealth in a Northwest Coast Native American potlatch). When looked at in this light, it appears as if there has been little productive innovation since the advances of biotechnology and internet expansion in the 1990s. There have been none in energy, certainly biofuels and ethanol have been shown to be poor changes in existing technology and not very productive and raise the cost of food.
The main overall change in technology investment in the past 8 years has been in security and military spending and this has produced little in new technology and general applications. If there is a recession it is due to low real investment in the developed countries and low saving and too much spending on luxury and prestige goods in the Anglo-American sector and this includes a large segment of spending in the housing area on renovations and overbuilding of large energy dependent housing units.
Niccolo Caldararo, Ph.D. Dept. of Anthropology San Francisco State University
This post first appeared on May 9, 2008: Is the Commodities Boom Driven by Speculation « naked capitalism
The question above may seem foolish. Oil has just passed $124 a barrel despite improvement in the dollar. Commodities prices are moving less in lockstep than before (gold and wheat in particular have backed off significantly from their highs) suggesting that buying is not the result of the basic materials version of a land grab. Opinion among economists, at least those polled by the Wall Street Journal, is unusually united: 89% think that skyrocketing commodity prices are the result of fundamentals, not too much cash chasing too few raw materials.
Yet bubble-like enthusiasm abounds. Tim Iacono pointed to a Money Magazine cover as proof that the end of the commodities run was not too far away. However, we have yet to see the storied counter-indicator, a Business Week cover story. In fact, Business Week ran an op-ed by Ed Wallace, “There is No Gas Shortage,” that pointed out that inventories were growing, which in combination with rising prices, suggests some speculative hoarding:
Gasoline reserves on hand are at the highest levels since the early 1990s, which is remarkable considering the nation’s refineries have been cutting back on the production of gasoline because their margins have declined. In fact, average gasoline reserves on hand have risen since this past October, while oil reserves in this country have gone up virtually every week this year—and only fog in the Houston Ship Channel that kept oil tankers from unloading their crude one week kept it from being every week…..
In January of this year, the U.S. used 4% less petroleum than we did a year ago. (Oil demand was down 3.2% in February.) Furthermore, demand has been falling slowly since July of last year. Ronald Bailey of Reason Online has pointed out that worldwide production of oil has risen 2.5% in the first quarter, while worldwide demand has grown by only 2%. Production is expected to increase by 3.3% in the second quarter, and by as much as 4.1% by the third quarter. The net result is that the U.S. daily buffer for oil production against demand, which was a paltry 1.5 million barrels as recently as 2005, is now up to 3 million barrels in excess capacity today…..
“The [oil] fundamentals are no problem. They are the same as they were when oil was selling for $60 a barrel, which is in itself quite a unique phenomenon.” — Jeroen van der Veer, chief executive officer, Royal Dutch Shell; Washington Post, Apr. 11, 2008.
But what is intriguing is that commodities veterans are distressed by recent market action. They seem more inclined than outsiders and newbies to point to the role in the bull market not of fundamentals but of new cash and perhaps more important, new vehicles, such as ETFs.
Reader Michael e-mailed us an paper and a series of posts by Michael Frankfurter, a commodities industry analyst (the article was co-authored with Davide Accomazzo of Pepperdine). The posts are broader in focus and discuss the “financialization” of commodities. As we will see soon enough, this development has worrisome parallels to recent history in real estate, with an asset intended primarily for use increasingly treated as an investment vehicle.
An old Wall Street saw illustrates the dangers of this approach:
On a slow afternoon, trader A decided to open a market for a can of sardines. Bidding started at $1. B bought it for $2 and sold it to C for $3. D and E decided to get into the act, with the result that E became the owner for $5.
E decided to open the can and discovered the sardines had gone bad. He went back to A to get his money back, protesting that the sardines were rotten. A smiled broadly, and said, ” You don’t understand. Those were trading sardines, not eating sardines.”
The paper, “Is Managed Futures an Asset Class? The Search for the Beta of Commodity Futures,” has some disconcerting findings from the standpoint of investors. It says that the normal risk/return paradigms of securities markets do not operate in commodities markets, nor do the pricing models for commodities offer an adequate substitute:
Our research indicates that these models have inherent shortcomings in being able to pinpoint a definitive source of structural risk premium within the complexity of the commodity futures markets. We hypothesize that the classic arbitrage pricing theory contains circular logic, and as a consequence, its natural state is disequilibrium, not equilibrium. We extend this hypothesis to suggest that the term structure of the futures price curve, while indicative of a potential roll return benefit, in fact implies a complex series of roll yield permutations. Similarly, the hedging response function elicits a behavioral risk management mechanism, and therefore, corroborates social reflexivity. Such models are inter-related and each reflects certain qualities and dynamics within the overall futures market paradigm.
With respect to managed futures, it is an observable materialization of behavioral finance, where risk, return, leverage and skill operate un-tethered from the anchor of an accurate representation of beta. In other words, it defies rational expectations equilibrium, the efficient market hypothesis and allied models – the CAPM, arbitrage pricing theory or otherwise – to single-handedly isolate a persistent source of return without that source eventually slipping away.
The article provide a nice survey of the issues surrounding CAPM and its successors, and then reminds us of why commodities are traded:
The secondary benefit provided by the futures market is that it functions as a mechanism for transparent price discovery and liquidity, which therefore mitigates price volatility. The primary benefit provided by these markets, however, is that it allows commercial producers, distributors and consumers of an underlying cash commodity to hedge. This reduces the risk of adverse price fluctuations that may impact business operations, which in turn theoretically results in increased ‘capacity utilization.’
And bear in mind, there are more prosaic reasons to be cautious about commodities. From the first in a series of three posts by Frankfurter,
Futures and forward contracts are intrinsically different instruments than securities which are derived from the capital markets (e.g., fixed income or equities). This is underappreciated.
Derivatives are risk management tools, a “zero-sum game,” fundamentally different from the “rising tide raises all ships” concept of the capital formation markets. While, there is an established theoretical basis and considerable empirical evidence that link investment in capital market assets to positive expected returns over time, notwithstanding the recent surge in commodity prices, the same cannot be said about commodities.
With that as a backdrop, let’s then turn to Frankfurter’s third post, “The Mysterious Case of the Commodity Conundrum, Securitization of Commodities, and Systemic Concerns.” His case is straightforward: financialization of commodities, including the growth of OTC markets, is pushing prices well out of line with fundamentals (note I have excerpted his key points; the piece provides far more evidence):
Rising prices and a widespread bull market in commodities should indicate that there is a growing scarcity of hard assets. However, traditional forces of supply and demand cannot fully account for recent prices.
To be precise, the normal price-inventory relationship has been altered. This is the assertion of an expanding list of bona fide hedgers, commodity professionals and economists. Specifically, dynamics have changed because securitized commodity-linked instruments are now considered an investment rather than risk management tools. Of late, this has been causing a self-perpetuating feedback loop of ever higher prices.
That means a bubble. Back to Frankfurter:
In a statement to the CFTC, Tom Buis, president of National Farmers Union, testified, “If [farmers] can’t market their crops at these higher prices, we’ve got a train wreck coming that’s going to be greater than anything we’ve ever seen in agriculture.” Billy Dunavant, head of cotton merchant Dunavant Enterprises, was more blunt, “The market is broken, it’s out of whack—someone has to step in and give some relief.”
Even CFTC Commissioner Jill Sommers acknowledged charges that speculators are skewing the market, in an apparent turnaround from the CFTC statement of April 21st which implied that commodity markets are functioning properly…..
the predominant view is currently biased to commodities as an investment hedge against inflation and speculators as an easy scapegoat for all the world’s commodity woes.
Unfortunately, this thinking is a self-fulfilling prophecy which ultimately may feed into a negative economic cycle where legitimate commercials are squeezed out of business thereby reducing supply, protectionism gains traction, trade breaks down, hoarding ensues, riots occur and wars erupt over access.
This may sound alarmist, but industry insiders are not buying into the one-size fits all answer that emerging economies are the primary factor driving up prices from the demand side, reinforced by supply-side shocks and peak production fears. In a slowing global economy hit by a major credit crisis and reeling from a falling dollar, it is likely that money flows seeking safe haven in hard assets is the key driver of recent volatility…..
Even if one accepts all the arguments that there is an economic shift in fundamentals which has resulted in rising commodity demand in emerging economies, as well as arguments that there are supply-side constraints bottle-necking commodity production, it is imprudent to deny that this perfect storm has been accompanied by a paradigm shift in how the commodity markets have historically operated.
We’ve been hear before… Economic problems related to OTC derivatives first occurred n 1994 which included the bankruptcy of Orange County , in 1998 with the collapse of Long-Term Capital Management, then during the California electricity crisis of 2000 and 2001 due to market manipulation by Enron, and most recently the credit crisis as a result of mortgage securitization repackaged into complex derivatives.
