When the Federal Reserve gave JPMorgan (JPM) Chase & Co. approval in 2005 for hands-on involvement in commodity markets, it prohibited the bank from expanding into the storage business because of the risk.
Five years later, JPMorgan bought one of the world's biggest metal warehouse companies.
While the Fed has never explained why it let that happen, the central bank announced July 19 that it's reviewing a 2003 precedent that let deposit-taking banks trade physical commodities. Reversing that policy would mark the Fed's biggest ejection of banks from a market since Congress lifted the Depression-era law against them running securities firms in 1999.
"The Federal Reserve regularly monitors the commodity activities of supervised firms and is reviewing the 2003 determination that certain commodity activities are complementary to financial activities and thus permissible for bank holding companies," said Barbara Hagenbaugh, a Fed spokeswoman. She declined to elaborate.
That reconsideration comes as a Senate subcommittee prepares for a July 23 hearing to explore whether financial firms such as Goldman Sachs Group Inc. and Morgan Stanley (MS) should continue to be allowed to store metal, operate mines and ship oil. At a time when JPMorgan faces a potential fine for alleged manipulation of U.S. energy prices, the panel will discuss possible conflicts of interest in the business model, said its chairman, U.S. Senator Sherrod Brown, an Ohio Democrat.
Potential Manipulation
"When Wall Street banks control the supply of both commodities and financial products, there's a potential for anti-competitive behavior and manipulation," Brown said in an e-mailed statement. Goldman Sachs, Morgan Stanley and JPMorgan are the biggest Wall Street players in physical commodities.
The 10 largest banks generated about $6 billion in revenue from commodities, including dealings in physical materials as well as related financial products, according to a Feb. 15 report from analytics company Coalition. Goldman Sachs ranked No. 1, followed by JPMorgan.
While banks generally don't specify their earnings from physical materials, Goldman Sachs wrote in a quarterly financial report that it held $7.7 billion of commodities at fair value as of March 31. Morgan Stanley had $6.7 billion.
On June 27, four Democratic members of Congress wrote a letter asking Fed Chairman Ben S. Bernanke, among other things, how Fed examiners would account for possible bank runs caused by a bank-owned tanker spilling oil, and how the Fed would resolve a systemically important financial institution's commodities activities if it were to collapse.
Hearing Critics
Given such attention, the Fed's re-examination of its policy shows the central bank isn't tone deaf to criticism, said Joshua Rosner, managing director at New York-based research firm Graham Fisher & Co. and a witness scheduled to testify at the hearing of a subcommittee of the Senate Banking, Housing and Urban Affairs Committee.
"Given the inconsistencies on its oversight on these issues, the Fed seems to be trying to cover its backside," Rosner said.
For more than 50 years, the Bank Holding Company Act prevented federally guaranteed banks, such as JPMorgan, from direct participation in commodity markets. The prohibition didn't pertain to Goldman Sachs and Morgan Stanley, which were investment banks, until they became bank holding companies in 2008. After that, the Fed gave both banks a five-year grace period, which expires in September, while regulators decided whether to curtail their activities related to metals, fuels and other goods.
'Virtually Impossible'
Now, "it is virtually impossible to glean even a broad overall picture of Goldman Sachs's, Morgan Stanley's, or JPMorgan's physical commodities and energy activities from their public filings with the Securities and Exchange Commission and federal bank regulators," Saule T. Omarova, a University of North Carolina-Chapel Hill law professor, wrote in a November 2012 academic paper, " Merchants of Wall Street: Banking, Commerce and Commodities."
The added complexity makes the financial system less stable and more difficult to supervise, she said in an interview.
"It stretches regulatory capacity beyond its limits," said Omarova, who is slated to be a witness at the Senate hearing. "No regulator in the financial world can realistically, effectively manage all the risks of an enterprise of financial activities, but also the marketing of gas, oil, electricity and metals. How can one banking regulator develop the expertise to know what's going on?"
