Casino Capitalism Is Back!

One of the aggravating factors in the credit crisis was the proliferation of financial products being traded between banks and hedge funds that had no underlying economic rationale. Unfortunately, after a short period of restraint in the aftermath of the crisis, this manifestation of "casino capitalism" is making a comeback. Individual investors need to be aware of this trend and the spillover effects on asset prices -- particularly in commodity markets.

Welcome to the casino!
In casino capitalism, speculative interests are not content to take on risks that result from the financing of trade and industry. Instead, they create risks from whole cloth. For example, when John Paulson made the "greatest trade ever" by betting against subprime mortgages, he wasn't bearing a risk that arose naturally in the housing finance market.

Instead, he engaged Goldman Sachs (NYSE: GS  ) to manufacture a specific bet for him ex nihilo. Goldman then went out and found a counterparty for the trade, which ended up having speculators on both sides (unfortunately for the investors that took the other side, they didn't have the sense to realize they were speculating).

Don't hate the player. Hate the game.
I don't begrudge John Paulson his winnings. His mandate is to preserve and grow the wealth of his investors, and he has succeeded beyond all expectations. As George Soros once said: "My defense is that I operate within the rules. If there is a breakdown in the rules, that is not the fault of the lawful participant but the fault of those who set the rules." All the same, one shouldn't confuse the social and economic utility of a casino and that of an insurance company.

How we know there's been a resurgence of a casino mentality:

  • Do you remember "naked" credit default swaps -- buying insurance on bonds that you don't own just to speculate on the perception of a firm's creditworthiness (a pure casino bet)? Banks including Goldman, Barclays (NYSE: BCS  ) and Deutsche Bank (NYSE: DB  ) are doing one better by trading credit default swaps on General Motors (NYSE: GM  ) debt, despite the fact that the company has virtually no debt on its balance sheet as a result of its restructuring.

Oil aboard!
The signs are also prevalent in commodity markets:

  • According to the Commodity Futures Trading Commission's weekly Commitments of Traders report, during the seven days ended Feb. 22, speculators including hedge funds and commodity trading advisors increased their bullish positions by 30%. The aggregate net long position of 240,000 futures and options is the largest total since June 2006.

I see no reason why oil couldn't revisit the all-time high it set in 2008 (which doesn't mean it will). Individual investors may be tempted to try to capture a piece of oil's positive momentum through the United States Oil Fund (NYSE: USO  ) or the iPath S&P GSCI Crude Oil TR ETN (NYSE: OIL  ) , but I would strongly discourage them from participating in this mug's game. Forecasting price action is extremely tricky, and the structure of these derivatives-based products contains some quirks.

  • ICE Futures, the largest U.S. soft commodity exchange, is considering limiting speculation in cotton futures by requiring that traders with long or short positions in excess of 30,000 bales of cotton demonstrate their underlying economic rationale. That's a highly unusual move, but it's a response to a highly unusual market. Cotton was the best-performing commodity in the S&P GSCI Commodity index last year, and price strength has continued into 2011 -- the benchmark futures has risen a vertiginous 154% over a 12-month period to Feb. 2.

    That sort of increase inevitably attracts hedge funds and other speculators. Nothing wrong with that in principle; in practice, however, regulators and market participants are concerned that these flows are overwhelming fundamental demand and could disrupt the market, hurting those who treat cotton as more than just a financial asset.

Fundamental, then speculative
Are there sound fundamental reasons behind the increases in commodity prices? Assuredly. Growing demand from emerging markets, political unrest, and adverse weather events: All these phenomena are real. However, the price impact of speculative money can't be ignored. As Warren Buffett observed at the 2006 Berkshire Hathaway annual meeting:

In metals and oil there's been a terrific [price] move. ... As the old saying goes, "What the wise man does in the beginning, fools do in the end." With any asset class that has a big move, first the fundamentals attract speculation, then the speculation becomes dominant.

In several commodity markets -- I'd mention oil, cotton, and gold -- we may be at or dangerously near that point today.

Instead of making wild bets, invest in businesses that create enduring value for their customers and their shareholders: Here are 5 Stocks The Motley Fool Owns -- and You Should, Too.

Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. The COO of Paulson & Co. is a member of The Motley Fool's board of directors. Berkshire Hathaway and General Motors are Motley Fool Inside Value recommendations. Berkshire Hathaway is a Motley Fool Stock Advisor recommendation. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 03, 2011, at 10:34 AM, jimmy4040 wrote:

    "I see no reason why oil couldn't revisit the all-time high it set in 2008 (which doesn't mean it will). Individual investors may be tempted to try to capture a piece of oil's positive momentum through the United States Oil Fund (NYSE: USO) or the iPath S&P GSCI Crude Oil TR ETN (NYSE: OIL), but I would strongly discourage them from participating in this mug's game"

    Hmmm, why does every value investor want to compare their investing method to Buffet? When I play golf, I don't think to myself "this is just the way Tiger does it". When I'm in my small car on a windy country road, I don't open it up and think "this is what it's like to be in the Grand Prix". LOL

    What you call a mug's game has made many investors a ton of money. You're just as much of a "mug" to invest in MSFT if you don't know the industry, as you are to invest in commdities. (actually you're a dope to invest in MSFT for any reason until Ballmer leaves, but I digress)

    Investing in commodites as the sole basis of your portfolio would be stupidity. However as a hedge against inflation and worldwide disruption like the past month, it is a form of insurance that is vital.

