A group of large financial institutions don't have anywhere near the capital they need to offset potential catastrophic risk associated with their physical commodities businesses, according to a 403-page congressional report released Wednesday. At the same time as the operations are giving the institutions an unfair trading advantage that isn't being fully disclosed to their primary regulator, the report adds.
At issue is a two-year study and report produced by retiring Sen. Carl Levin, D-Mich. and his staff of the Permanent Subcommittee on Investigations that was released in advance of two days of hearings Thursday and Friday, with top bank officials and regulators set to testify.
The report raises a number of different concerns and included examples of how major banks have sought to corner the market for certain commodities so they can profit from trading of derivatives referencing those underlying commodities. In addition, the report suggests that a group of four big banks don't have sufficient capital buffers to cover potential losses associated with an "extreme loss scenario" involving their physical commodity businesses, which include large stakes in oil tankers, pipelines and metals warehouses. It cites a 2012 confidential Federal Reserve staff analysis comparing losses experienced with the Exxon Valedez oil spill and British Petroleum's Deepwater Horizon oil spill event suggesting that each of the four big institutions are underinsured and they have a shortfall in the capital buffer department of between $1 billion and $15 billion to offset these kinds of potential losses.
The two year investigation has already put pressure on the Fed to have the primary big banks in the business -- Goldman Sachs & Co. (GS) , Morgan Stanley (MS) and JPMorgan Chase & Co. (JPM) – wind down or divest what remains of their physical commodity businesses. And while some of the institutions have started to wind down these businesses others are seeking to get into commodities.
In a briefing with reporters, Levin fell short of saying that big banks should be required to divest their physical commodities units, which include ownership of coal mines, nuclear power plants and oil pipelines as well as various metals including uranium. However, he said the report puts pressure on the Fed, arguing that it should impose a separation of banks and commodity operations.
"The regulators should restore the true role of banks, which should not involve owning pipelines, oil and aluminum and engaging in these kind of activities," Levin told reporters. "They've got to stop this activity because there is great risk to the economy – because if these large banks engage in these kinds of major deals and if natural disaster create a huge loss as a result of an oil spill, this can affect the whole economy and you get into the whole issue of bailouts by taxpayers because these banks are too-big-to-fail."
Levin added that he hasn't decided whether or not to refer his findings to the Justice Department for prosecution, adding that he will make a decision after the hearings are completed.
In one example, the report noted that Goldman acquired Nufcor International Ltd., a uranium trading company that stored and traded uranium in various stages of enrichment, in 2009. After the acquisition, Goldman significantly hiked the unit's uranium trading from 1.3 million pounds bought and sold annually to 13 million in by 2012, raising questions in the report about unfair competition and conflicts as well as a lack of capital and insurance to protect against a catastrophic event. The report also questioned whether this was a window dressing-type sale designed to create a shell corporation, noting that Nufcor's employees left when Goldman bought it and as a result it became operated by Goldman employees.
According to the report, Goldman never took possession of the uranium but had title to it. It argues that any Goldman assertions that Nufcor is liable, not the mega-bank, for a catastrophic costs don't hold up. "They had possession -- they owned it," said one congressional staffer. "There is no Nufcor, it's a shell. Goldman employees buy and sell uranium and arrange for the transport of it."
In a statement Goldman said it "enhanced" its insurance program after acquiring Nufcor but added that the cost was low in light of "the remoteness of any potential risks." It adds that Nufcor's activities have been limited to buying and selling "unenriched" uranium, which they argue does not present concerns raised by Levin. It added that any suggestion that Goldman abuses client information related to Nufcor is "utterly false."
Earlier this year, likely under pressure from Levin's investigation, Goldman sought to sell Nufcor but was unsuccessful and said it plans to wind down the business. Goldman said it plans to limit Nufcor's activities to meet "current supply obligations," which extend through 2018.
In addition, the case study also examines Goldman's ownership of two open-pit coal mines in Colombia, noting that they carry risks of methane explosions, mining mishaps and air and water pollution. In its investigation, the report noted that the coal mines experienced extended labor unrest – a 244-day strike resolved in September 2013 with 120 current or former mining employees with each of the 120 receiving a $10,000 payment. There are also port infrastructure issues Goldman must contend with.
