Archive for May, 2008

Credit bubble- red herring

Monday, May 19th, 2008

Full story here.

“…Professor Mishkin’s speech offered at best only a flicker of hope that the Federal Reserve is moving away from failed Greenspan/Bernanke doctrine:

Financial history reveals the following typical chain of events: Because of either exuberant expectations about economic prospects or structural changes in financial markets, a credit boom begins, increasing the demand for some assets and thereby raising their prices. The rise in asset values, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more.

This feedback loop can generate a bubble, and the bubble can cause credit standards to ease as lenders become less concerned about the ability of the borrowers to repay loans and instead rely on further appreciation of the asset to shield themselves from losses. At some point, however, the bubble bursts. The collapse in asset prices then leads to a reversal of the feedback loop in which loans go sour, lenders cut back on credit supply, the demand for the assets declines further, and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets.

 [Extra credit here: which part of the cycle are we in now? Anyone?]

Clearly, all the theorizing in the world will have no impact whatsoever on the burst technology and mortgage finance/housing bubbles. There are, however, present-day issues of pressing vital concern. First of all, if a new regulatory approach is central to combating “episodes of financial instability”, I strongly suggest Professor Mishkin and the entire Bernanke Fed move immediately toward assuming GSE oversight (which they will avoid like the plague). Fannie, Freddie, and the FHLB have in total increased their “businesses” by over US$900 billion during the past year – and have been getting geared up to move full speed ahead. The GSE’s top regulator, commenting on CNBC back in March, stated that Fannie and Freddie “could do over $2.0 trillion in business this year if the market needs that money.” That was a blaring warning that “regulation” will remain a major part of the problem.

I’ll posit that the entire issue of “central bankers versus asset bubbles” has become little more than a red herring. While it is as of yet too early in the unfolding financial and economic crisis for “consensus opinion” to have reached a similar conclusion, in reality contemporary monetary management can already be proclaimed an unmitigated failure. Cloaked in ideology and a flawed conceptual framework, the Greenspan/Bernanke Fed sat idly by as history’s greatest credit inflation and myriad resulting bubbles irreparably damaged the underlying structure of the US credit system and real economy (before going global). And while the Fed executes its latest round of post-asset bubble “mop up”, precarious credit bubble dynamics are left to run similarly roughshod through global financial and economic systems. Better to downplay the asset bubble issue for now, as we contemplate the nature of what will be a much altered post-global credit approach to central banking.

From Mishkin:

The ultimate purpose of a central bank should be to promote the public good through policies that foster economic prosperity. Research in monetary economics describes this objective in terms of stabilizing both inflation and economic activity. Indeed, these objectives are exactly what is embodied in the dual mandate that the Congress has given the Federal Reserve.

In no way do I believe “the ultimate purpose of a central bank” is to “foster economic prosperity”, and I certainly don’t expect any such grandiose mandates to survive in the post-bubble environment. On many levels the notion that central bank policies are instrumental in creating prosperous economic conditions is problematic. For one, it grossly over promises in regard to the long-term benefits derived from the government’s manipulation of interest-rates. Secondly, it virtually guarantees an accommodative policy regime and, inevitably, a strong inflationist bias. Thirdly, such a nebulous objective invites overly discretionary policymaking, along with an activist and experimental approach to monetary management. Fourthly, such an approach ensures that policymaking errors beget greater and compounding errors.

From Mishkin:

After a bubble bursts and the outlook for economic activity deteriorates, policy should become more accommodative … If monetary policy responds immediately to the decline in asset prices, the negative effects from a bursting asset price bubble to economic activity arising from the decline in wealth and increase in the cost of capital to firms and households are likely to be small. More generally, monetary policy should react to asset price bubbles by looking to the effects of such bubbles on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability.

This passage, in particular, goes right to the heart of several key failings of current doctrine. The entire framework of ignoring asset bubbles when they are expanding and “mopping up” when they burst is a recipe for disastrous policy mistakes. And how was this not made unmistakably clear when the post-tech bubble “mop up” stoked the fledgling mortgage finance and housing bubbles?

The problem with post-asset bubble “accommodation” is that it specifically accommodates the very credit infrastructure and related monetary processes that financed the preceding boom. It works to validate the present course of financial innovation (think “Wall Street securitizations,” “CDOs” and “carry trades”), while emboldening those at the cutting edge of risk-taking (think “leveraged speculating community”). To be sure, the same Wall Street credit infrastructure that financed the tech bubble was empowered to regroup, reemerge, and aggressively expand to grossly over-finance much more expansive credit and speculative booms in mortgage-related securitizations and housing. These days, powerful forces have been unleashed to over-finance the world…”

The article goes much further in depth, I recommend you read it all. The bigger part of the iceberg is still lurking under the waves. Personally, I think your best bet is to make more friends and fewer creditors.

