Griftopia: Bubble Machines, Vampire Squids, and the Long Con That Is Breaking America

by Matt Taibbi

  The system seemed to work well enough for a long period of time, but by the early nineties there was a new class of economists who had come to believe that the prudent man rule was needlessly restrictive. When I spoke with John Langbein, a Yale professor who helped draft the law that would eventually turn the prudent man rule on its head, he was dismissive, almost to the point of sneering, of the prudent man standard.

  “It tended to use a sort of … widows and orphans standard,” he said in an irritated voice.

  I paused. “What do you mean by widows and orphans?” I asked.

  “Well, what that means is that there was an extreme aversion to loss,” he said. “Everyone had to do a lot of bonds and real estate, you understand.”

  While I was sitting there trying to figure out what was so bad about that, Langbein proceeded to tell me about how he helped draft something called the Uniform Prudent Investor Act of 1994, some form of which would eventually be adopted by every state in the union. The Prudent Investor Act was something of a financial version of the Clear Skies Act or the Healthy Forests Restoration Act, a sweeping deregulatory action with a cheerily Orwellian name that actually meant close to the opposite of what it sounded like.

  The rule now said that there was no one-size-fits-all industry standard of prudence and that trusts were not only not barred from investing in certain asset classes, they were actually duty bound to diversify as much as possible.

  “It made diversification a presumptive responsibility” of the trust manager, Langbein said proudly, adding, “It abolished all categoric prohibitions on investment types.”

  This revolution in institutional investment laws on the state level coincided with similar actions on the federal level—including yet another series of very quiet changes to the rules in 2003 by the CFTC, which for the first time allowed pension funds (which are regulated not by the states but by the federal government) to invest in, among other things, commodity futures. At that same time, the CFTC also loosened the rules about who could buy and sell commodity futures. Whereas once upon a time you had to be accredited to trade commodities, there were now all sorts of ways that outsiders could get into the market.

  Coupled with the new interpretation of prudence—this notion that institutional investors not only could diversify into other types of investments, but should or had to—there was suddenly a huge inpouring of money into the commodity futures market.

  “Once upon a time, you had to be an accredited investor, and commodities weren’t considered an asset class,” says Pat McHugh, a trader in natural gas futures who has spent upwards of twenty years watching changes in the market. “Now all of a sudden commodities, it was like it was something you had to have.”

  Now, with all these changes, the massive pools of money sitting around in funds like CalPERS (the California state employees pension funds) and other state-run pension plans were fair game for the salesmen of banks like Goldman Sachs looking to pitch this exciting new class of investment as a way of complying with what Langbein, the Yalie professor, called the “powerful duty to diversify broadly.” These plans tended to be guarded by midlevel state employees with substandard salaries and profound cases of financial penis envy who were exquisitely vulnerable to the bullshit sales pitches of the Wall Street whiz kids many of them secretly wanted to be.

  When I told Langbein that I was interested in how it came to be that so many institutional investors ended up putting gobs of money into the commodity futures market in the late part of the last decade, he immediately interjected that such investing was not a good idea for everyone. “Just because it is not prohibited does not mean it’s prudent for everyone to invest in oil futures,” he said. “Because they are very volatile.”

  Well, I said, given that they are volatile, what would be an example of a situation in which it would be prudent for a trust—something, again, that is supposed to be supersafe—to invest in oil futures?

  “Well, um…,” he began. “Say … Well, let’s say the trust portfolio owns real estate that contains oil, real estate whose value fluctuates with oil prices. Then you might want to buy oil futures as a hedge.”

  Sounds like the kind of extremely common eventuality that is worth completely revamping the regulatory environment for.

  Anyway, commodity index investing had one more thing going for it. It was about to be the last thing left on the institutional investment menu that Wall Street did not completely fuck up. By the mid-to-late 2000s the stock market, the consumer credit market, and the housing market had all either imploded spectacularly or were about to implode spectacularly. Those big pools of money had to go somewhere, and the key word that everyone was interested in hearing, after all these disasters, was “safety.” And “quality,” that was another word. And hell, what seemed more solid than oil? Or sugar? Or wheat?

  That was the pitch, anyway. And the banks started hitting that theme really hard in the middle part of the decade.

  “Going long on index investing has long been popular in the securities markets,” wrote a cheerful Will Acworth in the May 2005 issue of Futures Industry magazine. “Now it is coming into fashion in the futures world, and bringing a new source of liquidity to commodity futures contracts.”

  That probably doesn’t make much sense to you now, and wouldn’t have made much sense to you in 2005. It did, however, make sense, back then, to the people who managed the great pools of money in this world—the pension funds, the funds belonging to trade unions, and the sovereign wealth funds, those utterly gigantic quasi-private pools of money run by foreign potentates, usually Middle Eastern states looking to do something with their oil profits. It meant someone was offering them a new place to put their money. A safe place. A profitable place.

