Cezary Salad

On April 27th, the US Senate, power of subpoena in hand, brought to its chambers executives from the world’s most powerful financial firm, Goldman Sachs, to testify on the cause of the biggest financial meltdown in decades – and their role in contributing to the disaster.

Eleven hours of testimony later, comedians had much more material for late night jokes and the Democrats had much more momentum for their financial reform bill.

But key questions about the financial crisis and Goldman’s activities remained unanswered, and solid financial reform is still far from certain.

It’s easy enough to see why. Take a look at the video from the hearing and you’ll hear Senators trying over and over again to get Goldman chief Lloyd Blankfein and other executives to admit that the firm had a conflict of interest vis-à-vis its clients. Reams of documents, hand-picked by the Senate’s Permanent Subcommittee on Investigations, were designed to show that the firm had shorted, or bet against, the US’ residential mortgage market, even though it was helping clients structure the opposite bet.

“You went short – big time,” Democrat Carl Levin of Michigan, the committee chairman, told Blankfein in his concluding remarks. “You don’t want to acknowledge it, I know. But that’s what your documents show.”

Now, why couldn’t Chairman Levin just get Blankfein to say as much? Or to just give up and say, “you’re right - we’re conflicted?” After all, the SEC had just accused the firm of committing fraud by not disclosing to one of its clients, German bank IKB, that Goldman had let another client influence the selection of a portfolio of mortgage-backed securities that IKB had bet on. IKB suffered heavy losses when the so-called “Abacus” portfolio went bad, while the other client, hedge fund Paulson & Co., got $1 billion off its short position and paid Goldman a $15 million fee in exchange for structuring the deal.

I think the reason Goldman was so coy – and why the committee wasted its time trying to corner the firm into admitting conflicts – boils down to something simple I heard a hedge fund manager say on the same night of the Goldman testimony.

I was at an event in New York (“Forgotten Lessons of Finance 101” put together by Ed Grebeck, a structured finance lecturer at the NYU School of Continuing and Professional Studies) where James Chanos, the short hedge fund manager famous for spotting the Enron collapse in 2001, was sharing his views.

I asked him what he thought about the SEC’s lawsuit against Goldman; he declined to comment on Goldman or the lawsuit, but he did make one remark that really put the hearing in perspective:

“I think Wall Street generally has a real, inherent problem . . . with conflicts of interest,” he said.

He pointed to equity underwriting as an example. “At its basic heart, in equity underwriting, is a conflict of interest because on the one hand you’re telling your corporate client, ‘this is a good time to raise equity money, it’s cheap, the ducks are quacking, feed them’ . . . on the other hand, you’re then telling your investment clients that this is a good deal.”

That doesn’t mean it’s all hopeless: “we build upon that and we have Chinese walls and we deal with it,” Chanos said. But it doesn’t take away from the basic fact that big investment banks of any stripe face very serious and real conflicts of interest that they have to work real hard to mitigate.

Which is why Goldman wasn’t going to go before the Senate and say anything that would indicate that it’s different from the rest of the pack by being conflicted with its clients. Democratic Senator Claire McCaskill of Missouri at least acknowledged that it wasn’t fair to single out the firm. But she still proceeded to ask the same leading questions aimed at cornering the firm’s executives into admitting conflicts of interest as all the other Senators.

Instead, here are three hard-hitting questions the Senators could have asked which, rather than trying to expose conflicts which are endemic to investment banking, could have given us a much better understanding of how to regulate the industry (fair disclosure - I used to work in investment banking and once interviewed with Goldman for a position):

1) Goldman said in response to the SEC lawsuit that it actually lost money on the Abacus deal with Paulson and IKB. Sure – they got $15 million, but lost $90 million on the transaction overall.

But how much money did the firm really make on the transaction?

Investment banks are very crafty when it comes to fees. Various divisions of an investment bank will work on one deal together and book fees from their individual contributions, though the bank may not (and often does not) disclose all the fees. Why? Because investment banks don’t have to. And if they did, telling their clients that they actually made many multiples more money than they said they did wouldn’t exactly make them look good.

