Strap in boys, this is gonna get bumpy...

Let me tell you something about my dear friend Titus. Intelligent goes without saying. And in this forum he is typically quite analytical, and deliberate in his research. Which is what makes this so ... well, you'll get the picture.

It just didn't make sense to me. I once read, under the heading "Don't Make Excuses, Make Good" that your gut is His conduit, you need only listen. And my gut was telling me that this didn't add up. Let me explain ...

I once listened to Chris Matthews, back when his show still had a scintilla of relevance, describe exactly how many "private" meetings that Dick Cheney had as VP with oil and energy companies. He even went so far as to describe his theory on how the hunting trip went in which Cheney emerged as CEO of Haliburton. This was the level (and still is in some circles) of obsession with connecting "evil big oil" with the GOP in general, and G.W. Bush in particular. So the idea that this lot would simply roll over or ignore the fact that Bush deregulated the crude oil futures market simply didn't add up to me. Not MSNBC, not the DNC, not even Obama - who's apt to blame his runny morning eggs on Bush - didn't hammer this one home. And forget hammer, they haven't even mentioned it. I mean think about it, the chance to blame high gas prices on Bush because he deregulated the playing field for his "buddies", they passed on THAT story line? Really?

So I did a little digging. First on these Reagan era regulations. Stay with me here, this is the most comprehensive research on this matter I've done and it gets a little technical, so I'll attempt to be as succinct as possible.

In 1936 the the congress passed, and FDR signed into law the Commodity Exchange Act (which replaced the 1922 Grain Futures Act). The 1936 Act, the "CEA", provides federal regulation of all commodities and futures trading activities and required all futures and commodity options to be traded on organized exchanges. Remember that term - "organized exchanges."

Within the 1936 CEA was a provision providing for the Commodity Exchange Authority which was the body that directly oversaw the futures market monitoring, enforcing, etc. In 1974 congress amended the CEA (under Ford), creating a more comprehensive regulatory framework operating in tandem (in reality taking on many of its overburdened duties) with the CEA. That body was called the Commodity Futures Trading Commission, an entity technically independent of the government, which directly enforces the prohibition of fraudulent conduct in the trading of futures. In 1982, under Reagan, this CFTC begot the National Futures Association. This is also an independent, self regulating organization meant to serve as a watchdog over the commodities and futures industry.

Now let me pause for a moment - you may be asking yourself why between 1936 and 1982 did the congress keep creating new agencies to do the same job? I asked myself that. What we must understand is this is the reality of a government so bloated as ours. If agency A seems to not be functioning to keep up with the demands of its task, then our congress(s) don't repeal A and create a bigger, better A. They simply pass agency B in addition to A, in order to take on the overflow, or the more specialized aspects of the field the agency is monitoring, who's original authors never anticipated (say, online trading for example).

Ok, back to the story. Under Reagan futures markets reached the zenith of their regulation. For the new (new as in 1982) National Futures Association (headquartered in Chicago), not only enforced anti-fraud laws, but provided mediation and arbitration for consumer complaints.

So, gas prices remain steady and smooth due to all this oversight until Bush and his cronies come in and shoot the place up, right?

Wrong.

The fundamental "deregulation" of the crude futures market, which Titus rails against (even suggesting crucifixion for its' author) didn't technically roll back any of these agencies, their budgets, or their authority. It did an end around.

Meet the Commodity Futures Modernization Act of 2000.

You may of, Titus, heard (read) my and Jambo's railing against something called an "Over The Counter" (OTC) derivative. We posted a great many rants and opinions on this financial instrument as a result of a Frontline special which cenetered on the September 2008 housing crash. By and large we were right about what they did - act as a virus throughout every major shareholder of mortgages in the land (including AIG, Leihman Brothers, get the picture of this line up?). But even that special didn't go into detail about how virulent these things are. They aren't limited to the housing market either, via this act. I'll explain ...

I told you to remember the term "organized exchanges." The primary organized exchange for stocks is of course the New York Stock Exchange. Similarly the primary organized exchange for commodities is the NYMEX, or the New York Mercantile Exchange. In fact, it's the largest physical commodities futures exchange in the world. An OTC operates outside of an organized exchange such as this. Be they stocks, mortgages guarantees, or futures, an OTC is a contract of sale between two private parties. Think gun show loop hole - to by a gun at a gun show from an authorized dealer participating in that show the consumer is subject to the applicable federal laws (i.e. instant background checks) in addition to the laws of the state they're physically in. But private citizens walk around these shows with rifles slung over their backs and a price fixed atop, like a small flag. The two private citizens can then conduct a sale completely outside of any government oversight, which is exactly what an OTC is. That OTC can take any form, under any financial market, with almost zero oversight, as long as the two participants are members of the "exempt" group.

