Streetwise Professor

February 18, 2012

Saint? Warren Ain’t

Filed under: Commodities,Derivatives,Economics — The Professor @ 8:24 am

I have long been nauseated by the hagiography surrounding Warren Buffett.  The veneration of St. Warren has reached a peak of late, as he is Obama’s go to guru, providing protection against accusations that the president is anti-business, and giving cover to Obama’s plans to jack up taxes on the wealthy.  After all, if a man richer than God is on your side, how can you possibly be a class warrior?

My cynicism about the saintly Buffett dates from almost exactly 14 years ago. There is substantial evidence that in February, 1998, Buffett cornered the silver market.

I repeat: there is substantial evidence that Warren Buffett cornered the silver market.  Cornered, as in manipulated.

Yes, Saint Warren was almost certainly a manipulator.

The story in a broad outline. Beginning on 25 July, 1997, Buffett began to accumulate large quantities of silver via Phibro, a subsidiary of Salomon Brothers, an investment bank in which Buffett had a big stake, and which he had saved from extinction when Salomon traders cornered the Two Year Treasury note market in 1991.  He eventually acquired nearly 130 million ounces of silver.

He stood for big deliveries in February, 1998.  The market went nuts.  All of the inidicia of a corner were present.  Nearby prices skyrocketed relative to prices for delivery in the spring.  The following chart depicts the spread between the March, 1998 COMEX silver price, and the prices for May and July. 

Note that the spread blows out when Buffett stood for delivery, during the first week of February, with the March-July spread going from -.2 cents/oz on 1/29/98 to 20 cents/oz on 2/5/98.  The March 98 price went up a dizzying $1.25/oz (about 20 percent) during that week.

The loco London lease market for silver also showed acute signs of a squeeze.  (The lease rate is the cost of borrowing metal.  If you need silver in a hurry to make delivery, you are willing to pay a big premium for nearby delivery, that is, you are willing to pay a lot to borrow/lease silver.  Formally, the forward price of silver is the spot price times one plus the interest rate minus the lease rate.  If the lease rate is very high, the forward price will be below the spot price: that is, the market is in backwardation.)

This depicts the one month lease rate for silver.  Note it skyrocketing right around the time of the deliveries.  In early February, the lease rate was quoted as much as 75 percent annualized (some press reports say 80 percent).

There were physical distortions characteristic of a squeeze.  People around the world scrambled to get silver and transport it to London–often by plane.  The silver market in India, a major consumer, almost shut down:

But in the past two months, work at the refinery has slowed–because of one man half a world away. Until a few days ago, most Indians had never heard of Warren Buffett. They even say his name wrong, confusing it with buffet. No matter. Since last October, when Buffett began buying silver, imports into India have nearly stalled as Indians decided that the metal costs too much. Today, more and more Indians are selling their dishes and jewelry made of silver, which now fetches $7.25 an ounce, 20% above the normal $6. That makes for an interesting match-up: 960 million Indian sellers vs. one billionaire buyer from Omaha. “Tell [Buffett] he can’t last,” thunders dealer and refiner Mukul Sonawala. “Indians say the price is too high. They’re saying: `Mr. Buffett, have your buffet, we’ll wait till the price drops. Good-bye.”‘

There were backlogs processing the silver flooding into London: the official weighers couldn’t keep up.  The London Bullion Market Association responded to the bottleneck by extending the normal 5 day delivery period to 15 days.

There was plenty of silver in New York, but Buffett didn’t buy it there, even though it was cheaper there (more on this below).  Instead, silver was shipped from NY to London, by airfreight(!) mainly, where it had to be re-assayed because the assay marks were from a firm no longer in existence.  This created yet another bottleneck.

As soon as the deliveries were completed, prices, spreads and lease rates collapsed: by 27 February, the London price had fallen 22.5 percent off its peak, and lease rates were down to where they’d been before the frenzy began in the immediate aftermath of a Buffett press release (see below).  These price and price relation changes are also symptomatic of a corner.  They are the manifestations of what is often referred to as “burying the corpse”–a phrase I’ve been accused of coining.*

What did Buffett have to say?  This (on February 3, 1998):

During 1998, Berkshire has accepted delivery of 87,510,000 ounces in accordance with the terms of the purchase contracts and the remaining contracts for 42,200,000 ounces call for delivery at varied dates until March 6, 1998. To date, all deliveries have been made on schedule. If any seller should have trouble making timely delivery, Berkshire is willing to defer delivery for a reasonable period upon payment of a modest fee.

