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The Perils of the New Financial Architecture (NFA)

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					I. The Commodity Bubble As An Extreme NFA Pathology II. Structured Mortgage Finance As The NFA’s Contribution To The History Of Ponzi Finance III. The NFA And The Emergence Of A Dangerous Parallel Financial System IV. The US Consumer Imbalance And A U.S. Recession As A Precipitating Event For Crisis To: PPI Summer 2007 Roundtable On Global Competition For Natural Resources From: Frank Veneroso Fairmont Empress Hotel Victoria, British Columbia July 25, 2007 Introduction When Catherine and Marsha called and asked me if I would speak at this conference, my response was, you really don’t want me to speak. My positions are too extreme, too negative, and surely too far removed from an increasingly bullish consensus. Especially when it comes to commodities. For everyone else, markets are simple these days: we live in a world of rapidly expanding liquidity and central banks are not going to interfere and spoil the party. All risk assets are rising and they will continue to do so. And, in a world so awash in liquidity, there is no risk to the underlying economic expansion as well. Add to that the miraculous growth of China and India, with their two billion people, and commodities are likely to be a more bullish market than most. I said to Catherine and Marsha, I believe my cautious positions are logical and well supported, but they are just not being borne out by the action of markets. Hence they are discredited. Two years ago I argued that the U.S. had a housing bubble and it would burst. Well, it has burst. I predicted an outright decline in U.S. home prices for the first time since the 1930’s. Well, that too has begun to happen. I argued that U.S. mortgage finance was another bubble and that it would end with defaults and creditor revulsion. That too has happened. I argued that commodities in this cycle were a bubble created by hedge funds with derivatives and there would be accidents. One large one did surface, but there was no fallout. And no recurrences.

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I argued that the mortgage finance bubble would lead to collapses in mortgages values that would lead to similar accidents among leveraged mortgage holders. That is now happening. But most markets simply do not care. I stressed that U.S. households spend way in excess of their incomes – and this has been made possible only by rising home values and sustained mortgage equity withdrawal. Home values have fallen and mortgage equity withdrawal has collapsed. Yet, despite a slowdown in aggregate income due to a sharp fall in residential construction, our statisticians tell us real consumer expenditures have actually accelerated. Over the last two months there have been some signs that U.S. economic activity is now picking up despite all the possible constraints I cited. So now there is a really confident consensus: whatever risks I cited are now behind us and in any case, the U.S. consumer never falters. The U.S. mid cycle slowdown is past, the consensus says. Central banks will remain gradualist. The Chinese authorities will let their economy run wild until after the 2008 Olympics. The global economy will accelerate and risk assets, including commodities, will keep rising. All because of the overwhelming and unstoppable flood of global liquidity. So, why, Catherine and Marsha, does anyone want to hear from me? Especially on the subject of commodities. Catherine and Marsha’s response was, it is useful to at least hear something other than the bullish consensus. Why I Have Been Bearish For years now I have been cautious. Far too cautious. Including on the subject of commodities. Why? My caution is because we have been in an economic expansion in which debt financed speculation has been allowed to go wild – not by central banks, who are quite concerned but by the development of a parallel financial system without regulation dominated by hedge funds, private equity funds, and investment banks and their derivatives and their structured finance. This caution is rooted in a knowledge that throughout history, when debt financed speculation runs amok, bad things happen. I have not been alone with this longstanding caution. The most well known bond manager in the world, Bill Gross, has also been much too cautious, and for similar reasons. He put it best in a piece he wrote three and a half years ago called “The Last Vigilante”.
We are hooked on debt; we are a finance-based economy.

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And so? Why not just keep on going. So far so good the New Agers would claim. What’s wrong with 400% of GDP or 500% of GDP? What’s wrong with dropping it from helicopters if we have to as good Ben Bernanke has suggested? Well, let me tell you what’s wrong. Debt levels and debt ratios have limits. When and if interest rates do go up, the servicing costs of an accelerating debt economy eventually bite the hand of its master. My point is that at some point on this seemingly never ending ascent of debt/GDP, someone will say “no más.” Maybe it’ll be PIMCO and PIMCO think-alikes; maybe it’ll be foreign holders of bonds grown tired of currency/inflationary erosion of principal; maybe it’ll be risk takers in high yield/emerging market/levered hedge funds scared to death from a future LTCM crisis. Hard to tell, but I’m telling you it’ll happen, helicopter or no helicopter and with it will come an economic slowdown/recession unseen since at least the early 1980s when Volcker began his vigil. High noon. -The Last Vigilante, Bill Gross, PIMCO, February 2004