Now, flip through the sales document for the Abacus deal (available here) and you’ll note on page 50 that different parts of Goldman provided interest rate hedges and collateral services for the transaction – fees that may not be included in the $15 million Goldman earned from Paulson.

So one thing the Senate could do to make the industry more transparent would be to require more transparency on fee disclosure and income reporting from all divisions working on a particular deal. Once investors see where the money is, they can make better choices about who to invest with and how to align interests.

2) Goldman’s lawyers said that ACA Capital, the third party it had contracted to select the securities in the deal, ended up not picking many of the mortgage securities Paulson suggested for inclusion in the Abacus pool. Paulson suggested 123 mortgage-backed securities but “ACA rejected more than half of the securities, and sent Goldman Sachs a revised spreadsheet listing 86 securities, including 55 from the list of 123,” the lawyers wrote in a letter to the SEC last year.

So don’t you think that the Abacus portfolio was doomed fail from the beginning?

The reason this is important is because Paulson wanted to take a short position on the deal. So obviously, the more of these securities they packed into the Abacus transaction vehicle, the better. But the structure of deals like Abacus – called synthetic collateralized debt obligations – is such that it doesn’t take many homeowners to stop paying before the equity in the transaction becomes worthless. Those 55 securities were most likely more than enough to poison the whole transaction for IKB from the outset. So Paulson’s influence on the deal may not be as small as Goldman claims it is.

The larger point:  investment banks who participate in these types of transactions can simply hide behind the fact that they are dealing with “big boys” – large, sophisticated institutional investors who know what they’re doing. But as the Abacus deal clearly shows, investors like IKB aren’t as sophisticated as they’re made out to be. Perhaps there’s a need to revisit this defense and require more disclosure where needed.

3) Goldman’s co-general counsel, Greg Palm, said on a conference call with reporters after the SEC filed its lawsuit that if Goldman “had evidence that someone here was trying to mislead someone, that’s not something we’d condone at all and we’d be the first to take action.”

But did Goldman notice the activities of the investment banker in question, Fabrice Tourre, and simply not think they were misleading or did it not notice his activities at all?

The latter option doesn’t seem like a big possibility since there are two ways to get noticed by your superiors in the world of investment banking: make a lot of money, or make very little money. If you make very little money, you’ll likely get fired. But if you make a lot of money, clearly, there is an incentive to keep you on and let you keep doing what you’re doing.

And Tourre was doing well. Anyone who brings in a $15 million fee on a single deal at the age of 27 is going to get noticed, whether it’s at Goldman or any other investment bank. And superiors will have an inherent incentive to overlook questionable dealings if overall they come out ahead on the deal. With each deal, you stretch a little more and take another step into whatever activity is minting the gold, until – like Lehman Brothers or Bear Stearns – you end up going under and are mired in lawsuits for ethical breaches.

Luckily, Goldman was able to escape that fate and is now going to re-examine its business practices. But that’s as clear an indication as any that there is a need for more accountability in investment banking from the top down and better supervision of twenty-somethings inking complex, billion-dollar deals.

With that in mind, none of the panelists at the “Finance 101” event were happy with the structure of the current financial industry reform package being championed by Democratic Connecticut Senator Chris Dodd.

“It doesn’t go far enough,” Chanos said, referring to the Dodd bill.

With hearings like these, I don’t wonder why.

Open up any paper today and you’re sure to read something along the lines of “the government’s leverage over US banks is weakening” because so many of them are exiting the Troubled Asset Relief Program (aka the bailout fund). With Citi and Wells Fargo announcing within hours of each other that they will be paying back their bailout packages, the banking sector as a whole will have paid back $161 billion of the $245 billion it received from the bailout fund, according to the Wall Street Journal.

To be sure, there is no denying that by repaying their bailout funds the banks are freeing themselves from the kind of scrutiny and tight control over pay and perks that comes with being a taxpayer-supported entity.

But let’s not kid ourselves: the US never really had much - if any - leverage over the banks it bailed out. I realized as much last week when I went to hear William Dudley, President of the Federal Reserve Bank of New York and a key behind-the-scenes player for bailout of insurer AIG, speak at my university (video available on the Columbia World Leaders Forum website).

