Streetwise Professor

June 21, 2014

Channeling Tino de Angelis in Qingdao

Filed under: China,Commodities,Economics,Regulation — The Professor @ 3:22 pm

Back in the early-60s, a guy named Tino de Angelis*, owner of the Allied Crude Vegetable Oil Refining Corporation, carried out a huge scam based on commodity finance. He bought soybean oil, against with American Express issued warehouse receipts. De Angelis took the warehouse receipts to banks, who took them as collateral against loans issued to Allied. And not just banks. Companies like Bunge and Proctor and Gamble also lent against the warehouse receipts.

So far, this is routine: commodity traders and processors routinely use their inventories as collateral against loans they use to finance them. The scam came in the fact that Allied obtained loans on non-existent bean oil. De Angelis had a variety of schemes to fool Amex into believing he owned more bean oil than he really did. Some of the tanks at Allied’s facilities did have oil in them, and those would be shown to Amex inspectors. The inspectors would then be led through the firm’s labyrinthine facility, allegedly to another tank to inspect. Except they’d been led back to the tank they had already inspected, but the number on the tank had been changed. Another con was to fill the tanks with water, with some oil sitting on top of the water. Allied also linked the tanks with pipes, and would shuttle the oil between tanks to keep ahead of the inspectors.

Through these means, de Angelis amassed warehouse receipts for quantities of oil that exceeded the entire amount in the US, and borrowed about $200 million against the phantom inventories (well over $1 billion in current dollars). Eventually, inspectors figured out the scheme, and the fraud was uncovered. The revelation caused Amex’s stock price to plummet (Warren Buffet scooped up some and made good money off the deal). Moreover, soybean oil futures also crashed.

De Angelis went to jail. Went released, he tried to run a Ponzi scheme.

This all happened more than 50 years ago: the scam was revealed a few days before JFK was assassinated. But a replay appears to be occurring in China, in the port of Qingdao specifically (though there are concerns that other ports may have similar problems). One trading firm has found to have borrowed large sums collateralized by non-existent aluminum allegedly stored in the port.

This is a major concern because commodity-based lending is a big deal in China, and if the practice is indeed widespread it could result in large losses. Commodity-based lending has been used in carry trades involving using letters of credit to borrow dollars buy commodities (initially mainly copper, but now other metals, iron ore, and ag products) that are imported into China and put in warehouses. The warehouse receipts are then used to collateralize loans in China, the proceeds of which are invested in high yielding, speculative endeavors.

This entire structure was already very fragile (because carry trades are inherently fragile), but if it turns out that even of a modest proportion of the collateral doesn’t exist it could collapse altogether. This could impose substantial losses on many banks. CITIC and Standard Charter are facing losses on the loans to the Qingdao trader. If there are many others, many more banks (and perhaps some western trading firms) could be hit hard.

One note of caution: some (notably Zero Hedge) are saying that collateral has been “rehypothecated.” This is not correct. Rehypothecation involves the lender pledging the collateral received from the original buyer as collateral to a loan. This process may occur several times. This results in the issuance of gross debt that is a multiple of the value of the collateral (the multiple could be as large as the inverse of the “haircut” on the collateral). But the net debt is approximately equal to the value of the collateral, and fraudulent receipts are not created. These collateral chains are potentially fragile, but the fragility does not result from the creation of fraudulent receipts.

In contrast, as described, the Qingdao scheme is like de Angelis’s, in that receipts are issued on non-existent goods. In this scheme, fraudulent receipts are created, and the net debt exceeds the value of the actual collateral. Of course, if the fraudulent receipts are rehypothecated, things will get uglier still.

Dealing with this mess would be hard enough in a jurisdiction with a solid and transparent legal system, reliable judges, and the rule of law. One can just imagine how this will play out in China, which has none of the above.

Then there are potentially broader implications. The commodity loans are one part of China’s vast shadow banking system. Concerns about the fragility of this system abound. If (a) the commodity loan problems are more pervasive, and (b) these problems are symptomatic of shoddy and fraudulent practices in the shadow banking system more generally, there is an appreciable risk of a financial crisis in China.

* Interestingly, de Angelis made money primarily on government programs, namely the National School Lunch Act and Food for Peace.

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  1. there is an appreciable risk of a financial crisis in China.

    Well, if China is smart, and it is, it’ll render the various parties that make up the core of its banking system Too Big To Fail like the U.S. did several years ago and allow said banks to value their assets and liabilities according to which way the wind is blowing. The only impediment is China’s currency is not the world’s reserve currency — not yet at least, but give it time.

    The West and China have structurally been on the same path for a couple decades now — State Capitalism, which is a hybrid of Communism and its central planning and the Crony Capitalism of the Gilded Age. The result is graft on a level never witnessed heretofore writ large with State sanction, complicity and protection.

    Comment by Cold N. Holefield — June 22, 2014 @ 6:42 am

  2. Here’s an excellent exposé on the Salad Oil Scandal that was authored in proximity to the event.

    The Congressman and the Salad Oil Swindler

    The following is an ironic quote, considering. Where did all the money go? I think the answer’s obvious. The linked website gives it away.

    The swarm of creditors are putting most of their hopes for recovery on American Express, waiting patiently for an offer to settle the $100 million in claims against its warehousing subsidiary. But no one is pressing, and things are proceeding with glacial deliberation. According to executives of export companies that passed the receipts along, the banks plan to let American Express off the hook by accepting compromise payments over a period of several years, and avoid a court contest that would further embarrass finahcils. “An investigation would only increase the scandal,” says the head of one export company. “What we need is a settlement so we can get back to business as usual.”
    The “business as usual” attitude explains the curious reluctance of any of the victims to explain how all this could have happened. Since the whole swindle depended on the tolerance of the victims, exploiting their desire for bigger commissions and more business on any terms, any probe that strikes too deep may upset things and even force some changes in procedure. Thus, the Chicago Board of Trade, which waited until midDecember before it bothered to suspend Tino as a “member in good standing,” appointed a committee of its own members to look into the fiasco. The New York Produce Exchange conducted a similar investigation. Spokesmen for both exchanges have found no need to make any significant change in the rules governing the market. They blame the whole mess on the Government’s failure to provide warning, but insist that there is no need for more government involvement in futures trading.

    They may get a chance to explain this logic before congressional committees later this year. The Agriculture Department intends to ask Congress for power to set high margins on commodity trading and injunction powers to stop anyone from dominating the market as Tino did.

    Comment by Cold N Holefield — June 22, 2014 @ 11:24 am

  3. Touché SWP !

    Hope you could write more about Commodities and Trading, less about Vladimir.

    Simon, reader

    Comment by Simon Jacques — June 28, 2014 @ 10:52 pm

  4. SWP:

    Yes, Street. Less about me, heh heh heh. And what I am doing.

    … and more about ANYthing.

    Vlad [soon to be Lizzy's running mate]

    Comment by Vlad — July 18, 2014 @ 10:56 pm

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