Since Bill Gross wrote that piece 3 ½ years ago debt has grown. GDP has grown, and debt has grown faster. Strangely, the bubble in housing that it fostered has burst. House price collateral has fallen. Mortgage defaults have risen. Some mortgage securities have crashed in price. But, all that said, there has been only a benign mid cycle slowdown in the U.S. economy and no slowdown whatsoever in the rest of the world. There has been no significant investor revulsion. High noon never came. Catherine and Marsha first contacted me, before the blowup of the Bear Stearns hedge funds. Then, after the pain of being wrong for years, the “bond king” had seemingly thrown in the towel. I missed the reality of great global growth, he said. That will carry the U.S. economy. We will work it out. No High Noon. By the way, in addition to raising the upper end of his “secular” bond yield forecast, the “bond king” recommended commodities. Well, respectfully, I didn’t agree with the consensus nor the crestfallen bond king. Yes, there has been a great surge of global liquidity. So great, in fact, that it has done something that has never happened before – all asset classes have been kited ever higher together. There has been no inverse correlation among markets. There have been no straw hats in winter. But unlike the consensus and even Bill Gross I believed things had gotten worse, not better. Unlike the consensus, I do not believe the so-called flood of liquidity has at its origin central banks. Rather, I believe that it has as its origin a NEW FINANACIAL ARCHITECTURE run amok. An explosion of the growth of assets under management by hedge funds and private equity funds, aided and abetted by investment banks with their structured finance and complex derivatives, has led to the explosion of a vast opaque parallel financial system. This system lies outside the purview and controls of the
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world’s financial authorities. It is almost a pure laissez-faire financial market in keeping with the extreme ideology of our market place today. There is something more to this new financial architecture than its institutions and instruments. Perhaps of even greater importance is the behavioral regime that now prevails. This behavior is driven by short run fee seeking. It embodies a rising risk preference that has been fostered by decades of central bank behavior, which has created pervasive moral hazard and, more importantly, an expectation of ever more moral hazard forever forward in time. This behavior incorporates transgression after transgression of all the rules governing financial behavior and structures that were promulgated since the 1930’s to ensure financial stability. In sum, the behavior characteristic of the New Financial Architecture is the very antithesis of financial prudence. Despite all the hullabaloo that all the market players in the New Financial Architecture make about their wondrous risk management systems. This short run fee driven speculative behavior, with all the derivatives and structured finance at its disposal, can lead to speculative spirals that can be burgeoning liquidity creation in one moment and liquidity destruction in the next – liquidity destruction which the world’s financial authorities may be powerless to manage. The reigning market consensus surely doesn’t see it this way. Paul Krugman has called the current state of affairs in markets an “irrational complacency”. Except for the world’s financial authorities. Oddly central banks, finance ministries, and international financial authorities almost every day engage in some measure of public hand wringing over excessive risk taking and leverage. The BIS has given us the shrillest warning yet: BIS warns of Great Depression dangers from credit spree By Ambrose Evans-Pritchard Last Updated: 9:02am BST 25/06/2007 The Bank for International Settlements, the world's most prestigious financial body, has warned that years of loose monetary policy has fuelled a dangerous credit bubble, leaving the global economy more vulnerable to another 1930s-style slump than generally understood. "Virtually nobody foresaw the Great Depression of the 1930s, or the crises which affected Japan and southeast Asia in the early and late 1990s. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a 'new era' had arrived", said the bank. The BIS, the ultimate bank of central bankers, pointed to a confluence a worrying signs, citing mass issuance of new-fangled credit instruments, soaring levels of household debt,

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extreme appetite for risk shown by investors, and entrenched imbalances in the world currency system. In a thinly-veiled rebuke to the US Federal Reserve, the BIS said central banks were starting to doubt the wisdom of letting asset bubbles build up on the assumption that they could safely be "cleaned up" afterwards - which was more or less the strategy pursued by former Fed chief Alan Greenspan after the dotcom bust. It said this approach had failed in the US in 1930 and in Japan in 1991 because excess debt and investment built up in the boom years had suffocating effects. I find this amazing. I have followed the worlds’ financial authorities closely ever since I went to Washington 3 ½ decades ago to advise governments, multilaterals, bilaterals and the like on financial development and stability. During that period there were many crises somewhere or other. Never did the authorities see it coming in advance. Relative to the markets they were tardy and blind, always behind the curve. But now they are issuing warnings almost every day to the irrationally complacent. In what follows I will explain why I am with the once tardy and even blind authorities as opposed to the complacent consensus and why. That of course may not be your interest. Your interest is with natural resource investments and also the new investment fad and fashion of shifting funds from stodgy bonds and stocks to sexy alternatives. So I will address commodities in some detail. And then I will go from there to the fad and fashion for sexy alternatives. But I think you will see as we follow this course that the debate over whether one should be chasing commodities and alternatives is really a debate about whether the complacent consensus or the hand wringing global financial authorities have it right.

