Who Guards Whom at the Commodity Exchange? (Fortune Classics, 1980)

May 8, 2011: 8:54 AM ET

Editor's Note: Every Sunday, Fortune publishes a favorite story from our archive. Editor-at-Large Shawn Tully introduces this story from the  July 28, 1980 issue of Fortune:

This isn't the first time silver prices have boomed. The precious metal more than tripled in the late 1970s, and the biggest investors, and believers were the Hunt brothers of Texas. Oilmen Bunker and Herbert Hunt, convinced that inflation would keep raging and paper money would drastically shrink in value, watched their huge holdings rise to an estimated $13 billion as prices more than tripled to $50 in 1979.

But silver then cratered as people unloaded their cupboards and brought their tea sets and bracelets to Holiday Inns to sell for cash. So in the summer of 1980, veteran writer Roy Rowan and I went to Dallas and spent a weekend with the Hunts, listening to their account of the wild ride in silver in what Rowan described as a "moveable journalistic feast." It's instructive to recall the Hunt's crucial error: When sliver prices dropped in to the high $30s, they bought billions more, thinking that the selloff presented a matchless opportunity. But the free fall continued, as prices fell 80%, and remained at a fraction of their late-1970s for decades. Now, we'll see if those who buy on the recent dip are sages heralding a new era, or the Hunts of 2011. --Shawn Tully

By Roy Rowan, with reporting by Shawn Tully

FORTUNE -- Something about the Hunt brothers just doesn't inspire public sympathy. After taking a financial drubbing in their recent struggle to hang on to $4 billion worth of silver, both Nelson Bunker and brother William Herbert cried foul before congressional committees. They charged the New York Commodity Exchange's Board of Governors with "manipulative actions" that had crippled them. Stoically, both Congress and public managed to suppress any tiny quiver of compassion.

The Hunts' accusations were nevertheless quite pertinent and accurate. The chummy board members of the Comex -- as the New York exchange is called -- make up a club that had a powerful, personal, and collective interest in sending the price of silver into a tumble. They are still trying hard to mask their role as double agents-as governors and traders; rulers and ruled-in the seething Comex arena. All through silver's upward flight, they had stubbornly clung to their own short positions, binding them to being sellers at fixed future prices; and the carrying charges had come close to ruining them. But they found their remedy-by putting on their governors' robes in the exchange boardroom, switching regulations on their own trading, and neatly turning a misbegotten gamble into an assured success.

The performance of these acrobatics is no new stunt, of course. In the treacherous world of commodity trading, the alarm has long and often been sounded: "The foxes are guarding the chicken coop." To this, the typical retort is echoed anew by the 36-year-old Comex president, Lee Berendt: "Nonsense. The Hunts have been participating in this marketplace a long time. They know we are self-regulated and the rules can change."

Technically, according to lawyer Berendt, the rules weren't tampered with: "We merely executed our authority within parameters that we always had a right to do."

In the Hunts' ordeal, these conveniently elastic parameters were stretched by a Comex emergency edict decreeing that silver futures (contracts to receive or deliver at a specified date and price) could be traded only for the purpose of liquidating speculative positions. There was one cunning exception: the short sellers, a key power faction on the exchange, could sell for purposes of effecting delivery, thus reducing their own bullion inventories—and risk. In other words, as of last January 21, the Hunts and their Saudi partners-and all the smaller fry caught by this sudden rule change-could unload as many silver contracts as they wanted to on the New York Commodity Exchange, but they couldn't buy into any new positions. A market thus comprising only sellers' obviously could only collapse. It did on March 27, in the crash soon christened Silver Thursday.

A strut in the pit

The plunge did not follow, of course, entirely and exclusively from a single rule change. In commodities, even more than in stocks, the hypnotic skill of the seller, as well as the greed or ignorance of the buyer, can cause its own grief. Dexterity—or duplicity—can reign here.

A clear case in point arises with the controversy surrounding ContiCommodity Services Inc. and more particularly the activities of Norton Waltuch, its flamboyant vice president in New York. If it hadn't been for a quick $80-million capital infusion from its parent company, Continental Grain Co., Conti would have gone bankrupt by Silver Thursday. Yet Waltuch himself emerged from the crash with a personal profit believed to be more than $10 million. Two weeks ago, Waltuch was summoned before Senator Donald Stewart's agriculture subcommittee, which is investigating the commodity futures market (see the box on page 42). Conti's lawyers originally sought to prevent Waltuch's appearance, hazily claiming "it wouldn't be appropriate."