Weekly commentary May 19 thru 23, 2008

Saturday, May 17th, 2008

This week we saw the Dow begin to gain ground and hold it. The Dow is very close now to retaking 13,000. And the VIX is back to 16. (more…)

The Global Slump

Monday, May 12th, 2008

Full story here.

 ”The avalanche of bankruptcies has begun. Six US companies of substance have defaulted on bonds over the past fortnight, against 17 for the whole of last year.

As a “non-believer” in the instant rebound story, I am not easily shocked by gloomy reports. But the latest note by Standard & Poor’s — “The Bust After The Boom” — gave me a fright.

The sick list is varied, though most for now are victims of the housing crash: Linens ‘n Things, ($650 million), Kimball Hill ($703 million), Home Interiors ($310 million), French Lick Resorts ($142 million), Recycled Paper Greetings ($187 million), and Tropicana Entertainment ($2.49 billion).

As the Fed’s latest loan survey makes clear, lenders have dropped the guillotine. With the usual delay, the poison is spreading from banks to the real world.

Diane Vazza, S&P’s credit chief, says defaults are rising at almost twice the rate of past downturns. “Companies are heading into this recession with a much more toxic mix. Their margin for error is razor-thin,” she said.

Two-thirds have a “speculative” rating, compared to 50 percent before the dotcom bust, and 40 percent in the early 1990s. The culprit is debt. “They ramped it up in the last 18 months of the credit boom. A lot of deals were funded that should not have been funded,” she said.

Some 174 US companies are trading at “distress levels.” Spreads on their bonds have rocketed above 1,000 basis points. This does not cover the carnage among smaller firms outside the rating universe.

The California city of Vallejo (117,000 inhabitants) has just made history by opting for Chapter 9 bankruptcy, the result of tax erosion from a 26 percent fall in local house prices. Half Moon Bay may be next.

“This is the tip of the iceberg. Everybody is going to line up for Chapter 9 in California,” said John Moorlach, Orange County board chief.

US consumers are juggling plastic to put off their day of reckoning. The Fed survey said credit card debt had jumped 6.7 percent in the first quarter to $957 billion, or $6,000 per working American, despite usury rates near 20 percent.

“My guess is that many Americans continue to run up massive credit card debt because they have little intention of paying it off,” said Peter Schiff at Euro Pacific Capital. Quite.

Thankfully, the Fed’s monetary blitz has averted a depression. Emergency lending under the “unusual and exigent circumstances” clause of the Fed Act — the nuclear Article 13 (3), unused since the 1930s — has put a floor under the banking system.

There will be no “reset Armaggedon” as rates vault on honey-trap mortgages. Drastic Fed cuts — to 2 percent from 5.25 percent in September — have conjured away that disaster, at least.

One dreads to think what would have happened if Fed liquidationists (Plosser, Hoenig, Fisher) had prevailed, as they did in 1930 — and still do in Euroland, where Germany’s Axel Weber holds sway, and nobody of sense dares lead a mutiny.

Despite the rescue, US house prices are likely to fall 25 percent from peak to trough (Lehman Brothers, Goldman Sachs). We are barely half done, yet 10 to 12 million households are in negative equity already.

The bears at Societe Generale are going into Siberian hibernation, issuing an “Ice Age” alert. They have slashed exposure to global equities to a minimum 30 percent for the first time ever.

Their weighting of super-safe “AAA” government bonds has been raised to a maximum 50 percent. This is a bet on gruelling “Japanese” deflation. The bank expects equities to fall by 50 to 75 percent.

“Nowhere and nothing will be immune. We are on the cusp of an equity meltdown that will slash and shred portfolios,” said Albert Edward, SG’s global strategist.

“We see a global recession unfolding. Liquidity will drain away and crush the twin emerging market and commodity bubbles. The recent hope that ‘the worst might be over’ is truly staggering. Profits are disintegrating,” he said.

Today’s “bear rally” may live on into June. Don’t count on it. Global bourses are no longer rising hand-in-hand with oil in exuberant celebration of liquidity relief (US, UK, and Canadian rate cuts).

Crude ceased to be a friend of equities when it reached around $110 a barrel. At last week’s close of $126, it became an outright threat. The Bush rescue package — $800 in rebate cheques per household — has been rendered null and void by the latest spike. The average US home is now spending over 8 percent of income on energy or fuel.

OPEC is playing with fire by refusing to pump more oil to offset rebel attacks in Nigeria. The cartel’s output drop of 350,000 barrels a day in April is a hostile act at this point.

But there again, why should Middle Eastern states help America as long as the White House keeps filling the US petroleum reserve to prepare for war with Iran? Bush is playing with fire too.

The oil spike will burn itself out. China has hit the buffers. With inflation at 8.5 percent, it risks political turmoil. Moreover, it has repeated Japan’s mistakes in the 1980s, building too many factories shipping too many goods at slender margins into a crumbling export market.

Lehman Brothers’ Sun Mingchun says China will tip over in the second half of this year. “With so much latent overcapacity, an export-led slowdown could trigger a chain reaction which, in the worst case, could threaten the stability of [its] financial and economic system,” he said.