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Part I. Commodities Commodities Are A Bubble Metals May Be A Manipulation My assumption is that most of you believe that commodities are in a new era secular bull market because of the great economic growth trajectory of Chindia and the BRICs and the like. And, secondarily, because of resource constraints. In my long companion piece delivered to the central bankers in Washington on April 16 at the IMF Spring meetings I laid out the case in great detail that commodity markets in this cycle are a bubble. I will move quickly in this presentation, focused on the following slides. For those who want the details look at my April Washington presentation. My real objective is not to make the case that commodities in this cycle are a bubble but they are an extreme example of the outcome of the instruments and behavior of the New Financial Architecture. One sees this most clearly in the case of metals. Here whole metal markets have been overwhelmed by speculators with asymmetric reward risk payoffs. Prices are allegedly maneuvered to preposterous levels to generate marks that lead to huge fees, even if there may be no easy exit strategy from such maneuvering. So first, the fundamentals on the bubble, and then, second, the behavior reflected in the alleged maneuvering and manipulating. In the following two graphics we can see that the increase in commodity indices in this cycle in nominal terms is higher than it has been over the last three decades. In this cycle there has been very little general price inflation. In the only (but not quite) comparable bull market in the late 1970s there was a great deal of general price inflation. If one goes back a bit further to the bull move in commodities from the late 1960s to 1974 there was also a great deal of such inflation. Therefore, this has been the biggest bull market in commodities in real or inflation adjusted terms of the entire post war period.

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In Real Terms, The Biggest Commodity Bull Market Ever CRB Index

GSCI Index

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Amazingly, this is probably the biggest bull market in commodities in real terms since the onset of the industrial revolution two and a half centuries ago. In the following chart we have an index of commodity prices going back to 1741. If one studies this chart very carefully one sees that there were not many big commodity bull markets and that virtually all of these big commodity bull markets occurred during a generalized price inflation, usually associated with a war. Therefore, almost all of these commodity spikes were in large part nominal, not real, price events. And, adjusted for general price inflation, perhaps none of them were bigger than the bull market this time around. 256 Years of Commodity Prices

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So why, then, has there been such a big bull market in commodities in this decade? The usual answer is that we are in a new super cycle of global GDP growth in commodity demands. The data says this is “bunk”, pure and simple. In the next graphic I present year over year global GDP growth as calculated by the IMF. The measure of GDP used is based on exchange rates and not Purchasing Power Parity (PPP). This is the appropriate measure for comparing the GDPs of different economies when it comes to commodities. Why? Because commodities are tradables and it is the flow of tradables that determines exchange rates for the most part. PPP measures of GDP diverge from exchange rate measures largely because of the underestimation of the value of non-tradables in some economies relative to others. For the most part, the commodities in our familiar commodity index baskets are not an important part of these non-tradables that make PPP measures of economies diverge from exchange rate measures.

Global Real GDP, % Annual Change

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It is very striking that GDP growth in this cycle is peaking below the peaks of the 1980s, even more below the peaks of the 1970s, and even more below the peak of the late 1960s. I understand this strikes all of today’s commodity aficionados as wrong. This cannot be, they say. China and India and the rest of the emerging world are now far too important. Below is a table showing the relative shares of the different global economies in total world GDP. Again, this is based on exchange rate measures of GDP. We see that the United States is still by far the dominant economy in the world and the developed economies are still far larger than even the most important emerging economies like China and India.

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If global economic growth has not driven this record commodity bull market in real terms, what has? The answer comes from that New Financial Architecture world of hedge funds and derivatives. In the following chart we see that one window on the world of commodity derivatives shows an explosion in such derivatives over the last three years. I say this is one window because it does not encompass some OTC commodity derivatives “associated” with pure investment banks and excludes all commodity derivatives traded on futures exchanges. I do not want to go into what these derivatives correspond to exactly. Nor do I want to explain how an explosion in commodity derivatives can inflate commodity prices. This is a complex subject which I touch upon in my Washington speech to the central bankers. Suffice to say that the early years of this commodity bull market – from 2001 to 2004 – was probably driven by fundamentals. The increased amplitude and duration since then has probably been due to the explosion in commodity derivatives, even though, for many commodity markets, surpluses have been emerging and surpluses have always ended commodity bull runs in the past.

