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Insight: As banks deepen commodity deals, Volcker test likely

By David Sheppard and Alexandra Alper
NEW YORK/WASHINGTON | Tue Jul 3, 2012 1:28am EDT

(Reuters) – The subtext of JPMorgan‘s landmark deal to buy crude and sell gasoline for the largest oil refinery on the U.S. East Coast was barely disguised.

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.

This was about helping conclude a deal that would preserve jobs and avert a potential fuel price spike during the heat of an election year summer — not another risky trading venture after the more than $2 billion ‘London Whale’ loss.

But the deal also highlights a largely overlooked clause in the Volcker rule that threatens to squeeze banks out of physical markets if applied strictly by regulators, one that JPMorgan and rivals like Morgan Stanley have been quietly fighting for months.

While it has long been known the Volcker rule will ban banks’ proprietary trading in securities, futures, and other financial tools like swaps, a draft rule released in October cast a net over commercial physical contracts known as ‘commodity forwards’, which had previously been all but exempt from financial oversight.

The banks say that physical commodity forwards are a world away from the exotic derivatives blamed for exacerbating the financial crisis. A forward contract in commodities exists somewhere in the gray area between a derivative like a swap – which involves the exchange of money but not any physical assets – and the spot market, where short-term cash deals are cut.

Banks say they are also essential to conclude the kind of deal that JPMorgan lauded on Monday.

“JPMorgan’s comprehensive solution, which leverages our physical commodities capabilities… demonstrates how financial institutions with physical capabilities can prudently, yet more effectively, meet our clients’ capital needs,” the bank said in a press release.

But regulators say they are keen to avoid leaving a loophole in their brand new rule, named after former Federal Reserve Chairman Paul Volcker, that could allow banks to shift high-stakes trades from financial to physical markets.

“We intended the Volcker Rule to prohibit a broad swath of risky bets, including bets on the prices of commodities,” said Democratic Senator Carl Levin, who helped draft the part of the 2010 Dodd-Frank financial reform law that mandates the proprietary trading ban.

“The proposed Volcker Rule should cover commodity forwards because those instruments often constitute a bet on the future prices of commodities.”

In the latest example of a refining company outsourcing its trading operations to Wall Street, JPMorgan will not only provide working capital for the joint venture between Carlyle Group and Sunoco Inc, but will also operate a ‘supply and offtake’ agreement that has the bank’s traders shipping crude oil from around the world to the plant, then marketing the gasoline and diesel it makes.

If the rule is finalized as it stands the question will turn on whether banks can convince regulators that their physical deals are only done on behalf of clients, making them eligible for an exemption from the crackdown.

BANKS GET PHYSICAL

Over the last decade Wall Street banks quietly grew from financial commodity traders into major players in the physical market of crude oil cargoes, copper stockpiles and natural gas wells, often owning and operating vast assets too.

Bankers argue that forward contracts are necessary if they are to help refineries like Philadelphia curb costs and free up capital, to help power plants to hedge prices, or to let metals producers and grain farmers finance storage.

Forwards are essentially contracts to buy or sell a certain amount of a physical commodity at an agreed price in the future. Their duration can range from a few days to a number of years.

“To pull forwards into the Volcker rule just because someone has a fear that they could, in some instances, be used to evade the swap rules is just ridiculous,” one Wall Street commodities executive said.

“We move oil all over the world. We have barrels in storage. They are real, not just things on paper. They go on ships and they go to refineries. It is basically equating forwards with intent for physical delivery as swaps – and they’re not.”

She added: “You can’t burn a swap in a power plant.”

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.

Historically the physical commodity markets have remained beyond financial regulatory supervision and forwards are not mentioned specifically in the part of the 2010 Dodd-Frank law that mandates the drafting of the Volcker rule.

But the drafters of Dodd-Frank say it was always their aim to prevent banks that receive government backstops like deposit insurance from trading for their own gain. They worry that banks could quickly boost trading for their own book in forward markets rather than purely for the benefit of clients.

“The issue is the potential for evasion,” said one official at the Commodity Futures Trading Commission (CFTC) who was not authorized to speak on the matter. He said traders could easily buy and sell the same commodity forward contract, profiting on the price difference, without the goods ever changing hands.