Britain, Europe, Japan, and China will go down before America comes back up. This is turning into a synchronised bust, after all. The Global Slump of 2008-09 is under way.”

Shadowtraders Weekly Commentary May 12, 2008

Sunday, May 11th, 2008

This week we saw the Dow lose ground once again. The week started with the Dow above 13,000 and ended at 12,745. We saw the S&P 500 go from 1425 down to 1388, down 1.8% for the week. What happened? (more…)

Crisis of honesty in the marketplace

Thursday, May 8th, 2008

Our entire finance system relies on trust, particularly when we use fiat money. Not only is the gov’t printing more money, diluting the worth of the existing pile, it then compounds the sin by handing it out freely to the parties most responsible for the debacle and the most likely to use the money they receive in a damaging manner. It is like the policeman coming upon the mugger in the act and his victim, then letting the mugger go off with the victim’s wallet and further handing the mugger another $100 (so he could keep the economy moving).

This is the greater crisis in truth, honesty and believability. Triple A ratings were there to mean something. It was abused, now all AAA products suffer and individual and organized investors stay away from all, unable to discern the “lepers” in the crowd. Lower than AAA are treated as worthless, since there has been so much pain in the higher classification. Corporate earnings figures are pure lies, and have been for some time–and thus the P/E ratios and stock prices themselves.  Corporations are desperate to have some accounting trick they can use to “prove” that their worth is “X” amount, and collect their immense bonuses. Taking huge writeoffs to the point of disclosing that the corporation really isn’t worth anything near what the stock price might indicate (or that it’s basically broke) cuts into their gravy train. You’d have a better chance of pulling a bone away from a hungry pit bull than making a banker be honest and have to pass up a bonus. And why must boards (and ultimately all individual shareholders) bow to these ridiculous demands for compensation? Because all the ‘talent’ will leave if they don’t get their pay? Hold the door open for them on the way out. I would wager that I could find almost anyone who could manage to be less criminally incompetent, at a tenth or less of the current ransom.

What am I getting at here? I’m getting at really observing the financial and economic scene exactly for what it is. Only then, when all sides of a problem are seen, can we achieve a true solution, not a further sloppy patch job.

If I were a long-term holder of stocks, bonds, mutual funds, annuities, etc (which I am not), I would not be sleeping well at night. Because when I look at these, I see a pack of lies, not a valuable asset. And this is nothing to base your future happiness on. Which is probably why there is a blindness in the average person of their current (and coming) fate, because their neat little facade of financial stability is a mirage. The smart ones will divest from this cesspool sooner rather than later, and change their investing habits accordingly.

I know what my portfolio is worth because I get in a trade, make 2 ticks, then get out. I am in cash at the end of the day, and that cash grows every day, because of the strategies and discipline I apply. I don’t try and hit homeruns every time–it’s not possible. That is a truly lazy thinking and principle to work from, and ultimately gets punished–which is what we are witnessing now in the greater marketplace. Obscene amounts were made by doing nothing, lying or cheating. There is always a limit to such activity, and we’ve come to it. The question is: will we push through all the lies and get this ship righted, or will we keep “redefining the waterline” as we sink into the sunset?

Musings on the “liquidity issue”

Thursday, May 8th, 2008

 I’ve been subjecting myself to endless articles in the mainstream which preach how we have a liquidity issue in the marketplace. If this were sorted, all else would be fine and we could go back to 20% annual appreciation on our homes, stocks, etc. Uh huh…I’ve assembled some reasonable arguments, from myself and others, to bring out more data with which to address the problem

One pundit, who was keen for gov’t bonds in exchange for toxic securities, posed:

“Can we break the link between the illiquidity of banksâ?? securitised assets, which prevents their orderly liquidation, and the shortage of funding liquidity, which is the driving force of the negative feedback originating from the process of deleveraging?”

In other words, “can we prop up the value of the underlying assets to something near what the banks paid for them?” Nope. House prices have fallen and foreclosures have increased dramatically, ergo mortgage-backed securities are worth significantly less than when they were packaged. This is the reality of the situation. Let us not confuse an asset price decline with illiquidity.

What we have here is a solvency crisis. If these securitized assets are valued either where the market presently assesses them (if poorly on too little information) or in relation to any historical norm for the underlying debt and properties, then the holders of these assets are, nearly all of them, insolvent. That is the real problem, and we should be talking about how to restore solvency, to whom, on what terms, and under what regulatory regimes to avoid a redo. Calling this ‘a liquidity crisis’ embeds the assumption that as liquidity ‘returns’ to the system the price of the asset-backed securities will ‘recover’ toward their ‘underlying values,’ i.e. return to near-face value. This is an absurd assumption, as the face-values of these securitized corpses are far too high. Liquidity will right itself when instead the face values of punk assets adjust downward to real world values—which hasn’t happened. The reason these securities are illiquid is that anyone with half a brain knows they aren’t remotely worth face-value, and won’t be again ever.