Within the link above you'll find that those exempt groups include -

(a) regulated financial institutions;
(b) regulated insurance companies;
(c) regulated investment companies;
(d) regulated commodity pools with total assets in excess of $5 million;
(e) a corporation, partnership, trust or other business entity that either (A)
has total assets in excess of $10 million, (B) enters into transactions
that are guaranteed by certain other Eligible Contract Participants, or
(C) in the case of a transaction that relates to the conduct of the entity's
business, has a net worth in excess of $1 million;
(f) employee beneŽt plans that have total assets in excess of $5 million
and have their investment decisions made by certain independent
advisers;
(g) governmental entities that either (A) transact with certain other Eligible
Contract Participants, (B) own and invest on a discretionary basis morethan $25 million of assets, or (C) regularly enter into transactions with
respect to the underlying commodity;
(h) regulated broker–dealers (except that individuals or proprietorships
that are broker–dealers must meet certain minimum net worth or other
conditions);
(i) regulated futures commission merchants (except that individuals or
proprietorships that are futures commission merchants must meet
certain minimum net worth or other conditions);
(j) CEA–regulated floor brokers or traders in connection with transactions
that take place on or through CEA–regulated or CEA–exempt boards
of trade;
(k) individuals with total assets in excess of $10 million (or $5 million in
the case where the transaction relates to the risk management of an asset
or liability of the individual); and
(l) any other person the CFTC determines to be eligible in light of the
financial or other qualifications of the person.

I'm not a stock broker, nor a day trader, nor an economist. But I am a thinker (as I hope this post is proving), and I can't see where there is any major (or medium even) player that is not exempt. Do you?

Now let me back up just a second, This doesn't mean there is zero regulation. It means that OTC's were deregulated to the point of being regulated only under "general safety and soundness" standards. Which meant unless there was a beef in which at least one of the parties complained, there wasn't much monitoring, let alone an investigation.

These OTC's, these contracts between private parties, took various forms, the financial market is full of creative minds. In the housing market (by the way, "debt" is not allowed as an OTC), they sold OTC's in the form of guarantees on martgages. Bank A makes a loan, sells it to bank B. Bank B sells it to C. Bank C sells it to Fannie or Freddie. Now, the guarantee, the "insurance policy" if you will that it would be good, sold as an OTC, is sold to each party along the way. That sale goes straight to the sellers bottom line for the cost of the paper it was printed on (and ok, the ink). So what happened when that homeowner defaulted? Fannie goes to bank C, to collect on the insurance policy, the OTC contract. Bank C goes to bank B. After all they have an OTC insurance policy that the loan would be good too. Bank B goes to bank A. But bank A isn't there anymore. Or they don't have the money to cover the bad loan. Either way, they can't make good on the OTC. Because the economy is going South and there is a cascade of bad loans. Now the collapse doesn't just effect the guy at the end, holding the toxic debt. That toxic debt is spread amongst every seller of the mrtgage via the OTC, the insurance policy that the mortgage would be good. Guess who owed millions to Leinmahn Brothers in the form of these mortgage OTC's? AIG. And on and on, everyone who ever touched that bad loan, who sold an OTC guarantee along with it, to pad the bottom line, is infected. And why did the loans go bad? Freddie and Fannie, directed by congress, stepped in and demanded that more loans be made to "less than qualified", that is to say unqualified under normal circumstances, applicants. Minorities, the poor, they all have a "right" to a house. No down payments, proof of income (or citizenship for that matter), etc, etc. So when bank A made that loan, accompanied by the OTC guarantee, up the food chain infecting the entire hard drive the virus went.

Back to futures. How is this new class of exempt trading, OTC's, been put to use in the crude oil market?

Well, this deregulation law (the CFM Act of 2000) was passed against the explicit recommendations of a multi-agency review of derivatives markets. The November 1999 release of a report by the President’s Working Group on Financial Markets—a multi-agency policy group with permanent standing composed at the time of Lawrence Summers, Secretary of the Treasury; Alan Greenspan, Chairman of the Federal Reserve; Arthur Levitt, Chairman of the Securities and Exchange Commission; and William Rainer, Chairman of the CFTC—concluded that energy trading must not be deregulated. The Group reasoned that “due to the characteristics of markets for nonfinancial commodities with finite supplies … the Working Group is unanimously recommending that the [regulatory] exclusion (OTC's) not be extended to agreements involving such commodities.”

