The House Always Wins

The following is an excellent excerpt from the book “MAKERS AND TAKERS: The Rise of Finance and The Fall of American Business” by Rana Foroohar from Chapter 6: “Financial Weapons of Mass Destruction: Commodities, Derivatives, and How Wall Street Created a Food Crisis from page 194 and I quote: “The House Always Wins – As financial institutions expanded their commodities wheeling and dealing, they moved beyond the trading done on behalf of bank clients, and began doing more and more trading for “the house,” meaning for the bank itself.  While these operations were often quite small, they were very profitable–at Goldman, for example, commodities trading for the house historically represented as much as 20 percent of the entire commodity trading unit’s revenue.  One telling anecdote based on Bloomberg research in 2010 showed that while the bank was consistently losing clients’ money during a particularly tricky quarter, it made trading profits for itself every single day of that same quarter, an indication not only of the informational advantage large banks have, but of where emphasis within such firms lies–namely, with the bank’s own interests above all.

Meanwhile, some of the commodities being traded by financial institutions were no longer linked to one specific risk or product.  Instead, they were now linked to many risks, spliced and diced in such a way that it became impossible even for the buyers and sellers themselves to know exactly what was at stake.  Because derivatives trading has historically been quite opaque, with a large chunk of it being done off the public trading exchanges, it has always been difficult to pinpoint how much of what’s being done involves the real economy, and how much is just virtual.  But here’s a telling statistic on the credit default swaps, those risky securities that blew up the housing market: Back in 2008, their notional value was $67 trillion, while the market value of all the outstanding bonds issued by US companies underlying that market was only $15 trillion.  When the value of what’s being traded is more than four times the underlying asset that actually exists in the real world, it’s safe to say that a good chunk of what’s happening in the market is purely speculative.

While some portions of the derivatives markets, including credit default swaps, have contracted sharply since the 2008 crisis, the overall market remains enormous.  Globally, the value of all outstanding derivatives contracts (including credit default swaps, interest rate derivatives, foreign exchange rate derivatives, commodities-linked derivatives, and so on) was $630 trillion at the beginning of 2015, while the gross market value of those contracts was $21 trillion.

One big problem with derivatives is that it’s often difficult to tell apart speculation and healthy hedging of real risks, especially when large, complex institutions are doing it.  The commodities market, in which various players may both own raw assets and trade them, is especially tricky.  There are essentially four ways that commodities can be traded.  One is pure hedging–these are single bets on the future prices of raw materials that are actually owned by the individual or company doing the hedging (such as a farmer or, to the extent that it’s hedging a product in the amount that it’s actually planning to use, an airline).  When your actions are a matter of simply insuring what you already own, it’s all aboveboard.

There’s also hedging on behalf of customers or clients.  Banks do this, but so do big firms like BP or Cargill, as we learned in chapter 5.  Then there’s market making and pure trading–that’s what Goldman Sachs or Glencore, the Swiss-based trading firm founded by Marc Rich, might do–though, again, industrial companies like BP can also do it in their capacity as swaps dealers.  Lines start to get blurry here between what’s socially useful and what’s not, especially when you get into a fifth category, proprietary trading, or “prop” trading as it’s known in the industry.  That’s when financial intermediaries and other big market makers are simply trading for their own profit, rather than to hedge any underlying assets.  Activities of this kind are now illegal under the Volcker Rule, but as former CFTC chairman Gary Gensler says, “it’s very tough to prove what is permitted prop trading, what is legitimate market making, and what is pure speculation.”  As he explains, “the lines can get very blurry,” and companies can “start off doing one thing, and then move into other areas, because they are at that center of the market’s information hourglass” that allows them to do so.