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Who, may we ask, is buying all these commodity derivatives and creating the commodity price bubble in this cycle? Many think it is you pension funds through the purchase of commodity index baskets. But that is not the case. Taken all together the gross value of these commodity derivative baskets lies somewhere around $150 billion. Though there is great double counting in all the statistics we have on commodity derivatives, the net increase in such derivative positions probably dwarfs the increase in such commodity baskets in this decade. The real source of demand for commodity derivative positions has been hedge funds. This was revealed in the demise of the hedge fund Amaranth. A Senate study has shown that the exposure of one hedge fund, Amaranth, in U.S. natural gas by way of derivatives greatly exceeded the value of all natural gas positions in all commodity derivative baskets combined. In this presentation I am not going to focus on the oil market. The oil price has gone up in this cycle more than the commodity price indices and by almost as much as the wildest of the base metals. However, the oil price may not be terribly out of whack with its underlying fundamentals. There clearly is something of a constraint on the supply of oil. It is not as absolute as the Peak Oil advocates might claim, but there is something of a constraint. There has also been some price rationing of oil demand, but it has not been severe like it was in the last cycle – so far at least. As a result oil demand growth and oil supply growth have both been a couple of percent a year, give or take. That is not out of line with the behavior of the oil market or other commodity markets of the past decades. I think global oil capacity has been modestly outpacing global oil demand in recent years as a result of the high price of oil in this cycle. I believe that there is something of a

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“speculative premium” in the oil price because a considerable share of the explosion in commodity derivatives can be attributed to oil derivatives. But because the oil market statistics are very questionable, one cannot be precise about these claims. That said, I want you to look at the following chart prepared by Grantham, Mayo, and VanOtterloo. Jeremy Grantham provided this chart in a letter to his investors about two years ago. He made the point that his firm has looked at two standard deviation moves above the mean in real or inflation adjusted prices in all the markets throughout history. And that, in every case, such a price spike was followed by mean reversion. One might describe a true bubble as a more than two standard deviation move from the mean. History tells us that when that happens a reversal of the spike inevitable ensues. Grantham says that if he has ever seen a candidate where mean reversion might not follow, it is the present oil market. But he does not know. We will see.

Because I am discussing oil, for a moment I am going to get ahead of myself and consider in the case of oil what I will focus on in the case of metals: manipulation. Because of the collapse of Amaranth and the sensitivity of the American voter to the price of his motor and home heating fuels, several Congressional committees have been pushing the CFTC to look into possible cases of manipulation of energy prices. This was made public in a statement by the CFTC head of enforcement in the Financial Times in April. Head of Enforcement at the CFTC “The cases are getting larger. That is because we are now in markets where sophisticated, institutional money has moved in. The other reason that figure’s gone up is that we have changed our focus to go after the most egregious cases,” Mr Mocek says in an interview.” “Mr Mocek says his division is investigating about 100 individuals and companies, including hedge funds and utilities, for allegations of energy market manipulation. It is small wonder that the energy markets are attracting the closest scrutiny. This week, the

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fall-out from $6bn in losses chalked up by hedge fund Amaranth on over-the-counter (OTC) natural gas swaps reverberated in Washington as senate energy committee chairman Jeff Bingaman raised concerns about “potential anomalies in natural gas markets”. What has shocked me is that two weeks ago the Acting Chairman of the CFTC indicated a high prevailing level of active investigation of alleged manipulations. This suggests disclosure of a real energy manipulation may be awaiting us in the wings. Acting Chairman of the CFTC “The Commodity Futures Trading Commission is actively investigating about 100 allegations of energy market manipulation, the agency’s chairman said today. Speaking at a U.S. House agriculture subcommittee hearing, CFTC chief Walter Lukken said that historically, less than half the CFTC’s cases were successfully prosecuted.” Let us go on to commodities where price increases have been as extraordinary as the price increase in oil but where the underlying supply/demand fundamentals are not only clear, but are clearly bearish. The best examples of this are in the base metals sector. In my April Washington speech I covered in considerable detail the fundamentals of nickel, copper, and aluminum. For those of you interested in the details of the fundamentals I refer you to that speech. For now, given time constraints, I will focus on only one; copper. In this cycle the price of nickel in nominal terms has gone up ten times and by almost as much in real terms. The price of lead has gone up by nine times and almost as much in real terms. Next comes copper, which went up six and a half times in nominal terms. Zinc had a comparable move. The increase in each of these prices has no comparable in their respective histories. Only aluminum, which has only tripled in price in this cycle, has fallen short of its historical antecedents. In the following two charts you can see the enormity of the price rise in copper in this cycle relative to past cycles. In the second of these two slides I present a chronicle of all the bull markets in copper in nominal terms since 1860. The 575% increase in the copper price in this cycle has been more than two times in amplitude the next biggest bull market over the prior past century and a half.

