What you didn’t read in the Barron’s cover story

I spent the better part of 2 weeks working with Gene Epstein on his cover story on the commodity bull markets. Obviously most of the material gets cut. Rightfully so, I am sure. There are a couple of points about the commodity bull markets that I think were missed. Here is the link, although you might have to sign up for a free 4-week trial to read the article:


First so far as I can tell, small investors trading through commodity index mutual and exchange funds appears to be the minor part of the commodity speculation problem. In trying track down these funds and total their assets, I found less than $40 billion. This leaves $300 billion unaccounted for. How did I arrive at this number?

The commodity indexes most popularly used as benchmarks for commodity investment include in their list a number of British commodity markets. While the US markets, by my estimate quoted in Barron’s, have absorbed $211 billion currently, the total figure including London is $358 billion.

Where is the rest of the money coming from? Institutional investors including pension funds, endowment funds, and even sovereign funds have made significant forays into commodities in recent years as way of boosting and diversifying returns. They have done so up until now in what has to a great extent been a self-fulfilling forecast.

The total open interest (market cap) of U.S. commodity markets peaked out recently at less than Microsoft stock reached during the tech boom ($600b). What would happen to Microsoft stock today if you tried to accumulate $200b in stock on the open market. It would go through the roof, just as commodities have done. These markets are just too small to absorb the “investment” they have attracted.

The Commodity Exchange Act addresses excess speculation in commodity markets, and states that “the Commission shall…fix such limits on the amounts of trading which may be done or positions which may be held by any person.” The only exceptions are “to permit producers, purchasers, sellers, middlemen, and users of a commodity or a product derived therefrom to hedge their legitimate anticipated business needs”(7 USC 6a).

The CFTC regulations 17 CFR 1.3(z) further spells out who is to be considered a bona fide hedger in such intricate detail as to make it unmistakable that exemptions to speculative limits are intended only for those commonly known as “the trade” who carry on a cash business in the commodity itself.

The Commission acknowledges that speculative limits apply to indexers: “Mutual funds (or for that matter institutional traders) who want to gain commodity exposure”, whether in an individual commodity future or in several commodity futures that make up an index, are not entitled to an exemption as a bona fide hedger.”

But what agency takes away with one hand, it gives back with the other: “Swaps dealers that have swap agreements with clients that provide the clients with a return on an index of commodities can hedge the exposure from that agreement by buying futures contracts in the commodities underlying the index.”

The illogic of limiting position sizes for indexers dealing directly in futures while exempting indexers who use a swap deal intermediary has apparently not escaped the Commission’s attention. And it has a proposal on the table to correct this inequity. In November the agency proposed new exemptions for “risk management positions,” which would open the door to all indexers while, of course, leaving the swap dealer exemptions in place.

The National Grain and Feed Association, whose members handle more than 70 percent of all US grains and oilseeds, has officially protested new exemptions, citing dramatic adverse impact the current level of speculation has had on grain elevators, feed mills and grain processors. Demand for futures has caused them to maintain a premium to cash prices when they should be converging, and high volatility has dramatically increased margins required to maintain hedges.

In proposing the new exemptions, the CFTC acknowledges that index-based positions differ enough from bona fide hedges as to make hedge exemptions inappropriate under current law. It does not state where it found the authority to classified swap dealers as hedgers in the first place. It is also unclear why swap dealers should be accorded special treatment.

Their cozy arrangement began during the Reagan Administration under CFTC Chairman Wendy Graham (the other half of the Texas Senator Phil Grahm’s duo that Barron’s dubbed “Mr. & Mrs. Enron”). She began exempting swaps from CFTC oversight in 1989, and in 1992 granted Enron regulatory exemption for its energy-swap operation just five days before resigning her Chair to join Enron’s audit committee.

In 2000 the CFTC officially granted dealers broad relief with the result that today swaps are cleared through the US futures clearing systems alongside futures contracts, thus affording exchange level payment guarantees to non-exchange traded and non-regulated derivative contracts.

Then in 2006, in undertaking a “Comprehensive Review of the Commitments of Traders Report” the Commission acknowledged that its practice of reporting the positions of swap dealers under the “commercial” category may be misleading. Though it received a record public response with practical unimity for continued and expanded position reporting, it bowed to the one dissenter.

The International Swaps and Derivatives Association (ISDA), although opposed to a separate reporting category altogether, allowed that “If the Commission decides otherwise, we recommend that any additional reporting be in a no more than two-year pilot program that we would be prepared to work with the Commission to design with a limited number of commodities.” The resulting “COT-Supplemental” report consists of just twelve markets and its two-year mandate expires at the end of this year.

More enlightening than the swap dealers wish for anonymity, was the reason stated in the ISDA’s letter to the CFTC: “the [swap dealer] category is highly concentrated, with, we believe, the top four swap dealers composing over 70% of the category. In some of the lower-volume commodities markets, only a single swap dealer is a dominant participant”.

With one to four unregulated swap dealers controlling upward of 60% of the long open interest in some markets, the CFTC’s has created a nightmarish level of concentration. Even assuming that their dealings in fact originate from non-leveraged investors, sudden setbacks in other investment areas could easily jeopardize a swap dealer’s ability to meet margin calls, al la Bear Stearns.

Sadly, futures markets are but the tip of the iceberg that the financial system is headed for. The five derivative giants are among the firms that will write off an estimate $600 billion in the sub-prime debacle. The concentration in derivatives trading among US investment banks is astounding. The most recent report on bank derivative dealing from the Comptroller of the Currency noted:

Derivatives activity in the U.S. banking system is dominated by a small group of large financial institutions. Five large commercial banks represent 97% of the total industry notional amount, 78% of total trading revenues and 87% of industry net current credit exposure.

Source: http://www.occ.treas.gov/deriv/deriv.htm

According to my calculations (admittedly, my calculator was not designed for this many zeros) it appears that these five bank’s derivatives holdings aggregate to more than 30 times capital, much of it OTC, and thus difficult to accurately price. Their total investment in exchange traded futures contracts–this includes stock indexes, currency, and financial futures– is $16 trillion notional value, for which they typically put up 5% or less margin deposit.

It is perhaps with a great deal of irony that the financial system should carry huge exposure–most of it illiquid and impossible to price accurately–in derivatives that Alan Greenspan and others who let it grow insisted were designed to make markets safer. Each of these banks undoubtedly believe (or believed at one time) that they had all of their risk laid off on someone else. It stands to reason that somebody will be without a chair when the music stops. When the last guy can’t pay the whole business will be unravel like a ball of yarn dropped from the top of the Bear Stearns tower.

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