Price manipulation is a time-honored tradition in structured finance. There will be abuse anytime there is a price “fixing” or a price set on the basis of a trade.
Instances of abuse are the dragons that “regulators” are supposed to constantly slay. When regulators are too slow, unwilling, or unable to do the job—and if you haven’t been paying attention, regulators have been all three for decades—market professionals take matters into their own hands.
Breathless financial media reports focus on “scandals” as if they are extraordinary or shocking events, instead of business as usual. If you trade metals, any commodity, interest rate swaps, foreign exchange, futures, options, CDOs, credit derivatives, stocks, bonds, or any other financial instrument, expect price manipulation. Within limits, price manipulation is tolerated in every financial market.
If you’re a market professional, your job isn’t to express shock or outrage at the existence of price manipulation. Your job is to figure out how much is being done, and how it is being done. If it were easy, we wouldn’t call it work.
Your outrage is better directed elsewhere. So-called regulators, executives, supervisors, and managers make egregious price manipulation dead easy, instead of slaying these inevitable dragons. Laxity simply enables and encourages manipulation.
William K. Black has supplied a speechless market with the proper vocabulary. In a criminogenic environment, control fraud is an expected outcome. In a control fraud, bonus-seeking employees will manipulate financial markets, even if it damages their own financial institution, the host upon which the parasites feed.
In August 2007, Jamie Dimon, CEO of JPMorgan Chase, told me litigation is a game to him. The only thing that interests him is whether the other side is “good for it.” This was in the middle of a discussion about flawed CDOs and growing problems at AIG, thirteen months before it required a massive taxpayer-funded bailout. JPMorgan wasn’t a key counterparty of AIG (Goldman Sachs and cronies were), but it was the top U.S. bank in credit derivatives. AIG’s woes posed systemic risk to the entire credit derivatives market.
Since then, JPMorgan lost money on a massive coal short, larger than the entire coal market, in the commodities unit headed by Blythe Masters. The bank manipulated this important market while the U.S. is at war. It was reported because it was a big loser. You don’t hear about the big manipulated winners.
Masters was allegedly a key player in the manipulation of electricity prices according to the Federal Energy Regulatory Commission (FERC), and she allegedly committed perjury. It’s likely she would have faced criminal charges had JPMorgan not paid FERC a $410 million penalty. Other banks are fighting FERC’s fines, but their officers weren’t accused of lying.
[Update August 20, 2013: Dan Fitzpatrick and Devlin Barrett at the Wall Street Journal report that U.S. Attorney Preet Bharara is now investigating JPMorgan for some of the issues raised by FERC, but at this time it isn’t known whether a potential indictment, if any, would be civil or criminal.]
JPMorgan’s “London Whale” losses show that CEO Jamie Dimon is willing to downplay a potential $1 billion loss and call it a “tempest in a teapot.” (See: “Dimon Saw $1 Billion Potential Loss When He Made ‘Teapot’ Remark,” by Michael J. Moore and Dawn Kopecki, Bloomberg News, June 13, 2012.) He also didn’t disclose that at the time of his comment, losses had a reasonable chance of ballooning by multiples, and they subsequently did. Many finance pros and bloggers called Dimon out in real time on this nonsense, but regulators act as if it wasn’t Dimon’s responsibility to know better than to make public misleading statements.
Meanwhile, JPMorgan’s problematic CIO unit was a poster child for risk management worst practices—contrary to JPMorgan’s signed financial filings—and credit derivatives prices were actively manipulated.
LIBOR fixing involved several banks. Main stream financial media reports this as a news flash. Yet this is no surprise to anyone who has been in the interest rate markets for more than a month. Banks colluded on prices of mortgage loans, credit derivatives indexes, synthetic collateralized debt obligations, CDO-squared and more, and the price fixing was even more blatant.
By the time Congress holds a hearing to wag a finger in an executive’s face (right after lauding him), by the time a fringe-dwelling show-trial is launched by the SEC and DOJ, by the time a junior scapegoat is indicted, the damage to investment portfolios will be fully realized. The lesson here is that you are on your own.
What do market professionals do when a market is being manipulated and “regulators” are ineffective? First, here’s what they don’t do. They don’t wring their hands and stress about how mainstream media seems to take dictation from banks’ PR firms. Instead, they proactively solve their own problem.
By the way, this is why market manipulators cover-up and hire spin doctors. The game is to provide as much misinformation as possible, so that their opponents don’t get wise and gang up on them.
Arbitrage is an entertaining film about financial shenanigans written, produced, and directed by Nick Jarecki, son of Dr. Henry Jarecki, one of the most colorful and entertaining characters the metals markets and futures markets have ever produced. I can imagine how Dr. Henry Jarecki might have inspired some of the bravado displayed by Richard Gere’s character.
