The so-called "Too Big to Fail" (TBTF) Banks - Goldman Sachs (GS), Morgan Stanley (MS) and JPMorgan Chase (JPM) generated an estimated $4 billion in commodity revenues last year and now face growing pressure from a number of investigations into their operations, and as the Federal Reserve yesterday reviewed Wall Street's right to operate in the Commodity markets.
Escalating threat to Wall Street's physical Commodity Trading divisions:
Several experts told a Senate subcommittee Tuesday that allowing financial holding companies to have increasing control over physical commodities such as aluminum and oil could give them too much power over producers and manufacturers. Lawmakers took the opportunity to criticize the Federal Reserve for allowing banks to expand their commodity trading activities, and once again questioned the wisdom of scrapping the Glass-Steagall law that separated corporate and investment banking, a decision that helped open the door to commodity dealing. The Financial Institutions and Consumer Protections subcommittee hearing addressed a recent investigation by The New York Times regarding ownership of aluminum warehouses by Goldman Sachs. Goldman says it is not deliberately creating aluminum shortages and that all accusations about it are nothing but sheer rampant confusion. The banks are using various strategies in order to convince the Federal Reserve that they should be allowed to retain the metal warehouses, pipelines and oil tankers that they have purchased over the past seven years. Big aluminum buyers represented by MillerCoors, the second largest brewer in the U.S., told the packed hearing that the banks' control of metal warehouses that are part of the London Metal Exchange network drove up their costs by as much as $3 billion last year by distorting supplies. JPMorgan and Goldman Sachs, which bought LME warehouses in 2010, "have created a bottleneck which limits the supply of aluminum," Tim Weiner, global risk manager for the brewer, the combined U.S. operations of Molson Coors and SABMiller, told the U.S. Senate banking committee. The banks were not present at the hearing, but as it got underway Goldman Sachs issued its first public rebuttal of mounting criticism of its metals warehousing unit, denying that Metro International Trade Services has deliberately caused aluminum shortages and inflated prices.
Here is what Goldman had to say:
As part of our activities as a market maker, or intermediary between buyers or sellers, in commodities and commodity futures and derivatives, Goldman Sachs, like a number of other financial institutions, holds physical commodities in inventory.
We hold an inventory position in a particular physical commodity for the purposes of meeting the needs of our clients or as a hedge for positions in commodity futures or derivatives we assume as a market maker.
And, to fulfill this market making role, we sometimes take delivery of physical commodities just as we do government bonds and stocks in financial markets.
We also hold other physical commodity operations as investments. This includes Metro International Trade Services, a metal warehousing company we bought in 2010, and which operates under the regulations of the London Metals Exchange (LME).
During the financial crisis, warehouse companies played the important role of allowing metal producers, who are often unable to adjust immediately to changes in demand, to store excess metal in the face of weak consumer demand. In fact, LME aluminum inventories more than tripled from 1.2 million tonnes pre-crisis to more than 4.5 million tonnes by the middle of 2009. As a result, large amounts of metal accumulated at some locations.
Recent news reports have inaccurately accused Metro of deliberately creating aluminum shortages and incorrectly asserted that Metro moves aluminum from one warehouse to another in order to earn more rent fees.
In fact, it is the owners of the metal who direct warehouse operators to dispose of stored metal or transport metal from LME-approved warehouses to warehouses outside the LME system to meet their own needs or objectives.
Some additional key facts about global aluminum markets and the LME system:
Aluminum stored in Metro warehouses amounts to approximately 1.5 million tonnes, compared with global aluminum production in 2012 of about 48 million tonnes.
Approximately 95 percent of the aluminum that is used in manufacturing is sourced from producers and dealers outside of the LME warehouse system.
The LME warehouse companies do not own the metal in their facilities. They merely store it on behalf of the ultimate owners.
In fact, LME warehouses are strictly prohibited from trading all LME products. Trading affiliates of a warehouse operator do not have any information regarding warehouse operations as such trading is separated by LME-mandated information barriers, the integrity of which is verified through regular independent audits.