The logical extension, that if any public authority guarantees bonds to be swapped out for misvalued securitized debt, the result is the absolute definition of ‘a gift of money’. Rather than face a solvency crisis, we socialize the concealed loss [and presumably then inflate it away, the logical next assumption--but that's another story]. But the whole idea of ’swapping out illiquid securities’ is specifically designed to avoid price discovery until their present holders are relieved of the fatal inconvenience of possessing them. After that, it’s the problem of this issuing institution conveniently multi-lateral and hence not subject to the ire of any one set of voters or a direct liability on any one public fisc. This seems something like the MOLECH super-SIV concept of Paulson, just exponentially bigger. Yes, pile all those rotting bonds and their risk in a warehouse on a remote bomb-proof location and then pretend that no one government has any obligation to them. . . . Right.

Depression of the 2010’s

Tuesday, May 6th, 2008

Full story here. A great piece by Darrell Schoon. This neatly sums up the present financial/economic situation. Gads, whatever else you do, read and understand the below data. Don’t just go back to watching ESPN or American Idol and think this will go away since the world didn’t explode from Bear Stearns. This is the death of 1,000 cuts if you don’t get up and do something about it. Trade with ShadowTraders.

Economics is not rocket science. Neither is power.

Depressions are monetary phenomena caused by central bank issuance of excessive credit. In 1913, the newly created US central bank, the Federal Reserve, began issuing credit-based money in the US. Within ten years, the central bank flow of credit ignited the 1920s US stock market bubble; and shortly thereafter, following the collapse of the bubble in 1929, the world entered its first Great Depression in 1933.

Investment banks are the undoing of central banking. While all banks, central, commercial and investment, view credit as the opportunity to exploit societyâ??s growth and productivity, investment bank exploitation of growth and productivity exposes society to extreme risks – for investment banks use societyâ??s savings to make their volatile and speculative bets.

The speculative risks undertaken by investment banks is done by leveraging the savings of society; and, when investment bank bets are sufficiently large enough and the bets go bad – as they inevitably do as the luck of investment bankers is due more to their proximity to credit than to their ability to foresee the future – it is society that will bear the brunt of the pain in the loss of its savings.

Inevitably, investment bankers cannot resist the temptations of excessive credit and, like the buyers of teaser-rate home mortgages, they will always overreach themselves – an overreaching that will have disastrous consequences for the society whose savings they bet.

The leveraged overreaching by investment banks in the 1920s caused the Great Depression of the 1930s and their more recent overreaching in this decade, the 2000s, is about to cause another Great Depression in the next, the 2010s.

It is the proximity of investment banks to the pools of savings that allows investment banks to profit. By their access to societyâ??s savings, investment banks use societyâ??s wealth as the foundation of their highly leveraged bets in financial markets; and in so doing, they have now placed all of us in harms way.


The collapse of financial markets in the first Great Depression led to the US Congress to enact laws that would hopefully insure that such a collapse would never again happen. To that end, in 1933 the Glass-Steagall Act was passed by Congress and signed into law.

Acknowledging the role that investment banks had played in the Great Depression, the passage of the Glass-Steagall Act in 1933 separated investment banking and commercial banking to insure that investment bank speculation would not again destabilize commercial banks as it did during the Great Depression leading to the loss of Americaâ??s savings.

What bankers hath joined together let no man put asunder

However, in 1999, the US Congress repealed the Glass-Steagall Act and America was once again vulnerable to the highly leveraged shenanigans of Wall Street. This time, however, it was not only the US but the entire world whose futures were to be bet and lost by Wall Street gamblers.

The globalization of financial markets had spread the dangers of US investment banking to banks, insurance companies, and pension funds around the world. Now, the savings of Europe and Asia as well as the US were to be impacted by the wagers of Wall Street who in the 2000s literally bet the house on the possibility that subprime CDOs were actually worth their AAA ratings.

Glass-Steagall, the law enacted in 1933 to prevent another Great Depression was repealed at the behest of bankers. While it is true that at certain times the US government will act in the best interest of society, usually (and usually in the guise of so doing) the US government is the pawn of the special interests that benefit from the trough of government largesse and regulation. The repealing of the Glass-Steagall Act in 1999 was therefore a reversion to the mean.

We are today in the initial stages of another collapse that will lead to another Great Depression. The safeguards put in place to prevent such from happening were not only disassembled in 1999; but, now in 2008, the US government has moved even closer to exposing its citizenry and indeed the world to the speculative carnage and folly of investment banking excess.


As credit markets seized up, the Fed gave the 20 primary dealers in U.S. government bonds the same access to discount- window loans that had previously been reserved for banks. The central bank now auctions as much as $100 billion to lenders a month, and has cut the cost on direct loans to just a quarter- point above the overnight rate on loans between banks.

