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Is the new fad for securitising commodities creating dangerous parallels with the subprime crisis? It’s an observation we made the other day. But it turns out we’re not the only ones to share this view.
The logic is simple. If by leveraging housing stock — using the stock as collateral — the process of mortgage securitisation encouraged subprime lending to people who (arguably) couldn’t afford them, could leveraging commodities in the same way be encouraging equally uncouth lending practices?
Leave the massive commodity operators aside for a minute — though, that’s not to say they are not being impacted — and consider smaller corporate entities that utilise commodities in their daily manufacturing processes.
It’s always been common practice for commodity inventory to be financed by banks by being pledged as security for the loans in question.
The problem comes if such enterprises, instead of using the inventory for general business purposes, are encouraged to stockpile for the sole purpose of liquidity provision and the opportunity to punt on the underlying commodities themselves. It’s a process which arguably artificially pumps up demand for the underlying inventory.
Bundle all those loans together, meanwhile — ideally into a product that can be sold to buyside investors seeking exposure to commodities — and suddenly you’ve got a direct source of funding for an ever-more speculative game.
When it comes to the larger players, meanwhile, this arguably transcends ‘trade finance’ even further — especially if it involves the setting up of a large number of special purpose vehicles to accomplish the process.
Here, for example, are the thoughts of Brian Reynolds, chief market strategist at Rosenblatt Securities, regarding what’s going on:
A little more than a year ago we picked up on a trend that we termed the "sub-priming" of commodities. Wall Street has been increasingly been doing structured finance deals wrapped around commodities, and this has added a bid for them while also making them vulnerable to downdrafts.
We know that many equity investors think (or at least hoped) that, after the disastrous record of wrapping pipeline and telecom assets in the 1990's and sub-prime housing in the last decade, financial market reforms such as Dodd-Frank would have eliminated structured finance as a macro driver. When Dodd-Frank was proposed it envisioned standardized derivatives being placed on exchanges and clearinghouse. We felt it would encourage more non-standardized, exotic, and opaque structures to be created, and in the two years since it was enacted that's what seems to have happened.
Important trends indeed. Yet, as Reynolds also notes, they’re also very hard to quantify given they mostly occur off-balance sheet:
This process is virtually impossible to quantify. We know that's a disappointment to equity investors who are used to dealing with voluminous information, but that's the nature of structured finance. Many structured finance deals are private in nature. As such most people, even those in the credit markets, did not know the full extent of the structuring going on in the 1990's or the last decade until those firms, which were trapped by "Special Purpose Vehicles" (SPVs), such as Enron, WorldCom and Citigroup, became forced sellers. But over the last year we've heard more and more anecdotal evidence of Wall Street increasingly structuring commodity deals, such as structured notes and swaps and even using commodities as collateral.
In Reynold’s opinion — even though he’s not a commodity expert per se — this activity significantly increases the risk of a sharp drop in oil in the coming year, especially since structured finance transactions usually come with caps and floors, which act as important support and resistance levels.
As he concludes:
In the case of a downdraft, it leaves people with unwanted long positions in a declining market, prompting even more sales. This has happened to gold a few times in the last year and anecdotally we get the sense that there such support in the $95 and $80 dollar areas for oil. A breaking of those areas might prompt further sales from structured finance participants.
We for one would definitely like to see more of this data quantified.
Related links: Collateral crunch, commodities financing edition "“ FT Alphaville Just like a giant secured loan to commodity producers "“ FT Alphaville Collateralised commodity borrowing, BP edition "“ FT Alphaville Copper Dominant Holding "Adding Fuel to Fire,' Galena Says – Bloomberg Shale Gas Hype: Subprime 2.0? – Naked Capitalism
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