Delivered aluminum prices are nearly 40 percent lower than they were in 2006. The warehousing system is not driving up the price of aluminum.
Certain facilities owned by non-bank holding companies have queues, while certain facilities owned by bank holding companies do not have queues. The queues that exist in various warehouses are a function of market structure and LME rules.
At any time, a company can buy aluminum from a producer. In fact, in recent years there has been more production than consumption. The more immediate sourcing of aluminum from the LME system would be a last resort for a corporate end user given that it always takes a certain amount of time to get inventory out of a warehouse.
Goldman Sachs, Morgan Stanley and JPMorgan Chase are using several legal means to maintain their multibillion-dollar commodity franchises, including a longstanding rule allowing banks to invest in commercial enterprises and an exemption they carved out of legislation 15 years ago. The 1996 change meant "Congress finally tore down the wall. Over the next six years, the rules became looser and looser. The so-called holding companies' control is raising prices for producers such as MillerCoors (TAP), Coca-Cola (KO) and car manufacturers. These bank holding companies are slowing the load-out of physical aluminum from [warehouses] to ensure that they receive increased rent for an extended period of time. But as per latest market reports, these financial companies are not just controlling aluminum warehouses. Copper, oil, energy, solar power and energy warehouses are also largely controlled by these big banks. While a 1956 law constrained banks to "banking activities" and restrained banks from owning physical commodities, a 1999 law allowed banks to extend their reach into loosely defined "financial activities."
Commodity Trading Woes:
JPMorgan is reportedly close to a more than $400 million settlement with the Federal Energy Regulatory Commission (FERC), as the bank tries to put to rest allegations that its traders manipulated power markets in the Midwest and California. JPMorgan's alleged activity in those markets was linked to its control over real power plants and energy supplies, a fact likely to sharpen questions over the rules for ownership. The hearing was the first to address the oversight of banks in physical commodity markets since a Reuters report last year revealed that Goldman and Morgan Stanley were still awaiting a Fed decision on whether they can still own physical assets after becoming bank holding companies in 2008. Commercial banks are prohibited from owning trading assets, but the two former investment banks argued that their commodity activities are permitted under a "grandfathering" clause in a 1997 law that effectively scrapped much of the Glass-Steagall act separating the commercial and investment banks.
Goldman Sachs and Morgan Stanley converted to Bank Holding Company status in 2008 and gained access to the Fed's discount lending window, which also gave the freedom and flexibility as unregulated investment banks that included largely unfettered commodity trading activities. The 1999 Gramm-Leach-Bliley act modified key parts of the BHC Act, effectively ending the separation of commercial and investment banking. Within that amendment was a clause that said any bank converting to holding company status "may continue to engage in, or directly or indirectly own or control shares of a company engaged in, activities related to the trading, sale, or investment in commodities and underlying physical properties that were not permissible for bank holding companies to conduct in the United States as of September 30, 1997." In other words, if you traded and invested in commodities before 1997, you should still be allowed to do so if the bank was engaged in "any of such activities" before then and so long as it does not exceed 5 per cent of the bank's total assets. The question the Fed has grappled with is: If a company traded one type of a commodity before 1997, say gasoline, should it be allowed to trade ethanol, for example, or own a crude oil pipeline?
Separately, JPMorgan - which as a commercial bank has never been allowed to own assets - is believed to have reconfigured its Henry Bath metal warehousing business in order seek qualification as a "merchant banking" investment with the Fed. When Royal Bank of Scotland (RBS) purchased Sempra Commodities in 2008 - including its Henry Bath warehouse operation, the Fed ordered it to sell the warehousing unit within two years, which RBS ultimately sold Henry Bath and most of the Sempra business to JPMorgan for $1.7 billion - a deal that closed in July 2010. JPMorgan changed the composition of the Henry Bath board last year in an effort to gain approval from the Fed to retain the business as a merchant banking operation, sources have said. It is unclear whether that effort was successful. More recently it has floated a possible sale of Henry Bath.