  Why not bet on something that people can’t do without—like food or gas or oil? What could be safer than that? As if people will ever stop buying gasoline! Or wheat! Hell, this is America. Motherfuckers be eating pasta and cran muffins by the metric ton for the next ten centuries! Look at the asses on people in this country. Just let them try to cut back on wheat, and sugar, and corn!

  At least that’s what Goldman Sachs told its institutional investors back in 2005, in a pamphlet entitled Investing and Trading in the Goldman Sachs Commodities Index, given out mainly to pension funds and the like. Commodities like oil and gas, Goldman argued, would provide investors with “equity-like returns” while diversifying portfolios and therefore reducing risk. These investors were encouraged to make a “broadly-diversified, long-only, passive investment” in commodity indices.

  But there were several major problems with this kind of thinking—i.e., the notion that the prices of oil and gas and wheat and soybeans were something worth investing in for the long term, the same way one might invest in stock.

  For one thing, the whole concept of taking money from pension funds and dumping it long-term into the commodities market went completely against the spirit of the delicate physical hedger/speculator balance as envisioned by the 1936 law. The speculator was there, remember, to serve traders on both sides. He was supposed to buy corn from the grower when the cereal company wasn’t buying that day and sell corn to the cereal company when the farmer lost his crop to bugs or drought or whatever. In market language, he was supposed to “provide liquidity.”

  The one thing he was not supposed to do was buy buttloads of corn and sit on it for twenty years at a time. This is not “providing liquidity.” This is actually the opposite of that. It’s hoarding.

  When an investment banker coaxes a pension fund into the commodities markets, he’s usually not bringing it in for the short term. “Pension funds and other institutional investors have extremely long time horizons,” says Mike Masters of Masters Capital Management, who has been agitating against commodity speculation for years. He notes, for example, that the average duration of a pension fund’s portfolio is designed to match the average employee’s years until retirement. “Which could be twenty years, or more,” says Masters.
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  The other problem with index investing is that it’s “long only.” In the stock market, there are people betting both for and against stocks. But in commodities, nobody invests in prices going down. “Index speculators lean only in one direction—long—and they lean with all their might,” says Masters. Meaning they push prices only in one direction: up.

  The other problem with index investing is that it brings tons of money into a market where people traditionally are extremely sensitive to the prices of individual goods. When you have ten cocoa growers and ten chocolate companies buying and selling back and forth a total of half a million dollars on the commodities markets, you’re going to get a pretty accurate price for cocoa. But if you add to the money put in by those twenty real traders $10 million from index speculators, it queers the whole deal. Because the speculators don’t really give a shit what the price is. They just want to buy $10 million worth of cocoa contracts and wait to see if the price goes up.

  To use an example frequently offered by Masters, imagine if someone continually showed up at car dealerships and asked to buy $500,000 worth of cars. This mystery person doesn’t care how many cars, mind you, he just wants a half million bucks’ worth. Eventually, someone is going to sell that guy one car for $500,000. Put enough of those people out there visiting car dealerships, your car market is going to get very weird very quickly. Soon enough, the people who are coming into the dealership looking to buy cars they actually plan on driving are going to find that they’ve been priced out of the market.

  An interesting side note to all of this: if you think about it logically, there are few reasons why anyone would want to invest in a rise in commodity prices over time. With better technology, the cost of harvesting and transporting commodities like wheat and corn is probably going to go down over time, or at the very least is going to hover near inflation, or below it. There are not many good reasons why prices in valued commodities would rise—and certainly very few reasons to expect that the prices of twenty-four different commodities would all rise over and above the rate of inflation over a certain period of time.

  What all this means is that when money from index speculators pours into the commodities markets, it makes prices go up. In the stock markets, where again there is betting both for and against stocks (long and short betting), this would probably be a good thing. But in commodities, where almost all speculative money is betting long, betting on prices to go up, this is not a good thing—unless you’re one of the speculators. But chances are that’s not who you are in this drama. You are far more likely to be Priscilla Carillo or Robert Lukens, dealing with a sudden price hike for reasons you know nothing about.

  “It’s one thing if you’re getting people to invest in IBM or something,” says McHugh, the natural gas futures trader. “But wheat and corn and soybeans … this stuff actually affects people’s lives.”

  Anyway, from 2003 to July 2008, that moment when Priscilla started living in her car, the amount of money invested in commodity indices rose from $13 billion to $317 billion—a factor of twenty-five in a space of a little less than five years.

  By an amazing coincidence, the prices of all twenty-five commodities listed on the S&P GSCI and the Dow-AIG indices rose sharply during that time. Not some of them, not all of them on the aggregate, but all of them individually and in total as well. The average price increase was 200 percent. Not one of these commodities saw a price decrease. What an extraordinarily lucky time for investors!

  In and around Wall Street, there was no doubt what was going on. Everyone knew that the reason the price of commodities was rising had to do with all the new investor flows into the market. Citigroup in April 2008 called it a “Tidal Wave of Fund Flow.” Greenwich Associates a month later wrote: “The entry of new financial or speculative investors into global commodities markets is fueling the dramatic run-up in prices.”