Think back to September 2008. When Fed Chairman Ben Bernanke and former Treasury Secretary Hank Paulson went to Capitol Hill to ask Congress for the bailout funds, their rationale was simple: the very existence of the US financial system is at stake. As Dudley put it:

“The choice that faced us was financial Armageddon or saving the financial system. It was a choice between two bads and we picked what we thought was the less bad. But it wasn’t a great outcome - we agree with that.”

The reason it wasn’t a great outcome, of course, is that there was seemingly no way to separate saving the financial system from saving the financiers who nearly felled it. As a recent inspector general report uncovered, the US Treasury made its initial $85 billion loan to AIG last year knowing full well that substantial chunks would be used to make payments to the bankers it dealt with - i.e. Société Générale, Goldman Sachs, Merrill Lynch, Banc of America, among others.

Providing the loan was necessary to avoid the aforementioned Armageddon. But it also resulted in the so-called “backdoor bailout” of these banks, as they got their money and they got it at 100 cents on the dollar. So now that many of them are doing better and have either awarded or are about to award billions of dollars in taxpayer-funded bonuses, “wasn’t a great outcome” is putting it lightly.

Dudley acknowledged as much; he said multiple times that this was unfair, adding “if there were some way that we had the tools to save the financial system and not save the bankers, that would have been a better way to go. But we didn’t have that choice.”

New York Times columnist Paul Krugman thinks they did. In a scathing November 19 editorial, he accused the Fed of treating the financial industry with “kid gloves” because Dudley and his team did not exact concessions from the bankers who got AIG’s - rather, the taxpayers’ - money.

Krugman’s “kid gloves” comment was on my mind when I asked Dudley why he couldn’t wrestle even the slightest concession from, say, Goldman Sachs. After all, the investment bank held a call with business reporters in early March to say, in essence, that it had hedged its bets well enough that it did not need the $13 billion it received from AIG. Dudley was curt in his answer:

“If you’re preventing a bankruptcy, you’re supporting all the counterparties. You cannot pick and choose. And so whether Goldman Sachs was well hedged or not was immaterial.”

In other words, at the point when you say, “we’re going to avoid a bankruptcy,” you lose your leverage. The normal rules of the financial system apply and everyone gets paid what they’re owed, as opposed to a bankruptcy situation, where the senior creditors would have gotten their money first and counterparties like Goldman would likely have ended up empty-handed.

“To put it starkly, power in a negotiation comes either from being able to issue a credible threat or from coercion,” Dudley said in his prepared remarks. He freely admitted that the Fed clearly had neither tool at its disposal.

And so the financial system was saved - as were the bankers.

Lesson learned? Well, if the US gave $85 billion to an insurance company that then went on to post a world record $61.6 billion quarterly loss and reward the executives responsible for the loss with bonuses, that doesn’t say much about our ability to attach strings to bailout funds to limit these not-so-great-outcomes. Indeed, as with AIG, so with the other TARP recipients, who took when they needed and haven’t much changed their behavior.

And why should they? To paraphrase Dudley, power in negotiation comes from leverage. And the only leverage the US has these days is $12 trillion in national debt.

This is the last of a three-part series of posts reflecting on what’s really driving the price of oil in today’s markets. Last Thursday’s post focused on the role of dollar depreciation. Then, on Saturday I reflected on the tightening outlook for global supply and demand. Today’s post will examine the impact of commodity price speculators.

The third - and definitely the most controversial - long-term trend that has put upward pressure on oil prices is increasing commodity price speculation.

Under most circumstances, financial theory would dictate that the inflow of speculative capital can’t have an outsize effect on a market as large, open and actively traded as oil futures. That’s because such a market is bound to have a large variety of participants - technical traders, physical hedgers, fundamental investors, passive investors, mean reversion traders - all following various objectives and trading strategies that can’t really have a measurable impact on it.

However, this fails to hold true if there’s so many participants all following the same strategy that they do in fact move the market by creating an imbalance between the number of buyers and sellers, resulting in either a spike (via excessive buying) or a crash (via excessive selling).

And, by the looks of it, that’s precisely what’s going on in the oil futures market right now. Over the past five years, an influx of new investors have flooded the commodity markets with speculative capital, much of it following the same strategy - go long and hold - which helped to create a spike in oil prices.

