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What You Should Fear Most Right Now

In the wake of The Great Financial Implosion of 2008, we've seen a major push to stop Wall Street from taking insane risks and blowing up our economy again.

On the other hand, hedge funds, Wall Street lobbyists, and financial commentators are warning about the possibility of "over-regulation." Their position -- that rules limiting risky speculation could reduce "financial innovation" and efficient pricing -- was exemplified in a March editorial in The Washington Times: "Speculators make money by reducing price differences. ... [For example,] they buy oil when it is still relatively plentiful and put it aside for when oil is expected to be scarce. ... Markets have gotten extremely good at smoothing out these prices."

Really? How's that working out?
Now, I forget a lot of things -- asparagus, chicken, and milk left to rot in the fridge. But like you -- if you have heating bills, drive a car, or were conscious in 2008 -- I remember what happened to oil prices. "Smooth" is not how I'd describe them.

OK, so speculators didn't do such a great job smoothing out those prices, but at least we can concede that heightened speculation tended to ease oil's volatility, right?

Not so much
A prominent Forbes article tells the tale of an SEC and bankruptcy court investigation into possible oil price manipulation by a number of Wall Street firms that may have cost us up to $500 billion in higher oil prices.

Last year, Semgroup, the now-bankrupt oil pipeline giant, bet reckless amounts of money that oil prices would fall -- much of it against a Goldman Sachs (NYSE: GS  ) trading arm. When that didn't happen and Semgroup ran into trouble, Goldman, along with Merrill Lynch and Citigroup (NYSE: C  ) , offered to help Semgroup raise money. Goldman then reportedly examined Semgroup's trading positions before retracting its offer.

Meanwhile, Semgroup was destroyed as a number of Wall Street firms bid oil prices up from the mid-$90s to $147 per barrel -- the biggest of those gains on no news. After Semgroup collapsed, there was no reason to continue bidding oil higher, and prices promptly fell. The results were windfall profits for one of Goldman's trading arms and whichever firms participated in the short squeeze against Semgroup.

Oh yeah, and a possible $500 billion price tag, which, if you believe John Catsimatidis, is "how much the world would have overpaid for crude had a successful scam pushed up oil prices by $50 a barrel for 100 days," reported to Forbes. (Granted, Catsimatidis isn't an impartial bystander in this -- he's been battling to gain control of the bankrupt Semgroup.) If true, that money would've benefitted not only ExxonMobil (NYSE: XOM  ) and other Big Oil players -- who garnered so much bad press for last year's windfall profits -- but also places like Saudi Arabia, Iran, Russia, and Venezuela.

Not the first time this has happened
A similar confluence of events occurred in 1998 when a group including Goldman Sachs, Salomon Smith Barney, AIG, and others ganged up against Long Term Capital Management (LTCM) as Goldman and JPMorgan (NYSE: JPM  ) downloaded the faltering hedge fund's trading files, according to interviews of the participants recounted in Roger Lowenstein's expose of the debacle, When Genius Failed.

Far from reducing pricing inefficiencies, the banks' actions and LTCM's reckless accumulation of $1 trillion in derivatives made Treasury spreads go crazy and nearly brought down the entire financial system -- before the Fed stepped in to broker a bailout.

Is this the "innovation" we must protect?
Stories like these and the recent blowup of the financial system -- in addition to common sense -- should make us suspicious when Wall Street complains that increased oversight could limit its ability to create amazing new "innovations." Remember that its most recent innovations, like credit default swaps and collateralized debt obligations cubed -- mind-bogglingly convoluted bundles of bundles of bundles of toxic mortgages -- not only had little practical function, but they nearly destroyed our economy, impacting even strong firms unrelated to the financial industry like Microsoft (Nasdaq: MSFT  ) .

As Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) Vice Chairman Charlie Munger observed, "It isn't as though the economic world didn't function quite well without [credit-default swaps], and it isn't as though what has happened has been so wonderfully desirable that we should logically want more of it."

All of this has happened before and could happen again
Recently, when we asked Warren Buffett and Charlie Munger for their thoughts on the subject, they lamented that "even after this mess it'll be tough to get anything passed" because, they said, Wall Street spent $500 million over the last decade in lobbying and financial contributions. And given that lobbying efforts are now apparently intensifying, it's not the specter of too much reform, but rather a return to business as usual for Wall Street that we should fear most right now.

Buffett has been warning for years that we need improved oversight over financial institutions -- especially on the use of derivatives and leverage -- so that we aren't faced with a repeat crisis, telling CNBC: "Derivatives enable people entirely to get around margin regulations. ... So we need something new."

