Steam rises from Cogentrix power plant in Sioux Falls, Idaho. Goldman Sachs bought Cogentrix in 2003.
Wall Street's biggest banks are currently under the gun for their massive role in global commodities markets. But what many don't realize is the vast expansion of that role was, in large part, an unintended consequence of the chaos of the financial crisis.
Should we be shocked that the ramifications of the financial crises are still reverberating years later with unexpected repercussions? Not in the slightest.
Without the financial crisis, Wall Street's legally designated, FDIC insured, bank holding companies (FHCs) would not have had the opportunity to build massive portfolios of oil, natural gas, metals and more. They would not have been able to buy the things that transport and house those commodities either.
Right now, bankers might be daydreaming of an alternate reality where they didn't build the huge, now tenuous, commodities portfolios which are drawing increased scrutiny.
Such scrutiny as the July 20th The New York Times story that accused Goldman Sachs of using its aluminum warehouses to manipulate the price of the commodity — an assertion the bank emphatically denies — costing consumers billions.
Then there's JP Morgan, which just agreed to pay a $410 million fine for using trading strategies to manipulate energy markets — the bank neither confirms nor denies the manipulation charges.
It won't stop there.
In September, The Fed will rule on whether or not to allow Wall Street banks — specifically JP Morgan, Goldman Sachs, and Morgan Stanley — to keep the physical commodities they purchased during a five-year, post-financial-crisis shopping spree.
This could be The Fed's chance to correct mistakes it made while it was asleep at the wheel, allowing the commodities businesses at Wall Street banks to get bigger and more interconnected than anyone in American history ever intended.
Andrew Jackson originally crushed the national bank because he didn't want it to centralize commercial and financial power. You can almost hear him turning in his grave.
Softening the rules to grease the commodity wheels
In 1956 the U.S. enacted the Bank Holding Companies Act (BHCA) effectively barring any company that owned a commercial bank (a bank holding company) from engaging in activities outside the business of banking.
The idea was that commerce and banking should be separate, and, more importantly that banks should never become something that Americans really hate — monopolies.
Certain institutions were designated “financial holdings companies” (FHCs) so that they could do complex things like underwrite insurance/bonds or deal in securities. Still, FHCs remained subject to the regulations of the BHCA, and were not supposed to be in the business of warehousing or transportation, which are only a few of the logistical non-finance businesses that Wall Street banks are involved in now.
In 1999 the BHCA was softened by a provision in the Gramm-Leach-Bliley Act, the one that repealed Glass-Steagall. Through the 1990s, banks argued they needed telephone help lines and data processing units to conduct their activities. They said they should be able to own those businesses too. With Gramm-Leach-Bliley FHCs were allowed to petition the Fed for special permission to buy “complementary” non-financial businesses.
The meaning of “complementary” was kept quite vague. According to Gramm-Leach-Bliley, FHCs were ... “to engage, to a limited extent, in activities that appear to be commercial if a meaningful connection exists between the proposed commercial activity and the FHC’s financial activities.” And if they posed no risk to the greater financial system, of course.
Between 2000 and 2012 banks used this rule almost exclusively to take advantage of the commodities boom and buy physical assets. Citigroup was the first to use it in 2003, requesting permission to sell oil, gas, and other commodities on the spot market.
Two years later, JP Morgan got in the mix and JP Morgan Ventures Energy Corporation — the business that was just fined by federal regulators — was born in 2005. It, too, was subject to the Fed's stipulations about the size of its business — it could only equal 5% of the bank's core capital, for one.
The Fed specified that JP Morgan could trade only in the commodities it petitioned for. It also said that to minimize the bank's exposure risk, it didn't want JP Morgan owning any of the transportation companies or storage facilties involved in commodities.
These facilities were to be owned and operated by third parties not insured by the FDIC. If something went wrong, the Fed wanted to make sure taxpayers wouldn't be on the hook.
Reading the Fed's language, it isn't hard to understand why critics feel today's Wall Street commodities business of oil refineries, wind farms, and warehouses has strayed away from what Gramm-Leach-Bliley intended. The question now, is whether or not Wall Street banks should be allowed to continue in the commodities business.
And of course, who's to blame for their straying in the first place?
How Goldman Sachs and Morgan Stanley got in the game
While JP Morgan was asking the Fed for special permission, Goldman Sachs and Morgan Stanley didn't have to. Until the financial crisis they were investment banks without commercial operations and thus not subject to the regulations of the BHCA. During the commodities boom of the early 2000s they purchased businesses that would do what these banks do best — make money.
As a result, Morgan Stanley became a huge player in the oil and energy business. By 2005 it was the 2nd most active seller of power in the United States. In 2006 it bought oil tanker company Heidmar Inc. for an estimated $200 million. That same year it acquired Colorado oil company TransMontaigne for $11.35 a share.
By 2012 Reuters estimated that Morgan Stanley's bank commodities businesses had netted it $17 billion over 10 years.
