Goldman Sachs aluminum scam?

Today's NY Times has an interesting article about an apparent scam that Goldman Sachs is pulling, we are told at consumers' expense, involving lots of aluminum that is moved desultorily around between lots of warehouses.  But the one thing the article doesn't do is explain how the scam actually works, as an economic matter.

Matt Yglesias asks exactly the same question I had:

"[The article] seems to allege that Goldman Sachs uses its control of aluminum warehouses to increase prices to end-users by billions of dollars.  And yet having read the piece twice, I don't understand how the scam works. The basic idea seems to be that by shuffling aluminum around rather than delivering it promptly, Goldman can charge more rent and boost its profits.

"But this (a) doesn't appear to have anything in particular to do with Goldman Sachs' well-known investment banking activities and (b) sounds like far too ridiculous a scam to actually work. It amounts to saying that Goldman's amazing business strategy is to deliberately provide terrible customer service (shipping delays) and high prices (charging extra rent to cover the delays). If it were that easy to make billions of dollars, we'd all be doing it. The story is entirely missing a clear explanation of why this doesn't just lead someone else to open aluminum warehouses and undercut them."

OK, let's go back to the beginning.  Apparently there's a regulation that limits the time you can spend just holding aluminum in a given warehouse.  Goldman dodges the regulation through economically pointless activity in the form of just shipping aluminum endlessly back and forth again in a circle.  I get how that dodges the regulation, but I don't understand the rationale for this regulation any more than the underlying profit scheme.  (Does the former combat the latter somehow?)

A hint somewhere else in the article appears to suggest that it all has something to do with Goldman's playing games with regulations that control aluminum spot prices.  Playing games with pricing regs, so that Goldman can reap large profits from pure arbitrage transactions, not only might be plausible economically if the right sorts of regulations exist, but is exactly the sort of thing one might imagine Goldman being good at.  But again, if that's the story, I'm hoping someone will come forward and explain it to all of us.

The article also suggests a connection between Goldman's profits and the idea that aluminum speculators enjoy getting to bet on price movements (and might pay Goldman for this privilege).  But you shouldn't need actual aluminum in warehouses to bet on aluminum price movements - why not just use derivative financial instruments, such as notional principal contract?

Anyway, there seems to be enough smoke here that I really do suspect there is a fire.  (Why would Goldman be moving aluminum back and forth otherwise?)   But we do need to learn more about it.

UPDATE: A reader suggests that the regulation against keeping aluminum in the warehouse aims to prevent speculators from artificially suppressing demand by taking it out of circulation and driving up the price.  A la, the Hunt brothers' play with silver a few decades back.  Surely that is indeed the reason for the regulation about keeping aluminum in the warehouse, and Goldman is clearly making a farce of the reg by shipping aluminum back and forth between warehouses.

But the mystery remains re. what they are actually doing.  Pulling a Hunt brothers-type squeeze is very risky because others have every reason to step in and satisfy the shortfall.  Indeed, the Hunt brothers lost more than a billion dollars trying to corner the silver market.  It also doesn't sound like the type of thing Goldman would want to pull, unless it was very pre-wired to work.  So while we have a plausible explanation for that regulation, and for how Goldman gets around it, we still need to explain how they are making money.  Something other than cornering the aluminum market has got to be playing a large role here (even if they might be trying a bit of that on the side), and my guess (from the Times article) is that it has something to do with spot prices, some bit of regulatory arcana that I don't know about, etcetera.

FURTHER UPDATE: Izabella Kaminska explains what has actually been going on.  A large part of the story is not entirely bad from an economic efficiency standpoint.  The 2008 meltdown created pricing anomalies that Goldman could make money from eliminating, both on its own behalf and to help customers who wanted to do it without overly encumbering their balance sheets.  (While going off-balance sheet is often a recipe for trouble, here things appear to have been reasonably secure given possession of the underlying aluminum.)

Kaminska's bottom line:

"The end result: the mass encumbrance of physical commodities for the purpose of collateralising implied future demand from retail and pension funds — which would otherwise take the shape of a much less tangible and uncollateralised futures investment.

"And there’s nothing wrong with that apart from the fact that:

"1.The process creates the means by which speculation does end up driving and influencing physical prices (rather than being priced off physical realities).  [NOTE: One could say the same thing about, say, rampant stock market day-trading 10 years ago.]

"2.There is a fiduciary issue because banks have an incentive to maintain the illusion of physical scarcity to mislead investors....  [Ah, the Goldman we know and love.]

"3.The dark inventory hoards can be used to the trading advantage of the banks."  Here the point is that Goldman can manipulate publicly known inventory size, and thus win short-term pricing bets the easy way, by driving price changes through its own out-of-view manipulations of the available information that the market has.

My own bottom line on this is that it does indeed significantly strengthen the case for reinstating the Fed's one-time ban on banks trading in physical commodity markets - although admittedly I am far outside my core expertise here.  More broadly, it offers one more anecdotal illustration of the extent to which profitable financial sector activity, while having elements of both societal wealth enhancement and mere rent extraction, is so heavily flavored by the latter that the net contribution to economic efficiency may be negative even before you start thinking about socially externalized default risk.