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Insight: Wall Street uses 'merchant' workaround to cling to commodity assets

Traders work just before the end of trading for the day on the floor of the New York Stock Exchange, November 18, 2013. REUTERS/Lucas Jackso
Traders work just before the end of trading for the day on the floor of the New York Stock Exchange, November 18, 2013. REUTERS/Lucas Jackso

By Jonathan Leff and David Sheppard

NEW YORK/LONDON (Reuters) - Wall Street's commodity trading giants are using a 14-year-old law to hold on to their oil storage terminals and metals warehouses a little bit longer, even as the Federal Reserve considers cracking down on such investments.

Under the so-called "merchant" authority, U.S. financial holding companies are allowed to invest their own capital in just about any type of business - so long as they do so at arm's length, for purely passive financial purposes, and for no more than 10 years. Banks have been allowed to take small equity stakes for decades, but a controversial 1999 banking law vastly expanded the scope of such investments.

Morgan Stanley gave approval to TransMontaigne LP to re-purchase a major stake in a new oil terminal in Houston, Texas late last year after the investment was restructured as a "merchant" deal that would comply with the law, according to a person familiar with the project.

The legal maneuver, which hasn't been previously reported, is likely only a temporary measure for Morgan Stanley, which has been looking at ways to spin off or sell the whole commodities business since last year. The bank's oil trading desk is too deeply intertwined with the wider TransMontaigne oil terminal and pipeline business to separate the two.

It is unclear whether the arrangement offers a longer-term solution for Goldman Sachs , which has said publicly that its Metro International Services metals warehousing unit - the target of political and regulatory scrutiny due to allegations that it has inflated the cost of aluminum - is structured as a merchant business. The same goes for a Colombian coal mine.

Executives at Goldman have been the most outspoken on Wall Street about the importance of commodity trading, saying its J. Aron commodities arm is "core" to the bank and stressing that it is allowed to hold onto Metro for another six years. However, the bank is informally resuming efforts to sell the warehouses after drawing interest in recent months, a source said.

The merchant deal tag has allowed the banks to press ahead with certain investments or stave off an immediate forced sale. However, it also means the assets they purchased during the height of the commodity boom are of little use to their trading desks, as the Fed enforces strict Chinese walls.

If the banks can show that they are not involved in the "routine management or operation" of the firm, as required under the merchant clause, the bank would be largely protected from liability, lawyers say - in theory satisfying the Fed's primary objective of keeping the banks and financial system safe from potentially devastating disasters.

"The Federal Reserve might interpret merchant banking as potentially containing less legal risk and therefore requiring fewer prudential controls," said Karen Petrou at Federal Financial Analytics.

It is unclear whether it would satisfy politicians, however, some of whom are campaigning for a much deeper review of banking rules that would restore sharper divisions between basic commercial services and riskier trading activities.

A second Senate Banking Committee hearing to examine the rules governing Wall Street's expansion into everything from oil terminals to electricity generation to aluminum storage was postponed this week. It had been slated for Wednesday.

Last week, Janet Yellen, speaking at a Senate hearing on her nomination to become Fed chairman, said the central bank may create new rules as part of its comprehensive review of Wall Street's physical commodity trading, the first time a senior official has publicly raised the prospect of tougher restrictions.

Regulatory and legal experts say the most likely target is the direct ownership and operation of crude tankers, power plants, and other trading assets that could potentially undermine a bank in the event of a catastrophe.

BACK IN BOSTCO

In 2010, Morgan Stanley's TransMontaigne staked a claim to what would be a major new project - the $400 million Battleground Oil Specialty Terminal Co (BOSTCO) - a massive storage complex in Houston, Texas, an area that is on the brink of a major boom in trading as U.S. fuel exports grow.

But by the middle of 2011, the project had hit a snag: the Federal Reserve had yet to tell Morgan Stanley whether it could continue to own and operate physical commodity assets as part of its trading business. The question had been unresolved since Morgan Stanley and Goldman Sachs converted to become Fed-regulated banks at the 2008 peak of the financial crisis.

While such investments have long been off-limits to commercial banks, Morgan and Goldman Sachs argued that they should be able to pursue them thanks to a "grandfather" clause in the 1999 Gramm-Leach-Bliley Act.

With growing uncertainty over the Fed's interpretation of the clause, TransMontaigne agreed in late 2011 to sell its stake in the project to its partner, Kinder Morgan Energy Partners . Hoping that a positive decision might come soon, however, TransMontaigne included an option that would allow it to buy back into BOSTCO within a year.

Almost 12 months later, despite the lack of a Fed ruling on grandfathering, that's what happened: TransMontaigne exercised the option. It paid approximately $79 million to regain a 42.5 percent stake in the Battleground Oil Specialty Terminal Co LLC. It had sold its 50 percent share in the project for $10.8 million a year earlier.

In an SEC filing earlier this month, TransMontaigne said its BOSTCO investment was "approved by Morgan Stanley based on the specific facts and circumstances of the BOSTCO project and the structure of our investment in BOSTCO, and is not indicative of whether Morgan Stanley will approve any other acquisition or investment that we may propose in the future."

According to a source familiar with the matter, Morgan Stanley had won the Fed's blessing to proceed with this particular investment under the merchant authority, allowing it to return to the project - with merchant restrictions.

In October, the first stage of BOSTCO started commercial operations, exporting diesel from the Gulf Coast to international markets.

A spokesperson for Morgan Stanley declined to comment on the BOSTCO project. TransMontaigne also declined to comment.

THE OLD MEN OF COMMODITIES

Even if they are allowed to retain the assets, banks may have little interest in keeping businesses that must be kept strictly segregated from their trading desks, which may benefit from information or insight gleaned from operators. Such interaction is strictly prohibited by the Fed.

"The purpose of a merchant is to be a passive financial investment," said one person who has dealt with the Fed on issues related to commodity trading.

"So if day-to-day market information is flowing back to the traders - that's not what a passive financial investor would get."

The merchant clause also arises from Gramm-Leach-Bliley, which contained the grandfather clause. In theory, any bank can undertake a merchant investment, but only Goldman and Morgan can claim that their right to own commodity assets is grandfathered due to their long history of operating in those markets prior to 2008.

The law does not require banks to secure the Federal Reserve's explicit approval to invest under the "merchant" authority, although the Fed has the ability to review such deals to ensure that they comply with the law.

Goldman has resumed talks with parties interested in buying its Metro warehouses, a source familiar with the matter said on Monday. It bought the business for some $550 million in 2010, and owns it under what Chief Operating Officer Gary Cohn called a "private equity exemption" - the merchant clause.

JPMorgan Chase & Co last year reshuffled the board of the Henry Bath & Sons metals warehouse it bought from Royal Bank of Scotland in 2010 in an effort to conform to merchant status, Reuters reported earlier this year. It is unclear if that effort was successful. The bank has opted to sell its physical business.

(Reporting by Jonathan Leff in New York and David Sheppard in London)

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