Commodities are Different (In a “Full World”): Part 3

(This post is the third in an occasional series on why stronger oversight of commodity markets must be a public policy priority.)

JPMorgan has announced that it plans to exit the physical commodities businesses, while remaining committed to its historic roots in commodity financing and risk management, and to the precious metals business.  Is this Jamie Dimon recognizing an unstoppable paradigm shift now taking place in the financial sector as policymakers finally find the political will to reign in the power of too big to fail banks?

This announcement comes in the wake of market manipulation accusations by the Federal Energy Regulatory Commission against Wall Street commodity dealers, including Barclays, which was ordered to pay a $487.9 million fine, and JPMorgan, where a $500 million settlement is rumored.  Barclays denies wrong-doing and said it would fight the penalties.

Stunning how half a billion-dollar settlements no longer elicit a reaction.

JPMorgan’s decision also follows the extraordinary New York Times expose of Goldman Sachs’s alleged manipulation of the aluminum markets.  Senator Sherrod Brown, invoking Louis Brandeis’s warning against the unchecked power of Trusts a century ago, opened a Senate subcommittee hearing on the role of banks in the commodities markets just last week.  Clearly, this issue is finally getting the attention it deserves.

Commodity market manipulation is fundamentally different and far more dangerous than the garden-variety manipulation of financial markets such as in single stock pump and dump schemes, or even the brazen manipulation of LIBOR.  Nobody eats LIBOR.

The most important consideration here is the macro context.  It’s the context of a world heading into increasing shortages of natural resources, and anticipated climate-induced shortages of agricultural commodities, that makes this an urgent public policy issue well beyond the now all too familiar need to police bad behavior on Wall Street.  This time is different.

The second most important consideration here is scale.  Just as an oil tanker entering a busy port poses a different kind of threat than the oil tank in a pleasure boat, a TBTF bank, leveraging massive taxpayer subsidies with control of material physical commodity infrastructure such as power plants and oil terminals, poses a different kind of market manipulation threat than the private commodity merchants of days gone by.

We have a toxic mix on our hands—a combination of increasing physical resource scarcity (resulting from the demands on the earth’s physical resources of a finance-driven economy relentlessly pursuing exponential growth), increasing concentrations of power and conflicts of interest, the well-documented shady behavior of certain commodity market participants, and ongoing ethical deficiencies on Wall Street.  It is an accident waiting to happen with widespread casualties, limited primarily by the self-imposed restraint of those in positions of power.  Not comforting.

Our natural response will be for more and better regulation—good in theory, very difficult in practice.  Commodity markets are notoriously arcane, idiosyncratic, devoid of the concept of illegal inside information, and highly subject to manipulation due to their physical nature.  Only the hard medicine of structural reform can cure the disease.

What we need in addition to more comprehensive and effective regulatory oversight is a fresh look at the Sherman Antitrust Act.  Heavily criticized by Alan Greenspan and other free-market ideologues, the concept of antitrust is due for a resurrection.  In 1890, the Republican Senator from Ohio’s concern about concentration of power was driven by his desire to protect consumers from monopolistic price increases.  Contemporary concerns regarding unhealthy and uncompetitive concentrations of power are more complex, driven primarily by advances in technology, the mobility of capital across global markets, information asymmetries, conflicts of interest, and the interconnectedness of markets and risks.  These concerns and the ever-greater concentration of corporate power demand a new look at our anti-competition laws.

Senator Brown, also from Ohio, is rightly focusing on what role FDIC-insured banks should be playing, if any, in physical commodity markets.  His timing is good and he should press.  The Federal Reserve is “currently reviewing the 2003 determination that certain commodity activities are complementary to financial activities and thus permissible for bank holding companies.”

The Davis Polk attorney’s attempt to make a plausible theoretical case for bank involvement in physical commodities at Senator Brown’s hearing sounded much like the arguments I made to regulators back in 1995 when I ran JPMorgan’s Commodities business.  However he spoke so matter-of-factly as if in the intervening years the following events never happened:  the collapse of Bear Stearns, Lehman, AIG, Merrill Lynch, Countrywide, Fannie and Freddie, and the systematic mortgage fraud behind these failures; the ensuing global recession, the Eurozone crisis, the bankruptcy of GM and Chrysler, TARP and numerous other system bailouts; the ongoing expansion of central bank balance sheets by $7 Trillion; robo-signing fraud, Abacus-like securities designed to blow up; the Jefferson County bankruptcy; the LIBOR scandal; the London Whale debacle; and let’s not forget the Madoff Ponzi scheme.

A paradigm shift occurs when the belief system within which a system operates no longer applies.  We are witnessing a paradigm shift in finance.  Finally.  The belief system that says just because an activity might be “complementary” to existing financial activities it should be allowed may be coming to an end.

Instead, the new paradigm or belief system says the TBTF banks that have profoundly failed society with long-lasting and dire consequences must finally be checked.  They must not be allowed to engage in unnecessary activities like physical commodity trading, filled with conflicts of interest and opportunities to manipulate vital strategic markets, and which are inherently proprietary and therefore in violation of Dodd-Frank.  And although it may have seemed like a good idea in the now-bankrupt old paradigm, we will soon re-examine whether we want these institutions in the securities business.  (On this issue, Senators Warren and McCain recently introduced a bill that would re-create the Glass-Steagall Act, separating commercial banking from investment banking.)

Before we are done, it is likely that we will be debating why we give banks, responsible or not, the sole authority to create money for the economy.  Yes, it is the banks, not the government that create the money supply and direct what that new money is used for.   As private corporations, they understandably allocate credit as it best suits their private interests.  This means lending first to Stephie Cohen’s criminal hedge fund enterprise because the associated trading commissions are so big and profitable before more labor-intensive lending to the Main Street economy, which is less profitable but more valuable.

With his decision to exit the physical commodity markets, perhaps Jamie Dimon is beginning to feel the paradigm-shifting under his feet, a shift leading to the end of TBTF.  Or then again, perhaps it’s just part of a calculated settlement to keep the FERC investigation from getting too close to home.  Either way, I suspect he and his friend Mr. Blankfein are beginning to hear Dylan in the background:

Then you better start swimmin’

Or you’ll sink like a stone

For the times they are a-changin’.