This history should not be misconstrued, however. Derivative products in themselves are not necessarily the problem. Rather, it is the unregulated environment in which such instruments are traded, and the lack of a cohesive infrastructure to manage the trading, clearing and mark-to-market pricing of such instruments. The regulated futures industry, on the other hand, provides a robust alternative model for trading derivatives.
An aside: perhaps I have been asleep at the switch, but aside from a mention in a New York Times article of a AIG, which manages commodity funds, entering directly into a contract with a farmer, I have not seem any mention in the mainstream media about OTC commodity trading, yet Frankfurter indicates this is a significant and growing factor. I wonder if this oversight is leading to incomplete analysis.
Back to Frankfurter:
Unfortunately, the most important tool of the CFTC to monitor potential market manipulation and excessive speculation, the Commitment of Traders (COT) report, was materially impacted by the CFMA [Commodity Futures Modernization Act of 2000]. In fact, this cornerstone of market surveillance has been so severely damaged as to make reliance on it nearly useless, and those who cite COT as justification for a balance between speculators and hedgers, not credible…..
The CFTC’s ability to monitor the commodity markets was further eroded when the CFTC permitted the Intercontinental Exchange (ICE) to use its trading terminals in the United States for the trading of U.S. commodity futures contracts on the ICE futures exchange in London . Subsequently, ICE Futures allowed traders in the United States to use ICE terminals in the United States to trade its synthetic futures contracts on the ICE Futures London exchange. This allowed unregistered funds to effectively bypass registration.
According to the U.S. Senate Staff Report, “Despite the use by U.S. traders of trading terminals within the United States to trade U.S. oil, gasoline, and heating oil futures contracts, the CFTC has not asserted any jurisdiction over the trading of these contracts. Persons within the United States seeking to trade key U.S. energy commodities… now can avoid all U.S. market oversight or reporting requirements by routing their trades through the ICE Futures exchange in London instead of the NYMEX in New York.”……
In addition to the issue of index funds accumulating long positions and thereby imputing an upward bias to commodities, there is another opportunity for market manipulation with respect to the construction and rebalancing of prominent commodity benchmarks such as the Goldman Sachs Commodity Index (GSCI).
As reported by the New York Times on September 30, 2006 Goldman Sachs significantly readjusted in August of that year the GSCI’s gasoline weighting. Index products tracking the GSCI, and representing an estimated $60 billion in institutional investor funds, were forced to rebalance their portfolios resulting in an unwinding of positions. Originally, unleaded gasoline made up 8.75 percent of the GSCI as of 6/30/2006 , but this was changed to just 2.3 percent, representing a sell-off of more than $6 billion in futures contracts.
As a result, gasoline fell 82 cent in the wholesale market over a four-week period, an unprecedented move; and crude oil, which in July 2006 traded over $79 per barrel for August delivery—at the time an all-time record—subsequently fell to around $56 by January 2007.
Many at the time argued that these moves were due to fundamentals, but… it should also be noted that the U.S. was in the midst of mid-term elections with Republicans facing a major fight to retain control over both Houses. According to a Gallup poll at the time, 42% of respondents thought that the Bush administration “deliberately manipulated the price of gasoline so that it would decrease before the elections.”
We’ve also discussed other games Goldman plays with the GSCI, most notably “date rape“, which costs investors in that index a stunning 150 basis points a month.
There are, however, three concerns as a result of the securitization of gold, which can also be applied to commodity-linked ETFs generally:
The first is that increasing gold prices act reflexively upon investor sentiment as an indicator of inflationary pressures, therefore resulting in more gold accumulation and dollar dumping—a vicious feedback loop.
The second concern, while an indirect case in point, is that the securitization of gold bullion demonstrates how easy it is for a cash commodity to be hoarded, effectively taking the supply of that hard asset off the market. Theoretically, forward contracting by investors is causing the perception of inadequate supply due to perceived increase in demand…
Third, the StreetTracks gold ETF broke the mold and open the floodgates for additional securitizations of commodities in the U.S…..these vehicles ended up doing an end-run around the CFTC by exploiting the loopholes in the CFMA.
This is only a fairly small sampling from the posts (see parts one, two, and three) which includes citations at the end of the final offering.
How much of commodity speculation is driven by leverage? In other words how much is driven by borrowing from the government backed counterfeiting cartel?
For those who would get rich by driving up the cost of food:
He who withholds grain, the people will curse him, but blessing will be on the head of him who sells it. Proverbs 11:26
Phil and Wendy’s legacy remains with us. The side-effect is killing off productive farmers and family farms. Attaching fuel production to food production is insane.
Now lets leverage food into global dice throws affecting the ability of poorer nations to feed their populations. In the US, higher core soft commodity prices means the same thing. Those record breaking numbers and stunning growing numbers entering absolute poverty and dependent on govt assistance for food means those dollars buy less and less. The largest single class getting this assistance are non-voting, non-invested and dis-empowered… children.
So ok, lets have children go hungry in the US and around the world so the lords of high finance can make billions more in a quarter of trading in opaque markets.
If these aren’t crimes against humanity, I don’t know what is.
REPEAL the CFMA and RESTORE Glass-Steagall.
USA! USA! USA!
There is definitely “new normal” as for effects on markets by highly leverage hedge funds speculating in food commodities. Now it is easier then ever to “corner” the market. And huge leverage available to hedge funds along with complete regulatory paralysis create very dangerous environment, kind of financial jungle. I think that food commodities would be treated differently for regulatory purposes then say copper and gold.
In a way introduction of computers along with fiat currency converted the market into a large simulation game in which financial markets became completely detached from the needs of economy.
In July 2010, the price of cocoa shot to its highest level in three decades as a single hedge fund, Armajaro bought a a sizable chunk of the world stock of fresh beans. Cocoa prices have risen 150% since the start of 2008 and tripled since 2007.
The 240,200 tonnes of cocoa the speculator, Anthony Ward, chairman of Armajaro snapped up is equivalent to seven per cent of world cocoa production, 15 per cent of global stocks and a quarter of European stocks. The £658 million trade would fill more than five Titanics and is enough to manufacture 5.3 billion quarter-pound chocolate bars
Here is one relevant quote from the article by Noemi Pace, Andrew Seal, Anthony Costello Has financial speculation in food commodity markets increased food prices? (http://fex.ennonline.net/34/has.aspx, published in October 2008)
Masters proposes three actions to reduce speculation on food prices and in particular, to reduce the practice of index speculators. The US Congress should:
•Modify the regulation of pension funds to prohibit commodity index replication strategies because of the damage that they do to the commodities futures markets.
•Act to close a gap in legislation that allows ‘hidden’ trading in swaps.
•Compel the Commodity Futures Trading Commission to reclassify all the positions in the commercial category of the `Commitments of Traders Reports to distinguish those positions that are controlled by “bona fide” physical hedgers from those controlled by Wall Street banks. The positions of Wall Street banks should be further broken down into “bona fide” physical hedgers and speculators.
The argument is sometimes made that speculation is unimportant because the futures speculators will never take delivery of the actual food; but this is precisely the problem and it is why this speculation is highly destructive of the true market. Purchases of agricultural commodities futures contracts have classically been the means by which a limited number of traders stabilised future commodity prices and enabled farmers to finance investments in future crop production. Speculative purchases have no other purpose than to make money for the speculators, who hold their contracts to drive up current prices with the intention not of selling the commodities in the real market, but of unloading their holdings onto an artificially inflated market, at the expense of the ultimate consumer.
Selected Comments from May 9, 2008
I am one of those foolish investors who think that rising demand from some two billion people on a resource that is very likely to be reaching production limits (oil) in an age of weakening currencies would be a rational formula for rapidly rising prices. To some degree, this can also be extended to other “things” (rice, wheat, coal, zinc, copper, land). From what I can tell, blaming the “speculators” for creating of fueling inflationary expectations when the central bank of the world’s reserve currency is keeping interest rates at levels below the rate of misleadingly measure of inflation is reversing cause and effect. Finally, the difference with the housing bubble is that rising prices in this country was not the result of people who did not have shelter suddenly deciding to quit sleeping under bridges and move indoors, nor was it the result of our population demand rising from 300 million to 500 million people with a stable housing supply. Financialization corrupted and distorted the housing market in this country, of this there can be argument. Financialization of oil is but a minor matter when it comes to that shrinking global resource.
Yves Smith:Rootless Cosmopolitan:
Did you read the piece or just react to the headline? Frankfurter is a commodities analyst and point to regulatory gaps and failings which lead to incomplete and misreported data, ample opportunities for market manipulation (he provides examples) and evidence of disconnect of commodities prices from fundamentals.
Commodities markets are small in size relative to bond and stock markets. It would not take much of a reallocation to produce distortions.