Following an environmental law change in Columbia, Goldman has been prohibited from using barges from its port to load coal onto ocean-going ships. According to the report, Goldman decided not to build direct-loading equipment needed to do so and as a result it has not exported any coal from Columbia since Jan. 1, 2014. (The report suggests that Goldman didn't invest in the direct-loading infrastructure because its ownership of the asset falls under an exemption for "merchant banking" that requires divestiture after 10 years – as a result the institution didn't want to invest in building a direct-loader at its port.) In addition, the report said Goldman made a September 2013 presentation to its board noting that it had entered into a "short coal hedge" to offset declining coal prices and the unit's declining market value producing "accounting gains" of $246 million.
The anecdote also raises a concern identified throughout the report – that key details of their operations and trading were not disclosed to the Fed. A person familiar with the situation argues that while the Fed knew Goldman owned the mines and had a large hedge on coal prices it may not have been aware of the strike and export problems and whether that may have contributed to the short position.
A spokesman for Goldman acknowledged that the report's details about the strike are accurate and he agreed that, due to the law change, it hasn't exported coal from Columbia since January. However, he declined to comment on the report's "short coal hedge" assertion and added that the firm discloses to the Fed what is required. It also said it has the "highest international standards for environmental safety and management" for the mines.
The report also raised concerns about Goldman's Metro International Trade Services LLC aluminum warehousing business, which the report argues engaged in hundreds of "merry-go-round" transactions where aluminum was transported hundreds of times from one warehouse to another, sometimes a few miles away and in one case to another warehouse 200 feet away across a parking lot, forcing metal owners to wait up to two years to get their metal out of storage, a situation that the report contends raised the price of aluminum for U.S. aluminum buyers and consumers.
The report adds that two Metro sales people resigned, one shortly after the firm was acquired by Goldman and another after raising concerns about the effectiveness of so-called 'Chinese walls" between Metro and J. Aron, Goldman's primary commodity trading unit. "This morning's confrontation was extremely questionable," the Metro employee said in an email, according to the report. The report also charges that roughly 50 Goldman employees got confidential metal info, including some who supervised aluminum traders. "We're relying on a glass wall between two people next to each other on the trading floor," said one person familiar with the investigation.
A Goldman spokesman said that the aluminum transactions complied with rules set by the London Metal Exchange and were entered into based on the economic interests of aluminum owners.
The report also raised questions about Morgan Stanley and its infrastructure fund, which acquired Southern Star Central Corp., an owner of natural gas storage facilities and pipelines in the Midwest. It raised concerns about whether any catastrophic liability associated with facilities or pipelines will remain within the fund or be felt by the bank and that the institution may have greater liability than they are willing to admit or plan for.
Until recently, Morgan Stanley controlled over 55 million barrels of oil storage capacity, 100 oil tankers – which they lease -- and 6,000 miles of pipeline, the report noted. In addition, Morgan Stanley's sale of its TransMontaigne oil pipeline business reduced its footprint in the oil barrel business, but not substantially. Nevertheless, another deal it announced in December 2013 to sell its remaining oil transportation and storage business to OAO Rosneft, appears to have unraveled amidst tensions between the U.S. and Russian governments. Nevertheless, Morgan Stanley has said it plans to sell that business regardless of whether it succeeds at selling it to Rosneft and that the company has reduced its physical commodity business substantially beyond what it has sold or is selling. One person familiar with the bank said that the oil tanker leasing business has been reduced to 20 oil tankers. A spokesman for Morgan Stanley said the institution is "proud" of its comprehensive approach to risk management "which has enabled the firm to manage its commodities business prudently and effectively over the last three decades."
The report also goes into historical detail, noting that the trading activity at several large financial institutions is reminiscent of Enron prior to its much publicized 2001 collapse. It notes that Enron convinced a number of U.S. banks, including JPMorgan Chase, to finance or participate in energy commodity trades, which got them interested in eventually owning physical commodities. "There was an Enron impact," said one staffer.