Lessons (not) learned: Staying the hell of out something you don’t know anything about

A pin lies in wait for every bubble and when the two eventually meet, a new wave of investors learns some very old lessons. - Warren Buffet

One would think the several economic bubbles (and their inevitable violent bursts) experienced by the world and U.S. economy would provide some caution for investors looking for the next “big thing”. Unfortunately, this does not always seem to be the case, and even at the beginning of this recession, some investors poured a great deal of money into agricultural real estate. Last year, when commodity prices soared, farmland was seen by many people (most completely outside of the agricultural industry) as a solid investment. Farmland was purchased by investors and rented to farmers to work the land (50% of U.S. farmland is rented in this way). One of the key components of figuring out the value of the rents is the price of the commodities the land will produce. Investors bought the land and charged rents for farmers based on 2008 commodity prices, not anticipating the global financial meltdown. Of course, due to the recession, commodities prices are down. This creates an obvious problem for a lot of farmers, especially small farms.

So far, the recession hasn’t forced land prices down too far, based on the recent data from the USDA. The stronger dollar and lack of demand abroad has pushed prices for U.S. exports down, and hence, overall farm revenue. In other words, the land values are out of sync with the value of what the land produces—an obvious problem, with a number of parallels (think tech stocks and price to earnings ratios circa 1998, average home prices versus average household incomes circa 2005, etc.)

Of course, this is a problem—this kind of outside influence on the price of land hurts small farmers, especially those transitioning to sustainable and/or organic practices. At the end of the day, this kind of speculation raises food prices for everyone to the benefit of a few investors, encourages non-sustainable, short-term farming, will eventually lead to a collapse that will affect small farms disproportionately, not to mention consumers. The impact of agriculture is enormous, and touches each of us—we must, as citizens, demand that our governments do a better job at ensuring our agricultural viability.

What do we do about this? The government could financially fertilize programs like the First Time Farm Purchase Loan program (funded by the 2008 Farm Bill with a paltry $350 million), and other kinds of direct loans to farmers to purchase land. There should also be increased power for the FDA, working with the SEC, to regulate purchases of land by entities that will not be working the land. This agricultural “middle man” (the investors) only serves to raise food prices for the rest of us—taxing the hell out of renting farm land to farmers might be a way to encourage non-involved investors to stay out of the farmland business. Protecting vital and special resources like agricultural land should be a no-brainer—we’ve seen the damage bubbles can do to other, less important sectors of the economy, and we can ill afford this to happen to our food supply.

Commodities Markets: Now with Artificial Filler!

I posted a while back on the recent rise in food prices. The trend continues, and today the Commodity Futures Trading Commission (the commodities version of the Securities and Exchange Commission) announced an investigation into the manipulation of commodities prices.
Recently, the CFTC has been expending most of its energy on oil futures, but this announcement heralds an expansion of focus into the rising cost of food, cotton, and other important commodities. Some minor reforms to the futures markets have been proposed, and the CFTC (under pressure from Congress, including several prominent Democratic leaders) seems poised to implement them. As much as I applaud the rethinking of certain rules and procedures, I don’t think these efforts will do much to stabilize the markets, nor do I have much confidence in the CFTC’s leadership (see below).

The biggest contributing factor to the price volatility is not fraud or manipulation—it is simple economics. As reported by the AP’s Rachel Beck, over the past five years, investment dollars have been heavily poured in to commodity index funds, rising from $13 billion per year to $260 billion per year. In that same time span, the price of basic commodities (25 of which comprise the index) has risen 183%. Oil has a lot to do with this, as many “capital I” investors (institutional investors that handle unfathomable amounts of money) are pouring money into oil (as well as food), betting on a continued rise in price.

Before a Senate hearing, George Soros suggested that this rise in investment in commodities “mostly on one side” (up!) has the effect of distorting “the otherwise prevailing balance between supply and demand”. The above mentioned AP article contains a very telling quote from the chief market strategist at LPL Financial:

“The rise in the price of oil has weakened the demand for the physical commodity, but it has boosted the demand for the financial commodity since more investors are chasing returns”.

