From The New York Times -
Off Limits, but Blessed by the Fed
By GRETCHEN MORGENSON
The good news arrived in a confidential letter from the Federal Reserve Board in Washington. The nation’s biggest bank, JPMorgan Chase, had won the right to expand its reach in a lucrative business that has nothing to do with banking: electricity.
Areas like electricity are generally off limits to banks because of the
risks involved. But with its June 2010 letter, the Fed let JPMorgan take
an even bigger role selling electricity in California and the Midwest,
saying the push would “reasonably be expected to produce benefits to the
public that outweigh any potential adverse effects.”
Three months later, JPMorgan traders began a scheme to manipulate
electricity prices, ultimately forcing consumers in those regions to pay
more every time they flicked on a light switch or an air-conditioner,
the Federal Energy Regulatory Commission subsequently contended.
The story of how the Fed cleared the way for JPMorgan — a decision that
brought many millions in profits to the bank — illuminates how the Fed
has allowed the bank into a variety of markets for basic goods. Since
1956, a federal law has limited banks’ involvement in physical
commodities. But confidential documents, many obtained under the Freedom
of Information Act, show that since 2005 the Fed has granted three
special exemptions to JPMorgan Chase alone.
In 1999, Congress permitted Wall Street investment banks like Goldman
Sachs and Morgan Stanley to keep their commodity operations. Since then,
other banks have been allowed to expand into commodities, but in recent
years no bank has gotten more leeway from the Fed than JPMorgan,
experts in the field contend. In California and the Midwest, JPMorgan’s
subsequent dealings in electricity echoed actions of Enron a decade
earlier. The Federal Energy Regulatory Commission contended that
JPMorgan engaged in price manipulation that generated $125 million in
“unjust profits.” Last July, JPMorgan agreed to pay $410 million in penalties and restitution; it neither admitted nor denied wrongdoing.
Maneuvering in markets for electricity, metals, oil
and more added billions to the bottom line at banks like JPMorgan,
Goldman Sachs and Morgan Stanley in recent years. But their involvement
in commodities has now come under intense scrutiny. Industrial users of
aluminum and other metals contend that questionable activities by major
banks have increased their costs. Regulators like the Commodity Futures
Trading Commission have been investigating the issue, and congressional
hearings have also explored potential problems.
Amid this heightened scrutiny, the Fed said last July that it would
review its recent decisions to let banks expand their commodities
operations. A ruling is expected early next year. A Fed spokeswoman
declined earlier this month to comment further. JPMorgan, for its part,
has scaled back its activities in the electricity market and, last
summer, said it was putting its entire commodities unit up for sale. The
decision comes as prices — and profits — have fallen in the commodities
arena.
The opposite held true in 2005, when banks began asking the Fed for the
right to expand into commodities trading. The banks argued that this
business was complementary to their financing operations and thus should
be allowed. The Fed agreed.
In these rulings, the Fed consulted the Bank Holding Company Act, a 1956 law designed to protect
banks and the financial system from risks associated with nonfinancial
activities. The basic idea is that for banks, some businesses are simply
too risky. An institution that owned oil tankers, for example, might be
threatened by the costs associated with a large oil spill.
And so, between 2005 and 2008, the Fed allowed seven banks, most of them
foreign, to expand their commodities activities, but in a limited way.
They could trade commodities contracts and could also take delivery of
physical goods — such as natural gas and crude oil — to satisfy those
arrangements. Previously, taking such deliveries had been disallowed.
But in these rulings, the Fed barred the banks from owning or operating
physical commodities businesses, like storage warehouses, pipelines or
other transportation facilities. United States banks subject to the
restrictions were JPMorgan Chase, Citibank and Bank of America.
Privately, however, eight confidential letters between the Fed and
JPMorgan show the regulator taking a more accommodative approach. The
letters, which were obtained by The New York Times, show how the Fed
gave the bank free rein to push into commodities time and again. It has
let JPMorgan expand in areas like electricity tolling agreements, where
the bank essentially took over a power plant, providing its fuel and
selling its output. And since 2010, the Fed has also allowed the bank to
own and operate Henry Bath & Son, a big metals storage company, the
type of operation it had barred the bank from owning in 2005.
Since 2012, the letters show, JPMorgan has twice appealed to the Fed to
let it keep Henry Bath, succeeding both times. As recently as last July,
the Fed granted the bank an extension — until July 2014 — to meet
banking law requirements or sell the company. In the three years that
JPMorgan has owned Henry Bath, it has generated $161 million in profit
for the bank.
“With the big banks, everything is negotiated,” said Edward J. Kane, a
professor of finance at Boston College and an authority on regulatory
failure. “The rule provides a constraint on the negotiation, but
ultimately the Fed and these banks are married. They are, day after day,
dealing with each other and as in a marriage you almost never issue an
ultimatum.”
Back in 2005, when the Fed prohibited JPMorgan from owning storage and
transportation facilities, it did so to “minimize the exposure of
JPMChase to additional risks, including storage risk, transportation
risk, and legal and environmental risks,” it said in a Fed order published that November.
But then, in 2008, when Bear Stearns collapsed into the arms of JPMorgan
during the financial crisis, JPMorgan inherited the investment bank’s
commodities business. Two years later, JPMorgan acquired Sempra
Commodities, a global giant in oil, metals, coal and power, from another
troubled bank — Royal Bank of Scotland.