That isn’t to say that some of the price rise is not due to fundamentals, but when market participants, the producers themselves, say prices are distorted, I suggest they are closer to the action than the rest of us are.
Dear Ms Smith,
It is great that you highlighted this. I believe there are two forces here.
First is the global concentrated wealth exploiting the regulatory differences in global markets. Crudely speaking we can imagine world markets are connected at the top – where capital can flow in and out easily – and disconnected at the bottom in terms of benefit percolating into the population. Global wealth moves in chunks between these markets leading to illogical movements in the market. Moreover, this happens between asset classes (commodities, currencies, etc) and between economies or class of economies (OECD, BRIC, GEM etc). This is one force affecting the commodities markets.
The second is driven by commodity manufacturers beginning to realize how much is the real bargaining power of their products. Therefore, when Oil trading takes it to $120/barrel the producers sit up and take notice of how world reacts. If world does not end – prices of $120/barrel seem ok to them. I believe many producers, too fragmented earlier, are discovering the limits to which they can price their products. This may bring out a second wave of inflation.
Third is just a hypothesis I am trying to word please bear with me. Over years of inflation targeting we have actually suppressed the prices of certain commodities (food mainly). Therefore, some part should be fundamental increase. In addition, fundamental commodity prices generally tend to adjust in steps rather than smooth upward line. This event, occurring concurrently with the first force, could have set up a positive spiral in motion.
Of course, over course of time – the other forces from Porters five forces model (mainly threat of substitutes) start creating a downward force.
Do you think this makes sense? Rahul
P.S. Your blog is amazing and something I read daily. I am amazed at how much you are able to put together each day and all of it absolutely top-class. Kindly accept my sincere compliments.
“This issue of The Petroleum Economics Monthly begins with a short discussion of the difference between this commodity price cycle and the six earlier cycles noted since 1970 … [they] suggest that the current price rise is being driven by cash from investors, not market tightness.”
“…half to three-quarters of all commercial long positions in agricultural commodities are now held by “index funds,” the term used to describe investors who take and hold long-term positions in commodities.”
“The phenomenon is quantified for agricultural futures because CFTC data provide hard information on activity. It is extended here to energy…”
“Calculations presented in the third section of this report suggest that up to three-quarters of the long-side positions in the WTI crude contract may now be held by such investors. This conclusion has important implications for the future trend in oil prices.”
What happens when real but hard to measure trends of diminishing supply and increasing demand meet in the public mind?
Commodities: Supply: “The world is running out of resources!” Demand: “Two billion new consumers are reaching for middle class lifestyles in China and India!”
Housing: Supply: “They aren’t making any new land for building houses!” Demand: “The population is growing! There’s never been a nationwide fall in housing prices!”
Technology/NASDAQ: Supply: “Companies with first-to-market advantage will dominate the new markets!” Demand: “The new economy has done away with the business cycle and need for profits and a ‘long boom’ has begun!”
Once the vast majority of people (even economists!) become sure that prices at any level are fundamentally driven and can only go up, and that they are a “sure thing” investment, then a speculative bubble seems inevitable no matter what the underlying supply and demand trends are.
I think that when this one turns (this year, say Soros and some others?) it will deflate much faster than the housing bubble, and perhaps with similar speed to the NASDAQ bubble since it will likely be paired with a negative demand shock. The consequences of potentially rapid adjustment seem likely to be more complex and far reaching (both positive and negative) than the previous two bubbles, since commodities are inputs to every industry on the planet (when you include energy) and factor so heavily into trade flows between countries.
I too have been feeling that the current price spike in commodities, esp. oil, is bubblicious, but I’m actually hoping it lasts a little while longer. I work in the alternative energy field and these prices are providing great incentive to keep doing the research I do.
On a different topic, I second rahuldeodhar’s comments at the end – great blog Yves.
Here are some quotes from a post last week by Dan Dicker, a contributer over at thestreet.com, he has been a floor trader at the New York Mercantile Exchange with more than 20 years’ experience and is a licensed commodities trade adviser:
“The bottom line has been clear to me — speculation has been the key driver of the oil market for the past two years and will continue to be the single most important factor going forward. As crude makes new highs seemingly every day, figuring out why this destructive rally inexorably continues becomes almost more important than the rally itself.
I hope that cold-bloodedly parsing the true causes for this rally will give us the insight to predict how high oil might go and even more, how oil will trade going forward. As a floor trader of oil for 25 years, I have, I believe, a unique perspective on this rally — after all, I was immersed in this market, almost exclusively, every day of my trading life.
…the growth of commodities as an asset class is unprecedented. We need no litany of numbers to prove this point. We can merely look at the volume numbers being posted by all the major commodity exchanges over the last few years.
In oil, I will draw upon numbers from my previous trading home, the New York Mercantile Exchange. At the end of 2007, Nymex reported average daily volumes of 1.485 contracts per day, an increase of 25% over 2006. So far in 2008, growth has continued at an astronomical pace: January volumes increased 6% over the same period in 2007, February was up 28% and March increased an astounding 62%.
We don’t need to be geniuses to recognize where most of this growth is coming from. It’s not new commercial interests looking to hedge exposure to the ramping oil markets. Whether from managed futures, algorithmic programs, hedge funds or individual traders who are widening their repertoire from just stocks, it all represents an enormous increase in flow of speculative trade.
Second, the energy complex can give us a clue as to how deeply speculative action has skewed the markets. Along with the crude barrel, other oil products are traded alongside, most notably heating oil (HO) and reformulated gasoline (RB). I have written often about these in regard to the refiners — the price of finished products, particularly gasoline, have been outstripped by the quick rise of the crude barrel.
In essence, speculative action in crude is swamping out other fundamental factors, while gasoline prices are being arrived at still using fundamental measurements.
…As my old trading mentor used to tell me, “In an up market, all news is bullish.” He’s right — analysts are forced to find reasons to fill time on CNBC every day for the inexorable rise of the crude barrel and reach for fundamental reasons that are simply insufficient.”
I suspect we are at the beginning of a bubble here. Baby boomers are in their peak earnings and savings and they need a high rate of return in order to retire. The first couple of years of a bubble fundementals are not that far out of whack. But when others see the rates of return they pile on and it goes through the roof. I believe this is what happened in both the tech and housing markets and there is still a lof of money out there looking for a high rate of return.
Absolutley the most revealing set of posts that I have read in a long time. More evidence, if any were need, as to why the corporate journalists despise the bloggers. Keep up the good work.
Bubbles are a form of a legalized robbery. They are designed into existence by tremendous amount of money chasing purely speculative returns. This time around we also have a currency which seems to have lost its value store property. It forces people to search an alternative, making it even easier for the speculators to ride this trend. Speculators, using newly invented financial instruments of robbery, have a unique ability of monopolizing he prices even when there is no underlying monopoly. There is no chance of returning to normal for as long as the official currency keeps loosing its value.
A lot of this data is dicey, Yves.
First, the oil production data provided by Ed Wallace is misleading. Worldwide oil production went up a very little bit in January/February 2008 (no way it was 2.5%–more like 0.2% in each of those months–he is completely ignoring the decline rate in existing wells, and counting only new production). And that was why the price went into that trading range we saw in January and February. But production has been dropping roughly 200,000 barrels per day, per month, since then (March and April), and the strikes in the UK and Nigeria knocked about 400,000 barrels per day out of May supply. Saudi Arabia brought a new 300,000 barrels per day online at the end of April that would have given us about two months of price stability, but this was more than wiped out by the strikes and the ongoing 200,000 barrels per day per month decline rate.
Some people point to the adequacy of current gasoline supply as “proof” that fundamentals are not behind the rise in oil price. But the gasoline supply doesn’t matter right now, because the product shortage is in diesel, which is now being used to power electric plants in the Middle East because of a shortage of natural gas there. Gasoline is now basically a by-product of diesel manufacture, and is being sold for whatever you can get for it. (http://www.bi-me.com/main.php?id=19968&t=1&c=33&cg=4) But diesel spreads more than make up for the lack of profits on gasoline. That means the price of oil will stay high, even as gasoline inventories grow, at least for the foreseeable future.
Regarding the ICE issue–it’s pretty bogus, Yves. I can see manipulation in a very small market, like silver. But no way in a market as big as oil, which is traded in many markets all over the world. If the price of WTI gets out of line on NYMEX or ICE, we would have a flood of oil coming to the U.S. from all over the world. The inventory reports would soon take care of matters.
I think the reports that farmers can’t sell their crops is also bogus. Farmers can sell on the spot market or futures exchange to a speculator whenever they want to. There is no evidence whatsoever of farmers selling en masse to speculators, and then letting the corn rot in the fields because no one wants to take delivery!
