by Matt Taibbi
The most famous of these cases involved a major Wall Street power broker named Arthur Cutten, who was known as the “Wheat King.” The government accused Cutten of concealing his positions in the wheat market to manipulate prices. His case eventually went to the Supreme Court as Wallace v. Cutten and provided the backdrop for passage of the new 1936 commodity markets law, which gave the government strict watchdog powers to oversee the functioning of this unique kind of trading.
The commodities markets are unlike any other markets in the world, because they have two distinctly different kinds of participants. The first kind of participants are the people who either produce the commodities in question or purchase them—actual wheat farmers, say, or cereal companies that routinely buy large quantities of grain. These participants are called physical hedgers. The market primarily functions as a place where the wheat farmers meet up with the cereal companies and do business, but it also allows these physical hedgers to buy themselves a little protection against market uncertainty through the use of futures contracts.
Let’s say you’re that cereal company and your business plan for the next year depends on your being able to buy corn at a maximum of $3.00 a bushel. And maybe corn right now is selling at $2.90 a bushel, but you want to insulate yourself against the risk that prices might skyrocket in the next year. So you buy a bunch of futures contracts for corn that give you the right—say, six months from now, or a year from now—to buy corn at $3.00 a bushel.
Now, if corn prices go up, if there’s a terrible drought and corn becomes scarce and ridiculously expensive, you could give a damn, because you can buy at $3.00 no matter what. That’s the proper use of the commodities futures market.
It works in reverse, too—maybe you grow corn, and maybe you’re worried about a glut the following year that might, say, drive the price of corn down to $2.50 or below. So you sell futures for a year from now at $2.90 or $3.00, locking in your sale price for the next year. If that drought happens and the price of corn skyrockets, you might lose out, but at least you can plan for the future based on a reasonable price.
These buyers and sellers of real stuff are the physical hedgers. The FDR administration recognized, however, that in order for the market to properly function, there needed to exist another kind of player—the speculator. The entire purpose of the speculator, as originally envisioned by the people who designed this market, was to guarantee that the physical hedgers, the real players, could always have a place to buy and/or sell their products.
Again, imagine you’re that corn grower but you bring your crop to market at a moment when the cereal company isn’t buying. That’s where the speculator comes in. He buys up your corn and hangs on to it. Maybe a little later, that cereal company comes to the market looking for corn—but there are no corn growers selling anything at that moment. Without the speculator there, both grower and cereal company would be fucked in the instance of a temporary disruption.
With the speculator, however, everything runs smoothly. The corn grower goes to the market with his corn, maybe there are no cereal companies buying, but the speculator takes his crop at $2.80 a bushel. Ten weeks later, the cereal guy needs corn, but no growers are there—so he buys from the speculator, at $3.00 a bushel. The speculator makes money, the grower unloads his crop, the cereal company gets its commodities at a decent price, everyone’s happy.
This system functioned more or less perfectly for about fifty years. It was tightly regulated by the government, which recognized that the influence of speculators had to be watched carefully. If speculators were allowed to buy up the whole corn crop, or even a big percentage of it, for instance, they could easily manipulate the price. So the government set up position limits, which guaranteed that at any given moment, the trading on the commodities markets would be dominated by the physical hedgers, with the speculators playing a purely functional role in the margins to keep things running smoothly.
With that design, the commodities markets became a highly useful method of determining what is called the spot price of commodities. Commodities by their nature are produced all over the world in highly varying circumstances, which makes pricing them very trying and complicated. But the modern commodities markets simplified all that.
Corn, wheat, soybean, and oil producers could simply look at the futures prices at centralized commodities markets like the NYMEX (the New York Mercantile Exchange) to get a sense of what to charge for their products. If supply and demand were the ruling factors in determining those futures prices, the system worked fairly and sensibly. If something other than supply and demand was at work, though, then the whole system got fucked—which is exactly what happened in the summer of 2008.
The bubble that hit us that summer was a long time in coming. It began in the early eighties when a bunch of Wall Street financial companies started buying up stakes in trading firms that held seats on the various commodities exchanges. One of the first examples came in 1981, when Goldman Sachs bought up a commodities trading company called J. Aron.
Not long after that, in the early nineties, these companies quietly began to ask the government to lighten the hell up about this whole position limits business. Specifically, in 1991, J. Aron—the Goldman subsidiary—wrote to the Commodity Futures Trading Commission (the government agency overseeing this market) and asked for one measly exception to the rules.
The whole definition of physical hedgers was needlessly restrictive, J. Aron argued. Sure, a corn farmer who bought futures contracts to hedge the risk of a glut in corn prices had a legitimate reason to be hedging his bets. After all, being a farmer was risky! Anything could happen to a farmer, what with nature being involved and all!
Everyone who grew any kind of crop was taking a risk, and it was only right and natural that the government should allow these good people to buy futures contracts to offset that risk.