Indeed, that’s exactly what some academics and regulators believe was happening with the Goldman Sachs aluminum case–lines blurred between the interests of the bank and its clients, and what may have started as a legitimate business could have ended up as market-distorting speculation.  After Goldman purchased Metro in 2010 and increased its holdings of aluminum, it also started increasing its aluminum trades.  This raised concern that there may have been collusion between Metro and Goldman’s trading desk, which were supposed to be strictly separated.  By 2013, the Justice Department, the CFTC, and the Senate’s permanent Subcommittee on Investigations, led by Senator Carl Levin, began looking into the issue.  The Senate report, issued in 2014, found that almost fifty Goldman executives, including two of the most senior members of the commodities trading team, had access to confidential and “commercially valuable” Metro information through internal memos and emails.  There were also emails from Metro employees expressing concerns about possible collusion.

And that wasn’t all.  During the Senate hearings, testimonies pointed to many other potentially troublesome scenarios unfolding not just within Goldman, but also at other banks.  It emerged, for example, that Goldman played a big role in the uranium trading business via a subsidiary that employed Goldman staff, and that a now sidelined Morgan Stanley natural gas project was essentially a shell company set up by executives from Morgan Stanley’s commodities arm.  The list of problematic commodities deals goes on.  In two others, J.P. Morgan was accused of manipulating copper and electricity markets; it paid $410 million in penalties to settle the latter case.  All of this led Senator Levin to conclude, “We’ve got to get banks out of its kind of business because of the risk to the economy and the possibility of manipulation.”

Goldman Sachs, for its part, denied all wrongdoing in the aluminum case and claimed in Senate hearings and public comments that it was always acting on customer orders and needs, and was willing to sell and deliver supplies to customers at any time.  In the end, the Senate investigations couldn’t prove collusion.  This result underscored a bitter truth about the commodity markets: even though they are arguably more important to the real economy than, say, the stock markets, it’s much harder to prove market manipulation and insider trading in commodities.  That’s because big owners of raw materials, too, are legally able to be big traders.  Indeed, to become a true player in the trading of physical commodities, you have to be willing to take delivery of some of the raw materials, since such knowledge about what’s going on at the ground level is crucial to understanding the trading market.

Gaining that informational edge is exactly why large banks pushed for additional tweaks in the Gramm-Leach-Bliley Act of 1999, the famous legislation that repealed Glass-Steagall and lowered the barriers that financial institutions faced in getting into real businesses like mining, oil delivery, and the owning and storage of physical commodities.  The law did more than create loopholes allowing banking conglomerated to increase their trading operations by conducting activities that were “financial in nature” (like securities dealing and insurance underwriting).  It also introduced important new provisions allowing banks to engage in purely commercial types of business, ones that they had historically been banned from, as long as they were perceived as being “complementary” to their normal financial activities.  In their lobbying at the time, the banks pointed to innocuous areas of commerce like publishing or travel that might be of interest to them, and potentially “complementary” to their core businesses.

“Financial firms. . . engage in activities that arguably might be considered non-financial, but which enhance their ability to sell financial products,” said Michael Patterson, the vice chair of J.P. Morgan at the time, during congressional testimony in 1999.  “One example is American Express, which publishes magazines of interest to its cardholders–Food & Wine and Travel & LeisureTravel & Leisure magazine is complementary to the travel business. . . in that it gives customers travel ideas which the company hopes will lead to ticket purchases and other travel arrangements through American Express Travel Service.”  Such plain-vanilla examples helped make legislators comfortable with the idea of granting exemptions for commercial activities.

But the truth is that banks didn’t want to be in the magazine publishing business–they wanted to be in to Silicon Valley startups and, later, in the oil, gas, electricity, and minerals business.  And indeed, between 2000 and 2012, all but one of the “complementary” activities that firms would seek to engage in via the loophole in the law had to do with commodities ownership and trading.  Referring to Goldman’s purchase of metal warehouse space, Nick Madden, chief supply chain officer for the giant aluminum maker Novelis, says, “It had all the appearance of being part of an engineered market squeeze.  I mean–why would you buy a warehouse?  Why not an ice cream parlor?  If not to have a lever to move the market, than. . . for what reason?”