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What is responsible for this gargantuan rise for the price of copper in this period? You will say the New Era super cycle of demand growth. I will respond, bunk! It is not in the data.

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Is There A New Super Cycle of Demand Growth This Time? No

In the above chart I show global copper consumption growth for last year, the prior five year period, the prior fifteen year period, and the prior twenty-five year period. In the early years of this twenty-five year span the Chinese economy was small and lagging under communist control. India was small and lagging, buried in its bureaucracy. Now China and India are large economies and roaring ahead. So why has global copper consumption growth not appreciably changed with each successive five year period over this two and a half decade time period? The answer lies in that chart of global GDP growth based on IMF data I showed you earlier. GDP growth in this cycle is little different than GDP growth in all the cycles going back two and a half decades. Early in this long time span, Europe and Japan were still fairly rapid growers. Productivity restraints and adverse demographics have now made them slow growers. Some emerging economies like the Asian tigers and Brazil had growth rates then that were two times what they are now. So China and India have become a larger share of world GDP and are growing more rapidly, but their emergence as superstars in the global economy has been offset by the loss of luster of so many other economies which were once so much more dynamic. I know your response. You must be wrong, since we hear everywhere that the now very large Chinese economy is growing its copper consumption at a furious pace. That is true. But only because the most developed countries are transferring the primary processing of copper cathodes from their own country to China. In the world of commodities we define demand as the absorption of the primary product – in this case the copper cathode – by primary processors like a wire-rod mill or a brass mill. For decades the advanced countries have been sending this relatively low-tech industrial activity to the third world. In the end the fabricated metal ends up in a product which is exported to, and consumed by, the first world. But it is not the latter consumption of copper we measure; it is the first. So, as the chart below shows, as

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China’s demand for primary copper has exploded the demand for copper in the advanced world has fallen. What About Booming China? China’s Demands Displace Fabrication in the First World.

Earlier I said that a tsunami of demand for commodities by way of derivatives has inflated commodity prices through the second half of this cycle. The evidence suggests hedge funds have been the primary protagonists. It is widely reported that in some cases hedge funds have bought physical metals in addition to futures and forwards. Why would hedge funds buy physical metal and not just forwards? For the last several years most of the base metals have been in a forward discount or backwardation. If one takes a long position in such forwards and rolls it as each successive contract comes due, one earns that backwardation or roll yield, as it is called. By contrast, if one buys physical metal one must pay the cost of interest, storage, insurance, and transport which can come to 7% per annum No fund with a pure investment motive would have bought physical base metals when there were base metal forwards in less than a full contango as has been the case over the last several years. Doing so was tantamount to forgoing a relative return, often in the double digits annually. And sometimes the big double digits annually. So why then would hedge funds have bought physical? The history of base metals markets has been rife with manipulations basically, – squeezes and corners. Integral to conducting such manipulations has been the purchasing and hiding of physical metal to create an artificial shortage. In the past these activities were the domain of shadowy merchants. It is widely said that, in this cycle, hedge funds have joined the more traditional players who have held stocks of physical metals in backwardated bull markets..