It would be a useful tool “if you want to hide activities or evade margin requirements,” he added.

RISKY BET OR HARMLESS HEDGE?

Kurt Barrow, vice president at IHS Purvin & Gertz in Houston and lead author of a Morgan Stanley-commissioned report on the impact of the Volcker rule on banks’ commodity businesses said deals like JPMorgan’s with Carlyle and Sunoco could be in jeopardy.

“One of the problems with Volcker is the way it is written assumes that every trade the banks make is in violation of it, and then they have to go through a series of steps to prove that it’s not,” Barrow said.

“If the banks have physical obligations they need to hedge, like in supply and off-take agreements with refineries, there are already concerns that they could be seen to be in violation of the Volcker rule. The rules are geared toward equity trading and don’t take account of how commodity markets really work.”

Goldman Sachs and Morgan Stanley, which alongside JPMorgan dominate physical commodity trading on Wall Street, also take part in supply and offtake agreements with independent refiners.

Without leeway to trade forward contracts, banks would have little reason to retain the metal warehouses, power plants, pipelines, and oil storage tanks that are the crown jewels of their commodity empires.

The future of those assets is already in question as the Federal Reserve must soon decide if banks backstopped by the government will be allowed to retain those assets indefinitely.

In the years preceding the financial crisis, major banks were at times booking as much as a fifth of their total profits from their commodity trading expertise, but drew criticism they could combine their physical market knowledge with huge balance sheets to try and push prices in their favor.

That criticism has resurfaced this year.

“Americans are already paying heavily at the pump for excessive speculation in the oil markets,” Senator Jeff Merkley, who co-authored the Volcker provision with Senator Levin, told Reuters.

“The last thing they need is more of that speculation and risk-taking, especially when it would not only drive gas prices even higher but could also contribute to another 2008-style meltdown.”

NO FORWARDS, NO PHYSICAL, NO SERVICE

The inclusion of forwards in the proposed Volcker rule has created concern beyond Wall Street. Some industry groups argue banks have become so embedded in the structure of both financial and physical commodity markets that they are now key trading partners for a wide range of firms.

“We were surprised,” said Russell Wasson at the National Rural Electric Cooperative Association (NRESCA). “To us they are straightforward business contracts because they’re associated with physical delivery. They’re being treated as derivatives when they never have been before.”

The concerns are the same as with other aspects of the Dodd-Frank reforms, the biggest overhaul of financial regulation since the Great Depression: tough new limits will reduce liquidity, thereby increasing market volatility and hedging costs.

The Volcker rule does include key exemptions to allow banks to hedge risk and make markets for clients.

But some commodities experts say proving that forwards fit into these categories may be too onerous to be helpful.

University of Houston professor Craig Pirrong, an expert in finance and energy markets who has generally argued against the proposed regulation, said he was skeptical of the hedging exemption’s utility, and was sure regulators would take a tough line in the wake of JPMorgan’s recent losses.

“They will have to provide justification that these (commodity forwards) are hedges or entered into as part of their “flow” business with customers,” he said.

“In the post-Whale world, banks are on the defensive and I would not bet on them prevailing on an issue like this.”

Banking executives say they are now desperate to convince skeptical regulators that their physical arms have been transformed into purely market making and client facing businesses.

“Banks have been working to reposition their commodities business… under the assumption that physical markets would be covered by Volcker,” one senior Wall Street commodities executive said.

“Several banks shut down their proprietary trading about two years ago in anticipation of this. The argument that physical commodity markets will present some kind of Volcker loophole for banks is false.”

(Reporting By David Sheppard; Editing by Bob Burgdorfer)

Is JPM “The Burning LOH”?

https://i1.wp.com/www.mcoscillator.com/data/charts/weekly/T-Bonds_1993-2012.gif

May 11, 2012

“The target is marked by the burning LOH.”

When I was an reconnaissance helicopter pilot in the Army many years ago, that was a popular saying that was passed down by the more experienced pilots, some of whom had flown during the Vietnam War.  It was meant to convey our own frailty, and the foolishness of being too eager about finding the enemy’s location.