I agree that Goldman successfully manipulated gasoline prices for the 2006 elections with the forced rebalancing. But gasoline has just about recovered its prior weight in the year and a half or so since then. Goldman was “forced” to sell the GSCI to S&P after that scam, and I don’t think the markets would accept another scandal like that. If you want to make a point about regulation of the markets, I’d agree that Goldman should have been prosecuted for market manipulation.
Blaming speculators for the supply and demand imbalance in energy is very unfortunate, because it stops investors and citizens from dealing effectively with the problem. It’s a form of denial.
And I would recommend taking industry analysts with a grain of salt. The longer these guys have been in the biz, the more difficult a time they seem to have dealing with the reality of the current situation. They’re all stuck in the 1980s, when the price collapse hit. But even CERA’s Daniel Yergin came out a day or two ago with a statement that said we needed to start gearing up alternative energy sources pronto because of problems with oil supply, and this was after years of wrong predictions that the price was about to fall.
This is Moe Gamble again. Before anyone panics and rushes out to buy oil, I did want to say that I expect the price to enter a trading range in June, because we will see a small amount of production gain then. But the price will resume its rise by the fall.
I also fully expect a Soviet style approach to oil prices in the U.S. within a couple of years. It will only make things worse, but it is clear to me that people in the U.S. will not deal with reality until they have run out of people to blame.
If we are in a commodity bubble, then the question of whether this is the early or late stage of the bubble is very interesting… I can think of three big factors that have the potential to derail commodity price increases sooner (within 1-2 years) rather than later:
1. Real demand shock (i.e., consumption) due to high commodity prices and slowing or recessionary economies
2. Regulators seeing evidence of speculation and perhaps finally leaning against a bubble due to its real world harm, rather than cheering it on
3. The “great deleveraging” actually playing out in the near term (and consequently reducing broad money supply despite the best efforts of central bankers to pump up base money supply)
Clearly we do have long term resource constraints and we do have to find sustainable sources of energy, encourage closed loop systems that emulate nature, etc, but with respect to what fundamental prices should be, it’s all a question of degrees and timeframe.
“It’s a form of denial.”–Moe Gamble
I think the biggest thing Americans–and especially major oil company executives–are in denail about is the diminishing importance of the United States in world affairs.
One can only laugh when Ed Wallace talks about the fall in gasoline consumption in the U.S.–as if that had some great importance in the grand scheme of things. There WILL be demand destruction in the United States, but not because Americans want it. What an incredibly arrogant and parochial attitude that man has! The U.S. has 4% of the world’s population, but uses 25% of its petroleum. As time goes on we will undoubtedly see that figure drop to 20%, then 15%, then 10%.
And the executives of publicly traded major oil companies? They’re little more than spectators. They control a piddling 10% of the world’s reserves.
No, the real power resides in OPEC, home to 40% of world oil production and almost 3/4 of reserves. OPEC claims to have 3 million barrels per day of excess capacity, so I suppose if it wanted it could drive down world oil prices.
So here’s a simple thought that flies in the face of all those incredibly complex models and theories the quants are so enamored of: If Saudi Arabia wants the price of oil to go down, it will. If Saudi Arabia wants the price of oil to go up, it will.
But some even doubt that. They believe OPEC’s claim of excess capacity is a lie. If that is so, then OPEC too has been relegated to spectator status, and can do nothing but stand back and watch as this things plays itself out on the world stage.
Saudi has excess supply, but it’s in oil nobody wants because it’s less efficient for making diesel. Again, see this important article: http://www.bi-me.com/main.php?id=19968&t=1&c=33&cg=4
But Saudi Arabia has also made clear that future production will do nothing but make up for their own decline rate. They really cannot increase worldwide oil supply beyond what they’ve done.
I agree with anonymous 1:01 that demand destruction in the U.S. will not be enough to bring down prices, and that the U.S. and its Anglo allies need to wake up to the fact of other people in the world who will be competing for resources. Demand destruction will not bring prices down because the decline in production will be faster.
Regarding a bubble in energy prices, I don’t think so, and believe me, I’d be glad to short a bubble. But I just don’t see anything like the speculator interest we’d have to be seeing to have a bubble, or anything close to the inventory build-up we’d have to have.
Prices are maybe a couple of bucks over the “correct” price right now, and that couple of bucks is due to fear of shorting in the face of supply declines due to the UK and Nigeria strikes. Still, you can see commercials holding back any major buying for June, and you can see speculators taking profits. Saudi’s Khursaniyah production should bring those shorts back in soon, and we should see a price stabilization for a bit. But only a bit.
I think people should get hedged against rising energy prices, and you don’t have to do it by speculating in oil. Your next car should be chosen for fuel efficiency. You should be checking out your state’s incentives for adding solar panels, and adding them now.
You should not expect the prices of things like solar panels to come down, because even though we can expect a price decline due to volume and manufacturing efficiency, it’s unlikely from this point on to overcome the increased energy costs of manufacture. (I do not own any solar stocks, by the way, so I’m not trying to pump my own book.)
And people should be careful about investing in oil-related stocks. The oil companies are producing less each year, and costs for new production are skyrocketing due to high energy costs and difficult geology. If you invest in an oil or natural gas producer’s stock, understand that what you are really buying is their “good” reserves–the reserves that can be produced cheaply.
Regarding analysts, and how much cred you should give to their analysis, from Bloomberg:
“This is the 18th straight week that analysts have forecast a drop in [oil] prices.”
In only four of those weeks, however, did we actually see a drop in prices.
“The oil survey has correctly predicted the direction of futures 50 percent of the time since its introduction in April 2004.”
Oil analysts, as a group, have the record of a monkey throwing darts.
I published some articles in NYT and the Baltimore Sun on energy in 1979 and have followed that market on and off since then. I liked the following piece in The Daily Telegraph even if it is a couple of months old http://www.telegraph.co.uk/opinion/main.jhtml?xml=/opinion/2008/05/03/do0311.xml
Far be it from me to argue with NYMEX floor traders but with some trepidation and humility I second the comment about people fighting the Battle of 1981– expecting oil prices to collapse because they did so in previous cycles. We have had oil prices trend steadily up for six years while supply flattened out two years ago. That would point to a supply constraint in my opinion. Note there has been no embargo or politically driven supply disruption in all this time as in the Seventies — even though supply has been hurt at the margin by above ground problems in places like Iraq and Nigeria. Could financialization be a part of the price rise? Who am I to say? But given the realities on the ground, who wouldn’t want to get interested in oil as an investment? Full disclosure — I have positions in Suncor (the leading player in the Canadian tar sands) and Encana (the Canadian natural gas producer) both of which have long lived reserves. I would go with players like this (at the right price, judge for yourselves please) or with the oil services group — the international oil majors simply can’t replace their production with new reserves, as the Daily Telegraph correctly states. That problem would also point to emerging physical scarcity in my opinion.
As for gold: as you have pointed out, we are not close to closing either our trade deficit or fiscal deficit, so we are debasing the dollar. Investor interest in gold is fed by justified distrust (in my opinion, anyway) of dollar denominated assets. So yes, the interest of ETFs has added a dimension to a market that was once dominated by commercial hedgers. But I have difficulty seeing a reversal of gold’s longterm uptrend, unless you can make a case for renewed soundness in the dollar.
I too am a naked capitalism addict and thanks so much Yves for all the effort.
Look…a few of the anonymouses are missing the point of the post.
The point was that there is a structural problem with our futures markets and the regulation that is in place for those markets. Futures markets were designed for hedging. There is an economic benefit for producers and consumers because they can plan and make the proper capital investments in order to produce and consume.
Speculators are present solely to provide liquidity…with arb players keeping them in check.
But when too much money chases too few paper assets…your market breaks down and ceases to provide accurate pricing. Producers are dropping out of futures markets because they don’t want to get leveled by margin calls (selling futures)…that doesn’t mean they let their products rot…it just means they don’t hedge themselves anymore…so what’s the point of the hedging market if the participants it was initially designed for are dropping out?
Peak oil, demand, supply, saudi arabia aside — there is a problem with the capacity and regulation …like a 300lb person riding a big wheels instead of a harley problem.
and RE: “I can see manipulation in a very small market, like silver. But no way in a market as big as oil, which is traded in many markets all over the world. If the price of WTI gets out of line on NYMEX or ICE, we would have a flood of oil coming to the U.S. from all over the world. The inventory reports would soon take care of matters.” – that’s just it, thre is no oil moving…the OTC/ICE allow trading of “sythetic” futures contracts that are hedged by real contracts…so the synthetic contracts expire and the real contracts are rolled. No oil really ever makes delivery. You will never see this trading show up in inventory reports…cushing every now and again, but not often.
Nobody has a frickin clue. Go read Matt Simmons. He has been warning of peak oil for years.
Why are we focusing on high U.S gas inventories or high U.S crude oil inventories?
The reality is that global crude oil production is stuck at 85 million barrels/day, while global consumption is 87 millions barrels/day.