Exactly. And since commodities indexes have fantastically outperformed stock-based indexes, it may be some time before a correction comes. Many investors are slogging money into commodities to offset stock losses and hedge inflation, but the very act of inflating commodities prices is driving inflation. With all of this information, much of it fueled by Michael Master’s excellent research and congressional testimony, you’d think the CFTC would listen.

But, no. The CFTC’s chief economist has stated in a rebuke to Masters that “fundamental economic forces and the laws of supply and demand” are solely to blame. Not that he isn’t somewhat correct—fundamental economic forces are the issue, but because they are affecting the laws of supply and demand.

It is my hope that in a new administration, with new presidential appointees to oversee the CFTC, that we take a long and hard look at the volatility of the commodities market. It is vastly and inherently different from the stock market. Changes in the former affect nearly everyone in the world (and most acutely the poor and working class). It needs to be regulated much tighter, and at this point, it just doesn’t look like it’s going to happen.

Bread & Houses

The price of one is up and the other is down. What do they have in common?

Much has been written about the housing market (with particular emphasis on my soon-to-be home base in California)—the subprime market, interest-only loans, predatory lending, zero down programs, etc. One of the factors that hasn’t taken its proper share of the blame is the practice of selling mortgages in large bundles on securities markets. In the past, a bank would offer mortgages (including subprime loans) according to procedures that would minimize the risk to their investments. Lenders then had a vested interest in making mostly good loans and fewer risky ones because they intended to hold the note for the life of the loan (the premise behind hometown banking, in the age before multinational banks). With the practice of selling off large lots of loans to hungry speculators, many lenders became less than diligent about making loans to qualified buyers (after all, what happens after the loans are sold doesn't affect the originator). When more money is available for riskier and riskier loan seekers, the prices in a market get inflated, as there is more money flooded into the system. When these mortgages go into default, the lenders that made the original loans aren’t left holding the bag, but people lose their homes and the market becomes glutted with foreclosures, driving down prices as quickly as they inflated.

But what does this have to do with the cost of bread? Wheat has suffered from a run up in price, as much as 45% year to date. The devastating Australian drought, most assuredly one of the many climate change-based challenges facing contemporary agriculture, has a lot to do with it, as does the increased interest in corn for ethanol production. These factors are important, and seem to get a good deal of press. However, the commodities markets and commodities speculators have a huge, if underreported, role in this as well-- just like in the real estate market. On the heels of the challenges faced by a dwindling wheat crop, commodities speculators have made a run on wheat, driving up the prices.

Washington Post writer Anthony Faiola has a very good article on rising food prices and their effects on the global community, in which he provides a min-history of the run on wheat in the commodities market (which has part of its impetus in the credit crisis):

Investors fleeing Wall Street's mortgage-related strife plowed hundreds of millions of dollars into grain futures, driving prices up even more. With fewer places to turn, and tempted by the weaker dollar, nations staged a run on the American wheat harvest.

Foreign buyers, who typically seek to purchase one or two months' supply of wheat at a time, suddenly began to stockpile. They put in orders on U.S. grain exchanges two to three times larger than normal as food riots began to erupt worldwide. This led major domestic U.S. mills to jump into the fray with their own massive orders, fearing that there would soon be no wheat left at any price.

It is time to take a long, hard, and heinously overdue look at how easy it is for a handful of wealthy and powerful investors to manipulate the prices of basic necessities—in these cases, food and housing. Needless to say, increased regulation would go a long way to insure sanity and long term stability in these essential markets (we are already seeing the worldwide chain-reaction of economic consequences from the credit/housing market bubble). As the clock winds down on the 2008 Farm Bill, I seriously doubt any kind of real reform will happen-- the message from the government on food prices has heretofore been something along the line of "let's wait and see what happens"-- waiting for a market correction that may or may not happen. What is certain, however, is that global agriculture is changing, and increased demand on farmland, population growth, and climate change are poised to fundamentally change how we get our food. Government has to be able to address these issues with some progressive forethought. Until that happens, we all are at the mercy of a powerful few-- and the hardest hit victims are those in developing countries. To quote Faiola quoting French Agriculture Minister Michel Barnier, “We must not leave the vital issue of feeding people to the mercy of market laws and international speculation.”

Well said, sir.

(Wheat is a truly beautiful plant)