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To understand this one must first understand a pecularity of metal market statistics. First, demand does not refer to the consumption of metal in products by the final user. That is too difficult to estimate. It is defined as the demand for the primary metal unit – ingot, slab, cathode, etc – by the first stage processor. But even that is too difficult to estimate. So the statisticians have recourse to a concept of “apparent” demand which is calculated as total supply from imports and domestic production adjusted for changes in visible stocks. Therefore, a build of unrecorded stocks appears as an increase in apparent demand. Given the way the market statisticians construct their statistics, when merchants and or hedge funds buy and hide physical metals, these builds in hidden stocks are recorded as instances of demand. When merchants and funds add to hidden metal stocks and conduct squeeze operations they inflate metal demand growth. In doing so surpluses are made to look like deficits. In my April Washington speech to the World Bank, The Commodity Bubble And The Metals Manipulation A Window On Hedge Fund Over Positioning, Leverage, Risk Seeking And Subsequent Price Distortion In More Important Markets? I quoted many parties who contend that this has happened in this cycle in base metals. We can see this in a comparison of the official statistics on China’s “apparent” demand for copper and China’s recorded production of semi-fabricated copper products. Over the last three years, reflecting a flood of imports of cathodes and an unreported build in stocks, China’s apparent copper has demand soared. Its production of semis has risen at a far more moderate pace. All supplies of the primary product – cathode – should sooner or later – more sooner rather than later – result in the output of semis. There is only a difference when there is a large unreported build up of hidden copper stocks.

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Hedge Funds Buy and Hide Metal, Which Inflates Apparent Demand China: Apparent Copper Demand

To the above I should add that two official Chinese bodies – NDRC and Minmetals – have estimates of real (as opposed to apparent) demand for copper. In recent years their estimates of growth in Chinese demand corresponds to the above data on semi production.
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Data such as the above indicates two things: someone may be squeezing and cornering by creating artificial shortages. That is, someone may be manipulating. But it also tells us that the demand growth reported by the statisticians over the last several years has been inflated by some kind of build of hidden stocks. In effect, the two and a half percent demand growth recorded for the last two years for global copper consumption is probably too high. The copper price has risen more in this cycle then it has ever risen, both in absolute terms and relative to copper’s substitutes. There has probably already been considerable price rationing of demand. Demand growth has probably been almost non-existent. Such price rationing has probably taken demand growth down a few percent from its usual historical trajectory during business cycle expansions. How severe can such price rationing of demand be? Today’s ubiquitous base metals bulls tell us that there will be no significant demand rationing. In fact, they are almost all predicting that, at today’s stratospheric prices, the growth rate of demand will exceed that of global GDP and will exceed that of all periods in the past. But microeconomic theory and history tell us that when commodity prices rise by a great deal, price rationing of demand becomes great – so great we say there has been a “destruction” of demand. This takes time because substitution and economization involve new processes and new capital equipment which takes time to decide on, adopt, and implement. But when severe price rationing eventually comes demand is destroyed. To illustrate this look at what happened to base metal demand growth in the 1970s after the lesser but still large real price increase in metals from the late 1960s to the early 1970’s. What High Metal Prices Can Do To Demand Metals Demand Destruction – 1973 Forward ! The figures are as follows for metal consumption: ! Copper: Western World only just under 7M tonnes in 1973, back to >7Mt in 1978 ! Lead: Western World 4.1Mt in 1973, 4.12Mt in 1977 ! Lead: World 5.2Mt in 1973 5.4Mt in 1977 ! Aluminum: Western World only 13.9Mt in 1974, 13.97Mt in 1976 ! Zinc: Western World 4.8Mt in 1973, 4.9Mt in 1986(!) ! Zinc: World 6.2Mt in 1973, 6.4Mt in 1979 In sum it took on average half a decade of global economic growth for demand to simply recover to the peak prior to “demand destruction”. If one looks to other commodities with comparable price increases in that time period, one finds the same: demand destruction in oil in the early 1980s caused such a decline in demand that it took over a decade of global economic growth coupled with an oil price collapse to simply bring global demand back to the level that prevailed in 1981.

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Let us go on to the supply side. I said earlier that the supply of oil was truly constrained. Despite a seven or eight fold increase from its downside price spike low in 1998 the world is unable to grow crude oil capacity by more than a few percent a year. But this is not the case with base metals which are as scarce as dirt. To be sure, after the very low base metals prices in the late 1990s there was under investment in exploration and production. Mines were closed. When the global boom took off in 2003 supply lagged. But we have now had high prices for years. This price signal has led to restarts of shut in capacity, expansions of existing mines, and the construction of new mines and smelters. Not surprisingly supply in almost all base metals has soared. I provide detail on this surge in base metals capacity and production in my April Washington speech for those who want details. Suffice it to say here that, in all of the base metals, on average aggregate supply is now running at a 10% rate, give or take a bit. This is unprecedented: never have all the base metals experienced supply increases that are two to four times the past historical trend rate of growth of global supply and demand. If one plays with the numbers – and, in particular, if one assumes some price rationing of demand relative to the historical trend – these supply increases are now generating surpluses, and sometimes very large surpluses, in all of the base metals. One of the great ironies in all of this is that China, cited as the demand engine behind this cycle’s metal bull market, has actually become an engine of supply. China is growing its supply of alumina at a 50% plus rate now. This is taking the global alumina production growth up to a 15% rate. China is increasing its production of aluminum by well over 30% and has now become an exporter. China accounts for almost a third of global production of lead and zinc and the Chinese statistics tell us that their primary lead and zinc production are growing at 15% to 20%, providing a five percentage point increment from this one country alone to global demand growth. Something even more dramatic is occurring with Chinese production of nickel from abundant imported low-grade laterite ores, and we all know that China has become the world’s powerhouse steel manufacturer for domestic use as well as export. This dramatic contribution by China to the burgeoning supply side of the metals equation can be seen in the following chart of gross Chinese exports of refined zinc.