So please stop with talks of a bubble, it is not a bubble.
Its peak oil, accept it. The longer we make faulty excuses for high oil prices the longer it will take to transition to alternative energy sources. The population will think oil is rigged and that prices will come down shortly, when in fact they should be told they are never coming down into we move to alternatives and consume less fossil fuel.
Russia, Mexico, Norway and others have likely seen peak oil production
On the flip side, fuel subsidies in China, India, Iran, and Venenzula continue unabated.
So with the majority of developing world subidizing oil demand, it will fall on the developed world to use less oil, which means lower economic growth.
So yes we can get lower oil prices, but it will happen at the expense of a steep US recession.
The days of goldilocks are over, we have the inverse. A little bit of growth produces horrible commodity inflation and horrible growth produces low inflation.
I almost forgot. Weren’t we blaming the weak U.S dollar for high oil prices. That proved to be BS as well. THe dollar has firmed and crude has taken off to a new high.
Nice try guys. Stop trying to make excuses. ACCEPT PEAK OIL AND ADJUST ACCORDINGLY. I WISH OUR POLITICIANS WOULD STOP BLAMING OPEC AND PRICE GOUGING AND INSTEAD LOOK AMERICANS STRAIGHT IN THE EYES AND TELL THEM THE TRUTH.
I used to think oil prices were driven by demand but as oil crossed $100 and passed $120 in record time even as U.S. demand declined, I’m thinking much of the current price increases are driven by speculation. For people who argue it’s all demand driven, oil has now doubled in about a year: have India and China really grown that fast to justify such a stunning rise? Especially in the absence of significant supply disruptions?
2 other points:
1) It’s funny that every time oil reaches a new record, someone points to some supply disruption somewhere in the world as proof that it’s legitimate. The fact is, with a commodity produced, transported, and consumed worldwide like oil, there will be problems in the supply chain all the time. Were there no hurricanes or civil wars or exploding pipelines 10 years ago? Such explanations reek of finding evidence for a pre-conceived conclusion rather than a real analysis of supply and demand fluctuations.
2) In previous posts, Yves, you’ve mentioned how the spot price for many commodities on the contract closing day is often significantly lower than what the contract settles for. In other words, actual buyers/suppliers on the spot market, are valuing the same commodity at significantly less than the price set by investors in the exchanges. This is happening because the enormous volume of contracts traded has overwhelmed the physical delivery systems that are supposed to tie contract prices to actual prices. That to me is almost prima facie evidence for speculators overwhelming the system.
While I agree that we’ll never go back to gas being $1/gal, I highly doubt that demand has risen so fast in the past year to justify the incredibly rapid increase in prices we’ve seen.
Perhaps in a few years, when peak oil hits and India and China have significantly higher demands, then perhaps oil will legitimately be priced at $120 (or $150 or whatever). But today? I doubt it.
Regarding michael’s comment:
“But when too much money chases too few paper assets…your market breaks down and ceases to provide accurate pricing. Producers are dropping out of futures markets because they don’t want to get leveled by margin calls (selling futures)…that doesn’t mean they let their products rot…it just means they don’t hedge themselves anymore…”
Oh, puh-leeze. Con-Agra can’t afford to hedge anymore??? You really think it was small family farmers hedging their crops all these years?
Besides, the thing that has everyone bitching is that prices are always going UP. If prices can be expected to go up, there is no need for Farmer Joe to hedge.
And how can there possibly be too much money chasing too few paper assets, when you can always create more paper assets? You can just as easily sell a contract for which you have no intention of delivering the commodity as buy a contract for which you have no intention of delivering the commodity, and producers speculators both routinely do exactly that to make trading profits.
As for michael’s comment “the OTC/ICE allow trading of “sythetic” futures contracts that are hedged by real contracts…so the synthetic contracts expire and the real contracts are rolled. No oil really ever makes delivery. You will never see this trading show up in inventory reports…cushing every now and again, but not often”, it shows a complete lack of understanding of the markets. Both contracts MUST BE CLOSED. If I have a contract to buy 1000 barrels of oil, I can close it out by taking delivery or I can close it out by taking out a contract to sell 1000 barrels of oil, but either way it must be closed. “Rolling it over” requires you to first close out one contract. The party who agrees to buy when I close out this contract has to be someone who either needs the commodity or needs to close out his own contract.
Regarding jj’s comment, “On the flip side, fuel subsidies in China, India, Iran, and Venenzula continue unabated”, it should be noted that the U.S. subsidizes gasoline prices as well, only the U.S. does it through the subsidization of ethanol. Since we get little to no energy gain from ethanol beyond the fossil fuel inputs, this amounts to little beyond subsidizing consumption of fossil fuels.
lune asks if demand in China can really account for current prices. The answer is that, in addition to growth in demand from China, we have an oil production decline rate–in other words, even if worldwide demand was constant (which it’s not), prices would have to go up because supply is going down. Even the recent supply plateau was not really a plateau, because it has taken so many extra rigs (and so much extra energy) to extract the oil we’ve been extracting.
The second part of the answer to lune’s question is that China and the Gulf states are consuming an awful lot: Emerging Market Oil Use Exceeds U.S. as Prices Rise (http://www.bloomberg.com/apps/news?pid=20601109&sid=a_YCEx7do3LQ&refer=home)
lune also says “you’ve mentioned how the spot price for many commodities on the contract closing day is often significantly lower”… First of all, it was never significantly lower. It was a little lower. Second, it turns out that this was essentially a small premium charged by middlemen (grain silo people) to producers (Farmer Joe, who can’t afford to hedge) for taking on price risk in slightly more volatile markets.
lune points out, correctly, that problems in the pipeline can’t account for the price rise in oil because there are always problems in the pipeline. But that’s a problem with reporting on commodity prices, not the market for commodities. Essentially, reports never have a clue why prices are going up or down, and so they assign the event of the day to explain things.
Last week we had a significant increase in oil inventory, yet the price of oil went up. This was due to significant commercial buying in anticipation of a lack of supply coming this month from Nigeria. What had happened was that commercial buyers put off buying in April as prices rose, because they expected a better price in May due to some production coming online. And at the end of April, producers jumped on prices, likewise expecting this production, and drove down the price about $9. The price should have then settled down into roughly 2-3 months of trading range between $110ish and $120ish. Unfortunately, we then saw strikes in the UK and Nigeria that wiped out such a large amount of May supply that the price had to go up. Commercial buyers who had held off buying in April were suddenly aware that the price wouldn’t be coming down any further in May, and jumped to buy.
that should say “as buy a contract for which you have no intention of taking delivery of the commidity”
Call me naive, but when I’ve been watching CNBC the most seemingly most common hedge they talk about has been the short dollar/long oil and/or commodities. Of course, this trade is based on the believe that the dollar will continue with its fall and commodities will continue with their increases, and the net position will be protected due to the offsetting positions. (note to claim that the dollars climb vs. the euro debunks oil prices are not speculative, see the recent Brad Sester article on the possibiliity of China dumping their Euro positions, http://www.rgemonitor.com/blog/setser/252577/ )
This trade in itself is speculative in its nature and while those who make the trade may state that it is based on market fundamentals the end result is speculation. Just think blackjack and imagine everyone at the table taking an insurance bet based on the dealer showing an ace. This movement will result in a lot more money being thrown on the table.
Please note, that I am still bullish on oil, and I believe that it will likely continue due to negative real interest rates and the lack of other notable investments. But don’t fool yourself to believe that oil prices are solely based on demand/supply variables. Money is cheap and oil/commodities is the largest publicized growth sector in the economy. For a recent case study on how everything will end, please go back and read all the garbage being written in 2003-2005 about the housing market and also note the lack of investment options and the negative real rates at that time. However, I believe this cycle may differ a bit from the last, I believe inflation and not growth will force the fed to increase rates and thusly deflating the oil/commodity bubble.
One last comment: It’s actually extremely important that blame not be incorrectly assigned to speculators for the energy price increases. If we hurt the markets, we increase the control of the few over energy prices and supply, and more important, we distort price signals. This is exactly what we saw going into the 2006 elections, when Hank Paulson arranged for Goldman to reweight gasoline futures out of the Goldman Sachs Commodity Index.
With one mark of the pen, Goldman was able to crash the price of gasoline and oil roughly 50%. Consumers were happy, and it probably boosted the economy for a while. But we’re paying the price for that manipulation of the price signal now. Consumers bought an entire extra year of Hummers they shouldn’t have bought, etc., and the price rise now is unnaturally fast and sharp.
As Simmons has long argued, production data has been of questionable quality. I would note that accurate data requires a very unlikely access to proprietary information, equally, access to strategic planning. Simply, there is no way to avoid selection bias and its relation to, lets say, induced and historic social psychologies.
Neoclassical economics contains particular axioms to do with methodological individualism and equilibrium. Efficient market theory is a derivative of the neoclassical and, as such, is inherently biased against artificial price.