  And the top oil analyst at Goldman Sachs quietly conceded, in May 2008, that “without question the increased fund flow into commodities has boosted prices.”

  One thing we know for sure is that the price increases had nothing to do with supply or demand. In fact, oil supply was at an all-time high, and demand was actually falling. In April 2008 the secretary-general of OPEC, a Libyan named Abdalla El-Badri, said flatly that “oil supply to the market is enough and high oil prices are not due to a shortage of crude.” The U.S. Energy Information Administration (EIA) agreed: its data showed that worldwide oil supply rose from 85.3 million barrels a day to 85.6 million from the first quarter to the second that year, and that world oil demand dropped from 86.4 million barrels a day to 85.2 million.

  Not only that, but people in the business who understood these things knew that the supply of oil worldwide was about to increase. Two new oil fields in Saudi Arabia and another in Brazil were about to start dumping hundreds of thousands more barrels of oil per day into the market. Fadel Gheit, an analyst for Oppenheimer who has testified before Congress on the issue, says that he spoke personally with the secretary-general of OPEC back in 2005, who insisted that oil prices had to be higher for a very simple reason—increased security costs.

  “He said to me, if you think that all these disruptions in Iraq and in the region … look, we haven’t had a single tanker attacked, and there are hundreds of them sailing out every day. That costs money, he said. A lot of money.”

  So therefore, Gheit says, OPEC felt justified in raising the price of oil. To 45 dollars a barrel! At the height of the commodities boom, oil was trading for three times that amount.

  “I mean, oil shouldn’t have been at sixty dollars, let alone a hundred and forty-nine,” Gheit says.

  This was why there were no lines at the gas stations, no visible evidence of shortages. Despite what we were being told by both Barack Obama and John McCain, there was no actual lack of gasoline. There was nothing wrong with the oil supply.

  But despite what Wall Street players were saying amongst themselves, the message to potential investors was very different. In fact, it still is. Banks like Goldman Sachs continually coaxed new investors into the commodities market by arguing that there would be major disruptions to the world oil supply that would cause oil prices to spike. In the beginning of 2008, Goldman’s chief oil analyst, Arjun Murti, called an “oracle of oil” by the New York Times, predicted a “super spike” in oil prices, forecasting a rise in price to two hundred dollars a barrel.

  Despite the fact that there was absolutely no evidence that demand was rising or supply falling, Murti continually warned of disruptions to the world oil supply, even going so far as to broadcast the fact that he owned two hybrid cars, adding with a straight face: “One of the biggest challenges our country faces is its addiction to oil.”

  This was a continuation of a theme Goldman had shamelessly pimped for years, that high prices were the fault of the piggish American consumer; in 2005 a Goldman analyst even wrote that we wouldn’t know when oil prices would fall until we knew “when American consumers will stop buying gas guzzling sport utility vehicles and instead seek fuel efficient alternatives.”

  “Everything that Goldman cooked up or predicted, by hook or by crook, it happened,” Gheit says. “[Goldman and Morgan Stanley] pushed these prices up.”

  All of these factors contributed to what would become a historic spike in gas prices in the summer of 2008. The press, when it bothered to cover the story at all, invariably attributed it to a smorgasbord of normal economic factors. The two most common culprits cited were the shaky dollar (investors nervous about keeping their holdings in U.S. dollars were, according to some, more likely to want to shift their holdings into commodities) and the increased worldwide demand for oil caused by the booming Chinese economy.

  Both of these factors were real. But neither was any more significant than the massive inflow of speculative cash into the market.

  The U.S. Department of Energy’s own statistics prove this to be the case. It was true, yes, that China was consuming more and more oil every ye
ar. The statistics show the Chinese appetite for oil did in fact increase over time:

  YEAR CONSUMPTION

  (barrels per year)

  2002 1,883,660,777

  2003 2,036,010,338

  2004 2,349,681,577

  2005 2,452,800,000

  2006 2,654,750,989

  2007 2,803,010,200

  2008 2,948,835,000

  If you add up the total increase between each of those years, i.e., the total increase in Chinese oil consumption over the five and a half years between the start of 2003 and the middle of 2008, it turns out to be just under a billion barrels—992,261,824, to be exact.

  During the same time period, however, the increase in index speculator cash pouring into the commodities markets for petroleum products was almost exactly the same—speculators bought 918,966,932 barrels, according to the CFTC.

  But it was almost impossible to find mention of this as a cause for the spike in gas prices anywhere in the American media, which at the time was focused on more important things, like the geographical proximity of Bill Ayers to Barack Obama, or whether Geraldine Ferraro was being racist or just stupid when she said that Obama would not be winning the nomination “if he were a white man.”

  I was out there, covering the campaign, and what I remember was a lot of ginned-up anger between working-class Democrats (who supported Hillary) and yuppie Democrats (who supported Obama), a lot of anger emanating from female Hillary supporters (at a Hillary rally in Washington, DC, I saw two women tear an Obama sign away from a young girl and call her a “traitor”), and in general a lot of noise about things that, in retrospect, had nothing to do with anything at all.