Big Banks Dangerously Exposed to Risks from Commodities Business: Lawmakers

WASHINGTON — A Senate report released Thursday reveals new details about the role certain banks played in the physical commodities markets, specifics that lawmakers say supports the Federal Reserve Board's plans to restrict bank participation in that area.

The report by the Senate Permanent Subcommittee on Investigations lays out the extent of banks' ownership of commodities and commodity infrastructure, much of which was not publicly known. It also says that, though there is no evidence that banks directly interfered with or colluded with commodity infrastructure managers under their umbrellas, there is reasonable suspicion of such collaboration or at least the potential for abuse.

"We found evidence that physical commodities activities put Wall Street in a position to profit from valuable nonpublic information, the kind of information that is barred from influencing our stock markets," said Sen. Carl Levin, D-Mich., chairman of the subcommittee. "This isn't a secondary effect, but in fact central to the plans of some banks to have access to that kind of information."

The report comes ahead of a two day hearing on the subject scheduled for Thursday and Friday featuring representatives from the government and the banks involved in such trading.

Levin said the report makes it clear that the legal liability and credit risks posed by an industrial accident or other disaster outweigh the safeguards put in place, making physical commodities a systemic risk if an accident occurred at a bank-owned facility. That conclusion echoes the Fed's concerns when it released an advance notice of proposed rulemaking to bar banks from certain commodity infrastructure ownership.

"One way or another, we have got to stop this activity," Levin said. "We have to restore the differentiation between banking and commerce."

Levin's ability to force the issue is limited, however, since he is retiring at the end of the current Congress and his party will be in the minority in January. Sen. John McCain, the top panel Republican, echoed Levin's sentiment, saying he hopes Republican leaders take up the issue when they assume control early next year.

"These activities raise serious concerns about the potential for market manipulation, excessive risk, and in extreme circumstances, more taxpayer bailouts," McCain said.

Banks have downplayed the concern that environmental liabilities could lead to a financial calamity. In comments sent to the Fed in April, a coalition of banking and market trade groups said the risk of an environmental accident is not contagious — if one bank suffers such a setback, other banks will not necessarily be similarly affected.

"Even if a commodities affiliate or portfolio company of one [financial holding company] suffers a catastrophic loss... there is no reason to believe that the commodities affiliates or portfolio companies of other [banks] will suffer similar accidents and losses that are correlated with the first company's accident and losses," the groups' comments said.

Banks' involvement with physical commodities is relatively recent and spans just the biggest banks, notably JPMorgan Chase, Goldman Sachs and Morgan Stanley.

Goldman, for its part, got ahead of the report by holding its own briefing Tuesday in which the company released a report detailing its activities in the commodities arena and defended them as legal and fair. The firm also said that owners and operators of facilities are liable for environmental damages, and since it does not own such facilities it would not be liable in the event of a disaster.

Senate staff said that, depending on the circumstances of a disaster, Goldman's assertion may be correct, but courts assign liability in the case of such a disaster, and that process can take years. That potential liability can be as damaging to shareholders and a company's credit profile.

"The unique thing about banks is that they rely on credit to operate," one committee staffer said. "Assuming that something bad happens [to a bank-owned facility], that really bad thing may not be resolved for two years, four years... [but] the immediate reaction may also be very severe."

Among the more notable activities detailed in the report is Goldman's ownership of Metro International, an aluminum warehousing hub in Detroit that acts as a terminal for aluminum warrants traded on the London Metal Exchange. The report alleges that Goldman heavily incentivized clients to keep their aluminum warehoused at the facility, and worked around LME mandatory delivery deadlines by moving stockpiles between warehouses.

The effect of that "merry-go-round" warehousing is long waiting times for physical delivery and an effective devaluation of aluminum warrants traded on the LME, the report says. The Commodity Futures Trading Commission last year issued subpoenas to Goldman to investigate possible price manipulation with the warehousing company.

With respect to its aluminum warehousing business, Goldman said in its report that it was simply doing what its clients were asking it to do, which is to keep aluminum out of a cratered global market, and were competing with non-LME warehouses for that storage business. The incentives offered were no different than those offered by warehouses elsewhere and were undertaken in order to attract and retain clients, Goldman claimed.

"Metal warehousing is a globally competitive business," the Goldman report said. "Other warehouse companies provided the same or similar forms of incentives."

The Senate report also details the outsized roles that other banks play in other commodities businesses. JPMorgan notably entered the electricity generation market when it took over Bear Stearns in 2008. The company last year paid $410 million to settle price manipulation charges with the Federal Energy Regulatory Commission. The PSI report also details Morgan Stanley's footprint in the oil markets, saying that the company owns more than 6,000 miles of oil pipelines and more than 100 oil tankers. Though the company is working to exit the crude oil merchanting business, "it still operates a vast physical oil business."

Indeed, many banks are curbing their involvement in the physical commodities business. JPMorgan earlier this year sold much of its physical commodity business to Geneva-based trading firm Mercuria, and is in the process of selling much of the remaining business to other buyers. Morgan Stanley announced its intention to sell much of its oil business to Russian oil company Rosneft, and Deutsche Bank similarly has sold off most of its commodities business in the past year.

But Senate subcommittee staff members say the concern about bank involvement remains, largely because some banks remain firmly entrenched in the market. Goldman, for one, has expressed its intention to sell certain commodities businesses — including Metro — but said in its report that acting as a market maker in the commodities markets is a "core function" of the company. Citi has also increased its profile in electricity trading by buying Deutsche Bank's energy and metals trading books earlier this year. Morgan Stanley, meanwhile, bought the German bank's bulk trading book.