Nevertheless, there is a long history of price movements deviating from such wonders as supply/demand curves and, when price discovery for a physical commodity is determined not through arms length trade in that commodity but, instead, by financial markets, it is worth considering that price and fundamentals might differ, even over longer periods.
Herding behaviour is not a new phenomenon nor is it manipulation and can, at the individual level, be perfectly rational even as, at the macro level, it is not. But this leads into a critique of neoclassical economics and its offshoots, so out of place here.
OK, in re. “the thing that has everyone bitching is that prices are always going UP” did not apply to the same Matt Simmons who, in a January 1998 paper, argued against what he took to be a too low price, stating:
Our intention in this report is to highlight that in the NYMEX crude oil market, price is not the beacon for fundamentals. Rather, it reflects the psychology of a small group of financial players. (Is Another “MG” At Work? (Or, What is Driving Down the Price of Oil?, 27 January 1998))
Admittedly, Simmons is not ‘everyone’ but has been an important ‘peak oil’ opinion creator.I actually don’t understand the argument mentioned in Yves’s post and used in some of the comments that commodity prices were driven upward, since newly created cash/capital flows into the commodity (future) markets or because traders/investors move cash/capital from other asset classes into the commodity markets. Like the different markets were containers in which money can be poured or from which it can be taken out or between which it can be shuffled. While an individual trader/investor certainly can sell assets of one class to buy assets of another class, therefore, moving his/her cash, every buyer meets sellers who sell the same asset for exactly the same cash amount for which the buyer is buying. Summed over the cash flow of both buyers and sellers in the market of this asset there isn’t any net moving of cash/capital in or out of this asset market at any point of time. There are only traders/investors willing to buy the asset at increasing prices. This hasn’t anything to do with moving of cash/capital into the market. I think there is a quite common false perception about what is happening when assets are traded, about an alleged “money flow” in and out of assets.S:
Therefore any explanation which uses the cash flows into the commodity markets argument, whatever the specific cause for the alleged cash flow is given, which treats markets as containers of cash in the economy, is based on a logical fallacy and can’t be true.
Or what am I missing here?Critical point in this article is the psychological sign that gold price sends. In looking at the gold oil ratio, it is screaming reversion (7x vs. 12x historically). That reversion whether oil goes up or down means gold goes up longer term. Note that gold started to break 10 days or so before the G7 meeting. It shrugged off the Treasury Dept. reversal on IMF gold sales earlier on, but when the market basically decided that intervention on the dollar was coming, they sold the metal off. Just this week we got the FT confirm article but several weeks ago we got the Canadian Finance minister musing about how the market wasn’t listening to the G7 on $. Oil may or may not be speculation, but like copper it has a relativily believable supply demand proposition. Thus it has the appearance of underlying fundamental support, plus it bolsters the longed after thesis of the global growth story. On the other hand gold is either Jewelry or inflation. Since there is really no “fundamental” story, aside from those believing a sound currency matters (hard one at that), it is far more subject to coordinated attack. It is also a threat, albiet a weak one now, to fiat. It is unimaginable that at this stage GCBs keep buying garbage treasury paper instead of gold.Anonymous:
We are clearly engaged in a massive game of chicken. The i-banks and their assets with the Fed. The commerical banks with the Fed/Treasury. The Treasury and Fed are trying to hold it together long enough for banks to recover. If for some outlier reason, depositers begin to withdraw their deposits, it would mark the end of the Fed. The perverse game of cramdown. Perhaps it is just wishful thinking to hope that the American people are educated before the full fleecing occurs.
Reload that short dollar long gold trade – and look for a nice spike when the Fed comes back to the confessionalRootless,Rootless Cosmopolitan:
Look out the window. If what you said was valid, there would be no such thing asset bubbles.
What you are missing:
1. Trading prices set at the margin, but every asset holder revalues based on marginal prices. If everyone tried to realize those prices at the margin, they’d swiftly find they were unattainable.
2. High use of leverage. Futures are intrinsically highly geared11:24 pm anonymous,Michael:
“Look out the window. If what you said was valid, there would be no such thing asset bubbles.”
Define “asset bubble”. Of course, there can be price increases of assets, anyway. It just doesn’t have anything to do with cash “flowing” into the markets. As I said, markets are no cash containers. Every buyer meets sellers who sell the same asset for exactly the same cash amount for which the buyer is buying. The net cash flow summed over both buyer and seller is Zero. The same money amount which is put into the market by the buyer is taken out by the seller. Buyers are just more eager to buy than sellers to sell, therefore higher prices.
“1. Trading prices set at the margin, but every asset holder revalues based on marginal prices. If everyone tried to realize those prices at the margin, they’d swiftly find they were unattainable.”
True, in their mind, asset holders will put new price tags at the assets which they are holding, when prices increase (or decrease). It’s a change in the book value of the asset. But this doesn’t have to do anything with my argument that there isn’t any net money flow in or out of the asset market due to buying/selling of the asset.
“2. High use of leverage. Futures are intrinsically highly geared”
In what way is high leverage supposed to invalidate my argument that each buyer meets sellers who sell the asset for exactly the same money amount? Whether the money is borrowed or not which is used for buying the asset doesn’t matter for the argument.
I still say there is a common mis-perception. In up markets, markets seem to be seen from the buyer’s perspective, who invests money to buy the asset, in down markets from the seller’s perspective, who realizes cash by selling the asset, as if the counterpart of the trade didn’t exist who exactly does the opposite.
Think about it.11:53 pm Anonymous…you’re nuts. 7% collateral is obscene leverage. And that’s not even using REAL leverage. Imagine borrowing 2x (or 30x in BSC’s case). This game gets outta hand really quick. That’s the whole point of the post. Futures markets aren’t designed to handle this type of trading. They were designed for producers and consumers to hedge…speculators were merely liquidity providers.JJ:
Producers and consumers are dropping out b/c the asset prices do not reflect their information sets.
And Apparently, the market belives Goldman Sachs has better information than do the people that actually produce the products. Amazing how that works.
But please, continue listening to “$100 trillion of infrastructure still needs to be built” Matt Simmons…he’s not batt-*hit insane, i promise.Micheal— Why would producers drop out in an asset bubble? If indeed oil prices are inflated, producers have every incentive to maximize profit by selling an extra barrel into the market. They sell the futures at a price at deliver into it with physical supply.Anonymous :
THE WORLD CAN’T PRODUCE MORE OIL, IF IT COULD IT WOULD.
Please don’t tell me that every single oil producer woke up this morning with the intent to lengthen the production cycle, but at $20 barrel, they were happy to rapidly deplete reserves.
When prices get crazy, as you say, producers respond by selling more crude. Its that simple.
Just like when stocks get expensive, insiders sell out en masse.5:19 am “but at $20 barrel, they were happy to rapidly deplete reserves.” Oil producers were very unhappy about those prices and they don’t want a return of that time. So many new actors piled into the oil markets in the 80s that prices were severely depressed. Even OPEC members were forced to break quotas just to cover their own spending and trade deficits. Now prices are high again and the biggest worry of most oil exporters is how to efficiently handle all that surplus income. The OPEC cartel has teeth again and they see little point in cranking the taps to the max.Richard Kline :I could believe oil at $90-100 on demand fundamentals—but $125 in a global environment of economic downtrend at the moment? Chickpeas shooting higher: in relation to . . . soaring population, what? Naw, not credible. There are clearly ’speculative’ processes in play in commodities, but not all speculation is created equally.Ingolf :
Much of the discussion of potential commoditiy speculation at present is made in regard to ‘hedges against inflation.’ Surely some of that is in play, but I don’t think this is the main story. Consider: the hedgies were many of them major issuers of credit default swaps to the mortgage security market, both internally to the securities themselves in some cases by apparently more actively as counterparties to major _holders_ of CDOs. [Clarification on this issue by knowledgable parties is most welcome.] This means that the hedgies or the hedgie-like i-bank arms must all be miles down on many of their CDSs outstanding. Other CDS issuers are taking a bath in carbon tetrachlorhyde at present; look at AIG’s losses in Q1. Why aren’t more hedgies stone dead?
