Was This Just Another Rigged Market?

Was This Just Another Rigged Market?

One month ago, Bloomberg News reported:

“Goldman Says ‘Underweight’ on Commodities for 3-6 Months”

Yesterday Bloomberg News reported:

“Goldman Sees Commodity Recovery as Slump Erases $99 Billion”

You can see how commodity prices have performed during the past month from a chart of the CRB Index below:

Source: Barchart.com

Did Goldman Sachs make an ingenious call on the commodities market?  Or is it just that Goldman Sachs controls the commodities market?

No choice for traders

The drop in the commodity index from 360 – when Goldman Sachs made the “underweight” call – to 340 may not seem a big deal.

But you have to remember that commodities trading is a super-leveraged market.

As Diggers & Drillers editor, Dr. Alex Cowie noted about the silver price slump in his weekly update:

“This fall was predominantly due to Chicago and New York commodity exchanges raising margins.  This effectively means traders suddenly faced higher trading costs – the price of trading silver futures jumped 84% in a fortnight.  It’s as though your broker suddenly doubled your brokerage.”

Actually, increasing margins is worse than doubling brokerage.

If your broker doubles their charges you can choose to trade or not.

But when the margins change, there’s no choice.  If you’re in a trade as a futures trader, you’ve got to lodge more collateral with the exchange.

The way margining works in the futures markets is that for every contract open, a trader needs to post a “bond” with the exchange.  It protects the exchange against any adverse price movement that may result in the trader losing money.

It works in the same way as a landlord requiring a bond on a rental property, or a bank requiring a deposit on a home loan.  The idea is that if the buyer or tenant does a runner, the landlord or bank can use the bond to offset any potential losses.

The difference is that in commodity markets, the “bond” or margin can change.

So, as commodity prices have risen, exchanges have increased margins.  For example, on May 2nd, the Chicago Mercantile Exchange (CME) raised its initial margin for the third time in a week, from USD$14,513 to USD$16,200.  And raised its maintenance margin from USD$10,750 to USD$12,000.

Again, that may not seem like much, but it is.

Betting thousands to risk millions

By the time the CME increased it’s margins a third time, the underlying value of one futures contract on silver was about USD$240,000.

In other words, traders were taking out a quarter-of-a–million-dollar exposure in the silver market using just $14,513… or to put it another way, paying a 6% deposit!

But here’s the thing… While the initial margin increase may have put off new traders, the increase in the maintenance margin caused the bigger shock.  This had the effect of whacking both long and short traders.

The way the maintenance margin works is this: once you’ve entered the trade using an initial margin of $14,513, the exchange requires traders to hold at least USD$10,750 in their account.

As soon as the account falls below USD$10,750 then the account is in margin call and the trader needs to deposit more money in order to keep the position open.  To give you an idea of how leveraged the market is, consider this…

The silver price only had to move 75 cents the wrong way from when a trader first entered the position to when they would receive a margin call.  Take a look at the chart below:

It’s the silver price chart for the past 30 days.  The price moved up UDS$8 and then down $13 in just one month.  Yet the price move to trigger fully leveraged traders was just 75 cents.

From the first 75 cent move to the downside, each additional one-cent move would have triggered margin calls… it was a snowball effect.

Even without margin increases, traders were living on the edge.  Now factor in the impact of a margin increase and…

Well, overnight, traders had to find thousands of extra dollars to deposit into their trading account.

And when you consider on any given day more than 350,000 contracts can change hands, that’s almost USD$360 million that futures traders had to get their hands on.

For many, they just couldn’t do it.  And besides, even if they could, why would any trader risk holding on if they feared the price could get smashed?

Better to just bolt for the exits.  The result: prices driven down 30% in just a few days.

Goldman’s timely call

Of course, silver wasn’t the only commodity to get touched up – oil, gold, soft commodities, everything got whacked.

Which makes Goldman Sachs’ decision in mid-April to go “underweight” commodities all the more timely.

Especially when, until just two weeks earlier, commodities had been the one asset class Goldman was punting big on.  As this report from Reuters revealed on April 19th:

“Goldman Sachs’s commodities risk rose for the first time in a year during the first quarter as it staked 60 percent more money than the previous quarter to trade in rallying raw materials market.”