Norton Waltuch

During the big run-up in silver, Waltuch had traded mainly for Arab clients. The biggest, Naji Nahas, at one time owed Conti $51 million. According to Waltuch's office colleagues, it was his ceremonial custom, late in trading sessions, to don his yellow Conti jacket and strut confidently into the Comex silver pit, where his mere presence would buoy the market. "The major silver long is in the ring," an audio hot line would report to all Conti offices around the world. "Someday they'll make a movie about this," Waltuch announced to his coterie in the pit one day as silver continued to soar. Short of making a film, he proceeded to make a fortune, bailing out in time-not at the top, perhaps, but still a big winner. He didn't share his belated queasiness about silver with his customers. In the blunt judgment of one of his associates: "Norton betrayed us."

There have been complicated repercussions. A Chicago commodities lawyer retained by Nahas, Philip Bloom; does not expect to sue Waltuch, but he does contemplate suing Comex. He claims that late last year a series of purportedly confidential meetings with Comex induced his client to roll forward his silver contracts, instead of taking delivery. As Nahas cooperated, he relieved the squeeze on the traders to come up with, the scarce silver bullion. According to Bloom, however, word of his client's intentions leaked onto the trading floor, making the cost of rolling forward prohibitive. Bloom further assails Comex for issuing its "liquidation trading only" edict, on the ground that a true emergency did not exist. "The only emergency," he says, "was the financial crisis incurred by the shorts."

To buttress his charges, Bloom has demanded the minutes of the Comex board meetings held on January 7, 8, and 21. He particularly wants to determine if the members who were short disqualified themselves from the voting, as Chairman Ralph Peters did at the Chicago Board of Trade (CBOT). So far Comex has refused to release the minutes. "The information is confidential," Comex President Lee Berendt has told Bloom. Meanwhile, a number of other suits threaten-quite possibly including one, of course, by the Hunts.

A magic floor for prices

Just as collusion in the marketplace helped bring silver down, it may also have taken some connivance to keep the metal's price from falling through the floor. When silver hit bottom ($10.80 per ounce) on March 27, it seemed bound to go lower under heavy selling pressure here and abroad. Bache Halsey Stuart Shields, which held about 25 million ounces of the Hunts' silver as collateral, was an active seller. There also were signs that Merrill Lynch, quietly holding 20 million ounces of silver and $40 million in Treasury bills as collateral for the Hunts, would be a seller. "Yet almost magically," claims a government official who does not wish to be identified, "the price rose."

In this connection, Dr. Henry Jarecki, chairman of the Comex margin committee, made an interesting revelation to the Senate Committee on Banking, Housing, and Urban Affairs, chaired by Senator William Proxmire. In yet another of those Janus-like roles, Jarecki is also chairman of Mocatta Metals Corp., as well as a veteran of many silver deals with the Hunts. Jarecki told the Senators that bullion dealers and investment bankers were prepared "to prevent silver prices from falling to harmfully low levels." He and a number of bankers had organized a syndicate to purchase "the entire overhang of silver" if a massive selling wave hit. Despite rampant rumors to the contrary, Jarecki still claims that normal market forces, rather than any collective action, kept prices from collapsing.

A former Yale Medical School professor, Jarecki has a computer-quick mind appreciated even by critics. Within Comex, however, he has become highly controversial, accused of playing a decisive role in imposing the "liquidation trading only" rule that undid the Hunts. Along the way, Mocatta Metals -- whose corporate slogan is "Adhere and Prosper" -- had a banner first quarter in 1980 and ranks as the second-largest privately owned company in the U.S. (behind Cargill Inc., the wholesale grain company).

Right after silver hit bottom, Green's Commodity Market Comments, a leading newsletter for precious-metals experts, found this particular history spiced with irony. Green's recalled that it was the Hunts who had bailed Mocatta out of a desperate predicament-only last October. At that time, Mocatta, which is capitalized at $40 million, owed $400 million to the banks financing its short position on Comex. Instead of going deeper into debt by borrowing more margin money as the price of silver continued to rise, Mocatta decided to reduce its short position by what is known as an E.F.P. (Exchange for Physicals-i.e., silver). Magnanimously, the Hunt brothers accepted silver coins -"junk silver," in trade jargon. Jauntily, Jarecki shrugs off this incident. "The Hunts are not noted for their impecunious-silver-dealer bailouts," he says.

