As some of you know all too well, $160 billion of bank loans – and maybe more – have been collateralized by commodities that Chinese “entrepreneurs” may very well not exactly have. Following as this does Citi’s Banamex embarrassment, the cases are reminders that it doesn’t take structured-investment vehicles, CDOs, leveraged loans, or any of the new-fangled products that preoccupy policy-makers to bring down a bank or, maybe, more than one. I don’t think all the post-crisis rules dealing with all the really fancy stuff in financial markets are wrong. I do, though, think they’ve led a lot of risk managers and regulators to take their eye off the simple stuff that can still cost big. The losses to come now are almost exact repeats of those that befell big banks in the 1960s in the great “salad-oil swindle.” Systemic risk then was averted by a combination of coincidences. Now?
Salad oil? Actually, the commodity in question was soybean oil – a key ingredient in salad dressing, at least if you like yours ranch. The swindler involved – a man named Anthony De Angelis – had previously been caught bilking the national school lunch program, selling it over two million pounds of what one politely calls “uninspected” beef for the little tots. Nothing much happened to him when this was discovered – he did go bankrupt, but it was just a learning experience. De Angelis started the Allied Crude Oil Refining Company. Moving on from school lunches, he focused on the Food for Peace program intended to feed a still-starving Europe.
After about seven years of mostly straight dealing, De Angelis was prosperous enough to contemplate cornering the soybean-oil market. So, guess what – he used his large holdings in soybean oil as collateral for loans from the biggest banks of the day. Then, he used futures to drive up the price of his holdings and, then, keep some of the money for fun and get still more bank loans for profit.
Like a lot of rogue traders, De Angelis actually thought he could stay one step ahead of the bankers and pay everyone back at some point. This proved a lot harder when he started falsifying his holdings, filling tanks with water topped only by a slim little layer of soybean oil. Eventually, bribery attempts and other brazen acts tipped inspectors from some of the savvier players. $150 million in collateral – a lot of money in the day – turned out to be worth just $6 million, crashing the futures market for soybean oil.
A lot of people lost a lot of money even as one savvy investor – a then-young whippersnapper named Warren Buffett – made bundles. However, only the soybean-oil market took a systemic dive – the rest of the critical commodities market took losses, but recovered over time.
The reason, historians say, is that the swindle didn’t turn systemic was largely a coincidence of tragic proportions. De Angelis was caught the day John F. Kennedy was assassinated in Dallas. Markets closed and, by the time they reopened the following week, losses were allocated to the most unlucky and the system staggered on into the rest of the 1960s.
So, back to China. As told in Thursday’s New York Times, the tale is essentially a sequel. Leveraged loans are collateralized by commodities in warehouses located in a port with all-too-accommodating inspectors. Tipped somehow, banks have begun looking in the warehouse windows, only to find that stockpiles of copper and other metals supposed to be their collateral are figments. Major commodity players are also involved, raising the specter that risk will go beyond manageable credit losses, especially if this scandal triggers a larger crisis in China’s all-too-fragile shadow-finance system.
Could it? That’s TBD, but so far I doubt it. If the $160 billion total exposure number is right and if the metal stockpiles aren’t leveraged elsewhere in the commodities market and if the major commodity-pool operators and traders in it have the funds with which to back their bad bets, then likely not. But, that’s a lot of ifs and no one knows.
Fans of regulatory reform have pushed hard for forcing banks out of the physical-commodity business and some have recently left of their own – or at least sort-of their own – accord. But, saying banks can’t hold physical commodities doesn’t mean they can’t lend against them and then lever this up with non-bank commodity dealers. Risk lies in the exposure, not the manner in which an exposure is taken.
That is, holding physical commodities is little different than collateralizing loans with them. If you want the copper or whatever to be a store of value, you need to be able to find it in a hurry. And, you need not to deal with counterparties as fast and loose as Mr. De Angelis, Banamex’s borrowers and, we would expect, the Chinese hustlers who – along with their collateral – are now so hard to find.