The US Federal Reserve is now underwriting, i.e. subsidizing, the commercial activities of global private investment banks. The 20 primary dealers in US government bonds include the worldâ??s largest investment banks – BNP Paribas Securities Corp. (French), Barclays Capital Inc (British), Banc of America Securities LLC (USA), UBS Securities LLC (Swiss), Dresdner Kleinwort Wasserstein Securities LLC (German), Daiwa Securities US Inc. (Japan) etc.

In truth, these investment banks are global entities and have no actual nationality no matter what jurisdiction in which they are legally domiciled. As such, they also have no allegiance except to their own self-interests.


Why is the US government allocating public resources for the benefit of private international investment banks?


US resources are subsidizing international investment banks through the Federal Reserve Bank, a quasi private entity which was given governmental powers in 1913 (some allege in violation of the US Constitution). That a quasi private bank is bailing out private banks with public monies does make sense. What doesnâ??t make sense is why the public allows it.

There is much discussion as to the justification and reasons for US, UK, European, and Japanese central banks bailing out private banks with public money. Issues such as moral hazard are now being raised in questioning the right and consequence of so doing.

In truth, such issues are irrelevant. Not that they are in themselves not important, but issues such as moral hazard will have no effect whatsoever on what is going to happen.

Intent is the underlying motive that explains what is about to occur. The intent of private bankers is not public stability, nor growth, nor productivity – it is the pursuit of private profit via the use of public credit and debt.

Today, most governments, especially the US and UK, are controlled by private bankers – which is why government policy continues and will continue to favor the interests of private bankers over the public good.


I am sure that in some quarters of the Catholic Church objections were raised (perhaps even on theological grounds) about the torture used by the Church during the Spanish Inquisition; just as today, there have been objections raised by some in the US in regards to the use of torture in its “war on terror”.

Objections are always tolerated by those in power as long as the objections do not rise to the level of action. The objection to central bank credit and influence in our monetary affairs is therefore rhetorical. The influence of private bankers and central banking in our monetary affairs will not change until their influence has run its course – which is now about to happen.

The present epoch of central banking will perhaps be known as the period when bankers roamed the earth. Just as during the Jurassic Age, when dinosaurs roamed freely eating whatever and whomever they encountered, bankers did much the same in the present epoch that is now about to end – profiting by the productivity of society and the public and private debts incurred as a result of bankersâ?? induced credit-based spending.

Bankers achieved their immense power during this era by exploiting flaws in human nature and systemic flaws in the economic system they constructed for their own benefit. But as with all flaws, human or economic, the consequences of so doing are exposed over time. That time has now arrived.

Money is not credit, nor is money created de jure by circulating paper coupons imprinted with a government stamp stating the coupons are now legal tender to be used in the settlement of debts.

The idea that central bank coupons/paper money, sic debt, can be used to settle another debt is astounding. That we have been led to accept it is so is even more astounding. Throughout history, every experiment with paper “money” as a settlement of debt has failed. Our experiment with paper money towards that end will be no different.

The recent correction in the price of gold and silver is just that, a correction in an otherwise direct repudiation of the on-going attempt by governments and bankers to substitute paper coupons for real money.

A paper yen, a paper euro, a paper dollar, when no longer backed and convertible to gold or silver is but a paper coupon masquerading as money – a coupon with an expiration date in invisible ink.

In truth, the bankersâ?? real gambit is not their bet that paper money can be substituted for gold and silver or that subprime mortgages can be passed off as AAA securities. Their real gambit is that central bank issuance of debt as money and their control of governments will never be discovered by the public.


The world of credit and debt and all it has created has been made possible by bankers and their debt based system of money and central banking. Its cost, however, will be born by future generations who were not present when the debts were incurred.

Those who utter in pious simplicity those wonderful words, “our children are our future”, have no idea what they have done to those very children and their future by spending today what future generations will have to earn tomorrow.

Here, in the US, an entire generation has grown up on the suspect promises of easy credit and paper money. That generation is now beginning to suspect that something is wrong, that the price of their gas, food and healthcare is rapidly rising and their dream of home ownership is a trap from which bankruptcy is increasingly their only escape.

Still, this generation has no idea of how terribly wrong it actually is and why it has happened; and their ignorance of such will give them little comfort during the Great Depression that lies directly ahead.

The chickens are coming home to roost; and they closer they come, the more they are looking like vultures.

Darryl Robert Schoon

Perhaps 60% of Oil Cost is Speculation

Sunday, May 4th, 2008

Full story here. Another great article from F. William Engdahl, who’s made some tremendously astute and timely observations in economics, war and commodities. This is someone you should keep up with on your own.

“By F. William Engdahl, 2 May 2008
The price of crude oil today is not made according to any traditional relation of supply to demand. Itâ??s controlled by an elaborate financial market system as well as by the four major Anglo-American oil companies. As much as 60% of todayâ??s crude oil price is pure speculation driven by large trader banks and hedge funds. It has nothing to do with the convenient myths of Peak Oil. It has to do with control of oil and its price. How?

