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Wall Street, Fed face off over physical commodities
Wall Street’s biggest banks are locked in an increasingly frantic struggle with the Federal Reserve over the right to retain the jewels of their commodity trading empires: warehouses, storage tanks, and other hard assets worth billions of dollars.
While the battle over proprietary trading and new derivatives regulations has taken place largely in public view since the 2008 financial crisis, the fight by JPMorgan Chase, Morgan Stanley, and Goldman Sachs to retain or expand their prized physical commodity operations — most acquired in only the past six years — has remained hidden.
The debate is nearing an inflection point: Within 18 months, the Fed will likely either allow banks more freedom to invest in the physical commodity world than ever; or force them to sell off the assets that many banks are counting on to buttress their trading books at a time when they are already vulnerable because of intensifying competition and new trading curbs.
The banks are now locked in deep debate with the Fed, multiple sources involved in the discussions told Reuters. Goldman and Morgan Stanley argue the right to own such assets is “grandfathered” in from their lightly-regulated investment banking days, or that at least they should be allowed to retain them as “merchant banking” investments, kept segregated from the trading desks.
But regulators and lawmakers may not be in the mood to give way. Banks are under pressure to reduce risk on their balance sheet; as commodity prices rise again, they may face more allegations that they could use these assets to drive prices higher or lower, squeezing them for trading profits.
“The Fed’s not going to be terribly accommodating,” said Oliver Ireland, a former associate counsel to the U.S. Federal Reserve and a partner with law firm Morrison Foerster in Washington, D.C. “There doesn’t seem to be a lot of sentiment in this town for people doing new things and taking new risk.”
Should these banks lose the debate, the result may be the biggest shake-up in commodity markets since the early 1980s, when Wall Street first discovered the potential profits to be made by wading deep into the murky world of crude oil cargoes, copper stockpiles, and power plants.
“Adding large-scale, complex commodity market activities to ‘too-big-to-fail’ bank portfolios, with dangerous potential ramifications to the real economy — as demonstrated in California by Enron — is not comforting,” says John Fullerton, who ran JPMorgan’s commodity business in the 1990s and is now a markets activist at the Capital Institute in Connecticut.
The loss of their coveted assets would be a blow for the banks at the worst possible moment, with their proprietary trading desks shut down, commodity merchants trying to poach their top traders and new Basel III capital regulations requiring them to further build capital reserves.
Morgan Stanley’s commodity trading revenues have fallen by some 60 percent over the past three years. Goldman Sachs’ commodities business revenues fell from $4.6 billion in 2009 to $1.6 billion in each of the past two years.
The Fed declined to discuss specific companies directly or the likely final outcome of the talks. Spokespeople for Morgan Stanley, Goldman Sachs, and JPMorgan declined to comment on detailed questions put to them by Reuters.
To a degree, it is a story that has been hiding in plain sight. In last year’s second-quarter Securities and Exchange Commission filing, Morgan Stanley added the following new text to its lengthy Supervision and Regulation disclaimer:
“The company is engaged in discussions with the Federal Reserve regarding its commodities activities. If the Federal Reserve were to determine that any of the company’s commodities activities did not qualify for the BHC (Bank Holding Company) Act grandfather exemption, then the company would likely be required to divest any such activities.”
That disclosure was made at about the same time the bank began to have second thoughts about a new $430 million storage tank investment undertaken by its publicly listed oil transport and logistics subsidiary TransMontaigne, according to two people familiar with the transaction. In October, TransMontaigne reduced its stake in the project to 50 percent; it sold the rest in January.
The bank’s abrupt change of stance last year is the clearest sign yet that the Federal Reserve may be taking a harder line.
Yet it may be JPMorgan, which has eclipsed long-time market leaders Goldman and Morgan under commodities chief Blythe Masters, that will be first to feel its effects.
The bank has begun sounding out possible buyers for its small operation trading metal concentrates, according to one source who examined the business late last year. It acquired that business when it bought most of RBS Sempra in mid-2010, but because metal concentrates aren’t traded on any exchange, they were not covered by a 2008 Federal Reserve order that allowed RBS to begin trading physical commodities.
More importantly, the sale has also raised questions about JPMorgan’s ownership of its global metals warehousing business Henry Bath, which had also been excluded from the RBS waiver. The Fed’s rules give banks a two-year grace period in which to divest any non-compliant businesses they acquire; sources say it’s not clear why JPMorgan would be exempt from this rule.
Goldman too faces scrutiny of its ownership of Detroit-based metal warehousing firm Metro International. Goldman has come under fierce criticism from companies such as Coca-Cola, which has accused it of inflating metal prices.
Since buying the privately held firm in early 2010, the bank has taken great pains to avoid any direct involvement in its business to minimize regulatory scrutiny, according to two industry sources. But questions remain.
The warehouses are lucrative on their own: As surplus metal stocks accumulated during the recession, profits at the UK-based Henry Bath surged to more than $110 million in 2009 and near $80 million in 2010, about $1 million per employee per year, according to annual reports filed to UK Companies House in November. These units could, in theory, be run as “merchant banking” investments, as with Metro, but that requires they be kept at arm’s length and divested within 10 years.
But for trading firms, that’s only half the benefit.
“The truth of it is that having access to the physical markets is about optimization and knowledge — it gives you the visibility of the market to make far more successful proprietary trading decisions in both physical and financial markets,” said Jason Schenker, President and Chief Economist at Prestige Economics in Austin, Texas.
“That’s why for many years the most successful traders had access to both markets, and why we’ve seen little sign they’re moving quickly to divest these assets now. It’s trading with material non-public information. The difference compared with equity markets is that it’s perfectly legal.”
Based on past precedent, financial holding companies would still be allowed to be involved in trading physical commodities like oil or metals, even if they are not allowed to outright own the physical infrastructure which supports their operations.
Between 2003 and 2008, the Federal Reserve granted permission for nearly a dozen banks to engage in such trading, which it deemed “complementary” to financial operations within certain limits. Citigroup was the first in, seeking approval on behalf of its aggressive trading unit Phibro.
But there are signs that the Fed may be reassessing. The permit to form RBS Sempra in March 2008 is one of the last it has granted, according to the Fed’s quarterly bulletins. That took eight months to negotiate, and covered a range of activities including third-party refining that the Fed had not previously approved.
In 2009 Bank of America told the Fed of its plans to trade a broad range of commodities following its acquisition of Merrill Lynch, which had not been subject to Fed regulations, a source familiar with the discussion said. BoA secured its own approval from the Fed to engage in physical trading in 2007, but Merrill’s operation was much larger — although still within the scope of what the Fed had approved for other banks such as RBS.
That request is still pending, the source said, even though BoA has not sought permission to own or operate physical assets.
“Beginning in 2009 we have been working with regulators to ensure that we will continue to service our clients in the physical commodity market with products and services on which they have relied,” a BoA spokeswoman told Reuters in response to questions.
On the other hand, if the Fed allows Goldman, Morgan Stanley, and JPMorgan to retain all their assets, it may open up a Pandora’s box. Rivals are already up in arms about the potential for a competitive disadvantage.
“It’s a space we’d love to be in, but have had to limit our investments to Europe and Asia due to the Financial Holding Company regulations,” one lawyer with a rival European bank said.