Spreads, straddles, and contangos

As this suggests, the whole U.S. commodity market has for years operated about as cavalierly as the stock market before Black Thursday back in 1929. Curbs on excessive speculation, compliance with trading regulations, even surveillance for malfeasance-all have been left pretty much to Comex, the Chicago Board of Trade, and other exchanges.

94 silver bars cleaned by an employee of the Archeological Museum in Herne, Germany, 25 February 2010. Silver prices are on the highest point since 1980.

The case for self-regulation has always turned on the argument that the commodity pit -- with its complicated squeezes (commodity shortages), straddles (simultaneous buying and selling of futures contracts for different delivery months), spreads (differences between futures prices), and contangos (premiums for futures over spot prices) -- was far too exotic and complex to be presided over by outside referees. Neither disinterested businessmen nor government bureaucrats could master its subtleties or gyrations. The safety of the system supposedly lay in the mix of the directors, variously representing traders, dealers, brokers, and the public at large.

When a futures market starts running too hot, as with silver about a year ago, the individual exchange can take a series of actions to slow it down. Margin requirements can be increased, position limits on the number of contracts allowed can be set, unethical members can be banned from buying or selling. If things really spin out of control, the market can be closed.

In the silver boom-and-plunge, Comex took a number of these steps -- but slowly. It raised margins from $2,000 to $60,000, and it sharply reduced position limits before the "liquidation only" rule was imposed. From Washington, the Commodity Futures Trading Commission started legal action to ban from trading 45 Arabs and Europeans who had funneled their silver accounts through the Banque Populaire Suisse and failed to make necessary financial disclosures.

The deterrent to applying any brakes more promptly, of course, is that they tend to reduce trading volume, and consequently the earnings of the members who run the exchange. For this reason, the Chicago Board of Trade-which does a much smaller metals volume and had a lot less to lose-responded much more swiftly than Comex to the silver crisis.

Lee Berendt, 36, has served as Comex president for the past ten years. A former haberdasher and a law-school graduate, he staunchly champions his exchange's right to self-regulation. He claims the action taken to force silver speculators to liquidate their positions was designed simply to restore sanity to the trading, not to serve the interests of Comex board members. "I'd still like to know what the Hunts' motive was," he says. "I know what ours was--to regulate a market."

A monumental market

These days, the lusty frontier spirit that ordinarily pervades the commodity pits is heightened' by inflation, with all its pressures for fast profits. The gambling fever is further stimulated because some of the exchanges dealing in precious metals now also deal in financial instruments. Any market where a $2,000 down payment will buy you a futures contract on a $l-million Treasury bill promises the customer action that can match any packed casino for electrifying excitement.

No wonder, then, that investors less sophisticated and less well-heeled than the Hunts are enticed into the game, sometimes to suffer staggering losses. Last year the trading volume in T-bill futures soared to $2 trillion, a monumental market to be trusted largely to its own supervision.

A semblance of federal regulation began five years ago with the creation of the Commodity Futures Trading Commission, intended as an SEC for commodities. The present chairman of CFTC is the aggressive, 32-year-old James Stone. He has been gingerly groping toward controls that won't smother the freedom generally believed necessary to keep a futures market humming.

Until the scary silver drama, the government seemed almost oblivious to the abuses in the commodities chicken coop. Belatedly, the CFTC is trying to track down the foxes. At the same time, the Treasury Department, Securities and Exchange Commission, Federal Reserve Board, and no less than four congressional committees are suddenly flapping protective wings over the industry.

The Indy 500 of markets

On the same May 29 when Herbert and Bunker Hunt were sighing before the House agriculture subcommittee on conservation and credit, Senator Proxmire's Committee on Banking was hearing testimony from Fed Chairman Paul Volcker and Treasury Deputy Secretary Robert Carswell on how the "speculative frenzy in futures" brought the country perilously close to financial chaos. "The futures markets," warned Chairman Proxmire, "have become the Indianapolis 500 for individuals hoping to strike it rich in the highrisk, highly leveraged, and fast-moving marketplace." At times, he added, alluding to the absence of government controls, "the futures market more closely resembled a demolition derby." Proxmire had already introduced a bill empowering the Fed to regulate gold and silver margins, just as it already sets securities margins to curb undue stock speculation.

The Proxmire bill is anathema to the futures industry, which assumes that government control would surely bring higher margins. As a result, the three biggest precious-metals markets-Comex, the Chicago Board of Trade, and the Chicago Mercantile Exchange-have joined to hire the high-powered Washington lobbyists Charls E. Walker Associates to fight this bill and another introduced after Silver Thursday.