Over 30 years ago, Warren Buffett, CEO of Berkshire Hathaway, made his first purchase of silver in anticipation of the metal’s demonetization by the U.S. Government. Since that time he has followed silver’s fundamentals but no entity he manages has owned it. In recent years, widely-published reports have shown that bullion inventories have fallen very materially, because of an excess of user-demand over mine production and reclamation. Therefore, last summer Mr. Buffett and Mr. Munger, Vice Chairman of Berkshire, concluded that equilibrium between supply and demand was only likely to be established by a somewhat higher price.

On which I call Bull!

If it was a long term investment, why did Buffett take delivery at a huge premium over deferred prices? If he was betting on the long term fundamentals, why not sell nearby silver at its huge premium, and buy silver at a much lower price for delivery in July, say?  If he was right about the fundamentals, the July price would rise as the “equilibrium [was] established.”

Taking delivery at a premium price was actually foolish, if long term investment was the actual goal.  Buffett paid a premium of about 45 cents/oz to get silver in early-February.  He was buying high and selling low. If he wasn’t manipulating, and his trading wasn’t causing the price distortions, he could have sold spot silver, bought silver for delivery in a month, and picked up 45 cents/oz by doing so (instead of standing for delivery).  Warren Buffett did not get that rich by being that stupid.  No, the evidence clearly shows he had another, very short-term objective in mind.

Put differently, if Buffett had been acting purely as a long term investor, why would he have needed people around the world–as far away as India–to scrape up all the silver they could find, put it on planes, fly it to London to get in the customs queue to be delivered in a five day window (later extended to 15 days)?  Why did Mr. Long Term need silver on those 5 (15) days? What was the big hurry, if he was taking the long view?

And why did he need it in London? This chart depicts the difference between the London silver fix and the COMEX March futures price.  Note the spike when Buffet was taking deliveries in early February.  At the margin, he paid a premium of 56 cents/oz–representing almost 8 percent of the NY price–to get silver in London in early February rather than getting it in NY.  Note too that the premium crashed after the bottleneck cleared.

The answer to these questions: demanding delivery in a short time window in a single location had nothing to do with a long term view on silver.  It was a corner, pure and simple, exploiting the frictions involved in bringing large quantities of silver to London on short notice. That made it very costly to deliver, allowing Buffett to loan out silver very profitably at the inflated lease rate.  He created an artificial shortage, and likely profited accordingly.  An investor acquiring silver based on a long-term view would attempt to minimize cost by purchasing in the cheapest locations and dates.  Buffett bought a lot of silver at the most expensive location and the most expensive date.

And note well the little insult that Buffett added to economic injury:

If any seller should have trouble making timely delivery, Berkshire is willing to defer delivery for a reasonable period upon payment of a modest fee.

A reasonable period.  A modest fee.  How saintly.  Note well again: the market rate for deferring delivery by as little a month was as high as 75 percent on an annualized basis.  In dollar terms, about 45 cents/oz (6 percent of the price) to defer delivery by one month.  Does that sound “modest” to you? Not to me.  Does it sound like the actions of a purely long term investor, who shouldn’t need to get the silver RIGHT NOW? Couldn’t a long term investor wait a month? Wouldn’t a long term investor want to buy at the cheapest location, not the most expensive?

The lease rate tells you exactly what that “modest fee” was.  Deferring delivery for one month cost 75 percent annualized–over 6 percent per month.  That’s not even that modest for loan sharks.

No, the market showed acute signs of shortage, and that shortage had one cause: Buffett standing for huge deliveries.

So keep this in mind when you hear Buffett praised to the heavens.  He is more than willing to play smash mouth to add to his fortune.  He is also very willing to lie about it, and to claim sanctimoniously that he is doing those he is smashing a favor.

That doesn’t sound too saintly to me.

* I wish.  Actually, the phrase originates with P. D. Armour, a famous Chicago grain and meat magnate in the 19th and early-20th centuries.  (You might have had Armour chili–same company.)  He was asked whether it was easy to corner the market.  He responded that it was like a murder: ” to commit murder is very simple, the trouble is to bury the corpse”, the corpse being the excessive quantities of the commodity delivered to the market, that the cornerer had to unload later at a loss.

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  1. If I understand this “strategy” correctly, Buffet bought silver at a hefty premium. But was able to exploit sky high lease rates. So what he gained from the leases more than compensated for the enormous losses he had to take after silver prices collapsed… that the case?

    Comment by Surya — February 18, 2012 @ 1:06 pm

  2. @Surya-market power manipulation involves a trade-off. The cornerer takes too many deliveries in order to drive up the cost that shorts incur to make additional deliveries; in essence, the cornerer forces the market up the supply curve, and the steeper the supply curve, the smaller the number of deliveries required to get a price pop of a given size. The remaining shorts (the ones who haven’t delivered) then liquidate the remainder of their positions at this inflated price. The long (the cornerer) makes money of the contracts liquidated at this high price (or, in the case of silver, lending silver–effectively extending delivery dates at usurious rates). He loses money on the deliveries that he overpays for. This is the cost of “burying the corpse” of the manipulation.