LOH back then stood for Light Observation Helicopter, either a Hughes OH-6 Cayuse or a Bell OH-58.  It was pronounced as “loach”.  They were 4-seat commercial helicopters that were bought by the Army and adapted for use in scouting for enemy forces.  A pilot had little more than his eyes and his wits as weapons, and the .040″ aluminum skin and Plexiglas windows were not much protection from enemy fire.  The idea was to fly low, using the terrain for cover and concealment, and try to find the enemy so that fighter planes or attack helicopters could be called in to deliver ordinance on the enemy’s position.

But given the fact that enemy soldiers are usually not stupid, and don’t want to be spotted, often the first indication that a pilot had located the enemy’s position was that he was taking fire from the enemy.  A lot of them got shot down.  So then another helicopter crew would step in to radio the fast movers and guide them into the target.  The fighter pilots would acknowledge that call, and the existence of enemy fire in the area, and then ask:

“Roger, how is the target marked?”  The question was about the possible use of colored smoke, landmarks, or other features that can be seen while zooming in at 500 MPH.

And the answer would be, “The target is marked by the burning LOH.”

There is a corollary to this in the financial markets.  Quite often at the end of a big price move, we learn about a big institution blowing up because they did not think that the trade would go so far against them.  The 2006 case of Amaranth Advisors would be a classic example, with its bankruptcy in late 2006 marking the bottom for natural gas prices ahead of the big commodity bubble in 2008.  There were several portfolios that blew up at the top of that bubble.

In this week’s chart, I have labeled several notable news events that served as markers of important turns for T-Bond prices.  Back in 1994, Orange County, California went bankrupt because its treasurer, Robert Citron, had overextended his bets the wrong way in the bond market.  That bankruptcy marked the bottom for the big price decline.  Orange County was the burning LOH.

In late 1998, the money management firm Long Term Capital Management (LTCM) famously made huge bets on T-Bonds that were based on the limits of how far price moves had historically gone in the past.  And the market taught them a lesson about how trends can persist longer than one can stay solvent.  The Federal Reserve had to intervene, lining up several major banks to help take apart LTCM’s positions and keep it from cascading into a bigger problem.  LTCM’s collapse was the burning LOH for that up move.

More recently, the collapses of Bear Stearns, Lehman Brothers, and MF Global each coincided with peaks in bond prices.  Each was the burning LOH for its particular moment in history.

So now this week, we find out that J.P. Morgan Chase (NYSE:JPM) has suffered a $2 billion loss on financial derivative bets that went bad.  And this news comes as T-Bond prices are once again getting back up to the price levels seen at last year’s MF Global collapse.  The implication is that the news of JPM’s big loss is serving as the “burning LOH” of this current time frame, and the news arrives just as the stock market is about at the end of the corrective period suggested by both our eurodollar COT leading indication and the Presidential Cycle Pattern.  Subscribers to our twice monthly newsletter and our Daily Edition have been watching the current stock market correction unfold pretty much right on schedule relative to those models, and now we have a portfolio blowup to help mark the beginning of the end of that corrective process.

Tom McClellan
Editor, The McClellan Market Report

Bernanke Knows Europe Is Out Of Options And On The Verge Of Collapse

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By Phoenix Capital Research  
 Market Overview 
Apr 08, 2012 09:22AM GMT

Having finished his “damage control” PR campaign (for now) Ben Bernanke decided to discuss… Europe, urging the Big Banks to help prop up the system over there.

Exclusive: Bernanke breaks bread with top bankers
After completing a series of public lectures in Washington, D.C. last week, Federal Reserve Chairman Ben Bernanke quietly slipped into New York City for a private luncheon on Friday with Wall Street executives.

Fortune has learned that attendees included Jamie Dimon (J.P. Morgan), Bob Diamond (Barclays), Brady Dougan (Credit Suisse), Larry Fink (Blackrock), Gerald Hassell (Bank of New York Mellon), Glenn Hutchins (Silver Lake), Colm Kelleher (Morgan Stanley), Brian Moynihan (Bank of America), Steve Schwarzman (Blackstone Group) and David Vinar (Goldman Sachs).

Sources say Bernanke spoke at length about monetary policy, in an apparent effort to persuade attendees that they needed to take a more active role in helping to deal with the European debt crisis. He spent virtually no time discussing regulation, although that mantle got taken up by both Dimon (domestic regulation) and Schwarzman (global regulation).

The lunch was held at the New York Fed, and hosted by NY Fed president William Dudley. Before leaving New York, Bernanke separately addressed NY Fed staffers.

http://finance.fortune.cnn.com/2012/04/04/exclusive-bernanke-breaks-bread-with-top-bankers/

This is an interesting progression from the last time Fed officials went to New York:

Fed met with major financial firms to discuss Volcker Rule impact

Documents released by the Federal Reserve on Monday show that its officials met with some of Wall Street’s major financial firms earlier this month to discuss Volcker Rule implications.

The Fed met with representatives from Goldman Sachs, JPMorgan Chase and Morgan Stanley on Nov. 8, according to Bloomberg.com. Bank lawyers H. Rodgin Cohen and Michael Wiseman from Sullivan & Cromwell were also present during the meeting.

According to the documents, the meeting entailed a discussion on “possible unintended consequences of the rule.”

http://bankcreditnews.com/news/fed-met-with-major-financial-firms-to-discuss-volcker-rule-impact/2773/

Notice that during discussions of regulations, it was “Fed officials” who attended these meetings, NOT Bernanke himself (at least he’s not mentioned anywhere). So why is Bernanke, the head of the Fed wanting to meet with bankers to discuss Europe instead of Regulation?

You guessed it: Bernanke realizes Europe is totally and completely bust… and that the coming fall-out will be disastrous for the global banking system.

After all, the ECB spent over $1 trillion trying to prop up the system over there. And already the effects of LTRO 2 (which was worth $712 billion) have been wiped out. If you don’t think this sent a chill up Bernanke’s spine, you’re not thinking clearly.

Consider the following facts which I guarantee you Bernanke is well aware of:

  • 1) According to the IMF, European banks as a whole are leveraged at 26 to 1 (this data point is based on reported loans… the real leverage levels are likely much, much higher.) These are a Lehman Brothers leverage levels.
  • 2) The European Banking system is over $46 trillion in size (nearly 3X total EU GDP).
  • 3) The European Central Bank’s (ECB) balance sheet is now nearly $4 trillion in size (larger than Germany’s economy and roughly 1/3 the size of the ENTIRE EU’s GDP). Aside from the inflationary and systemic risks this poses (the ECB is now leveraged at over 36 to 1).
  • 4) Over a quarter of the ECB’s balance sheet is PIIGS debt which the ECB will dump any and all losses from onto national Central Banks (read: Germany)

So we’re talking about a banking system that is nearly four times that of the US ($46 trillion vs. $12 trillion) with at least twice the amount of leverage (26 to 1 for the EU vs. 13 to 1 for the US), and a Central Bank (the ECB) that has stuffed its balance sheet with loads of garbage debts, giving it a leverage level of 36 to 1.

I guarantee you Bernanke knows about all of the above. He also knows the ECB’s used up all of its ammunition fighting the Crisis over there. And lastly, he knows that the Fed cannot move to help Europe without risking his job. After all, even the Dollar swap move the Fed made in November 2011 saw severe public outrage and that didn’t even include actual money printing or more QE!

Moreover, Bernanke knows that the IMF can’t step up to help Europe. The IMF is, after all, a US-backed entity. How many times has it requested more money to help Europe? Maybe a dozen? And the answer from the US has always been the same: “No.”

Finally, the G20 countries have made it clear they don’t want to spend more money on Europe either. They keep dangling a bailout carrot in front of the EU claiming they’ll cough up more dough if the EU can get its monetary house in order… knowing full well that they actually cannot provide more funds (otherwise they’d have already done it).

This leaves the private banks as Bernanke’s last resort for a “backdoor” prop for Europe. If private meeting with the TBTFs that focuses on Europe doesn’t scream of desperation, I don’t know what does.

And do you think the big banks, which have all depleted their capital to make their earnings look better, actually have the money to help Europe? No chance.

Which means that Europe is going to collapse. Literally no one has the firepower or the political support to stop it.

Remember, we’re talking about banking system that’s a $46 trillion sewer of toxic PIIGS debt that is leveraged at more than 26 to 1 (Lehman was leveraged at 30 to 1 when it went under).

Again, NO ONE has the capital to prop the EU up much longer. And the collapse is coming.

If you’re not already taking steps to prepare for the coming collapse, you need to do so now.

Source

Top Justice officials connected to mortgage banks

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By Scot J. Paltrow
Fri Jan 20, 2012 9:31am EST

(Reuters) – U.S. Attorney General Eric Holder and Lanny Breuer, head of the Justice Department’s criminal division, were partners for years at a Washington law firm that represented a Who’s Who of big banks and other companies at the center of alleged foreclosure fraud, a Reuters inquiry shows.

The firm, Covington & Burling, is one of Washington’s biggest white shoe law firms. Law professors and other federal ethics experts said that federal conflict of interest rules required Holder and Breuer to recuse themselves from any Justice Department decisions relating to law firm clients they personally had done work for.

Both the Justice Department and Covington declined to say if either official had personally worked on matters for the big mortgage industry clients. Justice Department spokeswoman Tracy Schmaler said Holder and Breuer had complied fully with conflict of interest regulations, but she declined to say if they had recused themselves from any matters related to the former clients.

Reuters reported in December that under Holder and Breuer, the Justice Department hasn’t brought any criminal cases against big banks or other companies involved in mortgage servicing, even though copious evidence has surfaced of apparent criminal violations in foreclosure cases.

The evidence, including records from federal and state courts and local clerks’ offices around the country, shows widespread forgery, perjury, obstruction of justice, and illegal foreclosures on the homes of thousands of active-duty military personnel.

In recent weeks the Justice Department has come under renewed pressure from members of Congress, state and local officials and homeowners’ lawyers to open a wide-ranging criminal investigation of mortgage servicers, the biggest of which have been Covington clients. So far Justice officials haven’t responded publicly to any of the requests.

While Holder and Breuer were partners at Covington, the firm’s clients included the four largest U.S. banks – Bank of America, Citigroup, JP Morgan Chase and Wells Fargo & Co – as well as at least one other bank that is among the 10 largest mortgage servicers.

DEFENDER OF FREDDIE

Servicers perform routine mortgage maintenance tasks, including filing foreclosures, on behalf of mortgage owners, usually groups of investors who bought mortgage-backed securities.

Covington represented Freddie Mac, one of the nation’s biggest issuers of mortgage backed securities, in enforcement investigations by federal financial regulators.

A particular concern by those pressing for an investigation is Covington’s involvement with Virginia-based MERS Corp, which runs a vast computerized registry of mortgages. Little known before the mortgage crisis hit, MERS, which stands for Mortgage Electronic Registration Systems, has been at the center of complaints about false or erroneous mortgage documents.

Court records show that Covington, in the late 1990s, provided legal opinion letters needed to create MERS on behalf of Fannie Mae, Freddie Mac, Bank of America, JP Morgan Chase and several other large banks. It was meant to speed up registration and transfers of mortgages. By 2010, MERS claimed to own about half of all mortgages in the U.S. — roughly 60 million loans.

But evidence in numerous state and federal court cases around the country has shown that MERS authorized thousands of bank employees to sign their names as MERS officials. The banks allegedly drew up fake mortgage assignments, making it appear falsely that they had standing to file foreclosures, and then had their own employees sign the documents as MERS “vice presidents” or “assistant secretaries.”

Covington in 2004 also wrote a crucial opinion letter commissioned by MERS, providing legal justification for its electronic registry. MERS spokeswoman Karmela Lejarde declined to comment on Covington legal work done for MERS.

It isn’t known to what extent if any Covington has continued to represent the banks and other mortgage firms since Holder and Breuer left. Covington declined to respond to questions from Reuters. A Covington spokeswoman said the firm had no comment.

Several lawyers for homeowners have said that even if Holder and Breuer haven’t violated any ethics rules, their ties to Covington create an impression of bias toward the firms’ clients, especially in the absence of any prosecutions by the Justice Department.

O. Max Gardner III, a lawyer who trains other attorneys to represent homeowners in bankruptcy court foreclosure actions, said he attributes the Justice Department’s reluctance to prosecute the banks or their executives to the Obama White House’s view that it might harm the economy.

But he said that the background of Holder and Breuer at Covington — and their failure to act on foreclosure fraud or publicly recuse themselves — “doesn’t pass the smell test.”

Federal ethics regulations generally require new government officials to recuse themselves for one year from involvement in matters involving clients they personally had represented at their former law firms.

President Obama imposed additional restrictions on appointees that essentially extended the ban to two years. For Holder, that ban would have expired in February 2011, and in April for Breuer. Rules also require officials to avoid creating the appearance of a conflict.

Schmaler, the Justice Department spokeswoman, said in an e-mail that “The Attorney General and Assistant Attorney General Breuer have conformed with all financial, legal and ethical obligations under law as well as additional ethical standards set by the Obama Administration.”

She said they “routinely consult” the department’s ethics officials for guidance. Without offering specifics, Schmaler said they “have recused themselves from matters as required by the law.”

Senior government officials often move to big Washington law firms, and lawyers from those firms often move into government posts. But records show that in recent years the traffic between the Justice Department and Covington & Burling has been particularly heavy. In 2010, Holder’s deputy chief of staff, John Garland, returned to Covington, as did Steven Fagell, who was Breuer’s deputy chief of staff in the criminal division.

The firm has on its web site a page listing its attorneys who are former federal government officials. Covington lists 22 from the Justice Department, and 12 from U.S. Attorneys offices, the Justice Department’s local federal prosecutors’ offices around the country.

As Reuters reported in 2011, public records show large numbers of mortgage promissory notes with apparently forged endorsements that were submitted as evidence to courts.

There also is evidence of almost routine manufacturing of false mortgage assignments, documents that transfer ownership of mortgages between banks or to groups of investors. In foreclosure actions in courts mortgage assignments are required to show that a bank has the legal right to foreclose.

In an interview in late 2011, Raymond Brescia, a visiting professor at Yale Law School who has written about foreclosure practices said, “I think it’s difficult to find a fraud of this size on the U.S. court system in U.S. history.”

Holder has resisted calls for a criminal investigation since October 2010, when evidence of widespread “robo-signing” first surfaced. That involved mortgage servicer employees falsely signing and swearing to massive numbers of affidavits and other foreclosure documents that they had never read or checked for accuracy.

Recent calls for a wide-ranging criminal investigation of the mortgage servicing industry have come from members of Congress, including Senator Maria Cantwell, D-Wash., state officials, and county clerks. In recent months clerks from around the country have examined mortgage and foreclosure records filed with them and reported finding high percentages of apparently fraudulent documents.

On Wednesday, John O’Brien Jr., register of deeds in Salem, Mass., announced that he had sent 31,897 allegedly fraudulent foreclosure-related documents to Holder. O’Brien said he asked for a criminal investigation of servicers and their law firms that had filed the documents because they “show a pattern of fraud,” forgery and false notarizations.

(Reporting By Scot J. Paltrow, editing by Blake Morrison)

Source

JP Morgan Managed to Get Its MF Global Money Before Bankruptcy

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Dino Grandoni

Those farmers, traders, and other assorted customers of busted trading firm MF Global probably won’t like hearing the news that JP Morgan got money it was owed, on the day before it filed for bankruptcy, The New York Times reports. And even worse in the hunt for the missing $1 billion in customer funds after the collapse of former New Jersey governor and Goldman Sachs CEO Jon Corzine‘s trading firm, The Times reports that the  “roughly $200 million that JPMorgan Chase received is said to be entirely customer money.” There were other transfers to other, unspecified trading partners on October 28, the day before MF Global filed its bankruptcy papers, as well, the paper reports. Meanwhile, customers have only gotten back a third of their money and are short roughly $1.2 billion. For its part, JP Morgan apparently questioned the source of the money itself, asking for assurances that it wasn’t coming from customers (which it didn’t get).

Source

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