Big money, big market

Let’s start with the numbers. In May, Michael Masters, manager of hedge fund Masters Capital Management, estimated that assets allocated to commodity index trading have risen twenty-fold from $13 billion at the end of 2003 to $260 billion as of March 2008. Fair disclosure: his hedge fund stood to lose a lot of money with rising oil prices, so he had an interest in arguing for greater regulation of the commodity markets. Moral hazards aside, though, in early July, CNNMoney.com reported that the International Energy Agency had came up with nearly identical figures: $15 billion in 2003, growing to $260 billion by 2008.

Where did all this money come from? The inflow of speculative capital was enabled in large part by an innovation in the world of Exchange-Traded Funds (ETFs), which track indexes but can be traded like stocks. Since 2005, when Barclays Global Investors created the first broad-based commodity ETF, commodity ETFs dedicated to tracking the performance of futures commodity indexes like the Dow Jones AIG Commodity Index (DJAIG) or the Goldman Sachs Commodity Index (GSCI) have mushroomed. This empowered investors worldwide to participate in the commodities bull market like they never could before and naturally led to a huge influx of capital - and not just from hedge funds. In late 2006, for example, CalPERS - one of the largest U.S. public pension schemes - announced that it would earmark $500 million for a pilot commodities investment program. And CalPERS definitely wasn’t alone. By 2008, Masters estimated that investors bet nearly $1 billion per day on commodity indexes in the first 52 trading days of the year.

But it is important to view these numbers in context: there are trillions of dollars’ worth of commodities contracts traded every day (New York Times business columnist Joe Nocera puts the figure at $5 trillion). In this light, a couple hundred billion worth of speculators’ capital can only have a material impact if their positions are so concentrated on any one strategy that a large-scale retreat from or a run to that position reverberates through the market.

Crowded investment strategy

To see how this can happen, it’s important to first draw some distinctions. The Commodities Futures Trading Commission (CFTC), the regulatory body tasked with overseeing the commodity futures markets, distinguishes between two types of participants: commercial and non-commerical. Commercial participants are those who have a legitimate commercial reason to hedge their exposure to a given commodity - such as a grain farmer or an oil refinery - whereas non-commercial participants are those who participate in the market purely for financial gain (i.e. speculators). Both, however, act in the same global market and therefore answer to the same oil prices. Furthermore, there are two types of trading strategies of interest in examining non-commercial participants’ impact on the market: long and short. Long positions bet on rising prices and therefore their accumulation tends to put upward pressure on prices; short positions bet on falling prices (by borrowing shares, selling them high, repurchasing when low, returning them to the borrower and pocketing the difference) and therefore their accumulation tends to put downward pressure on rising prices.

Armed with this knowledge, let’s look at the trends. Last year, the same Congressional committee that Masters testified in front of tasked Edward Krapels, manager of the gas and power practice at consultancy Energy Security Analysis, Inc., to answer essentially the same question: what is the effect of index speculators on oil prices? To answer the question, Krapels examined the difference between non-commercial speculators’ long and short positions on West Texas Intermediate (WTI) crude oil from 1986-2007. What he found was that, with some exception, between 1986 and 2002 non-commercial investors were net short on oil. Between 1992 and 2001, they oscillated between net long and net short interest. But between 2002 and 2007 - a period which saw WTI rise from $20 to $100 - the non-commercial investors were usually net long. For the sake of convenience, below I’ve reproduced the charts that Krapels uses to illustrate these trends (sorry for the bad resolution):

If anything, after Krapels’s testimony in December 2007 we can only guess that this trend continued to snowball. The public spotlight on the tight global supply and demand conditions as well as the plunging dollar gave non-commercial commodity investors few reasons to go short - an indication of how inter-connected these three trends really are. And again, the credit crunch stands out as the common element because in its wake, with the debt markets frozen and the equity markets in disarray, commodities indexes stood out as the only relatively safe place for skittish investors to park their vacant capital. The result? More capital chasing futures contracts using predominantly the same strategy: go long and hold.