But what about people on Wall Street? Were not they, too, like farmers, in the sense that they were taking a risk, exposing themselves to the whims of economic nature? After all, a speculator who bought up corn also had risk—investment risk. So, Goldman’s subsidiary argued, why not allow the poor speculator to escape those cruel position limits and be allowed to make transactions in unlimited amounts? Why even call him a speculator at all? Couldn’t J. Aron call itself a physical hedger too? After all, it was taking real risk—just like a farmer!
On October 18, 1991, the CFTC—in the person of Laurie Ferber, an appointee of the first President Bush—agreed with J. Aron’s letter. Ferber wrote that she understood that Aron was asking that its speculative activity be recognized as “bona fide hedging”—and, after a lot of jargon and legalese, she accepted that argument. This was the beginning of the end for position limits and for the proper balance between physical hedgers and speculators in the energy markets.
In the years that followed, the CFTC would quietly issue sixteen similar letters to other companies. Now speculators were free to take over the commodities market. By 2008, fully 80 percent of the activity on the commodity exchanges was speculative, according to one congressional staffer who studied the numbers—“and that’s being conservative,” he said.
What was even more amazing is that these exemptions were handed out more or less in secret. “I was the head of the Division of Trading and Markets, and Brooksley Born was the chair [of the CFTC in the late nineties],” says Michael Greenberger, now a professor at the University of Maryland, “and neither of us knew this letter existed.”
And these letters might never have seen the light of day, either, but for an accident. It’s a story that reveals just how total the speculators’ hold over government is.
One congressional staffer, a former aide to the Energy and Commerce Committee, just happened to be there when certain CFTC officials mentioned the letters offhand in a hearing. “I had been invited by the Agriculture Committee to a hearing the CFTC was holding on energy,” the aide recounts. “And suddenly in the middle of it they start saying, ‘Yeah, we’ve
been issuing these letters for years now.’ And I raised my hand and said, ‘Really? You issued a letter? Can I see it?’ And they were like, ‘Uh-oh.’
“So we had a lot of phone conversations with them, and we went back and forth,” he continues. “And finally they said, ‘We have to clear it with Goldman Sachs.’ And I’m like, ‘What do you mean, you have to clear it with Goldman Sachs?’ ”
The aide showed me an e-mail exchange with a then-CFTC official who was telling him he needed to clear the release of the letters with Goldman. The aide wrote first:
We are concerned there is a reluctance to release this 1991 letter involving hedge exemptions for swaps dealers that we requested.
Please let me know the name and date of this letter.
Please advise on the cftc posture on this letter. We cannot fathom the need for secrecy.
The CFTC official wrote back:
Can you give people a couple of days to agree with you?
“People,” in this case, referred to the recipients of the letters, specifically Goldman Sachs. To which the congressional staffer wrote back:
what is the sensitivity of a 17 year old letter which shaped agency policy? I am baffled.
Adding to the problem were a series of other little-known exceptions, including the so-called swaps loophole (which allowed speculators to get around position limits if they traded through a swaps dealer), the Enron loophole (which eliminated disclosure and trading limits for trades conducted on electronic exchanges—like Goldman’s ICE), and the London loophole (loosening regulation of trades on foreign exchanges—like the one Goldman owned part of in London). The loopholes were political/regulatory absurdities, not at all unlike the fictional old British laws lampooned in the classic British TV satire Brass Eye, in which the sale of dangerous narcotics was strictly prohibited, unless it was done “through a mandrill.”
“The concepts here were ridiculous,” says another congressional aide. “You’ve got something that’s illegal if you do it one way, but perfectly okay if you do it through a swap. How does that make sense?”
All of these loopholes created—out of thin air, almost in a literal sense—a massive government subsidy for those few companies like Goldman’s J. Aron that got those semisecret letters from the CFTC. Because at the same time these companies were getting those letters, they were creating a new kind of investment vehicle, a new table at the casino as it were, and the way that vehicle was structured forced everyone who wanted to play to give them a cut.
The new investment vehicle was called index speculation. There were two main indices that investors could bet on. One was called the GSCI, or the Goldman Sachs Commodity Index. The other was the Dow Jones–AIG Commodity Index. The S&P GSCI traditionally held about two-thirds of the index speculation market, while the Dow-AIG Index had the other third, roughly.
It’s a pretty simple concept on the surface. The S&P GSCI tracks the prices of twenty-four commodities—some agricultural (cocoa, coffee, cotton, sugar, etc.), some involving livestock (hogs, cattle), some involving energy (crude oil, gasoline), and some involving metals, precious and otherwise (copper, zinc, gold, silver).
The percentages of each are different—the S&P GSCI, for instance, is heavily weighted toward the price of West Texas Intermediate Crude (the price of oil sold in the United States), which makes up 36.8 percent of the S&P GSCI. Wheat, on the other hand, only makes up 3.1 percent of the S&P GSCI. So if you invest money in the S&P GSCI and oil prices rise and wheat prices fall, and the net movement of all the other commodities on the list is flat, you’re going to make money.