The facts unearthed by the Proxmire inquiry, however, already confirm how hungrily Comex members had feasted off the Hunts. Confidential data furnished by the CFTC-which Proxmire promptly made public-reveal that while the price of silver was climbing precipitously last winter, nine dealers and traders represented on the 23-man Comex board held net short positions totaling some 75 million ounces. Reasonably enough, the Senator detects "an appearance of very substantial self-interest by the very people who were making the decisions as to margins and position limits."

In a bizarre twist to this story, though, Proxmire notes that "when the last chapter is written, the Hunts may still come out on top," even though the Comex governors have locked in their own enormous profits. As the Senator's staff director points out, the estimated $1.7 billion dropped by the Hunts traveled a circuitous route. It went from the banks to the Hunts to the shorts, who then deposited their gains in the banks-which turned around and loaned $1.1 billion back to the Hunts so they wouldn't have to dump their remaining 93 million ounces of silver onto the depressed market. So if silver rises again, the Hunts may yet emerge the big winners.

Despite all the misgivings of Proxmire and countless other skeptics, a number of commodity experts claim that the futures market has performed precisely as it should. When prices soared, the world grew a new crop of silver-from candlesticks to coins that were melted down to "triple-nine bars," as the 99.9% pure bullion is called. Supply and not skullduggery, according to these experts, finally broke the market fever. But their claim fails to explain why the price kept right on rising while the silver refineries were going full blast.

Advice to Henry

One of the most articulate defenders of the present market system is lawyer Thomas Russo, a partner at Cadwalader Wickersham & Taft in New York City band a former director of the trading and markets division of the CFTC. "The self part of self-regulation means there are going to be conflicts," concedes Russo. "But serving yourself may make the market grow, and that's not such a bad thing." In any case, Russo claims, the members of the board of one or two exchanges can't affect prices. "Price isn't a function of rules and regulations, but of supply and demand."

Henry Jarecki, 47, chairman of Mocatta Metals Corp., also sits on the Comex board and is chairman of the margin committee. He denies that this creates any conflict of interest.

It is noteworthy that Russo is Henry Jarecki's lawyer, and counseled the Mocatta chairman on the conflict-of-interest problem posed by his position on the Comex board. "My advice to Henry," states Russo, "was simply to use good business judgment. He had disclosed his position regarding the Hunts. If Henry had not voiced his opinions, he would not have fulfilled his legal obligations as a member of the Comex board."

In his extensive writings on commodities, Russo has been an outspoken critic of the government's avowed intent to raise margins. "That merely eliminates the small speculator and increases market volatility," he argues. Yet he concedes that the silver crisis is likely to produce certain useful reforms. Undue concentration of positions will probably be prohibited. The use of futures to obtain physical products may also be curbed, since it distorts the purpose of the market, which is to determine price and to provide the users and producers with a way of protecting themselves against price fluctuations. Another change that Russo sees coming is an "aggregation rule" against speculators operating in concert. He stresses that these rule changes should apply to all futures whether wheat, T-bills, or silver: "A future is a future is a future."

Still more reform is likely to come out of the skull sessions in Chairman Stone's aerie at the CFTC. The brash young former insurance commissioner of Massachusetts has committed himself to fighting for more restrictive margins. "The exchanges cannot be expected to set them high enough," he says. He also advocates position limits. "Changing the position limits," he concedes, "caused the silver bubble to burst. That's one of the few things on which the Hunts and  I agree." For all this, Stone nonetheless recognizes the danger of undue regulation that would drive speculators to flee to foreign markets, far from the nuisance of being monitored.

Unfortunately, Stone and his commissioners have little notion of how to root out the conflicts of interest plaguing the exchanges. Just as unfortunately, the conflicts of personality within the commission itself may have to be resolved before it can make rational rules for others. On Silver Thursday, the commission displayed unusual unity and decided to do nothing at all. For the day, this turned out to be no disaster. In the long run, however, a crucial question has to be answered: must not the exchanges be required to have enough independent, outside directors to stand up to insiders who have a vested interest in the basic rules governing the whole conduct of business?

What really alarms Stone are the vast new concentrations of wealth in the world. "The Hunts should not have been able to take a vast supply of a vital commodity off the market," he says. "Once they did, the market couldn't operate as it should have. But what we have seen with the Hunts is nothing compared to what would happen if some cash-rich foreign government decided to play this game in our futures market."

In this, there may be a final flourish of irony. It is too early to know whether the Hunts will end as winners or losers. But the stress of their experiences may qualify them—altogether without their design—as key agents in reforming the markets they have loved to play.

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