“This acquisition extensively expands our global commodities
capabilities, enabling us to extend our reach in the commodities space
dramatically,” said James E. Staley, then the head of JPMorgan’s
investment bank, said at the time. “This addition is a great fit for our
business as it helps us further serve our clients.”
As part of that $1.6 billion deal, JPMorgan acquired Henry Bath. Headquartered in Liverpool,
England, Henry Bath stores copper, aluminum, nickel, tin and zinc at
warehouses in Italy, the Netherlands, Singapore, Turkey and the United
States.
Just a few years earlier, the Fed objected to the ownership of Henry
Bath by Royal Bank of Scotland and ordered it to sell. But the Fed
allowed JPMorgan to buy Bath and fold it into its operations.
Josh Rosner, a financial services analyst at Graham Fisher who provided
The Times with one of the Fed’s approval letters, questioned the Fed’s
flip-flop in which it disallowed Royal Bank from owning Henry Bath but
let the bank sell it to JPMorgan. “The Fed seems to have been picking
winners and losers,” he said.
In the summer of 2010, commodities markets were hot, and JPMorgan wanted
a bigger piece of the action in this highly profitable arena. Unlike
investment banks such as Goldman Sachs and Morgan Stanley, whose
commodity operations had been deemed permissible by Congress in the
Gramm-Leach-Bliley Act of 1999, JPMorgan Chase had to get approval from
the Fed to go deeper into commodities.
Such Fed decisions are usually kept confidential, and it is unclear why the Fed allowed the bank to expand.
A JPMorgan spokesman declined to comment on private communications with
the Fed. But according to letters received under the Freedom of
Information Act, the Fed cited a section of the Bank Holding Company Act
that allows the purchase of operations if they are largely financial —
and not physical — in nature. The approval came with a condition: If
JPMorgan did not restructure Henry Bath to meet certain requirements of
the banking law within two years, the bank would have to sell the
storage facilities.
JPMorgan neither reduced Henry Bath’s physical commodities focus, nor
divested it. In April 2012, two top bank executives, Blythe Masters, the
head of JPMorgan’s commodities unit, and Francis Dunleavy, head of its
principal investing group, joined Henry Bath as directors. (Mr. Dunleavy
was identified in the FERC manipulation case and has resigned from
JPMorgan and Henry Bath’s board.)
Then, just two days before the two-year grace period was up, JPMorgan
wrote a letter asking the Fed for another year to meet the requirements
of the law. The letter, sent to Ivan J. Hurwitz, a vice president for
bank applications at the Federal Reserve Bank of New York, said JPMorgan
was requesting the extension so it could “complete the necessary steps
to conform its holding in Henry Bath to the requirements of merchant
banking.”
Merchant banks are not subject to the same commodities prohibitions as commercial banks.
Four months later, the Fed granted JPMorgan’s request, letting the bank
hold the company until July 1, 2013. The Fed required that the bank
provide it with quarterly reports outlining actions it was taking to
divest or restructure the business.
In March 2013, a letter from JPMorgan to the Fed noted that discussions
with potential buyers of Henry Bath were continuing. The bank also said
it had discussed shifting the storage of metals held in Henry Bath
warehouses to reduce the percentage of metals owned by the bank itself
and held in its own facility. Such a reduction would help JPMorgan
conform to banking laws that restrict the size of a bank’s holdings in
physical commodities.
“We are working actively to achieve the results stated in the letter and
will keep you apprised of our progress,” the bank said in the letter.
But on May 1, the bank wrote a letter requesting a second yearlong extension.
“This extension will provide time for JPMC to continue efforts to divest its interest in Henry Bath,” the bank said.
The Fed granted the second extension in a letter dated July 11, 2013.
JPMorgan had “taken substantial measures during the extension period to
conform or divest the remaining activities of Henry Bath,” the Fed said.
Another extension “is appropriate in view of these good faith efforts.”
The nature of those efforts is not clear from the documents.
The timing of the communications between JPMorgan and the Fed suggests
that the bank viewed the regulatory approval on both its proposed
electricity expansion and the Henry Bath purchase as a fait accompli.
For example, its request to enlarge its electricity business was made to
the Fed on Dec. 30, 2009 — after it had already contracted to add two
power plants to its operations.
The plants figured in the manipulation case that FERC filed against
JPMorgan last summer. Investigators for the commission found that from
September 2010 to November 2012, bank officials engaged in a dozen
electricity bidding strategies aimed at wringing profits from the
high-cost and inefficient power plants it controlled. The bank’s bids
created artificial market pricing, forcing customers to pay premium
rates, the regulator said.
Saule T. Omarova, a professor of law at the University of North
Carolina, Chapel Hill, is critical of banks’ expansion into commodities,
which the Fed has blessed.
“By allowing this expansion into tolling and energy contracts, it really
expands the power of JPMorgan to influence markets and market prices,”
Ms. Omarova said. “The Fed seems to be completely incapable of embracing
the concerns over market power and potential market manipulation and
systemic and concentration issues.” http://www.nytimes.com/2013/12/22/business/off-limits-but-blessed-by-the-fed.html?pagewanted=all&_r=0
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