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.