Banning Banks From Owning Commodities Won't Lower Prices

Includes: GS, JPM, MS
by: Hard Assets Investor

By Amine Bouchentouf

Government intervention has finally reached the commodities markets. Ever since the 2008 financial meltdown, governments around the world have embarked on a policy of reducing risk-taking activity by banks. The U.S. government has been leading the charge with both domestic and international banks that do business in America.

Specifically, Congress has enacted the Dodd-Frank legislation, which aims to limit the amount of risk on banks' balance sheets as well as the type of activity that banks can engage in. As a result, many banks have been forced to sell off their noncore traditional lending businesses, such as internal hedge fund and private equity units. Regulators have insisted bank-owned hedge funds have nothing to do with a banking institution's traditional banking activities, which is to manage customer deposits and oversee lending activity. This has led banks to sell or spin off their alternative investment units.

Banks and Commodities at Risk?

Last week marked the first time that the Fed, through congressional hearings and the Federal Reserve, have taken aim at banks' activities in the commodities space. Banks have been in the space since there were commodities to be traded. Specifically, banks are active in the industry through both the traditional banking model (lending to buyers and sellers of raw materials and acting as market makers), as well as through the alternative-asset model (by owning physical assets such as metals storage warehouses or electric transmission lines).

Now the government is telling the banks that it's OK to lend money to airlines that want to buy or trade jet fuel, or other companies that want to hedge their commodity exposure. However, it's drawing a line at activity that doesn't fall within this sphere.

Beginning in the late 1990s (after the repeal of the Glass-Steagall act), banks became very active in the commodities space, purchasing everything from lithium-storage facilities to oil tankers and electric transmission lines. While a large number of banks got into the physical side of the business, three banks stand out in this area: Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS) and JPMorgan (NYSE:JPM). In all, the three banks control physical commodity assets in excess of $20 billion.

Government Motives

It's important to realize that the latest government action doesn't come in a vacuum. The fact of the matter is that this all comes after one of the greatest potential financial meltdowns since the Great Depression and amid a growing conflict-of-interest scandal against Wall Street trading. Let's take the first motivation. The government has embarked on its stated mission of ending "too big to fail." This is the phenomenon where a bank becomes so ingrained and entwined in the economic fabric of the country that its failure threatens the economy as a whole and requires unprecedented government action. AIG comes to mind.

"Too big to fail" poses a systemic risk to the economy, and the government wants to remove that risk; at least that's the publicly stated objective. Removing banks from a vital industry such as commodities will help reduce the risk. Think about it: If a bank controls the transmission lines in the state of California, it will be much more difficult to let it fail than if it didn't. The second motivation has to do with issues of conflict of interest and insider trading. The government has taken unprecedented actions against potential insider trading and misconduct by Wall Street.

Let's just take the recent prosecution of SAC Capital, one of the nation’s pre-eminent hedge funds, which is facing insider trading charges. And let's not forget that JPMorgan just this week settled a case with the government that accused it of manipulating California's energy markets. JPMorgan paid a $400 million fine to settle the charges.

What's Next?

In a pre-emptive move, JPMorgan also announced last week that it will get out of the physical commodity business. This just happened to coincide with the record fine it paid to settle energy market manipulation charges. Next in line are Goldman and Morgan Stanley. Goldman and Morgan have spent billions of dollars in acquiring commodities assets, and it won't be straightforward to divest them. However, my expectation is that all banks will be forced to divest their physical commodities businesses.

The most likely outcome is twofold: First, businesses within the commodities unit will become independently managed, and, second, external players will gobble up the rest. Already, we're seeing companies such as Glencore Xstrata Plc (OTCPK:GLCNF) knocking on doors to see which assets it can get from the banks.

As far as customers are concerned, the new owners will have the same motivation as the banks, which is to increase margins and remain profitable. So it's unlikely that the end user is going to see lower prices as a result of this change. The most visible change is that ownership risk will be spread out among different players that don't include banking institutions. Regarding traders and investors, this latest action means that we should all be mindful of governmental regulation and ways in which it can impact our industry. My expectation is that there will be more regulation coming from Washington, and it's important to understand the ramifications it will have on commodities.

Disclosure: The author holds no positions in the stocks mentioned.