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China: As Much a Producer As a Consumer

If there is no super cycle in metals demand and, worse yet, if there is demand rationing relative to the underlying trend, and if in addition there is burgeoning supply equal to two or three or four times the underlying trend, the base metals markets should all be moving into surpluses. In fact, given the lags in these microeconomic processes, there should soon emerge vast surpluses. That should lead to the mean reversion in metals prices that Jeremy Grantham says always follows the two standard deviation bubble move. So far that has not happened. I will get around to that in a moment. But let us stick to the fundamentals and ask, where will these microeconomic forces take base metals prices? Below I present the copper cost curve.

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Where Is Reversion to Mean? Way, Way Below Prevailing Prices

We all know that the price of a commodity eventually settles at marginal cost which is the intersection of the demand curve and the supply curve. The supply curve is a curve that reflects cash operating and not total costs. The cash operating costs of today’s least efficient mines are a fraction of prevailing prices. That is our first clue as to how far prices will fall. And I should add, when the mining boom subsides the costs of mining, which have escalated considerably, will subside. I know you don’t believe me, but it always happens in every down cycle. See my April Washington paper for details. The 2006 (and even higher 2007) cost curves will fall back toward the 2004 level, and with that, so will marginal cost. But the situation is worse yet. Today’s high prices encourage exploration, development, and the construction of new mines. These often have high capital costs but low cash operating costs. As they come on stream they push the supply curve outward, and faster than the demand schedule shifts outward due to global income growth. The low inframarginal costs of some of today’s mines become the marginal costs of tomorrow’s market. Today’s highest costs mines are then discarded to the dustbin, has always happened in mining history since the days of the Roman Empire. Marginal cost falls and so will in time the future price of metals. It will be worse yet when the full impact of demand destruction is felt. Some demand destruction is reversible, but not all. Permanent demand destruction impedes the outward shift of the demand curve. When this happens the point of intersection of the demand and the supply curve falls. And with it, eventually the metals prices will fall further.

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You will then ask, if the fundamentals are so bearish, why are the base metals prices still in the stratosphere. The answer is speculation possibly to the point of manipulation. It is widely reported that some hedge funds own physical metals. As investors they should hold forwards rather than physical in the less than full contango markets that have prevailed in these recent years. If they hold physical metals, it is possible they have joined in with the perennial squeezing and maybe more that has always plagued these markets. It is no longer a secret that today’s metals markets may be rife with manipulation. There is talk about it everywhere. Just look at the updated appendix to my April Washington speech. There we have compiled some, but not all, of the endless public commentary about possible manipulation in the metals markets. A month and a half ago nickel, up ten times in this cycle, was the most obvious manipulation candidate. Finally the LME was forced to act against the shenanigans. It changed the rules that apply to the “dominant longs” in the nickel market and in a way that implied possible collusion and manipulation. Since the peak of early June the spot price of nickel has fallen by 40%. Perhaps this action by the regulators was meant to curb rampant speculation, possibly to the point of manipulation in other metals markets. Apparently, it has not.

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Despite LME Action Against the Nickel Manipulation By Hedge Funds – LME LEAD

Let us consider the lead market. The price of lead has literally gone vertical in the last two months. Is this the result of supply/demand? Not according to most market commentators. It is simply the “big boys” “cracking the whip” in a very thin market. A Day In the Life of LME Lead ! Metal Bulletin has an article titled "Lead Prices Race Higher as Funds Crack Whip". In another piece today, Stephen Briggs of Socgen is quoted as saying: ! "Lead is the new nickel and they are not going to let it go. The fundamentals are not what people are claiming, but lead is going up, it will continue to go up and then it will crash." ! "The only question is when this will happen" Another Day In the Life LME Lead • ““Lead is hitting a new high everyday now. It is just trending up and up and people are nervous about going short. The market is getting thinner and thinner”, said a category II trader. “

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•

“We continue to see speculative buying and short covering with lead and we are hearing that it is because the big boys want it higher. It is easy to bully lead up as it is a thin market and if this is the case then it will turn when the big boys decide they’ve had enough,” he said.”