First, the role of the international oil exchanges in London and New York is crucial to the game. Nymex in New York and the ICE Futures in London today control global benchmark oil prices which in turn set most of the freely traded oil cargo. They do so via oil futures contracts on two grades of crude oilâ??West Texas Intermediate (WTI) and North Sea Brent.

A third rather new oil exchange, the Dubai Mercantile Exchange (DME), trading Dubai crude, is more or less a daughter of Nymex, with Nymex President, James Newsome, sitting on the board of DME and most key personnel British or American citizens.

Brent is used in spot and long-term contracts to value as much of crude oil produced in global oil markets each day. The Brent price is published by a private oil industry publication, Plattâ??s. Major oil producers including Russia and Nigeria use Brent as a benchmark for pricing the crude they produce. Brent is a key crude blend for the European market and, to some extent, for Asia.

WTI has historically been more of a US crude oil basket. Not only is it used as the basis for US-traded oil futures, but it’s also a key benchmark for US production.

â??The tail that wags the dogâ??
All this is well and official. But how todayâ??s oil prices are really determined is done by a process so opaque only a handful of major oil trading banks such as Goldman Sachs or Morgan Stanley have any idea who is buying and who selling oil futures or derivative contracts that set physical oil prices in this strange new world of â??paper oil.â?

With the development of unregulated international derivatives trading in oil futures over the past decade or more, the way has opened for the present speculative bubble in oil prices.

Since the advent of oil futures trading and the two major London and New York oil futures contracts, control of oil prices has left OPEC and gone to Wall Street. It is a classic case of the â??tail that wags the dog.â?

A June 2006 US Senate Permanent Subcommittee on Investigations report on â??The Role of Market Speculation in rising oil and gas prices,â? noted, â??â?¦there is substantial evidence supporting the conclusion that the large amount of speculation in the current market has significantly increased prices.â?

What the Senate committee staff documented in the report was a gaping loophole in US Government regulation of oil derivatives trading so huge a herd of elephants could walk through it. That seems precisely what they have been doing in ramping oil prices through the roof in recent months.

The Senate report was ignored in the media and in the Congress.

The report pointed out that the Commodity Futures Trading Trading Commission, a financial futures regulator, had been mandated by Congress to ensure that prices on the futures market reflect the laws of supply and demand rather than manipulative practices or excessive speculation. The US Commodity Exchange Act (CEA) states, â??Excessive speculation in any commodity under contracts of sale of such commodity for future delivery . . . causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity.â?

Further, the CEA directs the CFTC to establish such trading limits â??as the Commission finds are necessary to diminish, eliminate, or prevent such burden.â? Where is the CFTC now that we need such limits?

They seem to have deliberately walked away from their mandated oversight responsibilities in the worldâ??s most important traded commodity, oil.

Enron has the last laughâ?¦

As that US Senate report noted:
Until recently, US energy futures were traded exclusively on regulated exchanges within the United States, like the NYMEX, which are subject to extensive oversight by the CFTC, including ongoing monitoring to detect and prevent price manipulation or fraud. In recent years, however, there has been a tremendous growth in the trading of contracts that look and are structured just like futures contracts, but which are traded on unregulated OTC electronic markets. Because of their similarity to futures contracts they are often called â??futures look-alikes.â?

The only practical difference between futures look-alike contracts and futures contracts is that the look-alikes are traded in unregulated markets whereas futures are traded on regulated exchanges. The trading of energy commodities by large firms on OTC electronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron and other large energy traders into the Commodity Futures Modernization Act of 2000 in the waning hours of the 106th Congress.

The impact on market oversight has been substantial. NYMEX traders, for example, are required to keep records of all trades and report large trades to the CFTC. These Large Trader Reports, together with daily trading data providing price and volume information, are the CFTCâ??s primary tools to gauge the extent of speculation in the markets and to detect, prevent, and prosecute price manipulation. CFTC Chairman Reuben Jeffrey recently stated: â??The Commissionâ??s Large Trader information system is one of the cornerstones of our surveillance program and enables detection of concentrated and coordinated positions that might be used by  one or more traders to attempt manipulation.â?

In contrast to trades conducted on the NYMEX, traders on unregulated OTC electronic exchanges are not required to keep records or file Large Trader Reports with the CFTC, and these trades are exempt from routine CFTC oversight. In contrast to trades conducted on regulated futures exchanges, there is no limit on the number of contracts a speculator may hold on an unregulated OTC electronic exchange, no monitoring of trading by the exchange itself, and no reporting of the amount of outstanding contracts (â??open interestâ?) at the end of each day.â?

Then, apparently to make sure the way was opened really wide to potential market oil price manipulation, in January 2006, the Bush Administrationâ??s CFTC permitted the Intercontinental Exchange (ICE), the leading operator of electronic energy exchanges, to use its trading terminals in the United States for the trading of US crude oil futures on the ICE futures exchange in London â?? called â??ICE Futures.â?