What you’re doing when you invest in the S&P GSCI is buying monthly futures contracts for each of these commodities. If you decide to simply put a thousand dollars into the S&P GSCI and leave it there, the same way you might with a mutual fund, this is a little more complicated—what you’re really doing is buying twenty-four different monthly futures contracts, and then at the end of each month you’re selling the expiring contracts and buying a new set of twenty-four contracts. After all, if you didn’t sell those futures contracts, someone would actually be delivering barrels of oil to your doorstep. Since you don’t really need oil, and you’re just investing to make money, you have to continually sell your futures contracts and buy new ones in what amounts to a ridiculously overcomplex way of betting on the prices of oil and gas and cocoa and coffee.
This process of selling this month’s futures and buying the next month’s futures is called rolling. Unlike shares of stock, which you can simply buy and hold, investing in commodities involves gazillions of these little transactions made over time. So you can’t really do it by yourself: you usually have to outsource all of this activity, typically to an investment bank, which makes fees handling this process every month. This is usually achieved through yet another kind of diabolical derivative transaction called a rate swap. Roughly speaking, this infuriatingly complex scheme works like this:
You the customer take a concrete amount of money—let’s say a thousand dollars—and “invest” it in your commodity index. That thousand dollars does not go directly to the index, however. Instead, you’re buying, say, a thousand dollars’ worth of U.S. Treasury notes. The money you make from those T-bills goes, every month, to your investment bank, along with a management fee.
Your friendly investment bank, which might very well be Goldman Sachs, then takes that money and buys an equivalent amount of futures on the S&P GSCI, following the price changes.
When you cash out, the bank pays you back whatever you invested, plus whatever increases there have been in commodity prices over that period of time.
If you really want to get into the weeds of how all this works, there’s plenty of complexity there to delve into, if you’re bored as hell. The monthly roll of the S&P GSCI has achieved an almost mythical status—it is called the Goldman roll, and there are lots of folks who believe that knowing when and how it works gives investors an unfair advantage (particularly Goldman)—but in the interest of not having the reader’s head explode, we’ll skip that topic for now.
Minus all of that, the concept of index commodity speculation is pretty simple. When you invest in commodities indices, you are not actually buying cocoa, gas, or oil. You’re simply betting that prices in these products will rise over time. It might be a short period of time or a long period of time. But that’s all you’re doing, gambling on price.
To look at this another way—just to make it easy—let’s create something we call the McDonaldland Menu Index (MMI). The MMI is based upon the price of eleven McDonald’s products, including the Big Mac, the Quarter Pounder, the shake, fries, and hash browns. Let’s say the total price of those eleven products on November 1, 2010, is $37.90. Now let’s say you bet $1,000 on the McDonaldland Menu Index on that date, November 1. A month later, the total price of those eleven products is now $39.72.
Well, gosh, that’s a 4.8 percent price increase. Since you put $1,000 into the MMI on November 1, on December 1 you’ve now got $1,048. A smart investment!
Just to be clear—you didn’t actually buy $1,000 worth of Big Macs and fries and shakes. All you did is bet $1,000 on the prices of Big Macs and fries and shakes.
But here’s the thing: if you were just some schmuck on the street and you wanted to gamble on this nonsense, you couldn’t do it, because your behavior would be speculative and restricted under that old 1936 Commodity Exchange Act, which supposedly maintained that delicate balance between speculator and physical hedger (i.e., the real producers/consumers). Same goes for a giant pension fund or a trust that didn’t have one of those magic letters. Even if you wanted into this craziness, you couldn’t get in, because it was barred to the Common Speculator.
The only way for you to get to the gaming table was, in essence, to rent the speculator-hedger exemption that the government had quietly given to companies like Goldman Sachs via those sixteen letters.
If you wanted to speculate on commodity prices, you had to do so th
rough a government-licensed speculator like Goldman Sachs. It was the ultimate scam: not only did Goldman and the other banks undermine the 1936 law and upset the delicate balance that had prevented bubbles for decades, unleashing a flood of speculative money into a market that was not designed to handle it, these banks managed to secure themselves exclusive middleman status for the oncoming flood.
Now, once upon a time, this kind of “investing” was barred to institutional investors like trusts and pension funds, which by law and custom are supposed to be extremely conservative in outlook. If you’re the manager of a pension fund for Ford autoworkers, it kind of makes sense that when you invest the retirement money of a bunch of guys who spent their whole lives slaving away at hellish back-breaking factory work, that money should actually be buying something. It should go into blue-chip stocks, or Treasury bills, or some other safe-as-hell thing you can actually hold. You shouldn’t be able to put that money on red on the roulette wheel.
In fact, for most of the history of the modern American economy, there had been laws specifically barring trusts and pension funds and other such entities from investing in risky/speculative ventures. For trusts, the standard began to be set with an influential Massachusetts Supreme Court case way back in 1830 called Harvard College v. Amory, which later became the basis for something called the prudent man rule.
What the Harvard case and the ensuing prudent man rule established was that if you’re managing a trust, if you’re managing someone else’s money, you had to follow a general industry standard of prudence. You couldn’t decide, say, that your particular client had a higher appetite for risk than the norm and go off and invest your whole trust portfolio in a Mexican gold mine. There were numerous types of investments that one simply could not go near under the prudent man rule, commodity oil futures being a good example of one.