The Gramm-Leach-Bliley (GLB) act that swept aside Glass-Steagell rules also gave financial holding companies far more leeway to invest in non-financial corporate enterprises - so long as those investments meet certain criteria to qualify for "merchant banking" status, an issue that is key for JPMorgan and possibly Goldman Sachs. After 1999, major U.S. commercial banks were quick to register under the new heading of "Financial Holding Companies", allowing them to compete with then-investment banks like Goldman and Morgan to make direct investments into the commercial world.
The issue of whether banks are allowed to trade in physical commodity markets - taking title to a cargo of crude oil or a container of coffee beans - is separate from the question of whether they should be able to own infrastructure or assets. As of last Friday, the question of commodity trading is also in doubt as the Fed announced a "review" of a key 2003 ruling. Historically investment banks had no material restrictions on what they could trade. While Fed-regulated commercial banks have long been allowed to trade commodity derivatives, it wasn't until a 2003 Fed order that they were allowed to participate more deeply in the physical marketplace.
Commodity Trading and Warehousing Permissions:
The Federal Reserve, in 2005, allowed JPMorgan Chase to purchase physical commodities business, relaxing the limitations of "financial activity. When Citigroup (C) bought Travelers Group in 1998, it sought the Fed's permission to trade in oil markets in order to retain a small but lucrative Westport, Connecticut-based trading firm called Phibro, a vaunted commodity merchant with a century-old history and a focus on trading physical crude oil benchmarks worldwide. Citi argued that it was inhibited from trading effectively in derivative markets because counterparties knew that they would not be able to take physical delivery. The Fed agreed with Citi, saying that trading in real commodities would allow the banks to "transact more efficiently with customers". It said the trading must be "complimentary" to their main activities, contribute to the public good and should not pose a "substantial risk" to the bank. It said banks must take precautions by frequently inspecting stockpiles, place age limits on the tankers they use and carry substantial pollution insurance, among other things. Importantly it also added the stipulation that the banks could only trade in commodities for which there was an equivalent commodity derivative contract already regulated by the Commodity Futures Trading Commission (CFTC). That decision, which came at the start of a decade-long boom in commodity trading, opened the door to a dozen more applications from global giants like Deutsche Bank (DB) and domestic players like Wells Fargo. With many of the permits, the Fed gave greater and greater leeway in what and how they could trade. After converting to holding companies, Goldman Sachs and Morgan Stanley faced greater limitations in which commodities they could trade. Goldman has approached the Fed several times over the past year to seek permission to trade in iron ore, but has been rebuffed since no such U.S. futures contract exists.
Commodity assets and activities "raises potentially serious public policy concerns," Saule Omarova, (associate professor of law at University of North Carolina Chapel Hill) said, advocating for greater disclosure from banks. "This has been going on a long time that banks have engaged in various levels of physical commodity dealing," said Pennsylvania Republican Sen. Pat Toomey, adding that the profitability of commodity handling "might actually diminish risks rather than enhance risks." While senators acknowledge that bank ownership of commodities might have some positive effects on consumer prices, they questioned how Congress and the Fed should balance regulations on large banks moving forward. "These institutions are so complex, dense and opaque that they are impossible to fully understand -the six largest US. bank holding companies have 14,420 subsidiaries, only 19 of which are traditional banks," Ohio Democratic Sen. Sherrod Brown, chairman of the subcommittee. said. "We've have created a tangle and it takes time to undo that," said Senator Elizabeth Warren of Massachusetts, a Democrat. She said her recently introduced "21st century Glass Steagall" bill would help to "disentangle what has become a mess that is both hard to regulate and is creating additional risk." Sherrod Brown said. "After the hearing, the Senate Banking Committee will ask the banks and the Fed to give testimony at another hearing in September."