The word complementary was a loophole big enough to drive millions of tons of aluminum through, and it provided a legal way around one of the core principles of another decades-old piece of legislation, the Bank Holding Company Act of 1956, which separates banking and commerce.  The idea behind that law was that banks were supposed to lend to businesses, not compete with them.  It’s a fundamental assumption at the heart of most banking regulation.  But financial institutions managed to jump over that hurdle and make their way into lucrative commodities businesses by arguing that this move was in the interests of their clients.  Banks needed to be able to do a variety of things aside from simple lending, they said, including underwriting securities, trading complex swaps and futures, even owning pipelines or oil wells–because being in such businesses made things easier, cheaper, or more efficient for their corporate customers, and sometimes even consumers.

Yet the truth is that when banks start doing business in areas that involve real, tangible products that people rely on to live, their meddling invariably benefits just one party: the financial institutions themselves.  Indeed, the more complex the business, the more likely it is to benefit the banks vis-a-vis anyone else, given their ability to leverage their superior assets and informational advantages.

It’s important, perhaps, to pause here and point out that this isn’t really about individual bankers trying to be venal (not to say that doesn’t happen).  All too often, banker bashing actually misses the point and distracts form a more nuanced and important conversation about the problems in our overall market system.  It’s easy to understand the populist rage that makes people call for, say, Jamie Dimon or Lloyd Blankfein’s head on a platter, and individuals should certainly be held responsible for any wrongdoing.  But the truth is that financiers are usually just trying to make as much money as the law allows them to.  It’s the particular rules of our market system that are more often the problem, because they are set up in such a way that the largest financial institutions are able to exploit huge advantages in pretty much every industry, often with federal subsidies that other players don’t enjoy and with little, if any, responsibility for the collateral damage to the underlying economy.  “Investment banks are at the center of the marketplace of money and risk,” says Gary Gensler.  “At the center of all that information, it’s possible to profit from it.  It’s sometimes said on Wall Street that ‘volatility is our friend.’  That is not something you’d generally hear at an airline, or at General Mills, or probably at a community bank.'”

But for the Too Big to Fail institutions like Goldman, volatility most certainly is an advantage.  It enables them to employ their potent combination of massive amounts of capital, up-to-the-minute knowledge of developments in the financial markets, and ownership and information about raw materials, to make money at the expense of other players, be they consumers or big firms like Coke or Coors (who then pass the cost on to consumers in the form of higher prices).  As Saule Omarova points out, a great irony of the commodities trading scandals is that the very arguments banks employ to defend their right to own and trade physical commodities are also those that clearly demonstrate the unfair advantages from all the insider information that such ownership brings.

“Financial institutions will say, ‘we need to know physical oil to trade oil derivatives more efficiently and serve our clients better,'” says Omarova.  That’s considered complementary under Gramm-Leach-Bliley, and so it’s okay.  “And yet, when the CFTC inquires whether these institutions might have improperly benefited in their derivatives trading, from say, bottlenecks that they created in the warehouses they control, the standard response is, ‘oh, there’s a strict informational wall between those units–they don’t talk.’  But if it’s the access to information that’s the basis for finding physical trading complementary to derivatives trading, why wouldn’t this information be shared among the firm’s units?  Isn’t the whole point of dealing in various raw materials to get valuable market information, such as the expected delivery backlog at major metals warehouses, for example–and use it to price derivatives trades?  Somehow, this fundamental inconsistency in the banks’ arguments often gets lost on the regulators.  And it leaves big banks always on the winning side.”

It’s worth noting that arguments of this exact type were employed by bankers and public officials who lobbied for the repeal of Glass-Steagall and the creation of the Too Big to Fail banks themselves.  Economist Joseph Stiglitz, who was the head of President Clinton’s Council of Economic Advisers in the run-up to the repeal, remembers arguing with Treasury officials on this very point.  “People wanted the law overturned to create ‘synergies’ between different divisions of the banks.  And I said, ‘what are we going to do about conflicts of interest?’  And they said, ‘don’t worry, we have Chinese walls.’ And I said, ‘well if you really constructed Chinese walls, then where are the synergies?'”

