Published November 27, 2013
The U.S. Federal Reserve was pressing JPMorgan Chase & Co (JPM.N) to distance itself from its metals warehousing business more than a year ago, documents seen by Reuters show, long before the issue became a focal point in the debate over Wall Street's role in physical commodities trading.
A series of letters between JPMorgan's lawyers and the Fed, released to Reuters through a Freedom of Information Act request, show Wall Street's primary regulator took a tough stance on the bank's efforts to hold onto the global network of Henry Bath & Sons warehouses, part of the larger RBS Sempra commodity trading business it bought in mid-2010.
The correspondence shows the Fed balked at JPMorgan's request to turn the one-time trading assets into a strictly arms-length financial investment back in June 2012, and told the bank it must provide quarterly updates on what it was doing to either comply with banking rules, or sell the business.
The Fed also pressured JPMorgan to dilute the amount of metal held by its own traders in Henry Bath, an issue that has riled major metal consumers and critics of a copper investment fund the bank was trying to launch.
Eventually, by May this year, JPMorgan had decided to simply sell the business, the letters show. Three months later, with broader pressure mounting over Wall Street's involvement in the raw materials supply chain, JPMorgan would put its entire physical commodity trading business on the block.
The documents, which consist of six letters over a period of 13 months, provide the deepest look yet at how the Federal Reserve has wrestled with the thorny regulatory question of banks and physical commodity markets.
They show the Fed has at times taken a tough line with banks in the sector, and may darken the outlook for Goldman Sachs (GS.N) and Morgan Stanley (MS.N), both of which still own physical commodity trading assets such as warehouses, pipelines and oil storage tanks. Both banks argue that a 1999 law gives them greater latitude to own and operate assets as they are former investment banks.
The letters also raise questions about the Fed's willingness to allow Wall Street to convert former trading assets into passive merchant investments that they can own for up to a decade. Both Goldman and Morgan Stanley have claimed this authority to retain or pursue new investments in recent years, Reuters reported last week.
Spokespeople for JPMorgan and the Fed both declined to comment on the letters.
WALL STREET'S WAREHOUSES
The Federal Reserve announced in July that it was reviewing the broader role of Wall Street banks in physical commodity trading amid rising political scrutiny, and fears that so-called "too big to fail" banks may be taking on unnecessary risks by operating oil tankers and power plants.
But it has been tackling the issue for years as Wall Street deepened its collective push into commodity markets, a trend that reached its zenith with JPMorgan's $1.6 billion purchase in 2010 of RBS Sempra, which included Henry Bath.
JPMorgan knew from the outset that the warehouses presented a problem. As a Fed-regulated commercial bank, it did not have the authority to own "non-conforming" assets such as warehouses for longer than a two-year grace period (with three possible one-year extensions). The Fed had already ordered the previous owner, Edinburgh-based Royal Bank of Scotland (RBS.L), to get out of the business of owning commodities storage.
In addition, metals warehousing has drawn attention due to allegations that banks and merchants have tried to game the London Metal Exchange (LME) warehousing rules, deliberately creating bottlenecks for aluminum consumers such as drinks can makers to boost storage income, while raising physical prices.
JPMorgan has long said its Henry Bath customers face no long queues, in contrast to the Metro International Trade Services warehouses operated by Goldman Sachs, where metal owners have to wait as long as a year. Goldman has previously denied Metro was driving up prices or violating any laws.
But JPMorgan has nevertheless been named in a series of class-action lawsuits targeting the industry, and is the subject, alongside other banks and merchants, of a Commodity Futures Trade Commission (CFTC) probe. The Department of Justice is also looking into the matter.
JPMorgan also created controversy in metal markets by trying to launch a physical copper exchange-traded fund for small investors, which would have been backed by metal stored in Henry Bath sheds. Many in the market feared it would artificially tighten supplies and drive up prices.
By early 2012, other metals traders said JPMorgan was directing aluminum supplies into its own warehouses in Rotterdam, Europe's largest port, and in Chicago. Since the late 1980s, Henry Bath has been owned by trading firms that tended to use it primarily as a place to store their own metal rather than rent out space to other companies.
It is not clear what percentage of metal held in Henry Bath was owned by JPMorgan's traders, but it was high enough to alarm the Federal Reserve and to make it difficult for JPMorgan to classify the asset as a strictly passive investment. By law, banks can only claim the so-called "merchant" authority if there is no interconnection between the bank and the business.
Although JPMorgan operated Henry Bath at arm's length on a corporate level, the commercial ties ran deeper, according to a person familiar with the matter.
"Henry Bath has always been a creature of its owners," said an executive at a rival warehousing firm. Prior to JPMorgan and RBS, Henry Bath had been owned by Sempra Commodities, Enron and legendary German trading house Metallgesellschaft.
Despite the apparent obstacles, JPMorgan initially told the Fed it wanted to keep Henry Bath under its merchant authority, which would have allowed it to keep the firm until 2020.
In June 2012, it requested a one-year extension of the grace period to conform the business. But the Fed paused. Instead, after what JPMorgan said were "conversations with (Fed) Board staff", the bank's lawyers submitted a revised request in August, seeking three one-year extensions all at once, with no mention of how it intended to own the business.
Again, the Fed balked, eventually granting just a basic one-year extension that November, and stipulating that the bank must file a detailed road-map on plans to either conform or sell the business, including quarterly updates.
It is not clear why the Fed declined the three-year extension to the grace period, or what occurred during the discussions held during the interim. But the tone suggests a clear shift in approach.
"It seems that long before July they made a decision to sell it because the focus of the letters seemed to shift from conformance to divestiture," said a banking lawyer who reviewed the letters but was not authorized to speak to the press.
By March of this year, it was holding discussions regarding an "outright sale" of the business while also continuing efforts to conform it. JPMorgan was talking to other commodity companies about storing more metal in Henry Bath, in an attempt to "decrease the average percentage" of metals owned by the bank in its 75 warehouses, according to a letter that month.
Just over one month later however, JPMorgan had given up attempting to retain the business as a merchant investment, a letter dated May 1 shows.
JPMorgan's decision to sell Henry Bath this year was made after "internal and external" discussions, said a source familiar with the matter.
RBS had also contemplated seeking to keep Henry Bath as a merchant deal after buying into the Sempra Commodities business in 2008, but ultimately decided that it would be better to divest Henry Bath than hold it at arm's length, according to a person familiar with the decision.
The sources were not authorized to speak to the media.
To be sure, even as the Fed was pressing, the attraction of being in the metals storage business was waning.
The LME was working on a major overhaul of its warehousing policy aimed at appeasing industrial users who have complained about long wait times and inflated prices for their metal. It proposed a series of tougher new rules this July, and beefed up those measures early in November.
Henry Bath reported a profit of just $2.4 million last year, down from $28 million in 2011 mainly due to higher taxes, according to filings with British commercial register, Companies House.
Others are also feeling the heat.
Even though Goldman Sachs and Morgan Stanley have argued that their physical commodity businesses should be grandfathered, both are moving to sell or spin out some parts.
Goldman Sachs executives have publicly said the business remains "core" to its operations, but last week it emerged that the bank would resume talks with parties interested in buying Metro, and was also moving to sell its uranium trading desk.
"JPMorgan and other banks have adjusted their game depending on the playing field," said Saule Omarova, associate professor of law at the University of North Carolina and a visiting professor at Cornell.
"The calculus remains complex. And the economics depend on regulatory decisions."
(Editing by Richard Chang)