Previously, the ICE Futures exchange in London had traded only in European energy commodities â?? Brent crude oil and United Kingdom natural gas. As a United Kingdom futures market, the ICE Futures exchange is regulated solely by the UK Financial Services Authority. In 1999, the London exchange obtained the CFTCâ??s permission to install computer terminals in the United States to permit traders in New York and other US cities to trade European energy commodities through the ICE exchange.

The CFTC opens the door

Then, in January 2006, ICE Futures in London began trading a futures contract for West Texas Intermediate (WTI) crude oil, a type of crude oil that is produced and delivered in the United States. ICE Futures also notified the CFTC that it would be permitting traders in the United States to use ICE terminals in the United States to trade its new WTI contract on the ICE Futures London exchange. ICE Futures as well allowed traders in the United States to trade US gasoline and heating oil futures on the ICE Futures exchange in London.

Despite the use by US traders of trading terminals within the United States to trade US oil, gasoline, and heating oil futures contracts, the CFTC has until today refused to assert any jurisdiction over the trading of these contracts.

Persons within the United States seeking to trade key US energy commodities â?? US crude oil, gasoline, and heating oil futures â?? are able to avoid all US market oversight or reporting requirements by routing their trades through the ICE Futures exchange in London instead of the NYMEX in New York.

Is that not elegant? The US Government energy futures regulator, CFTC opened the way to the present unregulated and highly opaque oil futures speculation. It may just be coincidence that the present CEO of NYMEX, James Newsome, who also sits on the Dubai Exchange, is a former chairman of the US CFTC. In Washington doors revolve quite smoothly between private and public posts. 

A glance at the price for Brent and WTI futures prices since January 2006 indicates the remarkable correlation between skyrocketing oil prices and the unregulated trade in ICE oil futures in US markets. Keep in mind that ICE Futures in London is owned and controlled by a USA company based in Atlanta Georgia.

In January 2006 when the CFTC allowed the ICE Futures the gaping exception, oil prices were trading in the range of $59-60 a barrel. Today some two years later we see prices tapping $120 and trend upwards. This is not an OPEC problem, it is a US Government regulatory problem of malign neglect.

By not requiring the ICE to file daily reports of large trades of energy commodities, it is not able to detect and deter price manipulation. As the Senate report noted, â??The CFTC’s ability to detect and deter energy price manipulation is suffering from critical information gaps, because traders on OTC electronic exchanges and the London ICE Futures are currently exempt from CFTC reporting requirements. Large trader reporting is also essential to analyze the effect of speculation on energy prices.â?

The report added, â??ICE’s filings with the Securities and Exchange Commission and other evidence indicate that its over-the-counter electronic exchange performs a price discovery function — and thereby affects US energy prices — in the cash market for the energy commodities traded on that exchange.â?

Hedge Funds and Banks driving oil prices

In the most recent sustained run-up in energy prices, large financial institutions, hedge funds, pension funds, and other investors have been pouring billions of dollars into the energy commodities markets to try to take advantage of price changes or hedge against them. Most of this additional investment has not come from producers or consumers of these commodities, but from speculators seeking to take advantage of these price changes. The CFTC defines a speculator as a person who â??does not produce or use the commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on price changes.”

The large purchases of crude oil futures contracts by speculators have, in effect, created an additional demand for oil, driving up the price of oil for future delivery in the same manner that additional demand for contracts for the delivery of a physical barrel today drives up the price for oil on the spot market. As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the purchase of a futures contract by a refiner or other user of petroleum.

Perhaps 60% of oil prices today pure speculation

Goldman Sachs and Morgan Stanley today are the two leading energy trading firms in the United States. Citigroup and JP Morgan Chase are major players and fund numerous hedge funds as well who speculate.

In June 2006, oil traded in futures markets at some $60 a barrel and the Senate investigation estimated that some $25 of that was due to pure financial speculation. One analyst estimated in August 2005 that US oil inventory levels suggested WTI crude prices should be around $25 a barrel, and not $60.

That would mean today that at least $50 to $60 or more of todayâ??s $115 a barrel price is due to pure hedge fund and financial institution speculation. However, given the unchanged equilibrium in global oil supply and demand over recent months amid the explosive rise in oil futures prices traded on Nymex and ICE exchanges in New York and London it is more likely that as much as 60% of the today oil price is pure speculation. No one knows officially except the tiny handful of energy trading banks in New York and London and they certainly arenâ??t talking.

By purchasing large numbers of futures contracts, and thereby pushing up futures prices to even higher levels than current prices, speculators have provided a financial incentive for oil companies to buy even more oil and place it in storage. A refiner will purchase extra oil today, even if it costs $115 per barrel, if the futures price is even higher.

As a result, over the past two years crude oil inventories have been steadily growing,
resulting in US crude oil inventories that are now higher than at any time in the previous eight years. The large influx of speculative investment into oil futures has led to a situation where we have both high supplies of crude oil and high crude oil prices.