Wellll, they all putatively carried counter-hedges of their own. Earlier on, many of these were in gold and shorting the $ for other currencies. Other hedges were clearly in commodities, specifically oil. Well, gold and the $ both came under pressure of intervention or other counter-momentum activities . . . just about the time that commodities of all sorts went vertical in their price lines. Not surprisingly as the Frankfurter says above, commodities futures markets have been ‘wired’ so that shadow players can get in without being observed, and these markets are significantly susceptible to market manipulation. For hedgies looking to offset their CDO driven CDS losses, it matters not what the intrisinc ‘value’ of soybeans, oil, or rubber is, to anyone, anywhere; all that matters is that the momentum stays up until they clear their positions for a profit. Or for the CDO market to return to ‘normal,’ i.e. balloon up again. The mystery to me for most of ‘08 so far has been, “Where are the losses from the huge paper asset declines?” I think we see the answer: In the wallets of everyone buying ballooning commodities. . . . The world will be a better if noisier place when we line the hedgie boys up against the wall, click off the safties, and close out their positions in our lives, speaking figuratively or otherwise. Or so I’d like to think. They are NOT value-added to our society.9:05 am Rootless Cosmopolitan, in a strict sense you’re right about the money flow issue (although net flows do occur whenever there are changes in the outstanding stock of a commodity or security) and it’s a point worth making. But only, I think, in passing.Anonymous :
I don’t see that it helps us much in trying to understand price changes and how well founded they may be. As someone has already noted, prices are made at the margin based on the relative eagerness of buyers and sellers. If a whole new class of relatively uninformed and price insensitive buyers turns up in a market, prices will be pressed much higher than they would otherwise have been. If you like, the ecology of that market will have been profoundly disturbed.
By the way, jj, your assumption about the reactions of sellers doesn’t necessarily hold true. It certainly hasn’t in stocks. Through much of the last decade, US corporations have been huge net buyers of stock. It’s been a bit like a long running short squeeze.Rootless Cosmopolitan:
Money transformed to claim F Claim F transformed to money
is not just MoneyX-MoneyX
but contains transforming mediations which help determine price change of both Claims and from this the underlying. Balanced reciprocity between futures and spot can become imbalanced with the former becoming determinant.
To say a purchase is a sale and a sale is a purchase hence circulation takes place is a tautology that fails to account for asymmeteries within a still not instantaneous process infected with not-so-perfect information and irrationalities.ingolf,Richard Kline:
“(although net flows do occur whenever there are changes in the outstanding stock of a commodity or security)”
Yes, there is net cash/capital flow between households (private, corporate, government) in the economy. No one could get rich, if it were otherwise. Here, that would be a net cash flow to the producer of the commodity or the issuer of the security from the unlucky ones who only will be able to re-sell the commodity/security for lower than the purchase price. There is also a net cash flow from those ones to the ones who aren’t the producer or issuer, but are able to re-sell higher than the purchase price w/o a change in the size of the stock even necessary. The market for the asset intermediates the cash flow between households, like a boundary between buckets, but the asset market itself is not the bucket to which or from which the cash flow takes place.
In the case of things that are consumed, there is also a permanent net cash flow from the consumers, the sink of the good, to the producer, the source, w/o a change in the size of the stock even necessary, either. The market of the good just intermediates this cash/capital flow also.
What goes into a boundary at one side comes out of the boundary at the other side. Markets are like boundaries. Boundaries don’t have sinks or sources. Commodity prices can’t increase because cash/capital allegedly flows from other asset markets to the commodity markets. Those capital flow explanations are bogus.
Perhaps the term “asset bubble” used for irrationally increasing prices of assets both results from and re-produces the false perception of what is going on. It supports a false association that price increases are a function of an increased volume of something. But prices are better compared to a variable like the temperature, measuring the “hotness” for the asset. Maybe the term “asset fever” would be more appropriate than “asset bubble”. High fever also can lead to delusions which can be observed quite often while watching market participants. :)So Rootless:Ingolf:
Most markets have intermediaries, who take fees; that’s a sink any way you count it.
Also in that argument, you treat commodities units as if they are of uniform expression regardless of where they are in ‘market space.’ For some assets, this is true; for others, their form changes/is changed as they pass through the market in ways that re-paramaterize their value without affecting physically or directly the asset itself. For one example securitization of sub-assets. For another example the entailment of derivatives tied to an asset unit. For a third example, a change in the currency in which they are priced. For a fourth example, a change in the exchange or clearinghouse in which the transaction is settled. Markets are not a zero-dimensional vacuum in the way that your example suggests. I’m not disputing the broad validity of your comments in saying that, only adding a layer of complexity to the picture. : )
Rootless, sorry about the delay. I haven’t checked in to the site for a few days.
You said: “The market for the asset intermediates the cash flow between households, like a boundary between buckets, but the asset market itself is not the bucket to which or from which the cash flow takes place.”
That this isn’t always so was the very point I was trying to make, all the while accepting your more general point about money flows.
To take the share market as an example, stock buybacks and cash takeovers on the demand side and IPOs, secondary issues, option exercises and other insider sales on the supply side change the number of shares outstanding. The “bucket’, to use your term, becomes either more full or less so. In most established and deep markets, of course, such changes in stock outstanding will be small and incremental. Still, the distinction is worth noting both as a general principle and because such net changes in stock outstanding can at times become very important indeed.
It struck me this week that maybe I ought to get rid of all other "finance" sources and just read/watch London's Financial Times. I won't, but might find the move efficient. For example, I spent time watching FT "View from the Market" video interviews with Nouriel Roubini, Henry Kaufman, George Soros, and Peter Bernstein. Today I ran across this very good Gillian Tett historical perspective on Financial Derivatives, looking at both the bright and dark sides of "animal spirits", Shupeterian "creative destruction", innovation, regulation and more. To Tett:Derivative Thinking, Gillian Tett, Financial Times, May 30, 2008: … If you believe in the concept of what Joseph Schumpeter called "creative destruction" — the idea that innovation is best served by letting market forces decide which ideas fail and which ones flourish — then the finance industry is entering a crucial phase. In the past eight months, it has experienced a brutal shake-out that has pushed some hallowed institutions, such as Northern Rock and Bear Stearns, over the edge. This, in turn, has prompted some politicians to call for an overhaul of how finance is practised — an overhaul that would, perhaps, impose greater control.Will we see effective regulation that doesn't unduly stifle needed innovation and proliferation of better derivative instruments? Or will the banking industry in succeed in once-again stifling all regulatory reform in order to retain their "complexity and opacity"? We'll see!
Yet some in the banking industry argue that restricting innovation is the wrong thing to do. … If you believe the bankers, the best response to the current crisis is more innovation, not less.
The issue of innovation in the financial world touches on questions that run far beyond banking alone. It even reaches the problem of whether the state should try to control the animal spirit of entrepreneurs. [The story] really starts a couple of decades ago when some bright young bankers on Wall Street hit upon the idea of derivatives. As the name suggests, derivatives are essentially instruments whose value derives from something else. If you buy an equity derivative, you are not buying shares in a company but instead a contract linked to the level of a share price. Sometimes, this type of contract can be used to help investors protect themselves from risk. If you are a pension fund manager worried about share prices falling, you might, in exchange for a small fee, buy equity market derivatives that allow you to sell shares at an above- market price if the market starts to tumble. In that sense, derivatives act rather like insurance.
However, investors also use derivatives to speculate. If a hedge fund manager thinks the stock market is going to fall, then he might buy equity derivatives contracts that pay out when share prices are low - meaning that they will benefit. And since these contracts can be created electronically, in an instant and in vast size, trading derivatives is often more efficient than buying and selling actual shares.
The first derivatives were created in the 1980s and known as interest-rate swaps or foreign-exchange swaps, since they enabled investors to place bets on movements in interest rates or currencies. Then, in the late 1980s, the business proliferated and became far more complex. There is a bitter irony that stalks the modern investment banking world: while many financial institutions exude vast power, they are highly vulnerable because it is so hard to patent their ideas. Thus, whenever a new product is invented, it tends to be copied quickly. That means that although new instruments — such as interest-rate swaps — typically start out as high-margin, bespoke products, they soon become low-margin, ubiquitous products. The only way that a bank can beat its competitors — other than having more capital or financial muscle — is to be much more creative.
However, in the early 1990s, there was another factor that made the derivatives world boom: interest rates were extremely low. That meant that the level of returns investors could achieve by holding, for example, a government bond were also low. Consequently, bankers hunted for other ways to help investors achieve good returns — such as using derivatives. "The thing to realise about the early 1990s was that you had a falling interest rate environment for several years following the recession of late '89/'90," recalls T.J. Lim, a Malaysian-born banker who was part of the original group of JPMorgan bankers who developed interest-rate swaps in the mid-1980s, and who went on to become one of the most senior bankers in the derivatives and debt world. "Everyone was looking for yield — it was a period when bankers could do almost anything you could dream of and people would buy it. For example, we had structures [with names] such as Libor squared, Inverse Floater, Power options, Convexity forwards, etc. That drove a lot of innovation."
However, in an uncanny echo of what has happened over the past year, the boom of the early 1990s ended badly. In 1994, the interest rate climate suddenly changed, unleashing wild market turbulence and causing many of the derivatives contracts to produce huge losses — or "blow up", as traders call it. For a while everyone hated derivatives — "it became a dirty word," says Lim. "I was very outspoken then in saying that there is nothing wrong with the product — it's just that the excesses got out of control. But it was a very humbling period. It brought down a number of traders and senior people. There was a lot of soul searching."