Let us go on to another little market – the tin market. Suddenly last week lagging tin broke out to a major new high. Is it a shortage of supply or booming demand? Not according to the market commentary which tells us that “cunning” speculators are now pushing tin though there is more physical tin around than you can shake a stick at. A Day in the Life of LME Tin The same players that have pushed lead to record highs over $3,400 per tonne this week could now have a hold on tin, traders told MB. • “All this is totally speculative – there were 640 lots traded on Select (on Wednesday) morning, these guys are cunning. They know that if they get through certain price levels then more people will come in and they want to get all the mugs in”, said a second trader. “There’s more tin around than you can throw a stick at, it’s the same as with lead – the nearby fundamentals are fine”, said the first trader.”

•

After years of complaints the LME has made a move against possible manipulation in their nickel market. But is it appropriate to let such games go on in all their other metals markets? Not according to the U.S. authorities, as exemplified by the CFTC’s Acting Chairman. He tells us that his market surveillance staff polices markets where the dominant long or longs become so dominant as to be able to squeeze or corner the shorts. CFTC Chairman Lukken to Congress • "The market surveillance staff focuses, for example, on looking for large positions, especially in comparison to potential deliverable supply of the commodity. Such a dominant position might provide a trader an opportunity to cause a price manipulation, such as in a “squeeze,” in which, for example, a single trader might hold a large long(buy-side) position and demand delivery of more of a commodity than is available for delivery. In such a situation, traders holding short (sell-side) positions may have no alternative but to buy back their positions at artificially high prices dictated by the dominant long trader. -Walter Lukken, July 12, 2007 But if we look at the positions of the dominant longs in the LME metals we see that in all of them they are so dominant as to bring down upon them the market surveillance staff if they were on this side of the Atlantic.

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Holding of LME Warrants as of Friday, 20, July 2007 Aluminum: No dominant long. Copper: 1 party owns 80-90% Nickel: 1 at 40-50% Zinc: 1 at 30-40% and 2 at 50-80%. Lead: 1 at 30-40% Tin: 2 at 30-40% ! In the recent nickel ruling, two holding 25% warranted concern. ! According to CFTC’s Lukken, surveillance should be acting in all the LME metals except aluminum. I should add, if you read my April Washington document, you will see that repeatedly dominant longs have surfaced in LME aluminum, holding almost all of the LME warrants. So blatant are these “operations” that the leading LME broker in base metals made the following statement to all its clients in an email just three days ago. Copper: The Squeeze Is On "The squeeze remains firmly in place on the London market: a dominant position holder has 50-80% of the stock, cash+tom+warrants equivalent to roughly the same amount, and metal is being steadily delivered out from LME registered warehouses to end-users, switching it for metal from producers put into private storage." "The market is primed for a sharp rally towards the target area of $9-10,000 per tonne. But LME prices are held back by the persistent weakness on the SHFE, contango trading there, and overhang of local stock. It needs SHFE prices to begin rallying to light the touch-paper." Where Are the London Regulators?! The dominant long is super dominant by Acting Chairman Lukken’s standards. He reportedly is switching metal out of the exchange into “private” storage and he is targeting much higher prices. And the only thing that is holding him back is a super weak condition of Chinese demand – of all things. So what do I conclude? If the New Financial Architecture hedge funds may do all they can to generate short term fees, even if their exit strategy over the long term is doubtful. They may do it with the aid of investment bankers and their instruments which provide leverage and derivatives. And the laissez-faire regulatory regime allow such practices – practices that were once allowed in the old wild west days of Fisk and Gould and Daniel Drew but that might not have been tolerated in earlier decades since the New Deal.. In the case of metals markets, which are small markets, funds and merchants have found that they can do such things with ease. They can overwhelm small markets with their large financial resources. In doing so they may be able to post prices for mark to market purposes and reap huge fees.

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What happens in the longer run? Maybe there is an exit, maybe not. In any case, with a 2% plus 20% compensation arrangement, when the “piper must be paid” the manager may have already been paid and the investor may have to suffer the outcome.

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Description: The Perils of the New Financial Architecture (NFA)