Colombian Coal
Goldman Sachs owns coal mines in Colombia, a stake in the railroad that transports the coal to port, part of an oil field off the coast of Angola and one of the largest metals warehouse networks in the world, among other investments. Morgan Stanley's involvement includes Denver-based TransMontaigne Inc. (TLP), a petroleum and chemical transportation and storage company, and Heidmar Inc., based in Norwalk, Connecticut, which manages more than 100 oil tankers, according to its website.
Mark Lake, a spokesman for New York-based Morgan Stanley, referred to company regulatory filings that said the bank didn't expect to have to divest any of its activities after the grace period ends. He declined to elaborate or to comment on the Fed's announced rule review.
Brian Marchiony, a spokesman for JPMorgan, also declined to comment on the review, as did Michael DuVally, a Goldman Sachs spokesman.
Citigroup's Creation
To gain Fed approval, bank holding companies must show that their involvement in physical commodities would relate to a financial activity of the bank, according to the law.
Citigroup Inc. (C) 's creation through mergers required Congress in 1999 to repeal the Depression-era Glass-Steagall Act, which had forced deposit-taking companies backed by government insurance to be separate from investment banks.
In a landmark decision in 2003, the Fed allowed Citigroup to continue making transactions in physical commodities after finding them complementary to the firm's trading and investing in financial instruments. The New York-based bank otherwise would have been forced to divest its Phibro energy-trading unit. Citigroup agreed to sell Phibro to Occidental Petroleum Corp. in 2009.
JPMorgan, the biggest U.S. bank, inherited electricity sales arrangements in California and the Midwestern U.S. in 2008 when it bought failing investment bank Bear Stearns Cos. Its February 2010 purchase of RBS Sempra Commodities LLP's worldwide oil and metal investments and European power and gas assets was also a distressed transaction. The European Union ordered Royal Bank of Scotland Group Plc to sell its controlling stake in the firm after a taxpayer bailout.
New Competition
Part of that deal was Liverpool, England-based Henry Bath & Son Ltd., a founding member of the London Metal Exchange in 1877 and the operator of 76 exchange-licensed warehouses in eight countries, according to LME data.
In a November 2005 order allowing JPMorgan to expand into trading physical commodities, the Fed mentioned such possible adverse effects as "undue concentration of resources, decreased or unfair competition, conflicts of interests or unsound banking practices." All of them would probably be outweighed by the public benefit of introducing new competition to markets for physical commodities and commodity derivatives, according to the order. Derivatives are financial instruments used for speculation or to hedge risks and can derive their value from the prices of commodities.
No Storage
The 2005 order also directed JPMorgan to stay out of the business of extracting, storing or transporting commodities to minimize its exposure "to additional risks."
The 2003 ruling now being reconsidered by the Fed marked "a radical departure" from bank holding companies' past practices, said Karen Shaw Petrou, managing partner of Washington-based Federal Financial Analytics, in an interview.
The Fed is "certainly going out of its way to send a signal," she said. While it's hard to predict whether officials will reverse the ruling, "it sounds like it is a real dialing back."
The central bank has not made public any order showing that it changed its mind. The Fed's Hagenbaugh declined to comment, saying that supervisory information on an individual bank was confidential. Marchiony, the JPMorgan spokesman, declined to comment. Neither Stephanie Allen, a Commodity Futures Trading Commission spokeswoman, nor Bryan Hubbard, her counterpart at the Office of the Comptroller of the Currency, which oversees retail banks, said they had any knowledge of a waiver.
Detroit Warehouses
In February 2010, Goldman Sachs bought Romulus, Michigan-based Metro International Trade Services LLC, which as of July 11 operates 34 out of 39 storage facilities licensed by the London Metal Exchange in the Detroit area, according to LME data. Since then, aluminum stockpiles in Detroit-area warehouses surged 66 percent and now account for 80 percent of U.S. aluminum inventory monitored by the LME and 27 percent of total LME aluminum stockpiles, exchange data from July 18 show.
"The warehouse companies, which store both LME and non-LME metals, do not own metal in their facilities, but merely store it on behalf of the ultimate owners," said DuVally, the Goldman Sachs spokesman. "In fact, LME warehouses are actually prohibited from trading all LME products."
