Can We Avoid Another Cataclysmic Meltdown Of The Global Financial System?

Chapter 6 Financial Weapons of Mass Destruction

Chapter 6 provides a comprehensive explanation of how the market for commodities-related financial instruments has changed. Historically, companies who were dependent on commodities used commodities future contracts to hedge against price volatility. Over time, a variety commodities-related securities (a.k.a., derivatives)were created and used by financial institutions as an alternative to other speculative investments, and that can be manipulated to generate  even higher rates of return. The list of financial institutions that began trading derivatives included the Too-Big-to-Fail (“TBTF”) mega-banks, as well as pension funds, hedge funds and private equity funds).

Provided in this chapter are descriptions of the various commodities and other natural resources that have undergone securitization.  Discussed are specific examples of how financial institutions had  manipulated commodities markets and commodity-related securities, and what had happened as a consequence. Also described are the major shifts in financialization of commodities that have occurred in the run up to the 2008 melt down and in its immediate aftermath. And insights are shared on what is still happening and what is expected to happen, if changes are not made  to regulate the behavior of those participating in the financialization of commodities markets.

Some Recent History

In 1991, Goldman Sachs a TBTF mega-bank, created a commodities index fund which allowed investors a new way to buy and  sell raw materials albeit, in the form of index fund shares.

In 2000, the US commodities markets were deregulated and pension funds looking for higher returns, commenced investing in commodities and commodity backed financial instruments. Between the years 2000 and 2007 financialization of commodities continued to grow dramatically as there was a doubling in the number of commodities futures contracts   between the year of deregulation in 2000 and 2006, two years prior to the 2008 crash.

In 2008 the financial crisis triggered a sell off of stock that triggered added demand for investments in raw materials and other commodities.  In response to this crash, the Federal Reserve instituted a $4.5 trillion quantitative easing “money dump”. At the same time the SEC and CMFT deregulated over-the-counter (“OTC”) trading of financial derivatives. Although this program was designed to bail out too-big-to fail banks and other investors who has invested heavily in the sub-prime mortgage market,  a good portion of this money dump ended up in the commodities market, causing a 183% run-up in the price of commodities immediately after the crash. This in turn caused a run-up in the value financial derivatives linked to various commodities.

It was also observed that commodities that were being traded by financial institutions were no longer linked to one specific product and it is difficult  to determine how much of this trading involves hedging of real commodity futures prices and how much is purely speculative.

All we know is that the overall commodities-linked derivatives market is enormous and is estimated to be $21 trillion at the beginning of 2015. A distinction is made between market making, hedging to protect  underlying asset values, and pure trading where mega-banks such as Goldman Sachs, Morgan Stanley and J.Morgan and commodities trading firms such as Cargill undertake trades purely for their own profit.

The Goldman Sachs Case

An example of how  complex derivatives were used as a “financial weapon of mass destruction” is presented in this chapter. The example used involves Goldman Sachs, the mega-bank who was named in a scheme that resulted in “goosing up” the price of aluminum by using derivatives trading combined with hoarding of aluminum, to manipulate its availability and price. The Goldman Sachs case was one of the first examples where a major financial institution actually got involved in owning a commodity and not just in trading commodities linked securities. Here is what happened.

In 2008, Goldman Sachs was already heavily involved in trading aluminum linked derivatives for its own account. In the summer of 2011, Goldman Sachs  was one of the first mega-bank to recognise the volatility in supplies of aluminum being used as well as a steady increase in prices being paid by end users. Goldman Sachs then developed a scheme to run up the price of aluminum and make windfall profits on resale of aluminum. Making use loopholes in the Bank Holding Act of 1956 and the London Metal Exchange anti-hoarding regulations, Goldman Sachs began acquiring aluminum and storing it in a set of  Goldman Sachs owned warehouses, and cornered the market on aluminum. Goldman Sachs then expanded the storage capacity of its warehouse subsidiary, Metro, and succeeded in acquiring large quantities of aluminum.

Metro’s aluminum acquisitions increased 30 fold, from 50,000 tons in 2008 to as much as 1.5 million tons  in 2013, which was 25% of the total amount of aluminum, enough to corner the world-wide market. By controlling the release of aluminum to major aluminum users, Goldman Sachs was able to run up the price it charged, thereby earning hundreds of millions of dollars of extra profits.  In addition, their warehouse subsidiary Metro, was able to charge aluminum storage fees of as much as $0.48/ton per day on aluminum that had been sold but was being held for future delivery. The charging of fees was made possible by Goldman Sachs’ hoarding that forced end users of this aluminum to enter into contracts for aluminum well in advance of their needs. This in-turn required these end users to store their excess inventory in Metro warehouses and pay Metro storage fees. Because Goldman Sachs was privy to  proprietary information on  what their customers needs were they could manipulate the supply to ensure that prices would remain high.  This illustrates financialization used to the extreme. 

Immediately after the crash, the SEC and CMFT deregulated the over-the-counter trading of financial derivatives. The increased speculation that ensued resulted in the 183% run up of 25 commodities prices. But the commodities that were being traded, no longer were linked to one specific product and as a consequence, it became difficult  to determine how much of this trading involved hedging of real commodity futures prices and how much was purely speculative.  All we know is that the overall commodities-linked derivatives market is enormous and is estimated to be $21 trillion at the beginning of 2015.

In this chapter, a distinction is made between market making, hedging to protect  underlying asset values, and pure trading where mega-banks such as Goldman Sachs, Morgan Stanley and J.Morgan and commodities trading firms such as Cargill undertake trades purely for their own profit.

Suggested Solutions

A conclusion reached in this chapter is that  The Federal Reserve (“The Fed”) should do more in limiting  the TBTF mega-banks’  virtually unfettered freedom to manipulate commodities. And in order to impose such limits, The Fed needs to decide which of a given TBTF bank’s  activities are indeed “complementary” to their financial activities and which are not. And even if such activities are deemed complimentary, The Fed  will still need to restrict TBTF bank complementary activities that are deemed to be too risky either for such banks or for the financial system as a whole.

However, we are forewarned that new rules to separate banking from commerce in risky areas such as commodities  are not to be expected any time soon as basic questions have yet to be asked. For example: Why do we allow our banks to operate in a way that is a hinderance to commerce and what needs to change? Why are they being allowed to pursue activities that create raw materials bottlenecks  and profit from the inconvenience these bottlenecks cause? And, how can the regulations be reshaped to prevent this from happening?

This chapter concludes that the problems illustrated by the Goldman Sachs aluminum scandal and the changes that this case illustrates that will be needed, will not easily be obtained. It is now expected that in order to get a modern version of the Glass Steagall Act  to break up the TBTF Bank oligopoly over commodities markets and legislative and regulatory changes that are proposed are expected to meet with resistance from the world’s most powerful financial institutions. As the aluminum scandal case illustrates, these TBTF banks make the markets for all major commodities, they trade the products in these markets and they own the commodities that are being traded in these markets. In other words, they are not about to relinquish control over  such a profitable  activity.

Note : The simplest form of derivative is the commodities futures contract, providing  contract holders with a hedge against adverse price changes of given commodities, such as oil, agricultural crop, metal, etc. Derivatives also include such complex financial instruments as interest rate swaps, foreign exchange bets, credit default swaps, etc. Complex derivatives are traded among banks, hedge funds and other financial institutions and are considered arbitrages for profit, not hedges against price changes.