As the turmoil mounted, calls emerged for derivatives to be more tightly controlled. But the International Swaps and Derivatives Association fought back furiously, arguing that a regulatory clampdown would not only run counter to the spirit of capital markets, but also crush creativity. Their aggressive lobbying campaign was effective: by the mid-1990s, regulatory pressure had died away, and the derivatives market was free to innovate — albeit under the close eye of lawyers. "We set out to design a business guided by market discipline because we believed that it should be an even better guide to good behaviour than regulatory proscription," explains Brickell, a principal architect of ISDA's public policy framework, which helped avert a regulatory clampdown back in the 1990s.
The financial community responded to this new lease of life with a vengeance — but not quite in the way that some had expected. In the years after the 1994 turbulence in the derivatives markets, activity in the swaps world slowly recovered. However, the business had lost much of its earlier glamour, not simply due to the huge losses on derivatives, but also because of a more mundane problem: the innovation cycle. Swaps had started life as a high-margin business, but by the early 1990s they had been copied so widely that they had turned into a mass-market product. Almost as soon as the derivatives scandals had died down, bankers started the hunt for the next big thing.
… In the mid-1990s … about 80 … bankers who worked in [JP Morgan's] derivatives business were summoned to a plush hotel in Boca Raton, Florida, for a brainstorming session. The man who ran that team was a British banker called Peter Hancock. Hancock had taken over the derivatives team in the late 1980s, and seen the business become commoditised. For a few days, the young JPMorgan bankers brainstormed ways of overcoming this. Eventually, the group alighted on a potentially fertile new frontier for derivatives: credit. Until that point, banks that made large loans didn't have a way of protecting themselves against the chance of a borrower defaulting. Similarly, investors who held bonds did not have any mechanism to insure against an issuer refusing to pay out. What would happen, the JPMorgan bankers asked, if somebody created a contract that mimicked that credit risk, and then sold that risk to another investor, for a fee?
The group in Boca Raton were certainly not the only ones playing around with these ideas: rival teams at institutions such as Bankers Trust and Credit Suisse were thinking along the same lines. But JPMorgan offered an unusually fertile laboratory for experimentation. One reason was that Hancock had gathered a close-knit team of young, highly creative bankers who were open to sharing ideas. Another was that JPMorgan had a vast pool of loans on its books, thus giving Hancock's team plenty of raw material with which to conduct experiments.
Most important of all, JPMorgan's top management had a compelling reason to innovate. At the time, the bank had so many loans on its books that it was finding it expensive to keep doing business: it needed large "rainy day" reserves to protect against the chance of the loans turning sour. Hancock's team believed that if they found a way to sell this "default risk" to somebody else by repackaging the loans into derivatives, then they could persuade the regulators that they did not need to post such big reserves. "They say necessity is the mother of invention," recalls Andrew Feldstein, a former lawyer who worked with Hancock. "In this case, JPMorgan had a good reason to look at how it handled credit."
In the late 1990s, men such as Feldstein were trying to develop financial techniques that would turn loans into derivatives they could sell on. They started off doing this on an ad-hoc basis but soon discovered that if they created bundles of derivatives contracts linked to loans, then it was easier to sell these instruments to investors — in the same way that it is easier for banks to sell an investor a stake in a mutual fund than shares in an individual company.
Later generations of bankers would refer to these derivatives bundles by the unwieldy name "synthetic collateral debt obligations". But JPMorgan christened its brainchild Broad Index Secured Trust Offering — or Bistro. Within a few months, it was feeding a wide range of assets into this financial machine, ranging from corporate debt to student loans, and generating fat profits. "The business we were doing grew exponentially," recalls Terri Duhon, a young banker from Louisiana who was part of the Bistro team. "We went out and 'Bistro-ed' everything we could."
But then the vagaries of the innovation cycle kicked in. Soon, the ideas behind Bistro started to leak out. Similar products proliferated across the financial world, with equally odd names: ABN Amro, for example, created structures called "Heineken" and "Amstel". But, as the copycat process grew more intense, margins started to fall again — spurring the bankers to hunt for even more exotic and creative ways to generate returns. Some banks started to put riskier assets into the mix.
As the new century dawned, the teams that had traditionally handled "subprime mortgage" finance — or loans extended to borrowers with a poor credit history — started talking to the derivatives groups. "One of the crucial points happened in late 1997 — around then credit derivatives structurers started to meet with securitisation structurers," recalls [Robert] Reoch, who by this time was working at the Bank of America. "The bingo moment was in the coffee queue of our Chicago office when the two groups met by chance and realised they needed to talk to each other."
Out of this collision of ideas, a new game was born: bankers began to use subprime loans to create these bundles of loan default risk, now called collateralised debt obligations (CDOs) on an explosively large scale.
Ironically, perhaps, JPMorgan itself never rushed too far down this new path. Indeed, this decade JPMorgan has been notably wary of turning subprime mortgage loans into synthetic CDOs. "We couldn't see how other banks made that business work," says Bill Winters, formerly a member of Hancock's team, but now co-chief executive officer of the investment bank. "[This] was a good stance to take, in retrospect."
Other banks had fewer qualms. When the credit turmoil finally erupted last summer, investment banks such as Merrill Lynch and UBS discovered that they were holdings tens of billions of dollars of CDOs, many of which have subsequently led to losses even more devastating than in the derivatives blow-up of 1994.
"It is all about the herd instinct. People do stupid things in search of yield when interest rates are so low without proper risk-reward considerations," says T.J. Lim, who has been warning for at least three years that the boom in CDOs was heading for disaster — largely because he has always believed there were powerful parallels between this latest leg of the innovation cycle and what happened in the early 1990s.
The bankers who stoked the derivatives market boom are, unsurprisingly, at pains to distance themselves from the current credit turmoil. "This crisis has nothing to do with innovation. It is about excesses in banking," says Bill Winters, another former member of the pioneering JPMorgan team and now the co- chief executive of its investment bank. "Every four to five years there is a new excess in banking — you had the Asian crisis, then the internet bubble. The problem this time is extraordinary excess in the housing market." Or, as Hancock says, "a lot of the problems in structured finance have not been due to too much innovation, but a failure to innovate sufficiently... People have just taken the original Bistro idea, say, added zeros and done it over and over again without really thinking about the limits of diversification as a risk management tool. There is a big difference between using this structure for corporate loans, as we did at JPMorgan, and subprime mortgages."
Meanwhile, the ISDA is now fighting to ensure that regulators do not try again to clamp down on the industry. "This credit crunch gives good evidence that market discipline has guided the derivatives business better than regulation has steered housing finance," Brickell told a recent conference in Vienna.
Paul Calello, head of the investment bank at Credit Suisse, told the same conference that the derivatives industry needed to engage more fully with regulators. Winters thinks that it is time for banks to think about creating a centralised system for processing credit derivatives trades to make the market more transparent and reliable. "We need to have that debate," he says.
Hancock, the credit derivatives pioneer, thinks that more innovation is needed in terms of how bankers pay themselves — to prevent them from taking crazy risks in pursuit of fat bonuses. Meanwhile, Reoch recently co-wrote a reform paper for the European Parliament calling for changes in the incentives that drive the financial world. He also thinks it could be time to standardise complex instruments, making it easier for investors to understand them. "There is scope to create a standard CDO product," he says.
It is an open bet whether any of these ideas for reform will fly. After all, when products become simpler and more transparent, the margins typically fall. Bankers, in other words, have a strong motive to retain complexity and opacity — which is why the innovation cycle keeps turning. "I think in the next year or two, finance may become simpler," says one senior banker. "But after that we will probably just go back to the old ways again."
As the debate rumbles on, some bankers are already getting creative. These days Lim works in Mayfair as a consultant in the booming business of helping to restructure CDOs for investment groups suffering losses. Duhon works in another Mayfair consultancy, training lawyers and others to understand how credit derivatives work. Other former members of the JPMorgan team, such as Andrew Feldstein, are running hedge funds.
Meanwhile, JPMorgan itself recently bought Bear Stearns, the Wall Street brokerage felled by the credit turmoil, for a knockdown price. With Bear Stearns, it acquired a vast pile of complex financial instruments it is now trying to restructure. JPMorgan has also recently acquired a huge portfolio of so-called equity-release mortgage loans from Northern Rock and is using these to create a flurry of innovative new derivatives contracts, involving issues such as "longevity" (or placing bets on how long mortgage-borrowers might live).
"The speed at which the market has found opportunities [after this crisis] is impressive," says Winters. "I suppose you could call that innovation." Or, at least, creativity in search of another fat profit.
Gillian Tett is capital markets editor of the FT.
Tett also provides a handy list of working definitions for key terms. Back to Tett:
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