    A profit maximizing manipulator trades off these considerations. In a successful manipulation, the gains on the liquidations (leases) exceeds the losses on the deliveries taken.

    Sometimes manipulators mis-calculate, and demand too many deliveries, and end up with a corpse to bury that is far larger than they had counted on. My favorite story in this regard involves P.D. Armour. The son of Marshall Field’s partner Levi Leiter, Joseph Leiter, tried to corner the Chicago wheat market in 1898. He figured that only small deliveries were possible, since the available wheat was mainly in Duluth, and Lake Superior and Lake Michigan were frozen. He held out, refusing to liquidate, as the price skyrocketed, figuring that shorts would become even more desperate. But Armour borrowed wheat from Peavey Grain, and used every means available to bring it to Chicago. Here’s a description from William Ferris’s The Grain Traders:

    To bring wheat down from the Northwest, Armour chartered the biggest lake carriers and sent them to Duluth. He had his tugs plow through the harbor ice, keeping water open for the ships. He also chartered tugs to keep the Soo Canal open, and more tugs to cut the ice in Thunder Bay where he sent ships for wheat stored in Fort William, Ontario. He brought down hundreds of thousands of bushels by rail. At his massive elevators, freight trains were backed up for miles while steamships in the blocked river fought for space to unload.

    In the end Leiter lost $10 million, back when $10 mil was real money. Daddy Leiter had to bail out his playboy son.

    This episode was the the basis for Frank Norris’s somewhat famous naturalistic novel, The Pit.

    This is why cornering can be a dangerous game. Miscalculate on the costs that shorts incur to deliver, and you get buried along with the corpse.

    The ProfessorComment by The Professor — February 18, 2012 @ 1:33 pm

  3. One interesting issue is the inability of the insiders to force the manipulators into eating the corps: I am thinking of the actions taken in NY by the Merc(?) against the Hunt Brothers in 1979 1980 silver bubble. Not being an that knowledgeable in the non financial futures markets, I would love to hear your analysis of this, however brief.

    Bravo on taking down Buffett: he has pulled more stunts in the insurance business than you can imagine. For years he has refused to take permanent impairments against some of his investments, manipulated rules, enabled “earnings management” through reinsurance contracts, most notably for AIG, etc. Indeed regulators and the auditors have recently been enforcing rules against him – I often wondered whether his recent high profile in political circles – not his normal public stomping grounds – has been a result of regulatory problems.

    Comment by sotos — February 19, 2012 @ 7:50 pm

  4. Will Buffet pay when some catastrophic event happens to his re-insurance contracts? Even if he has the capacity to pay, I wonder if he has the dignity to pay his liabilities, or will run for cover under some legal or political scheme. Cornering a commodity market is above-aboard and scrupulous compared to the shenanigans in the re-insurance market. Sell piece of mind to corporations for 30 years, then decide not to pay.

    Comment by scott — February 19, 2012 @ 8:20 pm

  5. Scott–indeed ironic that Buffett is the world’s biggest buyer of tail risk. You are describing what would be the biggest airport trade ever.

    The ProfessorComment by The Professor — February 19, 2012 @ 8:51 pm

  6. Sotos–It was COMEX, which was bought by NYMEX in the late-90s or early-00s (can’t remember exactly). Exchanges are often political bodies, that respond to the pressures of interest groups among the membership. This means that outsiders are typically treated differently than insiders. The Hunts were definitely outsiders, and their actions were putting huge pressure on insiders, e.g., big, established metals firms like Mocatta. Industry pressure and government pressure (which itself was driven in part by industry pressure) eventually induced COMEX to take measures that eventually broke the Hunts.

    Another example of the inside-outside dichotomy was Ferruzzi in the soybean market in ’89.

    Exchanges don’t like to intervene. They truly do want to avoid appearing to favor one side of the market (long or short), but the pressure is tremendous, and if insiders are on the losing end, the exchange is likely to intervene. Insider vs. insider, much less likely that the exchange will intervene.

    The ProfessorComment by The Professor — February 19, 2012 @ 9:01 pm

  7. Sotos-NYMEX bought COMEX in ’94. One of the first major exchange mergers.

    The ProfessorComment by The Professor — February 19, 2012 @ 10:04 pm

  8. […] from competition, taking risks that they damn in public-perhaps thereby scaring off competition, cornering markets) to make it.  Just saying don’t fall for the folksy shtick, and think that Buffett is a […]

    Pingback by Streetwise Professor » A Better Brand of Billionaire? — September 13, 2012 @ 11:22 am

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