The article continues:

“Value-at-risk (VaR) for commodities at the No. 1 U.S. investment bank averaged $37 million in the three months to March 31, versus $23 million in the fourth quarter of 2010…”

At the same time, competitor Morgan Stanley was staying fully exposed to commodities.  Hussein Allidina, head of commodity research at Morgan Stanley, told Bloomberg News that getting out of commodities two weeks ago was “premature”.

So, it’ll be interesting to see what impact the commodities price slump has had on the profitability of Wall Street’s former investment banks.

The following chart shows you the commodities VaR of Wall Street’s five major firms at the end of the March 2011 quarter:

Source: Reuters

As you can see, at the end of March, Goldman’s exposure was greater than Morgan Stanley’s.  But that was two weeks before Goldman’s went bearish on commodities.

There are two questions about this. One: how much did Goldman reduce its exposure to commodities leading up to the commodity price slump in early May?  And two: did Morgan Stanley back up its bullish commentary by increasing its exposure?

We ask these questions because, according to the VaR data, Morgan Stanley could potentially have lost over USD$30 million each day for being on the wrong side of the commodities trade.

Of course, that’s the maximum calculated using VaR.  But as the markets proved in 2008, the maximum daily losses forecast using VaR don’t always work out as the actual daily losses.

The problem with VaR is – to put it simply – it’s based on risk assumptions.  In other words, the $37 million VaR for Goldman Sachs during the first quarter is based on a “95 percent confidence level.”

That given all the probabilities, 95 times out of a hundred, the maximum daily loss will be no more than $37 million… of course, it ignores the other 5% chance.  Which is exactly why so many financial firms were blindsided as markets collapsed in 2008.

What happens when the airbags fail?

In a paper titled, Private Profits and Socialized Risk, written for the Global Association of Risk Professionals in June/July 2008, investor David Einhorn argues against reliance on VaR:

“A risk manager’s job is to worry about whether the bank is putting itself at risk in the unusual times – or, in statistical terms, in the tails of distribution.  Yet, VaR ignores what happens in the tails.  It specifically cuts them off.  A 99% VaR calculation does not evaluate what happens in the last 1%.  This, in my view, makes VaR relatively useless as a risk management tool and potentially catastrophic when its use creates a false sense of security among senior managers and watchdogs.  This is like an airbag that works all the time, except when you have a car accident.”

Bearing in mind that at the time Einhorn wrote the paper, his firm – Greenlight Capital – was short-selling Lehman Brothers stock.  He wrote:

“From a balance sheet and business mix perspective, Lehman is not that materially different from Bear Stearns…

“Given that Lehman hasn’t reported a loss to date, there is little reason to expect that it will any time soon.  Even so, I believe that the outlook for Lehman’s stock is dim.”

Even the bearish Einhorn didn’t expect markets to collapse as they did.  Three months later, Lehman Brothers was dead and Einhorn’s fears proved correct.

If an investor who is short-selling a stock can’t imagine the worst happening, what are the odds of the risk-management guys at an investment firm factoring all possible scenarios into their VaR model?

Not forgetting the events that happen at the tails – the unknown unknowns, if you like – that no-one can foresee.

And so, having ramped up its exposure to the commodities markets, Goldman’s was either lucky, super smart or had some idea the futures exchanges were about to drastically increase margins.

We won’t say the last couple of months have been anywhere near as bad for markets as mid- to late-2008…

But it doesn’t take too much imagination to think the Japanese tsunami and earthquake, followed by G7 foreign-exchange intervention, and then soaring and collapsing commodity prices weren’t part of the 95% confidence in the VaR modelling.

The more we look at it, to us, it seems further proof the G7 currency intervention was more about propping up the balance sheets of Western banks than it was to do with supporting the Japanese economy.

Supporting the banks is becoming a regular occurrence for governments and central bankers.  We look forward to the next bailout.  We surely can’t have long to wait…

Cheers.

Kris Sayce
Money Morning Australia

Tagged as: commodities, Goldman Sachs, market, rigged, risk, traders