Wall Street's $300 Billion 'Ponzi Scheme'

A Ponzi scheme is defined as a phony investment program where the introduction of new funds is used to create “profits” for those already in the game. Ponzi schemes typically have some purported economic rationale for the profits, but at the end of the day, the basis is shown to be a sham as well. This is a pretty good description of Wall Street’s commodities-as-an-asset class machinations.

Wall Street positioned long-only commodity index investing as a core asset class and critical diversification. Investors piled into this strategy, particularly in the first half of last year, with total participation estimated to have peaked around $300 Billion. These inflows drove prices higher which produced positive returns for earlier investors, leading to yet more investors becoming attracted, again driving up prices, creating a vicious cycle analogous to a classic pyramid. Unlike a true Ponzi scheme, it was not just the investors who ultimately were harmed, but the economy as a whole. Mike Masters and Adam White recently released a report chronicling the damage done to the economy by the commodity bubble fueled, at least in part, by the participants in this investment strategy. The damage easily exceeds $100 Billion.

Given the damage done, it’s more than fair to ask whether the commodity-as-asset-class strategy had any legitimacy to begin with. As I’ve written before about this approach, just because you can run numbers through a model doesn’t mean they make sense. The core rationale for Wall Street’s commodity “pitch” was the argument that commodities provided unique portfolio exposure. The chart below (click to enlarge) brings this key argument into question.

Commodity Futures vs. Commodity-Related Equities

The chart shows the 5-year price history of the Reuters Jefferies CRB index (black), a broad index of commodity futures, versus the Morgan Stanley Commodity Related Equities Index (purple), an equal weighted index of 20 equities whose core businesses are linked to commodities. The high correlation (roughly 80%) shows that portfolio managers can capture the portfolio characteristics of commodities by using stocks. In fact, running a more robust set of analytics over longer periods suggest that the equity approach is actually superior — what it loses in correlation is gained in better protection in downturns. Finally, the stocks in this index have an average dividend yield of roughly 2.6%. The much hyped “roll yield” of commodities is now negative, and significantly so for energy-oriented indices like the popular S&P-Goldman Sachs Commodity Index.

So why the rush into commodity futures? In the industry it’s been said that, “some products are bought and some products are sold.” The manufacture and distribution of products tied to commodity futures (swaps, structured notes, etc.) is far more profitable that the penny-per-share stock business. It should be no surprise that Wall Street’s investment banks sought to highlight and promote a lucrative product at the expense of a more effective strategy. Nor should it be a surprise that these same firms are fighting the restoration of traditional market rules which might have prevented these market distortions.

The Ponzi scheme analogy is an imperfect comparison of course. The Wall Street firms which promoted commodities in this manner put the money into the markets as promised and no laws were broken. However, this should not deter our policymakers from understanding the true nature of the strategy – it was built on flawed assumptions and Wall Street hype. Like anything else built on bad ideas, bad consequences have been the inevitable result.

Congress is in the early stages of considering legislation that would help: The Derivatives Markets Transparency and Accountability Act of 2009. Let’s hope we can construct barriers that will prevent a repeat of the 2008 debacle.

Comments

[bosun.j:]

The ten most feared words ever spoken: "I'm from the Bank and I'm here to help you."

Feb 10 05:31 AM

[User 208370:]

you need to learn the difference between providing access to a momentum trade and a ponzi scheme...really.

Feb 10 08:08 AM

[Stock Marke...:]

Great headlilne, but the above comment is really the sticking point to the argument. Again, great headline, can't fault you there, but a momentum trade and ponzi scheme are very different and once is actually illegal.

Feb 10 10:00 AM

[notsosmart:]

legal or illegal.just human shennanigans.its all ponzi & the sheeples continue to get fleeced. if the bubble had not burst mr.made-off would still be the hero as long as the ponzi participants(a lot knew) kept getting their 10-12 % return.we would be better off if they legalized the ponzi as then more folks would be alert to phony returns. then we would know its all ponzi & we would take our chances.

Feb 10 11:16 AM

[AndrewBaker:]

When more money is in futures for commodities that will never be delivered, then it's time to get worried. How much is now in oil futures? More than the amount of oil inventory and oil being produced, as I understand. And much of that in ETF where the cost of contango (running the expiring month into the next month's futures contract) eats up a big amount of the invested money. Some will get it right and earn a profit, but at some point, this trading will cease to be able to support all those trying to make a living from it. One more financial bubble to burst to make this depression last that much longer.

Feb 10 03:57 PM