    Even if you consider the market gambling, then you must know that every successful bookie lays off some of the risk.

    Investing in gold today would be foolish. However investing a month or so ago, when it had dropped to about $1300 would have put you much more at ease

    in recent times.

    I love MF, but if there's any area where they are deficient as a whole, it's financial and commodity related investments and until recently, using options as a hedge. So take the best of what advice is here and go elsewhere for those other type investments.

    It's a big world.

  • Report this Comment On March 03, 2011, at 12:35 PM, MrCainThaler wrote:

    "...he wasn't bearing a risk that arose naturally in the housing finance market."

    Your argument against derivatives is quaint. There is no such thing as a "natural" risk in equity markets anyway. And the instruments he used were identical to most other forms of insurance.

    Moreover, it wasn't a "bet from nothing," as he was paying people a considerable sum of money in monthly installments. I don't believe for one second that the men and women he entered into those engagement with were "duped."

    Who are you imagining Paulson was betting against - yourself? If you don't have a billion dollars under management, you aren't trading in CDO's. Hell, Jeff Greene almost couldn't do it, and he had a few hundred million.

  • Report this Comment On March 03, 2011, at 12:54 PM, TMFAleph1 wrote:

    You appear to have only a surface-level understanding of capital markets, and you misunderstand what I wrote:

    - By their very nature, the equity markets enable investors to bear the risk that is an integral part of the capital formation process.

    - A "bet from nothing" does not refer to whether or not the bet requires a cash outlay; rather, it refers to the fact that the bet is not related to an underlying economic transaction. The CDSs Paulson bought are identical to other forms of insurance in their structure, not in their nature.

    - I never said or implied that John Paulson's couterparties had been "duped". I don't believe this, either.

    - I don't see what the fact that John Paulson was trading with institutions has to do with the price of tea in China.

    Alex Dumortier

  • Report this Comment On March 03, 2011, at 1:50 PM, jimmy4040 wrote:

    I'm hurt! LOL McCain got a response but nothing for me?

    " Banks including Goldman, Barclays (NYSE: BCS) and Deutsche Bank (NYSE: DB) are doing one better by trading credit default swaps on General Motors (NYSE: GM) debt, despite the fact that the company has virtually no debt on its balance sheet as a result of its restructuring"

    I forgot that I wanted to address this. There is nothing inherently wrong with GS doing this. Remember, Paulson didn't make a billion because he took an enormous risk. He made a billion because in doing so he WASN'T taking an enormous risk! That fact escapes a LOT of people.

    Has the banks properly priced their CDS's, Paulson NEVER would have been able to afford to buy a large number of them. It was the improper pricing of the risk that was the issue, not the risky practice itself.

    I always use the example for laymen that Paulson was able to go to Miami and buy hazard insurance on a lot of homes he didn't own, during hurricane season, after a National Weather Service warning, for about the same average costs as insuring a house in Seattle, in the rainy season, outside of any flood plain, and located next door to a fire station.

    Any bookie who screws up the odds, gets slaughtered, otherwise, it's a positive cash flow business!

  • Report this Comment On March 03, 2011, at 2:10 PM, TMFAleph1 wrote:

    @jimmy4040

    I agree with your analysis/ analogy; however, were we may not agree is that I don't think that being able to purchase flood insurance on a home you don't own has the same economic/ social utility as a homeowner buying the same insurance. As I allude to in the article, that is the exactly the difference that exists between the utility that a casino provides and that which an insurance company provides.

    Alex Dumortier

  • Report this Comment On March 03, 2011, at 2:47 PM, jimmy4040 wrote:

    Thanks for the reply.

    "that is the exactly the difference that exists between the utility that a casino provides and that which an insurance company provides"

    I would say that the lack of social utility is caused by the fact that this is an opaque market. If there was the same disclosure requirements as shorting, it would serve as a canary in a coal mine.

    That was a huge failure of Dodd Frank, the inability to make these markets open, if not regulated.

  • Report this Comment On March 03, 2011, at 4:55 PM, TMFAleph1 wrote:

    Agreed, those OTC trades don't even provide information to the market.

    AD

  • Report this Comment On March 04, 2011, at 11:04 AM, ershler wrote:

    I understand the point jimmy4040 is making but the goal of bookies is to get a 50/50 split in the betting so when they collect off the loser and take their cut from the winners they come out ahead no matter what the outcome of the game. The reason odds change is because more people are betting on one side of the wager. The other way bookies make money is exploding local conditions, i.e. frat boys taking even money their 15 seed is going to beat a 2 seed in the tournament. Gamblers are the ones who are mainly responsible for evaluating risks.

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