All the adults on the hill saw this coming. If you create an energy "sub market" in which all the heavy (and as I said, medium and small - who's not on that exemption list?) hitters are allowed to trade directly with each other, virtually out of sight (or oversight as the case is here), then that market will catch fire. And I mean "fire" in a good way if you're in on the speculating, because the activity will drive up the value of the commodity. The ease of trades between private entities creates a demand for that product. And the price of the commodity, based on the demand to get in on an unregulated market for a product we all must have, responds to that increased demand, it goes up. Trading in regulated exchanges like NYMEX is declining as more capital flees to the nearly unregulated OTC markets, such as those run by the Intercontinental Exchange (ICE). Trading on the ICE has skyrocketed, with the 93 million contracts traded in 2006 representing a 120% increase from 2005, and the 12.6 million contracts traded in January 2007 is a 166% increase from a year earlier. And its only boomed from there.

Now this is not to say, as some have alleged, that anything nefarious is occurring. Unregulated (or virtually unregulated) shouldn't be confused with "illegal." These trades are all perfectly legitimate. It's just that more firms, people and funds are likely to purchase futures contracts on oil since the 2000 Act because the purchase of that contract can occur outside the purview of real oversight, or interference. In other words, people jumped in on this because that 2000 law made it easy to. Made it attractive. So now when Libya gets bombed, and it affects the price of oil, that effect isn't a ripple, its a tidal wave, because millions and millions of more people are in that market, and are all responding to those events.

Now the president takes the alternate tact. Just last week, undoubtedly feeling the political pinch high gas prices are causing, announced that he has directed the DoJ to investigate potential fraud and manipulation in the commodities and futures market. This is predictable, and will do nothing. He's attempting to score "I'm on your side points", I think we can all see that. But what I don't get is why not use this as yet one more opportunity to nail "Bush era policy"? Why not clamor to repeal the Commodities Future Modernization Act. Why not nail Phil Gramm, a leading Texan Republican with ties to big oil (buzz words, hello?)? After all, he pushed this act in congress, sheparded it through. And he's a Bush family friend. It's the Democrat's (especially those of "The Order of Fundamental Change" variety) wet dream. It's got it all baby - oil, Republicans, deregulation, obscene profits! It's just missing one thing ... George W. Bush. I guess now would be a good time to lay out the opening of the Act's overview (which is also within the link above) ...

"The Commodity Futures Modernization Act of 2000 (the ‘‘Act’’), approved by Congress on December 15, 2000 and signed into law by President Clinton on December 21, 2000, contains provisions affecting the regulatory and supervisory roles of the Commodity Futures Trading Commission (‘‘CFTC’’) and the Securities and Exchange Commission (the ‘‘SEC’’). Two of these changes are of particular importance to the derivatives and commodities markets. First, the Act clarifes that certain over–the–counter (‘‘OTC’’) derivatives transactions are outside of the jurisdiction of the CFTC. Second, under certain conditions, the Act allows trading of futures contracts based on single stocks and narrowly–based stock indices, with oversight being shared by the CFTC and the SEC."

This is me clearing my throat at the thought of "crucifying" Bush. And believe me, I'm no "Dubya" apologist, he's ticked me off 6 ways from Sunday in various respects. But if we're going to point blame for skyrocketing crude prices, lets just make sure we suit up the right guy for the cat of 9 tails, shall we?

I should add here that just 2 weeks ago, a week before Obama's announcement that he is directing the DoJ to set up a task force (yes, please give me another task force... I'm begging you, do the task force thing - sigh), Goldman Sachs released a note to clients that put an actual dollar amount on the impact speculators were having on the price of crude. They named that premium, when oil was at $113.46, at $27 per barrel. That translates into roughly 70 cents per gallon of gas (the current national average being $3.86). I don't know about you, but oil at $86.13 per barrel, and gas at at $3.16, does sound better, but not much better. Not much at all in fact. My point? I think you were much closer to solving the problem in your gold standard post.

And as that task force enjoys coffee and donoughts on our dime, I think we might as well strap in and expect $3 0r $4 a gallon gas to be the new norm.

How was that for a lame poster? :-)