Goldman Sachs wasn't going to get left behind. The bank has a long history in the commodities derivatives business. In 1981 it bought commodities trading company J. Aron and Company, which is where CEO Lloyd Blankfein and COO Gary Cohn both got their starts.
The bank moved into physical assets with the commodities boom purchasing Cogentrix Energy (which owned coal-fired and solar power plants as well as an oil pipeline) in 2003.
With a crisis comes opportunity
This semblance of order — freedom to enter physical commodities markets for banks without commercial arms, and the requirement of special permission for banks with commercial arms — was turned on its head with the financial crisis.
In the chaos of shoring up the global banking system, Goldman and Morgan Stanley became FHCs subject to BHCA regulation overnight.
In the heat of the moment Hank Paulson and Ben Bernanke were surely not combing through the banks' books looking for BHCA conflicts. Also, according to BHCA regulation, these banks had five years to divest themselves of any conflicting businesses. It was a matter that could be dealt with at another time. “Another time” being now.
JP Morgan, though already an FHC, also found itself in a special position at the start of the financial crisis — the bank was first in line at a Bear Stearns fire sale.
When JP Morgan acquired Bear Stearns, it also acquired Bear Stearns' energy commodities business, Arroyo Energy Investors.
When Europe's banking system was on its knees begging for mercy, regulators ordered The Royal Bank of Scotland to sell its commodities business, RBS Sempra. JP Morgan snapped it up. JP Morgan then purchased the “global oil, global metals, including Henry Bath, global coal and European power, gas, and non-U.S. emissions assets” — $1.7 billion of assets — for $1.6 billion in 2010.
With those deals, JP Morgan officially welcomed itself to the Big Leagues.
“We are fortunate to welcome the talented employees of RBS Sempra Commodities to J.P. Morgan today,” said Blythe Masters, head of Global Commodities. “With their deep market knowledge and expertise, they complement the team at J.P. Morgan and will provide a powerful competitive advantage as we extend our Commodities business globally.”
JP Morgan also bought now-defunct commodities brokerage MF Global's stake in the London Metals Exchange (LME) in 2011, becoming its largest shareholder with a 10.9% stake. It also considered getting more aggressive in the warehousing space in 2012.
No one wants to admit that they dropped the ball.
Through all of this, Blythe Masters, already known on Wall Street, became legendary for running the bank's commodities unit. This May, however, regulators told JP Morgan that they were investigating the bank's activity in energy markets, and in a 70-page document pointed to Masters as an executive who had made “scores of false and misleading statements and material omissions” about the business, according to The NYT.
While JP Morgan had an unprecedented growth spurt, Goldman continued to make acquisitions in the physical commodities space despite its new FHC status. Morgan Stanley, also a newly minted FHC, merely let the money roll in.
Goldman acquired its controversial Metro warehouses, one of the largest in the LME network, in 2010. In 2012, it led a group that bought a coal business Brazil's Vale for $407 million.
Morgan Stanley, sitting pretty, retained TransMontaigne Partners, which earned over $152 million in 2011.
Letting go is hard to do, especially for Big Banks
With the five-year grace period for BHCA divestment coming to an end, banks know that the Fed is weighing its policy options.
“The Fed is in a difficult position as well,” said UNC Law Professor and banking expert Saule Omarova. “No one wants to admit that they dropped the ball.”
Omarova maintains that it's truly impossible for anyone outside the inner circles of banks and the Fed to know what banks are actually holding. She says the truth lies in the living wills banks were forced to write after the financial crisis. They detail all of the assets banks have on their vast balance sheets, but those wills are kept as secrets inside the Federal Reserve.
According to Omarova, banks even quibbled about the number of lawyers who could be present as the wills were being written. Too many loose lips sink ships — and banks.
For its part, JP Morgan has said it may exit the physical commodities business entirely. Goldman, on the other hand, seems ready to fight on. After The New York Times published the damning story about Goldman's aluminum warehouses, the bank released a fact sheet defending the business. This week, Goldman Sachs COO Gary Cohn went on CNBC to discuss the matter live.
This may be because BHCA regulation has a grandfather clause. As Omarova points out in her research paper, “The Merchants of Wall Street, Banking Commerce and Commodities,” banks that have been designated FHCs after November 1999 can continue “activities related to the trading, sale, or investment in commodities and underlying physical properties,” as long as they meet certain conditions.
The Bank for International Settlements (BIS) put out a working paper detailing the risks associated with holding commodities. Instead of being a hedge, researchers Marco Jacopo Lombardi and Francesco Ravazzolo determined that commodities actually add volatility to portfolios as the correlation between commodity and equity returns has increased since the financial crisis.
Politicians fear that with Wall Street banks owning commodities, the cost of a BP oil spill-sized accident could fall on the backs of taxpayers. They fear a whole new set of risks we haven't seen yet. After all, this whole story could be considered one of unintended consequences.
If what Washington wants to do is make banking boring, simple, and less risky, Wall Street may have to prepare to let go of the goods that it acquired in chaos.
Historically, letting go hasn't necessarily been the Street's strong suit.
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