In his self-published book, An Alchemist’s Road, Henry tells his own matter-of-fact story about silver price manipulation. Henry bought coin dealers’ silver certificates based on each morning’s “Comex opening price,” the price of the first silver trade in the spot month, because this is the price American dealers understood. But he sold the silver represented by the certificates later in the day in London, based on the previous London silver price fixing.
Then something odd happened. Henry noticed the Comex price remained higher than the London price fixing for several weeks. Then he got a call from Alan Rosenberg, a coin dealer. Rosenberg sold silver certificates to an entity called Metals Quality. Rosenberg knew Henry also sold silver certificates from his Federal Coin & Currency operation to Metals Quality. But Rosenberg didn’t realize that Henry was also indirectly buying both Rosenberg’s and Federal’s silver certificates, because Henry was involved with Metals Quality.
Rosenberg figured out how to drive up the Comex price by having his broker bid up the price of just one contract at the opening, the first contract trade of the day. That way, he got 3 or 4 more cents per ounce when he sold his pile of silver certificates to Metals Quality. Everyone else who sold silver certificates that day to Metals Quality also benefited from the higher price, although they didn’t know why.
Each contract is for 10,000 ounces. Rosenberg paid 3 or 4 more cents for the first contract of the day, and then he had to sell the 10,000 ounces at a loss. Rosenberg more than made up for the loss, when he sold his huge stash of silver certificates to Metals Quality at the higher manipulated price. But it bugged Rosenberg that he had to lose money on the first contract.
Why did Rosenberg take the risk of calling Henry? Perhaps you’ll find the reason in “The Psychology of Loss Aversion.” None of this surprised Henry who was a Yale professor and practicing psychiatrist before becoming a metals magnate.
Rosenberg wanted to lower his cost, so he called Henry and proposed to tell Henry on the days that he was manipulating the price. Then he and Henry could split the loss from manipulating the price of the first contract to trade. They would both profit by selling their silver certificates to Metals Quality only on the days that Rosenberg manipulated prices higher.
Henry’s cousin’s cousin, Paul Guterman, worked at Bache and advised Henry to get his own broker to sell a contract at a low price at the Comex open. Henry found floor broker Gunther Garbe, to counter what Rosenberg’s floor broker, Lowell Mintz, was doing. Over the next few days, Garbe sold a contract at a very low price, and Henry bought the coin dealers’ silver at a cheaper price then where he sold it in London.
Then Lowell and Garbe realized their game was a shoving match and agreed that they’d alternate days so that Lowell would buy very high one day, and the next day Garbe would sell very low. It wasn’t long before everyone realized that it wasn’t worth anybody’s time or trouble to continue playing the game.
Somewhere there is an economist chortling as he rocks back and forth in his chair thinking: See, Janet, I told you we don’t need regulators, the market self-corrects!
It’s true that if Henry had waited for regulators to act, he’d be poorer for it, and he might still be waiting. That only demonstrates that regulators were as ineffective in the 1960’s as (for the most part) they are today. But anyone else who wasn’t in on the game would have to take their chances. They might be paid the artificially high price or the artificially low price. But they had no way of knowing. They weren’t in a position to get a phone call from Rosenberg—Henry was lucky to get the call—or to have their own floor broker.
Effective regulation involves constant investigation. You have to find manipulation and prosecute it. Criminal charges and jail time are powerful deterrents. Today’s bloated and ineffective regulators eschew criminal charges. Regulators are a source of market inefficiency, when they only act as overpaid overhead.
The unfortunate reality is that in the global financial markets, you will usually have to find and slay your own dragons. Find other dragon slayers to help you, if you can. Self-defense is reasonable, when gangs collude against you. In the securitization and credit derivatives markets, people conspired across firms to fix prices. That was worthy of RICO charges, since sometimes they earned money from the same pot. Yet we have yet to see meaningful prosecution.
Structured finance makes it easy to disguise market manipulation, because it’s opaque. Investors can be exposed through surprising terms in structured notes, asymmetric risk language in credit derivatives contracts, futures manipulation, options market manipulation, manipulation of trades against which gold was posted as collateral, and/or due to the basis risk of certain exchange traded funds (ETFs), among other things.
If a “gold” ETF doesn’t allocate gold to investors, doesn’t guarantee it receives “good delivery,” doesn’t purchase insurance on the gold, and allows the “gold” to be leased to short sellers (and others), the ETF poses basis risk versus other ETFs that are managed more prudently.
In March 2010, I wrote a tongue-in-cheek commentary: “How to Corner the Gold Market.” One issue I didn’t raise is Central Bank gold price manipulation. I also didn’t explain why many reasonable investors (including me) have diversified some of their investments into gold in spite of all of this. I’ll have more to say on that later this summer.
This is part one of a four-part series. See also: