Blubber Blubber Oil and Trouble?

Electricity consumers in northern Nevada can expect to pay about $9.25 in basic service charges, and $75.17 for 745 KWH of power per month.  [NVenergy pdf] There are some other charges which would increase a basic monthly power bill to approximately $84.20.   The average price for a gallon of ‘regular’ unleaded gasoline in Nevada is now $3.509. [NGP] So, what is the connection between Wall Street and the price of turning on the air conditioner or filling the gas tank in Nevada?

Electricity and oil are commodities.  Commodities are traded. Derivatives based on the value of the commodities are traded.  The key word here is value.  What’s the value of a barrel of oil? Of a megawatt of power?  So, Nymex Crude futures say the value of a barrel is now $87.43.  [Bloomberg] From Bloomberg’s reporting we know that a megawatt of power (Palo Verde on peak spot) is valued at $29.71 and Ercot Houston is now at $28.92.  [Bloomberg]  If value = price then we know the value of the oil and the megawatt of power.

The factors which affect the price of a barrel of oil or a megawatt of electricity are knowable for the most part, including production costs, transportation costs, personnel costs, and so on.  What is more difficult to assess is the role played by speculation in the energy markets.  This is where the banks come on stage.

If banks are buying and trading oil and electricity these transactions are classified as Physical Commodities, and JPMorgan has been engaging in some physical transactions.  Here’s an example:

In joining private equity firm Carlyle Group to help rescue Sunoco Inc’s Philadelphia plant from likely closure, the Wall Street titan cast its multibillion-dollar physical commodity business as an essential client service, financing inventory and trading on behalf of the new owners. [Reuters]

Sounds good, JPMorgan and the Carlyle Group saved a plant and traded  the physical commodity, in this case oil, on behalf of the new owners of the Philadelphia Sunoco plant.  However, now we get to the sticky part (pun intended.)

Do we want banks to dabble in “physical commodity forwards?”  A physical commodity forward in the simplest possible terms is a non-standardized contract between two parties to buy or sell an asset at a specified future date for a price agreed upon today.   But wait, there’s more.

A commodity forward can also be used to hedge risk (as in interest rate, or exchange rate risk), to allow one party to take advantage of an element of the contract that’s time sensitive, or … (you guessed it) to speculate.  If the commodity forward is a non-standard contract, then how can it be regulated to minimize the systemic risk involved in the speculation, or betting operations, which can devolve from Wall Street’s engagement in the commodity forwards markets?  We’ve had a taste of this during the Credit Crisis of ’08 when exotic derivatives turned into toxic assets.

The Volcker Rule was supposed to prevent bankers from indulging their acquired taste for gambling on a host of non-standard contracts like derivatives, including bets on the prices for commodities — as in electricity and oil.  But, what do we do when the commodity forward isn’t really a swap, because in that type of transaction money but not the actual commodity changes hands, and  what if it’s not really a spot market transaction because the contract is long term?

The Reuters article explains this problem succinctly:

“Unlike a swap, which will be settled between counterparties on the basis of an underlying financial price, a forward will usually turn into a real asset after time. Unlike hard assets, however, the forward contract can be bought or sold months or years before the commodity is produced or stored.”

Now we have transactions which are neither fish nor fowl.  What might be the result if more energy producers outsourced their financing to Wall Street?  There are already three, very familiar, very big players on The Street: JPMorgan, Goldman Sachs, and Morgan Stanley, all three of which received taxpayer relief the last time their derivatives trading went south of Penguin Territory.

Trust But Verify?

The bankers are arguing that there should be no restrictions on commodity forwards because they are acting on behalf of their clients.  Some smaller energy producers and regulators argue that these same contracts and the derivatives thereof could be easily used to trade on price differences without the oil or electricity going anywhere.  The word “evasion” appears in the article.

It would be lovely to be able to take the bankers’ word for it, that they have learned their lessons from 2008 and “repositioned” their books away from commodity gambling activities, and are operating solely for the benefit of their clients.  In that case they could be exempt from the Volcker Rule.

The London Whale couldn’t have been harpooned at a more unfortunate time for the bankers.   Just when, as in the Sunoco example, they might have made their case that they are trading solely on behalf of their clients and with the client’s best interests at heart, the Whale cannon balls into the pool. His haven’t been the only waves.

Tuesday, July 3, 2012: “The Federal Energy Regulatory Commission (FERC) on Monday filed a petition in U.S. federal court to require JPMorgan to produce emails as part of a formal probe into JPMorgan power market bidding practices in those areas.”  [Reuters]

Oh good. No sooner does the wave action abate from the Whale Plunge to $9 billion in potential losses, but the FERC is “formally” probing into power market bidding — making it all the more difficult to sustain the argument that Wall Street bankers should not have to PROVE their transactions are client based because this would be “onerous.”    Additionally, there are still some waves coming from across the pond.

Barclays CEO Robert Diamond resigned in the wake of the LIBOR rate rigging scandal.  [IndepUK] His resignation was bemoaned by some bankers, others were more forthcoming:

Speaking at the FSA’s annual meeting, chairman Lord Adair said the Libor scandal had caused a huge blow to the reputation of the banking industry. “The cynical greed of traders asking their colleagues to falsify their Libor submissions so that they could make bigger profits has justifiably shocked and angered people, in particular when we are facing hard economic times provoked by the financial crisis,” he said. [IndepUK]

These are not the comments one wishes to hear while strenuously arguing that more regulation of commodity trading and other proprietary trading operations are in the “client’s best interest.”

The City of London has been quite proud of its reputation as an “easy” place for financiers to do business.  Politicians were pleased to reign with a “soft touch,” which now seems to be light years distant, while major UK parties try to distance themselves from the Whale and the LIBOR backwash.

Trust is not advanced by having four major UK banks enter into a settlement with the FSA concerning the mis-selling of interest rate swaps to small businesses as a condition of further credit, a mere four days ago.  [BBC] [FSA]  Nor is trust earned by having the Whale, the LIBOR, and the Interest Rate Swaps, coming a year after the resolution of the PPI scandal. [Risk]  The British Bankers Association might now be wishing that there had been at least an pine fist inside the velvet glove of oversight and regulation?  That might have spared the bankers this ringing attack from the FSA:

“There are no free lunches, and shoddy wholesale practice is not a victimless act, even in those cases where it is not defined as a crime,” Turner said today. Banks and regulators must determine “how to purge the industry of the culture of cynical entitlement which was far too prevalent before the crisis.” [BusWeek]

Lest we take any comfort in the notion that all the icky stuff resulting from a “culture of cynical entitlement” takes place Over There, British banks weren’t the only ones being investigated in the LIBOR mess.  The traders involved were based in both London and New York; the City of Baltimore, Maryland filed a lawsuit, as did Charles Schwab in California, and the investigations and litigation don’t stop there.

“At least 16 of the world’s biggest banks, including UBS, Deutsche Bank, Citigroup, HSBC, RBS and Lloyds, are likely to be looked at by the FBI or other US federal agencies. As well as Britain and the US, investigations are taking place in other European countries, Japan, Canada and Singapore.”  [DailyMail]

If trust were a commodity, trust prices in the global banking system would be sinking.   While the bankers are displaying their  “culture of cynical entitlement,” they are simultaneously asking the American public and U.S. regulators to “trust” them not to use commodity forwards in ways to evade oversight and hide questionable transactions. We are asked to take their words at face value that they are working only for the betterment of our economy and the benefit of their clientele.

We’re left to ask: How much of what they are saying is Whale Oil, and how much is Blubber?

Word Salad Shooting At The Volcker Rule

The Big Banks don’t like the Volcker Rule.   For reference, and so we’re all talking about the real thing, here’s the little culprit: The Volcker Rule “separates investment banking, private equity and proprietary trading (hedge fund) sections of financial institutions from their consumer lending arms. Banks are not allowed to simultaneously enter into an advisory and creditor role with clients, such as with private equity firms. The Volcker rule aims to minimize conflicts of interest between banks and their clients through separating the various types of business practices financial institutions engage in.”  [investopedia]

Prepping

We can simplify this further.  A bank, insured by the FDIC, may not combine their proprietary trading activities with their consumer lending ones.   And, why do we need the Volcker Rule?

“The Volcker Rule seeks to keep activities essential to banking within a safety net, while excluding other, riskier, activities from this safety net. There are a variety of special regulations, and protections, banks get, ranging from federal deposit insurance (known as FDIC) to access to the Federal Reserve’s discount borrowing window, designed to keep the system working through panics. Banks currently engage in a wide variety of non-banking activities with safety net protection. For example, they speculate in currencies and run hedge funds and proprietary trading desks for their own benefit. These activities made the financial crisis worse; one estimate has the major Wall Street firms suffering $230 billion dollars in prop trading losses a year into the crisis. And right now, these activities are subsidized by access to the banking safety net.”  [Nation]

So, the message to the Big Banks is relatively clear:  Your consumer lending activities on behalf of your clients are covered by the “safety net” (FDIC coverage or access to the Fed’s discount window) BUT your hedge funds and proprietary trading desks aren’t.

Slicing and Dicing

Opponents of the implementation of the Volcker Rule make some basic points, all of which deserve more scrutiny.  (1) They argue that the rule making process is creating “uncertainty” because we don’t know what the final rules will be.  The word “tautology” comes to mind because this argument circles back on itself nicely, as in ‘ we can’t make rules because while we’re drafting the rules we don’t know what the rules are.’  If we applied this argument to any other phase of life there would never have been any rules.

Here is an example of the tautological thinking:

“Since neither the banks nor the regulators have any idea what the final regulations will say, they will have no idea what constitutes good faith efforts to comply. Because of the continuing confusion and its effects on the financial system, Congress should immediately begin a serious re-examination of the Volcker Rule’s likely effect both in this country and abroad and repeal it as quickly as possible.”  [Heritage]

Why bother to “seriously re-examine” the rule if the initial purpose is to quickly repeal it?  Imagine for a moment waiting for Moses to return from the mountain.  If our moral judgments aligned with the Uncertainty Proponents we’d not necessarily know that we shouldn’t dispatch each other because we’d have to know in advance if the Almighty intended to incorporate justifiable homicides or excusable homicides, manslaughters or negligent homicides, within the proscription of killing each other — and, further, we couldn’t have a Rule until all of these nuances had been properly phrased and found to be acceptable to all the stakeholders.

(2) A more cogent argument against devising regulations pertaining to the Volcker Rule asks:  How do specific short term banking services apply to the separation of traditional banking and modern client services?   At this point we get into the “liquidity” swamp.

Suppose the executives of SlamBang Corp. want to purchase some stocks for the purpose of generating some revenue for the firm by going to its banker and asking the bank to make the purchase, hold on to the stocks, and if the price of the stocks goes up then selling the stocks, and returning the proceeds of the sale to the SlamBang Corp?  (Less, of course, the fees, commissions, etc. for the bank)  Would this be a violation of the Volcker Rule?

Now we’ve waded into the edges of the Liquidity Swamp, liquidity being “The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets.”   And, our next step takes us into “leverage.”

Leverage means the extent to which a company is operating on borrowed money.   The good news is that if the company isn’t too far in debt it will be financially stable and lenders will want to make loans to it for a variety of very legitimate purposes.  The bad news is that if it’s as underwater as a Sand State homeowner with a NINJA loan it will be bankrupt, and no one will want to lend the corporation another nickel.  (Think Lehman Brothers)

Life can get messy if and when the SlamBang Corp. gets its revenue from making something tangible AND from making speculative bets in the equities markets — with borrowed money (like asking the bank to hold on to the “stuff” it bought until the price goes up.)  The more the SlamBang Corp. is leveraged — borrowing money to make money — the riskier the entire proposition.  Where will our SlamBang Corp. go to borrow more money to make more money?

Bankers, having set up sizable trading desks, or having once been one big trading desk (Goldman Sachs), were only too happy to transform themselves into bank holding companies for the benefit of their very own social safety net (FDIC coverage, Fed Discount Window, etc.) when they were collapsing like Macy’s Thanksgiving Day Parade balloons in a shooting gallery — now that they have returned to profitability they aren’t the least bit interested in returning to “core banking activities,” and divesting themselves of the revenue generating proprietary trading functions.

Re-enter the financial officers of the SlamBang Corp.  into the lobby of the Big Bank.  Under the terms of the Volcker Rule the Big Bank may not act BOTH as their adviser AND their creditor.  What Big Bank fears at this point is that SlamBang Inc. will take its “speculation in liquid assets for the purpose of leveraging its position” elsewhere, to a private equity or hedge fund for example.

It’s important to notice at this point that SlamBang Corp. isn’t hurt by the Rule, it can easily send its business to an alternative source of credit or financial services — it’s the Big Bank that wants a fork in every plate on the table.    Advocates of Big Bank say:

“The situation becomes even more confused if the bank serves as a “market maker” for a security. A market maker plays a vital role in ensuring the efficient running of financial markets by both buying and selling that security so that others can be assured of buying and selling opportunities, an activity that requires the bank to own a certain inventory of the security.” [Heritage]

Translation:   Banks are now market-makers and market-makers have to own securities in order to be market-makers.   The problem for our economic system is that when the “markets” are made by the banks, and those “markets” are extraordinarily speculative, AND the Big Banks expect the FDIC or the Fed to rescue them if the speculation goes south — then how best can we sustain the traditional functions of our financial sector in a capitalist system without allowing the Big Banks to put us all in jeopardy?

The Volcker Rule.