Compelling evidence also suggests that the oft-cited geopolitical, economic, and natural factors do not explain the recent rise in energy prices can be seen in the actual data on crude oil supply and demand. Although demand has significantly increased over the past few years, so have supplies.

Over the past couple of years global crude oil production has increased along with the increases in demand; in fact, during this period global supplies have exceeded demand, according to the US Department of Energy. The US Department of Energyâ??s Energy Information Administration (EIA) recently forecast that in the next few years global surplus production capacity will continue to grow to between 3 and 5 million barrels per day by 2010, thereby â??substantially thickening the surplus capacity cushion.â?

Dollar and oil link

A common speculation strategy amid a declining USA economy and a falling US dollar is for speculators and ordinary investment funds desperate for more profitable investments amid the US securitization disaster, to take futures positions selling the dollar â??shortâ? and oil â??long.â?

For huge US or EU pension funds or banks desperate to get profits following the collapse in earnings since August 2007 and the US real estate crisis, oil is one of the best ways to get huge speculative gains. The backdrop that supports the current oil price bubble is continued unrest in the Middle East, in Sudan, in Venezuela and Pakistan and firm oil demand in China and most of the world outside the US. Speculators trade on rumor, not fact.

In turn, once major oil companies and refiners in North America and EU countries begin to hoard oil, supplies appear even tighter lending background support to present prices.

Because the over-the-counter (OTC) and London ICE Futures energy markets are unregulated, there are no precise or reliable figures as to the total dollar value of recent spending on investments in energy commodities, but the estimates are consistently in the range of tens of billions of dollars.

The increased speculative interest in commodities is also seen in the increasing popularity of commodity index funds, which are funds whose price is tied to the price of a basket of various commodity futures. Goldman Sachs estimates that pension funds and mutual funds have invested a total of approximately $85 billion in commodity index funds, and that investments in its own index, the Goldman Sachs Commodity Index (GSCI), has tripled over the past few years. Notable is the fact that the US Treasury Secretary, Henry Paulson, is former Chairman of Goldman Sachs.

Weekly Commentary May 5 through May 9

Sunday, May 4th, 2008

This week we saw the Dow hold and close above 13,000 for the first time in months. The S&P 500 closed and held above 1400. (more…)

Fed sinks the dollar

Thursday, May 1st, 2008

Full story here. Use ShadowTraders to get yourself out of debt and into a level of operation where dumb Fed activities don’t cause you life-threatening impact.

“…Changing the interest rate alone meant that the Fed didnâ??t have to â??think,â? didnâ??t have to regulate markets, raise reserve requirements on bank loans to fuel the asset-price inflation that the Fed confused with real â??wealth creation.â? It didnâ??t have to regulate subprime lending or reign in widespread financial fraud. All it had to do was raise interest rates when this gave banks an opportunity to charge more and increase their earnings â?? or cut interest rates to lower cost of bank borrowing from the Fed.

But surely not even the ideologically hide-bound Federal Reserve can still imagine that a structural problem â?? the looming depression from the Fedâ??s favoritism to the banking sector promoting de-industrialization of the economy â?? can be solved by lowering interest rates yet again. While the Fed lowers its rate for lending to banks, these banks have not been passing on the rate cuts to their customers. Credit card rates are going up, and entire Christmas trees of penalties are further increasing banksâ?? rake-off. Mortgage rates remain high, so that real estate markets remain in the doldrums. The banks simply are not lending…

What they are doing is speculating, above all against the dollar. They thus are emulating what Japanese banks did after that nationâ??s financial bubble burst in 1990. Japanâ??s banks became the most active players in the international â??carryâ? trade: borrowing at very low interest rates in a weak currency (the yen after 1990, the dollar today) to lend to high-interest borrowers, preferably with strong or at least stable currencies (such as to Iceland before it became so debt-ridden that its currency began to collapse last year; and today, the to European borrowers in euros).

So fiat US credit is being directed to Europe. US banks create or borrow credit at 2%, and lend it out at 6% or more â?? and get a speculative foreign-currency gain as the euro continues to rise against the dollar.

The aim evidently the same as it was in Japan after 1990. Many banks are nearly insolvent as a result of the b ad real estate loans on their balance sheets. To rescue them (so that it is not necessary to nationalize them, as England recently had to do with Northern Trust) is to help banks â??earn their way out of debtâ? â?? by making profitable loans.

But bank lending and profitability has become decoupled from the economy at large. Banks are not lending to finance tangible capital investment and new hiring. Helping them thus does not help pull the US economy out of the deepening depression. (A recession is short and is followed by recovery. Todayâ??s looming economic depression is headed toward a widespread forfeiture and transfer of property from debtors to creditors.)

The ultimate effect is to inflate the power of finance, credit and real estate relative to laborâ??s wages and industrial capital. This is not a way to encourage new tangible investment. It is just the opposite of Keynesianism. Rather than signaling â??euthanasia of the rentier,â? it is empowering finance and applying euthanasia to labor and industry.”