Yes, our economy is facing tremendous challenges, but as Buffett reminded his shareholders, the United States has overcome two world wars, more than a dozen recessions, stagflation in the 1970s and early 80s, and massive unemployment during the Great Depression.

Yet despite these challenges, and without credit default swaps, Buffett explained that Americans' standard of living rose seven-fold last century, while the Dow increased from 66 to 11,497: "Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America's best days lie ahead."

Ilan Moscovitz owns shares of Berkshire Hathaway, a Stock Advisor recommendation. Microsoft and Berkshire Hathaway are Inside Value selections. The Fool owns shares of Berkshire Hathaway. The Fool is investors writing for investors.

Read/Post Comments (9) | Recommend This Article (38)

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  • Report this Comment On June 15, 2009, at 12:43 AM, booyahh wrote:

    "You should worry first about a stock market correction...Commodities are the place to hide." case you haven't noticed, it's the commodities stocks that have been rallying the most recently. Why would there be a stock market correction if it's the commodities stocks that have been rallying?

  • Report this Comment On June 15, 2009, at 6:24 PM, robertf36009 wrote:

    Well the long awaited correction has begun down over 200 points at the close. I took some profit earlier in the day and will figure out where to park it later in the week. As for the run up in oil prices before the election just follow the money. You will find the Soros group at the other end. That oil bubble was generated for political gain and appearantly it worked (in conjunction with some other neffarious activity). It was deflated by more political chicanery and had nothing to do with rational markets.

  • Report this Comment On June 15, 2009, at 7:24 PM, EdMcswindle wrote:

    More of this please. 'Case study' of market manipulation can certainly keep one from stepping into the middle of it (or future similar manip's) with a fistful of 20's and the party hat on. Good article, thank you.

  • Report this Comment On June 15, 2009, at 8:02 PM, TMFDarwood11 wrote:

    In the area of "regulation" how about putting in place some regulation of the mortgage industry. I don't mean the people selling the loans. I am referring to the people getting the loans.

    As someone said to me today "Everybody working at Wendy's has a $400,000 home". (That was an unsolicted comment from an independent contractor attempting to sell my business an upgrade to our shipping package at UPS). The problem with these "homeowners" is, they can't afford it and it will take another "bailout" to keep them in "their" homes.

    Run that past me again: I buy a home with 0% down, and I say that it is "my home"? No, it isn't. The "homeowner" in that situation is a serf, who maintains the property, pays the taxes and then sends money to the true owner, the bank or mortgage company. That's why the default rate is as high as it is. When the "free money" dries up, the "homeowner" walks. These people aren't stupid!

    What I fear most is the data indicated in the Credit Suisse chart, which is shown at the following link:

    By the way, when found the original of this chart, at a financial site in late 2007, I completely altered my investments and have profited thereby.

  • Report this Comment On June 15, 2009, at 11:34 PM, predfern wrote:

    Credit Default Swaps do not create new risk, but simply move existing risk. They represent a major advance in risk management and restricting their use will create more risk than it will eliminate. There is an excellent article at the American Enterprise Institute called "Everything You Wanted to Know about Credit Default Swaps--but Were Never Told" (,pubID.29158/pub_d...

    The financial crisis was caused by government overregulation, lowering the loan standards and forcing banks to make bad loans (

    There have been tons of new regulations in recent years but the regulators never saw the recession or Bernie Madoff coming. Government workers with their pay grades will never be able to outthink the sharp minds in the private sector. "In setting rules that can't possibly account for the myriad decisions of the marketplace, regulators at best tell well-intentioned market actors what rules they need to get around in order to stay compliant. At worst, greater regulatory oversight tells the crooked among us which regulators and regulations to finesse in order to remain crooked." (

    "the regulation that we have didn’t work very well." "regulators will never be in a position to accurately evaluate or second-guess many of the most important market transactions. In finance, trillions of dollars change hands, market players are very sophisticated, and much of the activity takes place outside the United States." "financial regulation has produced a lot of laws and a lot of spending but poor priorities and little success in using the most important laws to head off a disaster." (

  • Report this Comment On July 27, 2010, at 12:10 AM, RaulChapin wrote:


    "but simply move existing risk"

    This is a very short sigthed view, you might want to consider the following.

    If I Believe that by paying 1% "insurance" on a loan against default, that loan is now 100% risk free... I will then be tempted to allocate more capital to another loan, that even if riskier will be deemed 100% free by paying, say, 2% in "insurance".

