The Commodities Market: A Big Bank Love Story

AP Images/Charles Dharapak

Who becomes the next Federal Reserve chair matters, not only because of the implications for economic and monetary policy, but because the Fed remains one of the nation’s chief financial regulators. There are dozens of policies, some we don’t even know about, over which the Fed wields critical influence. While the past year has seen a small but important shift toward tighter controls, particularly on the largest Wall Street institutions, all of that could change if President Barack Obama selects another deregulator in the Greenspan tradition.

A perfect example of the Fed’s centrality to the financial regulatory space came last week, when a Senate hearing focused on an unseemly practice that the Fed perpetuated and has the power to stop. As reported in The New York Times and elsewhere, large investment banks like Goldman Sachs have purchased warehousing facilities for aluminum and shuffled the product from one facility to another. When a purchaser buys the metal, it finds it takes much longer—up to 18 months in some cases—to satisfy their order. Buyers pay rent on the storage in the meantime, but Goldman makes its real money, in this case, on trading in aluminum futures.

As Izabella Kaminska explains, a commodity market is in a situation called a “contango” when the future price is higher than the cash price for immediate delivery (known as the spot market). Investment banks that own large warehousing facilities (and through control of the market, can warehouse at a below-market rate) can make lots of money from more passive speculators and purchasers, who will buy futures at the higher price. After the Great Recession, contango yields rose significantly, because lower consumer demand meant that purchasers just wanted a place to store commodities like aluminum until they needed it. Shuffling around the aluminum also creates the illusion of scarcity in supply, increasing prices. Even though only 5 percent of the world’s supply of aluminum passes through Goldman’s warehouses, the “premium” price of storage added to purchases on the spot market affects the other 95 percent, and Goldman’s shenanigans increase the premium, along with the profits. Moreover, if the banks know that there’s this “dark inventory” that they can put on the market at any moment, they have a knowledge advantage that can be used to make more trading profits. Ultimately, these costs are passed on to the consumer, who pays more for beer or soft drinks.

When done properly, commodity trading can limit price spikes for producers. But when a speculator can own commodity assets or the physical commodity itself—as banks are starting to do with copper and several other products—profits extracted from speculation can soar, to the detriment of producers and consumers. As University of North Carolina law professor Saule Omarova said in a Senate Banking Subcommittee hearing on the subject, “Investment banks are turning into trade and financial super-intermediaries. … Bank holding companies should not be involved in this.” Josh Rosner, a financial analyst, compared the situation to the housing bubble, when banks went from making loans to taking over the entire mortgage complex. In this case, they went from being speculators to having large ownership stakes in the commodities or elements that move commodity prices. In securing funding for these commodity purchases, Rosner notes, banks pitch investors on the “advantage of monopolistic and quasi-monopolistic assets, allowing prices to rise even when demand falls.”

The aluminum shuffle did raise the attention of Congress, which held hearings last week. The fact that commercial users of aluminum include multinational corporations like Coca-Cola and beer makers, which have clout in Washington and factories that employ large numbers of people, may mean that the banks overreached here. But even if this opportunity is ending, the question remains: Why are mega-banks allowed to purchase commodity assets or physical commodities and manipulate prices to their benefit in the trading markets?

The answer is the Federal Reserve, which granted exemptions to firms restricted by the Bank Holding Company Act from making investments in nonfinancial businesses. A 2003 rule determined that “certain commodity activities are complementary to financial activities and thus permissible for bank holding companies,” and later exemptions allowed ownership of trading assets like warehouses, power plants or oil storage tanks. About a dozen banks took advantage of this Fed ruling. In addition, part of the Gramm-Leach-Bliley Act—which eliminated the Glass-Steagall firewall between commercial and investment banks—allowed investment banks that converted to bank holding companies (basically, companies that control a deposit-taking bank; Goldman Sachs and Morgan Stanley did this in 2008 to gain access to the Federal Reserve’s emergency lending facilities) to “grandfather” in their asset holdings, as well as engage in so-called merchant banking activities, like buying up commodities. It appears to be easy for bank holding companies to justify their nonfinancial purchases as part of those merchant banking investments. There’s also little transparency in these approvals; Senator Sherrod Brown, who chaired last week’s subcommittee hearing, noted that the form banks have to fill out to justify their merchant banking acquisitions to the Fed is not even available to the public.

In his three-point plan for ending the physical commodity shuffle, Brown targeted the Fed’s opaque operations facilitating massive bank profits. “The Federal Reserve must issue clear guidance on permissible non-bank activities,” Brown wrote, “and consider placing limitations on those that expose banks and taxpayers to undue risk.” In June, Congressman Alan Grayson and three colleagues highlighted multiple examples of bank ownership of commodities in a letter to the Fed. “Goldman Sachs, JP Morgan, and Morgan Stanley are no longer just banks—they have effectively become oil companies, port and airport operators, commodities dealers, and electric utilities as well,” the letter reads. “This shift has many consequences for our economy, and for bank regulators. We wonder how the Federal Reserve is responding to this shift.”

On the regulatory front, the Fed has been somewhat better of late. Under the direction of Fed Governor Daniel Tarullo, it has approved rules that would increase leverage requirements on the largest financial institutions, forcing them to absorb their own losses rather than throwing them on the taxpayer. Tarullo reportedly faced major resistance from inside the Fed, still populated at the staff level with Greenspan-era officials who never met a regulation they liked. But Tarullo won the day, and in public pronouncements has shown himself attuned to the potential systemic risk associated with giant, interconnected mega-banks. There is also evidence that the Fed is rethinking not only the exemptions granted to banks to own commodity trading assets but the ability for bank holding companies to trade in physical commodity markets altogether. In advance of this decision, JPMorgan Chase said last Friday it would consider selling its physical commodities unit.

This is why the rumors that President Obama could choose Larry Summers to be Fed chairman are so troubling. As Treasury secretary, Summers oversaw Gramm-Leach-Bliley, as well as deregulation of commodity futures and derivatives. During the Dodd-Frank debate, he reportedly lined up consistently on the side of looser controls on Wall Street. And he showed his cards on regulatory enforcement when writing about foreclosure fraud, the largest consumer fraud in history, in 2011. While noting that just compensation to victims was legitimate, he added that “allowing negotiation over past actions to be the dominant thrust of policy creates overhangs of uncertainty that impose huge costs on the financial system and inhibit lending.” In other words, when it comes to unethical or even criminal actions by banks, we should look forward and not backward, a position that virtually guarantees future misconduct.

This partially explains why a significant number of liberal Democrats in the Senate have written to the president, asking him to choose Fed Vice Chair Janet Yellen, the main alternative to Summers, to run the central bank. The ringleader behind that letter was Sherrod Brown, the very senator exploring the expansion of the financial system into these realms of commerce. He understands that letting another deregulator run the Fed will only entrench this concentration of power on Wall Street.

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