Material impact on price

Now, keep in mind that futures prices are driven by expectations. As I argued in my last post, worries about fundamental supply and demand are already putting upward pressure on futures. But this effect is exacerbated by specualtors’ increasing net long interest in oil futures contracts because as more index speculators wishing to go long and hold crowd the market, the marginal futures contract becomes more expensive to purchase, which bids their prices even higher.

Here it is crucial to point out that commodity futures contracts expire every month, which forces their holders to either take the physical delivery of the commodity or to sell the contract. In practice, only about 5% of futures contracts ever result in physical delivery, and this figure isn’t any different in today’s market than in years past. So critics argue that non-commercial commodity investors cannot possibly be bidding up the price of oil since they are not removing a single drop of oil from the market (this is a point espoused by New York Times columnist Paul Krugman); they simply use calendar swaps to sell the contract to someone else before it expires and physical delivery is ultimately accepted by a commercial market participant. Thus, were non-commercial interests bidding up the price of oil, we would see huge pile-ups in oil inventories thanks to the likes of Goldman Sachs and JPMorgan, which is not the case.

But this line of reasoning misses the point. It is not the physical delivery of oil today that determines its price. Instead, it is the futures markets that are at the very front and center of how oil is priced since - as I explained in my last post - oil is priced over a futures benchmark.

Mixing water with oil

This distinction helps explain why comparisons to other commodities markets which are not as heavily traded as oil but are nonetheless surging in price - such as the global market for iron ore - are off the mark.

Yes - by all measures, prices for iron ore globally are booming thanks to growing demand from China. And because this is a market in which the only market-making activities are individual contracts between buyers and sellers, there is no room for speculative influences. Ergo: fundamental demand must be driving iron ore prices, not fundamentals.

Fair enough. But to point to this and to say it this is evidence that oil must also therefore be booming purely because of fundamental demand brushes over several crucial differences that don’t make this an apples-to-apples comparison:

• Oil pricing is benchmarked off of futures contracts. Iron ore pricing is based on spot contracts between individual market makers
• Oil has far more sophisticated market mechanisms that allow for greater price discovery (exchange-based trading, swaps, futures). Iron ore doesn’t
• No one market participant is large enough to significantly impact the price of oil. Conversely, the market for iron ore is dominated by big players who have significant control over price; when Brazilian miner Vale announced in February that it would sell iron ore to South Korean and Japanese steelmakers for 65% more than its 2007 prices, that deal effectively set the price benchmark for the whole industry
• The price of oil is growing by leaps and bounds. Iron ore is experiencing a more modest price escalation. Even a 65% year-over-year increase isn’t bad compared with the more-than-doubling of oil over the last year

Clearly, this well-intended comparison mixes water with oil.

Stormy outlook

Considering all of this, it is difficult to argue that speculators aren’t having any impact on the skyrocketing price of oil. Rather, the appropriate questions are: how much of an impact and how big relative to the other two trends. This is difficult to quantify, but estimates such as 50% of today’s oil price being caused by speculation - as offered by Masters during his testimony - don’t pass the smell test and only galvanize those who wish to keep speculators’ hands clean (in which case, rather than focusing their efforts on rebutting Masters’s testimony point-by-point, critics should try to deconstruct the much more balanced analysis offered by Krapels).

At the same time, though, it is important to remember that any price tag that we apply to speculation’s share of a barrel of oil would not be as high as it is without dollar depreciation and concerns about tight supply and demand since the three are very closely interconnected. As Krapels put it, “it would be naïve to expect any sustained causation between trading strategies and prices,” but “there are, nevertheless, several areas where causation should not be dismissed, all of them consistent with normal economic analysis,” among which he names:

1. Perfect storm episodes: there are likely to be periods of time when the condition of the physical energy market and trading strategies of financial market participants are in such good alignment as to produce “herding” and “bubbles” or their opposite, crashes
2. Variations on the market power syndrome: It is possible that the positions of some market participants - index funds as one example - are so large as to constitute witting or unwitting market power. A large-scale infusion or retreat from any of the various positions very large index funds might have price effects

By the looks of it, we are currently experiencing both situations: the mixing of these three trends has indeed created the perfect storm, and the resulting influx of long-and-hold speculators helped to grow it into the hurricane that it is today.