Interestingly, the crisis of 2008, which turned Goldman Sachs and Morgan Stanley into Fed-regulated Too Big to Fail holding companies as a condition of getting government bailouts, also legitimized their meddling in the aluminum markets.  That’s because of a fine-print clause grandfathered into the Gramm-Leach-Bliley Act that Stiglitz and others had opposed, which allowed any entity that became a bank holding company following the act’s passing to conduct physical commodities activities.  The only prerequisite was that this entity had entered the commodities business before 1997.

And so, in the aftermath of the 2008 crisis, both Goldman and Morgan went from being stand-alone investment banks to bank-owned financial holding companies regulated by the Fed.  By becoming federally backed banking companies regulated by the Fed.  By becoming federally backed banking entities, these institutions got both the freedom to control as many aspects of the market as possible and precious direct access to government subsidies and federal underwriting J.P. Morgan, already a bank holding company, ended up benefiting too; it got to acquire the large commodities assets of Bear Stearns and RBS Sempra (the energy trading business previously co-owned by the Royal Bank of Scotland) at rock-bottom prices.  Just as J.P. Morgan emerged as a bigger and more systemically important bank after 2008, so it became the five-hundred-pound gorilla of the commodities trading markets, boasting a physical commodity inventory valued at over $17 billion.  It even bought a stake in the LME, which it purchased from the bankrupt futures firm MF Global, becoming the exchange’s largest shareholder.

All this happened despite the fact that the original regulatory exemptions that allowed J.P. Morgan to do physical commodities trading in the first place didn’t specially allow it to generate, store, transport, or process physical commodities.  The bank had to rely on the good graces of regulators to not look too hard at the fine print–a job made easier by the fact that there are multiple regulators (including the Fed, the CFTC, the SEC, and the Federal Energy Regulatory Commission).  Each has its individual areas of responsibility, but none is big enough to examine complex and problematic deals in this entirety.  The fact that they are wildly underresourced doesn’t help.  The CFTC, for example, has around 650 people on the payroll, which may seem like a lot of regulators, but it’s just 8 percent more than the agency’s staff size in the 1990s when the futures market was worth a fifth of today’s $40 trillion.  And that’s no even counting the $400 trillion swaps market, which the agency didn’t have to cope with then.

There are, of course, huge risks inherent in all this trading, especially when it’s done by Goldman Sachs, Morgan Stanley, J.P. Morgan, and the like, since we all pick up the bill when things go bad, thanks to the implicit taxpayer backing of these Too Big to Fail institutions.  Sure, the Dodd-Frank regulation promises that taxpayers would never again have to foot the bill, but in practice, it’s unclear how the government would avoid future bailouts, particularly given that these banks are bigger and more important now than they were before 2008. What’s more, a loophole pushed into the 2015 federal spending bill by the financial lobby means that these banks don’t have to separate out that risky trading into new entities that wouldn’t be taxpayer backed.  All this allows such institutions to retain huge market advantages not enjoyed by any other players.  In the commodities markets and any other market where they can leverage the word complementary, they get the privilege of being in a nonbanking business, with access to information held only by large banks, and with subsidies enjoyed only by Too Big to Fail institutions.  It’s an unfair advantage over other businesses, as well as a risk to our economic health and safety as a nation.  That doesn’t please many people, even the creators of the original 1999 loophole that made the whole thing possible.  As the ex-congressman Jim Leach, one of the authors of Gramm-Leach-Bliley, said in 2013, around the time of the Senate subcommittee hearings on commodities manipulation, “I assume no one at the time [of the act’s writing] would have thought it would apply to commodities brokering of a nature that has recently been reported.””


“Rana Foroohar is among the best economic commentators we have today, able to write about complex economic issues in a clear and lively way.  Here she draws a compelling portrait of the many ways in which our overgrown and excessively powerful financial industry perverts incentives, hampers innovation, exacerbates inequality, and takes its toll on the rest of the economy.  Anyone concerned about the future economic health of this country should read this persuasive and disturbing book.”  —LIAQUAT AHAMED, Pulitzer Prize-winning author of Lords of Finance


LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran


About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog ( and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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