Traders employed by the bank can steer metal owned by others into Metro facilities, creating a stockpile, said Robert Bernstein, an attorney with Eaton & Van Winkle LLC in New York. He represents consumers who have complained to the LME about what they call artificial shortages of the metal.
Supply Accumulates
With so much metal already in storage, the warehouses can afford to offer incentives to owners of the metal to store even more, earning additional rent through volume. The LME requires a daily minimum amount of metal to leave the warehouses; it doesn't specify how much can enter. As supply accumulates, traders can finance the metal, Bernstein said.
Financing typically involves the purchase of metal for nearby delivery and a promise to sell it at a later date to take advantage of a market in contango, where prices rise into the future, Bernstein said. The transactions are made easier by record-low borrowing costs after central banks cut interest rates to boost economic growth.
"Users who need the metal can't get it, and the money they make is coming at the expense of the American consumer," Bernstein said.
Since 2010, the additional cost to aluminum users is about $3 billion annually, according to the Beer Institute, a Washington-based trade group that represents brewers.
Glut Premiums
Buyers have to pay premiums over the LME benchmark prices even with a glut of aluminum being produced. Premiums in the U.S. surged to a record 12 cents to 13 cents a pound in June, almost doubling from 6.5 cents in summer 2010, according to the most recent data available from Austin, Texas-based researcher Harbor Intelligence.
Warehouses are creating logjams, said Chris Thorne, a Beer Institute spokesman.
"Restrictive and outdated warehousing rules are interfering with normal supply-and-demand dynamics, creating supply-chain bottlenecks, and preventing brewers and other aluminum users from getting aluminum in time and at fair market prices," Thorne said.
The LME has proposed new guidelines, slated to take effect in April, that would link the amount of metal leaving a warehouse to the amount going in. The proposal would affect warehouses with waiting times longer than 100 days. The queue in Detroit is more than 400 days, according to a July 9 report by Barclays Plc analysts led by Gayle Berry. If rents stay where they are, the rule change would cut Detroit-area warehouse fees by as much as 70 percent, the analysts said.
Risky Forays
It's difficult to say how expansive the central bank's review of banks' commodities activities might be, said Rosner.
"Even if the Fed forces the sale of the warehouses, it's unclear if they are serious about addressing our systemically risky banks' forays into critical non-financial businesses," he said.
Already, tougher regulations and lower profits have persuaded JPMorgan and Goldman Sachs to look for buyers for their warehouse networks, the Financial Times said on July 14, without citing a source.
Pressures on banks to curtail commodities businesses include stiffening capital rules, a regulatory crackdown on trading practices and an industry slump. Commodities revenue at the 10 largest firms slid 24 percent in 2012, and was down 54 percent in the first quarter from a year earlier amid low volatility and fewer client trades, according to Coalition.
Different Structures
Morgan Stanley is cutting 10 percent of its workforce in commodities, a person briefed on the matter said last month. Chief Executive Officer James Gorman said in an interview last week that he's open to different structures in that business.
"We have no compulsion to act rashly," he said. Morgan Stanley held talks last year with Qatar's sovereign-wealth fund about selling a stake in the business. The deal could have added capital.
JPMorgan is nearing an agreement with the Federal Energy Regulatory Commission to settle allegations that the bank manipulated electricity prices in California and the U.S. Midwest, the Wall Street Journal reported. A deal could cost the bank $500 million, the New York Times said, citing people briefed on the matter. JPMorgan's Marchiony declined to comment.
The negotiations come after FERC ordered London-based Barclays and Deutsche Bank AG, Germany 's biggest bank, to pay fines for allegedly manipulating energy markets. Deutsche Bank agreed in January to pay $1.6 million with no admission of wrongdoing. Barclays said this month it would "vigorously" fight the $487.9 million in combined fines and penalties.
Financial regulators face an increasingly complex task at the largest U.S. banks. In 1990, the four biggest bank holding companies had, combined, about 3,000 subsidiaries, according to researchers at the Federal Reserve Bank of New York. By 2011, the top four had more than 11,000.
To contact the reporter on this story: Bob Ivry in New York at bivry@bloomberg.net.
To contact the editor responsible for this story: Gary Putka at gputka@bloomberg.net.
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