    I will continue to leverage until I hit the following magic spot:

    Interest rate paid to me on the loan=interest rate charged to me for a loan + insurance rate + costs to manage the loan (expresed as a % on principal)

    the total count of loans that i would have out, would far exceed the total loans that i would have if i had to carry 100% of the risk of default as opposed to a perceived 0% of the risk.

    So far in this example, free markets still work in that basically i am just an agent that is looking to redistribute risk.

    The problem starts when the other party of the insurance agreement (second party to the credit default swap) sells me insurance coverage beyond that which its assets are able to cover. They thus bet with money they do not have. They get paid for this bet as long as there are no defaults, but when there are defaults, they are unable to pay up, and then go bankrupt or demand a bailout thus forcing the tax payer to pay the bill (or at least UNWILLINGLY lend the money needed to cover the losses in the short term. Consider that if someone takes your car without your permission even if just to go run some errands... you would still have a problem with that), in the case of no bailout, there is still a problem in that I can not possibly know what is the total risk that my insurer is carrying as they are not forced to declare the liability from CDS with other parties on their balance sheet or disclose it in any other way. So even with no bailout, honest lenders can still get burned by a defaulting counterparty which unbeknownst to them was super leveraged.

    So problem #1 with the default swaps. Companies are allowed to offer services they can not provide in all scenarios, only in the best case scenarios... when something less than rossy happens, they go bust and take others with them, even unwilling/unknowing participants.

    Problem #2

    Due to being unregulated, default swaps can turn "insurance against loss" into "assurance of gain" a sample would be to buy two default contracts covering each 100% of the principal. If i can then directly or indirectly cause the loan to go into default, I profit from an event that in theory I should try to prevent. Since this insurance is not regulated I do not have to declare that the proceeds from default swaps come from the same underlying event.

    The problem with the above is compounded when i am able to write say 10 of such contracts... now the effect of one default is 9 fold.

    Again giving the borrower straight cash would be too clearly illegal... but lending to a Wendy's worker a sum that would bust him the moment his weekly hours go from 40 to 39.5 is border line legal.

    The possibility of insuring through default swaps an amount higher than my total amount at risk encourages me to NOT do my due dilligence. (Thus lending to anyone with a pulse)

    In traditional insurance, one can not receive a windfall due to the insurance becoming payable. (Life insurance is a bit of an exception, however there are strict laws to regulate it so that it does not become abused )

    Another big problem with derivatives is that the companies involved in buying and selling them, do not have to disclose the details on what they bought or sold, thus the shareholders have no way of assessing the risk that their agents (board of directors, CEO etc) are taking on their behalf.

    Agency does not work when the agent can profit from making the entity they represent take risk without the entity's knowledge and then profiting from that action.

    BTW I am a libertarian, but I feel the need to be the devil's advocate sometimes LOL

  • Report this Comment On July 27, 2010, at 12:17 AM, RaulChapin wrote:

    Ahhh yes, needless to say, if the agents lending an borrowing to lend were normal individuals, they would only be risking their capital and that of those who trust them... but since many times they are banks with access to the fed window... they have virtually unlimited credit and those directly providing the credit don't even know it (the tax payers left to pay the bill if the loan from the FED is not paid)

    Soooo the answer is not more regulation, it is probably... "end the FED" (There my libertarianism is showing LOL) but since "the fed" will not be ended... then at least add on to the pile of ... regulation (for lack of a better word)

  • Report this Comment On July 28, 2010, at 8:19 PM, TMFAleph1 wrote:

    What's this passage about?

    "a group including Goldman Sachs, Salomon Smith Barney, AIG, and others ganged up against Long Term Capital Management (LTCM) as Goldman and JPMorgan (NYSE: JPM) downloaded the faltering hedge fund's trading files."

    Ilan, I apologize for being blunt, but it appears to me that you are either sensationalizing or misrepresenting what happened.

    Using the expression "gang up" suggests there was some sort of conspiracy targeting LTCM while the second part of the sentence appears to imply that Goldman and JPMorgan misappropriated LTCM's data. As far as I know, neither are true. Can you explain or provide a reference?

  • Report this Comment On December 01, 2010, at 2:37 AM, TMFDiogenes wrote:

    It's from When Genius Failed. I don't recall it being particularly conspiratorial, but in the account everyone knew what LTCM's positions were and traded against them as the firm had to deleverage its positions due to the liquidity squeeze. And presumably everyone knew that's what everyone else was doing. The account is hilarious.

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