New York/Washington: Nuclear fuel belonging to Goldman Sachs goes missing, a Morgan Stanley oil tanker ruptures and pollutes a reservoir, a JPMorgan Chase power plant explodes.
These sorts of remote but catastrophic events could cost banks $1 billion-$15 billion more than their insurance, according to a confidential 2012 Federal Reserve Bank of New York report cited by the US Senate’s investigative wing.
The Senate’s investigation provides the most detailed disclosures yet of the Fed’s review of banks’ involvement in physical commodities, which complement their derivatives trading books in oil, gas or copper with the messier business of moving cargoes around.
Faced with a combination of political and regulatory pressure, many banks have chosen to back away from the business, with JPMorgan and Morgan Stanley looking to sell or close significant businesses. Notably, the Senate report uses the significant caveat “until recently” before describing how Morgan Stanley had “controlled over 55 million barrels of oil storage capacity, 100 oil tankers and 6,000 miles of pipeline”.
The real holdout, with the most to lose from any tightening of the restrictions on banks’ involvement in physical commodities, is Goldman.
The report points to several reasons why those restrictions should be tightened, including possible market manipulation as well as the threat to the financial system from a bank failing after a catastrophe.
At the top end, the Fed’s $15 billion cost estimate is more than twice the losses suffered by JPMorgan on its “London whale” trading fiasco and almost 50 per cent more severe than the worse quarterly loss Morgan Stanley recorded during the financial crisis.
The biggest banks might expect to survive even a loss of that magnitude, but the Senate committee, which holds two days of hearings on Thursday and Friday, concluded a giant hit could be exacerbated by a loss of confidence among creditors: “In a worst-case scenario, the Federal Reserve and ultimately US taxpayers could be forced to step in with financial support to avoid the financial institution’s collapse and consequential damage to the US financial system and economy,” wrote the committee’s staff.
Fed officials were quoted as saying: “The severity of this risk is in proportion to the potential damage and associated liability of industrial accidents in handling different commodities. Some, like uranium, may be more severe than other ...”
For its part, Goldman noted the uranium linked to its Nufcor subsidiary was “unenriched”, “not harmfully radioactive” and it only had “non-possessory ownership interests”. i.e. the nuclear incident causing financial Armageddon was unrealistic.
According to the Senate investigation, Fed officials found that banks had different approaches to quantifying the risk of an accident. JPMorgan found that an oil spill into water “would cause the largest potential single loss to the firm of all its physical commodities businesses, and estimated that the maximum oil spill loss would be $497 million” but applied “diversification benefits” to reduce its capital exposure to about $50 million. Goldman “had developed a power plant destruction loss model”, though its upper limit was the value of the plant, while Bank of America “had no total loss model for its commodity activities at all”.
The Senate report — and Fed officials quoted in it — were critical of JPMorgan’s reporting of its physical commodities activities. The bank used a way of looking at its holdings of aluminium which was lower than the Fed’s. Fed examiners concluded that JPMorgan had “pressed on the boundaries of permissible activities” and “pushed regulatory limits and their interpretation”.
The report also shows that JPMorgan parried with the Fed as it sought to retain ownership of three power plants it owned in Florida, Maryland and Michigan.
JPMorgan, which in 2013 paid $410 million to settle charges it manipulated the California power market, later informed the Fed it planned to sell all its power plant holdings, though it had not divested the three as of October.
The report sheds new light on how JPMorgan devised the California trading strategy. It hired John Bartholomew, then employed at the Southern California Edison energy company, who stated in his CV that he had identified a “flaw in the market mechanism” in the California electricity grid that caused its operator to misallocate millions of dollars.
Hours after receiving the CV, a top JPMorgan commodities executive instructed others to “get him in ASAP”, according to the report. Shortly after his hire Mr Bartholomew began to develop manipulative trading strategies, the report said.
— Financial Times
