Sunday, August 10, 2008

Where Are the Losses from the Commodities Bust?

The price of oil has recently plummeted from $147 a barrel to $115. The stock market has responded exuberantly. In spite of continuing losses to the big banks and Fannie and Freddie from the mortgage and real estate messes, stocks have reached a six-week high, mostly due to a rising dollar and falling oil prices. The financial news has been positively glowing.

But, in the markets, when there are winners, there will also be losers. A sharp drop-off in the price of something as important as oil will be costly to those that own oil, and those that were speculating that oil prices would rise further. Americans today understandably have little sympathy for owners of oil. Oil owners have made money hand over fist over hand over fist in the last three years. If they lose some money now, only crocodiles will cry for them.

But oil speculators are another matter. The image of the speculator--a greedy financial sharpy who heartlessly profits at the expense of honest, hardworking folks--is somewhat off the mark these days. Many speculators are the pension funds, mutual funds, college endowments and other financial institutions that ordinary Americans depend on for their retirements or educations. While the sharpies of yore still lurk in the markets, much of the flood of capital in recent years into the commodities markets came from bastions of the American investment community. They have been taking losses, probably big ones considering the prevalence of leverage in commodities speculation.

Where there is leverage, there are lenders. In the case of commodities, the commodities firms will be the lenders in the first instance. Of course, they don't keep piles of cash on their credenzas in case a customer wants to trade on a leveraged basis. They borrow funds from banks and relend it to their customers. That, in effect, puts the banks at risk if the customer can't repay. When you have price drops as sharp as the ones we've seen in recent weeks, some customers will probably be hurting. The banks aren't likely to be indulgent; they learned the painful way about the costs of being indulgent from the losses they took lending to real estate and mortgage speculators. Those who borrowed to trade in commodities futures will have to repay their loans promptly, or lose their investments.

Recall the collapse of Amaranth Advisors in 2006. This hedge fund made highly leveraged bets in the natural gas market, taking on billions of dollars of exposure. Things, as they say, didn't quite work out, as prices moved in the opposite direction of Amaranth's bets. Billions were lost and the fund collapsed in short order.

Given the more than 20% drop in oil prices in recent weeks, it's likely that aggregate losses from the drop in oil prices run in the tens of billions, at least. Moreover, others who were speculating in currency futures have likely taken losses from the rise of the dollar (which came at the expense of the Euro, yen and pound). All of these losses have received no attention from the financial press, but they are there. And they could be large enough to further erode the already eroding capital positions of the major financial institutions. We can be confident that more losses from the mortgage and real estate mess will hit the banks. They've admitted, although not quantified, as much. Only Merrill has chosen to confront the beast by selling off a large amount of CDOs and taking what it's had coming in the wood shed. We can only hope it doesn't have more losses coming from off-balance sheet sources. While stock market gains may, to some degree, offset the commodities trading and commodities lending losses of the major banks, let's remember that the commodities exposure involves leverage, and leverage can magnify the pain many times over. Stock market gains are likely to be less leveraged.

The key question now is where are the losses from the commodities bust? In addition to sinking oil prices, the prices of other commodities like copper, gold and platinum have been dropping. That means more losses. It's important for banks and financial regulators to pinpoint the location of these losses quickly, and deal with them. Waiting for them to emerge in due course, as was the m.o. with mortgage and real estate losses, has led to the death of a thousand cuts. We don't want to replay that videotape.

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