Wednesday, July 15, 2009

Goldman's Influence and the CFTC Exception

There has been a lot of notice of the significant number of alumni of Goldman Sachs who have entered into the government. This has gotten so obvious that, near the end of the last Administration, one reporter remarked to me that there just might as well be a sign at the Treasury Department saying "Goldman Sachs South."

Recently, a sensational article about Goldman Sachs appeared in Rolling Stone -- "The Great American Bubble Machine" by Matt Taibbi. The author seeks to blame Goldman for financial market bubbles going back to the 1920s. There is much to criticize about this article and its simplistic approach of focusing on the actions of one firm without much analysis of what else was going on. Current Goldman management is reportedly upset by what they view as an unfair characterization of their firm.

However, while I disagree with much of the Taibbi's article, the point about regulatory capture is valid. If the political appointees going to the Treasury and the financial regulatory agencies share similar Wall Street backgrounds, they are probably more inclined to see things the same way as those currently on Wall Street and to be more receptive to their point of view than that of others. There are, of course, exceptions.

Curiously, the biggest exception at the moment is Gary Genlser, who worked at Goldman prior to his appointment to the Treasury Department in the Clinton Administration. His nomination by President Obama to head the CFTC was held up by Senators Bernie Sanders and Maria Cantwell, who were skeptical of him because, as a Treasury official, he worked to get the Commodity Futures Modernization Act of 2000 passed. When the holds were released after the Treasury announced more details about its plans for regulating the entire OTC derivatives market, my guess was that the two Senators would be pleasantly surprised by Gensler.

In fact, Gensler has been talking tough about both OTC derivatives and oil futures. With regard to oil, his apparent inclination to put on restrictive speculative position limits on oil futures has many market participants upset. He is doing no favors to Goldman and others by following this course.

The irony is that, while Gensler is convincingly demonstrating that he is not under the influence of Goldman or Wall Street generally, he may not be right in his analysis in this case. Analysts of the oil market are puzzled by the movement of oil prices. (For example, see this recent Washington Post article.) The conclusion is that it must be the speculators and the futures markets.

But that is a jump without any analysis behind it. Remember, that in the oil futures markets, as in all futures markets, the total long positions exactly equal the total short positions and that oil futures are forced to converge with the cash market because of the potential (or threat) of delivery. In other words, for there to be significant moves in the price of oil, something has to be happening to underlying supply and demand conditions in the cash market.

For example, if oil futures prices increase above the cost of carry, the arbitrage is to buy oil in the cash market, store it somewhere, and sell in the futures market. If enough oil is held off the market, then the price will rise.

Given the expense of storage, the voluminous nature of oil, and the limited amount of storage facilities, there are not that many entities that can hold oil off the market once it is out of the ground. Once oil is pumped out of the ground and enters into a transportation, refining, and distribution system, most of it has to be sold in order to make room for the oil entering into this system.

In other words, any analysis of oil prices that focuses solely on the futures market is incomplete. To understand what is going on, one needs to study the large and not very transparent global cash market.

I doubt that putting tough speculative position limits on oil futures will materially affect the price. As an aside, it is funny that no one blames the speculators when oil prices fall sharply, but, of course, speculators don't care about the direction of prices, they only care that they have bet correctly.

If Gensler gets his way on this, restrictive speculative position limits may also not have the dire affect on the ability of entities to hedge. It may turn out not to be that important

What is interesting is that Gensler is pursuing this issue aggressively, even though it not only runs counter to Wall Street interests but to the economic analysis of his own agency in the previous Administration.